decision-making method that utilizes the concept of relevant costs; also known as relevant cost approach or differential analysis. Under this method, the decision involves the following steps: (1) gather all costs associated with each alternative; (2) drop the sunk cost; (3) drop those costs that do not differ between alternatives; and (4) select the best alternative based on the remaining cost data.
At first glance, it appears that the new machine provides an increase in net income of $7500 per year. The book value of the present machine, however, is a sunk cost and is irrelevant in this decision. Furthermore, sales and fixed costs such as insurance and taxes are also irrelevant since they do not differ between the two alternatives being considered. Eliminating all the irrelevant costs leaves us with only the incremental costs, as follows:
|Savings in variable costs||$15,000|
|Less: Increase in fixed costs||10,000||(a $2500 sunk cost is irrelevant)|
|Net annual cash savings arising from the new machine||$ 5,000|