CHAPTER 5

RELEVANT INFORMATION, PRICING AND SPECIAL DECSION

Cont’d
Decision making encloses:
 acquisition of equipment
 mix of product
 method of production The major part of mgt decisions
 pricing of product and services
Obtaining Information: Relevance, Accuracy and Timeliness

3 criteria
Relevance – information is relevant if it is pertinent to a decision
problem
Accuracy – Information that is pertinent to a decision problem must
also be accurate or it will be of little use
 Timeliness- available in time for a decision
Cont’d
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 within one year. Time value is ignored
DECISION MAKING PROCESS

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.
DECISION MAKING PROCESS

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 feedback 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.
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.

RELEVANT REVENUE: Are expected future revenues that differ

among alternative course of action
Cont’d
The following are the common decision for which information on
relevant cost is necessary.
Pricing special offer
Make or Buy decision
 Further Processing
Changing Product mix
Adding or dropping product line
Determination of the optimum level of production.
Identifying Relevant costs
Relevant costs are future cash flows arising as a direct consequence of
a decision.
Relevant costs are future costs
Relevant costs are cash flows
Relevant costs are incremental costs, arising as a direct
consequence of the decision
Definition of Relevant Costs
A relevant cost is a future cash flow arising as a direct consequence of
a decision.
1. It must be a cost that will occur in the future. Any cost that has
already been incurred in the past cannot be a relevant cost.
2. It must be a cost (or benefit) that results in cash flow. Depreciation
charges and overhead absorption costs cannot be relevant costs.
3. It must arise as a direct consequence of the decision. Any costs (or
benefits) that will happen any way, regardless of the decision,
cannot be a relevant cost.
Definition of Irrelevant Costs
It follows from this definition that:
a. Sunk costs cannot be relevant costs. Sunk costs are costs that have
already been incurred.

b. Committed costs cannot be relevant costs. These are costs that

will be incurred in the future, but they cannot be avoided because
they have already been committed by a previous decision.
Machinery User Costs
Once a machine has been bought its purchase cost is a sunk cost.
Depreciation is not a relevant cost, because it is not a cash flow.

 However, using machinery may involve some incremental costs.

These costs may be referred to as user costs (hire charges, fall in
value)
Example: Machine user costs
Bronty Co is considering whether to undertake some contract work
for a customer. The machinery required for the contract would be as
follows.

a. A special cutting machine will have to be hired for three months

for the work (the length of the contract). Hire charges for this
machine are $75 per month, with a minimum hire charge of $300
Example: Machine user costs ….
b. All other machinery required in the production for the contract
has already been purchased by the organisation on hire purchase
terms. The monthly hire purchase payments for this machinery are
$500. This consists of $450 for capital repayment and $50 as an
interest charge. The last hire purchase payment is to be made in
two months time. The cash price of this machinery was $9,000
two years ago. It is being depreciated on a straight line basis at the
rate of $200 per month. However, it still has a useful life which will
enable it to be operated for another 36 months
Example: Machine user costs ….
The machinery is highly specialised and is unlikely to be
required for other, more profitable jobs over the period
during which the contract work would be carried out.
Although there is no immediate market for selling this
machine, it is expected that a customer might be found in
the future. It is further estimated that the machine would
lose $200 in its eventual sale value if it is used for the
contract work
What is the relevant cost of machinery for the contract?
Relevant cost of Labor
Often the labour force will be paid irrespective of the
decision made and the costs are therefore not
incremental.
Take care, however, if the labor force could be put to
an alternative use, in which case the relevant costs
are the variable costs of the labor and associated
variable overheads plus the contribution forgone
from not being able to put it to its alternative use
Example: Relevant cost of Labor

Suppose that a special job would require 50 hours of labour time.

Employees are paid $10 per hour. There is sufficient idle capacity
among the work force for 40 hours of the work. The extra ten hours
would be worked in overtime, for which the additional pay is $12.50
per hour
Relevant cost of Materials
The relevant cost of raw materials is generally their current
replacement cost, unless the materials have already been purchased
and would not be replaced once used

If materials have already been purchased but will not be replaced,
then the relevant cost of using them is either (a) their current resale
value or (b) the value they would obtain if they were put to an
alternative use, if this is greater than their current resale value.
Relevant cost of Materials

