Topic 4:

Relevant information for

decision making
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The concept of Relevance

• 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.

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Relevant Costs and Benefits

A relevant cost is a cost that differs

between alternatives.

A relevant benefit is a benefit that

differs between alternatives.

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1
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Identifying Relevant Costs

An avoidable cost is a cost that can be eliminated,
in whole or in part, by choosing one alternative
over another. Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.

Two broad categories of costs are never relevant

in any decision. They include:
Sunk costs (incurred in the past).
A future cost that does not differ between the
alternatives.
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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.
• Note that incremental cost and differential
cost are sometimes used interchangeably
in practice.

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Some Types of Decisions that need to be made:

• One-time-only special orders

• Short-run pricing decisions
• Insourcing vs. outsourcing (Make-or-Buy)
• Product-mix with capacity constraints
▫ Bottlenecks, Theory of Constraints, and
Throughput-Margin Analysis
• Customer profitability and Relevant Costs
• Branch/segment: adding or discontinuing
• Equipment replacement

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Key Terms and Concepts

A special order is a one-time
order that is not considered
part of the company’s normal
ongoing business.

When analyzing a special

order, only the incremental
costs and benefits are
relevant.
Since the existing fixed
manufacturing overhead costs
would not be affected by the
order, they are not relevant.
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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.

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Short-run pricing decision

•A special order decision is, in many respects, a
short-run pricing decision.
•Decision rule: Any price above incremental costs
will improve operating income.
•However, consideration must be given to capacity
constraints, current market conditions, customer
demand, competition, etc.

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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.
• This is often referred to as an outsourcing
decision.
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Insourcing v outsourcing
Make-or-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.

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Insourcing v outsourcing
Make-or-Buy decision
• 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.

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Product-Mix Decisions with

Capacity constraints
•Product-mix decisions are decisions managers
make 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 (not the
highest contribution margin per unit of
the product).

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Key Terms and Concepts

When a limited resource of
some type restricts the
company’s ability to satisfy
demand, the company is
said to have a constraint.

The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.
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Bottlenecks - Theory of constraints

Throughput-margin analysis

 A bottleneck is a phenomenon where the

performance or capacity of an entire system is
limited by a single or limited number of
components or resources.
Such limiting components of a system are
sometimes referred to as bottleneck points.

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Bottlenecks - Theory of constraints

Throughput-margin analysis
 The Theory of Constraints (TOC) describes methods
to maximize operating income when faced with
some bottleneck and some non-bottleneck
operations. The TOC defines these three measures:
Throughput margin
Investments
Operating costs
The objective of the TOC is to increase throughput
margin while decreasing investments and operating
costs. The TOC focuses on managing bottleneck
operations.

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Customer profitability and relevant costs

• 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.

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Adding or Discontinuing
Branches or Segments

• 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.

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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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Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale

Common
Joint Final
Production Gasoline
Input Sale
Process

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point Product
Costs
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Sell or Process Further

With respect to sell or process further decisions, it is

profitable to continue processing a joint product after the
split-off point so long as the incremental revenue from
such processing exceeds the incremental processing
costs incurred after the split-off point.
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End of topic 4