Management decision making often involves first determining what information is relevant to the decision-making process. Understanding cost behavior and relevance allows managers to streamline the decision-making process. Profitability depends on the accurate interpretation of the revenues and costs associated with each decision. Determining the difference between relevant and irrelevant costs makes the decision process more efficient and accurate.
Evaluate relevant versus irrelevant information, and provide an example of each irrelevant cost discussed in your text.
Propose a scenario when differentiating between relevant and irrelevant costs is essential to the decision-making process.
Justify the reason that an opportunity cost would or would not be relevant to decision making. Use specific business examples.
Full Answer Section
Irrelevant information includes:
- Sunk costs.
- Historical costs.
- Costs that are the same for each alternative.
Examples of irrelevant costs
- Sunk costs are costs that have already been incurred and cannot be recovered. For example, the cost of a machine that is no longer being used is a sunk cost.
- Historical costs are costs that have been incurred in the past. For example, the cost of advertising a product last year is a historical cost.
- Costs that are the same for each alternative are irrelevant because they do not affect the decision. For example, the cost of electricity is the same whether a company produces 100 widgets or 1000 widgets.
Scenario when differentiating between relevant and irrelevant costs is essential to the decision-making process
A scenario when differentiating between relevant and irrelevant costs is essential to the decision-making process is when a company is considering whether to discontinue a product line. In this case, the company needs to consider the relevant costs of continuing to produce the product line, such as the variable costs and the opportunity costs, and compare them to the revenue that the product line generates. The irrelevant costs, such as the sunk costs and the fixed costs, should not be considered in this decision.
Reason why an opportunity cost would or would not be relevant to decision making
An opportunity cost is the cost of the next best alternative. For example, if a company is considering whether to invest in a new project, the opportunity cost of the investment is the return that the company could earn by investing in the next best alternative.
An opportunity cost is relevant to decision making if it is a cost that will be incurred if a particular decision is made. For example, if a company is considering whether to discontinue a product line, the opportunity cost of discontinuing the product line is the revenue that the company would lose by discontinuing the product line.
An opportunity cost is not relevant to decision making if it is a cost that will not be incurred if a particular decision is made. For example, the sunk costs are not relevant to the decision of whether to discontinue a product line because the sunk costs have already been incurred and cannot be recovered.
Specific business examples
Here are some specific business examples of relevant and irrelevant costs:
- A company is considering whether to open a new store. The relevant costs for this decision include the cost of rent, the cost of inventory, and the cost of labor. The irrelevant costs for this decision include the cost of the land, which has already been purchased, and the cost of the building, which has already been built.
- A company is considering whether to discontinue a product line. The relevant costs for this decision include the variable costs of producing the product line and the opportunity cost of the sales that would be lost if the product line is discontinued. The irrelevant costs for this decision include the fixed costs of producing the product line, which would still be incurred even if the product line is discontinued.
Sample Answer
Relevant versus irrelevant information
Relevant information is information that is helpful in making a decision. Irrelevant information is information that is not helpful in making a decision.
In the context of management decision making, relevant information includes:
- The costs and benefits of each alternative.
- The potential impact of each alternative on future profits.
- The probability of each alternative occurring.