Cost and Management Accounting II

Chapter Two

Relevant Information and Decision

Making [Short-term Decisions]
 Learning Objectives

By the end of this chapter, you should be able to:

LO-1 Identify the steps in management’s decision making
process

LO-2 Describe the concepts of relevant information and

incremental analysis

LO-3 Use the relevant information concept in making

special (short-term) decisions
 LO-1 Identify the steps in management’s
decision making process
• Making decision is an important management
function.
• Management’s decision-making process does not
always follow a set of pattern as decisions vary
significantly in their scope, urgency, and importance.

• Steps in decision making:

– Identify the problem and assign responsibility
– Determine and evaluate possible course of action
– Make a decision
– Review results of the decision
 LO – 1 … steps in management’s decision making process

• In business DM, management ordinarily considers

both financial and nonfinancial information.
• Financial => is related to revenues and costs and
their effect on the company’s overall profitability.
• Nonfinancial => relates to CSR factors such as effect
of employee turn over, the environment, image of
the company in the community.
 LO-2 Describe the
concepts of relevant
information and
incremental analysis
LO-2 Describe the concepts of relevant
information and incremental analysis
• Relevant information:
– Is the most important concept in DM which includes relevant costs
and relevant revenues (benefits).
• The relevant costs and benefits:
– refer only those that will be affected by the decision.
• Accordingly, costs and benefits that are independent of a
decision are obviously not relevant and need not be
considered when making that decision.
• The relevant financial inputs for decision making purposes
are therefore future cash flows, which will differ between the
various alternatives being considered.
LO-2 Describe the concepts of relevant information
and incremental analysis
• In other words, only differential (or incremental) cash flows
should be taken into account, and cash flows that will be the
same for all alternatives are irrelevant.
– Relevant costs: are those expected future costs that differ among
alternative courses of action.
– Relevant revenues: are those expected future revenues that differ
among alternative courses of action.

• We focus on the future because:

– every decision deals with the future – nothing can be done to alter the
past and
– the future costs must differ among the alternatives because if they do
not, there will be no difference in costs no matter what decision is made.

• Incremental analysis: means analyzing the changes in costs and

revenues caused by a change in activity.
 What makes information relevant to
a decision problem?
◼ Two criteria are important:
❑ Bearing on the future:
◼ The consequence of the
decisions are born in the future,
not in the past.
❑ Different under competing
alternatives
◼ Must involve costs or
benefits that differ
among the alternatives
Some cost concepts + Question
◼ Common costs:
❑ Are costs which will be identical for all alternatives.
e.g. rent or rates on a factory.
◼ Sunk costs (past costs):
❑ These costs are monies already spent or money
already contracted to be spent.
❑ E.g. money that has been spent on market research
for a new product development
◼ Committed costs:
❑ Are costs that would be incurred in the future but
cannot be avoided because the company has already
committed to them.
❑ E.g. two years lease for a piece of machinery
 some cost concepts
➢ An avoidable cost is a cost that can be
eliminated, in whole or in part, by choosing
one alternative over another.

➢ Avoidable costs are relevant costs.

➢ Unavoidable costs are irrelevant costs.

 some cost concepts
• Opportunity cost is the benefit sacrificed or
foregone when one alternative is chosen over
another.
• An opportunity cost is relevant because it is
both a future cost and one that differs across
alternatives.

• While an opportunity cost is never an

accounting cost, because accountants do not
record the cost of what might happen in the
future (i.e., they do not appear in financial
statements), it is an important consideration in
relevant decision making.
 Decision Making: A Two-Step Process

Step One:
- Eliminate costs and benefits that do not differ
between alternatives.
Step Two:
- Use the remaining costs and benefits that differ
between alternatives in making the decision.
The costs that remain are the differential, or
avoidable, costs.
 LO-3 Use the relevant information
concept in making special decisions
Types of incremental analysis
• A number of different types of decisions involve
incremental analysis. The more common types of
decisions are whether to:
a) Accept or reject an order at a special price
b) Make or buy component parts or finished products.
c) Sell products or process them further
d) Eliminate an unprofitable business segment or
product
e) Existence of Limiting factor
Accept or reject an order at a
special price
 Special Orders Decisions:
• XYZ Co. has received a one-time offer for 500 prints
at a special price of Br. 0.40 per print (Br.200).

• The regular price is Br. 0.50. should the offer be accepted

or rejected.

Sales for the week (5,000 prints at Br. 0.50) Br.2,500

Less: Variable costs, including paper, maintenance,
and etc (5,000 copies at Br. 0.20) 1,000
Total contribution margin Br. 1,500
Less: Fixed costs (supplies, plus allocated costs
of the print shop) 1,200
Operating profit for the week Br. 300
 Special Orders Decisions
Condition I: Analysis of Special Order: Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special Difference
Offer) Offer) (Af – Bf)
Comparison of Totals
Sales revenue Br.2,500 Br.2,700 Br.200
Variable costs (1,000) (1,100) (100)
Total contribution Br.1,500 Br.1,600 Br.100
Fixed costs (1,200) (1,200) -0-
Operating profit Br. 300 Br. 400 Br.100

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. 0.40 Br. 200
Less: Differential costs, 500 at Br. 0.20 100
Differential operating profit (before taxes) Br. 100

The special order should be accepted

 Special Orders Decisions
Condition II: Analysis of Special Order: No Idle capacity
Status
Quo: Alternative:
(Without (with
Special Special
Offer) Offer) Difference
Comparison of Totals
Sales revenue Br.2,500 Br.2,450 Br.(50)
Less: Variable costs 1,000 1,000 -0-
Total contribution Br.1,500 Br.1,450 Br.(50)
Less: Fixed costs 1,200 1,200 -0-
Operating profit Br. 300 Br. 250 Br.(50)

Alternative Presentation: Differential Analysis

Differential sales, 500 at Br. (0.10) Br. (50)
Less: Differential costs, -0-
Differential operating profit (before taxes) Br. (50)

The special order should be rejected

Make or Buy Component
Parts or Finished Goods
b) Make or Buy - Illustration
• ENTOTO Plc is an electric motorcycle manufacturer.
When it assembles component parts in producing a
finished product, management must decide whether to
make or buy the components. It incurs the following
annual costs in producing 25,000 ignition switches.
Item Cost
Direct materials Br. 50,000
Direct labor 75,000
Variable MOH 40,000
Fixed MOH 60,000
Total manufacturing costs Br. 225,000
Total Cost Per Unit Br. 9.00
b) Make or Buy - Illustration…
• Instead of making its own switches, ENTOTO Plc. might
purchase the ignition switches from Habesha Plc at a
price of Br. 8 per unit.
• A review of operations indicates that if the ignition
switches are purchased from Habesha Plc, all of
ENTOTO Plc’s variable costs but only Br. 10,000 of its
fixed manufacturing costs will be eliminated or avoided.

• What is your recommendation to the Management: make

in house or buy from the vendor?

• Incremental Analysis: see the next slide

 b) Make or Buy - Illustration…
Increase /
Item Make Buy Decrease

Direct Material Br. 50,000 Br. 0 Br. 50,000

Direct Labor 75,000 0 75,000

Variable MOH 40,000 0 40,000

Fixed MOH 60,000 50,000 10,000

Purchase price [25,000 x Br. 8] 00000 Br. 200,000 (200,000)

Total Annual Cost Br. 225,000 Br. 250,000 Br. (25,000)

Decision: ENTOTO should make the ignition than buy from Habesha
Sell products or process them
Further
 Part I : Single Product Case
• Assume WANZA Furniture sells its unfinished tables for Br. 500. The
cost to manufacture an unfinished table is Br. 350, computed as
follows.
Item Unit Cost
Direct Materials Br. 150.00
Direct Labor 100.00
Variable MOH 60.00
Fixed MOH 40.00
Manufacturing cost per Unit Br. 350.00
• WANZA currently has unused productive capacity that is expected to
continue indefinitely. Some of this capacity could be used to finish the
tables and sell them at Br. 600 per unit. For a finished table, direct
materials will increase Br. 20 and direct labor cost will increase Br. 40.
Variable MOH cost will increase Br. 24 (i.e. 60% of direct labor cost).
No increase is anticipated in fixed manufacturing overhead. Should
WANZA further process the unfinished tables?
Part I: Single Product Case: Solution Rule:
Process further only if
incremental revenues >
• Incremental Analysis incremental costs

Item Sell Sell after Difference

Unfinished further
Table process
Sales Per Unit: Br. 500.00 Br. 600.00 Br. 100.00
Cost Per Unit
Direct Materials Br. 150.00 Br. 170.00 Br. 20.00
Direct Labor 100.00 140.00 40.00
Variable MOH 60.00 84.00 24.00
Fixed MOH 40.00 40.00 0
Manufacturing cost per Unit Br. 350.00 Br. 434.00 84.00
Income Per Unit Br. 150.00 Br. 166.00 Br. 16.00
 Activity
• B2B Plc makes unfinished bookcases that it sells
for Br. 620. Production costs are Br. 360 variable
and Br. 100 fixed. Because it has unused capacity,
B2B is considering finishing the bookcases and
selling them for Br. 700. Variable finishing costs per
unit are expected to be 70% of the incremental with
no increase in fixed costs. Should B2B go for
further processing?
 Part II Joint Product Decisions

Two or more products produced from a

common input are called joint products.

Product A
Joint costs are
the costs of
Joint Costs
Product B processing prior to
the split-off point.

Product C
The split-off point is the point in a process where
joint products can be recognized as separate products.
 Joint Product Decisions

• Joint costs are really common costs incurred to

simultaneously produce a variety of end
products.

• General rule:
Process further only if:
incremental revenues > incremental costs
 Joint Product Decisions

Addis Mfg Co. produces two products, X and Y, from thisprocess.

Further Final
OIL X Revenue
Revenue
Br.
Br.80,000
80,000 Processing Sale
Br. 50,000 Br.120,000

Joint Common
Cost Joint
Production
Br. 120,000 Product
Process

CHEMICALS Y Revenue Further Final

Br. 70,000 Processing Sale
Br. 40,000 Br.115,000
Split-Off
Point

Should the products be sold at split-off or processed further?

 Joint Product Decisions
Incremental Incremental
Product Revenue Cost Difference
X Br. 40,000 Br. 50,000 Br.(10,000)
Y 45,000 40,000 5,000

Product X incremental revenue = Br. 120,000 - 80,000

Product Y incremental revenue = Br. 115,000 - 70,000

Decision:
Process product Y, but sell product X at the split-off point.
Note that the Br.120,000 joint cost is irrelevant to the
processing decision.
 Eliminate an unprofitable
business segment or product
 Eliminate an Unprofitable Segment or Product
• Illustration:
• Assume Horizon Addis Tyre manufactures three different models:
A, B and C. A and B are profitable Models. Model C operates at a
loss.
Item Model A Model B Model C Total
Sales Br. 800,000 Br. 300,000 Br. 100,000 Br. 1,200,000
-Variable Cost 520,000 210,000 90,000 820,000
Cont. Margin Br. 280,000 Br. 90,000 Br. 10,000 Br. 380,000
-Fixed Costs 80,000 50,000 30,000 160,000
Net Income Br. 200,000 Br. 40,000 Br. (20,000) Br. 220,000

• Analysis of documents show that if Model C segment is

eliminated, its fixed cost will be allocated 2/3 to Model A and
1/3 to Model B.
• Should Horizon eliminate Model C?
 d) Eliminate an Unprofitable Segment or
Product
• Incremental Analysis – If Model C is Eliminated
• Item Continue with Continue without Difference
Model C Model C

Sales Br. 1,200,000 Br. 1,100,000 Br. (100,000)

-Variable Cost 820,000 730,000 90,000
Cont. Margin Br. 380,000 Br. 370,000 Br. (10,000)
-Fixed Costs 160,000 160,000 0
Net Income Br. 220,000 Br. 210,000 Br. (10,000)

• Hence, Horizon Addis Tyre should not eliminate Model C?

Existence of Limiting Factor
Product Choice Decisions

Constraints
Activities, resources, or policies that limit the
attainment of an objective are called constraints.

Contribution Margin per Unit of Scarce Resource

Contribution margin per unit of a particular input with

limited availability.
 Product Choice Decisions
XYZ Co
Revenue and Cost Information
Metal Wood
frames frames
Price
Less: Variable costs per unit Br.50 Br.80
Material 8 22
Labor 8 24
Overhead 4 4
Contribution margin per unit Br.30 Br.30
Fixed costs:
Manufacturing Br.3,000
Marketing and administrative 1,500
Total Br.4,500
 Product Choice Decisions
XYZ Co.
Revenue and Cost Information
Metal Wood
frames frames

Per unit:
Contribution margin Br. 30 Br. 30
Machine hours required ÷ 0.5 ÷ 1.0
Contribution margin per machine hour Br. 60 Br. 30

Metal Frames have a higher contribution margin

per machine hour.
Product Choice Decisions
Suppose XYZ Co. has 200 machine hours per
month available.
Metal Wood
frames frames
Capacity 400 200
Contribution margin per unit × Br.30 × Br.30
Total contribution margin Br.12,000 Br.6,000
Less: Fixed manufacturing costs 3,000 3,000
Less: Fixed marketing and admin. costs 1,500 1,500
Operating profit Br. 7,500 Br.1,500

Selling metal frames will result in higher profits than

selling wooden frames.
 Activity
• SNOW Co. makes three kinds of snowboards, but it has a
limited number of machine hours available to make them.
Product line data are as follows:
Particular Wood Plastic Graphite

Machine hours per unit 1.25 1.00 1.50

Selling price per unit Br. 100.00 Br. 120.00 Br. 200.00
Variable manufacturing cost per unit 45.00 50.00 100.00

Variable selling costs per unit 15.00 26.00 40.00

• In what order should the snowboard product lines be

produced?
 Activity - 2
• JB produces three products: A, B, and C which all require
skilled labor. This is limited to 6,100 hours per month.
A B C
Labor hours per unit 1 3 1.5
UCM Br. 30 Br. 45 Br. 30
Maximum sales 2,500 units 1,000 units 2,000 units

• In order to maximize profits for the month, production quantities

of each product should be:
• A. 2,500 (A) B. 2,000 (C) C. 200 (B)
• A. 2,500 (A) B. 2,000 (C) C. 1,000 (B)
• A. 2,500 (A) B. 1,000 (C) C. 1,000 (B)
• A. 2,000 (A) B. 2,000 (C) C. 1,000 (B)
Activity – 2 Solution
• Limiting factor : labor hours
A B C
UCM Br. 30 Br. 45 Br. 30
Labor hour per unit 1 3 1.5
Contribution per limiting factor Br. 30 Br. 15 Br. 20
Rank 1 3 2

Product Units Hours

A 2,500 [2,500 U x 1 Hr./unit] = 2,500 Hrs.
C 2,000 [2,000 U x 1.5 Hr./unit] = 3,000 Hrs
B 200 [200 U x 3 Hrs. / unit] = 600 Hrs
Total 6,100 Hrs
 Activity - 3
• JB produces three products: A, B, and C which all require
skilled labor. This is limited to 6,100 hours per month. But,
there was a contractual obligation to produce 500 units of
product B, how should the products now be produced

A B C
Labor hours per unit 1 3 1.5
UCM Br. 30 Br. 45 Br. 30
Maximum sales 2,500 units 1,000 units 2,000 units

• A. 500 (B) B. 2,500 (A) C. 2,800 (C)

• A. 500 (B) B. 2,500 (A) C. 1,400 (C)
• A. 500 (B) B. 2,000 (A) C. 1,200 (C)
• A. 500 (B) B. 2,000 (A) C. 1,000 (C)
Activity – 3 Solution
• Limiting factor : labor hours

Product Units Hours

B 500 [500 U x 3 Hr./unit] = 1,500 Hrs.
A 2,500 [2,500 U x 1 Hr./unit] = 1,500 Hrs
C 1400 [1,400 U x 1.5 Hrs. / unit] = 2,100 Hrs
Total 6,100 Hrs
End of Chapter Two