COST FOR DECISION MAKING
1.1 Definition of Decision Making
Decision making is the essence of all management activity and naturally, accounting plays a role in informing decisions. Making correct decisions is one of the most important tasks of a successful manager.Every decision involves a choice between at least two alternatives.Decision making is a process of choosing among a set of alternative courses of action with a view to attain the firm’s objectives.The costing system of any organisation is integral in the decision making process. The costing system of the firm, for which the accountant is responsible, has to report on the cost of products and services from which decisions to discontinue redesign, make or buy, etc. have to be made. The quality of the decision generally reflects the quality of the information provided to management by the accountant.
Decision making is a future oriented activity; it involves forecasting and planning. What has happened in the past is only of historical value. The function of decision making is to choose alternatives for the future. There two perquisites for making efficient and effective decisions. First, of all possible alternatives should be carefully delineated. A manager may choose a best alternative form among the alternatives considered by him; but he may fail to consider some other available alternatives which may be better than the chosen alternative. Second, the objective should be correctly set. A wrong objective can lead to the adoption of undesirable and unprofitable course of action.
The decision process may be complicated by volumes of data, irrelevant data, incomplete information, an unlimited array of alternatives, etc.The role of the managerial accountant in this process is often that of a gatherer and summarizer of relevant information rather than the ultimate decision maker. In this regard, cost data are the most crucial quantitative factors needed for making decisions. A distinction between relevant and irrelevant cost data should be drawn. All costs are not relevant in decision making. A cost is relevant if it is pertinent to the decision under consideration. A relevant cost is also a cost that differs between alternatives. In other words, cost which varies as a consequence of the decision is a relevant cost. A relevant cost for a particular decision is one that changes if an alternative course of action is taken. Relevant costs are also calleddifferential costs.Any cost that does not differ between alternatives is irrelevant and can be ignored in adecision. Sunk costs (costs already irrevocably incurred) are always irrelevant since they will be the same for any alternative.In addition, an avoidable cost which can be eliminated (in whole or in part) by choosing one alternative over another is a relevant cost. Relevant cost includes concepts such as differential cost and marginal cost and contrition approach.
To identify which costs are relevant in a particular situation, take this three step approach:
1. Eliminate sunk costs
2. Eliminate costs that do not differ between alternatives
3. Compare the remaining costs and benefits that do differ between alternatives to make theproper decision
1.1.1 Decision Making Process
A manager should take the following steps to make decision s intelligently and skilfully;
1. Definition of objectives/ Identification of problems: The first stage in decision making process should be to specify the goal and objectives of the organisation. The basic objective of most businesses is to maximise profit or shareholders’ wealth. Also, the firm should recognise the problems for which the decisions have to be made.
2. Search for Alternatives: The firm must search for a range of possible alternatives or courses of action that might help achieve the objectives of the firm or solve the problem on hand. For decision making be successful, the firm must be able to identify all available alternatives. It must have information in order to make a valid choice between the alternative courses of action. The search for alternatives involves information concerning future opportunities and environments
3. Evaluation of Alternatives: The firm should evaluate the alternatives by analysing the costs and benefits. All alternatives should be assessed on their own merits to ascertain their contribution to the attainment of the objectives of the firm. In this regard several techniques or methodologies can be used to evaluate the viability of the various courses of action available to the firm.
4. Selection of Alternative: Once alternative courses of action have been selected, they should be implemented. Implementation forms a crucial aspect of the decision making process in that no matter how good the decision is, if not implemented, it will not yield the necessary results.
5. Comparison of Actual to Planned Outcome: After the selected alternative courses of action have been implemented, the outcome of the implemented course of action is compared to the planned to ascertain whether the alternative has generated the desired results.
6. Taking Corrective Measures: The firm should take corrective actions to correct any deviations in the implemented courses of action.
1.2 Relevant Information for Decision Making
Relevant costs are costs which are influenced by decisions taken. Therefore all other costs are irrelevant. The same distinction can apply to information concerning revenues. Costs generally fixed but variable for the period of the decision are relevant while all generally variable but fixed for the period of the decision are irrelevant. It is important to appreciate that all in all decision analysis economic values are used and not historical costs which mean that it will not be possible to extract this data directly from the financial accounts. Some values in the financial accounts will not be relevant.
1.2.1 Guidelines for Determining Relevant Costs
1. Materials: If raw materials has been acquired and held in the stock records at its purchase cost this will be the purposes of the financial accounting records. This purchase cost is not the relevant cost for material for any future decision. The relevant cost of the material will be determined by whatever courses of action are opened to the firm. If the material to be used in the production of a product is in regular use, the relevant cost is the future replacement cost, on the basis that once applied to the chosen decision a further material purchase will be needed to restore the company to its original state. If, on the other hand the company cannot conceive of a use for the material except for its use on the product then the relevant cost to be used is the anticipated disposal value of the material (realisable value)when evaluating and costing the product. To incorporate this disposal value into a costing of the product is to use it as an opportunity cost. Finally, if the material cannot be disposed of and the only option is to use it on the product then the relevant cost is zero, this material can be used for nothing. Incidentally, its use on the product saved the company from having to pay for disposal of the material. Notice in no case is the original acquisition cost used.
