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1. Use the five-step decision process to make decisions
2. Differentiate relevant from irrelevant costs and revenues in decision situation
3. Distinguish between quantitative and qualitative factors in decisions
4. Beware of two potential problems in relevant-cost analysis
5. Explain the opportunity-cost concept and why it is used in decision making
6. Know how to choose which products to produce when there are capacity constraints
7. Discuss what managers must consider when adding or discontinuing customers and segments
8. Explain why the book value of equipment is irrelevant in equipment-replacement decisions
9. Explain how conflicts can arise between the decision model used by a manager and the performance
evaluation model used to evaluate the manager

Chapter 11 is about the decision-making process. Accountants are an integral part of this process,
providing information to decision makers. A five-step approach to making decisions, beginning with the
point in the process in which the accountants typically become involved, is described in the chapter.
An extremely useful concept is presented. The information needed for the decision process must be
relevant to the decision. Relevant is defined as revenues and costs that occur in the future and differ
among the alternative courses of action available to the decision maker. This definition is illustrated
through various situations. In this chapter the information needed for decisions of one-time-only special
orders, make-or-buy, drop-or-add, and keep-or-replace are explained. Several of the chapters that follow
will introduce other types of decisions that use the concept of relevant revenues and costs.
A major theme of the text is that information generated by the accounting system is used for the benefit of
managers in making decisions. The roles performed by accountants are implicit in the illustrations of
relevant information gathered for decisionsproblem solving, scorekeeping, and attention directing. A
review of those roles from Chapter 1 could be used to highlight their importance in the decision process.
The last step of the decision process is evaluating performance. The last section of the chapter deals with
conflicts between the decision model used by a manager and the performance model then used to evaluate
that manager. This is an important discussion.
Linear programming as a tool in the decision process is described in the appendix.

Decision Making and Relevant Information 141


Information and the decision process

A. Define the decision under consideration

TEACHING TIP: A clear understanding of the purpose of the decision is helpful in working through the
steps in the decision process. By carefully and quite specifically defining the decision to be made, the
determination of relevant costs and relevant revenues for each alternative is usually easier. Continued
emphasis on the definition of relevant cannot be overdone.
Learning Objective 1:
Use the five-step decision process to make decisions
B. Employ five-step decision-making process [Exhibit 11-1]
1. Obtain information
a. Historical costs
b. Other information
2. Make predictions
3. Choose an alternativemust have at least two
4. Implement decision
5. Evaluate performance to provide feedback
C. Use feedback [Refer to Chapter 1]
1. Affect future decisions
2. Affect prediction method
3. Affect implementation of the decision
Do multiple choice 1.

Assign Exercise 11-16.

II. The meaning of relevance [Exhibit 11-2]

Learning Objective 2:
Differentiate relevant from irrelevant costs and revenues in decision situations
A. Definition of relevant costs and revenues
1. Occur in the future

142 Chapter 11

a. Past costs may be useful basis for making informed predictions of expected future
b. Unavoidable past costs that cannot be changed are sunk costs
2. Differ among alternative courses of action (What difference does it make?)
a. Same conclusion if use only that which differs and if use all data
b. Pertinent data used saves time and maintains focus
Do multiple choice 2.

Assign Exercise 11-18.

B. Outcomes of alternatives [Exhibit 11-3]

Learning Objective 3:
Distinguish between quantitative and qualitative factors in decisions
1. Quantitative factors: outcomes measured in numerical terns
2. Qualitative factors: outcomes that cannot be measured in numerical terms
III. Illustrations of relevance
A. Choosing output levelsexample of one-time-only special order [Exhibits 11-4 and 11-5]
1. Understand conditions of decision (obtain information)
a. Decision to accept or reject one-time-only special order
b. Idle capacity available
c. No long-run implications of accepting the order
2. Identify relevant revenues and costs
a. Income statement formatmaximize income
b. Full costs identified by amount and type
Do multiple choice 3.

