Relevant Cost: Definition, Types and

Examples
Relevant cost is a term that describes the changing costs of a particular decision.
Businesses use relevant costs to determine if one decision is more cost-effective than
another. Learning about this concept can help you and the company for which you work
to make more financially savvy decisions.

In this article, we discuss what a relevant cost is, explain why it's important and review
some examples to help you better assess the relevant costs of your own business.

What is relevant cost?

Relevant cost, sometimes called differential cost, refers to the financial costs that result
from a business decision. The cost is not a stagnant metric and varies based on each
decision. For example, If a decision can affect the cash flow, then the matter is relevant,
and the costs of that decision are worth consideration.

Businesses base their decisions around the projected relevant costs in order to
minimize unnecessary spending and to determine profitable investments. There are four
main types of relevant costs:

 Avoidable: Avoidable relevant costs are those where a company can

make a different decision to avoid incurring potential additional costs.
 Incremental: Incremental costs are those that can change over time.
This usually relates to the amount of production in progress.
 Opportunity: Opportunity cost is the value lost by choosing a specific
option. For example, you might save money by outsourcing production
but could lose additional expertise in certain areas.
 Future cash flow: Future cash flow is a cost that can occur in the future
based on the choices you make today.

Related: Cost Structure: Definition, Key Terms and Examples

Types of relevant cost decisions

Here are four relevant costs to consider when making business and management
decisions:
Make vs. buy costs

Make vs. buy costs refer to the necessity of components and pieces to complete a
product. This relevant cost considers the choice between manufacturing the product
internally or outsourcing its development from another vendor.

The actual relevant cost of this is the total costs incurred by paying an outside vendor to
do the work. If the outside vendor can manufacture and produce the product at a
lower price point than it would cost to complete the product internally, then outsourcing
it's the most financially efficient decision.

Special order costs

A special order refers to the occasions when a customer wants to order a product near
the end of the month after a company calculates its sales and uses those profits to
cover the production costs for that time period.

For a customer who is looking to receive a quote on the price of a special order, the
management team's sole concern is the costs incurred to produce the product. These
relevant costs include the cost of additional materials and production labor.

Continue vs. closing costs

Continue vs. closing refers to the relevant costs of deciding whether to close a particular
business unit or continue operating it. The relevant costs in this type seek to determine
the cost savings and the revenue loss when a business unit closes down. If the costs
saved from closing the unit outweigh the loss of consistent revenue, then it's probably
best to choose the most cost-efficient option.

Opportunity costs

Opportunity costs refer to the potential gains that a business or person may receive
depending on which option they select over another. Opportunity costs seek to identify
whether an opportunity is worth the investment. When making decisions regarding a
particular opportunity, it's very important to weigh the pros and cons before selecting to
pursue it or forgo it.

Read more: Opportunity Cost: Definition and Example

Examples of relevant costs

Here are four examples that represent the four previously mentioned types of relevant
costs:
Make vs. buy

A manufacturer of luxury beds has started a campaign to create bed frames from new
and innovative materials. However, this new material is expensive and much more
labor-intensive for the carpenters to build than any previously produced bed frames.
Management is weighing the cost of manufacturing the bed frames compared to
outsourcing the materials and labor to a foreign company.

After evaluating the relevant costs, producing the bed in-house would cost more money.
To save money, they outsourced the production of the bed frames.

Related: How To Calculate Manufacturing Cost

Special order

The holiday season is closing and a company that makes pastries just finished
producing their seasonal holiday cakes. The ingredients for these holiday cakes are
much more expensive than anything else they've sold before. Just as the company is
about to switch to normal business operations and calculate its final holiday earnings, a
large special order for their seasonal holiday cakes comes through.

When deciding whether to make the order, the company determined that the relevant
cost to produce more would not cover the costs of the placed order, so they denied the
customer's request.

Continue vs. closing

A large clothing store considers rebranding itself into a smaller luxury boutique store.
They currently have 50 stores across the nation and want to consolidate to 10 stores.
They consider the relevant costs incurred from closing stores and losing valuable
revenue or keeping the stores open and continuing to make more money.

Ultimately, management determined that closing the stores was not worth losing the
relevant costs, so they remained open.

Opportunity

A celebrity approached a small ice cream brand wanting to collaborate with them to
create a limited-edition ice cream flavor using a rare fruit from overseas. The small ice
cream brand must determine whether the costs of pursuing the opportunity will be more
profitable than the costs to produce this ice cream with the rare and costly fruit.

The brand concludes that the revenue gains from this opportunity outweigh the cost of
acquiring this rare fruit, so they move forward with the collaboration.
Related: How To Do Project Cost Analysis (With Example)

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When to use relevant costs

Here are some of the decisions you might make that relevant cost could inform:

Time to develop

This is a relevant cost decision that refers to the time it takes to develop each option, as
cost may increase as the development stage continues. For example, a small family-
owned business has a product that requires additional hours of labor before the final
product is ready to sell.

If the costs incurred from increased production time are less than the potential gains,
then the product may be worth investing time and resources into making. In this
scenario, relevant costs refer to the price of having to pay for more labor because of the
extended production time.

Development resources

This is a relevant cost decision because of all the resources that are needed before the
conclusion of a final decision. Variables, like the number of people, the price of their
wages and the materials required, affect the relevant cost value. You might evaluate
these at the start of the project and establish an acceptable threshold before continuing
with a project.

Time to market

Time to market is a relevant cost decision about delivery times. It refers to the length of
delivery times between a development and its availability on the market. It seeks to
determine how that time affects sales and costs. For example, if you hope to enter an
existing market, the sooner you release a product to the market you might receive more
revenue.

Perception of performance

This refers to how well the outcome of a decision may perform and seeks to answer if
one decision offers better returns than another. The relevant costs can change
drastically depending on what people think of the outcome.
This is because customers and investors are less likely to financially support a business
that is underperforming or makes business decisions that affect the quality of their
provided products and services.