CHAPTER 11 DECISION MAKING AND RELEVANT INFORMATION LEARNING OBJECTIVES Use the five-step decision process to make decisions Differentiate relevant from irrelevant costs and revenues in decision situation Distinguish between quantitative and qualitative factors in decisions Beware of two potential problems in relevant-cost analysis Explain the opportunity-cost concept and why it is used in decision making Know how to choose which products to produce when there are capacity constraints Discuss what managers must consider when adding or discontinuing customers and segments Explain why the book value of equipment is irrelevant in equipment-replacement decisions Explain how conflicts can arise between the decision model used by a manager and the performance evaluation model used to evaluate the manager CHAPTER OVERVIEW Chapter 11 is about the decision-making process Accountants are an integral part of this process, providing information to decision makers A five-step approach to making decisions, beginning with the point in the process in which the accountants typically become involved, is described in the chapter An extremely useful concept is presented The information needed for the decision process must be relevant to the decision Relevant is defined as revenues and costs that occur in the future and differ among the alternative courses of action available to the decision maker This definition is illustrated through various situations In this chapter the information needed for decisions of one-time-only special orders, make-or-buy, drop-or-add, and keep-or-replace are explained Several of the chapters that follow will introduce other types of decisions that use the concept of relevant revenues and costs A major theme of the text is that information generated by the accounting system is used for the benefit of managers in making decisions The roles performed by accountants are implicit in the illustrations of relevant information gathered for decisions—problem solving, scorekeeping, and attention directing A review of those roles from Chapter could be used to highlight their importance in the decision process The last step of the decision process is evaluating performance The last section of the chapter deals with conflicts between the decision model used by a manager and the performance model then used to evaluate that manager This is an important discussion Linear programming as a tool in the decision process is described in the appendix Decision Making and Relevant Information 141 CHAPTER OUTLINE I Information and the decision process A Define the decision under consideration TEACHING TIP: A clear understanding of the purpose of the decision is helpful in working through the steps in the decision process By carefully and quite specifically defining the decision to be made, the determination of relevant costs and relevant revenues for each alternative is usually easier Continued emphasis on the definition of relevant cannot be overdone Learning Objective 1: Use the five-step decision process to make decisions B Employ five-step decision-making process [Exhibit 11-1] Obtain information a Historical costs b Other information Make predictions Choose an alternative—must have at least two Implement decision Evaluate performance to provide feedback C Use feedback [Refer to Chapter 1] Affect future decisions Affect prediction method Affect implementation of the decision Do multiple choice Assign Exercise 11-16 II The meaning of relevance [Exhibit 11-2] Learning Objective 2: Differentiate relevant from irrelevant costs and revenues in decision situations A Definition of relevant costs and revenues Occur in the future 142 Chapter 11 a Past costs may be useful basis for making informed predictions of expected future costs/revenues b Unavoidable past costs that cannot be changed are sunk costs Differ among alternative courses of action (What difference does it make?) a Same conclusion if use only that which differs and if use all data b Pertinent data used saves time and maintains focus Do multiple choice Assign Exercise 11-18 B Outcomes of alternatives [Exhibit 11-3] Learning Objective 3: Distinguish between quantitative and qualitative factors in decisions Quantitative factors: outcomes measured in numerical terns Qualitative factors: outcomes that cannot be measured in numerical terms III Illustrations of relevance A Choosing output levels—example of one-time-only special order [Exhibits 11-4 and 11-5] Understand conditions of decision (obtain information) a Decision to accept or reject one-time-only special order b Idle capacity available c No long-run implications of accepting the order Identify relevant revenues and costs a Income statement format—maximize income b Full costs identified by amount and type Do multiple choice Assign Exercises 11-19 Learning Objective 4: Beware of two potential problems in relevant-cost analysis c Beware of two potential problems in relevant-cost analysis i Avoid incorrect general assumptions such as all variable costs are relevant and all fixed costs are irrelevant Decision Making and Relevant Information 143 ii Avoid losing sight of grand totals and focusing instead on unit costs • Unit costs mislead when