Relevant and Irrelevant Cost Accounting Explained

Relevant and Irrelevant Cost Accounting Explained

relevant and irrelevant cost

Relevant costs include expected costs to be incurred as well as benefits forgone when choosing one alternative over another (known as opportunity costs). For example, in case of idle capacity utilization; additional costs that will be incurred for utilizing idle capacity are relevant costs. Additional costs are compared with the additional revenue from utilizing idle capacity. If the additional revenue is greater than the additional cost, it is profitable to utilize the idle capacity. E.) After analyzing the relevant costs, the company will have a net annual savings of $18,000. The company will be able to decrease its variable costs by $28,000 but will incur in incremental costs of $10,000 due to increase in depreciation.

Sunk costs are irrelevant, as they do not affect the future cash flows. Irrelevant costs are costs which are independent of the various decisions or alternatives. A managerial accounting term for costs that are specific to management’s decisions.

relevant and irrelevant cost

E.g., HIJ is a furniture manufacturing company that plans to undertake a new order which will result in a net cash flow of $ 500,000 within a period of 6 months. Only the costs, which can be avoided if a particular decision is not implemented, are relevant for decision making. E.g. A total of $ 178, 560 will have to be incurred as direct material cost if HIJ undertakes the above-mentioned project. E.g., In addition to the above order, HIJ recently received another order that will result in a net cash flow of $ 650,450 that will span over a period of 10 months. The emphasis laid on future is because every decision is based on selection of courses of action for the future. Because this cost is positive, this means that the company would be losing money if it were to continue in its Jean Jacket product line.

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. The relevant costs affect the future cash flows, whereas the irrelevant costs do not affect future cash flows. Both relevant costs and irrelevant costs are required to provide estimates of average cost of production or service offering of an organization or business. Both relevant cost and irrelevant cost are taken into account, while determining the total cost of operations or running a factory or business. While evaluating two alternatives, the focus of analysis is on finding out which alternative is more profitable.

Similarities between Relevant and Irrelevant Cost:

The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. For example, suppose your retail business pays an annual building rent of $200,000, which is a fixed cost (unless the rental contract with the landlord also has a rent escalation clause based on your sales revenue). The rent, which gives the business the legal right to occupy the building, provides 15,000 square feet of retail and storage space. The future costs and revenues that are expected to differ among the courses of actions under consideration are referred to as relevant costs and revenues. The key consideration to the meaning given above is that the costs and revenues must occur in future and they must as well differ amongst alternative courses of action.

relevant and irrelevant cost

A non-cash cost is a cost that results from a reduction in the value of assets. Overhead costs are a part of general business operations that keep the business functioning. Various types of relevant costs are variable or marginal costs, incremental costs, specific costs, avoidable fixed costs, opportunity costs, etc. The irrelevant costs are fixed costs, sunk costs, overhead costs, committed costs, historical costs, etc. The types of relevant costs are incremental costs, avoidable costs, opportunity costs, etc.; while the types of irrelevant costs are committed costs, sunk costs, non-cash expenses, overhead costs, etc. Variable costs are also relevant costs for management decision making.

What is an Irrelevant Cost?

They do not make any difference and make no impact in making decisions. Assume that a department in the University of California is considering the financial implications of 25 percent increase in the students population. This would cause the department to appoint full-time lecturers on a permanent contract at a cost of $170,000 per annum and hence an increase in the part-time lecturers budget at $20,000 (400 hrs @$50 per hr) per annum.

Don Lavoie on the Continuing Relevance of the Knowledge Problem – Econlib

Don Lavoie on the Continuing Relevance of the Knowledge Problem.

Posted: Mon, 07 Aug 2023 17:15:48 GMT [source]

For example, at the time of decision to replace typewriters by computers, all corporations ignored the cost of typewriters, even though some of them were bought just some time before the decision. If the cost of typewriters had been taken into consideration, some of the corporations could have erred and delayed the computerization decision. For example, a company truck carrying some goods from relevant and irrelevant cost city A to city B, is loaded with one more ton of goods. The relevant cost is the cost of loading and unloading the additional cargo, and not the cost of the fuel, driver salary, etc. It is due to the fact that the truck was going to the city B anyhow, and the expenditure was already committed on fuel, drive salary, etc. It was a sunk cost even before the decision of sending additional cargo.

Relevant versus Irrelevant Costs

Sometimes in a very complicated and significant scale business decision, it will be difficult to clearly distinguish to which extent certain costs will affect the business if they decide to proceed with a new decision. In such cases, the use of relevant and irrelevant cost becomes very important to find out whether the new decision will be profitable or not. 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.

