Hello! Welcome back to our course on Managerial Accounting.
In our last lesson, we explored Activity-Based Costing (ABC), a method for achieving a more accurate understanding of product and service costs. We saw that accuracy is crucial for good strategy. Today, we shift from calculating costs to using them for specific, non-routine business decisions.
This lesson focuses on relevant cost analysis. The learning outcome is to use relevant cost analysis for non-routine decisions, such as make-or-buy and special orders. We will establish a clear framework for identifying which costs matter in a decision and which should be ignored. Then, we will apply this framework to two common managerial scenarios: evaluating a one-time special sales order and deciding whether to outsource production (a "make-or-buy" decision).
1. The Core Principles of Relevant Costing
When faced with a decision, it's tempting to analyze every piece of financial data available. However, effective decision-making hinges on focusing only on the information that is actually relevant. The core idea is to isolate only the costs and benefits that will change as a direct result of the decision you make.
Conceptually, this is similar to formulating an objective function for an optimization problem: you identify the variables that are affected by your choice and disregard the constants that remain the same regardless of the outcome.
A cost or revenue is considered relevant if it meets two criteria:
- It is a future cost/revenue (you can't change the past).
- It differs between the alternatives under consideration (if it's the same for all options, it's irrelevant).
The following video provides an excellent and intuitive introduction to these concepts, distinguishing between relevant, sunk, and differential costs using a simple real-world example.
MA49 - Relevant Costs for Decision Making
This video, 'MA49 - Relevant Costs for Decision Making' by Tony Bell, clearly explains the fundamental principles that we will use throughout this lesson.
Please watch from 00:31 to 05:04. Focus on how the stoplight example is used to illustrate two key ideas: Sunk Costs: Why past events (the first stoplight) are irrelevant to a future decision. Differential Costs: Why costs that are the same between two options (the shared stoplights) are also irrelevant.
As the video explains, the costs that matter are the ones that are not sunk and are differential. This leads us to a formal definition of the key terms.
10. Differential Decision Making
To solidify these definitions, please read the introductory sections of the chapter 'Differential Decision Making' from the textbook by University of Cincinnati Press.
Read the sections titled 'Differential decision making' and 'Relevant and irrelevant costs of differential decision making'. Pay close attention to the definitions of relevant vs. irrelevant costs, avoidable costs, and sunk costs.
Key Types of Costs in Decision-Making
- Relevant Costs: Future costs that differ between alternatives. These are also called avoidable costs or differential costs.
- Irrelevant Costs: Costs that do not differ between alternatives. These include:
- Sunk Costs: Costs that have already been incurred and cannot be recovered (e.g., the original purchase price of existing equipment).
- Common Fixed Costs: Fixed costs that will be incurred regardless of the decision (e.g., the rent for a factory that will be paid whether you accept a special order or not).
A critical type of relevant cost that is not always obvious on an income statement is opportunity cost. This is the potential benefit that is given up when one alternative is selected over another. For example, if you use your factory's capacity to produce Product A, the opportunity cost is the profit you could have earned by using that same capacity to produce Product B.
2. Application 1: Special Order Decisions
A special order is a one-time order from a customer that is not part of a company's normal stream of business, often for a large quantity and at a discounted price. The key decision is whether to accept or reject the order.
The analysis should only include the incremental revenues and incremental costs associated with the order. If the incremental revenue exceeds the incremental costs, accepting the order will increase the company's overall profit.
This analysis typically relies on two critical assumptions:
- The company has sufficient idle capacity to fulfill the order without disrupting normal production.
- Accepting the special order will not affect the sales or prices of the company's regular products.
The following video provides a detailed walkthrough of a typical special order problem.
Part 5 - Relevant Costs for Decision Making - Special Order
In 'Part 5 - Relevant Costs for Decision Making - Special Order', Tony Bell works through a comprehensive example. This will show you exactly how to structure the analysis.
Watch from the beginning to 12:48. As you watch, focus on: Problem Setup (00:00 - 05:30): Understand the business context and the specifics of the special order. Identifying Relevant Costs (06:57 - 10:16): Note which costs from the company's standard cost sheet are included in the analysis (direct materials, direct labor, variable overhead, modified variable selling) and, just as importantly, which are excluded (fixed overhead, fixed selling). Calculating the Impact (10:16 - 12:48): See how the final decision is made by comparing the incremental revenue to the sum of the relevant costs.