irrelevant costs are included • Unit costs mislead when same unit costs are used at different output levels iii Require each item to be expressed as total future revenue or cost B Insourcing-versus-outsourcing—example of make-versus-buy decisions Understand conditions of decision (obtain information) a Idle capacity available b Qualitative factors c If outsourcing, what use made of idled facility (new choice) Identify relevant revenues and costs a Minimize costs b Know full costs by amount and type i Incremental costs: additional total costs incurred for an activity ii Differential cost: difference in cost between two alternatives Use strategic and qualitative factors in choosing among alternatives [Exhibit 11-6] a In-house to maintain control over design, quality, reliability, delivery schedules b Outsource to be smaller and leaner organization, focusing on areas of core competencies i Use long-run contracts to minimize risks of dependence on suppliers ii Build partnership with suppliers iii Allow suppliers to gain expertise and grow [VW Concepts in Action] Choose best use of available facilities [Exhibit 11-7] a Continue to make product—do not outsource b Buy product – choice of use for idled facilities and of schedule for purchasing product Do multiple choice Assign Exercise 11-20 and Problem 11-35 Learning Objective 5: Explain the opportunity-cost concept and why it is used in decision making 144 Chapter 11 i Consider opportunity cost: contribution to income that is forgone by not using a limited resource in its next-best alternative use ii Include opportunity cost because it represents best alternative way organization may have used its resources had it not made the decision it did [AA Concepts in Action] Do multiple choice and Assign Exercise 11-21 and Problems 11-30 and 11-31 C Product-mix decisions under capacity constraints Learning Objective 6: Know how to choose which products to produce when there are capacity constraints Understand conditions of decision (obtain information) a Level of capacity is a constraint—only be expanded in the long run b Demand is a constraint c Other constraints: availability of direct materials, components, skilled labor, financial factors, display space, etc Identify relevant revenues and costs a Maximize operating income b Analyze individual product contribution margin c Focus on maximizing total contribution margin by choosing products with highest contribution margin per unit of the constraining factor Do multiple choice Assign Exercises 11-22 and 11-23, Problems 11-29 and 11-32 D Add or discontinue a product line—example of customer profitability Understand conditions of decision (obtain information) a Customer (product line) as cost object b Activities associated with servicing customer (activity-based costing approach) Identify relevant revenues and costs [Exhibit 11-8] a Maximize profit b Know full costs of activities and types of costs (hierarchy) Learning Objective 7: Discuss what managers must consider when adding or discontinuing customers and segments Decision Making and Relevant Information 145 c Ignore allocated overhead costs d Focus on how total costs differ among alternatives [Exhibit 11-9 and 11-10] Choose among alternatives a Reduce company’s costs of supporting the customer b Charge higher prices to customer c Discontinue the customer as an account d Work with customer to reduce costs of supplying product e Consider strategic factors and long-run relationship Do multiple choice Assign Exercises 11-24, 25, and 26, Problems 11-33 and 11-34 E Keep or replace decisions—example of equipment Learning Objective 8: Explain why the book value of equipment is irrelevant in equipment-replacement decisions Understand conditions of decision a If keep, company has equipment because of past decision (past cost) b Past costs, particularly book value of existing equipment, is irrelevant Identify relevant revenues and costs [Exhibit 11-11] a Minimize costs (maximize income if revenues are relevant) b Future revenues and costs are relevant [Exhibit 11-12] i Cash operating cost relevant ii Disposal price of old machine relevant iii Cost of new machine relevant Do multiple choice Assign Exercises 11-27 and 11-28 Learning Objective 9: Explain how conflicts can arise between the decision model used by a manager and the performance evaluation model used to evaluate the manager IV Decisions and performance evaluation 146 Chapter 11 A Manager will favor decision alternative that looks best for performance whether decision is best for company B Time frame for decision is longer than time frame for performance evaluation C Accounting systems rarely track each decision separately so impacts of many different decisions are combined in a single performance report D Managers may hesitate because of how a decision would “look” to supervisors if supervisors have no knowledge of alternative choices Do multiple choice 10 Assign Problems 11-37 and 11-38 V Appendix: Linear programming [Exhibit 11-13] A Steps in solving a linear programming problem Determine the objective function: goal to be maximized (income) or minimized (costs) Specify the constraints: mathematical inequality or equality that must be satisfied by