Chapter 14—Decision Making: Relevant Costs and Benefits
The Decision-Making Process
Providing relevant information
: The
managerial accountant’s role in the decision-making process is to provide
relevant information to managers who then make the decisions.
Characterized by six steps
: The six steps characterizing the whole
process are:
clarify the decision process
;
specify the criterion upon which the decision will be made
;
identify the alternatives
;
develop a decision model
: Develop a decision model that brings
together the criterion, the constraints, and the alternatives;
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;
select an alternative
.
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 morale—factors
that do not fit easily into numerical decision models.
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.
RELEVANT INFORMATION
Relevance to opportunity: The information gathered should be
relevant to the opportunity or problem at hand.
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.
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.
Net difference
: A differential cost is the net difference in
cost between two alternatives.
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.
SPECIAL DECISION SITUATIONS
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:
Cost behavior
: Unless told otherwise, assume that fixed costs remain
fixed and variable costs change.
Qualitative considerations
: These include, among other things, the
reaction of present customers should they find out about the special price,
and price discrimination regulations.
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.
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.
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.
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.
Consider lost C.M.
: The opportunity costs of lost contribution
margin is also factored into the decision.
Sell or process further
: When two or more products result from a
common manufacturing process, the products are called joint products.
Distinguishable from each other
: The point in the process where
products are distinguishable from one another is the split-off point.
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.
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.
Limited resource allocation
: Decision may involve the use of limited
labor hours, limited materials, and limited machine hours.
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.
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.
ACTIVITY-BASED COSTING AND DECISION MAKING
Relevant-costing concepts same: The relevant-costing concepts in
an activity-based-costing environment do not change.
Decision maker’s ability changes
: What will change is the decision
maker’s 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.
OTHER ISSUES IN DECISION MAKING
Managerial performance same factors
: Managerial performance should
be judged on the same factors that are considered in making decisions.
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.
Important points in decision making
:
ignore sunk costs
;
beware of unitized fixed costs in decision making
;
beware of allocated fixed costs; identify the avoidable costs
;
pay special attention to identifying and including opportunity costs in
a decision analysis