What is meant by the terms relevant and irrelevant costs and revenues

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The management accountant's job is to assist the manager by clearly identifying the alternatives and projecting the relevant costs and revenues for each of the alternatives. • Differential Costs. A very important concept in aggregating the costs

Differential Costs. A very important concept in aggregating the costs for alternatives is that of differential costs and revenues. The latter may also be referred to as incremental costs or revenues. A differential cost/revenue simply means the cost that differs between two alternatives. Differential costs are aggregated by the management accountant for a particular problem facing management and are not included in the accounting records under this name.

Opportunity Costs. A concept closely related to differential costs/revenues is that of opportunity costs, which is defined as the potential benefit (cost savings or profit) that is foregone by selecting one alternative over another. Opportunity costs are identified in a decision situation and are not included in the accounting records. Consider an example for an individual: A person has $10,000 to invest and faces the decision of depositing it into an interest bearing account and receiving 5% interest. Alternatively, that person could invest it in a stock with a projected rate of return of 8%. If this person decides to accept the risk and invest in a stock then the 5% interest lost would be an opportunity cost to the alternative of having invested in the stock.

Berry, Eugene Leonard. Management Accounting Demystified.

Blacklick, OH, USA: McGraw-Hill Professional Publishing, 2005. p 41.

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• Sunk Cost. Finally, another important decision making cost is that of sunk cost. This simply means that in considering new alternatives any past costs that might relate to either alternative has already been incurred and is not relevant to the decision relating to the future. A sunk cost is the book value of an asset and is found in the accounting records as cost of an asset less its accumulated depreciation. For example, a business in January 2006 decides to purchase a more efficient machine. Six months later a breakthrough improvement in the machine is developed by another company. Should the purchasing company acquire the new machine, having purchased a new one only six months ago? Of course, it depends on the benefits and costs of the new machine that becomes available six months later. However, the cost (actually the book value) of the machine purchased six months earlier would not be relevant, regardless of any costs and benefits of the new machine. It is a sunk cost and management can do nothing to change that; only future costs matter in decision making.

Berry, Eugene Leonard. Management Accounting Demystified.

Blacklick, OH, USA: McGraw-Hill Professional Publishing, 2005. p 42.

http://site.ebrary.com/lib/segi/Doc?id=10156016&ppg=42

Copyright © 2005. McGraw-Hill Professional Publishing. All rights reserved.

In this chapter we cover costing for managerial decision making. The following topics will be discussed: the managerial decision making model, the cost concepts relating to decision making, application of the model to various short-run decisions faced by management, pitfalls in using relevant costing in decision making, and costs for long-run decision making including capital expenditure analysis. Managers in every company make important decisions every day. A manager at Bank of America may be considering whether to close a branch office or keep it open. A Home Depot executive may wonder whether the company should buy facilities to make lawn mowers or purchase them already finished from an established vendor. A Coca-Cola technology manager could be faced with a problem of whether to recommend the replacement of the company's existing information system. Smaller companies may ask such questions as: "Should I replace a piece of equipment?" or "Should I accept a special offer to sell my product below my established selling price?" These and a host of other problems present themselves to managers in large and small companies every day. In making decisions managers are always guided by the company's overall mission, strategic goals, and objectives. However, they need a carefully constructed decision paradigm and process to ensure a successful outcome. This chapter will discuss the decision process and how the management accountant can aid managers by gathering information, arranging the data for evaluation, and assisting in its interpretation. Decision Making Model The alternative-choice decision model that managers often use in problem solving situations is shown in Figure 8-1. The decision model works as follows. 1. Clearly Define the Problem. This may be easier said than done, because the problem usually requires refining. For example, defining the overall problem as unsatisfactory earnings growth is much too broad. Is the problem caused by poor marketing strategy, poor cost control, outdated equipment, or something else? Management may hold a strategy meeting or a company retreat of key executives to identify specifics and to develop viable solutions. For example, the executives in a small bank may decide that the problem is poor profit performance, decide that the problem is cost control, and, using analysis described in this chapter, consider closing underperforming branches. Identify the Alternatives. This really involves projecting all possible solutions for consideration. This provides an opportunity for all relevant

Berry, Eugene Leonard. Management Accounting Demystified.

