RELEVANT COSTING & DECISION

MAKING

BY

Dr. Helena Thomas

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 Learning Objectives
1. Explain generally the meaning of decision model and its basic
steps, which are involved in business contexts.

2. Identify and explain major types of business decisions

managers face in their quest to manage businesses effectively
and in a profitable manner.

3. Explain the meanings of relevant costs and relevant revenue as

well as irrelevant costs and revenue in decision making.

4. Describe the concept of differential and incremental analysis

in decision making process.

5. Analyze different types business decision making problems and

suggest the relevant/appropriate decisions to pursue .

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 Decision Model and Basic Steps Involved

❑ Important management function – it involve making

choices or making selection regarding appropriate
action(s) to pursue given between or among
different alternatives in business undertakings.
❑ In practice decision making may not always follow a
set pattern, and can vary in scope, urgency and
importance.
❑ Academically, however, a decision model is oftenly
considered as basis of guiding and facilitating
organization of key ideas – how the decision should
proceed, and latter its effectiveness to be
evaluated.
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 Decision Model and Basic Steps Involved
⚫ Decision model is defined as a formal method
of making a choice involving analysis of key
issues by considering both quantitative and
qualitative factors.

Accounting gets involved more in step 2 because each course

of action need analysis of revenue and cost data – in step 4
internal reports are prepared that review actual impact of a
decision
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 Major Types of Business Decisions
⚫ Business problems requiring managers to make
decisions are many and may include the following:
i. Eliminating unprofitable/loss making product
or business segment.
ii. Make or buy decisions (in-sourcing or
outsourcing)
iii. One time special order pricing decisions
iv. Sale or process further decisions
v. Retain or replace a particular equipment, and
vi. Allocation of limited resources to a more
profitable products.
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 Relevant Costs & Revenue for Decision Making

❑ In order to solve decision making problems, one

need different types of information provided
it is relevant in a particular circumstance.
❑ Information is considered to be relevant if it
is pertinent/appropriate/closely related to the
problem at hand, and should posses two
important characteristics:
❑ Must have a bearing impact/effect in the future or
it will occurs in the future
❑ Should indicates the differences between or among
alternative courses of actions being considered.

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 Relevant Costs & Revenue for Decision Making

❑ Thus relevant information as far as cost and

relevant are being can be explained as
follows:
❑ Relevant cost = expected future costs, and
must be different between alternatives
concerned in decision making process.
❑ Relevant revenues = are the expected
future Revenues, and must be different
between alternatives.

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 Relevant Costs & Revenue for Decision Making

❑ Typical classes of relevant costs from our 1st

session can be considered; a follows:
❑ 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 while
unavoidable costs are irrelevant costs.
❑ Broadly “Sunk costs” aka historical or past costs
are irrelevant in decision making because they
are irreversible costs. Similarly, future costs
that do not differ between the alternatives, are
also considered as irrelevant.
❑ Others include replacement costs and
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opportunity costs – discussed in 1st session.
 Summarized Basic Features of Relevant Costs/Revenue
❑ Past (historical) costs may be helpful as a basis for
making predictions – b’s they show trends. However,
past costs themselves are always irrelevant when making
actual 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 non

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financial factors and quantitative financial factors.
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 Summarized Basic Features of Relevant
Costs/Revenue
❑ Financial information includes revenues and costs as
well as their effect on overall profitability.

❑ Non-financial information includes effect on employee

turnover, the environment, or overall company image and
reputation.

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 Differential & Incremental Analysis
❑ Incremental Cost – additional total cost incurred for
an activity.
❑ Differential Cost – difference in total cost between
two alternatives.
❑ Incremental Revenue – additional total revenue from
an activity.
❑ Differential Revenue – difference in total revenue
between two alternatives
❑ Differential/Incremental analysis is a decision analysis
technique, which identifies the financial data that
change under alternative courses of action.
❑ Both costs and revenues may vary or
❑ Only revenues may vary or
❑ Only costs may vary

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 Management’s Decision-Making Process

How Incremental Analysis Works

Illustration 1

Comparison of Alternative B with Alternative A:

❖ Incremental revenue is $15,000 less under Alternative B.
❖ Incremental cost savings of $20,000 is realized, if B is
chosen.
Page ❖ Alternative B produces $5,000 more net income than A.
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 How Incremental Analysis Works

❑ Sometimes involves changes that seem contrary to intuition.

