Difficulty: Intermediate | Prerequisites: Familiarity with basic cost classifications (variable, fixed, mixed) and contribution margin concepts from earlier chapters.
This chapter is where cost accounting stops being about recording costs and starts being about using them. Everything you have learnt about cost behaviour, allocation, and budgeting feeds into one question here: which costs matter when you are choosing between alternatives? The answer is narrower than most students expect, and getting it wrong leads to decisions that look rational on paper but destroy value. If you are behind, make sure you are comfortable with the difference between variable and fixed costs before reading on.
Not every cost belongs in a decision. Only future costs that differ between your options are relevant. Sunk costs are already spent and cannot be recovered, so they should never influence your choice. The chapter applies this logic to short-run pricing, make-or-buy decisions, and opportunity costs.
Decision model
A formal, structured method of making a choice that incorporates both quantitative (numerical) and qualitative (non-numerical) information. Think of it as a step-by-step framework that forces you to gather data, predict outcomes, and evaluate results rather than going on gut feeling.
Relevant costs
Expected future costs that differ among the alternative courses of action being considered. Two conditions must both be met: the cost must occur in the future, and it must differ between the options on the table. In simple terms, if a cost is the same regardless of what you decide, you can ignore it for that decision.
Relevant revenues
Expected future revenues that differ among the alternatives. The same two-part test applies: future and different.
Sunk cost
A cost that has already been incurred, is unavoidable, and cannot be changed no matter which action is taken. Think of it as money already out the door. The purchase price of a machine you bought last year is sunk; no future decision can undo that spend.
Quantitative factors
Outcomes that can be measured in numerical terms, such as costs, revenues, and units produced.
Qualitative factors
Outcomes that are difficult to measure numerically but still matter for the decision. Employee morale, brand reputation, and supplier reliability are common examples. In simple terms, these are the "soft" considerations that the spreadsheet does not capture.
Opportunity cost
The contribution to operating income that is forgone by not using a limited resource in its next best alternative use. Think of it as the value of the road not taken. If a machine could earn £5,000 making Product B but you use it for Product A instead, the opportunity cost of choosing A is £5,000.
Incremental cost
The additional cost incurred from choosing one alternative over another. Also called differential cost.
Outsourcing
Purchasing goods or services from outside vendors rather than producing them internally.
Insourcing
Producing goods or providing services internally rather than buying them from an external supplier.
Make-or-buy decision
A decision about whether a producer of goods or services will insource or outsource a particular component or activity. Quality, supplier dependability, and costs all feed into the analysis.
Short-run pricing decision
A pricing decision with a time horizon of only a few months, where the focus is typically on covering variable (incremental) costs rather than full costs.
The chapter centres on a structured approach to decision-making:
Step 1 – Identify the problem and uncertainties. Define what you are deciding and what you do not know.
Step 2 – Obtain information. Gather historical costs, market data, and any other relevant inputs.
Step 3 – Make predictions about the future. Use the information to forecast costs, revenues, and other outcomes.
Step 4 – Make the decision by choosing among alternatives. Apply the relevant-cost framework to compare options.
Step 5 – Implement, evaluate performance, and learn. After acting, check actual results against predictions and feed lessons back into future decisions.
The core skill in this chapter is filtering. When comparing alternatives, include only costs that meet both criteria:
The cost must be a future cost (not already incurred).
The cost must differ between the alternatives.
Everything else, including sunk costs, is noise for that particular decision.
Unit fixed cost data can lead managers astray in two specific ways:
Including irrelevant costs. If a fixed cost will not change between alternatives, folding it into a per-unit figure makes one option look artificially expensive.
Using the same fixed unit cost at different output levels. Fixed costs per unit change as volume changes. A unit cost calculated at 10,000 units is meaningless if the decision involves producing 15,000 units.
These decisions have a time horizon of only a few months. The key points:
In the short run, many fixed costs are unavoidable and therefore irrelevant.
The relevant costs are typically the variable manufacturing costs, because there are often no incremental marketing or fixed overhead costs.
Strategic and other factors still matter: when bidding, consider how competitors will view your price.
When deciding whether to make a component internally or buy it from a supplier:
Compare the relevant costs of each option (incremental manufacturing costs vs. the supplier's price).
Factor in qualitative considerations: quality control, dependability of the supplier, lead times, and the risk of losing internal capability.
