Irrelevant costs, in the context of managerial accounting and decision-making, refer to costs that will not change or be affected by a management decision. These costs are not considered when deciding between different alternatives because they will remain the same regardless of the outcome of the decision.
There are two main types of irrelevant costs:
- Sunk Costs: These are costs that have already been incurred and cannot be recovered. Since these costs cannot be changed and will not affect future cash flows, they are irrelevant to decision-making. For example, if a company has spent money on research and development for a product that is now under consideration for launch, the money spent on R&D is a sunk cost. Regardless of whether the product is launched or not, that money cannot be recovered.
- Committed Costs: These are future costs that a company is obligated to incur, regardless of the decision made. For example, if a company has signed a lease for a warehouse, the future lease payments are committed costs. They have to be paid whether the company uses the warehouse or not, making them irrelevant to a decision about whether to use the warehouse for storage or sublease it to another company.
In contrast, relevant costs, which may include things like variable costs, opportunity costs, and incremental costs, do change based on the decisions a company makes, and thus should be considered in decision-making processes.
Example of Irrelevant Costs
Let’s consider a scenario where a manufacturing company is deciding whether to continue producing a product or to stop its production.
Let’s say the company produces Product A, which is not selling well. The company is considering whether to discontinue Product A and focus on its other offerings.
The costs associated with Product A include:
- $5,000 in monthly rent for the factory space (this space cannot be used for anything else)
- $1,000 in depreciation of the machinery used to produce Product A
- $3,000 in direct labor costs to produce Product A
- $2,000 in raw material costs to produce Product A
- $10,000 that was spent on a marketing study to assess the potential of Product A (already paid and completed)
In this case, the monthly rent of $5,000 and the depreciation of machinery of $1,000 are irrelevant costs. Whether they continue to produce Product A or not, they will have to pay the rent and the machinery will depreciate.
The marketing study cost of $10,000 is also an irrelevant cost because it is a sunk cost. The money has already been spent and cannot be recovered, so it should not factor into the decision about whether to continue producing Product A.
The costs that would change if they stop producing Product A are the direct labor costs of $3,000 and the raw material costs of $2,000. These are relevant costs because they can be avoided if the production of Product A stops.
So in their decision-making process, the company should focus on the relevant costs. If the profit from Product A does not cover these relevant costs, it might be financially sensible to stop its production.