Most financial measures of revenues and costs from accounting systems are based on historical
costs. Although historical costs are important and useful for many tasks such as product
pricing and the control and monitoring of business activities, we sometimes find that
an analysis of relevant costs, or avoidable costs, is especially useful. Three types of costs
are pertinent to our discussion of relevant costs: sunk costs, out-of-pocket costs, and opportunity
A sunk cost arises from a past decision and cannot be avoided or changed; it is irrelevant
to future decisions. An example is the cost of computer equipment previously purchased by a
company. Most of a company’s allocated costs, including fixed overhead items such as depreciation
and administrative expenses, are sunk costs.
An out-of-pocket cost requires a future outlay of cash and is relevant for current and future
decision making. These costs are usually the direct result of management’s decisions. For instance,
future purchases of computer equipment involve out-of-pocket costs.
An opportunity cost is the potential benefit lost by taking a specific action when two or
more alternative choices are available. An example is a student giving up wages from a job to
attend summer school. Companies continually must choose from alternative courses of action.
For instance, a company making standardized products might be approached by a customer to
supply a special (nonstandard) product. A decision to accept or reject the special order must
consider not only the profit to be made from the special order but also the profit given up by
devoting time and resources to this order instead of pursuing an alternative project. The profit
given up is an opportunity cost. Consideration of opportunity costs is important. The implications
extend to internal resource allocation decisions. For instance, a computer manufacturer
must decide between internally manufacturing a chip versus buying it externally. In another
case, management of a multidivisional company must decide whether to continue operating or
close a particular division.
Besides relevant costs, management must also consider the relevant benefits associated with
a decision. Relevant benefits refer to the additional or incremental revenue generated by
selecting a particular course of action over another. For instance, a student must decide the
relevant benefits of taking one course over another. In sum, both relevant costs and relevant
benefits are crucial to managerial decision making.