Chapter 5 Relevant Information and Decision Making with a Focus on Pricing Decisions PDF

Chapter 5 Relevant Information and Decision Making with a Focus on Pricing Decisions  The purpose of management accounting as we emphasized before is: To provide information that enables managers to make sound decisions. Accountants have an important role i...

Chapter 5 Relevant Information and Decision Making with a Focus on Pricing Decisions  The purpose of management accounting as we emphasized before is: To provide information that enables managers to make sound decisions. Accountants have an important role in the decision making process, not as a decision makers but as a collectors and reporters of relevant information. The accountant's role in decision making is primarily that of a technical expert on financial analysis who helps managers focus on relevant data, information that will lead to the best decisions.  Objective 1 Discriminate Between Relevant and Irrelevant Information for Making Decisions  Meaning Meaning of of Relevance Relevance This chapter introduces the topic of relevant information. Relevant means pertinent or applicable. When managers make choices among alternatives, all the relevant costs and revenues associated with each alternative must be considered. Decision analysis can be based either on cash flow changes or on changes in accounting income. Long-run decision analysis generally uses cash flow as the decision criterion. Short-run decision analysis, the focus on this chapter, often uses accounting income, although some past costs, such as depreciation on old assets, may be excluded. Relevance defined Relevant information is the predicted future costs and revenues that will differ among the alternatives Note that:  Relevant information is a prediction of the future, not a summary of the past. Historical (past) data are irrelevant to the  decision itself, because the decision cannot affect past data. Decisions affect the future. Nothing can alter what has already happened.  Of the expected future data, only those that differ from alternative to alternative are relevant to decision. Any item that will remain the same regardless of the alternative selected is irrelevant.  For example, let us consider a situation where an individual is uncertain as to whether he should purchase a monthly rail ticket to travel to work or whether he should use his car. Assuming that the individual will keep his car, whether or not he travels to work by train, the cost of his road fund license and insurance will be irrelevant since these costs remain the same irrespective of his mode of the travel. The cost of his petrol will, however, be relevant as this cost will vary depending on which method of transport he chooses.  Let us move on now to consider an example in a business environment. A company is considering the alternative of either purchasing a component from an outside supplier or producing the component itself. The estimated costs to the company of producing the component are as follows: 300 Direct material 100 Direct labor 50 Variable overheads 100 Fixed overheads 550  The outside supplier has quoted a figure of L.E. 500 for supplying the component. Should the company buy or make the component? The comparative cost statements for the two alternatives are as follows: Company Company To Purchase To Component Manufacture.L.E Component.L.E - 300 Direct material - 100 Direct labor - 50 Variable overheads 100 100 Fixed overheads 500 - Supplier's purchase price 600 550  it is assumed in this example that the share of fixed overheads apportioned to the component will still be incurred whether or not the company purchases the component from an outside supplier. Fixed overheard therefore is irrelevant in deciding which alternative to choose. It is also assumed that the company will not incur the direct material, labor, and variable overhead costs if the component is purchased form the outside supplier: These costs will be different depending on which alternative will be chosen and are therefore relevant in making the decision. The supplier's purchase price is also a relevant cost as it will be different for each of the alternatives.  We can therefore represent the cost statements for the two alternatives using only relevant cots as follows: Company Company To To Purchase Manufacture Component Component.L.E.L.E - 300 Direct material - 100 Direct labor - 50 Variable overheads - - Fixed overheads 500 - Supplier's purchase price 500 450  You can see that the two approaches can be used for presenting relevant cost information. You can present cost Alternatively, cost information which information could be include irrelevant costs presented which excludes or revenues, (that is, the the irrelevant costs and fixed cost in this revenues because they example) provides that are identical for both they are included under alternatives. both alternatives and do not mislead the decision maker. Both methods show that future costs will be L.E. 50 lower if the company manufactures the component.  