Therefore, the machine running costs will not change, so are not relevant to the decision. Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years as a result of the decision to invest. The material is regularly used in current manufacturing operations. The material has no use in the company other than for the project under consideration. Types of decisionWe will now look at some typical examples where you have to decide which costs are relevant to decision-making.

Likewise, the wages of employees retained after the sale of a division would be irrelevant to the decision to sell it. 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.

Continue or Shutdown Decision

For instance, a company’s lease payment for factory space is a fixed cost that remains constant regardless of the volume of production. When deciding whether to produce more units of a product, this fixed cost remains unchanged and is therefore irrelevant to the incremental analysis. Sunk costs include historical costs that have been taken up or paid by the company, hence will not be affected by future decisions. Unavoidable costs are those that the company will incur regardless of the decision it makes. Good examples include committed fixed costs such as insurance and current depreciation.

For instance, the book value of a company’s equipment and machinery cannot change regardless of the managerial decision that is reached. Formal documentation of irrelevant costs is important, these costs are likely to be ignored when reaching decisions but they must be accurately documented. Also, it is important to note that it is possible for an irrelevant cost in a managerial decision to be a relevant cost in another managerial decision. One prevalent misconception about irrelevant costs is the belief that all fixed costs are irrelevant in decision-making.

Relevant Costs for Decision-making & How They Apply To Common Decisions

The closure of Production Line A would also result in the revenue lost being greater than the value of the costs saved, so this isn’t a good idea either. Relevant costs are those which are stated to be avoidable while a decision is implemented. For example, a person has to choose between vacationing and spending time with their family.

They do not make any difference and make no impact in making decisions. In commercial entities, the cost accounting is a prominent aspect for internal control and decision making. Some of its salient functions are identification and application of various types of costs as well as controlling and managing those costs. These managerial functions often require the bifurcation of costs into various categories. We have already discussed different categories of costs in current chapter – classification of costs.

1. Setting the price for a product or service involves not just covering the costs but also ensuring competitive positioning in the market.
2. Unavoidable costs are those that the company will incur regardless of the decision it makes, e.g. committed fixed costs like depreciation on existing plant.
3. Make vs. buy decisions are often an issue for a company that requires component parts to create a finished product.
4. The basic costing process of both the relevant cost and irrelevant cost is almost same.
5. For example, in case of idle capacity utilization; additional costs that will be incurred for utilizing idle capacity are relevant costs.

The difference between relevant and irrelevant cost is based on  whether the cost will have to be incurred additionally due to a new decision. Yet, it helps in make or buy decision, accepting or rejecting an offer, extra shift decision, plant replacement, foreign market entry, shut down decisions, analyzing profitability, etc. Costs that are affected by a decision are relevant costs and those costs that are not affected are irrelevant costs. As irrelevant costs are not affected by a decision, they are ignored in decision making. The final piece of the puzzle is the use of relevant cost analysis in evaluating financial performance.

Note that the $2m total profit is the same as the profit of $6m from Production Line A and the loss of $4m from Production Line B as shown in the table at the start of relevant and irrelevant cost this example. Therefore, the closure of Production Line B is not a good idea as the revenue lost is greater than the value of the costs saved. Next we should consider whether the components should be further processed into the products. These costs are never being taken into consideration while making a decision. We assume the units in inventory will not be used—the selling price at $13.

Relevant Costing Decisions & Examples

Sunk costs, on the other hand, are existing expenses that have already been incurred and are unrecoverable. Relevant costs can be thought of as future expenses that are incurred only if an opportunity is pursued. They are studied by companies to determine if one decision is more cost-effective than another. Costs that are incremental to the decision are considered relevant.

These examples underscore the importance of distinguishing between relevant and irrelevant costs to make sound business decisions. Another common misunderstanding is the assumption that irrelevant costs are always easy to identify. In reality, distinguishing between relevant and irrelevant costs can be complex, especially in large organizations with intricate financial structures. Costs that appear irrelevant at first glance may have indirect implications that affect the decision at hand.

In these scenarios, managers must evaluate costs that are subject to change based on the decision at hand. For example, when considering whether to accept a special order at a discounted price, only the additional costs incurred to fulfill the order are relevant. These may include extra materials and labor, but not the fixed overhead, which would be incurred regardless of the decision.