Chapter 10:

Relevant Information for

Decision Making
Cost Accounting:
Foundations and Evolutions, 8e
Kinney ● Raiborn

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Learning Objectives
 What factors determine the relevance of information to
decision making?
 What are sunk costs, and why are they not relevant in
making decisions?
 What information is relevant in an outsourcing decision?
 How can management achieve the highest return from
use of a scarce resource?
 What variables do managers use to manipulate sales
mix?
 How are special prices set, and when are they used?
 How do managers determine whether a product line
should be retained or discontinued?
 (Appendix) How is linear programming used to optimally
manage multiple resource constraints?

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Relevant Costing

 Relevant Costing focuses managerial

attention on a decision’s relevant facts
 Relevance
 Associated with the decision under consideration
 Important to the decision maker
 Connected to or bearing on some future endeavor
 Most variable costs are relevant
 Most fixed costs are not relevant

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Incremental Revenue, Cost, & Profit/Loss

 Incremental Revenue—the amount of

revenue that differs across decision choices
 Incremental Cost or Differential Cost—the
amount of cost that varies across decision
choices
 Incremental Profit or Loss—the difference
between incremental revenue and
incremental cost

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Opportunity & Sunk Costs

 Opportunity Costs—benefits foregone

because one course of action is chosen over
another
 Sunk Costs—costs incurred in the past to
acquire an asset or a resource
 Not relevant because they cannot be changed
regardless of future actions
 Not recoverable
SUNK COSTS ARE IRRELEVANT.
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Relevant Costing & Business
Decisions
 Outsourcing a product or part
 Allocating scarce resources
 Accepting special orders
 Determining the sales/production mix

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Outsourcing & Make-or-Buy Decions

 Outsourcing—having work performed for one

company by an off-site non-affiliated supplier
 Offshoring—sending a job formerly performed in the
home country to a foreign country
 Make-or-Buy decisions compare internal production
and opportunity costs with purchase cost
 Relevant information:
 Strategic
 Economic
 Technological
 Management and human resources
 Most outsourcing relates to operating costs not to
strategic core competencies
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Make-or-Buy—Quantitative Factors

 Incremental production costs per unit

 Cost to purchase outside
 Number of available suppliers
 Production capacity available
 Opportunity costs of production facilities
 Space available for storage
 Inventory carrying costs
 Increase in throughput from buying
components
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Make-or-Buy—Qualitative Factors

 Reliability of supply sources

 Ability to control quality of items purchased
outside
 Nature/importance of the work to be
subcontracted
 Impact on customers and markets
 Future bargaining position with supplier(s)
 Perceptions about future price changes
 Perceptions about current product prices
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Outsourcing Risk Pyramid
Outsource under Never
Tight Control Outsource
Strategic
Direction,
Unique Core
Outsource under Competencies
Service Levels Tax, Audit, Legal
Information Technology Low-Risk
Outsourcing
Help Desk, Call Centers
Data Centers, Logistics
Facility, Network, Supply-Chain
Management, Temporary Staffing,
Payroll, Security Services, Food Services

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Services Often Outsourced

 Accounting and legal services

 School bus programs
 Medical—blood testing
 Process design activities
 Utilities
 Engineering services
 Employee health services

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Scare Resources
 Essential to production  Choose product or service
activity but available only in with highest contribution
limited quantity margin per unit of scarce
 Machine hours resource
 Skilled labor hours  When there are several
 Raw materials limiting factors, use linear
 Production capacity programming to choose
product or service
 Before eliminating products
or services, consider
qualitative factors
 Company reputation
 Impact on customer base
 Market saturation
 Company stagnation

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Production Choices

 Production and sale of some less

profitable products may be necessary to
maintain either customer satisfaction or
sales of other products

Low CM on razors may be

required to obtain high CM
on razor blades

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Sales Mix Decisions

 Sales Mix—relative quantities of the

products that make up the total sales of
a company
 Factors affecting sales mix:
 Product selling prices
 Sales force compensation

 Advertising expenditures

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Impact of Change in Sales Price

 Quantitative Factors  Qualitative Factors

 New contribution margin  Customer goodwill
per unit of each product  Customer loyalty
 Changes in product  Response of competitors
demand and production  Production of new
volume products
 Best use of scarce
resources

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Pricing New Products

 Consider the product’s entire life cycle (long

run)
 To set prices at various stages in the
product’s life cycle, make assumptions about:
 Consumer behavior
 Competitor behavior
 Pace of technology changes
 Government posture
 Environmental concerns
 Size of potential market
 Demographic changes
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Impact of Change in Compensation

