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Strategic Cost Management · Decisions involving Alternative Choices

Pricing, Replacement and Alternative Choice Decisions

Updated 11 October 2026 · Fact-checked

Alternative choice decisions compare two or more courses of action using only relevant costs and revenues: those that are future and differ between options. For replacement, pricing or channel choices, list each option's incremental cash flows, ignore sunk costs, compare, and recommend the option with the better incremental result.

Understand Pricing, Replacement and Other Alternative Choice Decisions

Every alternative choice decision asks one question: which option leaves the business better off? You answer it by comparing what changes. Costs and revenues that are the same under both options do not affect the choice, so you leave them out.

The test for relevance has three parts. A cost is relevant if it is future, if it is a cash (or avoidable) item, and if it differs between alternatives. Sunk costs such as the book value of an old machine are not relevant. Allocated fixed overheads are not relevant unless they change because of the decision. Opportunity cost, the benefit given up by choosing one option, is relevant.

In an equipment replacement decision you compare keeping the old asset with buying a new one. The old asset's book value is sunk. Its current resale value is relevant, because selling it is possible only if you replace it. Compare the savings in running cost, the extra investment and the resale proceeds. If the life is long, use discounted cash flows; in short-life problems a simple total-cost comparison is usually enough.

In pricing decisions the relevant price is the one that covers incremental cost and earns the needed contribution. For a special or one-off order with spare capacity, any price above incremental cost adds to profit. When capacity is limited, the price must also cover the opportunity cost of the contribution lost elsewhere. Long-run prices must recover full cost and a profit.

Choices between methods or sales channels (own sales team versus distributors, manual versus automated process) are solved the same way. Work out the incremental revenue and incremental cost of each channel, then compare the net benefit. Qualitative factors such as quality, control, customer relationships and risk support the final recommendation. They do not replace the numbers.

Key rules to remember

Relevant cost of an asset or material
Relevant cost = Cash outflow avoided or incurred in future + Opportunity cost
Use the higher of resale value and value in alternative use as the opportunity cost. Ignore book value.
Incremental profit of an option
Incremental profit = Incremental revenue − Incremental cost
Compare options on this basis. Pick the higher figure.
Minimum price for a special order
Minimum price = Incremental cost + Opportunity cost (contribution lost on displaced work)
With idle capacity, the opportunity cost is zero.
Replacement decision (undiscounted)
Net benefit of replacing = Total running-cost saving over the period + Scrap value of new asset at end − (Cost of new asset − Resale value of old asset today) − Scrap value of old asset at end
Use present values if the problem gives a discount rate. A positive result favours replacement.
Cost-plus price
Price = Cost per unit + Mark-up % × Cost per unit
Use this for long-term pricing. Check that the cost base is stated: full or variable.

How to solve Pricing, Replacement and Other Alternative Choice Decisions questions

Use this sequence for any alternative choice question, whether it is about price, replacement or channel.

  1. 1Identify the decision and list the alternatives, including the option of doing nothing.
  2. 2Decide the time period and whether the question needs discounting.
  3. 3List every cost and revenue under each alternative.
  4. 4Strike out sunk costs, allocated fixed costs that do not change, and items equal under all options.
  5. 5Add opportunity costs, such as resale value forgone or contribution lost on displaced work.
  6. 6Compute the incremental result for each option in a clear table or line-by-line format.
  7. 7Recommend the best option and state the figure that supports it.
  8. 8Add one or two qualitative points, such as risk, quality or capacity, and state any assumption you made.

Quickest way: Differential statement shortcut

When to use it: Use when two options are given and you have under ten minutes for the question.

  1. Write the two options in two columns.
  2. Enter only items that differ. Do not bother with common items.
  3. Subtract one column from the other to get the difference.
  4. Convert any one-time item (resale value, new cost) into the same period as the rest.
  5. State the decision from the sign of the difference and add one qualitative factor.

Common mistakes in Pricing, Replacement and Other Alternative Choice Decisions

  • Including the book value or depreciation of the old machine as a cost of keeping it

    Students treat accounting figures as decision figures.

    Fix: Book value is sunk. Use only the resale value today and future cash flows. Loss on sale is not a relevant item.

