MAKE OR BUY AND SHORT TERM DECISIONS: COMPLETE GUIDE TO RELEVANT COSTING, SPECIAL ORDERS, AND OUTSOURCING
Every business faces short-term decisions that can significantly impact profitability. Should you make a component in-house or buy it from a supplier? Should you accept a special order at a reduced price? Should you outsource a non-core activity? These decisions require careful analysis of relevant costs—costs that will change as a result of the decision.
Get this wrong, and you will make poor decisions that reduce profitability, waste resources, and damage your competitive position. Get it right, and you unlock the ability to make informed, cost-effective decisions that drive business success. This guide breaks down everything: the concept of relevant costing, make-or-buy decisions, special order decisions, outsourcing, and practical examples with calculations. Let us get into it.
The Pain Points: Why Businesses Struggle with Short-Term Decisions
Confusing Sunk Costs with Relevant Costs
One of the most common mistakes in decision-making is the failure to ignore sunk costs. Sunk costs are costs that have already been incurred and cannot be recovered. They should not influence future decisions. But human psychology makes it hard to let go. Leaders feel they have invested too much to walk away. This is the sunk cost fallacy. It leads to poor decisions, wasted resources, and missed opportunities.
Consider a business that has spent N10 million developing a new component. The component is not performing as expected. The business should consider outsourcing. But the leaders feel they cannot walk away because they have already invested N10 million. This is the sunk cost fallacy. The N10 million is gone. It should not influence the decision to continue making the component or to outsource it.
Including Allocated Fixed Costs
Many businesses make the mistake of including allocated fixed costs in short-term decisions. These are fixed costs that are allocated to different products or departments. They are not incremental costs. They do not change with the decision. Including them can lead to incorrect decisions.
For example, a business may allocate a portion of factory rent to each product line. If the business is considering accepting a special order, the allocated rent should not be included. The rent will still be paid regardless of the decision. Including it makes the special order appear less profitable than it really is. This can lead to the rejection of profitable opportunities.
Overlooking Opportunity Costs
Opportunity costs are the benefits foregone by choosing one alternative over another. They are often overlooked in decision-making. But they are real costs that should be considered. Failing to consider opportunity costs leads to suboptimal decisions.
For example, a business owns a building that it could rent out for N5 million per year. If it uses the building for its own operations, the opportunity cost is N5 million. This should be included in the decision-making process. Similarly, if a business has limited machine hours and uses them to produce one product, the opportunity cost is the contribution foregone from not producing another product.
The Short-Term Focus Trap
Many businesses focus too narrowly on short-term financial benefits while ignoring long-term consequences. A special order might appear profitable in the short term. But it could damage relationships with regular customers who pay full price. It could also set a precedent for future discounts, eroding the company’s pricing power.
Outsourcing a non-core activity might appear cheaper in the short term. But it could lead to loss of control, quality issues, and reduced flexibility. These long-term consequences can outweigh the short-term savings.
The Capacity Constraint Problem
Many businesses struggle to make decisions when resources are limited. Should you use scarce machine hours to produce Product A or Product B? Should you outsource production to free up capacity for more profitable products? These decisions require careful analysis of contribution per limiting factor. Many businesses fail to identify the right limiting factor or miscalculate the contribution per unit of the limiting factor.
The Cost of Getting It Wrong
A manufacturing company in Lagos decided to accept a special order at a reduced price. It failed to consider that it was already operating at full capacity. The special order displaced regular sales. The company lost profitable regular customers. The net result was a loss, not a profit. The cost of getting it wrong was significant.
Another business in Abuja considered outsourcing a non-core function. It focused only on the cost savings and ignored the qualitative factors. The outsourced service was of poor quality. Customer complaints increased. The business lost customers. The cost of outsourcing was far greater than the savings.
A third business in Port Harcourt continued to make a component in-house because it had invested heavily in the equipment. The equipment was old and inefficient. The component could be bought cheaper from a supplier. The business continued to make it, losing money on every unit. The sunk cost fallacy led to years of poor decisions.
