CHAPTER TWO:

RELEVANT INFORMATION AND DECISION MAKING

The Role of Accounting in special decisions:
The basic purpose of accounting is providing of relevant accounting information for users to
make decisions. Decision-making is the process of choosing among alternatives to change the
future in favor of the firm.
The basic role of management accountant in decision making process is to provide relevant
information to managers who make decision. For example, production managers make decisions
about alternative production process, marketing managers make pricing decisions etc. all of these
managers require relevant information that is pertinent for their decision.
Good accounting information helps an organization achieve its goal and objectives in the
following areas:
a. Scorekeeping: is the accumulation and classification of data which enables both internal
and external parties to evaluate organizational performance.
b. Attention directing: means reporting and interpreting information that helps management
to focus on operating problems, inefficiencies, and opportunities.
c. Problem solving: is the aspect of accounting that quantifies the likely result of several
alternatives and recommends the best alternative to follow.
Steps in decision making process
There are six steps that characterize the decision making process.
a. Define or clarify the decision problem
b. Identify alternative solutions to the problem
c. Evaluate alternatives through cost benefit analysis
d. Develop a decision model: brings the criterion, constraints and alternatives together.
e. Gather the data
f. Select an alternative
g. Implement and follow up
After the decision model is formulated and the pertinent data are collected, the management
makes a decision. The information that is to be provided by management accountant must fulfill
the following three characteristics: Relevance, Accuracy and Timeliness.
In general, the management accountant’s primary role in the decision making process is:

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  Decide what information is relevant to each decision problem
 Provide accurate and timely data
Relevant information
The most important element in decision-making process is identifying relevant and non-relevant
information (revenues and costs).
 The only revenues and costs that are relevant in making decisions are those expected
future revenues and costs that will differ among the alternatives. These are called
incremental or differential revenues and costs. The incremental costs are avoidable costs,
since a company can change a cost by taking one alternative as opposed to the other.
 On the other hand, irrelevant information is information that doesn’t help decision
making. Revenues and costs that have already earned or incurred are irrelevant
information in making decisions.
 Future costs and revenues that are the same across all alternatives are not relevant.
There are two other costs that should be encountered in making decisions.
 Opportunity cost: is the benefit lost by taking one alternative as opposed to the other. it
is relevant for decision making.
 Sunk cost: is a cost that has already been incurred and cannot be altered no matter which
decisions will be made. Sunk costs are irrelevant costs for decision making because they
are not differential.
All in all, relevant costs and revenues satisfy the following two criteria:
a. They affect the future
b. They differ between alternatives
Special decision areas
1. Make or Buy decision:
Manufactured products consist of several components that are assembled into final product.
Many of these components can be bought from an outsider or made inside.
Decisions about whether to buy or produce within the organization are often called make-or-buy
decisions. The make or buy decision is also called in-sourcing and outsourcing.
Example: Suppose XYZ Company now makes a component for its major product. A manager
has prepared the following estimates of costs at the volume of 10,000 units per year.
Total cost for Cost per

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 10,000 units unit
Direct material Br.20,000 Br.2
Direct labor 50,000 5
Variable overhead 30,000 3
Fixed overhead 60,000 6
Total costs Br.160,000 Br.16
An outside supplier offers to supply the component at Br.14 per unit for a two year period.
Should the company accept the offer?
The answer depends on the difference in expected future costs between the alternatives. Assume
that of the total fixed overhead cost of Br. 6 per unit, Br. 2 is direct cost for the components and
the other Br. 4 is common cost (i.e. it is unavoidable cost regardless of whether the company
produces the components inside the organization or not).
The following schedule focuses on the relevant costs for each available course of action.
Decisions_______
Make Buy-_
Direct materials Br. 20,000 Br. 0
Direct labor 50,000 0
Variable overhead 30,000 0
Direct fixed overhead 20,000 0
Purchase price 0 140,000
Total Br. 120,000 Br. 140,000
XYZ saves Br. 20,000 by making the component.
The following analysis shows only the differentials of a decision to make the component.
New cost-purchase from suppliers Br. 140,000
Less: Cost savings-material Br. 20,000
-labor 50,000
-variable overhead 30,000
-direct fixed overhead 20,000
Total savings…………………………………………………………
120,000
Difference favoring the components………………………………… Br. 20,000

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Considering only the quantitative data, XYZ should make the components until some other
opportunity cost arises-the benefit to be gained by using the space and equipment for other
purpose-exceeds the Br. 20,000 cost savings available by using those resources to make the
component. Such a benefit could come from renting the space and equipment or using them to
make another product that would bring more than br. 20,000 incremental profit.
In such situations, the company might consider buying the component from outside supplier.
2. Special sales order decisions:
At a time a customer may offer special sales orders at less than full cost. At the beginning, it may
appear that accepting the offer reduce the overall profitability of the firm. However, the full cost
(production cost) contains fixed costs that do not change whether the special order is accepted or
not. Such special orders should come once in a while.
Factors that should be considered under such type of decisions are:
 The special orders must not be with regular customers
 There has to be an excess capacity within the organization
 The price should be more than the variable cost, and additional costs associated with
the special offer
Example: the management of Ethio Airways receives an offer from Nile tourist agency about
flying tourist from Finfinnee to Dambi Dolo. The tourist agency has offered the airline Br.
75,000 per round-trip flight on a 737 jet. Given the airline’s usual occupancy rate and air fares, a
round-trip 737 jet flight between Finfinnee to Dambi Dolo brings revenue of Br. 140,000.
Assume that the airline has two 737 jets that are not currently being used.
Data pertains to a typical round trip 737 jet flight between Finfinnee and Dambi Dolo is as
shown below:
Revenue Br. 140,000
Expenses:
Variable expenses Br. 45,000
Fixed expenses 50,000
Total expenses 95,000
Profit Br. 45,000
Further assuming that the airline has reservation and ticketing expenses amount to Br. 2,500 for a
scheduled flight. The fixed cost allocated to each flight cover the airline’s fixed cost such as air

