Decision Making & Relevant

Information:
Non-Routine Decisions

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 Decision-making Process
The term decision implies that the decision maker is faced with
more than one alternative to choose from. Obviously one
cannot make a decision if only one action is available.

Decision-making process frequently involves the following

steps:
1) Define clearly the problem to be solved or the situation
about which a decision is to be made.
2) Identify all possible alternative courses of action.
3) Gather relevant information about each alternative.
4) Make a decision.
5) Review the results of the decision to obtain feedback so as
to
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improve future decisions.
 The Concept of Incremental Analysis
Business decisions involve a choice among
alternative courses of action. In making such
decisions, management considers both financial
and non-financial information.
The process used to identify the financial data
that change under alternative courses of action
is called incremental analysis.
In incremental analysis, both costs and
revenues may change.

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 The Concept of Relevant Information
Managers should include in the decision model only
data (information) that are relevant to the decision
under consideration.
Relevant information can be defined as expected
Future cash flow (costs and revenues) that will
differ among the alternative courses of action
available to the decision maker.
These data are relevant to the decision because they
will vary in the future among the possible
alternatives.

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 Relevant Information
Historical costs - are sunk costs, and hence, they are
irrelevant to decision-making.
Opportunity costs are income forgone on the next-
best alternative. Opportunity cost is an economic
concept that represents potential gain or income that
could have been earned from the next best use of a
resource (alternative course of action).
Opportunity costs are relevant to decision-making and
should be considered in the decision making process
whenever it is possible.
The difficulty with opportunity costs is that they do not
represent actual out-of-pocket costs, and therefore, they
are not recorded by the accounting system.

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Quantitative and Qualitative Information
Quantitative factors are outcomes that are
measured in numerical terms
E.g., expected costs, sales revenues and
volumes
Qualitative factors are outcomes that
cannot be measured in numerical terms
E.g., employee morale, customer satisfaction,
product quality and efficiency

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 Accepting a Special Order
Sometimes, when a company has spare (idle)
production capacity, it may be willing to fulfill
Special Orders for non-regular customers.
Normally, the prices quoted are lower than those
for regular customers.

Special orders are one-time orders that do not

affect a company's normal sales. The profit from
a special order equals the incremental revenue
less the incremental costs.

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 Accepting or Rejecting a one time only special order

An order at a special price should be accepted when the

incremental revenue from the order exceeds the incremental
costs:
1) It is generally assumed that sales to regular customers will
not be affected by the special order.

2) If the units of the special order can be produced within

existing plant capacity (i.e., using the idle capacity of
production), generally only variable costs will be affected.

3) If the units of the special order can not be fulfilled using the
idle capacity, then, the company should consider either:
(i) giving up some of its regular sales or
(ii) incur additional fixed costs to increase the existing capacity
to satisfy the special order. 8
 One time only special orders

Minimum selling price = incremental

costs associated with the special order. These
costs usually include variable costs.

What about Fixed costs? It depends on

whether idle capacity exists or not:
- If Yes - fixed costs are irrelevant.
- If No - Incremental fixed costs to obtain
added capacity are relevant.
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Example 1:
Company A has capacity to produce 100,000 units of product X.
The cost estimate per unit based on current capacity of 80% is as
follows:
$ per unit
Direct material $5.00
Direct labor $3.00
Variable production overhead $2.00
Fixed production overhead $4.00
Shipping cost $1.00
Sales Commission $2.00
Fixed production overhead $3.00
Total $20.00
Selling price/unit 25.00

A non- regular customer has approached the company

to purchase 20,000 units at $16 each.
Required: Should Company A accept this special order?

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Example 2: (Special Order)

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Example 3
XYZ manufactures MP3 players (personal digital audio players) in Hamilton. The company operates this
year at 90% of its total production capacity. XYZs manufacturing capabilities are limited by the total
machine hours available. The plant capacity is 90,000 machine hours per year. Each unit requires .25
machine hours. The company allocates variable factory overhead to production using machine hours as an
allocation base. Financial data for the XYZ MP3 player are:

Regular selling price per unit $ 100

Costs per unit:
Raw materials $ 35
Direct labor, 0.5 hour @ $ 60 30
Variable overhead, 0.25 machine hour @ $ 16 4
Fixed overhead 6
$ 75

XYZ has received a special-order inquiry from Avignon Co. for 20,000 MP3 players at $ 65 each. These
MP3s would be marketed under the Avignon label. The Avignon MP3 player requires $ 40 of Raw
Material, 0.25 hour of direct labor, and 0.5 hour of machine time. In addition, XYZ will incur $ 15,000
in additional setup costs and will have to purchase a $ 45,000 special device to manufacture Avignons
players; this device will be sold at $ 5,000 once the special order in completed.

