See Also: Show
Sunk Cost DefinitionWhat is sunk cost? A sunk cost is a cost that has been incurred and cannot be recovered. The
money is spent. In accounting, a sunk cost is a type of irrelevant cost. When facing a
potential project or investment, a manager must only consider relevant costs and ignore all irrelevant costs. Sunk Costs FallacyThe sunk
cost fallacy is when someone considers a sunk cost in a decision and subsequently makes a poor decision. Sunk Costs ExamplesLet’s say a company spent $5 million building an airplane. Before the plane is complete, the managers learn that it is obsolete and no airline will buy it. The
market has evolved and now the airlines want a different type of plane. What Is Relevant Cost?Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. As an example, relevant cost is used to determine whether to sell or keep a business unit. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision. Key Takeaways
Example of Relevant CostAssume, for example, a passenger rushes up to the ticket counter to purchase a ticket for a flight that is leaving in 25 minutes. The airline needs to consider the relevant costs to make a decision about the ticket price. Almost all of the costs related to adding the extra passenger have already been incurred, including the plane fuel, airport gate fee, and the salary and benefits for the entire plane’s crew. Because these costs have already been incurred, they are "sunk costs" or irrelevant costs. The only additional cost is the labor to load the passenger’s luggage and any food that is served mid-flight, so the airline bases the last-minute ticket pricing decision on just a few small costs. Types of Relevant Cost DecisionsContinue Operating vs. Closing Business UnitsA big decision for a manager is whether to close a business unit or continue to operate it, and relevant costs are the basis for the decision. Assume, for example, a chain of retail sporting goods stores is considering closing a group of stores catering to the outdoor sports market. The relevant costs are the costs that can be eliminated due to the closure, as well as the revenue lost when the stores are closed. If the costs to be eliminated are greater than the revenue lost, the outdoor stores should be closed. Make vs. BuyMake vs. buy decisions are often an issue for a company that requires component parts to create a finished product. For example, a furniture manufacturer is considering an outside vendor to assemble and stain wood cabinets, which would then be finished in-house by adding handles and other details. The relevant costs in this decision are the variable costs incurred by the manufacturer to make the wood cabinets and the price paid to the outside vendor. If the vendor can provide the component part at a lower cost, the furniture manufacturer outsources the work. Factoring in a Special OrderA special order occurs when a customer places an order near the end of the month, and prior sales have already covered the fixed cost of production for the month. If a client wants a price quote for a special order, management only considers the variable costs to produce the goods, specifically material and labor costs. Fixed costs, such as a factory lease or manager salaries, are irrelevant because the firm has already paid for those costs with prior sales. What costs are relevant to decision making?There are four types of relevant costs;. Avoidable costs.. Incremental costs.. Opportunity costs.. Future cash flows.. Which one of the following costs is not relevant for decisions?1. Sunk costs (past costs) or committed costs are not relevant. Sunk, or past, costs are monies already spent or money that is already contracted to be spent. A decision on whether or not a new endeavour is started will have no effect on this cash flow, so sunk costs cannot be relevant.
What 2 types of costs are never relevant to a decision?Two broad categories of costs are never relevant in any decision. They include: Sunk costs. Future costs that do not differ between the alternatives.
Which of the following statements is true fixed costs may be relevant in a decision avoidable costs are irrelevant costs in decisions?The answer is True
Fixed costs are irrelevant in decision making since fixed cost are unavoidable and will always be incurred no matter what the decision of the management will be.
|