A note on the tricky items in relevant cost analysis: for advanced management accounting students

A note on the tricky items in relevant cost analysis: for advanced management accounting students

 

Regarding the topic of relevant cost analysis, highlight 4 main ideas of the topic and then provide examples of 3 relevant cost items that tend to incorrectly treat in analysis, and also provide examples of 3 relevant revenue items that are also relatively tricky to treat in the analysis.

Relevant cost analysis is a decision-making framework: include only future, incremental cash flows that differ between alternatives. Sunk costs, unavoidable common costs, and non-cash accounting allocations should be excluded.

Four main ideas

1.    Relevance depends on the decision. A cost or revenue is relevant only if it changes between the available alternatives; the same item can be relevant in one decision and irrelevant in another.openstax+2

2.    Use future incremental cash flows. Relevant items must be future-oriented and cash-based; depreciation, amortisation, and historical costs are generally not relevant because they do not represent a future cash movement.

3.    Include opportunity costs. When a resource is scarce, the benefit forgone by using it for one option rather than the next-best alternative is a relevant cost—even though it is not an out-of-pocket cash payment.

4.    Separate avoidable from unavoidable costs. Avoidable costs are relevant because they can be saved by choosing one alternative; unavoidable fixed costs, such as rent that continues under either option, are irrelevant.

Tricky relevant cost items

Cost item	Why it is tricky	Correct treatment
Sunk cost of an existing machine	Managers may want to “recover” the original purchase price by continuing to use the machine.	Exclude the original purchase cost; include only future repair, disposal, operating, or replacement cash flows that differ between options.
Allocated fixed overhead	A product or department may appear unprofitable because it receives an allocation of head-office rent, depreciation, or supervisor salary.	Include only the fixed overhead that would actually be avoided if the product or department is dropped; common allocated overhead remains irrelevant.
Opportunity cost of scarce capacity	A special order may look profitable using only its direct materials and labour, but it may displace more profitable normal sales.	Add the contribution margin forgone on displaced regular sales as a relevant opportunity cost.

Example: A factory operating at full capacity receives a one-off order. Its incremental materials and labour cost is $8,000, while the order’s incremental revenue is $12,000. If accepting it requires cancelling regular work with a $6,000 contribution margin, the true relevant comparison is $12,000 revenue against $14,000 of relevant cost ($8,000 incremental cost + $6,000 opportunity cost), so the order should be rejected.

Tricky relevant revenue items

Revenue item	Why it is tricky	Correct treatment
Incremental revenue from a special order	Managers may compare the order’s selling price with full absorption cost, including fixed overhead that will not change.	Compare the additional revenue with only the incremental costs; if spare capacity exists and no extra fixed costs arise, fixed overhead is irrelevant.
Lost revenue from cannibalisation	A new product’s sales may partly replace sales of an existing product, so its gross sales overstate the true benefit.	Count only the net additional revenue: new-product revenue minus the revenue lost from existing products.
Revenue forgone from using a scarce resource	Revenue that would have been earned from the next-best use of labour, machine time, or materials is easy to overlook because it is not an invoice or cash receipt.	Treat the forgone contribution or revenue as an opportunity cost of the chosen alternative.

Example: A retailer considers using shelf space for a new product expected to generate $50,000 in sales. If that space currently generates $38,000 in contribution from another product, the relevant incremental benefit is only $12,000—not $50,000—after considering the revenue forgone.

Practical rule

Before including any figure, ask: Will this cash flow change if I choose Alternative A instead of Alternative B? If the answer is no—because it is sunk, unavoidable, common to both options, or a non-cash allocation—it does not belong in the relevant cost analysis.

 

For the three tricky relevant cost items, please provide more concrete and straightforward examples to further clarify them.

Here are three simple, concrete examples that show why each cost is easy to mishandle.

1. Sunk cost: old machine

A bakery bought an oven two years ago for $100,000. It is now deciding whether to keep using the oven or replace it with a newer model.

·        The $100,000 already paid is a sunk cost: it cannot be recovered regardless of the decision.

·        It should not be included in the comparison.

·        What matters is the future difference: for example, the new oven costs $60,000, saves $15,000 in electricity and repairs each year, and the old oven can be sold now for $20,000.

Correct analysis: Compare the future cost of keeping the old oven with the future cost of buying and operating the new oven, then include the $20,000 resale value of the old oven as a relevant cash inflow from replacing it. The original $100,000 is irrelevant.

