Exhibit 25-1 illustrates how managers make decisions among alternative courses of action.
Managerial accountants help with the third step: gather and analyze relevant information to compare alternatives.
Learning Objective 1 Identify information that is relevant
for making short-term decisions
1 Identify information that is relevant for making short-term decisions
2 Make regular and special pricing decisions
3 Make decisions about dropping a product, product mix, and sales mix
4 Make outsourcing and processing further decisions
Chapter 25 Learning Objectives
Exhibit25-1 | How Managers Make Decisions
Define Business
Goals Identify Alternative
Courses of Action
Gather and Analyze Relevant Information:
Compare Alternatives Choose the Best Alternative
Target Profit
Market Share Alt 1
Accept special order
Alt 2
Reject special order
Special Order Inc. Rev.
Inc. V.C.
Contrib.
Margin
Alt 1 Contrib.
margin is negative
Alt 2 Contrib.
margin is positive
(XX)XX
XX
Relevant Information
When managers make decisions, they focus on information that is relevant to the decisions.
Relevant information is expected future data that differ among alternatives. Relevant costs are costs that are relevant to a particular decision. To illustrate, if the fictitious company Smart Touch Learning was considering purchasing a new delivery truck and was choosing between two different models, the cost of the trucks, the sales tax, and the insurance pre- mium costs would all be relevant because these costs are future costs (after Smart Touch
Relevant Information Expected future data that differ
among alternatives.
Relevant Cost A cost that is relevant to a particular
decision because it is a future cost and differs among alternatives.
Learning decides which truck to buy) and differ between alternatives (each truck model has a different invoice price, sales tax, and insurance premium). These costs are relevant because they can affect the decision of which truck to purchase.
Irrelevant costs are costs that do not affect the decision because they are not in the future or do not differ among alternatives. For example, if the two truck models have simi- lar fuel efficiency and maintenance ratings, we do not expect the truck operating costs to differ between those two alternatives. Because these future costs do not differ, they do not affect Smart Touch Learning’s decision. In other words, they are irrelevant to the decision.
Sunk costs are costs that were incurred in the past and cannot be changed regardless of which future action is taken. Sunk costs are always irrelevant to the decision. This does not mean we cannot learn from past decisions—managers should always consider the results of past decisions when making future decisions. However, because sunk costs are already spent, the cost is not relevant to future decision making. For example, perhaps Smart Touch Learning wants to trade in its current truck when the company buys the new truck. The amount Smart Touch Learning paid for the current truck—which the company bought for $15,000 a year ago—is a sunk cost. No decision made now can alter the sunk costs spent in the past. All the company can do now is keep the current truck, trade it in, or sell it for the best price the company can get—even if that price is substantially less than what Smart Touch Learning originally paid for the truck.
What is relevant is the amount Smart Touch Learning can receive if it sells the truck in the future. Suppose that one dealership offers an $8,000 trade-in value for the truck, but another dealership offers $10,000. Because the amounts differ and the transaction will take place in the future, the trade-in value is relevant to Smart Touch Learning’s decision. The same principle applies to all situations—only relevant data affect decisions.
Relevant Nonfinancial Information
Nonfinancial, or qualitative, factors also play a role in managers’ decisions and, as a result, can be relevant. For example, closing manufacturing plants and laying off employ- ees can seriously hurt employee morale. The decision to buy or subcontract a product or service rather than produce it in-house can reduce control over delivery time or product quality. Offering discounted prices to select customers can upset regular customers and tempt them to take their business elsewhere. Managers must always consider the potential quantitative and qualitative effects of their decisions.
Managers who ignore qualitative factors can make serious mistakes. For example, the City of Nottingham, England, spent $1.6 million on 215 solar-powered park- ing meters after seeing how well the parking meters worked in countries along the Mediterranean Sea. However, they did not consider that British skies are typically overcast. The result was that the meters did not always work because of the lack of sunlight. The city lost money because people parked for free! Relevant qualitative infor- mation has the same characteristics as relevant financial information. The qualitative effect occurs in the future and differs between alternatives. In the parking meter example, the amount of future sunshine required by the meters differed between the alternatives.
The mechanical meters did not require any sunshine, but the solar-powered meters needed a lot of sunshine.
Irrelevant Cost
A cost that does not affect the decision because it is not in the future or does not differ among alternatives.
Sunk Cost
A cost that was incurred in the past and cannot be changed regardless of which future action is taken.
Is relevant
information always financial?
out irrelevant information—the revenues and costs that will not differ between alternatives.
In this chapter, we consider several kinds of short-term business decisions:
• Regular and special pricing
• Dropping unprofitable products and segments, product mix, and sales mix
• Outsourcing and processing further
As you study these decisions, keep in mind the two keys in analyzing short-term busi- ness decisions:
1. Focus on relevant revenues, costs, and profits. Irrelevant information only clouds the picture and creates information overload.
2. Use a contribution margin approach that separates variable costs from fixed costs. Because fixed costs and variable costs behave differently, they must be analyzed separately. Traditional income statements, which blend fixed and variable costs together, can mislead managers. Contribution margin income statements, which isolate costs by behavior (variable or fixed), help managers gather the cost behavior information they need. Keep in mind that manufacturing costs per unit are mixed costs, too—so they can also mislead managers. If you use manufacturing costs per unit in your analysis, be sure to first separate the unit cost into its fixed and variable portions.
We use these two keys in each decision.
Try It!
Doherty Company is considering replacing the individual printers each employee in the corporate office currently uses with a network printer located in a central area. The network printer is more efficient and would, therefore, cost less to operate than the individual printers. However, most of the office staff think having to use a centralized printer would be inconvenient. They prefer to have individual printers located at each desk. Identify the following information as financial or nonfinancial and relevant or irrelevant. The first item has been completed as an example.
Financial Nonfinancial Relevant Irrelevant
1. Amount paid for current printers ✓ ✓
2. Resale value of current printers 3. Cost of new printer
4. Operating costs of current printers 5. Operating costs of new printer 6. Employee morale
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercise S25-1. MyAccountingLab