Management Accounting - Chapter 07 - Decision Making Relevant Information

CHAPTER 07
DECISION MAKING AND RELEVANT

INFORMATION
30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 1

CHAPTER 08
CASE STUDY RERIEW
Relevant Costs, JetBlue and Twitter

LEARNING OBJECTIVE
 Use the five-step decision-making process;
 Distinguish relevant from irrelevant information in

decision situations;
 Explain the concept of opportunity cost and why

managers should consider it when making insourcing-
versus-outsourcing decisions;
 Know how to choose which products to produce when

there are capacity constraints;

LEARNING OBJECTIVE
 Explain how to manage bottlenecks;
 Discuss the factors managers must consider when

adding or dropping customers or business units;
 Explain why book value of equipment is irrelevant to

managers making equipment-replacement decisions;
 Explain how conflicts can arise between the decision

model a manager uses and the performance-evaluation
model top management uses to evaluate managers.

CHAPTER CONTENT
7.1. Information and the decision process;
7.2. The Concept of Relevance;
7.3. Insourcing-versus-Outsourcing and Make-versus-Buy

Decisions;

7.1. Information and the
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
analyses.
 Management accountants analyze and present relevant

data to guide managers’ decisions.
 Managers use the five-step decision-making process

presented in Chapter 1 to make decisions.

7.1. Information and the
decision process

7.2. The Concept of
Relevance
7.2.1.Relevant Costs and Relevant Revenues Relevant:
 Relevant information has two characteristics:

It occurs in the future
It differs among the alternative courses of action.
 Relevant costs are expected future costs.
 Relevant revenues are expected future Revenues.
 Past costs (historical costs) are never relevant and are also
called sunk costs.
7.2. The Concept of
Relevance
7.2.2. Qualitative and Quantitative Relevant Information:

Types of Information
 Quantitative factors are outcomes that can be measured in

numerical terms.
 Qualitative factors are outcomes that are difficult to

measure accurately in numerical terms, such as
satisfaction.
 Qualitative factors are just as important as quantitative

factors even though they are difficult to measure.
7.2. The Concept of
Relevance

Types of Information:
Features of Relevant Information
 Past (historical) costs may be helpful as a basis for making
predictions. However, past costs themselves are always
irrelevant when making decisions.
 Different alternatives can be compared by examining
differences in expected total future revenues and expected
total future costs.
`
7.2. The Concept of
Relevance

Features of Relevant Information
 Not all expected future revenues and expected future costs
are relevant. The key question is always, What difference
will an action make?
 Appropriate weight must be given to qualitative factors and

quantitative nonfinancial factors.

7.2. The Concept of
Relevance
Relevant Cost
Illustration

7.2. The Concept of
Relevance
7.2.3. 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.

7.2. The Concept of Relevance
An order that will not
7.2.3. One-Time-Only affect other sales and is
Special Orders usually a one-time
Option 1 occurrence.
Value of
Option 1
Status Quo: Reject special offer
Accept Is Option 1
Special Short-run Pricing Decisions: >
Order? Special Orders Option 2?
Alternative: Accept special offer

Value of
Option 2
Option 2

7.2. The Concept of
Relevance
7.2.3. One-Time-Only Special Orders:
Ex 1: Special Order decision

7.2. The Concept of Relevance
Ex 2: Analysis of Special Order U-Develop
7.2.3. One-Time-Only
Special Orders Status Quo: Alternative:
Comparison of Totals Reject Special Order Accept Special Order Difference
Sales revenue $2,500 $2,700 $200
Variable costs (1,000) (1,100) (100)
Total contribution $1,500 $1,600 $100
Fixed costs (1,200) (1,200) 0
Operating profit $300 $400 $100
Alternative Presentation: Differential Analysis
Differential sales, 500 at 40¢ $200
Less differential costs, 500 at 20¢ 100
Differential operating profit (before taxes) $100
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201048- DECISION MAKING AND RELEVANT INFORMATION
7.2. The Concept of
Relevance
7.2.4. Potential Problems in Relevant-Cost Analysis:
 Managers should avoid two potential problems in relevant–
cost analysis:
 Avoid incorrect general assumptions such as that “All

variable costs are relevant and all fixed costs are
irrelevant.”
 Be aware that unit-fixed-cost data can potentially mislead

managers in two ways.