2. Allocated fixed overhead: product-line decision

A company produces three products. Product C is currently allocated $50,000 of factory rent and depreciation each year. Management is considering stopping Product C.

·        If the factory rent and depreciation will continue whether Product C is made or not, the $50,000 allocation is irrelevant.

·        Stopping Product C does not eliminate the rent or depreciation; it merely reallocates those costs to Products A and B.

·        However, if stopping Product C would allow the company to dismiss one supervisor whose $30,000 salary is directly attributable to Product C, that $30,000 is avoidable and therefore relevant.

Correct analysis: Include only the $30,000 avoidable supervisor salary, not the $50,000 common fixed-overhead allocation.

3. Opportunity cost: limited machine hours

A furniture maker has only 100 spare machine hours next month. It can use them to make chairs, which would earn a contribution margin of $20 per hour, or accept a special order for tables.

·        The special order requires all 100 hours.

·        Making tables means giving up the opportunity to make chairs.

·        The forgone contribution from chairs is $100\times \mathrm{\$}20=\mathrm{\$}2,000$ 

·        This $2,000 is an opportunity cost of accepting the table order, even though no cash is actually paid for it.

Correct analysis: If the table order generates $8,000 of incremental revenue and uses $5,000 of incremental variable costs, its apparent contribution is $3,000. But after deducting the $2,000 opportunity cost of the chairs, its net benefit is only $1,000. The order may still be acceptable, but the analysis must include the forgone chair contribution.

Common mistake to avoid

Do not treat every “cost” in the accounting records as relevant. Ask whether the amount will change in the future because of the choice being made. If it is already spent, unavoidable, or merely an allocation of a cost that continues anyway, exclude it.

 

Also provide concrete straightforward examples to clarify the 3 tricky relevant revenue items.

Here are three concrete examples for the tricky relevant revenue items. The key question is: will this revenue change if the company chooses one alternative rather than another? Relevant revenue must be future revenue that differs between alternatives.

1. Special-order revenue

A T-shirt manufacturer normally sells shirts at $20 each. It has unused capacity and receives a one-time order from a school for 1,000 shirts at $12 each.

·        The order adds $12,000 of incremental revenue: $1,000\times \mathrm{\$}12$

·        Even though $12 is below the normal $20 selling price, that does not automatically make the order unattractive.

·        If the extra variable cost is $8 per shirt, the incremental cost is $8,000.

·        The order adds $\mathrm{\$}12,000-\mathrm{\$}8,000=\mathrm{\$}4,000$to profit, assuming it does not reduce normal sales or require extra fixed capacity.

Correct treatment: Include the $12,000 incremental revenue from the special order, but compare it with only the additional costs caused by accepting it—not with the normal selling price or full product cost.

2. Cannibalisation: new product replacing old sales

A phone shop plans to launch a new basic phone model. It expects the new model to generate $100,000 in sales next year.

However, 20% of those customers would otherwise have bought the shop’s existing premium phone.

·        New-model sales: $100,000.

·        Sales diverted from the existing premium phone: $20\mathrm{\%}\times \mathrm{\$}100,000=\mathrm{\$}20,000$ 

·        Net incremental revenue: $\mathrm{\$}100,000-\mathrm{\$}20,000=\mathrm{\$}80,000$

·        The shop should not count the full $100,000 as new revenue, because $20,000 merely moves sales from one product to another.

Correct treatment: Use the net additional revenue—new revenue minus revenue lost from the existing product. If the lost sales also have a contribution margin, the lost contribution should be considered as well.

3. Revenue forgone from a scarce resource

A café has one small downstairs room that can either be rented to a yoga instructor for $3,000 per month or used for a new weekend dessert workshop expected to earn $5,000 per month in sales.

·        If the café uses the room for workshops, it gives up the $3,000 rental income.

·        The $3,000 is revenue forgone, or an opportunity cost, even though no invoice is issued for it.

·        If the workshop has $2,500 of incremental costs, its apparent profit is $2,500.

·        After considering the $3,000 rental income forgone, the workshop reduces monthly profit by $500.

Correct treatment: Include the $5,000 workshop revenue, but deduct the $3,000 rental revenue that would be lost by choosing the workshop. The better decision is to rent the room.

Quick rule

For each revenue item, compare the company’s total revenue with the decision against total revenue without the decision. Include only the difference: extra revenue earned, revenue lost through cannibalisation, or revenue forgone because a scarce resource is used in another way.