CHAPTER

SIX

Relevant Information &

Alternative Choice Decisions
 Relevant Information & Alternative Choice Decisions
Making decisions is one of the basic functions of
a manager.
To be successful in decision making, managers
must be able to tell the difference between
relevant and irrelevant data and must be able to
correctly use the relevant data in analyzing
alternatives.
The purpose of this chapter is to develop these
skills by illustrating their use in a wide range of
decision-making situations.

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 6.1 Relevant Information

 Making business decisions requires managers to

compare two or more alternative courses of action.
 Accountants should use two criteria to determine if
information is relevant.
1) It must be expected future revenue or cost, and
2) It must have an element of differences that will differ
among the alternatives.
 Relevant information is the predicted future costs and
revenues that will differ among the alternatives.
 (Relevant Information, Cont’d)
Relevant information is the prediction of the
future, not a summary of the past.
Historical (past) data have no direct bearing on a
decision: such data can have an indirect bearing
on a decision because they may help in predicting
the future.
But past figures, in themselves, are irrelevant to
the decision itself. Why? Because the decision
cannot affect past data. Decisions affect the
future. Nothing can alter what has already
happened.
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 (Relevant Information, Cont’d)
Relevant costs are often termed avoidable costs.
An avoidable cost is a cost that can be eliminated,
in whole or in part by taking a specific course of
action or by choosing one alternative over another.
Avoidable costs are relevant costs. Unavoidable
costs are irrelevant costs.
Any item that will remain the same regardless of the
alternative selected is irrelevant.
 Any cost or benefit that does not differ between
alternatives is irrelevant and can be ignored in a
decision.
Two broad categories of costs are never relevant in any decision:
Sunk costs (cost that has already been incurred).
Future costs that do not differ between the alternatives.
 6.2 Quantitative and Qualitative Relevant
Information

 We divide the outcomes of alternatives into two broad

categories: Quantitative and Qualitative.
Qualitative factors are
Quantitative factors are outcomes outcomes that cannot be
that are measured in numerical measured in numerical
terms. Some quantitative factors are terms. Example:
financial - that is, they can be employee morale.
expressed in financial terms like Relevant cost analysis
costs of raw materials, direct generally emphasizes
manufacturing labor and marketing. quantitative factors that
Other quantitative factors are can be expressed in
nonfinancial– i.e., they cannot be financial terms.
measured numerically. Ex: reduction
 6.3 The Challenge of Changing Markets

 Product markets can change quickly due to competitor price

cuts, changing customer preferences, and introduction of
new products by competitors.
 Managers must make short-run decisions, with a fixed set
of resources, to react to the changing market place. These
decisions include:

Special Product Make Joint

order mix or buy product
decisions decisions decisions decisions
 Relevant Cost Analysis
Relevant Cost Analysis could be possible through:

Eliminating costs and benefits that do not

differ between alternatives.
Use the remaining costs and benefits that
differ between alternatives in making the
decision. The costs that remain are the
differential, or avoidable costs.
 6.4 Decision Making

Decision making involves five steps:

 Define the problem.

 Identify the alternatives.
 Collect information on alternatives.
 Eliminate irrelevant information.
 Make a decision with the remaining relevant
information.
6.5 Relevant Information in Business Decisions

Information that varies among the possible

courses of action being considered.
— Incremental costs and revenues —

Important cost concepts for 2

1
business decisions.
 Opportunity costs.
 Sunk costs.
 Out-of-pocket costs.
 Opportunity Cost

The benefit that could have been attained by pursuing an

alternative course of action.

Example: If you were not

attending college, you could
be earning Br. 250,000 per year.
Your opportunity cost of
attending college for one
year includes the Br. 250,000.

Opportunity costs are not recorded in the accounting records, but

are relevant to decisions because they are a real sacrifice.
 Sunk Costs Versus Out-of-Pocket Costs

Sunk Costs - all costs incurred in the past that cannot

be changed by any decision made now or in the future.

Sunk costs should not be considered in decisions.

Example: You bought an automobile that cost Br.

270,000 two years ago. The Br. 270,000 cost is sunk
because whether you drive it, park it, trade it, or sell
it, you cannot change the Br. 270,000 cost.
(Sunk Costs Versus Out-of-Pocket Costs,
Cont’d)

Cost = Br. 270,000 Cost = Br. 450,000

Trade ?
two years ago today

The dealer will trade for Br. 320,000 plus your car.
What amount is relevant to your decision,
the Br. 270,000 sunk cost of your car or the
Br. 320,000 out-of-pocket cash differential?
 6.6 Incremental Analysis in Common Business Decisions
It examines several different types of managerial decisions.

