What you'll learn
Relevant costing answers one question: which costs should actually enter a decision? The answer is narrower than most people expect. A cost is relevant only if it is a future cash flow that differs between the alternatives. Every word in that test does work, and applying it strictly is what separates a sound decision from an expensive one.
The costs that fail the test are the ones businesses most often include by instinct. Money already spent cannot be recovered by any choice made now, so it is irrelevant however large it was. Depreciation is not a cash flow at all. An apportioned share of head office rent does not change because a division accepts an order, so it does not belong in the calculation for that order.
The costs that pass the test include one that does not appear in any ledger — opportunity cost, the benefit given up by choosing one option over the next best. Leaving it out is the most consistent error in the topic, because nothing in the accounting records prompts you to remember it.
By the end of this topic you should be able to classify costs as relevant or irrelevant, value materials and labour correctly for a decision, apply opportunity cost, and structure the common decisions: accepting a special order, making or buying, dropping a product line, and allocating a scarce resource.
Key terms and definitions
Relevant cost — a future cash flow that differs between the alternatives under consideration.
Sunk cost — a cost already incurred. Never relevant, whatever its size.
Committed cost — a cost the business is already contractually bound to pay. Not relevant, because it will be paid under either alternative.
Opportunity cost — the value of the benefit forgone by choosing one option rather than the next best.
Incremental (differential) cost — the change in total cost caused by the decision.
Avoidable cost — a cost that would not be incurred if the alternative were chosen. Relevant by definition.
Limiting factor — the resource in short supply that constrains output: machine hours, skilled labour, a scarce material.
Contribution per unit of limiting factor — contribution per unit divided by the units of the scarce resource each product consumes. The ranking basis when a resource is constrained.
Core concepts
The three-part test
Ask three questions of every cost in a decision question.
Is it in the future? If it has already been spent, it is sunk. The $40,000 already paid for a feasibility study cannot be recovered by any decision now, and a business that continues a failing project because of what it has already spent is committing the classic error this topic exists to prevent.
Is it a cash flow? Depreciation, apportioned overhead and notional charges are accounting allocations, not cash movements. They do not change the bank balance and do not belong in the decision.
Does it differ between the alternatives? Fixed costs that will be incurred either way are irrelevant to the choice, even though they are certainly real costs of the business.
A cost has to pass all three. Most textbook traps are a cost that passes two and fails the third.
Valuing materials
The rule depends on whether the material is in regular use.
If the material is not held in inventory, the relevant cost is the current purchase price, because that is what the decision will cause the business to spend.
If it is held and in regular use, the relevant cost is still the replacement price. Using it on this job means buying more to replace it, so the decision causes a purchase either way.
If it is held but no longer used, the original cost is sunk. The relevant cost is what the business gives up by using it — its scrap or resale value, which is an opportunity cost. If it has no alternative use and no scrap value, the relevant cost is nil.
Valuing labour
If there is spare capacity, the workers are being paid anyway, so using them on this job costs nothing extra. The relevant cost is nil unless overtime is required.
If labour is fully employed, taking workers off existing work sacrifices the contribution that work was earning. The relevant cost is the wage plus the contribution forgone — an opportunity cost again.
This is the point where candidates most often under-cost a decision, and it is worth stating the capacity assumption explicitly in any answer.
The standard decisions
Special order. Compare the price with the incremental cost of fulfilling it. Fixed overhead is irrelevant where capacity is spare. Accept if contribution is positive, subject to the conditions on capacity and market separation.
Make or buy. Compare the incremental cost of making with the price of buying. Fixed costs that continue either way are excluded. If making frees capacity that could earn contribution elsewhere, include that as an opportunity cost.
Dropping a product line. The test is whether the line makes a positive contribution, not whether it shows a profit after apportioned fixed overhead. A line showing an accounting loss may still be worth keeping, because dropping it removes the contribution while the apportioned overhead simply moves onto the remaining lines.
Limiting factor. Rank products by contribution per unit of the scarce resource, not by contribution per unit. The product with the highest contribution per unit may consume so much of the constrained resource that it earns less per hour than a humbler product.
What relevant costing does not settle
The technique is short-run and financial. It assumes the fixed costs really are fixed over the horizon considered, and it ignores everything not expressed in money.
A special order accepted at a low price may damage the regular market, sour a relationship with a full-price customer, or commit capacity that a better order would have used. Buying rather than making may cost jobs, weaken quality control, or make the business dependent on a single supplier. None of that appears in the calculation, and an answer that recommends purely on the numbers has stopped halfway.
Worked examples
Example 1 — Sorting relevant from irrelevant (5 marks)
A business is deciding whether to accept a contract. It has already spent $40,000 on a feasibility study. The contract needs materials costing $18,000 to buy now, and 500 hours of labour from a workforce that is fully employed earning contribution of $12 an hour on other work, at a wage of $20 an hour. Head office overhead of $9,000 would be apportioned to the contract.
Feasibility study $40,000 — sunk, irrelevant. Materials $18,000 — relevant, a future cash flow caused by the decision. Labour: wages 500 × $20 = $10,000, plus contribution forgone 500 × $12 = $6,000 — $16,000 relevant. Apportioned head office overhead $9,000 — irrelevant, it does not change.
Relevant cost of the contract = $18,000 + $16,000 = $34,000.
