Question

According to the tactical decision making guidelines, only relevant costs should be considered. What is a relevant cost, and how does one determine relevance? Explain why it might be difficult for decision maker to ignore sunk costs. Support your position with references.

Answer 1

Relevant costs are those costs which are relevant for a business decision and hence should be considered in total cost analysis and calculations. These cost are called relevant because they might be needed to be incurred for a particular decision only or for a particular project and might be altogether avoided in another project. The difference between relevant and irrelavant cost lies in this point. Irrelevant costs are not considered important in any decision because they might be the ones which are common in all business decisions and projects. Hence they do not have any relevance in decision making. Examples of irrelevant costs are rent of office building, CEO's salary, depreciation of plant.

Relevancy is determined by nature of the cost. If a particular project needs a specific expenditure to be incurred then that specific expenditure becomes relevant to that project. For example cost of raw materials required for the project will be relevant to the project only and not the entire organisation, salaries paid to workers hired especially for the project is relevant.

Sunk costs are costs which are already incurred and hence are irrelevant in the decision making process. They should be ignored by decision makers because decision making is about future planning. Costs which are incurred in past and can't be recovered can't become part of decision making process. In most projects, the initial cost is the sunk cost which shouldn't be considered in the middle of the project if the project encounters some problem and its future continuity is questioned. In such situation, only benefits that can be derived from the project post completion shall be considered.

In some cases, a situation called sunk cost fallacy arises. Theoretically, it is suggested to ignore sunk costs in future planning. In real life situation, the scene becomes quite different. The sunk cost in any project is the amount invested. The more amount is invested with every passing year towards completion, the more difficult it becomes to abandon a project. This is because the amount of money invested becomes bigger and bigger and sentimental values gets attached to it. No one wants to abandon a project in which a big chunk of hard earned money is invested. On the other hand, the future of the project also seems uncertain. Such projects are thus responsible for sunk cost fallacy and it really becomes hard for decision makers to decide the right thing.