CHAPTER FIVE

DECISION MAKING AND

RELEVANT INFORMATION
5.1.INTRODUCTION
 Cont….
• Managers within an organization make many
decisions regarding the economic activity of a
company.
• Decisions like:
• To make or buy component parts
• Price of product
• Channels of distribution
• Accepting special orders at special price
• Every decision involves choosing among at
least two alternatives.
• While making a decision, managers need to
see the cost and benefit of each alternative.
• Managers usually follow a decision model for
choosing among different courses of actions.
• A decision model is a formal method of
making a choice that often involves both
quantitative and qualitative analyses.
• It uses the five-step decision-making process
to make decisions which are identify the
problem and uncertainties; obtain
information; make predictions about the
future; make decisions by choosing among
alternatives; and implement the decision,
evaluate performance, and learn.
• In business organizations, to make a decision,
managers need to understand what relevant
costs and revenues are.
• 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.
5.2.COST CONCEPTS FOR DECISION MAKING
• Understanding the following costs is important
for clearly seeing relevant costs.
• Differential costs: a difference in cost between
any two alternatives.
• Is a broad term which incorporates incremental
and decrement costs.
• Incremental cost: could also refer to an increase
in cost from one alternative to another.
• Avoidable cost: a cost that can be eliminated in
whole or in part by choosing one alternative over
another.
• Opportunity cost: the potential benefit that is
given up when one alternative is selected over
another.
• Sunk cost: is a cost that has already been
incurred and that cannot be changed by decision
made now or in the future.
• The following two criteria’s are important to
identify relevant costs and benefits
• It has to occur in the future
• It must differ among
• For example: Suppose that a company is about to
make a decision to purchase office supplies.
• The required supplies can be purchased, from
supplier A, for $5,000 and from Supplier B, for
$4,800. However, Supplier B is in another state
and, if the purchase is made from supplier B, the
company must pay freight in cost amounted
$300.
• Also, the company has $500 of supplies on hand.
• One approach is to include all costs including
irrelevant costs:
• In the above analysis, the cost of supplies to be
purchased is relevant because there is a
difference of $200 in favor of buying from
supplier B.
• The cost of supplies on hand is irrelevant for two
reasons:
(1) the cost is the same and
(2) It is a past cost already made.
• Supplies on hand are not a future cost.
Regardless from which supplier the supplies are
purchased, the same amount of past /or future
supplies cost will appear as irrelevance.
• Therefore, by considering only the relevant
costs, the company will decide to purchase
from supplier A because its costs only $5000
which is less than cost of buying from supplier
B which is $5100.
• The make or buy decision
• This decision is encountered when whether a
company should make a component part or buy it
from a supplier which is called make or buy
decision for products and insourcing VS
outsourcing for service giving companies.
• The make or the outsourcing decision is
purchasing goods and services from outside
vendors rather than producing the same goods or
providing the same services within the
organization, which is making or in sourcing.
• When a certain company is providing product or
services, it needs to pass through many steps which are
called value chain.
• Some of the steps in the value chain might be
performed by the company and some might be given
to other companies.
• When a company is involved in more than one activity
in the entire value chain, it is vertically integrated.
• Vertical integration could be upward integration or
downward integration.
• Upward integration is when a company is producing its
own raw material to be used in the production process
were as downward integration is when a company is
involved in the next process in the value chain.
• A decision to carry out one of the activities in
the value chain internally rather than to buy
externally from a supplier is called the make
or buys decision.
• This decision involves whether to buy a
particular part or make it internally.
• This is also applicable for service giving
companies and the decision is whether to
outsource a given task or not.
• Advantage of vertical integration _ deciding to
make
• Companies will be less dependent on suppliers.
• They can control quality of the inputs
• Companies could get additional profit from parts
it is making
• Advantages of non-integration _deciding to buy
from outside supplier
• Outside suppliers have economics of sale
therefore the parts will have lower cost than if
they were produced internally.
• While making this decision, managers need to
concentrate on relevant costs.
• Those are costs which can be eliminated by
choosing to make rather than buy or those
costs that can be eliminated by choosing to
buy rather than make.
• If there was an opportunity cost which could
be incurred, it needs to be considered while
making decision.
• Special orders
• A special order: is a onetime order that is not considered part of the
company’s normal ongoing business.
• In this case managers should decide whether to accept these
special orders and how much price to charge.
• Basic decision criterion:
• Determine if you have the "capacity" to accept the special order.
• If the special order has to be produced, then all variable
manufacturing costs will be relevant. (If the units have already been
produced, the production costs are sunk costs, therefore
irrelevant.)
• Determine if all or part of the normal selling costs might be avoided
on the special order. If so, then the avoidable selling costs are
irrelevant to your decision to accept the special order.