If any of the future costs and benefits have applying to them some contractual obligation this is not relevant. In other words, the company is already committed to them, ay due to a past contract of some kind, then these committed future costs and benefits are not relevant to the decision at hand.
2. Labour: The principle here is if there is spare capacity then the labour cost will only be relevant if either extra hand were contracted or overtime work was done by the workers. If there is no spare capacity but the production of another product has to be abandoned to create space, then the relevant cost is the contribution from alternative products which must be abandoned to create spare capacity. This is against the backdrop that contracts of employment and acknowledged social responsibility of employers it is possible that reduction, removal or manipulation of a work force may not be easy or cost free.
3. Overheads: Only future costs and benefits are relevant. Hence only those overheads that vary as a direct result of the decision taken are relevant overheads. For instance, depreciation, an overhead cost is never relevant to a decision about its use or non-use.
Short-term management decisions can be made using full costing, variable costing, or incremental analysis. Full costing often involves preparing side-by-side income statements and identifying the differences. Incremental analysis is most often the straightest forward, the shortest, the easiest, and the best approach to decision making because it helps managers focus on the relevant parts of a decision. A manager that uses full or variable costing wastes a lot of time capturing and listing costs that will not impact the decision at hand. This is because they do not differ between decisions.
Two potential problems that should be avoided in relevant cost analysis are
(i) Do not assume all variable costs are relevant and all fixed costs are irrelevant.
(ii) Do not use unit cost data directly. It can mislead decision makers because
a. it may include irrelevant costs, and
b. comparisons of unit costs computed at different output levels lead to erroneous conclusions
1.3 Types of Decisions
Relevant cost and revenue information can be used to make decisions with regards to;
a. Make, lease or buy
b. Make special orders
c. Sell or process further
d. Keep or drop products
e. Multiple products and limited resources
1.3.1 Cost Analysis in Make, Lease or Buy Decisions
Management sometimes may have to make a choice between manufacturing the component parts of a product, or buying them from outside. Such a situation of make or buy decision may arise whenever the firm has the idle plant capacity and the technical capacity of manufacturing the component parts. In a make or buy situation, the decision will hinge upon both qualitative and quantitative factors qualitative consideration include product quality and the necessity for long-run business relationships with subcontractors. The key quantitative factors are the differential costs of the make and buy alternatives and the consequences of the alternative uses of the idle facilities. These factors are best seen through the relevant cost approach. The relevant cost of the buying alternative will include the purchase price and the ordering costs. Costs relevant for the make alternative would include the variable costs, viz, direct material, direct labour and variable overheads and those fixed costs which are avoidable. If fixed costs are expected to remain unaltered, hey would be irrelevant in the make or buy decision. The firm should also consider the alternative uses of the idle facilities. If a more profitable use than manufacturing the parts exists, then the firm may procure the parts from outside and use facilities for the more profitable alternatives.
Also, you can analyze the costs of the lease or buy problem through discounted cash flows analysis. This analysis compares the cost of each alternative by considering the timing of the payments, tax benefits, and interest rate on a loan, the lease rate, and other financial arrangements. To make t analysis you must first make certain assumptions about the economic life of the equipment, salvage value, and depreciation. A straight cash purchase using the firm’s existing funds will almost be more expensive than the lease or loan/buy options because of the loss of the use of funds.
Reasons to Buy from Outside
· Flexibility to meet urgent demand of customers;
· Overcome limiting factor problem
· Concentrate on its own core competencies;
· Take advantage of the specialist skill and expertise of the outsiders;
· Overcome production bottleneck and
· Solve seasonal demand problem
Illustration 1
Suppose a firm manufactures 1000 units of a part and has the following cost structure:
Cost / Per Unit Cost (GH¢) / Cost of 1000 units (GH¢)Direct materials / 2 / 2000
Direct labour / 6 / 6000
Variable overheads / 3 / 3000
Fixed Overheads / 4 / 4000
Total / 15 / 15000
An outside supplier offers to the firm to sell the parts for GH¢13 each. Should the company accept the offer? One may argue that the answer is obvious. The cost of buying the part GH¢1 is less than the cost of manufacturing the part (GH¢15), therefore, the part should be bought. The comparison is not correct. To decide correctly, the differential manufacturing cost of GH¢4000 should be considered, which may be unavoidable, that is, it will have to be incurred whether the part is made or bought from outside. Then those fixed costs are not relevant in making the comparison. The relevant cost of manufacturing part, thus, would be GH¢11 only. If we assume that the idle facilities cannot be put to an alternative use, then the firm should decide to me the part rather than buy it from outside.
Illustration 2
For many years Lansing Company has purchased the starters that it installs in its standard line of garden tractors. Due to a reduction in output, the company has idle capacity that could be used to produce the starters. The chief engineer has recommended against this move, however, pointing out that the cost to produce the starters would be greater than the current GH¢10.00 per unit purchase price. The company’s unit product cost, based on a production level of 60,000 starters per year, is as follows: