Relevant Costing and Short-Term Decisions

Introduction and Context

Managers frequently face decisions that do not involve designing a long-term strategy or preparing a full annual budget. Instead, they must decide what to do now: whether to manufacture a component or purchase it, accept a one-time customer order, discontinue a product, close a department temporarily, replace equipment, or allocate limited machine hours among competing products. These decisions are commonly called short-term or tactical decisions.

Relevant costing provides a disciplined method for analysing such choices. It focuses on revenues and costs that will differ between alternatives. This is important because accounting reports are designed primarily to describe performance, not necessarily to identify the financial consequences of a specific decision. A cost included in a financial statement may be irrelevant to a decision, while an opportunity cost that does not appear in the accounting records may be highly relevant.

Relevant costing is not a complete substitute for managerial judgement. Quantitative analysis must be combined with consideration of quality, reliability, employee welfare, customer relationships, legal obligations, environmental effects, operational resilience and ethical conduct. The strongest decisions integrate financial and non-financial evidence.

Learning Objectives

By the end of this chapter, you should be able to:

1. Define relevant revenues, relevant costs, avoidable costs, sunk costs and opportunity costs.
2. Distinguish relevant from irrelevant information in short-term decisions.
3. Analyse make-or-buy, outsourcing, special-order, product-discontinuation, shutdown, replacement and scarce-resource decisions.
4. Use contribution and opportunity-cost analysis to compare alternatives.
5. Incorporate qualitative, risk, ethical and governance considerations.
6. Explain the limitations of short-term relevant-cost analysis.

1. The Foundation of Relevant Costing

1.1 The decision-focused definition

A relevant cost is a future cost that differs between the alternatives under consideration. A relevant revenue is a future revenue that differs between those alternatives. Relevance therefore has three tests:

• Future: the amount has not already been incurred.
• Differential: the amount changes between alternatives.
• Decision-specific: the amount relates to the alternatives being compared.

A useful general expression is:

Here, ΔProfit is the change in profit resulting from choosing one alternative rather than another, ΔRevenue is the change in revenue, and ΔCost is the change in relevant cost. The expression applies when the decision does not alter taxes, financing, capacity investment or other items that need separate analysis. A positive result favours the proposed alternative on financial grounds; a negative result favours the existing or competing alternative.

1.2 Relevant and irrelevant information

The following categories are especially important:

The word “usually” matters. For example, a future fixed cost is relevant if it can be avoided, but irrelevant if it is contractually committed. Similarly, an allocated cost is not automatically irrelevant: if accepting a decision causes the underlying resource or expenditure to be eliminated, the cost may be relevant.

1.3 Sunk costs

A sunk cost is a cost already incurred that cannot be recovered or changed by the present decision. Historical purchase cost, accumulated depreciation and past research expenditure are common examples. Sunk costs may be important for reporting, taxation or performance evaluation, but they should not determine a choice between future alternatives.

For example, a machine purchased for $100,000 has a book value of $40,000. If management is deciding whether to retain or replace it, the $40,000 book value is sunk. The machine’s current disposal value, future operating costs and replacement cost may be relevant; its historical purchase price is not.

1.4 Opportunity costs

An opportunity cost is the benefit forgone when a resource is used for one purpose rather than its best alternative use. It is economically relevant even though it may not appear in the accounting records.

Suppose a component can be produced internally using capacity that could otherwise generate $18,000 of contribution. The $18,000 is an opportunity cost of making the component. If the component is purchased, that opportunity disappears and should not be included as a cost of buying.

1.5 Avoidable and unavoidable costs

An avoidable cost disappears, wholly or partly, when an activity is discontinued or an alternative is selected. An unavoidable cost remains regardless of the decision. Only the avoidable portion is relevant to a discontinuation or shutdown decision.

A common error is to treat all allocated fixed costs as avoidable. For example, a product may be charged with $30,000 of corporate rent, but the rent may continue after the product is discontinued. The allocation is not evidence that the cost is avoidable.

2. A Structured Relevant-Costing Process

A reliable decision process can be organised into six stages.

Stage 1: Define the decision and alternatives

State precisely what is being decided, the time horizon, and the feasible alternatives. “Should we outsource?” is incomplete unless the analysis specifies which component, supplier, period, volume and service requirements are involved.

