ACC 410 Chapter Notes - Chapter 8: Earnings Before Interest And Taxes, Sunk Costs, Opportunity Cost

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14 May 2011

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This chapter focuses on developing skills which are necessary to be successful in decision making. Managers will learn to tell the difference between relevant and irrelevant data and will be able to correctly use the relevant data to analyze alternatives. Every decision involves a choice from among at least two alternatives. The costs and benefits of the alternatives should be compared when making the decision. Only those costs or benefits that differ between alternatives are relevant in a decision. Any cost or benefit that does not differ across alternatives is irrelevant and can be ignored. All future costs that do not differ across alternatives are also irrelevant: any cost that is avoidable is potentially relevant. An avoidable cost is a cost that can be eliminated (in whole or in part) as a result of choosing one alternative over another: different costs for different purposes. Costs that are relevant in one decision situation are not necessarily relevant in another.

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Tactical decision making

Tactical decision making means choosing among alternatives withan immediate or limited end in view. For example, a company mayaccept a special order for less than the normal selling price touse idle capacity. Tactical decisions tend to be short-runin nature; however, it should be emphasized that short-rundecisions often have long-run consequences. A general tacticaldecision-making model is outlined here.

1.	Recognize and define theproblem.
2.	Identify possible alternativesolutions to the problem, and eliminate any unfeasiblealternatives.
3.	Identify the costs and benefitsassociated with each feasible alternative. Eliminate the costs andbenefits that are not relevant to the decision.
4.	Compare the relevant costsand benefits for each alternative.
5.	Assess qualitative factors.
6.	Select the alternative with thegreatest overall benefit.

Identifying and comparing relevant costs and revenues is theheart of the tactical decision model. Relevant costs (revenues) arefuture costs (revenues) that differ across alternatives. (Revenuesare treated in the same way as costs, so we will simplify thediscussion by referring to costs.) All decisions relate to thefuture; so, only future costs can be relevant. In addition, thecost must differ from one alternative to another. If a future costis the same for more than one alternative, it has no effect on thedecision. Such a cost is an irrelevant cost.

Assume that Reeves Company is considering accepting a specialorder for $25 per unit when the normal selling price is $30 perunit. Reeves has enough excess capacity to make the order withoutdisplacing normal sales. The alternatives facing Reeves Company are(Select "Yes" for the statements that are applicable and "No" forthe items that do not apply):

Accept the special order.	- Select your answer -YesNoItem1
Reject the special order.	- Select your answer -YesNoItem2
Sell normal sales for $25 perunit.	- Select your answer -YesNoItem3

Choose which of the following are relevant in deciding whetheror not to accept the special order. (Select "Yes" for thestatements that are applicable and "No" for the items that do notapply)

$25 price.	- Select your answer -YesNoItem4
$30 normal price.	- Select your answer -YesNoItem5
Variable cost of making the unitsin the special order.	- Select your answer -YesNoItem6
Depreciation on factory equipmentused in making the special order units.	- Select your answer -YesNoItem7
Increased property taxes on thefactory building which are due while the special order would bemade.	- Select your answer -YesNoItem8

While cost and revenue information is important, otherinformation may be needed to make an informed decision. Thesenon-financial factors are termed qualitative and are often relevantin decision making. For example, in deciding whether to make acomponent in-house or purchase it from an outside supplier, thecompany may consider any difference in quality or in responsivenessto the company's production schedules.

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Costs that will differ between alternatives and influence the outcome of a decision are

a. Unavoidable cost

b. Relevant cost

c. Product cost

d. Sunk cost

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Identify a decision from your personal experience that fitsunder one of the categories of differential analysis presented inthe chapter (make or buy, sell or process further, accept or rejectadditional business, continue or discontinue). Describe thealternative courses of action and the information gathered that wasrelevant to your decision.

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ACC 410 Chapter Notes - Chapter 8: Earnings Before Interest And Taxes, Sunk Costs, Opportunity Cost

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