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Relevant & Irrelevant Costs for Decision-Making

Relevant & Irrelevant Costs for Decision-Making
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  • 0:00 Relevant & Irrelevant…
  • 0:34 What Are Relevant Costs?
  • 2:21 What Are Irrelevant Costs?
  • 3:05 Relevant & Irrelevant…
  • 5:14 Lesson Summary
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Lesson Transcript
Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

In accounting, there are relevant and irrelevant costs. Relevant costs include differential, avoidable, and opportunity costs. Irrelevant costs include sunk and fixed overhead costs. In this lesson, we will learn about these and calculate them.

Relevant and Irrelevant Costs In Accounting

If you ever had a lemonade stand as a kid, you have thought about relevant and irrelevant costs. Say you are deciding whether you want to just sell lemonade or you might sell lemonade and cookies at your stand. There are certain costs that will change with whichever you decide. The additional supplies that you would need to produce, transport, and sell your cookies instead of just selling lemonade are relevant costs. The cost of your lemonade stand, however, will stay the same. This is an irrelevant cost. Let's look at these costs in more detail.

What Are Relevant Costs?

Relevant costs are those costs that change with each decision you make. If you have two choices, and you choose A instead of B, relevant costs are those costs that will be different from those associated with choice B. These are costs that directly affect cash flow, the money coming in and going out of a business. Relevant costs include differential, avoidable, and opportunity costs.

Differential costs are those costs that make up the difference between your available choices. If your costs are $150 for producing lemonade, and your costs are $325 for selling lemonade and cookies, your differential costs are $175 ($325 - $150).

Avoidable costs are those costs that are avoided by making one choice over another. If we choose to just sell lemonade at our stand, we will no longer need the costs of ingredients for cookies, access to an oven and kitchen tools, labor for creating the cookies, and electricity to heat the oven to make the cookies. These are avoidable costs.

Opportunity costs are the revenues that are lost by choosing one decision over another. In our lemonade stand example, the money that you would make from also selling cookies is an opportunity cost of choosing to just sell lemonade. Say you would make $2,000 if you sold lemonade and cookies, but you'd only make $750 if you just sold lemonade. Your opportunity costs are $1,250 ($2,000 - $750) in cash flow. You will lose this money if you choose to sell only lemonade.

Certain costs will not change when deciding whether to sell cookies. You will have these costs regardless of your decision. These are irrelevant costs.

What Are Irrelevant Costs?

Irrelevant costs are those that will not change in the future when you make one decision versus another. They are costs that will continue to happen. Considering our lemonade stand, we will still have to squeeze lemons and maintain our lemonade stand regardless of whether we sell cookies or not.

Irrelevant costs are things like sunk costs, which include the cost of the lemon squeezer, and fixed overhead costs, which would be the costs of maintaining the lemonade stand. Sunk costs are those costs that cannot be changed because they were from prior decisions. Typical examples are technology, machinery, tools, and vehicles. Fixed overhead costs are the costs needed to operate a business. Rent, insurance, and utilities are included here.

Relevant and Irrelevant Costs Example

Let's look at an example of what are relevant and irrelevant costs.

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