What Is an Irrelevant Cost?
Irrelevant costs are costs, either positive or negative, that would not be affected by a management decision. 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.
- Irrelevant costs are costs that won’t be affected by a managerial decision.
- Relevant costs are costs that will be affected by a managerial decision.
- Irrelevant costs are those that will not change in the future when you make one decision versus another.
- Examples of irrelevant costs are sunk costs, committed costs, or overheads as these cannot be avoided.
- There is no correct answer for each business, it will often alter per situation.
Understanding Irrelevant Costs
Classifying costs as either irrelevant or relevant is useful for managers making decisions about the profitability of different alternatives. Costs that stay the same, regardless of which alternative is chosen, are irrelevant to the decision being made.
Because an irrelevant cost may be a relevant cost in a different management decision, it is important to formally define and document costs that should be excluded from consideration when reaching a decision.
It helps to understand the difference between irrelevant and relevant costs to make a critical business decision. These costs can either make your company more profitable or put the company under. These small decisions are very crucial in day-to-day business. Here are some examples of why irrelevant or relevant costs must be considered:
- Shutting down a specific division within the business,
- Accepting a special order at a lower or higher price,
- Outsourcing a product or making it in-house,
- Selling a half-finished product or continue processing it.
It can be noted that fixed costs are often irrelevant because they cannot be altered in any given situation.
Types of Irrelevant Costs
Fixed overhead and sunk costs are examples of irrelevant costs that would not affect the decision to shut down a division of a company, or make a product instead of purchasing it from a supplier. For example, if a company bought a machine that broke and could not be returned, this sunk cost would be irrelevant to the decision to replace the machine or get a supplier to do the manufacturing. Likewise, the wages of employees retained after the sale of a division would be irrelevant to the decision to sell it.
The book value of fixed assets like machinery, equipment, and inventory is another example of irrelevant sunk costs. The book value of a machine is a sunk cost that does not affect a decision involving its replacement.
Examples of irrelevant costs:
- Sunk costs: Expenditures which have already been incurred
- Committed costs: Future costs which cannot be altered
- Non-cash expenses: Depreciation and amortization
- Overheads: General and administrative overheads
Irrelevant Costs vs. Relevant Costs
A relevant cost is any cost that will be different among various alternatives. There is seldom a “one-size fits all” situation for relevant or irrelevant costs. This is why they are often called differential costs. They differ among different alternatives.
Relevant costs are affected by a managerial choice in a certain business situation. In other words, these are the costs which shall be incurred in one managerial alternative and avoided in another.
Examples of relevant costs include:
- Future cash flows: Cash expenses which will be incurred in the future,
- Avoidable costs: Only the costs which can be avoided in a certain decision,
- Opportunity costs: Cash inflow which would have to be sacrificed,
- Incremental Costs: Only the incremental or differential costs related to the different alternatives.