Topic 6

Relevant Information for

Decision Making
 Learning Objectives
LO1: Distinguish between relevant and irrelevant costs and
revenues
LO2: Explain the importance of qualitative factors in
relevant costs
LO3: Consider relevance in relation to various situations,
i.e.
1. Make or buy (in-house or outsource)
2. Continue or discontinue
3. Special order
4. Limiting factor
 Relevant/Irrelevant costs

RELEVANT COSTING

• Internal decision makers are faced with tough

decisions on a regular basis. When faced with
a financial decision, managers are often
overwhelmed by a mountain of information.
• Relevant costing is the process of
determining which pieces of information are
relevant to the decision at hand.
 Relevant costs

DETERMINING RELEVANT COSTS

• To be relevant to a management decision,

information must possess BOTH of these
characteristics:
• it must be a future cost or revenue, and
• it must differ between decision alternatives.

• Reasoned decision makers use only relevant

information when making an economic decision.
 Relevant costs

DIFFERENTIAL COSTS

• Differential costs is the difference in total

cost between two alternatives
• Eg: the difference in total cost between the
make-parts and buy-parts of products
 Relevant costs

AVOIDABLE COSTS

• Are costs that can be eliminated by choosing

on alternative over another
• Ex: the wages of the foreman for a product line
that can be saved when that product line is
discontinued
 Relevant costs

OPPORTUNITY COSTS

• An opportunity cost is something of value that

is given up when one alternative is chosen over
another.
• There is usually an opportunity cost involved
when faced with a make or buy decision. If we
choose not to make an item, those productive
resources can usually be put to a profitable
alternative use.
 EXAMPLES OF OPPORTUNITY
COST

• Example 1 Vicki has a part-time job that pays $200 per

week while attending college. She would like to spend a
week at the beach during spring break, and her employer
has agreed to give her the time off, but without pay. The
$200 in lost wages would be an opportunity cost of
taking the week off to be at the beach.
• Example 2 Steve is employed by a company that pays
him a salary of $38,000 per year. He is thinking about
leaving the company and returning to school. Because
returning to school would require that he give up his
$38,000 salary, the forgone salary would be an
opportunity cost of seeking further education.
 Irrelevant costs

UNAVOIDABLE COSTS

• Are costs that do not differ between the

alternatives.
• Eg: the rental costs of a factory having
numerous product line that would not be
reduced even though one of its product
line is discontinued.
 Irrelevant costs

SUNK COST
• A sunk cost is a past cost that cannot be
changed by current or future actions.
• Examples of sunk costs:
• Equipment, land, or buildings purchased in
the past
• Equipment leased on a long-term lease
• New vehicle purchased and used
• One-year old computer equipment
 Irrelevant costs

- Irrelevant information possesses either of the

following characteristics:

it is a sunk cost or revenue, or

it does not differ between alternatives.
- Irrelevant costs are those that are not affected by
the decision making
Irrelevant costs include
(1) Fixed costs
(2) Depreciation
(3) Sunk costs
A cost can be relevant or irrelevant depends upon
the circumstances in the decision
 Decision Making

- - A decision model is a formal method for

making a choice, often involving
quantitative and qualitative analysis.
- + A decision making involves choosing
among alternative course of action,
based on both quantitative and
qualitative factors.
 Decision Making

QUANTITATIVE OR QUALITATIVE FACTORS?

• Quantitative factors can be expressed as a

number.
• Qualitative factors cannot be expressed
numerically and must be described in words. They
cannot be expressed in monetary terms

• Most management decisions require the

consideration of both quantitative and qualitative
factors.
 Decision Making
QUANTITATIVE OR QUALITATIVE FACTORS?

• Eg: Consider that management wants to purchase a new copier.

• Quantitative factors include:
• Cost of the machine; Cost of machine maintenance
• Cost per copy of supplies
• Qualitative factors include:
- Ease of operation; Quality of copies made
- Change in environment for users (noise, heat, etc.)
- A decline in employee morale that results from redundancies
arising from a closure
- The decision to purchase from an outside supplier which has
cheaper price could result in the closing down of the company’s
facilities for manufacturing the component.
 Decision Making

Variety short-term business decisions:

1. Equipment replacement(hire or buy)
2. Special order decisions(accept or reject orders)
3. Make or buy decisions( in-house/ insourcing or
outsourcing)
4. Limiting factors
5. Continue or discontinue decisions(eliminate or retain
an unprofitable segment decisions)
 RELEVANT COST FOR DECISION
MAKING

• When making a relevant cost decision, follow

these steps in the process:
• Step 1: Gather all costs/revenues associated
with the decision.
• Step 2: Determine the relevant cost/revenues
of each alternative.
• Step 3: Compare relevant costs/revenues and
select an alternative.
 Relevant cost for Decision Making

