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Managerial Accounting Unit 9: Relevant Costs for Decisions

Short-term decisions depend only on future costs and revenues that differ between options. This unit applies that rule to special orders, outsourcing, dropping segments, joint products and bottlenecks.

Covers: Relevant, sunk, avoidable and opportunity costs, Special orders, Make or buy (outsourcing), Keep or drop a segment, Sell or process further, Constrained resources, Qualitative factors

Study guide

Every decision compares alternatives, and the rule is simple: a cost or revenue is relevant only if it is in the future and differs between the alternatives. Sunk costs, like the price paid for existing equipment or its book value, are never relevant. Future costs that are the same under every option, such as allocated headquarters costs that will continue, can also be ignored. Relevant items include avoidable costs, which disappear if an option is chosen, and opportunity costs, the benefit given up by choosing one alternative. Differential analysis lists only the items that change and totals them to find the better choice.

A special order is a one-time order, often at a reduced price. With idle capacity, accept it if the price covers the incremental costs: variable costs plus any order-specific fixed costs such as special tooling. Allocated fixed overhead is irrelevant because it is incurred anyway. If the plant is at full capacity, accepting means giving up regular sales, so the lost contribution margin is an opportunity cost that must be added. Make-or-buy decisions compare the supplier's price with the avoidable costs of making: variable costs, avoidable fixed costs and the opportunity cost of the space or capacity that buying would free up.

When deciding whether to keep or drop a product line or segment, compare the contribution margin lost with the fixed costs avoided. Allocated common costs stay whether the segment is dropped or not, so they are irrelevant. A segment showing a net loss after allocations may still be worth keeping if its contribution margin exceeds its avoidable fixed costs. Also consider effects on other segments, since a dropped line can reduce sales of related products. For joint products, costs before the split-off point are irrelevant to whether a product should be processed further. Process further only if the incremental revenue exceeds the incremental processing cost.

When a resource such as machine-hours limits output, the goal is to earn the most contribution margin from the scarce resource. Rank products by CM per unit of the constraint, not CM per unit of product, and fill demand in that order. The value of one more hour of the constraint equals the CM per hour of the product that would use it, which tells managers how much they could pay to relax the bottleneck through overtime, outsourcing or new equipment. Finally, numbers are not the whole story: supplier reliability, quality, employee morale, customer reactions to special prices and long-run strategy can outweigh a small short-run gain.

Key ideas

• Relevant costs and revenues are future amounts that differ between alternatives.
• Sunk costs, including book values, are always irrelevant.
• Allocated common fixed costs that continue regardless are irrelevant.
• With idle capacity, accept a special order if price exceeds incremental cost; at full capacity add lost CM.
• Drop a segment only if avoidable fixed costs exceed its contribution margin, including effects on other segments.
• Joint costs are irrelevant to sell-or-process-further decisions.
• With a constraint, rank products by CM per unit of the scarce resource.

Formulas and rules

Common mistakes

• Including allocated fixed overhead or the book value of old equipment in a decision.
• Ignoring opportunity costs, such as lost regular sales or the alternative use of freed space.
• Dropping a segment because of a net loss caused by allocated common costs.
• Allocating joint costs and using them to decide whether to process further.
• Ranking constrained products by CM per unit instead of CM per unit of the constraint.

Before the test, make sure you can

• Identify relevant, sunk, avoidable and opportunity costs in a scenario.
• Evaluate a special order with and without idle capacity.
• Decide whether to make or buy a part, including opportunity costs.
• Decide whether to keep or drop a product line or segment.
• Decide whether to sell a joint product at split-off or process it further.
• Allocate a constrained resource to maximize total contribution margin.
• Calculate the minimum acceptable price for a special order.
• Describe qualitative factors that can override the numbers.

Words to know

Relevant cost

A future cost that differs between the alternatives being considered.

Differential analysis

Comparing alternatives using only the revenues and costs that differ.

Avoidable cost

A cost that can be eliminated by choosing one alternative over another.

Sunk cost

A cost already incurred that cannot be changed by any decision.

Opportunity cost

The benefit given up by choosing one alternative over the next best.

Special order

A one-time order, often at a reduced price, that is not part of normal sales.

Make-or-buy decision

Deciding whether to produce a part internally or buy it from an outside supplier.

Vertical integration

Owning more stages of the value chain, such as making parts instead of buying them.

Segment margin

A segment's contribution margin minus its traceable fixed costs.

Common fixed cost

A fixed cost that supports several segments and would not disappear if one were dropped.

Joint costs

Costs incurred before the split-off point to produce several joint products together.

Split-off point

The point in a joint process where individual products become separately identifiable.

Sell or process further

Decision on whether to sell a joint product at split-off or process it more.

Constraint (bottleneck)

A resource that limits a company's total output.

CM per unit of constrained resource

Contribution margin divided by the amount of the scarce resource each unit uses.

Relaxing a constraint

Increasing the capacity of a bottleneck, worth doing if added CM exceeds its cost.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.