7.2. The Concept of
Relevance
7.2.4. Potential Problems in Relevant-Cost Analysis:
 Unit-fixed-cost data can be misleading in two ways:
 Fixed costs per unit may include costs that are

irrelevant to a particular decision or may be irrelevant in
total for a particular decision, and;
 Unit fixed costs are accurate only for that particular

level of output. For this reason, managers often use
total fixed costs for a particular decision.

7.2. The Concept of
Relevance
7.2.5. Short-run pricing decision:
 A special order decision is, in many respects, a short-run

pricing decision;
 Sometimes, the decision is simply about setting an

acceptable price;
 Remember the decision rule?
 Any price above incremental costs will improve

operating income.

7.3. Insourcing-versus-
Outsourcing and Make-
versus-Buy Decisions
7.3.1. Make versus Buy Decision:
 Outsourcing is purchasing goods and services from
outside vendors.
 Insourcing means you’ll produce the good (or provide

the service) within the organization.
 Decisions about whether to insource or outsource are

called Make-or-Buy decisions.
 Opportunity Costs are the contribution to operating

income forgone by not using a limited resource in its
next-best alternative use.
 Decision rule: Select the option that will provide the firm
with the lowest cost, and therefore the highest profit.
 Same as special order: choose the alternative that

maximizes operating income.

7.3.Insourcing-versus-Outsourcing
and Make-versus-Buy Decisions
7.3.1. Make versus Decision to make goods or
Buy Decision: services internally or externally.
Cost directly traceable Per Unit 100,000 prints
Direct materials $0.05 $5,000
Direct labor 0.12 12,000
Variable manufacturing overhead 0.03 3,000
Fixed manufacturing overhead 4,000

Ex: Make or
Common costs allocated to this product line 10,000
buy?
$34,000
30-Jul-20 22
7.3.1. Make versus Buy Decision: Make or Buy, Continued. . .
Outsource
100,000 Prints Process Prints Processing Difference
Direct Costs
Direct Materials $5,000 $25,000a $20,000 Higher
Labor 12,000 -0- 12,000 Lower

Variable Overhead 3,000 -0- 3,000 Lower
Fixed Overhead 4,000 -0- 4,000 Lower
Common Costs 10,000b 10,000b -0-
Total Costs $34,000 $35,000 $1,000 Higher
Differential costs increase by $1,000, so reject alternative to buy.

a 100,000 units purchased at $.25 = $25,000.
bThese common costs remain unchanged for these volumes. Because they do not change, they
could be omitted from the analysis.
30-Jul-20 23
7.3.1. Make versus Buy Decision: Make or Buy, Continued. . .
50,000 Prints Process Prints Outsource Difference

Direct Costs
Direct Materials $2,500c $12,500d $10,000 Higher
Labor 6,000 -0- 6,000 Lower

Variable Overhead 1,500 -0- 1,500 Lower
Fixed Overhead 4,000 -0- 4,000 Lower
Common Costs 10,000b 10,000b -0-
Total Costs $24,000 $22,500 $1,500 Lower
Differential costs decrease by $1,500, so accept alternative to buy.

b These common costs remain unchanged for these volumes. Because they do not change,
they could be omitted from the analysis
c 100,000 units purchased at $.25 = $25,000. d 50,000 units purchased at $.25 = $12,500.
30-Jul-20
201048- DECISION MAKING AND RELEVANT INFORMATION 24
U- Develop: Make or Buy Analysis with Opportunity Cost
Status Alternativ
Quo e
Process Outsource
Prints Processin Difference
g
Total Cost of 100,000 Prints $34,000 $35,000 $1,000 Highera
Opportunity cost of using 2,000 -0- 2,000 Lowera
facilities to make covers
Total costs, incl. opportunity $36,000 $35,000 $1,000 Lowera
cost
Differential costs decrease by $1,000, so accept the alternative.
a These indicate whether the alternative is higher or lower than the status quo.
Example: Opportunity Cost of Making

