Imagine a customer asks you to make a batch of goods for a price lower than normal. Your costing system says the batch “costs” ₦2.9 million, including a share of factory rent, depreciation of the machine and the original price of materials already in the store. Do you refuse? Not necessarily.
Much of that figure will be paid whether or not you accept the order, and some of it was spent long ago. What matters is what changes in future cash if you say yes, and relevant costing is the method for answering it.
This topic explains why decisions need future cash flows, defines relevant and irrelevant costs, and covers the terms examiners use: incremental, differential, avoidable, unavoidable, committed, sunk and opportunity costs. It then shows how to find the relevant cost of materials, labour, overheads and the use of a machine, and how relevant costing applies to special orders, make-or-buy, discontinuation and pricing. A full contract evaluation brings everything together.
In 30 seconds
A relevant cost is a future cash flow that will occur as a direct consequence of the decision. Past costs (sunk), costs that will be paid anyway (committed, unavoidable), and non-cash items (depreciation, absorbed fixed overhead) are irrelevant. Include incremental and differential cash flows, avoidable costs and opportunity costs (the benefit lost by taking this option). Materials in regular use: replacement cost.
Materials not in regular use: the higher of resale and alternative use. Labour: nil if idle time is already paid for; otherwise pay plus the contribution lost (or overtime, whichever is cheaper). Only variable overhead and extra cash spending on fixed overhead are relevant.
Information for decision making
Managers decide about the future. They choose between options, aiming to raise profit or value or to cut cost, and need reliable estimates of what each option will produce. The key points are:
- Traditional cost information is historical. It is used to assess profitability and control by comparing actual with budget or standard.
- Decision information must be about the future. A decision cannot change what has already happened, so it should not be influenced by historical costs.
- Decisions should consider only what can be changed. Costs that will happen anyway, perhaps because of past commitments, should be left out.
- Decisions should be based on future cash flows, not accounting profits. Accruals accounting and depreciation do not reflect economic reality. Cash flows do.
Marginal costing and decisions
Marginal costing is appropriate for decisions when it can be assumed that future fixed costs are the same whatever is decided, and that all variable costs are future cash flows resulting from the decision. When those assumptions fail, for example when a decision changes fixed cash costs or uses an asset that has other uses, relevant costing must be used instead.
Relevant costs
A relevant cost is a future cash flow that will occur as a direct consequence of making a particular decision. Each part of this definition matters.
- Future. Costs that have already occurred cannot be relevant.
- A direct consequence of the decision. Costs that will be incurred anyway, whatever is decided, cannot be relevant.
- Cash flows. Notional costs such as depreciation, notional interest and absorbed fixed costs are not cash flows, so they cannot be relevant.
| Aspect | Relevant costs | Irrelevant costs |
|---|---|---|
| Effect on the decision | Change the outcome | Do not change it |
| Timing | Future | Past, or unchanged by the decision |
| Avoidability | Can be avoided if the decision changes | Cannot be avoided whatever is decided |
| Differences between options | Differ between alternatives (differential or incremental) | The same in all options |
| Examples | Variable costs, incremental costs, opportunity costs, avoidable fixed costs | Sunk costs, committed costs, unchanged fixed costs, depreciation, absorbed overhead |
Terms used in relevant costing
Incremental cost
An incremental cost is an extra cost that will occur if a decision is taken. If it is a cash flow, it is relevant. A unit costs ₦50,000 of materials, ₦20,000 of labour and has ₦30,000 of absorbed fixed overhead (total ₦100,000). Making one more unit does not change fixed costs, so the incremental cost is ₦70,000, not ₦100,000.
Differential cost and revenue
A differential cost is the amount by which future cost will be higher or lower depending on the option chosen. It is an incremental cost. Example. A firm rents a photocopier for ₦2,000 a month and can switch immediately to a larger one costing ₦3,600. The differential cost is ₦1,600 a month.
A differential revenue is the same idea for income: a fruit seller whose sales of ₦15,000 a month would rise to ₦25,000 in a better location has a differential revenue of ₦10,000, to be compared with the differential costs (higher rent, more stock, other costs) of the move.
