CHAPTER TWO
DECISION MAKING AND RELEVANT INFORMATION
Decision making is a fundamental part of management. The managerial accountant’s role in the decision-making
process is to provide relevant information to the managers who make the decisions. Thus, the managerial accountant
needs a good understanding of the decisions faced by those managers. A key function of a Financial Manager is to
both facilitate and part take in the decision-making process.
Decision-making is the process of choosing the best course of action from the alternative available. That is, when
you are faced with making a decision (or choice), you need to perform a number of tasks before making the final
decision (choice).
Decision Making Process
The formal method used by managers for making a choice involves the following decision-making process.
1.
2.
3.
4.
5.
6.
7.
8.
Recognize and define the problem
Identify alternatives as possible solution to the problem
Identify the cost and benefit associated with each feasible alternative
Total the relevant costs and benefits for each alternative
Assess qualitative factors
Select the alternative with the greatest overall benefits
Implement the alternative selected
Follow-up
The concept of Relevance
Relevance is one of the key characteristics of good management accounting information. This means that
management accounting information produced for each manager must relate to the decisions which he/she will have
to make. Before the management of an enterprise can make an informed decision on any matter, they need to
incorporate all of the relevant costs which apply to the specific decision at hand in their decision making process. To
include any non-relevant information or to exclude any relevant information will result in management basing their
decision on misleading information and ultimately to poor decisions being taken.
Relevant Costs and Relevant Revenue
Relevant costs are expected future costs and relevant revenues are expected future revenues that differ among the
alternative courses of action being considered. Revenues and costs that are not relevant are said to be irrelevant.
Be sure you understand that to be relevant costs and revenues must
❖ Occur in the future—every decision deals with selecting a course of action based on its expected future
results. The Consequences of decisions are borne in the future, not the past. To be relevant to a decision,
cost or revenue information must involve a future event.
❖ Differ among the alternative courses of action—costs and revenues that do not differ will not matter and,
hence, will have no bearing on the decision being made. Relevant information must involve costs or revenue
that differs among the alternatives. Costs or revenues that are the same across all the available alternatives
have no bearing on the decision.
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Importance of Identifying Relevant Costs and Benefits
Why it is important for the managerial accountant to isolate the relevant costs and benefit in a decision analysis?
The reasons are two. First, generating information is a costly process. The relevant data must be sought, and this
requires time and effort. By focusing on only the relevant information, the managerial accountant can simplify and
shorten the data-gathering process.
Second, People can effectively use only a limited amount of information. Beyond this, they experience information
overload, and their decision-making effectiveness declines. By routinely providing only information about relevant
costs and benefits, the managerial accountant can reduce the likelihood of information overload.
Now let us see how we are going to use the relevant information to make decision through example and we will start
with the special order and we will proceed using the above order of decision making area.
Generally, the term that are used to describe the relevant costs are:
1. Avoidable costs.-those costs that would not be incurred I f the activity to which thy related did not exist. All
incremental costs are also referred as avoidable costs. What are incremental costs? This are costs which are
specifically incurred by following a course of action and which are avoidable if such action is not taken. That
is, there are costs that are directly affected by the decision or occur as direct consequences of the making a
decision (they are costs that will be incurred if the decision is implemented but not incurred if the decision
is rejected or not implemented). Such costs are known as incremental costs and considered as relevant cost
for decision. They are also termed as avoidable costs. Because, such costs can be avoided or would not be
incurred, if the activity to which it relates did not exist.
2. Opportunity costs. - Opportunity costs are the benefit which could have been earned, but which has been
given up, by the choosing one option instead of another option. In other words, it is the value of an option,
which cannot be selected because of choosing a different option. You may find the idea of opportunity costs
difficult to grasp at first. This is because they are costs, which are not included in the accounting books and
records of an enterprise. They are, however, relevant in certain decision-making situation and you must bear
in mind the fact that that exists when assessing any such situations.
Non-Relevant cost
Non-relevant costs are costs which are either not a future cash flows or which are costs which will be incurred any
wary, regardless of the decision taken. Fore example, expenses for full time salaries, heat and light, and the
apportionment of other administrating costs are usually unaffected by the decision and are considered as irrelevant
for the decision.
The common types of non-relevant costs are explained as follow:
1. Non-Incremental costs: - These are costs which will not be affected by the decision at hand. Non-incremental
costs are non-relevant costs because they are not related to the decision at hand (that is non-incremental costs
will remain the same no matter what decision is taken). An example of non-incremental costs would be fixed
costs, which by their very nature shouldn’t be affected by decisions (at least in the short term). If, however, a
decision gives rise to a specific increase in fixed costs then the increase in fixed costs would e an incremental (or
additional) and, hence, considered as relevant cost.
