Difficulty: Intermediate | Prerequisites: Basic cost behaviour, contribution margin, relevant cost concepts (see Incremental Analysis study notes).
Segment elimination asks whether dropping a business unit, product line, or department will improve overall company profit. The answer hinges on whether the segment's fixed costs are avoidable (they disappear if the segment is dropped) or unavoidable (they get reallocated to remaining segments). Make-or-buy asks whether to produce a component in-house or purchase it from an outside supplier, factoring in relevant costs and any opportunity cost of freed capacity.
Avoidable cost (traceable fixed cost)
A fixed cost that would be eliminated entirely if a segment is dropped. Examples: the segment's own rent, its dedicated equipment depreciation, salaries of staff who would be let go. Think of it as a cost that exists only because this segment exists.
Unavoidable cost (common fixed cost / shared fixed cost)
A fixed cost that continues even if the segment is dropped, because it supports the company as a whole. Examples: factory-wide rent, corporate headquarters costs, shared IT infrastructure. These costs simply get reallocated to the remaining segments.
Segment margin
Contribution margin minus traceable (avoidable) fixed costs. This is the true profitability of a segment after accounting for all costs that are directly caused by its existence. A negative segment margin is a strong signal that the segment should be considered for elimination.
Opportunity cost
The benefit forgone by choosing one alternative over another. In make-or-buy decisions, if the freed capacity could be used for something profitable, that forgone profit is an opportunity cost of continuing to make the component in-house.
Make-or-buy decision (outsourcing decision)
The choice between producing a component internally or purchasing it from an external supplier. The relevant comparison is between the avoidable costs of making (typically variable manufacturing costs) plus any opportunity cost of the capacity used, versus the purchase price from the supplier.
When fixed costs are traceable and avoidable (rent, depreciation, and other costs specific to the segment), the decision rule is: drop the segment if its contribution margin is less than its avoidable fixed costs. In other words, if the segment cannot cover the costs it directly causes, the company is better off without it.
Worked example: Boris Company, Unit B
Sales revenue: $300,000
Variable expenses: $200,000
Fixed expenses: $150,000 (traceable and avoidable)
Analysis:
Contribution margin: $300,000 - $200,000 = $100,000
Avoidable fixed costs: $150,000
Segment margin: $100,000 - $150,000 = -$50,000
Unit B loses $50,000 after covering its own traceable costs. Eliminating Unit B removes $300,000 in revenue, $200,000 in variable costs, and $150,000 in avoidable fixed costs. The net effect: total profit increases by $50,000.
When fixed costs are shared across the company (factory rent allocated evenly, corporate overhead), those costs do not disappear if you drop a segment. They simply get redistributed to the remaining segments. In this case, the only relevant items are the contribution margin the segment generates and any truly avoidable fixed costs.
Worked example: Opal Company, Unit 1
Sales revenue: $200,000
Variable expenses: $140,000
Fixed expenses: $100,000 (shared capacity costs, allocated evenly)
Relevant items in this decision:
The $200,000 in sales revenue is relevant (lost if Unit 1 is dropped)
The $140,000 in variable expenses is relevant (eliminated if Unit 1 is dropped)
If the fixed expenses are avoidable, they are relevant
If the fixed expenses are unavoidable, they are not relevant (they continue regardless)
Since the fixed costs are described as shared capacity costs allocated evenly, they are likely unavoidable. The contribution margin of Unit 1 is $200,000 - $140,000 = $60,000. Dropping Unit 1 would lose this $60,000 contribution while the $100,000 in fixed costs would simply shift to the other units. Profit would decrease by $60,000.
The critical distinction: avoidable fixed costs disappear when the segment goes. Unavoidable fixed costs stay.
The make-or-buy decision compares the relevant costs of producing in-house against the purchase price from an outside supplier. Relevant costs of making are typically the variable manufacturing costs. Allocated fixed costs are excluded unless they would actually be eliminated by outsourcing.
If the freed capacity has an alternative use, its benefit is an opportunity cost that tips the scale toward buying.
Worked example: Lillian Corporation
Current per-unit manufacturing costs:
Materials: $12
Labour: $18
Variable manufacturing overhead: $8
Fixed costs: $12 (allocated from total factory fixed costs)
Total: $50 per unit
Third-party supplier price: $54 per unit
Volume: 1,000 units per year
Alternative use of freed capacity: $14,000 additional profit
Analysis:
Relevant cost to make (variable costs only): $12 + $18 + $8 = $38 per unit
Total relevant cost to make 1,000 units: $38 x 1,000 = $38,000
Opportunity cost of capacity (forgone alternative profit): $14,000
Total cost of making (including opportunity cost): $38,000 + $14,000 = $52,000
Total cost of buying: $54 x 1,000 = $54,000
Difference: $54,000 - $52,000 = $2,000 in favour of making.
