Decision Making: Relevant Costing
Domain focus
Relevant costing supports short-term decisions by isolating future differential cash flows. Exam scenarios include special orders, make or buy, accept or reject, shutdown, scarce resources and opportunity cost.
Core rules
- Relevant costs are future, incremental and cash-related; they differ between alternatives.
- Sunk costs, committed fixed costs and arbitrary allocations are irrelevant.
- Opportunity cost is the contribution forgone and is relevant when capacity is scarce.
- For a scarce resource, rank products by contribution per unit of limiting factor, not by selling price or unit profit.
- Qualitative factors include quality, reputation, customer reaction, legal and strategic effects.
Worked example
A special order for 1,000 units at ₹45 is offered. Variable cost is ₹30 per unit; absorbed fixed cost is ₹12 per unit; extra fixed cost for the order is ₹5,000; no normal sales are lost. Relevant revenue is ₹45,000. Relevant cost = variable ₹30,000 + incremental fixed ₹5,000 = ₹35,000. Relevant benefit = ₹10,000, so accept. The full cost of ₹42,000 per unit includes allocated fixed cost that does not change; using it would wrongly reject the order.
Traps
Including sunk research cost; including allocated fixed overhead; ignoring opportunity cost when capacity is full; comparing unit profit instead of total contribution; forgetting that a special order may affect future prices.