Week 5 Discussion Topic:
Why do you think it is important to consider only relevant costs when conducting a differential analysis for a major purchase? Why not consider all possible costs in your decision? Be sure to provide specific examples to back up your ideas related to relevant and irrelevant costs. In addition, include in your discussion how the irrelevant costs you have identified may impact future company profits or losses if they had been included in your decision-making process.
Week 5 Discussion: Relevant and Irrelevant Costs
The purchase of any material undergoes differential analysis undertaken by the firms which considers relevant costs. Before understanding the concept of differential analysis one needs to know about the relevant costs.
Relevant costs are those costs that are affected if the decision to purchase a specific material is taken in comparison to any other alternative (Karnon, Partington & Afzali, 2021, p.2). That is why relevant costs are also known as opportunity costs i.e. the cost foregone for purchasing one alternative instead of another. Other than the relevant costs all other costs are irrelevant or sunk costs and they do not need to be considered in the purchase decision. The reason we do not consider sunk costs is due to their being unaffected whether the purchase is made or not (Olivola, 2018, p.1080). For instance, if the company decides to purchase a new truck for 50000$ for the supplier chain, the parts of the old truck originally costing 30000$ can be sold for the scrap value of 12000$ and the rest is sunk cost.
Now coming back to our concept of differential analysis, it means recognizing all those revenues and costs that differ for different alternatives. These costs are the very relevant costs that have been discussed above. Thus, we can say that the differential analysis for making a purchase decision refers to taking into consideration all the relevant costs to be incurred on the purchase and the expected revenue from the purchase to be made.
To answer the question of why sunk costs are not considered while making purchase decisions is because these costs would remain unchanged regardless of the decision of purchase. As stated earlier the example of purchasing the truck, the lost value of 18000$ on the old truck could never be recovered whether the new truck is purchased or not. To conclude irrelevant or sunk costs do not contribute to future decision-making since they remain unaffected and fixed.
Reference list:
Karnon, J., Partington, A., & Afzali, H. (2021). Strategies for avoiding neglect of opportunity costs by decision-makers. Applied Health Economics and Health Policy, 1-3.
Olivola, C. Y. (2018). The interpersonal sunk-cost effect. Psychological science, 29(7), 1072-1083.