Avoidable and unavoidable costs
An avoidable cost can be saved depending on the decision, so it is incremental to it and relevant. An unavoidable cost will be incurred anyway and is not relevant.
Example. A company has one year left on a lease of a warehouse it no longer needs, at ₦100,000 a year. If it stops using it, it must still pay the rent but would save local taxes of ₦16,000 and security costs of ₦40,000. The rent is unavoidable and ignored. The taxes and security (₦56,000) are avoidable and relevant. The warehouse should be closed if it has no use that earns more than ₦56,000.
Committed cost
A committed cost is a kind of unavoidable cost: an obligation already made which cannot be avoided by any means. It is not relevant. Leases are normally committed costs for their whole term.
Example. A machine was bought a year ago with a three-year maintenance contract of ₦20,000 a year. The product it makes sells only ₦15,000 a year for the next two years, and the machine could be sold for ₦25,000. Relevant: the ₦25,000 sale proceeds against ₦30,000 of sales revenue lost over two years, a net loss of ₦5,000 from selling. The maintenance is irrelevant, because ₦20,000 a year is payable whether the machine is kept or sold.
Sunk cost
A sunk cost has already been incurred (a historical cost) or committed by an earlier decision. It must be ignored. A company that has spent ₦900,000 developing a product and ₦80,000 on market research should ignore the ₦980,000 when deciding whether to launch. Only future costs and revenues count.
Opportunity cost
An opportunity cost is the benefit that will be lost by taking one course of action instead of the next-best alternative. It is a relevant cost. If a special job would need 20 hours of skilled labour moved from other work earning a contribution of ₦600 an hour, the contribution forgone (20 × ₦600 = ₦12,000) is an opportunity cost of doing the job.
Why wages are still relevant. The syllabus points out that the labour wage is also relevant in that case. Suppose skilled labour costs ₦400 an hour and each hour currently earns a contribution of ₦600. Then the work being done must sell for ₦1,000 an hour (₦600 contribution plus ₦400 wage). If the hours are moved to the special job, that ₦1,000 of sales is lost, while the ₦400 wage is paid either way.
So the relevant cost per hour is ₦1,000 (contribution lost ₦600 plus wage ₦400), because the wage is a cost that the other work covers. The special job is worthwhile only if it brings in more than ₦1,000 for each hour.
Relevant cost of materials
The relevant cost of materials is the additional cash flow incurred (or benefit lost) by using the materials for the decision under consideration.
- Materials not in stock: the purchase cost.
- Materials in stock: the original cost is a sunk cost and not relevant. The relevant cost is the “deprival value”, the value the company would lose if deprived of the stock.
- Materials in regular use: if used here, they must be replaced for other work, so the relevant cost is the replacement cost.
- Materials not in regular use: the relevant cost is what the company would give up: the higher of the net scrap or resale value and the benefit from any alternative use (such as the purchase cost of another material that could be avoided by using the stock as a substitute).
Example 1: regular use. A contract needs 3,000 kg of material M, which the company uses regularly. It holds 2,000 kg that cost ₦500 a kg; the price is now ₦540. Relevant cost = 3,000 × ₦540 = ₦1,620,000. The old ₦500 does not matter, and the stock and the extra 1,000 kg are all valued at replacement cost.
Example 2: not in regular use. A contract needs 1,200 units of material N. The firm holds 800 units that originally cost ₦900 each, which are no longer used and have a scrap value of ₦250. New purchases cost ₦950.
- Relevant cost.
stock 800 × ₦250 = ₦200,000 (the scrap value given up) plus 400 × ₦950 = ₦380,000 purchased = ₦580,000. - If instead the 800 units could replace another material that would otherwise cost ₦600 each, the benefit forgone is ₦480,000 (higher than scrap), and the relevant cost is ₦480,000 + ₦380,000 = ₦860,000.
