Difference Between Relevant Cost and Irrelevant

Cost
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Between Relevant Cost and Irrelevant Cost

Relevant and irrelevant costs refer to a classification of costs. It

is important in the context of managerial decision-making.
Costs that are affected by a decision are relevant costs and those
costs that are not affected are irrelevant costs. As irrelevant
costs are not affected by a decision, they are ignored in decision
making.

While evaluating two alternatives, the focus of analysis is on

finding out which alternative is more profitable. The
profitability is judged by considering the revenues generated by
and costs incurred. Some costs may remain the same; but some
costs may vary between the alternatives. Proper classification of
 costs between relevant and irrelevant costs is useful in such
situations.

The situations in which the relevant and irrelevant

classification is useful are decisions regarding:
 Shutting down or carrying on a business division,
 Accepting or rejecting a special order,
 Making a product in-house or buying from outside,
 Selling a semi-finished product or processed one.
Costs that are same for various alternatives are not considered
e.g. fixed costs. Only those costs that are different for each
alternative are the relevant costs and are considered in decision
making e.g. variable costs.

Fixed costs can also be relevant if they change due to a decision.

For example, in case of idle capacity utilization; additional costs
that will be incurred for utilizing idle capacity are relevant
costs. The costs that are already incurred are irrelevant costs.
Additional costs are compared with the additional revenue from
utilizing idle capacity. If the additional revenue is greater than
the additional cost, it is profitable to utilize the idle capacity.

Various types of relevant costs are variable or marginal costs,

incremental costs, specific costs, avoidable fixed costs,
opportunity costs, etc. The irrelevant costs are fixed costs, sunk
costs, overhead costs, committed costs, historical costs, etc.

Relevant Cost:
A relevant cost is any cost that will be different among various
alternatives. Decisions apply to future, relevant costs are the
future costs rather than the historical costs. Relevant cost
describes avoidable costs that are incurred to implement
decisions.

For example, a company truck carrying some goods from city A

to city B, is loaded with one more ton of goods. The relevant
cost is the cost of loading and unloading the additional cargo,
and not the cost of the fuel, driver salary, etc. It is due to the
fact that the truck was going to the city B anyhow, and the
expenditure was already committed on fuel, drive salary, etc. It
was a sunk cost even before the decision of sending additional
cargo.

Relevant costs are also referred to as differential costs. They

differ among different alternatives. They are expected future
costs and relevant to decision making.

Types of Relevant Costs

Future Cash Flows

Cash expense, which will be incurred in future because of a

decision, is a relevant cost.

Avoidable Costs

Only the costs, which can be avoided if a particular decision is

not implemented, are relevant for decision making.
Opportunity Costs

Cash inflows, which would have to be sacrificed as a result of a

decision, are relevant costs.

Incremental Costs

Only the incremental or differential costs related to the

different alternatives, are relevant costs.

Irrelevant Cost:
Irrelevant costs are costs which are independent of the various
decisions or alternatives. They are not considered in making a
decision. Irrelevant costs may be classified into two categories
viz. sunk costs and costs which are same for different
alternatives.

Sunk cost is a cost which is already incurred. It cannot be

changed by any current or future action. For example if a new
machine is purchased to replace an old machine; the cost of old
machine would be sunk cost. Irrelevant costs are fixed costs,
sunk costs, book values, etc.

Irrelevant or sunk costs are to be ignored when deciding on a

future course of action. Otherwise, these costs could lead to a
wrong decision. For example, at the time of decision to replace
typewriters by computers, all corporations ignored the cost of
typewriters, even though some of them were bought just some
time before the decision. If the cost of typewriters had been
taken into consideration, some of the corporations could have
erred and delayed the computerization decision.

Sunk costs include costs like insurance that has already been
paid by the company, hence it cannot be affected by any future
decision. Unavoidable costs are those that the company will
incur regardless of the decision it makes, e.g. committed fixed
costs like depreciation on existing plant.

These are the costs that will be incurred in all the alternatives
being considered. As they are the same in all alternatives, these
costs become irrelevant and should not be considered in
decision making.

