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AC 519

The Concept of Relevance

Relevant Costs are expected future costs which will differ between or among the alternative
courses of action being considered. Not all future costs are relevant because not all future costs
are affected by the decision to be made. Similarly, not all variable costs are relevant nor are all
fixed costs irrelevant. If an alternative may result in fixed cost savings or increase therein, the
fixed costs become relevant.

Irrelevant Costs are those which do not vary from one alternative to another. Allocated,
common or indirect fixed costs are irrelevant to the decision of optimizing product mix (OPM)
because these costs will not change regardless of the production mix used. Past Costs are also
called Sunk Costs because they are unavoidable and cannot be changed no matter what action is
taken, thus they are irrelevant costs.

Accountants Role in Decision Making

To provide assistance to management in collecting, summarizing and reporting information

relevant to the problem at hand. Although management may request the accountant for
recommendations, the final choice always rests with the management. Managerial accountants
often serve as a cross-functional team member, making a wide range of decisions.
Selecting data pertinent to decision making is one of the managerial accountants most important
roles in an org. Oftentimes, errors in decision making are brought about by the misapplication of
cost concepts.

Qualitative vs. Quantitative Analysis

Quantitative factors are outcomes that are measured in numerical terms or those that can be
measured financially or expressed in monetary terms. Other quantitative factors are nonfinancial
as they can be measured numerically but they are not expressed in monetary terms like reduction
in new product-development time for a manufacturing firm and the percentage of on-time flight
arrivals for an airline company.

Qualitative factors are outcomes that are difficult to measure accurately in numerical terms like
employees' morale, opposition from the labor union, maintenance of labor force, adequate supply
of raw materials, desire to maintain secrecy of formula or design and social responsibility.
But how important are these qualitative considerations to the top managers? Weighing the
quantitative and qualitative considerations in making decisions is the essence of management.
The skill, experience, judgment, and ethical standards of managers all come to bear on such
difficult choices.

Relevant and accurate data are of value only if they are timely, that is, available just in time
for a decision to be made. Thus, relevance, accuracy and timeliness are the 3 important
criteria for determining the usefulness of information. In some situations, it may involve a trade-
off between the accuracy and the timeliness of information. More accurate
information may take longer to produce. Therefore, as accuracy improves, timeliness suffers, and
vice versa. Highly accurate but irrelevant data are of no value at all to a decision maker.

What makes information relevant to a decision problem?

First, it must have a bearing on the future since the consequences of the decisions are
borne in the future, not the past.

Second, it will make a difference among the competing alternatives. Relevant information must
involve costs or benefits that differ among the alternatives. Costs or benefits that are the same
across all the available alternatives have no bearing on the decision, hence, they are regarded as
irrelevant.
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Relevant cost analysis generally emphasizes quantitative factors that can be expressed in
financial terms. Just because qualitative factors and quantitative, nonfinancial factors cannot be
measured easily in financial terms does not make them unimportant. In fact, managers must at
times give more weight to these factors. Trading off nonfinancial and financial considerations is
seldom easy. So the key is to focus on the data that change under the alternative courses of
action. The computation of differential costs is a convenient way of summarizing the relative
advantage of one alternative over the other.

Unique decisions arise infrequently or only once. Compiling data for unique decisions usually
requires a special analysis by the managerial accountant. In contrast, repetitive decisions
are made over and over again, either at regular or irregular intervals. Such a routine decision
makes it worthwhile for the managerial accountant to keep a special file of the information
relevant to a particular situation or scenario.

Identifying Relevant Costs and Benefits

Why is it important for the managerial accountant to isolate the relevant costs and benefits in a
decision analysis?

First, generating information is a costly process. The relevant data must be sought, and this
requires time and effort. By focusing on only the relevant information, the managerial accountant
can simplify and shorten the data-gathering process.

Second, people can effectively use only a limited amount of information. Beyond this, they
experience information overload, and their decision-making effectiveness declines. By routinely
providing only information about relevant costs and benefits, the managerial accountant can
reduce the likelihood of information overload.

