Relevant Cost

When making a decision, it is tempting to include every cost involved. But costs that will be the same whatever option is chosen, or that have already been spent, do not help choose between alternatives.

For a cost to be relevant, it must be a future cost and it must differ between the options. Sunk costs are never relevant, because they have already been incurred. Fixed costs that will continue regardless of the decision are usually not relevant either.

For example, a company is deciding whether to accept a special order for 1,000 units at 40 each. The variable cost of making each unit is 30, and the factory has spare capacity, so rent and other fixed costs will not change. The relevant costs are the 30,000 of variable costs. Against 40,000 of revenue, the order adds 10,000 of profit, so it is worth accepting, even though the full cost per unit including overheads might be higher than 40.

Opportunity costs, the benefits given up by choosing one option over another, are relevant and should be included. Thinking in terms of relevant costs leads to clearer, better business decisions.