BUSMGT713 Chap.8 Relevant costs for keep or discontinue decisions
Relevant costs for keep or discontinue decisions
The Week 3 title includes relevant costs, and the course learning outcomes ask students to use relevant costing together with qualitative factors to support decisions. This chapter applies that to the question the practice mid-term ends with: should a business stop a line that reports a loss? The answer turns on which figures would actually change.
Revenue, variable costs and fixed costs that exist only because of the line disappear if it closes, so they are relevant. Allocated shares of shared or head-office costs remain with the business whichever choice is made, so the practice solution treats them as irrelevant and removes them.
What is left, the line's relevant profit, is compared with the best alternative use of the resources closing would release, after that alternative's own extra costs. The recommendation then needs at least one qualitative reason. A café group's catering business carries the method here: its kitchen could instead make wholesale pies for a supermarket.
In this case the numbers point towards switching, which shows that the rule, not the verdict, is what transfers.
What this chapter covers
- 01
Relevant and irrelevant costs in a keep or discontinue decision
- 02
Avoidable fixed costs against allocated fixed costs
- 03
Sunk costs and why depreciation on past spending stays out
- 04
Valuing the alternative use of released capacity, net of its own costs
- 05
The volume at which the decision switches
- 06
Qualitative factors that complete or reverse a recommendation
Worked example · free
Ōtāhuhu Café Group: a $5,000 reported loss against the pie alternative
- +2The $21,000 head-office share stays with the group under both options, so it is irrelevant; the reported -$5,000 includes it.
- +2Relevant profit of keeping catering = $96,000 minus $58,000 minus $22,000 = $16,000.
- +2Pies = 24,000 x $1.50 = $36,000 contribution minus $14,000 extra fixed cost = $22,000, which beats catering by $6,000.
Key terms
- Relevant cost
- A future cost that differs between the options being compared, and so is the only kind that can change the decision.
- Avoidable fixed cost
- Fixed spending that exists only because a segment operates, such as its own staff or leases, and ends when it closes.
- Sunk cost
- Money already spent that no future choice can recover, so it is ignored when comparing options.
- Segment margin
- What a segment earns after its variable costs and its own avoidable fixed costs, before any shared allocation.
- Qualitative factor
- A consequence of a decision that is hard to put in dollars, such as customer loyalty, staff morale or reputation.
Relevant costs for keep or discontinue decisions FAQ
Why are allocated fixed costs irrelevant to a discontinue decision?
They are shares of costs the business pays anyway, such as head-office salaries or building rent. If the line closes, the cost is simply reallocated to the remaining lines, so including it makes a line look worse than the true effect of closing. The practice solution removes allocated fixed costs before comparing options.
What should I compare when deciding whether to drop a product line?
Compare the line's relevant profit, revenue less variable costs less its avoidable fixed costs, with the value of the best alternative use of what is released: another product's contribution less its own extra fixed costs, rent, or nothing if capacity would sit idle. Then state which option leaves the business better off and by how much.
Is a sunk cost ever relevant?
No. A sunk cost has already been incurred and will not change whatever is decided, so depreciation on equipment that has no resale value stays out of the comparison. If the equipment could be sold, the sale proceeds are relevant, but that is a future cash flow, not the original cost.
What qualitative factors matter in a keep or drop decision?
Common ones are dependence on a single new customer for the alternative, staff who would be made redundant, food-safety or quality risk in a new product, and the firm's standing with existing clients. The practice paper asks for one qualitative reason in a single sentence, so choose the factor most tied to the facts in the question.
Can the same method recommend keeping one line and dropping another?
Yes. The method is fixed but the figures are not. In the practice paper the line's own profit exceeds the alternative, so it continues; where the alternative earns more than the relevant profit, switching is the better choice. Show the volume at which the answer flips so the verdict visibly follows from the numbers.
Assessment move
Take any segment report showing a loss and mark each cost as avoidable, allocated or sunk before doing arithmetic. Compute the relevant profit of keeping the line from revenue, variable costs and avoidable fixed costs only. Then value the alternative: its contribution less any new fixed costs it brings.
Compare the two totals, state the difference and the verdict in one sentence, and find the volume at which the verdict would flip. Add one qualitative factor tied to the facts given. Practise both outcomes by changing the alternative's volume so the verdict changes, so you learn to trust the comparison rather than an expected answer. Time yourself to about ten minutes per question.
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