CHAPTER FOUR Cost & Management Accounting Handout

DECISION MAKING &RELEVANT INFORMATION

Decision making is a fundamental part of management decision about the acquisition of equipment, mix of
product, method of production and pricing of product and services confront managers in all types of
organizations.

Obtaining information: Relevance, Accuracy and Timeliness

What criteria should the managerial accountant use in designing the accounting information system that supplies
data for decision making.
1. Relevance – information is relevant if it is pertinent to a decision problem
2. Accuracy – Information that is pertinent to a decision problem must also be accurate or it will be of little use.
This means the information must be precise, highly accurate but irrelevant data are of no value to decision.
3. Timeliness- Relevant and accurate data are of value only if they are timely, that is available in time for a
decision. Thus timeliness is the third important criteria for determining the usefulness of information.

 Decision making means selecting a course of action from among a set of alternatives.
 There are mainly two types of decision i.e. long term & short term decisions.
 Time value of money& return on investment are the prime considerations in long term decision.
 Short term decision means selection of alternatives of which can be implemented with in one year.
Variable costing techniques helps management to take short term decision in many areas.

DECISION MAKING PROCESS

Each manager has a method often called a decision model, for deciding among different course of action.
A decision model is a formal method for making a choice frequently involving quantitative &qualitative
analysis. Accountants serve as technical experts supplying managers with relevant data to guide their
decisions.
To make a decision management proceeds in sequence of 5 steps in decision process.

Step1: Gathering of information: the information is collected for decision making should be relevant.
Step2: Making predictions: _ use the information from step1 together with an assessment of probability as a
basis predicting the future costs.
Step3: Choosing an alternative: the predicted benefits of the different alternatives in step2 are compared
&are related to the size of the required investment along with other consideration.
Step4: Implementation the decision: the manager implements the decisions reached in step3.
Step5: Evaluating performance: Evaluation of performance of the decision implemented in step 4 provides
the feed back as the 5step sequence is then repeated in whole or in part.

THE MEANING OF RELEVANT REVENUE &COSTS

RELEVANT COSTS: Are those expected futures costs that differ among alternative course of action.
The two key affects to these definitions are that the costs must occur in the future &that they must differ
among the alternative course of action. We focus on the future because every decision deals with the future
nothing can be done to alter (change) the past.
We will see in the foregoing discussions that variables cost in variably change whenever, a decision is made.
They are avoidable costs and are therefore relevant for the decision. We will see that fixed costs do not
generally change in the short run, particularly when the range of the companies operation is with in normal
capacity.
Costs which don’t change with a decision are unavoidable costs &are not relevant in making the decision are
but certain fixed cost can be avoided and there relevant costs.

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RELEVANT REVENUE; Are expected future revenues that differ among alternative course of action
The following are the common decision for which information on relevant cost is necessary.
1. Pricing special offer
2. Make or buy decision
3. Changing product mix
4. Adding or dropping product line
5. Dropping a division
6. Determination of the optimum level of production.

1) PRICING SPECIAL OFFER

Special offer may come to a company once in a while. They may travel a lower than normal pricing being offered
for the company’s products. How should the company decide whether to accept an offer or not?
Illustration 2.1
MS Company manufactures special steel tea sets. Its normal capacity is 100,000 tea sets per year. The
company is able to utilize only 60% of its capacity due to recession in domestic market. Current selling price of
each tea set is $1000. Annual fixed is $12,000, 000. The cost schedule at capacity of 60,000 sets is
Cost item per set ($) total (000,000)
Materials ¾ kg @ $400 per kg) $300 18
Labor (10hr @ $20 per hr 200 12
Variable overhead 910hr@10 per hr) 100 6
Total Variable cost 600 36
Total Fixed cost 200 12
Total cost 800 48

Let as assume that the company receives an offer from Song Swing Company of Singapore to 20,000 tea seats 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.
Should the company accept the offer?

2. Make or Buy Decision

Companies are often required to decide whether same components of a product should be manufactured in house
or bought from outside supplier. Even service may be provided in house or contracted out. Cost comparison of
make or buy option is natural step in taking the decision but only relevant costs should be compared.