Types of Irrelevant Costs:

Sunk Cost

Sunk costs refer to the expenditures which have already been

incurred. Sunk costs are irrelevant, as they do not affect the
future cash flows.

Committed Costs

Future costs, which cannot be altered, are not relevant as they

will have to be incurred irrespective of the decision made.

Non-cash expenses

Non-cash expenses like depreciation are not relevant as they do

not affect the cash flows of a firm.
Overheads
General and administrative overheads, that are not affected by
the alternative decisions, are not relevant.

Similarities between Relevant and Irrelevant

Cost:

The basic costing process of both the relevant cost and

irrelevant cost is almost same. Both are based on the sound
principles and techniques of accounting and costing. Both the
costs aim at recording the various business expenses. Both want
to accurately reflect the costs in the financial statements and
records.

Both relevant costs and irrelevant costs are required to provide

estimates of average cost of production or service offering of an
organization or business. Both relevant cost and irrelevant cost
are taken into account, while determining the total cost of
operations or running a factory or business.

Usually, most variable costs are relevant as they vary depending

on selected alternative. 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.
Key Differences between Relevant and Irrelevant
Cost:
Nature

Relevant costs are usually variable in nature, while irrelevant

costs are usually fixed in nature.

Coverage

The relevant costs are mainly related to the operational or

recurring expenditures, whereas the irrelevant costs are mainly
related to the capital or one-off expenditures.

Time Horizon

The relevant costs are usually related to the short term, while
the irrelevant costs are usually related to the long term.

Level

The relevant costs are incurred mainly by the lower

management, whereas the irrelevant costs are mainly incurred
by top management.

Scope

The relevant costs are usually related to a particular division or

section, whereas the irrelevant costs are usually related to
organization wide activities.

Focus
The relevant costs are focused on daily or routine activities,
whereas the irrelevant costs are focused on non-routine
activities.

Avoidance

The relevant costs may be avoided, whereas the irrelevant costs

are usually unavoidable.

Effect of a New Decision

Relevant costs are affected by a new decision. Irrelevant costs

have to be incurred irrespective of a new decision.

Effect on Future Cash Flows

The relevant costs affect the future cash flows, whereas the
irrelevant costs do not affect future cash flows.

Types

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.

Relevant Cost and Irrelevant Cost – Main

Differences:

Criterion Relevant Cost Irrelevant Cost

Nature Variable. Fixed
Operational or recurring
Coverage Capital or one-off expenditures
expenditures
Time Horizon Usually short term Usually long term
 Incurred mainly by lower Incurred mainly by top
Level
management management
Usually related to a division or Usually related to organization
Scope
section wide activities
Focus Daily or routine activities Non-routine activities
Avoidance May be avoided Usually unavoidable
Effect of a New Incurred irrespective of a new
Affected by a new decision.
Decision decision.
Effect on Future Future cash flows are affected by Irrelevant costs do not affect
Cash Flows relevant costs. future cash flows.
committed costs, sunk costs,
Incremental costs, avoidable costs,
Type overhead costs, non-cash
opportunity costs, etc.
expenses.

Summary:

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.

The difference between relevant and irrelevant cost is based on

whether the cost will have to be incurred additionally due to a
new decision. Sometimes, it is difficult to clearly distinguish
between the two. Yet, it helps in make or buy decision,
accepting or rejecting an offer, extra shift decision, plant
replacement, foreign market entry, shut down decisions,
analyzing profitability, etc.
 Relevant Cost vs. Irrelevant Cost
– All You Need to Know
Relevant and Irrelevant costs are the classification of cost based on
their importance. Cost data is vital for a business as it helps in
decision making regarding maximizing profit or meeting other
business objectives. But, not all costs are essential to a company
when making a particular decision. Thus, to improve decision
making or to make better decisions, a business needs to understand
the difference between relevant cost vs. irrelevant cost.

When a company faces two or more alternatives, the choice

depends on the more profitable option. The profitability, in turn,
hinges on the revenue and cost of each option. Some costs would
vary for each option, while some costs are the same. Thus, we must
classify costs as relevant and irrelevant to make a better decision.

