- Decision Making is critical aspect of managing an organization
- Decision should lead to outcomes that contribute to achieving the performance goals
identified as part of the organization's strategic objectives (e.g., grow revenues, reduce
costs, improve return on investment, etc.)
- The key is to identify and compare only the relevant costs and benefits for each
- Relevant costs are those that differ among the alternatives under consideration and that
will be incurred in the future (i.e., the cost has not already been incurred).
- Two aspects of the decision situations and the related analysis presented in this chapter
are important to emphasize.
o First, none of the situations involve capital expenditures (e.g., replacing
production equipment), where the time value of money can be an important factor
in the analysis.
o Second, the key criterion used in the various decision situations presented in this
chapter is the maximization of operating income.
Cost Concepts For Decision Making
Identifying relevant costs and benefits
- Only those costs and benefits that differ in total among alternatives and that will be
incurred in the future are relevant in a decision.
- If a cost will be the same regardless of the alternative selected, then it can be ignored.
- Relevant costs = avoidable costs (cost that can be eliminated in whole or in part by
choosing one alternative over another.)
- Irrelevant costs = unavoidable
- Two categories of costs are never relevant in decisions: SUNK costs, and FUTURE
COSTS that don‘t differ between the alternatives (i.e. lease payments)
- Sunk costs are always irrelevant – they don‘t change and should always be ignored
- Future costs that are same under each alternative should also be ignored because they
do not impact the decision
- Future costs that differ between alternatives are relevant
- Avoidable, differential, incremental, relevant costs = same to same
- To identify costs and benefits that are relevant in particular decision situation:
o Eliminate costs and benefits that do not differ between alternatives. These
irrelevant costs consist of (a) sunk costs and (b) future costs and benefits that do
not differ between alternatives
o Use the remaining costs and benefits that do differ between alternatives in making
the decision. The costs that remain are the differential, or avoidable, costs Different costs for Different Purposes
- Important to recognize that costs which are relevant in one decision aren‘t relevant in
- Must therefore isolate the relevant costs
- ‗different costs for different purposes‘
- Study such unitized costs carefully (i.e., costs stated in terms of a dollar amount per unit,
per kilometre, per direct labour-hour, per machine-hour, and so on)—they are often
o There is a huge difference between AVERAGE cost and INCREMENTAL
COST = THE COST TO DRIVE AN ADDITIONAL KM (may have irrelevant
components) and should be interpreted correctly
- A positive number in the Differential Costs and Benefits column indicates that the
difference between the alternatives favours the new machine; a negative number indicates
that the difference favours the current situation.
- A zero in that column simply means that the total amount for the item is exactly the same
for both alternatives.
- We get the same answer when doing just incremental analysis
- The only costs and benefits that matter in the final comparison of the operating incomes
are those that differ between the two alternatives and therefore are not zero in the last
Why isolate relevant costs?
- Desirable str at least two reasons
o 1 , rarely will have enough info to prepare I/S for both alt (like shown above)
o 2 , combining irrelevant w/ relevant may cause confusion and distract attention Analysis of Various Decision Situations
- For situations like keeping/dropping product line, making component vs buying, special
order be accepted/rejected, etc – approach to analysis is the similar in each case
- For each situation, the relevant costs and benefits must be quantified, and the alternative
with the most favourable impact on operating income selected.
Adding and Dropping Product Lines and Other Segments
- Decision regarding whether existing product line should be dropped and new ones added
- Insurance expense: avoidable* if it represents insurance carried on inventories within
each of the three product-line areas
- ABC costs can be used to determine which costs are avoidable and which aren‘t**
Beware of Allocated Fixed Costs
- Why keep a line that is showing a loss? The explanation for this apparent inconsistency
lies at least in part with the common fixed costs that are being allocated to the product
- One of the great dangers in allocating common fixed costs is that such allocations can
make a product line (or other segment of a business) look less profitable than it really
- By allocating the common fixed costs among all product lines, the camera line has been
made to look as if it was unprofitable, whereas, in fact, dropping the line would result in a
decrease in overall company operating income
- Data should thus be recasted using segmented approach (pg 563)
o Segment margin + sunk costs = loss/gain of dropping/keeping the product
- Managers may choose to retain an unprofitable product line if the line is necessary to the
sale of other products or if it serves as a ―magnet‖ to attract customers
The Make/Buy Decision - Lots of steps involved in getting finished product into hands of consumer; 1 , raw mtlst
have to be obtained through mining, drilling, etc, 2 : raw mtlrdhave to be processed to
remove impurities and extract desirable/usable mtls; 3 : usable mtls have to undergo
conversion so that they can be used in final products 4 actual mfting of finished product
must take place, 5 , finished product needs to be distributed to ultimate consumer
- Sep co‘s may carry out each of the steps in the value chain or a single co may carry out
several of the steps
o Involved in more than one of these steps in the value chain, following a policy of
vertical integration – very common; some firms control all of the activities in
the value chain (from making basic raw mtls right up to the mfter and distribution
of final goods)
- A decision to produce internally, rather than to buy externally from a supplier, is called a
make or buy decision.
- Any decis