CHAPTER FIVE

DECISION MAKING AND RELEVANT INFORMATION

Information and the Decision Process

Managers usually follow a decision model for choosing among different courses of action. A decision
model is a formal method of making a choice that often involves both quantitative and qualitative
analyses. Management accountants analyze and present relevant data to guide managers’ decisions.
Consider a strategic decision facing management at Precision Sporting Goods, a manufacturer of golf
clubs: Should it reorganize its manufacturing operations to reduce manufacturing labor costs? Precision
Sporting Goods has only two alternatives: Do not reorganize or reorganize. Reorganization will eliminate
all manual handling of materials. Current manufacturing labor consists of 20 workers—15 workers
operate machines, and 5 workers handle materials. Each worker works 2,000 hours annually.
Reorganization is predicted to cost $90,000 each year (mostly for new equipment leases). Production
output of 25,000 units as well as the selling price of $250, the direct material cost per unit of $50,
manufacturing overhead of $750,000, and marketing costs of $2,000,000 will be unaffected by the
reorganization.
The managers of Precision Sporting Goods are applied Five-Step Decision- Making Process to make the
decision
Step 1: Identify the Problem and Uncertainties Should Precision Sporting Goods reorganize its
manufacturing operations to reduce manufacturing labor costs? An important uncertainty is how the
reorganization will affect employee morale.
Step 2: Obtain Information the management should have to obtain Historical Costs and Other
Information Historical hourly wage rates are $14 per hour. However, a recently negotiated increase in
employee benefits of $2 per hour will increase wages to $16 per hour. The reorganization of
manufacturing operations is expected to reduce the number of workers from 20 to 15 by eliminating all 5
workers who handle materials. The reorganization is likely to have negative effects on employee morale.
Step 3: Make Predictions about the Future under the existing do-not reorganize alternative, costs are
predicted to be $640,000(20 workers * 2,000 hours per worker per year * $16 per hour), and under the
reorganize alternative, costs are predicted to be $480,000 (15 workers * 2,000 hours per worker per year
* $16 per hour). Recall, the reorganization is predicted to cost $90,000 per year.
Step 4: Make Decisions by Choosing among Alternatives Managers compare the predicted benefits
calculated in Step 3

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 ($640,000 - $480,000 = $160,000 against the cost of the reorganization ($90,000) along with other
considerations (such as likely negative effects on employee morale). Management chooses the reorganize
alternative because the financial benefits are significant and the effects on employee morale are expected
to be temporary and relatively small.
Step 5: Implement the Decision, Evaluate Performance, and Learn
The Concept of Relevance
Relevant Costs and Relevant Revenues
Relevant costs are expected future costs, and relevant revenues are expected future revenues that differ
among the alternative courses of action being considered. Revenues and costs that are not relevant are
said to be irrelevant. It is important to recognize that to be relevant costs and relevant revenues they
must:
Occur in the future—every decision deals with selecting a course of action based on its expected future
results.
Differ among the alternative courses of action—costs and revenues that do not differ will not matter
and, hence, will have no bearing on the decision being made.
Key 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.
Qualitative and Quantitative Relevant Information
Managers divide the outcomes of decisions into two broad categories: quantitative and qualitative.
Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are
financial; they can be expressed in monetary terms. Examples include the cost of direct materials, direct
manufacturing labor, and marketing. Other quantitative factors are nonfinancial; they can be measured
numerically, but they are not expressed in monetary terms. Reduction in new product-development time and
the percentage of on-time flight arrivals are examples of quantitative nonfinancial factors.
Qualitative factors are outcomes that are difficult to measure accurately in numerical terms. Employee morale
is an example.

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An Illustration of Relevance
One-Time-Only Special Orders
One type of decision that affects output levels is accepting or rejecting special orders when there is idle
production capacity and the special orders have no long-run implications. We use the term one-time-only
special order to describe these conditions.
Example 1: Surf Gear manufactures quality beach towels at its highly automated Burlington, North
Carolina, plant. The plant has a production capacity of 48,000 towels each month. Current monthly
production is 30,000 towels. The company assumes all costs can be classified as either fixed or variable
with respect to a single cost driver (units of output). As a result of a strike at its existing towel supplier,
Azelia, a luxury hotel chain, has offered to buy 5,000 towels from Surf Gear in August at $11 per towel.
No subsequent sales to Azelia are anticipated. Fixed manufacturing costs are based on the 48,000-towel
production capacity. That is, fixed manufacturing costs relate to the production capacity available and not
the actual capacity used. If Surf Gear accepts the special order, it will use existing idle capacity to
produce the 5,000 towels, and fixed manufacturing costs will not change. No marketing costs will be
necessary for the 5,000-unit one-time-only special order. Accepting this special order is not expected to
affect the selling price or the quantity of towels sold to regular customers. Should Surf Gear accept

