Chapter Two

Decision Making and

Relevant Information
 Five-Step Decision Process
 A decision model is a formal method for making a choice,
often involving quantitative and qualitative analysis.
Management’s decision-making process frequently
involves the following steps:
1. Identify the problem and assign responsibility.
2. Determine and evaluate possible courses of action.
3. Make a decision.
4. Review results of the decision.
 Five-Step Decision Process

Historical Costs
Step 1. Gather Information
Other Information

Step 2. Make Predictions Specific Predictions

Feedback

Step 3. Choose an Alternative

Step 4. Implement the Decision

Step 5. Evaluate Performance

 Management’s Decision-
Making Process
 In making decisions, management ordinarily considers
both financial and nonfinancial information.
 Although nonfinancial information can be as
important as, and in some cases more important than,
financial information, the following discussion will
primarily be limited to financial information that is
relevant to decisions since that is the kind of
information accounting usually provides (primarily in
steps 2 and 4).
 The Meaning of Relevance

 Relevant information has two characteristics:

– It occurs in the future

– It differs among the alternative courses of action
 Relevant costs—expected future costs
 Relevant revenues—expected future revenues
 The Meaning of Relevance

Relevant costs and relevant revenues are

expected future costs and revenues that
differ among alternative courses of action.

Historical costs Sunk costs

Differential income Differential 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.
 Incremental Analysis
 Business decisions involve a choice among alternative courses
of action.
 The process used to identify the financial data that change under
alternative courses of action is called incremental analysis.
 In some cases, both costs and revenues will change under
alternative choices. In other cases only costs or revenues will
vary.
 It is important to recognize that
– variable costs may not change under the alternatives, and
– fixed costs may change.
 Incremental Analysis

 Incremental analysis involves not only identifying

relevant revenues and costs, but also determining the
probable effects of decisions on future earnings.
 Data for incremental analysis often involves estimates
and uncertainty.
 Gathering data may involve market analysts,
engineers, and accountants.
 How Incremental Analysis
Works
The basic approach in incremental analysis is illustrated in
the following illustration:
Alternative Alternative Net Income
A B Increase (Decrease)
Revenues $125,000 $110,000 $(15,000)
Costs 100,000 80,000 20,000
Net income $ 25,000 $ 30,000 $ 5,000

•In this illustration, alternative B is being compared with

alternative A. The net income column shows the differences
between the alternatives. Alternative B will produce $5,000
more net income than alternative A.
 Key Cost Concepts in
Incremental Analysis
Three important cost concepts used in incremental
analysis follow:
 In incremental analysis, the only factors to be
considered are those costs and revenues that differ
across alternatives. Those factors are called relevant.
 Costs and revenues that do not differ across
alternatives can be ignored when trying to chose
between alternatives.
 Key Cost Concepts in
Incremental Analysis
 Often in choosing one course of action, the company
must give up the opportunity to benefit from some other
course of action. This lost benefit is referred to as
opportunity cost.
 Costs that have already been incurred and will not be
changed or avoided by any future decision are referred to
as sunk costs. Sunk costs are not relevant costs.
 Types of Incremental
Analysis
A number of different types of decisions involve
incremental analysis. The more common types of
decisions are whether to:
 Accept an order at a special price.
 Make or buy component parts or finished products.
 Sell products or process them further.
 Retain or replace equipment.
 Eliminate an unprofitable business segment.
 Accept an Order at a
Special Price
 Sometimes a company may have an opportunity to obtain
additional business if it is willing to make major price
concessions to a specific customer.
 An order at a special price should be accepted when the
incremental revenue from the order exceeds the incremental
costs.
 It is assumed that sales in other markets will not be affected by
the special order. If other sales were affected, the lost sales
would have to be considered in making the decision.
 If the units can be produced within existing plant capacity,
generally only variable costs will be affected.
 Accept an Order at a
Special Price
To
To illustrate,
illustrate, assume
assume that
that Sunbelt
Sunbelt Company
Company produces
produces 100,000
100,000
automatic
automaticblenders
blendersper
per month,
month,which
whichis
is80%
80%of
ofplant
plantcapacity.
capacity.
Variable
Variable manufacturing
manufacturing costs
costs are
are $8
$8 per
per unit,
unit, and
and fixed
fixed
manufacturing
manufacturingcosts
costsare
are$400,000,
$400,000,or
or$4
$4per
perunit.
unit. The
Theblenders
blendersare
are
normally
normallysold
soldto
toretailers
retailersat
at$20
$20each.
each.

