DECISION MAKING & RELEVANT INFORMATION:

Chapter 11

1) DECISION MODELS

A decision model is a formal method of making a choice, often involving both

quantitative and qualitative analyses

Managers often use some variation of the Five-Step Decision-Making Process

Five-Step Decision-Making Process

Terminology

Incremental Cost – the additional total cost incurred for an activity

Differential Cost – the difference in total cost between two alternatives

Incremental Revenue – the additional total revenue from an activity

Differential Revenue – the difference in total revenue between two alternatives

1

2) RELEVANCE

Relevant Information has two characteristics:

It occurs in the future

It differs among the alternative courses of action

Relevant Costs = expected future costs

Relevant Revenues = expected future revenues

KEY POINTS: From the above fundamental definition

1.) Relevant costs are FUTURE CASH FLOWS arising as a direct

consequence the decision being taken.

NON-relevant costs are those that will remain unaltered (No

DIFFERENCE) regardless of the decision being taken.

2) PAST costs are already incurred & therefore SUNK costs.

Past cost may be useful as a basis for cost prediction

3) COMMITTED costs, though will be paid in future, are costs that had

already been decided & committed in the past. This future cash flow will be

incurred anyway regardless of the decision being considered i.e. it makes no

difference in the alternatives.

2

Relevant Costs (or Revenues) are expected FUTURE cash flows ( costs or revenues) that DIFFER among alternative courses of action

4) OPPORTUNITY COST is a special type of relevant cost. It represents

the benefit sacrificed or forgone when choosing one course of action in

preference to an alternative. E.g. benefits or revenue forgone

Opportunity Cost is the contribution to operating income( or profit) that

is foregone by not using a limited resource in it’s next-best alternative use

“How much profit did the firm ‘lose out on’ by not selecting this alternative?”

E.g. Opportunity Cost for holding Inventory = Funds tied up in inventory

are not available for investment elsewhere

5) AVOIDABLE COST is relevant : Costs that would be avoided if a

decision is being taken.

Cost saving due to more efficient plant,

tax savings

6) DIFFERENTIAL or INCREMENTAL Cost is relevant : It is the

difference in the TOTAL cost between alternatives.

7) GAIN OR LOSS on disposal or sale of assets

a) The Gain or Loss represent the ARITHMETICAL difference between the

Disposal Price(relevant) and Book Value(irrelevant historical Cost). It

is MEANINGLESS

b) To consider SEPRATELY the relevant items :

- the Disposal Price inflows

- the disposal costs outflows

- cash tax on disposal gain outflows

8) DEPRECIATION: Asset depreciation (be it increase or decrease in amount of

depreciation charged) is irrelevant since it is NOT a cash low. The only relevant

amount is the change in TOTAL Asset cost ( e.g. purchase of new asset) which

involves cash flow.

9) COST OF CAPTAL

3

Can be considered as part of Opportunity Cost. It represents cost of fund

tied up or alternative income forgone for using own fund

Examples:

- Cost of working capital( net change in inventory, AR, AP)

- Carrying cost of inventory

- Interest income on savings deposit forgone

Note: Under Capital Budgeting where DCF is applied, the Cost of Capital is

embedded(or built-in) in the Discounting Rate as part of WACC

10) UNIT Costs – Cautious !

The danger of unitization of fixed cost . Example: Production(fixed) overhead

of $ 4 per unit ( derived by total production overhead of $800,000 divided by

200,000 units ). This gives the impression the cost would vary with volume

and therefore would WRONGLY treat it as relevant variable cost.

Unitized cost depends on the volume level (denominator) used, and therefore

can be misleading

How to overcome these issues? Use TOTAL cost ($800,000)rather than the

unit cost($4 per unit)

11) FIXED & VARIABLE Costs Can be Relevant & Irrelevant

4

a) In general, variable costs will be relevant costs and fixed costs

will be irrelevant to a decision.

Unless you are given an indication to the contrary, you should ASSUME the

following.

Variable costs are relevant costs.

Fixed costs are irrelevant to a decision.