Blacklick, OH, USA: McGraw-Hill Professional Publishing, 2005. p 196.

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Copyright © 2005. McGraw-Hill Professional Publishing. All rights reserved.

managers to suggest ways to solve the problem. In our bank example above, management may consider closing Branch A and Branch D or it may focus on one branch, which means the alternatives are close the branch or not close the branch. In projecting alternatives, management is often faced with too many alternatives to evaluate. So part of the process is to whittle the number down. Gather Relevant Information. This stage involves gathering two broad types of information: quantitative and qualitative. Gathering quantitative information usually starts with historical revenues and costs. We will see shortly that historical revenues and costs, per se, cannot be used in formulating the final decision model. However, they may serve as the starting point for projecting the revenues and costs into the future.

Berry, Eugene Leonard. Management Accounting Demystified.

Blacklick, OH, USA: McGraw-Hill Professional Publishing, 2005. p 197.

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Copyright © 2005. McGraw-Hill Professional Publishing. All rights reserved.

Management will also need other quantitative data for analysis. In our banking example, management needs to know data on projected population growth, competition threats, and other economic trends relevant to the location where a branch may potentially close.

The management accountant is particularly helpful in this step because most of the data needed to quantify each alternative reside in the accounting department. The management accountant can also help present the information in a logical, understandable format.

Gathering qualitative information is also very important, for it may contribute something different from what quantitative analysis can. Qualitative information may be important in ensuring the selected alternative is in agreement with company goals. In the banking example above, management may have a goal to serve low-income areas. A branch in the bank's market area may be underperforming all other branches and appear to be a good candidate to close. However, this conflicts with management's goal of serving all of the communities in its market area. Closing the branch would not be in agreement with the company's goal and, in fact, may generate negative media attention that could harm the company's image.

Another example of qualitative information relates to the environment. A company may be considering several locations in which to place its headquarters. One location may provide strong economic incentives for the company, but be in an area with severe air pollution, a factor that would conflicts with a company objective of providing a healthy environment for its employees and maintaining their high morale.

4)Evaluate the Information. To do this effectively, the data need to be in a format that facilitates the evaluation. One approach used by companies is called a decision tree, which is a graphic representation of various decision alternatives and their outcomes and related probabilities (risks) that are visually available to the decision maker. This technique is particularly useful when there are more than two alternatives to be considered. It helps ensure that all relevant information is included and errors minimized. Each "limb" of the tree represents an alternative and normally contains both revenues (or benefits) and costs pertaining to that alternative. The outcome of each alternative would be stated in both quantitative and qualitative format.

5)Select the Best Alternative and Implement the Decision. Generally, the alternative with the higher return or the alternative that has the greater relevant revenues over related costs will be selected, considering qualitative

Berry, Eugene Leonard. Management Accounting Demystified.

Blacklick, OH, USA: McGraw-Hill Professional Publishing, 2005. p 198.

http://site.ebrary.com/lib/segi/Doc?id=10156016&ppg=198

Copyright © 2005. McGraw-Hill Professional Publishing. All rights reserved.

factors. Implementation of the decision may require training personnel, reorganizing operations, integrating a merger, or any other action dependent on what the decision involves.

6)Evaluate the Decision. Sometimes decision applications do not succeed, and management needs to know what went wrong, in order to "learn from your mistakes," as the old adage goes. Thus, some companies perform a postaudit of the implementation results to provide the necessary feedback for this important stage of future decision processes.

Important Accounting Concepts for Decision Making

Relevant revenues and costs are critical to the decision making process. For revenues and costs to be relevant, they must meet two tests. First, they must be future revenues and costs. Costs that occurred in the past are not relevant. These are usually labeled sunk costs because they have already happened and thus cannot be affected by any future decision. Second, the revenues and costs must be different for each alternative. If there is no difference, they are irrelevant and can be left out of the analysis. For example, a company may be considering the replacement of a machine in the production process. The book value of the old machine is historical- it is a sunk cost. The relevant cost in this case is the cost of a new machine. Of course, if the old machine were to be sold, then the cash flow from the sale would become relevant, because it would become a future cash flow.

