Admas university college of Business and Economics 2020

CHAPTER FIVE
RELEVANT INFORMATION AND DECISION MAKING

INTRODUCTION
WE have discussed various cost concepts in the preceding duties. Not all cost concepts/costs are relevant in
decision-making. The purpose of this chapter is to identify and analyses relevant costs for making decisions.
The decisions considered here are those decisions, which involve alternative-choices. Decision-making is
one of the basic functions of a manager. Managers are constantly faced with problems of deciding what
products to sell and what prices to charge, what producing methods to use, whether to make or buy
component parts, what channels of distribution to use, whether to accept or reject a onetime-only special
orders at special prices, insourcing or outsourcing products or services, replacing or keeping equipment, and
so forth
In this chapter, we focus our attention on some of the following important decisions:
 Pricing special offer  Adding or dropping product line
 Make or buy decision  Dropping a division
 Changing product mix  Determination of the optimum level of
production.

The Accountant Role in Special Decisions

Working with managers to make decisions is one of the main functions of the cost and management
accountant and an important driving force or thrust of this chapter. The use of accounting information for
decision-making has been a consistent theme in earlier chapters. The accountant is responsible for seeing that
relevant, reliable, timely and understandable data are available to guide management in its decisions,
particularly these decisions relating to special, non-routine situations. Reliance by management on irrelevant
data can lead to incorrect decisions, reduced profitability, and inability to meet stated objectives.

1. Identify, define, and clarify the decision problem

Before making decisions of any type, the problem needs to be identified, defined, and clarified in more
specific terms. Considerable managerial skill is required to define a decision problem in terms that can be
addressed effectively. Notice that this is the most important phase of the decision making process as all other
steps in the process depends on this phase. Incorrectly defined problems could result in wastage of time and
resources. That is why it is usually being said, “Defining a problem correctly is half a solution”. Sometimes
the decision problem is clear, but it is seldom clear and unambiguous.

2. Specify the criterion

Once a decision problem has been clarified, the manager should specify the criterion upon which a decision
will be made. Is it to maximize profit, increase market share, minimize cost, or improve public service?
Sometimes the objectives are in conflict, as in a decision problem where production cost is to be minimized
but product quality must be maintained. In such cases, one objective is specified as the decision criterion,
for example, cost minimization. The other objective is established as a constraint, for example, product
quality must not fall below one defective part in 1,000 manufactured units.

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Compiled By:- instructor Dego B. Cost and Management Accounting II
Admas university college of Business and Economics 2020
3.Identify the possible alternatives
A decision involves selecting between two or more alternatives. Thus, determining the possible alternative
courses of action is a critical and vital step in the decision-making process. If, for instance, a machine breaks
down, the alternative courses of action could be to repair the machine or replace it through acquisition or
lease.

4.Develop a decision model

A decision model is a simplified representation of the choice problem. Unnecessary details are stripped
away, and the most important elements of the problem are highlighted. Thus, the decision model brings
together the elements listed above: the criterion, the constraints, and the alternatives.
5.Collect the data
Information could be subjective or objective, internal or external to an organization, historical (past) or future
(expected). Selecting data pertinent to decisions is one of the most important roles of a managerial
accountant in an Organization. Notice that every piece of data collected may not be relevant and decisions
should, therefore, be based only on the relevant data. Collection of data is primarily the responsibility of the
managerial accountant.

6.Make a Decision
After each possible alternative is evaluated in terms of its costs and benefits, the best alternative is selected
and implemented.
1. PRICING SPECIAL OFFER
A special order is a one-time order that is not considered part of the company’s normal ongoing business.
Occasionally, a company receives an offer to sell its goods at a price significantly below its normal selling
price. Therefore, management must assess whether the special order should be accepted or rejected and
determine the price that should be charged if the order is accepted. The relevant costs are the additional
(incremental) costs that will be incurred as a result of accepting the special order or, stated differently, costs
that could be avoided if the special order is rejected. No doubt, if a special order is accepted, the amount of
revenue will increase and this change in revenue is relevant too. Thus, in a special order decision, we
consider only the relevant revenue and the relevant avoidable costs.

In general, a special order is profitable if the incremental (differential) revenue from the special order
exceeds the incremental (differential) costs of the order. The profit from a special order is simply the
difference between incremental revenue and incremental costs. Consequently, if incremental revenue is
greater than the incremental costs and present sales are unaffected, accepting a special order will be the right
decision. The following two points are worth mentioning:
If the incremental (differential) revenue exceeds the incremental (differential) costs, the special
order should be accepted. That is,
Incremental revenue > Incremental cost = Accept order.
If the incremental (differential) revenue falls short of the incremental (differential) costs, the special
order should be rejected, That is,
Incremental revenue < Incremental cost = Reject order.
Let as assume that the company receives an offer from Song Swing Company of Singapore to 20,000 tea sets
at a price of 700/seats. If the order is accepted, the company will have to incur an expenditure of $500,000 on
handling, transportation etc.