It is important that great care is taken in presenting financial information for decision making. If, in the above example, the company had produced the same component in the pervious period, the component would be valued at L.E. 550 for stock valuation as all manufacturing costs should be taken into account when stock is valued ( for financial accounting purposes). For decision making purposes only future costs that will be relevant to the decision should be included. Costs accumulated for stock valuation purposes must not be used for decision making purposes.  When you are trying to establish which costs are relevant to a particular decision you may find that some costs will be relevant in one situation but irrelevant in another. In the above example direct labor was considered to be a relevant cost, based on the assumption that the company will hire additional labor on a causal basis to produce the component. But now consider what the relevant labor cost will be if the company has a temporary excess supply of labor and intends to obtain the necessary labor hours from its existing labor force at no extra cost? In this situation the labor cost will be the same whichever alternatives is chosen and will not be a relevant cost. :Let us now take the example a stage further Direct materials will not be a relevant cost if the company has purchased the materials in the past and now finds that they are surplus to requirements. If the materials have no alternative use and cannot be sold then the cost will be the same irrespective of which alternative is chosen. Therefore the cost of direct materials is not a relevant cost in this situation.  The above examples show that the identification of relevant costs depends on the circumstances. In one situation a cost may be relevant but in another situation the same cost may not be relevant. It is not therefore possible to provide a list of costs which would relevant in particular situations. In each situation you should follow the principal that the relevant costs are future costs that differ among alternatives.  The important question to ask when determining the relevant cost is: ?What difference will it make It is necessary that the accountant should be aware of all the circumstances under which a decision will be taken and ascertain full details of the changes that will result from the decision, and then proceed to select the relevant financial information to present to management. Quantitative and Qualitative Factors In many situations it is difficult to quantify in monetary terms all the important elements of a decision. Those factors which can be expressed in monetary terms only with much difficulty or imprecision are classified as qualitative factors. It is essential that qualitative factors are brought to the attention of management during the decision-making process, as otherwise there may be a danger of making a wrong decision.  For example, the cost of manufacturing a component internally may be more expensive than purchasing from an outside supplier. However, the decision to purchase form outside supplier could result in the closing down of the company's facilities for manufacturing the component. The effect of such a decision might lead to redundancies and a decline in employee's morale which could affect the future output. In addition the company will become dependent on an outside supplier, who may not always deliver on time. The company may not then be in a position to meet customer requirements in turn this could result in a loss of customer goodwill and a decline in future sales.  It may not be possible to quantify in monetary terms the effects of a decline in employees morale or loss of customers goodwill but the accountant in such circumstances should present the relevant quantifiable financial information and draw attention to those qualitative items which may have an impact on future profitability. In circumstances such as those given in the above example, management must estimate the likelihood of the supplier failing to meet the company’s demand for future supplies and the likely effect on customer goodwill if there is a delay in meeting orders. If the component can be obtained from many suppliers and repeat orders for the company's products are unlikely then the company may give little weighting to these qualitative factors.  