Chapter Two

Relevant information and Decision Making

2.1 Relevant and irrelevant information
Explain the concept of relevant costs and relevant revenues and how this is potentially different from the
notion of fixed and variable costs.
Explain ‘sunk costs’ and why they are considered irrelevant to decisions.
Explain such terms as ‘opportunity costs’, ‘avoidable costs’, ‘differential costs’ and ‘incremental costs’.
Marketing Decisions
Production Decisions
Relevant Information and Decision Making

Cost Concepts for Decision making

Differential cost:- is a difference in cost between any two alternatives. It is also known as an
incremental cost, although technically an incremental cost should refer only to an increase in
cost from one alternative to another, decreases in cost should be referred to as decremental cost.
Differential cost is a broader term, encompassing both cost increases (incremental cost) and cost
decreases (decremental cost) between alternatives.

Opportunity Cost: is the potential benefit that is given up (lost) when one alternative is selected
over another.

Suppose Seble is employed in Dashen Brewery S.C. with annual salary of Br. 13,200. She is
thinking about leaving the company and returning to school. Since returning to school would
require that she give up her 13,200 salary, the foregone salary would be an opportunity cost of
seeking further education.

Sunk Cost: - is a cost that already been incurred and that cannot be changed by any decision
made now or in the future. Since sunk costs cannot be changed by any decision, they are not
differential costs. Therefore, they can and should be ignored when a decision is made.

Traceable Cost: - Costs which are directly related to a cost object and can be traced to that cost
object in an economically feasible (cost-effective) way. Cost tracing is used to describe the
assignment of direct costs to the particular cost object.

Inventoriable Costs:- are all costs of a product that are regarded as assets when they are incurred
and then become cost of goods sold when the product is sold. For manufacturing companies, all
manufacturing costs are inventoriable costs. For merchandising companies, inventoriable costs
are the costs of purchasing the goods that are resold in their same form.

Avoidable Costs:- is a cost that can be eliminated in whole or in part by choosing one alternative
over another.

Relevant Information
Relevant information is information that is provided by managerial accountants to a manager and
consists of data that are pertinent to a decision.

In designing the accounting information system, the three characteristics of information

determine its usefulness:

Relevance

Accuracy

Timeliness

In general, the managerial account’s primary role in decision making process is twofold:

Decide what information is relevant to each decision problem.

Provide accurate and timely data, keeping in mind the proper balance between these often
conflicting criteria.

To be relevant, any costs and revenues must:

Occur in the future:- every decision deals with selecting a course of action based on its
expected future results.

Differ among 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.

Potential Problems in Relevant Cost Analysis

There are two potential problems that should be avoided in relevant cost analysis:
Watch out for general assumptions; such as
All variable costs are relevant
All fixed costs are irrelevant
Unit cost data can potentially mislead decision makers in two ways:
When irrelevant costs are added
When the same unit costs are used at different output level
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. Some
quantitative factors are financial; they can be expressed in monetary terms. Examples include the
cost of direct materials, direct manufacturing labor, and marketing. Other quantitative factors are
nonfinancial; they can be measured numerically, but they are not expressed in monetary terms.
Reduction in new product-development time and the percentage of on-time flight arrivals are
examples of quantitative nonfinancial factors. Qualitative factors are outcomes that are difficult
to measure accurately in numerical terms. Employee morale is an example.
Relevant-cost analysis generally emphasizes quantitative factors that can be expressed in
financial terms. But just because qualitative factors and quantitative nonfinancial factors cannot
be measured easily in financial terms does not make them unimportant. In fact, managers must
wisely weigh these factors.

Key Features of Relevant Information

Past (historical) costs may be helpful as a basis for making predictions. However, past
costs themselves are always irrelevant when making decisions.
Different alternatives can be compared by examining differences in expected total future
revenues and expected total future costs.
Not all expected future revenues and expected future costs are relevant. Expected future
revenues and expected future costs that do not differ among alternatives are irrelevant
and, hence, can be eliminated from the analysis. The key question is always, “What
difference will an action make?”
Appropriate weight must be given to qualitative factors and quantitative nonfinancial
factors.

