Relevant Costs: How do you make a “make or buy” decision?
Relevant Costs: How to Make the “Make or Buy” Decision?
Relevant Costs: A practical guide on how to distinguish between Sunk Costs and Avoidable Costs to make critical financial decisions such as “Make vs. Buy” or Outsourcing—Digital Salla.
- What are Relevant Costs and what are the two criteria for a cost to be relevant?
- Identifying Irrelevant Costs: Sunk costs and unavoidable fixed overhead.
- The logic of Avoidable Costs in the “Make or Buy” decision.
- A numerical case study for Outsourcing a manufacturing component.
- Qualitative factors to consider beyond the financial math.
1) The Concept of Relevant Costing
Relevant Costing is a management accounting technique that eliminates “Noise” from decision-making by focusing only on costs and revenues that will change as a direct result of the choice. It is the foundation of Differential Analysis.
2) The Two Criteria for Relevancy
A cost is only relevant if it passes these two filters:
3) Common Irrelevant Costs (Sunk & Fixed)
Items that should be immediately discarded from your decision model include:
- Sunk Costs: Costs already spent (e.g., last year’s machinery purchase, research and development fees).
- Unavoidable Fixed Costs: Shared overhead that will continue regardless of the choice (e.g., general office rent, factory insurance).
- Future Costs that don’t differ: A monthly subscription that you will pay regardless of which project you start.
4) Logic of the Make or Buy Decision
The Make or Buy decision is a choice between producing a component internally or purchasing it from a third-party supplier (Outsourcing).
Break-even & Sensitivity Model - Excel File
Decision Rule
Compare the Avoidable Costs of making the item with the Purchase Price from the supplier.
5) Case Study: Outsourcing Component X
A factory produces 10,000 units of a component. A supplier offers to sell it for $18 per unit.
| Cost Element | Make (Total) | Buy (Total) | Is it Relevant? |
|---|---|---|---|
| Direct Materials | $50,000 | $0 | Yes (Avoidable) |
| Direct Labor | $80,000 | $0 | Yes (Avoidable) |
| Variable Overhead | $20,000 | $0 | Yes (Avoidable) |
| Allocated Fixed Overhead | $50,000 | $50,000 | No (Irrelevant) |
| Purchase Price ($18/unit) | $0 | $180,000 | Yes (Incremental) |
| Total Relevant Cost | $150,000 | $180,000 |
6) What is an Avoidable Cost?
An Avoidable Cost is a cost that can be eliminated (in whole or in part) as a result of choosing one alternative over another.
- If you stop making the component, do you fire the machine operator? If yes, that salary is Avoidable (Relevant).
- Does the factory rent stay the same? If yes, the rent is Unavoidable (Irrelevant).
7) Strategic and Qualitative Factors
The math is only half the story. Management must consider:
- Quality Control: Can the supplier match our internal standards?
- Reliability: What happens if the supplier has a strike or delivery delay?
- Opportunity Cost: If we “Buy,” can we use the idle factory space for a more profitable new product? (If yes, add this lost profit to the “Make” path cost).
- Expertise: Are we losing the technical skill required to innovate in the future?
8) Operational Controls & Readiness Checklist
To ensure your Decision Support models are robust:
Decision Quality Gate Checklist
- Are Direct Labor costs truly avoidable (e.g., can staff be reassigned or let go)?
- Have all Sunk Costs (like depreciation) been stripped from the report?
- Is the Opportunity Cost of using the current space quantified?
- Are supplier price quotes guaranteed for at least 12 months?
- Is the Segment Margin logic used for the analysis?
9) Common Errors and How to Prevent Them
- The Allocated Cost Trap: Including a “Share” of general management salaries in the cost of producing a component.
- Ignoring Capacity: Assuming you can “Make” more without incurring new fixed costs (Ignoring the Relevant Range).
- Confusing Unit Costs with Total Costs: Unit fixed costs change with volume, which can mislead a decision model. Always use Total Relevant Dollars.
- Neglecting Opportunity Costs: Forgetting that idle space has a value.
10) Frequently Asked Questions
What is the difference between a Sunk Cost and a Relevant Cost?
A sunk cost happened in the past and cannot be changed. A relevant cost is a future cost that changes depending on your decision.
When is a fixed cost relevant?
When it is Avoidable. For example, if you close a specific department and fire its dedicated supervisor, that supervisor’s salary is a relevant fixed cost.
Is Outsourcing always about saving money?
No. Sometimes companies outsource to focus on their “Core Competencies” or to gain access to specialized technology that they cannot develop internally.
11) Conclusion
Mastering Relevant Costing is what separates a bookkeeper from a Financial Strategist. By stripping away Sunk Costs and unavoidable overhead, and focusing on Avoidable Costs, you provide the clarity needed for high-stakes “Make or Buy” decisions. This methodology ensures that every choice the entity makes is grounded in incremental financial reality and strategic qualitative foresight.
Action Step Now (30 minutes)
- Identify one component or service you currently “Make” or perform in-house.
- List only the costs that would actually disappear if you stopped doing it tomorrow.
- Compare that total with a quote from an external supplier. Which path is truly cheaper?