Relevant costs for short-run decisions

Learning goals

• Identify future cash flows that differ between alternatives.
• Include opportunity cost and exclude sunk or unavoidable allocated cost.
• Combine quantitative analysis with capacity, risk, and strategy.

Prerequisite check

A cost is relevant only if it is future and differs between choices. Book value of equipment already purchased is usually sunk; proceeds forgone by using capacity for one option are an opportunity cost even though no invoice records them.

Vocabulary

• Relevant cost: future cost or benefit differing across alternatives.
• Sunk cost: past cost unchanged by the decision.
• Avoidable cost: cost eliminated if an activity stops.
• Opportunity cost: benefit sacrificed by choosing one option.
• Incremental analysis: comparison of differential cash flows rather than full allocated totals.

Core idea

Decision reports are not external product-cost statements. They strip away amounts that remain under every alternative and add real sacrificed benefits. The time horizon matters: a fixed cost may be unavoidable next month but avoidable when a lease or job contract expires.

Why this treatment makes sense

Allocated common fixed costs can make a profitable segment look unprofitable even though closing it would not save the allocation. Relevant analysis asks what actually changes, protecting decisions from accounting labels.

A repeatable method

1. Define alternatives, horizon, capacity, and objective.
2. List future cash flows under each alternative.
3. Cross out identical flows and sunk amounts.
4. Add avoidable fixed cost and opportunity cost.
5. Calculate net differential benefit.
6. Test volume, price, quality, delay, legal, people, and reversibility assumptions.
7. Recommend with threshold and monitoring plan.

Worked example

Vancouver Trail Tours considers a one-time group booking for 120 seats at $55 each. Normal price is irrelevant if empty capacity exists. Incremental costs per passenger: meal $14, booking fee $3, guide support $6. A dedicated permit costs $900. Regular customers will not be displaced.

Incremental revenue = 120 × $55 = $6,600. Incremental variable cost = 120 × $23 = $2,760; permit $900; net benefit = $2,940. Allocated bus depreciation of $1,500 is irrelevant because it continues either way.

If accepting displaces 30 regular seats earning $40 contribution each, add $1,200 opportunity cost; revised benefit $1,740. Accept financially if assumptions and brand/ contract considerations remain acceptable.

Journal, ledger, and statement connection

The decision schedule itself creates no entry. If accepted, normal sales and cost transactions enter the ledger. Reconcile projected incremental amounts to actual job results afterward to improve future estimates.

Common mistakes

• Using full absorption unit cost as the automatic minimum price.
• Including sunk book value but omitting opportunity cost.
• Assuming fixed cost is always irrelevant.
• Ignoring capacity displacement or long-run customer expectations.

Guided practice

Special order revenue $18,000; variable cost $11,000; special setup $2,500; unavoidable allocated fixed cost $4,000. Incremental benefit is $4,500; ignore the allocation.

Independent practice

Level 1 — classify: Label past research cost, avoidable supervisor salary, and forgone rental income.

Level 2 — calculate: Order revenue $30,000; variable production $19,000; special freight $2,000; opportunity cost $4,500. Find net benefit.

Level 3 — risk: A positive order uses all spare capacity for six months. Identify three non-quantitative or longer-run checks.

Self-check and solutions

Level 1: Sunk/irrelevant; relevant if eliminated; relevant opportunity cost.

Level 2: $30,000 − $19,000 − $2,000 − $4,500 = $4,500 benefit.

Level 3: Regular-customer displacement, quality/overtime, supplier reliability, future price expectations, contract penalties, worker safety, and strategic fit are valid checks. Quantify thresholds where possible.

Retrieval practice

1. What two tests define a relevant amount?
2. Is an allocated fixed cost automatically relevant?
3. Where does opportunity cost appear in the ledger?

Answers: future and different; no; generally it does not, but belongs in the decision schedule.

Exam-style application

Prepare an incremental special-order analysis with a planted sunk cost and opportunity cost, calculate the break-even offer price, and write a conditional recommendation.

Lesson summary

Relevant analysis follows future differences, not accounting labels, and explicitly adds capacity trade-offs and strategic consequences.