UNIT TWO

RELEVANT INFORMATION AND DECISION MAKING

2.1. INFORMATION AND THE DECISION PROCESS
Decision making is the process of choosing the best course of action from alternatives
available. Decision model is a method used by managers for deciding among courses of
action. Accounting information (revenue and cost information) are basic inputs in to decision
model. However, other quantitative as well as qualitative information can also be used. In
general information is divided in to relevant and irrelevant information. Relevant information
is information which is useful for decision making where as irrelevant information is not
useful for decision making. The management accountant’s role in the decision making
process is to produce relevant information to the managers who make the decisions. Thus, the
primary role of cost accountant in decision process is to: decide what information is relevant
to each decision problem, and provide accurate and timely information (data)
Decision making process involves basically the following activities.
i. Identify and Define the Problem. The most important phase of decision making
process because all other activities in the process depend on this phase. Incorrectly defined
problems waste time and resources. That is why it is usually said that defining a problem is
solving half of the problem.
ii. Specify the Criterion. The phase in which the purpose of decision is to be made. Is
the objective to maximize profit, increase market share, minimize cost, or improve public
service? For example, cost minimization, increase the quality of product, maximize profit,
etc.
iii. Identify Possible Alternatives: Determining the possible alternatives is a critical
step in the decision process.
iv. Gathering Relevant Information. Information could be subjective or objective,
internal or external to the organization, historical (past) data, or future (expected) ones.
v. Making the Decision: Select the best alternative (course of action).
2.2. THE CONCEPT OF RELEVANCE
 Relevance is one of the key characteristics of good management accounting
information.
• Relevant information includes the predicted future costs and revenues that differ
among the alternatives.
• Any cost or benefit that does not differ between alternatives is irrelevant and can be
ignored in a decision. All future revenues and/or costs that do not differ between the
alternatives are irrelevant
There are two criteria that qualify information to be relevant for decision making.
i. Bearing on the Future: To be relevant to a decision, cost or benefit information must
involve a future event. Relevant information is a prediction of the future, not a
summary of the past.
ii) Different under Competing Alternatives
Relevant information must involve future costs or benefits that differ among the alternatives.
These are called differential revenues and costs.
In cost and management accounting, the term differential cost is synonymous with avoidable
cost and relevant cost.
Costs or benefits that are the same across all the available alternatives have no bearing on the
decision.
Sunk Costs and Opportunity Costs
• The emphasis on differential revenues and costs gives rise to two related concepts
• sunk costs and opportunity costs.
• A sunk cost is one that has already been incurred and therefore will be the same no
matter which alternative a manger selects. Sunk costs are never relevant for decision
making because they are not differential.
• An opportunity cost is the benefit lost by taking one action as opposed to another.
The “other” action is the best alternative available other than the one being
contemplated
Avoidable costs and Unavoidable costs
Fixed costs are divided into two categories, avoidable and unavoidable
 Avoidable costs are costs that will not continue if an ongoing operation is changed,
deleted or eliminated. These costs are relevant costs in decision-making.
 Unavoidable costs are costs that continue even if a subunit or an activity is
eliminated and are not relevant for decision.
 Unavoidable costs include many common costs, which are defined as those costs of
facilities and services that are shared by users. Examples are store depreciation,
general management expenses…..
Association with Decision
Costs or revenues are relevant when they are logically related to a decision and vary from one
decision alternative to another. Cost accountants can assist managers in determining which
costs and revenues are relevant to decisions at hand. To be relevant, a cost or revenue item
must be differential or incremental. An incremental revenue is the amount of revenue that
differs across decision choices and incremental cost (differential cost) is the amount of cost
that varies across the decision choices.
To the extent possible and practical, relevant costing compares the incremental
revenues and incremental costs of alternative choices. Although incremental costs can be
variable or fixed, a general guideline is that most variable costs are relevant and most fixed
costs are not. The logic of this guideline is that as sales or production volume changes, within
the relevant range, variable costs change, but fixed costs do not change. As with most
generalizations, some exceptions can occur in the decision-making process.
The difference between the incremental revenue and the incremental cost of a
particular alternative is the positive or negative incremental benefit (incremental profit) of
that course of action. Management can compare the incremental benefits of alternatives to
decide on the most profitable (or least costly) alternative or set of alternatives.
2.3. RELEVANT INFORMATION AND MARKETING DECISIONS
2.3.1. Special Order Decisions
One type of decision that affects output level is accepting or rejecting a special order. A
special order is a one-time order that is not considered part of the company’s normal ongoing
business. In general, a special order is profitable as long as the incremental revenue from the
special order exceeds the incremental costs of the order. Thus, conditions to consider in a
special order decisions are: (i) Customers must be from markets not ordinarily served by the
company, and (ii) the company must operate below it maximum productive capacity
Example6.3.Consider the following details of the income statement, on absorption costing
basis (that is, both variable and fixed manufacturing costs are included in inventor able costs
and cost of goods sold), of Samson Company for the year just ended December 31, 20X4
Total per unit
Sales (1,000,000 units) Br 20,000,000 Br 20
Cost of Goods Sold 15,000,000 15
Gross Margin Br 5,000,000 Br. 5
Selling and Administrative Expenses 4,000,000 4
Operating Income Br. 1,000,000 Br. 1
Samson’s fixed manufacturing costs were Br 3 million and fixed selling and administrative
expenses were Br 2.9 million. Near the end of the year, Ethio Company offered Samson Br
13 per unit for 100,000 unit special order. The special order would not affect Samson‘s
regular business in any way. Furthermore, the special sales order would not affect total fixed
costs and would not require any additional variable selling and administrative expenses.
Required:

