Relevant Cost

A relevant cost is a cost that will be incurred in the future and will differ depending on which alternative a business chooses. Only relevant costs, together with relevant revenues, should influence a decision such as whether to accept a special order, make or buy a component, drop a product line or keep an old machine. Costs that have already been spent, or that will be the same whatever the choice, can be ignored because they cannot change the outcome.

The idea is central to managerial accounting and short-term decision making. It is closely linked to incremental cost, also called differential cost, and to opportunity cost, the benefit given up by choosing one option over another. Relevant costs often differ from the full costs shown in cost accounting records, which include allocations made for reporting rather than for decisions.

A cost is relevant only if it passes both tests:

• It is a future cost. Money already spent, known as a sunk cost, is never relevant. The price paid for a machine last year does not change whether it should be used, sold or scrapped now.
• It differs between alternatives. A cost that stays the same under every option, such as head office rent that will be paid whether or not a product is made, is not relevant to that choice.

Common examples of relevant costs include direct materials that must be bought, extra direct labor or overtime, variable overhead, fixed costs that can be avoided by stopping an activity, and the opportunity cost of using scarce capacity or materials that could otherwise be sold. Common examples of irrelevant costs include depreciation on existing equipment, allocated fixed costs that will continue, and committed costs that cannot be cancelled.

A company makes 10,000 units a year of a component. Its cost records show a full cost of $30 per unit: direct materials $12, direct labor $8, variable overhead $4 and allocated fixed overhead $6. A supplier offers to provide the part for $26. At first glance buying saves $4 a unit.

A relevant cost analysis looks at what would actually change. If the company stops making the part, it saves materials, labor and variable overhead of $24 per unit. Of the $6 of fixed overhead, suppose only $1 per unit, a supervisor's salary of $10,000, would be avoided; the rest is factory rent and depreciation that continue regardless. The relevant cost of making is therefore $25 per unit, against $26 to buy, so making the part is cheaper by $1 per unit, or $10,000 a year.

The answer changes if the freed capacity has another use. If the space could be rented out for $25,000 a year, that income is an opportunity cost of continuing to make the part, adding $2.50 per unit and making the relevant cost of making $27.50. Buying would then save $15,000 a year. This is the kind of reasoning behind any make or buy decision.

• Special orders: if spare capacity exists, an order is worth accepting if its price covers the relevant costs, usually the variable costs plus any extra fixed costs, even if it is below full cost.
• Dropping a product or segment: compare the contribution margin lost with the fixed costs that would truly be avoided.
• Replacing equipment: the old machine's book value is sunk; what matters is the new machine's cost, the old machine's disposal value and the difference in operating costs.
• Scarce resources: when a resource limits output, the relevant measure is contribution per unit of that resource.

Relevant cost analysis is mainly a short-term tool. Repeatedly accepting orders that cover only variable costs can leave fixed costs unrecovered over time. Qualitative factors also matter, such as the reliability and quality of a supplier, the effect on employees, and the risk of losing know-how. For long-term investments, relevant cash flows are discounted using techniques such as capital budgeting rather than added up directly.