For a cost to be considered relevant, it must be a future item that differs across alternatives. When a cost is the same across other options, it is deemed irrelevant, which is sometimes known as a sunk cost. Sunk costs are not affected by future decisions and are usually unavoidable, like depreciation. While relevant costs describe costs related to a specific business decision(s), businesses must understand these costs as it helps future decision-making. While there are a few different types of relevant costs, one of the most commonly known is opportunity costs.
Opportunity costs are the profit/benefit when one alternative is chosen over another. Relevant costs are essential in making short-run decisions because it helps eliminate avoidable costs and help managers select the alternative that will provide the most significant benefit. An example of this would be time spent studying instead of doing something else or the profit a business gains by selling one product over another. Relevant costs can help managers in situations like whether or not to make a product or buy it from a supplier, accept a special order at less than the usual price to get rid of inventory on hand, keep or drop a product line, or whether or not they should sell or process joint products further. Managers need to be cautious when making short-run decisions as most can have long-run consequences, and in order to be able to maximize the benefit of the decision, they should follow the decision-making model.
In the decision-making model, you first need to identify the problem, and then you must identify all possible solutions you can take and eliminate the ones that are not feasible and clearly do not show any benefit to the company. After you determine all the alternatives, you must identify the costs and benefits associated with each option. You must then estimate the relevant costs and benefits to each choice, assess the qualitative factors, and then make the decision by choosing the alternative that shows the most overall benefit to the business.
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