Note: Indeed this is the assumption when applying CVP analysis and

Marginal Costing, where variable costs are assumed to vary with volume

and fixed costs remain fixed over the relevant range of volume. (see Note

on CVP)

b) HOWEVER, this need not be the case, and you should analyse

variable and fixed cost data carefully. Do not forget that 'fixed'

costs may only be fixed in the short term & in relation to a

relevant range of activity. See examples below.

Example of Non-relevant Variable Costs

There might be occasions when a variable cost is in fact a sunk cost (and

therefore a non-relevant variable cost). For example, suppose that a company

has some units of raw material in inventory. They have been paid for already, and

originally cost $2,000. They are now obsolete and are no longer used in regular

production, and they have no scrap value. However, they could be used in a

special job which the company is trying to decide whether to undertake. The

special job is a 'one-off' customer order, and would

use up all these materials in inventory.

(a) In deciding whether the job should be undertaken, the relevant cost of the

materials to the special job is nil. Their original cost of $2,000 is a sunk cost,

and should be ignored in the decision.

(b) However, if the materials did have a scrap value of, say, $300, then their

relevant cost to the job would be the opportunity cost of being unable to sell them

for scrap, ie $300.

( c ) Assuming if the useless material is not utilized, it would need to be disposed off

by incurring disposal cost of $500. Then the relevant cost (or relevant saving) for

using up this material would be the cost saving of $500.(inflow)

5

Example of Relevant Fixed Costs : Attributable fixed costs

There might be occasions when a fixed cost is a relevant cost, and you

must be aware of the distinction between :

'specific' or 'directly attributable' fixed costs, and

general fixed overheads.

Directly attributable fixed costs are those costs which, although fixed

within a relevant range of activity level, are relevant to a decision for either

of the following reasons.

(a) They could increase if certain extra activities were undertaken. For

example, it may be necessary to employ an extra supervisor if a

particular order is accepted. The extra salary would be an attributable

fixed cost.

(b) They would decrease or be eliminated entirely if a decision were

taken either to reduce the scale of operations or shut down entirely.

General fixed overheads are those fixed overheads which will be unaffected

by decisions to increase or decrease the scale of operations, perhaps because

they are an apportioned (see APPORTIONED COST)share of the fixed costs

of items which would be completely unaffected by the decisions. General fixed

overheads are not relevant in decision-making.

FAST FORW

ARD

12) APPORTIONED COST is a notional accounting cost and is NOT

relevant. BUT increase in TOTAL overhead incurred is relevant

6

Example: The apportionment of overhead would be IRRELEVANT if the total

overhead incurred remain the same.

e.g. Overhead apportioned to project A of $40.000 is irrelevant since the total

overhead incurred remains the same at $100,000.

Project A Project B Project C TOTALOverhead Incurred

Overhead Allocation BEFORE decision to have Project A

Nil $70,000 $30,000 $100,000

Overhead Allocation AFTER decision to have Project A

$40,0000 $35,000 $25,000 $100,000

Overhead Allocation AFTER decision to have Project A

$70,0000 $40,000 $10,000 $120,000

But if the TOTAL overhead incurred increase to say $120,000 because of

decision to have Project A, then the RELEVANT overhead would be $20,000(i.e.

increase in total overhead incurred which is cash outflow). The new

apportioned overhead $70,000 is IRRELEVANT

7

13 ) QUALITATIVE NON-FINANCIAL FACTORS

Equally important

Major Non-financial or qualitative information :

Reputation

Brand

Quality & reliability

Trade secret

Management experience

Staff Skills

Customers loyalty & reaction

External factors – Political(government), economic, social &

technology(PEST)

Examples: In the case of out-sourcing & make or buy decisions

- Quality of supply

- reliability of supply

- risk of dependency on suppliers

- Reputation of suppliers

- Control over product design and trade secrets

Example: A Special Order ( at lower price)

Though it makes business sense to accept a special order if the Relevant Revenue >

Relevant Cost ( i.e. result in positive contribution), this might have the following

qualitative implication:

Existing regular customers, if they come to know about it, would not be

happy(Customer ) . This might in turn affect your business reputation

If the selling price is a government-controlled price, this special price would violate

the rule. (External Factor – political)

This special pricing (below economic market equilibrium price) would also disrupt supply

& demand. (External Factor – economic)

8

Relevant Cost Analysis: ALL items vs. RELEVANT items Approach

2 ways to do Relevant Cost Analysis:

1) ALL items(revenues & costs) approach

2) RELEVANT items(revenues & costs) approach

Both gives the same outcome

9

Potential Problems with Relevant-Cost Analysis

1) Incorrect general assumptions that :

all variable costs are relevant

all fixed costs are irrelevant

Fixed costs could be relevant, as long as they meet the “Relevant cost Criteria”

2) Unit Cost ( or Average Cost) : Unitization of Cost

This can potentially mislead decision makers in 2 ways:

( i ) When irrelevant costs are wrongly considered as relevant costs

( ii ) The same unit costs (or average costs) are applied at different output level

Example: Production of Notebooks

Output :Total number of notebooks produced = 1,000 units

Total direct(variable) production cost =$2,000,000

Total indirect production cost =$3,000,000

Note :Indirect production cost is assumed fixed & would not change whatever the

decision( i.e. sunk cost)

Therefore Total production cost = $5,000,000

Unit Cost = $5,000,000 / 1,000 units = $5,000 per unit

( i ) When irrelevant costs are wrongly considered as relevant costs:

Very often this Unit Cost ($5,000 per unit) makes it appears to be like variable

cost & therefore wrongly treated as relevant cost for decision making.

Irrelevant cost of $3,000 had been included in this Unit Cost of Notebook

above. Therefore, a special order at a price of $3,500 each would have been

wrongly rejected as “below cost” if Unit Cost of $5,000 is taken as variable &

therefore relevant cost.

( ii ) The same unit costs (or average costs) are applied at different output

level (or Relevant Range)

Unit costs should be used cautiously. Since unit costs change with a

different level of output or volume, it may be more prudent to base

decisions on a TOTAL dollar basis.

Unit costs that include fixed costs should always be in reference to a

given level of output or activity(relevant range)

10

Therefore, the average(or unit) cost of $5,000 is ONLY CORRECT at

output level of 1,000 units. But the Unit Cost of $5,000 makes it appears

that it is the correct unit cost at any output level !

Example: What is the total cost of production for 1,200 units ?

Applying the Unit Cost of $5,000 would give a Total Cost of $6,000,000. , which

consist of:

Variable cost ($2,000 X1,200 units) = $2,400,000

Fixed cost ($3,000 X1,200 units) = $3,600,000

This wrongly concludes that the Fixed Cost had increased from

$3,000,000 to $3,600,000. Similarly, if a lower units of say 900 units is

considered which gives Fixed Cost as $2,700.000 - a decrease from

$3,000,000 !!!

HOW TO OVERCOME THESE PROBLEMS ?

a) Use TOTAL costs (or revenues), instead of Unit cost(revenue)

b) Apply the “Relevant Cost Criteria” & continually evaluate data to ensure that it

meets the requirements of relevant information

In summary: What is relevant ?

Expected TOTAL FUTURE costs (or revenues) that DIFFER among

the alternatives

11

MAJOR AREAS of Relevant Costs: 1) The relevant cost of materials

2) The relevant cost of labour

3) The relevant cost of an asset: The Deprival Value

1) The relevant cost of materials

The relevant cost of raw materials is generally their current replacement cost, unless

the materials have already been purchased and would not be replaced once used. In

this case the relevant cost of using them is the higher of the following.

Their current resale value

The value they would obtain if they were put to an alternative use

If the materials have no resale value and no other possible use, then the relevant

cost of using them for the opportunity under consideration would be nil.

Question Note: See ACCA Text Page 347 for examples

2) The relevant cost of labour

Where labour must be hired from outside the

organisation, the relevant cost of labour will be the variable costs incurred.