the variables in a mathematical model Compute the optimal solution a Trial-and-error approach b Graphic approach B Sensitivity analysis Do multiple choice 11 through 16 CHAPTER QUIZ SOLUTIONS: 1.c 2.b 3.a 4.d 5.b 6.a 7.c 8.d 9.c 10.b 11.b 12.a 13.d 14.b 15.c 16.d Decision Making and Relevant Information 147 CHAPTER QUIZ Which of the following should not be considered for every option in the decision process? a Relevant revenues b Relevant costs c Historical costs d Opportunity costs What is always the question to ask to determine if revenues or costs are relevant? a What is the time frame for achieving results? b What difference will an action make? c Who will be responsible? d How much will it cost? [CPA Adapted] Mikaelabelle Products sells product A at a selling price of $40 per unit Mikaelabelle’s cost per unit based on the full capacity of 500,000 units is as follows: Direct materials Direct labor Indirect manufacturing (60% of which is fixed) $ 10 $19 A one-time-only special order offering to buy 50,000 units was received from an overseas distributor The only other costs that would be incurred on this order would be $4 per unit for shipping Mikaelabelle has sufficient existing capacity to manufacture the additional units In negotiating a price for the special order, Mikaelabelle should consider that the minimum selling price per unit should be a $17 b $19 c $21 d $23 The following data apply to questions and Troy Instruments uses ten units of Part Number S1798 each month in the production of scientific equipment The unit cost to manufacturing one unit of S1798 is presented below Direct materials Materials handling (10% of direct materials cost) Direct manufacturing labor Indirect manufacturing (200% of direct labor) Total manufacturing cost $ 4,000 400 6,000 12,000 $22,400 Materials handling represents the direct variable costs of the Receiving Department that are applied to direct materials and purchased components on the basis of their cost This is a separate charge in addition to indirect manufacturing cost Troy’s annual indirect manufacturing cost budget is one-fourth variable and three-fourths fixed Duncan Supply, one of Troy’s reliable vendors, has offered to supply Part Number S1798 at a unit price of $17,000 [CMA Adapted] If Troy purchases the S1798 units from Duncan, the capacity Troy used to manufacture these parts would be idle Should Troy decide to purchase the parts from Duncan, the unit cost of S1798 would a decrease by $3,700 b decrease by $5,600 c increase by $3,600 d increase by $5,300 [CMA Adapted] Assume that Troy Instruments does not wish to commit to a rental agreement to rent all idle capacity but could use idle capacity to manufacture another product that would contribute $60,000 per month If Troy elects to manufacture S1798 in order to maintain quality control, Troy’s opportunity cost is a $(53,000) 148 Chapter 11 b $7,000 c $(24,000) d $36,000 6 Which of the following is not a correct use of the term “opportunity cost”? a Opportunity costs are considered period costs rather than inventoriable costs for accounting purposes b Opportunity costs must be considered by managers when making decisions c Opportunity cost plus the incremental future revenues and costs equal the relevant revenues and costs of any alternative when capacity is constrained d The opportunity cost of holding inventory is the income forgone by tying up money in inventory and not investing it elsewhere Nicholas, Inc., has provided the following unit data for review: Simple Product $22.75 10.00 Selling price Variable cost Pounds of scarce raw material per unit Advanced Product $55.00 34.50 Which product, Simple or Advanced, is most profitable for Nicholas, Inc., to manufacture? a Both in ratio of : b Both in ratio of : c Simple d Advanced RCG Services is investigating its profitability relationship with each of its customers What is the key question RCG should ask in deciding to keep or to drop a particular customer? a b c d Will the customer meet a specific designated gross margin percentage? Will the customer be willing to pay a higher price to insure RCG’s profitability? Will enough customers be found to replace any customers dropped for lack of profitability? Will expected total corporate office costs decrease if decision is to drop the customer? [CPA Adapted] At December 31, 2001, Brown Co had a machine with an original cost of $90,000, accumulated depreciation of $75,000, and an estimated salvage value of zero On December 31, 2001, Brown was considering the purchase of a new machine having a five-year life, costing $150,000, and having an estimated salvage value of $30,000 at the end of five years In its decision concerning the possible purchase of the machine, how much should Brown consider as sunk cost at December 31, 2001? a $150,000 b $120,000 c $90,000 d $15,000 10 Which of the following is not a reason for the performance evaluation model to differ from the decision model? a b c d The use of different time frames: one being an annual basis, the other a period of several years The accounting systems enable each decision to be tracked separately The accrual accounting method incorporates irrelevant costs Top management is rarely aware