6.6.1 Special Order Decisions

A special order is a one-time order that is not considered part
of the company’s normal ongoing business.

 The decision to accept additional

business should be based on
incremental costs and incremental
revenues.
 Incremental amounts are those that
occur only if the company decides to
accept the new business.
Only the incremental costs and benefits are relevant
since the existing fixed manufacturing overhead costs
would not be affected by the order, they are not relevant.
 6.6.2 Production Constraint Decisions
Managers often face the problem of deciding how
scarce resources are going to be utilized.
Usually, fixed costs are not affected by this
particular decision, so management can focus
on maximizing total contribution margin.
Product which is the more valuable use of the scarce
resource should be more emphasized.

If there are no other considerations, the best plan would be to

produce to meet current demand for Product of high
contribution margin and then use any capacity that remains to
make other Product.
 6.6.3 Make or Buy Decisions

Should I
continue to make
the part, or should
I buy it?
I suppose I
should compare What will I
the outside purchase do with my
price with the additional idle facilities if
costs to manufacture I buy the part?
the part.
 (Make or Buy Decisions, Cont’d)
Incremental costs also are important in the
decision to make a product or buy it from a
supplier.
The cost to produce an item must include
(1) direct materials, (2) direct labor and
(3) incremental overhead.
We should not use the predetermined overhead
rate to determine product cost.
 The Make or Buy Decision…
When a company is involved in more than
one activity in the entire value chain, it is
vertically integrated.
A decision to carry out one of the activities in the
value chain internally, rather than to buy
externally from a supplier is called a “make or
buy” decision.

Itopportunity
The is knowncost that:
of facilities changes Fixed costs are
the decision. irrelevant to decision.
Vertical Integration- Advantages

Smoother flow of
parts and materials

Better quality
control

Realize profits
Vertical Integration- Disadvantage
Companies may fail to
take advantage of
suppliers who can
create economies of
scale advantage by
pooling demand from
numerous companies.
While the economics of scale factor can be
appealing, a company must be careful to retain
control over activities that are essential to
maintaining its competitive position.
 6.6.4 Joint Product Decisions

Two or more products produced from a

common input are called joint products.

Product 1
Joint costs are
the costs of
Joint Costs Product 2 processing prior to
the split-off point.

Product 3
The split-off point is the point in a process where
joint products can be recognized as separate products.
 Joint Products….
For example, in the
Oil petroleum refining
industry, a large
number of products
Joint
Common are extracted from
Production Gasoline crude oil, including
Input
Process
gasoline, jet fuel,
home heating oil,
Chemicals lubricants, asphalt,
and various organic
chemicals.
Split-Off
Point
 Joint Products…
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
The Pitfalls of Joint Products Allocation

Joint costs are traditionally allocated

among different products at the split-
off point. A typical approach is to
allocate joint costs according to the
relative sales value of the end products.

Although allocation is needed for some

purposes such as balance sheet inventory
valuation, allocations of this kind are very
dangerous for decision making.
 (Joint Product Decisions, Cont’d)
Joint costs are not relevant in decisions regarding what to
do with a product after the split-off point.
Businesses are often faced with the decision to sell
partially completed products at the split-off point or to
process them to completion.
As a general rule . . .
It is always profitable to continue processing a joint
product after the split-off point so long as the
incremental revenue exceeds the incremental processing
costs.
 6.6.5 Sell or Process Further Decisions

Joint costs are irrelevant in decisions regarding what

to do with a product from the split-off point forward.
Therefore, these costs should not be allocated to end
products for decision-making purposes.
With respect to sell or process further decisions, it is
profitable to continue processing a joint product after
the split-off point so long as the incremental revenue
from such processing exceeds the incremental
processing costs incurred after the split-off point.
 Activity-Based Costing (ABC) and Relevant
Costs
While direct costs are traceable, indirect costs are
allocated to cost objects.
Indirect costs allocated to cost object based on
the cost object’s consumption of some measure
of activity, usually labor hours.
Traditional Overhead Allocation assumes all
overhead is volume-related, factory-wide or
departmental rates, departmental focus not process
focus, Focus on costs incurred not cause of costs.
 But, ABC allocates costs to the indirect costs object based
on the object’s consumption of activities or causal
activities, it results in better allocation.
ABC can be used to help identify potentially relevant costs for decision-making purposes.
 Advantages of ABC
Activity-based costing is very useful in firms . . .

With multiple
products and
services.
That have products
and services that use
indirect activities
in different ways.
That have a high
percentage of indirect
product costs.
Problems With ABC
Proper identification
of cost drivers is
difficult.
ABC ignores the
difference between
the fixed and variable
costs of an activity.
ABC is more costly
because additional
measurements and
observations must
be made.
End of Chapter 6