This lesson covers the critical concept of relevant costs and benefits, which is the foundation of differential decision-making. It explains the distinction between relevant and irrelevant costs, including sunk costs, opportunity costs, avoidable costs, and allocated fixed costs, as covered in both US and European management accounting curricula.

• The Concept of Relevant Costs and Benefits: Relevant costs or benefits are defined as costs or benefits that differ between alternatives. If a cost or benefit does not differ between alternatives, it is not considered relevant to the decision. The underlying theory is that costs or benefits that do not differ would not change regardless of which decision is made, so it is not necessary to consider them when making a decision.

• Characteristics of Relevant Costs:

  • Future-Oriented: Relevant costs are always future costs. Past costs have already been incurred and cannot be changed by a current decision.

  • Differ Between Alternatives: A cost is only relevant if it differs between the alternatives being considered.

• Types of Costs – Relevant vs. Irrelevant: A key skill is classifying costs correctly:

  • Sunk Costs: Costs that have already been incurred and cannot be avoided. They are not relevant to a decision. For example, the cost of a car you would drive to a restaurant is a sunk cost when deciding where to eat.

  • Opportunity Costs: The value of the next best alternative foregone. This is a relevant cost because it represents a benefit that is sacrificed by choosing one alternative over another.

  • Avoidable Costs: Costs that can be eliminated by choosing a particular alternative. Avoidable costs are always relevant.

  • Unavoidable Costs: Costs that will continue regardless of the decision. They are not relevant.

• Fixed Costs in Decision Analysis: Fixed costs are more difficult to analyse since some fixed costs are generated by a particular segment and some fixed costs are common to multiple segments. Therefore, fixed costs are divided into two categories:

  • Avoidable Fixed Costs: Fixed costs that can be traced directly to a segment and would be avoided if the segment were eliminated. Since these fixed costs can be avoided they are relevant to the decision.

  • Allocated Fixed Costs (Unavoidable): Fixed costs that are common to, or shared by, more than one segment. Allocated fixed costs are not relevant to a segment decision if they would not be eliminated if the segment were eliminated. For example, if two departments share the same building, the rent is an allocated fixed cost that would continue regardless of which department is eliminated.