Relevant Costs to Selling or Processing Materials Further

Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

Companies know that there is a point where they sacrifice profit in favor of other aspects of production. However, knowing where that line is can be difficult. In this lesson, we learn about the relevant costs of further production.

To Sell or Process Further?

Have you ever created a painting? Just when you think you've finished it, you wonder if there's something else you could add to make it better. Many companies often have the same problem. They could always do something else to their products. However, while your painting is ultimately your creativity's responsibility, a company's primary goal is to make sure that it is maximizing profitability. As a result, the decision to sell a good or process it further in order to gain a higher price is one that many companies face. In order to make the right decision, a company has to know what to look for. In this lesson, we'll look at the relevant costs to selling or processing a product further, first conceptually and then through use of an example.

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  • 0:00 To Sell or Process Further?
  • 0:43 Considering Relevant Costs
  • 1:18 Making the Decision
  • 2:14 Example
  • 3:07 Lesson Summary
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Considering Relevant Costs

When looking at the decision to sell or further process a product, one must always be mindful of the relevant costs, or those costs affected by a given course of action. Often, they include manufacturing or sales costs, and they exclude costs like accounting or administration.

However, there two different types of costs to look at. The first are variable costs, which are those costs that increase with each additional unit produced, such as additional labor or materials costs. The second are fixed costs, which may go up as a result of the decision as a whole. If you have to train your staff or build a new factory, those are both fixed costs.

Making the Decision

In either event, it is only worthwhile to proceed if the total expected units sold brings in more money than the sum of the fixed costs and the variable costs. Meanwhile, each unit sold should sell for a price that exceeds the variable cost.

So, what does that all boil down to? Simply look at the variable costs of either option and then subtract them from the expected selling prices. If the difference between the refined selling price and refined variable cost is low, then it's not worth pursuing. Otherwise, factor in fixed costs by asking yourself how many units you expect to sell and then multiply that by the profit per unit. If your profits are higher than pre-upgrade profits, then you should consider further refining the product.

Since your expected units sold and costs can fluctuate depending on market conditions, you should also reevaluate your decision if conditions change. For example, your production costs may fall or rise, or you may find yourself having to sell each unit for a lower price to stay competitive.

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