Alternatively, if the component can be obtained from only one supplier and the company relies heavily on repeat sales to existing customers, then the qualitative factors will be of considerable importance. In the latter situation the company may consider that the quantifiable cost savings from purchasing the component from an outside supplier are insufficient to cover the risk of the qualitative factors occurring. Accuracy and Relevance In the past, information used for decision making would be perfectly relevant and accurate. However in reality, the cost of such information often exceeds its benefits. Accountants often trade off relevance versus accuracy. Of course, relevance information must be reasonably accurate but not precisely so. Precise but irrelevant information is worthless for decision making. On the other hand, imprecise but relevant information can be useful. For example, sales predictions for a new product may be subject to great error, but they still are helpful to the decision of whether to manufacture the product.  The degree to which information is relevant or precise often depends on the degree to which it is qualitative or quantitative. Qualitative Aspects are: Those for which measurement in pounds and piasters is difficult and imprecise; Those for which measurement is easy and precise.  Just as we noted that relevance is more crucial than precision in decision making, So a qualitative factor may easily carry more weight than a quantitative financial impact in many decisions. For example, mangers sometimes introduce new technology (e.g. advanced computer systems) even though the expected quantitative results seen unattractive. Mangers defend such decisions on the grounds that failure to keep abreast of new technology will surely bring unfavorable financial results sooner or later.  Concept Concept of of Differential Differential Costs Costs and and Revenues Revenues Differential Cost Is a cost that would be different if one alternative, rather than another alternative, were selected. Differential costs are also called relevant costs. The term refers both to certain items of cost and to amounts of cost. Thus in many situations, direct labor is an item of differential cost; also, if the amount of cost that differs in a certain problem is L.E. 1000, the L.E. 1000 is said to be the amount of differential cost.  Differential costs always relate to a specific situation. Contrasts with Full Costs There are three important differences between full costs and differential costs: 1.Nature of the cost : The full cost of a product is the sum of its direct costs plus its equitable share of indirect costs. Differential costs (relevant costs) include only those elements of cost that are different under a set of conditions.  2.Source of Data : Information on full costs is taken directly from a company’s cost accounting system. There is no comparable system for collecting differential costs. The appropriate items that constitute differential costs are assembled to meet the requirements of a specific problem. Each problem is different. Some of the data used to construct differential costs may come from the cost accounting system, but some data come from other sources. 3.Time perspective : The full cost accounting system collects costs on a historical basis, that is it measures what the costs were. Deferential costs always related to the future; they are intended to show what the costs would be if a certain course of action were adopted, rather than what the costs were in some pest period. Note that the accounting system is designed so that it can provide the raw data that are used in estimating the differential costs for a specific problem. Differential Costs Contrasted with Variable Costs Differential costs are not necessarily the same as variable costs. Variable Costs Are those that vary directly with the volume of output. If in a specific problem, the alternatives being considered involve a change in volume, then variable costs, by definition, are differential costs. Differential costs may include fixed costs as well as variable costs. Thus, variable costs are differential costs in problems that involve changing the volume of output, but not otherwise. Opportunity Costs A Special type of relevant costs is an opportunity cost. An Opportunity Cost Represent a potential benefit that is given up because one course of action is chosen over anther. For example, the XYZ company owns a piece of land acquired at a total cost of L.E. 100,000. The company has the opportunity to sell the land for L.E. 500,000. the company’s managers decide to keep the land and use it as the location for the company’s new headquarter. The opportunity cost of this is L.E. 500,000 - the benefit foregone by choosing the alternative of keeping the land rather than selling it. The historical cost of L.E. 100,000 is not relevant to the decision; it is a sunk cost.  