Choosing the Best Production Methods with Relevant Costs Analysis

Every manufacturing business eventually faces the same question: which machine, process, or method should we use to make our product? Sometimes it is a choice between two machines with different capacities. Sometimes it is a choice between making a component in-house or buying it from an outside supplier. These are called alternative methods of production, and getting the decision right can make or break a company’s profitability. This is where relevant costing steps in, helping managers cut through the noise of accounting numbers and focus only on the costs that actually change with the decision.

What are alternative methods of production 🔗

Alternative methods of production simply refer to the different ways a company can manufacture the same output. A firm might be able to produce a component using a semi-automatic machine, a fully automatic machine, or by outsourcing production to a job worker. Each option comes with its own combination of fixed investment, operating expenses, and output capacity.

The management’s job is not to pick the option that looks cheapest on paper, but the one that is cheapest when all the relevant costs and benefits are properly compared over a common basis, usually per unit or per annum. This requires isolating costs that genuinely change with the decision from those that stay the same no matter what is chosen.

Why relevant costs, not total costs, drive the decision 🔗

A common mistake students and even junior managers make is comparing the full cost of each alternative, including costs that will be incurred regardless of which option is chosen. Relevant costing corrects this by asking one simple question for every cost item: does this cost change if we pick a different alternative? If the answer is no, the cost is irrelevant and should be dropped from the comparison.

Costs that vary between alternatives are known as differential costs, and this technique of comparing them is sometimes called differential cost analysis. It is important to remember this is a technique, not a separate costing method, and it is only meaningful when it is calculated between two or more genuine alternatives. Fixed costs that remain unchanged across all the choices, and historical or sunk costs already paid for, have no place in this analysis.

Sunk costs and committed costs stay out 🔗

Suppose a company already owns an old machine that has been fully depreciated. The original purchase price of that machine is a sunk cost. It was spent in the past and cannot be recovered or changed by today’s decision, so it is excluded when comparing alternative production methods. Similarly, costs the company is contractually committed to pay irrespective of the choice, such as a fixed lease rental already locked in, do not enter the comparison either.

The three pillars of the comparison: operating cost, depreciation, and interest 🔗

When evaluating alternative machines or processes, three cost elements typically decide the outcome.

Operating or production cost 🔗

This includes the running costs of actually producing units: direct material, direct labour, power, and variable overheads tied to the machine or process. A more automated machine often has lower labour cost per unit but higher power consumption, while a manual process may need more workers but less capital equipment. These operating costs usually change directly with the volume of production, so they are almost always relevant.

Depreciation 🔗

Depreciation represents the systematic write-off of a machine’s cost over its useful life. While depreciation itself is a non-cash, notional expense, it becomes relevant in production-method decisions because different machines have different purchase prices and useful lives, which means the annual depreciation charge differs between alternatives. Where the future cash outflow underlying that depreciation, that is, the machine’s price, differs across options, the resulting depreciation figure is treated as relevant for comparison purposes, even though the cash was technically spent at the time of purchase.

Interest on capital employed 🔗

Buying a machine ties up capital that could otherwise be invested elsewhere or earn a return. Management accounting problems on this topic typically include a notional interest charge, calculated on the capital invested in the machine, to represent the opportunity cost of using funds this way rather than investing them at the prevailing rate of return. Since different machines require different amounts of investment, the interest charge varies between alternatives and becomes an important part of the comparison, even though no interest is actually paid to anyone.

A worked example: choosing between two machines and outsourcing 🔗

Consider a company that needs 10,000 units of a component every year. It is evaluating three alternatives: buying a smaller Machine P, buying a larger Machine Q with more automation, or outsourcing production entirely to a supplier who quotes a fixed price per unit.

On the basis of this comparison, Machine P works out to be the cheapest alternative. Machine Q, despite lower labour cost per unit thanks to automation, is pulled down by a much higher depreciation and interest burden because of the larger capital outlay. Outsourcing looks convenient but carries the highest total annual cost at the current volume of 10,000 units. This is the essence of relevant costing for production-method decisions: every rupee that changes between alternatives is counted, and every rupee that stays fixed is ignored.

What changes as volume changes 🔗

It is worth noting that this conclusion is volume-dependent. Machine Q’s higher fixed costs, such as depreciation and interest, get spread over more units as production volume rises, so at a sufficiently high output level, Machine Q could become the cheaper option per unit. Management accountants often calculate a break-even volume, the point at which two alternatives cost the same, to guide decisions when demand is expected to grow.

Make versus buy: a closely related decision 🔗

Alternative methods of production frequently overlap with the classic make-or-buy decision. A company deciding whether to manufacture a part internally or purchase it from a vendor is essentially comparing two production methods. Only the costs that vary between making and buying are relevant to this choice; fixed factory overheads that will be incurred either way should not influence the decision, unless production capacity is freed up for another profitable use.

This is also where opportunity cost enters the picture. If choosing to outsource frees up factory space or machine hours that can be used to manufacture something else profitably, that forgone contribution margin becomes a relevant cost of continuing to make the part in-house.

Absorption costing versus variable costing in this analysis 🔗

Another practical consideration is which costing method is used to build up the operating cost figures for each alternative. Under absorption costing, fixed manufacturing overheads get allocated to each unit produced, which can distort comparisons between machines with very different fixed cost structures. Variable or marginal costing, which includes only costs that change with output, is generally considered more suitable for short-term production-method decisions because it keeps fixed and variable elements separate, making the true incremental impact of each alternative easier to see.

Beyond the numbers: qualitative factors matter too 🔗

Relevant cost analysis gives a clear, numbers-based answer, but production decisions are rarely made on cost alone. Factors such as product quality consistency, delivery reliability of an outside supplier, the skill level of the existing workforce, government incentives for certain kinds of machinery, and the strategic importance of retaining manufacturing know-how in-house all matter. A company might choose a slightly costlier alternative if it offers better quality control or reduces dependence on external vendors. Non-routine decisions like this typically weigh quantitative relevant costs alongside these qualitative considerations before a final call is made.

Good cost and management accounting practice also stresses that this kind of analysis should feed into, rather than replace, sound managerial judgement. The numbers tell you which option is financially efficient at a given volume; the final decision still rests on strategy, risk appetite, and long-term goals.

A simple checklist before comparing production alternatives 🔗

• Identify true alternatives – list only the realistic options actually available to the business.
• Strip out sunk and committed costs – anything already spent or unavoidable stays out of the comparison.
• Include notional interest and updated depreciation – reflect the true cost of capital tied up in each option.
• Check the volume assumption – recalculate at expected future output levels, not just current demand.
• Weigh qualitative factors – quality, reliability, and strategic fit alongside the pure cost figures.

What do you think? If a company’s expected production volume is likely to grow significantly over the next three years, should it still choose the machine with the lowest cost at today’s volume, or plan around future capacity needs? And how much weight should qualitative factors like supplier reliability carry against a purely cost-based recommendation?

References

1. https://www.wallstreetmojo.com/relevant-cost/
2. https://egyankosh.ac.in/bitstream/123456789/84042/3/Block-5.pdf
3. https://fitsmallbusiness.com/relevant-costs-for-decision-making-accounting/
4. https://accountingforeveryone.com/variable-costing-alternative-accounting-method-internal-decision-making/
5. https://www.accountingverse.com/managerial-accounting/relevant-costing/