## Relevant Costs

### Definition

A cost is relevant only if it satisfies both of the following conditions simultaneously:

1. It will be incurred in the future (not a past/sunk cost)

2. It differs between alternative courses of action

Relevant costs are the only costs that should influence management decisions. Costs identical across all alternatives are irrelevant and must be excluded from the analysis.

### Why the Two-Condition Test Matters

Condition	Reason
Future	Past costs (sunk costs) cannot be changed by any decision — including them distorts analysis
Differential	If a cost is the same regardless of which option is chosen, it cancels out and has no decision impact

### Classic Example: Plant Replacement

When evaluating whether to replace an old machine with a new one:

Irrelevant: Original (book) cost of the old machine — already spent, a sunk cost
Relevant: Current disposal/scrap value of old machine, cost of new machine, future operating cost differences between old and new machine

Worked example

### Example 1

Classify each cost as relevant or irrelevant:

(i) A company paid ₹5 lakhs for raw material two years ago. It is now deciding whether to use it in a new product or sell it at ₹3 lakhs.

→ The ₹5 lakh original cost is irrelevant (sunk cost). The ₹3 lakh current market value is relevant.

(ii) Direct labour costs differ by ₹20,000 between two manufacturing methods being evaluated.

→ Relevant — future cost that differs between alternatives.

(iii) Factory rent of ₹10,000/month that will be paid regardless of which product is manufactured.

→ Irrelevant — same under all alternatives; does not affect the decision.

(iv) A manager's salary that will be incurred under both Option A and Option B.

→ Irrelevant — even though it is a future cost, it does not differ between alternatives.

⚠️ Common exam mistakes

Including sunk costs in decision analysis — past costs cannot be changed by any decision and are always irrelevant
Assuming all fixed costs are irrelevant — a fixed cost that changes between alternatives IS relevant (e.g., avoidable fixed cost under one option)
Forgetting that BOTH conditions must be satisfied — a future cost that is identical across all alternatives is still irrelevant
Confusing relevant costs with variable costs — relevance depends on whether the cost changes with the decision, not on whether it is fixed or variable

Reference:

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