When We Make Decisions We Should Only Entertain the Relevant Information in Our Decision

Transcripts T8M3

Slide 1

When we make decisions we should only entertain the relevant information in our decision making process. Thus, when making a business decision we need to sort out the costs into relevant and irrelevant costs. Relevant costs are those costs that differ from one alternative business opportunity to another. Think of them as the costs that could be avoided if the other decision was made. Those are the costs that are pertinent to the decision at hand.

Slide 2

Managerial accounting is rich in terms that can have similar but different meanings. Relevant costs are not just avoidable costs but they can be differential costs or incremental costs. All these terms are relevant to the decision making process. What is a differential cost? It is the difference between two alternatives costs. What are incremental costs? Those are the increased costs from one business opportunity over another. All these terms are relevant costs and thus are critical to the decision making process

Slide 3

The flip side of relevant is irrelevant. Irrelevant costs can be defined as the future costs that do no change between opportunities. They are also sunk costs. Sunk costs are those costs that have already been acquired and cannot be changed in regards to the business decision. For instance, the cost of your car is irrelevant to your decision to drive the car to work or take mass transit.

Slide 4

So, why identify these costs. I mean why not just total all the costs up for each alternative and look at the difference between the two totals. Well, you could do it that way but when ever possible you should simplify the information to just what you need. It keeps the clutter down. In addition when you understand which costs are relevant you have a better understanding of those costs and can make better cost reduction decisions in the future. In order to manage costs you need to understand their behavior within different perspectives.

Slide 5

Here we have an example. Jill is a junior in college and has been offered two great internships for the summer. The first internship is working for a business in Jill’s home town. This is a great opportunity for Jill and better yet she can live at home during the summer and save most if not all of her summer earnings. The second internship is an overseas internship. It is an internship in China. The internship is an unpaid internship but the learning opportunities are incredible. In addition, Jill has to pay for travel, room and board and any other associated costs. Jill’s grandmother has told her she will give her a no interest loan to go to China and she can begin paying her back after graduation.

Slide 6

On this slide we have quantified the costs and potential income from both of the internships. As you can see it is a runaway train when you look at the numbers. If the decision was based upon the available cost information the decision would be clear. Jill should stay home and take the home town internship. What isn’t clear is the potential career opportunity that might be associated with the international internship. One cannot deny that it is relevant to the decision but it is very hard to quantify.

Slide 7

The path the product takes from input of the raw material to the distribution of the product to the consumer is called the value chain. When a company controls all aspects of the value chain from the raw material to the distribution we say they are vertically integrated. The main advantages for a company to make its own parts is the company is less dependent on suppliers meeting delivery deadlines and they also have control over quality. The advantage of purchasing or outsourcing a part of the product is economies of scale. This allows for the company to achieve higher quality at a much lower cost.

Slide 8

Before a company makes the decision to make or buy a part for their product they need to identify the relevant costs to the decision. Here we have an example of Ross & Simon who manufacture skateboards. Within the narrative they tell us that they have a supplier that will make the part for $10 per unit. From the data below we see it currently costs us $12 per unit. They also tell us that the special equipment used to make the wheels cannot be used for any other purpose, and the allocated general overhead will have to be absorbed in another area because it is unavoidable. First determine which costs will be relevant to the decision and which costs are irrelevant. Add up the relevant costs per decision and compare.

Slide 9

In this slide we have defined the relevant costs for each decision and added them together. Based upon this information should Ross & Simon buy the wheels or make them. It appears that they are better off making the wheels.

Slide 10

In addition to make or buy decisions, sometimes companies receive special orders. Special orders are one time orders that are not part of the company’s ongoing business. If a company has excess capacity entertaining a special order can pump up the income statement. However, if the special order is at a special reduced price then the company needs to be careful not to upset its current clients. Current clients would be upset if they thought they unfairly paid a higher price than someone else.

Slide 11

Here we have a problem illustrating a special order. Christmas-in-July Inc produces an ornamental tree topper that they sell to outlets throughout the Pacific Northwest. A Floridacompany wants to use that specific topper in its Christmas ads and floor displays. They will need 500 units. This is a one time order that should not impact the company’s normal sales. In addition there is a reduction in variable expenses by $0.35 per unit. Christmas-In-July normally sells the toppers for $4.00 per unit. The Florida company has offered them $3.75 per unit. Should Christmas-In-July accept the special order?

Slide 12

Here we have the cost of producing one ornamental tree topper broken down into its components.

Slide 13

First, determine the relevant variable costs associated with the ornament. This will include direct material, direct labor and variable expenses. That value has been determined to be $2.35. Now determine the variable cost per special order unit taking into account the $0.35 reduction in variable costs. The cost of the unit for the special order is now $2.00. What impact does this have on operating income?

Slide 14

Now let us put it all together. From the information we calculate a $1.75 contribution margin and multiply that by 500 units. The resulting value is the additional income to operating income. Thus, if there is no impact on Christmas-in-July Inc’s normal day-to-day business they should accept the special order.