chpt 11- decision making & relevant information
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DECISION MAKING & RELEVANT INFORMATION:
Chapter 11
1) DECISION MODELS
A decision model is a formal method of making a choice, often involving both
quantitative and qualitative analyses
Managers often use some variation of the Five-Step Decision-Making Process
Five-Step Decision-Making Process
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
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2) RELEVANCE
Relevant Information has two characteristics:
It occurs in the future
It differs among the alternative courses of action
Relevant Costs = expected future costs
Relevant Revenues = expected future revenues
KEY POINTS: From the above fundamental definition
1.) Relevant costs are FUTURE CASH FLOWS arising as a direct
consequence the decision being taken.
NON-relevant costs are those that will remain unaltered (No
DIFFERENCE) regardless of the decision being taken.
2) PAST costs are already incurred & therefore SUNK costs.
Past cost may be useful as a basis for cost prediction
3) COMMITTED costs, though will be paid in future, are costs that had
already been decided & committed in the past. This future cash flow will be
incurred anyway regardless of the decision being considered i.e. it makes no
difference in the alternatives.
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Relevant Costs (or Revenues) are expected FUTURE cash flows ( costs or revenues) that DIFFER among alternative courses of action
4) OPPORTUNITY COST is a special type of relevant cost. It represents
the benefit sacrificed or forgone when choosing one course of action in
preference to an alternative. E.g. benefits or revenue forgone
Opportunity Cost is the contribution to operating income( or profit) that
is foregone by not using a limited resource in it’s next-best alternative use
“How much profit did the firm ‘lose out on’ by not selecting this alternative?”
E.g. Opportunity Cost for holding Inventory = Funds tied up in inventory
are not available for investment elsewhere
5) AVOIDABLE COST is relevant : Costs that would be avoided if a
decision is being taken.
Cost saving due to more efficient plant,
tax savings
6) DIFFERENTIAL or INCREMENTAL Cost is relevant : It is the
difference in the TOTAL cost between alternatives.
7) GAIN OR LOSS on disposal or sale of assets
a) The Gain or Loss represent the ARITHMETICAL difference between the
Disposal Price(relevant) and Book Value(irrelevant historical Cost). It
is MEANINGLESS
b) To consider SEPRATELY the relevant items :
- the Disposal Price inflows
- the disposal costs outflows
- cash tax on disposal gain outflows
8) DEPRECIATION: Asset depreciation (be it increase or decrease in amount of
depreciation charged) is irrelevant since it is NOT a cash low. The only relevant
amount is the change in TOTAL Asset cost ( e.g. purchase of new asset) which
involves cash flow.
9) COST OF CAPTAL
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Can be considered as part of Opportunity Cost. It represents cost of fund
tied up or alternative income forgone for using own fund
Examples:
- Cost of working capital( net change in inventory, AR, AP)
- Carrying cost of inventory
- Interest income on savings deposit forgone
Note: Under Capital Budgeting where DCF is applied, the Cost of Capital is
embedded(or built-in) in the Discounting Rate as part of WACC
10) UNIT Costs – Cautious !
The danger of unitization of fixed cost . Example: Production(fixed) overhead
of $ 4 per unit ( derived by total production overhead of $800,000 divided by
200,000 units ). This gives the impression the cost would vary with volume
and therefore would WRONGLY treat it as relevant variable cost.
Unitized cost depends on the volume level (denominator) used, and therefore
can be misleading
How to overcome these issues? Use TOTAL cost ($800,000)rather than the
unit cost($4 per unit)
11) FIXED & VARIABLE Costs Can be Relevant & Irrelevant
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a) In general, variable costs will be relevant costs and fixed costs
will be irrelevant to a decision.
Unless you are given an indication to the contrary, you should ASSUME the
following.
Variable costs are relevant costs.
Fixed costs are irrelevant to a decision.