Stage 2: Establish the constraint and assumptions

Identify available capacity, demand, contractual restrictions, quality standards, lead times and resource limitations. Relevant costing is only as reliable as its assumptions.

Stage 3: Separate future from past information

Remove sunk costs. Identify future cash flows and future non-cash consequences that differ between alternatives.

Stage 4: Identify differential revenues, costs and opportunity costs

Include incremental revenue, avoidable cost, additional fixed cost and the value of resources used elsewhere. Exclude costs that remain unchanged.

Stage 5: Compare alternatives

Use a contribution or incremental analysis. A schedule should show each relevant item under each alternative rather than merely presenting total accounting costs.

Stage 6: Test qualitative and risk implications

Assess quality, supplier dependence, employee effects, customer relationships, legal compliance, sustainability, data security, reputation and uncertainty. Where estimates are uncertain, perform sensitivity or scenario analysis.

3. Make-or-Buy and Outsourcing Decisions

A make-or-buy decision compares internal production with external purchase. The relevant cost of making normally includes:

• direct materials and direct labour that would be incurred;
• variable manufacturing overhead;
• avoidable fixed costs; and
• opportunity cost of capacity used.

The relevant cost of buying normally includes the purchase price, delivery, inspection, transition and other additional costs caused by procurement. Existing fixed overhead that continues under both alternatives is excluded.

The basic comparison is:

These equations assume that the component specifications, volume and time period are comparable, and that no significant tax, financing or contractual differences have been omitted.

Worked example: make or buy

A company requires 10,000 units of a component. Internal production would cost $6.20 variable cost per unit. Avoidable fixed costs are $12,000. The factory is operating below capacity, so using the capacity has no opportunity cost. A supplier offers the component for $7.00 per unit, with an additional inspection cost of $0.20 per purchased unit.

Relevant cost of making:

• Variable cost: 10,000 × $6.20 = $62,000
• Avoidable fixed cost = $12,000
• Total = $74,000, or $7.40 per unit

Relevant cost of buying:

• Purchase cost: 10,000 × $7.00 = $70,000
• Inspection cost: 10,000 × $0.20 = $2,000
• Total = $72,000, or $7.20 per unit

Buying saves $2,000 and is financially preferable, assuming quality and supply conditions are equivalent.

Now suppose internal capacity could instead be used to produce another item generating contribution of $1.50 per machine hour. Each component requires 0.5 machine hour. The opportunity cost is:

• 10,000 × 0.5 × $1.50 = $7,500.

The relevant cost of making becomes $81,500. Buying is then preferable by $9,500. This illustrates why idle capacity and constrained capacity produce different answers.

Strategic and qualitative issues in outsourcing

Management should also examine supplier financial stability, delivery reliability, intellectual property protection, labour standards, geopolitical exposure, cybersecurity, environmental performance and the risk of losing internal expertise. Outsourcing may reduce current cost but increase dependence on a single supplier. A robust decision may involve dual sourcing, a contractual service-level agreement or retaining a minimum internal capability.

4. Special Orders and One-Time Business

A special order is an additional order, often at a price below the normal selling price. It should be accepted when the incremental revenue exceeds the incremental cost, provided that ordinary sales are not displaced and strategic or legal concerns are acceptable.

If spare capacity exists, relevant costs may include materials, labour, variable overhead, special packaging, shipping and order-specific fixed costs. Normal fixed manufacturing overhead is irrelevant if it will be incurred regardless.

Worked example: special order

A manufacturer has idle capacity and receives an order for 4,000 units at $19 each. Incremental costs are:

• Materials: $8 per unit
• Labour: $4 per unit
• Variable overhead: $2 per unit
• Special packaging: $1 per unit

Incremental revenue is:

• 4,000 × $19 = $76,000.

Incremental cost is:

• 4,000 × ($8 + $4 + $2 + $1) = $60,000.

Incremental profit is $16,000. The order is financially attractive if it does not impair regular business, establish an unsustainable price expectation, violate contractual commitments or create unacceptable quality and reputational risks.

If the order uses scarce capacity, the contribution sacrificed from the best alternative use must be added to the special order’s relevant cost. A low price is not automatically acceptable merely because it exceeds variable production cost.

5. Product Discontinuation and Segment Decisions

A product, branch, service line or customer segment should not be discontinued solely because it reports an accounting loss. The correct question is whether discontinuation improves total profit after considering lost contribution and avoidable costs.