The contract should be accepted if it earns more than $34,000. Including the study and the apportionment would have put the figure at $83,000 and could have caused a profitable contract to be turned down.
Example 2 — Valuing materials three ways (5 marks)
A job needs 200 kg of a material.
If none is held, and it costs $15 per kg: relevant cost = 200 × $15 = $3,000.
If 200 kg is held, bought at $11, and the material is in regular use at a current price of $15: relevant cost = 200 × $15 = $3,000. Using it forces a replacement purchase, so the current price applies and the $11 is irrelevant.
If 200 kg is held, bought at $11, and the material is obsolete with a scrap value of $4 per kg: relevant cost = 200 × $4 = $800, the opportunity cost of not scrapping it.
Same material, same quantity, three different relevant costs, decided entirely by what the business gives up.
Example 3 — Make or buy (6 marks)
A component can be bought for $46 each. Making it in-house costs: direct materials $20, direct labour $14, variable overhead $6, and apportioned fixed overhead $9 — a total of $49.
Relevant cost of making = $20 + $14 + $6 = $40. The $9 apportioned fixed overhead continues whether or not the component is made, so it is excluded.
Making is $6 per unit cheaper than the $46 buy-in price, so on cost grounds the business should make. Judging on the $49 full cost would have pointed the other way.
But suppose making it uses 2 machine hours that could otherwise produce a product earning $5 contribution per machine hour. The opportunity cost is 2 × $5 = $10, bringing the relevant cost of making to $50, and buying becomes the better choice by $4 per unit.
The lesson is that a make-or-buy answer is incomplete until capacity has been considered.
Example 4 — Limiting factor ranking (6 marks)
Two products compete for machine hours, of which only 900 are available.
Product A: contribution $24 per unit, 3 machine hours each → $24 ÷ 3 = $8 per machine hour. Product B: contribution $18 per unit, 2 machine hours each → $18 ÷ 2 = $9 per machine hour.
Product B ranks first, despite A having the higher contribution per unit — B earns more from each unit of the scarce resource.
If demand for B is 300 units, it uses 300 × 2 = 600 hours, leaving 900 − 600 = 300 hours. A then makes 300 ÷ 3 = 100 units.
Total contribution = (300 × $18) + (100 × $24) = $5,400 + $2,400 = $7,800.
Ranking by contribution per unit instead would have made 300 units of A, using all 900 hours for a contribution of only $7,200 — $600 worse.
Common mistakes and how to avoid them
Including sunk costs. Money already spent cannot be changed by any decision made now.
Including apportioned fixed overhead. If it does not change with the decision, it is irrelevant.
Including depreciation. It is an allocation, not a cash flow.
Forgetting opportunity cost. It appears in no ledger, so nothing prompts you to remember it — check every scarce resource for one.
Valuing materials at what was paid. Use replacement cost where the material is in regular use, and scrap value where it is not.
Costing labour at the wage rate when capacity is full. Add the contribution forgone.
Ranking by contribution per unit under a limiting factor. Rank by contribution per unit of the scarce resource.
Dropping a line because it shows an accounting loss. Test whether its contribution is positive.
How this links to your Internal Assessment
Relevant costing gives an Internal Assessment a decision to analyse rather than a position to describe, which is usually what lifts the analysis marks.
Find a decision the business you studied has actually faced — whether to make or buy an input, whether to take on a discounted bulk order, whether to keep a product the owner suspects is losing money. Build the relevant cost from the records, and show explicitly which costs you excluded and why. The exclusions are the analysis; anyone can add up the inclusions.
Then go past the numbers. State the qualitative factors your recommendation depends on: whether capacity is genuinely spare, whether a discounted price would reach regular customers, whether buying in would leave the business dependent on one supplier. A recommendation that names its own limits is far stronger than one that presents a figure as the whole answer.
Exam technique for relevant costing
These questions are usually structured as a list of costs, several of which are deliberately irrelevant. Work down the list and label every item relevant or irrelevant with a reason before totalling anything. Mark schemes award marks for correct exclusions as well as inclusions, and a labelled list captures both.
State your capacity assumption. Whether labour and machine time are spare or fully employed changes the answer completely, and where a question is ambiguous an examiner will credit a clearly stated assumption.
Command words are consistent. Identify the relevant costs wants the list with reasons. Calculate the relevant cost wants the total with workings. Advise whether to accept wants a recommendation, the figure that supports it, and the conditions it depends on. Discuss the non-financial factors wants two or three developed, not a list of eight named.
Never present the relevant cost as the whole answer to a real decision. One sentence on what the numbers do not capture reliably earns a mark and never costs one.
Quick revision summary
- A cost is relevant only if it is a future cash flow that differs between the alternatives.
- Sunk costs, committed costs, depreciation and apportioned fixed overhead are all irrelevant.
- Opportunity cost is relevant and appears in no ledger — check for it deliberately.
- Materials in regular use: replacement cost. Materials no longer used: scrap or resale value. Not held: purchase price.
- Labour with spare capacity: nil. Labour fully employed: wage plus contribution forgone.
- Special order: accept if it covers incremental cost, subject to capacity and market separation.
- Make or buy: compare incremental making cost with the buy-in price, including any opportunity cost of the capacity used.
- Dropping a line: test contribution, not profit after apportioned overhead.
- Limiting factor: rank by contribution per unit of the scarce resource, never by contribution per unit.
- The technique is short-run and financial; state the qualitative factors it cannot capture.