Chapter 5

RELEVANT INFORMATION FOR

DECISION MAKING

MA. Le Hoang Oanh

LEARNING OBJECTIVES

Identify relevant and irrelevant costs and benefits in

a decision
Using relevant costs for decision making
IDENTIFY RELEVANT AND
IRRELEVANT COSTS AND
BENEFITS IN A DECISION
DECISION MAKING

Definition
Decision making is a process of choosing among
alternative courses of action in order to attain goals
and objectives

2
1
Relevant Information

Relevant Information
differs between the alternatives
under consideration and is
future oriented.

Sunk Cost
has already been incurred in a
past transaction, and cannot be
avoided. Not a relevant cost.
Relevant Revenues and Costs

Relevant Revenues
are expected future revenues that
differ between the alternatives
under consideration.

Relevant Costs
are avoidable costs that can be
eliminated by taking a specified
course of action.
 Relevance is an Independent Concept

The management of Better Bakery is trying to decide

whether the production of cakes or pies would be
more profitable.

Cost of Cost of
Cakes Pies
relevant Materials (per unit) $ 1.50 $ 2.00
not relevant because the same Direct Labour (per unit) 1.00 1.00
not relevant
Supervisor's Salary 25,000 25,000
relevant Franchise Fee 50,000
relevant Advertising 40,000
Relevance is an Independent Concept

The cakes will be distributed under a nationally

advertised label and requires a franchise fee. The
pies will be sold under Better Bakery’s own name
and additional advertising is necessary.
For either alternative we will hire a production
supervisor at a cost of $25,000.

Which costs are relevant?

Relevance is an Independent Concept

We could avoid 50¢ of

materials by choosing to
make cakes instead of pies!
So, this is a relevant cost.
Relevance is an Independent Concept

Labour costs are the same

under either alternative, so they
are not relevant. The same
for the supervisor’s salary.
Relevance is an Independent Concept

We can
avoid the
franchise fee
if we make
pies!
I know. But, we can avoid
the advertising costs if we
make cakes.
Opportunity Costs are Relevant

Opportunity Cost
The sacrifice of a potential benefit
associated with a lost opportunity.

By attending college, you

miss the opportunity to
earn a salary by working
full time.
RELEVANT COST ANALYSIS
Example1:
Rita Company is anxious about two alternatives – remains
using old machine or replaces old machine by new one.
Information related two alternatives is given as follows
(Table1):
Old machine New machine
Original Cost $120,000 $140,000
Remaining book value 80,000 140,000
Remaining life 5 years 5 years
Disposal value now 50,000
Annual variable exp to operate 60,000 40,000
Revenue per year 100,000 100,000
 TOTAL COST APPROACH

Table 2a: Estimated Income statements of two

machines over 5 years
Dr 214 40.000 dr 111 50.000 Old New Differential
dr 811 80.000 cr 711 50.000 machine machine income
cr 211 120.000

Sales 5y 500.000 500.000 -

Annual variable exp to operate (300.000) (200.000) 100.000

New machine, Dep exp 0 (140.000) (140.000)

Old machine, Dep exp (80.000) (80.000) -

Disposal value of the old machine 50.000

- 50.000
now
Total net O.I over the 5 years
 RELEVANT COST ANALYSIS

Table 2b: Relevant information analysis

Old New Differential

machine machine income
Annual variable exp to operate (300,000) (200,000) 100,000
New machine, Dep exp 0 (140,000) (140,000)
Disposal value of the old 50,000 50,000
machine now
Total (300,000) (290,000) 10,000
RELEVANT COST ANALYSIS
Example 2:
Nazi Company is contemplating the purchases of a new laborsaving
machine. The machine will cost $15,000 and have a 10-year useful
life. The company’s sales and cost structure on an annual basis with
and without the new machine are shown bellow (table 3) :
Current Expected costs with
costs the new machine
Units produced and sold 3,000 3,000
Selling price per unit 10 10
Direct materials cost per unit 3 3
Direct labor cost per unit 2.5 1.5
Variable Mfg overhead per unit 1 1
Fixed costs, other 4,500 4,500
Fixed costs, new machine 1,500
RELEVANT COST ANALYSIS

Table 4a: Estimated Income statements

Without new New Differential

machine machine income
Sales 30.000 30.000 -
Variable expenses 19.500 16.500

Direct materials 3*3000=9000 3*3000=9000 -

Direct labor 2.5*3000=7.500 1.5*3000=4.500 3000

Variable overhead 3000

3000 -

Contribution margin 10.5 13.5 3000

Less fixed expenses 4.500 6000 (1500)