Opportunity costs are not measured in accounting records. Costs that are collected within the accounting system are based on past payments. Sometimes it is necessary for decision-making to impute costs which will not require cash outlays, and these imputed costs are called opportunity costs. It is important to not that opportunity costs only apply to the use of scarce resources. Where resources are not scarce no sacrifice exists from using these resources. Note that opportunity costs are of vital importance for decision-making. If no alternative use of resources exists, the opportunity cost is zero. But if resources have an alternative use, and are scarce, then an opportunity cost does exist. Out – Of – Pocket Costs The term out-of-pocket costs refer to cost items that will cause the company to pay money out of its “packet” if the alternative under consideration is adopted. Out-of-pocket costs therefore are the same thing as differential costs in many situations. Opportunity costs however, often are not out-of- pocket costs, so the out-of-pocket costs is not always relevant.  Sunk Costs Is a cost that has already been incurred and, therefore, is irrelevant to the decision making process. Sunk cost should have the same meaning of past cost or historical cost. Depreciation is ordinarily a sunk cost because depreciation is a write-off of the cost of fixed asset, and the cost of the asset was incurred when the asset was acquired. Similarly, the book value of a fixed asset is a sunk cost, it represents that portion of the acquisition cost that has not yet been written off as depreciation expense.  A sunk cost exists because of actions taken in the past, therefore, a sunk cost is not a differential cost. No decision made today can change what has already happened. Sunk costs are irrelevant for decision making, but they are distinguished from irrelevant costs because not all irrelevant costs are sunk costs. For example, a comparison of two alternative production methods may resulting identical direct material expenditure for both alternatives, So the direct material cost is irrelevant because it will remain the same whichever alternative is chosen, but it is not a sunk cost as it will be incurred in the future.  Objective 2 Diagram the Relationships Among the Main Elements of the Decision Process Exhibit 5-1 presents a diagram of decision process and role of information. ) A( (B) )1( Historical Other Informatio Informatio n n )2( Prediction Method Predictions as inputs to Decision Model (3) Decision Model Decisions by Managers With Aid of Decision Model (4) Implementation and Evaluation Feedbac k  represents historical data from the : Box 1 (A) accounting system. represents other data, such as, price : Box 1 (B) indices or industry statistics gathered from outside the accounting system. The data in step (1) help the formulation of predictions in step (2). Note that Although historical data may act as a guide to predicting, they are irrelevant to the decision itself.  In step (3) these predictions become inputs to the decision model. Decision Model Is defined as any method for making a choice. Some models often require elaborate quantitative procedures, such as mathematical programming. A decision model, however, may also be simple.  In step (4) once alternative course of action have been selected, they should be implemented. To monitor performance the accountant produces performance reports. Performance Reports Provide feedback information by comparing planning and actual results.  Objective 3 Analyze Data by Contribution Approach to Support a Decision for Accepting or Rejecting a Special Sales Order  The The Special Special Sales Sales Order Order A special order decision requires that management determines a sales price below the normal price. Special order situations include: 1. Jobs that require a bid, are taken during slack periods, or are made to buyer’s specifications. 2. Private – label orders in which buyer’s name (rather than the sellers) is used on the product. Companies may accept these jobs daring slack periods to more efficiently utilize available capacity. 3. Orders of unusual nature (because of quantity, method of delivery, or packaging), or because the products are being tailor-made to customer instructions. 4. Special pricing can be used when producing goods for a one- time job, such as an overseas order that will not affect domestic sales. Typically, the sales price quoted on a special order should be high enough to cover the variable costs of the job and any incremental fixed costs and generate a profit.  Some important factors must be considered before recommending acceptance of a special order:  It is assumed that future selling price will not be affected by selling at a price below the normal or the going market price  It would not affect total fixed costs  It would use some idle manufacturing capacity  It would not require any additional variable selling and administrative expenses. Special pricing may provide work for a period of time, but it can not be continued over the long run. To remain in business, a company must set selling prices to cover total costs and provide a reasonable profit. Example The Current Income Statement (thousand of dollars ) (thousand of dollars ) 20,000 Sales Less: (15,000) Manufacturing cost Of goods sold (3,000 Fixed + 12,000 variable) 5,000 Gross profit Less 4,000 Selling & administrative expenses (2,900 Fixed + 1,100 variable ) 1,000 Operating income  Contribution Margin Income Statement 20,000 Sales Less: Variable expenses (12,000) Manufacturing cost (1,100) Selling & admin. expenses 13,100 6,900 Contribution Margin Less : Fixed expenses (3,000) Manufacturing cost (2,900) Selling & admin. expenses 5,900 1,000 Operating income  Suppose a customer offered L.E.13 per unit for a 100.000 units special order. :Assuming that this order 1. Would not affect the normal prices 2. Would not affect total fixed costs 3. Would not require any additional variable selling and administrative expenses 4. Would use some idle manufacturing capacity.  