Managerial Accounting - Chapter 14 - Decision Making: Relevant Costs and Benefits

Unavoidable Expenses

Expenses that will continue to be incurred even if a subunit or activity is eliminated.

Avoidable Expenses

Expenses that will no longer be incurred if a particular action is taken.

Pitfalls to Avoid

Identification of the relevant costs and benefits is an important step in making any economic decision. However, analysts often overlook relevant costs or incorrectly include irrelevant data. 1. Sunk costs: A common behavioral tendency is to give undue importance to book values in decisions that involve replacing an asset or disposing of obsolete inventory. Ignore sunk costs! 2. Unitized Fixed Costs: In a decision analysis, it is usually wise to include a fixed cost in its total amount, rather than as a per unit cost. Beware of unitized fixed costs in decision making. 3. Allocated Fixed Costs: It is also common to allocate fixed costs across divisions, departments, or product lines. A possible result is that a product or department may appear unprofitable when in reality it does make a contribution toward covering fixed costs and profit. Before deciding to eliminate a department, be sure to ask which costs will be avoided if a particular alternative is selected. A fixed cost that has been allocated to a department may continue, in total or in part, even after the department has been eliminated. Beware of allocated fixed costs; identify the avoidable costs. 4. Opportunity costs: People tend to overlook opportunity costs, or to treat such costs as less important than out of pocket costs. Yet opportunity costs are just as ral and important to making a correct decision as are out of pocket costs. Pay special attention to identifying and including opportunity cots in a decision analysis.

Separable Processing Cost

Cost incurred on a joint product after the split-off point of a joint production process.

Split Off Point

The point in the production process where the joint products are identifiable as separate products. (Example: Slaughtering of animals for various cuts of meat and the processing of petroleum into various products, such as kerosene and gasoline.)

Steps in the Decision Making Process

1. Clarify the decision problem. 2. Specify the criterion. 3. Identify the alternatives. 4. Develop a decision model. 5. Collect the data. 6. Select an alternative. 7. Evaluate decision effectiveness. (Page 589)

Theory of Constraints (TOC)

Calls for identifying such limiting constraints and seeking ways to relax them. Also referred to as managing constraints, this management approach can significantly improve an org's level of goal attainment.

Relative Sales Value Method

A common method of allocating a joint cost. Joint cost is allocated between the joint products in proportion to their sales value at the split-off point.

Outsourcing decision

Also called a make-or-buy decision, entails a choice between producing a product or service in-house and purchasing it from an outside supplier.

Sunk costs

Are costs that have already been incurred. They do not effect any future cost and cannot be changed by any current or future action. They are irrelevant to decisions.

Repetitive Decisions

Are made over and over again, at either regular or irregular intervals.

Qualitative Characteristics

Are the factors in a decision problem that cannot be expressed effectively in numerical terms. (Example: Worldwide Airways effects of closing its London hub on the morale of its remaining employees in the airline's Paris, Atlanta and Tokyo hubs.)

Unique Decisions

Arise infrequently or only once. Compiling data usually requires a special analysis by the managerial accountant. The relevant info often will be found in many diverse places in the org's overall info system.

Decision Model

Is a simplified representation of the choice problem. Unnecessary details are stripped away, and the most important elements of the problem are highlighted. Those the model brings together the elements listed above: the criterion, the constraints, and the alternatives.

Differential Cost

Is the difference in a cost item under two decision alternatives. The computation is a convenient way of summarizing the relative advantage of one alternative over the other.

Opportunity Cost

Is the potential benefit given up when the choice of one action precludes a different action.

Sensitivity Analysis

One common technique for addressing the impact of uncertainty. Is a technique for determining what would happen in a decision analysis if a key prediction or assumption is proved to be wrong.

Three Characteristics of Useful Information

Relevance - Info is relevant if it is pertinent to a decision problem. Accuracy - Info that is pertinent to a decision problem also must be accurate, or it will be of little use. This means the info must be precise. Timeliness - Relevant and accurate data are of value only if they are timely, that is available in time for a decision. Summary: 1. Decide what info is relevant to each decision problem. 2. Provide accurate and timely data, keeping in mind the proper balance between these often-conflicting criteria.

Joint Production Process

Results in two or more products, called joint products. (Example: Processing of cocoa beans into coca powder and cocoa butter.)

Short Run versus Long Run Decisions

Short-Run Decisions: affect only a short time period, typically year or less. The process of identifying relevant costs and benefits is largely the same whether the decision is viewed from a short-run or long-run perspective. One important factor that does not change in a long-run analysis is the time value of money.

Joint Cost

The cost incurred in a joint production process before the joint products become identifiable as separate products.

Expected Value

The sum of the possible values for a random variable, each weighted by its productivity.

Relevant Information

What makes information relevant to a decision problem? Two criteria are important: 1. Bearing on the future: To be a relevant decision, cost or benefit information must involve a future event. Relevant information must involve costs and benefits to be realized in the future. However, the accountant's predictions of those costs and benefits often are based on data from the past. 2. Different under Competing Alternatives: Relevant information must involved costs or benefits that differ among the alternatives. Costs or benefits that are the same across all the available alternatives have no bearing on the decision.