1. Decision Making and Relevant Information
CHAPTER 11
Decision Making
and
Relevant Information

2. Chapter 11 learning objectives
Use the five-step decision-making process
Distinguish relevant from irrelevant information in decision situations
Explain the concept of opportunity cost and why managers should consider it when making insourcing-versus-outsourcing decisions
Know how to choose which products to produce when there are capacity constraints
Explain how to manage bottlenecks
In chapter 11, we study decision making. While doing so, we distinguish between relevant and irrelevant information. Here are the first 5 of our 8 learning objectives.
Use the five-step decision-making process
Distinguish relevant from irrelevant information in decision situations
Explain the concept of opportunity cost and why managers should consider it when making insourcing-versus-outsourcing decisions
Know how to choose which products to produce when there are capacity constraints
Explain how to manage bottlenecks

3. Chapter 11 learning objectives, concluded
Discuss the factors managers must consider when adding or dropping customers or business units
Explain why book value of equipment is irrelevant to managers making equipment- replacement decisions
Explain how conflicts can arise between the decision model a manager uses and the performance-evaluation model top management uses to evaluate managers
Here are the last 3 of our 8 learning objectives for the chapter.
Discuss the factors managers must consider when adding or dropping customers or business units
Explain why book value of equipment is irrelevant to managers making equipment-replacement decisions
Explain how conflicts can arise between the decision model a manager uses and the performance-evaluation model top management uses to evaluate managers

4. Information and the decision process: Decision Models
Managers usually follow a decision model for choosing among different courses of action.
A decision model is a formal method of making a choice that often involves both quantitative and qualitative analyses.
Management accountants analyze and present relevant data to guide managers’ decisions.
Managers use the five-step decision-making process presented in Chapter 1 to make decisions.
Managers make many decisions every day and usually follow a decision model for choosing among different courses of action.
A decision model is a formal method of making a choice that often involves both quantitative and qualitative analyses.
Management accountants analyze and present relevant data to guide managers’ decisions.
Managers use the five-step decision-making process presented in Chapter 1 to make decisions.

5. Five-Step Decision-Making Process
You may recall that the 5-step decision making process is:
Identify the problem and uncertainties
Obtain information
Make predictions about the future
Make decisions by choosing among alternatives
Implement the decision, evaluate performance, and learn
Note how step 5 evaluates performance to provide feedback about actions taken in the previous steps. This feedback might affect future predictions, the prediction methods used, the way choices are made, or the implementation of the decision. Exhibit 11-1 page 426

6. The concept of Relevance
Relevant information has two characteristics:
It occurs in the future
It differs among the alternative courses of action.
Relevant costs are expected future costs.
Relevant revenues are expected future Revenues.
Past costs (historical costs) are never relevant and are also called sunk costs.
Relevant information has two characteristics:
It occurs in the future
It differs among the alternative courses of action
Relevant costs are expected future costs
Relevant revenues are expected future revenues
Past costs (historical costs) are never relevant and are also called sunk costs.

7. Types of Information
Quantitative factors are outcomes that can be measured in numerical terms.
Qualitative factors are outcomes that are difficult to measure accurately in numerical terms, such as satisfaction.
Qualitative factors are just as important as quantitative factors even though they are difficult to measure.
Managers divide the outcomes of decisions into two broad categories: quantitative and qualitative.
Quantitative factors are outcomes that can be measured in numerical terms.
Qualitative factors are outcomes that are difficult to measure accurately in numerical terms, such as satisfaction.
Relevant-cost analysis generally emphasizes quantitative factors that can be expressed in financial terms. Although qualitative factors and quantitative nonfinancial factors are difficult to measure in financial terms, they are important for managers to consider.

8. Features of Relevant Information
Past (historical) costs may be helpful as a basis for making predictions. However, past costs themselves are always irrelevant when making decisions.
Different alternatives can be compared by examining differences in expected total future revenues and expected total future costs.
Not all expected future revenues and expected future costs are relevant. Expected future revenues and expected future costs that do not differ among alternatives are irrelevant and, hence can be eliminated from the analysis. The key question is always, What difference will an action make?
Appropriate weight must be given to qualitative factors and quantitative nonfinancial factors.
Some features of relevant information are presented on this slide. The concept of relevance applies to all decision situations.
Past (historical) costs may be helpful as a basis for making predictions. However, past costs themselves are always irrelevant when making decisions.
Different alternatives can be compared by examining differences in expected total future revenues and expected total future costs.
Not all expected future revenues and expected future costs are relevant. Expected future revenues and expected future costs that do not differ among alternatives are irrelevant and, hence can be eliminated from the analysis. The key question is always, What difference will an action make?
Appropriate weight must be given to qualitative factors and quantitative nonfinancial factors.
Exhibit 11-3 page 428