❑ Variable costs sometimes do not change under alternatives.

❑ Fixed costs sometimes change between alternatives.

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 How Incremental Analysis Works

Sample of MCQ
Incremental analysis is the process of identifying the
financial data that
a. Do not change under alternative courses of
action.
b. Change under alternative courses of action.
c. Are mixed under alternative courses of
action.
d. None of the above.

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 On Time Special Order Pricing Decisions
❑ A company may have an opportunity to obtain additional
business if it is willing to make major price concessions
(reductions/discounts) to a specific customer – this is
called special order pricing decisions.
❑ Should be considered after observing whether the
company has idle production capacity and the special
order’s long-run implications e.g. sales in other markets
not affected by the special order.
❑ Further decision Rule: does the special order generate
additional operating income?
❑ Yes – accept
❑ No – reject
❑ Determine change in profitability by comparing relevant
revenues and relevant costs - incremental revenue
Page should exceeds the incremental costs.
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 Example on Special Order & Pricing
Sunbelt Company produces 100,000 automatic blenders per
month, which is 80 percent of plant capacity. Variable
manufacturing costs are $8 per unit. Fixed manufacturing
costs are $400,000, or $4 per unit. The blenders are normally
sold directly to retailers at $20 each. Sunbelt has an offer
from Mexico Co. (a foreign wholesaler) to purchase an
additional 2,000 blenders at $11 per unit. Acceptance of the
offer would not affect normal sales of the product, and the
additional units can be manufactured without increasing plant
capacity.
Required: advice mgt on the appropriate decision to take.

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 Answer to Example on Special Order

❑ Fixed costs do not change since special order will be produced

within existing capacity (2000 units › 25,000 units; 20% i.e.
100% - 80%). Thus fixed costs are not relevant.

❑ Variable manufacturing costs and expected revenues change

thus both are relevant to the decision (Rev. $22,000 = 2,000 x
$11 & $16,000 = 2,000 X $8) .
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 Make (in-sourcing) or Buy (Out-sourcing)
Gandhi Bajaj Accessories Ltd (GBAL) located in India incurs
the following annual costs in producing 25,000 ignition switches
for its famously known Bajaj products.

Instead of making its own switches, GBAL might purchase

the ignition switches at a price of $8 per unit. If this
decision is implemented, GBAL will avoid a total of $10,000 in
fixed manufacturing OH. Qn. What should mgt do?
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 Make or Buy Decisions

Make financial analysis comparing two decisions

❑ Note that total manufacturing cost is $1 higher than

purchase price. However in both cases, GBAL must absorb at
least $50,000 of fixed costs. The analysis shows that by
purchasing profit will be decreasing by $25,000 – GBAL
should continue producing the switches rather than buying.
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 Make or Buy Decision
GBAL has been approached by a newly established company
namely USA Company. This intends to rent the productive
capacity used to manufacture ignition switches for $28,000.
Mgt of USA Company convinces GBAL to continue with the
buying the switches because it believes that this additional
additional income is more beneficial for GBAL. If your were
the MD of GBAL what would be your response to this offer?

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 Review Question

In a make-or-buy decision, relevant costs are:

a. Manufacturing costs that will be saved.

b. The purchase price of the units.
c. Opportunity costs. costs that will be saved.
a. Manufacturing
d. All
b. ofThe
thepurchase
above. price of the units.
c. Opportunity costs.
d. All of the above.

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 Sell or Further Processing Decisions
❑ The company may face decision to sell or to engage in
further processing activity at a given point in production
process thus being able to sell at higher price. In TZ it
has been established that, Tanzanian exporters, rather
than exporting raw agricultural products to foreign
markets, should process further in order to get higher
prices and income. Rather than exporting unprocessed
leather, they should process further ready to be used in
production of shoes and other related products. What is
our take in MA?
❑ Decision Rule: Process further as long as the
incremental revenue from such processing exceeds the
incremental processing costs.
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 Sell or Further Processing – Single Product

International Woodmasters Inc. (IWS) makes tables – the cost to

manufacture an unfinished table is $35 while the selling price per
unfinished unit is $50.
Management concludes
that some of the unused
capacity may be used to finish the tables and sell them at $60 per
unit. For a finished table, direct materials will increase by $2 and
direct labor costs will increase by $4. Variable manufacturing
overhead costs will increase by $2.40 (60% of direct labor). No
increase is anticipated in fixed manufacturing overhead. Should IWS
Sell or engage in further processing tables before exporting?
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 Solution to Sell or Further Processing

The incremental analysis on a per unit basis is as follows.

