Cost Accounting for Decision Making
Cost Accounting for Decision Making tests whether you can strip a situation down to relevant, differential cash flows and then recommend an action with its assumptions stated.
Relevant costing
A cost is relevant only if it is a future cash flow that differs between alternatives. Sunk costs, committed costs and apportioned fixed overheads are excluded. Opportunity cost - the contribution lost by using a scarce resource elsewhere - must be included even though no cash leaves the business.
Decision rules
- Make or buy: compare the buy price plus unavoidable costs with the marginal cost of making plus avoidable fixed costs, adjusted for the opportunity cost of freed capacity.
- Special order: accept if incremental revenue exceeds incremental cost; fixed costs already covered are irrelevant.
- Shut down: continue while contribution covers avoidable fixed costs.
- Limiting factor: rank products by contribution per unit of the scarce resource, not contribution per unit.
Worked example
Make 10,000 components: variable cost ₹40 each = ₹4,00,000, plus avoidable fixed cost ₹1,20,000, total ₹5,20,000. Buy at ₹48 each = ₹4,80,000, but the released space can be rented for ₹30,000, which is an opportunity cost of making. Net cost to buy = ₹4,80,000 − ₹30,000 = ₹4,50,000. Buying saves ₹70,000, so buy - subject to quality and supply security being acceptable.
Traps
Including sunk development cost in a launch decision; adding general fixed overhead to a special-order cost; ranking by contribution per unit when machine hours are scarce; and ignoring qualitative factors such as quality, supplier reliability and employee morale, which carry marks in discussion parts.