Relevant cost of labour
The relevant cost of labour is the additional cash spending (or saving) caused by the decision.
| Situation | Relevant cost |
|---|---|
| Variable cost labour, not in short supply (e.g. part-timers paid by the hour) | Its variable cost. 100 hours at ₦18 = ₦1,800 |
| Fixed-pay labour with spare capacity | Nil. The time would be paid for as idle time anyway, so there is no extra cash cost |
| Labour in short supply (no spare capacity) | Wage plus the contribution lost by diverting the labour (opportunity cost). If overtime is available at a premium, compare the cost of overtime and the cost of diversion, and take the lower |
Examples.
- Spare capacity. A contract needs 250 hours in a department where the workforce is paid fixed weekly wages and has 300 hours of spare time each week with no plans to cut staff. Relevant cost = nil.
- Full capacity, choice of overtime or diversion. A contract needs 120 hours in a department at full capacity. The wage is ₦500 an hour. Overtime would be paid at a 50% premium (₦750).
Or labour could be diverted from work earning ₦300 an hour of contribution, so the cost per hour is ₦500 + ₦300 = ₦800.
Overtime (₦750) is cheaper, so the relevant cost is 120 × ₦750 = ₦90,000. - Short supply, product forgone. A contract needs 200 hours in a department where all time is spent making product Q. The wage is ₦600 an hour.
Q takes 3 hours and earns a contribution of ₦1,200 per unit after labour cost, so ₦1,200 ÷ 3 = ₦400 per hour.
Relevant cost per hour = ₦600 + ₦400 = ₦1,000.
For 200 hours = ₦200,000.
Relevant cost of overheads
The normal rules apply: only future cash flows that arise because of the decision count.
- Fixed overhead absorption rates are irrelevant. Absorbed fixed overhead is not spending and not cash.
- Variable overhead rates are usually relevant. A variable overhead rate per hour is a reasonable estimate of the cash cost for each extra hour.
- Fixed overhead: only extra cash spending caused by the decision (for example, a supervisor hired for the contract) or cash saved by it is relevant.
- Depreciation is not a cash flow, so it is irrelevant.
Relevant cost of using a machine or other asset
The original price and written-down value of an asset are sunk and irrelevant. The relevant cost of using an asset in a project is the difference between what it could be sold for now and what it will be worth after the project, plus any running costs, or the income lost from another use.
Example. A machine bought five years ago for ₦800,000 has a written-down value of ₦200,000. It is no longer used. It could be sold now for ₦150,000. If used for a six-month project it would be sold afterwards for ₦90,000. Relevant cost = ₦150,000 − ₦90,000 = ₦60,000. The ₦800,000 cost and ₦200,000 book value are ignored.
Applications of relevant costing
Special order pricing
When a customer offers an order at a price below normal, relevant costing looks at the incremental costs of the order. If there is spare capacity, only variable costs (and any extra fixed cash spending) matter, because the other fixed costs will not change. The order is acceptable if its price covers the relevant costs and contributes to fixed costs.
Other considerations include the effect on regular customers who may demand the lower price, whether it is a one-off, and whether capacity could be used more profitably.
Make or buy
The company compares the incremental costs of making a product itself with the supplier’s price. Only avoidable costs are considered. Fixed costs that remain whatever is decided are irrelevant. This is developed in a later topic.
Discontinuation decisions
Only the costs that would be saved if a product is discontinued are relevant. Example. Product Z has sales of ₦1,200,000 and variable costs of ₦900,000, so contribution is ₦300,000. Directly attributable fixed costs of ₦150,000 would be saved if it stopped, and ₦200,000 of general fixed costs apportioned to it would continue. Contribution ₦300,000 − avoidable fixed costs ₦150,000 = ₦150,000 positive. Dropping Z would lose ₦150,000 of profit.
The apportioned ₦200,000 is irrelevant, even though it makes Z look loss-making in a full cost statement. (If it can be replaced by a product earning more, it may still be right to drop it.)
Cost-plus and competitive pricing
Relevant costing ensures the price covers the costs caused by production, mainly variable costs and relevant fixed costs. In a competitive market, a target price must be at least the relevant cost to avoid losing money, while remaining attractive to customers.
Pricing under limited capacity
When a resource is scarce, the opportunity cost of the scarce resource is part of the relevant cost, and contribution per unit of the scarce resource guides which products to make (next topic).
