Relevant and Irrelevant Costs for Short Term Decision Making

Relevant Cost – Definition and Explanation with Example:

“The term relevant cost is used to describe not only changes in cost but also changes in revenue”. Relevant cost is considered for decision making.

In the short term, decisions are made within the given capacity limitations and the ultimate objective is to maximize short-term profits. However all costs are not equally important in decision making and decision makers have to identify the costs that are relevant to a particular decision. The term relevant cost is used to describe not only changes in cost but also changes in revenue. The term relevant factors may be a better term to describe relevant costs.

A relevant cost or relevant revenue is any future cost/revenue that will be different among different alternative options and will affect the final result. As a decision applies to future actions, relevant costs are future costs rather than historical costs. A relevant cost therefore has two important attributes; one that it must be a future cost and the other is, the cost must be different in different decision alternatives.

When deciding between two alternatives, the difference in their costs must be considered. However, if the costs are the same, they may be ignored provided it has already been decided that one of the alternative must be decided, e.g., if a decision has already been made to purchase one of the two new cars and their price is the same, the choice will be based on car’s reputation, features, styling and so on, not on its price. However, if a decision is to be made about whether purchase a new car, then price will obviously play an important role.

Irrelevant Cost – Definition, Types and Example:

“Costs and benefits which are independent of the decision are obviously irrelevant costs and are not considered in making decision”.

An irrelevant decision is the one that will not affect the decision. Irrelevant costs fall into two categories; sunk costs and costs those are same for each alternative.

Sunk cost is a cost which has already incurred and cannot be altered by any current or future action. For example if a firm decides to replace an old machine with a new one then the cost of the old machine would be sunk cost as the purchase of new machine will not lessen or change the amount paid for the old machine. Sunk costs include both amounts paid in the past and past commitments to pay.