MAKE OR BUY DECISION

• Some companies purchase certain products or parts

instead of manufacturing them. Each product or part
represents a separate make or buy decision.
• When a company chooses to purchase a service,
product, or part from an outside vendor, it is called
outsourcing.
 Relevant cost for Decision Making

Make or Buy Decision

Outsourcing : buy (purchase)

In house : manufacture (make)
The relevant cost is the differential costs
between the two options.
 Relevant cost for Decision Making

Make or Buy
Example: The EFG Company currently manufactures all of
the parts used in the production of remote control toy cars.

The EFG Company

Per Unit Total
Units currently manufactured 1 30,000

Manufacturing costs:
Direct materials cost $ 2.50 $ 75,000
Direct labor cost 1.50 45,000
Variable overhead cost 1.00 30,000
Fixed overhead cost 2.00 60,000
Total costs $ 7.00 $ 210,000
 Relevant cost for Decision Making

MAKE OR BUY

EXAMPLE

A company has offered to supply the remote control

device at a cost of $5.50 per unit. Quality and availability
of the controls is not an issue.
Question 1: Should EFG agree the offer?
Question 2: Assume that the EFG Company would
experience a $20,000 reduction in their fixed overhead
costs if they started to buy the remote controls from the
outside vendor. Should EFG agree the offer?
Make or Buy Example

QUESTION 1: RELEVANT COST COMPARISON

Make Buy Difference(Cost

saving or wasting
when making)
Units 30,000 30,000 0
Cost to purchase 165,000 (165,000)
(5.5/unit)
Direct material 75,000 75,000
cost
Direct labour cost 45,000 45,000
Variable costs 30,000 30,000

Total variable costs 150,000 165,000 (15,000)

Make or Buy Example

QUESTION 2: RELEVANT COST COMPARISON

Make Buy Difference(Cost saving

or wasting when
making)
Units 30,000 30,000 0
Cost to purchase 165,000 (165,000)
(5.5/unit)
Direct material cost 75,000 75,000

Direct labour cost 45,000 45,000

Variable cost 30,000 30,000
Fixed cost 60,000 40,000 20,000
Total costs 210,000 205,000 5,000
To p r o v i d e a n i l l u s t r a t i o n o f a m a k e o r b u y d e c i s i o n , c o n s i d e r m o u n t a i n
g o a t c yc l e s . T h e c o m p a n y i s n o w p ro d u c i n g t h e h e a v y - d u t y g e a r
s h i f t e rs u s e d i n i t s m o s t p o p u l a r l i n e o f m o u n t a i n b i k e s . T h e c o m p a n y’s
accounting department reports the following costs of producing 8,000
u n i t s o f t h e s h i f t e r i n t e rn a l l y e a c h ye a r:

An outside supplier has offered to sell 8,000 shifters a year to

Mountain Goat Cycles at a price of only $19 each. Should the
company stop producing the shifters internally and buy them
from the outside supplier?
EXERCISE 12–3 make or buy a component [LO3]
troy engines, ltd., Manufact ur e s a variet y of engines for use in
h e a v y e q u i p m e n t . T h e c o m p a n y h a s a l wa ys p ro d u c e d a l l o f t h e
necessary parts for its engines, including all of the
c arburet o rs . A n out s i de s uppl i er has off ered t o s el l one t ype
of carburetor to troy engines, ltd., For a cost of $35 per unit.
To e v a l u a t e t h i s o f f e r, t r o y e n g i n e s , l t d . , H a s g a t h e r e d t h e
following information relating to its own cost of producing the
carburetor internally :
REQUIRED:
A s s u m i n g t h a t t h e c o m p a n y h a s n o a l t e r n a t i ve u s e
for the facilities that are now being used to produce
t h e c a r b u r e t o r s , s h o u l d t h e o u t s i d e s u p p l i e r ’s o ff e r
be accepted? Show all computations.

