CHAPTER #02

RELEVANT INFORMATION AND DECISION MAKING

INTRODUCTION
Decision-making is a fundamental part of management. Managers are constantly faced with
problems of deciding what product to sell, what production method to use, whether to make or
buy component parts, what prices to charge, what channels of distribution to use, whether to
accept special orders at special prices, and so forth. This chapter covers the role of management
accounting information in a variety of marketing and product decisions. However, in this session,
you will consider short-run decisions. The term "short run" implies that the time of payoff is
short enough that the decision maker can safely ignore the time value of money.
TERMINOLOGIES
 Relevant costs are expected future costs that differ among the alternative courses of
action being considered.
 Relevant revenues are expected future revenues that differ among the alternative courses
of action being considered.
To be relevant to a decision costs and relevant revenues must:
1. Occur in the future—every decision deals with selecting a course of action based on its
expected future results. So, to be relevant to a decision, cost or benefit information must
involve a future event. Relevant information is a prediction of the future, not a summary of
the past. Historical (past) data have no bearing on a decision. Such data can have an
indirect bearing on a decision because they may help in predicting the future. But past
figures, in themselves, are irrelevant to the decision itself. Why? Because decision-
making affect future, but not past. Nothing can alter what has already happened.
2. Differ among the alternative courses of action—relevant information must involve
future costs or benefits that differ among the alternatives. Costs or benefits that are the
same across all the available alternatives have no bearing on the decision.
 Differential revenues and costs are future costs and revenues which differ between
alternatives. Another term used for "differential" is "incremental," and these two terms can
be used interchangeably. They are relevant to decisions.
 Marginal costs or revenues, on the other hand, refer to the increase in total costs resulting
from the production and/or sale of one more unit.

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 Opportunity Cost: the potential benefits that are lost when one alternative is chosen over
another. They are always relevant to decisions.
Examples of opportunity cost may be given.
i. If you have been given a choice of two jobs and job A pays Br. 60,000 per year and
job B pays Br. 55,000 per year, then the opportunity cost of accepting job A is Br.
55,000. Other things equal, you are only Br. 5,000 better off financially with job A.
ii. If you own land that could be sold for Br. 100,000 and the land is not now earning
any income other than appreciation in value, then there is an opportunity cost of not
earning interest. Assuming you could earn at a minimum 6% interest in a CD, the
opportunity cost of keeping the land and not selling is Br. 6,000 per year. Interest in
the amount of Br. 6,000 is being forgone each year in favor of the land appreciating
in value.
iii. You own a building that you can easily rent for Br. 10,000 a month. If you decide to
use the building to open a business for yourself, then you incur an opportunity cost
in the amount of Br. 10,000, (rent given up, forgone, or sacrificed) by going into
business.
iv. If you are a student and you spend 30 hours a week in class and in studying, there is
an opportunity cost of being a student. The opportunity cost is the income you could
be earning by working rather than attending class or studying.
 Sunk Costs: are costs that have already been incurred. They cannot be changed by any
current or future actions: sunk costs are irrelevant to decisions. Example depreciation, book
value of assets.
 Avoidable costs: are costs that can be eliminated in whole or in part by choosing on
alternative over another
 Common fixed costs are fixed costs that support the operation of more than one segment,
but are not traceable in whole or in part to any one segment. Thus they continue even when
the product line is dropped. allocated common fixed costs can make a segment look
unprofitable even though dropping the segment might result in a decrease in overall company
net operating income.
Identification of relevant costs
To identify which costs are relevant in a particular situation, take this three-step approach:

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 1. Eliminate sunk costs
2. Eliminate costs and benefits that do not differ between alternatives
3. Compare the remaining costs and benefits that do differ between alternatives to make
the proper decision.
The key element in these definitions of relevant costs is that between the two alternatives each
cost should be different in amount. Secondly, the cost must be a future cost. Historical costs, as
will be explained, are always irrelevant and may be safely excluded from the analysis.

Analysis of Special decisions

Decision making refers to selecting the best alternative from the given course of action. Hence,
to make such kinds of selection Managers have to determine the problem that needs
consideration and identify alternative courses of action, and evaluate the effect that each
alternative will have on their organization. The method of comparing alternatives by focusing on
the differences in their projected revenues and costs is called incremental analysis. Incremental
analysis is a worksheet technique in which the relevant costs of one alternative are listed in
one column and the relevant costs of another alternative are listed in an adjacent column.
Frequently, an optional third column is used to show the difference in the costs. When
management accountants produce information, they must consider both qualitative and
quantitative or financial and non-financial information which the decision maker must use to
select the best alternative. The best decision is the one with the least amount of relevant costs or
the greatest relevant revenue.
Under appropriate circumstances, incremental analysis is a tool for evaluating decision
alternatives such as:
1. Make or Buy decision 4. Product Mix decisions with
2. Special Order decisions Scarce Resource
3. Add or Drop decisions 5. Sell now or process further
1. Make–or–buy decision: which are decisions about whether to make a part internally or buy it
from an external supplier, may leads to outsourcing.
• Outsourcing is the use of suppliers outside organization to perform services or produce
goods that could be performed or produced internally.

