Unit Five

Relevant Information
and
Decision Making
 Cont…
Managers usually follow a decision model for
choosing among different courses of action.
A decision model is a formal method of
making a choice that often involves both
quantitative and qualitative analyses.
Management accountants analyze and present
relevant data to guide managers’ decisions.
The following is steps that should be followed
in the decision model.
Step 1: Define the Problem

The first step is to recognize and define a specific

problem.
For example, the members of a given company’s
management team all recognized the need for
additional space for warehousing, offices, and the
production of plastic moldings.
The amount of space needed, the reasons for the
need, and how the additional space would be used
are all important dimensions of the problem.
However, the central question is how to acquire
the additional space.
Step 2: Identify the Alternatives

The company has to identify possible solutions

and alternatives of solving the problem at hand
Step 3: Identify the Costs and Benefits
Associated with Each Feasible
Alternative
The costs and benefits associated with each
feasible alternative are identified.
At this point, clearly irrelevant costs can be
eliminated from consideration.
The management accountant is responsible for
gathering necessary data.
Step 4: Total the Relevant Costs and
Benefits for Each Feasible
Alternative

To choose the best alternative, we should have the

total costs and benefits of each alternative.
Step 5: Assess the Qualitative Factors
Qualitative factors can significantly affect the
manager’s decision.
Qualitative factors are those factors that are hard to
put a number on.
Examples, the reliability of supply sources, the
expected stability of prices over the next several
years, labor relations, community image, and so on.
 Step 6: Make the Decision

Once all relevant costs and benefits for each

alternative have been assessed and the
qualitative factors weighed, a decision can be
made.
Relevant Costs and Relevant Revenues
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.
 Cont…
 To be relevant, costs and relevant revenues
must:
1. Occur in the future
 every decision deals with selecting a course of
action based on its expected future results.
2. Differ among the alternative courses of action

 costs and revenues that do not differ will not

matter and, hence, will have no bearing on the
decision being made.
 Qualitative and Quantitative Relevant Information

Managers divide the outcomes of decisions into two broad

categories:
 Quantitative and
 Qualitative.
Quantitative factors are outcomes that are measured in
numerical terms.
Quantitative factors are financial and non-financial.
A. Financial that can be expressed in monetary terms.
Examples
- the cost of direct materials, direct manufacturing
labor, and marketing.
B. Non-financial; that can be measured numerically, but that
are not expressed in monetary terms.
 Cont…
Qualitative factors are outcomes that are difficult
to measure accurately in numerical terms.
Example - Employee morale.
Relevant-cost analysis emphasizes quantitative
factors that can be expressed in financial terms.
But just because qualitative factors and
quantitative non financial factors cannot be
measured easily in financial terms does not make
them unimportant.
In fact, managers must wisely weigh these factors.
 Cont…
Based on the above concept, the following
decision making alternatives will be
illustrated:
 Special sales order
 Deletion or Addition of Products or
Departments
 Make or buy decisions
 Sell or further process decisions
 Pricing decisions
 1. Accept or reject the special sales order

A special order
a one-time order

not considered part of the company’s normal or on-going
business.
offer prices is less than the usual (regular) selling prices of

the firm.
Some times, the price offered may be below the full cost.

Full cost- refers the total manufacturing costs including the

fixed and variable costs.
The basic conditions that must be considered

Whether the price of special order affects the regular
selling price or not, and
Whether the firm has an idle capacity to fulfill the quantity
required by the special order.
Illustration:
Geda Company manufactures and sells 10,000
staplers per year. The total manufacturing cost of
these staplers is Br 400,000. Suppose that kiya
Trading, a local merchandiser has offered Geda
Company Br 38 per stapler for 1,000 staplers special
order that:
Would not affect the regular business in any way
Would not affect fixed costs
Would not require any additional variable selling and
administrative expenses
Would use some other wise idle manufacturing
capacity
.

Additional Information:
The income statement of Geda Company for the most recent
period is given below:
Sales----------------------------------------------- 500,000
Variable costs
Manufacturing---------------------------360,000
Selling and administrative --------------30,000
Total Variable costs------------------------------------ 390,000
Contribution margin------------------------------------ 110,000
Fixed costs
Manufacturing-----------------------------40,000
Selling and administrative---------------50,000
Total Fixed cost-------------------------------------- 90,000
Operating income----------------------------------- 20,000
Required: Should Geda Company accept the

special order?
 Without special With special Effect of
order order special order
Sales 500,000 538,000 38,000
Variable costs
Manufacturing 360,000 396,000 36,000
Selling &admin 30,000 30,000
Total variable cost 390,000 426,000
Contribution margin 110,000 112,000 2,000
Fixed costs
Manufacturing 40,000 40,000
Selling & admin 50,000 50,000
Total fixed cost 90,000 90,000
Operating income 20,000 22,000 2,000
Decision: -

