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.
A graphic design company is trying to decide whether to continue its home design branch. This division is new and only accounts for a small part of its revenue. If this branch is eliminated, certain costs will change in the future. Salaries from the graphic design branch, for example, will change because those in the home design department will be terminated. These are relevant costs. Let's also see what makes up our differential, avoidable, and opportunity costs.
Differential costs are those costs that make up the difference between keeping the home design branch and eliminating it. If your costs are $150,000 for eliminating the branch, and your costs are $325,000 for keeping the branch, your differential costs are $175,000 ($325,000 - $150,000).
Avoidable costs are those costs that are avoided by choosing to eliminate the home design branch versus keeping it. If we choose to eliminate the division, we will no longer have the costs of the employees' salaries, trucks to move materials, and licenses for home design software. These are avoidable costs.
Opportunity costs are the revenues that are lost by choosing to keep the home design branch versus eliminating it. The money that you would make from continuing to do home design is an opportunity cost of choosing to eliminate it. Say you would make $1,250,000 if you kept the division but you'd only make $1,000,000 if you eliminated it. Your opportunity costs are $250,000 ($1,250,000 - $1,000,000) in cash flow. You will lose this money if you choose to eliminate the branch.
What is relevant for one situation may not be for another. What makes up our irrelevant costs in our example? Things that are fixed overhead costs, like building rent and facility insurance, are irrelevant costs. These costs will stay the same whether we keep our home design branch or eliminate it. Looking into our sunk and fixed overhead costs we see that the salaries of those who work outside the division, costs of existing equipment, and rents paid to maintain the facility will not change. Therefore, these are irrelevant costs.
To summarize relevant costs and irrelevant costs in accounting, we learned that determining these costs depends on the situation. Differential, avoidable, and opportunity costs are considered relevant costs. Sunk and fixed overhead costs are irrelevant. Using examples to demonstrate these costs show us that which costs are included in what places depend on what decision is made and the specific situation.
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Making Decisions using Relevant and Irrelevant Costs - A Business Case:
In the following case study, you will play the role of a consultant that will help a client of yours make an important strategic business decision. This will allow you to apply your knowledge of relevant and irrelevant costs.
You receive a phone call from a new client, Janice, that needs your help. Fuzzy Muzzy Jeans Co. (Fuzzy) makes fashionable jeans and their jeans are targeted to teenage men and women. It is controlled and operated by Janice and her husband, Luke.
"Hello, Consultant. I am reaching out to you because I just got into an argument with my husband and business partner, Luke. We launched a new product line last year: A Jean Jacket line. The Jean Jacket was supposed to be a major growth catalyst for our business, but it turns out that it's been a flop thus far. I want to shut down the clothing line, but my husband disagrees, stating that we've invested way too much of our time and savings in order to turn away now. I received some cost data from our accountant (attached below), but we want an external person's opinion before making a decision. Luke and I are both emotionally invested in this project, and thus, we do not have the mindset required to make such an important decision. Can you help us?"
You review the cost information and accept the engagement. Which costs would you include in your decision and what would you recommend?"
|Present value of profit foregone by the company by not using the denim material to make jeans instead of jackets||$124,500|
|Amount invested in the marketing campaign to launch the product line||$75,000|
|Salaries paid to clothing designers to develop Jacket concept last year||$50,000|
|Production supervisor salary for the Jean Jacket line (the supervisor can be transferred to the denim line, and Fuzzy does not want to lay off employees)||$60,000|
|Proceeds from liquidating Jean Jacket inventory||$10,000|
|Cost item||Amount||Relevant cost?|
|Present value of profit foregone by the company by not using the denim material to make jeans instead of jackets||$124,500||Yes, this is the opportunity cost of not producing jeans instead.|
|Amount invested in the marketing campaign to launch the product line||$75,000||No, this is a sunk cost (i.e. already paid and not refundable)|
|Salaries paid to clothing designers to develop Jacket concept last year||$50,000||No, this is a sunk cost (i.e. already paid and not refundable)|
|Production supervisor salary for the Jean Jacket line (the supervisor can be transferred to the denim line, and Fuzzy does not want to lay off employees)||$60,000||No, this is a non-differential overhead cost that will be incurred regardless of the decision made.|
|Proceeds from liquidating Jean Jacket inventory||$10,000||Yes, this is a differential cost because if the jacket product line is continued, the current inventory will not be liquidated.|
Based on the above information, the relevant costs of continuing the product line would be as follows:
Because this cost is positive, this means that the company would be losing money if it were to continue in its Jean Jacket product line. Fuzzy should thus shut down its product line and revert to making denim pants.
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