Difficulty: Intermediate | Prerequisites: Cost Behaviour and CVP Analysis (Parts 1 and 2)
Relevant cost analysis is where managerial accounting becomes practical. Instead of recording what happened (financial accounting's job), you are now deciding what to do next. The core principle: only costs and revenues that differ between alternatives matter for the decision. Sunk costs are out. Allocated costs that will not change are out. The question is always "what changes if we choose option A instead of option B?" This material covers special orders, outsourcing, dropping product lines, and make-or-buy decisions.
When making a decision, ignore sunk costs and unavoidable fixed costs. Focus only on the revenues and costs that will change as a result of the decision. The net effect of those changes tells you whether the decision improves or worsens profit.
Relevant cost
A cost that differs between decision alternatives and will be incurred in the future. Only relevant costs matter for decision making. In simple terms, if it changes depending on what you decide, it is relevant.
Sunk cost
A cost already incurred that cannot be recovered. Sunk costs are never relevant to future decisions. Depreciation on equipment already purchased is the textbook example.
Avoidable cost
A cost that can be eliminated if a particular action is taken (such as discontinuing a product or outsourcing). Avoidable costs are relevant because they change with the decision.
Unavoidable cost
A cost that will continue regardless of the decision. Allocated corporate overhead that will not actually decrease if a department is closed is unavoidable and therefore irrelevant.
Opportunity cost
The benefit foregone by not choosing the next-best alternative. Opportunity costs are relevant even though they never appear in the accounting records.
Special order
A one-off order at a price different from the normal selling price. The decision rule: accept if the incremental revenue exceeds the incremental costs, provided there is spare capacity and it does not affect regular sales.
Outsourcing (make-or-buy)
The decision whether to produce a component or service internally or purchase it from an outside supplier. Compare the avoidable costs of making it in-house against the purchase price.
Differential (incremental) analysis
A decision framework that compares only the costs and revenues that differ between alternatives, ignoring everything that stays the same.
For any decision, follow these steps:
Identify the alternatives.
For each alternative, list the costs and revenues that will change.
Ignore sunk costs (already spent, cannot be undone).
Ignore allocated costs that will not actually change.
Include opportunity costs (benefits foregone).
Compare the net effect on profit.
Depreciation from a prior purchase is a sunk cost and therefore not relevant. Savings in fixed costs that can actually be eliminated (avoidable fixed costs) are relevant.
The salary of a regional manager who will be kept regardless of whether a store closes is not relevant to the store-closing decision. Lost sales, variable cost savings, and avoidable rent are all relevant.
Accept a special order if the incremental revenue exceeds the incremental cost, provided there is excess capacity and the order does not displace regular sales.
Worked example (Borders Inc.): Regular production 10,000 units. Budgeted sales $250,000, so selling price = $25/unit. COGS = $165,000, including $45,000 fixed. Variable COGS = $165,000 - $45,000 = $120,000, so variable cost per unit = $12. Special order: 4,000 units at $20 each.
Incremental revenue = 4,000 x $20 = $80,000
Incremental cost = 4,000 x $12 = $48,000 (only variable costs, since there is excess capacity and fixed costs do not change)
Incremental profit = $80,000 - $48,000 = $32,000 increase
Worked example (BT Corporation tablas): Capacity 6,000 units, currently at 90% = 5,400 units. Excess capacity = 600 units. Special order from MMA at $410 each. Variable manufacturing cost = $270. Variable S&A = $90, but special orders typically exclude variable selling costs (the order came to them). Fixed costs do not change.
Incremental revenue = 600 x $410 = $246,000
Incremental cost = 600 x $270 = $162,000 (variable manufacturing only, assuming no variable S&A on the special order)
Wait: the problem says the special order would not affect regular sales or total fixed costs. Variable S&A ($90/unit) may or may not apply. If variable S&A is excluded: profit increase = 600 x ($410 - $270) = 600 x $140 = $84,000. If included: 600 x ($410 - $270 - $90) = 600 x $50 = $30,000.
