Decision Making:

Relevant Costs
and Benefits -
Introduction

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Learning Objective 1

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Short-Run Decision Making
Short-run decision making consists of
choosing among alternatives with an
immediate or limited end in view.
Also referred to as tactical decisions because
they involve choosing between alternatives
with an immediate or limited time frame in
mind.

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Short-Run Decision Making
(cont.)
Example: Accepting a special order for less
than the normal selling price to utilize idle
capacity and to increase this years profits.
Some decisions tend to be short run in nature.
Short-run decisions often have long-run
consequences.

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The Managerial Accountants Role in
Decision Making

Managerial
Managerial
Accountant
Accountant
Cross-functional
Cross-functional
management
management teams
teams
Designs
Designs and
and implements
implements who
who make
make
accounting
accounting information
information production,
production, marketing,
marketing,
system
system and
and finance
finance decisions
decisions

Make
Make substantive
substantive
economic
economic decisions
decisions
affecting
affecting operations
operations
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The Decision-Making Process
1.
1. Clarify
Clarify the
the Decision
Decision Problem
Problem

2.
2. Specify
Specify the
the Criterion
Criterion

3.
3. Identify
Identify the
the Alternatives
Alternatives
Quantitative
Analysis
4.
4. Develop
Develop aa Decision
Decision Model
Model

5.
5. Collect
Collect the
the Data
Data

6.
6. Make
Make aa Decision
Decision
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The Decision-Making Model
A decision model, a specific set of
procedures that produces a decision, can be
used to structure the decision makers
thinking and to organize the information to
make a good decision.
The following is an outline of one decision-
making model:
Step 1. Recognize and define the problem.
Step 2. Identify alternatives as possible
solutions to the problem. Eliminate alternatives
that clearly are not feasible.
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The Decision-Making Model
(cont.)
Step 3. Identify the costs and benefits
associated with each feasible alternative.
Classify costs and benefits as relevant or
irrelevant, and eliminate irrelevant ones from
consideration.
Step 4. Estimate the relevant costs and
benefits for each feasible alternative.
Step 5. Assess qualitative factors.
Step 6. Make the decision by selecting the
alternative with the greatest overall net benefit.

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Learning Objective 2

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The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

Primarily the
responsibility of the 3. Identify the Alternatives
managerial
accountant. 4. Develop a Decision Model

5. Collect the Data

Information
Information should
should be:
be:
1.
1. Relevant
Relevant
2.
2. Accurate
Accurate 6. Make a Decision
3.
3. Timely
Timely
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The Decision-Making Process
1. Clarify the Decision Problem

2. Specify the Criterion

3. Identify the Alternatives

Qualitative
Qualitative
Considerations 4. Develop a Decision Model
Considerations

5. Collect the Data

6. Make a Decision
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The Decision-Making Process
1. Clarify the Decision Problem
Relevant
Relevant
Pertinent
Pertinent to
to aa
decision 2. Specify the Criterion
decision problem.
problem.

Accurate
Accurate 3. Identify the Alternatives
Information
Information must
must
be
be precise.
precise. 4. Develop a Decision Model

Timely
Timely 5. Collect the Data
Available
Available in
in time
time
for
for aa decision
decision 6. Make a Decision
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Learning Objective 3

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Relevant Information
Information is relevant to a decision
problem when . . .
1.
1. It
It has
has aa bearing
bearing on
on the
the future,
future,
2.
2. It
It differs
differs among
among competing
competing
alternatives.
alternatives.

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Relevant Costs Defined
The decision-making approach just described
emphasized the importance of identifying and
using relevant costs.
Relevant costs possess two characteristics:
they are future costs AND
they different across alternatives.
All pending decisions relate to the future.
Accordingly, only future costs can be relevant
to decisions.

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Learning Objective 4

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Identifying Relevant
Costs and Benefits
Sunk
Sunk costs
costs
Costs
Costs that
that have
have already
already been
been incurred.
incurred. They
They do
do
not
not affect
affect any
any future
future cost
cost and
and cannot
cannot be
be
changed
changed byby any
any current
current or
or future
future action.
action.

Sunk costs are irrelevant to decisions.

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Sunk Costs
A sunk cost is a cost that cannot be affected
by any future action.
It is important to note the psychology behind
managers treatment of sunk costs.
Although managers should ignore sunk costs
for relevant decisions, it unfortunately is
human nature to allow sunk costs to affect
these decisions.

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Sunk Costs (cont.)
For example, depreciation, a sunk cost,
is sometimes allocated to future periods
though the original cost is unavoidable.
In choosing between the two
alternatives, the original cost of an asset
and its associated depreciation are not
relevant factors.