The financial effect of discontinuation can be stated as:

where contribution margin is revenue less variable costs. If the result is positive, discontinuation improves profit. This form assumes that all relevant revenues and costs have been correctly identified and that capacity has no alternative use. If released capacity can be used profitably elsewhere, the contribution from that alternative use must also be included.

Worked example: discontinue or retain

A service division reports:

The division’s reported loss is $55,000. Investigation shows that only $80,000 of traceable fixed costs can be avoided; corporate costs will continue. The division’s contribution margin is $90,000. If it is discontinued, the company loses $90,000 of contribution but saves $80,000, causing profit to fall by $10,000. Retaining the division is financially preferable, despite its reported accounting loss.

If the released facilities could generate $25,000 of contribution elsewhere, discontinuation would save $80,000 and create $25,000 of alternative contribution while sacrificing $90,000. Profit would then increase by $15,000. Capacity opportunity cost changes the conclusion.

6. Shutdown and Temporary Closure Decisions

A temporary shutdown decision asks whether operations should cease for a period, often because demand is weak. The analysis compares the contribution lost during closure with avoidable operating costs and any costs of closing and reopening.

A simplified condition for continuing is:

This comparison is valid only for the stated period. Long-term closure may involve redundancy payments, asset disposal, lease termination and loss of market presence. A temporary shutdown may also damage employee morale, customer confidence and supplier relationships.

Management should distinguish costs that are variable with production from costs that continue during closure, such as security, insurance, essential maintenance and property taxes. A closure that appears attractive for one month may be harmful over a year if restart costs or lost customers are significant.

7. Replacement of Equipment

Replacement decisions require careful treatment of historical book values. The book value of existing equipment is normally sunk. Relevant items include:

• purchase price and installation cost of new equipment;
• disposal proceeds or disposal costs for existing equipment;
• changes in operating, maintenance, labour and energy costs;
• tax effects where applicable;
• working-capital changes; and
• opportunity benefits from using the released equipment or facility.

For a simple short-term comparison, the net incremental cost of replacement is:

This expression is incomplete for a full investment appraisal because it excludes the time value of money, tax depreciation and future cash flows. For replacement decisions extending over several years, discounted cash-flow methods such as net present value are more appropriate.

Example: avoiding the sunk-cost trap

Old equipment has a book value of $50,000 and a current resale value of $12,000. A new machine costs $90,000 and reduces annual operating costs by $25,000. For a one-year decision, ignoring tax and discounting, the relevant acquisition difference is:

• New machine cost: $90,000
• Less disposal proceeds: $12,000
• Net cash outflow: $78,000
• First-year operating saving: $25,000

The book value of $50,000 is excluded. Whether replacement is attractive depends on the decision horizon and future savings; the historical book value does not change the economic comparison.

8. Scarce Resources and Product Mix

When capacity is constrained, products should be ranked by contribution per unit of the scarce resource, not necessarily by contribution per unit of product or selling price.

The relevant measure is:

Unit contribution equals selling price less relevant variable cost. The formula assumes demand exists for the products, resource requirements are known, and fixed costs do not change within the relevant range.

Worked example: machine-hour constraint

A factory produces Products A and B:

Although A provides greater contribution per unit, B should be prioritised because it provides $18 per constrained machine hour compared with $10 for A. If demand for B is fully met, remaining capacity should be allocated to A. The conclusion must be revised if minimum customer commitments, technical sequencing, labour constraints or multiple bottlenecks exist.

With several scarce resources, a simple ranking may not be sufficient. Linear programming can identify the product mix subject to constraints such as machine hours, labour hours, materials and demand. The model should reflect real operational constraints rather than treating contribution ratios as universally decisive.

9. Risk, Uncertainty and Sensitivity Analysis

Relevant-cost analysis often uses estimates. Prices may change, demand may be uncertain, suppliers may fail and production yields may vary. A single-point answer can create false confidence.

Sensitivity analysis changes one assumption at a time to examine its effect. For a make-or-buy decision, management might test the purchase price, internal material cost, production volume and opportunity cost of capacity. Scenario analysis changes several related assumptions simultaneously, such as a recession scenario involving lower demand and supplier price reductions.