  • Allocating fixed overheads to the special order or alternative

    Habit from full costing and cost sheets.

    Fix: Include fixed cost only if it will actually increase or be avoided because of the decision.

  • Ignoring opportunity cost when capacity is limited

    Students only see the direct cost of the order.

    Fix: Ask what the resources would earn otherwise. Add the lost contribution to the cost of the option.

  • Comparing options over different periods without adjustment

    The old machine has 3 years left and the new one has 5.

    Fix: Compare over a common period or use equivalent annual cost, and state your approach.

  • Giving figures without a recommendation

    Students stop after calculating.

    Fix: End with a clear sentence such as 'Replace the machine, as it saves ₹X over the period', and mention qualitative factors.

Worked examples

Example 1

Sundaram Textiles has a machine with a book value of ₹4,00,000 and a remaining life of 4 years. It can be sold today for ₹1,00,000; its scrap value after 4 years is nil. Running cost is ₹3,00,000 a year. A new machine costs ₹5,00,000, has a 4-year life, nil scrap value and running cost of ₹1,50,000 a year. Ignore tax and the time value of money. Should the company replace the machine?

Show the solution
  1. Book value of ₹4,00,000 is sunk. Ignore it.
  2. Running-cost saving per year = ₹3,00,000 − ₹1,50,000 = ₹1,50,000.
  3. Saving over 4 years = ₹1,50,000 × 4 = ₹6,00,000.
  4. Net investment = ₹5,00,000 − ₹1,00,000 resale = ₹4,00,000.
  5. Net benefit of replacing = ₹6,00,000 − ₹4,00,000 = ₹2,00,000.

Answer: Replace the machine. It gives a net benefit of ₹2,00,000 over 4 years. The loss on sale of the old machine does not affect the decision.

Example 2

Kaveri Appliances has spare capacity. Its regular selling price is ₹800 a unit, with variable cost of ₹500 a unit and fixed cost absorbed at ₹150 a unit. A customer offers to buy 2,000 units at ₹560 a unit. Fixed costs will not change. Should the company accept the order, and what is the minimum acceptable price?

Show the solution
  1. Relevant cost per unit = variable cost = ₹500. Absorbed fixed cost of ₹150 is not relevant.
  2. Contribution per unit at offered price = ₹560 − ₹500 = ₹60.
  3. Total extra contribution = ₹60 × 2,000 = ₹1,20,000.
  4. There is spare capacity, so there is no opportunity cost.
  5. Minimum price = ₹500 a unit, since opportunity cost is nil.

Answer: Accept the order. It adds ₹1,20,000 to profit. The minimum price is ₹500 a unit. Check that the order will not disturb regular customers' prices.

Exam tips

  • Begin every answer by stating which costs you are ignoring and why. Examiners reward this.
  • Show a differential or incremental table. It is easy to mark and reduces errors.
  • For replacement problems, check whether the question gives a discount rate. If it does, use present values.
  • In MCQs, look for the sunk cost trap: the option that uses book value is usually wrong.
  • Always close with a recommendation and one qualitative factor.

Practice questions from Decisions involving Alternative Choices

Pricing, Replacement and Other Alternative Choice Decisions in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Pricing, Replacement and Other Alternative Choice Decisions: frequently asked questions

What is the relevant cost in an equipment replacement decision?

It is the future cash flows that differ between keeping and replacing: running costs, the cost of the new asset, and the resale value of the old asset today. Book value and depreciation on the old asset are not relevant.

How is a make or buy decision different from a lease or buy decision?

Make or buy compares the incremental cost of producing a part in-house with the price of buying it from outside. Lease or buy compares the cash flows of leasing an asset with those of buying it, usually using present values. The first is mainly an operating choice and the second is a financing choice.

How do you set a price for a special order?

Start with the incremental cost of the order. If there is idle capacity, any price above that cost adds to profit. If capacity is limited, add the contribution lost on displaced work to get the minimum price.

Should I use discounted cash flows in replacement problems?

Use them when the question gives a discount rate or the life is long. If the question says to ignore the time value of money, a simple total comparison is enough.