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 When a company has unused capacity and wants to manufacture some components, it has
two alternatives:
(a) To make within the organization or
(b) To buy from the market.
Often, firms face the question whether to outsource production of a component or continue to
make it in the factory. The answer depends upon whether the firm has the option to use the
unused capacity, profitably, or not. The decision maker will be interested in the difference
between the suppliers’ selling price and the cost of producing in-house.
Essentially in this analysis, costs which will be eliminated if the product is no longer
produced internally (i.e., the benefits of not producing internally) must be compared with
the costs (purchase price, freight charges, insurance, sales taxes, import duties, etc.) of an
outside purchase.
The following qualitative factors will also be considered in deciding whether or not to produce
in-house:
i. The quality of the product that will be bought from outside;
ii. The reliability of the outside supplier;
iii. The effect of future market prices;
iv. The possible problems of transport and handling costs; and
v. Government regulations, especially on import from overseas.
The decision to buy or make the product internally depends on whether the capacity that is
released by the non-manufacture of the component can be profitably utilized, elsewhere, or
not.
i. When Machinery remains idle: If the machinery remains idle, existing fixed costs
related to that machinery is not to be considered for decision-making. Compare variable
costs only with the market price of the material. If we stop making the component in the
factory and buy it from the market, what we can save is only future variable costs, but not
the fixed costs, already incurred. The firm would continue to incur costs on the idle
machine. In other words, we consider those costs that can be saved or avoided.
Put the question, what costs are saved? Compare the saved costs with the
corresponding market price for decision-making to buy or continue to produce. Costs
that can be saved are only Variable Costs. So, compare variable costs with market price

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 for decision making, when the machinery remains idle.
ii. When Machinery utilized profitably, elsewhere: The second situation is that the
existing machinery can be utilized, elsewhere, profitably. Hence the fixed costs can be
considered as saved. In such an event, costs saved are both variable costs and fixed costs.
So, comparison is to be made between the aggregate costs saved with the corresponding
market price.
When the machine is not idle and can be profitably utilized, elsewhere, compare total costs
saved, both variable and fixed costs, with the market price for decision-making.

 If saved costs are more than the market price, buying is cheaper rather than producing.
Produce, if market price is more than saved costs.
Illustration #01
ABC Company is producing a part at a cost of Br. 11 per unit. The composition of the cost is as
follows:
Materials per unit ……………………. Br. 3.00
Direct labor per unit ………………… 4.00
Overheads –Variable per unit ……… 2.50
Fixed cost per unit ………… 1.50
Total cos per unit …………………….…… Br. 11.00
Presently, the firm has been incurring a total fixed cost of Br. 15,000 for manufacturing the
current production of 10,000 units. An outsider is offering the same component, in all aspects
identical in features, for Br. 10 per unit. On enquiry, it is found from the firm that the machine
that is manufacturing the parts would remain idle as the machinery cannot be utilized elsewhere.
a) Should the offer be accepted?
b) Would your answer would be different, if the outside firm reduces the price to Br. 9, after
negotiation. What is the impact of the fixed costs in the decision-making process?
Solution:
The variable cost of the product is as under:
Amount in Br.
Materials 3.00
Direct labor 4.00

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 Overheads–Variable 2.50
Total Variable Cost 9.50
a) Here, the additional costs (variable costs) for making are Br. 9.50. The outside market
price is Br. 10. The outside offer is on a higher side by Br. 0.50 per unit, so the offer is to
be rejected. For every unit bought outside, it results in a loss of Br. 0.50 per unit.
b) Now, the outside firm is willing to reduce the price to Br. 9, while the variable cost is Br.
9.50. The offer is to be accepted.
So far as the fixed costs Br. 15,000 is concerned, the firm would incur, whether the firm
makes the product itself or buys it outside. In other words, the existing fixed costs are not
to be considered, while taking a decision.
2. Special Order Decisions
This situation usually involves a potential sale to a customer at a price lower than normal.
Most special-order problems are set up as a "one-time" deal.
Basic decision criterion:
1. Determine if you have the "capacity" to accept the special order.
2. If the special order has to be produced, then all variable manufacturing costs
will be relevant. (If the units have already been produced, the production costs
are sunk costs, therefore irrelevant.)
3. Determine if all or part of the normal selling costs might be avoided on the
special order. If so, then the avoidable selling costs are irrelevant to your
decision to accept the special order.
Other considerations:
1. If the special order is "ongoing" then fixed costs may need to be considered.
2. If you expand capacity to accept the special order, additional fixed production
costs will have to be added to the total production costs.
3. Are your regular customers affected by accepting the special order? If you are
unable to service your regular customers because of accepting the special order,
then the lost revenue from regular customers becomes an opportunity cost. This
opportunity cost must be added in to the costs of producing the special order.
Illustration #02