Analysis of Special Decisions

One Time Only Special Order

One type of decision that affects output levels is accepting or rejecting special orders when there
is idle production capacity and the special orders have no long-run implications. Under this
condition, it is assumed that:
There is idle capacity
The price discrimination has no effect on the regular customers
There is no reoffer
It has no long run implications
Example:
Given the following data, should the company accept or reject the offer?
Normal selling price Br. 20/ unit
Special Order Selling price 13/unit
Normal units sold 1,000,000 units
Special order in units 100,000
Variable manufacturing cost 12/unit
Variable operating costs 1.1/unit
Total Fixed costs 5,900,000
Solution
Comparative Income Statement
Descriptions Without With SalesDifference
Sales order Order

Units Sold 1,000,000 1,100,000 100,000

Revenue 20,000,000 21,300,000 1,300,000

Variable Costs

Variable Mfg Cost 12,000,000 13,200,000

Variable Operating Expense 1,100,000 13,100,000 1,210,000 14,410,000 1,310,000

Contribution Margin 6,900,000 6,890,000 (10,000)

Total Fixed Costs 5,900,000 5,900,000

Operating Income 1,000,000 990,000 (10,000)

Therefore, the company should not accept the special order, because it will incur loss of Br.
10,000.
Example
XYZ Company is currently producing jewelers and considering a special order for 10 gold
bracelets. The normal selling price of a gold bracelet is Br. 3,895 and its unit product cost is Br.
2,640 as shown below:
Direct Materials Br. 1,430
Direct Labor 860
MOH 350
Unit product cost 2,640
Most of the MOH is fixed and unaffected by variations in how much jewelry is produced in any
given period. However, B. 70 of the MOH is variable with respect to the number of bracelets
produced. The customer who is interested in the special bracelet order would like special filigree
applied to the bracelets. This filigree would require addition materials costing Br. 60 per bracelet
and would also require acquisition of a special tool costing Br. 4,650 that would have no other
use once the special order is completed.
This order would not have effect on the company’s regular sales and the order could be fulfilled
using the company’s existing capacity without affecting any other order.
Required: If the special order selling price is Br. 3,499.5 per bracelet, should the company accept
or reject?
Solution
Descriptions Per Unit Total 10 Bracelets

Incremental Revenue 3,499.5 34,995

Descriptions Per Unit Total 10 Bracelets

Incremental Variable Cost

Direct Materials 1,490 14,900

Direct Labor 860 8,600

MOH 70 700

Total Incremental Variable Cost 2360 24,200

Contribution Margin 1,139.5 10,795

Incremental Fixed Cost 4,650

Operating Income 6,145

Therefore, the company should accept the offer because the special order will increase its
operating income by Br. 6,145.
Exercise
AGC Company produces a single product. The cost of producing and selling a single unit of this
product at the company’s current activity level of 8,000 units per month is as follows:
Direct materials Br. 25
Direct labor 30
Variable MOH 5
Fixed MOH 42.5
Variable selling and Administrative expenses 15
Fixed selling and Administrative expenses 20
The normal selling price is Br. 150 per unit. The company’s capacity is 10,000 units per month.
An order has been received from an overseas source for 2,000 units at a price of Br. 120 per unit.
This order would not change the company’s total fixed costs.
Required: Should the company accept or reject the offer?

Make or Buy Decision

Decisions about whether a producer of goods or services will insource or outsource are also
called make-or-buy decisions. 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.
To approach the decision from a financial point of view, the manager should focus on the
relevant costs. The costs that remain after eliminating the sunk costs and the future costs that will
not differ between alternatives are the costs that are avoidable to the company by purchasing
outside. If avoidable costs are less than the outside purchase price, then the company should
 continue to manufacture the product and reject the outside supplier’s offer. That is, the company
should purchase outside only when purchase price is less than the cost that can be avoided by
halting its own production of the product.
Example
ABC Company is currently producing its component parts of the finished goods by its own
operation. The company is producing component part IV in its vertically integrated
manufacturing process with the following listed unit product costs:
Variable costs:
Direct materials Br. 60
Direct labor 40
Variable MOH 40
Fixed Costs:
Supervisory Salaries 40
Common Fixed MOH 70
Unit Product Cost Br. 250
An outside producer has offered to supply the part for Br. 210 each. If ABC Company stops
manufacturing component part IV, it will save all variable costs but only Br. 10 of the fixed
supervisory costs. The remaining fixed costs will incur even if the component part IV were
purchased.
Required: Should the company make or buy the component part at the offered price?
Solution
Description Make Buy

Variable Costs:

Direct Materials 60 -

Direct labor 40 -

Variable MOH 40 -

Fixed costs 10 -

Purchase Cost - 210

Total Unit Product cost 150 210

Difference in favor of Br.60

continuing to make

Therefore, the company should make the part.