30-Jul-20 25
7.3.2. Relevant-Revenue and Relevant-Cost Analysis of
Dropping or Adding a Customer:
When the cost object is a customer, managers must decide

about adding or dropping the customer.
 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 incremental income of the

customer, not how much revenue a customer generates.
30-Jul-20
7.3.2. Relevant-Revenue…
Fourth Quarter Product Line Income Statement, U-Develop
Total Prints Cameras Frames
Sales revenue $80,000 $10,000 $50,000 $20,000
Cost of sales (all variables) 53,000 _ 8,000 30,000 15,000
Contribution margin $27,000 $2,000 $20,000 $5,000
Less fixed costs:
Rent 4,000 1,000 2,000 1,000
Salaries 5,000 1,000 2,500 1,500
Marketing and administrative _3,000 __500 _1,500 _1,000
Operating profit (loss) $15,000 $(500) $14,000 $1,500
EX 1: Add or drop a segment?

27
30-Jul-20
7.3.2. Relevant-Revenue… versus-Buy Decisions
Keep Prints Drop Prints Difference
Sales revenue $80,000 $70,000 $10,000 decrease
Cost of sales (all variables) 53,000 45,000 _8,000 decrease
Contribution margin $27,000 $25,000 $2,000 decrease
Less fixed costs:
Rent 4,000 4,000 0
Salaries 5,000 4,000 1,000 decrease
Marketing and administrative _3,000 _2,750 __250 decrease
Operating profit (loss) $15,000 $14,250 $750 decrease
Profits decrease $750 so keep prints.
EX 1 extended : Add or drop a segment?

30-Jul-20 28
Ex2: Customer Profitability Analysis

30-Jul-20
Ex2: Customer Profitability Analysis, Extended

30-Jul-20
Closing or Adding Branch Offices:
 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 incremental income of the branch

or segment, not how much revenue the branch or
segment generates.

30-Jul-20
Customer Profitability Analysis, example 1

30-Jul-20
Customer Profitability Analysis, example extended

30-Jul-20
7.3.4. Irrelevance of Past Costs and Equipment
Replacement Decisions:
 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.
 Decision rule: Select the alternative that will generate

the highest operating income.

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Ex1 :Equipment-Replacement Decisions, data for
decision

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Ex 1 extended

30-Jul-20
Ex 1 extended

30-Jul-20
7.3.5. Decisions and Performance Evaluation:
The five-step sequence process of decision making
and performance evaluation
Identify
Problem
Obtain
Implemti
ng Informat
ion
Process
Predicti
Decision
on

30-Jul-20
 Despite the quantitative nature of some aspects of

decision making, not all managers will choose the best
alternative for the firm.
 Managers will consider how the company will judge his

or her performance after the decision is implemented.
 Many managers consider it unethical to take actions that

make their own performance look good when these
actions are not in the best interests of the firm.

30-Jul-20
 The decision model analysis (step 4) can dictate one

decision but in the real world, would the manager want
to follow it?
 An important factor is the manager’s perception of

whether the decision model is consistent with the
company judgements (step 5).

30-Jul-20
Terms to learn
TERMS TO LEARN Vietnamese
Book value Giá trị sổ sách
Business function costs Chi phí hoạt động kinh
doanh
Constraint Quan điểm
Decision model Mô hình ra quyết định
Differential cost Chi phí khác biệt
Differential revenue Doanh thu khác biệt
Full costs of the product Chi phí sản phẩm
Incremental cost Chi phí bộ phận
Incremental revenue Doanh thu bộ phận

Terms to learn
Linear programming (LP) Lập trình tuyến tính
Make-or-buy decisions Quyết định sản xuất hay mua
Objective function Chức năng mục tiêu
One-time-only special
Đơn đặt hàng đặt biệt
order
Opportunity cost Chi phí cơ hội
Outsourcing Thuê ngoài gia công
Product-mix decisions Quyết định sản phẩm hỗn hợp
Qualitative factors Nhân tố chất lượng
Quantitative factors Nhân tố lượng

Terms to learn
Relevant costs Chi phí thích hợp
Relevant revenues Doanh thu thích hợp
Sunk costs Chi phí chìm
Theory of constraints (TOC) Lý thuyết TOC

Chapter Summary

Q&A

Self- Preparation
Exercise: Chapter 11 Text book of Cost Accounting A

Managerial Emphasis 11-16,17,18 P. 480-
P.481.

