Relevant Costing and Decision Making

Quick Answer: Relevant costs are future costs that differ between alternatives. Sunk costs are never relevant. For make-or-buy, compare avoidable internal costs to external price plus opportunity costs. Accept special orders when incremental revenue exceeds incremental cost. Maximize contribution margin per constraint unit for product mix decisions.

Effective decision-making requires identifying which costs are relevant to a specific decision. Irrelevant costs can lead to poor choices.

Relevant vs. Irrelevant Costs

Relevant Costs

A cost is relevant if it meets BOTH criteria:

Irrelevant Costs

Examples of Relevance

Opportunity Costs

Opportunity cost is the benefit foregone by choosing one alternative over another.

Opportunity Cost = Value of the Next Best Alternative

Example: Using factory space for Product A means giving up the $50,000 contribution margin from Product B. The $50,000 is an opportunity cost of producing A.

Key Point: Opportunity costs are never recorded in accounting systems but are always relevant to decisions.

Make-or-Buy Decisions

Should the company make a component internally or buy it from an outside supplier?

Relevant Costs for Make-or-Buy

Make-or-Buy Example

Current Cost to Make (10,000 units):

Outside Supplier Quote: $15.00 per unit

Analysis:

Decision: Continue to make—saves $20,000.

Note: The $50,000 allocated fixed overhead is NOT relevant because it will continue regardless of the decision.

Make-or-Buy with Opportunity Cost

If the freed capacity can generate $25,000 contribution margin:

Decision: Buy from supplier—saves $5,000.

Special Order Decisions

Should the company accept a one-time order at a price below normal selling price?

Decision Rule

Accept if: Incremental Revenue > Incremental Costs

Special Order Considerations

Special Order Example

Normal Operations:

• Selling price: $100 per unit
• Variable cost: $60 per unit
• Fixed costs: $200,000 (at 10,000 unit capacity)
• Current production: 7,000 units

Special Order: 2,000 units at $75 each

Decision: Accept—adds $30,000 to profit.

Important: Fixed costs are not relevant if they don't change. The $75 price exceeds the $60 variable cost, so the order contributes to fixed costs and profit.

Product Mix with Constraints

When resources are limited (labor hours, machine time, materials), maximize contribution margin per unit of the constrained resource.

Decision Rule

CM per Constraint Unit = CM per Product ÷ Constraint Used per Product

Prioritize products with the highest CM per constraint unit.

Constrained Resource Example

Machine capacity: 10,000 hours

Optimal Production Order: C, then A, then B

If demand is: A = 3,000 units; B = 2,000 units; C = 4,000 units

Product A is partially produced (2,000 of 3,000 demanded); Product B is not produced.

Segment Elimination Decisions

Should a product line, department, or division be eliminated?

Decision Framework

Segment Elimination Example

Analysis:

Decision: Keep Product Line X—eliminating it reduces total company profit by $50,000.

Key Insight: The $80,000 allocated fixed costs will continue regardless of the decision, so they are irrelevant. The $150,000 CM exceeds the $100,000 avoidable fixed costs.

Sell or Process Further

Should a product be sold at split-off or processed further?

Decision Rule

Process further if: Incremental Revenue > Incremental Costs

Incremental Revenue = Final Sales Value - Sales Value at Split-off
Incremental Costs = Further Processing Costs

Sell or Process Example

Analysis:

Incremental Revenue = \$120,000 - \$80,000 = \$40,000
Incremental Cost = \$25,000
Incremental Profit = \$40,000 - \$25,000 = \$15,000

Decision: Process further—adds $15,000 to profit.

Note: Joint costs (costs incurred before split-off) are sunk costs and irrelevant to this decision.

Summary: Relevant Cost Decision Framework