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 Types of Incremental Analysis

Sell or Process Further - Multiple-Product Case

Joint product situation for Marais Creamery. Cream and skim
milk are products that result from the processing of raw milk.

Joint product costs are sunk costs and thus not relevant to the
sell-or-process further decision.
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 Types of Incremental Analysis

Sell or Process Further - Multiple-Product Case

Cost and revenue data per day.
Illustration 7-11

Determine whether the company should simply sell the cream

and skim milk, or process them further into cottage cheese
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 Sell or Process Further - Multiple-Product C

Analysis of whether to sell cream or process into cottage cheese.

Marais should or should not process the cream further?

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 Sell or Process Further - Multiple-Product Case

Analysis of whether to sell skim milk or process into condensed

milk.

The skim milk should further be processed into condensed milk

because by doing so the company earn more by $7,000. Note
the joint costs are irrelevant in deciding whether to sell or
process further.
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 Question to Ponder ……

The decision rule is a sell-or-process-further

decision:
Process further as long as the incremental
revenue from processing exceeds:
a. Incremental processing costs.
b. Variable processing costs.
c. Fixed processing costs.
d. No correct answer is given.

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 Retain or Replace Equipment
A Chinese Company is considering whether to replace a factory
machine with a new machine – relevant data are given below
Assessment of replacement of factory machine:

Old Machine New Machine

Book Value $ 40,000
Cost $ 120,000
Remaining useful life four years four years
Salvage value -0- -0-

Variable manufacturing costs decrease from $160,000 to

$125,000 if new machine purchased.

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 Retain or Replace Equipment

Prepare the incremental analysis for the four-year period.

Illustration 7-14

Retain or Replace?

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 Retain or Replace Equipment

Additional Considerations
❑ The book value of old machine does not affect the decision.

❑ Book value is a sunk cost.

❑ Costs which cannot be changed by future decisions

(sunk cost) are not relevant in incremental analysis.

❑ However, any trade-in allowance or cash disposal value of

the existing asset is relevant.

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 Eliminate an Unprofitable Product/Segment
❑ Key: Focus on Relevant Costs.
❑ Consider effect on related product lines.
❑ Fixed costs allocated to the unprofitable segment must be
absorbed by the other segments.
❑ Net income may decrease when an unprofitable segment is
eliminated.
❑ Decision Rule: Retain the segment unless fixed costs
eliminated exceed contribution margin lost.

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 Eliminate an Unprofitable Product/Segment

Korea International Sports Ltd (KISL) manufactures three

models of tennis rackets:
❑ Profitable lines: Pro and Master
❑ Unprofitable line: Champ
Segment
income
data

Should Champ be eliminated? Assume fixed costs are

allocated 2/3 to Pro and 1/3 to Master.

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 Eliminate an Unprofitable Segment

Solution:

prepare income statement after eliminating Champ product

line.

Total income is decreased by $10,000.

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 Eliminate an Unprofitable Segment

Incremental analysis of Champ should also provide the

same results:

Do Not Eliminate Champ because by eliminating it

The net income will decrease by $10,000

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 Question to Ponder

If an unprofitable segment is eliminated:

a. Net income will always increase.

b.
a. Variable expenses
Net income of the
will always eliminated segment
increase.
will have to be absorbed by other segments.
b. Variable expenses of the eliminated segment
c. Fixed expenses
will have allocated by
to be absorbed to other
the eliminated
segments.
segment will have to be absorbed by other
c. Fixed expenses allocated to the eliminated
segments.
segment will have to be absorbed by other
d. Net income will always decrease.
segments.
d. Net income will always decrease.

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 Qualitative Factors

Potential effects of decision on existing employees

and the community.

Cost savings that may be obtained from outsourcing or

from eliminating a plant should be weighed against
these qualitative attributes.

Cost of lost morale that might result.

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