MBA Relevant Costs Concept Card Template

Relevant Costs Concept Card: [Decision, product or course]

A concept card for relevant costing, the decision tool of the managerial accounting core: which costs and revenues to count when a manager chooses between alternatives, and which to ignore. It covers sunk, avoidable, incremental and opportunity costs, and the five classic decisions: make or buy, special order, drop or keep a product or segment, use of a constrained resource (contribution per bottleneck unit), and keep or replace equipment. It is for MBA students preparing for class, cases and exams, and for managers who must defend a one-off decision with numbers. Every number is computed, with the Excel formula next to it. Source basis: the relevant-cost and opportunity-cost principles of the management accounting literature, the theory of constraints (Goldratt and Cox 1984) for bottleneck decisions, and the standard textbooks named in the reading list, written up in original words. The companies and numbers are fictional and were computed in Python. Replace every [bracketed] value and every row marked Example.

Document control

Contents

• When to use it
• The idea in plain language
• Formulas and notation
• Assumptions and limits
• How managers use it
• Worked example A (fully solved)
• Dropping a product line
• Worked example B (half solved)
• Exercise C (unsolved)
• Connections to other cards
• Common mistakes and misconceptions
• Self-test questions
• My notes and next steps
• Sources and further reading
• Answer key

When to use it

One-sentence rule: when choosing between alternatives, count only the future costs and revenues that differ between them, including the opportunity cost of resources that have another use, and ignore everything else.

The idea in plain language

A decision is a choice between futures. Anything that is the same in every future, or that has already happened, cannot change which future is better, so it is irrelevant to the choice, however large it is. A cost or revenue is relevant only if it is both:

1. Future: it will happen after the decision, and
2. Differential: its amount differs between the alternatives.

Five labels follow from that rule.

Two consequences surprise most students. First, allocated fixed costs usually look relevant on a product cost sheet but are not: dropping a product does not make the head-office rent disappear, it just spreads it over the other products. Second, costs that never appear in the accounts can be the most relevant of all: the opportunity cost of a bottleneck hour, or of warehouse space that a new product line could use, is not recorded anywhere, but it decides the answer.

When capacity is scarce, the rule becomes: rank products by contribution per unit of the constrained resource, not by contribution per unit or margin percentage. This is the managerial accounting expression of the theory of constraints (Goldratt and Cox 1984): an hour lost at the bottleneck is an hour lost for the whole system, so the bottleneck hour is what you must spend well. The contribution of the marginal product per bottleneck hour is the shadow price of that hour: the most it is worth paying for one more hour of capacity (overtime, a subcontractor, a second shift).

Qualitative factors always sit next to the numbers: supplier reliability and quality in a make-or-buy, the signal a discounted order sends to regular customers, the effect of dropping a product on the brand, on employees and on customers who buy across lines. A good recommendation states the quantitative difference and then the two or three qualitative factors that could reverse it.

Formulas and notation

The decision rule compares the relevant totals of two alternatives A and B:

Make or buy (per period, quantity $N$):

Special order (quantity $q$, price $p$, incremental variable cost $v'$, one-off cost $S$):

Constrained resource (product $i$, contribution $CM_i$, use of the constrained resource $r_i$ per unit):

Drop a segment:

Assumptions and limits

Relevant costing is a short-run, incremental lens. Applied repeatedly to long-run questions, it can lead a company to accept many orders that cover variable cost but never cover the fixed cost of the capacity they use. That is why pricing for regular business uses full or activity-based cost, while relevant costing decides the exceptions.

How managers use it

• Sourcing and outsourcing. Operations and procurement teams compare a supplier quote with the avoidable cost of making, not with the full cost on the standard cost sheet, and add the value of the freed capacity.
• Sales and pricing of exceptions. Sales leaders use the minimum price of a special order (incremental cost plus opportunity cost) as the floor in a negotiation.
• Portfolio reviews. Category managers judge a product or store by its segment margin (contribution minus traceable avoidable fixed cost), not by profit after allocated head-office costs.
• Bottleneck management. Plant managers and service operations leaders (clinics, fulfilment centres) rank work by contribution per bottleneck hour and price extra capacity at the shadow price; see mba/mba-process-analysis-card.
• Asset replacement. Finance teams ignore the book value of old equipment (sunk) and compare future cash flows, discounted when the horizon is long.

