A plant manager finds idle capacity and a one-time customer offering $60 per unit when full cost is $67. Accept or reject? Marginal analysis isolates the dollars that actually change.
A cost or revenue is relevant to a decision only if it (1) occurs in the future and (2) differs across the alternatives. Past cash flows cannot change, and amounts identical under every option cancel out of the comparison. Relevant revenues follow the same test.
KEY: "Future and differential" is the entire definition. Bookkeeping classification (fixed vs variable, direct vs indirect) does not control relevance. A variable cost that is identical under both choices is irrelevant. A fixed cost that disappears if you outsource is relevant.
- Incremental cost is the additional total cost from a decision. Differential cost is the synonym used when comparing two alternatives explicitly. Both contain only relevant amounts.
- Marginal cost is the cost of producing one more unit at the current output level. In short-run CMA decisions, marginal cost typically equals variable cost per unit.
Common mistakes
- Treating allocated fixed overhead as relevant. Allocated FOH that continues whether or not the decision is taken is irrelevant. Comparing the $60 special-order price to full absorption cost $67 and rejecting is the classic trap.
- Including sunk R&D or training in a go-forward decision. A $2M development cost already spent is not part of the incremental analysis. Only future cash flows count.
- Forgetting opportunity cost at full capacity. Under idle capacity the rule is price > variable cost. Under full capacity the rule is price > variable cost + displaced contribution margin. Switching capacity status without re-running the opportunity-cost line is the most common make-or-buy and special-order error.
Bottom line
- Relevant costs are future cash flows that differ between alternatives. Sunk costs (already-paid R&D, training) and unavoidable allocated overhead are irrelevant.
- Opportunity cost equals contribution margin forgone from the next-best use of a scarce resource, added to the cost of the alternative that consumes it.
- Special order with idle capacity: accept if price exceeds variable cost per unit plus any order-specific incremental cost. Full absorption cost and allocated fixed overhead are distractors.
- At full capacity the rule tightens to price > variable cost plus displaced contribution margin.
Exam shortcut
When the question gives full absorption cost and asks about a special order with idle capacity, strip out the allocated fixed overhead and compare price against variable cost plus any order-specific incremental cost only. When capacity status is full, immediately add displaced contribution margin to the cost side. The same special-order math accepts under idle capacity and rejects under full capacity. For sell-or-process-further, ignore the joint cost number entirely.
The full lesson (about 2,844 words, 19 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2C2
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