CHAPTER TWO

RELEVANT INFORMATION AND DECISION MAKING

The Role of Accounting in special decisions

 The basic purpose of accounting is providing of relevant accounting
information for users to make decisions.
 Decision-making is the process of choosing among alternatives to
change the future in favor of the firm.
 The basic role of management accountant in decision making process
is to provide relevant information to managers who make decision.
 Example, production managers make decisions about alternative
production process, marketing managers make pricing decisions etc.
all of these managers require relevant information that is pertinent
for their decision.
 Cont’d…
• Good accounting information helps an organization achieve its
goal and objectives in the following areas:
• a. Scorekeeping: is the accumulation and classification of
data which enables both internal and external parties to
evaluate organizational performance.
• b. Attention directing: means reporting and interpreting
information that helps management to focus on operating
problems, inefficiencies, and opportunities.
• c. Problem solving: is the aspect of accounting that quantifies
the likely result of several alternatives and recommends the
best alternative to follow.
 Steps in decision making process
• There are seven steps that characterize the decision making
process.
a) Define or clarify the decision problem
b) Identify alternative solutions to the problem
c) Evaluate alternatives through cost benefit analysis
d) Develop a decision model: brings the criterion, constraints and
alternatives together.
e) Gather the data
f) Select an alternative
g) Implement and follow up
 Relevant information

 The most important element in decision-making process is identifying relevant

and non-relevant information (revenues and costs).
 The only revenues and costs that are relevant in making decisions are those
expected future revenues and costs that will differ among the alternatives. These
are called incremental or differential revenues and costs.
 The incremental costs are avoidable costs, since a company can change a cost by
taking one alternative as opposed to the other.
 On the other hand, irrelevant information is information that doesn’t help decision
making.
 Revenues and costs that have already earned or incurred are irrelevant
information in making decisions.
 Future costs and revenues that are the same across all alternatives are not
relevant.
 Cont’d…
• There are two other costs that should be encountered in making
decisions.
 Opportunity cost: is the benefit lost by taking one alternative as
opposed to the other. it is relevant for decision making.
 Sunk cost: is a cost that has already been incurred and cannot be
altered no matter which decisions will be made. Sunk costs are
irrelevant costs for decision making because they are not
differential.
 Special decision areas
1. Make or Buy decision:
• Manufactured products consist of several components that are assembled
into final product. Many of these components can be bought from an
outsider or made inside.
• Decisions about whether to buy or produce within the organization are
often called make-or-buy decisions. The make or buy decision is also
called in-sourcing and outsourcing.
• Example: Suppose XYZ Company now makes a component for its major
product. A manager has prepared the following estimates of costs at the
volume of 10,000 units per year.
Total cost for Cost per
10,000 units unit
Direct material Br.20,000 Br.2
Direct labor 50,000 5
Variable overhead 30,000 3
Fixed overhead 60,000 6
Total costs Br.160,000 Br.16
 Cont’d…
An outside supplier offers to supply the component at Br.14 per unit for a two year period.
Should the company accept the offer?
The answer depends on the difference in expected future costs between the alternatives. Assume
that of the total fixed overhead cost of Br. 6 per unit, Br. 2 is direct cost for the components and
the other Br. 4 is common cost (i.e. it is unavoidable cost regardless of whether the company
produces the components inside the organization or not).
The following schedule focuses on the relevant costs for each available course of action.
Decisions_______
Make Buy-_
Direct materials Br. 20,000 Br. 0
Direct labor 50,000 0
Variable overhead 30,000 0
Direct fixed overhead 20,000 0
Purchase price 0 140,000
Total Br. 120,000 Br. 140,000
XYZ saves Br. 20,000 by making the component.
 Cont’d…
XYZ saves Br. 20,000 by making the component.
The following analysis shows only the differentials of a decision to make the component.
New cost-purchase from suppliers Br. 140,000
Less: Cost savings-material Br. 20,000
-labor 50,000
-variable overhead 30,000
-direct fixed overhead 20,000
Total savings…………………………………………………… 120,000
Difference favoring the components………………………………… Br. 20,000

