Relevant costs for short-term decisions

Learning goals

• Identify future costs and benefits that differ between alternatives.
• Exclude sunk and unavoidable allocated costs from incremental analysis.
• Include opportunity cost and capacity displacement.
• Analyze make-or-buy, special-order, and keep-or-drop decisions.
• Integrate quality, people, risk, strategy, and ethics into a recommendation.

Prerequisite check

1. Why is an allocated fixed cost not automatically avoidable?
2. In a capacity constraint, what does displaced contribution represent?

Vocabulary

• Relevant cost/benefit: future amount that differs between alternatives.
• Sunk cost: past cost that cannot be changed by the current decision.
• Avoidable cost: cost eliminated by choosing an alternative.
• Unavoidable cost: continues regardless of the alternative.
• Opportunity cost: benefit forgone by using a resource one way rather than the best alternative.
• Differential/incremental amount: difference between alternatives.
• Qualitative factor: decision consequence not adequately captured in the numeric schedule.

Core idea

A recorded cost can be irrelevant, and an unrecorded opportunity cost can be crucial. Compare total future consequences that differ. Do not let historical cost, book value, or arbitrary allocation enter unless it changes future cash/ benefits or is relevant to a stated non-financial objective.

Why this treatment makes sense

Financial statements measure past performance and position; decisions choose future alternatives. Using full product cost without separating avoidable and unavoidable amounts can reject profitable special orders, outsource an important capability, or close a segment that contributes toward common costs.

A repeatable method

Use ALTERNATIVES–DIFFERENCES–CAPACITY–QUALITATIVE–CHECK:

1. Define feasible alternatives and time horizon, including “do nothing.”
2. List only future revenues/costs that change; label sources and confidence.
3. Add opportunity cost, displacement, tax, timing, and capacity effects.
4. Evaluate quality, staff, supplier, customer, legal, ethical, and strategic effects.
5. Check sensitivity, implementation, reversibility, and post-decision measures.

Worked example

Make or buy

For 10,000 components, internal unit cost is:

Relevant make cost = 10,000 × ($8 + $5 + $2 + $2) = $170,000. Supplier price is $18 × 10,000 = $180,000. Making saves $10,000 before qualitative effects.

If buying frees capacity that can generate $25,000 contribution, making carries a $25,000 opportunity cost. Make becomes $195,000 versus buy $180,000, so buying has a $15,000 advantage on the revised facts.

Keep or drop

A segment has revenue $200,000, variable cost $120,000, traceable avoidable fixed cost $50,000, and allocated common fixed cost $40,000. It reports a $10,000 loss, but contribution after avoidable fixed cost is $30,000. Dropping loses $80,000 CM and saves $50,000, reducing total profit $30,000 if common cost continues.

Journal, ledger, and statement connection

Decision schedules do not rewrite historical ledgers. If a choice is implemented, future purchase, payroll, contract-termination, impairment, or disposal entries follow their accounting basis. Avoidable cost is not itself an account. Reconcile predicted benefits to actual ledger and operational data after implementation.

Common mistakes

• Including book value or past research cost because it appears in the ledger.
• Treating all fixed overhead as avoidable.
• Ignoring lost regular sales in a special order.
• Comparing a supplier quote excluding freight, inspection, currency, transition, or quality costs.
• Dropping a segment based on its reported loss after common allocations.
• Treating idle capacity as permanently free.
• Ignoring privacy, safety, labour agreements, resilience, community impact, or loss of capability.

Guided practice

A one-time order requests 1,000 units at $30 each. Unit variable production cost is $22; special setup is $3,000; no regular sales are displaced and no other cost changes. Calculate incremental profit and state three facts to verify.

Independent practice

A campus café makes 20,000 sandwiches. Unit costs are ingredients $2.20, labour $1.40, variable overhead $0.40, and allocated fixed overhead $1.50. A supplier offers $4.50 each. Of fixed overhead, $12,000 would be avoided if purchased. Buying would free space that could be rented for $9,000 annually. Compare make and buy. Then recompute if $8,000 severance is required in year one. Recommend for year one and later years, plus four qualitative factors.

Self-check and solutions

Guided: Revenue $30,000 − variable cost $22,000 − setup $3,000 = $5,000 incremental profit. Verify capacity/displacement, credit and collection, product differences/quality, setup completeness, shipping, brand/channel conflict, future pricing expectations, and legal terms.

Independent: Relevant make = 20,000($2.20 + $1.40 + $0.40) + $12,000 = $92,000. Buy = 20,000($4.50) − $9,000 rental benefit = $81,000. Buying advantage $11,000 annually before transition effects. With $8,000 severance, year-one buy cost $89,000, still a $3,000 advantage; later advantage $11,000.

Recommendation is provisional: evaluate supplier quality/reliability, food safety and traceability, labour/community impact, rental certainty, price escalation/currency, capacity flexibility, customer experience, and ability to restart production. Show sensitivity to supplier increases.

Retrieval practice

1. State the two conditions for a financial amount to be relevant.
2. Define sunk, avoidable, and opportunity cost.
3. Why can a reported segment loss mislead a drop decision?
4. Name five supplier factors beyond quoted price.

Exam-style application

Normal price $80, variable cost $46, allocated fixed cost $20. A 500-unit special order offers $55. Idle capacity exists, but special packaging costs $3 per unit. No other effects. Accept or reject, and quantify.

Target: Incremental CM per unit = $55 − $46 − $3 = $6; total $3,000 benefit. The $20 allocation is irrelevant if unchanged. Accept on quantitative facts, subject to qualitative/strategic checks.

Lesson summary

Relevant analysis looks forward, compares alternatives, and values scarce capacity. Strip away sunk and unavoidable allocations, then put operational, ethical, and strategic consequences back into the recommendation.