The answer to this question is based on

Qualitative factors. For instance, some manufacturers always make parts because they want to control
quality .Alternatively some companies always purchase parts to protect Long- run relation ship with
their suppliers.
What qualitative factors are relevant to the decision of whether there is idle capacity or not? Many
companies make parts only when their facility can not be used to better advantage.

Example: RAM Company produces coolers. The company considering whether it should continue to manufacture
air circulating it self or purchase them from out side. Its annual requirement is 25,000 units. An out side is
prepared to supply fans for 285 each. In addition, fresh air will have to incur costs of 1.5 per unit for freight & $

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10,000 per year for quality inspection, storing etc of the products. In the most recent year, Fresh Air Company
produced 25,000fans at the following total cost:
Material ----------------------------------------------------------------$ 5,000,000
Labor ------------------------------------------------------------------$ 2,000,000
Supervision & other indirect labor -----------------------------$ 200,000
Power & Light --------------------------------------------------------$ 50,000
Depreciation ----------------------------------------------------------$ 20,000
Factory rent-----------------------------------------------------------$5,000
Supplies ----------------------------------------------------------------$75,000
Total ---------------------------------------------------------------------$7,350,000

Power & light includes 20,000 for general heating &lighting which is an allocation based on the light point.
Indirect labor cost is attributable mainly to the manufacturing of fans. About 75% of it can be distributed with
along with direct labor in manufacturing is discontinued. However, the supervision who receives annual salary of
$75,000 will have to retain. The machine used for manufacturing fans which have a book value of $300,000 can
be sold for $125,000& the amount realized can be invested at 15% return. Factory rent is allocated on the basis of
area & the company is not able to see an alternatives use for the space which would be released. Should RAM Co.
manufacture the fan or buy them from out side supplier?

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.
Example: A firm can produce three different products form the same raw materials using the same production
facilities. The request labor is available in plenty at $8/hours for all products. The supply of raw materials
which is imported at $8 per kg is limited to 10,400kgs, for budget period. The variable overheads are
$5.60per hour. The fixed overheads are $50,000 from the following information you are requested to suggest
the most sustainable sales mix which will maximize the firm’s profits. Also determine the profit that will be
earned at that level.
Products marked u s p ($) labor hours raw materials
Did (unit) request per unit requested per units

X 8,000 30 1 0.7
Y 6,000 40 2 0.4
Z 5,000 50 1.5 1.5

1) 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. Example the
management of a company is thinking whether it should drop one product item from the product line
&replace it with another. Given below represents cost &output data.
Product price ($) u v c ($) %age of sales

Book shell 60 40 30%

Ta bale 100 60 20%
Bed 200

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Total f c $750,000 120 50%

Per year sales $2,500,000

The change under consideration consists in dropping the line of tables &adding the
Line of cabinets. If this change is made the manufacture forecasts the following cost output data.
Product price ($) u v c ($) %age of sales
Book shelf 60 40 50%
Cabinet 160 60 10%
Bed 200 120 40%
Total f c per year $750,000
Sales $2,600,000
Should this proposal to be accepted?

2) DROPPING A DIVISSION

Management of a company is sometimes required to decide whether a seemingly un profitable division or

department or product should be dropped one again, the relevant costs &impact on contributions should be
examined to made the decision e.g. Diversity company limited a diversified company ,has three
division ;cement ,fertilizers & textiles. The company summary of the company is profit is given below.
Cement fertilizer textiles totals (000,000)
Sales $20m $12m $18m $50m
Less: vs. $18m $19.6m $15.4m $23m
CM $12m $2.4m $12.6m $27m
Less: f c (allocated)
To divisions in proportion
Of sales $8m $4.8m $7.2m $20m
Profit (loss) $4m $2.4m 45.4m $27m
After allocating the company’s fixed overhead to products the fertilizer divisions increase a less of $2.4m.should
the company drops this divisions?

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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.
Example: accompany has a capacity of producing 100,000 units of a certain product in a month. The sales
department reports that the following schedule of sales price is possible.

Volume of production u s p ($)

At 60% 60,000 units $0.90

At 70% 70,000 units $0.80
At 80% 80,000 units $0.75
At 90% 90,000 units $0.67
At 100% 100,000 units $0.61
The v c of manufacture b/n these levels is $0.15&f c $40,000
Prepare the statement showing incremental revenues &differential cost of earn stage. At which volume of
production will the profit be maximum?

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