Note: Indeed this is the assumption when applying CVP analysis and
Marginal Costing, where variable costs are assumed to vary with volume
and fixed costs remain fixed over the relevant range of volume. (see Note
on CVP)
b) HOWEVER, this need not be the case, and you should analyse
variable and fixed cost data carefully. Do not forget that 'fixed'
costs may only be fixed in the short term & in relation to a
relevant range of activity. See examples below.
Example of Non-relevant Variable Costs
There might be occasions when a variable cost is in fact a sunk cost (and
therefore a non-relevant variable cost). For example, suppose that a company
has some units of raw material in inventory. They have been paid for already, and
originally cost $2,000. They are now obsolete and are no longer used in regular
production, and they have no scrap value. However, they could be used in a
special job which the company is trying to decide whether to undertake. The
special job is a 'one-off' customer order, and would
use up all these materials in inventory.
(a) In deciding whether the job should be undertaken, the relevant cost of the
materials to the special job is nil. Their original cost of $2,000 is a sunk cost,
and should be ignored in the decision.
(b) However, if the materials did have a scrap value of, say, $300, then their
relevant cost to the job would be the opportunity cost of being unable to sell them
for scrap, ie $300.
( c ) Assuming if the useless material is not utilized, it would need to be disposed off
by incurring disposal cost of $500. Then the relevant cost (or relevant saving) for
using up this material would be the cost saving of $500.(inflow)
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Example of Relevant Fixed Costs : Attributable fixed costs
There might be occasions when a fixed cost is a relevant cost, and you
must be aware of the distinction between :
'specific' or 'directly attributable' fixed costs, and
general fixed overheads.
Directly attributable fixed costs are those costs which, although fixed
within a relevant range of activity level, are relevant to a decision for either
of the following reasons.
(a) They could increase if certain extra activities were undertaken. For
example, it may be necessary to employ an extra supervisor if a
particular order is accepted. The extra salary would be an attributable
fixed cost.
(b) They would decrease or be eliminated entirely if a decision were
taken either to reduce the scale of operations or shut down entirely.
General fixed overheads are those fixed overheads which will be unaffected
by decisions to increase or decrease the scale of operations, perhaps because
they are an apportioned (see APPORTIONED COST)share of the fixed costs
of items which would be completely unaffected by the decisions. General fixed
overheads are not relevant in decision-making.
FAST FORW
ARD
12) APPORTIONED COST is a notional accounting cost and is NOT
relevant. BUT increase in TOTAL overhead incurred is relevant
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Example: The apportionment of overhead would be IRRELEVANT if the total
overhead incurred remain the same.
e.g. Overhead apportioned to project A of $40.000 is irrelevant since the total
overhead incurred remains the same at $100,000.
Project A Project B Project C TOTALOverhead Incurred
Overhead Allocation BEFORE decision to have Project A
Nil $70,000 $30,000 $100,000
Overhead Allocation AFTER decision to have Project A
$40,0000 $35,000 $25,000 $100,000
Overhead Allocation AFTER decision to have Project A
$70,0000 $40,000 $10,000 $120,000
But if the TOTAL overhead incurred increase to say $120,000 because of
decision to have Project A, then the RELEVANT overhead would be $20,000(i.e.