The higher of (a) or (b) is then the opportunity

cost of the materials. If the materials have no
resale value and no other possible use, then the
relevant cost of using them for the opportunity
under consideration would be nil.
Example: Relevant cost of Materials
Xy Co has been approached by a customer who
would like a special job to be done for him, and
who is willing to pay $22,000 for it. The job
would require the following materials:
Example: Relevant cost of Materials …
Example: Relevant cost of Materials …
a. Material B is used regularly by XY Co, and if units of B are required
for this job, they would need to be replaced to meet other
production demand
b. Materials C and D are in inventory as the result of previous over-
buying, and they have a restricted use. No other use could be found for
material C, but the units of material D could be used in another job as
substitute for 300 units of material E, which currently costs $5 per unit
(of which the company has no units in inventory at the moment).
What are the relevant costs of material, in deciding whether or not to
accept the contract?
Answer
1. Material A is not owned and would have to be bought in full at the
replacement cost of $6 per unit.
2. Material B is used regularly by the company. There is existing
inventory (600 units) but if these are used on the contract under
review a further 600 units would be bought to replace them.
Relevant costs are therefore 1,000 units at the replacement cost of
$5 per unit.
Answer …
3. Material C: 1,000 units are needed and 700 are already in
inventory. If used for the contract, a further 300 units must be bought
at $4 each. The existing inventory of 700 will not be replaced. If they
are used for the contract, they could not be sold at $2.50 each. The
realizable value of these 700 units is an opportunity cost of sales
revenue forgone.
4. Material D: these are already in inventory and will not be replaced.
There is an opportunity cost of using D in the contract because there
are alternative opportunities either to sell the existing inventory for
$6 per unit ($1,200 in total) or avoid other purchases (of material E),
which would cost 300 * $5 = $1,500. Since substitution for E is more
beneficial, $1,500 is the opportunity cost. Total cost $15,450
Make or Buy Decisions
In a make or buy decision, the choice is between making items in-
house or purchasing them from an external supplier.
Example
1. Whether a company should manufacture its own components, or
else buy the components from an outside supplier
2. Whether a construction company should do some work with its own
employees, or whether it should sub-contract the work to another
company
3. Whether a service should be carried out by an internal department
or whether an external organization should be employed.
Make or Buy Decisions …
The 'make' option should give management more direct control
over the work, but the 'buy' option often has the benefit that the
external organisation has a specialist skill and expertise in the work

Issues such as control, quality, flexibility, reliability of delivery, and

speed of delivery may all affect the decision to make or buy

 The relevant costs for the make or buy decision are the differential
costs between the two options.
Example: Make or Buy Decision
Shellfish Co makes four components, W, X, Y and Z, for which costs in
the forthcoming year are expected to be as follows.
Example: Make or Buy Decision
Example: Make or Buy Decision
Directly attributable fixed costs are all items of cash expenditure that
are incurred as a direct consequence of making the product in-house.
A sub-contractor has offered to supply units of W, X, Y and Z for $12,
$21, $10 and $14 respectively.

Should Shellfish make or buy the components?

The relevant costs are the differential costs between making and
buying, and they consist of differences in unit variable costs plus
differences in directly attributable fixed costs. Subcontracting will
result in some fixed cost savings
Example: Make or Buy Decision
In this example, relevant costs are the variable costs of in-house
manufacture, the variable costs of sub-contracted units, and the saving
in fixed costs.
Further considerations
i. If components W and Z are sub-contracted, the company will have
spare capacity. How should that spare capacity be profitably used?
ii. Would the sub-contractor be reliable with delivery times, and would he
supply components of the same quality as those manufactured
internally?
iii. Does the company wish to be flexible and maintain better control over
operations by making everything itself? Are the estimates of fixed cost
savings reliable?
Further Processing Decisions
A further processing decision often involves joint products from a
common manufacturing process. The decision is whether to sell the
products at the split-off point, as soon as they emerge from the
common process, or whether they should be processed further
before selling them.

 Joint products are two or more products which are output from the
same processing operation, but which are indistinguishable from each
other up to their point of separation
Further Processing Decisions
The point at which joint products become separately identifiable is
known as the split-off point or separation point.
 Costs incurred prior to this point of separation are common or joint
costs
Example: Further Processing Decision
The Poison Chemical Company produces two joint products, Alash and
Pottum from the same process. Joint processing costs of $150,000 are
incurred up to split-off point, when 100,000 units of Alash and 50,000
units of Pottum are produced. The selling prices at split-off point are
$1.25 per unit for Alash and $2.00 per unit for Pottum.