The ideas in more depth
Why not use full cost?
A full cost includes costs that do not change with the decision. If full cost is used as the minimum price, good opportunities with spare capacity are turned down. On the other hand, relevant costs are a floor, not a target. If all work were priced at relevant cost, the business would not cover its fixed costs.
Special orders are acceptable at relevant cost only if regular sales still cover fixed costs.
Qualitative factors
Numbers are not the whole story. Cutting price for one customer may start price demands from others. Dropping a product may harm sales of related products. Outsourcing may risk quality and supply. Managers should list these alongside the financial analysis.
Spare capacity
Many relevant cost answers depend on whether spare capacity exists. If it does, labour and fixed overhead are often nil. If it does not, there is an opportunity cost. Read the question to see which applies, and say so in your answer.
Sunk costs and psychology
People tend to continue a project because of money already spent. Relevant costing deals with this directly: the money spent is gone and should not matter. Only future cash flows should.
Worked example: a full contract evaluation
Scenario. Ede Fabrics Ltd is asked to quote for a one-off contract.
It needs:
- (1) 3,000 kg of material M (regular use; 2,000 kg in stock at original cost ₦500; replacement price ₦540)
- (2) 1,200 units of material N (800 in stock, not in regular use, original cost ₦900, scrap value ₦250; new purchases ₦950)
- (3) 250 hours in department A (fixed wages, spare capacity), 120 hours in department B (full capacity, wage ₦500, overtime 50% premium or diversion costing ₦300 lost contribution an hour), and 200 hours in department C (wage ₦600, contribution forgone ₦400 per hour)
- (4) use of a machine that could be sold now for ₦150,000 or after the contract for ₦90,000
- (5) variable overhead of ₦150 per labour hour
- fixed overhead is absorbed at ₦400 per labour hour
- (6) a supervisor hired for the contract at ₦40,000
- (7) delivery costs of ₦35,000
Calculate the minimum price.
| Item | Relevant cost (₦) | Reason |
|---|---|---|
| Material M | 1,620,000 | 3,000 kg × ₦540. Regularly used, so replacement cost; original cost is sunk |
| Material N | 580,000 | 800 × ₦250 scrap given up + 400 × ₦950 to buy |
| Labour, department A | nil | Fixed wages, spare capacity, paid anyway |
| Labour, department B | 90,000 | 120 hours × ₦750 (overtime is cheaper than diversion at ₦800) |
| Labour, department C | 200,000 | 200 hours × (₦600 + ₦400) |
| Machine | 60,000 | ₦150,000 − ₦90,000. The book value is irrelevant |
| Variable overhead | 85,500 | 570 labour hours × ₦150 |
| Fixed overhead absorbed | nil | Not a cash flow, and unchanged by the decision |
| Supervisor | 40,000 | Extra cash cost caused by the contract |
| Delivery | 35,000 | Cash cost caused by the contract |
| Total relevant cost | 2,710,500 | The minimum price to break even on the contract |
(Hours: 250 + 120 + 200 = 570.) If Ede Fabrics quotes ₦3,100,000, the incremental profit is ₦3,100,000 − ₦2,710,500 = ₦389,500. A full-cost view, including absorbed fixed overhead (570 × ₦400 = ₦228,000) and the original cost of stock, would give a higher cost and could wrongly lead the firm to turn the contract down.
Common mistakes in the exam
- Including sunk costs, such as the original cost of stock or research already spent.
- Including depreciation or absorbed fixed overhead.
- Using the original cost of materials in regular use instead of the replacement cost.
- Charging labour at full pay when there is spare capacity (the relevant cost is nil).
- Ignoring the opportunity cost of labour in short supply, or adding the wage twice.
- Choosing the dearer of overtime and diversion.
- Forgetting extra cash costs of the decision, such as a new supervisor or delivery.
- Treating relevant cost as the price to charge, instead of the minimum price.
- Not stating the assumption about spare capacity.
Quick revision
- Relevant cost = future, incremental, cash. Ignore sunk, committed, unavoidable costs, depreciation and absorbed overhead.
- Terms: incremental and differential (extra), avoidable (can be saved), opportunity (benefit lost).
