What are the relevant and irrelevant costs?
Two partners who own Progressive Business Solutions, which currently operates out of an office in a small town near Boston, just discovered a vacancy in an office building in downtown Boston. One of the partners favors moving downtown because she believes the additional business gained by moving downtown will exceed the higher rent at the downtown location plus the cost of making the move. The other partner at PBS opposes moving downtown. He argues, "We have already paid for the office stationery, business cards, and a large sign that cannot be moved or sold. We have spent so much on our current office that we can't afford to waste this money by moving now." Evaluate the second partner's advice not to move downtown. Illustrate and fully explain using an example of relevant cost (a cost whose value does affect the optimal decision) and an example of irrelevant cost (a cost whose value does not affect the optimal decision) to the business regarding this decision.
Never make decisions based on sunk costs, only future costs and future revenues. Never let an accountant tell you how to make decisions.
The second partner's advice not to move downtown is based on the concept of relevant and irrelevant costs. Relevant costs are costs that affect the optimal decision, while irrelevant costs do not factor into the decision-making process. To evaluate the second partner's advice, we need to identify relevant and irrelevant costs in this situation.
Example of a relevant cost: The cost of higher rent at the downtown location would be considered a relevant cost. This is because it directly impacts the financial aspect of the decision. The second partner's concern about the increased rent is valid, as it would be a relevant cost that should be carefully considered.
Example of an irrelevant cost: The cost of office stationery, business cards, and the large sign that cannot be moved or sold would be considered irrelevant costs. These costs have already been incurred and cannot be recovered. Therefore, they do not affect the current decision to move downtown. The second partner's argument based on these costs as a reason not to move is not valid because these costs should not be factored into the decision-making process.
In this case, it is important to focus on the relevant cost, which is the higher rent at the downtown location. If the additional business gained by moving downtown exceeds the higher rent and the cost of making the move, then it would be an optimal decision to relocate. The second partner's concern about the sunk costs (irrelevant costs) should not impact the decision because they are not relevant to the potential benefits and costs associated with moving downtown.
To properly evaluate the decision, the partners should analyze the potential increase in revenue and the additional costs of the downtown location, such as higher rent, moving expenses, and any other relevant costs. By considering only the relevant costs, they can make a more informed decision about whether moving downtown will be beneficial for Progressive Business Solutions.