Decision making and relevant costing
Domain 4 - Decision making and relevant costing - tests short-term decisions using only costs and revenues that differ between alternatives. Expect special orders, make-or-buy, product mix with a constraint, shutdown, sell-or-process-further and cost-volume-profit analysis.
Relevance rules
- Relevant costs are future, incremental, cash and different between alternatives. Sunk costs, committed fixed costs, allocated common costs and book values are irrelevant.
- Opportunity cost is the contribution forgone from the next best alternative; it is relevant when capacity is scarce.
- Qualitative factors include quality, customer relationships, supplier reliability, legal issues and strategic fit.
Decision contexts
- Special order: accept if incremental revenue exceeds incremental costs and regular sales are unaffected. With idle capacity, fixed costs may be irrelevant; without idle capacity, include the opportunity cost of lost contribution.
- Make-or-buy: compare avoidable making costs, including opportunity cost, with the buy price; ignore unavoidable fixed costs.
- Product mix with one limiting factor: rank products by contribution per unit of the scarce resource, not contribution per unit.
- Shut down: close only if avoidable fixed costs exceed contribution lost.
- CVP: contribution margin = sales - variable costs; break-even units = fixed costs / unit contribution; margin of safety = budgeted sales - break-even sales; operating leverage = contribution / profit.
Worked example
Machine capacity is 1,500 hours. Product X has contribution $24 and uses 3 hours; Y has contribution $30 and uses 5 hours. Contribution per machine hour: X = $8, Y = $6, so X ranks first. Demand is 400 X and 300 Y. Produce 400 X using 1,200 hours, leaving 300 hours for 60 Y. Total contribution = 400 x $24 + 60 x $30 = $9,600 + $1,800 = $11,400. Producing Y first would use all 1,500 hours for 300 Y and earn $9,000. Ranking by unit contribution would wrongly favour Y.
Traps
Including sunk R&D; allocating existing fixed overhead to a special order; using absorption cost per unit as the relevant cost; omitting opportunity cost when capacity is full; ranking by unit contribution under a constraint; ignoring qualitative and long-term effects.