Relevant costs and irrelevant costs

For decision making costs and

revenues can be classified according
to whether they are relevant to a
particular decision.

Decision making, planning and controlling process

Identify the objective

Profit
Wealth

Searching for alternative

course of action

Gather the data

Thesis
Anti thesis
Synthesis

Select the course of

action

Implement the decision

Compare the planned

and actual output

Respond to divergences
from plan

Relevant costs and irrelevant costs

For decision making costs and
revenues can be classified according
to whether they are relevant to a
particular decision.

Relevant Cost
Meaning:
Relevant costs represent those future costs that
will be changed by a particular decision, while
irrelevant costs are those that will not be
affected by that decision.

Relevant Costs
There are two aspects of these costs:
They must be expected Future costs
They must be different among
alternatives course of action.

Example
Past costs are not relevant costs. Historical
costs or sunk costs are not relevant.
Generally variable costs are relevant costs
but variable costs which do not differ by a
decision are not relevant.
Generally fixed costs are not relevant but
fixed costs which differ by decision
becomes relevant
Book value of equipment is not relevant but
disposal value of an equipment is relevant.
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Avoidable and unavoidable Costs

Avoidable costs are those costs that
may be saved by not adopting a
given alternative, where as
unavoidable costs can not be saved.
Therefore, only avoidable costs are
relevant for decision making.

Sunk Costs
Costs which do not change under
given circumstances and do not play
any role in decision making process
are known as sunk costs. They are
historical costs incurred in the past.
Sunk costs are irrelevant for decision
making but they are distinguished
from irrelevant costs because not all
irrelevant costs are sunk costs.
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Opportunity Costs
An opportunity cost is a cost that
measures the opportunity that is lost
or sacrificed when the choice of one
course of action requires that an
alternative course of action be given
up. It is important to note that
opportunity costs only apply to the
use of scarce resources. This concept
is used for decision making and cost
control.

Incremental Costs
Incremental costs and revenues are
the difference between costs and
revenues for the corresponding items
under each alternative being
considered. Incremental costs may or
may not include fixed costs. If fixed
costs change as a result of decision,
the increase in costs represents an
incremental costs. If fixed costs do
not change as a result, the

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Factors affecting Decision

Decision will be affected by two
factors:
1 Quantitative Factors
2 Qualitative Factors
Note: While taking decision qualitative
factors should also be considered.

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 Relevant costs and irrelevant costs

are always defined with reference to
the particular situation.

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Determining the relevant costs of

direct material
Determining the direct material costs
that are relevant to short term
decisions depends on the
circumstances:
That any materials required would
not be taken from existing stock but
would be purchased so the estimated
purchase price would be the relevant
material cost.
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 Where materials are taken from

existing stock do remember that
original purchase price represents a
past or sunk costs and is therefore
irrelevant for decision making.

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 If materials are to be replaced then

using the material for a particular
activity will necessitate their
replacement. Thus, the decision to
use the materials on an activity will
result in additional acquisition costs
compared with the situation if the
materials were not used on that
particular activity. Therefore, the
future replacement cost represents

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 Where the materials have no further

use apart from being used on a
particular activity and that materials
have some realizable value then
realizable value will be the relevant
cost. If the materials have no
realizable value the relevant cost of
material will be zero.
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Determining the relevant cost of

direct labor
Determining the direct labor costs
that are relevant to short term
decisions depends on the
circumstances.
Where a company has temporary
spare capacity and the labor force is
to be maintained in the short term,
the direct labor cost incurred will
remain the same for all alternative
decisions. The direct labor cost will

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 Where Casual labor is used and

where workers can be hired on a
daily basis to adjust the output level
in such case labor cost will be a
relevant costs for decision making
purpose.

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 In a situation where full capacity

exists and additional labor supplies
are unavailable in the short term and
where no further overtime is
possible, the only way that labor
resources could then be obtained for
a specific order would be to reduce
existing production. In such a case
labor costs will be hourly labor rate
plus an opportunity cost consisting of

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Important points to remember

1- While preparing relevant cost sheet
you should ask yourself what
difference it will make if the
alternative is selected. Never
allocate common fixed costs to the
alternatives.

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2- You should focus on how each

alternative will affect future cash
flows of the organization. changes in
the apportionment of fixed costs will
not alter future cash flows of the
company.

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3- You should also consider the

opportunity cost if resources are
scarce. Your analysis should
recommend the alternative that
yields the largest contribution per
limiting factor.

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 Remember that our aim should

always be to maximize long term net
cash inflows.

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 Remember that while determining

relevant costs always consider
whether the cost is incremental to
the company level and not at lower
levels with in the company.

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