These examples illustrate the real-world consequences of poor short-term decision-making. The key to avoiding these mistakes is a disciplined approach to relevant cost analysis.
What Is Relevant Costing?
Definition
A relevant cost is a cost that only relates to a specific management decision and will change in the future as a result of that decision. Relevant costs are future costs that differ between decision alternatives and therefore affect decision-making.
The Three Key Characteristics
For a cost to be relevant, it must meet three criteria:
Future Costs: A decision is about the future and cannot alter what has been done already. Costs that have been incurred in the past are totally irrelevant to any decision being made now. Such costs are called past costs or sunk costs and are irrelevant.
Cash Flows: Only cash flow information is required. Costs or charges which do not reflect additional cash spending, such as depreciation and notional costs, should be ignored for decision-making purposes.
Incremental Costs: It is the increase in costs and revenues that occurs as a direct result of a decision taken that is relevant. Common costs can be ignored for decision-making purposes. Relevant costs are avoidable costs—costs which would not be incurred if the activity to which they relate did not exist.
Non-Relevant Costs
Several types of costs should be ignored in short-term decision-making:
Sunk Costs: Costs that have already been incurred and cannot be recovered. They cannot be changed by any current or future decision. For example, the book value of an asset or depreciation charged in accounts is not a relevant cost.
Committed Costs: Future costs that cannot be avoided because of decisions that have already been made. These are non-relevant costs.
Notional Costs: Costs that do not represent actual cash spending, such as depreciation or amortization. These should be ignored for decision-making purposes.
Absorbed Fixed Overheads: Fixed overheads which have already been agreed to absorb based on pre-determined rates should not be treated as relevant unless they represent actual incremental fixed costs.
Opportunity Costs
Opportunity costs arise when resources are scarce and have alternative uses. When an alternative course of action is given up, the financial benefits lost are known as opportunity costs. They are the lost contribution from the best use of the alternative forgone. Opportunity costs are always incremental and must be considered in decision-making.
Make-or-Buy Decisions
What Is a Make-or-Buy Decision?
A make-or-buy decision involves deciding whether to produce a component internally or purchase it from an external supplier. The decision should be based on a comparison of the relevant costs of each alternative.
Identifying Relevant Costs for Make-or-Buy Decisions
The relevant costs to make a product include direct materials, direct labor, and variable overhead that will be incurred as a result of making the product. Fixed overhead that will continue regardless of the decision is not relevant. Depreciation on existing equipment is a sunk cost and is not relevant.
Worked Example 1: Basic Make-or-Buy Decision
A company currently makes a component internally. The cost per unit is:
Direct Materials: $2.50
Direct Labor: $2.00
Variable Overhead: $0.30
Depreciation of Equipment: Not relevant
Allocation of fixed overhead: Not relevant
Cost of buying from supplier: $5.00 per unit
Step 1: Identify Relevant Costs
| Cost Item | Make | Buy |
|---|---|---|
| Direct Materials | $2.50 | – |
| Direct Labor | $2.00 | – |
| Variable Overhead | $0.30 | – |
| Depreciation | Not relevant | Not relevant |
| Allocated Fixed Overhead | Not relevant | Not relevant |
| Cost of Buying | – | $5.00 |
| Total Relevant Cost | $4.80 | $5.00 |
Decision: The company should make the component because the relevant cost of making ($4.80) is lower than the cost of buying ($5.00).
Worked Example 2: Make-or-Buy with Opportunity Cost
A company produces ice-makers for installation in refrigerators. Costs per unit for 20,000 units:
Direct Materials: $7
Direct Labor: $12
Variable Overhead: $5
Fixed Overhead: $10 (Total costs: $34)
A supplier offers to sell 20,000 ice-makers for $28 per unit. If the company accepts the offer, the existing plant can be retooled to produce water filtration units with estimated revenues of $80,000 and variable costs of 60% of sales. Additionally, $6 per unit of the fixed overhead associated with the manufacture of ice-makers could be eliminated.
