Relevant and irrelevant costs

Q: What are the three criteria that define a relevant cost for decision-making?

A cost is relevant if it is a future cost, an incremental cost, and a cash flow .

BA2 – Fundamentals of Management Accounting · CIMA (CGMA Professional Qualification) · 6 min read

Introduction to Relevant and Irrelevant Costs

Welcome to one of the most practical chapters in your BA2 journey! In Management Accounting, we aren't just bean-counters looking at what happened in the past. We are often asked to help managers make decisions about the future. Should we accept a special order? Should we close a department? To answer these, we need to distinguish between costs that actually matter for the decision and those that don't.

Think of it like deciding whether to buy a new phone. The money you spent on your current phone two years ago shouldn't affect your decision today—that money is gone! This chapter will teach you how to filter out the "noise" and focus only on the numbers that change based on your choices.

What Makes a Cost "Relevant"?

For a cost to be considered relevant to a decision, it must meet three specific criteria. If it fails even one of these, you should ignore it when doing your calculations.

You can remember this using the mnemonic "F-I-C":

1. Future: It must be a cost that will occur in the future. Past costs (what we call sunk costs) are irrelevant because we cannot change them.
2. Incremental: It must be an "extra" cost. If the cost stays exactly the same regardless of which path you choose, it doesn't help you make the decision.
3. Cash Flow: It must be an actual movement of cash. Non-cash items (like depreciation) are not relevant.

Key Takeaway: Relevant costs are future, incremental, cash flows. If a cost doesn't change your bank balance because of the decision you are making right now, ignore it!

The "Ignore" List: Irrelevant Costs

Don't worry if this feels a bit counter-intuitive at first. In accounting, we are often told to include every single cost. But for decision-making, we have to be picky! Here are the most common items you should exclude:

1. Sunk Costs

A sunk cost is money that has already been spent or a debt that has already been incurred.
Example: You spent \$500 on a marketing report last month. Today, you are deciding whether to launch the product. The \$500 is "sunk." Whether you launch the product or not, that \$500 is gone. \n

\nCommon Mistake: Students often want to include "Book Values" of old machinery. The book value is just an accounting entry based on past costs. Only the current resale value or the cost of a replacement is relevant!\n

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2. Committed Costs

\nThese are future costs that you cannot avoid, usually because of a contract you've already signed.\n
\nExample: If you signed a non-cancellable 12-month lease for a warehouse, that rent is a committed cost. Even if you decide to stop production tomorrow, you still have to pay that rent. \n

\n

3. Non-Cash Items

\nThe most famous non-cash item is depreciation. Depreciation is just a way of spreading the cost of an asset over its life. It isn't a check you write every month.\n

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4. Apportioned General Overheads

\nManagement often adds a "share" of head office costs (like the CEO's salary or HR costs) to a department's budget. These are often called absorbed or apportioned overheads. Unless the CEO's salary actually increases because of your decision, these general shares are irrelevant.\n

\nQuick Review: If you see the words "allocated," "apportioned," "sunk," or "depreciation" in an exam question, a red flag should go up! They are usually irrelevant.\n\n

Opportunity Costs: The "Hidden" Cost

\nThis is a concept that can be tricky, but it’s very important for your BA2 exam. An opportunity cost is the benefit sacrificed by choosing one physical option over the next best alternative.\n

\nEveryday Analogy: If you spend two hours tonight studying BA2, the "cost" isn't just your pens and paper. It's also the 2 hours of sleep you gave up, or the \$20 you could have earned working a part-time shift.

In Management Accounting, we include opportunity costs as a relevant cost.
Scenario: A company is considering using a machine for a special project. If they use the machine for the project, they cannot use it to make their normal products, which would have earned them \$1,000 in contribution. \n
\nThe Relevant Cost of using that machine = $ \$1,000 $ (The lost contribution).

Key Takeaway: Opportunity cost is the value of the benefit lost. It represents what you "gave up" to make your choice.

The Relevant Cost of Materials

When a question asks for the relevant cost of materials, follow this step-by-step logic. It’s like a "decision tree":

Step 1: Do we already have the materials in stock?
- No: The relevant cost is the current purchase price.
- Yes: Go to Step 2.

Step 2: If we have them in stock, are we using them regularly?
- Yes (Regular use): If we use them for this project, we have to buy more to replace them. The relevant cost is the current replacement cost.
- No (Obsolete/Surplus): Go to Step 3.

Step 3: If they are surplus/obsolete, do they have another use?
- Can we sell them? The relevant cost is the Net Realizable Value (scrap value) you lose by using them.
- Can we use them for something else? The relevant cost is the opportunity cost (the cost saved elsewhere).

Did you know? If the materials are already in stock, have no resale value, and no other use, the relevant cost is actually zero!

The Relevant Cost of Labour

Similar to materials, we have to ask: "Does the company's total cash payout for wages change?"

1. If there is spare capacity: If workers are being paid anyway but have nothing to do, the relevant cost of their time is zero.
2. If we need to hire new workers: The relevant cost is the actual wages paid to them.
3. If labour is "scarce" (no spare time): If we take workers off their normal jobs to do a special project, the relevant cost is:
$ \text{Relevant Cost} = \text{Variable cost of labor} + \text{Contribution lost from the normal job} $

Example: A worker earns \$15 per hour. To do a special job, he is moved away from making Product X, which earns the company \$10 of contribution per hour (after paying his wages).
The relevant cost of his time is $ \$15 + \$10 = \$25 $ per hour.

Summary Checklist for Exam Success

Before you move on to practice questions, keep this mental checklist handy:

- Is it in the future? (If it's past/sunk, ignore it).
- Is it cash? (If it's depreciation, ignore it).
- Is it incremental? (Does the total cost change because of this decision? If not, ignore it).
- Is there an opportunity cost? (Am I giving something up to do this?).

Don't worry if this seems tricky at first! The key is to stop thinking like a bookkeeper and start thinking like a business owner. Ask yourself: "How much extra cash will leave my pocket if I say 'Yes' to this proposal?" That is your relevant cost.

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What are the three criteria that define a relevant cost for decision-making?

A cost is relevant if it is a future cost, an incremental cost, and a cash flow.

Why are sunk costs excluded from the decision-making process?

Sunk costs are past costs that have already been incurred and cannot be recovered, meaning they do not change based on future decisions.

What characterizes a committed cost in management accounting?

A committed cost is a future cost that cannot be avoided because of a prior obligation or contract.

Why is depreciation typically treated as an irrelevant cost?

Depreciation is a non-cash accounting entry that allocates the cost of an asset over time rather than representing an actual movement of cash.

When should apportioned general overheads be considered irrelevant?

They are irrelevant when they represent a shared allocation of existing head office costs that will not change in total due to the decision.

How is an opportunity cost defined in the context of business decisions?

An opportunity cost is the value of the benefit sacrificed when choosing one course of action over the next best alternative.

What determines the relevant cost of materials required for a project?

The relevant cost depends on whether the materials are in stock, and if so, whether they are used regularly or are obsolete.

How is the relevant cost of labour calculated when workers must be diverted from their normal tasks?

$ \text{Relevant Cost} = \text{Variable cost of labour} + \text{Contribution lost from the normal job} $

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