If production capacity is not sufficient to fulfill the special order, the manager of XYZ is willing to forgo
some of the regular sales as long as the special order is profitable.

Required:
Should XYZ accept the special order (show all calculations)?
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 Make-or-Buy Decision (Outsourcing )
A make or buy decision is concerned with whether
certain goods or services should be made internally or
purchased from an external supplier.
The decision to buy goods or services externally is also
known as outsourcing. Outsourcing is more commonly
associated with decisions by organizations to shift their
focus toward accomplishing core activities internally and
allowing outside organizations to accomplish peripheral
activities.
In recent years, many companies have chosen to
outsource support service activities such as information
systems technology, human resources, accounting and
payroll activities.

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 Make-or-Buy Decision
In a make-or-buy decision (also known as
outsourcing decision), the relevant costs are
(a) the variable manufacturing costs that will be
saved,
(b) the purchase price, and
(c) opportunity costs from using the released
facilities in different activities (e.g., renting
these facilities to another company or using
them to increase production of another
component) .
(d) avoidable fixed costs of the released
facilities.
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Example 1:
Company A has to decide whether to manufacture internally or to
buy from outsiders. Company A is able to contract with another
company to supply them the product at $5 each. The details of
Company A internal production costs are as follows:

Direct material/unit $2.00

Direct labour/unit $3.00
Variable production overhead $0.50
Fixed production overhead $0.50
Total production per unit cost $6.00

The company also need to pay for transport charges of

$5,000 for the delivery of 3,000 units of the product.
Required: Should Company A make or buy the product?
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Dropping an Unprofitable Production line or
a Department
Managers must sometimes decide whether to keep or drop a
business unit. A business unit may be a product, market
territory, department, facility, or any other type of segment
that can be identified as a distinct unit.
The decision to drop a business unit may occur for a variety
of reasons, including decline in market demand,
obsolescence of the product, or inability to remain
competitive.
Making the decision to keep or drop a business unit cannot
be made based on segmented income statements. Financial
statement information contains allocated costs that are not
relevant to the decision.
The decision must be based only on relevant costs and
revenues. If a segment is dropped, what revenues will go
away? What costs will go away? If the costs to be eliminated
exceed the revenues, then it is probably wise to discontinue
the segment.
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Example:

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 Equipment replacement decisions
In a decision to keep or replace equipment, management
compares the costs which are affected by the two alternatives.
Generally, these are variable manufacturing costs (e.g., operating
costs, maintenance cost etc.) and the cost of the new equipment.

Historical costs are always irrelevant:

- Cost of equipment (old)
- Book value of equipment
- Gain or loss on sale of old equipment
- Depreciation of old asset

Relevant costs include:

- Disposal value of old and new assets
- Purchase price of the new asset
- Operating expenses in the remaining useful life of both old and
new assets
- Effects on taxes from gain or loss on sale
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Example:

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Other Topics (not covered):

Joint Costs
Utilization of a Constrained Resource

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 Pricing Decisions
Among the many pricing decisions to be
made are:
Setting the price of a new product
Setting the price of products sold under
private labels
Responding to a new price of a competitor
Pricing bids in both sealed- and open-bidding
situations

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 Economic Theory and Pricing
Perfect Competition: a market in which a firm can sell as
much of a product as it can produce, all at a single
market price. If it charges more, no customer will buy; if
it charges less, it sacrifices profits

Marginal Cost: the additional cost resulting from

producing and selling one additional unit

Marginal Revenue: the additional revenue resulting from

the sale of an additional unit

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 Pricing Decisions
Price is a function of :
cost
legal requirements
elasticity of demand
competitors actions
marketing considerations
business strategy

Contribution Variable Mark-Up

Approach Costs 52.67%

Absorption Variable Fixed Mark-Up

Approach Costs Costs 5.26%

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 Target Pricing & Target Costing
Traditional Approach
Determine costs and add on a mark-up to set selling prices

Costs Mark-Up Price

+ =
Target Costing and Target Pricing
First determine the price at which the product will sell
Then design a product to be produced at a low enough
cost to provide an adequate profit margin over target cost

Target Target
Margin
Price - Costs =

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