For instance, depreciation on a piece of equipment spreads the cost of the asset over its useful life, but it does not require a cash payment each year. When making business decisions, non-cash expenses should be excluded from the analysis, as they do not affect the immediate financial position or liquidity of the company. Instead, attention should be given to cash-based costs and revenues that directly influence the company’s financial health.
Relevant costs are future potential expenses, whereas sunk costs are existing expenses that have already been made. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision. Classifying costs as either irrelevant or relevant is useful for managers making decisions about the profitability of different alternatives. Costs that stay the same, regardless of which alternative is chosen, are irrelevant to the decision being made. Undertaking certain business decisions has an impact on overall profit.
As they are the same in all alternatives, these costs become irrelevant and should not be considered in decision making. Irrelevant or sunk costs are to be ignored when deciding on a future course of action. If the cost of typewriters had been taken into consideration, some of the corporations could have erred and delayed the computerization decision. relevant and irrelevant cost Only the incremental or differential costs related to the different alternatives, are relevant costs. C.) The variable costs are relevant since the total variable cost will be different if the company chooses to buy the complementary machine.
Role of Relevant Costs in Short-Term Decisions
A relevant cost is a cost that only relates to a specific management decision, and which will change in the future as a result of that decision. The relevant cost concept is extremely useful for eliminating extraneous information from a particular decision-making process. Also, by eliminating irrelevant costs from a decision, management is prevented from focusing on information that might otherwise incorrectly affect its decision. Relevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process.
- Real-world examples illustrate the pitfalls of failing to recognize irrelevant costs in decision-making.
- Relevant costs are those which are stated to be avoidable while a decision is implemented.
- Irrelevant costs, such as fixed overhead and sunk costs, are therefore ignored when that decision is made.
- Here, we can price the expected ongoing-project revenues with the current value.
- Some fixed costs can become relevant in specific contexts, such as when evaluating the long-term viability of a business unit or considering a significant strategic shift.
Understanding and Managing Holding Costs in Inventory Management
Whether the company purchases the new equipment or not, it will still incur the $5,000 depreciation. Take note that the company has already paid for the old machine (a sunk cost) and will continue to use it. A big decision for a manager is whether to close a business unit or continue to operate it, and relevant costs are the basis for the decision.
Examples of irrelevant costs:
The influence of irrelevant costs on decision-making can be profound, often leading to misguided strategies and inefficient resource allocation. When managers allow these costs to seep into their analyses, they risk making choices based on outdated or immaterial financial data. This can result in missed opportunities and the perpetuation of ineffective practices. For instance, a company might continue investing in a failing project simply because significant resources have already been spent, a phenomenon known as the sunk cost fallacy. This misstep diverts attention and funds from more promising ventures, ultimately hampering growth and innovation. A difference is observed in the relevant cost per each alternative decision.
There are two main categories of irrelevant costs based on their characteristics. One is a sunk cost, and the other is constant regardless of any alternative. There are two main categories of irrelevant costs based on their characteristics, one which is sunk cost and the other which is constant regardless of any alternative. A relative cost is a type of cost that is different at different places. Future costs are considered while making decisions regarding relative costs.
These new costs could include transition expenses, such as training and integration, or costs related to quality control and communication with the external provider. ABC Company is currently using a machine it purchased for $50,000 two years ago. It is depreciated using the straight-line depreciation over its useful life of 10 years. The company is contemplating on buying an additional machine worth $80,000, to be used in conjunction with the old. Though units produced will stay the same, the company expects a significant decrease in variable costs from $68,000 to $40,000, annually.