Source: Final Exam Review, Cost Accounting, The Ohio State University
Tags: relevant costs, sunk costs, special orders, make-or-buy, outsourcing, drop or keep product line, constrained resources, product mix, joint costs, split-off, transfer pricing, incremental analysis, opportunity cost
Difficulty: Intermediate | Prerequisites: Understanding of cost behaviour (variable vs. fixed), contribution margin basics.
This is one of the most heavily tested areas in cost accounting. Every question boils down to the same principle: when choosing between alternatives, only the costs and revenues that differ between those alternatives matter. Sunk costs (money already spent) are irrelevant. Fixed costs that continue regardless of the decision are irrelevant. The skill is identifying which costs actually change.
If you are coming in cold, make sure you are comfortable with the distinction between variable and fixed costs, and between avoidable and unavoidable costs, before working through this material.
When making short-term decisions, ignore sunk costs and unavoidable fixed costs. Compare only the costs and revenues that differ between your alternatives. The "minimum acceptable price" on a special order is the incremental cost of filling it, and the "maximum price to pay" for outsourcing is the total cost you would avoid by not making the item yourself.
Relevant cost
A future cost that differs between decision alternatives. Only relevant costs should influence a decision. Past costs and costs that stay the same regardless of the choice are irrelevant. In simple terms, if a cost does not change no matter what you decide, you can ignore it for the purpose of that decision.
Sunk cost
A cost that has already been incurred and cannot be recovered. Sunk costs are always irrelevant to future decisions. Think of it as money already out the door. The $25,000 John paid for his Trail Blazer years ago cannot be un-spent, so it plays no role in deciding whether to repair it or buy a different car.
Incremental cost (differential cost)
The additional cost incurred by choosing one alternative over another. This is the cost that "moves" between options. In simple terms, it is the extra cost you take on by picking Option A instead of Option B.
Avoidable cost
A cost that will disappear entirely if a particular action is taken (e.g. dropping a product line or outsourcing a part). Think of it as: "If we stop doing this, does this cost go away?" If yes, it is avoidable.
Unavoidable cost
A cost that continues regardless of the decision. Often includes allocated fixed overhead that will simply be reassigned to other products. In simple terms, these costs stick around no matter what you choose, so they do not factor into the decision.
Opportunity cost
The benefit forgone by choosing one alternative over the next best alternative. Opportunity costs are relevant even though they do not appear in accounting records. Think of it as: "What am I giving up?" If idle factory space could be rented out for $45,000, that rental income is the opportunity cost of using the space to make parts instead.
Contribution margin
Selling price minus all variable costs. It represents what each unit contributes towards covering fixed costs and generating profit.
Split-off point
The stage in a joint process where individual products become separately identifiable. Joint costs incurred before split-off are sunk with respect to the "sell now vs. process further" decision.
Transfer price
The price one division of a company charges another division for an internal sale of goods or services. The minimum transfer price equals the selling division's incremental cost plus any opportunity cost of the transfer.
The original purchase price of an asset you already own is a sunk cost. It is the same under every alternative, so it drops out of the analysis.
In the Trail Blazer / Grand Cherokee example, the $25,000 acquisition cost of the Trail Blazer is sunk. John already owns it.
The relevant comparison is: repair the Trail Blazer for $6,000 + $2,280 operating costs = $8,280 in year one, versus buy the Grand Cherokee for $6,000 + $2,100 operating costs = $8,100 in year one.
Savings from buying the Grand Cherokee: $8,280 - $8,100 = $180 in year one.
The correct framing: both options cost $6,000 up front (repairs vs. purchase), so the first-year difference is just the operating cost gap of $180.
When a company has excess capacity and receives a one-time order, the minimum acceptable price equals the incremental (variable) costs of fulfilling that order. Fixed costs are excluded because they are already being incurred and will not change.
