A cost that is relevant for one decision may be irrelevant for another. For example, if a company is deciding whether to accept a special order from a customer, the relevant costs are the incremental costs of producing and delivering the order. However, if the company is deciding whether to discontinue a product line, the relevant costs are the avoidable fixed costs of the product line, such as advertising, salaries, and depreciation.
Understanding Irrelevant Costs
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A relevant cost is a future cash flow that will differ among the alternative courses of decision. The relevant cost concept is generally used to describe the short-run future cost that is pertinent to a particular decision at hand. The purpose of identifying and excluding irrelevant costs and focusing on relevant costs is to prevent the problem of cost being distorted, which in turn would affect management decision. Treatment of relevant costs and the way irrelevant costs are handled is a major thrust of management accounting practices. Irrelevant cost is any cost that would not change as a result of an action or decision.
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- In summary, recognizing irrelevant costs is essential for making informed decisions.
- Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions.
- Fixed overhead and sunk costs are examples of irrelevant costs that would not affect the decision to shut down a division of a company, or make a product instead of purchasing it from a supplier.
- By discerning which costs are truly significant and which can be disregarded, companies can make informed decisions that optimize profitability and drive growth.
- 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.
For example, if a company has a limited amount of capital and can invest in project X or project Y, the opportunity cost of choosing project X is the expected return from project Y that is given up. Cash inflows, which would have to be sacrificed as a result of a decision, are relevant costs. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market. The relevant costs are the costs that can be eliminated due to the closure as well as the revenue lost when the stores are closed. If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed. Relevant costs can be thought of as future expenses that are incurred only if an opportunity is pursued.
The human mind often succumbs to cognitive biases relevant and irrelevant cost when dealing with costs, making it challenging to identify what’s truly irrelevant. The sunk cost fallacy, for example, is a common cognitive bias where individuals are inclined to continue investing in a losing proposition simply because they’ve already spent money on it. This bias clouds the judgment of what costs are irrelevant in the decision-making process. It’s essential to be aware of these biases and train ourselves to differentiate between what’s relevant and what’s not.
- Unavoidable costs are those that the company will incur regardless of the decision it makes.
- For example, a furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which would then be finished in-house by adding handles and other details.
- Future costs, which cannot be altered, are not relevant as they will have to be incurred irrespective of the decision made.
- Fixed costs, such as rent or salaries, remain constant regardless of the decision.
- By separating relevant and irrelevant costs, managers can focus on the information that matters and avoid being distracted by the information that does not.
For example, if a company bought a machine that broke and could not be returned, this sunk cost would be irrelevant to the decision to replace the machine or get a supplier to do the manufacturing. Likewise, the wages of employees retained after the sale of a division would be irrelevant to the decision to sell it. Remember, identifying irrelevant costs is crucial for making informed decisions.
Identifying Irrelevant Costs in Decision MakingOriginal Blog
The irrelevant costs are the fixed costs of production, and the regular sales price of the product. The word ‘cost’ in the common sense means the amount incurred or payable in order to acquire goods or services. Cost may be denoted by money, material, labour, time; cut and drying cost pricing, relevant cost and irrelevant cost. The costs are classified into two categories such as relevant cost and irrelevant cost. These changes necessitate a careful examination of new assignments and a practical weighing of alternatives for a given situation. Many costs are variable in nature (directly proportional to volume of operations) and many invertible costs also bear a cause and effects relationship as between cost and volume of operations.
Therefore, reserved items should be discounted according to the actual remaining usage period. From a financial perspective, identifying irrelevant costs is crucial for maintaining profitability and maximizing returns. When resources are allocated towards expenses that do not generate value, it can lead to a decline in the company’s bottom line. By analyzing financial statements and conducting thorough cost evaluations, businesses can pinpoint areas where unnecessary expenditures are occurring.
If the cost is relevant, the uncertain future cost is affected by the decision. If there is a change in cost or benefit, the change cause by alternative option and can make the managers decide to choose between projects. Relevant costs are incremental or differential costs that change as a result of a decision. Irrelevant costs are sunk costs or committed costs that have already been incurred or are unavoidable regardless of the decision. For example, if a company is deciding whether to buy a new machine or keep using the old one, the purchase price of the old machine is a sunk cost and irrelevant for the decision. The relevant costs are the operating costs, maintenance costs, and depreciation costs of the two machines, which may differ depending on the choice.
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. Fixed costs other than depreciation expense will remain at $30,000. Because an irrelevant cost may be a relevant cost in a different management decision, it is important to formally define and document costs that should be excluded from consideration when reaching a decision.
These are the costs that will be incurred in all the alternatives being considered. As they are the same in all alternatives, these costs become irrelevant and should not be considered in decision making. 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. D.) The other fixed costs of $30,000 are irrelevant since it will not differ under the two choices. A.) The depreciation of the old machine, $5,000, is irrelevant since the company will continue to depreciate the machine until the end of its useful life.
Difference Between Relevant Cost and Irrelevant Cost
A cost will be referred to as a relevant cost if it affects a decision. In order for a cost to affect a decision, it must have a future incremental effect or otherwise especially on the cash flows (Jae & Joel, 2008). The incremental effect due to the decision that was made means that expenditure will be incurred by the organization or it can be avoided. The classification of costs as relevant and irrelevant is of great importance in cost and profitability analysis, especially when management has to choose between alternatives.
On the other hand, irrelevant costs, such as the cost of a fancy car accessory that does not affect the car’s functionality, should not be factored into the decision-making process. By focusing on relevant costs, individuals can make more informed choices and ensure that their financial resources are allocated wisely. When it comes to managing finances, understanding the concept of relevant and irrelevant expenses is crucial. In order to make informed decisions and effectively allocate resources, it is essential to be able to identify and differentiate between these two types of costs. While relevant costs directly impact the decision-making process, irrelevant costs have no bearing on the outcome and can often lead to misleading conclusions. Irrelevant costs are also known as sunk, committed, or unavoidable costs.