Chapter 2

Relevant Information and Decision Making

At the end of this chapter the learners should be able to:
 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 ‗opportunity costs‘, ‗avoidable costs‘, ‗differential costs‘a n d ‗incremental costs‘.
 Understand marketing decisions and production decisions
Introduction
Making decisions is one of the basic functions of a manager.
To be successful in decision making, managers must be able to tell the difference between
relevant and irrelevant data and must be able to correctly use the relevant data in analyzing
alternatives.
Accountants have an important role in the decision-making process, not as a decision maker
but as collectors and reporters of relevant information.
2.1. Relevant and irrelevant information
The decision making model
A decision model, a specific set of procedures that produces a decision, can be used to
structure the decision maker‘s thinking and to organize the information to make a good
decision.

The following is an outline of one decision-making model.

Step1. Recognize and define the problem.
Step2. Identify alternatives as possible solutions to the problem. Eliminate alternatives that
clearly are not feasible/possible.
Step3. Identify the costs and benefits associated with each feasible alternative. Classify costs
and benefits as relevant or irrelevant, and eliminate irrelevant ones from consideration.
Step 4. Estimate the relevant costs and benefits for each feasible alternative.
Step 5. Assess qualitative factors.
Step 6. Make the decision by selecting the alternative with the greatest overall net benefit.
Some Common Relevant Cost Applications
Relevant costing is of value in solving many different types of problems. Traditionally, these
applications include decisions.

 To make or buy a component.

 To keep or drop a segment or product line.
 To accept a special order at less than the usual price.
  To further process joint products or sell them at the split-off point.
Though by no means an exhaustive list, many of the same decision-making principles apply
to a variety of problems.
Quantitative and Qualitative Relevant Information

Quantitative factors are outcomes that are measured in numerical terms:

 Financial
 Nonfinancial
Qualitative factors are outcomes that cannot be measured in numerical terms:
 Nonfinancial
Non quantitative factors may be extremely important in an evaluation process for each of the
decisions we cover here, yet do not show up directly in calculations:
 Quality requirements
 Reputation of outsourcer
 Employee morale
 Logistical considerations—distance from plant, and so on
 For make/buy decisions, buying can be risky, especially if sourcing internationally.
The concept of Relevance
 Relevant information has two characteristics:
 It occurs in the future
 It differs among the alternative courses of action
 Relevant costs are expected future costs
 Relevant revenues are expected future revenues
 Past costs (historical costs) are never relevant and are also called sunk costs.
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
Relevant Costs and Benefits
The decision – making model just described emphasized the importance of identifying and
using relevant costs and benefits.
 A relevant cost is a cost that differs between alternatives.
 A relevant benefit is a benefit that differs between alternatives.
Identifying Relevant Costs
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.
Two broad categories of costs are never relevant in any decision. They include:
 Sunk costs.
 A future cost that does not differ between the alternatives.
Identifying Relevant Costs
Relevant costs possess two characteristics:
i. they are future costs and
ii. They differ across alternatives.
All pending decisions relate to the future.
Accordingly, only future costs can be relevant to decisions.
Differential Cost and Revenue
Decisions involve choosing between alternatives. In business decisions, each alternative will have
costs and benefits that must be compared to the costs and benefits of the other available alternatives.
A difference in costs between any two alternatives is known as a differential cost.
A difference in revenues between any two alternatives is known as differential revenue. A
differential cost 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 costs. Differential cost is a broader term, encompassing both cost increases
(incremental costs) and cost decreases (decremental costs) between alternatives.
The accountant‘s differential cost concept can be compared to the economist‘s marginal cost concept.
In speaking of changes in cost and revenue, the economist uses the terms marginal cost and marginal
revenue. The revenue that can be obtained from selling one more unit of product is called marginal
revenue, and the cost involved in producing one more unit of product is called marginal cost. The
economist‘s marginal concept is basically the same as the accountant‘s differential concept applied to
a single unit of output.
Differential costs can be either fixed or variable. To illustrate, assume that Nature Way Cosmetics,
Inc., is thinking about changing its marketing method from distribution through retailers t o
distribution by a network of neighborhood sales representatives. Present costs and revenues are
compared to projected costs and revenues in the following table:

According to the above analysis, the differential revenue is $100,000 and the differential costs total
$85,000, leaving a positive differential net operating income of $15,000 under the proposed marketing
plan.
The decision of whether Nature Way Cosmetics should stay with the present retail distribution or
switch to sales representatives could be made on the basis of the net operating incomes of the two
alternatives. As we see in the above analysis, the net operating income under the present distribution
method is $160,000, whereas the net operating income with sales representatives is estimated to be
$175,000. Therefore, using sales representatives is preferred because it would result in $15,000 higher
net operating income. Note that we would have arrived at exactly the same conclusion by simply
focusing on the differential revenues, differential costs, and differential net operating income, which
also show a $15,000 advantage for sales representatives.

