Managerial Accounting –Decision Making: Relevant Costs & Benefits

When you have a choice between two or more alternatives and you have to select one, you are making a decision. If there is no choice, you will have to simply follow or obey. So a decision implies a selection, a choice, a verdict or a nod.

In everyday life, decisions are made. A personal decision affects an individual but organizational decisions cause a change, good or bad, to a lot many people known as stakeholders. So decision making in an organization must be systematic and not off the cuff. A good executive must be good at decision making.

A formal definition of decision making by Wikipedia.org is given below:

Decision making can be regarded as an outcome of mental processes leading to the selection of a course of action among several alternatives. Every decision making process produces a final choice. The output can be an action or an opinion of choice.

It may be noted that every decision involves a certain degree of risk. Very few decisions are made with absolute certainty. So a good decision would be to choose a solution with the highest probability of success and in accordance with the goals, desires, lifestyle and values etc.

Relevant means linked or concerned. If an event has nothing to do with a situation, it is not relevant. Marble processing units at Karachi may suffer because of unrest in a far-off area like Swat. It would be relevant as Swat supplies marble rocks. But turmoil in Hyderabad, a town much near to Karachi than Swat, would be irrelevant for the marble units.

Any decision must be evaluated under cost-benefit criteria. The benefits must be more than the cost except in social projects where benefits may be equal to cost. Benefits can be in the form of cash return, perks, advantages, customer’s satisfaction or reputation of a company. While cost means value, worth or sacrifice made.

Only relevant cost should be considered. CIMA defines relevant costs as: ‘the costs appropriate to a specific management decision’ A study of relevant costs and benefits helps make better decision?

1. Clarify the decision problem. One must be clear about the problem. One must look for the root cause or hidden problem rather than the apparent problem. Some skill is required to define a problem in such terms that can be addressed effectively.
2. Specify the criteria. After clarifying a problem, criteria must be specified for decision-making. What is the objective: maximize profit, increase market share or social service.
3. Identify alternatives. Explore all alternatives, their pros and cons. This is a critical step in the decision making process.
4. Develop a decision model. This is an simplified version of the problem. No irrelevant information, only factors relevant to the problem are highlighted. It brings together all elements of a problem like the criteria, the constraints, and the alternative.
5. Collect the data. Relevant data must be collected to incorporate objectivity in the process. It may be primary data or secondary data. But it must be up-to-date, timely and accurate.
6. Select an alternative. One all formalities are completed, requisite information obtained and processed, a most suitable or appropriate choice should be selected.

Management Accountant mostly deal with financial data. But they also maintain records of physical units produced and quantities of raw material consumed, labor hours used. In addition, they asses qualitative factors such as employee morale, customers satisfaction, image of the company in the eyes of the public.

A management accountant is a member of cross functional team and, having unrestricted access to MIS, makes a contribution by providing facts and figure which bring objectivity to the report.

Besides, a management accountant would ensure that the information must be relevant (pertinent to the decision problem); accurate (precise); and timely (arrive in time for the decision to be made). Companies will occasionally trade-off accuracy for timeliness.

In order to qualify for relevancy, a cost must meet two criteria: (i) They affect the future and (ii) they differ among alternatives.

Normally, the following are relevant Costs:

DIFFERENTIAL COST

• A differential cost is the difference in cost items under two or more decision alternatives specifically two different projects or situations. Where same item with the same amount appears in all alternatives, it is irrelevant. For example, a plot of land can be used for a shopping mall or entertainment park. The plot is irrelevant since it would be used in both the cases. Similarly, future costs and benefits that are identical across all decision alternatives are not relevant.
• An example of differential cost would be of a company which is selling its products through distributors. It is paying them a commission of Rs.16 million. Any alternate which costs lesser would be considered. Let us suppose that the company is planning to appoint salespersons to sell its products and cancels the contracts with distributors. In this case, the selling expense is expected to be to Rs.12 million. There is cost differential Rs.4 million (Rs.16 m - 12m). This a good sign but the risk would have to considered for changing the channel of distribution. If there is low risk, it would be prudent to go for own arrangements for sales.
• Differential costs must be compared to differential revenues. In case, switching over to direct sales bring additional revenues of Rs.2 million, it would increase the net benefit to Rs.6 million. This would provide more comfort to the decision maker while considering a change in the distribution channel.

INCREMENTAL OR MARGINAL COST

• Where as differential cost is a difference between the cost of two independent alternatives, incremental or marginal cost is a cost associated with producing an additional unit. In case of a university, it could be cost of admitting another student. Even operating a second shift is an example of incremental cost. It would be noted that the two decisions are not independent as second shift depends upon first shift.
• Increamental cost must be compared with incremental revenues to arrive at a decision.

OPPORTUNITY COST

• It is cost of opportunity foregone. Mr. Ahmed Shah left a bank job which was paying him Rs.15,000 per month and got admission in a University. Monthly fee-charge in the university is Rs.10,000 per month. For Ahmed Shah, this would be Rs.25,000 per month (Rs.10,000 + Rs,15,000).
• Farhana is a fresh graduate from a business university. She got two offers, one of Rs.25,000 from an investment bank and another of Rs.15,000 for a teaching-assistant in a university. Another of her class-fellow, Shabana got the same offer from the same university. While Shabana would be happy to join the university, Faraha would not be as she would lose an opportunity to serve at the bank for Rs.25,000.
• Whenever an organization is deciding to go for a particular project, it should not ignore opportunities for other projects. It should consider (i) what alternative opportunities are there? (2) Which is the best of these alternative opportunities?

Sunk costs are past costs. These cannot be changed with any future decision. Suppose, a piece of land has already been purchased by a company for a sum of Rs.30 million. Also suppose, the company is consider covering it with a wall which would cost Rupees two million. While the sum of Rs.30 million is a sunk cost, the other of Rs.2 million is a future cost or out of pocket expenses. It is relevant to decision: whether to erect a wall now or postpone it for the next month, whether it should be two-meter or three-meter high. Whether a wall is erected or not and, if erected, whether it is 2 or 3 meter, the sum of Rs.30 million for land would remain the same. It is a sunk cost and therefore irrelevant to the decision.

Similarly, a cost which is identical in all decisions is irrelevant.

There are special decisions where relevant costs and benefits are to identified before proceeding further. Such decisions are:

• Accept or reject an order when there is excess capacity
• Accepting or reject an other when there is no excess capacity
• Outsource a product or service
• Add, drop a product, service or department
• Sell or process further
• Optimization of limited resources or working under constraint.

Management Accounting picks up data from cost database and prepare reports for the management to facilitate decision making. Both financial and non-financial data are used in the reports. In the non-financial data, both numerical and non-numerical information are used.

While numerical information consist of operational statistics such as units produced, raw materials considered and labor hours used, the non-numerical or qualitative information pertain to customers satisfaction, employees moral, access to markets and image of an organization.

For a particular decision, different types of cost and benefits are considered. Called relevant costs, these have a bearing on the future and differ under various decision alternatives. If any of these qualification is absent, it would be an irrelevant cost.

Since most decision are under uncertainty, some other techniques are used to given an insight in the problem such as best- worst case scenario, sensitivity analysis and simulation.

Though technology has made a lot of advancement in manufacture, concepts like cost : benefit analysis are still valid and useful. They have been made more strong and convincing with the introduction of ABC, ABM and EVA.