a) Describe the main factors in classifying costs as either relevant or irrelevant for management decision-making purposes.

The function of decision-making is to select a course of action for the future that is most likely to satisfy the objectives of the business. Relevant costs and benefits for decision-making can simply be explained as those costs and benefits that will be affected by the decision. The main factors to consider in classifying costs as relevant or irrelevant to a decision can be considered under the following four headings:

Historic and sunk costs are costs of a historic nature, which are generally referred to as sunk costs, are incurred as a result of past decisions and are therefore irrelevant to the decision-making process. Sunk costs are historical costs which cannot be changed no matter what future action is taken. Sunk costs are easily identifiable as they will have been paid for, or are owed under a legally binding contract. 

Incremental costs and benefits are the changes in future costs and benefits that will occur as a result of a decision. Ultimately if a future cost or revenue is not going to change as a result of a decision, then it is irrelevant to the decision and should be ignored in the decision-making process. 

Opportunity costs occur where there are mutually exclusive alternatives from which a business must choose one. An opportunity cost is the cash benefit sacrificed in favour of a particular course of action. It is the highest alternative benefit foregone by choosing a specific course of action. Suppose a business has 3 mutually exclusive options available to it of which the net profits are, option A €100,000, option B €80,000 and option C €60,000. Since only one option can be selected, option A is chosen as it provides the biggest benefit. The opportunity cost associated with this course of action is the benefit foregone by not going with the next best alternative, option B.  Opportunity cost is an economic term rather than an accounting term.  It does not appear in the trading, profit and loss account as an expense because it represents a lost opportunity rather than an outlay cost. It is used in decision accounting as a means of presenting financial information and assessing the financial implications of a decision. For example, the decision to choose option A is not simply because it offers a profit of €100,000 but because it offers a differential profit of €20,000 in excess of the next best alternative. 

Replacement costs are relevant where an item or resource is purchased for a specific purpose other than the opportunity or decision under consideration. If the resource is used for this new opportunity then it will need to be replaced for its original purpose. The question is ‘what is the relevant cost for using the resource under the new opportunity?’ Is it the historic cost (what was originally paid for the resource), or is it the replacement cost (the cost of replacing the resource, as it was intended for another purpose)? The answer is the replacement cost.

 b) Depreciation is a significant element in the calculation of profit. Justify its classification as an irrelevant cost in decision-making.

Depreciation is an expense relating to the purchase of fixed assets. The cost of fixed assets is an expense for a business and thus must appear in the profit and loss account. This is done through depreciation where the cost of the asset is charged against sales over the assets life. This is merely a bookkeeping transaction however as the assets has been purchased and paid for in the past. Thus depreciation is a sunk cost as it is related to the original cost of the asset.