Coroid Manufacturers: Variable costs relevant to the special order are direct materials ($120), direct labour ($60), and variable manufacturing support ($105). Marketing costs ($45 variable) are avoided on this order, so they are excluded. Minimum price = $120 + $60 + $105 = $285 ... but wait, the answer given is $330. That is because the question includes variable manufacturing support of $105 plus variable marketing of $45 that, on re-reading, the special order avoids marketing but includes manufacturing. The total of relevant variable manufacturing costs = $120 + $60 + $105 = $285, plus the fixed costs do not apply. The answer key shows A) $330, which equals $285 + $45 for variable marketing. On closer inspection the question states the company "will avoid marketing costs," meaning the $45 variable marketing is excluded. The answer $330 = $120 + $60 + $105 + $45 appears to include variable marketing. Different instructors may treat this differently; follow the logic your professor uses and note that the exam answer is $330 (A).
Contrafic's Kitchens: Relevant costs for the special order are the variable manufacturing costs that change. Start with variable costs: direct materials $546 + $60 cherry upgrade = $606, direct labour $360, variable manufacturing support $54, plus the unavoidable variable shipping of $180. Total relevant cost per unit = $606 + $360 + $54 + $180 = $1,200. The exam answer is $1,140 (B), which equals $546 + $60 + $360 + $54 + $180 = $1,200 ... actually $546 + $360 + $54 + $180 = $1,140, then + $60 = $1,200. The exam answer of $1,140 appears to use the base direct materials ($546) + direct labour ($360) + variable manufacturing support ($54) + shipping ($180) = $1,140, treating the $60 cherry upgrade separately or as already included. The exam-keyed answer is $1,140 (B).
Reggie Corporation: Variable costs per unit are: direct materials $2,400 + direct labour $960 + variable factory overhead (30% of $1,800 = $540) + variable admin (10% of $840 = $84) = $3,984. No selling expenses on the special order. To earn $18,000 profit on 100 units, the price must cover $3,984 + ($18,000 / 100) = $3,984 + $180 = $4,164 per unit.
Compare the avoidable costs of making in-house against the purchase price from the outside supplier. Include any opportunity costs (e.g. rental income from freed-up facilities).
Genent's Engine Company (TE456):
Variable costs of making: $46,000 + $11,500 + $34,500 = $92,000
Avoidable fixed overhead: 8% of $23,000 = $1,840
Total avoidable costs = $92,000 + $1,840 = $93,840
Cost to buy: 1,000 units x $97.75 = $97,750
Net effect of buying: $97,750 - $93,840 = $3,910 increase in costs, meaning operating income decreases by $3,910.
Maximum purchase price = avoidable cost per unit = $93,840 / 1,000 = $93.84 per unit.
Brockington Company (raw material Y):
Costs to make internally: direct material $2 + direct labour $2 + VOH $1 + supervisor salary ($27,000 / 12,000 units = $2.25) = $7.25 per unit.
FOH of $3/unit is allocated and would not be avoided, so it is irrelevant.
Indifference price from outside supplier = $7.25 per unit. At this price, making and buying cost the same.
Vest Industries:
Avoidable costs of making: DM $75,000 + DL $120,000 + Var. OH $45,000 = $240,000 (fixed OH of $60,000 is allocated and unavoidable).
Cost to buy: 40,000 x $12.75 = $510,000.
Rental income gained if buying: $45,000 (opportunity cost of making).
Net cost of buying: $510,000 - $45,000 = $465,000 vs. $240,000 to make.
Effect on income if outsourcing: costs increase by $465,000 - $240,000 = $225,000 decrease.
Piels Corporation:
Avoidable costs of making 10,000 units: DM $90,000 + DL $130,000 + Variable FOH $60,000 + Avoidable fixed FOH $60,000 = $340,000.
Cost to buy: 10,000 x $36 = $360,000.
Making saves $360,000 - $340,000 = $20,000, or $2 per unit. Continue making.
Maximum price willing to pay = avoidable cost = $340,000 for 10,000 units.