Example: Assume the following costs are reported by the managerial accountant of XYZ Company:
 Unit Cost Total cost for 20,000 units

Direct Materials 10 200,000

Direct labor 40 800,000

Variable MOH 20 400,000

Fixed MOH 40 800,000

Total costs 110 2,200,000

Another manufacturer offers to sell XYZ Company the same part for Br. 100. Perhaps, Br. 10 of
the fixed costs will be saved if the parts were bought instead of made.
Required:
Should the company make or buy the part, if we assume that the capacity now used to
make the part will become idle if the part is purchased?
Suppose the released capacity can be used advantageously in some other manufacturing
activity like to produce a product having a profit margin Br. 350,000 or can be rented for
Br. 500,000. Should the company make or buy the part?

Make Buy

Unit cost Total Cost Unit cost Total Cost

Direct Materials 10 200,000 - -

Direct labor 40 800,000 - -

Variable MOH 20 400,000 - -

Fixed MOH 10 200,000 - -

Purchase Cost - - 100 2,000,000

Total costs 80 1,600,000 100 2,000,000

Therefore, the company should make the part

Opportunity cost approach
Make Buy and leaveBuy and Rent Out Buy and produce
Idle facility Idle facility other product

Incremental total cost of 1,600,000 2,000,000 2,000,000 2,000,000

buying/making the part
 Make Buy and leaveBuy and Rent Out Buy and produce
Idle facility Idle facility other product

Opportunity Costs

Profit Margin Foregone 350,000 350,000 350,000 -

Rent Revenue foregone 500,000 500,000 - 500,000

Total relevant costs 2,450,000 2,850,000 2,350,000 2,500,000

Therefore, the company should buy and rent the idle facility.
Note: the profit margin foregone because the idle capacity will not be used to produce the other
product.
The rent revenue foregone, because the idle capacity will not be used to rent service.
Exercise
ABC Company manufactures 20,000 units of component part II each year for use on its
production line. The cost per unit for part II is as follows:
Direct materials Br. 48
Direct labor 70
Variable MOH 32
Fixed MOH 100
Total cost per part 250
An outside supplier has offered to sell 20,000 units of part II each year for Br. 235 per part. If
ABC Company accepts this offer, the facilities now being used to manufacture part II could be
rented to another company at an annual rental of Br. 1,500,000. However, ABC Company has
determined that Br. 60 of the fixed MOH being applied to Part II would continue even if part II
were purchased from outside supplier.
Required: prepare computation to show the net birr advantage or disadvantage of accepting the
outside supplier’s offer.
Sell or Process Further Decision

Nature of Joint Products

Joint costs are the costs of a production process that yields multiple products simultaneously.
The juncture in the process when one or more products in a joint-cost setting become separately
identifiable is called the split-off point. An example is the point where coal becomes coke, gas
and other products. Separable costs are costs incurred beyond the split-off point that are
assignable to one or more individual products. At or beyond the split-off point, decisions relating
to sale or further processing of individual products can be made independently of decisions about
other products.
Various terms have arisen in conjunction with production processes. A product is any output
that has a positive sales value (or an output that enables an organization to avoid incurring costs).
 Joint products all have relatively high sales value but are not separately identifiable as
individual products until the split-off point. When a single process yielding two or more products
yields only one product with a relatively high sales value, that product is termed a main product.
A by-product has a low sales value compared with the sales value of the main or joint product(s).
Scrap has a minimal sales value. The classification of products as main, joint, by-product or
scrap can change over time, especially for products (such as tin) whose market price can increase
or decrease by, say, 30% or more in any one year.
Features of Joint Products
The following are the important features of joint products:
Joint products are produced from the same raw materials.
They are produced from the common features of manufacturing process.
Joint products are of equal importance and value.
They may require further processing after their split off or point of separation.
Joint costs are irrelevant in decisions regarding what to do with a product from the split off point
forward. The reason is that regardless of what is done with the product after the split off point,
the joint costs were incurred to get the product to the split off point. Therefore, the joint costs are
common costs of all the intermediate and end products and should not be allocated to them for
the purpose of making decisions about the product.

Example
Suppose a company produces two type of soaps; popular and pelican, as a result of particular
joint process. The joint cost is Br. 17,000.
6,000 pieces of Popular @ 3.6 = Br. 21,600
Joint Cost Br. 17,000
4,000 pieces of Pelican @ 2.9 = Br. 11,600
The 6,000 pieces of popular can be processed further and sold as A-Grade soap with net selling
price of 4.20 per soap and incur an additional cost of Br. 0.20 per soap for manufacturing and
distribution.
Required: Pelican soap will be sold at the split off point. Should the company sell or process
further the popular soap?
Solution
Sell at split off asProcess further asDifference
Popular A-Grade

Revenue 21,600 25,200 3,600

Separable cost beyond split off point - 1,200 1,200

Income effect 21,600 24,000 2,400

 Or

Alternative 1 Alternative 2

Popular Pelican Total A-Grade Pelican Total Difference

Revenue 21,600 11,600 33,200 25,200 11,600 36,800 3,600

Joint Costs - - 17,000 - - 17,000 -

Separable Costs - - - 1,200 - 1,200 1,200

Total cost 17,000 18,200 1,200

Income effect 16,200 18,600 2,400

Therefore, the company should process further.

Example

ABC Company is producing three products with joint costs of Br. 100,000 per year. The sales
value of each product at the split off point is as follows: Product X, br. 50,000; Product y, Br.
90,000; and Product Z, Br. 60,000.

Each product can be sold at the split off point or processed further. Additional processing
requires no additional facilities. The additional processing costs and the sales value after further
processing for each product are shown below:

Product Additional processing costs Sales Value

X 35,000 80,000

Y 40,000 150,000

Z 12,000 75,000

Required: which product or products should be sold at the split off point and which product or
products should be processed further?

Solution

Analysis of the profitability of the overall operation:

Combined Sales Value (80,000+150,000+75,000) 305,000

 Costs of producing the end products:

Joint Cost 100,000

Separable cost (35,000+40,000+12,000) 87,000 187,000

Profit 118,000

Analysis of sell or process further

X Y Z

Final sales Value after further Processing 80,000 150,000 75,000

Less: Sales Value @ the split off point 50,000 90,000 60,000

Incremental Revenue b/c of further processing 30,000 60,000 15,000

Less: Separable Cost 35,000 40,000 12,000

Profit/loss from further processing (5,000) 20,000 3,000

As the analysis shows, the company would be better of selling product X as it is rather than
further processing, product Y and Z should be processed further.

Product –Mix Decision under Capacity Constraints

The product mix decisions are the decisions by a company about which products to produce and
sale and in what quantities. These decisions usually have only a short run focus because the level
of capacity can be expanded in the long run. Throughout this section, we assume that as short run
changes in product mix occur, the only costs that changes are costs that are variable with respect
to the number of units produced and sold. Since the company cannot satisfy demand, the
manager must decide how the constrained resources should be used. Fixed costs are usually
unaffected by such choices, so the course of action that will maximize the firm’s total
contribution margin should ordinarily be selected.

Example

XYZ Company produces three products A, B, and C. data concerning the three products as
follows (per unit):
Product A B C

Selling Price 80 56 70

Variable Costs

Direct materials 24 15 9

Labor & OH 24 27 40

Total variable Costs 48 42 49

Contribution Margin 32 14 21

Demand for the company’s products is very strong, with far more orders each month than the
company can produce with the available raw materials. The same material is used in each
product. The material costs Br. 3 per kg, with a maximum of 5,000 kg each month.

Required: which order would you advise the company to accept first, second, and third?

Solution

Product A B C

Contribution Margin 32 14 21

Direct Materials in kg Per unit 8 5 3

Contribution Margin per unit of DM 4 2.8 7

Total contribution margin for 5,000 kg 20,000 14,000 35,000

Therefore, the company should accept orders in the order of first C, second A, and third B.

Adding and Dropping product lines and other segments decision

Decisions relating to whether old product lines or other segments of a company should be
dropped and new ones added are among the most difficult decisions that a manager has to make.
Ultimately, however, any final decisions to drop an old segment or to add a new one is to link
primarily on the impact the decision will have on net operating income. To assess this impact, it
is necessary to carefully analyze the costs.
 Example

Segments

Total A B C

Revenues 900,000 260,000 400,000 240,000

Variable Costs 490,000 120,000 210,000 160,000

Contribution Margin 410,000 140,000 190,000 80,000

Fixed Costs

Depreciation Expense 68,000 8,000 40,000 20,000

Insurance expense 42,000 20,000 7,000 15,000

Seg. Admin. Salaries 115,000 40,000 38,000 37,000

General Admin. OH 180,000 52,000 80,000 48,000

Total Fixed costs 405,000 120,000 165,000 120,000

Operating income/loss 5,000 20,000 25,000 (40,000)

XYZ Company has the above three segment of production. The depreciation in segment C is for
a machine that is used to carry the production process. If the segment is discontinued, the
machine would be discarded because it has no market value currently. None of the general
administrative overhead would be avoided if segment C is dropped, but the insurance expense
and salary of segment administrator would be avoided.

Required: Should segment C be discontinued?

Solution

Keep SegmentDrop segmentD/ce Net

C C Operating
Income

Revenue 240,000 - (240,000)

Variable Cost 160,0000 - 160,000

 Keep SegmentDrop segmentD/ce Net
C C Operating
Income

Contribution Margin 80,000 - (80,000)

Fixed Costs

Depreciation Expense 20,000 - 20,000

Insurance expense 15,000 - 15,000

Seg. Admin. Salaries 37,000 - 37,000

General Admin. OH 48,000 48,000 -

Total Fixed Costs 120,000 48,000 72,000

Net Operating income/loss (40,000) (48,000) (8,000)

Or

The five years together:

The contribution Margin lost if segment C is dropped Br. (80,000)

Less: Fixed costs that can be avoided if segment C 72,000

discontinued

Decrease in overall company operating income (8,000)

Therefore, the company should not drop segment C.

Irrelevance of past costs and Equipment Replacement Decisions

We stress the idea that all past costs and, in particular, book value-original cost minus
accumulated depreciation- of existing equipment, are irrelevant. The book value, in this context
is sometimes called a sunk cost, which is really just another term for historical or past cost, a cost
that has already been incurred and, therefore, is irrelevant to the decision making process. All
past costs are down the drain. Nothing can change what has already happened.
 In deciding whether to replace or keep existing equipment, we must consider the relevance of
four commonly encountered items:

Book value of old equipment: Irrelevant, because it is past cost. Therefore, depreciation
on old equipment is irrelevant.

Disposal value of old equipment: Relevant (ordinarily), because it is an expected future

inflow that usually differs among alternatives.

Gain/loss on disposal: this is the difference between book value and disposal value. It is
therefore a meaningless combination of irrelevant and relevant items. The combination
form, gain/loss on disposal, blurs the distinction between the irrelevant book value and
the relevant disposal value. Consequently, it is best to think 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.

Example Three years ago XYZ Company bought a machine for Br. 8,000. The manager has just
suggested replacing the machine with a new, Br. 12,500. The manager has gathered the
following data:

Old Machine New Machine

Original cost Br. 8,000 Br. 12,500

Useful life in years 8 5

Current age in years 3 0

Useful life remaining in years 5 5

Accumulated depreciation Br. 3,000 Not yet acquired

Book value Br. 5,000 Not yet acquired

Disposal value (in cash) now Br. 2,000 Not yet acquired

Disposal value in 5 years 0 0

Annual cash operating cost Br. 4,500 Br. 2,000

Required: Should the company keep or replace the machine?

Solution
 Keep Replace Difference

Cash operating cost Br. 22,500 Br. 10,000 Br. 12,500

Old Equipment

Periodic write off as Br. 5,000

depn.

Lump sum write off Br. 5,000

Disposal Value - Br. (2,000) 2,000

New Machine acquisition cost - Br. 12,500 (12,500)

Total cost Br. 27,500 Br. 27,500 Br.2,000

Or

Keep Replace Difference

Cash operating cost Br. 22,500 Br. 10,000 Br. 12,500

Disposal value of old equipment (2,000) 2,000

Acquisition cost of new equipment 12,500 (12,500)

Total relevant cost 22,500 20,500 2,000

Therefore, the company should replace the machine.

Exercise

ABC Company has just today paid for and installed a special machine. It is the first day of the
company’s fiscal year. The machine cost Br. 20,000. Its annual cash operating costs total Br.
15,000. The machine will have a four year useful life and zero terminal disposal value.

After the machine has been used for only one day, the manager offers a different machine that
promises to do the same job at annual cash operating costs of Br. 9,000. The new machine will
cost Br. 24,000 cash. The old machine is unique and can be sold for only Br. 8,000. The new
machine, like the old one, will have a four year useful life and zero terminal disposal value.

Require: Should the company keep or replace the machine?