A break-even purchase price can be derived by equating the relevant costs of making and buying:

This is the highest supplier price that makes buying financially equal to making. It assumes the quantity, quality and capacity conditions remain unchanged.

For the earlier make-or-buy example, if relevant internal cost is $7.40 per unit and inspection costs $0.20 per purchased unit, the maximum supplier price is $7.20 per unit. Prices above $7.20 favour making; prices below $7.20 favour buying, subject to qualitative considerations.

10. Qualitative, Ethical and Governance Considerations

A financially favourable decision can still be unacceptable. Managers should evaluate the following dimensions:

• Quality and safety: Will the alternative meet specifications and protect users?
• Reliability: Can supply, service or production continue during disruption?
• Employees: Are layoffs, unsafe conditions or unfair labour practices involved?
• Customers: Could quality changes damage trust or contractual relationships?
• Environment: What are the effects on emissions, waste, resource use and compliance?
• Ethics: Is the decision exploiting suppliers, concealing defects or misleading stakeholders?
• Governance: Are conflicts of interest disclosed, approvals documented and procurement rules followed?
• Data and technology: Does outsourcing expose confidential data or create cybersecurity risks?

Ethical analysis should not be treated as an optional adjustment after the spreadsheet is complete. Cost information can be manipulated through selective assumptions, inappropriate allocations or omission of foreseeable liabilities. Professional accountants are expected to apply integrity, objectivity, professional competence, confidentiality and professional behaviour.

A well-governed decision record should identify assumptions, data sources, alternatives rejected, non-financial risks, responsible decision-makers and monitoring arrangements. This creates accountability and makes it possible to review whether the expected benefits were realised.

11. Technology and Contemporary Practice

Enterprise resource planning systems, operational dashboards and activity-based data can improve the identification of cost drivers. Cloud procurement platforms can provide supplier quotations and delivery performance, while artificial intelligence may assist with demand forecasting and scenario analysis.

However, technology does not make irrelevant data relevant. An algorithm trained on historical allocations may reproduce arbitrary overhead assignments. Automated recommendations may also conceal assumptions about labour, quality or environmental costs. Managers should validate data, test model sensitivity, protect confidential information and retain human accountability for decisions.

Digital systems are particularly useful for “what-if” analysis. A decision model can vary volume, supplier price, capacity and failure probability, then display the range of possible outcomes. The model should distinguish cash costs from accounting allocations and record the date and source of each assumption.

12. Illustrative Case: Northstar Components

Background

Northstar Components manufactures precision brackets for industrial equipment. Product R is currently made in-house. A supplier has offered to produce it at a lower quoted price. Northstar also has an opportunity to use its freed machine capacity for Product S, which is in strong demand.

Problem

The operations director must decide whether to continue making Product R or outsource it for the next 12 months. The decision must consider financial results, capacity, quality and supplier risk.

Financial information

Northstar requires 20,000 units of R. Internal relevant production costs are:

• materials: $11 per unit;
• labour: $7 per unit;
• variable overhead: $3 per unit;
• avoidable fixed cost: $20,000 for the year.

Each unit uses 0.4 machine hour. The machine could instead produce S, generating contribution of $9 per machine hour. The supplier’s price is $22 per unit, and incoming inspection would cost $0.50 per unit.

Analysis

Internal variable cost is $21 per unit, or $420,000 for 20,000 units. Avoidable fixed cost is $20,000. The opportunity cost of capacity is:

• 20,000 × 0.4 × $9 = $72,000.

Thus, the relevant cost of making is $512,000. The relevant cost of buying is:

• 20,000 × ($22 + $0.50) = $450,000.

Outsourcing provides an estimated financial advantage of $62,000.

Qualitative review

The supplier has only one production site and a history of late deliveries. Product R is safety-related, so defective units could create significant warranty and reputational costs. Northstar’s engineering team also believes that internal production knowledge supports future product innovation. The procurement team proposes a one-year contract with quality guarantees, penalties for late delivery, audit rights, dual-source development and retention of a small internal pilot capability.

Approach and outcome

Northstar should not accept the quotation solely because it is cheaper. Subject to satisfactory supplier testing and enforceable contractual protection, outsourcing appears financially attractive because it releases capacity for S. The board approves a controlled outsourcing arrangement with quarterly review and contingency planning. If supplier failure would cause losses exceeding the $62,000 expected advantage, the decision should be reconsidered.