Sunk costs are costs that have already been incurred. They do not affect any future cost and
cannot be changed by any current or future action. Hence, they are considered as irrelevant
costs.

Opportunity Cost is the cost of rejected alternative or the income foregone or rejected by
not using a limited resource in its next-best alternative use. It is also the potential benefit given up
when the choice of one action precludes a different action. Although people tend to overlook or
underestimate the importance of opportunity costs, they are just as relevant as out-of-pocket
costs in evaluating decision alternatives. They are not incorporated into formal financial
accounting records because historical record keeping is limited to transactions involving
alternatives that were actually selected, rather than the rejected alternatives. Rejected
alternatives do not produce transactions and so they are not recorded. However, it is a crucial
input into the make or buy decision. If excess capacity exists and no alternative uses are
apparent, then the opportunity cost is zero.

Avoidable costs are cost savings arising from a decision to discontinue an undertaking. It is
not synonymous to variable costs, out-of-pocket costs and sunk costs. Postponable costs are
not avoidable costs, since the incurrence of cost is merely deferred and not actually avoided.

THE 8-STEP DECISION-MAKING PROCESS

1. Define the decision issue.

The decision problem needs to be clarified and defined in more specific terms. Considerable
managerial skill is required to define a decision problem in terms that can be addressed
effectively.

2. Specify the decision objective and decision rule.

The manager should specify the criterion upon which a decision will be made. Is the objective
to maximize profit, increase market share, minimize cost, or improve public service?
Sometimes the objectives are in conflict, as in a decision problem where production cost is to
be minimized but product quality must be maintained.
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3. Identify the choices or alternatives.

A decision involves selecting between two or more alternatives. Determining the possible
alternatives or alternative courses of action is a critical step in the decision process.

4. Collect relevant data on the choices.

The managerial accountant is mainly responsible for collecting relevant data for decision
making.

5. Format and analyze information about each choice.

6. Decide

7. Implement the decision.

8. Evaluate the results of the decision.

After a decision has been implemented, the results of the decision are evaluated with the
objective of improving future decisions.

The fundamental ethical issue in incremental decision making is the validity of estimates of future
revenues and costs. The key question is always, what difference will it make?

* Make or Buy Alternatives * Choose the alternative with the LEAST COST

* With or Without Further Processing * Choose the alternative with the HIGHEST INCREMENTAL
PROFIT

* Shutdown or Continue Operations * Choose the lesser evil or the alternative with the LESSER
LOSS

If LCO >LFS then choose to SHUTDOWN;

If LCO<LFS then choose to CONTINUE the OPTNS.

* Optimizing Product Mix * Choose the alternative that MAXIMIZES PROFIT

If without constraint, produce more of the product/s
with the highest UCM;
If there is time/market constraints, rank the products
according to its CM/hr.

* Retention or Elimination of a Segment * If Lost CM<Avoidable Costs and expenses, then drop
or close the unprofitable segment

* If Lost CM>Avoidable Cost & expenses, then retain that

segment.

* Adding or Discontinuing a Business * Choose the alternative with highest incremental profit
Segment (ignore allocated costs)

* Lease or Operate * Choose the alternative that maximizes cash inflows

* Lease or Buy * Choose the alternative with the least cash outflows or
with the least cost

* Accept or Reject a Special Order * Choose the alternative with the highest incremental profit

* Pricing Product or Services * Choose the appropriate price

(either sold to outside customers or sold internally)

* Replacement of Fixed Assets * Choose the alternative with the least cost or net cash flows
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Make or buy decisions are frequently part of a more strategic analysis in which top management
makes a policy decision to move the company towards VERTICAL INTEGRATION. Any
decision relating to vertical integration is a make or buy decision, since the company is deciding
whether to meet its own needs internally or to buy externally. Managers consider make or buy
decisions in order to:

1. reduce costs;
2. use or free up capacity;
3. improve quality or delivery performance;
4. encourage greater productivity from internal operations by forcing competition with outsiders;
5. get new technology;
6. free scarce investment funds for other uses.

