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A relevant cost (also called avoidable cost or differential cost)^[1] is a cost that differs between alternatives being considered.^[2] In order for a cost to be a relevant cost it must be:

• Future
• Cash Flow
• Incremental

It is often important for businesses to distinguish between relevant and irrelevant costs when analyzing alternatives because erroneously considering irrelevant costs can lead to unsound business decisions.^[1] Also, ignoring irrelevant data in analysis can save time and effort.

Types of irrelevant costs are:^[3]

• Sunk costs^[4]
• Committed costs
• Notional or Non cash costs (e.g depreciation and amortization)

Example

A construction firm is in the middle of constructing an office building, having spent $1 million on it so far. It requires an additional $0.5 million to complete construction. Because of a downturn in the real estate market, the finished building will not fetch its original intended price, and is expected to sell for only $1.2 million. If, in deciding whether or not to continue construction, the $1 million sunk cost were incorrectly included in the analysis, the firm may conclude that it should abandon the project because it would be spending $1.5 million for a return of $1.2 million. However, the $1 million is an irrelevant cost, and should be excluded. Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action.

A managerial accounting term for costs that are specific to management's decisions. The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process.

References