Relevant costs and short-term decisions
Managers constantly make choices: accept a special order, make or buy a part, drop a product. Relevant costing focuses on what actually changes.
Relevant costs
A relevant cost or revenue differs between alternatives and lies in the future. Costs that are the same under every option, and sunk costs that have already been incurred, are irrelevant. Opportunity costs, the benefits given up by choosing one option, are relevant even though they never appear in accounting records.
Sunk costs
Sunk costs are past costs that cannot be recovered, such as money spent on equipment or research already completed. They should not affect decisions about the future. Continuing a failing project because of past investment is the sunk cost fallacy.
Special orders
When a customer offers a one-time order at a reduced price, a business with spare capacity should accept it if the price exceeds the incremental (variable) costs and the order does not hurt regular sales. Fixed costs that will be incurred anyway are irrelevant. Without spare capacity, the opportunity cost of displaced regular sales must be included.
Make or buy
In a make-or-buy (outsourcing) decision, compare the cost of making a component in-house (relevant variable costs plus any avoidable fixed costs) with the price of buying it, and consider what the freed-up capacity could be used for. Qualitative factors include quality control, supplier reliability, and protecting know-how.
Dropping a product or segment
A product line showing an accounting loss is not necessarily worth dropping. If its contribution margin is positive and its fixed costs would continue anyway (allocated common costs), dropping it would reduce overall profit. Only avoidable fixed costs should be compared with the lost contribution margin.
Sell or process further
When a product can be sold at one stage or processed further, the decision depends only on the incremental revenue and incremental costs of further processing. Joint costs incurred before the split-off point are irrelevant to the decision.
Scarce resources
When a resource such as machine hours is limited, a business should prioritise products with the highest contribution margin per unit of the scarce resource, not the highest contribution margin per unit. A product earning 20 dollars per unit using 4 machine hours (5 per hour) is less attractive than one earning 12 dollars using 2 hours (6 per hour).
Worked example
A factory with spare capacity normally sells widgets for 30 dollars; variable cost is 18 and allocated fixed cost is 7 per unit. A customer offers 22 dollars for 1,000 extra widgets. Relevant comparison: 22 versus 18 variable cost, giving 4 dollars per unit, or 4,000 dollars more profit. The 7-dollar fixed cost is irrelevant because it will be incurred anyway, so the order should be accepted if it does not undercut regular prices.
Key takeaways
Relevant costs differ between alternatives and lie in the future; sunk costs and unavoidable costs are irrelevant; opportunity costs are relevant. Accept special orders if price exceeds incremental costs and capacity allows. Make-or-buy compares relevant in-house costs with purchase price and alternative uses of capacity. Drop segments only if avoidable fixed costs exceed lost contribution margin. Process further if incremental revenue exceeds incremental cost. With scarce resources, rank by contribution margin per unit of the constraint.
Flashcard
Future cost that differs between alternatives
Check your understanding
Product A earns 30 dollars per unit and uses 6 machine hours; Product B earns 18 dollars per unit and uses 2 machine hours. Machine hours are limited. Which should be prioritised?