• Other considerations:
• If the special order is "ongoing" then fixed costs
may need to be considered. There are also
strategic implications. What might they be?
• If you expand capacity to accept the special
order, additional fixed production costs will have
to be added to the total production costs.
• Are your regular customers affected by accepting
the special order? If you are unable to service
your regular customers because of accepting the
special order, then the lost revenue from regular
customers becomes an opportunity cost.
• This opportunity cost must be added in to the
costs of producing the special order.
• In general, special order is profitable if
incremental revenue from special order
exceeds the incremental cost of the order.
3. Adding and dropping product line and other
segments
• Decision relating to whether product lines or other
segments of a company should be dropped and new
ones added are among the most difficult that a
manager has to make.
• In such decisions, many qualitative and quantitative
factors mush be considered.
• The question of dropping a product line or segment is
raised when one or more of the product or segment is
making loss.
• If the products or segments are making profit, then
need to bather about dropping the product or
segments.
• Likewise, a company wants to introduce a new
product line or segment if it believes it will
increase the profitability of the company.
• In this situation the decision criteria is that of cost
and benefit analysis.
• By adding a product line if the firms overall
profitability are increased, then the proposal for
adding the product line is acceptable.
• Basic rule of thumb: compare the contribution
margin that will be lost against the costs that can
be avoided if the product line or segment is
dropped.
• If the fixed cost that will be avoided is greater
than the contribution margin lost (i.e. avoidable
fixed cost > contribution margin lost), product
line or segment should be dropped.
• If the fixed cost that will be avoided is less than
the contribution margin lost (i.e. avoidable fixed
cost < contribution margin lost), then the product
line or segment should be kept.
• A segment should be added only if the increase in
total contribution margin is greater than the
increase in fixed costs.
• A new product line adding losses to the firm
should be dropped.
• Common fixed costs are fixed costs that support
the operation of more than one segment, but are
not traceable in whole or in part to any one
segment.
• Thus they continue even when the product line is
dropped.
• Remember: allocated fixed costs cannot be
avoided, unless the fixed asset giving rise to the
allocation is sold or disposed off.
• If the fixed costs that can be avoided are less than
the contribution lost, then do not drop the
product line.
 Utilization of a constrained resource (product
mix decision with constrained capacity)
• When a limited resource restricts a company’s ability to
satisfy demand, the company has a constraint or
scarcity.
• Constrained resource is the resource that restricts or
limits the production or sales of a product or service.
• In this case, managers have to decide how constrained
resources are going to be used .
• The constrained resource could be machine-hour,
labor-hour, office space, warehouse space, laborers,
material etc…
• A company is faced with such kind of decision 1.
If it is producing multiple products,
2. If it has constrained resource.
• Such kind of decision does not affect fixed costs.
• Therefore, managers should decide to select the
course of action that will maximize the company’s
total contribution margin.
• Managers, to decide between products that will
make the best use of the constrained resources,
should favor the product that provides the
highest contribution martin per unit of the
constrained resource
• CM/unit of constrained resource =
product CM/unit
Amount of the constrained
resource required for making
a unit of that product
 5.Joint product – sell or process further
decision
• Two or more products that are produced from a
common input are known as joint products.
• Important terminologies
• Joint cost: cost incurred up to the split-off point before
the joint product become separate and independent.
• Split-off point: point in manufacturing process at
which the joint products can be recognized as separate
products
• Intermediate product: a product which have not
reached the finished product stage.
• Separate cost: a cost incurred after the split off point.
• Remember the concept of relevant revenues and costs.
• Relevant revenues:-expected future revenues that differ
among alternative course of action.
• Relevant costs: - expected future costs that differ among
alternative course of action.
• We apply these concepts to decisions on whether a joint
product or main product should be sold at the split-off
point or processed further.
• Incremental revenues are additional revenues generated
for an activity.
• Incremental costs are additional costs incurred for an
activity.
• To process further, the incremental (differential) revenue
from further processing less the incremental processing
costs must be positive. The differential revenue is the
ultimate sales price less the sales price at the split-off
point.
• If incremental revenue is greater than
incremental cost, then process further;
otherwise, sell at the split-off point.
• The decision to incur additional costs for
further processing should be based on the
incremental operating income attainable
beyond the split off point
• Incremental revenues are greater than
incremental costs for products A, B and C
resulting in an increase in operating income,
so the manager decides to process further.
• But for product D, Incremental revenue is less
than incremental costs resulting in a decrease
in operating income, so the manager decides
to sell product D at the split off point.
• The $100,000 joint costs incurred before the
split off point are irrelevant in deciding
whether to process further.
Thank you!!!