1. Defining Financial Relevancy
For short-term tactical choices, managers must filter out irrelevant accounting data and focus strictly on Relevant Costs. A cost is relevant only if it meets two strict criteria:
- It is a Future Cost: Costs incurred in the past cannot be altered by a current choice and must be ignored.
- It is an Incremental (Differential) Cost: The cash outflow must change directly as a result of choosing one alternative over another.
2. Sunk Costs, Committed Costs, and Opportunity Costs
- Sunk Costs: Past cash outflows that cannot be recovered (e.g., a $50,000 market research study signed last year). Sunk costs are completely irrelevant to future decisions.
- Committed Costs: Future expenditures that cannot be avoided because of existing legal or structural obligations (e.g., a multi-year building lease).
- Opportunity Costs: The net economic benefit given up by choosing one alternative over the next best option (e.g., using a factory floor to build Product X means losing $12,000 in potential rent from an outside tenant).
3. Non-Cash Allocations
General corporate overhead allocations, book depreciation, and historical asset valuations are non-cash accounting adjustments. They do not alter actual future cash flows, meaning they are irrelevant for short-term tactical decisions.
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