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Effective decision-making involves defining alternatives and distinguishing between relevant and irrelevant costs and benefits. Relevant costs and benefits, such as differential costs and revenues, should be considered, while sunk costs and future costs that do not differ between alternatives are irrelevant. Opportunity costs, representing potential benefits lost when choosing one alternative over another, are also relevant in decision-making.

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morgan09.09.2009
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0% found this document useful (0 votes)
5 views2 pages

Notes

Effective decision-making involves defining alternatives and distinguishing between relevant and irrelevant costs and benefits. Relevant costs and benefits, such as differential costs and revenues, should be considered, while sunk costs and future costs that do not differ between alternatives are irrelevant. Opportunity costs, representing potential benefits lost when choosing one alternative over another, are also relevant in decision-making.

Uploaded by

morgan09.09.2009
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Every decision involves choosing from among at least 2 alternatives.

Therefore, the first step in decision-


making is to define the alternatives being considered.

✓ If a company is deciding whether to make or buy it from an outside supplier, the alternatives are
MAKE or BUY the component part.
✓ If a company is considering discontinuing a product, the alternatives are KEEP or DROP.

Once you’ve defined the alternatives, you need to identify the criteria for choosing among them. The key
to choosing among alternatives is distinguishing between Relevant and Irrelevant costs and benefits.

✓ RELEVANT COSTS AND RELEVANT BENEFITS – should be considered when making decisions.
✓ IRRELEVANT COSTS AND IRRELEVANT BENEFITS – should be ignored when making decisions.

The key to effective decision making is Differential Analysis – focusing on the future costs and benefits
that differ between the alternatives. Everything else is irrelevant and should be ignored. Differential
costs and benefits can be qualitative/quantitative.

✓ DIFFERENTIAL COST – a future cost that differs between any two alternatives. *Relevant
✓ DIFFERENTIAL REVENUE – future revenue that differs between any two alternatives. *Relevant

The terms Incremental Cost and Avoidable Cost are often used to describe Differential Costs.

✓ INCREMENTAL COST – an increase in cost between two alternatives. *Relevant


o If you are choosing between buying the standard model or the deluxe model of your
favorite automobile, the costs of the upgrades contained in the deluxe model are
incremental costs.
✓ AVOIDABLE COSTS – a cost that can be eliminated by choosing one alternative over the other.
*Relevant
o You are trying to choose between two alternatives—going to the movie theater or renting
a movie. The cost of the ticket to get into the movie is an avoidable cost. You would avoid
this cost by renting a movie. Similarly, the movie rental fee is an avoidable cost because you
could avoid it by going to the movie theater.
✓ SUNK COSTS – a cost that has already been incurred and cannot be changed regardless of what a
manager decides to do. It has no impact on future cash flows and remain the same no matter
what alternatives are being considered. *Irrelevant
o A company purchased a five-year-old truck for 12,000. The amount paid is a sunk cost
because it has already been incurred and the transaction cannot be undone. The 12,000
paid for the truck is irrelevant in making decisions such as whether to keep, sell, or replace
the truck.
o Any accounting depreciation expense related to the truck is irrelevant in making decisions.
This is true because accounting depreciation is a Noncash Expense that has no effect on
future cash flows. It simply spreads the sun cost of the truck over its useful life.
✓ Future costs and benefits that DO NOT DIFFER BETWEEN ALTERNATIVES are Irrelevant to the
decision-making process. *Irrelevant
o Continuing with the movie example, assume you plan to buy Angel’s pizza after watching a
movie. If you’re going to buy the same pizza regardless of your movie-watching venue, the
cost of pizza is irrelevant when choosing between the theater and the rental. The cost of
the pizza is not a Sunk Cost because it has not yet been incurred.
✓ OPPORTUNITY COST – is the potential benefit that is given up when one alternative is selected
over another. Not usually found in accounting records, but they are a type of Differential Cost that
must be considered in every decision a manager makes. *Relevant
o If you were considering giving up a high-paying summer job to travel overseas, the forgone
wages would be an opportunity cost of traveling abroad.
o Idle space that has no alternative use has an opportunity cost of zero.

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