- Materials: not held, purchase price. Held and regularly used, replacement cost. Held and not regularly used, higher of resale and alternative use.
- Labour: spare capacity, nil. Shortage, wage + lost contribution (or overtime, if cheaper).
- Overheads: variable rate relevant; fixed only if extra cash spending.
- Asset: sale value now minus sale value after use, plus running costs.
Practice questions
These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.
Section A style: multiple choice
Question 1. A relevant cost is:
- Any cost in the accounts
- A future cash flow arising as a direct consequence of the decision
- A past cost
- An absorbed overhead
Show the answer
B. It is future, incremental and cash.
Question 2. Money already spent on research is a:
- Sunk cost
- Relevant cost
- Opportunity cost
- Differential cost
Show the answer
A. It cannot be recovered and must be ignored.
Question 3. The benefit lost by choosing one option instead of the next best is the:
- Opportunity cost
- Sunk cost
- Committed cost
- Fixed cost
Show the answer
A. It is relevant.
Question 4. Material in regular use that cost ₦200 per kg has a replacement cost of ₦230. The relevant cost of using it is:
- ₦200
- ₦230
- ₦30
- Nil
Show the answer
B. It must be replaced, so replacement cost is relevant.
Question 5. Labour is paid a fixed wage and has spare capacity. The relevant cost of using it on a contract is:
- Nil
- The full wage
- Overtime rate
- Double the wage
Show the answer
A. It would be paid for anyway.
Question 6. Which of the following is irrelevant to a decision?
- Depreciation of existing machinery
- Variable labour cost of the order
- Extra supervisor hired for the order
- Lost contribution on diverted resources
Show the answer
A. It is not a cash flow.
Question 7. A machine could be sold now for ₦150,000 or, after a project, for ₦90,000. The relevant cost of using it in the project is:
- ₦60,000
- ₦150,000
- ₦90,000
- ₦240,000
Show the answer
A. ₦150,000 − ₦90,000 = ₦60,000.
Question 8. A cost that will be incurred whatever decision is taken is:
- Unavoidable and irrelevant
- Avoidable and relevant
- An opportunity cost
- A differential cost
Show the answer
A. It does not differ between options.
Question 9. The wage is ₦400 an hour and the contribution lost by diverting labour is ₦600 an hour. The relevant cost per hour is:
- ₦1,000
- ₦600
- ₦400
- ₦200
Show the answer
A. Wage plus contribution forgone.
Question 10. A fixed overhead absorption rate of ₦400 per hour is, in a special order decision:
- Relevant
- Irrelevant, because it is not a cash cost caused by the decision
- Always relevant if capacity is full
- An opportunity cost
Show the answer
B. Absorbed overhead is not spending.
Section B style: written questions
Question 11 (10 marks). Explain what is meant by relevant costs, and define sunk, committed, avoidable and opportunity costs with an example of each.
Question 12 (20 marks). Kano Mills Ltd is considering a contract.
It needs:
- 2,000 kg of material R (regular use; 1,500 kg in stock at original cost ₦300, replacement ₦340)
- 400 units of material S (none in stock; price ₦700)
- 500 kg of material T (in stock, not regularly used, original cost ₦200, scrap value ₦120, no other use)
- 300 hours of labour (100 hours from spare capacity paid fixed wages; the other 200 hours would be diverted from work with a contribution of ₦150 an hour after a wage of ₦400, or covered by overtime at 150% of the ₦400 wage)
- variable overhead of ₦80 per labour hour
- fixed overhead absorbed at ₦200 per hour
- depreciation of a machine ₦50,000 for the period, which could otherwise be hired out for ₦30,000
(a) Explain the principles used in identifying relevant costs. (6 marks)
(b) Prepare a schedule of the relevant costs of the contract. (10 marks)
(c) State the minimum price and advise on a quote of ₦1,300,000. (4 marks)
A further written question
Question 13 (10 marks). (a) A machine bought three years ago for ₦500,000 has a book value of ₦200,000. It could be sold now for ₦120,000. If used on a one-year project it would be sold afterwards for ₦70,000. Calculate the relevant cost of using it. (3 marks) (b) Product Z has sales of ₦800,000, variable costs of ₦560,000, directly attributable fixed costs of ₦180,000 and apportioned general fixed costs of ₦90,000.
