MODULE 1

Using Accounting Information in Decision Making, Relevant Costs and Benefits

OVERVIEW:

In this module, you will learn the decision making process and the role of accountants and how to identify
which costs and benefits are relevant in a decision.

LEARNING OUTCOMES:

At the end of this module, the student should be expected to:

1. Identify the six steps in the decision-making process and the managerial accountant's role in that
process.
2. Explain the relationship between quantitative and qualitative analyses in decision making.
3. Identify and discuss two criteria that must be satisfied by relevant information.
4. Understand relevant costs and benefits, giving proper treatment to sunk costs, opportunity costs,
and unit costs.

INTRODUCTION:

Managers are constantly beleaguered by decision problems in the performance of their everyday tasks.
Managers must decide what products to sell, whether to outsource component parts, what prices to
charge, what channels of distribution to use, whether to accept special orders at special prices, and so
forth. Making such decisions is often a difficult task that is complicated by numerous alternatives and
massive amounts of data, only some of which may be relevant.

DISCUSSION OF THE TOPIC:

1.1 The management accountant’s role in decision making

As we have learned in Management Accounting 1, the role of management accountant in an organization
is advisory in nature. As staff function, he advises and make recommendations to the management using
his knowledge and skills in gathering and analyzing data. In addition to serving in an advisory (staff)
capacity and being a provider of relevant information, the managerial accountant is often a member of a
cross-functional, decision making team.

1.1.1 The decision process consists of the following six steps.

1. Make clear the decision problem.
2. Specify the criterion upon which the decision will be made. Management
3. Identify the alternatives. accountants are
4. Develop a decision model that brings together the criterion, involved
the constraints, and the alternatives.
5. Collect the data.
6. Select an alternative. Function of management

Sample Problem:
A company located near Pasig River produces soap products. Its six main soap product lines
are produced from common inputs. Joint product costs up to the split-off point constitute the bulk
of the production costs for all six product lines. These joint product costs are allocated to the six
product lines on the basis of the relative sales value of each line at the split-off point.
A waste product results from the production of the six main product lines. The company loaded
the waste onto barges and dumped it into the Pasig River because the waste was thought to
have no commercial value. The dumping was stopped, however, when the company’s research division
discovered that with some further processing the waste could be sold as a fertilizer ingredient.
The further processing costs amounts to P375,000 per year. The waste was then sold to fertilizer
manufacturers for P500,000.

The accountants responsible for allocating manufacturing costs included the sales value of the
waste product along with the sales value of the six main product lines in their allocation of the joint
product costs at the split-off point. This allocation resulted in the waste product being allocated
P150,000 in joint product cost.

Let us apply the decision making steps to solve this problem:

Steps:
1. Make clear the decision problem The problem here is whether the company should
dump the waste or process it into fertilizer.
2. Specify the criterion upon which the The criterion is which alternative/decision will give
decision will be made. higher profit for the company.
3. Identify the alternatives. The alternatives are: Dump the waste or process it
further into fertilizer.
4. Develop a decision model that brings DECISION MODEL
together the criterion, the constraints, and the Dump the waste Process further
alternatives. Benefits (Revenue): XXX Benefits (Revenue): XXX
Costs : XXX Costs : XXX
Net Benefit : XXX Net Benefit : XXX
5. Collect the data Quantitative data:
Dump the waste Process further
Revenue 0 Revenue P500,000
Costs 0 Costs 375,000
Net benefit 0 Net benefit 125,000
Qualitative data:
The continuous dumping Further processing of the
of waste in Pasig river waste into fertilizer will
may pollute the water and help preserve the
endanger the environment and provide
environment. additional jobs.
6. Select an alternative After considering all the data, the management
decided to process further the waste into fertilizer.

1.1.2 Quantitative versus Qualitative Analysis

When managers make business decisions, they take into account qualitative factors like reputations,
quality of product and employee morale, as well as quantifiable data such as additional sales, profitability
and return on investment. Both qualitative and quantitative information should be used to make decisions.

1.1.3 Obtaining information

In obtaining information to aid in decision making, the managerial accountant consider the following:
relevance (pertinent to the decision problem), accuracy (precise) and timeliness (information is available
before a decision is made). Sometimes, accuracy must be sacrificed to have timely information. That is
why there is prevalence of the use of estimates in management accounting.

