RELEVANT INFORMATION AND DECISION MAKING
Making decision is choosing from alternatives. In this unit, several analytical techniques that aid managers in making a variety of business decisions are discussed. Your understanding of the previous units here determine the extent to which you comprehend the unit- “Relevant Information and Decision Making”. It includes three sections. The first section explains the nature of “relevant” information. The steps in the decision making process are discussed in section two. The last section illustrates the application of the concept of relevant costs and benefits to various marketing and production decisions. Emphasis is also given to the relevance of opportunity costs and to the irrelevance of sunk costs.
5.2 Relevant Costs and Decision Making Model
5.2.1 Relevant Costs Defined
What makes information relevant to a decision problem? Relevance is one of the key characteristics of good management accounting information. This means that management accounting information produced for each manager must relate to the decisions which he/she will have to make.
Relevant information includes the predicted future costs and revenues that differ among the alternatives. Any cost or benefit that does not differ between alternatives is irrelevant and can be ignored in a decision. All future revenues and/or costs that do not differ between the alternatives are irrelevant.
In brief, there are two criteria that qualify information to be relevant for decision making.
- Bearing on the Future: To be relevant to a decision, cost or benefit information must involve a future event. Relevant information is a prediction of the future, not a summary of the past. Historical (past) data have no bearing on a decision. Such data can have an indirect bearing on a decision because they may help in predicting the future. But past figures, in themselves, are irrelevant to the decision itself. Why? Because decision-making affect future, but not past. Nothing can alter what has already happened.
- Different under Competing Alternatives: Relevant information must involve future costs or benefits that differ among the alternatives. These are called differential revenues and costs. In cost and management accounting, the term differential cost is synonymous with avoidable cost and relevant cost. Costs or benefits that are the same across all the available alternatives have no bearing on the decision. For example, if management is evaluating the purchase of either a manual or an automated drill press, both of which require skilled labor costing Br. 10 per hour, the labor rate is not relevant because it is the same for both alternatives.
Sunk Costs and Opportunity Costs
The emphasis on differential revenues and costs gives rise to two other, related concepts that you may have already encountered in your study of economics: sunk costs and opportunity costs. A sunk cost is one that has already been incurred and therefore will be the same no matter which alternative a manger selects. Sunk costs are never relevant for decision making because they are not differential.
Suppose a company has spent Br.500, 000 developing a new product. Problems have risen and the managers must now decide whether or not to market it. The Br.500, 000 is irrelevant to the decision because it is not differential; that is, the cost will be the same whether or not the firm markets the product. Similarly, depreciation on a machine is irrelevant in decision which products to make with that machine. All historical costs, whether original cost or book value (cost minus accumulated depreciation), are sunk costs.
Opportunity costs play a vital role in a decision making. An opportunity cost is the benefit lost by taking one action as opposed to another. The “other” action is the best alternative available other than the one being contemplated.
Suppose Beza Company owns a warehouse and can either use it to store products or rent it to another company for Br.8, 000 per year. Using the space for storage requires that Beza forego the opportunity to rent it, which means that there is a difference to Beza if it chooses to take one action rather than another. When Beza considers any action that requires using the space for storage, the relevant cost of the space is its opportunity cost, the Br.8, 000 rent Beza will not collect.
5.2.2 Model for Decision Making
How does a company go about making good tactical decisions? The six steps in decision-making process are as follows:
- Define the problem.
- Identify alternatives as possible solutions to the problem; eliminate alternatives that are not feasible.
- Identify the relevant costs and benefits associated with each feasible alternative; eliminate irrelevant costs and benefits from consideration.
- Total the relevant costs and benefits for each alternative.
- Assess qualitative factors.
- Select the alternative with the greatest overall benefit (make the decision)
These six steps define a simple decision model. A decision model is a set of procedures, if followed, will lead to a decision. The paragraph that follows discusses the sequence of steps to be followed.
Define the problem. The first step in decision-making process is to recognize and define a specific problem. This is the most important stage because all other activities in the process depend on it. If one does not have a clear understanding of the specific problem, he/she may spend valuable time and energy in identify alternatives and gathering probably irrelevant data. Moreover, incorrectly defined problems waste time and resources. That is why it is usually said that defining a problem is solving 50 percent of the problem.
Identify the Alternatives. Decision- making is selecting between two or more alternatives. This step is concerned with listing and considering of possible solutions. If a machine breakdown, what are the alternative courses of action? The machine can be repaid or replaced, or a replacement can be leased. But perhaps repair will turn out to be more costly than replacement. Determining the possible alternatives is a critical step in the decision process. As part of this step, the company eliminates alternatives that are not feasible.
Identify relevant information Here, the costs and benefits associated with each feasible alternative are identified. At this step, clearly irrelevant costs can be eliminated from the consideration. The management accountant is responsible for gathering necessary data.
