What is Relevant Cost Analysis?
Relevant cost analysis identifies the future costs and revenues that actually differ between decision alternatives, so managers can ignore costs that won't change no matter what they choose.
A relevant cost is a future cash cost that differs between two or more decision alternatives; sunk costs, and costs identical across all options, are irrelevant and should be excluded from the decision.
- •Future costs, not yet incurred
- •Differ between the alternatives being compared
- •Avoidable if a specific option is not chosen
- •Include opportunity costs of resources used
- •Examples: incremental variable costs, avoidable fixed costs
- •Sunk costs — already spent, unrecoverable
- •Identical under every alternative
- •Unavoidable fixed costs that continue regardless
- •Historical cost of assets already owned
- •Examples: past R&D spend, depreciation on existing equipment
Step-by-step worked examples
A company paid $5,000 last year for market research on a product it may now discontinue. Is this $5,000 relevant to the discontinue-or-keep decision?
The $5,000 was already spent and cannot be recovered regardless of the decision. It is a sunk cost → irrelevant. Only future costs and revenues from keeping vs. discontinuing the product matter.
A firm can make a part in-house for $12/unit variable cost, or buy it externally for $15/unit. Fixed costs of $20,000 continue either way. Should it make or buy 2,000 units?
Relevant cost to make = $12 × 2,000 = $24,000 (fixed costs are unavoidable either way → irrelevant) Relevant cost to buy = $15 × 2,000 = $30,000 Making in-house saves $6,000 → Make is the better decision.
A machine originally cost $50,000 and has a book value of $20,000. It can be sold now for $8,000, or used to produce a product earning $30,000 in future contribution margin. What is relevant?
The $50,000 original cost and $20,000 book value are sunk → irrelevant. The relevant comparison is: sell now for $8,000 vs. keep and earn $30,000 in future contribution margin. Keeping and using the machine is more valuable by $22,000.
Flashcards
Quick quiz
Q1.Which of these is always irrelevant to a decision?
Q2.A company is deciding whether to accept a special order. Which cost is relevant?
Q3.What best defines an opportunity cost?
Q4.Why should sunk costs be excluded from decision making?
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Common mistakes
Including sunk costs, like a canceled project's past R&D spend, in a keep-or-drop decision. — Correct: Exclude sunk costs entirely — they don't change no matter which option is chosen.
Ignoring opportunity costs because no cash is paid out. — Correct: Include the value of the best forgone alternative — it's a real economic cost of the decision.
Treating all fixed costs as irrelevant. — Correct: Only unavoidable fixed costs are irrelevant; avoidable fixed costs that disappear under one option are relevant.
Assuming book value of an asset matters in a keep-vs-replace decision. — Correct: Book value is a sunk, non-cash accounting figure; only future cash flows and current disposal value matter.
FAQ
What is relevant cost analysis?
A managerial accounting technique that isolates the future costs and revenues that actually differ between decision alternatives, ignoring sunk and unavoidable costs.
What is the relevant cost formula?
There's no single formula — relevant cost analysis compares the total relevant (future, differential) costs and revenues of each alternative to see which is more profitable.
How do you identify a relevant cost?
Ask two questions: is it a future cost, and does it differ between the alternatives? If either answer is no, the cost is irrelevant.
What are examples of relevant cost analysis in business?
Make-or-buy decisions, special order pricing, keep-or-drop product line decisions, and equipment replacement decisions.