Answer C ($30,000 increase) is correct, indicating variable S&A costs do apply to the special order.
Worked example (CSCP Inc.): Current: 1,000 units at $70, variable cost $26, fixed $22,000. Current profit = $70,000 - $26,000 - $22,000 = $22,000. With lease: price $125, variable cost $26 + $15 = $41, fixed $22,000 + $9,000 = $31,000. New profit = $125,000 - $41,000 - $31,000 = $53,000. Increase = $53,000 - $22,000 = $31,000.
Compare the avoidable costs of doing it in-house against the cost of buying from outside. Allocated overhead that will not actually disappear is irrelevant.
Worked example (Robin Inc. PR outsourcing):
Avoidable costs if outsourced: PR salaries $410,000 + departmental overhead savings $20,000 = $430,000
Costs that do NOT change: admin assistants $90,000 (transferred, not eliminated) and corporate overhead $25,000 (just reallocated, still incurred by the company)
Cost of outsourcing: $415,000
Savings = $430,000 - $415,000 = $15,000
The admin salaries and reallocated corporate overhead are irrelevant because they do not go away.
Drop a product only if the avoidable costs saved exceed the lost contribution margin (or equivalently, the lost revenue).
Worked example (Buccaneers, product T20): Sales $810,000, variable costs $375,000. Contribution margin = $435,000. Avoidable fixed costs: $168,000 manufacturing + $161,000 S&A = $329,000. Unavoidable fixed costs: ($219,000 - $168,000) + ($176,000 - $161,000) = $51,000 + $15,000 = $66,000.
If T20 is dropped, the company loses $435,000 of contribution margin but saves $329,000 of avoidable fixed costs. Net effect: profit decreases by $435,000 - $329,000 = $106,000. Advice: do not drop the product. (Answer: A)
Worked example (SMT engines): Direct material $240,000, direct labour $450,000. Manufacturing overhead $585,000, which includes fixed OH at 50% of DL = $225,000 and variable OH at 80% of DL = $360,000.
Variable manufacturing cost = DM + DL + Variable OH = $240,000 + $450,000 + $360,000 = $1,050,000. Per unit = $1,050,000 / 15,000 = $70.
The fixed overhead ($225,000) and selling/admin expenses ($67,000) are excluded from the variable manufacturing cost per unit. Compare the $70 variable cost to the $75 purchase price to see whether making in-house saves money (it does, by $5 per unit on variable costs alone, before considering whether fixed OH is avoidable).
In a store-closing decision, the salary of the regional manager for all Dallas operations is not relevant if the manager will be retained regardless of whether one store closes. Lost sales, variable cost savings, and the store's own rent (if avoidable) are all relevant. (Answer: D)
Students often include allocated overhead that will not actually change in their relevant cost analysis. If corporate overhead is just reallocated to other departments, it is not a real saving. Only costs that truly go away are relevant.
Depreciation on existing equipment is a sunk cost, not an opportunity cost. Students sometimes confuse the two. Sunk costs are irrelevant. Opportunity costs are relevant.
"Savings in fixed costs" sounds contradictory, but avoidable fixed costs (ones that genuinely disappear with the decision) are relevant. The key word is "avoidable."
In special order problems, students sometimes include fixed costs in the incremental analysis. If the company has spare capacity and fixed costs do not change, they are excluded.
In the make-or-buy calculation, students sometimes forget to separate fixed and variable components of manufacturing overhead. Only the variable portion is relevant if fixed OH will continue regardless.
⚠️ The outsourcing question tests whether you can distinguish avoidable from unavoidable costs. Read carefully for words like "transferred elsewhere" (the cost stays) or "would be terminated" (the cost goes away).
⚠️ The dropping-a-product question hinges on avoidable fixed costs. The full allocated fixed cost is a red herring; only the portion that actually disappears matters.
