CHAPTER TWO

• Relevant Information and Decision Making

Relevant and Irrelevant Information
 Relevant information is any information that
would have an impact on the decision.
Relevant Information has two characteristics:
– It occurs in the future
– It differs among the alternative courses of action
Relevant costs are expected future costs that differ
among the alternative courses of action being
considered.
 Historical costs are irrelevant because they are
past costs and, therefore, cannot differ among
alternative future courses of action.
 Relevant costs are defined as those expected
future costs that differ among alternative courses
of action being considered.
 Thus, future costs that do not differ among the
alternatives are irrelevant to deciding which
alternative to choose.
Two potential problems that should be avoided in
relevant cost analysis are:
a. Do not assume all variable costs are relevant and all
fixed costs are irrelevant.
b. Do not use unit-cost data directly. It can mislead
decision makers because
i. it may include irrelevant costs, and
ii. comparisons of unit costs computed at different output
levels lead to erroneous conclusions
 Some variable costs may not differ among the
alternatives under consideration and, hence, will be
irrelevant.
 Some fixed costs may differ among the alternatives
and, hence, will be relevant.
 Some of the total unit costs to manufacture a
product may be fixed costs, and, hence, will not
differ between the make and buy alternatives.
 These fixed costs are irrelevant to the make-or-buy
decision.
 The key comparison is between purchase costs
and the costs that will be saved if the company
purchases the component parts from outside plus
the additional benefits of using the resources
freed up in the next best alternative use
(opportunity cost).
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
Making decisions is one of the basic functions of a
manager.
 To be successful in decision making, managers must be
able to perform differential analysis, which focuses on
identifying the costs and benefits that differ between
alternatives.
 Every decision involves choosing from among at least two
alternatives. Therefore, the first step in decision making is
to define the alternatives being considered.
 Once you have defined the alternatives, you need to
identify the criteria for choosing among them.
 Relevant costs and relevant benefits should be considered
when making decisions.
 Irrelevant costs and irrelevant benefits should be
 The key to effective decision making is differential analysis—
focusing on the future costs and benefits that differ between the
alternatives.
 Everything else is irrelevant and should be ignored.
 A future cost that differs between any two alternatives is known
as a differential cost.
 Future revenue that differs between any two alternatives is known
as differential revenue.
 An incremental cost is an increase in cost between two
alternatives.
 An avoidable cost is a cost that can be eliminated by choosing one
alternative over another.
 Sunk costs are always irrelevant when choosing among
alternatives since, it has already been incurred and cannot be
changed regardless of what a manager decides to do.
 Future costs and benefits that do not differ between alternatives
opportunity costs
 Opportunity costs also need to be considered when making
decisions.
 An opportunity cost is the potential benefit that is given up
when one alternative is selected over another.
 It is the contribution to income that is forgone (rejected) by
not using a limited resource in its next-best alternative use.
 When deciding on the quantity of inventory to buy,
managers must consider both the purchase cost per unit
and the opportunity cost of funds invested in the inventory.
For example, the purchase cost per unit may be low when
the quantity of inventory purchased is large, but the benefit
of the lower cost may be more than offset by the high
opportunity cost of the funds invested in acquiring and
holding inventory.
Avoidable and unavoidable Costs
 Management must determine if a cost is avoidable or
unavoidable because in the short run, only avoidable
costs are relevant for decision-making purposes.
 Costs that can be eliminated (in whole or in part) by
choosing one alternative over another are avoidable costs.
 Avoidable costs are relevant costs.
For example, assume that a bike shop offers their customers
custom paint jobs for bikes that the customers already own.
If they eliminate the service, the cost of the bike paint could
be eliminated. Also assume that they had been employing a
part-time painter to do the work. The painter’s compensation
would also be an avoidable cost.
 An unavoidable cost is one that does not change or go
away in the short-run by choosing one alternative over
another.
For example, a company might sign a long-term lease on
equipment or a production facility. These types of leases
typically don’t allow for cancellation, so if this one does not,
then their required payments are unavoidable costs for the
duration of the lease.
Unavoidable costs are never relevant and include:
 Sunk costs.
 Future costs that do not differ between the alternatives.
 Variable costs are avoidable costs, since variable costs do not exist if the
product is no longer made, or if the portion of the business (such as a
segment or division) that generated the variable costs ceases to operate.
 Fixed costs, on the other hand, may be unavoidable, partially
unavoidable, or avoidable only in certain circumstances.
 Remember that fixed costs tend to remain constant for a period of time
and within a relevant range of production and are not easily eliminated
in the short-run.
 Therefore, most fixed costs also are unavoidable. If a fixed cost is specific
only to one of the alternatives, then that fixed cost also may be
avoidable.
 Avoidable costs are future costs that are relevant to decision-making.
Past costs are never an avoidable cost.
 In the long run, virtually all costs are avoidable.
For example, assume that a company has a long-term, ten-year lease on a
production facility that cannot be cancelled. For the first ten years it would
be non cancellable and thus unavoidable. But after ten years it would
become avoidable.
example, suppose you have an old car, a hand-me-down
from your grandmother, and last year you spent $1,600
on repairs and new tires and were just told by your
mechanic that the car needs $1,200 in repairs to operate
safely. Your goal is to have a safe and reliable car.
 Your alternatives are to get the repairs completed or
trade in the car for a newer used car.
 The trade-in value of your old car will be the
minimum given by the dealer, or $200. The newer
used car will require you to make monthly payments
of $150 for two years.
Required: In analysing your two alternatives, what
costs do you consider?
Solution
 the $1,600 you have already spent is a sunk cost; it
is a consequence of a past decision.
 the relevant costs for each alternative are the
following:
o $1,200 in current repair costs to keep your
current car or
o $3,400 (from the 24 payments of $150 minus
$200 for the trade in) to buy a newer used car.
o Obviously, you also would consider qualitative
factors, such as the sentimental value of your
grandmother’s car or the excitement of having a
newer car.
Future Costs That Do Not Differ
 is not a relevant cost for the decision.
For example, if a company is considering baking
either bagels or doughnuts and both baked goods
require $0.30 worth of flour, then the cost of flour
would not be a relevant cost in determining which
of the two had the highest production cost.
In another example, if a company is planning to
produce either red widgets or blue wingdings and
will need to hire 10 additional employees to
produce either of the goods, the cost of those 10
employees is irrelevant because it does not differ
between the alternatives.
Opportunity Costs
 are the revenue lost associated with not choosing the
other alternative.
For example, if you are trying to choose between going to
work immediately after completing your undergraduate
degree or continuing to graduate school, you will have an
opportunity cost.
 If you choose to go to work immediately, your
opportunity cost is forgoing a graduate degree and any
potential job limitations or advancements that result
from that decision.
 If you choose instead to go directly into graduate
school, your opportunity cost is the income that you
could have been earning by going to work immediately
Differential Costs
Differential Cost: the difference in total cost between two
alternatives
 Differential cost is the difference between the cost of two
alternative decisions, or of a change in output levels.
Example of alternative decisions: If you have a decision to
run a fully automated operation that produces 100,000
widgets per year at a cost of $1,200,000, or of using direct
labour to manually produce the same number of widgets for
$1,400,000, then the differential cost between the two
alternatives is $200,000.
Example of change in output: A work centre can produce
10,000 widgets for $29,000 or 15,000 widgets for $40,000.
The differential cost of the additional 5,000 widgets is
$11,000.
• Incremental Analysis: is a decision-making tool in
which the relevant costs and revenues of one
alternative are compared to the relevant costs and
revenues of another alternative.
• positive change with decision
with decision vs with out decision..
Best decision: least relevant cost
most relevant revenue
Types of Decisions
• Keep or replace
• Sell now or process further
• One-Time-Only Special Orders
• Insourcing vs. Outsourcing
• Product-Mix
• Customer Profitability
• Branch / Segment: Adding or Discontinuing
• Equipment Replacement
The basic problem with incremental analysis
Ignores
the time period in which costs/revenue
incurred realized.
the time value of money
3 steps to identify relevant cost:
1. Eliminate sunk costs
2. Eliminate costs/ benefits that do not differ
b/n alternatives
3. Compare remaining costs and benefits which
differ between alternatives to make the proper
decision.
 The key element in the definitions/steps:
1.alternatives should be different in amount
2. must be a future cost.
3. Historical Costs are always irrelevant
Example 1
 a company is to make a decision to purchase six months office
supplies from supplier A, for $5,000 and from Supplier B, for $4,800.
However, Supplier B is in another state and, if the purchase is made
from supplier B, the company must pay freight in cost amounted
$300.
Also, the company has $500 of supplies on hand.
One approach is to include all costs including irrelevant costs:
Supplier A Supplier B D/ce
Cost of supplies to be purchased $ 5,000 $4,800 $200
Cost of supplies on hand 500 500 -0-
Freight 300 (300)
Keep Old Asset or Replace
Example 3
Assume that an asset currently in use (old asset) has a book value of
$1,000 and that this piece of equipment is tentatively under review for
replacement. The purchase price of the new asset is $5,000 and is
estimated to have a useful life of 10 years. The old asset can also last
10 years with some repairs now and then. The operating expense of the
old asset is now $8000 per year but the new asset is projected to have
only an operating expense of $2000 per year. The old asset has no
trade-in value. The alternatives are to keep the old asset or to replace it.
• The replacement should take place if the relevant cost of
replacing is less than the relevant costs of keeping.
10 Years Basis
Keep Old Asset Purchase New Asset Difference
Cost of new asset _ $5,000 (5,000)
Operating expenses $ 8,000 2,000 6,000
$8,000 $ 7,000 $1,000
Example 2: Assume machine B replaced machine A
which increase production capacity and sales by 50%
where A’s current production and sales is 1,000 units
(capacity) and selling price is $10 per unit & CGS is
$ 8 per unit.
Machine A Machine B Difference
Volume 1,000 1,500 500
Sales $10,000 $15,000 $ 5,000
CGS $ 8,000 $12,000 $ 4,000
$ 2,000 $ 3,000 $ 1,000
therefore it is better to replace Machine A with that
of Machine B.
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
Example: ABC Company receives a one-time order
that is not considered part of its normal ongoing
business.
• ABC Company only produces one type of silver key
chain with a unit variable cost of $16. Normal
selling price is $40 per unit.
• A company in XYZ offers to purchase 3,000 units
for $20 per unit.
• Annual capacity is 10,000 units, and annual
manufacturing fixed costs total $78,000, but ABC
company is currently producing and selling only
5,000 units as illustrated in the following table.
Required: Should ABC accept the offer?
 If ABC accepts the offer, net income will increase
by $12.000.
Increase in revenue($20 * 3,000) ---------- $60,000
Increase in costs (3,000 * 16 v. cost) ------ $48,000
Increase in net income ------------------------- $12,000
Using the incremental approach:
Special order contribution margin = $20 – $ 16 = $4
Change in income = $4 × 3,000 units = $12,000.
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.
 MA Company is thinking of buying a part that is
currently used in one of its products from outside.
 The unit cost to make this part is:
$/ u
Direct materials 27
Direct labor 15
Variable overhead 3

Depreciation of special equip. 9

Supervisor's salary 6
General factory overhead 30
Total cost per unit 90
 General factory overhead is allocated on the basis of direct labor
hours and is not going to change if the parts are bought from
outside.
 The $90 unit cost is based on 20,000 parts produced each year.
 An outside supplier has offered to provide the 20,000 parts at a
cost of $70 per part. Should we accept the supplier’s offer?
 Sunk Cost

Cos t
Pe r
Unit Cost of 20,000 Units
Make Buy
Outside purchase price 70 1,400,000

Direct materials 27 540,000

Direct labor 15 300,000
Variable overhead 3 60,000
Depreciation of equip. 9 0
Supervisor's salary 6 120,000
General factory overhead 30 0
Total cost 90 1,020,000 1,400,000

Not avoidable and is irrelevant. If the product

is dropped, it will be reallocated to other
products.
 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
• Firms often face the problem of deciding how to
best utilize a constrained resource.
• Usually, fixed costs are not affected by this
particular decision, so management can focus on
maximizing total contribution margin.
UM Company produces two products and selected
data is shown below:
Product
1 2
Selling price per unit $60 $50
Less variable expenses per unit 36 35
Contribution margin per unit $24 $15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

 Machine A1 is the constrained resource. There is

excess capacity on all other machines.
 Machine A1 is being used at 100% of its capacity, and
has a capacity of 2,400 minutes per week.

Should UM focus its efforts on Product 1 or 2?

Solution: Let’s calculate the contribution margin per
unit of the constrained resource, machine A1.
Product 1 Product 2
Contribution margin per unit $24 $15
Time required to produce one unit 1 minute 0.5 minute
Contribution margin per minute $24/minute $30/minute

Product 2 should be emphasized: Provides more valuable

use of the constrained resource machine A1, yielding a
contribution margin of $30 per minute as opposed to $24
for Product 1.
 If there are no other considerations, the best plan
would be to produce to meet current demand for
Product 2 and then use remaining capacity to make
Product 1.
 Let’s see how this plan would work.

Allocation of Constrained Resource

Weekly demand for Product 2 2.200 units

Time required per unit × 0,50 min.
Total time required to make
Product 2 1.100 min.

Total time available 2.400 min.

Time used to make Product 2 1.100 min.
Time available for Product 1 1.300 min.
Time required per unit ÷ 1,00 min.
Production of Product 1 1.300 units
 According to the plan, we will produce 2,200 units of
Product 2 and 1,300 of Product 1. Our contribution
margin looks like this.

Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $24 $15
Total contribution margin $31,200 $33,000

The total contribution margin for UM is $64,200.

 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
Example:
Digital Musical Instruments
Income Statement for 2007
Sales 1.000.000
Less: variable expenses
Variable mfg. costs 240.000
Variable shipping costs 10.000
Commissions 150.000 400.000
Contribution margin 600.000
Less: fixed expenses
General factory overhead 120.000
Salary of line manager 180.000
Depreciation of equipment 100.000
Advertising - direct 200.000
Rent - factory space 140.000
General admin. expenses 60.000 800.000
Net loss (200.000)

Assume that the equipment used in General Factory Overhead and General
manufacturing digital instruments has Administrative Expenses are unavoidable costs.
no resale value or alternative use.
Should
Should the
the company
company drop
drop digital
digital
instruments
instruments division?
division?
Incremental Approach
DECISION RULE
 UM should drop the digital instruments division
only if the avoided fixed costs of the division
exceed lost contribution margin of this division.
Contribution Margin
Solution
Contribution margin lost if digital
instrument division is dropped (600.000)
Less fixed costs that can be avoided
Salary of the line manager 180.000
Advertising - direct 200.000
Rent - factory space 140.000 520.000
Net disadvantage (80.000)

What about depreciation?

Comparative Income Approach
 Prepare comparative income statements showing
results with and without the digital instruments
division.
Com pa ra tive Incom e Approa ch
Solution

Ke e p Digital Dr op Digital
Ins tr um e nts Ins tr um e nts Diffe re nce
Sa le s 1.000.000 0 (1.000.000)
Le ss va ria ble e x pe nse s: 0
Mfg. e x pe nse s 240.000 0 240.000
Fre ight out 10.000 0 10.000
Com m issions 150.000 0 150.000
Tota l va ria ble e x pe nse s 400.000 0 400.000
Contribution m a rgin 600.000 0 (600.000)
Le ss fix e d e x pe nse s:
Ge ne ra l fa ctory ove rhe a d 120.000 120.000 0
Sa la ry of line m a na ge r 180.000 0 90.000
De pre cia tion 100.000 100.000 0
Adve rtising - dire ct 200.000 0 100.000
Re nt - fa ctory spa ce 140.000 0 70.000
Ge ne ra l a dm in. e x pe nse s 60.000 60.000 0
Tota l fix e d e x pe nse s 800.000 280.000 260.000
Ne t loss (200.000) (280.000) (340.000)
Joint Products-Sell or Process Further Decision.
In some industries, a number of end products are
produced from a single raw material input.
 Two or more products produced from a common
input are called joint products.
 The point in the manufacturing process where
each joint product can be recognized as a separate
product is called the split-off point.
To process further, the incremental revenue from
further processing greater than the incremental
processing costs.
Example: products A, B, C and D through a joint
process. The joint costs amount to $100,000.
 Solution:
 The incremental analysis for the decision to
process further is:
Products A B C D
Incremental Revenue 5,000 5,000 5,000 5,000
incremental processing costs 2,500 3,000 4,000 6,000
Increase in operating income $2,500 $2,000 $1,000 (1,000)
Process A,B, & C
SELL D