1.2 Relevant Information

1.2.1 Unique versus repetitive decisions

Repetitive decisions such as those decisions made concerning the day-to day operations of the
business, like daily productions typically can draw on a large amount of historical data. Since the
decisions have been made repeatedly in the past, the data from those decisions should be readily
available. Information relevant to unique decisions however, is harder to generate.
1.2.2 Importance of Identifying Relevant Costs and Benefits
Why do we have to identify relevant costs and benefits in decision analysis?
1. First, gathering information has costs. The data must be collected, and this requires time and
effort. By focusing on only the relevant information, the managerial accountant can simplify
and shorten the data-gathering process and thus save costs.
2. Second, people can effectively process only a limited amount of information. Beyond this,
they experience information overload, and their decision-making effectiveness declines.

1.3 Identifying Relevant Costs and Benefits

1.3.1 The information collected should be relevant to the opportunity or problem identified. Relevant
information are costs and benefits that:
(1) differ among the alternatives being considered
(2) future oriented

Both guidelines must be met. Relevance of a cost or benefit depends upon the decision at hand. Hence,
a cost maybe relevant to one decision but irrelevant to other decisions.

1.3.2 Sunk costs are past costs that have already been incurred. Such costs are irrelevant in decision
making because the amounts cannot be changed by any of the alternatives under review. Examples
include the book value of machinery and the cost of existing inventory. They are irrelevant to a decision.

1.3.3 A differential cost (or benefit) is the net difference in cost/benefit between two alternatives.
Example: If you used the old machine the maintenance cost is P15,000/month but if you used the new
machine the maintenance cost will be P5,000/month only. Differential costs are relevant to a decision.

1.3.4 Avoidable costs are costs that can be avoided if a different decision is made. Example is rent that
will not be paid if the company shut down its operations. Unavoidable costs are those whose total costs
will not be altered regardless of what decision is made. Example is depreciation expense and lease under
a contract. Only avoidable costs are relevant.

1.3.5 Direct costs are those that are economically traceable to the cost object. Direct costs are relevant if
they are avoidable. Example is supervisory salary that will not be incur if a division is closed. Indirect
costs on the other hand are generally irrelevant.

1.3.6 An opportunity cost is the benefit foregone by choosing one alternative over the other. Example is
the rent income that will be foregone if you choose to use a space as a store rather than rent it out to
others, such costs are relevant in the decision-making process.

1.3.7 An out-of-pocket cost is a potential future outlay of cash that management needs to decide whether
or not to make. Therefore, they are relevant.

1.3.8 Relevant costs of materials

The following guide should be used to determine the relevant cost of materials:
 Is the material in
stock?

YES NO

Was it regularly Relevant cost:

used? Purchase Price

YES
NO

Relevant cost: Relevant cost:

Purchase Scrap value or
Price Opportunity cost

Illustrative Problem: (Source: ACCAGLOBAL)

A company is considering making a new product which requires several types of raw material:

Units in inventory Units required Additional information

Material A Nil 40 Current purchase price is P7/unit.

Material B 100 purchased for 150 Current purchase price is P14/unit.

P10/unit The material has no use in the
company other than for the project
under consideration. Units in
inventory can be sold for P12/unit.

Material C 50 purchased for P20/unit 120 Current purchase price is P22/unit.

The material is regularly used in
current manufacturing operations.

What is the relevant cost of the materials required for manufacture of the new product?

Solution:

Material A – As there is no inventory, all 40 units required will have to be bought in at P7 per unit. This is
A clear cash outflow caused by the decision to make the new product. Therefore, the relevant cost of
Material A for the new product is (40 units x P7) = P280.
Material B - The 100 units of the material already in inventory has no other use in the company, so if it is
not used on the new product, then the assumption is that it would be sold for P12/unit. If the new product
is made, this sale won’t happen and the cash flow is affected. The original purchase price of P10 is a
sunk cost and so is not relevant. In addition, another 50 units are needed for the new product and these
will need to be bought in at a price of P14/unit.

