📘 Managerial Decision-Making Using Relevant Costs

 

🔹 1. Identifying Relevant Costs and Benefits

• Relevant Costs:
  Future costs that differ among alternatives.
• Irrelevant Costs:
  Past (sunk) costs or costs that do not change with the decision.

Example:
You’re considering replacing an old machine.

Item	Amount
Cost of new machine	$50,000
Trade-in value of old machine	$5,000
Sunk cost of old machine	Ignored

Only the cost of the new machine and
trade-in value are relevant.

🔹 2. Different Costs for Different Purposes

• Decision:
  Special order, outsourcing, discontinuation, etc.
• Costs considered:
  Variable, opportunity, avoidable fixed, etc.

Example: In pricing, variable costs are relevant; in make-or-buy,
avoidable fixed costs matter.

🔹 3. Reconciling the Total and Differential Approaches

• Total approach:
  Compares total future cash flows.
• Differential approach:
  Focuses only on differences.

Example:
Option A yields $10,000 more in future cash flows than Option B. Only the $10,000
difference matters.

🔹 4. Why Isolate Relevant Costs?

• Prevents decision bias.
• Avoids sunk cost fallacy.
• Focuses analysis on meaningful data.

🔹 5. Adding or Dropping Product Lines and Segments

Illustration:

Segment	Sales	VC	Traceable FC	Segment Margin
A	$100k	$40k	$30k	$30k

If Segment A’s contribution is
positive after removing traceable fixed costs, keep it.

🔹 6. Comparative Format

Used to show net
advantage/disadvantage.

Example:

Decision	Keep	Drop
CM	$50k	$0
FC Saved	$0	$20k
Net	$50k	$20k → Drop not advised

🔹 7. Beware of Allocated Fixed Costs

Allocated overhead can distort
decision-making. Only avoidable fixed costs are relevant.

⚙️
The Make or Buy Decision

🔹 8. Make or Buy

Example:

Cost Element	Make	Buy
Direct Material	$10	—
Direct Labor	$6	—
Variable Overhead	$4	—
Purchase Price	—	$22
Avoidable FC	$0	$0
Total	$20	$22 → Make preferred

🔹 9. Opportunity Cost

If using resources internally means
missing better use, the lost benefit is an opportunity cost.

Example: Internal use of a machine saves $2,000 but prevents $3,000
of outside use. Net = –$1,000.

🧾
Special Orders

🔹 10. Special Orders

Example:

Normal cost: $20/unit, Selling
price: $30
Special order: 1,000 units at $22

If fixed costs are covered and capacity
exists, accept if:

• Special price > variable cost
• Profit > 0

🔧 Utilization of Constrained Resource

🔹 11. Contribution Margin per Unit of Constraint

Example:

Product	CM/unit	Machine hours/unit	CM/hour
A	$10	2	$5
B	$12	4	$3

Choose Product A to maximize constrained resource.

🔹 12. Managing Constraints

• Shift demand to products with higher CM/resource.
• Improve efficiency or buy more capacity.

🔹 13. Multiple Constraints

Use Linear Programming or
prioritization by CM/unit of constraint.

🧪
Joint Product Costs and the Contribution Approach

🔹 14. Sell or Process Further

Example:

Item	Product A
Split-off Value	$10,000
Further Processing Cost	$3,000
Final Value	$14,000
Net Benefit	$1,000 → Process Further

Ignore joint costs—they’re sunk.

✅
Summary Table of Key Decisions and Numerical Approaches

Decision Type	Relevant Data	Method	Key Formula
Add/Drop Segment	Segment Margin	Comparative	CM – Traceable FC
Make or Buy	Variable Cost, Price	Differential	Compare Total Relevant Costs
Special Order	Variable Cost, FC	Contribution	SP – VC > 0
Constrained Resource	CM per Constraint	Ranking	CM ÷ Constraint
Joint Products	Incremental Revenue	Process Further	Revenue – Processing Cost

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