General office costs will generally not differ among the options, therefore they are not irrelevant.

 The question is what cost and revenue do you use in decision making?

The future costs and revenues that are expected to differ among the courses of actions under consideration are referred to as relevant costs and revenues. The key consideration to the meaning given above is that the costs and revenues must occur in future and they must as well differ amongst alternative courses of action.

The emphasis laid on future is because every decision is based on selection of courses of action for the future. Anything done in the past would be difficult to alter.

Relevant costs and revenues are those future costs and revenues that will be changed by decision while irrelevant costs and revenues are those costs and revenues that will remain unchanged irrespective of the decision made. For example, a bike owner is considering going to a friend’s house on his bike or going by public transport, the costs associated with bike’s insurance and tax are regarded as irrelevant since they will remain the same whatever alternative is selected. The costs of fuel for the bike will differ depending on whatever alternative chosen. This is essentially regarded as future cost.

 Another example of relevant and irrelevant costs and revenue is, assume that Abidex company bought raw materials that it intends to use for future production but later discovered that these materials cannot be used or sold except that its old customer is expected to make enquiry about that materials. The raw materials were bought at a price of $1,500. The customer indicated interest to buy the product that the materials would be used to produce at $2,000 per unit. It will cost the company $1,600 to convert the materials to the product required by the customer. The relevant cost and revenue are respectively $1,600 (conversion cost) and $2,000 per unit (future revenue). It appears the cost of the order is $3,100 i.e. the materials cost of $1,500 and conversion cost of $1,600 but this is wrong because the materials cost is irrelevant since it will remain the same whether the order is accepted or not.

Variable costs are also relevant costs for management decision making. Variable costs include Direct Material costs, Direct labour costs and variable overhead costs. Note that whereas all variable costs vary with the level of activity or output level, the fixed costs remain fixed within relevant range of activity. Relevant range means the output range at which a company expects to be operating at short term planning horizon. It also essentially represents the output levels that the company has had experience of operating in the past and for which cost information is available. However, example of fixed cost is salary of a factory supervisor which tends to remain fixed within a certain level of activity. Assume that a manufacturing company that is expected to have one factory supervisor intends to expand its operations and hence cites another factory in a different location, it is expected to employ another factory supervisor for this new location. Hence, the fixed cost which represents salary of factory supervisor will change. This therefore supports the assertion that fixed costs remain fixed within a relevant range of activity. Another example of fixed cost is administration costs. If for example, ABC Company Ltd has the intention of expanding its operations by citing another branch in a different location, it will definitely employ more staff and hence its fixed administrative costs will change.

The following are also true of relevant costs:

·        Only cash costs are relevant: From economic standpoint anything that does not bring about a cash change to the organization (immediate or future) is irrelevant to the decision. As many items are treated as cost for financial accounting purpose and in some aspect of management accounting, it is therefore important to emphasize cash basis in decision making. A typical example is depreciation. This is an allocation of the cost of a fixed asset (such as machine) over the periods during which the asset is used. Depreciation is itself not a cash outflow (the cash outflow was the original cost of asset) and this is why it is ignored in cash based decision-making. Please, it should be noted that since only cash costs are relevant, we must recognize all cash costs both direct and indirect cost.

·        Future costs and revenues: The expected future costs and revenues are of importance to the decision maker. The past costs and revenues are only useful in so far as they provide a guide to the future costs already spent, known as sunk costs are irrelevant for decision making.

·        Differential costs and revenues: Only those costs and revenues which change as a result of a decision are relevant where factors are common to all the alternatives being considered they can be ignored: only the differences are relevant.

Assume that a department in the University of California is considering the financial implications of 25 percent increase in the students population. This would cause the department to appoint full-time lecturers on a permanent contract at a cost of $170,000 per annum and hence an increase in the part-time lecturers budget at $20,000 (400 hrs @$50 per hr) per annum. The difference in costs (i.e. the differential cost) between the two alternatives of (a) no increase in the number of students (b) 25 percent increase in the number of students is $190,000. It should be noted that differential costs could or could not include fixed costs. If fixed costs change as a result of decision, the increase in costs represents a differential cost. If fixed costs do not change as a result of a decision the differential cost is zero.

  Examples of irrelevant costs are:

·        Sunk Cost already incurred costs

An example of sunk costs are the written down values of assets purchased in the past. If equipment was bought four years ago for $200,000 and its expected useful life of five years with a nil scrap value. Using a straight line depreciation method, the written down value over its useful life is $40,000. The figure has to be written off, no matter what possible alternative course of action might be chosen in future. Please note that whether the equipment is scrapped or used for production purposes, the $40,000 would still be written off. This cost cannot be changed as a result of future decision and hence is regarded as sunk cost and is irrelevant in decision making.

·        Book values of assets: Cost of fully utilized resource i.e. if a limiting factor exists it will be used to the full and will not therefore cost the same whatever alternatives is considered, the differential cost between alternatives is therefore zero.

·        Conventionally prepared depreciation is not a differential cost and therefore irrelevant.

·        Fixed costs.

What makes a cost relevant or irrelevant?

Are fixed costs relevant or irrelevant?

Which of the following costs are always irrelevant in decision making?

Which of the following is not a relevant cost?