In general, only the differences between alternatives are relevant in decisions. Those items that are the
same under all alternatives and that are not affected by the decision can be ignored. For example, in
the Nature Way Cosmetics example above, the ―Other expenses‖ category, which is $60,000 under
both alternatives, can be ignored because it has no effect on the decision. If it were removed from the
calculations, the sales representatives would still be preferred by $15,000. This is an extremely
important principle in management accounting.
Opportunity Cost
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.
To illustrate this important concept, consider the following examples:
Example 1 Vicki has a part-time job that pays $200 per week while attending college. She would like
to spend a week at the beach during spring break, and her employer has agreed to give her the time
off, but without pay. The $200 in lost wages would be an opportunity cost of taking the week off to be
at the beach.
Example 2 Suppose that Neiman Marcus is considering investing a large sum of money in land that
may be a site for a future store. Rather than invest the funds in land, the company could invest the
funds in high-grade securities. The opportunity cost of buying the land is the investment income that
could have been realized by purchasing the securities instead.
Example 3 Steve is employed by a company that pays him a salary of $38,000 per year. He is
thinking about leaving the company and returning to school. Because returning to school would
require that he give up his $38,000 salary, the forgone salary would be an opportunity cost of seeking
further education.
Opportunity costs are not usually found in accounting records, but they are costs that must be
explicitly considered in every decision a manager makes. Virtually every alternative involves an
opportunity cost.
Sunk Cost
A sunk cost is a cost that has already been incurred and that cannot be changed by any decision
made now or in the future. Because sunk costs cannot be changed by any decision, they are not
differential costs. And because only differential costs are relevant in a decision, sunk costs can and
should be ignored.
 It is important to note the psychology behind managers‘ treatment of sunk costs.
 Although managers should ignore sunk costs for relevant decisions, it unfortunately is
human nature to allow sunk costs to affect these decisions.
For example, depreciation, a sunk cost, is sometimes allocated to future periods though the
original cost is unavoidable. In choosing between the two alternatives, the original cost of an
asset and its associated depreciation are not relevant factors.
To illustrate a sunk cost, assume that a company paid $50,000 several years ago for a special-purpose
machine. The machine was used to make a product that is now obsolete and is no longer being sold.
Even though in hindsight purchasing the machine may have been unwise, the $50,000 cost has already
been incurred and cannot be undone. And it would be folly to continue making the obsolete product in
a misguided attempt to ―recover‖ the original cost of the machine. In short, the $50,000 originally
paid for the machine is a sunk cost that should be ignored in current decisions.
Importance of Identifying Relevant Costs and Benefit
� The reasons are two
1. Generating information is costly process. The relevant data must be sought and this
required time and effort.
2. Peoples can effectively use only limited amount of information. Beyond this they are
experiencing information overload and their decision making effectiveness decline.
2.2. Alternative Choice Decisions
Many of the decisions described in this chapter are frequently referred to as alternative choice
decision. Alternative choice decisions are situations with two or more courses of action from
which the decision maker must select the best alternative. The variety of alternative choice
decisions is limitless. Some business example follows:
 Should we accept a special order for a product below our normal selling price?
 Should we raise the price of a product or maintain the current price?
 Should we make or buy a component part?
 Should we sell a joint product at the split off point or process it further?
 Should we keep our copying machine or acquire a faster one?
The analyses of these and other types of alternative choice decisions are aided by relevant
cost and benefit data.
2.2.1. Special area Decisions
a) Make or Buy decision
Managers often face the decision of whether to make a particular product (or provide a
service) or to purchase it from an outside supplier. Make-or-buy decisions are those decisions
involving a choice between internal and external production. One type of relevant cost that is
becoming increasingly large due to globalization and the green environmental movement
concerns the disposal costs associated with electronic waste (or e-waste).
Example 2 – 1 Structuring a Make – or – Buy Problem
Be sure to read the analysis in Example 2 – 1 carefully. At first, the fixed overhead remains
whether or not the component is made internally. In this case, fixed overhead is not relevant,
and making the product is $9,500 cheaper than buying it. Later, in Requirement 4, part of the
fixed overhead is avoidable. This condition means that purchasing the component externally
will save $10,000 in fixed cost (i.e., Swasey can avoid $10,000 of fixed overhead if it buys
the component). Now, the $10,000 of fixed cost is relevant—it is a future cost and it differs
 between the two alternatives—and the offer of the supplier should be accepted; it is $500
cheaper to buy the component.
b) Special Order decisions
� From time to time, a company may consider offering a product or service at a price
different from the usual price.
� Firms often have the opportunity to consider special orders from potential customers in
markets not ordinarily served.
Special – order decisions focus on whether a specially priced order should be accepted or
rejected.
These orders often can be attractive, especially when the firm is operating below its
maximum productive capacity.