The $12 per-unit fixed cost is allocated from the factory total and will not disappear if Lillian outsources. It is irrelevant. Even after accounting for the $14,000 in opportunity cost, making remains cheaper by $2,000.
Conclusion: Lillian should not follow Bernard's plan. Outsourcing would decrease profits by $2,000.
Students often assume that all fixed costs are irrelevant. Fixed costs are irrelevant only when they are unavoidable (shared). Avoidable fixed costs, such as a segment's own lease or dedicated staff, are absolutely relevant because they disappear if the segment is dropped.
Students sometimes conclude that a segment should be eliminated simply because it shows an operating loss. A segment can show a loss after absorbing allocated common costs but still contribute positively to overall company profit. The segment margin (after only avoidable costs) is what matters.
In make-or-buy problems, students frequently forget to include opportunity cost. If freed capacity can generate additional profit, that forgone profit must be added to the cost of making.
Students often treat allocated fixed costs as avoidable. Allocated costs are a share of a common pool. Unless the problem explicitly states these costs would be eliminated, they are unavoidable and irrelevant to the decision.
⚠️ Segment elimination questions will often include an answer option showing the full revenue as the decrease in profit. This is wrong: the variable costs associated with that revenue also disappear.
⚠️ Exam questions frequently test whether you can distinguish avoidable from unavoidable fixed costs. Read the problem wording carefully. "Traceable" and "directly attributable" signal avoidable. "Allocated evenly" and "shared capacity costs" signal unavoidable.
⚠️ Make-or-buy problems almost always include a distractor answer that uses total manufacturing cost (including allocated fixed) instead of relevant variable cost. The allocated fixed cost per unit is the most common trap.
⚠️ Opportunity cost is regularly tested. A make-or-buy question that mentions an alternative use of freed capacity is testing whether you add that opportunity cost to the relevant cost of making.
True or false: If a segment shows an operating loss after allocated common costs, it should always be eliminated. (False. Look at the segment margin after only avoidable costs.)
Fill in the blank: Costs that remain even after a segment is dropped are called ______ costs. (Unavoidable or common fixed costs.)
True or false: In a make-or-buy decision, allocated fixed manufacturing overhead is a relevant cost. (False. It does not change with the decision.)
Fill in the blank: The benefit forgone by choosing to make rather than buy is called ______ cost. (Opportunity cost.)
True or false: If a segment's contribution margin is positive, eliminating it will always decrease total company profit. (False. Only if the contribution margin exceeds the avoidable fixed costs. If avoidable fixed costs are higher, elimination improves profit.)
Q: Division X has sales of $500,000, variable costs of $350,000, and traceable avoidable fixed costs of $180,000. What happens to total company profit if Division X is eliminated?
A: Contribution margin is $500,000 - $350,000 = $150,000. Avoidable fixed costs are $180,000. Segment margin is $150,000 - $180,000 = -$30,000. Eliminating Division X increases total profit by $30,000.
Q: Same Division X, but now the $180,000 in fixed costs are shared (allocated) and unavoidable. What happens if Division X is eliminated?
A: The contribution margin of $150,000 is lost, but the $180,000 in fixed costs continues and shifts to other divisions. Profit decreases by $150,000.
Q: A company makes a component for $25 per unit (variable costs only; fixed costs are allocated). An outside supplier offers $22 per unit. The freed capacity has no alternative use. Should the company outsource?
A: Yes. The relevant cost to make is $25 (variable). The cost to buy is $22. Outsourcing saves $3 per unit. Since allocated fixed costs continue regardless and there is no opportunity cost, buying is cheaper.
Q: Same scenario, but the freed capacity could generate $8,000 in additional profit, and the company needs 5,000 units. Should the company outsource?
A: Cost to make: $25 x 5,000 = $125,000 + $0 opportunity cost (wait, the capacity can generate $8,000). Total cost to make: $125,000 (but forgo $8,000). Cost to make including opportunity cost: $125,000 + $8,000 = $133,000. Cost to buy: $22 x 5,000 = $110,000. Outsourcing saves $133,000 - $110,000 = $23,000. Yes, outsource.
Q: In a segment elimination question, how do you know whether fixed costs are avoidable or unavoidable?
A: Read the problem language. "Traceable," "directly attributable," and "would be eliminated" signal avoidable costs. "Allocated evenly," "shared capacity costs," and "common costs" signal unavoidable. If the problem does not specify, you cannot assume they are avoidable.
These decisions share the same relevant cost framework as incremental analysis and special order pricing. All four decision types (sell or process further, special orders, segment elimination, make or buy) ask the same core question: which costs and revenues change between the alternatives?
Contribution margin reporting (variable costing income statements) provides the foundation for segment analysis. Understanding the difference between absorption costing and variable costing is essential, because allocated fixed overhead can make a profitable segment look unprofitable.
Opportunity cost connects to constrained-resource decisions and capital budgeting. Whenever capacity is limited, the concept reappears: what do you give up by using resources one way rather than another?
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