Decision Making

Concepts: Relevant
Costs and Benefits

Prepared by Group 2B:

 Arlene Manuel
 Mariano Corral Jr.
 Jerweine Rodillas

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Decision Making Concepts:
Relevant Costs and Benefits
A. Steps in the Decision-Making Process –
Jerweine Rodillas

B. Quantitative and Qualitative Analysis – Mariano

Corral Jr.

C. Identifying Relevant Costs and Benefits –

Arlene Manuel

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Steps in the
Decision-Making
Process
- Jerweine Rodillas

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Steps in the Decision-Making Process
Decision Making
 an outcome of mental processes leading to the
selection of a course of action among several
alternatives. Every decision making process
produces a final choice. The output can be an
action or an opinion of choice.

It may be noted that every decision involves a certain

degree of risk. Very few decisions are made with
absolute certainty. So a good decision would be to
choose a solution with the highest probability of
success and in accordance with the goals, desires,
lifestyle and values etc.
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Steps in the Decision-Making Process

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Steps in the Decision-Making Process

Structuring the Problem Analyzing the Problem

Define Identify Determine Identify Choose

the the the the an
Problem Alternatives Criteria Alternatives Alternative

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Steps in the Decision-Making Process
1. Clarify the decision problem
One must be clear about the problem. One
must look for the root cause or hidden problem
rather than the apparent problem. Some skill is
required to define a problem in such terms that
can be addressed effectively.

2. Specify the criteria

After clarifying a problem, criteria must be
specified for decision-making. What is the
objective: maximize profit, increase market share
or social service. 7
Steps in the Decision-Making Process
3. Identify alternatives
Explore all alternatives, their pros and
cons. This is a critical step in the decision
making process.

4. Develop a decision model

This is a simplified version of the problem.
No irrelevant information, only factors relevant
to the problem are highlighted. It brings
together all elements of a problem like the
criteria, the constraints, and the alternative.
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Steps in the Decision-Making Process
5. Collect the data
Relevant data must be collected to
incorporate objectivity in the process. It may
be primary data or secondary data. But it must
be up-to-date, timely and accurate.

6. Select an alternative
One all formalities are completed,
requisite information obtained and processed,
a most suitable or appropriate choice should be
selected.
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Quantitative and
Qualitative Analysis
- Mariano Corral Jr.

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 Quantitative factors

Financial Nonfinancial

Qualitative factors

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Quantitative Analysis
 analyst will concentrate on the quantitative
facts or data associated with the problem
 analyst will develop mathematical
expressions that describe the objectives,
constraints, and other relationships that
exist in the problem
 analyst will use one or more quantitative
methods to make a recommendation

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Quantitative and Qualitative Analysis
Potential Reasons for a Quantitative
Analysis Approach to Decision Making
The problem is complex.
The problem is very important.
The problem is new.
The problem is repetitive.

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Profit is made if the incremental revenue
exceeds incremental costs.

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This is a very common (frequent) decision made
by most organizations.

Purchase managers report three important factors:

(1) Quality
(2) Supplier dependability
(3) Cost

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In making a “make-or-buy” decision
it is often times useful and quick to
compare the cost to outsource versus
the costs saved if you outsource.

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 Deciding which
products to produce when there
are capacity constraints.
Answer: Produce/sell product(s) with the
highest CM/unit of constraint!

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Per unit Product #2 Product #3
Sales price P2.11 P14.50
Variable expenses 0.41 13.90
Contribution margin P1.70 P 0.60
Contribution margin ratio 81% 4%
ABC Co. has 3,000 machine-hours available.

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One unit of Prod. #2 requires 7 machine-hours.
One unit of Prod. #3 requires 2 machine-hours.
What is the contribution of each product
per machine-hour?
Product #2: P1.70 ÷ 7 = P0.24
Product #3: P0.60 ÷ 2 = P0.30

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Qualitative Analysis
 based largely on the manager’s judgment
and experience
 includes the manager’s intuitive “feel” for
the problem
 is more of an art than a science

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Qualitative Factors
Nonquantitative factors may be extremely
important in an evaluation process for
each of the decisions, yet do not show up
directly in calculations:
Quality requirements
Reputation of outsourcer
Employee morale
Logistical considerations—distance from
plant, and so on
For make/buy decisions, buying can be
risky, especially if sourcing internationally.

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Identifying Relevant
Costs and Benefits
- Arlene Manuel

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Relevant Costing
Relevant costing is a management
accounting tool that helps managers reach
decisions when they are posed with the
following questions:
1.Whether to buy a component from an
external vendor or manufacture it in-house?
2.Whether to accept a special order?
3.What price to charge on a special order?
4.Whether to discontinue a product line?
5.How to utilize the scarce resource
optimally?, etc.

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Relevant Costing
Relevant costing is an incremental analysis
which means that it considers only relevant
costs i.e. costs that differ between alternatives
and ignores sunk costs i.e. costs which have
been incurred, which cannot be changed and
hence are irrelevant to the scenario.

