Chapter 5

Making decisions and Relevant Information

Introduction
Making decisions is one of the basic functions of a manager.
To be successful in decision making, managers must be able to tell the difference between
relevant and irrelevant data and must be able to correctly use the relevant data in analyzing
alternatives.
Accountants have an important role in the decision-making process, not as a decision maker but
as collectors and reporters of relevant information.

The decision making model

A decision model, a specific set of procedures that produces a decision, can be used to structure
the decision maker’s thinking and to organize the information to make a good decision.

The following is an outline of one decision-making model.

Step1. Recognize and define the problem.
Step2. Identify alternatives as possible solutions to the problem. Eliminate alternatives that
clearly are not feasible.
Step3. Identify the costs and benefits associated with each feasible alternative. Classify costs and
benefits as relevant or irrelevant, and eliminate irrelevant ones from consideration.
Step 4. Estimate the relevant costs and benefits for each feasible alternative.
Step 5. Assess qualitative factors.
Step 6. Make the decision by selecting the alternative with the greatest overall net benefit.
Some Common Relevant Cost Applications

Relevant costing is of value in solving many different types of problems. Traditionally, these
applications include decisions:

 To make or buy a component.

 To keep or drop a segment or product line.
 To accept a special order at less than the usual price.
 To further process joint products or sell them at the split-off point.

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Though by no means an exhaustive list, many of the same decision-making principles apply to a
variety of problems.

Quantitative and Qualitative Relevant Information

Quantitative factors are outcomes that are measured in numerical terms:

 Financial
 Nonfinancial
Qualitative factors are outcomes that cannot be measured in numerical terms:
 Nonfinancial

Non quantitative factors may be extremely important in an evaluation process for each of the
decisions we cover here, yet do not show up directly in calculations:

 Quality requirements
 Reputation of outsourcer
 Employee morale
 Logistical considerations—distance from plant, and so on
 For make/buy decisions, buying can be risky, especially if sourcing internationally.

The concept of Relevance

 Relevant information has two characteristics:
 It occurs in the future
 It differs among the alternative courses of action
 Relevant costs are expected future costs
 Relevant revenues are expected future revenues
 Past costs (historical costs) are never relevant and are also called sunk costs.

Features of Relevant Information

Past (historical) costs may be helpful as a basis for making predictions. However, past costs
themselves are always irrelevant when making decisions.
Different alternatives can be compared by examining differences in expected total future
revenues and expected total future costs.
Not all expected future revenues and expected future costs are relevant. Expected future
revenues and expected future costs that do not differ among alternatives are irrelevant and,
hence can be eliminated from the analysis. The key question is always, what difference will
an action make?
Appropriate weight must be given to qualitative factors and quantitative nonfinancial
factors.

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Relevant Costs and Benefits
The decision – making model just described emphasized the importance of identifying and using
relevant costs and benefits.

 A relevant cost is a cost that differs between alternatives.

 A relevant benefit is a benefit that differs between alternatives.

Identifying Relevant Costs

An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one
alternative over another.
Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.

Two broad categories of costs are never relevant in any decision. They include:

 Sunk costs.
 A future cost that does not differ between the alternatives.

Identifying Relevant Costs

Relevant costs possess two characteristics:
i. they are future costs and
ii. They differ across alternatives.
All pending decisions relate to the future.
Accordingly, only future costs can be relevant to decisions.

Opportunity cost
Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over
another.

An opportunity cost is relevant because it is both a future cost and one that differs across
alternatives.

While an opportunity cost is never an accounting cost, because accountants do not record the
cost of what might happen in the future (i.e., they do not appear in financial statements), it is an
important consideration in relevant decision making.

Sunk cost

A sunk cost is a cost that cannot be affected by any future action.

It is important to note the psychology behind managers’ treatment of sunk costs.

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Although managers should ignore sunk costs for relevant decisions, it unfortunately is human
nature to allow sunk costs to affect these decisions.

For example, depreciation, a sunk cost, is sometimes allocated to future periods though the
original cost is unavoidable. In choosing between the two alternatives, the original cost of an
asset and its associated depreciation are not relevant factors.

IMPORTANCE OF IDENTIFYING RELEVANT COSTS AND BENFITIES

 The reasons are two

1. Generating information is costly process. The relevant data must be sought and this required
time and effort.

2. Peoples can effectively use only limited amount of information. Beyond this they are
experiencing information overload and their decision making effectiveness decline.

Special decision areas

a) Make or Buy decision

Managers often face the decision of whether to make a particular product (or provide a service)
or to purchase it from an outside supplier. Make-or-buy decisions are those decisions involving a
choice between internal and external production. One type of relevant cost that is becoming
increasingly large due to globalization and the green environmental movement concerns the
disposal costs associated with electronic waste (or e-waste).