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Compiled By:- instructor Dego B. Cost and Management Accounting II
Admas university college of Business and Economics 2020
Required: Should the company accept the offer?
Solution
Revenue 700 X 20,000 $14,000,000
Variable Cost 6000 X 20,000 $12,000,000
Contribution Margin $14,000,000 - $12,000,000 $2,000,000
Additional Profit $2,000,000 - $500,000 $1,500,000
Conclusion: We accept the project because we get $1,500,000 additional profit.

2. Make or Buy Decision

Management sometimes may have to make a choice between manufacturing the component parts of a
product and buying them from outside. Such a situation of make or buy decision may arise whenever the
firm has the idle plant capacity and the technical capability of manufacturing the component parts.
For a variety of reasons, one company may produce a product or service for total costs less than another
company. Wages rates, economies of scale, specialization, level of bureaucracy, motivation, reward
structure, technological competence, degree of automation, and many other cost-related factors differ among
companies. As a result, a company may purchase a product or service at a price below the cost that could
have been incurred if the company were to produce the product or service for itself. The practice of buying
goods and services externally from other companies is commonly known as outsourcing. Determining the
relevant cost of buying goods or services is usually an easy task.

Cost minimization is achieved by selecting the make-or-buy alternative with the lowest relevant costs.

An outsourcing decision, also called a make-or-buy decision, entails a choice between producing a product
or service in-house and purchasing it from an outside supplier. Such consideration arises when a company
has the capacity to produce some items it needs internally and the same items are available in the outside
market.
Continue to make an item internally and reject an outside supplier’s offer if the avoidable costs (costs
associated with the production of an item internally) are less than the outside purchase price. That is,
Avoidable costs < outside purchase price = Make internally.
Purchase an item from an outside supplier only if the outside purchase price is less than the costs that can be
avoided internally as a result of stopping the production of the item. That is,
Avoidable costs > outside purchase price = Purchase from outside.
3. Changing Product Mix
A Multiple product firm is at times faced with the problem of changing product mix to improve profits.
Different products have their own structure &selling prices. Thus they made different contribution towards
the companies fixed costs. Generally, the firm would prepare a product with higher contribution

4) ADDING OR DROPPING A PRODUCT LINE

In a multi-product company, the management may have to decide on adding or dropping a product line.
When a new product line is added its sales & certain costs will also be increased &reverse will happen when
a product line is dropped. In order to arrive at such a decision, the management should compare the
differential cost &incremental revenues & study its effect on the overall profit position of the company.

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Compiled By:- instructor Dego B. Cost and Management Accounting II
Admas university college of Business and Economics 2020
In dropping product lines and other segments of a company, carefully bear in mind the following two key
points:
 Drop (eliminate or discontinue) a product line or other segment if you can avoid more in fixed costs
than you lose in contribution margin. That is,
Fixed costs Avoided > contribution margin lost = Drop.
 Retain (keep or continue) a product line or other segment if you are not able to avoid as much in fixed
costs as you lose in contribution margin. That is,
Fixed costs Avoided < contribution margin lost = Retain.
You can as well compare the amount of unavoidable fixed costs with the amount of the loss to decide as to
whether to drop a segment or not. Thus,
If unavoidable fixed costs > the loss = don’t Drop a segment.
If unavoidable Fixed costs < the loss = Drop a segment.

5) DROPPING A DIVISSION
Management of a company is sometimes required to decide whether a seemingly unprofitable division or
department or product should be dropped one again, the relevant costs & impact on contributions should be
examined to made the decision
6) DETERMINATION OF THE OPTIMUM LEVEL OF PRODUCTION
The optimum level, in the level of production where profit is the maximum in order to arrive at a decision of
this type a differential costs are compared with the incremental revenues at various levels of output so long
as the incremental revenue exceeds differential costs it is profitable to increase the output . But as seen as the
differential costs equal or exceed incremental revenue it is not more profitable to increase the volume of
output.
Differential cost (Revenue) is the difference in total cost (revenue) between two alternatives For instance
decision to purchase a machine, both machine perform the same function.
Incremental Cost: Another term for deferential cost when one alternative includes all the costs of the other
plus some additional cost.
Incremental Cost of increasing production from 1000 automobiles to 1200 automobiles per week would be
the cost of producing the additional 200 automobiles each week.

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Compiled By:- instructor Dego B. Cost and Management Accounting II