Understanding the Concept of Relevant Costs in Decision Making

Every business decision, big or small, comes down to comparing costs. But here’s the catch: not every cost that appears in your accounting records actually matters for the decision in front of you. Some costs are relevant to what you’re about to choose, and others are simply noise from the past. Learning to tell the two apart is one of the most practical skills in management accounting, and it starts with understanding the concept of relevant costs.

What are relevant costs? 🔗

Relevant costs are future costs that change depending on which alternative a manager chooses. If a cost stays exactly the same no matter what decision is made, it has no bearing on that decision and can be ignored. AccountingTools defines a relevant cost as one that relates specifically to a management decision and will change in the future as a result of that decision.

This is why relevant costs are also called differential costs or avoidable costs. They represent the difference in cost between two or more courses of action. If choosing option A instead of option B changes how much cash goes out of the business, that difference is the relevant cost of the decision. The Chartered Institute of Management Accountants describes relevant costs, as outlined in this decision-making resource, as costs appropriate specifically to aiding a particular management decision, not costs in general.

The three tests of a relevant cost 🔗

Not every future expense automatically qualifies as relevant. Accountants generally apply three tests before treating a cost as relevant to a decision.

It must be a future cost 🔗

Only costs that have not yet been incurred can be influenced by a decision made today. Money already spent cannot be recovered or changed, regardless of what a manager decides next. This is why ACCA’s guidance on relevant costing treats sunk costs, amounts already spent on things like market research or a feasibility study, as automatically irrelevant, no matter how large they were.

It must involve a cash flow 🔗

A relevant cost must actually affect the amount of money moving in or out of the business. Notional or non-cash charges, such as depreciation on an asset the company already owns, do not represent real cash movement tied to the decision, so they generally fall outside relevant cost analysis. The same source notes that if a company’s total cash position stays the same regardless of the decision, there is no cash flow effect worth analysing.

It must be incremental 🔗

A cost is incremental if it would not exist without the decision being made. If a cost would be incurred anyway, whether or not the decision goes ahead, it isn’t relevant to the choice. Croner’s guide to relevant costs frames this simply: a cost or income only qualifies as relevant if the decision itself causes a change in cash flow, either up or down.

Relevant costs versus irrelevant costs 🔗

It helps to see the two categories side by side. The table below summarises how common cost types are typically classified in decision-making situations.

Opportunity cost deserves special attention here, since it doesn’t show up as a cash outflow but still belongs in relevant cost analysis. It is the value of the next best alternative that is given up when a resource is used for one purpose instead of another. If a company uses factory space to make a special order instead of renting it out, the rent it forgoes is a relevant cost of the order, even though no cash is directly paid out for it.

A student’s own relevant cost decision 🔗

The logic of relevant costing applies well beyond factories and boardrooms. Consider a college student deciding whether to continue full-time study or drop out to start a small workshop business instead.

The tuition fee already paid for the current semester is a sunk cost. It has been spent either way, so it should not influence the decision. What matters are the costs that will differ between the two paths going forward: next semester’s fees, the cost of textbooks and study material, and the potential income from working full time at the workshop instead. On the other side, the workshop option carries its own relevant costs, such as raw materials, rent for a workspace, and tools, weighed against the expected revenue it could generate.

The student’s decision should be based on comparing these future, incremental amounts, not on how much has already been spent on college so far. This is exactly the trap that businesses fall into too: treating money already committed as though it should still influence a forward-looking choice. The same principle that applies to a construction company that has already spent heavily on a partly built structure and must decide whether to keep going applies to this simpler, everyday version of the decision.

Where relevant costing is used in business 🔗

Relevant cost analysis is not a one-time exercise. It recurs across several classic types of business decisions.

Make or buy decisions 🔗

When a company decides whether to manufacture a component in-house or purchase it from a supplier, it compares the incremental cost of making it internally, materials, direct labour, and variable overhead, against the external purchase price. Fixed costs that will be incurred regardless of the choice are excluded from the comparison.

Special order decisions 🔗

A business may receive a one-off order at a price below its normal selling price. Here, relevant costs typically include only the additional materials, labour, and any opportunity cost of using capacity that could have gone to regular sales. Fixed overheads that don’t change because of the order are left out.

Shut-down or continue decisions 🔗

When evaluating whether to close a loss-making product line or department, managers compare the costs that would actually be saved by shutting it down against the revenue that would be lost. Costs like head-office allocations that continue regardless of the shutdown are irrelevant to this specific choice.

Sell or process further decisions 🔗

A company sometimes must decide whether to sell a product as-is or spend more to process it into a higher-value item. The relevant comparison is the extra processing cost against the extra revenue that further processing would generate, not the costs already incurred to bring the product to its current stage.

Why relevant costing matters for good decisions 🔗

Including irrelevant costs in an analysis can lead to poor conclusions. A manager who factors in sunk costs might reject a genuinely profitable path forward simply because it looks bad next to money already spent. Equally, ignoring a real opportunity cost can make an option look cheaper than it truly is. Study material published by the Institute of Chartered Accountants of India reinforces that cost concepts like opportunity cost, though not recorded in the books of account, remain essential inputs for sound managerial choices, especially when resources are limited and a decision requires choosing between options.

The discipline of relevant costing forces decision-makers to ask one simple question about every cost figure in front of them: will this actually change depending on what I choose? If the answer is no, it belongs in the “ignore” pile, no matter how large or emotionally significant the number feels. If the answer is yes, it earns a place in the comparison. This filtering process is what allows managers, and students working through similar choices in their own lives, to focus on what genuinely drives the outcome of a decision rather than getting distracted by numbers that will not budge either way.

What do you think? If you were advising the student in the workshop example, what other future costs or benefits, beyond fees and materials, would you want them to weigh before deciding? And can you think of a recent decision in your own life where a sunk cost nearly influenced your choice?

References

1. https://www.accountingtools.com/articles/what-is-a-relevant-cost.html
2. https://www.fao.org/4/w4343e/w4343e06.htm
3. https://www.accaglobal.com/us/en/student/exam-support-resources/fundamentals-exams-study-resources/f5/technical-articles/relevant-costs.html
4. https://app.croneri.co.uk/feature-articles/guide-relevant-costs-and-decision-making-part-one
5. https://www.icai.org/post/17759