BUSF_A01.qxd

Chapter 2 • A framework for financial decision making

Relevant and irrelevant costs

Tariq Ltd is a business that owns a machine that cost £5,000 when it was bought new a year

ago. Now the business finds that it has no further use for the machine. Enquiries reveal that

it could be sold in its present state for £2,000, or it could be modified at a cost of £500 and

sold for £3,000.

Assuming that the objective of the business is to make as much money as possible, what

should it do, sell the machine modified or unmodified?

Example 2.1

If the machine is modified, there will be a net cash receipt of £2,500 (that is, £3,000 less

£500). If the machine is not modified there will be a cash receipt of £2,000. Clearly, given that

the business’s aim is to make as much money as possible, it will modify and sell the machine

as this will make the business richer than the alternative.

Note that the original cost of the machine is irrelevant to this decision. This is because

it is a past cost and one that cannot now be undone. As a past cost it is common to both

possible future courses of action. The machine originally cost £5,000 irrespective of what is

now to happen.

Solution

It is important therefore to recognise what information is relevant to the decision

and what is not. Often, gathering the information can be costly and time-consuming,

and so restricting it to the relevant may well lead to considerable savings in the costs

Good decision making requires that the horizon should constantly be surveyed for

opportunities that will better enable the objectives to be achieved. In the business finance

context, this includes spotting new investment opportunities and the means to finance

them. Such opportunities will not often make themselves obvious, and businesses need

to be searching for them constantly. A business failing to do so will almost certainly be

heading into decline, and opportunities will be lost to its more innovative competitors.

Step 3: Assemble data relevant to the decision

Each possible course of action must be reviewed and the relevant data identified. Not

all data on a particular course of action are relevant. Suppose that a person wishes to

buy a car of a particular engine size, the only objective being to get the one with the

best trade-off between reliability and cost. Only data related to reliability and cost of

the cars available will be of any interest to that person. Other information, such as

colour, design or country of manufacture, is irrelevant. That is not to say that a car

buyer’s objectives should be restricted to considerations of cost and reliability, simply

that, if they are the only important issues in a particular case, then other factors

become irrelevant.

Even some data that bear directly on running cost, such as road tax, should be

ignored if they are common to all cars of the engine size concerned. As decisions

involve selecting from options, it is on the basis of differences between options that the

decision can sensibly be made. If the decision were between owning or not owning

a car, then road tax would become relevant as it is one of the costs of car ownership.

It will not be incurred if the car is not bought. If common factors are irrelevant to

decision making, then past costs must be irrelevant, since they must be the same for

all possible courses of action.