If making the component internally frees up or consumes capacity, the opportunity cost of that capacity must be included in the analysis.
Opportunity cost is the value of the best forgone alternative. It is not recorded in accounting systems, but it is a real economic cost:
It arises whenever a limited resource (machine time, floor space, skilled labour) has more than one possible use.
The opportunity cost of choosing Option A is the contribution margin you would have earned from the best alternative use of that resource.
Short-run pricing decisions arise constantly in industries with spare capacity, such as hotels discounting rooms midweek or airlines offering last-minute fares. The logic is identical: if the price covers variable costs and fixed costs are already committed, the sale adds to profit.
Make-or-buy analysis is the backbone of outsourcing decisions across manufacturing and services. A company deciding whether to run its own payroll or hire an external provider is working through this same framework.
Students often treat all fixed costs as irrelevant. Some fixed costs are avoidable (e.g. a lease you can cancel) and therefore relevant; the test is whether the cost differs between alternatives, not whether it is fixed or variable.
Students frequently include sunk costs in their analysis because the amounts feel large or "too important to ignore." The size of a sunk cost does not make it relevant. It is gone either way.
Opportunity cost is commonly forgotten entirely because it does not appear in the accounting records. Examiners test this regularly.
When using unit fixed costs, students often fail to recalculate them for the actual volume under consideration, applying a per-unit figure from one output level to a completely different scenario.
⚠️ Expect a question that gives you a list of costs and asks you to identify which are relevant. The sunk-cost trap is the most commonly tested mistake.
⚠️ Make-or-buy problems almost always include a capacity twist: what happens to the freed-up capacity? If you ignore the opportunity cost of that capacity, you will get the answer wrong.
⚠️ Short-run pricing questions test whether you know to use variable costs (not full costs) as the floor. Including allocated fixed costs in a one-off pricing decision is a classic error.
⚠️ Qualitative factors are often worth marks on written questions. Mentioning supplier reliability, employee morale, or long-term strategic positioning shows you understand that the numbers are not the whole story.
1. True or false: A cost incurred two years ago can be a relevant cost if it was large enough.
False. Relevance depends on whether the cost is future and differs between alternatives, not on its size.
2. Fill in the blank: The two conditions for a cost to be relevant are that it must occur in the ________ and it must ________ among the alternatives.
Future; differ.
3. True or false: Opportunity cost appears as a line item in the general ledger.
False. Opportunity cost is an economic concept, not a recorded accounting entry.
4. True or false: In a short-run pricing decision, the minimum acceptable price is typically the full product cost.
False. In the short run, the floor is the variable (incremental) cost, because fixed costs are already committed.
5. Fill in the blank: A make-or-buy decision is also known as an ________ vs. ________ decision.
Insourcing; outsourcing.
Q: A company purchased a machine for $50,000 three years ago. It is now deciding whether to keep the machine or replace it. Is the $50,000 purchase price a relevant cost? Why or why not?
A: No. The $50,000 is a sunk cost. It has already been incurred and cannot be recovered regardless of whether the company keeps or replaces the machine.
Q: Name two conditions that must both be satisfied for a cost to be classified as relevant.
A: The cost must (1) occur in the future and (2) differ among the alternative courses of action being considered.
Q: A supplier offers to sell a component for $8 per unit. The company currently makes the component at a variable cost of $6 per unit, but uses machine capacity that could instead be used to produce another product contributing $3 per unit. Should the company outsource?
A: The relevant cost of making is $6 variable cost + $3 opportunity cost = $9 per unit. Since the supplier's price of $8 is less than $9, the company should outsource, assuming qualitative factors (quality, reliability) are acceptable.
Q: Why can unit fixed costs mislead a manager when evaluating a special order at a different volume level?
A: Unit fixed costs change with volume. A per-unit figure calculated at one output level does not apply at a different level. Using the wrong unit fixed cost overstates or understates the true cost of the order.
Q: Give two examples of qualitative factors that might influence a make-or-buy decision.
A: Supplier dependability (risk of late deliveries or inconsistent quality) and the potential loss of internal expertise or capability if production is moved outside.
This material connects directly to cost-volume-profit analysis (earlier chapters), because understanding cost behaviour is what lets you identify which costs are relevant. It also sets up transfer pricing and performance evaluation in later chapters, where divisions within a company use opportunity costs to negotiate internal prices. If you have studied contribution margin, you already have the building block for every relevant-cost calculation here.
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