Relevant and Irrelevant costs are the classification of costs based on their importance. Cost data is vital for a business as it helps in decision-making regarding maximizing profit or meeting other business objectives. But, not all costs are essential to a company when making a particular decision. Thus, to improve decision-making or to make better decisions, a business needs to understand the difference between relevant cost vs. irrelevant cost.
When a company faces two or more alternatives, the choice depends on the more profitable option. The profitability, in turn, hinges on the revenue and cost of each option. Some costs would vary for each option, while some costs are the same. Thus, we must classify costs as relevant and irrelevant to make a better decision.
Following are some situations when differentiating between relevant cost vs. irrelevant cost is essential:
- Closing a division or starting a new department.
- Whether or not to accept special orders.
- To outsource or produce a product in-house.
- To buy a new machine or use an existing one.
Relevant cost vs. Irrelevant Cost – Differences
Following are the differences between relevant cost vs. irrelevant cost:
Relevant costs, as the name suggests, are the cost that is affected by the decision that the company or manager takes. Or, we can say these costs change with each choice. On the other hand, managerial choices do not affect irrelevant costs. Since irrelevant costs remain unaffected by a decision, businesses often ignore these costs.
Relevant costs play a crucial role when a company has several alternatives to choose from. Irrelevant costs have no bearing when selecting from different options. Irrelevant costs are not useful from the point of decision making, but they are as helpful as relevant costs due to the following reason:
- A company needs both costs to come up with the average cost of production or service.
- Both costs also help to determine the total cost of operations.
- A company records both costs in the financial statements.
What does it include?
Relevant costs include the expected costs that a company plans to incur. It may consist of differential, avoidable, and opportunity costs. Differential cost is the cost gap or difference between the two choices. Avoidable costs are the cost that a company can avoid by making one choice over another. Opportunity costs are the revenues that a company foregoes by making one decision over another.
On the other hand, Irrelevant costs include sunk costs and unavoidable costs or fixed costs. Sunk costs include the actual costs or the expenses that the company has already incurred.
Fixed costs can be relevant if it varies based on the decision. For example, fixed costs that a company incurs to utilize idle capacity are relevant costs. Thus, we can say that avoidable fixed costs are relevant.
Relevant costs are generally variable. Or, we can say they are operational or recurring expenditures. On the other hand, Irrelevant costs are usually fixed in nature or relate to the capital or one-off spending.
Relevant costs usually relate to the short-term. Irrelevant costs are generally for the long-term as they are mostly capital or one-off expenditures. In the long term, however, most costs are relevant. For instance, if a company is planning for ten years ahead, then it would consider all types of costs, including the fixed and sunk cost that it might incur.
Who Spends it?
Usually, lower management incurs the relevant costs, while top management oversees the spending of the irrelevant costs.
Effect on Cash Flows
Relevant costs affect future cash flows. Irrelevant costs do not have any effect on future cash flows.
A company must not avoid relevant costs when making a decision. One must consider them in all managerial analyses and calculations. On the other hand, a company must avoid irrelevant costs when deciding as it could cause you to make the wrong choice. Also, one must not consider them in managerial analysis and calculations.
Company A is using a two-year-old machine costing $24,000. The company uses straight-line depreciation, while the machine has a useful life of 10 years.
Company A is considering buying another machine costing $45,000 with a useful life of 9 years. The new machine won’t have any effect on the number of units that a company produces. Company A, however, expects the variable cost to come down from $34,000 to $22,000. Fixed costs will also be the same at $20,000.
In this case, depreciation ($2,400) on the old machine is an irrelevant cost. The company would have to depreciate the old machine irrespective of whether or not it buys a new machine. Also, the cost of the old machine is irrelevant (a sunk cost). The fixed cost of $20,000 is also not relevant as a company would have to incur it whether or not it buys a new machine.
Here depreciation of New Machine, say $4500, will be relevant cost. Company A will incur this cost only if it decides to buy the new machine. Another relevant cost will be the variable cost, as Company A will save $12,000 because of the new machine.
Thus, the depreciation on the new machine and variable cost saving is the only relevant cost. Based on these two costs, Company A will have a net saving of $7,500 ($12,000, Less $4,500) if it buys a new machine.
From the above differences, we now know the relevance of differentiating between the relevant and irrelevant costs. However, sometimes it may be difficult to distinguish between the relevant and irrelevant costs. Still, the manager must use his due diligence to differentiate one from another as they are crucial for decision making.