Azelia’s offer?
The relevant revenues and costs are the expected future revenues and costs that differ as a result of
accepting the special offer revenues of $55,000 ($11 per unit * 5,000 units) and variable manufacturing
costs of $37,500 ($7.50 per unit* 5,000 units). The fixed manufacturing costs and all marketing costs

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(including variable marketing costs) are irrelevant in this case because these costs will not change in total
whether the special order is accepted or rejected. Surf Gear would gain an additional $17,500 (relevant
revenues, $55,000 – relevant costs, $37,500) in operating income by accepting the special order.
Potential Problems in Relevant-Cost Analysis
Managers should avoid two potential problems in relevant-cost analysis.
First, they must watch for incorrect general assumptions, such as all variable costs are relevant and all
fixed costs are irrelevant.
Second, unit-cost data can potentially mislead decision makers in two ways: When irrelevant costs are
included and when the same unit costs are used at different output levels.
The best way for managers to avoid these two potential problems is to keep focusing on (1) total
revenues and total costs (rather than unit revenue and unit cost) and (2) the relevance concept. Managers
should always require all items included in an analysis to be expected total future revenues and expected
total future costs that differ among the alternatives.
In sourcing-versus-Outsourcing and Make-versus-Buy Decisions
Outsourcing is purchasing goods and services from outside vendors rather than producing the same
goods or providing the same services within the organization, which is in sourcing. For example, Kodak
prefers to manufacture its own film (in sourcing) but has IBM do its data processing (outsourcing).
Honda relies on outside vendors to supply some component parts but chooses to manufacture other parts
internally.
Decisions about whether a producer of goods or services will insource or outsource are also called make-
or-buy decisions. Surveys of companies indicate that managers consider quality, dependability of
suppliers, and costs as the most important factors in the make-or-buy decision. Sometimes, however,
qualitative factors dominate management’s make-or-buy decision.
Example 2: The Soho Company manufactures a two-in-one video system consisting of a DVD player
and a digital media receiver (that downloads movies and video from internet sites such as NetFlix).
Columns 1 and 2 of the following table show the expected total and per-unit costs for manufacturing the
DVD-player of the video system. Soho plans to manufacture the 250,000 units in 2,000 batches of 125
units each. Variable batch-level costs of $625 per batch vary with the number of batches, not the total
number of units produced.

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 Expected Total Costs of
Producing 250,000 Units in
2,000 Batches Next Year Expected Cost per Unit
(1) (2) = (1) ÷ 250,000

Direct materials ($36 per unit * 250,000 units) $ 9,000,000 $36.00

DL ($10 per unit *250,000 units) 2,500,000 10.00
VMOH cost of power and utilities
($6 per unit * 250,000 units) 1,500,000 6.00
Mixed batch-level MOH cost of materials
Handling and setup [$750,000 +
($625 per batch * 2,000 batches)] 2,000,000 8.00
Fixed MOH costs of plant lease, insurance,
And administration 3,000,000 12.00
Total manufacturing cost $18,000,000 $72.00
Broadfield, Inc., a manufacturer of DVD players, offers to sell Soho 250,000 DVD players next year for
$64 per unit on Soho’s preferred delivery schedule. Assume that financial factors will be the basis of this
make-or-buy decision. Should Soho make or buy the DVD player?
Based on the given information the company should buy DVD players because the expected $72-per-unit
cost of making the DVD player is more than the $64 per unit to buy it. But For the moment, suppose (a)
the capacity now used to make the DVD players will become idle next year if the DVD players are
purchased and (b) the $3,000,000 of fixed manufacturing overhead will continue to be incurred next year
regardless of the decision made. Assume the $750,000 in fixed salaries to support materials handling and
setup will not be incurred if the manufacture of DVD players is completely shut down.
Total Relevant Cost Relevant Costs per Unit

