Name: Samer Abou Saad

ID: 12130373
Instructor: Dr. Gabriel Paoli
Course Title: Managerial accounting
Topic: Decision Making and Relevant Information
Semester: Spring 2016
Introduction:
Regardless of whether decisions are major or routine, most people track a simple, logical process when
making them. This process involves gathering information, making predictions, making a choice, acting
on the choice, and evaluating results. The process also includes evaluating the costs and benefits of each
choice. For decisions that involve costs, some costs are irrelevant. For example, once you purchase a
coffee maker, its cost is irrelevant when calculating how much money you save each time you brew
coffee at home versus buy it at Starbucks. You incurred the cost of the coffee maker in the past, and you
can’t recoup that cost. More broadly, for example managers at Porsche gather cost information to decide
whether to manufacture a component part or purchase it from a supplier. The decision process may not
always be straightforward, but as Peter Drucker believed, “Wherever you see a successful business,
someone once made a courageous decision.”

I. Information and Decision Process:

Managers usually follow a decision model for choosing among different courses of action. A decision
model is a formal method of making a choice that often involves both quantitative and qualitative
interpretations. Management accountants analyze and present relevant data to guide managers’ decisions.
This model is made up of five step decision making process:

1.State The Problem

Identify the problem. Until the manager has a clear understanding of the problem, goal, or decision to be
made, it is meaningless to proceed. If the problem is stated incorrectly or unclearly then the decisions will
be wrong.

2.Gather Information
When making good decisions it is best to gather necessary information that is directly related to the
problem. Doing this will help the manager to better understand what needs to be done in solving the
problem, and will also help to generate ideas for a possible solution.

3.Consider the Consequences

This step can be just as important as step one because it will help the manager determine how his final
decision will impact the business, and/or others involved. In this step, managers will be asking themselves
what is likely to be the results of the decision.  This is an essential step because it allows managers to
review the pros and cons of the different options that they listed in the previous step.

4. Make the Decision

Now it’s time to make the choice. Managers should get rid of all the alternatives that do not fit and
proceed with their chosen solution or project.

5. Evaluate
Evaluating performance after the decision is implemented provides critical feedback for managers, and
the five-step sequence is then repeated in whole or in part. This can help managers make better
subsequent predictions. Managers will also try to improve implementation of other decisions after taking
into consideration the previous mistakes.
 II. Relevant Costs and Relevant
Revenues:

Relevant costs are expected future costs and

relevant revenues are expected future revenues that differ among the alternative courses of action being
considered. Costs and revenues that are not relevant are called irrelevant. It is important to recognize that
relevant costs and relevant revenues must:
a. Occur in the future: every decision deals with a manager selecting a course of action based on its
expected future results.
b. Differ among the alternative courses of action: costs and revenues that do not differ will not matter and,
therefore, will have no bearing on the decision being made.

Qualitative and Quantitative Relevant Information

Managers divide the outcomes of decisions into two broad categories: quantitative and qualitative.
Quantitative factors are outcomes that are measured in numerical terms. Some quantitative factors are
financial; they can be expressed in monetary terms. Examples include the cost of direct materials, direct
manufacturing labor, and marketing. Other quantitative factors are nonfinancial; they can be measured
numerically, but they are not expressed in monetary terms. Examples include reduction in new product-
development time for companies. Qualitative factors are outcomes that are difficult to measure
accurately in numerical terms. Employee morale is an example. In fact, Relevant-cost analysis generally
emphasizes quantitative factors that can be expressed in financial terms.

Potential Problems in Relevant-Cost Analysis

Managers should avoid two potential problems in relevant-cost analysis. First, they must watch for
incorrect general assumptions, such as all variable costs are relevant and all fixed costs are irrelevant.
Second, unit-fixed-cost data can potentially mislead managers by making them accept alternatives that are
not the right. The best way for managers to avoid these two potential problems is to keep focusing on
a. Total fixed costs (rather than unit fixed cost)
b. the relevance concept.
Managers should always require all items included in an analysis to be expected total future revenues and
expected total future costs that differ among the alternatives.
Examples of:
1. Relevant Costs:
a. Future Cash flows: Cash expenses that will be incurred in the future as a result of a decision.
b. Avoidable costs: Only those costs are relevant to a decision that can be avoided if the decision is not
implemented.
c. Opportunity costs: Cash inflows that will be sacrifices as a result of a particular management decision.
d. Incremental Cost: Where different alternatives are being considered, relevant cost is the incremental
cost between them.
2. Irrelevant Costs:
a. Sunk Costs: These are expenditures which has already been incurred in the past. These costs do not
affect the future cash flows of the business.
b. Committed Costs: Future costs that cannot be avoided because they will be incurred irrespective of the
business decision being considered.
c. Non-cash expenses: Such as depreciation because they do not affect the cash flows of a business.
d. General Overheads: These costs should be ignored if they are not affected by the decision.

