Question

Explain a situation you have observed (or read about) in which a firm made a decision considering irrelevant costs or did not consider relevant costs. What was the outcome of the decision, and what could have been done differently?

Answer 1

Relevant and irrelevant costs refer to a classification of costs. It is important in the context of managerial decision-making. 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.

While evaluating two alternatives, the focus of analysis is on finding out which alternative is more profitable. The profitability is judged by considering the revenues generated by and costs incurred. Some costs may remain the same; but some costs may vary between the alternatives. Proper classification of costs between relevant and irrelevant costs is useful in such situations.

The situations in which the relevant and irrelevant classification is useful are decisions regarding:

• Shutting down or carrying on a business division,
• Accepting or rejecting a special order,
• Making a product in-house or buying from outside,
• Selling a semi-finished product or processed one.

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.

Fixed costs can also be relevant if they change due to a decision. For example, in case of idle capacity utilization; additional costs that will be incurred for utilizing idle capacity are relevant costs. The costs that are already incurred are irrelevant 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.

A relevant cost is any cost that will be different among various alternatives. Decisions apply to future, relevant costs are the future costs rather than the historical costs. Relevant cost describes avoidable costs that are incurred to implement decisions.

For example, a company truck carrying some goods from 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 costs are also referred to as differential costs. They differ among different alternatives. They are expected future costs and relevant to decision making.

Irrelevant costs are costs which are independent of the various decisions or alternatives. They are not considered in making a decision. Irrelevant costs may be classified into two categories viz. sunk costs and costs which are same for different alternatives.

Sunk cost is a cost which is already incurred. It cannot be changed by any current or future action. For example if a new machine is purchased to replace an old machine; the cost of old machine would be sunk cost. Irrelevant costs are fixed costs, sunk costs, book values, etc.

Irrelevant or sunk costs are to be ignored when deciding on a future course of action. Otherwise, these costs could lead to a wrong decision. 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.

The basic costing process of both the relevant cost and irrelevant cost is almost same. Both are based on the sound principles and techniques of accounting and costing. Both the costs aim at recording the various business expenses. Both want to accurately reflect the costs in the financial statements and records.

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.

Usually, most variable costs are relevant as they vary depending on selected alternative. Fixed costs are thought to be irrelevant assuming that the decision does not involve doing anything that would change these fixed costs. But, a decision alternative being considered might involve a change in fixed costs, e.g. a bigger factory shade. Thus, both fixed cost and variable cost become relevant costs. In the long term, both relevant and irrelevant costs become variable 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. Sometimes, it is difficult to clearly distinguish between the two. 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.

1. CEO’s salary is irrelevant because it shall remain the same whether the dental care division exists or it is disposed off.
2. Salaries of employees who can be laid off is relevant because the cost shall continue to be incurred if the division exists but it shall be reduced to zero if the division is disposed off.
3. Salaries of employees who can’t be laid-off is irrelevant because it shall continue to be incurred regardless of whether the division is disposed off or not.
4. One-time retirement benefits cost is relevant because it shall be incurred only if the division is disposed off. If the division continues to operate, the cost shall continue to be incurred.
5. Cost of raw materials is relevant cost because it shall be zero if the division no longer operates because then there will be no production.
6. Annual directors fee is irrelevant cost because it shall stay the same even if dental care is disposed off.
7. Interest paid on dental care division loans is relevant because if the division is sold off the loan could be paid off which shall cease the interest cost.
8. Salary of the dental care chief operating officer is relevant because he will most likely lose his job. If he is accommodated in another division, this cost shall be irrelevant.
9. Company-wide quality certification fee is irrelevant because it shall continue to be incurred even if dental care division is no longer there.
10. License fee paid for manufacturing dental care products is a relevant cost because it shall cease with disposal of the division.
11. Head office rent is irrelevant because it shall remain the same regardless of the number of divisions. If a division is sold-off, head-office will still exist and the office rent shall be incurred.
12. Audit fee is irrelevant if it does not depend on the number of divisions. Audit shall be conducted even if there is one division less.