CHAPTER TWO

Relevant Information and Decision

Making
2.1. Relevant and Irrelevant Information
Relevant information is any information that
would have an impact on the decision.
Relevant Information has two characteristics:
– It occurs in the future.
– It differs among the alternative courses of action.
Relevant costs are expected future costs that differ
among the alternative courses of action being
considered.
Thus, future costs that do not differ among the
alternatives are irrelevant to deciding which
alternative to choose.
Historical costs are irrelevant because they are
past costs and, therefore, cannot differ among
alternative future courses of action.
Two potential problems that should be avoided in
relevant cost analysis are:
1. Do not assume all variable costs are relevant and all
fixed costs are irrelevant.
2. Do not use unit-cost data directly. It can mislead
decision makers because
i. it may include irrelevant costs, and
ii. comparisons of unit costs computed at different output
levels lead to erroneous conclusions.
 Some variable costs may not differ among the
alternatives under consideration and, hence, will be
irrelevant.
 Some fixed costs may differ among the alternatives
and, hence, will be relevant.
Some of the total unit costs to manufacture a
product may be fixed costs, and, hence, will not
differ between the make and buy alternatives.
These fixed costs are irrelevant to the make-or-buy
decision.
 The key comparison is between purchase costs
and the costs that will be saved if the company
purchases the component parts from outside plus
the additional benefits of using the resources freed
up in the next best alternative use (opportunity
cost).
Five-Step Decision-Making Process
Step 2:
Make Step 3: Step 4:
Step 1: Step 5:
Predictions Choose Implement
Obtain Evaluate
About An The
Information Performance
Future Alternative Decision
Costs