Spare capacity is assumed to be paid anyway and

therefore not relevant.

Opportunity costs: contribution forgone by losing

other work

Incremental cost.

Absorbed overhead is a notional accounting cost

and should be ignored.

Only the Actual overhead incurred is

relevant.

Note: See ACCA Text Page 348 for examples

12

3) The relevant cost of an asset: The Deprival Value The value to the business of any asset can be defined as its deprival value, i.e.

by how much the company would be worse off if it were to be deprived of the

asset (e.g. by selling it, or it being worn out after years of use as a fixed asset).

Deprival Value is derived as follow:

.

Note:

a) NRV (or value in exchange) = the sales proceeds less the future costs of sale.

b) The value in use is defined as the present value of the future cash flows

obtainable as a result of the continued use of an asset, including those resulting

from its eventual final disposal. This will involve the use of the technique of

discounting future cash flows.

An example of an asset for which value in use might be the

appropriate value to the business could be an old specialised machine

which would not be replaced but which is still producing cash flows with

a net present value which exceeds the asset's net realisable value. In a

situation like this, the company will logically retain and use the asset rather

than sell it.

13

Deprival Value = LOWER of:

Replacement Cost Recoverable Value, which is HIGHER of:

Net Realisable Value(NRV)= Sale Proceed – Sale costs

Value in Use= NPV on continuing use of asset

Note: See ACCA Text Page 350 for examples

Detailed Explanation : Deprival Value

The value to the business of any asset can be defined as its deprival value, i.e.

by how much the company would be worse off if it were to be deprived of the

asset (e.g. by selling it, or it being worn out after years of use as a fixed asset).

The deprival value of any asset can be defined as the LOWER of its:

- REPLACEMENT COST (if it can in fact be replaced) - i.e. its value in

exchange in the market in which the company can purchase the item

- RECOVERABLE VALUE, which in turn is defined as the HIGHER of:

what the company could SELL it for

the value that the company could create by USING the asset

within the business, i.e. the asset's value in use

This is a logical guide for the company to follow in making a rational value-

maximising decision.

a) If the recoverable value exceeds the replacement cost, then if the company

were deprived of the asset it would go out and buy another to replace it, if this

is possible. The replacement cost will therefore set a MAXIMUM loss that the

company can suffer if it were deprived of the asset, hence RC represents

the MAXIMUM asset value.

b) However if the economic benefit that arises from ownership of the asset (i.e. the

recoverable value) is less than the cost of replacing it, then if the company

were deprived of the asset it would logically choose NOT to replace it. How

the recoverable value is calculated depends on what the company is

planning to do with it (RATIONAL INTENT), which will of course depend on

how it considers that it can make most money (or other benefit) from it. It has 2

basic choices:

14

1) to sell it (NRV or value in exchange), or

2) to use it within the business (value in use);

and it will logically select whichever of these offers the highest return.

c) The MINIMUM value of asset is NRV . Why ? Because if RC or PV < NRV, it

would be logically NOT to hold the asset & sell it a NRV.

15

TYPES OF DECISIONS1.) One-Time-Only Special Orders

2.) Insourcing vs. Outsourcing or Make or

Buy

3.) Product-Mix & Capacity Constraint

(Limiting Factor)

4.) Customer Profitability

5.) Branch / Segment: Adding or

Discontinuing

6.) Equipment Replacement

7.) Decisions & Performance Evaluation

1.) One-Time-Only Special Orders

Accepting or rejecting special orders when there is idle production capacity and

the special orders has no long-run implications

Decision Rule: does the special order generate additional operating

income(profit)?

Yes – accept

No – reject

Compares relevant revenues and relevant costs to determine profitability

Importance of long-run implications on future revenues & costs .e.g.

acceptance of special orders at a price lower(and still make profit) than current

price to existing regular customers might trigger existing regular customers to

demand for a lower price. This would impact future revenues and therefore

relevant items for decision.

