Relevant versus Irrelevant Costs

Relevant versus Irrelevant Costs and Benefits

 

The rest of the chapter focuses on the third step of the decision-making process, which involves comparing the costs and benefits of the decision alternatives.  In particular, we want to compare only those costs and benefits that are relevant to the decision being made.  Although the decision-making process should include consideration of both costs and benefits, analysis will focus mainly on the cost side of the process.

 

  • ·        Relevant Cost – A relevant cost has the potential to influence a particular decision and will change depending on which alternative a manager selects.  Costs that differ between decision alternatives are also called differential costs or incremental costs.  Another term for relevant cost is avoidable cost—that is, a cost that can be avoided by choosing one alternative over another.

 

  • ·        Irrelevant Costs – those costs that will not impact a particular decision or differ between alternatives.  Two types of cost do not change depending on the alternative selected and should be ignored:

 

  • o       Costs that have already been incurred and are not relevant to future decisions (sunk costs)  – Because these costs have already been spent (that is, they are sunk), they will not change depending on which alternative the manager selects.

 

  • o       Costs that are the same regardless of the alternative the manager chooses – When a cost is the same for both options, it is not relevant to the decision and can be ignored.

 

  • ·        Opportunity Costs and Capacity Considerations – An opportunity cost is the forgone benefit (or lost opportunity) of choosing to do one thing instead of another.  We all face opportunity costs anytime we make a choice about what to do with limited time and money.  Similarly, business managers face opportunity costs when they are forced to choose one alternative over another because of limited resources such as cash, employee time, equipment availability, or space. 

 

Capacity is a measure of the limit placed on a specific resource.  It could be the number of people who will fit a restaurant or an airplane, the number of employees who are available to serve clients, the amount of machine time that is available to make a product, or the amount of warehouse space that is available to store inventory.  If a company has idle or excess capacity, it has not yet reached the limit on its resources, and therefore opportunity costs are not relevant.  When a company is operating at full capacity, the limit on one or more of its resources has been reached, and making the choice to do one thing means giving up the opportunity to do something else.  At full capacity, opportunity costs become relevant and should be incorporated in the analysis.