Relevant Costs and Decision Making: Special Orders, Shutdowns and Materials
Which costs matter when you choose between options, and which to ignore.
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The rules: what is and is not relevant
| Relevant (include) | Not relevant (ignore) |
|---|---|
| Future costs and revenues | Past costs (sunk costs) |
| Costs that differ between options (incremental) | Costs the same under every option |
| Cash flows | Non-cash items such as depreciation |
| Opportunity costs | Fixed overhead that is only absorbed, not actually changed |
Example 1: a special order
A firm is offered an order for 1,000 units at 20 each. The variable cost is 13 per unit. Fixed overhead absorbed is 6 per unit, but total fixed costs will not change.
(a) The firm has spare capacity. Relevant cost = 13 (variable cost only). Contribution = 20 − 13 = 7 per unit, so 7,000 extra profit. Accept the order.
(b) The firm has no spare capacity. Making the order means giving up normal sales that earn a contribution of 10 per unit. That lost contribution is an opportunity cost.
| Variable cost | 13 |
| Opportunity cost (lost contribution) | 10 |
| Relevant cost per unit | 23 |
|---|---|
| Offer price | 20 |
| Gain / (loss) per unit | (3) |
Reject the order: it loses 3 per unit, or 3,000 overall.
Example 2: the relevant cost of materials
A job needs 500 kg of a material. The firm holds 500 kg bought earlier at 6 per kg. The replacement cost is 8 per kg, and the stock could be sold for 5 per kg. The original cost of 6 is sunk. The relevant cost depends on the situation:
| Situation | Relevant cost per kg | Why |
|---|---|---|
| Material is used regularly, so using it means buying more | 8 (replacement cost) | Using it now means paying to replace it |
| Not needed elsewhere, but could be sold | 5 (sale proceeds) | Selling price is the benefit given up |
| No other use and cannot be sold | 0 | Using it costs nothing extra |
Example 3: should a product be dropped?
Product Q earns a contribution of 30,000. Its fixed costs are 45,000, of which 20,000 are avoidable if the product is dropped and 25,000 are unavoidable (shared costs that stay anyway).
| Keep Q | Drop Q | |
|---|---|---|
| Contribution | 30,000 | 0 |
| Avoidable fixed costs | (20,000) | 0 |
| Net benefit | 10,000 | 0 |
The full income statement shows Q making a loss of 30,000 − 45,000 = 15,000. But dropping it would remove only 20,000 of cost and lose 30,000 of contribution, reducing company profit by 10,000. The 25,000 of unavoidable cost remains either way. Keep Q.
Common mistakes
- Using the full absorbed cost. Absorbed fixed overhead does not change with the decision.
- Including sunk costs. Money already spent is gone whatever you decide.
- Forgetting opportunity costs when capacity or scarce materials are fully used.
- Including depreciation. It is not a cash flow that changes with the decision.
Quick check
1. A firm already spent 8,000 on a feasibility study. Is it relevant to the go-ahead decision?
No. It is a sunk cost and is the same whether the project goes ahead or not.
2. A product has a contribution of 12,000 and avoidable fixed costs of 15,000. Should it be dropped?
Net benefit of keeping = 12,000 − 15,000 = −3,000, so drop it (unless it supports sales of other products).
Practise with Problem 4 (special order) and Problem 5 (make or buy).
Frequently asked questions
What is a relevant cost?
A future cash cost that differs between the options being considered. Only relevant costs should influence the decision.
Why is depreciation not a relevant cost?
Depreciation is an allocation of a past cost, not a future cash flow, and it does not change with the decision.
What is the relevant cost of using scarce resources?
The direct cost plus the contribution lost by diverting the resource from its best alternative use.
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