16

Special Order : Using Absorption-Based Budgeted Income Statement as

Starting point

Both VC & FC of manufacturing are included in cost of inventory & cost of

goods sold

Full costs of product include ALL costs

Special Order Illustration : Contribution Margin Approach

Splitting FC & VC

Derive contribution margin

Identifying relevant & non relevant items

17

2) Insourcing vs. Outsourcing (or Make-or-Buy)

Insourcing (or Make)– producing goods or services within an organization

Outsourcing (or Buy)– purchasing goods or services from outside vendors

Decision Rule: Select the option that will provide the firm with the lowest cost,

and therefore the highest profit. E.g. below, make(or insourcing) has lower cost,

But also do consider qualitative factors such as the following when making Make or

Buy decision :

- Quality of supply

- reliability of supply

- risk of dependency on suppliers

- Reputation of suppliers

- Control over product design and trade secrets

18

Make-or- Buy Decision : Total Alternative vs. Opportunity

Costs Approach

Under Total Alternative approach Consider future costs & revenues for

ALL alternatives are considered

Under Opportunity Cost approach Focus on future costs + opportunity

cost of making or buying alternatives

Take note of the implication of capacity constraint.- impact on opportunity

lost or gain

19

3) Product-Mix Decisions & Capacity Constraints

With LIMITING FACTOR

The decisions made by a company about which products to sell and in what

quantities

Decision Rule: choose the product that produces the highest contribution

margin per unit of the constraining resource

RANKING of product mix: Rank in the order of “contribution margin per

unit of the constraining resource”

How to overcome Constraints or Limiting Factor ?

- outsourcing

- rescheduling

- improve efficiency & productivity

- Training

20

4) Customer Profitability: Adding or Dropping Customers

Decision Rule: Does adding or dropping a customer add operating income(i.e.

Profit) to the firm?

Yes – add or don’t drop

No – drop or don’t add

Decision Rule: based on impact on profitability of the customer, not how

much revenue a customer generates. i.e. focus on value not volume

Customer Profitability Analysis, Illustrated

Customer Profitability Analysis: Dropping & Adding Customer

Decisions: Effect on Profitability

Dropping Wisk results in lower profit by $15,000 Do not drop

Adding Loral results in MR>MC by $6,000 or increase profit by the same amount Add

21

5.) Adding or Discontinuing Branches or Segments

Decision Rule: Does adding or discontinuing a branch or segment add operating

income(or profit) to the firm?

Yes – add or don’t discontinue

No – discontinue or don’t add

Decision is based on impact on profitability of the branch or segment, not

how much revenue the branch or segment generates

Adding/Closing Offices or Segments, Illustrated

Decisions: Effect on Profitability

Closing Allied West results in lower profit by $42,000 Do not close

Opening Allied South results in MR>MC by $17,000 or increase profit by $17,000 Open

6.) Equipment-Replacement Decisions

22

Sometimes difficult due to amount of information at hand that is irrelevant:

Cost, Accumulated Depreciation and Book Value of existing equipment

Any potential Gain or Loss on the transaction – a Financial Accounting

phenomenon only & is IRRELEVANT

Decision Rule: Select the alternative that will generate the highest operating

income(i.e. Profit)

Equipment-Replacement Decisions, Illustrated (Considering Both Relevant &

Irrelevant Costs)

Equipment-Replacement Decisions, Illustrated (Considering Relevant Costs Only)

23

7.) Decisions & Performance Evaluation: Behavioral

Implications

Despite the quantitative nature of some aspects of decision making, not all

managers will choose the best alternative for the firm

Goal incongruency : conflict of managers’ & organisation’s goals

Managers’ performance evaluation : What get measured & rewarded get

done

Decisions model might not be consistent with Managers’ performance

evaluation model

E.g. Maintenance or replacement of plant might result in positive value over

long term under decision model, but would pull down the short-term

profitability(the basis the managers’ performances are judged). Under this

scenario managers could engage in self-serving behavior such as delaying the

needed equipment maintenance in order to meet their personal profitability

quotas for bonus consideration.

How to overcome this problem? Design Managers’ performance evaluation

model that are consistent with decision model.

24