S u p p o s e t h a t i f t h e c a r b u r e t o r s we r e p u r c h a s e d ,
troy engines, ltd., Could use the freed capacity to
l a u n c h a n e w p r o d u c t . Th e s e g m e n t m a r g i n o f t h e
n e w p r o d u c t wo u l d b e $ 1 5 0 , 0 0 0 p e r y e a r. S h o u l d
t r o y e n g i n e s , l t d . , A c c e p t t h e o ff e r t o b u y t h e
carburetors for $35 per unit? Show all
computations.
 SPECIAL ORDER DECISIONS

• A manufacturing company is sometimes presented with a

special order. Such an order usually includes:
- pricing decisions outside the main market
- involve one-time only orders or orders at a price below the
prevailing market price.
• The manufacturer must decide whether to accept or reject
the special order based on exists spare capacity within the
company:
a) If a company has spare capacity then the rule is to accept if
the product makes a contribution to fixed costs and profit
b) If no spare capacity then existing business should only be
turned away if the contribution from the order is greater than
the contribution from the business which must be sacrificed
 SPECIAL ORDER DECISIONS

• Quantitative factors to consider include:

• relevant manufacturing costs of the items,
• relevant selling/distribution costs of the items,
• selling price to be paid by the customer, and
• impact (if any) on regular sales volume.
• Qualitative factors may include the effect on the
workforce (avoid layoffs?), competitive
considerations, and prospects of future deals.
Special Order Decisions

EXAMPLE:

Assume that the

T he CBA Company Per Unit Total CBA Company
Units produced and sold 1 5,000 has received a
special order for
Normal selling price per unit $140.00 $ 700,000 1,000 units at a
price of $80 per
Direct materials cost 20.00 100,000
Direct labor cost 15.00 75,000 unit. Accepting
Variable overhead cost 10.00 50,000 this special order
Fixed overhead cost 30.00 150,000 will not have any
Variable selling cost 5.00 25,000 impact on CBAs
Fixed selling cost 20.00 100,000 normal sales
Total costs $100.00 $ 500,000 volume.
 Should CBA
accept the order?
Special Order Decisions
Example:

RELEVANT COST COMPARISON

The CBA Company Per Unit Total

Special order units 1 1,000

Special selling price per unit $ 80.00 $ 80,000

Relevant costs:
Direct materials cost 20.00 20,000
Direct labor cost 15.00 15,000
Variable overhead cost 10.00 10,000
Variable selling cost 5.00 5,000
Total costs $ 50.00 $ 50,000

Additional profit margin/CM $ 30.00 $ 30,000

EXERCISE 12–4 evaluati ng a special order [LO4]
i mp e r i a l j e w e l e r s i s c o n s i d e r i n g a s p e c i a l o r d e r f o r 2 0 h a n d c r a f t e d g o l d
b r a c e l e t s t o b e g i v e n a s g i f t s t o me m b e r s o f a w e d d i n g p a r t y. T h e n o r m a l
sellin g price of a gold bracelet is $189.95 and its unit product cost is
$149.00 as shown below :

Most of the manufacturing overhead is fixed and unaffected by variations in how much
jewelry is produced in any given period. However, $4.00 of the overhead is variable
with respect to the number of bracelets produced. The customer who is interested in
the special bracelet order would like special filigree applied to the bracelets. This
filigree would require additional materials costing $2.00 per bracelet and would also
require acquisition of a special tool costing $250 that would have no other use once
the special order is completed. This order would have no effect on the company’s
regular sales and the order could be fulfilled using the company’s existing capacity
without affecting any other order.
Required:
What effect would accepting this order have on the company’s net operating income if
a special price of $169.95 per bracelet is offered for this order? Should the special
order be accepted at this price?
 Relevant cost for Decision Making
Continue or discontinue

Example 1: The company is concerned about its poor profit performance,

and is considering whether or not to cease selling YY. It is felt that selling
prices cannot be raised or lowered without adversely affecting net income.
£5,000 of the fixed costs of YY are direct fixed costs which would be saved
if production ceased. All other fixed costs, it is considered, would remain the
same.
XX YY ZZ Total
Sales (£) 50000 40000 60000 150000
Variable cost (£) 30000 25000 25000 80000
Contribution (£) 20000 15000 35000 70000
Fixed cost (£) 17000 18000 20000 55000
Profit/loss (£) 3000 (3000) 15000 15000
Should the company stop producing YY?
 Relevant cost for Decision Making

Continue or discontinue
Example 1: The company is concerned about its poor profit performance,
and is considering whether or not to cease selling YY. It is felt that selling
prices cannot be raised or lowered without adversely affecting net income.
£5,000 of the fixed costs of YY are direct fixed costs which would be saved
if production ceased. All other fixed costs, it is considered, would remain the
same.
XX YY ZZ Total
Sales (£) 50000 40000 60000 150000
Variable cost (£) 30000 25000 25000 80000
Contribution (£) 20000 15000 35000 70000
Fixed cost (£) 17000 18000 20000 55000
Profit/loss (£) 3000 (3000) 15000 15000
By stopping production of YY, the consequence would be a £10,000 fall in
profits
Example 2: s ales and c os t inf or m ation f or the
prec eding m onth f or the dis c ount drug c om pany and its
thr ee m aj or produc t lines —dr u gs , c os m etic s , and
hous ewar es s how as belo w. A quic k r eview of this
report s ugges ts that dropping the hous ewar es s egm ent
would inc reas e the c om pany’s over all net operating
inc om e by $8,000. Should drop it or not?
 Relevant cost for Decision Making

Limiting factors

Limiting factor is a scarce resource which limits

the company from maximising its profits. It
could be sales, materials or labour.
Profits are maximised when contribution margin
is maximised per limiting factor.