2. Sunk Costs: - A sunk cost is a cost that has already been incurred and cannot be altered by any future decision.
If sunk costs are not affected by a decision then they must not be considered for decision-making purposes.
Generally Sunk costs are considered a s non-relevant for a particular decision.
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For example, assume that an organization, which incurs market research, costs in studding the market for
introducing a new product. After studying the market, the final decision on whether or not to launch the
product, would regard these market research costs as ‘sunk’ (that is irrecoverable past cost) and thus, not
incorporate them in making the launch decision.
3. Committed cost: - These are future cash flows that will be incurred anyway, whether decision is taken now about
alternative opportunities. Such costs are usually the result of the contract already entered by the organization.
Generally, committed costs are similar to sunk costs in that they exist because of previous decisions. Committed
costs are different from sunk costs because they are costs that have been committed by management. However,
the costs committed contractually are effectively a sunk cost.
4. Notional Costs: - Notional costs are hypothetical accounting costs to reflect the use of a benefit for which no
actual cash expense is incurred. Notional costs are also called Imputed cost. The primary objective of charging
notional costs is to enable management to make clearer internal decisions by making sure that internal decision
making become more realistic. Notional charges are typically used to charge responsibility centers. Were as,
notional interest is often charged for the use of internally generated funds. Examples of using notional costs, to
enhance internal management making decision, are intra division charges to enable management to see the
performance of certain departments.
5. Spare Capacity Costs: - Because of the recent advancements in manufacturing technology, most enterprises have
greatly increased their efficiency and as a result are often operating at a capacity, which is below full capacity.
Operating with spare capacity can have a significant impact on the relevant costs on any short-term production
decision the management of such an enterprise might have to make. If spare capacity exists in an enterprise,
some costs which are generally considered incremental may in fact be non-incremental and thus, no-relevant, in
the short term. For example, if an enterprise is operating at less than full capacity then its work force would be
a non-relevant cost for a decision on whether to accept or reject a once-off special order. The labor cost is nonrelevant because the wages will have to be paid whether the order is accepter or not. If the special order involved
and element of overtime then the cost of such overtime would be of course be a relevant cost (as it is an
incremental cost) for the decision.
I.
SPECIAL ORDER
Managers must often evaluate when a special order should be accepted, and if the order is accepted, the price that
should be charged. A special order is a one-time order that is not considered part of the company’s normal ongoing
business.
Example 2.1
A company produces a single product and has budgeted for the production of 100,000 units during
the next quarter. The costs estimates for the quarter are as follows:
Direct labor…………………$ 600,000
Direct materials……………… 200,000
Variable overheads………….200,000
Fixed overheads…………… …400,000
$ 1,400,000
The company has agreed to sell 80,000 units during the coming period at the generally accepted
market price of $18 per unit. It appears unlikely that orders will be received for the remaining 20,000
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units at a selling price of $18 per unit, but a customer is prepared to purchase them at a selling price
of $12 per units. Should the company accept the offer?
Additional Information. A study of the cost estimates indicates that during the next quarter the fixed
overheads and direct labor cost will remain the same irrespective of whether or not the special order
is accepted.
Solution
Sales
Order not accepted
Order accepted
(80,000 units @18)
(80,000@18 and 20,000 @ 12)
(80,000 x $18) = $1,440,0000 1,440,000 + (20,000 x $12)=$1,680,000
Less: Variable Cost:
Direct material
160,000
Variable overheads
160,000
Contribution Margin
Less: Fixed Overhead
Direct Labor
Operating income
200,000
(320,000)
200,000
1,120,000
(400,000)
(600,000)
400,000
1,280,000
400,000
(1,000,000)
120,000
600,000
1,000,000
280,000
Decision: Based on this analysis the company should accept the special order since the special order will add the
operating income of the company by 160,000, this may because there are unused capacity of the company with
regards to Fixed overhead and Direct Labor cost.
Summary: The decision to accept or reject a specially priced order is common in both service industry and
manufacturing firms. Manufacturers often are faced with decision about selling products in a special order at less
than full price. The correct analysis of such decisions focuses on the relevant costs and benefits. Fixed costs, which
often are allocated to individual units of product or service, are usually irrelevant. Fixed costs typically will not
change in total, whether the order is accepted or rejected.
When excess capacity exists, the only relevant costs usually will be the variable costs associated with the special
order. When there is no excess capacity, the opportunity cost of using the firm’s facilities for the special order are
also relevant to the decision.
II.