9. Relevant Cost Illustration
In this slide, we see how relevant costs and revenues are selected for the analysis.
In the example, we are deciding whether or not to reorganize. The revenues and costs associated with each decision are presented in the first two columns, which show a difference of $70,000 in operating income. The 3rd and 4th columns present only those values which are relevant to this decision, which include manufacturing labor and reorganization costs. The difference in operating income is the same $70,000.
It is helpful to focus on the relevant data only especially since sometimes all the information needed to present a full income statement for each alternative is not available. Exhibit 11-2 page 427

10. Sunk Costs Are Irrelevant in Decision Making
Costs that have already occurred and cannot be changed are classified as sunk costs.
Sunk costs are excluded because they cannot be changed by future actions.
As previously mentioned, past costs are called sunk costs and are never relevant in decision making.

11. Terminology
Incremental cost—the additional total cost incurred for an activity.
Differential cost—the difference in total cost between two alternatives.
Incremental revenue—the additional total revenue from an activity.
Differential revenue—the difference in total revenue between two alternatives.
Note that incremental cost and differential cost are sometimes used interchangeably in practice.
Let’s learn a few terms before we begin our decision-making.
Incremental cost—the additional total cost incurred for an activity
Differential cost—the difference in total cost between two alternatives
Incremental revenue—the additional total revenue from an activity
Differential revenue—the difference in total revenue between two alternatives
Note that incremental cost and differential cost are sometimes used interchangeably in practice.

12. Some Types of Decisions that need to be made:
One-time-only special orders
Short-run pricing decisions
Insourcing vs. outsourcing (Make-or-Buy)
Product-mix with capacity constraints
Bottlenecks, Theory of Constraints, and Throughput-Margin Analysis
Customer profitability and Relevant Costs
Branch/segment: adding or discontinuing
Equipment replacement
Several types of decision situations can occur. In this chapter we’ll cover the decisions listed here and in later chapters, we’ll review decisions about joint costs, quality and timeliness, inventory management, capital investments and transfer pricing.
One-time-only special orders
Insourcing vs. outsourcing
Make or buy
Product-mix
Customer profitability
Branch/segment: adding or discontinuing
Equipment replacement

13. One-Time-Only Special Orders
Accepting or rejecting special orders when there is idle production capacity and the special orders have no long-run implications.
Decision rule: Does the special order generate additional operating income?
Yes—accept
No—reject
Compares relevant revenues and relevant costs to determine profitability.
In our first example affecting output levels, we’ll look at an opportunity to accept a one-time-only special order.
Each decision will have a decision rule – the basis on which we will decide. For one-time-only special orders, the decision rule is whether or not the special order generates additional operating income. If it does, we should accept the order but if it doesn’t, we should reject the order.
Generally, the decision rule will be based on the affect on operating income.

14. Special Order decision
Here we see an example of a special order decision.
A customer offers to purchase 5000 units at $11 per unit, which is $9 less than the usual selling price. Should the special order be accepted?
Remember the decision rule: Does the special order generate additional operating income?
Yes—accept
No—reject
In this simple example, the only incremental costs are the variable manufacturing costs. In column D we see the operating income as is; Column F reports the revised operating income IF the new order was accepted and Column H shows the difference. According to our decision rule, this order should be accepted.
When making this type of decision, it is important to keep in mind those qualitative factors. For example, what if all customers began demanding the lower price? How would that affect profitability?
Exhibit 11-5 page 430

15. Potential Problems with Relevant-Cost Analysis
Managers should avoid two potential problems in relevant–cost analysis:
Avoid incorrect general assumptions such as that “All variable costs are relevant and all fixed costs are irrelevant.” Even in our simple example, we had irrelevant, variable marketing costs.
Be aware that unit-fixed-cost data can potentially mislead managers in two ways.
(See next slide for details)
There are some potential problems using relevant-cost analysis that managers should avoid or be aware of.
1. Avoid incorrect general assumptions such as that “All variable costs are relevant and all fixed costs are irrelevant.” Even in our simple example, we had irrelevant, variable marketing costs.
2. Be aware that unit-fixed-cost data can potentially mislead managers in two ways.
(See next slide for details)

16. Beware: unit-fixed-cost data
Unit-fixed-cost data can be misleading in two ways:
Fixed costs per unit may include costs that are irrelevant to a particular decision or may be irrelevant in total for a particular decision, and
Unit fixed costs are accurate only for that particular level of output. For this reason, managers often use total fixed costs rather than per unit data especially when output levels are a variable for a particular decision.
Unit-fixed-cost data can be misleading in two ways:
Fixed costs per unit may include costs that are irrelevant to a particular decision or may be irrelevant in total for a particular decision, and
Unit fixed costs are accurate only for that particular level of output. For this reason, managers often use total fixed costs rather than per unit data especially when output levels are a variable for a particular decision.

