Relevant and Irrelevant Costs Explained.

Summary

In this session, Professor Forhat explains the concept of relevant and irrelevant costs in non-routine decisions, emphasizing their importance in making informed business choices. Relevant costs are those that differ between alternatives and affect future decisions, such as avoidable costs, variable production costs, and opportunity costs. Irrelevant costs, like sunk costs and fixed costs that don't change between options, should be disregarded. The session also highlights real-world examples, such as Adam's decision to drive or take a train to New York, to illustrate how to apply these concepts. The video aims to clarify how differential analysis is used in complex decision-making scenarios.

Takeaways

• 😀 Relevant costs are those that differ between alternatives in a decision-making process, focusing on future costs and benefits.
• 😀 Irrelevant costs are costs that remain the same regardless of the decision, such as sunk costs or costs that don’t vary between alternatives.
• 😀 A differential analysis is used to identify relevant costs, which focuses only on the differences between alternatives.
• 😀 Unavoidable costs are irrelevant because they cannot be changed, such as the cost of a machine already purchased (sunk cost).
• 😀 Routine decisions are day-to-day decisions (like paying bills), while non-routine decisions involve unique situations requiring careful consideration of relevant and irrelevant costs.
• 😀 Non-routine decisions include add or drop a product, make or buy decisions, special orders, and whether to sell a product or process it further.
• 😀 Future variable production costs (e.g., direct materials, direct labor, variable overhead) are always relevant because they change with the decision.
• 😀 Opportunity costs represent the benefit foregone by choosing one alternative over another, making them a relevant cost.
• 😀 In a practical example, Adam's trip to New York, car depreciation is irrelevant since it doesn’t change whether Adam drives or takes the train, but parking fees are relevant because they depend on his mode of transport.
• 😀 The cost of a decision is made up of both quantitative factors (like dollars) and qualitative factors (like hassle or convenience), which should be considered when making a choice.
• 😀 When considering relevant and irrelevant costs, it is important to recognize that context matters—what is relevant in one situation may be irrelevant in another.

Q & A

What are relevant costs and how are they defined in the context of non-routine decisions?

Relevant costs, also known as relevant benefits or revenues, are costs or revenues that differ between alternatives in a decision. In non-routine decisions, these costs and revenues impact the future outcome, and thus should be considered when making a choice between options.

What is differential analysis, and why is it important in decision-making?

Differential analysis involves comparing the differences in costs and revenues between alternatives. It's important in decision-making because it helps identify which costs and revenues are relevant to the decision, aiding in choosing the option that provides the best financial outcome.

How does the concept of avoidable costs relate to relevant costs?

Avoidable costs are considered relevant costs because they can be eliminated if a specific decision is made. These costs directly impact the financial outcome of a decision and are incurred only when the decision leads to them.

Why are sunk costs considered irrelevant in decision-making?

Sunk costs are costs that have already been incurred and cannot be changed. Since they do not differ between alternatives and cannot be avoided, they are irrelevant for future decision-making.

What are non-routine decisions, and how do they differ from routine decisions?

Non-routine decisions are unique, one-time decisions that require specific analysis of costs and revenues, such as add or drop a product, make or buy decisions, or special orders. Routine decisions, on the other hand, are regular, frequent tasks necessary for daily operations, like ordering supplies or paying vendors.

Can fixed costs be considered relevant costs? Under what circumstances?

Fixed costs are generally irrelevant when they remain unchanged between alternatives. However, if the fixed costs are incurred specifically for a project or decision (e.g., buying a special machine for a new project), they become relevant.

In the example with Adam considering whether to drive or take the train to New York, which costs are relevant?

Relevant costs in Adam's decision include gasoline, maintenance and repair costs, reduction in sale value, and parking fees in New York. Irrelevant costs include car depreciation, insurance, and parking fees at his school in Philadelphia.

What role do qualitative factors play in non-routine decision-making?

Qualitative factors, such as personal preference, convenience, and hassle, can influence decisions even if they are not quantifiable in financial terms. For example, Adam may prefer the comfort of the train over driving, even though the train is more expensive.

How does opportunity cost affect the decision-making process?

Opportunity cost is the benefit that is foregone when one alternative is chosen over another. It is a relevant cost in decision-making because it represents the value of what could have been gained from choosing the next best alternative.

In the Adam example, why is the cost of insurance considered irrelevant?

The cost of insurance is considered irrelevant because it does not change whether Adam drives the car or takes the train. He must pay the insurance regardless of the decision, making it a fixed cost that doesn't differ between alternatives.