Question:
Question:
Sunbelt
Sunbelt has
has an
an offer
offer from
from Mexico
Mexico Co.
Co. to
to purchase
purchase an
an additional
additional
2,000
2,000 blenders
blenders at
at $11
$11 per
per unit.
unit. Acceptance
Acceptance of
of this
this offer
offer would
would not
not
affect
affect normal
normal sales
sales of
of the
the product,
product, and
and the
the additional
additional units
units can
can be
be
manufactured
manufacturedwithout
withoutincreasing
increasingplant
plantcapacity.
capacity.
 Accept an Order at a
Special Price: Incremental Analysis
If management makes its decision on the basis of total cost per unit of $12
($8 + $4), the order would be rejected, because costs ($12) would exceed
revenues ($11) by $1 per unit. However, since the units can be produced
within existing plant capacity, the special order will not increase fixed
costs. The relevant data for the decision, therefore, are the variable
manufacturing costs per unit of $8 and the expected revenue of $11 per unit.

Reject Accept Net Income

Order Order Increase (Decrease)
Revenues $ -0- $22,000 $ 22,000
Costs -0- 16,000 (16,000)
Net income $ -0- $ 6,000 $ 6,000

Decision:
Decision:
Sunbelt
Sunbeltwill
willincrease
increaseits
itsnet
netincome
incomeby
by$6,000
$6,000when
whenaccepting
acceptingthis
this
special
specialorder.
order.
 Make or Buy
 When a manufacturer assembles component parts in
producing a finished product, management must
decide whether to make or buy the components.
 This is often referred to as an outsourcing decision.
 If there is an opportunity to use the productive capacity
for another purpose, opportunity costs should be
considered.
 The decision to make or buy components should be
made on the basis of incremental analysis.
 Make or Buy
Assume
Assumethat
thatBaron
BaronCo.
[Link]
incursthe
thefollowing
followingannual
annualcosts
costsin
in
producing
producing25,000
25,000ignition
ignitionswitches
switchesfor
formotor
motorscooters.
scooters.

Direct materials $ 50,000

Direct labor 75,000
Variable manufacturing overhead 40,000
Fixed manufacturing overhead 60,000
Total manufacturing costs $225,000
Total cost per unit ($225,000  25,000) $9.00

Alternatively,
Alternatively,Baron
Baronmay
maypurchase
purchasethe
theignition
ignitionswitches
switchesfrom
from
Ignition,
Ignition,Inc.,
Inc.,at
ataaprice
priceof
of$8
$8per
perunit.
unit.

Question:
Question:
Should
ShouldBaron
Baronmake
makeor
orbuy
buythe
theignition
ignitionswitches?
switches?
 Make or Buy:
Incremental Analysis
At first glance, it appears that management should buy the switches for
$8 instead of make for $9. However, a review of operations indicates
that if the switches are purchased all of Baron’s variable costs, but only
$10,000 of its fixed manufacturing costs, will be eliminated. Thus,
$50,000 of fixed costs will remain. The incremental costs are:
Net Income
Make Buy Increase (Decrease)
Direct materials $ 50,000 $ - 0 - $ 50,000
Direct labor 75,000 -0- 75,000
Variable manufacturing costs 40,000 -0- 40,000
Fixed manufacturing costs 60,000 50,000 10,000
Purchase price -0- 200,000 (200,000)
Illustration 9-6 Total annual cost $225,000 $250,000 $ (25,000)

Decision:
Decision:
Barton
BartonCompany
Companywill
willincur
incur$25,000
$25,000of
ofadditional
additionalcosts
costsby
bybuying
buyingthe
the
switches.
switches. Therefore,
Therefore,Barton
Bartonshould
shouldcontinue
continuetotomake
makethe
theswitches.
switches.
 Make or Buy with Opportunity
Cost: Incremental Analysis
Assume that through buying the switches, Baron Co. can use the
released productive capacity to generate additional income of
$28,000. This lost income is an additional cost of continuing to
make the switches in the make-or-buy decision. This opportunity
cost is added to the “Make” column, for comparison.
Net Income
Make Buy Increase (Decrease)
Total annual cost $225,000 $250,000 $(25,000)
Opportunity cost 28,000 -0- 28,000
Total cost $253,000 $250,000 $ 3,000

