Definition of Relevant Costs
Relevant costs are future costs that will differ between two or more alternative actions. Expressed another way, relevant costs are the costs that will make a difference when making a decision.
Past costs may help you predict and estimate the future costs, but the past costs are otherwise irrelevant to the decision. That is why accountants will refer to a past cost as a sunk cost.
Examples of Relevant Costs
Assume that a company has five product lines: A, B, C, D, and E. Since E accounts for only 5% of the company’s sales, the company is deciding whether to eliminate E. If E is eliminated, the compensation of E’s employees and other expenses directly associated with E (amounting to $400,000) will be eliminated. However, the company’s other expenses (executives’ compensation, depreciation, general administration) will not be reduced.
The $400,000 of costs that are directly associated with E are relevant costs, since the company will see its total costs decrease by $400,000 when E is eliminated. Since the company’s other expenses will not change, the company’s other expenses are not relevant. In other words, it doesn’t matter for the decision to eliminate product line E whether the company’s other expenses are $500,000 or $5,000,000.