Step 1: Calculate Relevant Cost to Buy
Purchase cost: 20,000 × $28 = $560,000
Opportunity cost (retooling profit): $80,000 × 40% = $32,000
Total relevant cost to buy = $528,000
Step 2: Calculate Relevant Cost to Make
Variable costs: ($7 + $12 + $5) × 20,000 = $480,000
Avoidable fixed overhead: $6 × 20,000 = $120,000
Total relevant cost to make = $600,000
Decision: The company should buy from the supplier because the relevant cost of buying ($528,000) is lower than the cost of making ($600,000). The opportunity cost of retooling makes buying more attractive.
Worked Example 3: Make-or-Buy with Limiting Factor
A company makes four products, W, X, Y, and Z. All four products are made on the same machines, and the machine capacity is 3,500 hours per year. The company can obtain any of these products in unlimited quantities from a subcontractor.
| Product | W | X | Y | Z |
|---|---|---|---|---|
| Annual sales demand (units) | 4,000 | 6,000 | 3,000 | 5,000 |
| Sales price per unit | $150 | $200 | $180 | $170 |
| Variable cost per unit (in-house) | $50 | $70 | $60 | $70 |
| Cost of external purchase | $80 | $118 | $105 | $110 |
| Machine hours per unit (in-house) | 0.25 | 0.5 | 0.3 | 0.4 |
Step 1: Calculate Contribution per Unit
| Product | W | X | Y | Z |
|---|---|---|---|---|
| Contribution (in-house) | $100 | $130 | $120 | $100 |
Step 2: Calculate Contribution per Machine Hour
| Product | W | X | Y | Z |
|---|---|---|---|---|
| Contribution per hour | $400 | $260 | $400 | $250 |
Step 3: Rank Products for In-House Production
Products W and Y have the highest contribution per machine hour ($400), followed by X ($260) and Z ($250). The company should prioritize W and Y for in-house production.
Step 4: Allocate Machine Hours
The company should produce as many units of W and Y as possible, then use remaining hours for X, and outsource Z.
Special Order Decisions
What Is a Special Order Decision?
A special order decision involves whether to accept a one-time order at a reduced price. These orders can be attractive, especially when the firm is operating below its maximum productive capacity.
Identifying Relevant Costs for Special Orders
Relevant costs include additional materials, labor, and any other incremental costs directly related to the order. Fixed overheads are usually not relevant unless the order requires additional fixed costs such as special purpose tooling or inspection costs.
Important Considerations
If the company is operating at less than capacity, regular customers’ revenue will not be affected. If the company is operating at capacity, it will have to give up some regular sales in order to provide the special order. This creates an opportunity cost.
Worked Example 4: Special Order Decision
A company has a special order for 1,000 units at a price of $80 per unit. Current production is 5,000 units. Normal selling price is $100 per unit.
Cost Data (Per Unit):
Direct Materials: $30
Direct Labor: $20
Variable Overhead: $10
Fixed Overhead (Allocated): $15
Selling and Admin (Variable): $5
Step 1: Identify Relevant Costs
Direct Materials: $30 (Relevant – incremental)
Direct Labor: $20 (Relevant – incremental)
Variable Overhead: $10 (Relevant – incremental)
Fixed Overhead: $15 (Irrelevant – same regardless of order)
Selling and Admin (Variable): $5 (Relevant – incremental)
Step 2: Calculate Relevant Cost per Unit
Relevant Cost = $30 + $20 + $10 + $5 = $65
Step 3: Compare Price to Relevant Cost
Price per unit: $80
Relevant Cost per unit: $65
Contribution from special order: $15 per unit
Decision: The company should accept the order because it contributes $15 per unit ($15,000 total) towards covering fixed costs and increasing profit, assuming it has spare capacity.
