Decision-Making Techniques, Relevant Costs and Pricing
Decision-making techniques, relevant costs and pricing tests whether you can identify incremental cash flows and choose between alternatives. Typical tasks are make-or-buy, special orders, discontinuation, limiting-factor ranking and cost-plus or target pricing.
Core rules
- Relevant costs are future, incremental cash flows that differ between alternatives. Sunk costs, committed costs, allocated common fixed costs and non-cash book depreciation are normally irrelevant; opportunity cost is relevant.
- For a limiting factor, rank products by contribution per unit of the scarce resource, not contribution per unit.
- Special orders are assessed on incremental contribution, plus any extra fixed costs or lost contribution from displaced sales.
- Pricing approaches include full cost-plus, marginal cost-plus, target costing, penetration, skimming and discriminatory pricing.
Worked example
A company has spare capacity. Variable cost is ₦18 per unit and absorbed fixed cost is ₦7 per unit. A one-off order offers ₦22 per unit for 5,000 units and requires extra fixed setup cost of ₦5,000. Incremental contribution = (₦22-₦18)×5,000=₦20,000; less ₦5,000 = ₦15,000. The order should be accepted, because the ₦7 absorbed fixed cost is not incremental and spare capacity means no lost contribution. If the order displaced 5,000 units of normal sales at ₦30, the opportunity cost would be (₦30-₦18)×5,000=₦60,000, making the order unacceptable.
Traps
Including full absorption cost in a spare-capacity decision; ignoring opportunity cost; ranking by unit contribution when a resource is scarce; treating allocated head-office cost as avoidable; accepting a price below incremental cost.