  • It should be noted that differential costs could or could not include fixed costs.
  • This will allow you to apply your knowledge of relevant and irrelevant costs.
  • Relevant and irrelevant costs are not represented on a company’s cash flows and are not used for accounting purposes.
  • Both relevant costs and irrelevant costs are required to provide estimates of average cost of production or service offering of an organization or business.
  • It will cost the company $1,600 to convert the materials to the product required by the customer.

Another example can be when a business is considering opening another division of the company. There will be incurred costs related to adding business operations, which will include both relevant and irrelevant costs. The objective is to identify and reduce relevant costs to earn as much as possible to maximize revenues. Examining business in this fashion will inform decision-makers if adding a division of the company will be beneficial or not. Costs are categorized as either relevant or irrelevant for the purpose of managerial decisions.

Difference Between Relevant and Irrelevant Cost

This cost cannot be changed as a result of future decision and hence is regarded as sunk cost and is irrelevant in decision making. The students need to remember that the relevancy of a cost is seen only in relation to certain activities or decisions. For example, a cost which is relevant in respect of a particular activity or decision may turn out to be irrelevant for another one. Hence, the exercise of identifying relevant and irrelevant costs needs to be done afresh every time a new decision or activity is considered. The difference between relevant and irrelevant cost is based on  whether the cost will have to be incurred additionally due to a new decision.

Irrelevant costs are used in managerial accounting to describe costs that are relevant to managerial decisions but do not change as a result of the decision made. Sunk costs include costs like insurance that has already been paid by the company, hence it cannot be affected by any future decision. 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. Costs that are same for various alternatives are not considered e.g. fixed costs. Only those costs that are different for each alternative are the relevant costs and are considered in decision making e.g. variable costs. As mentioned earlier, relevant costs are those that will differ between different alternatives.

A irrelevant cost is any cost that has already been paid or accounted for when considering certain business decisions. When comparing relevant and irrelevant costs, a business owner’s main concern is to differentiate between which costs are which. Relevant costs are where a company should focus most of its attention because these expenses can be adjusted when necessary.

However, irrelevant costs can not be changed, and mistaking an irrelevant cost will wrongly inflate relevant costs. It is a sound business practice to reduce relevant costs as much as possible because they can be adjusted to produce financial benefits. Non-cash items, such as depreciation and amortization, are frequently categorized as irrelevant costs for most types of management decisions, since they do not impact cash flows. Sunk costs, such as the purchased cost of a fixed asset that was incurred in a prior period, are also usually considered irrelevant when making decisions on a go-forward basis. Committed costs are also usually considered irrelevant, since these are future costs for which the firm has made a firm commitment that cannot be abrogated. Irrelevant costs are the costs that are not affected by making a business decision since they do not affect the future cash flows.

  • An irrelevant cost is a category of cost that is not affected by managerial decisions.
  • Likewise, the wages of employees retained after the sale of a division would be irrelevant to the decision to sell it.
  • Fuzzy should thus shut down its product line and revert to making denim pants.
  • The emphasis laid on future is because every decision is based on selection of courses of action for the future.

However, the $1 million is an irrelevant cost, and should be excluded. Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action. Not every cost is important to every decision a manager needs to make; hence, the distinction between relevant and irrelevant costs. As a bookkeeper, you need to track the relevant costs and expose the irrelevant ones for appropriate future decision making. Sunk costs refer to the expenditures which have already been incurred.

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. Relevant costs refer to those that will differ between different alternatives.

Difference Between Nutrient Agar and Nutrient Broth

The relevant costs are incurred mainly by the lower management, whereas the irrelevant costs are mainly incurred by top management. Past costs, also known as sunk costs, are not relevant in decision making because they have already been incurred; therefore, these costs cannot be changed no matter which alternative is selected. An irrelevant cost is a cost that will not change as the result of a management decision. However, the same cost may be relevant to a different management decision. Consequently, it is important to formally define and document those costs that should be excluded from consideration when reaching a decision.

Future costs that do not differ between alternatives are irrelevant and may be ignored since they affect both alternatives similarly. E.g. HIJ incurred a cost of $ 85,400 to conduct a market research to collect data regarding the preference for their products by customers. Any cost, fixed or variable that would be different for a particular course of action being analyzed is relevant for that alternative. This refers to the cash expense that will be incurred as a result of the decision. General and administrative overheads, that are not affected by the alternative decisions, are not relevant. Future costs, which cannot be altered, are not relevant as they will have to be incurred irrespective of the decision made.