Total relevant costs and benefits This step involves determining the relevant costs and benefits of the possible alternatives.
Assess qualitative factors. Decision making is based on an evaluation of quantitative and qualitative factors. Typically, the quantitative factors are those for which measurement is easy and precise. In addition to this financial criterion, there are other factors that bear upon the decision and that are usually referred to as qualitative. Qualitative factors are simply those factors that are hard to put a number on. Put differently, qualitative aspects are those for which measurement in birrs and cents is difficult and imprecise
Qualitative factors can significantly affect the manager’s decision. For example in make-or –buy decision, the quality of the product purchased externally, the reliability of supply sources, the expected stability of price over the next years, labor relations, community image and so on. Therefore, qualitative factors must be taken into consideration in the final step of the decision making model.
Make the decision. Once all relevant costs and benefits for each alternative have been assessed, the qualitative factors weighed, a decision can be made.
5.3 Common Relevant Cost Applications
5.3.1 Marketing Decisions
A special order is a one-time order that is not considered part of the company’s normal on going business. For example, a discount department store chain planning a big sale offers to make a large one-time purchase of a firm’s product but wants a reduced price. In general, a special order is profitable as long as the incremental revenue from the special order exceeds the incremental costs of the order. The incremental revenue in this decision will be the price per unit offered by the potential customer times the number of units to be purchased. The incremental costs will be the amount of the expected cost increase if the offer is accepted. The incremental cost usually includes variable manufacturing costs of producing the units. Since the units being sold in the special order are not being sold through the firm normal distribution channel, the firm may or may not incur variable selling and administrative expenses in conjunction with the special order.
The incremental costs usually do not include fixed manufacturing costs. Although the fixed costs must be incurred to permit production, the amount of fixed costs incurred by the firm usually will not increase if the special order offer is accepted. For the same reason, other fixed expenses, such as fixed selling and administrative expenses, are usually not relevant in the special order price.
However, management must also be assured that it has sufficient capacity to produce the special order without affecting normal sales. When there is no excess capacity, the opportunity cost of using the firm’s facilities for the special order are also relevant to the decision. The opportunity cost would be the contribution margin forgone on regular sales that have to be reduced to accommodate the special order. The relevant costs to accept the special order, therefore, would include a forgone contribution margin on regular sales that could not be made in addition to the incremental costs associated with the special order that have already been discussed.
Often a manager needs to determine whether or not a segment or other segments of a company should be kept or dropped. Segment report prepared on a variable-costing basis provides valuable information for these keep-or-drop decisions. However, while segmented reports provide useful information for such decisions, relevant costing describes how the information should be used.
In keep-or-drop decisions, many factors must be considered that are both qualitative and quantitative in nature. Ultimately, however, any final decision to drop an old segment or to add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess this impact, it is necessary to make a careful analysis of the costs involved. To this end, let us try to distinguish the difference between avoidable and unavoidable fixed expenses.
Fixed costs are divided into two categories, avoidable and unavoidable.
- Avoidable costs are costs that will not continue if an ongoing operation is changed, deleted or eliminated. These costs are relevant costs in decision-making. Examples of avoidable costs include departmental salaries and other costs that could be avoided by not operating the specific department.
- Unavoidable costs are costs that continue even if a subunit or an activity is eliminated and are not relevant for decision. The reason for this is that such costs are not affected by a decision to delete a particular activity. Unavoidable costs include many common costs, which are defined as those costs of facilities and services that are shared by users. Examples are store depreciation, heating, air conditioning, and general management expenses.
Optimal Use of Limited Resources
Managers are routinely faced with the problem of deciding how scarce resources are going to be utilized. A scarce resource or a limiting factor refers to any factor that restrict or constraint the production or sale of a product or service. It include the following, among others, labor hours, machine hours, square feet of floor space, cubic meters of display space .A department store, for example, has a limited amount of floor space and therefore cannot stock every product that may be available. A manufacturing firm has a limited number of machine- hours and a limited number of direct labor-hours at its disposal. When capacity becomes pressed because of scarce resource, the firm is said to have a constraint.
When a plant that makes more than one product is operating at capacity, managers often must decide which orders to accept. The contribution margin technique also applies here, because the product to be emphasized or the order to be accepted is the one that makes the biggest total profit contribution per unit of the limiting factor. Fixed cost are usually unaffected by such choices.
In such kind of decision, the contribution margin technique must be used wisely. Managers sometimes mistakenly favor those products with the biggest contribution margin or gross margin per sales birr, without regard to scarce resources.
5.3.2 Production Decisions
Most manufactured products consist of several components that are assembled into finished unit. Many of these components can be bought from an outside supplier or made by the assembling firm. For each of these components, the firm’s managers must decide: make or buy. The make-or-buy decision is the act of making a choice between producing an item internally (in-house) or buying it externally (from an outside supplier). The buy side of the decision also is referred to as outsourcing. Make-or-buy decisions usually arise when a firm that has developed a product or part-or significantly modified a product or part-is having trouble with current suppliers, or has diminishing capacity or changing demand.