The total relevant cost for Material B is:

100 units x P12 (lost sale proceeds) = P1,200

50 units x P14 (current purchase price) = P700

P1,900

Material C – This material is regularly used in the company, so if the 50 units in inventory are diverted to
the new product then this will mean that inventory will need to be replenished. In order to do this, Material
C purchases for existing products will be accelerated by 50 units. The current purchase price of P22 will
be used to determine the relevant cost of Material C as this will be the value of each unit purchased. The
original purchase price of P20 is a sunk cost and so is not relevant. Therefore the relevant cost of
Material C for the new product is (120 units x P22) = P2,640.

Additional Readings:

Chapter 14-Decision Making: Relevant Costs and Benefits

Managerial Accounting: Creating Value in a Dynamic Business Environment
12th Edition
By Ronald Hilton and David Platt

Chapter 7- Incremental Analysis for Short-Term Decision Making

Managerial Accounting
4th Edition
By Stacey Whitecotton and Robert Libby and Fred Phillips

LEARNING ACTIVITIES:

Exercise I. Answer the following questions:

1. What are the steps in the decision making process and what is the role of the accountant in them?
2. What are the characteristics of relevant cost?
2. Define the following terms: differentia cost, opportunity cost, avoidable costs and sunk cost.
3. Are variable costs always relevant costs? Explain.
4. “Sunk costs are easy to spot—they’re the fixed costs associated with a decision.” Do you
agree? Explain.
5. “All variable costs are differential costs and therefore relevant.” Do you agree? Explain.
6. “All future costs are relevant in decision making.” Do you agree? Why?
7. Maganda Company is considering dropping one of its product lines. What costs of the
product line would be relevant to this decision? What costs would be irrelevant?

Exercise II. A number of costs are listed below that may be relevant in decisions faced by the
management of Matalino Company, a manufacturer of bicycles, which are currently in demand because
of the Covid-19 pandemic. For each of the case below, identify if the cost is relevant or not by placing a
check mark on the appropriate column.

Case 1 Case 2
Relevant Not Relevant Not
Relevant Relevant
a. Sales revenue
b. Direct materials
c. Direct labor
d. Variable manufacturing overhead
e. Depreciation—Model B100 machine
f. Book value—Model B100 machine
g. Disposal value—Model B100 machine
h. Market value—Model B300 machine (cost)
i. Fixed manufacturing overhead (general)
j. Variable selling expense
k. Fixed selling expense
l. General administrative overhead

Case 1. The company has no idle capacity and the old machine is the company’s constraint.
Management is considering purchasing a new machine to use in addition to the company’s present
machine. The old machine will continue to be used to capacity as before, with the new machine being
used to expand production. This will increase the company’s production and sales. The increase in
volume will be large enough to require increases in fixed selling expenses and in general administrative
overhead, but not in the fixed manufacturing overhead.

Case 2. The old machine is not the company’s constraint, but management is considering
replacing it with a new machine because of the potential savings in direct materials and direct labor hours
with the new machine. The old machine would be sold. This change will have no effect on production or
sales, other than some savings in direct materials and direct labor hours due to less waste. Variable
overhead is applied based on direct labor hours.

Exercise III. Trapo Industries Ltd. has been approached by a customer who would like a special job to be
done for him, and is willing to pay P60,000 for it. The job would require the following materials.
Material Total units Units already Book value of units Realizable value Replacement cost
required in stock in stock P/unit P/unit P/unit
A 1000 0 - - 16.00
B 1000 600 12.00 12.50 15.00
C 1000 700 13.00 12.50 14.00
D 200 200 14.00 16.00 19.00

a) Material B is used regularly by Trapo Industries Ltd, and if units of B are required for this job, they
would need to be replaced to meet other production demands.

b) Materials C and D are in stock due to previous over-buying, and they have restricted use. No other use
could be found for material C, but the units of material D could be used in another job as a substitute for
300 units of material E, which currently costs P15 per unit (of which the company has no units in stock at
the moment).

What are the relevant costs of materials for this special job?
FORMATIVE ASSESSMENT:

A quiz will be sent to you later.

SYNTHESIS:

Reflection:

Which topic/s I have understand better?

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Which topic/s is/are still unclear to me?

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