Advise whether it should be discontinued. (5 marks) (c) State two qualitative factors to consider. (2 marks)
Model answers
Show the model answer to Question 11
A relevant cost is a future cash flow that will occur as a direct consequence of a decision. It must be in the future, differ between the options, and be a cash flow, so depreciation and absorbed overhead are excluded.
Sunk cost: a cost already incurred or committed by an earlier decision, such as ₦900,000 already spent on developing a product. Committed cost: an obligation already made that cannot be avoided, such as the rent for the remaining term of a lease. Avoidable cost: a cost that can be saved if a decision is taken, such as security and local taxes of a warehouse that is closed.
Opportunity cost: the benefit lost by choosing one option over the next best, such as the contribution lost when skilled labour is diverted from other work.
Show the model answer to Question 12
(a) Relevant costs are future cash flows that arise as a direct consequence of the decision. Past costs (sunk costs) and costs that will be incurred anyway (committed or unavoidable) are ignored, and non-cash items such as depreciation and absorbed fixed overhead are ignored. Opportunity costs, the benefits lost by choosing the option, are included, as are incremental and avoidable costs.
(b) Schedule.
- Material R.
2,000 × ₦340 = ₦680,000 (regular use, so replacement cost). - Material S.
400 × ₦700 = ₦280,000. - Material T.
500 × ₦120 = ₦60,000 (scrap value given up). - Labour.
100 hours of spare capacity = nil - 200 hours: diversion costs ₦400 + ₦150 = ₦550 an hour
- overtime costs ₦400 × 1.5 = ₦600
- diversion is cheaper.
200 × ₦550 = ₦110,000. - Variable overhead.
300 × ₦80 = ₦24,000. - Fixed overhead absorbed: nil.
- Depreciation: nil.
- Machine: the ₦30,000 hire income forgone is an opportunity cost: ₦30,000.
- Total = ₦1,184,000.
(c) The minimum price is ₦1,184,000. A quote of ₦1,300,000 gives an incremental profit of ₦116,000, so the contract is worth accepting on financial grounds, provided the assumptions about spare capacity and the absence of a better use of the resources are valid, and the quote does not spoil prices with regular customers.
Show the model answer to Question 13
(a)
- Relevant cost.
sale value now − sale value after the project = ₦120,000 − ₦70,000 = ₦50,000. - The cost and book value are sunk.
(b)
- Contribution = ₦800,000 − ₦560,000 = ₦240,000.
- Directly attributable fixed costs of ₦180,000 would be saved if Z stopped, so the relevant benefit of keeping Z is ₦240,000 − ₦180,000 = ₦60,000.
- The apportioned ₦90,000 continues whether or not Z is made, so it is irrelevant.
- Z should not be discontinued unless the freed resources can earn more than ₦60,000 elsewhere.
- (A full cost statement would show a loss of ₦30,000, which is misleading.)
(c) Any two: effect on sales of related products; customer goodwill and brand; effect on employees and morale; reliability of suppliers; effect on regular customers’ price expectations.
Pathfinder on Relevant cost analysis
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
Multiple-choice items can ask which cost is relevant, the relevant cost of materials in regular use, labour with spare capacity or an asset, and the meaning of sunk and opportunity costs. Check Section A of every diet you practise.
Revise first: Relevant costs
Written questions often combine relevant costing with a special order, a make-or-buy choice or a limited resource. The newest papers set limiting factor questions (May 2026 Question 5 and November 2025 Question 4), which use the opportunity cost idea.
Revise first: Applications of relevant costing
Earlier papers set questions on the relevant cost of materials and labour for a contract. The same schedule layout as the worked example applies.
Revise first: Worked example: a full contract evaluation
Source: ICAN Pathfinder, Management Accounting. Diets covered: Newest diets: relevant costing appears inside limiting factor questions. May Diet, 2025 and November Diet, 2024 are not covered here.
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