In make or buy decisions, the appropriate means of analysis is to compare the relevant cost of buying the part with the relevant cots of making the part. Here relevant cost of buying the component is typically the amount paid to supplier. It may also include transportation costs incurred to get the component to the company’s plant and costs incurred to process the part upon receipt.
The relevant cost of making the component is often the variable costs incurred to produce the component. In some cases, however, the company will need to acquire special equipment to produce the product or will hire additional supervisory personnel to assist with making the product. These incremental fixed costs will be part of the relevant cost of making the part. The alternative chosen make or buy, is typically the one with the lowest cost.
Factors that may influence firms to make a part in-house include:
- Cost considerations (less expensive to make the part)
- Desire to integrate plant operations
- Productive use of excess plant capacity to help absorb fixed overhead (using existing idle capacity)
- Need to exert direct control over production and/or quality
- Better quality control
- Design secrecy is required to protect proprietary technology
- Unreliable suppliers
- No competent suppliers
- Desire to maintain a stable workforce (in periods of declining sales)
- Quantity too small to interest a supplier
- Control of lead time, transportation, and warehousing costs
- Greater assurance of continual supply
- Provision of a second source
- Political, social or environmental reasons (union pressure)
- Emotion (e.g., pride)
Factors that may influence firms to buy a part externally include:
- Lack of expertise
- Suppliers' research and specialized know-how exceeds that of the buyer
- cost considerations (less expensive to buy the item)
- Small-volume requirements
- Limited production facilities or insufficient capacity
- Desire to maintain a multiple-source policy
- Indirect managerial control considerations
- Procurement and inventory considerations
- Brand preference
- Item not essential to the firm's strategy
The two most important factors to consider in a make-or-buy decision are cost and the availability of production capacity. Cost considerations should include all relevant costs. Obviously, the buying firm will compare production and purchase costs. Elements of the "make" analysis include:
- Incremental inventory-carrying costs
- Direct labor costs
- Incremental factory overhead costs
- Delivered purchased material costs
- Incremental managerial costs
- Any follow-on costs stemming from quality and related problems
- Incremental purchasing costs
- Incremental capital costs
Cost considerations for the "buy" analysis include:
- Purchase price of the part
- Transportation costs
- Receiving and inspection costs
- Incremental purchasing costs
- Any follow-on costs related to quality or service
Sell or Process Further Decisions
In some manufacturing processes, several intermediate products are produced from a single input. Such products are known as joint products if they have relatively significant sales values and are not separately identifiable as individual products until their split off. The process that makes the joint products is called a joint process. The costs associated with making these products up to the point where they can be recognized as separate products (the split-off point) are called joint product costs.
Manufacturers of joint products must decide to sell them at the split-off point or process them further into another saleable product. It is profitable to continue processing a joint product after the split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs (separable costs). In such decisions, the joint product costs incurred before the split-off point are irrelevant and should be ignored. The joint product costs have already been incurred and therefore are sunk costs. However, allocation of joint product costs is need for some purposes, such as balance sheet inventory valuation. In case joint products are on hand at the end of an accounting period, some value must be assigned to them. To do so, joint product costs must be allocated to specific units of inventory. In addition, joint costs are also important for income determination.
Keep or Replace Equipment Decisions
Care must be taken to select only the data that are relevant for a decision whether to replace or keep the old equipment. In such kind of decision, the book value of the old equipment is not a relevant consideration, for instance.
In deciding whether to replace or keep existing equipment, four commonly encountered items differ in relevance:
- Book value of old equipment: Irrelevant, because it is a past (historical) Cost. Therefore, depreciation on old equipments irrelevant.
- Disposal value of old equipment: Relevant, because it is an expected future inflow that usually differs among alternatives.
- Gain or loss on disposal: This is the algebraic difference between book value and disposal value. It is therefore, a meaningless combination of irrelevant and relevant items. Consequently, it is best to think of each separately.
- Cost of new equipment: Relevant, because it is an expected future outflow that will differ among alternatives. Therefore depreciation on new equipment is relevant.
Cost and management accountants supply information for special types of decision-making. The essential quantitative factors influencing such decisions are differential revenues and costs, including opportunity costs. Costs and revenues that will be the same whatever action is taken can be ignored. Historical costs are sunk and irrelevant for current decisions because they cannot be changed by some current action. Avoidable fixed costs are relevant. Whether a cost is relevant to a particular decision does not always depend on whether the cost is variable or fixed.
Typical examples of special types decisions are whether to drop a product or product line, whether to produce a component internally or purchase it from an outside supplier, whether to further process joint products, whether to accept a special order, keep or replace an old equipment, and how to use limited supply of some critical input factors.