Relevant Items Make Buy Make Buy

Outside purchase of parts $16,000,000 $64
Direct materials $ 9,000,000 $36
Direct manufacturing labor 2,500,000 10
Variable manufacturing overhead 1,500,000 6
Mixed (variable and fixed) materials handling
And setup overhead 2,000,000 8
Total relevant costs $15,000,000 $16,000,000 $60 $64
Difference in favor of making
DVD players $1,000,000 $4
A common term in decision making is incremental cost. An incremental cost is the additional total cost
incurred for an activity.
The incremental cost of making DVD players is the additional total cost of $15,000,000 that Soho will
incur if it decides to make DVD players. Similarly, the incremental cost of buying DVD players from

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Broadfield is the additional total cost of $16,000,000 that Soho will incur if it decides to buy DVD
players. A differential cost is the difference in total cost between two alternatives.
Opportunity Costs and Outsourcing
In the simple make-or-buy decision, we assumed that the capacity currently used to make DVD players
will remain idle if Soho purchases the parts from Broadfield. Often, however, the released capacity can
be used for other, profitable purposes. In this case, the choice Soho’s managers are faced with is not
whether to make or buy; the choice now centers on how best to use available production capacity.
Example 3: Suppose that if Soho decides to buy DVD players for its video systems from Broadfield,
then Soho’s best use of the capacity that becomes available is to produce 100,000 Digiteks, a portable,
stand-alone DVD player. From a manufacturing standpoint, Digiteks are similar to DVD players made
for the video system. With help from operating managers, Soho’s management accountant estimates the
following future revenues and costs if Soho decides to manufacture and sell Digiteks:
Incremental future revenues…………………………………………………………. $8,000,000
Incremental future costs
Direct materials………………………………………………. $3,400,000
Direct manufacturing labor……………………………………. 1,000,000
Variable overhead (such as power, utilities)…………………….. 600,000
Materials-handling and setup overheads …………………………500,000
Total incremental future costs ………………………………………………………..$5,500,000
Incremental future operating income…………………………………………………. $2,500,000
Because of capacity constraints, Soho can make either DVD players for its video-system unit or Digiteks,
but not both. Which of the following two alternatives should Soho choose?
1. Make video-system DVD players and do not make Digiteks
2. Buy video-system DVD players and make Digiteks
The future incremental costs of buying video-system DVD players from an outside supplier
($16,000,000) exceed the future incremental costs of making video-system DVD players in-house
($15,000,000). Soho can use the capacity freed up by buying video-system DVD players to gain
$2,500,000 in operating income (incremental future revenues of $8,000,000 minus total incremental
future costs of $5,500,000) by making and selling Digiteks. The net relevant costs of buying video-
system DVD players and making and selling Digiteks are $16,000,000 – $2,500,000 = $13,500,000.

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We now examine how the concept of relevance applies to product-mix decisions—the decisions made
by a company about which products to sell and in what quantities.
These decisions usually have only a short-run focus, because they typically arise in the context of
capacity constraints that can be relaxed in the long run. In the short run, for example, BMW, the German
car manufacturer, continually adapts the mix of its different models of cars (for example, 325i, 525i, and
740i) to fluctuations in selling prices and demand.
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, at its
Lexington, Kentucky, plant.
Snowmobile Engine Boat Engine
Selling price …………………………………………………. $800………………………. $1,000
Variable cost per unit …………………………………………560……………………………625
Contribution margin per unit………………………………..$240………………………….. $375
Contribution margin percentage ($240 ÷ $800; $375 ÷ $1,000) 30% ……………………….37.5%
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 contribution
margin per unit of the constraining resource (factor). That’s the resource that restricts or limits the
production or sale of products.

