Irrelevant costs, such as fixed overhead and sunk costs, are therefore ignored when that decision is made. However, it’s critical for a manager to be able to distinguish an irrelevant cost in order to potentially save the business. Assume a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes. The airline needs to consider the relevant costs to make a decision about the ticket price.

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Annual insurance cost – this is a relevant cost as this is an additional fixed cost caused by the decision to invest. As the relevant cost is a net cash outflow, the machine should be sold rather than retained, updated and used. The material is regularly used in current manufacturing operations. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market. The relevant costs are the costs that can be eliminated due to the closure as well as the revenue lost when the stores are closed.

Further processing Component A to Product A incurs incremental costs of $6,000 and incremental revenues of $5,000 ($12,000 - $7,000). It is not worthwhile to do this, as the extra costs are greater than the extra revenue. These employees are difficult to recruit and the company retains a number of permanently employed staff, even if there is no work to do. There is currently 800 hours of idle time available and any additional hours would be fulfilled by temporary staff that would be paid at $14/hour. Relevant costs are future expenses related to a specific decision. They can be avoided and differ depending on which choice is taken.

Hence, these are called irrelevant, but on the other hand, these costs can be irrelevant to one business decision which might not be irrelevant for every business decision. Hence, these costs are important when a statement for costs is prepared; these can be eliminated by looking at the relevancy of the decision-making criteria. Generally speaking, most variable costs are relevant because they depend on which alternative is selected. Fixed costs are irrelevant assuming that the decision at hand does not involve doing anything that would change these stationary costs. The future expenses that might occur due to a decision made in the present are called future cash flows.

The classification of costs between relevant costs and irrelevant costs is important in the context of managerial decision-making. Irrelevant costs will not be affected regardless of any decision. E.) After analyzing the relevant costs, the company will have a net annual savings of $18,000.

Relevant versus Irrelevant Costs

The difference in costs in choosing one alternative over another is known as differential cost. Incremental cost refers to the increase in cost when choosing an alternative. Any cost, fixed or variable that would be different for a particular course of action being analyzed is relevant for that alternative. A company that needs a special item can either make one on its own or outsource it.

1. Irrelevant costs are costs that are not useful or rather not at all considered when a company is making a business decision.
2. The closure of Production Line A would also result in the revenue lost being greater than the value of the costs saved, so this isn’t a good idea either.
3. It happens when the company opt-out of other activities that can save it from incurring expenses.
4. Managers have to figure out the best way to utilize these capacities.

In addition, another 50 units are needed for the new product and these will need to be bought in at a price of $14/unit. 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. The importance of irrelevant costs can be explained in different ways because, on the one hand, it is the expense for which a business cannot produce revenues.

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. The decision could result in higher expenses or lower expenses as well as higher or lower revenue. Generally, the cost can be deemed worthwhile if it pays off and results in a higher overall profit.

Relevant vs Irrelevant Costs

This would allow production to be increased because the machine has to deal with only Operation 2. Sale proceeds – this is a relevant cost as it is a cash inflow which will occur in 10 years as a result of the decision to invest. 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.

Relevant cost is a management accounting term that describes avoidable costs incurred when making specific business decisions. This concept is useful in eliminating unnecessary information that might complicate the management’s decision-making process. Businesses use relevant costs in management accounting to conclude whether a new decision is economical.

An irrelevant cost is a category of cost that is not affected by managerial decisions. This means this cost does not change regardless of changes in decisions made by the management. Irrelevant costs are used in managerial accounting to describe costs that are relevant to managerial decisions but do not change as a result of the decision made. Material B - The 100 units of the material already in inventory has no other use in the company, so if it is not used on the new relevant and irrelevant cost product, then the assumption is that it would be sold for $12/unit. If the new product is made, this sale won’t happen and the cash flow is affected. The original purchase price of $10 is a sunk cost and so is not relevant.

Therefore, the closure of Production Line B is not a good idea as the revenue lost is greater than the value of the costs saved. Next we should consider whether the components should be further processed into the products. The company will hire new staff to meet this additional demand. According to the above illustration, it will cost XYZ $250,000 to buy from a supplier. Material - if the buy-in option is accepted, the material cost increases from $12 to $15 per unit. Component B can be converted into Product B if $8,000 is spent on further processing.