Question

There are three factors that need to be considered when deciding whether certain costs are considered relevant in a short-term decision. Identify and explain each of these three factors.

Answer 1

The three factors that are considered when deciding whether certain costs are considered relevant in the short-term decision are :

1) Whether the cost is related to future or is a sunk cost - Sunk cost or cost which have already been incurred are not relevant for decision making as they will not affect the decision making process. However costs which will be incurred in the future in either of the alternatives will be considered and therefore are relevant.

2) Costs incurred should be incremental and not common costs - Some costs are incurred in both the alternatives been considered and are therefore irrelevant for decision making. Incremental expenses means expenditure which will be incurred or avoided as a result of making a decision. Any costs which would be incurred whether or not the decision is made are not said to be incremental to the decision. Example Fixed costs are not incremental as they will incurresd irrespective of the decision made.

3) Cost considered should involve cashflow -  Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant.