Introduction to Relevant Costs and Decision Making

Relevant costs are those costs that differ between alternatives and should be considered when making decisions. Understanding how to identify and use relevant costs is crucial for managers to make informed decisions that optimize resource allocation and maximize profitability.

Common Terms and Definitions

Relevant Cost: A cost that differs between alternatives and should be considered when making a decision.

Irrelevant Cost: A cost that does not differ between alternatives and should be ignored when making a decision.

Opportunity Cost: The benefit foregone by choosing one alternative over another.

Sunk Cost: A cost that has already been incurred and cannot be changed by any future decision.

Incremental Cost: The additional cost incurred when choosing one alternative over another.

Avoidable Cost: A cost that can be eliminated by choosing a particular alternative.

Unavoidable Cost: A cost that will be incurred regardless of the alternative chosen.

Types of Managerial Decisions

Make or Buy Decision: Deciding whether to manufacture a product in-house or purchase it from an external supplier.

Special Order Decision: Deciding whether to accept a one-time order at a price lower than the regular selling price.

Product Mix Decision: Determining the optimal mix of products to produce and sell given resource constraints.

Sell or Process Further Decision: Deciding whether to sell a product at its current stage of production or process it further before selling.

Steps in Identifying Relevant Costs

1. Identify the alternatives being considered.
2. Determine which costs and benefits differ between the alternatives.
3. Ignore sunk costs and other costs that do not differ between alternatives.
4. Consider opportunity costs and any additional revenues or costs associated with each alternative.
5. Analyze the relevant costs and benefits to make an informed decision.

Example: Make or Buy Decision

Suppose a company is deciding whether to manufacture a component in-house or purchase it from an external supplier. The relevant costs to consider would include:

• Variable cost per unit of manufacturing the component in-house
• Purchase price per unit from the external supplier
• Any additional fixed costs associated with manufacturing in-house
• Opportunity costs, such as using the production capacity for other products

Sunk costs, such as the cost of equipment already purchased, would not be relevant to this decision.

Common Questions and Answers

Why are sunk costs irrelevant in decision making?

Sunk costs are irrelevant because they have already been incurred and cannot be changed by any future decision. Considering sunk costs in decision making may lead to suboptimal choices based on past investments rather than future benefits.

How do opportunity costs impact decision making?

Opportunity costs represent the benefits foregone by choosing one alternative over another. Considering opportunity costs ensures that managers take into account the full economic impact of their decisions, including the potential benefits of alternative courses of action.

What is the importance of incremental analysis in decision making?

Incremental analysis focuses on the additional costs and benefits associated with each alternative, ignoring costs that remain the same across all options. This approach simplifies the decision-making process and helps managers focus on the factors that differentiate the alternatives.

Conclusion

Understanding relevant costs and their role in decision making is essential for managers to allocate resources effectively and maximize profitability. By identifying relevant costs, considering opportunity costs, and applying incremental analysis, managers can make informed decisions that drive business success.