Relevant costs and make-or-buy decisions

A relevant cost is a future, incremental cash flow that differs between the options being considered. Everything else is noise for the decision — even if it's a real cost in the accounts.

Not relevant: - Sunk costs — already spent and can't be recovered: last year's market research, the price paid for machinery already owned. Depreciation and carrying amounts are sunk-cost allocations, not future cash. - Committed costs — future cash flows that will happen whichever option is chosen, such as a non-cancellable lease or contracted salaries. - Allocated fixed overheads that won't change in total: head-office costs or factory rent spread across products. Dropping a product doesn't make the landlord charge less. - Non-cash items such as depreciation.

Relevant: - Incremental (differential) costs and revenues — extra materials, extra labour hours that must actually be paid for, new hires, avoidable fixed costs (a supervisor who would be let go). - Opportunity costs — the benefit given up by choosing one option over the next best: rent you could earn on freed-up space, contribution lost when scarce capacity is diverted.

Typical decisions: - Make or buy: compare the supplier's price with the costs avoided by not making (variable costs plus avoidable fixed costs), and add any opportunity cost of using the capacity to make. - Special order: with spare capacity, accept if the price exceeds the incremental cost; if capacity is full, add the contribution of the work displaced. - Keep or drop a segment: drop only if the contribution lost is less than the fixed costs saved. A segment showing a 'loss' after allocated overheads may still be covering its own costs and contributing to the shared ones.

The numbers aren't the whole decision. Qualitative factors — supplier reliability, quality control, lost in-house skills, staff morale, customer relationships, the risk that a one-off low price becomes the expected price — can outweigh a small numerical advantage.