## Relevant Costs and Short-Term Decision Making

### Principles for Identifying Costs and Benefits

Two filters must both be passed for a cost to be relevant:

1. Controllability — the cost must be directly influenced by the choice being made

2. Relevance — a controllable cost is relevant only if it is:

(a) A future cost (not yet incurred)
(b) A differential cost (differs between the two options being compared)

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### Cost Relevance Classification

Cost Type	Relevant?	Reason
Historical Cost	Irrelevant	Already incurred; cannot be changed (e.g., book value of existing machinery)
Sunk Cost	Irrelevant	Already paid and unrecoverable regardless of decision
Committed Cost	Irrelevant	Pre-agreed, cannot be revoked; a type of sunk cost (e.g., rate agreements, fixed salaries)
Opportunity Cost	Relevant	Benefit foregone by choosing one option over the best alternative
Notional/Imputed Cost	Relevant	Relevant if the firm genuinely forgoes a benefit (e.g., notional interest on own funds)
Shut-down Cost	Relevant	Certain fixed costs can be avoided or extra costs incurred when shutting down — affects the shut-down decision

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### Principles of Estimating Costs and Benefits

Once relevant costs are identified, quantify them using:

Variability — how does the cost/benefit change based on the option chosen? (Variable vs fixed behaviour)
Traceability — how directly can the cost be linked to the option? (Direct assignment vs allocation)

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### Short-Term Decision Categories

#### Category 1: Excess Supply Decisions

(When the firm has idle/excess capacity)

Processing a special order (accept/reject)
Determining a price to stimulate demand
Local vs Export sale decision
Minimum price for quotations
Shut-down or continue decision

#### Category 2: Excess Demand Decisions

(When demand exceeds production capacity — a limiting factor exists)

Make or Buy / In-house vs Outsourcing
Product mix under resource constraints (limiting factor analysis)
Sales mix decisions
Sell or further process decision

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### Concept of Limiting Factors (Key Factors)

A limiting factor is anything that restricts or hinders an entity's activity.

Supply-side limiting factors (4 Ms):

Men — labour availability
Materials — raw material supply
Machine — production capacity
Money — funds/budget

Demand-side limiting factors:

Level of customer demand
Nature/uniqueness of the product
Regulatory and environmental requirements

Decision rule under a single limiting factor:

Rank products by contribution per unit of limiting factor (not contribution per unit) and allocate the scarce resource accordingly.

Worked example

### Example 1

Opportunity Cost — Own Premises for New Project

A company owns a building with a market rent value of ₹2,00,000/year. It is considering using it for a new project instead of renting it out.

The ₹2,00,000 rent forgone is an opportunity cost — it is relevant because:

It is a future benefit being sacrificed
It differs between the two options (use own building vs rent it out)

It should be included as a cost of the new project even though no cash changes hands.

### Example 2

Limiting Factor — Ranking Products

A factory produces Products X and Y. Machine hours are the limiting factor (available: 1,000 hours).

	Product X	Product Y
Contribution/unit	₹40	₹30
Machine hours/unit	4 hrs	2 hrs
Contribution/machine hour	₹10	₹15
Rank	2nd	1st

Despite X having higher contribution per unit, Y is preferred because it earns more contribution per unit of the scarce resource.

### Example 3

Shut-down Decision — Relevant Costs

A division incurs Fixed Costs of ₹5,00,000. On shut-down:

₹1,50,000 of fixed costs are avoidable (e.g., supervisory salaries)
₹50,000 additional shut-down costs arise (e.g., redundancy pay)

Relevant cost of shut-down = ₹50,000 − ₹1,50,000 = −₹1,00,000 (net saving of ₹1,00,000)

Only these items are relevant; the remaining ₹3,50,000 fixed costs continue regardless.

⚠️ Common exam mistakes

Including sunk costs in decision analysis — the most common error; past expenditure is always irrelevant.
Ignoring opportunity costs because no cash changes hands — opportunity costs are real economic costs even without a cash flow.
Ranking products by highest contribution per unit instead of highest contribution per unit of limiting factor.
Treating committed costs as relevant just because they are large — if they cannot be avoided under any option, they are irrelevant.
Confusing notional costs with sunk costs — notional costs are relevant when a genuine alternative use exists; they are future-oriented.

Reference:

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