Table of Contents
1. Relevant cost vs. Irrelevant Cost – Differences
1. Meaning
2. Relevance
3. What does it include?
4. Nature
5. Time Horizon
6. Who Spends it?
7. Effect on Cash Flows
8. Avoiding Cost
9. Example
2. Final Words

Following are some situations when differentiating between relevant

cost vs. irrelevant cost is essential:

 Closing a division, or starting a new department.

 Whether or not to accept special orders.
 To outsource or produce a product in-house.
 To buy a new machine or use an existing one.
Relevant cost vs. Irrelevant Cost –
Differences
Following are the differences between relevant cost vs. irrelevant
cost:

Meaning
Relevant costs, as the name suggests, are the cost that is affected
by the decision that the company or manager takes. Or, we can say
these costs change with each choice. On the other hand, managerial
choices do not affect irrelevant costs. Since irrelevant costs remain
unaffected by a decision, businesses often ignore these costs.

Relevance
Relevant costs play a crucial role when a company has several
alternatives to choose from. Irrelevant costs have no bearing when
selecting from different options. Irrelevant costs are not useful from
the point of decision making, but they are as helpful as relevant
costs due to the following reason:

 A company needs both the cost to come up with the average

cost of production or service.
 Both costs also help to determine the total cost of operations.
 A company records both costs in the financial statements.
What does it include?
Relevant costs include the expected costs that a company plans to
incur. It may consist of differential, avoidable, and opportunity
costs. Differential cost is the cost gap or difference between the two
choices. Avoidable costs are the cost that a company can avoid by
making one choice over another. Opportunity costs are the revenues
that a company foregoes by making one decision over another.

Irrelevant costs, on the other hand, include sunk costs and

unavoidable costs or fixed costs. Sunk costs include the actual costs
or the expenses that the company has already incurred.
Fixed costs can be relevant if it varies based on the decision. For
example, fixed costs that a company incurs to utilize idle capacity
are relevant costs. Thus, we can say that avoidable fixed costs are
relevant.

Nature
Relevant costs are generally variable. Or, we can say they are
operational or recurring expenditures. Irrelevant costs, on the other
hand, are usually fixed in nature or relate to the capital or one-off
spending.

Time Horizon
Relevant costs usually relate to the short-term. Irrelevant costs are
generally for the long-term as they are mostly capital or one-off
expenditures. In the long-term, however, most costs are relevant.
For instance, if a company is planning for ten years ahead, then it
would consider all types of cost, including the fixed and sunk cost
that it might incur.

Who Spends it?

Usually, lower management incurs the relevant costs, while top
management oversees the spending of the irrelevant costs.

Effect on Cash Flows

Relevant costs affect future cash flows. Irrelevant costs do not have
any effect on future cash flows.

Avoiding Cost
A company must not avoid relevant costs when making a decision.
One must consider them in all managerial analysis and the
calculations. On the other hand, a company must avoid irrelevant
costs when deciding as it could cause you to make the wrong
choice. Also, one must not consider them in managerial analysis and
calculations.
Example
Company A is using a two-year-old machine costing $24,000. The
company uses straight-line depreciation, while the machine has a
useful life of 10 years.

Company A is considering buying another machine costing $45,000

with a useful life of 9 years. The new machine won’t have any effect
on the number of units that a company produces. Company A,
however, expects the variable cost to come down from $34,000 to
$22,000. Fixed costs will also be the same at $20,000.

In this case, depreciation ($2,400) on the old machine is an

irrelevant cost. The company would have to depreciate the old
machine irrespective of whether or not it buys a new machine. Also,
the cost of the old machine is irrelevant (a sunk cost). The fixed
cost of $20,000 is also not relevant as a company would have to
incur it whether or not it buys a new machine.

Here depreciation of New Machine, say $4500 will be relevant cost.

Company A will incur this cost only if it decides to buy the new
machine. Another relevant cost will be the variable cost as Company
A will save $12,000 because of the new machine.

Thus, the depreciation on the new machine and variable cost saving
is the only relevant cost. Based on these two costs, Company A will
have a net saving of $7,500 ($12,000 Less $4,500) if it buys a new
machine.