An expected future cost that varies with alternative courses of action. Decision making involves choosing between such alternatives and to make the best choice a manager needs to identify the future cash flows for each decision. Costs that have already been incurred as a result of past decisions (sunk costs) are not relevant for decision making. Likewise, a future cost that will not be changed by a decision is irrelevant to that decision. See differential analysis.
An understanding of relevant costs is particularly important for the following types of decision:
A company manufactures doors. It has 10 doors in stock that have been difficult to sell as the design is not popular with customers. The doors were completed last year and the following costs have been identified by a manager:
All of these costs were incurred last year. A new customer has offered to purchase the doors for a total of £400 if they can be modified by the fitting of specialist locks. These locks will have to be purchased at a cost of £100 and the labour cost of fitting them will be £60. Finally, the delivery cost of the doors will be £50. Before deciding whether to accept the customer’s offer, managers will have to identify the relevant costs of having the doors modified.
The costs incurred last year (material, labour, and overheads) are not relevant to the decision. They are examples of past (sunk) costs. The original costs are not avoidable and are common to all alternatives.
The cost of the locks, the labour cost of fitting them, and the cost of delivery are differential cash flows that will be incurred if the doors are modified. They are therefore relevant costs.
The position can be summarized in table form as follows:
The total cost of £710 includes past costs and future costs. It is confusing and illogical to include both costs together. The relevant costs are the differential cash flows. The customer’s offer to pay £400 for the doors should therefore be accepted, as it is greater than the relevant costs of £210. It would be wrong to reject the order by saying that the £400 offered by the customer is less than the total cost of £710.
Costs incurred to date (past costs) (£)
Costs if doors modified (£)
Relevant costs (£)
labour cost of fitting locks