Summary of the Special Order Analysis
Let's summarize the analysis from the video. The decision was whether to accept an order for 5,000 units at a special price of $60 per unit.
| Item | Per Unit | Total for 5,000 Units | Relevant? | Explanation |
|---|---|---|---|---|
| Incremental Revenue | $60.00 | $300,000 | Yes | Additional revenue generated only if the order is accepted. |
| Relevant Costs: | ||||
| Direct Materials | $22.00 | $110,000 | Yes | Avoidable if the order is rejected. |
| Direct Labor | $12.00 | $60,000 | Yes | Avoidable if the order is rejected. |
| Variable Overhead | $4.00 | $20,000 | Yes | Avoidable if the order is rejected. |
| Variable Selling | $2.00 | $10,000 | Yes | Cost differs; it's reduced from the usual $8. |
| Special Machine | $8.00 | $40,000 | Yes | A new fixed cost incurred only for this order. |
| Total Relevant Cost | $48.00 | $240,000 | ||
| Net Financial Impact | $12.00 | $60,000 | Positive |
Since the incremental revenue ($300,000) exceeds the incremental costs ($240,000), accepting the order adds $60,000 to the company's profit. Therefore, the order should be accepted.
3. Application 2: Make-or-Buy (Outsourcing) Decisions
Another common non-routine decision is whether to produce a component or service internally ("make") or to purchase it from an external supplier ("buy"). This is also known as an outsourcing decision.
The analytical approach is to compare the relevant costs of each alternative.
- Cost to "Make": The avoidable costs incurred to produce the item internally. This includes direct materials, direct labor, and any variable overhead. It also includes any fixed overhead that would be eliminated if production ceased.
- Cost to "Buy": The purchase price from the external supplier, plus any associated costs like transportation.
Crucially, any fixed overhead that will continue regardless of the decision (like factory rent or a supervisor's salary, if they are not let go) is irrelevant and should be excluded from the analysis.
10. Differential Decision Making
The textbook chapter 'Differential Decision Making' also provides a clear example of a make-or-buy decision.
Please read the section titled 'Make or buy (outsourcing)'. Focus on the 'Shrooms' compost example. Note how the analysis correctly identifies the relevant costs of making the compost (untreated wood chips, indirect materials) and ignores the irrelevant costs (existing farm overhead, supervisor's salary).
The Role of Opportunity Cost in Make-or-Buy
The "Shrooms" example assumed there was unused capacity. A more complex scenario arises when making the component internally uses a constrained resource (e.g., machine time, specialized labor).
In this case, the opportunity cost of the foregone production must be included as a relevant cost of the "make" option.
For example, if the machine time used to make a component could have been used to produce another product that generates a contribution margin of $50,000, then that $50,000 is an opportunity cost of making the component. It must be added to the other relevant costs of the "make" alternative when comparing it to the "buy" alternative. This ensures the decision reflects the best possible use of the company's limited resources.
Conclusion
In this lesson, we developed a framework for making non-routine business decisions by focusing on relevant information. We saw that by systematically identifying future, differential costs and revenues, managers can cut through the noise of irrelevant data to make choices that maximize profitability.
Key Takeaways:
- Relevant costs are future costs that differ between decision alternatives. All other costs, such as sunk costs or common fixed costs that don't change, are irrelevant.
- Opportunity cost, the benefit foregone from the next-best alternative, is a crucial and often overlooked relevant cost.
- For special order decisions, you should accept the order if the incremental revenue is greater than the incremental (relevant) costs, assuming you have spare capacity and it won't cannibalize normal sales.
- For make-or-buy decisions, you should compare the avoidable costs of making the item internally against the cost of purchasing it externally, being sure to include any opportunity costs associated with using internal capacity.
Preview of the Next Lesson:
Now that we have explored how to use cost information for planning (CVP analysis) and for special decisions (relevant costing), our next step is to see how costs are used for control and performance evaluation. In the next lesson, we will learn how to prepare flexible budgets to control costs and analyze performance variances, a fundamental tool for any manager responsible for a budget.