Apply relevant costing to short-term decisions - special order pricing, make-or-buy, the use of a limiting factor, and discontinuing a product - identifying relevant and irrelevant costs and ranking options by contribution.

What this dot point is asking

The SQA wants you to make short-term business decisions using relevant costing: identifying which costs and revenues actually change as a result of a decision, ignoring those that do not, and ranking options by contribution. The standard decisions are special order pricing, make-or-buy, allocating a limiting factor, and whether to discontinue a product. The marks reward both the correct numbers and a justified recommendation with caveats.

Relevant versus irrelevant costs

The first skill is sorting the costs, because using the wrong ones gives the wrong decision.

The classic trap is allowing a sunk cost (money already spent on research, or the book value of an old machine) to influence a decision. The money is gone whatever you choose, so it cannot be relevant. Conversely, an opportunity cost feels invisible but is real and must be counted.

Special orders and make-or-buy

These two decisions both hinge on comparing the relevant cost of one option with the relevant cost or revenue of the other.

For a special order, the principle is the same: with spare capacity, fixed costs are irrelevant, so accept any price above variable cost because it adds contribution. The caveats matter for full marks - the order must not displace higher-margin sales, undercut the normal market, or set an unsustainable price expectation.

The limiting factor decision

When a resource is scarce, the firm cannot make everything it could sell, so it must choose the most profitable use of the constraint.

The key insight is that the limiting factor, not the product, is what is scarce, so contribution must be measured per unit of the constraint. A product with a high contribution per unit can be a poor choice if it consumes a lot of the scarce resource.

Discontinuing a product

The decision to drop a product is where absorbed overhead misleads most often.

A product showing a loss after a share of fixed overhead may still be worth keeping. If it makes a positive contribution, it is helping to cover fixed costs that would otherwise fall on the remaining products. Dropping it removes that contribution but usually not the fixed cost, so total profit falls. Only discontinue when the product's contribution is negative, or when dropping it genuinely removes fixed costs or frees capacity for something more profitable.

Why this matters later

Decision making is the practical pay-off of marginal costing: every decision here uses contribution rather than absorbed cost. It also connects to investment appraisal, which applies the same relevant-cash-flow thinking to longer-term decisions over several years. The recurring lesson - relevant costs only, contribution as the measure, and non-financial factors as a check - is the management accountant's core judgement.

Try this

Q1. A firm with spare capacity is offered GBP 22 per unit. Variable cost is GBP 16 and fixed costs are unchanged. Should it accept, and what is the contribution per unit? [3 marks]

• Cue. Contribution $= 22 - 16 = 6$ per unit; accept, as it adds GBP 6 per unit to profit.

Q2. Product P has contribution GBP 45 and uses 5 labour hours; product Q has contribution GBP 28 and uses 2 labour hours. Labour is the limiting factor. Which ranks first? [3 marks]

• Cue. P: $\dfrac{45}{5} = 9$; Q: $\dfrac{28}{2} = 14$; Q ranks first.