Outsourcing Decisions
What Is Outsourcing?
Outsourcing involves turning non-core functions over to specialist contractors. Companies increasingly concentrate on their core competences and outsource other functions.
Identifying Relevant Costs for Outsourcing
The same relevant costing principles apply. Relevant costs include the variable costs that would be saved by outsourcing and the cost of the outsourcing arrangement. Fixed costs that would continue regardless of the decision are not relevant.
Worked Example 5: Outsourcing Decision with Limited Resources
A company has three types of jobs: daily office cleaning, intensive cleaning, and minor repairs. In-house labor hours are limited to 8,000 hours.
| Job Type | In-house Cost | Sub-contractor Cost | Hours Saved | Extra Cost per Hour |
|---|---|---|---|---|
| Daily Office Cleaning | $600 | $800 | 4 | $50 |
| Intensive Cleaning | $1,080 | $1,500 | 6 | $70 |
| Minor Repairs | $560 | $1,000 | 3 | $147 |
Step 1: Rank Jobs for Outsourcing
The jobs with the lowest extra cost per hour saved should be outsourced first.
Step 2: Decision
Minor repairs should be prioritized for outsourcing (lowest extra cost per hour), followed by intensive cleaning, and then daily office cleaning.
Decision: The company should outsource the jobs with the lowest extra cost per hour saved to maximize the use of limited in-house resources.
Common Mistakes to Avoid
Mistake 1: Including Sunk Costs
Including costs that have already been incurred and cannot be recovered. Identify and eliminate all sunk costs. They are irrelevant.
Mistake 2: Including Allocated Fixed Costs
Including fixed costs that are allocated to products or departments. Only include costs that change with the decision. Allocated fixed costs are irrelevant.
Mistake 3: Overlooking Opportunity Costs
Failing to consider the value of foregone alternatives. Include opportunity costs in decision-making. They are real costs.
Mistake 4: Ignoring Qualitative Factors
Focusing only on financial factors and ignoring qualitative factors. Consider both quantitative and qualitative factors such as employee morale, supplier reliability, quality, and long-term strategic implications.
Mistake 5: Short-Term Focus Only
Focusing only on short-term benefits while ignoring long-term consequences. Consider the appropriate time horizon. A series of successive special orders over several periods constitutes a long-term decision with different implications.
How Qeeva Advisory Helps You Navigate Short-Term Decisions
We understand that short-term decisions can be complex. Many businesses struggle with identifying relevant costs, ignoring sunk costs, and considering opportunity costs. Our professionals specialise in cost analysis, financial modelling, and strategic decision-making.
Our Advisory Services Nigeria help you understand relevant cost analysis and apply it to your business decisions. We help you identify relevant costs, calculate differential costs, and make informed decisions.
Our Financial Advisory services help you build financial models that incorporate relevant costs. We help you evaluate make-or-buy decisions, special order decisions, and outsourcing decisions.
Our Management Consulting services help you redesign your decision-making processes to incorporate relevant cost analysis.
Our Risk Management services help you identify and manage risks associated with decision-making.
Our Business Plan Service helps you incorporate relevant cost analysis into your business plans.
And because decision-making is about people and processes, our Training & Mentoring Services help you develop the skills of your managers and employees.
Our Service Methodology
We do not do generic. We do thorough, transparent, and actionable.
Step 1: Cost Analysis
We analyse your costs and identify relevant and irrelevant costs. We help you understand which costs matter for your decisions. This step draws on our Advisory Services Nigeria expertise.
Step 2: Decision Analysis
We help you apply relevant cost analysis to your specific decisions. We evaluate make-or-buy decisions, special order decisions, and outsourcing decisions. Our Financial Advisory team ensures your analysis is robust and actionable.
Step 3: Opportunity Cost Identification
We help you identify and quantify opportunity costs. We ensure that you consider the value of foregone alternatives.