KEY DECISION RULE: To minimize costs.

Outsourcing or in-house sourcing? Often, one company's make or buy problem is another
company's special sales pricing problem. Examples of special pricing decisions include:

1. Generating discount-priced sales to use excess production capacity.

2. Accepting sales that only cover out-of-pocket costs to keep a workforce employed during a
recession.
3. Making a one-time sale to move stale merchandise.
4. Responding to a request for a special feature from a regular customer.
5. Pricing to enter a new competitive marketplace.

SPECIAL SALES PRICING DECISION

DECISION QUESTION: Will we benefit from special sales generally made at prices lower than
those charged to our regular customers?

KEY DECISION RULE:

Subject to the following specific guidelines, make the special sale if we earn a positive CM from
the special sale.

GUIDELINES OR ASSUMPTIONS necessary to allow the basic rule to work:

1. Excess capacity exists, with no alternative use of the capacity. The opportunity cost of using
the capacity is zero or at least very low.
2. Special sales should not interfere with regular sales. The special sale should be in a different
market segment than our regular business.
3. The special sale is a one-time order and will not become repeat business.

If all of these guidelines are not met, the analysis will have additional relevant revenues and costs
to consider. The minimum price must cover out of pocket costs plus any opportunity cost of
making the sale (lost profits from regular sales or lost production). The economic rule is to
produce and sell until the marginal revenue equals the marginal cost - that is, until a zero
incremental profit is reached.
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ADD OR DELETE A SEGMENT DECISION

DECISION QUESTION: Is the firm more profitable with or without the segment?

Examples of this decision include:

* Opening or closing a branch of a retail store
* Adding or eliminating a product or an entire product line
* Adding or eliminating a specialized service in a hospital
* Combining purchasing departments in two plants into one unit

KEY DECISION RULES:

Add the segment if the firm's profits are higher after adding it. Delete the segment if the firm's
profits are higher after eliminating it.

GUIDELINES:
1. Segment evaluations use direct contribution margin or segment margin.
2. Segment eliminations focus on lost revenue and avoidable costs.
3. Segment additions focus on incremental revenues and costs.

SELL OR PROCESS FURTHER DECISIONS

DECISION QUESTION: Should the product be sold as is or should it be processed further?

KEY DECISION RULE:

Process further if the incremental revenue from processing further is greater than the incremental
costs of processing further.

BASIC GUIDELINES:
1. Costs prior to split-off are irrelevant to the process further decision.
2. The decision is independent of product costing.

MANAGING CONSTRAINTS

When a limited resource of some type (ie. limited floor space, limited # of machine hours, limited
# of direct labor hours) restricts the companys ability to satisfy demand, the company is said to
have a CONSTRAINT. Because of the constrained resource, the company cannot fully satisfy
demand, so the manager must decide how the constrained resource should be used. Fixed costs
are usually unaffected by such choices, so the manager should select the course of action that
will maximize the firms total CM.

Because machines have different capacities, some machines will be operating at less than 100%
of capacity. However, if the plant as a whole cannot produce any more units, some machine or
process must be operating at capacity. The machine or process that is limiting overall output is
called the BOTTLENECK it is the constraint.

Profits can be increased by effectively managing the firms constraints. One aspect of managing
constraints is to decide how to best utilize them. If the constraint is a bottleneck in the production
process, the manager should select the product mix that maximizes the total CM. In addition, the
manager should take an active role in managing the constraint itself. Management should focus
efforts on increasing the efficiency of the bottleneck operation and on increasing its capacity. The
capacity of a bottleneck can be effectively increased in a number of ways, including:
* working overtime on the bottleneck
* subcontracting some of the processing that would be done at the bottleneck
* investing in additional machines at the bottleneck
* shifting workers from processes that are not bottlenecks to the process that is a
bottleneck
* focusing business process improvement efforts such as TQM and Business Process
Re-engineering on the bottleneck
* reducing defective units. Each defective unit that is processed through the bottleneck
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and subsequently scrapped takes the place of a good unit that could be sold.

