1.

Relevant and Irrelevant Costs and Revenues

Cost behavior and this section on relevant costs are central to management decision
making. For decision making, costs and revenues can be classified according to whether they are
relevant to a particular decision. Relevant costs and revenues are those future costs and revenues
that will be changed by a decision, whereas irrelevant costs and revenues are those that will not
be affected by the decision. For example, if you are faced with a choice of making a journey
using your own car or by public transport, the car tax and insurance costs are irrelevant, since
they will remain the same whether or not you use your car for this journey. However, fuel costs
for the car will differ depending on which alternative is chosen and this cost will be relevant for
decision-making.

Illustration of the classification of relevant and irrelevant costs. A company purchased raw
materials for £1,000 per unit and then found that it was impossible to use them in future
production or to sell them in their current state. A former customer is prepared to purchase a
product that will require the use of all these materials, but is not prepared to pay more than
£2,500 for this product. The additional costs of converting these materials into the required
product are £2,000. It might appear that the cost of the order is £3,000, consisting of £1,000
material cost and £2,000 conversion cost, but this is incorrect because the £1,000 material cost
will remain the same whether the order is accepted or rejected. The material cost is therefore
irrelevant for the decision. If the order is accepted the conversion costs will change by £2,000,
and this conversion cost is a relevant cost. If we compare the revenue of £2,500 with the relevant
cost for the order of £2,000, it means that the order should be accepted, assuming of course that
no higher priced orders can be obtained elsewhere. The following calculation shows that this is
the correct decision: The net costs of the company are £500 less; in other words, the company is
£500 better off as a result of accepting the order. This agrees with the £500 advantage which was
suggested by the relevant cost method.

In this illustration, the sales revenue was relevant to the decision because future revenue
changed depending on which alternative was selected. However, in some circumstances, sales
revenue may also be irrelevant for decision-making. Consider a situation where a company can
meet its sales demand by purchasing either machine A or machine B. The output of both
machines is identical, but the operating costs and purchase costs of the machines are different. In
this situation, the sales revenue will remain unchanged irrespective of which machine is
purchased (assuming, of course, that the quality of output is identical for both machines).
Consequently, sales revenue is irrelevant for this decision; the relevant items are the operating
costs and the cost of the machines. We have now established an important principle regarding the
classification of cost and revenues for decision-making; namely, that in the short term not all
costs and revenues are relevant for decision-making

2. Avoidable and Unavoidable Costs

Sometimes the terms avoidable and unavoidable costs are used instead of relevant and
irrelevant cost. Avoidable costs are those costs that may be saved by not adopting a given
alternative, whereas unavoidable costs cannot be saved. Only avoidable costs are relevant for
decision-making purposes. In the example that we used to illustrate relevant and irrelevant costs,
the material costs of £1,000 are unavoidable and irrelevant, but the conversion costs of £2,000
are avoidable and hence relevant. The decision rule is to accept those alternatives that generate
revenues in excess of the avoidable costs.

3. Sunk Costs

These costs are the cost of resources already acquired where the total will be unaffected by
the choice between various alternatives. They are costs that have been created by a decision
made in the past and that cannot be changed by any decision that will be made now or in the
future. The expenditure of £1,000 on materials that were no longer required, referred to in the
preceding section, is an example of a sunk cost. Similarly, the written down values of assets
previously purchased are sunk costs. For example, if equipment was purchased four years ago for
£100,000 with an expected life of five years and nil scrap value, then the written down value will
be £20,000 if straight line depreciation is used. This written down value will have to be written
off, no matter what possible alternative future action might be chosen. If the equipment was
scrapped, the £20,000 would be written off; if the equipment was used for productive purposes,
the £20,000 would still have to be written off. This cost cannot be changed by any future
decision and is therefore classified as a sunk cost.

Sunk costs are irrelevant for decision-making, but not all irrelevant costs are sunk costs.
For example, two alternative production methods may involve identical direct material
expenditure. The direct material cost is irrelevant because it will remain the same whichever
alternative is chosen, but the material cost is not a sunk cost since it will be incurred in the
future.