Example 2.2: A company produces a single product and has budgeted for the production of 100,000
units during the next quarter. The cost estimates for the quarter As follow;
Direct Labor------------------ $600,000
Direct material ---------------- $ 200,000
Variable overhead------------- 200,000
Fixed Overhead--------------- 400,000
Total $1,400,000
The company has agreed to sell 80,000 units during the coming period at the generally
accepted market price of $18 per unit. It appears unlikely that orders will be received for the
remaining 20,000 units at the selling price of 18 per unit, but a customer is prepared to
purchase them at selling price of $ 12 per units. Should the company accept the offer?
Additional Information ; A study of the cost estimates indicate that during the next quarter
the fixed overheads and direct labor cost will remain the same irrespective of whether or not
the special order is accepted.
Order not accepted Order accepted

Sales (80,000*18)= 1,440,000 (80,000*18)+(20,000*12)=1,680,000

Less; variable cost
Direct Material 160,000 200,000
Variable overhead 160000 (320,000) 200000 400,000
contribution margin 1,120,000 1,280,000
less fixed overhead cost 400,000 400,000
Direct labor cost 600,000 600000 1,000,000
(1,000,000)
operating income 120,000 280,000
 c) Keep or Drop decisions
� Often, a manager needs to determine whether a segment, such as a product line, should be
kept or dropped.
� Segmented reports prepared on a variable – costing basis provide valuable information for
these keep – or – drop decisions.
� Both the segment‘s contribution margin and its segment margin are useful in evaluating
the performance of segments.
� However, while segmented reports provide useful information for keep – or – drop
decisions, relevant costing describes how the information should be used to arrive at a
decision.
Example 2.3: Structuring a Keep – or – Drop Product Line Problem
 � Sometimes dropping one line would lower sales of another line, as many customers
buy both lines at the same time.
� This information can affect the keep – or – drop decision.

Example 2.3፡ Structuring a Keep-or-Drop Product Line Problem with Complementary

Effects
The roofing tile line has a contribution margin of $10,000 (sales of $150,000 minus total
variable costs of $140,000). All variable costs are relevant. Relevant fixed costs associated
with this line include $10,000 in advertising and $35,000 in supervision salaries. Assume
that dropping the product line reduces sales of blocks by 10 percent and sales of bricks by 8
percent.
Required:

1. If the roofing tile line is dropped, what is the contribution margin for the block line? For
the brick line?
2. Which alternative (keep or drop the roofing tile line) is now more cost effective and by
how much?

This Cornerstone provides some insights beyond the simple application of the keep – or –
drop decision model. The initial analysis (Example 2.3), which focused on two feasible
alternatives, led to a tentative decision to drop the product line. But additional information
provided by the marketing manager led to a reversal of the first decision. Perhaps other
feasible alternatives exist as well. These additional alternatives would require still more
analyses.
d) Further Processing of Joint Products
� Joint products have common processes and costs of production up to a split – off
point. At that point, they become distinguishable as separately identifiable products.
The point of separation is called the split – off point.
� Sometimes it is more profitable to process a joint product further, beyond the split –
off point, prior to selling it (sell – or – process – further decision).

Example 2.4፡ Structuring the Sell – or – Process Further Decision

e) Product Mix decisions
Most of the time, organizations have wide flexibility in choosing their product mix.

Product mix refers to the relative amount of each product manufactured (or service provided)
by a company.
Decisions about product mix can have a significant impact on an organization‘s profitability.

Every firm faces limited resources and limited demand for each product. These limitations
are called constraints.
A manager must choose the optimal mix given the constraints found within the firm.

Example 2.5፡ Determining the Optimal Product Mix with One Constrained Resource

The above illustration clearly illustrates a fundamentally important point involving relevant
decision making with a constrained resource. This point is that the contribution margin per
unit of each product is not the critical concern when deciding how much of each product type
to produce and sell. Instead, the contribution margin per unit of the scarce resource is the
deciding factor.