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ABC Company produces a single product the cost of producing and selling a single unit of this
product at the company’s normal activity level of 8,000 units per year is:
Direct materials Br. 2.50
Direct labor 3.00
Variable manufacturing overhead 0.50
Fixed manufacturing overhead 4.25
Variable selling and administrative expenses 1.50
Fixed selling and administrative expenses 2.00
The normal selling price is Br. 15.00 per unit. The company’s capacity is 10,000 units per year.
An order has been received from an overseas source for 2,000 units at the special price of Br.
12.00 per unit. This order would not affect regular sales.
Required:
(a) If the order is accepted, how much will monthly profits increase or decrease? (The order
will not change the company’s total fixed costs.)
(b) Assume the company has 500 units of this product left over from last year that are vastly
inferior to the current model. The units must be sold through regular channels at reduced
prices. What unit cost is relevant for establishing a minimum selling price for these units?
Explain.
Solution:
a.
Selling price Br. 12.00
Direct materials Br. 2.50
Direct labor 3.00
Variable manufacturing overhead 0.50
Variable selling and administrative expenses 1.50
Total variable expense 7.50
Contribution margin 4.50
Units sold 2,000
Total contribution margin Br. 9,000

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b. The relevant cost is Br. 1.50 (the variable selling and administrative costs). All other
variable costs are sunk, since the units have already been produced. The fixed costs would
not be relevant, since they will not be affected by the sale of leftover units.
3. Add or Drop decisions
Decisions relating to whether old product lines or other segments of a company should be
dropped and new ones added are among the most difficult that a manager has to make. In such
decisions, many factors must be considered that are both qualitative and quantitative in nature.
Fixed costs are divided into two categories, avoidable and unavoidable.
Avoidable costs are costs that will not continue if an ongoing operation is changed, deleted or
eliminated. These costs are relevant costs in decision-making. Examples of avoidable costs
include departmental salaries and other costs that could be avoided by not operating the specific
department.
Unavoidable costs are costs that continue even if a subunit or an activity is eliminated and are
not relevant for decision. The reason for this is that such costs are not affected by a decision to
delete a particular activity. Unavoidable costs include many common costs, which are defined as
those costs of facilities and services that are shared by users. Examples are store depreciation,
general management expenses etc.

Basic rule of thumb: compare the contribution margin that will be lost against the costs that can
be avoided if the line is dropped.
A segment should be added only if the increase in total contribution margin is greater than the
increase in fixed costs. A new product line adding losses to the firm should be dropped.
A segment should be dropped only if the decrease in total contribution margin is less than the
decrease in fixed costs.
Illustration #03
M&M Company a retailing company has two departments, X and Y. A recent monthly
contribution format income state for the company follows.
X Y Total
Sales Br. 3,000,000 Br. 1,000,000 Br. 4,000,000
Variable expenses 900,000 400,000 1,300,000
Contribution margin Br. 2,100,000 Br. 600,000 Br. 2,700,000

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Fixed expenses 1,400,000 800,000 2,200,000
Operating income (loss) Br. 700,000 (Br. 200,000) Br. 500,000
A study indicates that Br. 340,000 of the fixed expenses being charged to Y are sunk costs or
allocated costs that will continue even if Y is dropped. In addition, the elimination of Y will
result in a 10% decrease in the sales of X.
Required:
If Department Y is discontinued, will this be a positive move or a negative move for
the company as a whole?
Solution
Contribution margin lost if Y is dropped:
Department Y contribution margin lost (Br. 600,000)
Department X contribution margin lost (210,000)
Total contribution margin lost (810,000)
Avoidable fixed costs 460,000
Decrease in operating income (Br. 350,000)
Decision “y” should not be dropped
4. Product –mix decision under capacity constraints (Utilization of Constrained
Resources)
Managers are routinely faced with the problem of deciding how scarce resources are going to be
utilized. A scarce resource or a limiting factor refers to any factor that restrict or constraint the
production or sale of a product or service. It include the following, among others, labor hours,
machine hours, square feet of floor space, cubic meters of display space. A manufacturing firm
has a limited number of machine- hours and a limited number of direct labor-hours at its
disposal. When capacity becomes pressed because of scarce resource, the firm is said to have a
constraint.
When a plant that makes more than one product is operating at capacity, managers often must
decide which orders to accept. The contribution margin technique also applies here, because the
product to be emphasized or the order to be accepted is the one that makes the biggest total profit
contribution per unit of the limiting factor. Fixed cost are usually unaffected by such choices.