Net operating income 6000 7.500 1500

RELEVANT COST ANALYSIS

Table 4b: Relevant information analysis

Without new New Differential

machine machine income
Direct labor (7,500) (4,500) 3,000
Fixed expenses (4,500) (6,000) (1,500)
Total (12,000) (10,500) 1,500
APPLICATION OF RELEVANT
INFORMATION
FOR DECISION MAKING
APPLICATION OF RELEVANT INF FOR DECISION MAKING

Keep old machine or

Purchase new machine

Utilization of a Retaining or
constrained dropping
resource Decision segments
making

Sell or process Make or buy

further
APPLICATION OF RELEVANT INFORMATION
FOR DECISION MAKING

Prepare an analysis
showing whether a product
line or other business
segment should be dropped
or retained.
 RETAINING OR DROPPING SEGMENTS
Exam 3: Winglet company’s Segment I.S for the month of January
short term decision Product line
Item Total Yogurt Fresh Milk Elderly Milk powder

Sales 400,000 40,000 120,000 240,000

Less Variable costs 155,000 25,000 30,000 100,000
Contribution margin 245,000 15,000 90,000 140,000
Less segment fixed costs
- Salaries 26,700 5,700 6,000 15,000
- Depreciation - fixtures 64,000 2,000 12,000 50,000
- Advertising 17,800 4,000 3,800 10,000
- Short-term Rent - shop 38,500 6,300 7,200 25,000
- Long-term insurance 9,000 1,000 3,000 5,000
(3000)
Segment margin số dư bộ phận 89,000 (4,000) 58,000 35,000
Less common FC* all product 80,000 8,000 24,000 48,000
Net operating income 9,000 (12,000) 34,000 (13,000)
RETAINING OR DROPPING SEGMENTS

(*: including costs of factory space rent used to produce all

types of product, utility, advertising for company benefits,
administrative labor, depreciation of equipment used in office)

Requirements:
1) Should the Winglet retain or drop the Yogurt segment?
2) Should the Winglet retain or drop the Elderly milk powder
segment?
RETAINING OR DROPPING SEGMENTS

PRINCIPLES

If dropping the segment: Compare

Loss = Contribution margin 15.000

Gain = Savings avoidable segment FC 16000

If Loss < Gain à should drop

Or : Compare
+ Retaining: Segment margin = Current segment margin
+ Dropping: Segment margin = - unavoidable segment FC
If segment margin (retaining) < segment margin (dropping)
à Should drop
RETAINING OR DROPPING SEGMENTS

1) If the yogurt line is dropped:

Loss = CM margin (15000)

Gain = Savings avoidable fixed costs 16000

Segment salaries 5700

4000
Advertising
Short-term shop rent 6300

à …..crease
in in net operating income 1000
if dropping yogurt

drop
RETAINING OR DROPPING SEGMENTS

1) 2nd Way:
Keep Drop Differential
Yogurt Yogurt net income
CM
Segment fixed exp

Segment margin
 RETAINING OR DROPPING SEGMENTS – TRY
AGAIN
Product line
Item Total Yogurt Fresh Milk Elderly Milk
powder
Sales 360,000 - 120,000 240,000
Less Variable costs 130,000 - 30,000 100,000
Contribution margin 230,000 - 90,000 140,000
Less segment FC
- Salaries 21,000 - 6,000 15,000
- Depreciation - fixtures 64,000 2,000 12,000 50,000
- Advertising 13,800 - 3,800 10,000
- Short-term Rent - shop 32,200 - 7,200 25,000
- Long-term insurance 9,000 1,000 3,000 5,000
Segment margin 90,000 (3,000) 58,000 35,000
Less common FC* 80,000 26,667 53,333
Net operating income 10,000 (3,000) 31,333 (18,333)
RETAINING OR DROPPING SEGMENTS

First let’s look at incorrect reasoning

that leads to an incorrect decision.