The units of Alash could be processed further to produce 60,000 units of

a new chemical, Alashplus, but at an extra fixed cost of $20,000 and
variable cost of 30c per unit of input. The selling price of Alashplus
would be $3.25 per unit. Should the company sell Alash or Alashplus?
Answer
The only relevant costs/incomes are those which compare selling
Alash against selling Alashplus. Every other cost is irrelevant: they will
be incurred regardless of what the decision is.
Alash:
SP $1.25
Total sales= $ 1.25 * 100,000 units = $125,000
less : Incremental costing post-separation –
Process costing _
$ 125,000
Shut Down Decisions
Shutdown/discontinuance problems may sometimes be simplified
into short-run relevant cost decisions. A shutdown decision is whether
to close down an operation or stop making and selling a particular
product or service
The Nature of Shutdown Decisions
Discontinuance or shutdown problems involve the following
decisions.
Whether or not to close down a product line, department or other
activity, either because it is making losses or because it is too
expensive to run

If the decision is to shut down, whether the closure should be

permanent or temporary
Example: Adding or deleting products (or
departments
A company manufactures three products, Pawns, Rooks and Bishops.
The present net annual income from these is as follows.
Example: Adding or deleting products (or
departments

The company is concerned about its poor profit performance,

and is considering whether or not to cease selling Rooks. It is felt
that selling prices cannot be raised or lowered without adversely
affecting net income. $5,000 of the fixed costs of Rooks are direct
fixed costs which would be saved if production ceased (i.e there
are some attributable fixed costs). All other fixed costs, it is
considered, would remain the same
Example: Adding or deleting products (or
departments
Example: Adding or deleting products (or
departments
Suppose, however, it were possible to use the resources realised by
stopping production of Rooks and switch to producing a new item,
Crowners, which would sell for $50,000 and incur variable costs of
$30,000 and extra direct fixed costs of $6,000. A new decision is now
required.
Example: Adding or deleting products (or
departments
It would be more profitable to shut down production of Rooks and
switch resources to making Crowners, in order to boost profits by
$4,000 to $9,000
Pricing Decision
• The factors which influence pricing policy. In the modern world there
are many more influences on price than cost (eg competitors,
product range, quality).
Influences on Price
• Price sensitivity
• Price perception
• Quality
• Competitors
• Inflation
• Incomes (price may be a less important marketing variable than
product quality and convenience of access (distribution).
Demand
Economic theory argues that the higher the price of a good, the lower
will be the quantity demanded
The economic analysis of demand
There are two extremes in the relationship between price and demand.
Demand
Demand …
A more normal situation for companies that sell a unique product or
service is shown below. The downward-sloping demand curve shows
that demand will increase as prices are lowered, or demand will fall if
the selling price is raised
Demand Equation
Example: Deriving the demand equation
The current price of a product is $12. At this price the company sells
60 items a month. One month the company decides to raise the price
to $15, but only 45 items are sold at this price. Determine the
demand equation, which is assumed to be a straight line equation
Find the price at which demand would be nil
Question

The current price of a product is $30 and its the producers sell 100
items a week at this price. One week the price is dropped by $3 as a
special offer and the producers sell 150 items. Find an expression for
the demand curve, assuming that this is a linear equation.
Price Strategies
1. Cost-plus pricing (Full cost-plus pricing is a method of deciding the
sales price by adding a percentage mark-up for profit to the full cost of
the product
Example
A company budgets to make 20,000 units which have a variable cost of
production of $4 per unit. Fixed production costs are $60,000 per
annum. If the selling price is to be 40% higher than full cost, what is the
selling price of the product using the full cost-plus method?
Price Strategies
2. Marginal cost-plus pricing (Marginal cost-plus pricing, also called
mark-up pricing, involves adding a profit margin to the marginal cost of
the product)

Whereas a full cost-plus approach to pricing draws attention to net

profit and the net profit margin, a variable cost-plus approach to
pricing draws attention to gross profit and the gross profit margin, or
contribution.
Exampl
Market Skimming Pricing
Price skimming involves charging high prices when a new product is
first launched on the market

The aim of market skimming is to gain high unit profits early in the
product's life, in the hope of recovering the costs of investment
quickly
• Products to which the policy has been applied include:
Calculators Desktop computers
Video recorders
Market Penetration pricing
Penetration pricing is a policy of low prices when a product is first
launched in order to obtain strong demand for the product as soon as it
is launched on the market. Low prices should encourage bigger
demand.

The firm wishes to discourage new entrants into the market

Price Discrimination With
With price discrimination, the same product or service is sold at
different prices to different customers
 By market segment
 By product version
By place
 By time
There must be little or no chance of a black market developing (this
would allow those in the lower priced segment to resell to those in
the higher priced segment).