Drop a product only if its contribution margin is less than the avoidable fixed costs it would eliminate. Unavoidable fixed costs will be reallocated, not saved.
Rambo Company, Product C:
Contribution margin of C: $9,000
Avoidable fixed costs of C: $4,000
If dropped, the company loses $9,000 in contribution margin but saves only $4,000 in avoidable fixed costs.
Net effect: operating income decreases by $5,000.
The $5,400 in unavoidable fixed costs continues regardless, so it is irrelevant.
When a bottleneck limits production, prioritise products by contribution margin per unit of the constrained resource, not by contribution margin per unit.
Helmer's Rockers:
Standard: $18 CM / 3 machine-hours = $6 per machine-hour
Premium: $20 CM / 4 machine-hours = $5 per machine-hour
Standard is more profitable per hour of constraint. Produce all 100 Standard first (300 hours), then use remaining 196 hours for Premium: 196 / 4 = 49 units of Premium.
Optimal mix: 100 Standard, 49 Premium.
Walton Toy Company:
Calculate labour hours per unit: direct labour cost per unit / wage rate.
Debbie: $3.60 / $8 = 0.45 hrs; CM per hour = $5.20 / 0.45 = $11.56
Trish: $2.00 / $8 = 0.25 hrs; CM per hour = $1.50 / 0.25 = $6.00
Sarah: $5.60 / $8 = 0.70 hrs; CM per hour = $7.56 / 0.70 = $10.80
Mike: $4.20 / $7 = 0.60 hrs; CM per hour = $3.15 / 0.60 = $5.25
Sewing kit: $1.60 / $8 = 0.20 hrs; CM per hour = $2.80 / 0.20 = $14.00
Ranking by CM per labour hour: Sewing kit (14.00) > Debbie (11.56) > Sarah (10.80) > Trish (6.00) > Mike (5.25).
Allocate 130,000 hours in that order. Sewing kit: 325,000 x 0.20 = 65,000 hrs. Debbie: 50,000 x 0.45 = 22,500 hrs. Sarah: 35,000 x 0.70 = 24,500 hrs. Trish: 42,000 x 0.25 = 10,500 hrs. Total so far = 122,500 hrs. Remaining = 7,500 hrs for Mike: 7,500 / 0.60 = 12,500 units (demand is 40,000).
Mike's demand cannot be fully met.
Joint costs incurred before the split-off point are sunk. The decision to process further depends only on whether the incremental revenue from further processing exceeds the incremental cost.
Stars Manufacturing:
A1: Incremental revenue = $15,000 - $10,000 = $5,000; Incremental cost = $2,500. Net gain = $2,500. Process further.
B2: Incremental revenue = $35,000 - $30,000 = $5,000; Incremental cost = $3,000. Net gain = $2,000. Process further.
C3: Incremental revenue = $25,000 - $20,000 = $5,000; Incremental cost = $4,000. Net gain = $1,000. Process further.
D4: Incremental revenue = $45,000 - $40,000 = $5,000; Incremental cost = $6,000. Net loss = -$1,000. Sell at split-off.
Only D4 should be sold at split-off.
The minimum transfer price the selling division will accept = Incremental cost per unit + Opportunity cost per unit (lost contribution from foregone external sales).
Chemical Company, Mixing Division:
Variable costs: DM $3.00 + DL $2.40 + VOH $3.60 + Variable M&A $0.50 = $9.50
If selling to Bottling, variable M&A is avoided, so incremental cost = $3.00 + $2.40 + $3.60 = $9.00
At capacity: Every gallon transferred to Bottling is one fewer gallon sold externally at $15. Opportunity cost = $15.00 - $9.50 = $5.50 (the contribution margin lost on external sale, noting all variable costs including M&A are incurred on external sales). Minimum transfer price = $9.00 + ($15.00 - $9.50) = $9.00 + $5.50 = $14.50. The exam answer is $9.00 (C), which suggests the question defines opportunity cost differently or the answer treats it as incremental cost only. Follow your professor's framework.
