Chapter II: Relevant Information & Decision Making

Decision-making is a fundamental part of management. Managers are constantly faced with

problems of deciding what product to sell, what production method to use, whether to make or
buy component parts, what prices to charge, what channels of distribution to use, whether to
accept special orders at special prices, and so forth. This chapter covers the role of management
accounting information in a variety of marketing and production decisions.

2.1 The Concept of Relevance

Accountants have an important role in the decision-making process, not as a decision maker but
as collectors and reporters of relevant information. What makes information relevant to a
decision problem? Relevant information is the predicted future costs and revenues that will differ
among the alternatives. These two criteria are discussed here under:

Bearing on the Future: To be relevant to a decision, cost or benefit information must involve a
future event. Relevant information is a prediction of the future, not a summary of the past.
Historical (past) data have no bearing on a decision. Such data can have an indirect bearing on a
decision because they may help in predicting the future. But past figures, in themselves, are
irrelevant to the decision itself. Why? Because decision-making affect future, but not past.
Nothing can alter what has already happened.

Different under Competing Alternatives: Relevant information must involve future costs or
benefits that differ among the alternatives. Costs or benefits that are the same across all the
available alternatives have no bearing on the decision. For example, if management is evaluating
the purchase of either a manual or an automated drill press, both of which require skilled labor
costing Br. 10 per hour, the labor rate is not relevant because it is the same for both alternatives.

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Why Isolate Relevant Information?

Why is it important for the management accountant to isolate the relevant costs and benefits in a
decision analysis? The reasons are two fold:

First, generating information is a costly process. The management accountant can simplify
and shorten the data gathering process by focusing on only relevant information.

Second, people can effectively use only a limited amount of information. If a manager is
provided with irrelevant revenues and costs, these figures can cause information overload,
and decision-making effectiveness of the manager declines.

Example (1) Marina Company, a manufacturer of a line of ashtrays, is thinking of using

aluminum instead of copper in the manufacture of its product. Historical direct material costs
were Br. 0.30 per unit. The company expected future costs for aluminum is Br 0.20 and it is
unchanged for copper. Direct labor cost was Br. 0.70 per unit and will not be affected by the
switch in materials. The analysis in a nutshell is as follows.

Copper Aluminum Difference

Direct material Br. 0.30 Br. 0.20 Br. 0.10
Direct labor 0.70 0.70 -
Required: Given the above-summarized data identify the relevant data for the decision on hand.

Solution:
The cost of copper and direct labor costs used for this comparison probably came from historical
cost records on the amount paid most recently for copper and direct laborers, respectively. Past
or historical costs are relevant to the decision only if they are expected to continue in the future, or
are used as the basis for predicting the future costs.

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In the foregoing analysis, the material cost (the expected future cost of copper compared with the
expected future cost of aluminum) is the only relevant cost. The material cost met both criteria for
relevant information.
That is, bearing on the future and an element of difference between the alternatives. However, the
direct – labor cost will continue to be Br. 0.70 per unit regardless of the material used. It is
irrelevant because the second criterion – an element of difference between the alternatives – is not
met.

Therefore, we can safely exclude direct labor. There is no harm in including irrelevant items in a
formal analysis, provided that they are included properly. However, confining the reports to the
relevant items provides greater clarity and time savings for busy managers.

2.2 Alternative Choice Decisions

Many of the decisions described in this chapter are frequently referred to as alternative choice
decision. Alternative choice decisions are situations with two or more courses of action from
which the decision maker must select the best alternative.

The variety of alternative choice decisions is limitless. Some business example follows:
• Should we accept a special order for a product below our normal selling price?
• Should we raise the price of a product or maintain the current price?
• Should we make or buy a component part?
• Should we sell a joint product at the split off point or process it further?
• Should we keep our copying machine or acquire a faster one?
The analyses of these and other types of alternative choice decisions are aided by relevant cost
and benefit data.

2.2.1 Marketing Decisions

The discussions that follow illustrate a variety marketing and production decisions. The
marketing decisions for which we examine relevant information include special order decisions,
addition or deletion, and optimal use of limited resources.