a) Should Samson accept or reject the special order?

Solution:
a). The correct analysis to the above problem employs the contribution approach to income
statement, not the absorption or financial approach- that treats fixed costs, i.e., fixed
manufacturing costs as if it were variable.
 Variable manufacturing cost per unit═ 15,000,000 - 3,000,000 ═ 12per unit
1,000,000
 Total Variable manufacturing cost ═ Br. 12 x 1,000,000 ═ Br.12,000,000
 Variable selling and administrative cost per unit═4,000,000 -2,900,000═1.1per unit
1, 000, 0000
 Total Variable selling and administrative cost ═ Br. 1.1 x 1, 000, 0000 ═
Br.1,100,000( the special order does not affect this cost)

The analysis would be as follows on comparative contribution income statement.

Without special order With special order Difference: relevant
1,000,000 units to be 1,100,000 units to be amount for the
sold sold 100,000 units of
special order
Sales Br. 20,000,000 Br. 21,300,00 Br. 1,300,000
Variable Expenses:
Manufacturing Br. 12,000,000 Br.13,200,000 Br.1,200,000
Selling and Adm. 1,100,000 1,100,000
Total Variable Exp. Br. 13,100,000 Br. 14,300,000 1,200,000
Contribution Margin Br. 6,900,000 Br. 7,000,000 Br. 100,000
Fixed Expenses:
Manufacturing Br. 3,000,000 Br. 3,000,000
Selling and Adm. 2,900,000 2,900,000
Total Fixed Expenses Br.5,900,000 Br. 5,900,000
Operating Income Br.1,000,000 Br.1,100,000 Br. 100,000
The above comparative income statements for Samson illustrates two key complete to
analyzing relevant revenues for decision: (1) distinguish relevant costs and revenues from
irrelevant ones and (2) use the contribution income statement to focus on whether each
variable cost and each fixed cost is affected by the alternatives(i.e. reject or accept) under
consideration.
In this case, the relevant revenues and costs are the expected future revenues and costs that
differ as a result of accepting the special offer ---- sales of Br 1,300,000(Br 13 per unit X
100,000 units) and variable manufacturing costs of Br. 1,200,000 (Br 12 per units X 100,000
units). The fixed manufacturing costs and selling and Administration costs (including
variable costs) are irrelevant. That is because these costs will not change in total whether the
special order is accepted or rejected. Based on the relevant data analyzed above, Samson
would gain an additional Br100, 000(relevant revenues, Br 1,300,000 less relevant costs Br
1,200,000) in operating income by accepting the special order. In this example, comparing
total amounts for 1,000,000 units versus 1,100,000 units or focusing only on the relevant
amounts in the difference column in comparative income statement avoids misleading
implication --- the implication that would result from comparing the Br 13 per unit selling
price against the manufacturing cost per unit of Br 15 (from Samson’s income statement on
absorption costing basis) which includes both Variable and fixed manufacturing costs.
Thus, based on the relevant data analyzed above, Samson Company should accept the special
order because it brings an additional income of Br. 100,000 for the company as:
Income with special order Br. 1,100,000
Income without special order 1,000,000
Additional income if the order had been accepted Br. 100,000