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Opportunity Costs
Opportunity cost is the benefit sacrificed or
foregone when one alternative is chosen over
another.
An opportunity cost is relevant because it is
both a future cost and one that differs across
alternatives.
An opportunity cost is never an accounting
cost, because accountants do not record the
cost of what might happen in the future (i.e.,
they do not appear in financial statements).
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Differential Costs
increases (incremental) or decreases
(decremental) in total costs between two
options
may also be applied in revenues
(differential revenues)
relevant cost
Avoidable Costs
costs that will be saved or will not be
incurred if a certain decision is made
e.g. if a product line is to be dropped/
discontinued, materials, direct labor, and
some factory overhead may be avoidable
relevant costs
avoidable fixed costs are only relevant
when choosing to continue or discontinue
(drop) the product/segment
Joint Costs
costs incurred in purchasing and/or
manufacturing two or more products which
are not identifiable until the process
reaches point of separation or split-off point
encountered in sell as is or process
further problems
Not relevant since joint costs will not
change whether you sell products as is or
process them further
Allocated/Common Costs
indirect costs allocated to segment of a
large company
not relevant
Relevant Costs
Worldwide Airways is thinking about replacing a three
year old loader with a new, more efficient loader.
New
New loader
loader
List
List price
price $$ 15,000
15,000
Annual
Annual operating
operating expenses
expenses 45,000
45,000
Expected
Expected life
life in
in years
years 11
Old
Old loader
loader
Original
Original cost
cost $$100,000
100,000
Remaining
Remaining bookbook value
value 25,000
25,000
Disposal
Disposal value
value now now 5,000
5,000
Annual
Annual variable
variable expenses
expenses 80,000
80,000
Remaining
Remaining lifelife in
in years
years 11
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Relevant Costs
IfIf we
we keep
keep the
the old
old loader,
loader, we
we will
will have
have depreciation
depreciation
costs
costs of
of $25,000.
$25,000. IfIf we
we replace
replace the the old
old loader,
loader,
we
we will
will write-off
write-off the
the $25,000
$25,000 when
when sold. sold. There
There is
is
no
no difference
difference inin the
the cost,
cost, so
so itit is
is not
not relevant
relevant..

WeWe will
will only
only have
have depreciation
depreciation on
on the
the new
new loader
loader
ifif we
we replace
replace the
the old
old loader.
loader. This
This cost
cost is
is relevant
relevant..

The
The $5,000
$5,000 proceeds
proceeds will
will only
only be
be realized
realized ifif we
we
replace
replace the
the old
old loader.
loader. This
This amount
amount isis relevant
relevant..

The new loader will be depreciated in one year.

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Relevant Costs (Total Approach)

The
The difference
difference in in operating
operating costs
costs is
is relevant
relevant
to
to the
the immediate
immediate decision.
decision.

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Relevant Costs (Differential Approach)
Here is an analysis that includes only
relevant costs:

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Relevant Decision Making
You are an elected official in a major city that is considering
whether or not to move forward with a proposed plan to
demolish the citys existing professional sports stadium and
build an elaborate new stadium. One of the most difficult
aspects of this decision is estimating the new stadiums
incremental revenues and costs that would result if it were
built.

What specific types of relevant revenues and costs

would you consider in making this important decision?

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 Relevant Decision Making
There are many stadium events for which the associated relevant revenues and costs must be
estimated accurately if the correct decision is to be made. These stadium events (and their relevant
revenues and costs) include:

Main attraction sporting events (e.g., ticket revenues from baseball, basketball, and/or football
games for which the stadium would be built; additional staffing, cleanup, and insurance costs)
Concessions and other sales (e.g., contribution margins or fees earned from product and
service salesmost new stadiums boast as many high-end shopping opportunities as an
upscale mall!)
Television contract terms (e.g., the amount and percentage of revenue brought in by additional
games being televised in the new stadium, perhaps in primetime slots)
Offseason events (e.g., the ticket revenue from boxing matches, music concerts, etc.).

For this relevant stadium decision, estimating the relevant revenues might be even more difficult
than estimating the relevant costs. For instance, projecting how many more people will want to
attend games in a new stadium can be unclear, as well as how much money they
would be willing to spend for various seats located around the stadium.

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 Relevant Decision Making
Several New York City area stadiums experienced tremendous difficulty in accurately estimating these
same items. For example, the New York Yankees and New York Mets organizations built new
stadiums with price tags of over $1.2 billion and $800 million, respectively! However, in the new
Yankee stadium, many of the more expensive seatsthe ones behind the batter and, thus, most visible
on televisionremained empty because of their hefty $2,500 per seat price tag. In fact, the Yankee
organization decreased some of its highest ticket prices by 50% during the stadiums first season in an
attempt to fill these high profile empty seats. In other words, decision makers struggled to estimate the
amount of incremental revenue that would result from some of the more important seats in a new Yankee
stadium. Undaunted by such challenging relevant analyses, however, the New York area also built a $1.6
billion new Meadowlands Stadium to be shared by the New York Jets and New York Giants.
In addition to the previously mentioned relevant items, some citizens raise objections to such large
amounts of money being spent on replacing existing fully functional sporting facilities with gargantuan
sports palaces. They argue that $1 billion could be better spent on different causes. Such sentiments,
whether you agree or disagree with them, represent potentially important qualitative factors that effective
managerial accountants should take into account when performing relevant analyses for proposed new
stadiums, especially when these citizens represent tax payers or potential fans the stadium builders
count on for purchasing expensive tickets in the future.
When making such an important decision, relevant costs for things like sporting events,
concessions, television contracts, and off-season events must be considered in addition to
qualitative factors like citizen sentiment.
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End of Introduction

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