Relevant vs Irrelevant Costs
The classification of costs between relevant costs and irrelevant costs is important in the context of managerial decision-making.
In any managerial decision involving two or more alternatives, the prime focus of analysis is to find out which alternative is more profitable. The profitability of alternatives is determined by considering the revenues generated by and costs incurred under each alternative. Some costs may stay the same regardless of which alternative is chosen while some costs may vary between the alternatives. The classification between relevant and irrelevant costs is useful in such situations.
Examples of situations in which the relevant vs irrelevant classification is useful include decisions regarding:
- Shutting down a division of a business,
- Accepting an special order at lower price,
- Making a product in-house or purchasing it from outside,
- Selling a semi-finished product or processing it further, etc.
Relevant costs are costs that are affected by a managerial decision in a particular business situation. In other words these are the costs which shall be incurred in one managerial alternative and avoided in another. As the name suggests they are ‘relevant’ for managerial analysis and should be considered in all calculations made for the purpose.
Irrelevant costs are costs that are not affected by the ultimate decision. In other words, these are the costs which shall be incurred in the all managerial alternatives being considered. Since they are the same in all alternatives, they become irrelevant and need not be considered in calculations made for managerial analysis.
Vital Industries is a company that manufactures personal care products. It has three divisions: hair care, skin care and dental care. Following is an extract from the financial statements for the year ending 31 December 2014:
|Hair Care||Skin Care||Dental Care|
|Revenue||$900 million||$600 million||$300 million|
|Net income/(loss)||$210 million||$100 million||($50 million)|
In the board meeting summoned for review of financial statements, a director proposed that the company should dispose of the dental care division because it is loosing money. The CEO argued that the board can’t conclude that a segment is losing money just because it generated net loss for a period. He suggested that the company’s chief financial officer should conduct a detailed analysis for presentation in the next board meeting. Being the company’s management accountant, the CFO asked you to identify which of the following costs are relevant for the decision:
- CEO’s salary
- Salaries of Dental Care workers who can be laid-off
- Salaries of Dental Care workers who can’t be laid-off
- One-time retirement benefits to be paid to laid-off workers
- Cost of raw materials consumed by Dental Care division
- Annual directors’ fee
- Interest paid on loans raised for Dental Care division
- Salary of the Dental Care chief operating officer
- Company-wide quality certification fee
- License fee paid for the rights to manufacture dental care products
- Head office rent
- Audit fee (if it doesn’t depends on the number of divisions)
We have two alternatives: (a) dental care division is sold off and (b) dental care division continues to operate. Identifying relevant costs and irrelevant costs is easy when we see if a cost changes between two alternatives or not. If it changes it is relevant, if it doesn’t it is irrelevant.
- CEO’s salary is irrelevant because it shall remain the same whether the dental care division exists or it is disposed off.
- Salaries of employees who can be laid off is relevant because the cost shall continue to be incurred if the division exists but it shall be reduced to zero if the division is disposed off.
- Salaries of employees who can’t be laid-off is irrelevant because it shall continue to be incurred regardless of whether the division is disposed off or not.
- One-time retirement benefits cost is relevant because it shall be incurred only if the division is disposed off. If the division continues to operate, the cost shall continue to be incurred.
- Cost of raw materials is relevant cost because it shall be zero if the division no longer operates because then there will be no production.
- Annual directors fee is irrelevant cost because it shall stay the same even if dental care is disposed off.
- Interest paid on dental care division loans is relevant because if the division is sold off the loan could be paid off which shall cease the interest cost.
- Salary of the dental care chief operating officer is relevant because he will most likely lose his job. If he is accommodated in another division, this cost shall be irrelevant.
- Company-wide quality certification fee is irrelevant because it shall continue to be incurred even if dental care division is no longer there.
- License fee paid for manufacturing dental care products is a relevant cost because it shall cease with disposal of the division.
- Head office rent is irrelevant because it shall remain the same regardless of the number of divisions. If a division is sold-off, head-office will still exist and the office rent shall be incurred.
- Audit fee is irrelevant if it does not depend on the number of divisions. Audit shall be conducted even if there is one division less.
Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork