Chapter 4

Relevant Information and Decision Making

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 Chapter Outline
Learning Objectives
 Describe management’s decision-making process
 Analyze the relevant costs in accepting an order at a special price.
 Analyze the relevant costs in a make-or-buy decision.
 Analyze the relevant costs and revenues in determining whether to sell or
process materials further.
 Analyze the relevant costs to be considered in retaining, or replacing
equipment.
 Analyze the relevant costs in deciding whether to eliminate an
unprofitable segment or product.
 Decision-Making
Describe management’s decision-making process and
incremental analysis.
Management decision making involves five steps:
1. Define the decision task.
2. Identify alternative courses of action.
3. Collect relevant information on alternatives.
4. Select the preferred course of action.
5. Analyze and assess decisions made.
Incremental analysis: means analyzing the changes in costs
and revenues caused by a change in activity.
Decision-Making Process
In making business decisions, management Considers financial
and non-financial information
• Financial information
o Revenues and costs, and
o Effect on overall profitability
• Non-financial information
o Effect on employee turnover
o The environment
o Overall company image
Relevant Costs and Benefits
Relevant Costs
• Costs that are applicable to a particular decision.
• Costs that differ among alternative courses of action.
• Costs that are avoidable.
• Future costs that differ between alternatives.
• Costs that are pertinent to the discussion of relevant costs are:
• Sunk costs
• Common cost
• Committed cost
• Out-of-pocket costs
• Opportunity costs
© McGraw-Hill Education. 23-5
Relevant Costs
• Sunk costs are the result of past decisions and cannot be changed
by any current or future decisions. Sunk costs are irrelevant to
current or future decisions.
• Out-of-pocket costs are future outlays of cash associated with a
particular decision. Out-of-pocket costs are relevant to
decisions.
• Opportunity costs are the potential benefits given up when one
alternative is selected over another. Opportunity costs are
relevant to decisions.
 Common costs: Are costs which will be identical for all
alternatives. They are irrelevant to current or future decisions.
 Committed costs: Are costs that would be incurred in the future
but cannot be avoided because the company has already
committed to them. The are irrelevant cost
© McGraw-Hill Education. 23-6
Relevant Costs Charactestics
 Two criteria are important for cost to be relevant:
 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

© McGraw-Hill Education. 23-7

Types of decisions Incremental Analysis
Common types of decisions involving incremental analysis
are:
1. Accept or reject an order at a special price
2. Make or buy component parts or finished products
3. Sell or process further products
4. Repair, retain, or replace equipment
5. Eliminate an unprofitable business segment or product
 1. Accept or Reject Special Orders
• Special Order is a one time business offered by a specific
customer at a major price concession .
• Assumes that sales of products to other customers are not
affected by special order( No opportunity cost)
• Assumes that company is not operating at full capacity( no
additional fixed cost)
Decision Rule:
• Accept if contribution margin is positive or if revenue is greater
than variable cost.
 Special Orders - Example
 Assume a Company has a capacity to produces 100,000 units
of products per month and currently using 80% of plant
capacity.
 Variable manufacturing costs are $8 per unit and Fixed monthly
manufacturing costs are $400,000, or $4 per unit.
 The products are normally sold directly to retailers at $20 each.
 The company received special order request for 10,000 units
of its products at $11 per unit.
 Acceptance of the offer would not affect normal sales of the
product, and the additional units can be manufactured without
increasing plant capacity.
 Required:
a. What should management do? Accept or Reject the offer?

Full capacity and Special order

b. What if the company is at full capacity and will not
increase its production capacity for special order as the
order is just a one time order?
c. What if the company is at full capacity and will have to
increase its production capacity to accept the special order
? To increase production capacity additional FC of birr
100,000 is needed.

Copyright ©2018 John Wiley & Sons, Inc.

 Solution(a)

• Fixed costs do not change since within existing capacity – thus

fixed costs are not relevant
• Variable manufacturing costs and expected revenues change –
thus both are relevant to the decision
Incremental Analysis-Method
Increase in revenue (10,000 * 11)……..……$110,000
Increase in cost(VC)(10,000*8………………80,000
Increase in Net income…………………. $30,000
Decision : Accept the offer

Deferential Analysis Method

 Diffrecial Analysis method
Current Alternative:
(Without (with Special Difference
Special Offer)
Offer

Sales (80,000*20) (80,000*20,10,000*11) 1,600,000 1,710,000 110,000

Less: Variable Cost(80,000*8) (90,000*8) (640,000) (720,000) (80,000)
Less: Total Fixed Cost (400,000) ( 400,000) 0
operating profit 560,000 590,000 30,000

•Under case 2 , the company will sale total of 100,000 units:

90,000units at 20 and 10,000units at 11
•Under case 3, the company will be selling total of 110,000
units:100,000units at 20 and 10,000units at 11
Special Orders- Example 2
• Eastern Steel Company receives a one-time order that is not
considered part of its normal ongoing business.
• The Company produces Housing door keys with a unit
variable cost of birr 16 and its normal selling price is birr 40
per unit.
• Addis Ababa Housing Development Office offered Eastern
Steel a purchase order of 3,000 units of house key for birr
20 per unit.
• Annual capacity Eastern Steel is 10,000 units, and annual
fixed costs total birr 78,000, but the company is currently
producing and selling only 5,000 units.
Should it accept the offer?
 Exercise

FasTrac Company currently sells 100,000 units of its

product. They are operating at 80% of full capacity.
The company has per unit and annual total sales and
costs as shown in the following contribution margin
income statement.

© McGraw-Hill Education. 23-15

One of its current customer wants to purchase
additional units of 10,000 units at a price of $8.50
per unit. The offer price is low, but FasTrac is
considering the proposal because this sale would be
several times larger than any single previous sale
and it would use idle capacity.
Should FasTrac accept the offer?

© McGraw-Hill Education. 23-16

 2. Sell or Process Further
• A company may have option to sell product at a given point in
production( at split off point) or to process further and sell at a
higher price.
• Joint product costs are sunk costs and thus not relevant to the
sell-or-process further decision.

Decision Rule:
• Process further as long as the incremental revenue from such
processing exceeds the incremental processing costs.
• Its increase in revenue vs. Separable Cost
3. Retain or Replace a Fixed Asset/ Equipment
Relevant information
Replacing old equipment will have the following benefits:
• Manufacturing costs will decrease over the
remaining life of old asset
• Repair cost will decrease over the remaining life
of old asset
The cost Replacing Old equipment will the purchasing
price new for equipment less salvage value of old asset
Book value of old machine is sunk cost & does not affect
the decision
Decision Rule
• Accept if the benefit out weight the cost
Example:
•A Company has a factory machine with original cost of
$110,000,Accumulated Depreciation of $70,000, and a book
value is $40,000. It has a remaining useful life of four years.
The company is considering replacing this machine with a
new machine.
•A new machine is available at a costs of $120,000. It is
expected to have zero salvage value at the end of its four-year
useful life.
•If the new machine is acquired, overall manufacturing and
repair cost costs are expected to decrease from $160,000 to
$125,000 annually, and the old machine could be sold for
$5,000.
Should the company maintain the old or replace by new
machine?
Solution
Benefit:
Decrease in mfg & repair cost over 4 years
($35,000*4)…………….…..… $140,000
Cost:
Purchasing price of new less SV of Old:
($120,000-5,000)…………….…..… $115,000
Net benefit…………………………… $ 25,000
Decision: Replace the machine
4. Eliminate Unprofitable Segment or Product
Relevant Information
• Revenue of unprofitable segment is relevant information
• Variable cost of unprofitable segment is relevant information
• Fixed costs of unprofitable segment must be absorbed by the other
segments and cannot be avoided even if the segment is eliminated.
• Therefore, fixed cost of unprofitable segment will continue in the
short run even if the segment is eliminated
Decision Rule:
• Retain the unit as long us its Contribution Margin is Positive( loss is
less than the Fixed Cost)
• If a segment with positive Contribution Margin is closed, the loss
will increase by the amount of CM forgone .
Example: Segment income data
Illustration: Venus Company manufactures three models of tennis
rackets:
• Profitable lines: Pro and Master
• Unprofitable line: Champ
Pro Master Champ Total
Sales $800,000 $300,000 $100,000 $1,200,000

Variable costs 520,000 210,000 90,000 820,000

Contribution margin 280,000 90,000 10,000 380,000

Fixed costs 80,000 50,000 30,000 160,000

Net income $200,000 $40,000 $(20,000) $ 220,000

Should Champ be eliminated? If closed, FC will not be avoided but
10,000 CM will be lost , which will increase the loss to $30,000 from
20,00 and overall profit decrease by CM(10,000). See the figures in next
slide
Prepare income data if Champ product line is eliminated
Pro Master Champ Total
Sales $800,000 $300,000 $1,100,000

Variable costs 520,000 210,000 730,000

Contribution margin 280,000 90,000 370,000

Fixed costs 80,000 50,000 30,000 160,000

Net income $200,000 $40,000 (30,000) $210,000

Overall income is decreased by $10,000.

Decision: Therefore, the company should continue Chap segment

so that it can minimize its loss from $30,000 to 20,000

LO 6
 Exercise
• Addis Plc. manufactures three types of soups . A
laundry soup is making loss as summarized below
Sales br. 200,000
Variable costs 180,000
Fixed costs 30,000
Net loss Br (10,000)

a. If the laundry soup is eliminated, and the fixed costs cannot

be avoided . Should the soup be eliminated?
b. If the laundry soup is eliminated, Br. 10,000 of fixed can be
avoided . Should the soup be eliminated?
 5. Make or Buy
Analyze the relevant costs in a make-or-buy decision.

Making/Insourcing is Buying/Outsourcing is
producing goods purchasing goods
or providing services and services from
within the organization. outside vendors.
Make or Buy
• Incremental costs are important in the decision to make a
product or purchase it from a supplier.
• The cost to produce an item must include:
1) Direct materials
2) Direct labor
3) Incremental overhead ( Variable Overhead Cost)
• If the company has been already producing the product, it
will not avoid all Fixed overhead cost even when it
switches to buy option.
• We should not use the predetermined overhead application
rate to determine product cost in the decision.
© McGraw-Hill Education. 23-26
 Example: make-or-buy decision.
Illustration: Baron Company incurs the following annual costs in
producing 25,000 ignition switches (annual demand).

Direct materials $50,000

Direct labor 75,000
Variable manufacturing overhead 40,000
Fixed manufacturing overhead 60,000
Total manufacturing costs $225,000
Total cost per unit ($225,000 ÷ 25,000) $9.00

Instead of making switches, Baron might purchase ignition

switches at a price of $8 per unit. Fixed manufacturing overhead of
$50,000 is not avoidable out of $60,000. What should Baron do?
LO 3
 Solution: 25,000 units annual demand
Make option Buy option

Direct materials $50,000 $0

Direct labor 75,000 0

Variable manufacturing costs 40,000 0

Fixed manufacturing overhead costs 60,000 50,000

Purchase price (25,000 × $8) 0 200,000

Total annual cost $225,000 $250,000

Unit cost $9 $10
Decision: Continue making.
• However, if the company was not manufacturing it, all mfg
cost including fixed cost would be avoided when you buy .
Hence, the decision would have been to buy as manufacturing
cost($9) is $1 higher per unit than purchase price($8)
END