Decision:
Decision:
ItItis
isnow
nowadvantageous
advantageoustotobuy
buythe
theswitches.
switches. Barton
Bartonwill
willsave
save$3,000
$3,000
worth
worthofofcosts
costswith
withthis
thisalternative.
alternative.
 Sell or Process Further
 Many manufacturers have the option of selling products
at a given point in the production cycle or continuing to
process with the expectation of selling them at a higher
price.
 The sell-or-process further decision should be made
on the basis of incremental analysis.
 The basic decision rule in a sell or process further
decision is: Process further as long as the
incremental revenue from such processing exceeds
the incremental processing costs.
 Sell or Process Further
Assume
Assumethat
thatWoodmasters,
Woodmasters,Inc.
[Link]
makestables.
tables.
The
Thecost
costto
tomanufacture
manufactureananunfinished
unfinishedtable
tableis
is
$35,
$35,computed
computedas
asfollows:
follows: Direct materials $ 15
Direct labor 10
Variable manufacturing overhead 6
Fixed manufacturing overhead 4
Total manufacturing costs $35

The
The selling
selling price
price per
per unfinished
unfinished unit
unit is
is $50.
$50. Woodmasters
Woodmasters currently
currently has
has
unused
unusedproductive
productivecapacity
capacitythat
thatis
isexpected
expectedto tocontinue
continueindefinitely
indefinitelyand
andcan
can
be
be used
used to
to finish
finish the
the tables
tables and
and sell
sell them
them for
for $60
$60 each.
each. For
For aa finished
finished table
table
direct
direct materials
materials and
and direct
direct labor
labor costs
costs will
will increase
increase $2$2 and
and $4,
$4, respectively.
respectively.
Variable
Variable overhead
overhead will
will increase
increase by
by $2.40
$2.40 (60%
(60% of
of direct
direct labor).
labor). There
There will
will be
be
no
noincrease
increaseininfixed
fixedoverhead.
overhead.
Question:
Question: Should
ShouldWoodmasters
Woodmasterssell
sellthe
the
unfinished
unfinishedtables
tablesor
orprocess
processthem
themfurther?
further?
 Sell-or Process Further:
Incremental Analysis
The incremental analysis on a per unit basis is as follows:
Process Net Income
Sell Further Increase (Decrease)
Sales per unit $50.00 $60.00 $10.00
Cost per unit
Direct materials 15.00 17.00 (2.00)
Direct labor 10.00 14.00 (4.00)
Variable manufacturing overhead 6.00 8.40 (2.40)
Fixed manufacturing overhead 4.00 4.00 -0-
Total $35.00 $43.40 $(8.40)
Net income per unit $15.00 $16.60 $ 1.60

Decision:
Decision:
ItItwould
wouldbe beadvantageous
advantageousfor forWoodmasters
Woodmastersto toprocess
processthe
thetables
tables
further.
further. In
Inthis
thiscase,
case,the
theper
perunit
unitincremental
incrementalrevenue
revenueofof$10.00
$10.00from
from
the
theadditional
additionalprocessing
processingisis$1.60
$1.60higher
higherthan
thanthe
theper
perunit
unitincremental
incremental
processing
processingcosts
costsof
of$8.40.
$8.40.
 Retain or Replace Equipment

 Management often has to decide whether to continue using an

asset or replace it. In a decision to retain or replace equipment,
management compares the costs which are affected by the two
alternatives. Generally, these are variable manufacturing costs
and the cost of the new equipment.
 The book value of the old machine is a sunk cost which is a cost
that cannot be changed by any present or future decision. Sunk
costs are not relevant in incremental analysis.
 Any trade-in allowance or cash disposal value of the existing
asset is relevant.
 Retain or Replace Equipment

Assume
Assumethat
thatJeffcoat
JeffcoatCompany
Companyhas
hasaafactory
factorymachine
machinewith
withaabook
book
value
value of
of $40,000
$40,000 and
and aa remaining
remaining useful
useful life
life of
of four
four years.
years. AA new
new
machine
machine is
is available
available that
that costs
costs $120,000
$120,000 and
and is
is expected
expected to
to have
have
zero
zero salvage
salvage value
value at
at the
the end
end of
of its
its 4-year
4-year useful
useful life.
life. IfIf the
the new
new
machine
machine is
is acquired,
acquired, variable
variable manufacturing
manufacturing costs
costs are
are expected
expected
to
to decrease
decrease from
from $160,000
$160,000 to
to $125,000
$125,000 annually
annually and
and the
the old
old unit
unit
will
willbe
bescrapped.
scrapped.

