Decision-making is part of every day life. In making short term accounting decisions – choosing among several courses of action - we need to take into consideration information that is available. However, information can be relevant or irrelevant. Information that is relevant is taken into account but irrelevant information does not matter. So next, we ask the question: what makes information relevant?
Firstly, information must be an expected future revenue or cost. It has to be something that will be earned (if revenue) or incurred (if cost). It is not something that has already been received or paid.
Secondly, it must have an element of difference among the alternatives. In other words, it will be different whichever choice is picked.
For example, if one is buying a car, and is considering between a Toyota Altis (2000 model) versus a Honda Civic (2000 model). The Toyota originally cost $122,000 whereas the Honda cost $120,000. The original cost prices are NOT relevant as they refer to the past. The current market prices, which are applicable now, refer to the future.
Let’s say that the current prices are: Toyota $90,000 and Honda $60,000. Because the price for the Toyota is more expensive than that of the Honda, the information is different between the 2 alternatives.
Hence, the current market prices of the Toyota and Honda are considered relevant information.
A related concept is that of sunk costs. Sunk costs are those that have been incurred in the past and have no bearing on future decisions. An example is the cost of machine purchased, whereby the machine is now written off or scrapped. Sunk costs are not considered relevant as they pertain to the past.
Another concept is the opportunity cost, which measures the opportunity that is lost or sacrificed when the choice of one course of action requires that an alternative course of action be given up. For example, a person has a choice of taking a job which pays a fixed monthly salary of $5,000, versus running a business that brings in a variable monthly profit of $2,000 - $10,000. The opportunity cost of taking the job will be equal to $2,000 - $10,000 – in other words, taking the job will mean giving up the chance to earn the business profit. On the other hand, the opportunity cost of running the business will be $5,000 – the fixed salary sacrificed.