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In such kind of decision, the contribution margin technique must be used wisely. Managers
sometimes mistakenly favor those products with the biggest contribution margin or gross margin
per sales birr, without regard to scarce resources.

 The following calculation process/or steps should be applied:

1. determine the contribution margin per unit of the scarce resource for each product or
service;
2. Rank all of the products on the basis of this contribution margin per unit of scarce
resource, i.e. this calculated "productivity measure" for the scarce resource.
3. Assign the scarce resource (machine time, skilled labor hours, limited raw materials,
etc.) to the products based on the determined rankings.
Note: if a company is operating at less than full capacity, then any product which has a
positive contribution margin should normally continue to be produced.
To determine product mix, a company maximizes operating income, subject to constraints such
as capacity and demand. Throughout this section, we assume that as short run changes in product
mix occur, the only costs that change are costs that are variable with respect to the number of
units produced (and sold). Under this assumption, the analysis of individual product contribution
margins provides insight into the product mix that maximizes operating income.
Example 4: Power Recreation assembles two engines, a snowmobile engine and a boat engine.

Assume that only 600 machine-hours are available daily for assembling engines. Additional
capacity cannot be obtained in the short run. Power Recreation can sell as many engines as it
produces. The constraining resource, then, is machine-hours. It takes two machine-hours to
produce one snowmobile engine and five machine-hours to produce one boat engine. What
product mix should Power Recreation’s managers choose to maximize its operating income?
In terms of contribution margin per unit and contribution margin percentage, boat engines are
more profitable than snowmobile engines. The product that Power Recreation should produce
and sell, however, is not necessarily the product with the higher individual contribution margin
per unit or contribution margin percentage. Managers should choose the product with the highest

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contribution margin per unit of the constraining resource (factor). That’s the resource that
restricts or limits the production or sale of products.

Therefore, choosing to produce and sell snowmobile engines maximizes total contribution
margin ($72,000 versus $45,000 from producing and selling boat engines) and operating income.
5. A sell or process further decision: is a decision about whether to sell a joint product at the
split-off point or sell it after further processing.
Compare the incremental revenues which will be generated with the incremental costs
which will be incurred on the additional processing step under consideration.

 The incremental revenues are determined by comparing the revenues which will be
generated if the product is processed this additional step with the revenues which would
be generated from the sale of the output without additional processing.

 The incremental costs are only the costs incurred to perform this additional processing
step; thus, costs incurred in prior steps, including any joint costs which were incurred are
totally irrelevant.

Illustration # 05
Leonard Manufacturing Company produces products A, B, C and D through a joint process. The
joint costs amount to Br. 100,000.
Units’ sales value if processed further
Product produced at split-off additional costs sales value
A 1,500 Br. 10,000 Br. 2,500 Br. 15,000

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 B 2,500 30,000 3,000 35,000
C 2,000 20,000 4,000 25,000
D 3,000 40,000 6,000 45,000
Solution:
The incremental analysis for the decision to process further is:
Products A B C D
Incremental Revenues Br. 5,000 Br. 5,000 Br. 5,000 Br. 5,000
Deduct incremental processing costs 2,500 3,000 4,000 6,000
Increase in operating income Br. 2,500 Br. 2,000 Br. 1,000 (Br. 1,000)
Incremental revenues are greater than incremental costs for products A, B and C resulting in an
increase in operating income, so the manager decides to process further.
But for product D, Incremental revenue is less than incremental costs resulting in a decrease in
operating income, so the manager decides to sell product D at the split off point. The Br. 100,000
joint costs incurred before the split off point are irrelevant in deciding whether to process further.
That’s because the joint costs of Br. 100,000 are the same whether the products are sold at the
split off point or processed further. The decision whether to process further should not be
influenced by the total amount of joint costs; nor should it be influenced by the portion of joint
costs allocated to individual products.
Qualitative Considerations
A) In all decision analyses, after the relevant monetary impact of the different alternatives under
consideration has been determined, then non-quantitative issues must be considered.
B) Such factors as employee morale, customer long-term reactions, governmental intervention,
quality of the product which will be produced, the amount of risk which is acceptable or
appropriate, dependency on particular vendors, legal violations, ethical considerations and
meeting social responsibilities must all be considered.
C) In the final analysis, these qualitative considerations must be reviewed along with the
economic impact of any decision in arriving at a final decision.

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