 Commission based on fixed percentage of

gross sales dollar
 Sell highest priced product
 Commission based on product contribution
margin
 Sell most profitable product
 When considering compensation structure
 Ignore fixed costs unless the fixed costs are
incremental relative to the new policy or to
changes in sales volume
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 Impact of Change in Advertising
 Increase in advertising  Irrelevant costs include
costs may cause  Original fixed costs
 Change in sales mix  Contribution margin
generated by the current
 Change in sales volume
sales levels
 Advertising budget
changes Incremental Revenues
 Relevant costs Less: Incremental Variable Costs equals
 Increased sales revenue Incremental Contribution Margin
 Increased variable costs Less: Incremental Fixed Costs equals
Incremental Benefit (or Loss)
 Increased fixed costs

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Special Order Decisions

Special order decisions involve management

computing a reasonable sales price for products or
services not part of normal operations.

 Sales price should  Special prices can be

cover: considered for:
 Variable production and  Unusual quantity, delivery,
selling costs packaging, or
 Incremental fixed costs customization of product
 Profit  One-time job such as an
overseas order that will not
affect the domestic market

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Private-Label Orders, Low-Ball Bids
& Ad Hoc Discounts
 Private-label order  Low-ball bid
 Buyer’s name (not producer’s)
attached to the product
 To introduce product or
service to particular market
 Accept during slack periods to
use available capacity  Sales price at or below cost
 Fixed costs usually not  Cannot be continued over
allocated the long run
 Variable selling costs often  Ad Hoc Discounts
reduced/eliminated
 Sales price set to generate a  Price concessions related to
positive contribution margin real (or imagined)
competitive pressures
rather than to the location of
the merchandising chain or
volume purchased

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Special Order Decisions –
Qualitative Factors
 Impact on future prices and sales
 Sufficient contribution margin to justify the additional
burden on workers and management
 Impact on scarce resources and throughput
 Keep workforce employed during slow times
 Consider Robinson-Patman Act
 Prohibits companies from pricing the same product at
different levels when those amounts do not reflect related
cost differences
 Requires that cost differences result from actual variations
in the cost to manufacture, sell, or distribute because of
different methods of production or quantities sold

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Product Line and Segment Decisions

 Multiproduct Environments  Separate costs by

 Costs by product lines  Product Line
 Costs of divisions  Revenue
 Distinguish between relevant  Variable costs
and irrelevant information  Avoidable direct fixed costs
 Commingling relevant and  Unavoidable direct fixed
irrelevant information may costs
suggest a product line/  Common Costs
segment is operating at a  Unavoidable Direct Fixed
loss when it is actually Costs and Common Costs
operating at a profit
 Will continue even if a
product line or segment is
eliminated
 Are irrelevant costs when
deciding to eliminate a
product line or segment

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 Segment Margin Use segment margin
to decide to continue
Income Statement or eliminate a
Sales segment
<Variable Expenses>
Contribution Margin
<Avoidable/Attributable Fixed Expenses>
Segment Margin
<Unavoidable Fixed Expenses>
Product Line Result
<Allocated Common Expenses>
Net Income (Loss)

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Product Line Decisions – Beware

 Proceeds from sale of equipment are

relevant
 Costs that appear to be avoidable may not
be
 Depreciation on equipment is irrelevant
 Eliminating a product may affect
customers
 Customers seek products elsewhere due to
shrinking market assortment
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Appendix—Linear Programming
 Linear Programming
 Used to find the optimal allocation of scarce resources in a
situation involving one objective and multiple limiting factors
 Resource constraints
 Demand or marketing constraints
 Technical product constraints
 Nonnegativity constraints
 Whole number constraints
 Helps managers allocate scarce resources among competing
uses
 One objective
 Maximize contribution margin

 Minimize product cost

 Optimal solution—provides best answer to allocation problem

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Questions

 What are some relevant financial

considerations when making an
outsourcing decision?
 How are prices set for special orders?
 What types of decisions require segment
margin income statements?

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Potential Ethical Issues
 Ignoring qualitative factors in decisions
 Going offshore to exploit lax environmental and
labor standards
 Making decisions based on financial earnings
impact
 Using bait-and-switch advertising techniques
 Setting prices that violate the Robinson-Patman
Act or other pricing regulations
 Substituting materials that pose health or
environmental risks in a scarce resource situation

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a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.