Step 4: Decision Support
We provide data-driven recommendations to support your decisions. We help you choose the alternative with the best financial outcome. Our Management Consulting team ensures your decisions are aligned with your business strategy.
Step 5: Ongoing Monitoring and Support
Decision-making is not a one-time exercise. We help you monitor your decisions, learn from outcomes, and improve your processes. We provide ongoing support through our Advisory Services Nigeria and Risk Management services.
Frequently Asked Questions
Q: What is a relevant cost?
A: A relevant cost is a cost that only relates to a specific management decision and will change in the future as a result of that decision.
Q: What are the three characteristics of relevant costs?
A: Relevant costs must be future costs, cash flows, and incremental costs.
Q: What is a make-or-buy decision?
A: A make-or-buy decision involves deciding whether to produce a component internally or purchase it from an external supplier.
Q: What is a special order decision?
A: A special order decision involves whether to accept a one-time order at a reduced price.
Q: What is an opportunity cost?
A: Opportunity costs are the benefits foregone by choosing one alternative over another. They are relevant costs that should be included in decision-making.
Q: Why are sunk costs irrelevant?
A: Sunk costs are costs that have already been incurred and cannot be recovered. They are gone and cannot be changed by any future decision.
Q: How can Qeeva Advisory help with short-term decisions?
A: We provide cost analysis, decision analysis, opportunity cost identification, decision support, and ongoing monitoring to help businesses make better decisions.
The Bottom Line
Relevant costing is a powerful decision-making tool. It helps you identify which costs matter and which should be ignored. Understanding the difference between relevant and irrelevant costs is essential for make-or-buy decisions, special order decisions, and outsourcing decisions.
The key is to focus on costs that differ between alternatives. Ignore sunk costs. Include opportunity costs. Consider both quantitative and qualitative factors.
Your job is to be prepared. Understand the concept of relevant costs. Identify the decision. List all costs. Eliminate sunk costs. Eliminate costs that do not differ. Identify differential costs. Choose the best alternative.
With the right approach and the right partner, you can turn relevant costing from a theoretical concept into a practical tool for better short-term decision-making.
The choice is yours.
Suggested Reading from Our Blog
Decision Making Techniques: Relevant Cost Analysis– Understand how relevant cost analysis supports strategic decision-making.
Dealing with Risk and Uncertainty in Decision Making – Learn how to make decisions under uncertainty.
Cost Volume Profit Analysis – Understand the relationship between costs, volume, and profit.
Related Services
Our Advisory Services Nigeria are staffed by professionals specialising in cost analysis, financial modelling, and strategic decision-making.
Our Financial Advisory services help you build financial models that incorporate relevant costs.
Our Management Consulting services help you redesign your decision-making processes.
Our Risk Management services help you identify and manage risks associated with decision-making.
Our Business Plan Service helps you incorporate relevant cost analysis into your business plans.
Our Training & Mentoring Services help you develop the skills of your managers and employees.
Let’s Talk About Your Short-Term Decisions
Navigating short-term decisions can feel complex. At Qeeva Advisory, we understand the challenges businesses face in identifying relevant costs, ignoring sunk costs, and considering opportunity costs.
Whether you need help with make-or-buy decisions, special order decisions, or outsourcing decisions, we are here to support you.
📞 Call us: (+234) 802 320 0801, (+234) 807 576 5799
📧 Email: info@qeeva.com
📍 Visit us: 5, Ishola Bello Close, Off Iyalla Street, Alausa, Ikeja, Lagos, Nigeria
Contact us today to schedule a consultation. Let us help you make better decisions with relevant costing.
Your journey to better decision-making starts with a conversation. Let’s talk.
Reference Links / Sources
ICAN – Management Information Study Text
Lumen Learning – Make or Buy Decisions
AccountingTools – Relevant Cost Definition
aCOWtancy – Concept of Relevant Costing
University of Mumbai – Cost Accounting Study Material
University of Basrah – Relevant Costing Example
ICAI – Decision Making Chapter
