What Is an Irrelevant Cost?Irrelevant costs are costs, either positive or negative, that would not be affected by a management decision. Irrelevant costs, such as fixed overhead and sunk costs, are therefore ignored when that decision is made. However, it’s critical for a manager to be able to distinguish an irrelevant cost in order to potentially save the business. Show
Key Takeaways
Understanding Irrelevant CostsClassifying 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. 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. It helps to understand the difference between irrelevant and relevant costs to make a critical business decision. These costs can either make your company more profitable or put the company under. These small decisions are very crucial in day-to-day business. Here are some examples of why irrelevant or relevant costs must be considered:
It can be noted that fixed costs are often irrelevant because they cannot be altered in any given situation. Types of Irrelevant CostsFixed 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. 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. The book value of fixed assets like machinery, equipment, and inventory is another example of irrelevant sunk costs. The book value of a machine is a sunk cost that does not affect a decision involving its replacement. Examples of irrelevant costs:
Irrelevant Costs vs. Relevant CostsA relevant cost is any cost that will be different among various alternatives. There is seldom a “one-size fits all” situation for relevant or irrelevant costs. This is why they are often called differential costs. They differ among different alternatives. Relevant costs are affected by a managerial choice in a certain business situation. In other words, these are the costs which shall be incurred in one managerial alternative and avoided in another. Examples of relevant costs include:
Relevant Costs for Decision Making Learning Objectives 1. Identify relevant and irrelevant costs and benefits in a decision situation. Lecture Notes A. Cost Concepts for Decision-Making. Every decision involves a choice from among at least two alternatives. The costs and benefits of the alternatives should be compared when making the decision. 1. Identifying relevant costs. A relevant cost or benefit is a cost or benefit that differs between alternatives. Differential costs are relevant costs. Any cost or benefit that does not differ between alternatives is irrelevant and can be ignored in a decision. This is a tremendously powerful concept that allows us to ignore mounds of data when making decisions since most things are not affected by any given decision.a. All sunk costs (i.e., costs already irrevocably incurred) are irrelevant since they will be the same for any alternative. All future costs that do not differ between alternatives are irrelevant. B. Adding or Dropping a Segment. Decisions relating to dropping old products (or segments) and adding new products (or segments) are among the most difficult that a manager makes. Two basic approaches can be used to analyze data in this type of decision. 1. Compare contribution margins and fixed costs. A segment should be added only if the increase in total contribution margin is greater than the increase in fixed cost. A segment should be dropped only if the decrease in total contribution margin is less than the decrease in fixed cost. C. The Make or Buy Decision. A make or buy decision is concerned with whether an item should be made internally or purchased from an external supplier. 1. Advantages of making an item internally.a. Producing a part internally reduces dependence on suppliers and may ensure a smoother flow of parts and material for production. D. Special Order.Special orders are one-time orders that do not affect a company's normal sales. The profit from a special order equals the incremental revenue less the incremental costs. As long as the incremental revenue exceeds the incremental costs, the order should be accepted. If there is no idle capacity, opportunity costs should be included as part of the incremental costs. E. Utilization of a Constrained Resource. A constraint is whatever prevents an individual or organization from getting more of what it wants. There is always a constraint as long as desires are unsatisfied. The chapter focuses on one particular kind of constraint-a production constraint. A production constraint can be a raw material, a part, a machine, or a workstation. If the constraint is a machine or workstation, it is called a bottleneck. 1. Contribution Margin Per Unit of the Constrained Resource. Whenever demand exceeds productive capacity, there is a production constraint. This means that the company is unable to fill all orders and some choices have to be made concerning which orders are filled and which are not filled. The problem is how to most effectively use the constrained resource.a. Whether this order or that order is filled, the fixed costs will usually be the same. Therefore, maximizing the total contribution margin will also maximize profit. F. Joint Product Costs and the Contribution Approach. In some manufacturing processes, several end products are produced from a single input. Such end products are known as joint products. The costs associated with making these products up to the point where they can be recognized as separate products (the split-off point) are called joint product costs. 1. The pitfalls of allocation. Joint product costs are really common costs that are incurred to simultaneously produce a variety of end products. Unfortunately, these common costs are routinely allocated to the joint products. Allocated joint product costs are often misinterpreted as costs that could be avoided by producing less of one of the joint products. However, joint product costs can only be avoided by producing less of all of the joint products simultaneously. If any of the joint products is made, then all of the joint product costs up to the split-off point will have to be incurred. G. Activity-Based Costing and Relevant Costs. Activity-based costing is a resource consumption model, not a spending model. Activity-based costing gives an idea of the magnitude of resources involved in carrying out activities, but it should be used with a great deal of caution in making particular decisions. The costs assigned to products and other cost objects are only potentially relevant costs. Whether they are relevant or not in any particular situation should be carefully considered. For example, in most activity-based costing systems the fixed depreciation costs of a sophisticated milling machine would be allocated to products based upon their usage of that resource. Suppose you are trying to decide whether to drop a product that uses the milling machine. The fact that the product uses the milling machine is relevant only if the milling machine is a bottleneck (and opportunity costs are involved in its use) or somehow future cash flows associated with the machine will be affected by how much it is used. If the machine is not a bottleneck and using some of its excess capacity has no effect on future spending, then there really is no cost associated with using the machine. In this case, the costs assigned by the activity-based costing system to the product would not be relevant. What are future costs that do not differ between alternatives?A cost that can be avoided by choosing one alternative over another is relevant for decision purposes. Sunk costs are never relevant in decision making. Future costs that do not differ between the alternatives in a decision are avoidable costs.
What is a cost that Cannot be changed by any present or future decision?Sunk costs are the costs which have been created by a decision that was made in the past and cannot be changed by any decisions that will be made in the future. A sunk cost cannot be recovered and are considered irrelevant for future decision making.
When choosing between two alternatives costs that do not differ between the two alternatives can be considered to be relevant to that decision?Every decision involves choosing from among at least two alternatives. alternatives. Any cost or benefit that does not differ between the alternatives is irrelevant and can be ignored Relevant costs and benefits are also known as differential costs and and can be ignored.
Which of the following cost should be considered for decision making?variable costs. Variable costs are relevant for decision making as they change when a decision is made.
|