Multiple Choices
1) A decision model involves a(n) ________.
A) informal method of making a choice at the lower level

management using sensitivity analysis;
B) formal method of making a choice that often involves both

quantitative and qualitative analyses;
C) informal method of making a choice which is discussed in

detailed in the financial reports;
D) formal method of making a choice at the lower level

management using advanced management techniques such
as balance scorecard.
B
Multiple Choices
2) Feedback regarding previous actions may affect

________.
A) future predictions;
B) implementation of the decision;
C) the decision model;
D) All of these answers are correct.
201048- PRICING DECISIONS AND COST MANAGEMENT 49

30-Jul-20
Multiple Choices
3) Place the following steps from the five-step decision

process in order:
A= Obtain information including historical costs;
B= Evaluate performance to provide feedback;
C= Make decisions choosing among alternatives;
D= Make predictions about the future;
E= Identify the problem and uncertainties.
C
Multiple Choices
4) The formal process of choosing between alternatives

is known as a(n) ________.
A) relevant model;
B) decision model;
C) alternative model;
D) prediction model.
51
30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION

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CHAPTER 07

DECISION MAKING AND RELEVANT

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 1

CASE STUDY RERIEW

Relevant Costs, JetBlue and Twitter

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 2

 Distinguish relevant from irrelevant information in

 Explain the concept of opportunity cost and why

 Know how to choose which products to produce when

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 3

 Explain how to manage bottlenecks;

 Discuss the factors managers must consider when

 Explain why book value of equipment is irrelevant to

 Explain how conflicts can arise between the decision

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 4

7.1. Information and the decision process;

7.2. The Concept of Relevance;

7.3. Insourcing-versus-Outsourcing and Make-versus-Buy

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 5

 A decision model is a formal method of making a choice

 Management accountants analyze and present relevant

 Managers use the five-step decision-making process

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 6

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 7

7.2.1.Relevant Costs and Relevant Revenues Relevant:

 Relevant information has two characteristics:

 Relevant costs are expected future costs.

 Relevant revenues are expected future Revenues.

7.2.2. Qualitative and Quantitative Relevant Information:

 Quantitative factors are outcomes that can be measured in

 Qualitative factors are outcomes that are difficult to

 Qualitative factors are just as important as quantitative

7.2.2. Qualitative and Quantitative Relevant Information:

7.2.2. Qualitative and Quantitative Relevant Information:

 Appropriate weight must be given to qualitative factors and

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 11

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 12

Decision rule: Does the special order generate

Compares relevant revenues and relevant costs

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 13

Alternative: Accept special offer

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 14

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 15

Variable costs (1,000) (1,100) (100)

Total contribution $1,500 $1,600 $100

Fixed costs (1,200) (1,200) 0

Operating profit $300 $400 $100

Alternative Presentation: Differential Analysis

Differential sales, 500 at 40¢ $200

Less differential costs, 500 at 20¢ 100

Differential operating profit (before taxes) $100

 Avoid incorrect general assumptions such as that “All

 Be aware that unit-fixed-cost data can potentially mislead

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 17

 Fixed costs per unit may include costs that are

 Unit fixed costs are accurate only for that particular

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 18

 A special order decision is, in many respects, a short-run

 Sometimes, the decision is simply about setting an

 Remember the decision rule?

 Any price above incremental costs will improve

30-Jul-20 201048- DECISION MAKING AND RELEVANT INFORMATION 19

 Insourcing means you’ll produce the good (or provide