⚠️ Special order questions always test whether there is excess capacity. If there is no excess capacity, accepting the order displaces regular sales, and you must factor in the lost contribution margin from those displaced sales.
True or False: Depreciation on equipment bought two years ago is relevant to a current decision.
False. It is a sunk cost.
True or False: Allocated corporate overhead that will continue regardless of a decision is irrelevant.
True.
Fill in the blank: Accept a special order if incremental _______ exceeds incremental _______.
Revenue; cost.
True or False: If a product's contribution margin exceeds its avoidable fixed costs, the company should keep the product.
True. Dropping it would reduce profit.
True or False: Opportunity costs appear in the general ledger.
False. They are relevant to decisions but never recorded in the books.
Q: For decision making using relevant costs, depreciation resulting from prior purchases is what?
A: A sunk cost and therefore not relevant. (Answer: D)
Q: For decision making, savings in fixed costs are considered what?
A: Avoidable fixed costs and therefore relevant. If the fixed cost genuinely goes away, it matters. (Answer: A)
Q: CSCP Inc. makes a product for $26/unit variable, $22,000 fixed, sells 1,000 at $70. If it leases a machine for $9,000/month and adds $15/unit in features to sell at $125, what is the effect on monthly profit?
A: Current profit = (1,000 x $70) - (1,000 x $26) - $22,000 = $70,000 - $26,000 - $22,000 = $22,000. New profit = (1,000 x $125) - (1,000 x $41) - $31,000 = $125,000 - $41,000 - $31,000 = $53,000. Increase of $31,000.
Q: Borders Inc. receives a special order for 4,000 units at $20. Normal: 10,000 units, sales $250,000, COGS $165,000 (includes $45,000 fixed). Excess capacity exists. Impact on pretax income?
A: Variable cost per unit = ($165,000 - $45,000) / 10,000 = $12. Incremental profit = 4,000 x ($20 - $12) = 4,000 x $8 = $32,000 increase.
Q: BT Corporation, capacity 6,000, selling 5,400 tablas at $750. Variable manufacturing $270, variable S&A $90. MMA offers $410 for excess capacity (600 units). Impact on profit?
A: Incremental profit per unit = $410 - $270 - $90 = $50. Total = 600 x $50 = $30,000 increase. (Answer: C)
Q: Robin Inc. outsourcing PR. PR salaries $410,000 (terminated), admin $90,000 (transferred), overhead savings $20,000, reallocated corporate OH $25,000. Outside cost $415,000. Savings?
A: Avoidable costs = $410,000 + $20,000 = $430,000. Savings = $430,000 - $415,000 = $15,000.
Q: Buccaneers considering dropping T20. Sales $810,000, variable costs $375,000. Avoidable fixed: $168,000 mfg + $161,000 S&A = $329,000. Advice?
A: Contribution margin = $435,000. Avoidable fixed = $329,000. Net loss from dropping = $435,000 - $329,000 = $106,000. Do not drop. (Answer: A)
Q: SMT engines: DM $240,000, DL $450,000, MOH $585,000 (fixed = 50% of DL, variable = 80% of DL). What is the variable manufacturing cost per unit for 15,000 units?
A: Fixed OH = 0.50 x $450,000 = $225,000. Variable OH = 0.80 x $450,000 = $360,000. Variable mfg cost = $240,000 + $450,000 + $360,000 = $1,050,000. Per unit = $70.
Q: Games Buy is closing one of 25 stores. Which financial data is not relevant: lost sales, variable cost savings, store rent, or the regional manager's salary?
A: The regional manager's salary. The manager oversees all Dallas operations and will be retained regardless. (Answer: D)
Relevant cost analysis builds on cost behaviour (you need to know which costs are variable and which are fixed to determine what changes with a decision) and CVP analysis (contribution margin is the starting point for most of these decisions). These decision-making tools reappear in capital budgeting later in the course, where the same principle applies over longer time horizons: only incremental cash flows matter.
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