Decision Making and Relevant Information
Accounting for Decision Making — Chapter 12 Notes Summary (Horngren's Cost Accounting, 18th
Global Ed.)
1. Information and the Decision Process
Managers use a decision model — a formal method for choosing among courses of action — that
combines quantitative and qualitative analysis. Management accountants analyze and present the relevant
data managers need. The same five-step decision-making process from Chapter 1 applies here:
1 Identify the problem/uncertainties
2 Obtain information
3 Make predictions about the future
4 Make decisions by choosing among alternatives
5 Implement the decision, evaluate performance, and learn
Example (Precision Sporting Goods): Should the company reorganize manufacturing to cut labor costs?
Wages will rise from $14 to $16/hour, but the reorganization would cut the workforce from 20 to 15 workers.
Predicted labor costs: $640,000 (do-not-reorganize, 20 workers × 2,000 hrs × $16) vs. $480,000
(reorganize, 15 workers × 2,000 hrs × $16). The reorganization itself costs $90,000. Savings of $160,000
clearly outweigh the $90,000 cost, so management chooses to reorganize — accepting some risk to
employee morale. Step 5 (evaluating actual results) then feeds back into future predictions.
2. The Concept of Relevance
Relevant information has two defining characteristics:
•
It occurs in the future
•
It differs among the alternative courses of action
Relevant costs = expected future costs that differ across alternatives.
Relevant revenues = expected future revenues that differ across alternatives.
Past (historical) costs are never relevant — they are sunk costs, since they've already been incurred
and cannot be changed by any future decision.
3. Qualitative vs. Quantitative Factors
Decision outcomes fall into two broad categories:
• Quantitative factors — outcomes measured in numerical terms (financial and nonfinancial, e.g. units,
hours, dollars).
• Qualitative factors — outcomes difficult to measure accurately in numerical terms (e.g. employee morale,
customer satisfaction).
Even when quantitative-nonfinancial and qualitative factors can't be expressed in dollars, they still matter
and should be weighed alongside the numbers.
4. Relevant Cost Illustration
The key technique: strip out revenues/costs that are identical under every alternative, and compare only
what differs.
All Rev. & Costs
All Rev. & Costs
Relevant Only
Relevant Only
Do Not Reorg.
Reorganize
Do Not Reorg.
Reorganize
Revenues
$6,250,000
$6,250,000
—
—
Direct materials
1,250,000
1,250,000
—
—
Manufacturing labor
640,000
480,000
$640,000
$480,000
Manufacturing overhead
750,000
750,000
—
—
2,000,000
2,000,000
—
—
—
90,000
—
90,000
Total costs
4,640,000
4,570,000
640,000
570,000
Operating income
$1,610,000
$1,680,000
$(640,000)
$(570,000)
Marketing
Reorganization costs
Both approaches give the same $70,000 difference in favor of reorganizing — but the relevant-only
columns get there with far less clutter, since identical items (revenue, materials, overhead, marketing) drop
out entirely.
5. Sunk Costs Are Irrelevant
Sunk costs are costs that have already occurred and cannot be changed by any future action. Because no
decision can undo them, they must be excluded from relevant-cost analysis — no matter how large or
emotionally significant they feel.
6. Terminology: Incremental vs. Differential
Incremental cost
The additional total cost incurred for an activity.
Differential cost
The difference in total cost between two alternatives.
Incremental revenue
The additional total revenue from an activity.
Differential revenue
The difference in total revenue between two alternatives.
7. One-Time-Only Special Orders
Decision: whether to accept or reject a special order when there is idle production capacity and the order
has no long-run implications (e.g., won't affect regular pricing or future customer expectations).
Decision rule: Does the special order generate additional operating income?
Yes → accept
No → reject
This compares only relevant revenues and relevant costs for the order under consideration.
