What is relevant (incremental) costing, and how would you apply it to a make-versus-buy or special-order decision?
A core FP&A interview question — asked in analyst and associate interviews across IB, PE, and the Big 4.
THE SHORT ANSWER
Relevant costing isolates the costs and revenues that actually change as a result of the decision — incremental/avoidable costs and any opportunity costs — and ignores sunk costs and unavoidable allocated overheads that won't change. For make-vs-buy: compare the avoidable cost of making (incremental materials, labour, variable overhead, and any directly avoidable fixed cost) against the buy price, plus the opportunity cost or benefit of freeing up capacity (could the freed capacity earn contribution elsewhere?). For a special order at below-list price: accept if the price exceeds the incremental cost of fulfilling it and there's spare capacity and no damage to regular pricing — fixed overheads already incurred are irrelevant. The classic error is loading full-absorption allocated overhead into the decision and rejecting a profitable incremental order. So I'd build a contribution-based, incremental analysis and explicitly flag capacity and opportunity-cost effects.
WHAT INTERVIEWERS LISTEN FOR
- ✓Use incremental/avoidable costs + opportunity cost; ignore sunk/unavoidable allocated
- ✓Make-vs-buy: avoidable make cost vs buy price + freed-capacity value
- ✓Special order: accept if price > incremental cost with spare capacity
- ✓Don't load full-absorption overhead into the decision
COMMON MISTAKES
- ✗Including sunk costs or unavoidable allocations
- ✗Ignoring opportunity cost of capacity
- ✗Rejecting a profitable incremental order on full-cost
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