Relevant Information and Decision-Making Chapter 6

Relevant Information and Decision-Making

• Chapter 6 focuses on relevant information and decision-making, particularly regarding operational decisions.
• Objective 1: Defining and using opportunity cost to analyze income effects of alternatives.
• Opportunity cost: The maximum potential contribution to profit that is forgone by using limited resources for a particular purpose. It is not the usual recorded outlay cost but the contribution of the best alternative that is excluded.
• Outlay cost: A cost requiring a cash disbursement; the typical cost recorded by accounts.
• Differential cost (or incremental cost): The difference in total costs between two alternatives.

Opportunity Cost

• The contribution to profit of the rejected alternative is the opportunity cost. This alternative is excluded from consideration
• Example: Salary forgone by a person who quits a job to start a business.

Alternatives under Consideration

• A comparison of potential alternatives (e.g., remaining as an employee vs. opening a new business).

• Data is provided in a table format to determine revenue, outlay costs, and income effect for each alternative.

• The opportunity cost from the forgone salary is illustrated by one table showing the new business versus remaining as an employee.

Make or Buy Decisions

• Companies often decide whether to produce their parts internally or acquire them externally.
• Qualitative (like quality control) and quantitative (cost) factors influence the decision.
• Relevant costs in make-or-buy: Additional variable costs and fixed costs avoided if a part is bought instead of being manufactured.
• Tables show a comparison between 'Make' and 'Buy' options, including purchase cost, direct material, direct labor, variable factory overhead, fixed factory overhead (avoidable) and total relevant cost for both options.

Make or Buy: Use of Facilities

• Make-or-buy decisions depend on optimal utilization of available facilities.
• The choice includes whether to make or buy, how to use resources best.
• Resources can be used for other manufacturing or rented.

Alternatives

• Tables present various alternatives for the decision to 'make or buy'. Alternatives and the accompanying data show implications like rent revenues, contributions from other products or obtaining of parts.

Example

• Tables demonstrate revenue, variable costs, and the computation of contribution margin and operating income for different product lines (like electrical and mechanical components).

Required Analysis

• Examples of required analyses for prospective or alternative decisions, like special orders, impact of the company buying parts instead of making them, and producing alternative versions of a product.

Solution

• Demonstrates the calculations for special orders, highlighting the criticality of recognizing opportunity costs
• Detailed breakdown of costs to support decisions, highlighting relevant costs

Segment Margin (or Product Line Margin)

• Excess of revenue over both direct variable costs and avoidable fixed costs. Represents the amount left to cover unavoidable fixed costs plus generate profit.
• This figure forms the basis for making decisions on continuing or discontinuing product lines or specific segments.

Cost Categories (Avoidable & Unavoidable Costs)

• Avoidable Costs: These costs can be eliminated if a specific segment is discontinued.
• Unavoidable Costs: These costs will continue despite the segment's shutdown. Common costs are a key example of unavoidable costs.
• The focus in decision making is usually on avoidable costs

Deletion or Addition of Products/Departments

• The same principles for evaluating special orders apply to decisions on adding or deleting product lines/departments. Avoidable and unavoidable costs are critical factors.
• Avoidable costs are relevant
• Unavoidable costs are not relevant

Segment Margin Income Statement

• Provides a structure for analyzing cost structure (like avoidable and unavoidable costs) to inform product or segment decisions.
• Shows Sales, Variable costs, Contribution Margin, Avoidable fixed expenses, Segment margin, Unavoidable Fixed Costs and operating income
• Tables include categories with values, or examples of values to calculate a margin

Store as a Whole

• Tables showcase the impact of dropping certain segments on the store's performance (like in the case of the grocery department, and the effect of the store's overall performance) - This section analyzes the store's performance before and after a change.

Assumptions

• Clarifying assumptions that underlie a decision (e.g., no alternative use for assets released by dropping a segment).

Optimal Use of Limited Resources

• The contribution approach is used to identify the best product mix to maximize profit when limited resources (scarce resources).
• This involves ranking products based on contribution margin per unit of the limiting factor.
• Limiting factors (or constraints) are the factors that hold back production (like labor hours, machine hours or square footage).

Difficulties in Procedure

• Applying the procedure if more than one scarce resource exists requires more complex methods (e.g., linear programming).