2.3.2. Product Line Decisions
This is a decision relating to whether old product lines or other segments of a company
should be dropped and new ones added are among the most difficult decision that a manager
has to make. Operating results of multiproduct environments are often presented in a
disaggregated format that shows results for separate product lines within the organization or
division. In reviewing these disaggregated statements, managers must distinguish relevant
from irrelevant information regarding individual product lines. If all costs (variable and
fixed) are allocated to product lines, a product line or segment may be perceived to be
operating at a loss when actually it is not. The commingling of relevant and irrelevant
information on the statements may cause such perceptions.
In classifying product line costs, managers should be aware that some costs may appear to be
avoidable but are actually not. For example, the salary of a supervisor working directly with a
product line appears to be an avoidable fixed cost if the product line is eliminated. However,
if this individual has significant experience, the supervisor is often retained and transferred to
other areas of the company even if product lines are cut. Determinations such as these needs
to be made before costs can be appropriately classified in product line elimination decisions.
For instance, mostly on add or delete decisions, fixed costs are divided into two categories,
avoidable and unavoidable. Avoidable costs are costs that will not continue if an ongoing
operation is changed, deleted or eliminated. These costs are relevant costs in decision
making. Unavoidable costs are costs that continue even if a subunit or an activity is
eliminated and are not relevant for decision.
Example.5.4 Eyoha Department store has three major departments: groceries, general
merchandise, and drugs. Management is considering dropping groceries, which have
consistently shown a net loss, as shown below on statement of departments’ profitability
analysis of Eyoha.
Departments
Groceries General merchandise Drugs Total
Sales Br. 100,000 Br. 8,0000 Br. 10,000 Br.190,000
Variable CGS &
Expenses 80,000 56000 6,000 142,000

Contribution margin Br. 20,000 Br. 24000 Br. 4,000 Br. 48,000
Fixed expenses:
Avoidable Br. 15,000 Br. 10,000 Br. 1,500 Br. 26,500
Unavoidable 6,000 10,000 2,000 18,000

Total fixed expenses Br.21,000 Br. 20,000 Br.3,500 Br. 44,500

Operating income Br. (1,000) Br.4,000 Br. 500 Br. 3,500
(loss)

Required:
a) Which alternative would be recommended if the only alternatives to be considered are
dropping or continuing the grocery department? Assume that the total assets would be
unaffected by the decision and the space made available by dropping groceries would
remain idle.
b) Refer the income statement presented above. Assume that the space made available
by dropping groceries could be used to expand the general merchandise department.
The space would be occupied by merchandise that increase sales by Br. 50,000,
generate a 30% contribution margin percentage and have additional avoidable fixed
costs of Br.7, 000. Should Eyoha discontinue grocery and expand merchandise
department?

