Managerial Accounting –Decision Making:

Relevant Costs & Benefits

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BY HAFEEZRM

When you have a choice between two or more alternatives and you have
to select one, you are making a decision. If there is no choice, you will have to simply follow
or obey. So a decision implies a selection, a choice, a verdict or a nod.

In everyday life, decisions are made. A personal decision affects an individual but
organizational decisions cause a change, good or bad, to a lot many people known as
stakeholders. So decision making in an organization must be systematic and not off the cuff.
A good executive must be good at decision making.

DECISION MAKING

A formal definition of decision making by Wikipedia

.org is given below:

Decision making can be regarded as an outcome of mental processes leading to the
selection of a course of action among several alternatives. Every decision making process
produces a final choice. The output can be an action or an opinion of choice.

It may be noted that every decision involves a certain degree of risk. Very few decisions are
made with absolute certainty. So a good decision would be to choose a solution with the
highest probability of success and in accordance with the goals, desires, lifestyle and values
etc.

RELEVANT COST AND BENEFITS

Relevant means linked or concerned. If an event has nothing to do with a situation, it is not
relevant. Marble processing units at Karachi may suffer because of unrest in a far-off area
like Swat. It would be relevant as Swat supplies marble rocks. But turmoil in Hyderabad, a
town much near to Karachi than Swat, would be irrelevant for the marble units.

Any decision must be evaluated under cost-benefit criteria. The benefits must be more than
the cost except in social projects where benefits may be equal to cost. Benefits can be in the
form of cash return, perks, advantages, customer’s satisfaction or reputation of a company.
While cost means value, worth or sacrifice made.

Only relevant cost should be considered. CIMA defines relevant costs as: ‘the costs
appropriate to a specific management decision’ A study of relevant costs and benefits helps
make better decision?

See all 7 photos

Six steps in decision making process and MA role

1. Clarify the decision problem. One must be clear about the problem. One must look
for the root cause or hidden problem rather than the apparent problem. Some skill is
required to define a problem in such terms that can be addressed effectively.
2. Specify the criteria. After clarifying a problem, criteria must be specified for
decision-making. What is the objective: maximize profit, increase market share or social
service.
3. Identify alternatives. Explore all alternatives, their pros and cons. This is a critical
step in the decision making process.
 4. Develop a decision model. This is an simplified version of the problem. No
irrelevant information, only factors relevant to the problem are highlighted. It brings
together all elements of a problem like the criteria, the constraints, and the alternative.
5. Collect the data. Relevant data must be collected to incorporate objectivity in the
process. It may be primary data or secondary data. But it must be up-to-date, timely
and accurate.
6. Select an alternative. One all formalities are completed, requisite information
obtained and processed, a most suitable or appropriate choice should be selected.

Qualitative and Quantitative Analysis

Management Accountant mostly deal with financial data. But they also maintain records of
physical units produced and quantities of raw material consumed, labour hours used. In
addition, they asses qualitative factors such as employee morale, customers satisfaction,
image of the company in the eyes of the public.

Role of Management Accountant

A management accountant is a member of cross functional team and, having un-restricted
access to MIS, makes a contribution by providing facts and figure which bring objectivity to
the report.

Besides, a management accountant would ensure that the information must be relevant
(pertinent to the decision problem); accurate (precise); and timely (arrive in time for the
decision to be made). Companies will occasionally trade-off accuracy for timeliness.

Relevant Costs
In order to qualify for relevancy, a cost must meet two criteria: (i) They affect the future and
(ii) they differ among alternatives.