Question:
Question:
Should
ShouldJeffcoat
JeffcoatCompany
Companyretain
retainor
orreplace
replacethe
themachine?
machine?
 Retain or Replace:
Incremental Analysis
The incremental analysis for the 4-year period is as follows:
Net Income
Retain Replace Increase (Decrease)
Variable manufacturing costs $640,000a $500,000b $140,000
New machine cost 120,000 (120,000)
Total $640,000 $620,000 $ 20,000

a
(4 years x $160,000)
b
(4 years x $125,000)

Decision:
Decision:
In
Inthis
thiscase,
case,ititwould
wouldbe
beto
tothe
thecompany’s
company’sadvantage
advantageto
toreplace
replacethe
the
equipment.
equipment. TheThelower
lowervariable
variablemanufacturing
manufacturingcosts
costsdue
duetoto
replacement
replacementmore morethan
thanoffset
offsetthe
thecost
costof
ofthe
thenew
newequipment.
equipment.
 Eliminate an Unprofitable Segment

 Management sometimes needs to decide whether to eliminate

an unprofitable business segment.
 Again, the key is to focus on the data that change under the
alternative courses of action.
 Often fixed costs allocated to the unprofitable segment must be
absorbed by the other segments. It is possible, therefore, for net
income to decrease when an unprofitable segment is eliminated.
 In deciding whether to eliminate an unprofitable segment,
management should choose the alternative which results in the
highest net income for the company as a whole.
 Eliminate an Unprofitable
Segment
Assume
Assume that
that Martina
Martina Company
Company manufactures
manufactures tennis
tennis racquets
racquets in
in
three
three models:
models: Pro,
Pro, Master,
Master, and
and Champ.
Champ. Pro
Pro and
and Master
Master are
are
profitable
profitable lines,
lines, whereas
whereas Champ
Champ operates
operates at
at aa loss.
loss. Condensed
Condensed
income
incomestatement
statementdata
dataare:
are:

Pro Master Champ Total

Sales $800,000 $300,000 $100,000 $1,200,000
Variable expenses 520,000 210,000 90,000 820,000
Contribution margin 280,000 90,000 10,000 380,000
Fixed expenses 80,000 50,000 30,000 160,000
Net income $200,000 $ 40,000 $(20,000) $ 220,000

Question:
Question:
Should
Shouldthe
theChamp
Champsegment
segmentbe
beeliminated?
eliminated?
 Avoidable and Unavoidable Costs

 Avoidable costs are costs that will not continue if

an ongoing operation is changed or deleted.
 Unavoidable costs are costs that continue even if an
operation is halted.
 Common costs are costs of facilities and services
that are shared by users.
 Eliminate an Unprofitable Segment

•• Although
Although itit appears
appears that
that income
income would
would increase
increase ifif the
the Champ
Champ line
line
was
wasdiscontinued,
discontinued,ititis
ispossible
possiblefor
forincome
incometo
todecrease
decreaseififChamp
Champwas
was
discontinued.
discontinued. The
The reason
reason is
is that
that the
the fixed
fixed expense
expense allocated
allocated to
to
Champ
Champ will
will have
have to
to be
be absorbed
absorbed by
by the
the other
other products.
products. To
To illustrate,
illustrate,
assume
assume that
that the
the $30,000
$30,000 of
of fixed
fixed costs
costs are
are allocated
allocated 2/3
2/3 to
to Pro
Pro and
and
1/3
1/3to
toMaster.
[Link]
Therevised
revisedincome
incomestatement
statementdata
datais:
is:
Pro Master Total
Sales $800,000 $300,000 $1,100,000
Variable expenses 520,000 210,000 730,000
Contribution margin 280,000 90,000 370,000
Fixed expenses 100,000 60,000 160,000
Net income $200,000 $ 40,000 $ 210,000

Decision:
Decision: Total
Totalnet
netincome
incomehas
hasdecreased
decreased$10,000
$10,000($220,000
($220,000––$210,000).
$210,000).
 Unprofitable Segment:
Incremental Analysis
This result is also obtained in the following incremental
analysis:
Net Income
Continue Eliminate Increase (Decrease
Sales $100,000 $ -0- $(100,000)
Variable expenses 90,000 -0- 90,000
Contribution margin 10,000 -0- (10,000)
Fixed expenses 30,000 30,000 -0-
Net income $(20,000) $ 30,000) $ (10,000)