Accountants and managers may also call relevant revenues and costs differential revenues and costs or incremental revenues and costs. The economists may also use the term marginal costs. The terms all mean essentially the same thing.

Opportunity costs were introduced in Chapter 2. Briefly, an opportunity cost is the potential benefit (cost savings or profit) that is foregone by selecting one alternative over another. For example, a company may have excess capacity and has an offer to produce an object similar to the one it normally produces, but the selling price in the special offer is lower than the market price of its normal product. If the company has no other opportunity to use its excess facilities, it will have no opportunity costs to consider in the short run. However, if it had had a competing offer, then the amount of contribution margin foregone by not accepting the alternative offer would be an opportunity cost. Thus, even though identified opportunity costs are not be included in accounting records, the concept remains very important to decision analysis.

Berry, Eugene Leonard. Management Accounting Demystified.

Blacklick, OH, USA: McGraw-Hill Professional Publishing, 2005. p 199.

http://site.ebrary.com/lib/segi/Doc?id=10156016&ppg=199

Copyright © 2005. McGraw-Hill Professional Publishing. All rights reserved.

Hazards in Using Relevant Costing

When performing decision analysis using costs and revenues there are some important hazards to consider:

• Allocated Fixed Costs. Generally, these costs are irrelevant because they are sunk costs and don't have a bearing on the decision.

-Identifying All Variable Costs as Relevant and All Fixed Costs as Irrelevant. Some variable costs may vary depending on volume but are irrelevant. An example of a variable cost that is irrelevant is a telephone charge that varies with the amount of usage but the contract with the telephone company requires a minimum level of usage. An example of a fixed cost that is relevant is a special offer that requires a special piece of equipment to produce the order. In this case the cost is fixed but relevant to the decision.

- Using Unit Costs Instead of Total Costs. Unit or average costs at different output levels may include unit fixed costs; these change as output increases and may result in an erroneous decision. Some managers may mistakenly assume that all unit costs remain the same at different levels of production within the relevant range. •

• Now that we have discussed the decision making model and defined the concepts that will be used, we can turn to specific applications of the alternative-choice decision process.

Problem: Should a Product, Service, or Business Segment Be Dropped?

Managers are often faced with a product or service line that has declining sales and profitability. There could be several reasons for the decline. Some notable examples are a competitor has developed a competing product or service of higher quality, the market area has changing population patterns resulting in a decrease in demand, and a new technology has made the product obsolete. The decision model using relevant revenues and relevant costs can be helpful in framing the analysis.

Here are some key points to remember when considering dropping a product or service or closing a business unit:

Berry, Eugene Leonard. Management Accounting Demystified.

Blacklick, OH, USA: McGraw-Hill Professional Publishing, 2005. p 200.

http://site.ebrary.com/lib/segi/Doc?id=10156016&ppg=200

Copyright © 2005. McGraw-Hill Professional Publishing. All rights reserved.

Take the overall company perspective in deciding whether revenues and costs can be eliminated. Eliminating a product or service may affect the sales of other products or services. For example, a product may be a loss leader and bring customers into a retail store where they buy other products. This effect should be considered. Also, if costs are eliminated in a department but they are still shouldered by the company as a whole, then those costs have not been avoided. For example, if a large supermarket is considering dropping a section in its store, it will not reduce its utility bills because the section's location is part of the store's overall open space.

The use of the idle space is a major factor in the analysis. If the space ca be used for a viable alternative purpose, such as producing a new product or selling a new service, then the resulting incremental revenues and costs are relevant.

Berry, Eugene Leonard. Management Accounting Demystified.

Blacklick, OH, USA: McGraw-Hill Professional Publishing, 2005. p 201.

http://site.ebrary.com/lib/segi/Doc?id=10156016&ppg=201

Copyright © 2005. McGraw-Hill Professional Publishing. All rights reserved.

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