1 Chapter 16 Relevant Costs and Benefits for Decision Making

2 Information Relevance and Decision Making A decision involves a choice between two or more alternatives. Information is relevant if it is pertinent to a decision problem (differs across alternatives). Accuracy and timeliness are important components of relevant information, but there is often a tradeoff between timeliness and accuracy.

3 Types of Costs that are Relevant to Decisions Avoidable outlays - are relevant because they can be avoided/eliminated if we choose one decision over another. Examples: cost of raw material and cost of certain wages if we decide to outsource production. Variable costs are avoidable by definition, and some fixed costs may be eliminated with an alternative decision. Opportunity costs - relevant because choosing one alternative over another may allow the company to undertake other profitable projects. Example: outsource production of a component and free up part of the facility to manufacture a new product.

4 Types of Costs that are Irrelevant in Decisions Sunk costs - are unavoidable costs because they cannot be eliminated, and will not differ across alternatives. Example: cost of building, irrelevant to the decision regarding which product we choose to manufacture. The depreciation on these types of assets is also irrelevant. Note: if an asset (building, equipment, auto, etc.) can be sold for cash, the cash inflow IS relevant to the decision. Other unavoidable costs - manager’s salary where the manager may just be transferred to another department if his/her segment is eliminated.

5 Types of Strategic Short-Term Decisions 1.Accept or reject a special order. 2.Outsource a product or service (make or buy). 3.Resource utilization decision (constrained resources). 4.Decisions to sell or process further (joint costs).

6 (1) Accept or Reject A Special Order Relevant factors in the decision to accept or reject a special order: –Does excess capacity exist? –What are the differential revenues to be earned? –What are the differential costs? –What effect would filling this order have on regular sales volume and prices? –What effect would this order have on relations with other customers? Decision rule: Everything else being equal, accept the special order if the incremental revenues of accepting the order exceed the incremental costs; otherwise, reject the special order.

7 (2) Outsourcing (Make or Buy) Decisions Relevant factors in the decision to outsource a product or service: –What are the relevant costs in producing the product or providing the service? –Strategic issues: How important is it to have control over quality, availability, confidentiality? –What amount of productive capacity is foregone by producing the product or service internally? This opportunity cost, when quantifiable, should be included in the decision. Decision rule: Everything else being equal, outsource the product or service if the cost of outsourcing (buying) is lower than the avoidable costs of sourcing internally (making); otherwise, generate the product or service internally.

8 (3) Decisions Involving Constrained Resources The Theory of Constraints is a management tool for dealing with bottlenecks, or weak links in the chain. Once a bottleneck is identified, resources should be focused on the area until the bottleneck is relieved. Given scarce resources, firms must choose which products or services to deliver, and which ones to decline. Decision rule: Given a constraint on output, produce the product (or service) that maximizes the contribution margin per unit of the constrained resource. This requires conversion of contribution margin per unit to a more specific level (e.g. direct labor hours, machine hours) before analysis.

9 (4) Decision to Sell or Process Further At a certain point in processing, inventory may be sold or processed further. This decision process applies to joint products like oil or meat processing. It also is used for other products that might benefit from processing further. Reworking (to fix a flaw or error) and customization (to take a common product and add special options) are examples of decisions to sell or process further. Decision rule: Process the product further if incremental revenues from further processing exceed incremental costs of further processing (called separable processing costs); otherwise do not process further. Key point - costs incurred prior to the process-further decision are sunk costs and irrelevant to the process- further decision.