Identify relevant costs and apply relevant costing to special-order, make-or-buy and limiting-factor decisions

What this dot point is asking

SEAB wants you to identify relevant costs and apply relevant costing to three classic short-run decisions: special orders, make-or-buy, and limiting-factor (scarce-resource) problems. Relevant costing is the discipline of using only the costs and revenues that change as a result of a decision. The central insight is that many costs in the accounts, sunk costs, unavoidable fixed costs, are irrelevant to a decision, and including them leads to the wrong choice; only future, differential cash flows matter.

The answer

What makes a cost relevant

A relevant cost is a future cash flow that differs between the alternatives. Three tests must all be met: it is in the future, it is a cash flow, and it differs depending on the decision. This rules out:

A key relevant cost that is easy to miss is opportunity cost: the contribution forgone by using a resource for one purpose instead of its best alternative.

Special-order decisions

For a one-off order with spare capacity, the order is worth accepting if its price exceeds the relevant (usually variable) cost per unit, because fixed costs are already covered by normal business. The order adds its contribution to profit. Strategic factors (effect on regular customers, future pricing) should also be weighed.

Make-or-buy decisions

Compare the relevant cost of making (the variable, and any avoidable fixed, costs) with the buy-in price. Fixed costs that continue regardless are ignored. Make if the relevant make-cost is lower; buy if the buy price is lower, subject to quality, reliability and capacity considerations.

Limiting-factor decisions

When a resource is scarce (labour hours, machine hours, materials), rank products by contribution per unit of the limiting factor, not per unit of product:

Allocate the scarce resource to the highest-ranked product first to maximise total contribution.

Examples in context

Example 1. The misleading sunk cost. A firm has spent \50,000$developing a product and must decide whether to spend a further$\$30\,000$ to launch it, expecting \40,000$of revenue. The$\$50\,000$ already spent is sunk and irrelevant; the decision compares the future \30,000$cost with the$\$40\,000$ benefit, so launching adds \10,000$and is worthwhile. Counting the sunk$\$50\,000$ would wrongly suggest abandoning a profitable launch.

Example 2. A make-or-buy with an opportunity cost. A company could make a part using machine time that would otherwise produce a product earning \5$per hour of contribution. That forgone$\$5$ per hour is an opportunity cost and must be added to the relevant cost of making. Ignoring it would understate the true cost of in-house production and could lead to the wrong make-or-buy decision, showing why opportunity cost belongs in the analysis.

Try this

Q1. A special order is priced at \30$per unit; variable cost is$\$22$ and there is spare capacity. State whether to accept and why. [2 marks]

• Cue. Accept: the \30$price exceeds the$\$22$ variable cost, adding \8$ contribution per unit, since fixed costs are already covered by normal sales.

Q2. Explain why a sunk cost is irrelevant to a decision. [2 marks]

• Cue. It has already been incurred and cannot be changed by any future choice, so it does not differ between the alternatives and should be ignored.

Q3. Product X gives \40$contribution using$4$scarce hours; product Y gives$\$24$ using $2$ hours. Which should be prioritised? [3 marks]

• Cue. Contribution per hour: X = \dfrac{40}{4} = \10$; Y$= \dfrac{24}{2} = \$12$. Prioritise Y, the higher contribution per scarce hour, despite X's higher contribution per unit.