The same lens is used outside accounting: in consulting cases ("should the client close the plant?"), in product management ("should we keep the legacy feature?") and in personal decisions (tuition already paid is sunk; it should not keep you in a programme that no longer fits).

Worked example A (fully solved): make or buy and a bottleneck

Part 1: make or buy tent-pole sets

Situation (fictional). Northfield's production unit makes 40,000 tent-pole sets a year for its own tents. The standard cost sheet shows USD 15.00 per set. A supplier offers identical sets at USD 12.40 per set for a three-year contract. Fixed overhead of USD 160,000 is charged to the pole cell: USD 60,000 is a supervisor and an equipment lease that would end if production stopped; USD 100,000 is an allocation of plant rent and management that would continue. If Northfield buys, the freed space can assemble a new gear-repair kit expected to earn a contribution of USD 70,000 a year.

Spreadsheet layout: B1 = 40,000 sets, B2 = 6.50, B3 = 3.20, B4 = 1.30, B5 = avoidable fixed 60,000, B6 = supplier price 12.40, B7 = opportunity cost 70,000.

Reading the result. The full-cost comparison (USD 15.00 against USD 12.40) suggests a saving of USD 104,000, which overstates it: USD 100,000 of allocated overhead stays whether Northfield makes or buys. Without another use for the space, buying saves only USD 4,000 a year, too small to outweigh quality and supply risk. With the repair-kit line, buying saves USD 74,000 a year, and buying stays better up to a supplier price of USD 14.25. Recommendation: buy, provided the supplier passes a quality audit and the contract includes delivery-performance terms. The answer is robust to the kit forecast (buying wins even with no kit line) but not to the supplier price: if the kit line is cancelled, any supplier price above USD 12.50 makes in-house production cheaper.

Part 2: product mix with a sewing bottleneck

Situation (fictional). Next season, Northfield's sewing room has 18,000 machine hours. Demand at current prices would need 26,500 hours, so sewing is the binding constraint. Other resources have spare capacity.

Excel: CM per hour =B2/C2; rank =RANK.EQ(D2,$D$2:$D$4); hours used by a product =MIN(E2*C2, available hours left).

Ranking by contribution per bottleneck hour earns USD 150,000 more. The sleeping bag has the lowest CM per unit but the highest per sewing hour, because it uses so little of the scarce resource. The marginal product is the jacket, so the shadow price of a sewing hour is USD 40: Northfield should pay up to USD 40 per hour above normal variable cost for overtime or subcontracted sewing, and should value any order that uses sewing hours at USD 40 per hour of opportunity cost (used in Worked example B). The shadow price holds only for small changes: about 500 sewing hours now go to jackets, so an order needing more than that would next displace tents, at USD 48 per hour. With more than one binding constraint, set this up in Excel Solver: objective =SUMPRODUCT(CM,units), changing cells = units, constraints =SUMPRODUCT(hours,units)<=18000 and units <= demand.

Dropping a product line: a solved illustration

Northfield's store division reports three product lines. Footwear shows a loss after allocated head-office costs, and a board member asks whether to drop it.

Store data show that about 5% of apparel contribution comes from customers who come in for footwear. If Footwear is dropped and the space stays empty:

Company operating income would fall from USD 150,000 to a loss of USD 260,000. The fixture depreciation is sunk and the USD 300,000 of head-office cost would simply be reallocated to Apparel and Equipment. Dropping Footwear makes sense only if the space can earn more than USD 410,000 of contribution a year from another use, which becomes the hurdle for any replacement proposal.

Worked example B (half solved): a special order

Situation (fictional). A mountaineering club asks Northfield for 600 sleeping bags with its logo at USD 80 each. The regular price is USD 110 and the regular variable cost is USD 65, which includes a USD 5 store commission that does not apply to a direct club order. Embroidery adds USD 4 per bag, and a one-off machine set-up costs USD 3,000. Each bag uses 0.75 sewing hours. The club's members are not regular Northfield customers, and the order would not affect regular prices.

