Learning Outcomes
After studying this article, you will be able to apply relevant costing principles to make-or-buy, outsourcing, and shutdown decisions in a short-term context. You will distinguish between relevant and irrelevant costs, calculate opportunity costs, and assess both quantitative and qualitative factors that affect whether a product, component, or department should be made internally, bought in, outsourced, or closed. Practical worked examples prepare you for ACCA Performance Management (PM) exam assessment.
ACCA Performance Management (PM) Syllabus
For ACCA Performance Management (PM), you are required to understand the application of relevant costing in short-term decision-making. This includes make-or-buy choices, outsourcing options, and shutdown decisions. Your revision should focus on:
- The definition and identification of relevant and irrelevant costs
- Calculation of relevant costs and opportunity costs in practical scenarios
- Comparison of 'make' (in-house) and 'buy' (external) costs
- Assessment of other financial and non-financial factors in outsourcing
- Evaluation of shutdown proposals, including the treatment of fixed costs
- Application of relevant costing principles across various short-term decisions
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- A company can manufacture a part for $6 per unit (materials $2, labour $2, variable overhead $1, fixed overhead $1). An outside supplier offers it for $5.50 per unit, fixed overheads would not change. Which costs are relevant to the decision?
- Which of the following costs are always irrelevant to a make-or-buy decision?
a) Future variable costs
b) Sunk costs
c) Opportunity costs
d) Avoidable fixed costs - Define 'opportunity cost' and explain its role in relevant cost analysis.
- True or false? If an outsourced supplier is more reliable but more expensive than in-house production, the decision is always to choose the lowest cost.
Introduction
Short-term decisions in business often require a choice: whether to make products or services in-house or buy them externally, whether to outsource activities, or whether to temporarily or permanently shut down a loss-making operation. These decisions must be based on sound analysis of costs that are truly affected by the choice being made—these are called relevant costs. Correctly identifying and calculating relevant costs is critical for accurate decision making and is a core skill assessed in the ACCA PM exam.
Key Term: relevant cost
A cost that will be directly affected by a specific decision and therefore should be considered when making that decision.
RELEVANT COST ANALYSIS: PRINCIPLES
Relevant costs are future cash flows that arise as a direct consequence of the decision under consideration. Costs or revenues that will remain unchanged regardless of the decision—such as sunk costs (past expenditures)—should be ignored.
Key Term: sunk cost
A cost that has already been incurred and cannot be changed by any future action; not relevant for decision-making.Key Term: opportunity cost
The economic benefit foregone by choosing one option over the next best alternative.
Relevant costs:
- Are future cash flows
- Arise only if the decision is taken (incremental)
- Include opportunity costs (the benefit lost by using a resource in its current use instead of its next best alternative)
Irrelevant costs:
- Sunk costs
- Committed/Unavoidable future costs
- Non-cash costs (e.g., depreciation if there is no cash flow consequence)
- Apportioned or general fixed overheads that remain unchanged
Worked Example 1.1
A firm is considering a contract that requires 400kg of Material M. There are 200kg in stock, originally purchased for $5/kg but now only saleable for $1/kg. Replacement cost is $7/kg. What is the relevant cost of material for the contract?
Answer:
The 200kg in stock would be replaced if used for something else, but it can only be scrapped for $1/kg. If used, the company forgoes $1/kg in scrap proceeds. New material must be bought for the remaining 200kg at $7/kg. Relevant cost = (200kg × $1) + (200kg × $7) = $200 + $1,400 = $1,600
MAKE-OR-BUY DECISIONS
A make-or-buy decision evaluates the financial effect of producing a good or service internally versus buying it from an external supplier. Only costs that change as a result of the decision are relevant.
Key relevant costs to compare:
- Variable production costs (materials, labour, variable overheads)
- Specific avoidable fixed costs (only if they can actually be avoided)
- Opportunity costs (e.g., if releasing capacity would allow for profitable alternative use)
Costs to ignore:
- Unavoidable general fixed overheads
- Past costs (sunk costs)
- Non-cash or notional costs without a cash impact
Worked Example 1.2
Company Q needs 5,000 components per year. Making internally costs: Materials $3, Labour $2, Variable overhead $1, Fixed overhead $2 (of which $1 is avoidable if not made). An external supplier will charge $7.50 per unit. What is the annual cost difference? Should Q make or buy?
