Chapter 9
Relevant Information
and Decision
Learning Objective 1
Discriminate between relevant
and irrelevant information
The Concept of Relevance
What information is relevant?
It depends on the decision being made.
Decision making essentially involves
The Concept of Relevance
What is the accountant’s role in decision making?
It is primarily that of a technical expert on financial analysis.
Relevant Information
Relevant information is the predicted future costs and revenues that will
Learning Objective 2
The Decision Process
Historical Information
Historical Information Other InformationOther Information
Prediction Method Prediction Method
Decision Model Decision Model
Predictions as Inputs to Decision Model
Decisions by Managers
with Aid of Decision Model
(1)
(2)
(3)
(4)
The Decision Process
Gather relevant information using
historical accounting information and other
The Decision Process
Using the information gathered in Step 1, formulate predictions of expected future revenues or expected future costs.
The predictions formulated in Step 2 Step 3
The Decision Process
The decisions made by managers, with the aid of
the decision model, are implemented and evaluated.
Feedback is used to make future adjustments to the decision process.
Decision Model Defined
A decision model is any method used for making a choice, sometimes requiring
In the best of all possible worlds, information used for decision
making would be perfectly relevant and accurate.
In the best of all possible worlds, information used for decision
making would be perfectly relevant and accurate.
The degree to which information is relevant or precise often depends on the degree to which it is...
The degree to which information is relevant or precise often depends on the degree to which it is...
Accuracy and Relevance
Learning Objective 3
Decide to accept or reject a
special order using the
Special Sales Order Example
Solo Company is offered a special order of
$13 per unit for 100,000 units.
Should Solo accept the order?
The first step is to gather relevant
Special Sales Order Example
Solo Company Income Statement
Year Ended December 31, 2002 (dollars 000)
Sales (1,000,000 units) $20,000
Less: Variable expenses
Manufacturing $12,000
Selling and administrative 1,100 13,100
Special Sales Order Example
Solo Company Income Statement
Year Ended December 31, 2002 (dollars 000)
Contribution margin $6,900
Less: Fixed expenses
Manufacturing $3,000
Special Sales Order Example
Only variable manufacturing costs are
affected by the particular order, at a rate of $12 per unit ($12,000,000 ÷ 1,000,000 units).
All other variable costs and all fixed costs
Special Sales Order Example
Special order sales price/unit $13
Increase in manufacturing costs/unit 12
Additional operating profit/unit $ 1
Learning Objective 4
Decide to add or delete
a product line using
Avoidable and Unavoidable Costs
Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted.Avoidableif an ongoing operation is changed or deleted. costs are costs that will not continue
Department Store Example
Consider a discount department store that
has three major departments:
1 Groceries
2 General merchandise
Department Store Example
Department
General
(000) Groceries Mdse. Drugs Total
Sales $1,000 $800 $100 $1,900
Variable expenses 800 560 60 1,420
Department Store Example
Department
General
(000) Groceries Mdse. Drugs Total
Contribution margin $200 $240 $40 $480
Fixed expenses:
Avoidable $150 $100 $15 $265
Unavoidable 60 100 20 180
Total $210 $200 $35 $445
Department Store Example
For this example, assume first that the only alternatives to be considered are dropping or continuing the grocery department, which
shows a loss of $10,000.
Assume further that the total assets invested would be unaffected by the decision.
Dropping Products,
Departments, Territories
Total Before Change
Sales $1,900,000
Variable expenses 1,420,000
Contribution margin 480,000
Avoidable fixed expenses 265,000
Contribution to common
space and unavoidable costs $ 215,000
Dropping Products,
Departments, Territories
Effect of Dropping Groceries
Sales $1,000,000
Variable expenses 800,000
Contribution margin 200,000
Avoidable fixed expenses 150,000
Contribution to common
Dropping Products,
Departments, Territories
Total After Change
Sales $900,000
Variable expenses 620,000
Contribution margin 280,000
Avoidable fixed expenses 115,000
Contribution to common
space and unavoidable costs $165,000
Unavoidable fixed expenses 180,000
Learning Objective 5
Compute a measure of product
profitability when production
is constrained by a scarce
Optimal Use of Limited
Resources
A limiting factor or scarce resource restricts
or constrains the production or sale of a product or service.
The order to be accepted is the one that
Product Profitability Example
Constrained by a Scarce
Resource
Assume that a company has two products:
Plant workers can make 3 plain phones
in one hour or 1 fancy phone.
Product
Plain Fancy
Per Unit Phone Phone
Selling price $80 $120
Variable costs 64 84
Contribution margin $16 $ 36
Product Profitability Example
Constrained by a Scarce
Product Profitability Example
Constrained by a Scarce
Resource
Which product is more profitable?
If sales are restricted by demand for only a limited number of phones, fancy
Product Profitability Example
Constrained by a Scarce Resource
The sale of a plain phone adds $16 to profit.
Product Profitability Example
Constrained by a Scarce
Resource
Now suppose annual demand for phones of
both types is more than the company can produce in the next year.
Productive capacity is the limiting factor
Product Profitability Example
Constrained by a Scarce Resource
Which product should the company emphasize? Plain phone:
$16 contribution margin per unit × 3 units per hour
= 48 per hour
Fancy phone:
$36 contribution margin per unit × 1 unit per hour
Learning Objective 6
Pricing Decisions
Among the many pricing decisions to be
made are:
– setting the price of a new or refined product
– setting the price of products sold under
private labels
– responding to a new price of a competitor
– pricing bids in both sealed and open bidding
The Concept of Pricing
In perfect competition, a firm can sell as much of a product as it can produce,
all at a single market price.
The Concept of Pricing
Marginal cost is the additional cost resulting from producing one additional unit.
Marginal revenue is the additional revenue resulting from the sale of one additional unit.
Influences on Pricing
Several factors interact to shape the market
in which managers make pricing decisions:
– legal requirements
– competitors’ actions
Learning Objective 7
Compute a target sales price
by various approaches and
compare the advantages
Role of Costs in Pricing
Decisions
Two pricing approaches used by companies
are:
1 Cost-plus pricing
Target Sales Price
There are four popular markup formulas
for pricing:
1 As a percentage of variable manufacturing
costs
2 As a percentage of total variable costs
3 As a percentage of full costs
Relationships of Costs to
Same Target Selling Prices
Target sales price $20.00
Variable costs:
Manufacturing $12.00
Selling and administrative 1.10
Unit variable cost 13.10
Fixed costs:
Manufacturing $ 3.00
Relationships of Costs to
Same Target Selling Prices
Markup percentages
% of variable manufacturing costs:
($20.00 – $12.00) ÷ $12.00 = 66.67%
% of total
Costing Techniques
Target costing sets a cost before the product is created or even designed.
Value engineering is a cost-reduction
technique, used primarily during design.
Learning Objective 8
Use target costing to decide
Target Costing and
Cost-Plus Pricing Compared
Suppose that ITT Automotive receives an
invitation to bid from Ford on the anti-lock braking systems.
The current manufacturing cost is $154.
ITT Automotive’s desired gross margin rate
is 30% on sales.
Target Costing and
Cost-Plus Pricing Compared
What is the bid price using cost-plus pricing?
Bid price = Cost ÷ Cost % = $154 ÷ 0.7
Target Costing and
Cost-Plus Pricing Compared
Target cost = Market price × Cost %
= $200 × 0.7
Target cost = $140
Learning Objective 9
Understand how relevant
information is used when
Marketing Decisions
Accountants and managers must have a thorough understanding of relevant information, especially