Assign Exercises 11-19.

Learning Objective 4:
Beware of two potential problems in relevant-cost analysis
c. Beware of two potential problems in relevant-cost analysis

Avoid incorrect general assumptions such as all variable costs are relevant and all
fixed costs are irrelevant

Decision Making and Relevant Information 143

ii. Avoid losing sight of grand totals and focusing instead on unit costs

Unit costs mislead when irrelevant costs are included

Unit costs mislead when same unit costs are used at different output levels

iii. Require each item to be expressed as total future revenue or cost

B. Insourcing-versus-outsourcingexample of make-versus-buy decisions
1. Understand conditions of decision (obtain information)
a. Idle capacity available
b. Qualitative factors
c. If outsourcing, what use made of idled facility (new choice)
2. Identify relevant revenues and costs
a. Minimize costs
b. Know full costs by amount and type

Incremental costs: additional total costs incurred for an activity

ii. Differential cost: difference in cost between two alternatives

3. Use strategic and qualitative factors in choosing among alternatives [Exhibit 11-6]
a. In-house to maintain control over design, quality, reliability, delivery schedules
b. Outsource to be smaller and leaner organization, focusing on areas of core competencies

Use long-run contracts to minimize risks of dependence on suppliers

ii. Build partnership with suppliers

iii. Allow suppliers to gain expertise and grow [VW Concepts in Action]
4. Choose best use of available facilities [Exhibit 11-7]
a. Continue to make productdo not outsource
b. Buy product choice of use for idled facilities and of schedule for purchasing product
Do multiple choice 4.

Assign Exercise 11-20 and Problem 11-35.

Learning Objective 5:
Explain the opportunity-cost concept and why it is used in decision making

144 Chapter 11


Consider opportunity cost: contribution to income that is forgone by not using a

limited resource in its next-best alternative use

ii. Include opportunity cost because it represents best alternative way organization may
have used its resources had it not made the decision it did [AA Concepts in Action]
Do multiple choice 5 and 6.

Assign Exercise 11-21 and Problems 11-30 and 11-31.

C. Product-mix decisions under capacity constraints

Learning Objective 6:
Know how to choose which products to produce when there are capacity constraints
1. Understand conditions of decision (obtain information)
a. Level of capacity is a constraintonly be expanded in the long run
b. Demand is a constraint
c. Other constraints: availability of direct materials, components, skilled labor, financial
factors, display space, etc.
2. Identify relevant revenues and costs
a. Maximize operating income
b. Analyze individual product contribution margin
c. Focus on maximizing total contribution margin by choosing products with highest
contribution margin per unit of the constraining factor
Do multiple choice 7.

Assign Exercises 11-22 and 11-23, Problems 11-29 and 11-32.

D. Add or discontinue a product lineexample of customer profitability

1. Understand conditions of decision (obtain information)
a. Customer (product line) as cost object
b. Activities associated with servicing customer (activity-based costing approach)
2. Identify relevant revenues and costs [Exhibit 11-8]
a. Maximize profit
b. Know full costs of activities and types of costs (hierarchy)
Learning Objective 7:
Discuss what managers must consider when adding or discontinuing customers and segments

Decision Making and Relevant Information 145

c. Ignore allocated overhead costs

d. Focus on how total costs differ among alternatives [Exhibit 11-9 and 11-10]
3. Choose among alternatives
a. Reduce companys costs of supporting the customer
b. Charge higher prices to customer
c. Discontinue the customer as an account
d. Work with customer to reduce costs of supplying product
e. Consider strategic factors and long-run relationship
Do multiple choice 8.

Assign Exercises 11-24, 25, and 26, Problems 11-33 and 11-34.