Deletion or addition of product, service or department
Decision relating to whether product line, service or department of a company should be dropped and new ones
added are among the most difficult that a manager has to make. Ultimately, however, any final decision to drop a
business segment or to add a new one is going to hinge primarily on the impact the decision will have on net
operating income. To assess this impact, costs must be carefully analyzed. There are two main classifications of
expenses in this decision-making analysis. Unavoidable expenses, expenses that will continue to be incurred even
if a subunit or activity is eliminated. Avoidable expenses, expenses that will no longer be incurred if a particular
action is taken. All variable costs are avoidable.
In making such kind of decision, the main consideration is the contribution margin that can be given up if the product
line or factory is drooped and the fixed costs that can be avoided or that would be saved if the product line or factor
is dropped.
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Generally, if the contribution margin given up by dropping the product line, department, or factory is less than the
fixed costs that can be avoidable, then it is better to drop the segment or the product or the department. Similarly;
if contribution margin given up by dropping the product line, department, or factory is greater than the fixed cost
that can be avoidable the product or the segment should be kept to continue in function.
Example 2.2.
The following table provides sales and cost information for the preceding month for the Xyz Drug company
and its three major product lines—drugs, cosmetics, and house-wares.
Product Line
HouseTotal
Drugs
Cosmetics
Wares
Sales
250,000
125,000
75,000
50,000
Variable expenses
105,000
50,000
25,000
30,000
Contribution margin
145,000
75,000
50,000
20,000
Fixed expenses:
Salaries
50,000
29,500
12,500
8,000
Advertising
15,000
1,000
7,500
6,500
Utilities
2,000
500
500
1,000
Depreciation—fixtures
5,000
1,000
2,000
2,000
Rent
20,000
10,000
6,000
4,000
Insurance
3,000
2,000
500
500
General administrative
30,000
15,000
9,000
6,000
Total fixed expenses
125,000
59,000
38,000
28,000
Net operating income (loss)
20,000
16,000
12,000
(8,000)
Suppose the Xyz Drug company has analyzed the fixed costs being charged to the three product lines and
has determined the following:
1. The salaries expense represents salaries paid to employee working directly on the product.
2. The advertising expense represents advertisements that are specific to each product line and are
avoidable if the line is dropped.
3. The utility expense represents utilities costs for the entire company.
4. The depreciation expense represents depreciation of fixtures used to display the various product
lines.
5. The rent expense represents rent on the entire building housing the company; it is allocated to the
product lines on the basis of sales dollars.
6. The insurance expense is for insurance carried on inventories with in each of the three product lines.
7. The general administrative expense represents the costs of accounting, purchasing, and general
management, which are allocated to the product lines on the basis of sales dollars.
Required: Should the company keep the house-wares product line or drop it?
Page 5
Solution
Sales
Variable expenses
Contribution margin
Fixed expenses:
Salaries
Advertising
Utilities
Depreciation—fixtures
Rent
Insurance
General administrative
Total fixed expenses
Net operating income (loss)
Keep
Housewares
Drop
House-ware
50,000
30,000
20,000
$0
0
0
Difference: Net
operating
income Increase
(or Decrease)
$(50,000)
30,000
(20,000)
8,000
6,500
1,000
2,000
4,000
500
6,000
28,000
$(8,000)
0
0
1,000
2,000
4,000
0
6,000
13,000
$(13,000)
8,000
6,500
0
0
0
500
0
15,000
$(5,000)
Conclusion: As the above analysis show that if the house-wares product line is dropped, then overall
company net operating income will decrease by $5,000 each period so the company should not drop the
product line rather it should keep the product line.
Why keep a product line that is showing a loss? If you look at the first table of this example it shows that
the product line has a loss of (8,000) based on this simple analysis you may mistakenly conclude it should
be dropped but after the analysis we have conducted in the second table we have noticed that it should not
be drooped otherwise the company would loss $5,000 operating income. The explanation for this apparent
inconsistency lies in part with the common fixed costs that are being allocated to the product lines. In this
instance, allocating the common fixed costs among all product lines makes the house-wares product line
appear to be unprofitable. However, as we have shown above, dropping the product line would not avoid
all the allocated fixed costs; as a result if the product line is dropped the net operating income of the company
would decrease by $5,000.
III.
Make or Buy Decision (In-sourcing or out-sourcing Decision)
Make or buy decision involves a decision by an organization about whether it should make a product or carry out an
activity with its own internal resource, or whether it should pay another organization to make the product or carry
out the activity. An example for such types of decision usually includes whether a company should manufacture its
own component, or else buy the components from the outside supplier.
Out-sourcing is the process of purchasing goods or services from vender’s rather than producing the same good or
providing the same services within the organization, which is referred as in- sourcing. Even though, cost is the major
factor in deciding make or buy decision, usually qualitative factors will dictate managers make or buy decision. The
major qualitative factor in such situation includes;
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❖
❖
❖
❖
❖
Lack of know-how and technology to produce the component.
The need to maintain the long-term relationship with its existing suppliers,
The need to retain the quality control of the product and delivery to production area
The need to avoid too much dependency on the suppliers
Reduction of cost……etc
For example if the company decides to make the component, it will give the management more direct control over
the work or production of the component. Similarly, if the company decides to buy from the suppliers, they might
get the benefit that the external organization has a special skill and experts in the production of the component.
Thus, make or buy decision should certainly not be based exclusively on cost consideration.
If an organization has the freedom of choice about whether to make internally or buy externally and has no scare
resource that put a restriction on what it can do itself, the relevant costs for the decisions will be the differential
costs between the make and buy options. That is, we to identify and compare the relevant cost of making the part
with the relevant cost of buying from outside. If the relevant costs of making a part is greater than the relevant cost
of buying the part from outside, then the company is advised to buy from outside. In addition, if the relevant cost of
making a part is less than the relevant cost of buying the part from outside, then the company is advised to make the
component internally.
Example 2.3.
Suppose that Xyz mountain cycles company is producing the heavy-duty gear shifters used in its most
popular line of mountain bikes. The company’s accounting department reports the following costs of
producing 8,000 units of the shifter internally each year:
Direct materials
Direct labor
Variable overhead
Supervisor’s
Depreciation of special equipment
Allocated general overhead
Total Cost
Per
Unit
$6
4
1
3
2
5
$21
8,000
Units
$48,000
32,000
8,000
24,000
16,000
40,000
$ 168,000
An outside supplier has offered to sell 8,000 shifters a year to Xyz mountain cycle company at a price
of only $19 each. Should the company stop producing the shifters internally and buy them from the
outside supplier?
Solution
Direct materials
Direct labor
Variable overhead
Supervisor ‘s Salary
Depreciation of special equipment (not relevant)
Allocated general overhead (not relevant)
Outside purchase price
Total Cost
Total Relevant
Costs—8,000 units
Make
Buy
$48,000
32,000
8,000
24,000
$112,000
$152,000
$152,000
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Conclusion: Since it costs $40,000 less to make the shifters internally than to buy them from the
outside supplier, Xyz mountain cycles company should reject the outside supplier’s offer. However
the company may wish to consider one additional factor before coming to a final decision—the
opportunity cost of the space now being used to product the shifters. Now let’s consider the following
two possible situations.
1. If the space now being used to produce the shifters would otherwise be idle, then Xyz
Mountain Company should continue to produce its own shifters and the supplier’s offer should
be rejected, as stated above. Idle space that has no alternative use has an opportunity cost of
zero.
2. But what if the space now being used to produce shifters could be used for some other
purpose? In that case, the space would have an opportunity cost equal to the segment margin
that could be derived from the best alternative use of the space.
To illustrate assume that the space now being used to produce shifters could be used to produce
a new cross-country bike that would generate a segment margin of $60,000 per year. Under this
conditions, Xyz mountain cycle company should ace[t the supplier’s offer and use the available
space to produce the new product line:
Total annual cost……………………………………………………………………………………
Opportunity cost—segment margin forgone on a potential new product line
Total Cost……………………………………………………………………………………………….
Make
$112,000
60,000
$172,000
Buy
$152,000
$152,000
Decision: Xyz company should accept the supplier offer because there is $20,000 difference in
favor of purchasing from the outside supplier. The company should not produce the shifter
internally.
IV.
Product mix under capacity constraint
Management routinely faces the problem of deciding how constrained resources are going to be use. A department
store, for example, has a limited amount of floor space and therefore cannot stock every product that may be
available. A manufacturer has a limited number of machine-hours and a limited number of direct labor hours. When
a limited resource of some type restricts the company’s ability to satisfy demand, the company has a constraint.
Since the company cannot fully satisfy demand, mangers must decide which products or services should be cut back.
In other words, managers must decide which products or services make the best use the constrained resource. Fixed
costs are usually unaffected by such choices, so the course of action that will maximize the company’s total
contribution margin should ordinarily be selected.
Example 2.4
LTM private company makes two products, B and S. Unit variable costs are as follows;
B
S
Direct material……………………….
$1
$3
Direct labor ($3 per hour)…………
6
3
Variable overhead………………….
1
1
Total unit variable cost…………….
