Final answer:
In incremental analysis, relevant costs are those that will be affected by the decision at hand and include both variable and certain fixed costs. Sunk costs, which are past costs that cannot be recovered, are not considered relevant. Relevant costs are used in conjunction with a cost/benefit analysis to determine the additional costs and benefits associated with changing the level of production or service.
Step-by-step explanation:
In incremental analysis, relevant costs are those that are directly tied to a specific management decision and will change as a result of that decision. These costs include both variable and fixed costs that are affected by the decision. However, it is crucial to note that not all variable costs are relevant, and not all fixed costs are irrelevant. For a cost to be relevant, it must be a future cost that differs between alternatives. Thus, any sunk costs, or past costs that cannot be recovered, should not be considered.
A related concept in making economic decisions is a cost/benefit analysis, where the costs of a decision are compared against the potential benefits. Marginal costs and benefits are crucial in this comparison, as they reflect the additional costs and benefits of producing one more unit of a product or service. The law of diminishing marginal utility illustrates that marginal gains decrease as more units are added, emphasizing the importance of analyzing costs and benefits at the margin.
Ultimately, relevant costs for decision-making encompass those which will impact the firm's future expenditures and revenues directly related to the decision at hand. They do not encompass all variable costs, as some variable costs may not change with the specific decision being considered. Conversely, some fixed costs may be relevant if they're avoidable or can change as a direct result of the decision.