Chapter 4 Decision making and relevant informations

When performing the manufacturing and selling functions, management is constantly faced with the problem of choosing between alternative courses of action. Typical questions to be answered include: What to make? How to make it? Where to sell the product and what price should be charged? InThe short run management is typically faced with the following non-routine, nonrecurring types of decision 1. 2. 3. 4. 5. 6. Acceptance or rejection of a special order Pricing standard products Make or buy Sell or process further Add or drop a certain product line Utilization of scarce resources

In general there are five steps in decision process: i. ii. iii. iv. v. Obtain information Make prediction about future costs Choose an alternatives Implement the decision Evaluate the performance

Relevant Information Relevance is one of the key characteristics of good management accounting information. To be relevant accounting information must be capable of making difference in a decision. Information with no bearing on a decision is irrelevant. Relevantinformation helps users predict the ultimate outcome of past, present, and future events.That is, it has predictive value. Relevant information also helps users confirm or correctprior expectations; it has feedback value.Finally, relevant information is available to decision makers before it loses its capacity to influence their decisions. It has timeliness. For information to be relevant, it needs predictiveor feedback value, presented on a timely basis.

Relevant costs:  Incremental costs: a cost which is specifically incurred by following a course of actions and which is avoidable if such actions are not taken. Irrelevant costs:  Non incremental cost:costs which will not be affected by the decision at hand.  Sunk costs: costs that were incurred in the past. They cannot be changed, no matter what future course of action is taken because past expenditure is not recoverable, regardless of current circumstances.  Committed costs: costs that will occur in the future such as sunk costs and committed costs

Incremental Analysis for Short-Run Decisions

Once managers have determined that a problem or need is worthy of consideration and have identified alternative courses of action, they must evaluate the effect that each alternative will have on their organization. The method ofcomparing alternatives by focusing on the differences in their projected revenues and costs is called incremental analysis. If incremental analysis excludes revenues or costs that stay the same or that do not change between the alternatives,it is called differential analysis. Irrelevant Costs and Revenues A cost that changes between alternatives is known as a differential cost (also called an incremental cost). For example, suppose that managers at Dashen Bank, a local private bank, are deciding which of two ATM machinesC or Wto buy. The ATMs have the same purchase price but different revenue and cost characteristics. The company currently owns ATM B, which it bought three years ago for $15,000 and which has accumulated depreciation of $9,000 and a book value of $6,000. ATM B is now obsolete as a result of advances in technology and cannot be sold or traded in. A manager has prepared the following comparison of the annual revenue and operating cost estimates for the two new machines:
ATM C Increase in revenue Increase in annual operating costs: 16200 ATM W 19800

Direct materials Direct labor Variable overhead Fixed overhead (depreciation included)

4800 2200 2100 5000

4800 4100 3050 5000

The first step in the incremental analysis is to eliminate any irrelevant revenues and costs. Irrelevant revenues are those that will not differ between the alternatives. Irrelevant costs include sunk costs and costs that will not differ between the alternatives. A sunk cost is a cost that was incurred because of a previous decision and cannot be recovered through the current decision. An example of a sunk cost is the book value of ATM B. A manager might be tempted to say that the ATM should not be junked (scrapped or discarded) because the company still has $6,000 invested in it. However, the manager would be incorrect because the book value of the old ATM represents money that was spent in the past and so does not affect the decision about whether to replace the old ATM with a new one. The old ATM would be of interest only if it could be sold or traded in, and if the amount received for it would be different, depending on which new ATMwas chosen. Dashen Bank Incremental Analysis
Difference in favor of ATM W 3600

Increase in revenue Increase in annual operating costs that differ between alternatives Direct materials Direct labor Variable overhead Fixed overhead (depreciation included) Total increase in operating costs Resulting change in operating income

ATM C 16200

ATM W 19800

4800 2200 2100 5000 4300 11900

4800 4100 3050 5000 7150 12650

0 (1900) (950) 0 (2850) 750

Table 4.1 Incremental analysis In that case, the amount of the sale or trade-in value would be relevant to the decision because it would affect the future cash flows of the alternatives. Two examples of an irrelevant cost in the financial data for ATMs C and W are the costs of direct materials and fixed overhead (depreciation included). These costs can also be eliminated from the analysis because they are the same under both alternatives

Once the irrelevant revenues and costs have been identified, the incremental analysis can be prepared using only the differential revenues and costs that will change between the alternative ATMs, as shown in Table 4.1 above. The analysis shows that ATM W would produce $750 more in operating income than ATM C. Because the costs of buying the two ATMs are the same, this report would favor the purchase of ATM W. Opportunity Costs Because incremental analysis focuses on only the quantitative differences among the alternatives; it simplifies managements evaluation of a decision and reduces the time needed to choose the best course of action. However, incremental analysis is only one input to the final decision. Management needs to consider other issues. For instance, the manufacturer of ATM C might have a reputation for better quality or service than the manufacturer of ATM W. Opportunity costs are the benefits that are forfeited or lost when one alternative is chosen over another. To illustrate the concept of an opportunity cost, assume that on August 1, Abebe purchases a ticket for Br 50 at attend in Addis Ababa Stadium for the match between St. George and Ethiopia Buna to be played in November. In October, Abebe is presented with an opportunity to sell his ticket to a friend who is very eager to attend and watch this big game. The friend has offered Br 100 for the ticket. The Br 100 price offered by Abebes friend is an opportunity cost-it is benefit that Abebe will sacrifice if she chooses to attend and watch the game rather than sell the ticket.