$8
$7
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The sales price per unit is $14 per B and $11 per S, during July the available direct labor limited to
8,000 hours. Sales demand in July is expected to be 3,000 units for B and 5,000 units for S
Required: Determine the operating income-maximizing production levels
Solution
Step 1: Confirm to what extent the limiting factor is short to meet the demand.
Labor hour per unit
Sales demand
Labor hours needed
Labor hour available
Shortfall
B
2 hour
3,000 unit
6,000 hour
S
1 hour
5,000 unit
5,000 hour
Total
11,000 hour
8,000 hour
3,000 hour
From the above table, we came to know that labor is the limiting factor on the production of the
company.
Step 2: Identify the contribution earned by each product per unit of scares resource, that is , per
labor hour worked.
B
S
Sales price………………………………………………………………….
$14
$11
Variable cost…………………………………………………………………
$8
$7
Unit contribution margin………………………………………………
$6
$4
Labor hour per unit………………………………………………………
2 hour
1 hour
Contribution per labor hour (+unit of Constraint factor)
(6÷3)=$3 (4÷1)=$4
N.B. Although B’s has a higher unit contribution that S’s, two S can be made in the
time it takes to make one B. Because labor is in short supply, it is more profitable
to make S than B
Step 3: Work out the budgeted production and sales. Sufficient S will be made to meet the full sales
demand, and the remaining labor hours available will then be used to make B.
Product
S
B
Total
Less Fixed Cost
Operating income
Units
5,000
1,500
Hours needed
5,000
3,000
8,000
Unit contribution
$4
$6
Total
$20,000
$9,000
$29,000
($20,000)
$9,000
So, the company should produce 5,000 units of S and 1,500 units of product B, in order to maximize
the operating income given that there is a constraint of labor hours.
Note that, it is not more profitable to begin by making as many units as possible of the product with
the bigger unit contribution. We could make 3,000 unit of B in 6,000 hours and 2,000 units of S in
2,000 hours. However, the operating income would be only $6,000. Therefore, unit contribution is
not the correct way to decide priorities, because it takes two hours to earn $6 from B and one hour
to earn $4 from S, product S will result in a profitable use of scares resource that is labor hour.
Page 9
V. Sells or process further
This is the Short-term, non-routine decision about whether to sell a product at a particular stage of production or to
process it further in the hope of obtaining additional revenue. When two or more products are produced
simultaneously from the same input by a joint process, these products are called JOINT PRODUCTS. The term JOINT
COSTS is used to describe all the manufacturing costs incurred prior to the point where the joint products are
identified as individual products, referred to as the SPLIT-OFF POINT. At the split-off point some of the joint
products are in final form and salable to the consumer, whereas others require additional processing. In many cases,
the company might have the option to sell the products at the split-off point or process them further for increased
revenue. In connection with this type of decision, joint costs are considered irrelevant, since the joint costs have
already been incurred at the time of the decision, and therefore are SUNK COSTS. The decision will rely exclusively
on additional revenue compared to the additional costs incurred due to further processing. A separable processing
cost is incurred on a joint product after the split-off point of a joint production process.
Example 2.5.
International chocolate company import cocoa beans and processes them into cocoa powered and cocoa butter.
Only a portion of the cocoa powder is used by international chocolate company in the production of chocolate
candy. The remainder of the cocoa powder is sold to an ice cream producer. Mr. John, the president of the company
is considering the possibility of processing the remaining cocoa powder into an instant cocoa mix. The company
purchases the cocoa bean costing $500 per 1-ton in batch and incurred joint production process costing of $600
per ton. The joint production will result cocoa butter with sale value of $750 for 1,500 pound and cocoa powder
with sales value of $500 for 500 pound immediately after a split of point. The company should incur a separable
process costing of $800 to process further the cocoa powder after the split off point and this separable process will
result a product call Instant cocoa mix with the sales value of $2,000 for 500 pounds. The information can be
presented in graphic form as follows.
Cocoa
Beans
Costing
$500
per 1ton
batch
Cocoa
butter
sales
value:
$750 for 1,500
pounds
Joint
production
process
costing
$600 per
ton
Total Joint Cost: $1,100
Cocoa
Powder
Sales Value:
$500 for 500
pounds
Separable
process
costing
$800
Required: Should the company sell the cocoa powder immediately or process it further?
Instant
Cocoa mix
sales value;
$2,000 for
500 pounds
Page 10
Solution
Sales value of instant cocoa mix……………………………………………………………. $2,000
Sales value of cocoa powder…………………………………………………………………
500
Incremental revenue from further processing……………………………………….. 1,500
Less: Separable processing cost…………………………………………………………….
800
Net benefit from further processing………………………………………………………. $ 700
The Company should decide to process the cocoa powder into instant cocoa mix.
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