Irrelevant Cost Accounting Explained

The book value of a machine is a sunk cost that does not affect a decision involving its replacement. Take the following scenario and see how considering sunk and opportunity costs can improve decision-making and how your company does business. You have job A which pays very well but demands long hours and is not a role you will be happy in.

• B) Materials C and D are in stock due to previous over-buying, and they have restricted use.
• In practice, however, sunk costs can and do significantly influence decisions about the future.
• Calculate the relevant costs of material for deciding whether or not to accept the contract.
• Given sunk costs have already occurred, the cost will remain the same regardless of the outcome of a decision, and so they should not be considered in capital budgeting.
• Now, check your understanding of sunk costs and other irrelevant information.

However, for product Z, the decision to buy rather than make would only be financially attractive if the fixed cost savings of $8,000 could be delivered by management. To earn a target profit, the total contribution (S – V) must be sufficient to cover fixed costs plus the amount of profit required (F + P). The costs which should be used for decision making are https://turbo-tax.org/who-can-i-claim-as-a-dependant-on-my-tax-return/ often referred to as “relevant costs”. CIMA defines relevant costs as ‘costs appropriate to aiding the making of specific management decisions’. For example stepped fixed costs may be relevant if fixed costs increase as a

direct result of a decision being taken. This need not be the case, however, and you should analyze variable and

fixed cost data carefully.

Examples of Sunk Costs

Fixed costs may include lease and rental payments, insurance, and interest payments. A) Material B is used regularly by the company, and if units of B are required

for this job they would need to be replaced to meet other production

demand. These decisions are made by middle management and relates to the specialist

divisions of an organization.

However, if the materials did have

a scrap value of say Shs 3,000, then their relevant cost to the job would be

the opportunity cost of being unable to sell them for scrap, i. The CIMA defines relevant costs as “Costs appropriate to

aiding the making of specific management decisions”. A relevant cost is

future cash flow arising as a direct consequence of a decision taken. While relevant costs are useful in short-term; but for the long-term, price should provide a sufficient profit margin above the total cost and not just the relevant costs. Most costs which are irrelevant in the short term become avoidable and relevant in the long term. Sunk, or past, costs are monies already spent or money that is already contracted to be spent.

Sunk Costs

The costs and benefits of every other potential alternative must be examined and weighed in order to properly calculate opportunity costs. The students need to remember that the relevancy of a cost is seen only in relation to certain activities or decisions. For example, a cost which is relevant in respect of a particular activity or decision may turn out to be irrelevant for another one. Hence, the exercise of identifying relevant and irrelevant costs needs to be done afresh every time a new decision or activity is considered.

• Your newest manager, who understands sunk costs, explains the sunk cost fallacy to them.
• Explicit costs which will occur in the future, however, are relevant to business decisions as they will be direct costs to the company that could be avoided.
• Some managers in your company are wary of switching as they have already committed $50,000 to a training program and should just continue with it.
• In this case, part of the opportunity cost is how important the timeline of returns is and how badly the business needs liquid assets.

They tried to see if the sunk cost effect would reduce student effort. Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales. E) Employees affected by the closure must be made redundant or relocated, perhaps even offered early retirement. There will be lump sums payments involved which must be taken into consideration.

Business Case Studies

Fixed costs are thought to be irrelevant assuming that the decision does not involve doing anything that would change these fixed costs. But, a decision alternative being considered might involve a change in fixed costs, e.g. a bigger factory shade. Thus, both fixed cost and variable cost become relevant costs. In the long term, both relevant and irrelevant costs become variable costs. The types of relevant costs are incremental costs, avoidable costs, opportunity costs, etc.; while the types of irrelevant costs are committed costs, sunk costs, non-cash expenses, overhead costs, etc. For example, if a firm sinks $400 million on an enterprise software installation, that cost is “sunk” because it was a one-time expense and cannot be recovered once spent.

CVP analysis is based on the assumption of a linear total cost function (constant unit variable cost and constant fixed costs) and so is an application of marginal costing principles. Irrelevant costs are costs which are independent of the various decisions or alternatives. Sunk costs and costs which are same for different alternatives. Relevant and irrelevant costs refer to a classification of costs. Costs that are affected by a decision are relevant costs and those costs that are not affected are irrelevant costs.

What Factors Lead to the Sunk Cost Fallacy in Decision-Making?

Job B, on the other hand, is one in which you will be very happy, with shorter hours, but lower pay. It is easy to compare the opportunity costs of the salaries between the two jobs. It is much harder to calculate the levels of happiness you will experience or consider what you could do with extra time in the job with fewer working hours. The bygones principle is grounded in the branch of normative decision theory known as rational choice theory, particularly in expected utility hypothesis. Sunk cost, in economics and finance, a cost that has already been incurred and that cannot be recovered. In economic decision making, sunk costs are treated as bygone and are not taken into consideration when deciding whether to continue an investment project.