Feedback
Making decisions is one of the basic functions of a
manager.
 To be successful in decision making, managers must
be able to perform differential analysis, which
focuses on identifying the costs and benefits that
differ between alternatives.
 Every decision involves choosing from among at least
two alternatives. Therefore, the first step in decision
making is to define the alternatives being considered.
 Once you have defined the alternatives, you need to
identify the criteria for choosing among them.
 Relevant costs and relevant benefits should be
considered when making decisions.
 Irrelevant costs and irrelevant benefits should be
ignored when making decisions.
 The key to effective decision making is differential analysis—
focusing on the future costs and benefits that differ between
the alternatives.
 Everything else is irrelevant and should be ignored.
 A future cost that differs between any two alternatives is
known as a differential cost.
 Future revenue that differs between any two alternatives is
known as differential revenue.
 An incremental cost is an increase in cost between two
alternatives.
 An avoidable cost is a cost that can be eliminated by choosing
one alternative over another.
 Sunk costs are always irrelevant when choosing among
alternatives since, it has already been incurred and cannot be
changed regardless of what a manager decides to do.
 Future costs and benefits that do not differ between
alternatives are irrelevant to the decision-making process.
opportunity costs
Opportunity costs also need to be considered when making
decisions.
An opportunity cost is the potential benefit that is given up
when one alternative is selected over another.
It is the contribution to income that is forgone (rejected) by
not using a limited resource in its next-best alternative use.
When deciding on the quantity of inventory to buy, managers
must consider both the purchase cost per unit and the
opportunity cost of funds invested in the inventory.
For example, the purchase cost per unit may be low when the
quantity of inventory purchased is large, but the benefit of the
lower cost may be more than offset by the high opportunity cost
of the funds invested in acquiring and holding inventory.
Avoidable and unavoidable Costs
Management must determine if a cost is avoidable
or unavoidable because in the short run, only
avoidable costs are relevant for decision-making
purposes.
Costs that can be eliminated (in whole or in part)
by choosing one alternative over another are
avoidable costs.
For example, assume that a bike shop offers their
customers custom paint jobs for bikes that the
customers already own. If they eliminate the service,
the cost of the bike paint could be eliminated. Also
assume that they had been employing a part-time
painter to do the work. The painter’s compensation
would also be an avoidable cost.
Variable costs are avoidable costs, since variable costs do not
exist if the product is no longer made, or if the portion of the
business (such as a segment or division) that generated the variable
costs ceases to operate.
 Fixed costs, on the other hand, may be unavoidable, partially
unavoidable, or avoidable only in certain circumstances.
Remember that fixed costs tend to remain constant for a period
of time and within a relevant range of production and are not easily
eliminated in the short-run.
Therefore, most fixed costs also are unavoidable. If a fixed cost is
specific only to one of the alternatives, then that fixed cost also
may be avoidable.
Avoidable costs are future costs that are relevant to decision-
making. Past costs are never an avoidable cost.
In the long run, virtually all costs are avoidable.
For example, assume that a company has a long-term, ten-year
lease on a production facility that cannot be cancelled. For the first
ten years it would be non cancellable and thus unavoidable. But
after ten years it would become avoidable.
Sunk Costs
Historical costs are past costs that are irrelevant to decision
making.
– Also called Sunk Costs- cost that has already been incurred
and that cannot be avoided regardless of what a manager
decides to do.
A sunk cost will not change regardless of the alternative that
management chooses; therefore, sunk costs have no bearing on
future events and are not relevant in decision-making.
The basic premise sounds simple enough, but sunk costs are
difficult to ignore due to human nature and are sometimes
incorrectly included in the decision-making process.
For example, suppose you have an old car, a hand-me-down
from your grandmother, and last year you spent $1,600 on repairs
and new tires and were just told by your mechanic that the car
needs $1,200 in repairs to operate safely. Your goal is to have a
safe and reliable car.
Your alternatives are to get the repairs completed or trade in the car
for a newer used car.
The trade-in value of your old car will be the minimum given by the
dealer, or $200. The newer used car will require you to make monthly
payments of $150 for two years.
Required: In analysing your two alternatives, what costs do you
consider?
Solution
the $1,600 you have already spent is a sunk cost; it is a consequence
of a past decision.
the relevant costs for each alternative are the following:
o $1,200 in current repair costs to keep your current car or $3,400
(from the 24 payments of $150 minus $200 for the trade in) to
buy a newer used car.
o Obviously, you also would consider qualitative factors, such as
the sentimental value of your grandmother’s car or the
excitement of having a newer car.
Future Costs That Do Not Differ
Any future cost that does not differ between the alternatives
is not a relevant cost for the decision.
For example, if a company is considering baking either bagels
or doughnuts and both baked goods require $0.30 worth of
flour, then the cost of flour would not be a relevant cost in
determining which of the two had the highest production cost.
As relevant information for short-term decision-making, the
cost of sound protectors for your summer job would not be
relevant to your decision because that cost exists in both
scenarios.
Another irrelevant cost would be your transportation cost,
since that cost is also the same regardless of the job you
choose.
In another example, if a company is planning to produce either
red widgets or blue wingdings and will need to hire 10
additional employees to produce either of the goods, the cost
of those 10 employees is irrelevant because it does not differ
between the alternatives.
Opportunity Costs
When choosing between two alternatives, usually only one of
the two choices can be selected.
When this is the case, you may be faced with opportunity
costs, which are the costs associated with not choosing the other
alternative.
For example, if you are trying to choose between going to work
immediately after completing your undergraduate degree or
continuing to graduate school, you will have an opportunity cost.
 If you choose to go to work immediately, your opportunity cost
is forgoing a graduate degree and any potential job limitations or
advancements that result from that decision.
 If you choose instead to go directly into graduate school, your
opportunity cost is the income that you could have been earning
by going to work immediately upon graduation.
Differential Costs
Differential Cost: is the difference in total cost between
two alternatives.
Differential cost is the difference between the cost of
two alternative decisions, or of a change in output
levels.
Example of alternative decisions: If you have a
decision to run a fully automated operation that produces
100,000 widgets per year at a cost of $1,200,000, or of
using direct labour to manually produce the same
number of widgets for $1,400,000, then the differential
cost between the two alternatives is $200,000.
Example of change in output: A work centre can
produce 10,000 widgets for $29,000 or 15,000 widgets
for $40,000. The differential cost of the additional 5,000
widgets is $11,000.
Incremental costs
Incremental Cost: is the additional total cost incurred for
an activity.
Incremental cost can be useful when formulating the price to
charge a customer as part of a one-time deal to sell additional
units.
The concept can also be applied to cost reduction analysis,
to enhance company profits.
An incremental cost analysis only reviews those costs that
will change as the result of a decision. All other costs are
considered irrelevant to the decision.
For example, if a company has room for 10 additional units in its
production schedule and the variable cost of those units (that is, their
incremental cost) is a total of $100, then any price charged that exceeds
$100 will generate a profit for the company.
• Decision: is a choice between alternatives.
 It requires Incremental Analysis.
•Incremental Analysis: is a decision-making tool in which
the relevant costs and revenues of one alternative are
compared to the relevant costs and revenues of another
alternative.
•Best decision: least relevant cost
most relevant revenue
 The difference in the sum of relevant costs is either
called incremental cost or net benefit.
the alternative with a favorable incremental cost (net
benefit) is the desirable alternative.
Incremental analysis is an ideal tool for what-if
analysis.
Types of Decisions
•Keep or replace
•Sell now or process further
•One-Time-Only Special Orders
•Insourcing vs. Outsourcing
•Product-Mix
•Customer Profitability
•Branch / Segment: Adding or Discontinuing
•Equipment Replacement
The basic problem with incremental analysis is:
It ignores;
 The time period in which costs/revenue incurred realized.
The time value of money.
Relevant and irrelevant costs
Relevant cost :
- future costs differ under available
alternatives.
- costs that would be changed by making
decision.
•3 steps to identify relevant cost:
1. Eliminate sunk costs.
2. Eliminate costs/ benefits that do not differ b/n
alternatives.
3. Compare remaining costs and benefits which differ
between alternatives to make the proper decision.
 3. Historical Costs are always irrelevant.
Example 1
a company is to make a decision to purchase six months o
supplies from supplier A, for $5,000 and from Supplier B
$4,800. However, Supplier B is in another state and, if
purchase is made from supplier B, the company must pay fr
in cost amounted $300.
Also, the company has $500 of supplies on hand.
One approach is to include all costs including irrele
costs:
Supplier A Supplier B D
Cost of supplies to be purchased $ 5,000 $4,800 $
Cost of supplies on hand 500 500 -0
Freight 300 (30
$5,500 $5,600 ($10
Keep Old Asset or Replace
Example 2
Assume that an asset currently in use (old asset) has a book
value of $1,000 and that this piece of equipment is tentatively
under review for replacement. The purchase price of the new
asset is $5,000 and is estimated to have a useful life of 10 years.
The old asset can also last 10 years with some repairs now and
then. The operating expense of the old asset is now $8000 per
year but the new asset is projected to have only an operating
expense of $2000 per year. The old asset has no trade-in value.
The alternatives are to keep the old asset or to replace it.
•The replacement should take place if the relevant cost of
replacing is less than the relevant costs of keeping.
10 Years Basis
Keep Old Asset Purchase New Asset Difference
Cost of new asset _ $5,000 (5,000)
Operating expenses $ 8,000 2,000 6,000
$8,000 $ 7,000 $1,000
Example 3: Assume machine B replaced machine A
which increase production capacity and sales by 50%
where A’s current production and sales is 1,000 units
(capacity) and selling price is $10 per unit & CGS is
$ 8 per unit.
Machine A Machine B Difference
Volume 1,000 1,500 500
Sales $10,000 $15,000 $ 5,000
CGS $ 8,000 $12,000 $ 4,000
$ 2,000 $ 3,000 $ 1,000
therefore it is better to replace Machine A with that
of Machine B.
One-Time-Only Special Orders
•Accepting or rejecting special orders when there is
idle production capacity and the special orders have
no long-run implications.
•Decision Rule: does the special order generate
additional operating income?
– Yes – accept
– No – reject
Compares relevant revenues and relevant costs to
determine profitability.
Revenue (5,000 × $40) $200,000
Variable costs:
Direct materials $40000
Direct labor 10,000
Manufacturing overhead 20,000
Marketing costs 10,000
Total variable costs 80,000
Contribution margin 120,000
Fixed costs:
Manufacturing overhead $78000
Marketing costs 25,000
Total fixed costs 103,000
Net income $17,000
If ABC accepts the offer, net income will increase
by $12.000.
Increase in revenue($20 * 3,000) ---------- $60,000
Increase in costs (3,000 * 16 v. cost) ------ $48,000
Increase in net income ------------------------- $12,000
Using the incremental approach:
Special order contribution margin = $20 – $ 16 = $4
Change in income = $4 × 3,000 units = $12,000.
Insourcing vs. Outsourcing
•Insourcing: producing goods or services within an
organization
•Outsourcing: purchasing goods or services from
outside vendors
•Also called the “Make or Buy” decision
A decision concerning whether an item should be
produced internally or purchased from an outside
supplier is called a “make or buy” decision.
Decision Rule: Select the option that will provide the
firm with the lowest cost, and therefore the highest
profit.
MA Company is thinking of buying a part that is
currently used in one of its products from outside.
The unit cost to make this part is:
$/
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 Sunk Cost