E. Keep or replace decisionsexample of equipment

Learning Objective 8:
Explain why the book value of equipment is irrelevant in equipment-replacement decisions
1. Understand conditions of decision
a. If keep, company has equipment because of past decision (past cost)
b. Past costs, particularly book value of existing equipment, is irrelevant
2. Identify relevant revenues and costs [Exhibit 11-11]
a. Minimize costs (maximize income if revenues are relevant)
b. Future revenues and costs are relevant [Exhibit 11-12]

Cash operating cost relevant

ii. Disposal price of old machine relevant

iii. Cost of new machine relevant
Do multiple choice 9.

Assign Exercises 11-27 and 11-28.

Learning Objective 9:
Explain how conflicts can arise between the decision model used by a manager and the performance
evaluation model used to evaluate the manager
IV. Decisions and performance evaluation

146 Chapter 11

A. Manager will favor decision alternative that looks best for performance whether decision is best
for company
B. Time frame for decision is longer than time frame for performance evaluation
C. Accounting systems rarely track each decision separately so impacts of many different decisions
are combined in a single performance report
D. Managers may hesitate because of how a decision would look to supervisors if supervisors
have no knowledge of alternative choices
Do multiple choice 10.

Assign Problems 11-37 and 11-38.

V. Appendix: Linear programming [Exhibit 11-13]

A. Steps in solving a linear programming problem
1. Determine the objective function: goal to be maximized (income) or minimized (costs)
2. Specify the constraints: mathematical inequality or equality that must be satisfied by the
variables in a mathematical model
3. Compute the optimal solution
a. Trial-and-error approach
b. Graphic approach
B. Sensitivity analysis
Do multiple choice 11 through 16.


2.b 3.a 4.d 5.b 6.a 7.c 8.d 9.c 10.b

11.b 12.a 13.d 14.b 15.c 16.d

Decision Making and Relevant Information 147

1. Which of the following should not be considered for every option in the decision process?
a. Relevant revenues
b. Relevant costs

c. Historical costs
d. Opportunity costs

2. What is always the question to ask to determine if revenues or costs are relevant?
a. What is the time frame for achieving results?
b. What difference will an action make?

c. Who will be responsible?

d. How much will it cost?

3. [CPA Adapted] Mikaelabelle Products sells product A at a selling price of $40 per unit.
Mikaelabelles cost per unit based on the full capacity of 500,000 units is as follows:
Direct materials
Direct labor
Indirect manufacturing (60% of which is fixed)

$ 6

A one-time-only special order offering to buy 50,000 units was received from an overseas
distributor. The only other costs that would be incurred on this order would be $4 per unit for
shipping. Mikaelabelle has sufficient existing capacity to manufacture the additional units. In
negotiating a price for the special order, Mikaelabelle should consider that the minimum selling price
per unit should be
a. $17.

b. $19.

c. $21.

d. $23.

The following data apply to questions 4 and 5.

Troy Instruments uses ten units of Part Number S1798 each month in the production of scientific
equipment. The unit cost to manufacturing one unit of S1798 is presented below.
Direct materials
Materials handling (10% of direct materials cost)
Direct manufacturing labor
Indirect manufacturing (200% of direct labor)
Total manufacturing cost

$ 4,000

Materials handling represents the direct variable costs of the Receiving Department that are applied to
direct materials and purchased components on the basis of their cost. This is a separate charge in addition
to indirect manufacturing cost. Troys annual indirect manufacturing cost budget is one-fourth variable
and three-fourths fixed. Duncan Supply, one of Troys reliable vendors, has offered to supply Part
Number S1798 at a unit price of $17,000.
4. [CMA Adapted] If Troy purchases the S1798 units from Duncan, the capacity Troy used to
manufacture these parts would be idle. Should Troy decide to purchase the parts from Duncan, the
unit cost of S1798 would
a. decrease by $3,700.

b. decrease by $5,600. c. increase by $3,600.

d. increase by $5,300.

5. [CMA Adapted] Assume that Troy Instruments does not wish to commit to a rental agreement to rent
all idle capacity but could use idle capacity to manufacture another product that would contribute
$60,000 per month. If Troy elects to manufacture S1798 in order to maintain quality control, Troys
opportunity cost is
a. $(53,000).