Normally, the following are relevant Costs:

DIFFERENTIAL COST

• A differential cost is the difference in cost items under two or more decision
alternatives specifically two different projects or situations. Where same item with the
same amount appears in all alternatives, it is irrelevant. For example, a plot of land can
be used for a shopping mall or entertainment park. The plot is irrelevant since it would
be used in both the cases. Similarly, future costs and benefits that are identical across
all decision alternatives are not relevant.
• An example of differential cost would be of a company which is selling its products
through distributors. It is paying them a commission of Rs.16 million. Any alternate
which costs lesser would be considered. Let us suppose that the company is planning
to appoint salespersons to sell its products and cancells the contracts with distributors.
In this case, the selling expense is expected to be to Rs.12 million. There is cost
differential Rs.4 million (Rs.16 m - 12m). This a good sign but the risk would have to
considered for changing the channel of distribution. If there is low risk, it would be
prudent to go for own arrangements for sales.
• Differential costs must be compared to differential revenues. In case, switching over
to direct sales bring additional revenues of Rs.2 million, it would increase the net benfit
to Rs.6 million. This would provide more comfort to the decision maker while
considering a change in the distribution channel.

INCREMENTAL OR MARGINAL COST

• Where as differential cost is a difference between the cost of two independent

alternatives, incremental or marginal cost is a cost associated with producing an
additional unit. In case of a university, it could be cost of admiting another student.
Even operating a second shift is an example of incremental cost. It would be noted that
the two decisions are not independent as second shift depends upon first shift.
• Increamental cost must be compared with incremental reveues to arrive at a
decision.

OPPORTUNITY COST

• It is cost of opportunity foregone. Mr. Ahmed Shah left a bank job which was paying
him Rs.15,000 per month and got admission in a University. Monthly fee-charge in the
 university is Rs.10,000 per month. For Ahmed Shah, this would be Rs.25,000 per
month (Rs.10,000 + Rs,15,000).
• Farhana is a fresh graduate from a business university. She got two offers, one of
Rs.25,000 from an investment bank and another of Rs.15,000 for a teaching-assistant
in a university. Another of her class-fellow, Shabana got the same offer from the same
university. While Shabana would be happy to join the university, Farahan would not as
she would lose an opportunity to serve at the bank for Rs.25,000.
• Whenever an organisation is deciding to go for a particular project, it should not
ignore opportunities for other projects. It should consider (i) what alternative
opportunities are there? (2) Which is the best of these alternative opportunities?

IRRELEVANT COSTS

Sunk costs are past costs. These cannot be changed with any future decision. Suppose, a
piece of land has already been purchased by a company for a sum of Rs.30 million. Also
suppose, the company is consider covering it with a wall which would cost Rupees two
million. While the sum of Rs.30 million is a sunk cost, the other of Rs.2 million is a future cost
or out of pocket expenses. It is relevant to decision: whether to erect a wall now or postpone
it for the next month, whether it should be two-meter or three-meter high. Whether a wall is
erected or not and, if erected, whether it is 2 or 3 meter, the sum of Rs.30 million for
land would remain the same. It is a sunk cost and therefore irrelevant to the decision.

Similarly, a cost which is identical in all decisions is irrelevant.

Special Decisions

There are speical decisions where relevant costs and benefits are to identified before
proceeding further. Such decisions are:

• Accept or reject an order when there is excess capacity

• Accepting or reject an other when there is no excess capacity
• Outsource a product or service
• Add, drop a product, service or department
• Sell or process further
• Optimization of limited resources or working under constraint.

SUMMARY

Management Accounting picks up data from cost database and prepare reports for the
management to faciltate decision making. Both financial and non-financial data are used in
the reports. In the non-financial data, both numerical and non-numerical information are
used.

While numerical information consist of operational statistics such as units produced, raw
materials consided and labour hours used, the non-numerical or qualitative information
pertain to customers satisfaction, employees moral, access to markets and image of an
organisation.

For a particular decision, different types of cost and benefits are considered. Called relevant
costs, these have a beaing on the future and differ under various decision alternatives. If any
of these qualification is absent, it would be an irrelavant cost.
Since most decision are under uncertainty, some other techniques are used to given an
insight in the problem such as best- worst case scenario, sensitivity analysis and simulation.

Though technology has made a lot of advancement in manufacture, concepts like cost :
benefit analyis are still valid and useful. They have been made more strong and convincing
with the introduction of ABC, ABM and EVA.

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