of particular desirable alternatives that were not chosen by subordinate managers Decision Making and Relevant Information 149 Questions 11-16 demonstrate the use of linear programming (appendix to Chapter 11) Belmont Company manufactures and sells two products, shirts and gloves, in its two-department plant Belmont employs linear programming to determine its optimum product mix Economic data pertaining to the two products are presented below Shirt[S] $22 Selling price per unit Cost data per unit Variable manufacturing cost Variable marketing cost Fixed manufacturing cost Fixed marketing cost c d (1/6)S + (1/10)G ≤ 960; (1/4)S + (1/2)G ≤ 1,920 (1/6)S + (1/4)S + (1/10)G + (1/2)G ≤ 2,880 10S + 6G ≤ 960; 15S + 30G ≤ 1,920 10S + 15S + 6G + 30G ≤ 2,880 [WOS] The solution where S = and G = 3,000 would a b c d 14 MAX TCM = 10S + 16G MAX TCM = 12S + 24G MAX TCM = 14S + 28G MAX TCM = 7S + 15G [CMA Adapted] The algebraic formulation of Belmont's monthly direct labor constraints is a b c d 13 be the optimal solution be an infeasible solution be a corner point be a feasible solution [WOS] A feasible solution for Belmont Company is where [to the nearest whole dollar] a G = 0; S = 7,680 15 c G = 9,600; S = d G = 3,840; S = 5,760 have a contribution margin of $69,120 produce 5,760 shirts produce 3,840 gloves have no excess direct labor capacity [WOS] If the selling price of gloves is $34 rather than the predicted $40, what will be the cost to Belmont of this prediction error? a a 150 b G = 0; S = 5,760 [WOS] At the optimal mix, Belmont will a b c d 16 12 [CMA Adapted] The algebraic formulation of Belmont's objective function is a b 12 Direct Labor Data Cutting Finishing 10 minutes 15 minutes minutes 30 minutes 960 hours 1,920 hours Shirt [S] Gloves [G] Monthly capacity 11 Gloves[G] $40 $23,040 Zero, since gloves are not produced under either cost Chapter 11 c $8,238 d $14,802 WRITING/DISCUSSION EXERCISES Use the five-step decision process to make decisions How does a “five-step decision process” differ from the decision process illustrated for planning and control in an earlier chapter? Do different kinds of decisions require the use of different models? The basic model for decision making is quite similar to a “thinking model” because decision making is thinking The two processes mentioned are not different in approach but in how they are described Each thinking or decision model require the similar steps of ♦ defining or clarifying the problem to be solved or the situation about which a decision is to be made or an objective to be achieved ♦ gathering relevant information about the problem, situation, or objective ♦ choosing from among at least two different solutions, alternatives, or approaches ♦ implementing the solution, alternative, or approach chosen ♦ evaluating the results of the action taken ♦ using feedback to improve next decision Each decision does not require a formal process The steps are not rules or a checklist but are descriptive of how people process situations [Refer to Writing/Discussion Exercises Chapter 1, Learning Objective and Chapter 9, Learning Objective 7] Differentiate relevant from irrelevant costs and revenues in decision situations In the study of financial accounting, a primary characteristic of accounting information is relevance How does that fit with the concept of relevance in cost accounting? The In the Statements of Accounting Concepts issued by the Financial Accounting Standards Board, the two primary characteristics of accounting information are relevance and reliability These characteristics support the overall characteristic of decision usefulness Accounting information, whether developed for cost accounting or financial accounting, derives its value from improving decisions Each of the two primary qualities, relevance and reliability, have significance in any type of accounting As studied in financial accounting (FASB Statements of Accounting Concepts), relevance has three aspects: timeliness, feedback value, and predictive value These same aspects are incorporated in the definition of relevant in the text—future costs or revenues that make a difference among the alternatives Decision Making and Relevant Information 151 Distinguish between quantitative and qualitative factors in decisions Why should the accountants have to concern themselves with qualitative factors? Numbers are neutral Numbers are neutral but they are also symbols Symbols represent an idea, a thought, a concept, or some thing Qualitative factors are the more basic factors because numbers typically represent some quality Ways are found to value or assign numbers to those things that were considered quality factors, such as product quality that is now studied in cost accounting as “costs of quality” with numbers representing aspects of product quality Is a basketball player worth $2,000,000 when a day-care worker is paid $22,000 per year? The numbers are neutral but speak boldly to qualitative issues The imperative for accountants is that they understand what is “behind the numbers” so they know what numbers to gather and report Understanding the qualitative issues in any decisions will make a difference in the numbers gathered and reported