Most of the mistakes made in investment appraisal are made before any discounting begins, in deciding which numbers belong in the calculation. A sum of money already spent on a feasibility study, a depreciation charge that no one will pay, a share of head office cost that exists whatever happens: these appear in the accounts and the project papers, and they must all be left out.
Other items that do not appear as a cost at all, such as the sale value of a machine that the project will use up or the profit from work that staff will stop doing, must be put in.
This topic sets out the rules for deciding the relevant cash flows of a project: what makes a cost or benefit relevant, how to treat materials, existing equipment, labour, overheads and working capital, and which items to exclude, with worked examples. The next topic covers the time value of money, discounting and annuities.
The skill was the main part of the compulsory question in November Diet, 2025, Question 1(a) (16 marks), which gave a table of profit per unit for a new product and expected the candidate to strip out the feasibility study, depreciation and allocated head office costs, and to take only the extra salary of a manager net of the pension saved. Read capital expenditure, payback and accounting rate of return first.
In 30 seconds
Relevant costs and benefits are future cash flows that arise as a direct consequence of the decision. So: ignore non-cash items (depreciation), past (sunk) costs, committed costs that will be incurred anyway, allocated overheads that do not change, and financing costs (the discount rate covers them).
Include opportunity costs (the next best alternative given up) and the investment in working capital, treated as a cash outflow when it rises and an inflow when it is released. Materials: replacement cost if bought or regularly used; for materials with no other use, the higher of resale value and the contribution from another use. Existing equipment: the higher of disposal value and the present value of its alternative use.
Labour: only the extra cost, including the lost contribution when workers are diverted.
Which costs are relevant
Relevant costs and benefits are the future cash flows that arise as a direct consequence of the decision. It follows that:
- Relevant costs are cash flows. A non-cash cost, such as depreciation, is always ignored.
- Relevant costs are future. Money already spent (a sunk cost), such as an investigation or feasibility study, is irrelevant: it has been spent whatever is decided.
- Relevant costs are incremental. A cost that will be incurred whatever is decided, including an allocated share of fixed head office costs that will not change, is not relevant. Only the extra cost caused by the project counts.
- Financing costs are left out. The interest on the money to fund the project is covered by the discount rate and must not be deducted from the cash flows as well.
All cash flows are treated as arising at a distinct point in time, usually the end of a year, so a sale of ₦20m in year 4 is treated as a single amount at the end of year 4.
Materials
- Materials that must be bought because none is held: the relevant cost is the future purchase (replacement) cost.
- Materials in stock that are in regular use and would be replaced: the relevant cost is the current replacement cost, not the historical cost.
- Materials in stock that will not be replaced: the relevant cost is the higher of their net disposal value and the net contribution from using them elsewhere.
Example: a three-year project needs three materials. X: 8,000 kg a year, none in stock, replacement price ₦6.50, so ₦52,000 a year. Y: 5,000 kg a year; it is in regular use and the price has risen from ₦4.00 (the cost of the units in stock) to ₦4.80, so all 5,000 kg are costed at the replacement price: ₦24,000 a year.
Z: 9,000 litres a year; 6,000 litres are in stock, bought for ₦72,000, with no other use and a resale value of ₦30,000 (₦5 a litre); the rest must be bought at ₦11. In year 1 the cost is 6,000 × ₦5 = ₦30,000 (the sale proceeds given up) + 3,000 × ₦11 = ₦33,000, a total of ₦63,000; in years 2 and 3 it is 9,000 × ₦11 = ₦99,000. The original cost of ₦72,000 is not used.
Existing equipment
New equipment bought for the project is part of the initial capital expenditure. If the project uses equipment the company already owns, the relevant cost is the higher of its current disposal value and the present value of the cash flows it could earn in an alternative use: this is the benefit given up, sometimes called the deprival value.
Example: a plant could be sold for ₦400,000 or used elsewhere for cash flows with a present value of ₦360,000; the relevant cost is ₦400,000 (sell it). A machine could be sold for ₦150,000 or used elsewhere for flows worth ₦210,000 in present value; the relevant cost is ₦210,000. If the asset would be replaced were it taken, the cost is the lower of the replacement cost and the benefit given up.
Any later sale of the asset at the end of the project is an inflow, and any repair cost to prepare it is an outflow.
Labour and overheads
- Labour with spare capacity (already paid and idle): no relevant cost.
- New labour hired: the wage cost.