Decision:
Decision:
Once
Onceagain,
again,total
totalnet
netincome
incomehashasdecreased
decreased$10,000
$10,000($220,000
($220,000––
$210,000).
$210,000).This
Thiscorresponds
correspondsto tothe
theChamp
Champsegment’s
segment’scontribution
contribution
margin.
margin. Thus,
Thus,management
managementshould
shouldnotnotdiscontinue
discontinuethe
theChamp
Champ
segment
segmentunless
unlessother
otherlines
linescan
canrecover
recoversome
someororall
allof
ofthe
the
sales/contribution
sales/contributionmargin
marginlost
lostby
bythe
thediscontinued
discontinuedsegment.
segment.
 Limited Resources
 When a company has limited resources (floor space, raw
materials, or machine hours), management must decide which
products to make and sell in order to maximize net income.
 In an allocation of limited resources decision, it is necessary to
find the contribution margin per unit of limited resource.
 This is obtained by dividing the contribution margin per unit of
each product by the number of units of the limited resource
required for each product.
 Production should be geared to the product with the highest
contribution margin per unit of limited resource.
 Limited Resources
Assume
Assumethat
thatCollins
CollinsCo.
Co. manufactures
manufacturesdeluxe
deluxeand
andstandard
standardpen
penand
and
pencil
pencil sets.
sets. The
The limited
limited resource
resource is
is machine
machine capacity,
capacity, which
which is
is
3,600
3,600hours
hoursper
permonth.
month. Relevant
Relevantdata
dataconsists
consistsof:
of:
Deluxe Standard
Contribution margin per unit $8 $6
Machine hours required per unit .4 .2

Question:
Question:
Should
ShouldCollins
CollinsCo.
[Link]
shiftits
itssales
salesmix
mixtoward
towarddeluxe
deluxeor
orstandard
standard
sets?
sets?
 Limited Resources
•• Based
Based on on the
the previous
previous data,
data, itit might
might appear
appear that
that deluxe
deluxe is
is more
more
profitable
profitable since
since they
they have
have aa higher
higher contribution
contribution margin.
margin. However,
However,
standard
standardsetssetstake
takefewer
fewermachine
machinehours.
hours. Therefore,
Therefore,ititis
isnecessary
necessary
to
to find
find the
the contribution
contribution margin
margin per per unit
unit of
of limited
limited resource,
resource, as
as
shown
shownbelow:
below:
Deluxe Standard
Contribution margin per unit (a) $8 $6
Machine hours required per unit (b) .4 .2

Contribution margin per unit of

limited resource (a  b) $20 $30

Decision:
Decision: Since
Since the
the standard
standard set
set has
has the
the higher
higher contribution
contribution
margin
margin per
per unit
unit of
of limited
limited resource,
resource, sales
sales mix
mix should
should shift
shift towards
towards
that
thatproduct.
product.
 Limited Resources:
Incremental Analysis
This result is confirmed by the following incremental analysis:
If Produce If Produce
Deluxe Sets Standard Sets
Machine hours (a) 600 600
Contribution margin per unit of
limited resource (b) $20 $30
Contribution margin (a x b) $12,000 $18,000

Decision:
Decision:
Once
Onceagain,
again,ititis
isclear
clearthat
thatstandard
standardsets
setsproduce
producemore
morecontribution
contribution
margin.
margin. Thus,
Thus, given
given adequate
adequate demand
demand forfor standard
standard sets,
sets, the
the sales
sales
mix
mix should
should shift
shift to
to that
that product
product in
in order
order to to maximize
maximize Collins
Collins
Company’s
Company’sincome.
income.
 Other Considerations in
Decision Making
 In this chapter, the focus was primarily on the
quantitative (those attributes that can be easily expressed
in terms of numbers) factors that affect a decision.
 Many of the decisions involving incremental analysis
have important qualitative features that, while not easily
measured, should not be ignored.
 Other Considerations in
Decision Making
 It was noted that many companies have shifted to
activity-based costing (ABC) to allocate overhead costs
to products.
 The concepts presented in this chapter are completely
consistent with the use of ABC. In fact, ABC will result
in better identification of relevant costs, and therefore,
better incremental analysis.