The difference should not be due to bias but due to purpose Beware of two potential problems in relevant-cost analysis Can costs be stereotyped? If one deals with costs such that generalizations are always used in place of careful consideration of an individual situation, then the problem of stereotyping can occur To think that all fixed costs are irrelevant would be a kind of cost stereotyping To use a unit cost across several levels of activity without considering the relevant range might result in a generalization that could be harmful if used in making a decision Explain the opportunity-cost concept and why it is used in decision making Are opportunity costs like grass that is always greener on the other side of the fence? Opportunity costs are those costs that might have been Because they not happen, one cannot know opportunity costs with any certainty The exercise of considering “what might be if ” can be useful to a company Having to consider other alternatives clarifies the action to be taken—to choose this is also to reject that The use of scarce resources or limited resources should always be seen in the light of alternatives Obviously one cannot make a decision if only one action is available—with one action possible, there is dictate, not decision To have to think about other possibilities and realize opportunities as alternatives could expand the options The opportunities are not always better, but it is better to consider them before the decision is made Know how to choose which products to produce when there are capacity constraints How is the concept of constraining factors or resources related to the concept of the accounting system reflecting the underlying operations of a company? Constraining resources are a short-run concept, but accounting works for providing information for both the short run and the long range If the accounting systems accurately reflect the operations of a company, the accountant can notice trends and direct attention to them For example, in the case of limited machinehours, the accountant can report contribution margin per machine-hour If skilled labor is in short supply, the accounting reports can highlight costs in terms of how they support the workers in accomplishing their tasks The accounting system can be designed to insure that the company gets the most out of the things that the most for it 152 Chapter 11 Discuss what managers must consider when adding or discontinuing customers and segments In dropping or adding customers or segments, should the way in which costs are assigned to the cost objects be considered? Assigning costs to the cost object includes both cost tracing and cost allocation For decisions of adding or dropping customers or segments, one needs to be careful of those costs that have been allocated Allocated costs should be looked at as a total for all of the cost objects to which they relate If one cost object is dropped, does the total cost decrease? If another cost object is added, does the total cost increase? Total cost to be allocated is more important than how it is allocated in making these decisions Traced costs can be readily noted as to their disposal or addition Explain why the book value of equipment is irrelevant in equipment-replacement decisions Explain the statement “All future costs are not relevant but all relevant costs are future costs.” Book value that would be written off in the future is not a relevant cost Book value represents a cost that has already happened and any decision made afterwards could not change the decision that caused the equipment to be purchased initially (except in science fiction stories) Costs that not affect the decision, though they are costs yet to be, are not relevant A relevant cost must be one that makes a difference among the alternatives If nothing can be done to prevent the cost from occurring, that cost is not a matter of choice—decisions are making choices and a future cost that cannot be prevented from occurring is not relevant (must make a difference) One must have a choice as to whether to incur the cost or not to incur the cost for the cost to be relevant to a decision or choice A cost that has already been incurred is no longer in the category of to be or not to be Explain how conflicts can arise between the decision model used by a manager and the performance evaluation model used to evaluate the manager Why can the conflict between the decision model used by a manager and the performance model used to evaluate the manager be compared to a chemical change? As stated in the text, the practical difficulty is that accounting systems rarely track each decision separately Individual managers are making many decisions at any given time Hopefully the results of the decisions weave together in such a way that the company operates “like a well oiled machine.” One particular manager might look good because his/her decisions occurred in combination with decisions of another manager and that combination worked just right at that given moment in that given place Both managers benefit and are so evaluated Can a performance model be developed that would consider the wide possibilities that could result from the various