With excess capacity: No opportunity cost because no external sales are lost. Minimum transfer price = incremental cost = $9.00.
Students often include sunk costs (like the original purchase price of an existing asset) in a keep-or-replace analysis. The original cost is gone. Only future, differential costs matter.
Students frequently forget to check whether fixed overhead is truly avoidable. Allocated fixed overhead that will simply shift to other products is not a saving.
On special orders, students sometimes include the full product cost (including fixed overhead and markup) as the "minimum price." With excess capacity, fixed costs do not change, so only incremental variable costs set the floor.
On constrained-resource problems, students often rank by contribution margin per unit rather than contribution margin per unit of the bottleneck resource. The constraint is what matters.
⚠️ The phrase "minimum acceptable price" on a special order means incremental cost, not full cost.
⚠️ "Avoidable" vs. "unavoidable" fixed costs is tested repeatedly. Read carefully whether a percentage of fixed overhead disappears or not.
⚠️ On make-or-buy, do not forget opportunity costs like rental income from freed-up space.
⚠️ Joint costs before the split-off point are always irrelevant to the sell-or-process-further decision.
⚠️ Transfer pricing minimum = incremental cost + opportunity cost. If there is excess capacity, opportunity cost is zero.
True or false: The original purchase price of equipment should be included in a make-or-buy analysis. False. It is a sunk cost.
True or false: If a product line has a positive contribution margin, dropping it will reduce total operating income (assuming its avoidable fixed costs are less than its contribution margin). True.
Fill in the blank: When resources are constrained, products should be ranked by contribution margin per unit of the ________. Constrained resource (bottleneck).
True or false: Joint costs should be considered when deciding whether to process a product further after split-off. False. Joint costs are sunk at the split-off point.
Q: A company has excess capacity and receives a special order. Variable manufacturing costs are $285 per unit, and the order avoids $45 in variable marketing. What is the minimum acceptable price?
A: $285 per unit. The avoided marketing cost is not incurred, so only the $285 in variable manufacturing costs sets the floor. (Note: some exam keys may include additional variable costs depending on how the scenario is worded. Always identify exactly which costs change.)
Q: A part costs $115,000 to make (variable $92,000, fixed $23,000). If outsourced, 8% of fixed costs are avoidable. What are total avoidable costs?
A: $92,000 + (8% x $23,000) = $92,000 + $1,840 = $93,840.
Q: Product C has $9,000 contribution margin, $4,000 avoidable fixed costs, and $5,400 unavoidable fixed costs. What happens to operating income if Product C is dropped?
A: Operating income decreases by $5,000 ($9,000 lost contribution margin minus $4,000 saved in avoidable fixed costs).
Q: Two products compete for machine time. Product X has a CM of $18 and uses 3 hours; Product Y has a CM of $20 and uses 4 hours. Which should be prioritised?
A: Product X. Its CM per machine-hour is $6, versus $5 for Product Y.
Q: A product can be sold at split-off for $40,000 or processed further for $6,000 to generate $45,000 in sales. Should it be processed further?
A: No. Incremental revenue is $5,000 but incremental cost is $6,000. Sell at split-off.
Q: A division operating at capacity sells externally at $15/gallon. Its variable costs are $9.50 (including $0.50 M&A avoided on internal sales). What is the minimum transfer price to an internal buyer?
A: Incremental cost of internal sale ($9.00) + opportunity cost ($15.00 - $9.50 = $5.50) = $14.50. (Check your professor's specific approach to which variable costs are included in the opportunity cost calculation.)
This material connects directly to cost-volume-profit (CVP) analysis, since contribution margin is the foundation of both. It also feeds into capital budgeting for longer-term versions of these same decisions (where time value of money enters the picture). Variance analysis, covered in the companion notes, tests whether the cost estimates used in these decisions were accurate after the fact.
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