4.2 Relevant Cost Concepts

What Makes a Cost Relevant

A relevant cost has two traits at once: it lies in the future, and it differs between the alternatives under consideration. If a cost is the same no matter which option you pick, it is irrelevant and should be dropped from the analysis.

The same test applies to revenues — only revenues that change between alternatives matter. The goal is to strip a messy income statement down to the handful of cash flows that actually swing the decision, which prevents anchoring on totals that do not change.

Sunk Costs: Always Ignore

A sunk cost has already been incurred and cannot be changed by any current or future decision. Because it is identical across all alternatives, it is never relevant.

• The book value of old equipment is sunk; only its disposal/salvage value (a future inflow) is relevant.
• Past research and development, prior training, and money already spent on a project are sunk.
• Joint costs incurred before a split-off point are sunk for sell-or-process-further decisions.

Trap: the exam embeds a large sunk amount (e.g., "the machine originally cost $400,000") to bait you into including it. Cross it out.

Opportunity Costs: Always Include

An opportunity cost is the contribution or benefit forgone by using a resource for one purpose instead of its next-best alternative. It is never recorded in the accounting system, yet it is fully relevant.

Example

A factory uses a machine to make Product A, earning $30,000 of contribution. Accepting a special order requires that same machine, displacing Product A. The $30,000 forgone is an opportunity cost of the order — add it to the order's incremental costs. Ignoring opportunity cost is the single most common relevant-cost error.

Avoidable vs. Unavoidable Costs

• Avoidable cost: a cost that disappears if you choose a particular alternative (e.g., stop making a part, drop a segment). Avoidable costs are relevant.
• Unavoidable cost: a cost that continues regardless of the decision — typically allocated common fixed costs such as corporate headquarters overhead. These are irrelevant to the specific decision.

A fixed cost is not automatically irrelevant. A supervisor's salary that is eliminated when a product line closes is an avoidable fixed cost and counts. Always ask: does this cost go away under one of the options?

Differential (Incremental) Analysis

Differential analysis compares two alternatives by listing only the revenues and costs that differ. The change in total operating income is the differential (or incremental) profit.

Because Alternative B raises income by $17,000, choose B. Items unchanged between A and B (sunk costs, allocated overhead) never appear in the table.

The Relevant-Cost Decision Framework

1. Identify the alternatives and the decision (make/buy, accept/reject, keep/drop).
2. List all costs and revenues, then eliminate sunk costs and any item identical across alternatives.
3. Add opportunity costs for scarce resources displaced by the choice.
4. Compute the differential (incremental) income for each alternative and pick the higher one.
5. Weigh qualitative factors before finalizing.

Qualitative Factors

Numbers do not decide everything. Supplier reliability and quality, employee morale and layoffs, customer relationships, long-term strategic fit, and regulatory or reputational risk can override a small quantitative advantage. The exam often hands you a slim cost edge and a serious quality or reliability concern — name the qualitative factor.

Relevant Revenues and the "Future and Differs" Test

The relevance test applies to revenues exactly as it does to costs. A revenue that is the same under both alternatives drops out; only revenues that change belong in the analysis.

A disciplined way to screen every line item is the two-question filter:

1. Is it in the future? If the cash flow already happened, it is sunk — ignore it.
2. Does it differ between the alternatives? If both options produce the identical amount, ignore it.

Only an item that passes both questions is relevant. This filter automatically removes sunk costs, allocated common overhead, and any fixed cost that continues regardless of choice, while keeping incremental revenues, variable costs, avoidable fixed costs, and opportunity costs.

Two Formats: Total vs. Differential

Managers can present the same decision two ways, and both must reach the same answer.

• Total (comparative) format: build a full contribution-margin statement for each alternative, including irrelevant items, then compare bottom-line operating income.
• Differential format: list only the items that change, as in the table above. This is faster and less error-prone because it forces you to omit sunk and unavoidable costs.

The differential format is preferred under exam time pressure: a smaller table means fewer chances to accidentally include a sunk cost. If the two formats disagree, you have wrongly classified an item — usually by treating an allocated fixed cost as avoidable, or by forgetting an opportunity cost on a constrained resource.