The last 3 methods of increasing the capacity of the bottleneck are particularly attractive, since
they are essentially free and may even yield additional cost savings.

The Problem of Multiple Constraints

What does a firm do if it has more than one potential constraint? For example, a firm may have
limited raw materials, limited DLH available, limited floor space, and limited advertising amount to
spend on product promotion. How would it proceed to find the right combination of products to
produce? The proper combination or mix of products can be found by the use of a quantitative
method known as linear programming.

Q and A
Q-1 To be relevant to a particular decision, a cost must meet what criteria?

A-1 The criteria are (1) the cost must be an expected future cost, and (2) the cost must differ
between alternatives.

Q-2 Why is emphasis placed on the future in decision-making?

A-2 Emphasis is on the future because decisions will affect the future, not the past. Decisions
made in the present have no effect on what has happened in the past.

Q-3 Of what significance is the past in decision-making?

A-3 In decision making the past is important only as a guide in predicting the future.

Q-4 Non-cost factors may be significant in make or buy decisions. What are some non-cost
factors in favor of making, instead of buying a part or product?

A-4 Among the non-cost factors in favor of making instead of buying are:
1. Instability of supply.
2. Poor quality of supply.
3. Desire to maintain secrecy of process or design.
4. Difficulty of transporting part or product from supplier to company.
5. Availability of ideal plant capacity.
6. Maintenance of labor force.

Q-5 What are some non-cost factors in favor of buying instead of making?

A-5 Among the non-cost factors in favor of buying instead of making are:
1. Lack of capital, space, equipment, or time.
2. Lack of skill or experience.
3. Wider selection is possible.
4. Special services are furnished by supplier.
5. Goodwill of supplier who might also be a customer.

Q-6 Other things being equal, a profitable baking company that can sell sandwich bread, one
of several products, for only 90% of its total cost (allocated overhead makes up 30% of its
total cost) should:
a) buy extra equipment in order to increase output and thereby attempt to lower
production costs per loaf.
b) eliminate the sandwich bread.
c) allocate its overhead by some other method.
d) eliminate the sandwich bread only when its contribution to allocated overhead is
reduced to zero.

A-6 (d) An unprofitable product which has a contribution margin recovers part of the total fixed
overhead which would otherwise have to be absorbed by the other products, thus
reducing total net income if the unprofitable products were eliminated.

Q-7 The effect of a company's income before tax of discontinuing a department with a
contribution to overhead of P16,000 and allocated overhead of P32,000 of which P14,000
cannot be eliminated would be to:
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a) decrease income before tax by P2,000. c) increase income before tax by P2,000.
b) decrease income before tax by P18,000. d) increase income before tax by P16,000.

A-7 (c) The department is currently incurring a net loss of P16,000 after deducting the
contribution margin of P16,000 from the total allocated overhead of P32,000.
Elimination of the department will reduce overhead to P14,000 which amount must now
be absorbed by other departments. In effect, therefore, net loss is reduced from
P16,000 to P14,000, and overall net income is increased by P2,000.

Case #1:

Mr. Conrado Traba (alias Con Traba), Pinas Airways Vice-President for Operations, has been
approached by a Chinoy tourist agency about flying chartered tourist flights from Manila to
Hongkong. The tourist agency has offered Pinas Airways $150,000 per round-trip flight on a
jumbo jet. Given the airlines usual occupancy rate and air fares, a round-trip jumbo-jet flight
between Manila and Hongkong typically brings in revenue of $250,000. Thus, the tourist agencys
specially priced offer requires a special analysis by Mr. Con Traba. He knows that Pinas Airways
has two jumbo jets that are not currently in use. The airline has just eliminated several
unprofitable routes, freeing these aircraft for other uses. The airline is not currently planning to
add any new routes, and therefore the two jets were idle. To help make his decision, Traba asks
for cost data from the controllers office. The controller provides the information given below,
which pertains to a typical round-trip jumbo-jet flight between Manila & Hongkong. The variable
costs cover aircraft fuel and maintenance, flight-crew costs, in-flight meals and services, and
landing fees. The fixed costs allocated to each flight cover Pinas Airways fixed costs, such as
aircraft depreciation, maintenance and depreciation of facilities, and fixed administrative costs.
Revenue:
Passenger ..........................................................$250,000
Cargo .................................................................... 30,000 $280,000
Less Expenses:
Variable expenses of flight .................................. $ 90,000
Fixed expenses allocated to each flight ............... 100,000 190,000
Profit ............................................................................................. $ 90,000
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If Traba had not understood managerial accounting, he might have done the following incorrect
analysis:
Special price for the chartered flight................................................... $150,000
Total cost per flight ............................................................................. 190,000
Loss on chartered flight ..................................................................... $ (40,000)

This calculation suggests that the special charter offer should be rejected. What is the error in this
analysis? The mistake is the inclusion of allocated fixed costs in the cost per flight. This is an
error, because the fixed costs will not increase in total if the chartered flight is added. Since
the fixed costs will not change under either of the alternate choices, they are irrelevant.
Fortunately, Traba does not make this mistake. He knows that only the variable costs of the
proposed charter are relevant. Moreover, Traba determines that the variable cost of the charter
would be less than that of a typical flight, because Pinas Airways would not incur the variable
costs of reservations and ticketing. These variable expenses amount to $5,000 for a scheduled
flight. Thus, Trabas analysis of the charter offer is as shown below:

Assumes there is excess capacity (idle aircraft)

Special price for chartered flight ..........................................................$150,000

Variable cost per routine flight ............................................ $90,000
Less: Savings on reservations and ticketing ....................... 5,000 85,000
Contribution Margin from the chartered flight.........................................$ 65,000

Trabas analysis shows that the special chartered flight will contribute $65,000 towards the
recovery of the airlines fixed costs and profit. Since the airline has excess flight capacity, due
to the existence of idle aircraft, the optimal decision is to accept the special charter offer.

No Excess Capacity

Now lets consider how Trabas analysis would appear if Pinas Airways had no idle aircraft.
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Suppose that in order to fly the charter between Manila and Hongkong, the airline would have to
cancel its least profitable route, which is between Manila and Taiwan. This route contributes
$80,000 toward covering the airlines fixed costs and profit. Thus, if the charter offer is accepted,
the airline will incur an opportunity cost of $80,000 from the forgone contribution of the Manila
Taiwan route. Now Trabas analysis should appear as shown on the next page:

Assumes no excess capacity (no idle aircraft)

Special price for chartered flight...................................................... $150,000
Variable cost per routine flight ......................................... $90,000
Less: Savings on reservations and ticketing ........................ 5,000
Variable cost of charter ................................................... $85,000
Add: Lost CM on canceled ManilaTaiwan route ............... 80,000 165,000
Loss from chartered flight............................................................. $ (15,000)
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Thus, if Pinas Airways has no excess flight capacity, Mr. Con Traba should reject the special
charter offer.

Summary

The decision to accept or reject a specially priced order is common in both service-industry and
manufacturing firms. Manufacturers often are faced with decisions about selling products in a
special order at less than full price. The correct analysis of such decisions focuses on the relevant
costs and benefits. Fixed costs, which often are allocated to individual units of product or service,
are usually irrelevant. Fixed costs typically will not change in total, whether the order is accepted
or rejected. When excess capacity exists, the only relevant costs usually will be the variable
costs associated with the special order. When there is no excess capacity, the opportunity cost of
using the firms facilities for the special order is also relevant to the decision.