5 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 5 Relevant Information and

5 - 1©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

Chapter 5

Relevant Information

and Decision Making:

Marketing Decisions

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©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

Learning Objective 1

Discriminate between relevant

and irrelevant information

for making decisions.

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The Concept of Relevance

What information is relevant?

It depends on the decision being made.

Decision making essentially involveschoosing among several courses of action.

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The Concept of Relevance

What is the accountant’s role in decision making?

It is primarily that of a technical expert onfinancial analysis.

The accountant helps managers focus on therelevant information.

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Relevant Information

Relevant information is the predictedfuture costs and revenues that willdiffer among the alternatives.

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Use the decision process to

make business decisions.

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The Decision Process

Historical InformationHistorical Information Other InformationOther Information

Prediction MethodPrediction Method

Decision ModelDecision Model

Implementation and EvaluationImplementation and Evaluation

Predictions as Inputsto Decision Model

Decisions by Managerswith Aid of Decision Model

Feedback

(1)

(2)

(3)

(4)

(A) (B)

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Gather relevant information usinghistorical accounting information and otherinformation from outside the accounting system.

Step 1

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Using the information gathered in Step 1,formulate predictions of expected futurerevenues or expected future costs.

The predictions formulated in Step 2to the decision model.

Step 3

Step 2

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The decisions made by managers, with the aid ofthe decision model, are implemented and evaluated.

Feedback is used to make future adjustmentsto the decision process.

Step 4

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Decision Model Defined

A decision model is any method used for making a choice, sometimes requiring elaborate quantitative procedures.

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In the best of all possible worlds,information used for decisionmaking would be perfectlyrelevant and accurate.

In the best of all possible worlds,information used for decisionmaking would be perfectlyrelevant and accurate.

Accuracy and Relevance

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The degree to which information isrelevant or precise often dependson the degree to which it is...

The degree to which information isrelevant or precise often dependson the degree to which it is...

Accuracy and Relevance

QuantitativeQuantitativeQualitativeQualitative

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Decide to accept or reject a

special order using the

contribution margin

technique.

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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

information from Solo Company’s financial statements.

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Solo CompanyIncome Statement

Year Ended December 31, 2002 (dollars 000)

Sales (1,000,000 units) $20,000Less: Variable expenses

Manufacturing $12,000Selling and administrative 1,100 13,100

Contribution margin $ 6,900

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Solo CompanyIncome Statement

Year Ended December 31, 2002 (dollars 000)

Contribution margin $6,900Less: Fixed expenses

Manufacturing $3,000Selling and administrative 2,900 5,900

Operating income $1,000

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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 are unaffected and thus irrelevant.

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Special order sales price/unit $13Increase in manufacturing costs/unit 12Additional operating profit/unit $ 1

Based on the preceding analysis, should Solo accept the order?

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Decide to add or delete

a product line using

relevant information.

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Avoidable and Unavoidable Costs

Avoidable costs are costs that will not continueif an ongoing operation is changed or deleted.Avoidable costs are costs that will not continueif an ongoing operation is changed or deleted.

Unavoidable costs are costs that continue even if an operation is halted.Unavoidable costs are costs that continue even if an operation is halted.

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Department Store Example

Consider a discount department store that has three major departments:

1 Groceries2 General merchandise3 Drugs

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Department General

(000) Groceries Mdse. Drugs TotalSales $1,000 $800 $100 $1,900Variable expenses 800 560 60 1,420Contribution margin $ 200 $240 $ 40 $ 480

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Department General

(000) Groceries Mdse. Drugs TotalContribution margin $200 $240 $40 $480Fixed expenses:Avoidable $150 $100 $15 $265Unavoidable 60 100 20 180Total $210 $200 $35 $445Operating income $ (10) $ 40 $ 5 $ 35

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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.

The vacated space would be idle and the unavoidable costs would continue.

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Dropping Products,Departments, Territories

Total Before ChangeSales $1,900,000Variable expenses 1,420,000Contribution margin 480,000Avoidable fixed expenses 265,000Contribution to common space and unavoidable costs $ 215,000Unavoidable fixed expenses 180,000Operating income $ 35,000

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Effect of Dropping Groceries Sales $1,000,000Variable expenses 800,000Contribution margin 200,000Avoidable fixed expenses 150,000Contribution to common space and unavoidable cost $ 50,000

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Total After ChangeSales $900,000Variable expenses 620,000Contribution margin 280,000Avoidable fixed expenses 115,000Contribution to common space and unavoidable costs $165,000Unavoidable fixed expenses 180,000Operating income $ (15,000)

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Compute a measure of product

profitability when production

is constrained by a scarce

resource.

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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 makes the biggest total profit contribution per unit of the limiting factor.

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Product Profitability ExampleConstrained by a Scarce Resource

Assume that a company has two products: a plain cellular phone (C&W) and a fancier cellular phone (Digicel) with many special features.

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Plant workers can make 3 plain phonesin one hour or 1 fancy phone.

Product Plain Fancy Per Unit Phone PhoneSelling price $80 $120Variable costs 64 84Contribution margin $16 $ 36Contribution margin ratio 20% 30%


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Which product is more profitable?

If sales are restricted by demand for only a limited number of phones, fancy phones are more profitable.

Why?

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Product Profitability Example Constrained by a Scarce Resource

The sale of a plain phone adds$16 to profit.

The sale of a fancy phone adds$36 to profit.

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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 because only 10,000 hours of capacity are available.

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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 hourFancy phone:$36 contribution margin per unit × 1 unit per hour= $36 per hour

5 - 37©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton

End of Chapter 5

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5 - 1 ©2002 Prentice Hall Business Publishing, Introduction to Management Accounting 12/e, Horngren/Sundem/Stratton Chapter 5 Relevant Information and