How can you use relevant costs to evaluate performance?

1 What are relevant costs?

Relevant costs are the costs that differ between two or more alternatives. They are the only costs that matter for decision making, because they reflect the impact of choosing one option over another. Relevant costs can be variable or fixed, depending on the situation. For example, if you decide to outsource a part of your production, the variable costs of making that part in-house are relevant, because they can be avoided by outsourcing. However, the fixed costs of maintaining the factory are not relevant, because they will not change regardless of your decision.

3 How to identify relevant costs?

To identify relevant costs, you need to compare the total costs of each alternative and isolate the costs that differ. You can use a table or a diagram to organize the information and highlight the relevant costs. You should also consider the opportunity costs, which are the benefits foregone by choosing one option over another. For example, if you decide to use your existing capacity to produce a special order, the opportunity cost is the profit you could have earned by selling your regular products.

5 Examples of relevant costs

When considering different scenarios, there are a variety of relevant costs to consider. For example, when outsourcing, the variable costs of making the product in-house versus the outsourcing price should be taken into account, as well as any additional costs or savings related to transportation, inventory, and quality. When deciding whether to make or buy a product, the variable costs of making the product versus the purchase price should be considered, as well as any additional costs or savings related to capacity and overhead. Special orders should factor in the variable costs of producing the special order versus the incremental revenue, plus any opportunity costs or benefits related to regular sales, capacity, and customer loyalty. Lastly, when replacing equipment, the variable costs of operating the old machine versus the new machine should be weighed along with the initial cost of the new machine minus the salvage value of the old machine, adjusted for the time value of money.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?