Relevant and irrelevant costs definition, explanation, examples

Incremental cost refers to the increase in cost when choosing an alternative. Classifying costs as either irrelevant or relevant is useful for managers making decisions about the profitability of different alternatives. Costs that stay the same, regardless of which alternative is chosen, are irrelevant to the decision being made. Relevant cost is a term used in management accounting to refer to those costs that are accompanied by the management’s decision. These costs are used to eliminate the complications that may come with the decision making process.

Future costs, like ongoing maintenance expenses with the new machinery, should be treated as relevant. Irrelevant or sunk costs are to be ignored when deciding on a future course of action. 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.

In other words, relevant costs are future costs that differ among the alternatives, and irrelevant costs are past costs or future costs that are the same for all alternatives. In this section, we will discuss the concept of relevant and irrelevant costs, how to identify them, and how to use them in various decision scenarios. We will also provide some examples to illustrate the application of relevant and irrelevant costs. 2.2 Direct Labor Cost (Relevant) Direct labor represents a significant part of the total costs of a product. Direct labor may sometimes be considered relevant costs when the labor quantities and labor rates differ (are not the same) between alternatives.

Types of Relevant Costs

1. The old machine has a book value of $40,000 and a remaining useful life of 5 years.
2. The profitability is judged by considering the revenues generated by and costs incurred.
3. Therefore, in the calculation of product selling prices, the cost of depreciation will be included to ascertain the cost and market price.
4. For example, if a company bought a machine that broke and could not be returned, this sunk cost would be irrelevant to the decision to replace the machine or get a supplier to do the manufacturing.
5. Cash expense, which will be incurred in future because of a decision, is a relevant cost.

Cost data is important since they are the basis in making decisions that are geared towards maximizing profit, or attaining company objectives. Costs, when classified according to usefulness in decision-making, may be classified into relevant and irrelevant costs. Fixed costs remain constant regardless of production levels, while variable costs fluctuate with production.

2 Direct Labor Cost

A special order occurs when a customer places an order near the end of the month, and prior sales have already covered the fixed cost of production for the month. B.) The depreciation of the new additional machine, $10,000, is relevant since the company will incur such cost only when it decides to buy the new machine. Future costs, which cannot be altered, are not relevant as they will have to be incurred irrespective of the decision made. In various hospitality branches, businesses are increasingly collecting more data to predict consumer behavior and opinions. The present study provides an overview and synthesis of these changes, with ‘changes’ referring to all advancements and growth in general of th… IntroductionAn understanding of the relevance of Henry Fayol’s Principles of Management to today’s business environment is essential.

The irrelevant costs are fixed costs, sunk costs, overhead costs, committed costs, historical costs, etc. The types of decisions that involve relevant and irrelevant costs. For each type of decision, the relevant costs are those costs that are affected by the decision, and the irrelevant costs are those costs that are not affected by the decision. For example, if a company is deciding whether to accept a special order from a customer, the relevant costs are the variable costs of producing the order, and the opportunity cost of using the capacity for the order.

Key Differences between Relevant and Irrelevant Cost:

For example, a furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which would then be finished in-house by adding handles and other details. The relevant costs in this decision are the variable costs incurred by the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work.

1. Past costs, also known as sunk costs, are irrelevant because they have already been incurred and cannot be changed by any decision.
2. A relevant cost is any cost that will be different among various alternatives.
3. In summary, mastering the art of identifying relevant costs involves critical thinking, foresight, and a holistic perspective.
4. Classifying costs as either irrelevant or relevant is useful for managers making decisions about the profitability of different alternatives.
5. Relevant costs are avoidable and can differ depending on which action is taken.
6. But, a decision alternative being considered might involve a change in fixed costs, e.g. a bigger factory shade.

If the additional revenue is greater than the additional cost, it is profitable to utilize the idle capacity. Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. As an example, relevant cost is used to determine whether to sell or keep a business unit. Tax considerations can also blur the line between relevant and irrelevant costs. In some cases, tax deductions or incentives might render certain costs more or less significant.

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Any cost, fixed or variable that would be different for a particular course of action being analyzed is relevant for that alternative. Relevant costs stand out because they haven’t been incurred yet, can be avoided, and are only pursued if it’s believed the action will be profitable. Companies keep track of these costs and jobs could be in jeopardy if they don’t pay off. General and administrative overheads, that are not affected by the alternative decisions, are not relevant.

In the pursuit of long-term success, businesses must constantly evaluate their expenses and identify any irrelevant costs that may be hindering their growth. Irrelevant costs refer to expenditures that do not contribute to the overall value or profitability of the organization. These costs can range from unnecessary overhead expenses to outdated processes that no longer serve a purpose.

Most costs which are irrelevant in the short term become avoidable and relevant in the long term. 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. A managerial accounting term for costs that are specific to management’s decisions. The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process. E.) After analyzing the relevant costs, the company relevant and irrelevant cost will have a net annual savings of $18,000.

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. In the long term, both relevant and irrelevant costs become variable costs. 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.

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Direct labor represents the hourly labor costs of the workers required to produce the additional or incremental unit of a product. Direct labor may be classified as variable, semi-variable, or fixed costs. Irrelevant costs are those expenses or factors that do not contribute to the decision-making process and, therefore, should be ignored when calculating opportunity cost. They tend to obfuscate the true value of choices, making it challenging to make informed decisions.