Illustration:
Vita Industries is a company that manufactures personal care products. It has three divisions: hair care,
skin care and dental care. In the board meeting for review of financial statements, a director proposed that
the company should dispose of the dental care division because it is losing money. The CEO argued that
the board can’t conclude that a segment is losing money just because it generated net loss for a period. He
suggested that the company’s chief financial officer should conduct a detailed analysis for presentation in
the next board meeting. Being the company’s management accountant, the CFO asked to identify which
of the following costs are relevant for the decision:
1. CEO’s salary
2. Salaries of Dental Care workers who can be laid-off
3. Salaries of Dental Care workers who can’t be laid-off
4. One-time retirement benefits to be paid to laid-off workers
5. Cost of raw materials consumed by Dental Care division
6. Annual directors’ fee
7. Interest paid on loans raised for Dental Care division
8. Salary of the Dental Care chief operating officer
9. Company-wide quality certification fee
10. License fee paid for the rights to manufacture dental care products
11. Head office rent
12. Audit fee (if it doesn’t depends on the number of divisions)

Solution
We have two alternatives: (a) dental care division is sold off and (b) dental care division continues to
operate. Identifying relevant costs and irrelevant costs is easy when we see if a cost changes between two
alternatives or not. If it changes it is relevant, if it doesn’t it is irrelevant.
1. CEO’s salary is irrelevant because it shall remain the same whether the dental care division exists
or it is disposed off.
2. Salaries of employees who can be laid off is relevant because the cost shall continue to be
incurred if the division exists but it shall be reduced to zero if the division is disposed off.
3. Salaries of employees who can’t be laid-off is irrelevant because it shall continue to be incurred
regardless of whether the division is disposed off or not.
4. One-time retirement benefits cost is relevant because it shall be incurred only if the division is
disposed off. If the division continues to operate, the cost shall continue to be incurred.
5. Cost of raw materials is relevant cost because it shall be zero if the division no longer operates
because then there will be no production.
6. Annual directors fee is irrelevant cost because it shall stay the same even if dental care is
disposed off.
7. Interest paid on dental care division loans is relevant because if the division is sold off the loan
could be paid off which shall cease the interest cost.
8. Salary of the dental care chief operating officer is relevant because he will most likely lose his
job. If he is accommodated in another division, this cost shall be irrelevant.
9. Company-wide quality certification fee is irrelevant because it shall continue to be incurred even
if dental care division is no longer there.
10. License fee paid for manufacturing dental care products is a relevant cost because it shall cease
with disposal of the division.
11. Head office rent is irrelevant because it shall remain the same regardless of the number of
divisions. If a division is sold-off, head-office will still exist and the office rent shall be incurred.
12. Audit fee is irrelevant if it does not depend on the number of divisions. Audit shall be conducted
even if there is one division less.

III. Buy or Make Decisions:

Outsourcing is purchasing goods and services from outside vendors rather than in sourcing, producing
the same goods or providing the same services within an organization. Decisions about whether a
producer of goods or services will in source or outsource are called make-or-buy decisions. Surveys of
companies indicate that managers consider quality, dependability of suppliers, and costs as the most
important factors in the make-or buy decision. Sometimes managers might consider buying a material
rather than producing it if the out sourcing cost is less than in sourcing one (internally making it).
There are many factors that might influence a buy decision:
a. Lack of expertise
b. Suppliers' research and specialized know-how exceeds that of the
buyer
c. cost considerations (less expensive to buy the item)
d. Small-volume requirements
e. Limited production facilities or insufficient capacity
f. Desire to maintain a multiple-source policy
g. Item not essential to the firm's strategy

Illustration:
The estimated costs of producing 6,000 units of a component are:
  Per Unit Total
Direct Material $10 $60,000
Direct Labor 8 48,000
Applied Variable Factory
9 54,000
Overhead
Applied Fixed Factory Overhead 12 72,000
 
  $39 $234,000
The same component can be purchased from market at a price of $29 per unit. If the component is
purchased from market, 25% of the fixed factory overhead will be saved.
Solution
  Per Unit Total
Bu
  Make Make Buy
y
Purchase Price   $29   $174,000
Direct Material $10   $60,000  
Direct Labor 8   48,000  
Variable Overhead 9   54,000  
Relevant Fixed Overhead 3   18,000  
Total Relevant Costs $30 $29 $180,000 $174,000
Difference in Favor of
  $1   $6,000
Buying