Decision Making

and
Relevant Information

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-1
 Decision Models
A decision model is a formal method of
making a choice, often involving both
quantitative and qualitative analyses
Managers often use some variation of the
Five-Step Decision-Making Process

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-2
 Five-Step
Decision-Making Process

Step 2:
Make Step 3: Step 4:
Step 1: Step 5:
Predictions Choose Implement
Obtain Evaluate
About An The
Information Performance
Future Alternative Decision
Costs

Feedback

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-3
 Relevance
Relevant Information has two characteristics:
It occurs in the future
It differs among the alternative courses of
action
Relevant Costs – expected future costs
Relevant Revenues – expected future
revenues

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-4
 Irrelevance
Historical costs are past costs that are
irrelevant to decision making
Also called Sunk Costs

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-5
 Types of Information
Quantitative factors are outcomes that can be
measured in numerical terms
Qualitative factors are outcomes that are
difficult to measure accurately in numerical
terms, such as satisfaction
Are just as important as quantitative factors
even though they are difficult to measure

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-6
 Terminology
Incremental Cost – the additional total cost
incurred for an activity
Differential Cost – the difference in total cost
between two alternatives
Incremental Revenue – the additional total
revenue from an activity
Differential Revenue – the difference in total
revenue between two alternatives

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-7
 Types of Decisions
One-Time-Only Special Orders
Insourcing vs. Outsourcing
Make or Buy
Product-Mix
Customer Profitability
Branch / Segment: Adding or Discontinuing
Equipment Replacement

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-8
 One-Time-Only Special Orders
Accepting or rejecting special orders when
there is idle production capacity and the
special orders have no long-run implications
Decision Rule: does the special order
generate additional operating income?
Yes – accept
No – reject

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-9
 One-Time-Only Special Orders
Compares relevant revenues and relevant
costs to determine profitability

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-10
 Potential Problems with
Relevant-Cost Analysis
Avoid incorrect general assumptions about
information, especially:
“All variable costs are relevant and all fixed
costs are irrelevant”
There are notable exceptions for both costs

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-11
 Potential Problems with
Relevant-Cost Analysis
Problems with using unit-cost data:
Including irrelevant costs in error
Using the same unit-cost with different output
levels
 Fixed costs per unit change with different levels of
output

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-12
 Avoiding Potential Problems with
Relevant-Cost Analysis
Focus on Total Revenues and Total Costs, not
their per-unit equivalents
Continually evaluate data to ensure that they
meet the requirements of relevant
information

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-13
 Insourcing vs. Outsourcing
Insourcing – producing goods or services
within an organization
Outsourcing – purchasing goods or services
from outside vendors
Also called the “Make or Buy” decision
Decision Rule: Select the option that will
provide the firm with the lowest cost, and
therefore the highest profit.

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-14
 Qualitative Factors
Nonquantitative factors may be extremely
important in an evaluation process, yet do not
show up directly in calculations:
Quality Requirements
Reputation of Outsourcer
Employee Morale
Logistical Considerations – distance from plant,
etc.

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-15
 Opportunity Costs
Opportunity Cost is the contribution to operating
income that is forgone by not using a limited
resource in its next-best alternative use
 “How much profit did the firm ‘lose out on’ by not
selecting this alternative?”
Special type of Opportunity Cost: Holding Cost
for Inventory. Funds tied up in inventory are not
available for investment elsewhere

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 Product-Mix Decisions
The decisions made by a company about
which products to sell and in what quantities
Decision Rule (with a constraint): choose the
product that produces the highest
contribution margin per unit of the
constraining resource

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 Adding or Dropping Customers
Decision Rule: Does adding or dropping a
customer add operating income to the firm?
Yes – add or don’t drop
No – drop or don’t add
Decision is based on profitability of the
customer, not how much revenue a customer
generates

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 Adding or Discontinuing
Branches or Segments
Decision Rule: Does adding or discontinuing
a branch or segment add operating income to
the firm?
Yes – add or don’t discontinue
No – discontinue or don’t add
Decision is based on profitability of the
branch or segment, not how much revenue
the branch or segment generates

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 Equipment-Replacement Decisions
Sometimes difficult due to amount of
information at hand that is irrelevant:
Cost, Accumulated Depreciation, and Book
Value of existing equipment
Any potential Gain or Loss on the transaction –
a Financial Accounting phenomenon only
Decision Rule: Select the alternative that will
generate the highest operating income

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-20
 Behavioral Implications
Despite the quantitative nature of some
aspects of decision making, not all managers
will choose the best alternative for the firm
Managers could engage in self-serving
behavior such as delaying needed equipment
maintenance in order to meet their personal
profitability quotas for bonus consideration

To accompany Cost Accounting 12e, by Horngren/Datar/Foster. Copyright © 2006 by Pearson Education. All rights reserved. 11-21