148 Chapter 11

b. $7,000.

c. $(24,000).

d. $36,000.

6. Which of the following is not a correct use of the term opportunity cost?
a. Opportunity costs are considered period costs rather than inventoriable costs for accounting
b. Opportunity costs must be considered by managers when making decisions
c. Opportunity cost plus the incremental future revenues and costs equal the relevant revenues and
costs of any alternative when capacity is constrained.
d. The opportunity cost of holding inventory is the income forgone by tying up money in inventory
and not investing it elsewhere.
7. Nicholas, Inc., has provided the following unit data for review:
Simple Product

Selling price
Variable cost
Pounds of scarce raw material per unit

Advanced Product

Which product, Simple or Advanced, is most profitable for Nicholas, Inc., to manufacture?
a. Both in ratio of 3 : 5

b. Both in ratio of 5 : 8

c. Simple

d. Advanced

8. RCG Services is investigating its profitability relationship with each of its customers. What is the
key question RCG should ask in deciding to keep or to drop a particular customer?

Will the customer meet a specific designated gross margin percentage?

Will the customer be willing to pay a higher price to insure RCGs profitability?
Will enough customers be found to replace any customers dropped for lack of profitability?
Will expected total corporate office costs decrease if decision is to drop the customer?

9. [CPA Adapted] At December 31, 2001, Brown Co. had a machine with an original cost of $90,000,
accumulated depreciation of $75,000, and an estimated salvage value of zero. On December 31,
2001, Brown was considering the purchase of a new machine having a five-year life, costing
$150,000, and having an estimated salvage value of $30,000 at the end of five years. In its decision
concerning the possible purchase of the machine, how much should Brown consider as sunk cost at
December 31, 2001?
a. $150,000

b. $120,000

c. $90,000

d. $15,000

10. Which of the following is not a reason for the performance evaluation model to differ from the
decision model?

The use of different time frames: one being an annual basis, the other a period of several years.
The accounting systems enable each decision to be tracked separately.
The accrual accounting method incorporates irrelevant costs.
Top management is rarely aware of particular desirable alternatives that were not chosen by
subordinate managers.

Decision Making and Relevant Information 149

Questions 11-16 demonstrate the use of linear programming (appendix to Chapter 11)
Belmont Company manufactures and sells two products, shirts and gloves, in its two-department plant.
Belmont employs linear programming to determine its optimum product mix. Economic data pertaining to
the two products are presented below.

Selling price per unit

Cost data per unit
Variable manufacturing cost
Variable marketing cost
Fixed manufacturing cost
Fixed marketing cost


(1/6)S + (1/10)G 960; (1/4)S + (1/2)G 1,920.

(1/6)S + (1/4)S + (1/10)G + (1/2)G 2,880.
10S + 6G 960; 15S + 30G 1,920.
10S + 15S + 6G + 30G 2,880.

[WOS] The solution where S = 0 and G = 3,000 would



MAX TCM = 10S + 16G.

MAX TCM = 12S + 24G.
MAX TCM = 14S + 28G.
MAX TCM = 7S + 15G.

[CMA Adapted] The algebraic formulation of Belmont's monthly direct labor constraints is


be the optimal solution.

be an infeasible solution.
be a corner point.
be a feasible solution.

[WOS] A feasible solution for Belmont Company is where [to the nearest whole dollar]
a. G = 0; S = 7,680.


b. G = 0; S = 5,760.

c. G = 9,600; S = 0.

d. G = 3,840; S = 5,760.

[WOS] At the optimal mix, Belmont will




[CMA Adapted] The algebraic formulation of Belmont's objective function is



Direct Labor Data
10 minutes
15 minutes
6 minutes
30 minutes
960 hours
1,920 hours

Shirt [S]
Gloves [G]
Monthly capacity


have a contribution margin of $69,120.

produce 5,760 shirts.
produce 3,840 gloves.
have no excess direct labor capacity.