Solutions
(a). Analysis for dropping grocery department and leaving the space idle

(A) Total (B) Effect of (A – B) Total

Before change dropping grocery after change
Sales Br. 190.000 Br 100.000 Br 90.000
Variable COGS and Expenses 142.000 80.000 62.000
Contribution margin Br 48.000 Br 20.000 Br 28.000
Fixed expenses
Avoidable Br 26.500 Br 15,000 Br 11,500
Unavoidable 18.000 - 18,000
Total fixed expenses Br 44,500 Br 15,000 Br 29,500
Operating income (loss) Br 3,500 Br 5,000 Br (1,500)
In this analysis, column 2, presents the relevant –revenues and relevant-cost analysis using
data from the grocery column in department profitability analysis of Eyoha. Eyoha’s
operating income will be Br.5, 000 (income with grocery department, Br.3500 less loss
assuming grocery is dropped, Br.1500 or it implies that the cost savings from dropping the
grocery department, Br.95, 000 (Br.80, 000+ Br.15, 000), will not be enough to offset the loss
of Br.100, 000 in revenues. So, under this condition Eyoha’s managers should decide to keep
the grocery department rather dropping.
Notice that all of the grocery’s variable expenses are avoidable and relevant for decision
making. If the grocery department is discontinued, the Br 6,000 of the fixed expenses will
continue, which is irrelevant. And also note that there is no opportunity costs of using spaces
for grocery because without grocery, the space and equipment will remain idle.
(b) Analysis for dropping the grocery department and expanding general merchandise.
(A) Total (B) Effect of (C) Effect of (A – B) + C Total
before change Dropping Expanding after change
Groceries General Merchandise
Sales Br190,000 Br 100,000 Br 50,000 Br 140,000
Variable CGS and expense 142,000 80,000 35,000 97,000
Contribution margin Br 48,000 Br 20,000 Br 15,000 Br 43,000
Fixed expenses
Avoidable Br 26,500 Br 15,000 Br 7,000 Br 18,500
Unavoidable 18,000 - 18,000
Total fixed expenses Br 44,500 Br 15,000 Br 7,000 Br 36,500
Operating income (loss) Br 3,500 Br 5,000 Br 8,000 Br 6,500

Effect of expanding general merchandise:

Incremental revenue = Br 50,000
Incremental cost
Variable cost = (1-0.30) x 500,000 = (35,000)
Fixed cost = (7,000)
Incremental income = Br 8,000
Recommendation: As the above analysis shows, dropping grocery and using the vacated
space to expand general merchandise will be a good decision.

2.3.3. Optimal Use of Scarce Resources Decisions (Product Mix Decisions)

Scarce resources create constraints on producing goods or providing services and can include
machine hours, skilled labor hours, raw materials, and production capacity and other inputs.
Management may, in the long run, obtain a greater quantity of a scarce resource. For
instance, additional machines could be purchased to increase availability of machine hours.
However, in the short run, management must make the most efficient use of the scarce
resources it has currently.
Determining the best use of a scarce resource requires managerial recognition of company
objectives. If the objective is to maximize company profits, a scarce resource is best used to
produce and sell the product having the highest contribution margin per unit of the scarce
resource.
Example5.5 Jimma Computers manufactured two products, desktop computer and notebook
computer. The Company’s scarce resource is a data chip that it purchases from a supplier.
Each desktop computer requires one chip and each notebook computer requires three chips.
Currently, the firm has access to only 5,100 chips per month to make either desktop or
notebook computers or some combination of both. Demand is above 5,100 units per month
for both products and there is no variable selling or administrative costs related to either
product. The desktop’s Br. 650 selling price less its Br. 545 variable cost provides a
contribution margin of Br. 105 per unit. The notebook’s contribution margin per unit is
Br.180 (Br.900 selling price minus Br.720 variable cost). Fixed annual overhead related to
these two product lines totals Br. 6,570,000 and is allocated to products for purposes of
inventory valuation. Fixed overhead, however, does not change with production levels within
the relevant range
Instructions: on the bases of the above information which product is more profitable and on
which products should the firm spend its resources?
Solution:
Present information on two products being manufactured by Jimma Computers and total
contribution margin per unit and per chip would be:

