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Chapter 14óDecision Making: Relevant Costs and Benefits

 

  1. The Decision-Making Process
    1. Providing relevant information: The managerial accountantís role in the decision-making process is to provide relevant information to managers who then make the decisions.
    2. Characterized by six steps: The six steps characterizing the whole process are:
    1. clarify the decision process;
    2. specify the criterion upon which the decision will be made;
    3. identify the alternatives;
    4. develop a decision model: Develop a decision model that brings together the criterion, the constraints, and the alternatives;
    5. collect the data: The managerial accountant is primarily responsible for collecting the data, although he or she will act in an advisory capacity during the other steps;
    6. select an alternative.
    1. Importance of qualitative information: Although the managerial accountant collects and presents quantitative information, the role of qualitative information should not be underestimated. A skilled manager relies on experience to evaluate qualitative factors such as employee moraleófactors that do not fit easily into numerical decision models.
    2. Relevance, accuracy and timeliness: Information that is useful in decision making must be relevant (pertinent to the decision problem); accurate (precise); and timely (arrive in time for the decision to be made). Companies will occasionally trade-off accuracy for timeliness.
  1. RELEVANT INFORMATION
    1. Relevance to opportunity: The information gathered should be relevant to the opportunity or problem at hand.
    1. Difference among alternatives and future oriented: Relevant information involves costs and benefits that: (1) differ among the alternatives being considered; and (2) are future oriented. Both guidelines must be met.
    2. Cost already incurred: Sunk costs are costs that have already been incurred. Such costs are irrelevant in decision making because the amount cannot be changed regardless of the alternative selected. Examples include the book value of equipment and the cost of existing inventory.
    3. Net difference: A differential cost is the net difference in cost between two alternatives.
    4. Forgone alternatives: An opportunity cost is the cost of a forgone alternative. Because of limited resources, companies must frequently pass up profitable (beneficial) projects. The profit (benefit) forgone becomes an opportunity cost to the firm, and such costs are relevant in the decision-making process.
  1. SPECIAL DECISION SITUATIONS
    1. Key issues in special orders: In situations with special orders, a manager considers an order (often a one-time order) at a special price. Key issues to consider are:
    1. Cost behavior: Unless told otherwise, assume that fixed costs remain fixed and variable costs change.
    2. Qualitative considerations: These include, among other things, the reaction of present customers should they find out about the special price, and price discrimination regulations.
    3. Idle capacity: If there is insufficient idle capacity to manufacture a special order, then all or part of the order would have to be filled from the regular product supply. The opportunity costs of the lost contribution margin from regular, higher-priced sales must be factored into the decision.
    1. Outsourcing (make vs. buy): This situation requires careful consideration of fixed costs. The per-unit cost of a product includes a unitized portion of fixed costs, costs that may continue even if the product is purchased elsewhere at a lower price.
    2. Avoidable or unavoidable fixed costs: When assessing a add or drop problem, the key is the proper handling of fixed costs an ascertaining if such amounts are avoidable or unavoidable.
    1. Isolate costs: When a manager is considering dropping a product line, he or she should isolate costs that will disappear with that line. In many cases, fixed costs are not avoidable, particularly allocated common costs.
    2. Consider lost C.M.: The opportunity costs of lost contribution margin is also factored into the decision.
    1. Sell or process further: When two or more products result from a common manufacturing process, the products are called joint products.
    1. Distinguishable from each other: The point in the process where products are distinguishable from one another is the split-off point.
    2. Previous costs sunk: All manufacturing costs up to that point are sunk and irrelevant to the sell now or process further decision. In contract, processing costs after the split-off point (separable costs) are relevant.
    3. Consider only increase after split-off: The key to the correct decision is considering only the increase in processing costs after the split-off point and comparing it to the increase in revenue from the extra processing.
    1. Limited resource allocation: Decision may involve the use of limited labor hours, limited materials, and limited machine hours.
    1. Focus on greatest contribution: When one limited resource is present, a company should focus on products that have the greatest amount of contribution margin per units of the scarce resource.
    1. Uncertainty: Analysts can incorporate uncertainty into the decision process by weighing an alternative with its probability of occurrence. Multiplying the alternative by a probability and then summing the results will yield the expected value, an average that is used to make the decision.
  1. ACTIVITY-BASED COSTING AND DECISION MAKING
    1. Relevant-costing concepts same: The relevant-costing concepts in an activity-based-costing environment do not change.
    2. Decision makerís ability changes: What will change is the decision makerís ability to determine costs and benefits that are relevant to the decision. Costs that are fixed under a conventional costing system, for example, may not be fixed when multiple (and more appropriate) cost drivers are used.
  1. OTHER ISSUES IN DECISION MAKING
    1. Managerial performance same factors: Managerial performance should be judged on the same factors that are considered in making decisions.
    2. Conflicts with accrual accounting: Unfortunately, there may be a conflict between performance evaluation and decision making courtesy of accrual accounting. For example, losses may be incurred on the disposal of long-term assets, prompting a manager to reject the disposal (for fear of looking bad) when in fact it may benefit the firm.
    3. Important points in decision making:
    1. ignore sunk costs;
    2. beware of unitized fixed costs in decision making;
    3. beware of allocated fixed costs; identify the avoidable costs;
    4. pay special attention to identifying and including opportunity costs in a decision analysis.

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