Considering only the quantitative data, XYZ should make the components until some other
opportunity cost arises-the benefit to be gained by using the space and equipment for other
purpose-exceeds the Br. 20,000 cost savings available by using those resources to make the
component. Such a benefit could come from renting the space and equipment or using them to
make another product that would bring more than br. 20,000 incremental profits.
In such situations, the company might consider buying the component from outside supplier.
 2. Special sales order decisions:
o At a time a customer may offer special sales orders at less than full
cost.
o At the beginning, it may appear that accepting the offer reduce the
overall profitability of the firm.
o However, the full cost (production cost) contains fixed costs that do not
change whether the special order is accepted or not. Such special
orders should come once in a while.
o Factors that should be considered under such type of decisions are:
 The special orders must not be with regular customers
 There has to be an excess capacity within the organization
 The price should be more than the variable cost, and additional
costs associated with the special offer
 Example
The management of Ethio Airways receives an offer from Nile tourist agency about flying tourist
from Finfinnee to Dambi Dolo. The tourist agency has offered the airline Br. 75,000 per round-
trip flight on a 737 jet. Given the airline’s usual occupancy rate and air fares, a round-trip 737 jet
flight between Finfinnee to Dambi Dolo brings revenue of Br. 140,000.
Assume that the airline has two 737 jets that are not currently being used.
Data pertains to a typical round trip 737 jet flight between Finfinnee and Dambi Dolo is as
shown below:
Revenue Br. 140,000
Expenses:
Variable expenses Br. 45,000
Fixed expenses 50,000
Total expenses 95,000
Profit Br. 45,000
 Cont’d…
Further assuming that the airline has reservation and ticketing expenses amount to Br. 2,500 for a
scheduled flight. The fixed cost allocated to each flight cover the airline’s fixed cost such as air
craft depreciation, fixed administrative costs etc. Should the airline accept the special order or
not?
To make decisions, the only relevant costs are variable costs, the fixed costs are irrelevant costs
since they will be paid whether the airline accept the offer or not. Moreover, the reservations and
ticketing costs would not incur. Thus, the analysis of the offer is as shown below:
Special price for the offer Br. 75,000
Variable costs Br. 45,000
Less: savings on reservation
and ticketing 2,500
Variable cost of offer 42,500
Contribution from offer Br. 32,500
The analysis shows that the offer will contribute br. 32,500 toward covering the fixed costs and
profit. Therefore, since the airline has excess capacity, the decision is to accept the special offer.
 3. Add or Drop decisions
There are many ways to segment a company. Determining the best mix of segments is a problem
for managers who have to decide whether to drop a segment or to replace one segment with
another. Relevant information plays a great role in such type of decision.
Example: (adapted from Managerial Accounting, 9th edition) assume RTV Fashions uses its
available space for three product lines. The following is the income statement for last month and
management of RTV expects these results to continue in the near future.
Clothing Shoes Jewelry Total
Sales Br.45,000 Br.40,000 Br.15,000 Br.100,000
Variable costs 25,000 18,000 11,000 54,000
Contribution Br.20,000 Br.22,000 Br. 4,000 Br. 46,000
margin
Fixed costs:
Direct all (4,000) (3,400) (1,500) (8,900)
avoidable
Indirect (common) (9,450) (8,400) (3,150) (21,000)
Profit (loss) Br.6,550 Br.10,200 Br.(650) Br.16,100
 Cont’d…
Should the store drop the jewelry line because it shows a loss? To answer that question we
should know what would change if RTV dropped the line. Let’s start with a choice between two
simple alternatives:
Keep jewelry or drop it and rent the available space to another company for Br. 400 per month.
If it dropped jewelry, RTV would lose Br. 15,000 of sales but could avoid the Br. 11,000 of
variable costs of those sales as well as the Br. 1,500 avoidable fixed costs.
Suppose RTV’s analysis shows that dropping jewelry would reduce common costs by Br. 1,000.
The following analysis summarizes the decision.
Decision: Rent out the space rather than sell jewelry
Differential revenues:
Lost sales from jewelry Br. 15,000
New rent revenue 400
Net revenue lost Br. 14,600
Differential costs:
Variable costs saved on jewelry Br. 11,000
Direct fixed costs saved 1,500
Indirect fixed costs saved 1,000
Total cost saving 13,500
Differential loss from dropping jewelry Br. 1,100
Keeping jewelry seems the better choice because dropping it and renting the space will reduce
income by Br. 1,100 or total income drops from Br. 16,100 to Br. 15,000.
 4.Product mix decisions (under capacity constraints)
• Limited resource (factor) is the item that restricts or constrains the
production or sale of a product or service.
• Limited factors include labor hours, machine hours, the availability of
direct materials and components.
• When a firm produces more than one product with limited resources,
managers should decide which product should be more produced
and sold.
• Product mix decision is the decision about how much of each product
to sell.
• Consider Power Recreation, a company that manufactures engines
for a broad range of commercial and consumer products.
• At one of its plant, the company assembles two engines-a
snowmobile engine and a boat engine. Information on these
products is as follows:
 Cont’d…

Snowmobile Boat
Engine Engine
Selling price $800 $1,000
Variable cost per unit 560 625
Contribution margin per unit $240 $375
Contribution margin percentage 30% 37.5%
 Cont’d…
 Assume that only 600 machine hours are available daily for assembling
engines. Additional capacity cannot be obtained in the short run.
 The company can sell as many engines as it produces. The constraining
resource is the machine hours. It takes 2 machine hours for one snowmobile
engine and 5 machine hours to produce one boat engine. Which product
should the company emphasize?
 The product to be emphasized is not necessarily the product with higher
individual contribution margin per unit or contribution margin percentage.
 Managers should choose the product with the highest contribution margin
per unit of the constraining factor. The following table summarizes the
analysis of the decision.
Snowmobile Boat
Engine Engine
Contribution margin per engine $240 $375
Machine hours required per engine 2 5
Contribution margin per machine hour ($240/2; $120 $75
$375/5)
Total contribution margin for 600 machine hours $72,000 $45,000
($120*600; $75*600)
 Cont’d..
• Producing snowmobile engines contributes more margins
per machine hour that is the constraining resource in the
example. Therefore, choosing the snowmobile engine is the
right product-mix decision.

END OF CH2