Costing for Decision Making

Every day, managers must decide whether to manufacture a component in-house or outsource it, whether to accept a special order, or when it’s time to shut down an unprofitable segment. These choices demand a rigorous understanding of relevant costs and their impact on profit. Let’s understand the foundational principles and work through core scenarios together, so you gain both conceptual clarity and practical skills.

Relevant Costing Concept

Relevant costing focuses only on costs that will change as a result of a specific decision. Irrelevant costs are those that have already been incurred (sunk costs) or will remain unchanged, should never influence managerial decisions. This concept is the cornerstone for all short-term business choices.

Decision-Making Scenarios

a. Make or Buy Decision

A make-or-buy decision arises when a company must choose between manufacturing a component internally or purchasing it from an external supplier. The decision should be based on a comparison of relevant costs and not the total cost structure.

Relevant costs include:

• Direct materials and labor
• Variable overheads
• Any avoidable fixed costs
• Opportunity cost if resources could be better used elsewhere

Example:
A company needs 5,000 units of Part X. Internal cost per unit: ₹30 (Direct Material: ₹12, Direct Labor: ₹8, Variable Overhead: ₹5, Fixed Overhead: ₹5). Supplier offers at ₹28 per unit. Fixed overheads are unavoidable.

Relevant cost of making (excluding unavoidable fixed overhead): ₹12 + ₹8 + ₹5 = ₹25 per unit.
Total relevant cost to make: 5,000 × ₹25 = ₹1,25,000
Cost to buy: 5,000 × ₹28 = ₹1,40,000
Decision: Making in-house saves ₹15,000.
Conclusion: Continue to make the part unless there are additional qualitative factors.

b. Accept or Reject Special Order

Special order decisions involve taking an order at a price lower than normal selling price, typically when spare capacity exists. The key is to analyze if accepting the order covers all variable costs and contributes towards fixed costs and profit.

Example:
Normal selling price per unit: ₹100; Variable cost per unit: ₹60; Fixed cost per unit: ₹20 (already covered by other sales); Special order for 1,000 units at ₹75 each; spare capacity exists.

Incremental revenue: 1,000 × ₹75 = ₹75,000
Incremental cost: 1,000 × ₹60 = ₹60,000
Incremental profit: ₹15,000
Conclusion: Accept the order, as it increases profit by ₹15,000. Fixed costs are not relevant since they’re already covered.

c. Continue or Shut Down Product Line

Sometimes, a product or department appears unprofitable. Should it be discontinued? Here, only the avoidable costs and lost contribution need consideration. Unavoidable fixed costs remain, so discontinuation may not always be the best choice.

Example:
Product A: Sales ₹2,00,000; Variable costs ₹1,20,000; Fixed costs ₹90,000 (₹40,000 avoidable if shut down).

Contribution margin: ₹2,00,000 - ₹1,20,000 = ₹80,000
Net loss: ₹80,000 - ₹90,000 = -₹10,000
If shut down: Save ₹40,000 in fixed costs, but lose ₹80,000 contribution.
Net effect: Lose ₹80,000 (contribution) - Save ₹40,000 (avoidable fixed) = -₹40,000
Conclusion: Continuing results in a smaller loss. Don’t shut down unless alternative use of resources generates higher returns.

d. Export Pricing & Limiting Factor Analysis

Export pricing often involves quoting a lower rate for foreign buyers, especially if domestic demand is insufficient. The decision rests on whether the export price covers variable costs and provides incremental profit. Limiting factor analysis, or key factor analysis, helps allocate scarce resources (like machine hours or materials) across competing products for maximum total contribution.

Relevant Costing in Decision Scenarios

Remember: Focus on identifying and including only those costs and benefits that change as a result of the decision. Sunk costs and common fixed costs rarely influence the outcome. Carefully practice each scenario with fresh examples.