Descriptions Desktop Notebook

Selling price per unit (a) Br 650 Br 900
Variable production cost per unit:
Direct material Br.345 115 Br. 480
Direct labor 85 Br. 545 125
Variable overhead 115
Total variable cost (b) Br. 720
Unit contribution margin [(c) = (a) _ (b)] Br 105 Br.180
Chips required per unit (d) 1 3

Contribution margin per chip of per unit [(c) /(d)] Br.105 Br.60

In the above analysis, because fixed overhead per unit is not relevant in the short run, unit
contribution margin rather than unit gross margin is the appropriate measure of profitability
of the two products. Unit contribution margin is divided by the input quantity of the scarce
resource (in this case, data chips) to obtain the contribution margin per unit of scarce
resource. The last line in the above analysis table shows the Br. 105 contribution margin per
chip for the desktop compared to Br. 60 for the notebook. Thus, it is more profitable for
Jimma Computers to produce desktop computers than notebooks.
At first glance, it would appear that the notebook would be, by a substantial margin, the more
profitable of the two products because its contribution margin per unit (Br. 180) is
significantly higher than that of the desktop (Br. 105). However, because the notebook
requires three times as many chips as the desktop, a greater amount of contribution margin
per chip is generated by the production of the desktops. If these were the only two products
made by Jimma Computers and the company wanted to achieve the highest possible profit, it
would dedicate all available data chips to the production of desktops. Such a strategy would
provide a total contribution margin of Br. 535,500 per month (5,100 units * Br. 105), if all
units produced were sold.
2.3.4. Make or Buy (In source or out sourcing) decision
A concern with subcontracting or outsourcing has dominated business in recent years as
the cost of providing goods and services in-house is increasingly compared to the cost of
purchasing goods on the open market. Thus, a daily question faced by managers is whether
the right components and services will be available at the right time to ensure that production
can occur. Additionally, the inputs must be of the appropriate quality and obtainable at a
reasonable price. Traditionally, companies ensured themselves of service and part availability
and quality by controlling all functions internally. However, there is a growing trend toward
“outsourcing” (buying) a greater percentage of required materials, components, and services.
This outsourcing decision (make-or-buy decision) is made only after an analysis that
compares internal production and opportunity costs with purchase cost and assesses the best
uses of available facilities. Consideration of an in source (make) option implies that the
company has available capacity for that purpose or has considered the cost of obtaining the
necessary capacity. The make versus buy decision should be based on which alternative is
less costly on a relevant cost basis; that is, taking into account only future, incremental cash
flows. In other words, in a make or buy situation with no limiting factors, the relevant costs
for the decision are the differential costs between the two options.
For example, the costs of in-house production of a computer processing service that
averages 10,000 transactions per month are calculated as Br. 25,000 per month. This
comprises Br.0.50 per transaction for stationery and Br. 2 per transaction for labor. In
addition, there is a Br. 10,000 charge from head office as the share of the depreciation charge
for equipment. An independent computer bureau has tendered a fixed price of Br. 20,000 per
month.
Based on this information, stationery and labor costs are variable costs that are both
avoidable if processing is outsourced. The depreciation charge is likely to be a fixed cost to
the business irrespective of the outsourcing decision. It is therefore unavoidable. The fixed
outsourcing cost will only be incurred if outsourcing takes place.
The relevant costs for each alternative can be compared as shown in Table 2.1 below.
The Br. 10,000 share of depreciation costs is not relevant as it is unavoidable. The relevant
costs for this decision are therefore those shown in Table 2.2
Based on relevant costs, there would be a Br. 5,000 per month saving by outsourcing the
computer processing service.