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Example 5 – 1 Structuring a Make – or – Buy Problem

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Be sure to read the analysis in Example 5 – 1 carefully. At first, the fixed overhead remains
whether or not the component is made internally. In this case, fixed overhead is not relevant, and
making the product is $9,500 cheaper than buying it. Later, in Requirement 4, part of the fixed
overhead is avoidable. This condition means that purchasing the component externally will save
$10,000 in fixed cost (i.e., Swasey can avoid $10,000 of fixed overhead if it buys the
component). Now, the $10,000 of fixed cost is relevant—it is a future cost and it differs between
the two alternatives—and the offer of the supplier should be accepted; it is $500 cheaper to buy
the component.

b) Special Order decisions

 From time to time, a company may consider offering a product or service at a price
different from the usual price.
 Firms often have the opportunity to consider special orders from potential customers in
markets not ordinarily served.

◦ Special – order decisions focus on whether a specially priced order should be accepted
or rejected.

◦ These orders often can be attractive, especially when the firm is operating below its
maximum productive capacity.

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Illustration: A company produces a single product and has budgeted for the production of 100,000 units
during the next quarter. The cost estimates for the quarter As follow;

Direct Labor------------------$600,000

Direct material----------------$ 200,000

Variable overhead-------------200,000

Fixed Overhead---------------400,000

Total $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 units at the selling price of 18 per unit, but a customer is prepared to purchase them at
selling price of $ 12 per units. Should the company accept the offer?

Additional Information ; A study of the cost estimates indicate 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.

Order not accepted Order accepted

Sales (80,000*18)= (80,000*18)+(20,000*12)=1,680,000

1,440,000

Less; variable cost

Direct Material 160,000 200,000

Variable overhead 160000 200000 400,000

(320,000)

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contribution margin 1,120,000 1,280,000

less fixed overhead 400,000 400,000

cost

Direct labor cost 600,000 600000 1,000,000

(1,000,000)

operating income 120,000 280,000

c) Keep or Drop decisions

 Often, a manager needs to determine whether a segment, such as a product line, should be
kept or dropped.

 Segmented reports prepared on a variable – costing basis provide valuable information

for these keep – or – drop decisions.

 Both the segment’s contribution margin and its segment margin are useful in evaluating
the performance of segments.

 However, while segmented reports provide useful information for keep – or – drop
decisions, relevant costing describes how the information should be used to arrive at a
decision.

Example 5 – 3 Structuring a Keep – or – Drop Product Line Problem

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  Sometimes dropping one line would lower sales of another line, as many customers buy
both lines at the same time.

 This information can affect the keep – or – drop decision.

Example 5 – 4 Structuring a Keep-or-Drop Product Line Problem with Complementary

Effects

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The roofing tile line has a contribution margin of $10,000 (sales of $150,000 minus total variable
costs of $140,000). All variable costs are relevant. Relevant fixed costs associated with this line
include $10,000 in advertising and $35,000 in supervision salaries. Assume that dropping the
product line reduces sales of blocks by 10 percent and sales of bricks by 8 percent.

Required:

1. If the roofing tile line is dropped, what is the contribution margin for the block line? For
the brick line?
2. Which alternative (keep or drop the roofing tile line) is now more cost effective and by
how much?

This Cornerstone provides some insights beyond the simple application of the keep – or – drop
decision model. The initial analysis (Example 5 – 3), which focused on two feasible alternatives,
led to a tentative decision to drop the product line. But additional information provided by the

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marketing manager led to a reversal of the first decision. Perhaps other feasible alternatives exist
as well. These additional alternatives would require still more analyses.

d) Further Processing of Joint Products

 Joint products have common processes and costs of production up to a split – off point.
At that point, they become distinguishable as separately identifiable products. The point
of separation is called the split – off point.

 Sometimes it is more profitable to process a joint product further, beyond the split – off
point, prior to selling it (sell – or – process – further decision).

Example 5 – 5 Structuring the Sell – or – Process Further Decision

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e) Product Mix decisions
Most of the time, organizations have wide flexibility in choosing their product mix.

Product mix refers to the relative amount of each product manufactured (or service provided) by
a company.

Decisions about product mix can have a significant impact on an organization’s profitability.

Every firm faces limited resources and limited demand for each product. These limitations are
called constraints.

A manager must choose the optimal mix given the constraints found within the firm.

Example 5 – 6 Determining the Optimal Product Mix with One Constrained Resource

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The above illustrattion clearly illustrates a fundamentally important point involving relevant
decision making with a constrained resource. This point is that the contribution margin per unit
of each product is not the critical concern when deciding how much of each product type to
produce and sell. Instead, the contribution margin per unit of the scarce resource is the deciding
factor.

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