Worked Example — Surf Gear (5,000-unit special order)
Without Order
(30,000 units)
With Order
(35,000 units)
Difference
(5,000 units)
Revenues
$600,000
$655,000
$55,000
Variable mfg. costs
225,000
262,500
37,500
Variable marketing
150,000
150,000
0
Total variable costs
375,000
412,500
37,500
Contribution margin
225,000
242,500
17,500
Fixed mfg. costs
135,000
135,000
0
Fixed marketing
60,000
60,000
0
Total fixed costs
195,000
195,000
0
Operating income
$30,000
$47,500
$17,500
The special order adds $55,000 revenue at $20/unit and $37,500 variable manufacturing cost ($7.50/unit),
with no extra variable marketing cost (irrelevant here) and no change in fixed costs (irrelevant —
unaffected by the order). Net effect: operating income rises by $17,500, so the order should be accepted.
8. Potential Problems in Relevant-Cost Analysis
Two traps managers should avoid:
1. “All variable costs are relevant, all fixed costs are irrelevant” — this blanket assumption is wrong. In
the Surf Gear example above, variable marketing cost was actually irrelevant (unchanged by the order) even
though it's a variable cost.
2. Unit-fixed-cost data can mislead in two ways:
• Fixed unit costs may bury irrelevant costs — costs that won't change whether the order/decision is
accepted or not.
• Using the same unit fixed cost across different output levels is invalid, since unit fixed cost changes as
volume changes. Always work with total fixed costs, not per-unit fixed costs, when doing relevant-cost
analysis.
9. Short-Run Pricing Decisions
A special order decision is, in many respects, a short-run pricing decision — sometimes the real question is
simply what price to set. Applying the same decision rule: any price above incremental (relevant) cost
improves operating income. However, pricing decisions must also weigh capacity constraints, current
market conditions, customer demand, and competitive reactions — not purely the numbers.
10. Insourcing vs. Outsourcing (Make-or-Buy)
• Outsourcing — purchasing goods/services from outside vendors.
• Insourcing — producing the good or providing the service within the organization.
Choosing between the two is called a make-or-buy decision.
Opportunity cost = the contribution to operating income forgone by not using a limited resource in its
next-best alternative use. Opportunity costs matter heavily in make-or-buy decisions: if making the item
in-house uses capacity that could otherwise generate profit elsewhere, that forgone profit is a real cost of the
“make” option, even though it never appears in the accounting records.
11. Product-Mix Decisions with Capacity Constraints
Product-mix decisions: which products to sell, and in what quantities, when a resource (machine hours,
labor hours, floor space, etc.) is limited.
Decision rule: choose the product with the highest contribution margin per unit of the constraining
resource — NOT the highest contribution margin per unit of the product itself.
This is a common trap: a product can look more profitable per unit sold, but be less profitable per hour of the
bottleneck resource it consumes. When a resource is genuinely constraining production, ranking products
by CM per unit of that resource is what maximizes total operating income.
12. Wrap-Up: General Guidelines
•
Relevant costs occur in the future and differ among the alternative courses of action.
•
Past/historic costs are not relevant — they are sunk.
•
Incremental costs = additional costs incurred for a specific course of action/activity.
•
Relevant costs = Incremental costs (+ Opportunity costs).
•
All variable costs are incremental (and therefore relevant), unless explicitly stated otherwise.
•
All fixed costs are non-incremental (and therefore not relevant), unless explicitly stated otherwise.
•
If fixed costs are not relevant, the impact on contribution margin equals the impact on operating income.
•
Opportunity costs are $0 in the case of idle (unused) capacity.
•
Opportunity costs are NOT $0 in the case of limited capacity — they represent the contribution margin
forgone.
•
Avoid using full cost per unit (i.e., cost including an allocated fixed component) in relevant-cost analysis.
Source: Horngren's Cost Accounting: A Managerial Emphasis, 18th Global Edition, Chapter 12 — Decision
Making and Relevant Information (Datar & Rajan, Pearson).