increase in total overhead incurred which is cash outflow). The new
apportioned overhead $70,000 is IRRELEVANT
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13 ) QUALITATIVE NON-FINANCIAL FACTORS
Equally important
Major Non-financial or qualitative information :
Reputation
Brand
Quality & reliability
Trade secret
Management experience
Staff Skills
Customers loyalty & reaction
External factors – Political(government), economic, social &
technology(PEST)
Examples: In the case of out-sourcing & make or buy decisions
- Quality of supply
- reliability of supply
- risk of dependency on suppliers
- Reputation of suppliers
- Control over product design and trade secrets
Example: A Special Order ( at lower price)
Though it makes business sense to accept a special order if the Relevant Revenue >
Relevant Cost ( i.e. result in positive contribution), this might have the following
qualitative implication:
Existing regular customers, if they come to know about it, would not be
happy(Customer ) . This might in turn affect your business reputation
If the selling price is a government-controlled price, this special price would violate
the rule. (External Factor – political)
This special pricing (below economic market equilibrium price) would also disrupt supply
& demand. (External Factor – economic)
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Relevant Cost Analysis: ALL items vs. RELEVANT items Approach
2 ways to do Relevant Cost Analysis:
1) ALL items(revenues & costs) approach
2) RELEVANT items(revenues & costs) approach
Both gives the same outcome
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Potential Problems with Relevant-Cost Analysis
1) Incorrect general assumptions that :
all variable costs are relevant
all fixed costs are irrelevant
Fixed costs could be relevant, as long as they meet the “Relevant cost Criteria”
2) Unit Cost ( or Average Cost) : Unitization of Cost
This can potentially mislead decision makers in 2 ways:
( i ) When irrelevant costs are wrongly considered as relevant costs
( ii ) The same unit costs (or average costs) are applied at different output level
Example: Production of Notebooks
Output :Total number of notebooks produced = 1,000 units
Total direct(variable) production cost =$2,000,000
Total indirect production cost =$3,000,000
Note :Indirect production cost is assumed fixed & would not change whatever the
decision( i.e. sunk cost)
Therefore Total production cost = $5,000,000
Unit Cost = $5,000,000 / 1,000 units = $5,000 per unit
( i ) When irrelevant costs are wrongly considered as relevant costs:
Very often this Unit Cost ($5,000 per unit) makes it appears to be like variable
cost & therefore wrongly treated as relevant cost for decision making.
Irrelevant cost of $3,000 had been included in this Unit Cost of Notebook
above. Therefore, a special order at a price of $3,500 each would have been
wrongly rejected as “below cost” if Unit Cost of $5,000 is taken as variable &
therefore relevant cost.
( ii ) The same unit costs (or average costs) are applied at different output
level (or Relevant Range)
Unit costs should be used cautiously. Since unit costs change with a
different level of output or volume, it may be more prudent to base
decisions on a TOTAL dollar basis.
Unit costs that include fixed costs should always be in reference to a
given level of output or activity(relevant range)
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Therefore, the average(or unit) cost of $5,000 is ONLY CORRECT at
output level of 1,000 units. But the Unit Cost of $5,000 makes it appears
that it is the correct unit cost at any output level !
Example: What is the total cost of production for 1,200 units ?
Applying the Unit Cost of $5,000 would give a Total Cost of $6,000,000. , which
consist of:
Variable cost ($2,000 X1,200 units) = $2,400,000
Fixed cost ($3,000 X1,200 units) = $3,600,000
This wrongly concludes that the Fixed Cost had increased from
$3,000,000 to $3,600,000. Similarly, if a lower units of say 900 units is
considered which gives Fixed Cost as $2,700.000 - a decrease from
$3,000,000 !!!
HOW TO OVERCOME THESE PROBLEMS ?
a) Use TOTAL costs (or revenues), instead of Unit cost(revenue)
b) Apply the “Relevant Cost Criteria” & continually evaluate data to ensure that it
meets the requirements of relevant information
In summary: What is relevant ?
Expected TOTAL FUTURE costs (or revenues) that DIFFER among
the alternatives
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MAJOR AREAS of Relevant Costs: 1) The relevant cost of materials
2) The relevant cost of labour
3) The relevant cost of an asset: The Deprival Value
1) The relevant cost of materials
The relevant cost of raw materials is generally their current replacement cost, unless
the materials have already been purchased and would not be replaced once used. In
this case the relevant cost of using them is the higher of the following.
Their current resale value
The value they would obtain if they were put to an alternative use
If the materials have no resale value and no other possible use, then the relevant
cost of using them for the opportunity under consideration would be nil.
Question Note: See ACCA Text Page 347 for examples
2) The relevant cost of labour
Where labour must be hired from outside the
organisation, the relevant cost of labour will be the variable costs incurred.
