Lecture 3 - AMA

20/01/2023
RELEVANT INFORMATION
AND DECISION MAKING
LECTURE 3
Outline
• Decision making process

• Relevant costs and revenues
• Types of short term decision making
• Product mix decision
• Adding or dropping customers
• Equipment replacement decision
• Behavior implications
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Decision making process
• Relevant information has two characteristics:

o It occurs in the future
o It differs among the alternative courses of
action
• Relevant costs—expected future costs
• Relevant revenues—expected future revenues
Relevance
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Relevant Cost Illustration
Features of Relevant Information
Past (historical) costs are always irrelevant when making

decisions.
Different alternatives can be compared by examining
differences in expected total future revenues and expected
total future costs.
Expected future revenues and expected future costs that do
not differ among alternatives are irrelevant and
Appropriate weight must be given to qualitative factors and
quantitative nonfinancial factors.
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Costs that have already occurred

and can not be changed are
classified as sunk costs.
Sunk costs are excluded because

Sunk costs they can not be changed by
future actions.
Sunk costs are irrelevant in

decision making
Types of Information
Quantitative factors are outcomes that can be measured in numerical terms.
Qualitative factors are outcomes that Qualitative factors are just as important as
are difficult to measure accurately in quantitative factors even though they are
difficult to measure.
numerical terms, such as satisfaction.
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Terminology
Incremental Differential
Incremental cost— Differential cost—
revenue—the revenue—the
the additional total the difference in additional total difference in total
cost incurred for an total cost between
revenue from an revenue between
activity two alternatives activity two alternatives
One-time-only special orders
Insourcing vs. outsourcing
Make or buy
Types of Product-mix
Decisions
Customer profitability
Branch/segment: adding or
discontinuing
Equipment replacement
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Product-Mix Decisions
Decision rule (with a

The decisions made by a constraint): Choose the
company about which product that produces
products to sell and in the highest contribution
what quantities. margin per unit of the
constraining resource.
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Product-Mix Decisions – Wechsler Company produces three products:

Example – P12-42 A130,B324,and C587. All three products use
the same direct material, Brac. Unit data for
the three products are:
The demand for the products far exceeds the

direct materials available to produce the
products. Brac costs $9 per pound, and a
maximum of 5,000 pounds is available each
month. Wechsler must produce a minimum of
200 units of each product
1. How many units of product A130, B324, and
C587 should Wechsler produce?
2. What is the maximum amount Wechsler would
be willing to pay for another 1,200 pounds of
Brac?
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Product-Mix Decisions – Example – P12-42
• Identify constraint: DM Brac

• Identify contribution margin per unit of limiting factor (constraint)
• Ranking priority based on CM per unit of limiting factor
A130 B324 C587 Total
SP per unit $252 $168 $210
VC per unit $156 $126 $147
CM per unit $96 $42 $63
Brac used 8 lb 5 lb 3 lb
CM per pound of Brac $12 $8.4 $21
Ranking 2 3 1
Brac used for min qty 1,600 lb 1,000 lb 600 lb 3,200 lb
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Product-Mix Decisions – Example – P12-42
• Max quantity of Brac = 5,000 lb

• Remaining Brac above min requirement = 5,000 - 3,200 = 1,800 lb
• Used for C587 = 1,800 lb/3 = 600 units
1. Production:
• A130: 200 units
• B324: 200 units
• C587: 800 units
2. Max amount to pay for Brac = Purchase price + contribution foregone
= $9 + $21 = $30
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Decision rule: Does

adding or dropping a Yes—add or
don’t drop
customer add No—drop or
Adding or operating income to

the firm?
don’t add
Dropping
Customers Decision is based on profitability of
the customer, not how much
revenue a customer generates.
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Adding or Dropping
Customers – Example P12-47
The equipment has a zero disposal value.
Guide wages, supplies, and vehicle fuel are
variable costs. Administrative salaries are fixed
costs.
The president is considering dropping the deluxe
tour and offering only the basic tour.
If the deluxe tours are discontinued, one admin
position could be eliminated, saving $50,000.
Assuming no change in the sales of basic tours,
what effect would dropping the deluxe tour have
on the company’s operating income?
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Lost revenues from deluxe tours $(660,000)

Avoidable operating costs from
dropping deluxe tours:
Adding or Administrative salaries 50,000
Guide wages 380,000
Dropping Supplies 100,000
Customers – Vehicle fuel 24,000
Example P12-47 Total avoidable costs 554,000
Lost operating income from $ (106,000)
dropping deluxe tours
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Sometimes difficult due to amount of

information at hand that is irrelevant:
Any potential gain or loss
Cost, accumulated
on the transaction—a
depreciation, and book financial accounting
value of existing equipment
Equipment- phenomenon only
Replacement
Decisions
Decision rule: Select the alternative
that will generate the highest
operating income.
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Equipment-Replacement Decisions – Example

P12-50
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Equipment-Replacement Decisions – Example

P12-50
• Sanchez uses straight-line depreciation on all equipment. Annual

depreciation expense for the old machine is $180,000 and will be
$270,000 on the new machine if it is acquired. For simplicity,
ignore income taxes and the time value of money.
• Assume that Smith’s priority is to receive the promotion and she

makes the equipment-replacement decision based on the next one
year’s accrual-based net operating income. Which alternative
would she choose?
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Year 1
Cost
Replace Difference
With New Keep Old by
Machine Machine Replacing
(3) = (1) –
Equipment- (1) (2) (2)
Replacement Cash operating

costs $ 800,000 $ 995,000 $(195,000)
Decisions – Depreciation
($540,000 ÷ 2;
Example $900,000 ÷ 5)
Loss on disposal of
270,000 180,000 90,000
P12-50 old machine

($360,000 –
$216,000; $0) 144,000 0 144,000
$
Total costs $1,214,000 $1,175,000 39,000
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Despite the quantitative nature of

some aspects of decision making, not
all managers will choose the best
alternative for the firm.
Behavioral
Implications Managers could engage in self-serving
behavior such as delaying needed
equipment maintenance in order to
meet their personal profitability
quotas for bonus consideration.
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20/01/2023

• Decision making process

Decision making process

• Relevant information has two characteristics:

Relevant Cost Illustration

Features of Relevant Information

 Past (historical) costs are always irrelevant when making

Costs that have already occurred

Sunk costs are excluded because

Sunk costs are irrelevant in

Quantitative factors are outcomes that can be measured in numerical terms.

One-time-only special orders

Insourcing vs. outsourcing

Decision rule (with a

Product-Mix Decisions – Wechsler Company produces three products:

The demand for the products far exceeds the

Product-Mix Decisions – Example – P12-42

• Identify constraint: DM Brac

Product-Mix Decisions – Example – P12-42

• Max quantity of Brac = 5,000 lb

Decision rule: Does

Adding or operating income to

Lost revenues from deluxe tours $(660,000)

Sometimes difficult due to amount of

Equipment-Replacement Decisions – Example

Equipment-Replacement Decisions – Example

• Sanchez uses straight-line depreciation on all equipment. Annual

• Assume that Smith’s priority is to receive the promotion and she

Replacement Cash operating

P12-50 old machine

Despite the quantitative nature of

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Past (historical) costs are always irrelevant when making