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Relevant Costs
To be relevant, cost must meet two criteria:
they affect the future and
they differ among alternatives

The following are relevant costs:

Differential cost
Incremental or marginal cost
Opportunity cost

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Differential Costs
DIFFERENTIAL COST
 Is the difference in cost items under two or
more decision alternatives specifically two
different projects or situations.
 is a difference between the cost of two
independent alternatives
 Where same item with the same amount
appears in all alternatives, it is irrelevant.
 Similarly, future costs and benefits that are
identical across all decision alternatives are
not relevant.
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Example of Differential Cost
Choosing between renting a photocopier or
purchasing a photocopier - Differential costs would
be:
A)Cost of renting would include the monthly rental,
vs
B)Cost to purchase would include the depreciation of
the photocopier, the cost of repairs of the
photocopier, the cost of consumable parts of the
photocopier
Cost of paper & electricity consumption of the
copier would be irrelevant as the said costs would be
incurred in both alternatives
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Example of Differential Cost
Choosing between renting a photocopier or
purchasing a photocopier – Qualitative factors to
consider:
A)Renting:
Possible faster servicing when unit needs repair
Easier to upgrade to a newer unit or to a larger
capacity unit
B)Cost to purchase
Cost of money particularly when a large sum is
required for the upfront purchase

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INCREMENTAL OR MARGINAL
COST
Is a cost associated with producing an
additional unit.
Examples:
In case of a university, it could be cost of
admitting another student.
Operating a second shift is an example of
incremental cost. It would be noted that the two
decisions are not independent as second shift
depends upon first shift.
Incremental cost must be compared with
incremental revenues to arrive at a decision.
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Example
Company A manufactures bicycles. It can
produce 100 units in a month for a fixed cost
of PhP300,000 and variable cost of PhP2,500
per unit. Its current de1mand is 600 units
which it sells at PhP7,000 per unit. It is
approached by Company B for an order of
200 units at PhP5,500 per unit. Should the
company accept the order?

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Example
Solution
A layman would possibly reject the order
because he would think that the order gives
only a break-even result assuming that the
total cost per unit is PhP5,500 (fixed cost of
PhP300,000/100 and variable cost of PhP2,500
as compared to revenue of PhP5,500).

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Example
Solution
On the other hand, a management accountant will
go ahead with the order because in his opinion the
special order will yield PhP3,500 per unit. He
knows that the fixed cost of PhP300,000 is
irrelevant because it is going to be incurred
regardless of whether the order is accepted or not.
Effectively, the additional cost which Company A
would have to incur is the variable cost of PhP2,500
per unit. Hence, the order will yield PhP3,000 per
unit (PhP5,500 minus PhP2,500 of variable cost).

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OPPORTUNITY COST
It is cost of opportunity foregone
How do you calculate opportunity costs?
First, you will not find opportunity costs in
the general ledger. The reason is that opportunity
costs are the profits associated with a missed or
lost opportunity. For example, if a company has a
limited number of machine hours available on its
large specialized machine and the setup time is
four hours, the company is losing the opportunity
of producing profits during those four hours.

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OPPORTUNITY COST
Opportunity costs are often thought of as the lost
contribution margin, which
is revenues minus variable costs. If the large
specialized machine is billed out to customers at
PhP200 per hour and the variable costs of operating
the machine are PhP80 per hour, the contribution
margin and the opportunity cost is PhP120 per
machine hour. During the four-hour setup time, the
company is losing or foregoing the contribution
margin of PhP480. In other words, its opportunity
cost for the setup time is PhP480.

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OPPORTUNITY COST
While this opportunity cost of PhP480 per
setup cannot be recorded in the general
ledger accounts, it should be considered in
quoting or setting prices for customers. It
should also motivate the company to look for
ways to reduce the time needed to set up the
machine.

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OPPORTUNITY COST
Whenever an organization is deciding to go
for a particular project, it should not ignore
opportunities for other projects. It should
consider (i) what alternative opportunities are
there? (2) Which is the best of these
alternative opportunities?

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IRRELEVANT COSTS
Sunk costs are past costs. These cannot be
changed with any future decision. Once the
company's money is spent, that money is
considered a sunk cost. Regardless of what
money is spent on, sunk costs refers to money
already spent and permanently lost. Sunk
costs cannot be refunded or recovered.
For example, once rent is paid, that amount is
no longer recoverable - it is 'sunk.‘
Similarly, a cost which is identical in all
decisions is irrelevant.
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References
hubpages.com/education/Managerial-Accounting-
Decision-Making-Relevant-Costs-Benefits

http://accountingexplained.com/managerial/relevant-
costing/

http://www.accountingcoach.com/blog/calculate-
opportunity-cost

An Introduction to Management Science -

Quantitative Approaches to Decision Making by
Anderson Sweeney and Williams Martin
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