Spare capacity is assumed to be paid anyway and
therefore not relevant.
Opportunity costs: contribution forgone by losing
other work
Incremental cost.
Absorbed overhead is a notional accounting cost
and should be ignored.
Only the Actual overhead incurred is
relevant.
Note: See ACCA Text Page 348 for examples
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3) The relevant cost of an asset: The Deprival Value The value to the business of any asset can be defined as its deprival value, i.e.
by how much the company would be worse off if it were to be deprived of the
asset (e.g. by selling it, or it being worn out after years of use as a fixed asset).
Deprival Value is derived as follow:
.
Note:
a) NRV (or value in exchange) = the sales proceeds less the future costs of sale.
b) The value in use is defined as the present value of the future cash flows
obtainable as a result of the continued use of an asset, including those resulting
from its eventual final disposal. This will involve the use of the technique of
discounting future cash flows.
An example of an asset for which value in use might be the
appropriate value to the business could be an old specialised machine
which would not be replaced but which is still producing cash flows with
a net present value which exceeds the asset's net realisable value. In a
situation like this, the company will logically retain and use the asset rather
than sell it.
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Deprival Value = LOWER of:
Replacement Cost Recoverable Value, which is HIGHER of:
Net Realisable Value(NRV)= Sale Proceed – Sale costs
Value in Use= NPV on continuing use of asset
Note: See ACCA Text Page 350 for examples
Detailed Explanation : Deprival Value
The value to the business of any asset can be defined as its deprival value, i.e.
by how much the company would be worse off if it were to be deprived of the
asset (e.g. by selling it, or it being worn out after years of use as a fixed asset).
The deprival value of any asset can be defined as the LOWER of its:
- REPLACEMENT COST (if it can in fact be replaced) - i.e. its value in
exchange in the market in which the company can purchase the item
- RECOVERABLE VALUE, which in turn is defined as the HIGHER of:
what the company could SELL it for
the value that the company could create by USING the asset
within the business, i.e. the asset's value in use
This is a logical guide for the company to follow in making a rational value-
maximising decision.
a) If the recoverable value exceeds the replacement cost, then if the company
were deprived of the asset it would go out and buy another to replace it, if this
is possible. The replacement cost will therefore set a MAXIMUM loss that the
company can suffer if it were deprived of the asset, hence RC represents
the MAXIMUM asset value.
b) However if the economic benefit that arises from ownership of the asset (i.e. the
recoverable value) is less than the cost of replacing it, then if the company
were deprived of the asset it would logically choose NOT to replace it. How
the recoverable value is calculated depends on what the company is
planning to do with it (RATIONAL INTENT), which will of course depend on
how it considers that it can make most money (or other benefit) from it. It has 2
basic choices:
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1) to sell it (NRV or value in exchange), or
2) to use it within the business (value in use);
and it will logically select whichever of these offers the highest return.
c) The MINIMUM value of asset is NRV . Why ? Because if RC or PV < NRV, it
would be logically NOT to hold the asset & sell it a NRV.
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TYPES OF DECISIONS1.) One-Time-Only Special Orders
2.) Insourcing vs. Outsourcing or Make or
Buy
3.) Product-Mix & Capacity Constraint
(Limiting Factor)
4.) Customer Profitability
5.) Branch / Segment: Adding or
Discontinuing
6.) Equipment Replacement
7.) Decisions & Performance Evaluation
1.) One-Time-Only Special Orders
Accepting or rejecting special orders when there is idle production capacity and
the special orders has no long-run implications
Decision Rule: does the special order generate additional operating
income(profit)?
Yes – accept
No – reject
Compares relevant revenues and relevant costs to determine profitability
Importance of long-run implications on future revenues & costs .e.g.
acceptance of special orders at a price lower(and still make profit) than current
price to existing regular customers might trigger existing regular customers to
demand for a lower price. This would impact future revenues and therefore
relevant items for decision.