Answer:
Relevant internal cost per unit: $3 + $2 + $1 + $1 (avoidable fixed) = $7
Buy-in cost per unit: $7.50
Annual cost:
Make: 5,000 × $7 = $35,000
Buy: 5,000 × $7.50 = $37,500
Q should make in-house and save $2,500 per year.
Exam Warning
Do not include sunk or unavoidable fixed costs when comparing make-or-buy options. Including such costs may result in incorrect conclusions and lost marks.
OUTSOURCING DECISIONS
Outsourcing involves transferring business activities or processes to an external provider. Outsourcing decisions must consider:
- All variable and avoidable fixed costs saved by outsourcing
- Potential opportunity costs if resources can be repurposed profitably
- Non-financial factors (quality, reliability, supplier dependency, confidentiality, staff morale)
Non-financial considerations can be decisive, even if cost savings are apparent.
Worked Example 1.3
A department’s staff cost $80,000 per year. Outsourcing offers the same service for $60,000, but would require existing staff to be made redundant, costing $10,000 (one time). Should the process be outsourced in year 1?
Answer:
Year 1 cost if outsourced: $60,000 (fee) + $10,000 (redundancy) = $70,000
Cost saving: $80,000 – $70,000 = $10,000 in year 1
In subsequent years: saving is $20,000 per year.
SHUTDOWN DECISIONS
Sometimes a loss-making department, operation, or product line may be considered for closure (shutdown). Relevant costs and benefits of closure include:
- Contribution lost from stopping activity (sales less variable costs)
- Any avoidable fixed costs that can be saved (e.g., rents, supervision, utilities)
- Extra one-off costs of closure (e.g., redundancy, contract penalties)
- Alternative use of resources released (opportunity cost)
- Knock-on effects on other products or divisions
Key point: Fixed costs are only relevant if they will be saved due to the shutdown.
Worked Example 1.4
C Ltd operates three departments (A, B, C). Department C is loss-making and may be closed. By closing C, $4,000 fixed costs can be saved, but the closure would cause a $3,000 reduction in sales of departments A and B (lost cross-departmental benefits). Should department C be closed if its current loss is $5,000?
Answer:
Relevant costs/benefits:
- Loss avoided: $5,000
- Fixed cost saving: $4,000
- Lost contribution from A/B: (3,000) Net benefit: \5,000 + $4,000 – $3,000 = $6,000 improvement from closure.
Revision Tip
In shutdown and make-or-buy questions, clearly state all assumptions about which fixed costs are avoidable. Marks are awarded for justified application, not just for calculations.
OTHER SHORT-TERM DECISION FACTORS
Other practical considerations may determine the final decision:
- Supplier reliability, quality, lead times
- Confidentiality and potential loss of control
- Long-term strategic importance or risk of dependence
- Impact on workforce morale and skills retention
- Future price changes from suppliers
A strong recommendation must balance financial results with these strategic issues.
Summary
Relevant costing ensures that all decisions are based on future cash flows directly impacted by the decision, including opportunity costs. Make-or-buy and shutdown decisions focus only on costs and incomes that will change as a result of the action taken. Always supplement quantitative analysis with consideration of non-financial impacts, risks, and the effects on other parts of the business.
Key Point Checklist
This article has covered the following key knowledge points:
- Define and identify relevant, irrelevant, and opportunity costs in decision-making
- Calculate relevant costs in make-or-buy, outsourcing, and shutdown scenarios
- Explain why sunk and unavoidable fixed costs are excluded in relevant costing
- Apply opportunity costs where resources have alternative uses
- Structure a short-term decision statement to show all relevant incremental costs and benefits
- Explain qualitative considerations in make-or-buy and outsourcing decisions
- Assess shutdown proposals for both financial and strategic impacts
Key Terms and Concepts
- relevant cost
- sunk cost
- opportunity cost