Cos t
Pe r
Unit Cost of 20,000 Units
Make Buy
Outside purchase price 70 1,400,000

Direct materials 27 540,000

Direct labor 15 300,000
Variable overhead 3 60,000
Depreciation of equip. 9 0
Supervisor's salary 6 120,000
General factory overhead 30 0
Total cost 90 1,020,000 1,400,000

Not avoidable and is irrelevant. If the product

is dropped, it will be reallocated to other
products.
 Product-Mix Decisions
•The decisions made by a company about which
products to sell and in what quantities
•Decision Rule (with a constraint): choose the
product that produces the highest contribution
margin per unit of the constraining resource
•Firms often face the problem of deciding how to
best utilize a constrained resource.
•Usually, fixed costs are not affected by this
particular decision, so management can focus on
maximizing total contribution margin.
UM Company produces two products and selected
data is shown below:
Product
1 2
Selling price per unit $60 $50
Less variable expenses per unit 36 35
Contribution margin per unit $24 $15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.
Solution: Let’s calculate the contribution margin per
unit of the constrained resource, machine A1.
Product 1 Product 2
Contribution margin per unit $24 $15
Time required to produce one unit 1 minute 0.5 minute

Contribution margin per minute $24/minute $30/minute

Product 2 should be emphasized: Provides more valuable
use of the constrained resource machine A1, yielding a
contribution margin of $30 per minute as opposed to $24
for Product 1.
 If there are no other considerations, the best plan
would be to produce to meet current demand for
Product 2 and then use remaining capacity to make
Product 1.
Allocation of Constrained Resource

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.

Total time required to make

Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.

Time available for Product 1 1,300 min.

Time required per unit ÷ 1.00 min

Production of Product 1 1,300 units

 Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $24 $15
Total contribution margin $31,200 $33,000

The total contribution margin for UM is $64,200.

Adding or Dropping Customers
•Decision Rule: Does adding or dropping a customer
add operating income to the firm?
– Yes – add or don’t drop
– No – drop or don’t add
•Decision is based on profitability of the customer, not
how much revenue a customer generates
•Decision Rule: Does adding or discontinuing a branch
or segment add operating income to the firm?
– Yes – add or don’t discontinue
– No – discontinue or don’t add
•Decision is based on profitability of the branch or
segment, not how much revenue the branch or
segment generates
Example:
Digital Musical Instruments
Income Statement for 2007
Sales 1,000,000
Less: variable expenses
Variable mfg. costs 240,000
Variable shipping costs 10,000
Commissions 150,000 400,000
Contribution margin 600,000
Less: fixed expenses
General factory overhead 120,000
Salary of line manager 180,000
Depreciation of equipment 100,000
Advertising - direct 200,000
Rent - factory space 140,000
General admin. expenses 60,000 800,000
Net loss (200,000)

Assume that the equipment used in General Factory Overhead and General
manufacturing digital instruments has Administrative Expenses are unavoidable costs.
no resale value or alternative use.
Should
Should the
the company
company drop
drop digital
digital
instruments
instruments division?
division?
 Contribution Margin
Solution
Contribution margin lost if digital
instrument division is dropped (600,000)
Less fixed costs that can be avoided
Salary of the line manager 180,000
Advertising - direct 200,000
Rent - factory space 140,000 520,000
Net disadvantage (80,000)

What about depreciation?

Comparative Income Approach
Prepare comparative income statements showing
results with and without the digital instruments
division.
Comparative Income Approach
Solution

Keep Digital Drop Digital

Instruments Instruments Difference
Sales 1,000,000 0 (1,000,000)
Less variable expenses: 0
Mfg. expenses 240,000 0 240,000
Freight out 10,000 0 10,000
Commissions 150,000 0 150,000
Total variable expenses 400,000 0 400,000
Contribution margin 600,000 0 (600,000)
Less fixed expenses:
General factory overhead 120,000 120,000 0
Salary of line manager 180,000 0 90,000
Depreciation 100.000 100,000 0
Advertising - direct 200,000 0 100,000
Rent - factory space 140,000 0 70,000
General admin. expenses 60,000 60,000 0
Total fixed expenses 800,000 280,000 260,000
Net loss (200,000) (280,000) (340,000)
Example: products A, B, C and D through a joint
process. The joint costs amount to $100,000.
 Solution:
The incremental analysis for the decision to process
further is:
Products A B C D
Incremental Revenue 5,000 5,000 5,000 5,000
incremental processing costs 2,500 3,000 4,000 6,000
Increase in operating income $2,500 $2,000 $1,00 (1,000)
Process A,B, & C
SELL D