CMA relevant costing: incremental costs and opportunity cost
A relevant cost is a future cost that differs between alternatives. Exclude sunk costs and unchanged allocations. Include avoidable costs and the contribution lost by using scarce capacity. Start with the decision and available capacity before choosing numbers.
| Cost or benefit | Include? | Reason |
|---|---|---|
| Future incremental materials or labor | Yes, if it changes | The alternative creates or avoids the cash flow. |
| Past research expenditure | No | The expenditure cannot be changed by this decision. |
| Allocated head-office cost that remains | No | Changing an allocation does not avoid the underlying cost. |
| Fixed lease that can actually be canceled | Yes | Fixed does not mean irrelevant; avoidability matters. |
| Contribution lost from displaced sales | Yes | Scarce capacity has an opportunity cost. |
Special order with idle capacity
Assume the order does not change regular sales, has no other capacity use and creates no additional fixed cost beyond the stated setup.
| Incremental item | Calculation | Effect |
|---|---|---|
| Revenue | 500 units × $18 | +$9,000 |
| Variable cost | 500 units × $11 | -$5,500 |
| One-time setup | Avoidable if the order is rejected | -$1,000 |
| Contribution from accepting | $9,000 - $5,500 - $1,000 | +$2,500 |
Original worked example
Allocated fixed overhead is $7 per unit and remains either way. Should it be charged to this decision?
No. Under the stated assumptions the order improves profit by $2,500.
The full allocated unit cost is $18, but using it would hide the unchanged overhead. Also assess customer, quality and pricing consequences before making a real business decision.
Now make capacity scarce
The answer changes when accepting the order prevents a better use of the same capacity.
Original worked example
The same order now displaces regular sales with $3,200 total contribution. What is the incremental result?
$2,500 - $3,200 = -$700. Reject on the stated financial assumptions.
Opportunity cost is the benefit forgone, even if no invoice records it. Do not subtract displaced revenue alone; use the lost contribution after avoided variable costs.
A make-or-buy cost bridge
Compare the avoidable cost of making with purchase cost plus any relevant transition or quality costs. The word “fixed” alone cannot settle relevance.
| Per-unit item | Make | Buy |
|---|---|---|
| Avoidable production cost | $8 | $0 |
| Supplier price | $0 | $10 |
| Common overhead that remains | Excluded | Excluded |
| Relevant cost, idle capacity | $8 | $10 |
Original worked example
Buying also releases capacity worth $3 per unit in alternative contribution. Which option is cheaper economically?
Making now costs $8 + $3 opportunity cost = $11 versus $10 to buy. Buying is better by $1 per unit.
This conclusion depends on a real alternative use for the capacity. An unsupported “could use the space” claim is not a measured opportunity benefit.
Build the alternatives before filling in the cost table
Write a sentence describing each alternative, the period being evaluated and the resource that might be constrained. Then classify each amount. A historical amount cannot change, an allocated amount may or may not change, and a future amount matters only if the alternatives produce different outcomes.
Avoid double-counting opportunity cost. You can add the contribution lost by making to the make column, or deduct the contribution earned from freed capacity from the buy column. Doing both counts the same advantage twice. Keep one consistent baseline throughout the comparison.
Relevant-cost analysis often starts with a short-run financial comparison. It does not establish that a price is sustainable in the long run or that a supplier is reliable. Identify the qualitative conditions that could invalidate the arithmetic, such as a service commitment, quality requirement or effect on regular customers.
Dropping a segment: distinguish a reported loss from a saving
A segment income statement can include costs the business will still incur after the segment closes. Test avoidability before treating the reported loss as the benefit of closure.
| Annual item | Amount | Effect of closing |
|---|---|---|
| Revenue | $100,000 | Lost in full |
| Variable costs | $60,000 | Avoided in full |
| Traceable fixed costs | $30,000 | Only $20,000 can be avoided |
| Allocated common costs | $25,000 | Remain in the business |
Original worked example
The segment reports a $15,000 loss. Does closure improve total company profit? Assume no alternative use of capacity.
No. Lost contribution is $100,000 - $60,000 = $40,000. Avoided fixed costs are $20,000. Closing reduces company profit by $20,000.
The $10,000 unavoidable traceable cost and $25,000 common allocation remain. The apparent $15,000 segment loss is therefore not the cash or profit improvement from closing. Reassess if capacity can earn a genuine alternative contribution.
Common questions
- Are all fixed costs irrelevant?
- No. A fixed cost is relevant if it is future and differs between the alternatives, such as an avoidable rental payment.
- Are variable costs always relevant?
- Not automatically. Relevance depends on whether the specific cost changes for the decision being analyzed.
- What is the quickest relevance test?
- Ask whether the cost is future, whether it changes, and whether the alternative consumes a resource with another valuable use.
Sources and editorial notes
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