9. Write the recommendation for each capacity situation in one sentence. [ ]
10. Name two qualitative factors that could change the answer. [ ]

Exercise C (unsolved): keep or replace a test rig

Corvane Robotics tests every robot drive unit on a rig bought two years ago for USD 400,000. Its book value is now USD 240,000 and it has three years of life left. It costs USD 150,000 a year to operate and could be sold today for USD 60,000; at the end of three years it will be worth nothing. A new rig costs USD 330,000, also lasts three years with no final value, and costs USD 40,000 a year to operate. Output is the same with either rig. Ignore taxes.

1. Which figures are sunk, and which are relevant?
2. Compare the total relevant costs of keeping and replacing over three years, without discounting.
3. Repeat the comparison in present value at a 10% annual discount rate, with operating costs at the end of each year. Give the Excel formulas (=PV or an annuity factor).
4. Explain why the advantage of replacing shrinks so much once you discount.
5. A manager says: "We cannot replace the rig, we would book a USD 180,000 loss on disposal." Respond in two sentences.

Connections to other cards

Common mistakes and misconceptions

1. Counting sunk costs. Book value, past design spend and tuition already paid are irrelevant; only future cash flows count.
2. Comparing a supplier quote with full cost. Allocated fixed overhead that continues after outsourcing must stay out of the make cost.
3. Forgetting the opportunity cost of freed capacity. It often decides make-or-buy and drop decisions.
4. Dropping a segment because of allocated costs. Judge it on segment margin, and remember that its share of common costs moves to the survivors.
5. Ranking by CM per unit or margin percentage under a constraint. Rank by contribution per unit of the constrained resource.
6. Accepting special orders without checking capacity. At full capacity, the order displaces regular contribution.
7. Ignoring interdependence. Products sold together (footwear and apparel) lose contribution when one is dropped.
8. Treating all fixed costs as unavoidable. Ask which contracts, leases and salaries actually end, and when.
9. Using relevant costing for regular pricing. Pricing all business at incremental cost never recovers fixed cost.
10. Allocating joint costs to decide whether to process further. Joint costs incurred before split-off are sunk for that choice; compare only incremental revenue and incremental processing cost.

Self-test questions

1. State the two conditions that make a cost relevant, with one example of a cost that fails each condition.
2. Why is the USD 100,000 of allocated plant overhead irrelevant in Worked example A, Part 1?
3. In Part 1, if the repair-kit line is cancelled, at what supplier price would Northfield be indifferent between making and buying?
4. Why does the sleeping bag rank first in Part 2 although it has the lowest CM per unit?
5. A product can be sold at split-off for USD 30 a unit, or processed further at a cost of USD 18 a unit and sold for USD 52. Joint costs before split-off are USD 22 a unit. Should it be processed further? By how much per unit?
6. Overtime sewing costs USD 25 an hour above normal variable cost. Should Northfield buy 500 overtime hours, and what is the gain? (Assume jacket demand is still unmet.)
7. What is the shadow price of a constrained resource, and how does a manager use it?
8. Why should a segment be judged on segment margin rather than on operating income after allocations?
9. Give two qualitative factors in a make-or-buy decision and say how you would test each.
10. Why do multi-year relevant cost comparisons need discounting? Give one example from this card.

My notes and next steps

Sources and further reading

• Goldratt, E. M., and Cox, J. (1984). The Goal: A Process of Ongoing Improvement. North River Press. (Theory of constraints: the bottleneck governs system throughput.)
• Johnson, H. T., and Kaplan, R. S. (1987). Relevance Lost: The Rise and Fall of Management Accounting. Harvard Business School Press.
• Cooper, R., and Kaplan, R. S. (1988). Measure costs right: make the right decisions. Harvard Business Review, 66(5). (Why unit costs from volume-based allocation mislead product decisions.)
• Textbooks, by name only: Datar, S. M., and Rajan, M. V., Horngren's Cost Accounting: A Managerial Emphasis (Pearson); Garrison, R. H., Noreen, E. W., and Brewer, P. C., Managerial Accounting (McGraw Hill); Zimmerman, J. L., Accounting for Decision Making and Control (McGraw Hill).
• Open resource: OpenStax, Principles of Accounting, Volume 2: Managerial Accounting (CC BY-NC-SA 4.0), https://openstax.org/details/books/principles-managerial-accounting, chapter on short-term decision making.
• Spreadsheet tools: Microsoft Support pages for the Solver add-in and the PV function.