[WOS] If the selling price of gloves is $34 rather than the predicted $40, what will be the cost to Belmont
of this prediction error?

Zero, since gloves are not produced under either cost

150 Chapter 11

c. $8,238
d. $14,802

1. Use the five-step decision process to make decisions

How does a five-step decision process differ from the decision process illustrated for
planning and control in an earlier chapter? Do different kinds of decisions require the
use of different models? The basic model for decision making is quite similar to a thinking model
because decision making is thinking. The two processes mentioned are not different in approach but in
how they are described. Each thinking or decision model require the similar steps of
defining or clarifying the problem to be solved or the situation about which a decision is to be made
or an objective to be achieved
gathering relevant information about the problem, situation, or objective
choosing from among at least two different solutions, alternatives, or approaches
implementing the solution, alternative, or approach chosen
evaluating the results of the action taken
using feedback to improve next decision
Each decision does not require a formal process. The steps are not rules or a checklist but are descriptive
of how people process situations.
[Refer to Writing/Discussion Exercises Chapter 1, Learning Objective 3 and Chapter 9, Learning
Objective 7]
2. Differentiate relevant from irrelevant costs and revenues in decision situations

In the study of financial accounting, a primary characteristic of accounting information is

relevance. How does that fit with the concept of relevance in cost accounting? The In
the Statements of Accounting Concepts issued by the Financial Accounting Standards Board, the two
primary characteristics of accounting information are relevance and reliability. These characteristics
support the overall characteristic of decision usefulness. Accounting information, whether developed for
cost accounting or financial accounting, derives its value from improving decisions. Each of the two
primary qualities, relevance and reliability, have significance in any type of accounting. As studied in
financial accounting (FASB Statements of Accounting Concepts), relevance has three aspects: timeliness,
feedback value, and predictive value. These same aspects are incorporated in the definition of relevant in
the textfuture costs or revenues that make a difference among the alternatives.

Decision Making and Relevant Information 151

3. Distinguish between quantitative and qualitative factors in decisions

Why should the accountants have to concern themselves with qualitative factors?
Numbers are neutral. Numbers are neutral but they are also symbols. Symbols represent an idea, a
thought, a concept, or some thing. Qualitative factors are the more basic factors because numbers
typically represent some quality. Ways are found to value or assign numbers to those things that were
considered quality factors, such as product quality that is now studied in cost accounting as costs of
quality with numbers representing aspects of product quality.
Is a basketball player worth $2,000,000 when a day-care worker is paid $22,000 per year? The numbers
are neutral but speak boldly to qualitative issues. The imperative for accountants is that they understand
what is behind the numbers so they know what numbers to gather and report. Understanding the
qualitative issues in any decisions will make a difference in the numbers gathered and reported. The
difference should not be due to bias but due to purpose.
4. Beware of two potential problems in relevant-cost analysis

Can costs be stereotyped? If one deals with costs such that generalizations are always used in
place of careful consideration of an individual situation, then the problem of stereotyping can occur. To
think that all fixed costs are irrelevant would be a kind of cost stereotyping. To use a unit cost across
several levels of activity without considering the relevant range might result in a generalization that could
be harmful if used in making a decision.
5. Explain the opportunity-cost concept and why it is used in decision making

Are opportunity costs like grass that is always greener on the other side of the fence?
Opportunity costs are those costs that might have been. Because they do not happen, one cannot know
opportunity costs with any certainty. The exercise of considering what might be if . . . can be useful to
a company. Having to consider other alternatives clarifies the action to be takento choose this is also to
reject that. The use of scarce resources or limited resources should always be seen in the light of
alternatives. Obviously one cannot make a decision if only one action is availablewith one action
possible, there is dictate, not decision. To have to think about other possibilities and realize opportunities
as alternatives could expand the options. The opportunities are not always better, but it is better to
consider them before the decision is made.
6. Know how to choose which products to produce when there are capacity constraints

