Decision Making:

Relevant Costs and Benefits

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 The Managerial Accountant’s Role in
Decision Making
Managerial
Accountant
Cross-functional
management teams
Designs and (including managerial
implements Deliver accountants) who make
Accounting Relevant production, marketing,
information Information and finance decisions
system
Make substantive
economic decisions
affecting operations
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 The Decision-Making Process

1. Clarify the Decision Problem

2. Specify the Criterion

Quantitative
3. Identify the Alternatives
Analysis
4. Develop a Decision Model

5. Collect the Data

Qualitative
Considerations
6. Make a Decision

7. Evaluate Decision Effectiveness

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 Factors affect the decision alternatives

Can be Financial Cash

Quantitative presented units
Factors (expressed)
using Non- Physical
Numbers Financial units

Can not be Strategic

Qualitative presented Long Term
Factors using in
numbers nature
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 Cost Classifications for Decision Making

• Every decision involves choosing from among at least two

alternatives. Only those costs and benefits that differ
between alternatives are relevant in making the selection.

• Costs are classified for Decision Making into three types:

• Differential Costs
• Opportunity Costs
• Sunk Costs

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 Differential Costs and Revenues
Costs and revenues that differ among alternatives are differential
cost and revenues.
EXAMPLE: Bill is currently employed as a lifeguard, but he has been
offered a job in an auto service center in the same town. The differential
revenues and costs between the two jobs are listed below:

guard service differential cost &

revenue
Monthly salary 1,200 1,500 300
Transportation 30 90 (60)
Meals 150 150 0
Apartment rent 450 450 0
Uniform rental 0 50 (50)
Union dues 10 0 10
Increase in income 560 760 200 6
 Opportunity Costs
• The potential benefit that is given up when one alternative is
selected over another.
• It is an economic concept (does not appear in the accounting
records).
• It is common mistake for people to over look or underweight
opportunity costs.
• Example: piece of land currently used as a parking lot with annual
cash revenues $500,000. The company decided to use the land to
construct a new product line withy cash cost $1,000,000 (out-of-
pocket cost), and expected cash revenue $1,300,000 . This project
evaluated from an accounting view and economic view as follow:

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• Accounting View Economic View
• Expected revenues 1,300,000 1,300,000 -- Costs:
• cash costs (1,000,000) (1,000,000)
• opportunity costs ----------- (500,000)
• Net Return (loss) 300,000 (200,000)

• Notice that the $500,000 land rental, which will be forgone if the new
product line is added, is an opportunity cost of the option to construct
the new product line.
• It is a relevant cost of the decision, and it is just as important as any
out-of-pocket expenditure.

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 Sunk Costs

• Costs that have already been incurred.

• They do not affect any future cost and cannot be changed
by any current or future action.
• They should be ignored when making decisions.

Example: You bought an automobile that cost $10,000 two

years ago. The $10,000 cost is sunk because whether you
drive it, park it, trade it, or sell it, you cannot change the
$10,000 cost.
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 Relevant Information for Decision Making

• Information is relevant to a decision problem when . . .

1. It has a bearing (effect) on the future,
2. It differs among competing alternatives.

• Differential costs and opportunity costs should be the focus

of decision-making. They are the only relevant costs.
• All other costs that do not differ among competing
alternatives and sunk costs should be ignored.

• Let’s take a close look at some special decisions faced by

many businesses.
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 1 - Keep or Replace an Old Equipment
• The purpose of this discussion is to emphasize the point of ignoring
the sunk cost whenever we make decision in the short run.
• The following example explains this point:
A manufacturing company is comparing between keeping or
replacing the present machine with the following comparative data :
present proposed
Purchase cost new $ 60000 $ 90000
Acc. Depreciation 10000 ----------
Remaining Life 5 5
Annual operating costs 35000 15000
Market value now 20000 -----------
Salvage value 5000 9000
Sales revenue 100000 100000
1 - Do you recommend replacing the old by the new machine ? Why ?.
2 - Why do you think the management would refuse the replacing ? .
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Economic Analysis
According to the economic analysis focus is on the future
differentials cash flows only (The costs that will differ from
period to period in the future). All past costs and book values
(depreciations) are sunk and should be ignored as follows:
Differential Analysis for
Replacing
Cost of the new purchased machine ( 90 000 )
Annual Cost Savings [(35000 -15000) x 5] 100 000
Market value of old machine now 20 000
Salvage Value end of life (9000 – 5000) 4 000
Increase in the company profit 34 000
 Decision, agree (accept), because replacing the old machine (buying
the new machine) will increase the company profit by = 34 000.
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Accounting Analysis
According to the financial accounting view focus is on the past actual
(historical) events only. No opportunities lost and no future differential
costs and revenues.
Therefore, the management would refuse the replacement if the
management evaluate the decision from the accounting view as follow :
Market Value of old machine now 20 000
Book Value of old machine now 60000 – 10000 = (50 000)
Loss of selling the old asset now (30 000)

Decision, disagree (reject), because replacing the old machine (buying the
new machine) will decrease the company profit by = $30,000.

