Question

What makes a cost relevant or irrelevant? Identify the two types of relevant costs. Why are sunk costs irrelevant in deciding whether to sell a product in its present condition or to make it into a new product through additional processing?

Answer 1

When we have two or more alternatives then we should focus on such an alternative which will result more profits. Profits can be simply defined as Revenues generated less cost. These costs can be futher divided into relevant and irrelevant costs.

A relevant cost is a future cost which differs between alternatives. It can also be defined as any cost which is affected by decisions in hand. A relevant cost is a future cash flow arising as a direct consequence of the decision uder review because it is assumed that in the long run, future profits will be maximised if the cash profits of the company is maximised. Those costs that will be effected by manager's decision is known as Relevant Cost.

Irrelevant cost can be defined as those costs which would remain uneffected by manager's decision. These costs are not considered while evaluating future course of actions. All non cash expenditures are irrelevant costs. Whatever might be the alternative these costs would have no influence in decision making by the managers.The examples of irrelevant costs are Depreciation, Notional rent or interest, All overheads absorbed.

Two types of Relevant Cost

1. Differential or Variable Costs
2. Avoidable or Discretionary Fixed Costs

Sunk cost is a historical cost incurred in the past. In other words it is a cost of resource already acquired. Future decision in respect of this resource will not be affected by it. Therefore Sunk costs are irrelevant in decision making.

Thus it can be concluded that sunk cost is irrelevant in deciding whether to sell a product in its present condition or to make it into a new product through additional processing.