- Labour diverted from other work: the wages plus the contribution lost from the work they stop. For example 20 workers at ₦2.0m each cost ₦40m in wages and diverting them loses ₦15m of contribution, a cost of ₦55m; paying existing staff a 50% overtime premium to cover the work instead would cost ₦60m, so the lower cost of ₦55m is relevant.
- Overheads: only those that change because of the project, such as extra rent or power. A fixed overhead allocated at a rate per labour hour is irrelevant if the total does not change.
- Managers’ pay: only the extra cost.
If a manager is to be taken on for ₦600,000 who would otherwise retire on a pension of ₦150,000 paid by the company, the incremental cost is ₦600,000 − ₦150,000 = ₦450,000.
Working capital
An investment in working capital is strictly not a cash flow in itself, but actual cash flows differ from cash profits by the change in working capital, so it is treated as a cash flow: an increase is an outflow and a decrease (or release at the end of the project) an inflow.
For example, a project needs working capital of ₦200,000 at the start, growing by 10% a year, and recovers it at the end of year 3. The levels are ₦200,000, ₦220,000 and ₦242,000. The cash flows are year 0 −₦200,000, year 1 −₦20,000, year 2 −₦22,000, and year 3 +₦242,000.
Putting it together
| Item | Treatment |
|---|---|
| Feasibility study already paid | Ignore: sunk |
| Depreciation | Ignore: non-cash |
| Head office cost allocated, unchanged in total | Ignore: not incremental |
| Interest on funds raised | Ignore: in the discount rate |
| New machine bought now | Include at year 0 |
| Existing machine used | Include its deprival value |
| Working capital | Include the changes |
| Extra rent, power, wages | Include |
| Disposal value at the end | Include as an inflow |
| Tax effects | Include (next topics) |
The ideas in more depth
Why opportunity costs are real costs
If using a machine on the project means it cannot earn ₦210,000 elsewhere, that loss is as real as a payment. The accounts do not show it, because no cash leaves, but the company is poorer by that amount if the project goes ahead. This is why the relevant cost of an owned asset is not its book value or original cost.
Why interest is excluded
Discounting at the cost of capital already charges the project for the use of money. Deducting interest from the cash flows as well would charge it twice, and would make good projects look bad.
Sources and references
- No accounting standard governs relevant costing; the technique is part of decision accounting, taught in the course on management accounting. Taxation effects are added in a later topic.
These points are stated as at 5 November 2026.
Worked examples
Example 1: material in regular use. 5,000 kg a year; stock was bought at ₦4.00; replacement price ₦4.80. Required: the relevant cost.
- Cost.
5,000 × ₦4.80 = ₦24,000 a year (replacement cost).
Example 2: existing equipment. A machine could be sold for ₦150,000 or used elsewhere for flows worth ₦210,000. Required: the relevant cost.
- Higher of the two. ₦210,000, the benefit given up.
Example 3: a manager. Salary ₦600,000; the pension of ₦150,000 would otherwise be paid. Required: the incremental cost.
- Cost.
₦600,000 − ₦150,000 = ₦450,000.
How to answer in the exam
- Go through the data line by line and label each item: include, ignore or adjust.
- Explain each exclusion in a note (sunk, non-cash, not incremental) because the marks are for the reason.
- Time every flow at year 0 or year-end.
- Show working capital as the change each year and the recovery at the end.
Common mistakes in the exam
- Including depreciation in the cash flows.
- Including a feasibility study already paid.
- Using the historical cost of stock instead of the replacement cost or resale value.
- Including allocated head office costs.
- Deducting interest from the cash flows.
- Forgetting the recovery of working capital at the end.
Quick revision
- Relevant = future, cash, incremental.
- Ignore sunk costs, depreciation, unchanged allocations, financing costs.
- Include opportunity costs and working capital changes.
- Owned equipment: higher of disposal value and value in alternative use.
Practice questions
These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.
Recall check: multiple choice
Question 1. Relevant costs are:
- All costs in the accounts
- Past costs
- Future incremental cash flows caused by the decision
- Allocated overheads
Show the answer
C. Only costs that change with the decision.
Question 2. Depreciation is ignored because it is:
- Too large
- A non-cash item
- A tax
- A future cost
Show the answer
B. No cash leaves the company.
Question 3. A feasibility study already paid for is:
- A sunk cost, so irrelevant
- A relevant outflow
- An inflow
- A working capital item
Show the answer
A. It cannot be changed by the decision.
Question 4. For material in regular use, the relevant cost is:
- The original cost
- The book value
- The selling price
- The replacement cost
Show the answer
D. Because the stock would be replaced.
Question 5. For material with no other use, the relevant cost is:
- The original cost
- The higher of its resale value and the contribution from another use
- Zero always
- The replacement cost
Show the answer
B. The benefit given up.
Question 6. For existing equipment used on a project, the relevant cost is the higher of:
- Disposal value and the present value of its alternative use
- Cost and depreciation
- Book value and tax value
- Cost and scrap
Show the answer
A. This is the deprival value.
Question 7. An allocated head office cost that does not change is:
- Relevant
- An inflow
- Not relevant because it is not incremental
- A working capital item
Show the answer
C. It is incurred whatever is decided.
Question 8. An increase in working capital is treated as:
- An inflow
- Ignored
- Depreciation
- A cash outflow
Show the answer
D. And its release as an inflow.
Question 9. Interest on the funds is excluded because:
- It is tax free
- It is small
- The discount rate already charges for the use of money
- It is a sunk cost
Show the answer
C. Including it would count the cost twice.
Question 10. Idle labour that is already paid has a relevant cost of:
- Nil
- Their full wages
- Double wages
- Overtime rates
Show the answer
A. Nothing extra is spent.
Section B style: written questions
Question 11 (10 marks). (a) Define relevant costs. (3 marks) (b) State FOUR items that are not relevant and why. (4 marks) (c) State how working capital is treated. (3 marks)
Question 12 (15 marks). A two-year project needs 10,000 kg a year of material M (none in stock; replacement ₦8), and 4,000 kg a year of material N, of which 4,000 kg are in stock, bought at ₦5, with no other use, resale value ₦2 a kg and replacement price ₦7. It also uses an owned machine that could be sold for ₦120,000 or used elsewhere for flows worth ₦150,000. (a) Calculate the relevant material cost in each year.
(8 marks) (b) State the relevant cost of the machine. (3 marks) (c) State why the cost of the stock of N is not used. (4 marks)
A further written question
Question 13 (20 marks). A four-year project involves:
- a feasibility study of ₦3m already paid
- a machine bought now for ₦24m with no scrap value
- sales of ₦30m a year
- direct labour and materials of ₦14m
- variable overheads ₦3m
- depreciation ₦6m
- head office allocation ₦5m
- extra rent ₦2m
- a manager paid ₦4m who would otherwise retire on a pension of ₦1m
- working capital of ₦3m at the start, recovered at the end
(a) State which items are irrelevant and why. (6 marks) (b) Calculate the annual relevant cash flow. (6 marks) (c) Prepare the cash flows for years 0 to 4. (5 marks) (d) State TWO other items that could change the cash flows. (3 marks)
Model answers
Show the model answer to Question 11
(a) Future cash flows arising as a direct consequence of the decision (3).
(b) Depreciation (non-cash); feasibility study already paid (sunk); allocated fixed overheads that do not change (not incremental); interest (covered by the discount rate) (1 each).
(c) An increase in working capital is an outflow (1.5); its release at the end is an inflow (1.5).
Show the model answer to Question 12
(a)
- Year 1: M 10,000 × ₦8 = ₦80,000; N 4,000 × ₦2 (resale value given up) = ₦8,000; total ₦88,000 (4).
- Year 2: M ₦80,000; N 4,000 × ₦7 = ₦28,000; total ₦108,000 (4).
(b) The higher of ₦120,000 and ₦150,000, which is ₦150,000 (3).
(c) The original cost is a past cost that cannot change; what matters is what is given up (resale) or what must now be spent (replacement) (4).
Show the model answer to Question 13
(a) Feasibility study (sunk); depreciation (non-cash); head office allocation (not incremental); the part of the manager’s salary saved by the pension (not extra) (1.5 each).
(b) 30 − 14 − 3 − 2 − (4 − 1) = ₦8m a year (6).
(c) Year 0: −24 − 3 = −₦27m; years 1 to 3: +₦8m; year 4: 8 + 3 = +₦11m (5).
(d) (1.5 each, any two) Tax on profit and the capital allowances; inflation in prices and costs; the scrap value of the machine; extra working capital as sales change.
Pathfinder on Relevant cash flows in investment appraisal
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.
Part (a) asks for the net present value of a new product (16 marks), which depends on spotting the irrelevant items: the feasibility study already paid (sunk), depreciation (non-cash), allocated head office costs (not incremental), and a manager’s salary net of the pension saved.
Revise first: Which costs are relevant
Source: ICAN Pathfinder, Financial Management. Diets covered: Every diet in the Pathfinder, November Diet, 2025 and May Diet, 2026, was reviewed here. The diets listed above test this topic directly..
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