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 Snowmobile Engine Boat Engine
Contribution margin per unit ………………………………..$240…………………………. $375
Machine-hours required producing one unit…………. 2 machine-hours ……………5 machine-hours
Contribution margin per machine-hour
$240 per unit ÷ 2 machine-hours/unit ………………………. $120/machine-hour
$375 per unit ÷ 5 machine-hours/unit…………………………………………………... $75/machine-hour
Total contribution margin for 600 machine-hours
$120/machine-hour * 600 machine-hours……………………$72,000
$75/machine-hour * 600 machine-hours …………………………………………………. $45,000
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.
Customer Profitability (Dropping a Customer, Adding a Customer, Closing or Adding Branch
Offices or Segments)
Not only must companies make choices regarding which products and how much of each product to
produce, they must often make decisions about adding or dropping a product line or a business segment.
Similarly, if the cost object is a customer, companies must make decisions about adding or dropping
customers (analogous to a product line) or a branch office (analogous to a business segment). We
illustrate relevant-revenue and relevant-cost analysis for these kinds of decisions using customers rather
than products as the cost object.
Example 5: Allied West, the West Coast sales office of Allied Furniture, a wholesaler of specialized
furniture, supplies furniture to three local retailers: Vogel, Brenner, and Wisk. The Expected revenues
and costs of Allied West by customer for the upcoming year using its activity-based costing system.
Allied West assigns costs to customers based on the activities needed to support each customer.
Information on Allied West’s costs for different activities at various levels of the cost hierarchy follows:
 Furniture-handling labor costs vary with the number of units of furniture shipped to customers.
 Allied West reserves different areas of the warehouse to stock furniture for different customers.
For simplicity, assume that furniture-handling equipment in an area and depreciation costs on the
equipment that Allied West has already acquired are identified with individual customers
(customer level costs). Any unused equipment remains idle. The equipment has a one year useful
life and zero disposal value.

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  Allied West allocates rent to each customer on the basis of the amount of warehouse space
reserved for that customer.
 Marketing costs vary with the number of sales visits made to customers.
 Sales-order costs are batch-level costs that vary with the number of sales orders received from
customers; delivery-processing costs are batch-level costs that vary with the number of shipments
made.
 Allied West allocates fixed general-administration costs (facility-level costs) to customers on the
basis of customer revenues.
 Allied Furniture allocates its fixed corporate-office costs to sales offices on the basis of the
square feet area of each sales office. Allied West then allocates these costs to customers on the
basis of customer revenues.
Customer
Vogel Brenner Wisk Total
Revenues ……………………………………………. $500,000 $300,000 $400,000 $1,200,000
Cost of goods sold ……………………………………370,000 220,000 330,000 920,000
Furniture-handling labor ………………………………41,000 18,000 33,000 92,000
Furniture-handling equipment
Cost written off as depreciation ……………………….. 12,000 4,000 9,000 25,000
Rent ……………………………………………………14,000 8,000 14,000 36,000
Marketing support…………………………………….. 11,000 9,000 10,000 30,000
Sales-order and delivery processing………………….. 13,000 7,000 12,000 32,000
General administration………………………………... 20,000 12,000 16,000 48,000
Allocated corporate-office costs……………………… 10,000 6,000 8,000 24,000
Total costs…………………………………………… 491,000 284,000 432,000 1,207,000
Operating income ……………………………………..$ 9,000 $16,000 $ (32,000) $ (7,000)
To determine what to do, Allied West’s managers must answer the question, what are the relevant
revenues and relevant costs? Information about the effect of dropping the Wisk account follows:
 Dropping the Wisk account will save cost of goods sold, furniture-handling labor, marketing
support, sales-order, and delivery-processing costs incurred on the account.
 Dropping the Wisk account will leave idle the warehouse space and furniture handling
equipment currently used to supply products to Wisk.

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  Dropping the Wisk account will have no effect on fixed general-administration costs or
corporate-office costs.
Should Allied West drop the Wisk account? Should it add a fourth customer, Loral? Should Allied
Furniture close down Allied West? Should it open another sales office, Allied South, whose revenues
and costs are identical to those of Allied West?
ADD customer
Suppose that in addition to Vogel, Brenner, and Wisk, Allied West’s managers are evaluating the
profitability of adding a customer, Loral. Loral has a customer profile much like Wisk’s. Suppose Allied
West’s managers predict revenues and costs of doing business with Loral to be the same as the revenues
and costs described under the Wisk column.
Allied West would have to acquire furniture-handling equipment for the Loral account costing $9,000,
with a one-year useful life and zero disposal value. If Loral is added as a customer, warehouse rent costs
($36,000), general-administration costs ($48,000), and actual total corporate-office costs will not change.
Should Allied West add Loral as a customer?
CLOSE Allied west’s
Given Allied West’s expected loss of $7,000, should it be closed for the year? Assume that closing Allied
West will have no effect on total corporate-office costs and that there is no alternative use for the Allied
West space.
OPEN BRANCHE
Now suppose Allied Furniture has the opportunity to open another sales office, Allied South, whose
revenues and costs would be identical to Allied West’s costs, including a cost of $25,000 to acquire
furniture-handling equipment with a one-year useful life and zero disposal value. Opening this office will
have no effect on total corporate-office costs.

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