The management is recommended to accept the

offer, because by accepting the offer the company
could get an additional operating income of
Br. 2, 000
The relevant costs are
the variable manufacturing costs -------Br.
390,000.
Manufacturing -----------------------------Br.360,000
Selling and administrative ----------------Br. 30,000
 2. Deletion or Addition of a product / a department.
Both quantitative and qualitative factors should be
thoroughly considered before the final decision is
reached.
understand the two classification of fixed costs and
expenses; such as,
 avoidable and
 unavoidable.
Avoidable Costs: costs that will not continue if an
ongoing operation is changed or deleted (dropped).
These include department salaries and other costs
that could be eliminated by not operating the
specific department.
 Cont…
 These costs include all direct costs and indirect
costs which are incurred to run only that
product line or department
 Avoidable costs are relevant costs.
Unavoidable costs: costs that will continue
regardless of stopping (dropping) or a continuing
operating activity as long as the business
organization exists.
Unavoidable costs are not relevant.
Example:
Assume that Jk Company sells film processing
(prints), cameras, and frames. Jemal Kedir the
owner of the company is deciding whether to
drop processing because the volume of their
sales has declined.
The following table shows the financial
statements prepared by the company’s
accountant.
 Total Prints Cameras Frames
Sales revenue Br 80,000 Br 10,000 Br 50,000 Br 20,000

Cost of sales 53,000 8,000 30,000 15,000

(all variable)
Contribution 27,000 2,000 20,000 5,000
margin
Less: fixed
costs:
Rent 4,000 1,000 2,000 1,000
Salaries 5,000 1,000 2,500 1,500
Marketing and 3,000 500 1,500 1,000
administrative

Operating Br15,000 Br (500) Br14,000 Br1,500

profit (loss)
 Cont…
Although the economics of dropping the prints
appeared favorable, the manager asked the
accountant to investigate which costs were
differential (that is, avoidable in this case) if the
prints were dropped.
The accountant reported the following:
 All variable costs of goods sold for that line
could be avoided.
 All salaries presently charged to prints, Br 1,000,
could be avoided.
 None of the rent could be avoided.
 Marketing and administrative costs of Br 250
could be saved.
 Cont…
And the accountant prepared the differential cost and revenue
analysis as shown in the following table indicating the effects of
the decision.
Alternative-1 Alternative-2
Keep Prints Drop Prints Difference
Sales revenue . . . . . . . . . .Br 80,000 Br 70,000 Br 10,000 decrease
Cost of sales (all variable) 53,000 45,000 8,000 decrease
Contribution margin . . . . . 27,000 Br 25,000 Br 2,000 decrease
Less fixed costs:
Rent . . . . . . . . . . . . . . . . . . . 4,000 4,000 –0–
Salaries . . . . . . . . . . . . . . . . . 5,000 4,000 1,000 decrease
Marketing and admin….. …... 3,000 2,750 250 decrease
Operating profit (loss) . Br15,000 Br14,250 Br750 decrease
 Cont…
 From the above analysis one can note the following points:
 Assuming that the sales of the other product lines would
be unaffected, sales would decrease by Br 10,000 from
dropping the prints.
 Variable cost of goods sold of Br 8,000 would be saved
by dropping the product line.
 Fixed costs of Br 1,250 (Br 1,000 in salaries and Br 250
in marketing and administrative expenses) would be
saved.
 In total, the lost revenue of Br 10,000 exceeds the total
differential cost saving by Br 750.
 Thus, the net income of the company for the period would
have been Br 750 lower if prints had been dropped.
Therefore printers should not be dropped.
 3. Make or Buy Decisions (In sourcing-versus-Outsourcing)