Answer key

Worked example B. (1) USD 64. (2) USD 9,600. (3) =600*(80-64)-3000 = USD 6,600. (4) 450 hours, within the roughly 500 hours now spent on jackets, so the USD 40 shadow price applies. (5) =450*40 = USD 18,000. (6) =600*(80-64)-3000-450*40 = USD (11,400), a loss. (7) USD 69.00. (8) =64+(3000+18000)/600 = USD 99.00. (9) With spare sewing capacity, accept: the order adds USD 6,600. At full capacity, reject at USD 80 or counter at USD 99.00 or more, because the order would displace jackets worth USD 40 per sewing hour. (10) Risk that regular customers learn of the USD 80 price and ask for it; brand exposure from the club logo; delivery timing against the peak season.

Exercise C. (1) Sunk: the USD 400,000 purchase price and the USD 240,000 book value. Relevant: the USD 60,000 sale value today, the new rig's USD 330,000, and both operating costs. (2) Keep: 3 x 150,000 = USD 450,000. Replace: 330,000 - 60,000 + 3 x 40,000 = USD 390,000. Replace saves USD 60,000. (3) Annuity factor at 10% for 3 years = 2.48685 (=PV(10%,3,-1)). PV keep = USD 373,028 (=PV(10%,3,-150000)); PV replace = 330,000 - 60,000 + 99,474 = USD 369,474 (=330000-60000+PV(10%,3,-40000)). Replace saves USD 3,554 in present value. (4) The new rig's cost is paid today, while the savings of USD 110,000 a year arrive over three years and are worth less in today's money. (5) The book loss is an accounting consequence of a sunk cost; it does not change any future cash flow. Decide on the USD 3,554 present-value saving (and taxes, if the loss is tax-deductible, which would make replacing more attractive).

Self-test.

1. Future and differential. Fails "future": last year's consulting fee. Fails "differential": the CEO's salary in a make-or-buy.
2. It is charged to the pole cell but continues whether Northfield makes or buys; it is unavoidable.
3. USD 12.50 per set: the relevant cost of making, 500,000 / 40,000 (=(40000*(6.5+3.2+1.3)+60000)/40000). With the kit line the indifference price rises to USD 14.25.
4. It uses only 0.75 sewing hours per unit, so it earns USD 60 per sewing hour, the highest of the three.
5. Yes: incremental revenue 52 - 30 = 22 exceeds incremental cost 18, a gain of USD 4 per unit. The USD 22 joint cost is irrelevant.
6. Yes: each hour earns USD 40 of jacket contribution and costs USD 25 extra, a gain of USD 15 an hour, or USD 7,500 for 500 hours (=500*(40-25)).
7. The contribution earned by one more unit of the constrained resource used on the marginal product. Use it as the maximum price for extra capacity and as the opportunity cost charged to any work that uses the resource.
8. Allocated common costs do not disappear if the segment goes; segment margin shows what the segment adds to company profit.
9. Quality and supply reliability (audit the supplier, pilot order, delivery terms); loss of know-how or flexibility (scenario where volume doubles or the supplier fails).
10. Money has a time value, so a cost paid today weighs more than savings spread over later years. In Exercise C the undiscounted saving of USD 60,000 falls to USD 3,554 in present value.

Revision history

Standard and licence note

Based on the relevant-cost and opportunity-cost principles of the management accounting literature listed above (Johnson and Kaplan 1987; Cooper and Kaplan 1988) and on the theory of constraints (Goldratt and Cox 1984), as treated in the standard managerial accounting textbooks named as further reading. The text, the worked examples, the exercises and the questions are original; no textbook text or problem is copied or paraphrased, and Northfield Outdoor Co. and Corvane Robotics are fictional companies. This card is independent and not affiliated with or endorsed by any business school, publisher or professional body. Check your course's notation and your spreadsheet's current function documentation before you rely on it. Template licence: MIT.