2. Decision Model
• Managers usually follow a decision model for choosing among
different courses of action
• A decision model is a formal method for making a choice, often
involving quantitative and qualitative analysis.
• A decision model is any method used for making a choice,
sometimes requiring elaborate quantitative procedures
• Management accountants analyze and present relevant data to
guide managers’ decisions.
• According to Trewartha and New port (1976), Decision-making
involves the selection of a course of action from among two or more
possible alternatives in order to arrive at a solution for a given
problem.
3. Five-step Decision-Making Process
1. Obtain Information
2. Make prediction about future cost
3. Choose an alternatives
4. Implement the Decision
5. Evaluate Performance
4. The Concept of Relevance
• Relevant costs and relevant revenues are expected future costs and
revenues that differ among alternative courses of action.
• Two primary characteristics distinguish relevant from useless
information:
a. It differs among the alternatives under consideration
b. It is future oriented
Since, relevant revenues differ between the alternative, they are
sometimes called differential revenues.
They are included in making decisions.
Two broad categories of costs are never relevant in any decision.
They include:
1. Sunk Costs
2. A future cost that doesn’t differ between the alternatives
5. Quantitative and Qualitative Relevant Information
• Quantitative Factors: are out comes that can be measured in
numerical terms.
• Quantitative factors can be either financial or non-financial.
• Quantitative financial factors include: DMC, DLC, MOH, Marketing,
profitability, financial ratios etc….
• Quantitative non-financial factors include: Market share (%),
Reduction in new product development time, percentage of on time
flight arrivals, etc..
• Qualitative factors: are outcomes that are difficult to measure
accurately in numerical terms, such as satisfaction.
• Qualitative factors are just as important as quantitative factors even
though they are difficult to measure.
• Example: product & service quality, employee Morale, Supplier
reputation, delivery schedule, logistical considerations-distance
from plant, customer opinions etc.
6. Relevant information can have both quantitative
and qualitative characteristics
• For example, suppose you are deciding which of two laptops to
purchase. Computer A costs ETB 300 more than computer B. Both
computers satisfy your technical requirements; however Computer
A has a more attractive appearance.
• Question: Which computer do you prefer to purchase?
7. Qualitative factors: A bank industry applications
• For example, the qualitative factors a bank might consider when
deciding whether to keep or eliminate a branch location include the
following:
• Competition- Do our competitors have a branch office located here?
• Economic conditions-Is the community growing?
• Social Issues- Will keeping this branch benefit the community we
serve?
• Product or service quality- Can we attract more business because of
the quality of service at this branch?
• Timeliness- Does the branch promote customer service?
8. Key Features of Relevant Information
• Past(historical) costs may be helpful as a basis for making
predictions.
• However, past costs, are always irrelevant when making decisions.
• Relevance is context-sensitive: A particular cost that is relevant in
one context may be irrelevant in another.
• Not all expected future revenues and expected future costs are
relevant.
• Expected future revenues and expected future costs that do not
differ among alternatives are irrelevant and, hence can be
eliminated from the analysis.
• The key question is always, what difference will an action make?
• Appropriate weight must be given to qualitative factors and
quantitative non financial factors.
9. Terminologies
• Incremental cost- the additional total cost incurred for an activity.
• Differential cost- the difference in total cost between two
alternatives
• Incremental revenue- the additional total revenue from an activity
• Differential revenue- the difference in total revenue between two
alternatives
• Avoidable costs- are the costs managers can eliminate by making
specific choices.
• Unavoidable costs- are costs that continue even if a subunit or an
activity is eliminated and are not relevant for decision
• Avoidable costs are relevant costs
• Unavoidable costs are irrelevant costs.
10. Sunk Costs
• All costs incurred in the past that cannot be changed by any decision
made now or in the future.
• Sunk costs should not be considered in decisions
• Example: You bought an automobile that cost ETB 10,000 two years
ago. The ETB 10,000 cost is sunk because whether you drive it, park
it, trade it, or sell it, you cannot change the ETB 10,000 cost.
11. Exercises
• Capital corporation is considering eliminating one of its operating
segments. Capital employed a real estate broker to determine the
marketability of the building that houses the segment. The broker
obtained three bids for the building: ETB 250,000 ETB 262,000 and
ETB 264,000. The book value of the building is ETB 275,000. Based
on this information alone, what is the relevant cost of the building?
• Answer: The book value of the building is a sunk cost that is not
relevant. There are three bids for the building, but only one is
relevant because Capital could sell the building only once. The
relevant cost of the building is the highest opportunity cost, which
in this case is ETB 264,000.
12. Types of Decision
• Marketing Decisions:
One-time only special orders
Keep or Drop Decision
Product-mix with capacity constraints
• Productions Decisions:
Insourcing versus outsourcing (Make or Buy)
Sell or process further
13. Accept or Reject one time only special orders
• A special order is a one time order that is not considered part of the
company’s normal ongoing business.
• A special order occurs:
• When a customer requests a one-time order at a reduced sales price
or significantly below its normal selling price
• Often, these special orders are for large quantities
• Special Order Considerations:
• Do we have excess capacity available to fill this order?
• Will the reduced sales price be high enough to cover the
incremental costs of filling the order(the variable costs of filling the
order and any additional fixed costs)?
• Will the special order affect regular sales in the long run?
14. DECISION RULE: Accept Special Order?
• If the revenue from the special order exceeds the incremental costs
of filling the order-Accept the special order
• If the revenue from the special order is less than the incremental
costs of filling the order- Reject the special order
15. Example
• A company receives a special order for 200 units that requires
stamping the buyer’s name on each unit yielding an additional fixed
cost of ETB 400 to its normal costs. With out the order, the company
is operating at 75% of capacity and produces 7500 units of product
at the costs below. The company’s normal selling price is ETB 22 per
unit. The sales price for the special order is ETB 18 per unit.
Costs(7,500 units) Variable costs per unit Fixed Costs
Direct Materials ETB 37,500 ETB 5
Direct Labor 60,000 ETB 8
Overhead(30%
Variable)
20,000 ETB 0.8 ETB 14,000
Selling Expenses(60%
Variable)
25,000 ETB 2 ETB 10,000
16. Cont.….d
• The special order will not affect normal unit sales and will not
increase fixed overhead and selling expenses. Variable selling
expenses on the special order are reduced to one –half the normal
amount.
17. Solution
Without Special Order
7,500 Units
Effect of Special
Order
With Special Order
7,500 units
+ 200 units=7,700 units
Sales Br 7,500*22=165,000 Br 3,600 Br7500*22+200*18=168,600
Variable Expenses:
Direct Material Br 37,500 Br 1000 Br 37,500+200*5=38,500
Direct Labor 60,000 1600 60,000+200*8=61,600
MOH 20,000 160 20,000+200*0.8=20,160
Selling & Administrative 25,000 200 25,000+200*2*0.5=25,200
Total Variable Expenses Br 142,500 Br 2,960 Br 145,460
Contribution Margin Br 22,500 640 Br 23,140
Fixed Expenses
Manufacturing Overhead Br 14,000 Br 0 14,000
Selling & Admin 10,000 Br 0 10,000
Additional Fixed Cost 0 400 400
Total Fixed expenses Br 24,400 Br 400 Br 24,400
