If the total cost of alternative a is $50,000 and the total cost of alternative b is $34,000, then $16,000 is termed the differential cost.
A relevant cost (also called avoidable cost or differential cost) is a cost that differs between alternatives being considered. In order for a cost to be a relevant cost, it must be.
A construction company is building an office building and has spent $1 million so far. He also needs $500,000 to complete the construction. Due to the downturn in the real estate market, the completed building is expected to cost just $1.2 million, below its original estimate.
If a $1 million sunk cost was erroneously included in the analysis when deciding whether to proceed with construction, the firm would reject the project because it is $1.5 million against a $1.2 million return. We may conclude that it should be abandoned. However, $1 million is an irrelevant cost and should be excluded.
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