Management Accounting Chapter 5 Quiz

Chapter 5: Relevant Information and Decision Making

• Management accounting provides information for sound decisions.
• Accountants collect and report relevant information, not make decisions themselves.
• Accountants are technical experts in financial analysis, aiding managers in focusing on relevant data for best decisions.

Objective 1: Discriminating Between Relevant and Irrelevant Information

• Relevant information is pertinent or applicable to a decision.
• When making choices, consider all relevant costs and revenues for each alternative.
• Decisions can be based on cash flow changes or accounting income.
• Long-run decisions often use cash flow, whereas short-run decisions often use accounting income. Some past costs (e.g., depreciation) might be excluded from short-run analysis.
• Relevant information predicts the future; historical information is irrelevant to the current decision.
• Only items that differ between alternatives are relevant. Items staying the same across different alternatives are irrelevant.

Relevance Defined

• Relevant information is the predicted future costs and revenues differing across alternatives.
• Historical data, unaffected by the decision, is irrelevant.
• Example:
  • Costs like road fund license/insurance are irrelevant to choice of car vs. train travel if the individual will keep the car.
  • Petrol cost is relevant because it changes depending on transportation method

Business Example - Component Sourcing

• A company considers sourcing components either internally (producing themselves) or externally (from a supplier).

• Internally estimated component production costs are:

  • Direct materials: 300
  • Direct labor: 100
  • Variable overhead: 50
  • Fixed overhead: 100
  • Total internal cost: 550

• An external supplier quotes L.E. 500.

• Fixed overhead is irrelevant in the decision; it's incurred regardless of the choice.

• Direct material and labor, variable overhead associated with the decision to make are relevant, and will differ between the decision to make and buy.

• The supplier's quote (L.E. 500) is a relevant cost because it differs between the alternatives.

• The analysis is limited to relevant costs only to produce the component to compare with buying it from the supplier, thereby leading to making better decisions.

Relevant Costs and Alternatives

• Presented costs can either include or exclude irrelevant costs, leading to the same decision
• The final decision showed that producing internally would be cheaper by L.E. 50
• Managers should be mindful of the potential for future cost changes and potential issues, like quality control, supplier reliability or timely deliveries
• Accountants should focus their analysis of potential effects in any case

Relevant Costs vs. Accuracy

• In reality, providing perfectly accurate and relevant information is challenging and costly.
• Tradeoffs between accuracy and relevance are often made for decision-making.
• Precise but irrelevant information is useless, but imprecise but relevant data can still be helpful, especially when predicting future events.

Qualitative Factors

• Quantitative factors (e.g., monetary values) are essential but also consider qualitative factors.
• Qualitative factors are those difficult to express in monetary terms (employee morale, customer goodwill, etc.).
• Qualitative factors can significantly influence decisions, e.g., maintaining in-house manufacturing capacity even if slightly more costly, or choosing an external provider despite potential unforeseen external factors

Differential Costs

• Differential cost: A cost that differs between alternative courses of action.
• Relevant costs are also termed differential costs. Differential costs can be single items or amounts of cost.
• Examples:
  • Direct labor
  • Material cost

Differential Costs vs. Full Costs

• Full cost represents the total cost of a product, including direct plus allocated overhead.
• Differential cost only considers elements of cost that change between alternatives.
• Historical costs, unrelated to choosing between alternatives, are irrelevant.

Source of Data

• Data for full costing comes directly from the firm's accounting system, which records historical costs.
• Data for differential/relevant costing comes from various sources, including the accounting system, as well as external research.

Time Perspective

• Full costs are backward-looking; they reflect historic costs.
• Relevant costs are forward-looking, based on future costs that change, given certain operational decisions made.
• The accounting system gathers necessary historical and relevant data as required by a specific decision.

Differential Costs and Variable Costs

• Variable cost varies proportionally to the volume of output.
• If a decision involves changing the output volume, then variable costs (and even fixed) become differential/relevant costs.

Opportunity Cost

• Opportunity cost: Potential benefit sacrificed when selecting a particular course of action.
• Includes any benefit foregone because of a chosen action.
• Example: If a company could sell a piece of land, its opportunity cost is the potential revenue from the sale. A sunk cost would be the initial purchase cost, which is not relevant to the alternative options

Out-of-Pocket Costs

• Out-of-pocket costs: Costs that involve cash payments if a particular alternative is chosen.
• Often the same as differential/relevant costs but must consider opportunity costs.

Sunk Costs

• Sunk cost: Costs already incurred, irrelevant for decision-making today.
• Depreciation is often considered a sunk cost (it's a past/historical cost).
• Examples: Costs already paid for, investments of any value, past errors, and previous decisions

Special Sales Order Analysis

• Special sales orders often involve selling below normal prices in slack periods, private labeling, non-standard quantities and delivery methods, etc.
• Analysis focuses on incremental revenue and variable costs.
• Relevant factors include variable costs of the special order, whether it affects regular production or not, possible additional fixed costs and administrative expenses, and how the offer would affect the company's long term plans. (e.g. If the order will be sustainable, rather than a one time job)
• Opportunity costs are important and must be considered.

Quantitative and Qualitative analysis

• The decision making process involves careful evaluation of both quantitative (financial, numerical data) and qualitative (non-financial, like employee morale, customer relations, and so on) factors.

Conclusion(s)

Management accounting relies on relevant data to make sound judgments based on the choice of different alternatives, whilst carefully balancing the needs of short to long-term objectives, and qualitative impacts.

This quiz covers Chapter 5 of Management Accounting, focusing on how relevant information aids decision-making. It emphasizes distinguishing between relevant and irrelevant information and the role of accountants in providing necessary insights for managers. Test your understanding of decision-making based on relevant data.