17. Short-run pricing decision
A special order decision is, in many respects, a short-run pricing decision. Sometimes, the decision is simply about setting an acceptable price. Remember the decision rule? Any price above incremental costs will improve operating income; however, consideration must be given to capacity constraints, current market conditions, customer demand, competition, etc.
A special order decision is, in many respects, a short-run pricing decision.
Sometimes, the decision is simply about setting an acceptable price.
Remember the decision rule?
Any price above incremental costs will improve operating income; however, consideration must be given to capacity constraints, current market conditions, customer demand, competition, etc.
The focus here is on the price setting itself rather than on whether or not to accept an order at a particular price.

18. Insourcing v outsourcing and Make-or-Buy decision, terms
Outsourcing is purchasing goods and services from outside vendors.
Insourcing means you’ll produce the good (or provide the service) within the organization.
Decisions about whether to insource or outsource are called Make-or-Buy decisions.
Opportunity Costs are the contribution to operating income forgone by not using a limited resource in its next-best alternative use.
Outsourcing is purchasing goods and services from outside vendors
Insourcing means you’ll produce the good (or provide the service) within the organization
Decisions about whether to insource or outsource are called Make-or-Buy decisions
Opportunity Costs are the contribution to operating income forgone by not using a limited resource in its next-best alternative use

19. Insourcing v outsourcing and Make-or-Buy decision rule
Decision rule: Select the option that will provide the firm with the lowest cost, and therefore the highest profit.
Same as special order: choose the alternative that maximizes operating income.
The decision rule for the make-or-buy decision is clear: maximize operating income

20. Insourcing v outsourcing and Make-or-Buy decision, example
In this example, a company needs 250,000 units of a good produced in 2,000 batches of 125 units each. Variable batch level costs are $625.
The company could purchase the good for $64 per unit. Should the company make or buy the good?
On this slide, we see an analysis of the relevant costs for this decision. Since it costs less to make the item, production should remain in-house.
As with our special order decision, strategic and qualitative factors cannot be ignored. Regardless of this financial outcome, perhaps the company prefers to retain in-house control over quality or availability issues.
Exhibit 11-6 page 434

21. Make-or-Buy decision, Extended
In our prior example, we assumed that the capacity unused if we purchased the item would be idle. In this example, the released capacity will be used for other, profitable purposes. The decision is somewhat different, based on the available production capacity.
As seen here, we can make the comparison two ways:
Panel A shows the Total-Alternatives Approach which presents the future costs and revenues for ALL products
Panel B shows the Opportunity-Cost Approach which highlights the fact that if a company uses a resource one way, they must forgo the opportunity to use the resource in another way. Opportunity Cost is the contribution to operating income that is forgone by not using a limited resource in its next-best alternative use.
Note that the alternatives are defined differently under the two approaches. Exhibit 11-7 page 436

22. More on opportunity cost
Opportunity Cost is the contribution to operating income forgone by not using a limited resource in its next-best alternative use.
Opportunity Costs are not recorded in financial accounting systems because historical record keeping is limited to transactions involving alternatives that managers actually selected rather than alternatives that they rejected.
One type of opportunity cost is the carrying cost of inventory: the operating income forgone by tying up money in inventory and not investing it elsewhere.
Opportunity Cost is the contribution to operating income forgone by not using a limited resource in its next-best alternative use
Opportunity Costs are not recorded in financial accounting systems because historical record keeping is limited to transactions involving alternatives that managers actually selected rather than alternatives that they rejected.
One type of opportunity cost is the carrying cost of inventory: the operating income forgone by tying up money in inventory and not investing it elsewhere.