combinations of decisions and events? Cost-benefit approach would have to be used A chemical change results from a combination of individual factors creating a different product With enough experimentation, feedback, and knowledge, one can predict the product that will result from the combinations of different factors A performance evaluation model could be developed in a similar fashion Decision Making and Relevant Information 153 SUGGESTED READINGS Brimson, J., “Technology, Sunk Costs, and the Make-or-Buy Decision,” Journal of Cost Management (Fall 1987) p.52 [4p] Christensen, L and Sharp, D., “How ABC Can Add Value to Decision Making,” Management Accounting (May, 1993) p.38 [5p] Einhorn and Hogarth, “Going Forward in Reverse,” Harvard Business Review (January-February 1987) p.66 [5p] Harrison, P and Shanteau, J., “Do Sunk Cost Effects Generalize to Cost Accounting Students?” Advances in Management Accounting (1993) p.171 [16p] Rudd, M and Deutz, J., “Moving Your Company Online,” Management Accounting (February 1999) p.28 [5p] Yankelovich, D., “How Public Opinion Really Works,” Fortune (October 5, 1992) p.102 [7p] 154 Chapter 11 [...]... characteristic of accounting information is relevance How does that fit with the concept of relevance in cost accounting? The In the Statements of Accounting Concepts issued by the Financial Accounting Standards Board, the two primary characteristics of accounting information are relevance and reliability These characteristics support the overall characteristic of decision usefulness Accounting information, ...WRITING/DISCUSSION EXERCISES 1 Use the five-step decision process to make decisions How does a “five-step decision process” differ from the decision process illustrated for planning and control in an earlier chapter? Do different kinds of decisions require the use of different models? The basic model for decision making is quite similar to a “thinking model” because decision making is thinking The two processes... Relevant Information 153 SUGGESTED READINGS Brimson, J., “Technology, Sunk Costs, and the Make-or-Buy Decision, ” Journal of Cost Management (Fall 1987) p.52 [4p] Christensen, L and Sharp, D., “How ABC Can Add Value to Decision Making, ” Management Accounting (May, 1993) p.38 [5p] Einhorn and Hogarth, “Going Forward in Reverse,” Harvard Business Review (January-February 1987) p.66 [5p] Harrison, P and Shanteau,... feedback to improve next decision Each decision does not require a formal process The steps are not rules or a checklist but are descriptive of how people process situations [Refer to Writing/Discussion Exercises Chapter 1, Learning Objective 3 and Chapter 9, Learning Objective 7] 2 Differentiate relevant from irrelevant costs and revenues in decision situations In the study of financial accounting, a primary... cost accounting or financial accounting, derives its value from improving decisions Each of the two primary qualities, relevance and reliability, have significance in any type of accounting As studied in financial accounting (FASB Statements of Accounting Concepts), relevance has three aspects: timeliness, feedback value, and predictive value These same aspects are incorporated in the definition of relevant. .. Harrison, P and Shanteau, J., “Do Sunk Cost Effects Generalize to Cost Accounting Students?” Advances in Management Accounting (1993) p.171 [16p] Rudd, M and Deutz, J., “Moving Your Company Online,” Management Accounting (February 1999) p.28 [5p] Yankelovich, D., “How Public Opinion Really Works,” Fortune (October 5, 1992) p.102 [7p] 154 Chapter 11 ... important than how it is allocated in making these decisions Traced costs can be readily noted as to their disposal or addition 8 Explain why the book value of equipment is irrelevant in equipment-replacement decisions Explain the statement “All future costs are not relevant but all relevant costs are future costs.” Book value that would be written off in the future is not a relevant cost Book value represents... choice—decisions are making choices and a future cost that cannot be prevented from occurring is not relevant (must make a difference) One must have a choice as to whether to incur the cost or not to incur the cost for the cost to be relevant to a decision or choice A cost that has already been incurred is no longer in the category of to be or not to be 9 Explain how conflicts can arise between the decision. .. used by a manager and the performance evaluation model used to evaluate the manager Why can the conflict between the decision model used by a manager and the performance model used to evaluate the manager be compared to a chemical change? As stated in the text, the practical difficulty is that accounting systems rarely track each decision separately Individual managers are making many decisions at any... of decisions and events? Cost-benefit approach would have to be used A chemical change results from a combination of individual factors creating a different product With enough experimentation, feedback, and knowledge, one can predict the product that will result from the combinations of different factors A performance evaluation model could be developed in a similar fashion Decision Making and Relevant