Outsourcing is purchasing goods and services from

outside vendors rather than producing the same
goods or providing the same services within the
organization, which is in sourcing/ integration.
Decisions about whether a producer of goods or
services will insource or outsource are also called
make-or-buy decisions.
In make or buy decision, the following qualitative
factors, besides the quantitative considerations may
favor the decision to “buy”:
 Cont…
Advantage of long-term relationship with suppliers.
Possibility of shortage of material or labor for
making the component.
Uninterrupted supply of requisite quality from
reliable suppliers.
The internal demand for the product under
consideration is small and, as such, it is no use to
set up manufacturing facilities for it and so forth.
 Cont…
On the contrary, the following qualitative factors may
favor the decision “to make”:
The quality of the product is decided to be controlled.
If the purchase price is likely to rise due to increased
demand in the market, it becomes uneconomical to buy.
Where the technical know-how is to be kept secret and
not to be passed on to the suppliers and so on.
Illustration:
Assume that the following cost data relate to Meta
Company, a car assembler that it incurs currently to
make 10,000 units of its product used in the assembly.
 Cont…
Total cost Unit costs
Direct material---------40,000 4
Direct labor-------------160,000 16
FOH-variable-----------80,000 8
FOH-fixed-------------160,000 16
Total--------------------440,000 44
Metu Company, another manufacture of the same product
offered to sell Meta Company the part for Br. 40 per unit.
Assume that Br. 40,000 of the fixed cost will be eliminated
if the parts are bought instead of made and released facilities
will be left idle.
Required: Should Meta Company make or buy the
part?
Solution
 It seems that Br 40 (cost to buy) is less
than Br 44(cost of making the part) and
by just looking at a glance we may
suggest that the part be bought.
Let see the analysis using only relevant
information and suggest the best
alternative.
 Cont…
Make Buy
Total unit Total Unit
Purchase cost 400,000 40
Direct material 40,000 4
Direct labor 160,000 16
FOH-variable 80,000 8
FOH-Fixed 40,000 4
Total 320,000 32 400,000 40

From the above analysis, it can be seen that it is

better to make the part because the company will
save a total cost Br 80,000(Br 8 per unit)
Example:
Suppose the firm manufactures 1,000 units of a part
and
has the following cost structure.
Direct material------------------------------------Br.2/unit
Direct labor----------------------------------------Br.6/unit
Variable overhead--------------------------------Br.3/unit
Fixed overhead (unavoidable) -----------------Br.4/unit
Let us suppose further that the firm can lease its
facilities at a rate of Br.1, 000 or manufacture 1,000
units of another product and sell a new product that
can yield a contribution margin of Br.1, 500.
 Cont…
The firm has four alternatives:
Make the part
Buy and leave the facilities idle
Buy and lease(rent) the facilities
Buy and make other product.
Required: If the product (part) is purchased
from outside supplier it is available at a
Br.13/unit. Which is the best alternative for
the company?
 Cont…
Alternative: 1. Make the part
Total cost = 1,000 units x Br.11/unit
= Br.11,000
2. Buy and leave the facilities idle
Total cost = Br.13/unit x 1,000 units
= Br.13,000
3. Buy and rent the facilities
Facilities are rented at Br.1,000
Total cost to buy = Br.13,000
Br.13,000 – Br.1,000
=Br.12,000
 Cont…
4. Buy and make other product
total cost to buy Br.13,000
CM from producing a product Br. 1,500
Total cost = Br13,000 – Br. 1,500
= Br.11,500
Decision: the cost of manufacturing is the
least that is Br.11,000.
There fore, the firm should choose this
alternative (making it internally)
Sell or Process Further

Joint products have common processes and costs of

production up to a split-off point.
The common cost incurred to process joint products is
termed as joint cost.
Joint costs are all costs of production incurred to
process the joint products until the spilt-off point.
The point in the production process where the
individual products become separately identifiable is
called the spilt-off point.
If an item should be processed further after the spilt off
point, the costs incurred to process further are
identifiable as incremental costs.
Illustration:
Jitu Company manufactures three products
from common inputs in a joint processing
operation.
 Joint processing costs up to the spilt off
point total Br. 350,000 per year.
The company allocates this costs to the joint
products on the basis of their relative sales
value at the spilt off point.
Unit selling prices and total output at the
spilt off point are as follows:
 Cont…
Product SP/unit Yearly output
A Br.1615,000 units
B Br.8 20,000 units
C br.25 4,000 units
Each product can be processed further after the
spilt off point.
Additional processing requires no special facilities.
The additional processing cost (per year) and unit
selling prices after further processing are given
below:
 Cont…
 
Product Additional
processing cost SP/unit
A Br. 63,000 Br. 20
B Br. 80,000 Br. 13
C Br. 36,000 Br. 32
Required: Which product or products should be
sold at the spilt off point and which product or
products should be processed further? Show
computations.
 Cont…
 .

At a spilt off point After further process

Difference
Total Total
A B C A B C

Sales 240,000 160,000 100,000 500,000 300,000 260,000 128,000 688,000 188,000

Joint costs 168,000 112,000 70,000 350,000 168,000 112,000 70,000 350,000 ---

Separable 63,000 80,000 36,000 179,000 179,000

costs
Total costs 168,000 112,000 70,000 350,000 231,000 192,000 106,000 529,000 179,000

Income 72,000 48,000 30,000 150,000 69,000 68,000 22,000 159,000 9,000
effect
 Cont…
Product A and product C should be sold at a
spilt off point. If product A further processed
the income from this product decreased by
Br. 3,000, and income from product C
decreased by Br. 8,000 if further processed.
Only product B should be further processed.
By further processing this product the
company can earn additional income of Br.
20,000.
.

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