Relevant information and decision making


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Management Accounting lecture notes on Relevant Information and Differential Analysis

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Relevant information and decision making

  1. 1. NOTES ON RELEVANT INFORMATION AND DECISION MAKING ...for a course in Management Accounting
  2. 2. I. THE CONCEPT OF RELEVANCE <ul><li>A. What is Relevance? </li></ul><ul><li>Relevant Information - the predicted future costs and revenues that will differ among alternatives. Although past data may be helpful in predicting future costs and revenues, past data is irrelevant in making future decisions. </li></ul><ul><li>The expected future costs that differ between alternatives are the relevant costs to be used in selecting from the competing alternatives. </li></ul>
  3. 3. <ul><li>B. A Decision Model </li></ul><ul><li>Historical data from the accounting system is combined with other data from outside the accounting system to formulate predictions. </li></ul><ul><li>The predictions are then input into a Decision Model (i.e., any method used for making a choice) in order for a decision to be made. </li></ul>
  4. 4. <ul><li>C. Accuracy and Relevance </li></ul><ul><li>Accountants often trade off relevance versus accuracy. Precise but irrelevant information is worthless for decision making. Imprecise but relevant information can be quite useful. </li></ul><ul><li>Qualitative (i.e., measurement in monetary terms is difficult and imprecise) information can be as important, or more important, than quantitative information . </li></ul>
  5. 5. II. THE SPECIAL SALES ORDER <ul><li>Illustrative Example: </li></ul>
  6. 6. II. THE SPECIAL SALES ORDER (CONT’D) <ul><li>Misuse of Unit Cost: </li></ul><ul><li>Misinterpreting fixed unit costs may cause a manager to decide that a special order results in a bad decision due to a mistreatment of the fixed manufacturing costs (i.e., treating them as variable). </li></ul><ul><li>Avoid Confusing Variable and Fixed Costs! </li></ul><ul><li>Activity-Based Costing, Special Orders, and Relevant Costs: </li></ul><ul><li>Businesses that have identified all their significant cost drivers can predict the effects of special orders more accurately. </li></ul>
  7. 7. <ul><li>III. Deletion or Addition of Products, Services, or Departments </li></ul><ul><li>Avoidable Costs - will not continue if an ongoing operation is changed or deleted. These costs are relevant in making the decision. </li></ul><ul><li>Unavoidable Costs - will continue even if an operation is halted. These are not relevant because they will not differ between alternatives. Unavoidable costs may include Common Costs – costs of facilities and services that are shared by users (e.g., building depreciation, heating, air conditioning, and general management expenses). </li></ul><ul><li>The same principles regarding relevance applied to special orders apply to decisions concerning adding or deleting products or departments. </li></ul>
  8. 8. IV. OPPORTUNITY COSTS, OUTLAY COSTS, DIFFERENTIAL COSTS <ul><li>Opportunity Cost - maximum available contribution to profit forgone (i.e., rejected) by using limited resources for a particular purpose. </li></ul><ul><li>Outlay Cost - requires a cash disbursement sooner or later and is the typical cost recorded by accountants. </li></ul><ul><li>Presenting revenues, costs, and income of two alternatives and the differences in those revenues, costs, and incomes is referred to as differential analysis . </li></ul><ul><li>Differential Costs (or Incremental Costs ) – the difference in costs between two alternatives. Examples provided include an employee quitting her job to go into business for herself and changing the production level of automobiles. </li></ul><ul><li>It is important to consider opportunity costs when evaluating alternative courses of action. </li></ul>
  9. 9. V. MAKE-OR-BUY DECISIONS <ul><li>Basic Make or Buy and Idle Facilities </li></ul><ul><li>Manufacturers have to decide whether to make or buy parts and subassemblies that go into their final products. Some companies make all their own parts and subassemblies in order to assure product quality, while others buy most of theirs to protect mutually advantageous long-run relationships with suppliers. Many companies only make parts if their facilities cannot be used to better advantage. </li></ul><ul><li>When idle facilities exist, quantitative factors bearing on the decision typically include the direct material, direct labor, variable overhead, fixed overhead that may be avoided if the part is purchased, and the purchase cost of buying the parts. </li></ul>
  10. 10. V. MAKE-OR-BUY DECISIONS (CONT’D) <ul><li>Basic Make or Buy and Idle Facilities </li></ul><ul><li>(cont’d) (The key to make-or-buy decisions is identifying the additional costs for making (or the costs avoided by buying) a part or component. Using activity analysis can help in identifying these costs.) </li></ul><ul><li>The alternative uses for the facilities that would be occupied if the part was made should be considered. The basic example can be expanded to include the possible renting out of the space used to make the parts, and the possibility of producing other products in that space. In all cases, companies should relate these decisions to the long-run policies for the use of capacity. </li></ul>
  11. 11. VI. OPTIMAL USE OF LIMITED RESOURCES <ul><li>If a plant that makes more than one product is being operated at capacity, the orders to accept are those that make the biggest total profit contribution per unit of the limiting factor. </li></ul><ul><li>Limiting Factor or Scarce Resource - an item that restricts or constrains the production or sale of a product or service. For example, in retail sales, the limiting resource is often floor space. Thus, retail stores must either focus on products using less space or using the space for shorter periods of time (i.e., greater Inventory Turnover - number of times the average inventory is sold per year). Do not emphasize those products that give the largest contribution per sales Peso or per unit of product. </li></ul>