Difference Between Relevant and Irrelevant Cost

Key Difference – Relevant vs Irrelevant Cost
 

Relevant and irrelevant costs are two types of costs that should be considered when making a new business decision; thus, they are two main concepts in management accounting. Companies should clearly identify the changes to the cost structure as a result of a new decision they are going to make so that only the costs that are going to change or those that incurred additionally should be considered in deciding whether or not to proceed with a particular decision. The key difference between relevant and irrelevant cost is that relevant costs are incurred when making business decisions since they affect the future cash flows whereas irrelevant costs are the costs that are not affected by making a business decision since they do not affect the future cash flows.

CONTENTS
1. Overview and Key Difference
2. What is Relevant Cost
3. What is Irrelevant Cost
4. Side by Side Comparison – Relevant vs Irrelevant Cost
5. Summary

What is Relevant Cost?

Relevant cost is a term that explains costs that are incurred when making business decisions since they affect the future cash flows. The rule here is to consider the costs that will have to be incurred as a result of proceeding with the decision. The concept of relevant cost is used to eliminate unnecessary information that complicates the decision making process.

Cost of Future Cash Flow

This refers to the cash expense that will be incurred as a result of the decision.

E.g., HIJ is a furniture manufacturing company that plans to undertake a new order which will result in a net cash flow of $ 500,000 within a period of 6 months.

Avoidable Cost

The costs that only have to be incurred as a part of the decision i.e. costs which are avoidable if the decision is not made are avoidable costs. Continuing from the above example,

E.g., At present, HIJ operates at full capacity and does not have extra production capacity in its factory. Thus, if the company decides to proceed with the above order, HIJ will have to rent out new production premises temporarily for a cost of $ 23,000.

Opportunity Cost

Opportunity cost is the benefit forgone from the next best alternative and is especially important in selecting a project among multiple options. Continuing from the above example,

E.g., In addition to the above order, HIJ recently received another order that will result in a net cash flow of $ 650,450 that will span over a period of 10 months.

Incremental Cost

Incremental cost is the additional costs that will have to be incurred as a result of the new decision made. Continuing from the above example,

E.g. A total of $ 178, 560 will have to be incurred as direct material cost if HIJ undertakes the above-mentioned project.

What is Irrelevant Cost?

Irrelevant costs are the costs that are not affected by making a business decision since they do not affect the future cash flows. Irrespective of whether the decision is made or not, these costs will have to be incurred. Below mentioned are the types of irrelevant costs.

Sunk Cost

Sunk costs are the costs that already incurred and cannot be recovered. Continuing from the above example,

E.g. HIJ incurred a cost of $ 85,400 to conduct a market research to collect data regarding the preference for their products by customers.

Committed Cost

Committed cost is an obligation to incur a cost in the future, which cannot be altered. Continuing from the above example,

E.g. In another 3 months’ time, HIJ has to increase the salaries of employees that incurs a total cost of $ 15,200.

Non-cash Expenses

Non-cash expenses such as depreciation that do not affect the cash flows of a business are included in this category. Continuing from the above example,

E.g. HIJ writes off $ 20,000 per annum as depreciation expense

General Overhead Cost

General and administrative overheads are not affected by new decisions and should be incurred on an ongoing basis. Continuing from the above example,

E.g. HIJ incurs a cost of $ 150,400 as fixed overheads per annum

What is the difference between Relevant and Irrelevant Cost?

Summary – Relevant Cost vs Irrelevant Cost

The difference between relevant and irrelevant cost depends on whether the cost will be increased or will have to be incurred additionally as a result of the making a new business decision. Sometimes in a very complicated and significant scale business decision, it will be difficult to clearly distinguish to which extent certain costs will affect the business if they decide to proceed with a new decision. In such cases, the use of relevant and irrelevant cost becomes very important to find out whether the new decision will be profitable or not.

Reference:
1. “Relevant & Irrelevant Costs for Decision-Making” Study.com, n.d. Web. 24 May 2017. <http://study.com/academy/lesson/relevant-irrelevant-costs-for-decision-making.html>.
2. “Relevant Costing and Costing for Decision Making.” Relevant Costing, Relevant Costing for Decision Making. N.p., n.d. Web. 24 May 2017. <http://www.civilserviceindia.com/subject/Management/notes/relevant-costing-and-costing-for-decision-making.html>.
3. “Relevant Cost and Decision Making.” Relevant Cost | Explanation | Examples | Concept | Applications. N.p., n.d. Web. 24 May 2017. <http://accounting-simplified.com/management/relevant-costing/>.

Image Courtesy:
1. “Ppf2 small” By The original uploader was Mydogategodshat at English Wikipedia – Transferred from en.wikipedia to Commons by Jarry1250 using CommonsHelper (CC BY-SA 3.0) via Commons Wikimedia