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 2 - Adding/Dropping Segments

One of the most important decisions managers make is whether to

add or drop a business segment such as a product or a store.

Let’s see how relevant costs should be used in this type of decision.

• Decision Factors:
• 1- Product line contribution margin.
• 2- Segmental fixed costs.
• 3- Opportunity use of the line equipment.
• 4- Effect on the profitability of the other lines.

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• Following is an income statement of a manufacturing company with two
products ( A ) and ( B ) :
• (A) (B) Total
• Sales revenue 1000000 4000000 5000000
• - Variable cost 300000 1600000 1900000
• Cont. Margin 700000 2400000 3100000
• - Segment F. C. (375000) (750000) (1125000)
• - General F. C. (525000) (1050000) (1575000)
• Net income(loss) (200000) 600 000 400 000

1 - Do you recommend stopping product line (A) ? why ?

2 - Assume that stopping product line ( A ) will reduce the sales of product line
(B) by 10%, but, on the other hand, the equipments of (A) can be used for
producing 18 000 units of product ( C ) with selling price 100 $/unit and
variable cost 40 $/unit . Do you recommend stopping product line (A)?
Why? 15
 Differential Analysis for Stopping
(A)
Lost Contribution Margin of ( A ) ( 700 000 )
Cost Savings:
Segment Fixed Costs 375 000
Decrease in the company profit ( 325 000 )
 Decision: not to stop product line (A), because stopping product line
(A) will decrease the Company profits by (325000).

 To proof the answer, prepare the statement without product line (A)
as follow:

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 (B) Total
Sales Revenue 4 000 000 4 000 000
Variable costs (1 600 000) (1 600 000)
Contribution margin 2 400 000 2 400 000
Segment fixed costs (750 000) (750 000)
Segment net profit 1 650 000 1 650 000
General Fixed Costs (1 575 000)
Company Net Income 75 000
The company net income without (A) = 75000 compared to the company
net income with (A) = 400000, which proof that stopping (A) will
decrease the company profit by 400 000 – 75 000 = 325000.

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 The right income statement with (A) according to the Managerial
Accounting View should be as follow:
(A) (B) Total
Sales Revenue 1 000 000 4 000 000 5 000 000
Variable costs (300 000) (1 600 000) (1 900 000)
Contribution margin 700 000 2 400 000 3 100 000
Segment fixed costs (375 000) (750 000) (1125 000)
Segment net profit 325 000 1 650 000 1 975 000
General Fixed Costs (1 575 000)
Company Net Income 400 000

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 Differential Analysis for Stopping (A)
Lost Contribution Margin of ( A ) ( 700 000 )
Decrease in the CM of (B) 2400000x 10% ( 240 000 )
CM of product (C) [18000 x (100-40)] 1 080 000
increase in the company profit 140 000

 Decision: stop product line (A), because stopping product line (A) will
increase the Company profits by 140 000

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• When Mr. Ding L. Berry, president and chief executive of Berry, Inc.,
first saw the segmented income statement below, he flew into his
usual rage: "When will we ever start showing a real profit? I'm
starting immediate steps to eliminate those two unprofitable lines!"

* These traceable expenses could be eliminated if the product lines to

which they are traced were discontinued. Required:
Recommend which segments, if any, should be eliminated. Prepare a
report in good form to support your answer.
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• A segmented income report, without the allocation of common fixed expenses, will provide the basis for deciding which
segments to drop.

The only segment that possibly should be eliminated is segment

W, which shows a negative segment margin of $2,000.

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 3 - The Make or Buy Decision
• A decision concerning whether an item should be produced
internally or purchased from an outside supplier is often
called a “make or buy” decision.
• Factors to consider:
• 1- Cost of make vs. cost of buy.
• 2- Opportunity use of the equipments.
• 3- qualitative factors.