23. Qualitative Factors
Nonquantitative factors may be extremely important in an evaluation process for each of the decisions we cover here, yet do not show up directly in calculations:
Quality requirements
Reputation of outsourcer
Employee morale
Logistical considerations—distance from plant, and so on
For make/buy decisions, buying can be risky, especially if sourcing internationally.
Nonquantitative factors may be extremely important in an evaluation process for each of the decisions we cover here, yet do not show up directly in calculations:
Quality requirements
Reputation of outsourcer
Employee morale
Logistical considerations—distance from plant, and so on
For make/buy decisions, buying can be risky, especially if sourcing internationally

24. Product-Mix Decisions with Capacity constraints
Product-mix decisions are decisions managers make about which products to sell and in what quantities.
Decision rule (with a constraint):
Choose the product that produces the highest contribution margin per unit of the constraining resource (not the highest contribution margin per unit of the product).
A capacity constraint means that managers must choose to use resources for one thing and forgo using them for another.
Product-mix decisions are decisions managers make about which products to sell and in what quantities.
Decision rule (with a constraint):
Choose the product that produces the highest contribution margin per unit of the constraining resource (not the highest contribution margin per unit of the product)

25. Product mix decision with capacity constraint, example
Product A
Product B
Selling Price
$10.00
$30.00
Variable Cost per unit
$ 6.00
$15.00
Contribution Margin/unit
$ 4.00
Contribution Margin percentage
40%
50%
Machine Hours Required per unit
0.5
3.0
Contribution Margin/machine hour
$ 8.00
$ 5.00
In this simple example of a product mix decision, managers must choose how much of product A and B to sell. Machine Hours are limited and are the constraining resource, therefore, according to the rule, we will select the product that maximizes contribution margin per unit of the constraining resource.
Looking at contribution margin BY PRODUCT, the obvious choice would be Product B since it has a $15.00 margin per unit compared to $8.00 for Product A. However, Product B requires 3 hours of machine time vs. only ½ hour for Product A.
This type of decision usually has a short-run focus because they typically arise in the context of capacity constraints that can be relaxed in the long run.
CONCLUSION: Produce product A to maximize profitability.

26. Bottlenecks, theory of constraints and throughput-margin analysis
A bottleneck is a phenomenon where the performance or capacity of an entire system is limited by a single or limited number of components or resources. The term bottleneck is taken from the 'assets are water' metaphor. As water is poured out of a bottle, the rate of outflow is limited by the width of the conduit of exit—that is, bottleneck. By increasing the width of the bottleneck one can increase the rate at which the water flows out of the neck at different frequencies. Such limiting components of a system are sometimes referred to as bottleneck points.
A bottleneck is a phenomenon where the performance or capacity of an entire system is limited by a single or limited number of components or resources. The term bottleneck is taken from the 'assets are water' metaphor. As water is poured out of a bottle, the rate of outflow is limited by the width of the conduit of exit—that is, bottleneck. By increasing the width of the bottleneck one can increase the rate at which the water flows out of the neck at different frequencies. Such limiting components of a system are sometimes referred to as bottleneck points.

27. Bottlenecks, theory of constraints and throughput-margin analysis
The Theory of Constraints (TOC) describes methods to maximize operating income when faced with some bottleneck and some nonbottleneck operations. The TOC defines these three measures:
Throughput margin
Investments
Operating costs
The objective of the TOC is to increase throughput margin while decreasing investments and operating costs. The TOC focuses on managing bottleneck operations.
The Theory of Constraints (TOC) describes methods to maximize operating income when faced with some bottleneck and some nonbottleneck operations. The TOC defines these three measures:
Throughput margin
Investments
Operating costs
The objective of the TOC is to increase throughput margin while decreasing investments and operating costs. The TOC focuses on managing bottleneck operations.

28. Bottlenecks, theory of constraints and throughput-margin analysis, concluded
Four steps to manage bottleneck operations:
1. Recognize that bottleneck operations determines the contribution margin of the entire system.
2. Identify the bottleneck operations.
3. Subordinate all nonbottleneck operations to the bottleneck operation.
4. Take actions to increase the efficiency and capacity of the bottleneck operation.

29. Customer profitability and relevant costs
When the cost object is a customer, managers must decide about adding or dropping the customer.
Decision rule: Does adding or dropping a customer add operating income to the firm?
Yes—add or don’t drop
No—drop or don’t add
Decision is based on incremental income of the customer, not how much revenue a customer generates.
When the cost object is a customer, managers must decide about adding or dropping the customer.
Decision rule: Does adding or dropping a customer add operating income to the firm?
Yes—add or don’t drop
No—drop or don’t add
Decision is based on profitability of the customer, not how much revenue a customer generates.