Learning points

1. Opportunity cost can reverse a make-or-buy conclusion.
2. Relevant costing identifies the financial consequence but does not measure every risk.
3. Safety, resilience and knowledge retention may justify a different decision from the purely numerical answer.
4. Contracts and monitoring can reduce, but not eliminate, outsourcing risk.

Challenges and Limitations of Relevant Costing

Relevant costing is powerful but bounded. First, managers may misclassify fixed costs as avoidable or overlook opportunity costs. Second, short-term variable cost estimates may not remain linear when output approaches capacity. Third, qualitative factors may be difficult to quantify but can be economically significant. Fourth, decisions that appear short term may create long-term strategic effects, such as supplier dependence or loss of technical competence. Fifth, mutually dependent decisions may invalidate isolated analysis; outsourcing one component may affect the cost or quality of other products.

The remedy is not to abandon relevant costing. It is to state assumptions, use scenario analysis, include opportunity costs, consult operational specialists and combine financial analysis with strategic and ethical review.

Best-Practice Checklist

Before recommending a short-term decision, ask:

1. What exact alternatives are being compared?
2. Which revenues and costs are future and differential?
3. Which costs are sunk or unavoidable?
4. What opportunity cost arises from constrained resources?
5. Are volume, quality and capacity assumptions realistic?
6. Could the decision affect regular customers or contractual obligations?
7. Have risk, safety, employees, environment and reputation been considered?
8. Were conflicts of interest and ethical concerns disclosed?
9. Has sensitivity or scenario analysis been performed?
10. Is there a monitoring and exit plan?

Chapter Summary

Relevant costing focuses on future revenues and costs that differ between decision alternatives. Sunk costs and unavoidable allocations are normally irrelevant, while avoidable costs, incremental revenues and opportunity costs are relevant. Make-or-buy decisions compare avoidable internal costs and capacity opportunity costs with supplier and purchasing costs. Special orders are assessed using incremental revenue and cost, with attention to spare or constrained capacity. Product discontinuation and shutdown decisions require comparison of lost contribution with avoidable costs and alternative uses of released resources. Equipment replacement analysis excludes historical book values but includes disposal proceeds, new investment and operating-cost changes. Scarce resources should generally be allocated according to contribution per unit of the constrained resource. Because estimates are uncertain, sensitivity and scenario analysis are essential. Finally, financial results must be integrated with quality, resilience, legal, environmental, employee, ethical and governance considerations.

Key Terms

Relevant cost: A future cost that differs between decision alternatives.

Relevant revenue: A future revenue that differs between decision alternatives.

Incremental cost: The additional cost caused by selecting an alternative.

Incremental revenue: The additional revenue generated by selecting an alternative.

Sunk cost: A past cost that cannot be changed by a current decision.

Opportunity cost: The benefit sacrificed by using a resource for one alternative rather than its best alternative use.

Avoidable cost: A cost that can be eliminated by selecting a particular alternative.

Unavoidable cost: A cost that continues regardless of the decision.

Committed cost: A future cost that cannot readily be changed within the decision period.

Contribution margin: Revenue less variable cost.

Make-or-buy decision: A decision to produce internally or purchase externally.

Outsourcing: Obtaining an activity, product or service from an external provider.

Special order: A non-routine order evaluated using its incremental financial and qualitative effects.

Product discontinuation: Ending a product, service, segment or activity.

Shutdown decision: A decision to suspend operations temporarily or permanently.

Scarce resource: A constrained input that limits output or product mix.

Sensitivity analysis: Testing the effect of changing one assumption.

Scenario analysis: Testing outcomes under a set of internally consistent assumptions.

Relevant range: The activity range within which cost and operational assumptions remain valid.

Qualitative factor: A non-financial consideration affecting a decision.

Review Questions

Short Answer Questions

1. What three tests determine whether a cost is relevant?
2. Why is an allocated fixed overhead cost often irrelevant to a short-term decision?
3. Define opportunity cost and explain why it may not appear in accounting records.
4. What is the difference between an avoidable and an unavoidable cost?
5. Why should contribution per scarce-resource unit be used when capacity is constrained?

Long Answer Questions

1. Explain the relevant-costing process and discuss how it should be integrated with qualitative analysis.
2. Compare the financial and non-financial considerations in a make-or-buy decision.
3. Explain how a product can report an accounting loss while still being worth retaining.
4. Discuss the treatment of sunk costs and disposal proceeds in an equipment replacement decision.
5. Evaluate the limitations of using short-term relevant costing for decisions with long-term strategic consequences.

Analytical / Application Questions

1. A company can make a component for $5.80 variable cost per unit plus $18,000 avoidable fixed costs for 8,000 units. Buying costs $7.90 per unit. The capacity used internally could generate $0.75 contribution per machine hour, and each component requires 0.6 machine hour. Should the company make or buy, based on relevant financial information?
2. A product generates revenue of $180,000 and variable costs of $105,000. Of its $95,000 fixed costs, $60,000 is avoidable. If discontinuation releases capacity that can generate $20,000 contribution elsewhere, should the product be discontinued? Explain.
3. A special order offers $16 per unit for 5,000 units. Incremental variable cost is $11 per unit, but accepting the order displaces regular production with contribution of $3 per unit. Analyse the order and identify at least three qualitative issues management should investigate.

Multiple Choice Questions with Answers

Question 1

Which item is normally relevant to a short-term decision?

A. Historical purchase price of existing equipment

B. Allocated head-office rent that will continue

C. Avoidable fixed cost eliminated under one alternative

D. Past research expenditure

Correct Answer: C. Avoidable fixed cost eliminated under one alternative

Question 2

A company makes a component for $6 variable cost per unit and has $10,000 avoidable fixed costs for 5,000 units. A supplier charges $8 per unit, with no other differences. What is the financial advantage of buying?

A. $0

B. $5,000

C. $10,000

D. $20,000

Correct Answer: B. $5,000

Question 3

What is an opportunity cost?

A. A cost already recorded in the ledger

B. The benefit forgone from not using a resource in its best alternative use

C. A cost that cannot be avoided

D. A fixed cost allocated to a product

Correct Answer: B. The benefit forgone from not using a resource in its best alternative use

Question 4

A special order should generally be accepted when spare capacity exists if:

A. The order price exceeds total allocated cost

B. Incremental revenue exceeds incremental cost and no important qualitative objection exists

C. The order price exceeds normal selling price

D. The order eliminates all fixed costs

Correct Answer: B. Incremental revenue exceeds incremental cost and no important qualitative objection exists

Question 5

A product has contribution of $24 per unit and uses 3 machine hours. Another product has contribution of $18 per unit and uses 1 machine hour. Which should receive priority when machine hours are scarce?

A. The first product because its unit contribution is higher

B. The second product because its contribution per machine hour is higher

C. Both products must receive equal machine hours

D. The first product because it uses more machine hours

Correct Answer: B. The second product because its contribution per machine hour is higher

Question 6

Which amount is normally excluded from an equipment replacement analysis?

A. Disposal proceeds from the old equipment

B. Future operating savings

C. Historical book value of the old equipment

D. Installation cost of the new equipment

Correct Answer: C. Historical book value of the old equipment

Question 7

A division reports a loss because it is allocated $40,000 of corporate costs. The corporate costs will continue if the division closes. How should these costs be treated?

A. As avoidable costs

B. As relevant savings from closure

C. As irrelevant to the closure decision

D. As opportunity costs of the division

Correct Answer: C. As irrelevant to the closure decision

Question 8

Which analysis changes one assumption at a time to observe its effect on a decision?

A. Sensitivity analysis

B. Absorption costing

C. Variance allocation

D. Historical-cost analysis

Correct Answer: A. Sensitivity analysis

Question 9

In a temporary shutdown decision, which comparison is most appropriate?

A. Total historical cost versus total current revenue

B. Contribution lost versus avoidable operating and shutdown-related costs

C. Book value of assets versus replacement cost

D. Allocated overhead versus selling price

Correct Answer: B. Contribution lost versus avoidable operating and shutdown-related costs

Question 10

Why should qualitative factors be considered in outsourcing decisions?

A. They always replace financial analysis

B. They can create quality, supply, ethical or reputational consequences not captured in the short-term cost comparison

C. They eliminate the need to identify opportunity costs

D. They ensure that the lowest quoted price is selected

Correct Answer: B. They can create quality, supply, ethical or reputational consequences not captured in the short-term cost comparison