The idea of relevant cost
A cost is relevant to a decision only if it is in the future and differs between the options. Costs already incurred (sunk costs) are irrelevant, and so are future costs that will be the same whichever option you choose. This sounds obvious, but assignment questions are written to tempt you to include allocated overhead, past investments and historical book values.
| Item | Relevant? | Why |
|---|---|---|
| Cost of machine bought last year | No | Sunk: nothing you decide now can change it |
| Direct materials that would not be used if you stop making the product | Yes | Avoidable and future |
| Rent on a building you must pay anyway | No | Same under every option |
| Allocated head office overhead that continues regardless | No | Not avoidable |
| Fixed overhead that would be eliminated if the activity stopped | Yes | Avoidable |
| Cash from selling idle equipment if you stop | Yes | Future cash that differs by option |
| Opportunity cost of using scarce capacity | Yes | The best alternative use forgone |
Make or buy
Make or buy a component (hypothetical)
A firm makes 10,000 units a year of a component. Unit costs: direct materials $6, direct labor $4, variable overhead $2 and allocated fixed overhead $5 (a total of $50,000, of which $10,000 would be eliminated if production stopped). An outside supplier offers the part at $13.50.
The tempting answer: full cost is 6 + 4 + 2 + 5 = $17, so buy at $13.50 and save $3.50 per unit. This is wrong.
The relevant comparison: avoidable cost per unit = 6 + 4 + 2 + ($10,000 of avoidable fixed overhead / 10,000 units = $1) = $13.00. The remaining $40,000 of fixed overhead continues whichever option is chosen.
| Make | Buy | |
|---|---|---|
| Relevant cost per unit | $13.00 | $13.50 |
| Total for 10,000 units | $130,000 | $135,000 |
Making is cheaper by $5,000 a year. Buying would leave $40,000 of fixed overhead to be absorbed by other products.
Then go beyond the numbers. Discuss quality, supply reliability, flexibility, strategic control and what else the freed capacity could earn. If the capacity could be used to make a product with a contribution of $80,000 a year, the opportunity cost changes the answer: the relevant cost of making now includes that $80,000.
Special orders and the contribution approach
When a customer proposes a one-off order at a price below normal, compare the extra revenue with the extra cost. If there is idle capacity and the order does not damage normal pricing, any price above the variable cost adds profit.
Special order (hypothetical)
Normal price $30, variable cost $12 per unit, fixed cost unchanged by the order. A buyer offers $22 for 2,000 units with spare capacity available.
Contribution per unit = 22 - 12 = $10. Total gain = 2,000 x 10 = $20,000.
- Check capacity If capacity is full, the lost sales from regular customers are an opportunity cost.
- Check price effects Will other customers learn of the discount and demand it?
- Check extra fixed costs Include any one-off costs such as packaging or setup.
- Think long term A price that covers only variable cost is not sustainable for all business.
Activity-based costing
Traditional costing spreads overhead using one volume measure such as labor hours or units. If products use overhead in different proportions, volume-based costing distorts the picture. Activity-based costing (ABC) assigns overhead to the activities that cause it, such as machine setups, inspections and order handling, and then to products by their use of those activities.
Traditional versus ABC (hypothetical)
Overhead for setups is $120,000, caused by 400 setups. Product A: 20,000 units, 100 setups, direct cost $10, price $16. Product B: 10,000 units, 300 setups, direct cost $15, price $22.
Traditional (per unit): overhead rate = 120,000 / 30,000 units = $4. A margin = 16 - 10 - 4 = $2. B margin = 22 - 15 - 4 = $3.
ABC: rate per setup = 120,000 / 400 = $300. A receives 100 x 300 = $30,000, or $1.50 per unit. B receives 300 x 300 = $90,000, or $9.00 per unit.
| Traditional margin per unit | ABC margin per unit | |
|---|---|---|
| Product A | $2.00 | $4.50 |
| Product B | $3.00 | -$2.00 |
Product B looks profitable under the traditional method, but it is loss-making once the setups it causes are charged to it. Management would investigate raising its price, running larger batches or dropping it.
Evaluate ABC as well as applying it. It is more accurate, but it costs more to run, depends on choosing good cost drivers and can lead to wrong decisions if fixed costs are treated as if they vary with activity. Link it to relevant costs: ABC shows long-run cost, but only avoidable costs matter for a short-run decision.
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Get an instant quoteScarce resources: which product first?
When a resource is limited, rank products by contribution per unit of the scarce resource, not by contribution per unit sold.
Machine hours (hypothetical)
Product X contributes $20 per unit and uses 2 machine hours. Product Y contributes $24 per unit and uses 3 hours. 6,000 machine hours are available. Demand for X is 2,000 units.
Contribution per hour: X = 20 / 2 = $10; Y = 24 / 3 = $8. Make X first, even though Y has the higher unit contribution.
X uses 2,000 x 2 = 4,000 hours and contributes 2,000 x 20 = $40,000. The remaining 2,000 hours make 2,000 / 3 = 666.7 units of Y, contributing 666.7 x 24 = $16,000. Total contribution = $56,000.
If the answer uses whole units, say 666 units, the total is $55,984. Mention that buying more machine time, if possible, is worth up to $10 an hour while X has unmet demand and $8 an hour after, which tells management what extra capacity is worth.
Transfer pricing between divisions
When one division sells to another inside the same company, the transfer price shifts profit between them without changing the total. The right price lets each division decide in the company's interest. A general rule: the minimum price the selling division should accept is its variable cost plus the opportunity cost of the sale.
| Situation | Minimum transfer price | Maximum (buying division) | Decision |
|---|---|---|---|
| Seller has spare capacity; variable cost $40; buyer can purchase outside at $55 | $40 | $55 | Transfer at any price from $40 to $55 |
| Seller is at full capacity and can sell externally at $60 | $60 (variable cost 40 plus lost contribution 20) | $55 | No internal transfer; the buyer should buy outside |
In the second row, a head office instruction to transfer at $55 would cost the company $5 per unit (the seller gives up $60 outside for $55 inside). Your paper should state the rule, apply it and mention behavioral issues: managers judged on divisional profit may resist a transfer that helps the whole firm.
Common traps in managerial accounting questions
- Using full cost for a short-run decision Strip out unavoidable allocations.
- Forgetting opportunity cost If capacity is full, include the contribution lost.
- Treating fixed costs as variable in ABC Check which costs really change if activity changes.
- Ignoring timing A cost saving that arrives in three years is worth less than one today.
- Stopping at the number Add qualitative issues: quality, supplier risk, morale and strategy.
Writing the answer
| Step | What to write |
|---|---|
| State the decision | Make or buy, accept or reject, keep or drop |
| List relevant costs and revenues | Only future and differing items, with reasons for exclusions |
| Calculate | Show totals for each option and the difference |
| Add qualitative factors | Quality, supplier risk, capacity, morale, strategy |
| Recommend | Commit, and state what would change your mind |
Always explain why you exclude sunk costs and unavoidable allocations, because many marks go to that reasoning. For choices under uncertainty, see our guide to decision analysis and, for related financial modeling, the guide to valuation. If you want help with an accounting assignment, you can order MBA assignment help.