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Special Order : Using Absorption-Based Budgeted Income Statement as
Starting point
Both VC & FC of manufacturing are included in cost of inventory & cost of
goods sold
Full costs of product include ALL costs
Special Order Illustration : Contribution Margin Approach
Splitting FC & VC
Derive contribution margin
Identifying relevant & non relevant items
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2) Insourcing vs. Outsourcing (or Make-or-Buy)
Insourcing (or Make)– producing goods or services within an organization
Outsourcing (or Buy)– purchasing goods or services from outside vendors
Decision Rule: Select the option that will provide the firm with the lowest cost,
and therefore the highest profit. E.g. below, make(or insourcing) has lower cost,
But also do consider qualitative factors such as the following when making Make or
Buy decision :
- Quality of supply
- reliability of supply
- risk of dependency on suppliers
- Reputation of suppliers
- Control over product design and trade secrets
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Make-or- Buy Decision : Total Alternative vs. Opportunity
Costs Approach
Under Total Alternative approach Consider future costs & revenues for
ALL alternatives are considered
Under Opportunity Cost approach Focus on future costs + opportunity
cost of making or buying alternatives
Take note of the implication of capacity constraint.- impact on opportunity
lost or gain
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3) Product-Mix Decisions & Capacity Constraints
With LIMITING FACTOR
The decisions made by a company about which products to sell and in what
quantities
Decision Rule: choose the product that produces the highest contribution
margin per unit of the constraining resource
RANKING of product mix: Rank in the order of “contribution margin per
unit of the constraining resource”
How to overcome Constraints or Limiting Factor ?
- outsourcing
- rescheduling
- improve efficiency & productivity
- Training
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4) Customer Profitability: Adding or Dropping Customers
Decision Rule: Does adding or dropping a customer add operating income(i.e.
Profit) to the firm?
Yes – add or don’t drop
No – drop or don’t add
Decision Rule: based on impact on profitability of the customer, not how
much revenue a customer generates. i.e. focus on value not volume
Customer Profitability Analysis, Illustrated
Customer Profitability Analysis: Dropping & Adding Customer
Decisions: Effect on Profitability
Dropping Wisk results in lower profit by $15,000 Do not drop
Adding Loral results in MR>MC by $6,000 or increase profit by the same amount Add
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5.) Adding or Discontinuing Branches or Segments
Decision Rule: Does adding or discontinuing a branch or segment add operating
income(or profit) to the firm?
Yes – add or don’t discontinue
No – discontinue or don’t add
Decision is based on impact on profitability of the branch or segment, not
how much revenue the branch or segment generates
Adding/Closing Offices or Segments, Illustrated
Decisions: Effect on Profitability
Closing Allied West results in lower profit by $42,000 Do not close
Opening Allied South results in MR>MC by $17,000 or increase profit by $17,000 Open
6.) Equipment-Replacement Decisions
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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 & is IRRELEVANT
Decision Rule: Select the alternative that will generate the highest operating
income(i.e. Profit)
Equipment-Replacement Decisions, Illustrated (Considering Both Relevant &
Irrelevant Costs)
Equipment-Replacement Decisions, Illustrated (Considering Relevant Costs Only)
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7.) Decisions & Performance Evaluation: Behavioral
Implications
Despite the quantitative nature of some aspects of decision making, not all
managers will choose the best alternative for the firm
Goal incongruency : conflict of managers’ & organisation’s goals
Managers’ performance evaluation : What get measured & rewarded get
done
Decisions model might not be consistent with Managers’ performance
evaluation model
E.g. Maintenance or replacement of plant might result in positive value over
long term under decision model, but would pull down the short-term
profitability(the basis the managers’ performances are judged). Under this
scenario managers could engage in self-serving behavior such as delaying the
needed equipment maintenance in order to meet their personal profitability
quotas for bonus consideration.
How to overcome this problem? Design Managers’ performance evaluation
model that are consistent with decision model.
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