Relevant Costs Defined
Relevant Costs Defined
Relevant costs possess two characteristics:
(1) They are future costs and
(2) They differ across alternatives.
All pending decisions relate to the future; accordingly, only future costs can be relevant to decisions. However, to be relevant, a cost must not only be a future cost but must also differ from one alternative to another.
If a future cost is the same for more than one alternative, then it has no effect on the decision. Such a cost is irrelevant. The same relevance characteristics also apply to benefits. One alternative may produce an amount of future benefits different from another alternative (e.g., differences in future revenues).
If future benefits differ across alternatives, then they are relevant and should be included in the analysis. The ability to identify relevant and irrelevant costs (and revenues) is a very important decision-making skill. Another type of relevant cost is opportunity cost.
Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over another. Therefore, an opportunity cost is relevant because it is both a future cost and one that differs across alternatives. While an opportunity cost is never an accounting cost, because accountants do not record the cost of what might happen in the future (i.e., they do not appear in financial statements), it is an important consideration in decision making. For example, if you are deciding whether to work full time or to go to school full time, the opportunity cost of going to school would be the wages you give up by not working. Companies also include opportunity costs in many of their decision analyses.
Depreciation represents an allocation of a cost already incurred. It is a sunk cost, a cost that cannot be affected by any future action. Although we allocate this sunk cost to future periods and call that allocation depreciation, none of the original cost is avoidable. Sunk costs are always the same across
Relevant costs possess two characteristics:
(1) They are future costs and
(2) They differ across alternatives.
All pending decisions relate to the future; accordingly, only future costs can be relevant to decisions. However, to be relevant, a cost must not only be a future cost but must also differ from one alternative to another.
If a future cost is the same for more than one alternative, then it has no effect on the decision. Such a cost is irrelevant. The same relevance characteristics also apply to benefits. One alternative may produce an amount of future benefits different from another alternative (e.g., differences in future revenues).
If future benefits differ across alternatives, then they are relevant and should be included in the analysis. The ability to identify relevant and irrelevant costs (and revenues) is a very important decision-making skill. Another type of relevant cost is opportunity cost.
Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over another. Therefore, an opportunity cost is relevant because it is both a future cost and one that differs across alternatives. While an opportunity cost is never an accounting cost, because accountants do not record the cost of what might happen in the future (i.e., they do not appear in financial statements), it is an important consideration in decision making. For example, if you are deciding whether to work full time or to go to school full time, the opportunity cost of going to school would be the wages you give up by not working. Companies also include opportunity costs in many of their decision analyses.
Depreciation represents an allocation of a cost already incurred. It is a sunk cost, a cost that cannot be affected by any future action. Although we allocate this sunk cost to future periods and call that allocation depreciation, none of the original cost is avoidable. Sunk costs are always the same across
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