Relevant cost

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A relevant cost (also called avoidable cost or differential cost)[1] is a cost that differs between alternatives being considered.[2] It is often important for businesses to distinguish between relevant and irrelevant costs when analyzing alternatives because erroneously considering irrelevant costs can lead to unsound business decisions.[1] Also, ignoring irrelevant data in analysis can save time and effort. Non-cash items, such as depreciation and amortization, are frequently categorized as irrelevant costs, since they do not affect cash flows.[3]

Two common types of irrelevant costs are sunk costs and future costs that do not differ between alternatives.[1] Sunk costs are unavoidable because they have already been incurred.[4] Future costs that do not change between alternatives are also essentially unavoidable with respect to the alternatives being considered.

Example

A construction firm is in the middle of constructing an office building, having spent $1 million on it so far. It requires an additional $0.5 million to complete construction. Because of a downturn in the real estate market, the finished building will not fetch its original intended price, and is expected to sell for only $1.2 million. If, in deciding whether or not to continue construction, the $1 million sunk cost were incorrectly included in the analysis, the firm may conclude that it should abandon the project because it would be spending $1.5 million for a return of $1.2 million. However, the $1 million is an irrelevant cost, and should be excluded. Continuing the construction actually involves spending $0.5 million for a return of $1.2 million, which makes it the correct course of action.

A managerial accounting term that is used to describe costs that are specific to management's decisions. The concept of relevant costs eliminates unnecessary data that could complicate the decision-making process.

References

  1. ↑ 1.0 1.1 1.2 Garrison, Ray H., Noreen, Eric W., Brewer, Peter C. (2007). Managerial Accounting 12th Edition (p. 578) New York, NY: McGraw-Hill/Irwin. ISBN 978-0-07-352670-6.
  2. ↑ Williams, Jan R., Haka, Susan F., Bettner, Mark S., Meigs, Robert F. (2002). Financial and Managerial Accounting: The Basis for Business Decisions (p. 848) New York, NY: McGraw-Hill/Irwin. ISBN 0-07-239688-1.
  3. ↑ Accounting Tools: What is an irrelevant cost?
  4. ↑ Dennis Caplan. "Management Accounting: Concepts and Techniques". Oregon State University College of Business. Retrieved 2010-05-08. 
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