TOPIC 3

SHORT TERM
DECISION MAKING

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OUTLINE

 Decision making
 Characteristics of relevant information

 Identifying relevant costs and benefits

 Accept or reject a special order

 Make or buy a product

 Add or delete a product or department

 Joint products

 Incentives and pitfalls

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THE MANAGEMENT ACCOUNTANT’S ROLE
IN DECISION MAKING
 Provide relevant information to managers
to assist in decision-making
 Management accountants are often
members of cross-functional teams

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A MODEL OF THE DECISION-MAKING
PROCESS

Steps in the decision making process (Exhibit 19.1)

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CHARACTERISTICS OF
RELEVANT INFORMATION
 Relevant information relates to costs and
benefits that differ under competing courses of
action
 Relates to the future
 Past costs cannot be affected by the current action
(e.g. sunk costs)
 Timeliness versus accuracy
 More accurate information may take longer to
produce
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CHARACTERISTICS OF
RELEVANT INFORMATION
 Quantitative or qualitative
 Quantitative information can be expressed in
numeric terms
 Qualitative information cannot be expressed
effectively in numerical terms

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THE IMPORTANCE OF PROVIDING ONLY
RELEVANT INFORMATION
 Generating information is a costly process
 Supplying irrelevant data to managers
can lead to a waste of managerial
resources
 Information overload decreases the
effectiveness of decision making

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INFORMATION FOR UNIQUE VERSUS
REPETITIVE DECISIONS
 Unique decisions
 Arise infrequently or only once
 Relevant information will often be found inside and
outside the organisation
 Repetitive decisions
 Made at regular or irregular intervals
 May draw on a lot of historical data

 Relevant information should be readily available

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RELEVANT INFORMATION

 Relevant information meets the following

criteria:
 The costs or benefits relate to the future
 The costs or benefits differ between the
alternatives
 All pending decisions relate to the future.
 Accordingly, only future costs can be relevant to
decisions.

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IDENTIFYING RELEVANT COSTS AND
BENEFITS: TERMINOLOGY
 Sunk costs
 Already incurred in the past
 Irrelevant to the decision

 Opportunity costs
 The potential benefit given up when the choice of
one action precludes a different action
 Relevant to the decision

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IDENTIFYING RELEVANT COSTS AND
BENEFITS: TERMINOLOGY

 Out-of-pocket costs
 The incremental costs incurred if a particular
course of action is selected
 Relevant to the decision

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IDENTIFYING RELEVANT COSTS AND
BENEFITS: TERMINOLOGY
 Avoidable costs
 Costs that will not be incurred in the future if a
particular decision is made
 Relevant to the decision

 Unavoidable costs
 Costs that will continue to be incurred no matter
which decision alternative is chosen
 Irrelevant to the decision

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SOME COMMON
RELEVANT COST APPLICATIONS
 Relevant costing is of value in solving many
different types of problems. Traditionally, these
applications include decisions:
 to accept a special order at less than the usual price.
 to make or buy a component.
 to keep or drop a segment or product line.
 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.
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ACCEPT OR REJECT A SPECIAL ORDER

 Whether or not to supply a customer with a

single, one-off order
 Consider whether spare (idle) capacity can be
used to meet the special order
 If spare capacity is not available, meeting the
order will require using capacity that is usually
used for regular products

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INCREMENTAL REVENUES AND COSTS … WITH SPARE
CAPACITY, WALLABY AIRLINES

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INCREMENTAL REVENUES AND COSTS … WITH
NO SPARE CAPACITY, WALLABY AIRLINES

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ACCEPT OR REJECT A SPECIAL ORDER:
CONSIDERATIONS

 Is the order a one-off decision or does it

have long-term potential?
 Strategic issues
 Arethere any adverse effects on regular
business?
 Qualitative factors?

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MAKE OR BUY A PRODUCT
 An organisation chooses to produce or
purchase the product from a supplier
 Consider avoidable versus unavoidable costs

 Opportunity costs are often relevant

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TOTAL COSTS OF THE MAKE-OR-BUY DECISION,
WALLABY AIRLINES

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MAKE OR BUY A PRODUCT: CONSIDERATIONS

 Treat fixed costs carefully

 Strategic issues may include:
 Quality of the purchased product
 Delivery responsiveness, technical
capabilities, labour relations and financial
stability of the supplier
 Ability of the supplier to respect confidential
information

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OUTSOURCING DECISIONS

 When part of a manufacturing process, or

another function normally undertaken within an
organisation, is contracted to an outside
business
 Tends to be a long-term decision rather than a
tactical ‘make-or-buy’ decision
 Difficult and costly to reverse

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ADD OR DELETE A PRODUCT, SERVICE OR
DEPARTMENT
 Consider which costs and benefits will change
if the decision is taken
 Has long-term implications

 Traditional accounting data that contains cost

allocations should be treated with care

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WORLD HOPPERS CLUB MONTHLY INCOME
STATEMENT, WALLABY AIRLINES

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TOTAL REVENUES AND COSTS OF DECISION TO DROP
THE WORLD HOPPERS CLUB …

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OVERALL LOSS FROM THE DECISION TO DROP THE
WORLD HOPPERS CLUB …

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ADD OR DELETE A PRODUCT, SERVICE OR
DEPARTMENT: STRATEGIC ISSUES

 Consider any potential impact on other

areas of the organisation
 Will there be an impact on customers or
staff morale?

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JOINT PRODUCTS: SELL OR
PROCESS FURTHER
 Joint products: two or more products that are
produced simultaneously from one production
process
 Split-off point: the stage in the production process
where the two products are separately identifiable
 Joint cost: the manufacturing cost incurred in the
joint production process
 Relative sales method: the joint costs are
allocated to the joint products in proportion to
their sales value at split-off point
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JOINT PROCESSING OF COCOA BEANS,
INTERNATIONAL CHOCOLATE COMPANY

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TOTAL REVENUES AND COSTS OF THE DECISION TO
SELL OR PROCESS FURTHER

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INCENTIVES FOR DECISION MAKERS

 Managers typically make decisions that will

maximise their reported performance and
rewards
 Ideally systems should be designed to
encourage managers to make decisions
consistent with the organisation’s goals and
strategies

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PITFALLS TO AVOID WHEN USING
ACCOUNTING DATA FOR DECISIONS
1. Sunk costs are irrelevant and should be
ignored
2. Beware of unitised fixed costs

3. Beware of allocated fixed costs

4. Remember to determine and include

opportunity costs
PRICING STRATEGIES:
* PREMIUM PRICING STRATEGIES
* PENETRATING PRICING STRATEGIES
* ECONOMY PRICING STRATEGIES
* PRICE SKIMMING PRICING STRATEGIES
* BUNDLE PRICING STRATEGIES
* PSYCHOLOGICAL PRICING STRATEGIES

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