Should this company accept or this order?  What is the difference in the short run financial results between accepting and not accepting the order?  Illustrative cases Case (1) : : Assuming that special sales order (SSO) 1.Would not affect the normal prices and sales quantity 2. Would not affect total fixed costs 3. Would not require any additional variable selling expenses 4. Would use some idle manufacturing capacity.  Solution Comparative income statement With SSO Effect of SSO Without (100 000 units) SSO 1100 000 (1000 000 Per total units units) unit 21,300,000 13 1,300,000 20,000,000 Sales Less: Variable costs 13,200,000 12 1,200,000 12,000,000 Manufacturing cost 1,100,000 - - 1,100,000 Selling & admin. 14,300,000 1,200,000 13,100,000 Total variable cost 7,000,000 100,000 6,900,000 Contribution Margin 5,900,000 - 5,900,000 Less : Fixed expenses 1,100,000 100,000 1,000,000 Operating income  Case (2) : The same assumption of case (1), but require additional variable selling expense. Solution Additional cost :- 12 Manufacturing 1.1 Selling & admin. 13.1 (0.1) Decrease in profit Per unit of S.S.O Decrease in profit = 0.1 x 100 000 = 10 000 With SSO Effect of SSO Without )units 000 1000( SSO 000 1100 000 1000( Per total units )units unit 21,300,000 13 1,300,000 20,000,000 Sales Less: Variable costs 13,200,000 12 1,200,000 12,000,000 Manufacturing cost 1,210,000 1.1 110,000 1,100,000 Selling & admin. 14,410,000 13.1 1,310,000 13,100,000 Total variable cost 6,890,000 )10,000( 6,900,000 Contribution Margin  Case (3) : The same assumption as case (2), but assuming that The special sales order would require additional variable selling expenses and the variable selling expenses include 5 % sales commission Solution With Effect of SSO Without SSO SSO )units 00 100,0( (1000 000 units) 000 1100 Per total units Per unit total in unit million 21.3 13 1.3 20 20 Sales Less: Variable costs 13.2 12 1.200 12 12 Manufacturing cost 1.065 0.65 0.065 1 1 Selling & admin. 0.110 0.10 0.010 0.1 0.1 Other selling expense 14.375 12.75 1.275 13.1 13.1 Total variable cost 6.925 0.25 0.025 6.9 6.9 Contribution Margin 5,9 - - 5.9 5.9 Less : Fixed expenses 1.025 0.25 0.025 1 1 Operating income Case (4) : The same assumption as case (2), but assuming that the variable selling expenses include 5 % sales commission and the special sales order would require additional variable selling expenses sales commission Solution 13 S.S.O per unit Less:- 12 U.M.V.C. 0.1 U.S.V.C 12.1 0.9 Increase in profit Per unit Increase in profit = 0.9 x 100 000 = 90, 000  Case (5) : The same assumption as case (1), except that the order was for 250 000 units and a selling price of L.E. 11.5 Solution 2,875, 000 Additional revenue 250.000 units @ 11.5 per unit Less:- additional costs 3,000, 000 Manufacturing variable costs 250 000 unit @ L.E. 12 per unit 125, 000 Decrease in operating income from S.S.O  Comparative income statement With SSO Effect of SSO Without SSO (250 000 (1000 000 units) 1250 000 units) 22,875,000 2,875,000 20,000,000 Sales Less: Variable costs 15,000,000 3,000,000 12,000,000 Manufacturing cost 1,100,000 - 1,100,000 Selling & admin. 16,100,000 3,000,000 13,100,000 Total variable cost 6,775,000 (125,000) 6,900,000 Contribution Margin Less : Fixed expenses 3,000,000 - 3,000,000 Manufacturing cost (at an average rate of L.E.3 × 1000,000 = 3,000,000 & at an average rate of L.E.2.4 1250,000) 2,900,000 - 2,900,000 Selling & admin. 5,900,000 - 5,900,000 Total fixed cost 875,000 (125,000) 1,000,000 Operating income Note Notice that no matter how fixed costs are spread for unit product costing purposes, Total fixed cost are unchanged, even though manufacturing fixed cost per unit fall from L.E. 3.0 to L.E. 2.4  Case (6) : The same assumption as case (1), except that selling price is L.E. 13.5 instead of L.E. 13.00 but a manufacturers agent who had obtained the potential order would have to be paid a flat fee of L.E. 40 000 of the order were accepted what would be the new special-order difference in operating income of the order were accepted. Solution 1,350, 000 Additional revenue 100 000 x L.E. 13.5 Less: additional costs 1,200, 000 Manufacturing variable costs 100 000 unit @ L.E. 12 per unit Less: Fixed costs 40,000 Agent's fee 110, 000 Increase in operating income from S.S.O  you ank Th