Module 16
Relevant Costs
and Benefits for
Decision Making
Relevant and Irrelevant Costs


Relevant
Irrelevant
Future costs that
differ among
competing decision
alternatives
Future costs that
DO NOT differ among
competing decision
alternatives
Primary focus is profit maximization
Additional factors that should be considered
 Effects on long-run profit
 Nonquantitative factors
 Such as legal, ethical, social
Sunk Costs



Result from past decisions that cannot be
changed
Sunk costs are NEVER relevant
Sunk costs in decisions to replace a machine


Book value of old machine
Can cause ethical dilemmas

Managers often avoid disposing of old assets

Disposing may create a loss on the income statement,
making the manager’s performance look bad and decrease
their bonuses!
Disposal and Salvage Values

Disposal value
Amount of cash an old asset can be sold for at the
time the new asset is purchased
 Relevant cash inflow



Obtained only if the replacement alternative is accepted
Salvage value

Amount of cash an asset will bring at the end of its
useful life if held to that time
Opportunity Costs

Any benefit forgone as a result of rejecting
one alternative in favor of another
Make or Buy
Do we make a product, part, or service or do we
purchase it from the outside?
 Compare the total cost of purchasing with the
internal costs that may be saved (avoided) by
purchasing.
 Be careful on the long-term effects of such a
decision on quality and stability

Special Sales Orders
Do we accept a low priced sales order?
 Compare the additional revenues with the
differential costs.
 Be careful on sales to direct competitors,
especially retailers, as an price differences may
have to be defended in court. Only cost
differences allowed.

Budget Alternatives
Which alternative is best? Dropping products,
changing prices, advertising increases…
 Select the alternative with the highest positive
impact on profits?

Sell or Process Further
Do we sell products as is or process them further?
 Compare the increase in revenues with the
increase in costs.
 Joint products are a special case of this.

Use of Limited Resources
Which products or services do we produce with
our limited resources?
 Select the products first with the highest
contribution margin per unit of limited resource,
subject to sales and other constraints.

Equipment Replacement
How do we decide to replace a working piece of
equipment?
 Compare the impact on profits over the life of the
new equipment with the net cost of the new
equipment.
 Be sure to net out the disposal value of the old
equipment from the cost of the new equipment.
 Note that taxes saved from disposal losses can be
relevant in real situations.