Note: Limiting factors cover the product mix

decision when capacity constraints apply
 Relevant cost for Decision Making
Determine the profit-maximising production levels
Example 1:

Product Ace Product King Available

Direct materials (£) 2 4

Direct labour(£3 per hr) 6 3 8,000hrs

Variable overhead(£) 2 2
Sales price (£) 20 15
Sales demand (units) 3,000 5,000

Fixed cost equals to £5,000.

Determine the profit-maximising production levels?
 Relevant cost for Decision Making
Determine the profit-maximising production levels
Example:
Product Product
Step 3: Determine the profit-maximising King levels
production Total
Ace
Labour hours needed 6,000 5,000 11,000
(hrs)
Available hours (hrs) 8,000
Labour hour per unit 2 1
(hr/unit)
Contribution per unit 10 6
(£)
Contribution per unit ? ?
of the constrained
resource (£)
 Product Ace Product King Total

Labour hour per unit 2 1

(hr/unit)
Labour hours
Step 3: needed the profit-maximising
Determine 6,000 5,000 11,000
production levels
(hrs)
Contribution per unit 10 6
(£)
Contribution per unit 5 6
(£) per limiting factor
Products produced 1,500 5,000
(units)
Total contribution (£) 15,000 30,000 45,000
Fixed cost (£) 5,000
Profit (£) 40,000
 Relevant cost for Decision Making
Determine the profit-maximising production levels
Example 2:

Product A Product B Available

Direct materials (£2 per kg) 4 8 30,000 kg

Direct labour(£3 per hr) 9 4.5 10,000hrs

Variable overhead(£) 2 15,5

Sales price (£) 20 35
Sales demand (units) 3,000 5,000

Fixed cost equals to £5,000.

Determine the profit-maximising production levels?
 Relevant cost for Decision Making
Determine the profit-maximising production levels
Example 3:

Product A Product B Available

Direct materials (£2 per kg) £6 £4 15,000 kg

Direct labour(£3 per hr) £6 £3 12,000hrs

Variable overhead(£) £2 £2
Sales price (£) £20 £15
Sales demand (units) 3,000 units 5,000 units

Fixed cost equals to £5,000.

Determine the profit-maximising production levels?
E XA M P L E : M O U N TAIN GO AT C Y C LE S M AKE S
S AD D LE B A GS F O R B IC Y C LE S C ALLE D PA N N I E R S .
T H E S E PAN N IE R S C O M E IN T WO M O D E LS — A
TO U R IN G M O D E L AN D A M O U N TAIN M O D E L. C O S T
AN D R E V E N U E D ATA F O R T H E T W O M O D E LS O F
PAN N IE R S FO LLO W:
At m ountain goat cycles, the bottleneck ( i.E.,
Constraint) is a stitching m achine. The
m ountain pannier requires two m inutes of
stitching tim e per unit, and the touring pannier
requires one m inute of stitching tim e per unit.

By definition, because the stitching m achine is

a bottleneck, the stitching m achine does not
have enough capacity to satisfy the existing
dem and for m ountain panniers and touring
panniers therefore, som e orders for the
products will have to be turned down.

Which model should be turned down?

To verify that the touring model is indeed the more profitable
product, suppose an hour of additional stitching time is
available and that unfilled orders exist for both products. The
additional hour on the stitching machine could be used to
make either 30 mountain panniers (60 minutes 􏰁 2
minutes per mountain pannier) or 60 touring panniers (60
minutes 􏰁 1 minute per touring pannier), with the following
profit implications
1. EXERCISE 12–1 Identifying Relevant Costs-page 512
2. EXERCISE 12–2 Dropping or Retaining a Segment-page
513 (question 1)
3. EXERCISE 12–3 Make or Buy a Component-page 513
4. EXERCISE 12–4 Evaluating a Special Order-page 514
5. EXERCISE 12–5 Utilization of a Constrained Resource [-
page 514
HOMEWORKS
 REVISION QUESTIONS

1.“Variable costs and differential costs

mean the same thing.” Do you agree?
Explain.
2.“All future costs are relevant in decision
making.” Do you agree? Why?
3.How does opportunity cost enter into the
make or buy decision?
53