• Assume a manufacturing company received an offer from an

outside supplier to supply 20000 units with price 30 $/unit of a part
currently produced by the company with the following data :

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• per unit total (20000 units)
• V. M. costs $15 $300 000
• Supervisors salaries 4 80 000
• Dep. part equipments 5 100 000
• Accounting Dep. Costs 3 60 000
• Store Dep. costs 2 40 000
• General costs 10 200 000
• Total 39 780 000

1. Assume that there is no opportunity costs to the part equipments, do you

accept the offer? Why?

2. Assume that there is an alternative use to the part equipments that give
net return $260000 , do you accept the offer? Why?

3. How to make the final decision?

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 Differential Analysis for Buying
1- Offered Purchase Price ( 30 )
Cost Saving:
V. Manufacturing Costs 15
Supervisors Salaries 4
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Decrease in the Company profit ( 11 )

 Decision, disagree (reject), because the supplier offer will decrease

the company profit by = 20000 x (11) = (220000).

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 2- Differential Analysis for Buying
Offered Purchase Price
( 30 )
Cost Saving:
V. Manufacturing Costs 15
Supervisors Salaries 4
Return from alternative use (260000/ 20000 = 13 ) 13
Total Savings 32
Increase in the Company profit 2
 Decision, agree (accept), because the supplier offer will increase the
company profit by = 20000 x 2 = 40000.

 Decision is finalized by considering the qualitative (strategic) factors

such as :- Not to be under the mercy of the supplier
Quality concern. Delivery concern Future expansions.
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Make vs. Buy : other issues to be considered:
In addition to the relative cost of buying externally compared to making
in house, management must consider several other issues before a
final decision is made.
Reliability of external supplier;
can the outside company be relied upon to meet the requirements in
terms of :
 Quantity required.
 Quality required.
 Delivery on time.
 Price stability.
Specialist Skills:
the external supplier may posses some specialist skills that are not
available in house.

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Alternative use of resources: outsourcing will free up
resources which may be used in another part of the business.
Social: will outsourcing result in a reduction of the workforce?
Redundancy cost should be considered.
Legal: will outsourcing affect contractual obligations with
suppliers or employees?
Confidentiality: is there a risk of loss of confidentiality,
especially if the external supplier performs similar work for rival
companies.
Customer reaction: do customers attach importance to the
products being made in house?
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 4 - Special Orders - 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.
• Assume a manufacturing company producing and selling 23 000 units of
its product in the local market with selling price 65 $/unit (normal
capacity 25 000 units). Following are the cost data:
• Variable Manufacturing cost 30 $ / unit
• Fixed Manufacturing cost 15 $ / unit
• Variable S. & A. 5 $ / unit
• Fixed S. & A. 10 $ / unit
• Total cost 60 $ / unit
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• Required :

1. Assume a foreign customer is ordering 1000 units with selling

price 43 $/unit given that accepting the order will reduce the
variable S. & A. by 3 $/unit and requires special machine with
cost $9000, Do you accept the order? Why?

2. Same as requirement (1), except that the units ordered 3000

units.

3. How to make the final decision about this order?

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 Normal Capacity 25 000
Local Sales (23 000)
Remained for the order 2 000
Ordered units (1 000)
Remained Capacity 1 000
Then, accepting the order will not affect the sales in the local market
Therefore, there is no opportunity lost because of the order.
Customer Offered Price 43
Cost / unit:
V. Manufacturing Costs 30
V. S. & A. expenses 5 – 3 = 2
Cost of special machine 9000 / 1000= 9
(41)
Profit / order unit 2
Decision, agree (accept), because the customer offer will increase the
company profit by = 1000 x 2 = 2000.
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 Normal Capacity 25 000
Local Sales (23 000)
Remained for the order 2 000
Ordered units (3 000)
Decrease in the local sales (1 000)
 Then, accepting the order will affect the sales in the local market,
Then,
 Opportunity (CM) lost/ local market i=1000 x [ 65 – ( 30 + 5)] = $30000
 Opportunity lost / order unit = 30000 / 3000 = 10
Customer Offered Price 43
Cost / unit:
V. Manufacturing Costs 30
V. S. & A. expenses 5 – 3 = 2
Cost of special machine 9000 / 3000= 3
Opportunity Lost / order unit 10
(45)
loss / order unit (2) 31
 Decision, disagree (reject), because the customer offer will
decrease the company profit by = 3000 x (2) = (6000).

 Decision is finalized by considering the qualitative (strategic)

factors such as :
- New Customer, New Market.
- Source of hard (foreign) currency.
- Future expansions.

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