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craft depreciation, fixed administrative costs etc. Should the airline accept the special order or
not?
To make decisions, the only relevant costs are variable costs, the fixed costs are irrelevant costs
since they will be paid whether the airline accept the offer or not. Moreover, the reservations and
ticketing costs would not incur. Thus, the analysis of the offer is as shown below:
Special price for the offer Br. 75,000
Variable costs Br. 45,000
Less: savings on reservation
and ticketing 2,500
Variable cost of offer 42,500
Contribution from offer Br. 32,500
The analysis shows that the offer will contribute br. 32,500 toward covering the fixed costs and
profit. Therefore, since the airline has excess capacity, the decision is to accept the special offer.
3. Add or Drop decisions
There are many ways to segment a company. Determining the best mix of segments is a problem
for managers who have to decide whether to drop a segment or to replace one segment with
another. Relevant information plays a great role in such type of decision.
Example: (adapted from Managerial Accounting, 9th edition) assume RTV Fashions uses its
available space for three product lines. The following is the income statement for last month and
management of RTV expects these results to continue in the near future.
Clothing Shoes Jewelry Total
Sales Br.45,000 Br.40,000 Br.15,000 Br.100,000
Variable costs 25,000 18,000 11,000 54,000
Contribution Br.20,000 Br.22,000 Br. 4,000 Br. 46,000
margin
Fixed costs:
Direct all (4,000) (3,400) (1,500) (8,900)
avoidable
Indirect (common) (9,450) (8,400) (3,150) (21,000)
Profit (loss) Br.6,550 Br.10,200 Br.(650) Br.16,100

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Should the store drop the jewelry line because it shows a loss? To answer that question we
should know what would change if RTV dropped the line. Let’s start with a choice between two
simple alternatives:
Keep jewelry or drop it and rent the available space to another company for Br. 400 per month.
If it dropped jewelry, RTV would lose Br. 15,000 of sales but could avoid the Br. 11,000 of
variable costs of those sales as well as the Br. 1,500 avoidable fixed costs.
Suppose RTV’s analysis shows that dropping jewelry would reduce common costs by Br. 1,000.
The following analysis summarizes the decision.

Decision: Rent out the space rather than sell jewelry

Differential revenues:
Lost sales from jewelry Br. 15,000
New rent revenue 400
Net revenue lost Br. 14,600
Differential costs:
Variable costs saved on jewelry Br. 11,000
Direct fixed costs saved 1,500
Indirect fixed costs saved 1,000
Total cost saving 13,500
Differential loss from dropping jewelry Br. 1,100
Keeping jewelry seems the better choice because dropping it and renting the space will reduce
income by Br. 1,100 or total income drops from Br. 16,100 to Br. 15,000.
4. Product mix decisions (under capacity constraints)
Limited resource (factor) is the item that restricts or constrains the production or sale of a
product or service. Limited factors include labor hours, machine hours, the availability of direct
materials and components. When a firm produces more than one product with limited resources,
managers should decide which product should be more produced and sold.
Product mix decision is the decision about how much of each product to sell.
Example: (Adapted from Cost Accounting: A managerial emphasis, 10th edition).

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Consider Power Recreation, a company that manufactures engines for a broad range of
commercial and consumer products. At one of its plant, the company assembles two engines-a
snowmobile engine and a boat engine. Information on these products is as follows:
Snowmobile Boat
Engine Engine
Selling price $800 $1,000
Variable cost per unit 560 625
Contribution margin per unit $240 $375
Contribution margin percentage 30% 37.5%
Assume that only 600 machine hours are available daily for assembling engines. Additional
capacity cannot be obtained in the short run. The company can sell as many engines as it
produces. The constraining resource is the machine hours. It takes 2 machine hours for one
snowmobile engine and 5 machine hours to produce one boat engine. Which product should the
company emphasize?
The product to be emphasized is not necessarily the product with 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 factor. The following table summarizes
the analysis of the decision.
Snowmobile Boat
Engine Engine
Contribution margin per engine $240 $375
Machine hours required per engine 2 5
Contribution margin per machine hour ($240/2; $120 $75
$375/5)
Total contribution margin for 600 machine hours $72,000 $45,000
($120*600; $75*600)
Producing snowmobile engines contributes more margin per machine hour that is the
constraining resource in the example. Therefore, choosing the snowmobile engine is the right
product-mix decision.

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