How is the concept of constraining factors or resources related to the concept of the
accounting system reflecting the underlying operations of a company? Constraining
resources are a short-run concept, but accounting works for providing information for both the short run
and the long range. If the accounting systems accurately reflect the operations of a company, the
accountant can notice trends and direct attention to them. For example, in the case of limited machinehours, the accountant can report contribution margin per machine-hour. If skilled labor is in short supply,
the accounting reports can highlight costs in terms of how they support the workers in accomplishing
their tasks. The accounting system can be designed to insure that the company gets the most out of the
things that do the most for it.

152 Chapter 11

7. Discuss what managers must consider when adding or discontinuing customers and

In dropping or adding customers or segments, should the way in which costs are
assigned to the cost objects be considered? Assigning costs to the cost object includes both
cost tracing and cost allocation. For decisions of adding or dropping customers or segments, one needs to
be careful of those costs that have been allocated. Allocated costs should be looked at as a total for all of
the cost objects to which they relate. If one cost object is dropped, does the total cost decrease? If
another cost object is added, does the total cost increase? Total cost to be allocated is more important
than how it is allocated in making these decisions. Traced costs can be readily noted as to their disposal
or addition.
8. Explain why the book value of equipment is irrelevant in equipment-replacement decisions

Explain the statement All future costs are not relevant but all relevant costs are future
costs. Book value that would be written off in the future is not a relevant cost. Book value represents
a cost that has already happened and any decision made afterwards could not change the decision that
caused the equipment to be purchased initially (except in science fiction stories).
Costs that do not affect the decision, though they are costs yet to be, are not relevant. A relevant cost
must be one that makes a difference among the alternatives.
If nothing can be done to prevent the cost from occurring, that cost is not a matter of choicedecisions
are making choices and a future cost that cannot be prevented from occurring is not relevant (must make a
One must have a choice as to whether to incur the cost or not to incur the cost for the cost to be relevant
to a decision or choice. A cost that has already been incurred is no longer in the category of to be or not
to be.
9. Explain how conflicts can arise between the decision model used by a manager and the
performance evaluation model used to evaluate the manager

Why can the conflict between the decision model used by a manager and the
performance model used to evaluate the manager be compared to a chemical change?
As stated in the text, the practical difficulty is that accounting systems rarely track each decision
separately. Individual managers are making many decisions at any given time. Hopefully the results of
the decisions weave together in such a way that the company operates like a well oiled machine. One
particular manager might look good because his/her decisions occurred in combination with decisions of
another manager and that combination worked just right at that given moment in that given place. Both
managers benefit and are so evaluated. Can a performance model be developed that would consider the
wide possibilities that could result from the various combinations of decisions and events? Cost-benefit
approach would have to be used.
A chemical change results from a combination of individual factors creating a different product. With
enough experimentation, feedback, and knowledge, one can predict the product that will result from the
combinations of different factors. A performance evaluation model could be developed in a similar

Decision Making and Relevant Information 153

Brimson, J., Technology, Sunk Costs, and the Make-or-Buy Decision, Journal of Cost Management
(Fall 1987) p.52 [4p].
Christensen, L. and Sharp, D., How ABC Can Add Value to Decision Making, Management Accounting
(May, 1993) p.38 [5p].
Einhorn and Hogarth, Going Forward in Reverse, Harvard Business Review (January-February 1987)
p.66 [5p].
Harrison, P. and Shanteau, J., Do Sunk Cost Effects Generalize to Cost Accounting Students? Advances
in Management Accounting (1993) p.171 [16p].
Rudd, M. and Deutz, J., Moving Your Company Online, Management Accounting (February 1999) p.28
Yankelovich, D., How Public Opinion Really Works, Fortune (October 5, 1992) p.102 [7p].

154 Chapter 11