Table 2.1 Relevant costs – make versus buy

Cost to make Cost to
buy
Stationery 10,000 @ Br. 0.50 Br. 5,000
Labour 10,000 @ Br. 2 20,000
Share of depreciation costs 10,000 10,000
Outsourcing cost 20,000
Total relevant cost Br. 35,000 Br. 30,000

Table 2.2. Relevant costs – make versus buy, simplified

Relevant cost to make Relevant cost to
buy
Stationery 10,000 @ Br. 0.50 Br. 5,000
Labour 10,000 @ Br. 2 20,000
Outsourcing cost 20,000
Total relevant cost Br. 25,000 Br. 20,000

Note that relevant information for make or buy decision includes both quantitative and
qualitative factors. Such as:
Quantitative Factors
Buy Make
 the amount paid to supplier  variable costs incurred to produce the
component
 transportation costs  special equipment to produce the
product
 costs incurred to process  hire additional supervisory personnel
the part upon receipt to assist with making the product

Qualitative Factors
 Advantage of long term  The quality of the product is decided
relationship with suppliers to be controlled
 Possibility of shortage of  If the purchase price is likely to rise
material or labor for making due to increased demand in the
the component market, it becomes uneconomical to
buy
 Uninterrupted supply of  Where the technical know-how is to
requisite quality from reliable be kept secret and not to be passed
supplies on to the suppliers

2.3.5. Keep or Replace Equipment Decisions

Decisions to replace usable plants assets should be based on studies of relevant costs. The
relevant costs are the future costs of continuing to use the equipment versus replacement. The
book values of the plant assets being replaced are sunk costs and are irrelevant.
 In general, in deciding whether to replace or keep existing equipment, four commonly
encountered items considered in relevance:
i. Book value of old equipment: irrelevant, because it is a past (historical) cost. Therefore,
depreciation on old equipment irrelevant.
ii. Disposal value of old equipment: relevant, because it is an expected future inflow that
usually differs among alternatives.
iii. Gain or loss on disposal: this is the algebraic difference between book value and disposal
value. It is therefore, a meaningless combination of irrelevant and relevant items.
Consequently, it is best to think of each separately.
iv. Cost of new equipment: relevant, because it is an expected future outflow that will differ
among alternatives. Therefore, depreciation on new equipment is relevant.

As for example, assume that a business is considered disposing of several identical machines
having a total book value of Birr 1,000,000 and an estimated remaining life of five years. The
old machines can be sold for Birr 25,000. They can be replaced by a single high-speed
machine at a cost of Birr 250,000. The new machine has an estimated useful life of five years
and no residual value. Analyses indicate an estimated annual reduction in variable
manufacturing costs from Birr 225,000, with the old machine to Birr 150,000 with the
new machine. No other changes in the manufacturing costs or the operating expenses are
expected. The relevant costs are summarized in the differential report are as follows:

Proposal for Replacement Equipment (Differential Analysis Report – Replacement

Equipment):
Annual variable costs of present equipment (a) Birr 225,000
Annual variable costs - new equipment (b) 150,000
Annual differential decrease in cost(c= a-b) Birr 75,000
Number of years applicable (d) 5
Total differential decrease in cost (e=cxd) Birr 375,000
Proceed from sales of present equipment (f) 25,000
total (g =e+f) Birr 4, 00,000
Cost of new equipment (h) 2, 50,000
Net differential decrease in cost, 5 year total (i =g+h) Birr 1, 50,000
So, annual net differential decrease in cost – new equipment (i÷d) Birr 30,000
Additional factors are often involved in equipment replacement decisions. For example,
differences between the remaining useful life of the old equipment and the estimated life of
the new equipment could exist. In addition, the new equipment might improve the overall
quality of the product, resulting in an increase in sales volume. Other factors that could be
significant include the time value of money and other uses for the cash needed to purchase
the new equipment.