Management decision making often involves first determining what information is relevant to the decision-making process. Understanding cost behavior and relevance allows managers to streamline the decision-making process. Profitability depends on the accurate interpretation of the revenues and costs associated with each decision. Determining the difference between relevant and irrelevant costs makes the decision process more efficient and accurate.
Evaluate relevant versus irrelevant information, and provide an example of each irrelevant cost discussed in your text.
Propose a scenario when differentiating between relevant and irrelevant costs is essential to the decision-making process.
Justify the reason that an opportunity cost would or would not be relevant to decision making. Use specific business examples.
Full Answer Section
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Committed costs: These are costs that have been contracted for and cannot be changed, regardless of the decision made. For example, the cost of a lease agreement is a committed cost.
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Avoidable costs: These are costs that can be avoided by choosing one alternative over another. For example, the cost of shipping a product by air is an avoidable cost if the product can also be shipped by ground.
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Fixed costs: These are costs that do not change with the level of output. For example, the cost of rent is a fixed cost.
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Irrelevant information is any information that does not affect the decision being made. This includes irrelevant costs, as well as irrelevant benefits, revenues, and other factors.
Here is a scenario when differentiating between relevant and irrelevant costs is essential to the decision-making process:
A company is considering whether to discontinue a product line. The company has been losing money on the product line for the past few years. However, the company has already invested a lot of money in the product line, and it would be difficult to get rid of it.
In this scenario, the relevant costs are the future costs of continuing to produce the product line. These costs include the cost of materials, labor, and overhead. The irrelevant costs are the sunk costs, such as the cost of developing the product line.
The company needs to consider the relevant costs carefully before making a decision about whether to discontinue the product line. If the future costs of continuing to produce the product line are higher than the revenue that the product line generates, then the company should discontinue the product line.
- Opportunity cost is the benefit that is lost by choosing one alternative over another. Opportunity costs are always relevant costs, even if they are not monetary costs.
For example, a company is considering whether to open a new factory. The opportunity cost of opening the new factory is the profit that the company could have made by investing the money in another project.
In general, opportunity costs should be considered in all decision-making situations. By considering opportunity costs, managers can make sure that they are making the best decision for the company.
Here are some specific business examples of opportunity costs:
- A company decides not to expand its production capacity. The opportunity cost is the lost profit that the company could have made by producing and selling more products.
- A company decides to lay off employees. The opportunity cost is the lost productivity of the employees.
- A company decides to invest in a new technology. The opportunity cost is the lost profit that the company could have made by investing in another technology.