30. Customer Profitability Analysis, example
In this example, the company faces the question of whether or not they should drop customer Wisk who appears to have a negative impact on operating income.
They are also considering adding a customer, Loral, who would have the same revenues and costs as Wisk plus the requirement of additional equipment with $9,000 depreciation. Rent, G&A and actual total corporate office costs will not change.
What should the company do? Exhibit 11-8 page 445

31. Customer Profitability Analysis, Extended
Looking at this relevant revenues/cost analysis, we see that dropping the Wisk account would actually decrease operating income by $15,000.
Adding the Loral account will increase operating income $6,000.
Note that for Loral, Rent, G&A expense and Corporate Office costs are not relevant because they don’t change whether or not Loral is added. On the other hand, the additional depreciation cost IS relevant for Loral since the $9,000 will only occur if that customer is added. Exhibit 11-9 page 446

32. Adding or Discontinuing Branches or Segments
Decision rule: Does adding or discontinuing a branch or segment add operating income to the firm?
Yes—add or don’t discontinue
No—discontinue or don’t add
Decision is based on incremental income of the branch or segment, not how much revenue the branch or segment generates.
Here we see the decision rule for adding or discontinuing branches or segments.
The cost object here isn’t a product or customer, but a branch or segment of the business. The decision rule remains constant: Does adding or discontinuing a branch or segment add operating income to the firm?
Yes—add or don’t discontinue
No—discontinue or don’t add
Decision is based on profitability of the branch or segment, not how much revenue the branch or segment generates.

33. Equipment-Replacement Decisions
Sometimes difficult due to amount of information at hand that is irrelevant:
Cost, accumulated depreciation, and book value of existing equipment
Any potential gain or loss on the transaction—a financial accounting phenomenon only.
Decision rule: Select the alternative that will generate the highest operating income.
Equipment-replacement decisions can sometimes be difficult due to amount of information at hand that is irrelevant like the
Cost, accumulated depreciation, and book value of existing equipment, and
Any potential gain or loss on the transaction—a financial accounting phenomenon only
Decision rule: Select the alternative that will generate the highest operating income.

34. Equipment-Replacement Decisions, data for decision
In this chart, we see the information available with which we’ll make a decision about whether or not to replace equipment.
The company uses straight line depreciation and to keep the focus on relevance, we’ll ignore both the time value of money and income taxes. From page 448

35. Equipment-Replacement Decisions, example, operating income comparison
In this operating income comparison, we see that replacing the machine will increase operating income by $120,000.
Now, let’s take a look at the relevant costs only. Exhibit page 449

36. Equipment-Replacement Decisions, Illustrated (Relevant Costs Only)
Here, we see the same analysis showing relevant costs only.
Note the following:
Book value of the old equipment is not relevant (sunk)
Loss on disposal of old equipment is not relevant in total. However, the portion of this value that is the disposal value of the old machine is. Exhibit page 450

37. Decisions and performance evaluation
Despite the quantitative nature of some aspects of decision making, not all managers will choose the best alternative for the firm.
Managers will consider how the company will judge his or her performance after the decision is implemented.
Many managers consider it unethical to take actions that make their own performance look good when these actions are not in the best interests of the firm.
Despite the quantitative nature of some aspects of decision making, not all managers will choose the best alternative for the firm.
Managers will consider how the company will judge his or her performance after the decision is implemented.
Many managers consider it unethical to take actions that make their own performance look good when these actions are not in the best interests of the firm.

38. Decisions and performance evaluation, concluded
The decision model analysis (step 4) can dictate one decision but in the real world, would the manager want to follow it?
An important factor is the manager’s perception of whether the decision model is consistent with how the company will judge his or her performance after the decision is implemented (the performance evaluation model in step 5).
The decision model analysis (step 4) can dictate one decision but in the real world, would the manager want to follow it?
An important factor is the manager’s perception of whether the decision model is consistent with how the company will judge his or her performance after the decision is implemented (the performance evaluation model in step 5).
Top management faces a persistent challenge: making sure that the performance-evaluation model of lower-level managers is consistent with the decision model. A common inconsistency is to tell these managers to take a multiple-year view in their decision making but then to judge their performance only on the basis of the current year’s operating income.

39. Terms to learn TERMS TO LEARN PAGE NUMBER REFERENCE Book value
Business function costs
Page 429
Constraint
Page 455
Decision model
Page 425
Differential cost
Page 433
Differential revenue
Page 434
Full costs of the product
Incremental cost
Incremental revenue

40. Terms to learn, cont’d TERMS TO LEARN PAGE NUMBER REFERENCE Insourcing
Linear programming (LP)
Page 456
Make-or-buy decisions
Objective function
Page 455
One-time-only special order
Page 428
Opportunity cost
Page 436
Outsourcing
Product-mix decisions
Page 440
Qualitative factors
Quantitative factors
Page 427

41. Terms to learn, concluded
PAGE NUMBER REFERENCE
Relevant costs
Page 426
Relevant revenues
Sunk costs
Page 427
Theory of constraints (TOC)
Page 441
Throughput margin