Costs, when classified according to usefulness in decision-making, may be classified into relevant and irrelevant costs.
Cost data are important since they are the basis in making decisions that are geared towards maximizing profit, or attaining other objectives.
However, not all costs are important in decision-making. Relevant costs refer to those that will differ between different alternatives. Irrelevant costs are those that will not cause any difference when choosing one alternative over another.
As mentioned earlier, relevant costs are those that will differ between different alternatives. Relevant costs include expected costs to be incurred as well as benefits forgone when choosing one alternative over another (opportunity costs).
The difference in costs in choosing one alternative over another is known as differential cost. Incremental cost refers to the increase in cost when choosing an alternative. These terms are often used interchangeably.
Irrelevant costs do not have any bearing when choosing over different alternatives. They do not make any difference and make no impact in making decisions. Irrelevant costs include sunk costs and unavoidable costs.
Sunk costs include historical costs that have been taken up or paid by the company, hence will not be affected by future decisions. Unavoidable costs are those that the company will incur regardless of the decision it makes. Good examples include committed fixed costs such as insurance and current depreciation.
ABC Company is currently using a machine it purchased for $50,000 two years ago. It is depreciated using the straight-line depreciation over its useful life of 10 years. The company is contemplating on buying a machine worth $80,000. The new machine will have a useful life of 8 years. Though units produced will stay the same, the company expects a significant decrease in variable costs from $68,000 to $50,000, annually. Fixed costs other than depreciation expense will remain at $40,000.
a.) The depreciation of the old machine, $5,000, is irrelevant since the company will continue to depreciate the machine until the end of its useful life. Whether the company purchases the new equipment or not, it will still incur the $5,000 depreciation. Take note that the company has already paid for the old machine (a sunk cost).
b.) The depreciation of the new machine, $10,000, is relevant since the company will incur such cost only when it decides to buy the new machine.
c.) The variable costs are relevant since the total variable cost will be different if the company chooses to replace the machine. The company will save $18,000.
d.) The other fixed costs of $40,000 are irrelevant since it will not differ under the two choices.
e.) After analyzing the relevant costs, the company will have net annual savings of $8,000. The company will be able to decrease its variable costs by $18,000 but will incur in incremental costs of $10,000 due to increase in depreciation.