Elderly milk powder has

a loss. I do not want
to retain it
RETAINING OR DROPPING SEGMENTS
2) If the elderly milk powder line is discontinued
Loss = CM margin
Gain = Savings avoidable segment FC
Segment salaries
Advertising
Short-term shop rent
….crease in net operating income

retai
n
RETAINING OR DROPPING SEGMENTS

2) 2nd Way:
Keep Drop Differential
elderly milk elderly milk net income
powder powder
CM 15.000 - (15000)

Segment FC (19.000) (3000) 16000

Segment margin (4.000) (3000) 1000

In conclusion, when Winglet hasn’t got the alternative

better than the alternative of dropping the elderly milk
powder line, it should continue this segment.
RETAINING OR DROPPING SEGMENTS – TRY
AGAIN
Product line
Item Total Yogurt Fresh Elderly Milk
Milk powder
Sales 120,000 - 120,000 -
Less Variable costs 30,000 - 30,000 -
Contribution margin 90,000 - 90,000 -
Less traceable fixed costs
- Salaries 6,000 - 6,000 -
- Depreciation - fixtures 64,000 2,000 12,000 50,000
- Advertising 3,800 - 3,800 -
- Short-term Rent - shop 7,200 - 7,200 -
- Long-term insurance 9,000 1,000 3,000 5,000
Product line segment margin 0 (3,000) 58,000 (55,000)
Less common fixed exp* 80,000 - 80,000 -
Net operating income (80,000) (3,000) (22,000) (55,000)
APPLICATION OF RELEVANT INFORMATION
FOR DECISION MAKING

Prepare a make or buy

analysis.
MAKE OR BUY DECISION

A decision concerning whether an item should be produced

internally or purchased from an outside supplier is often
called a “make or buy” decision.

.
Make or Buy Decisions
Quantitative Should I
Factors continue to make
the part, or should
I buy it?

Number of available
I suppose I suppliers? Production
should compare capacity available?
the outside purchase
price with the additional
costs to manufacture
the part. What will I
do with my
idle facilities if
I buy the part?
Make or Buy Decisions
– Reliability of supply sources
Qualitative – Ability to control quality of items
Factors purchased outside

– Nature/importance of the
work to be subcontracted
– Impact on customers and
markets
– Outsourcing usually involves
employee
displacement.

– Future bargaining position with supplier(s)

MAKE OR BUY DECISION
Example 4:
Nathan company annually manufactures 50,000 parts C
that are used in one of its products. The unit product cost of
part C is:
Item Per unit Total
- Direct materials 30 1,500,000
- Direct labor 16 800,000
- Variable overhead 5 250,000
- Supervisor’s salary 2 100,000
- Depreciation of special 13 650,000
equipment
- Allocated general overhead 14 700,000
Total 80 4,000,000
MAKE OR BUY DECISION

An outside supplier has offered to provide the 50,000

parts C at a cost of $60 per part with the required quality.
Should the company accept the supplier’s offer?
MAKE OR BUY DECISION
Make Buy Different costs
Item
Per Total Per Total Per Total
unit unit unit
- Direct materials 30 1500000 30 1500000

- Direct labor 16 800000 16 800000

- Variable overhead 5 250000 5 250000

- Supervisor’s salary 2 100000 2

100000
- Outside purchase 60 3000000 60 (3000000)
price
Total 53 2650000 3000000
7 (350000)

Wow, that’s
à Nathan Company making ……. deal!
Part C would ………… $............
à Should ………… part C
MAKE OR BUY DECISION

Example 4 (cont.):
Assume that the space now could be used to produce a
new product that would generate a contribution margin of
$500,000
Should the company accept the supplier’s offer?
MAKE OR BUY DECISION
Make Buy Different costs

Item
Per Total Per Total Per Total
unit unit unit
- Direct materials 30 1,500,000 - - 30 1,500,000
- Direct labor 16 800,000 - - 16 800,000
- Variable overhead 5 250,000 - - 5 250,000
- Supervisor’s salary 2 100,000 - - 2 100,000
- Opportunity COST 10 500000 (10) (500.000) 10 500000
income of new product
- Outside purchase - - 60 3,000,000 (60) (3,000,000)
price
Total 63 3150000
60
3.000.000 3 150.000

à Nathan purchases parts C and manufactures new product would ………..........

$....................
à Should ………………… the supplier’s offer.
APPLICATION OF CVP RELATIONSHIP
FOR DECISION MAKING

Prepare an analysis
showing whether joint
products should be sold
at the split-off point or
processed further.
JOINT PRODUCTS

In some industries, a number of end products are

produced from a single raw material input.

Two or more products produced from a common input

are called joint products.

