Relevant Costing: Decision-Making & Special Orders

Key Concepts & Definitions

What is Relevant Costing?

Relevant costing is a decision-making tool that focuses only on future costs and benefits that differ between alternatives. It ignores irrelevant costs (sunk costs, committed costs) and emphasizes differential costs (the difference in costs between two options).

classDiagram
    class Cost {
        <<abstract>>
        +isRelevant() bool
    }
    class RelevantCost {
        +futureCost() bool
        +differential() bool
        +avoidable() bool
    }
    class IrrelevantCost {
        +sunkCost() bool
        +committedCost() bool
    }
    Cost <|-- RelevantCost
    Cost <|-- IrrelevantCost
    RelevantCost --> "1" DifferentialCost : "is a"
    IrrelevantCost --> "1" SunkCost : "is a"

Types of Costs in Decision-Making

In the Real World

1. Daraz (Nepal’s Amazon)

   • Special Order Decision: Daraz evaluates whether to accept a bulk order from a Nepali exporter by comparing the additional variable costs (packaging, shipping) against the profit margin. Sunk costs (existing warehouse space) are ignored.

2. Ncell (Telecom Operator)

   • Keep-or-Drop Decision: Ncell assesses whether to discontinue a low-margin prepaid plan by comparing avoidable costs (customer service for that plan) against contribution margin. Fixed costs (network infrastructure) are irrelevant.

3. Khalti (Digital Payment App)

   • Make-or-Buy Decision: Khalti decides whether to outsource its fraud detection system by comparing the cost of hiring a third-party vs. in-house development costs. Sunk costs (existing IT infrastructure) are excluded.

How to Apply Relevant Costing

Step-by-Step Decision Framework

1. Identify the Decision (e.g., accept a special order, drop a product line).
2. List All Costs & Revenues (both relevant and irrelevant).
3. Eliminate Irrelevant Costs (sunk costs, committed fixed costs).
4. Calculate Differential Costs & Benefits.
5. Make the Decision (choose the option with the higher net benefit).

Worked Example: Special Order for a Kathmandu Retail Shop

Scenario: Mega Mart, a retail chain in Kathmandu, receives a special order for 500 units of a product at ₹1,200 per unit. The shop’s normal selling price is ₹1,500, and variable cost per unit is ₹800. Fixed costs are ₹200,000/month, but the shop has idle capacity (can produce 1,000 extra units without affecting regular sales).

Step 1: Identify Relevant Costs & Revenues

Step 2: Decision Rule

• Accept if contribution margin > 0.
• Reject if contribution margin < 0.

Conclusion: Mega Mart should accept the order because it adds ₹200,000 to profit without affecting regular sales.

Common Decision Scenarios

1. Special Order Decision

• Rule: Accept if the additional revenue > additional variable costs.
• Example: A Nepalese exporter offers to buy 1,000 units at ₹900 (normal price: ₹1,200). If variable cost is ₹600, the contribution per unit is ₹300 → Accept.

2. Keep-or-Drop Decision

• Rule: Drop a segment if its contribution margin < avoidable fixed costs.
• Example: A Pathao driver considers quitting due to low earnings. If avoidable costs (fuel, maintenance) are ₹15,000/month and contribution margin is ₹12,000, he should keep driving (but optimize routes).

3. Make-or-Buy Decision

• Rule: Buy if external cost < internal cost (including opportunity cost).
• Example: A Nepali furniture manufacturer can buy chairs for ₹2,000 or make them for ₹1,800 (using idle capacity). Buy if external supplier offers ₹1,900 (saves ₹100 per unit).

Advantages & Limitations

Exam Tip

1. Always identify irrelevant costs first (sunk/committed).
2. Focus on differential costs—this is what examiners test.
3. Use tables to separate relevant vs. irrelevant costs (like the Mega Mart example).
4. Watch for traps:
   • Fixed costs are irrelevant unless avoidable.
   • Opportunity costs must be included (e.g., lost rent from unused space).
5. Practice numericals—most questions are scenario-based (e.g., "Should Ncell drop a low-margin plan?").

Final Checklist for Exam Questions

flowchart TD
    A["Decision Scenario Given"] --> B["List All Costs & Revenues"]
    B --> C["Eliminate Sunk/Committed Costs"]
    C --> D["Calculate Differential Costs"]
    D --> E["Compare Alternatives"]
    E --> F["Choose Higher Net Benefit"]
    F --> G["Write Clear Conclusion"]

Key Takeaway: Relevant costing is not about accounting rules—it’s about logical decision-making. Always ask: "Will this cost change if I choose Option A vs. Option B?" If yes, include it. If no, exclude it.