The point in the manufacturing process where each

joint product can be recognized as a separate product
is called the split-off point.
JOINT PRODUCTS

Joint
Costs Oil
Separate Final
Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
JOINT PRODUCTS

Semi-finished Final
Product A sale
Common
Joint Semi-finished Separate Product Final
Product
input Product B processing B’ sale
process
Semi-finished Separate Product Final
Product C processing C’ sale

Joint product Split-off point

costs Separate product
costs
SELL OR PROCESS FURTHER
Which product should be sold at Split-off point?
Which product should be processed further?
PRINCIPLES

Incremental revenue > Incremental costs Process further

sell finished product
Sold at split-off
Incremental revenue < Incremental costs
point
sell semi finished product

Incremental revenue = Sales value at after further processing

– Sales value at the split-off point

Incremental costs = Cost of further processing

(cost of separate processing)
SELL OR PROCESS FURTHER
Example 5: Using joint inputs by common production process,
Rose company produces 3 semi-finished products of B, C and
D. Then, those semi-finished products can be produced into
finished products of B’, C’ and D’
Product Product Product
B B’ C C’ D D’
- Sales value at the split-off 300 450 700
point
- Sales value after further 500 600 900
processing
- Allocated joint product costs 200 300 500
- Cost of further processing 220 100 160

Which product should be sold at Split-off point?

Which product should be processed further?
SELL OR PROCESS FURTHER

Types of products
B’ C’ D’
- Incremental revenue from further
processing
- Cost of further processing
- Incremental (decremental) income
from further processing

We should process Product “…..” and “…..” further

and sell Product “……” at the split-off point.

UTILIZATION OF A CONSTRAINED
RESOURCE

Determine the most

profitable use of a
constrained resource and
the value of obtaining more
of the constrained resource.
KEY TERMS AND CONCEPTS

When a limited resource

of some type restricts
the company’s ability to
satisfy demand, the
company is said to have
a constraint.

The machine or process

that is limiting overall
output is called the
bottleneck – it is the
constraint.
UTILIZATION OF A CONSTRAINED RESOURCE
When a constraint exists, a company should select a
product mix that maximizes the total contribution margin
earned since fixed costs usually remain unchanged.

A company should not necessarily promote those products

that have the highest unit contribution margin.

Rather, it should promote those products that earn the

highest contribution margin in relation to the constraining
resource.
UTILIZATION OF A CONSTRAINED
RESOURCE
1 CONSTRAINED RESOURCE
Ex6: The machine of Caltex corporation has a capacity of
6,000 hours per year used for manufacturing two kinds of
products, including M and N
Product M Product N
Selling price per unit 800 700
Variable costs per unit 400 420
Maximum numbers of 1,500 3,000
units sold
Machine hour per unit 4 2
Fixed costs 360,000
Should the Caltex focus its efforts on Product M or Product N?
UTILIZATION OF A CONSTRAINED
RESOURCE
1 CONSTRAINED RESOURCE

Product M Product N
SP/u 800 700 CM of M> CM of N
(-) VC/u 400 420 àShould choose M?
CM/u 400 280
(/) MH/u
CM/MH
Total MH
Total CM
Should choose product ……...
UTILIZATION OF A CONSTRAINED
RESOURCE
2 CONSTRAINED RESOURCES
Ex7: The machine of Caltex corporation has a capacity of 6,000
hours per year used for manufacturing two kinds of products,
including M and N
Product M Product N
Selling price per unit 800 700
Variable costs per unit 400 420
Maximum numbers of units sold 1,000 2,000
Machine hour per unit 4 2
Fixed costs 360,000

Which products should be sold and how much in order to

maximizing the profit?
UTILIZATION OF A CONSTRAINED RESOURCE
2 CONSTRAINED RESOURCE
Product M Product N
SP/u 800 700
(-) VC/u 400 420
CM/u 400 280
(/) MH/u
CM/MH
à in order to maximizing profit, the company should give priority to
produce Product …… and satisfy the entire market demand. The rest
surplus capacity should be used to produce Product …….
Product N: Number of units produced : …………….. units
Product M: Number of units produced: ………………… units
Retain/drop segment: E12.13
Make/Buy: E12.12
Sell/process: E12.8
Constraining factor: E12.13
Special orders: E12.4
Market demand: 900 units for product A; 2,000 units for
product B and 500 units for product C.
How many units the company should produce for each
products for maximizing its profit?