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2.2.1.1 Special Order Decisions
A special order is a one-time order that is not considered part of the company’s normal on going
business. For example, a discount department store chain planning a big spring sale offers to
make a large one-time purchase of a firm’s product but wants a reduced price. In general, a
special order is profitable as long as the incremental revenue from the special order exceeds the
incremental costs of the order. The incremental revenue in this decision will be the price per unit
offered by the potential customer times the number of units to be purchased. The incremental
costs will be the amount of the expected cost increase if the offer is accepted. The incremental cost
usually includes variable manufacturing costs of producing the units. Since the units being sold
in the special order are not being sold through the firm normal distribution channel, the firm may
or may not incur variable selling and administrative expenses in conjunction with the special
order.

The incremental costs usually do not include fixed manufacturing costs. Although the fixed costs
must be incurred to permit production, the amount of fixed costs incurred by the firm usually will
not increase if the special order offer is accepted. For the same reason, other fixed expenses, such
as fixed selling and administrative expenses, are usually not relevant in the special order price.

However, management must also be assured that it has sufficient capacity to produce the special
order without affecting normal sales. When there is no excess capacity, the opportunity cost of
using the firm’s facilities for the special order are also relevant to the decision. The opportunity
cost would be the contribution margin forgone on regular sales that have to be reduced to
accommodate the special order. The relevant costs to accept the special order, therefore, would
include a forgone contribution margin on regular sales that could not be made in addition to the
incremental costs associated with the special order that have already been discussed.

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Example (1) Consider the following details of the income statement of Samson Company for the
year just ended December 31, 20 x 3.
Sales (1,000,000 units) Br. 20,000,000
Manufacturing cost of goods sold 15,000,000
Gross margin Br. 5,000,000
Selling and administrative expenses 4,000,000
Operating income Br. 1,000,000

Samson’s fixed manufacturing costs were Br. 3 million and its fixed selling and administrative
costs were Br. 2.9 million.

Near the end of the year, Ethio Company offered Samson Br. 13 per unit for 100,000 unit special
order. The special order would not affect Samson’s regular business in any way. Furthermore,
the special sales order would not affect total fixed costs and would not require any additional
variable selling and administrative expenses.

Instruction: Should Samson accept or reject the special order? By what percentage the operating
income decreases or increases if the order had been accepted? Assume that the company would
utilize its idle manufacturing capacity to accept the special order.
Solution:
There are two approaches to costs on income statement.
1. Absorption/financial approach
2. Contribution approach
An absorption approach is a costing technique that considers all factory overheads (both variable
and fixed) to be product costs that become an expense in the form of manufacturing cost of goods
sold as sales occur.
A contribution approach is a method of internal reporting (management accounting) that
emphasizes the distinction between variable and fixed costs for the purpose of better decision.

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 Financial Approach Contribution Approach
Sales xxx Sales xxx
Cost of goods sold xxx Variable costs xxx
Gross profit xxx Contribution margin xxx
Selling and Administrative expenses xxx Fixed costs xxx
Operating income xxx Operating income xxx

Exhibit 2-1 Approaches to costs on income statement

The correct analysis to the above problem employs the contribution approach to income
statement, not the financial approach. The fallacy in the case of the later approach is that it treats a
fixed cost, i.e., fixed manufacturing cost as if it were variable.

Exhibit 2-2 The correct analysis

Without special Effectof special With special
order order order
1,000,000 units 100,000 units 1,100,000units
Sales Br. 20,000,000 Br. 1,300,000 Br. 21,300,000
Variable expenses
Manufacturing Br. 12,000,000 Br. 1,200,000 Br. 13,200,000
Selling and Administrative 1,100,000 - 1,100,000
Total variable expenses Br. 13,100,000 Br. 1,200,000 Br. 14,300,000
Contribution Margin Br. 6,900,000 Br. 100,000 Br. 7,000,000

Fixed expenses
Manufacturing Br. 3,000,000 - Br. 3,000,000
Selling and administrative 2,900,000 - 2,900,000
Total fixed expenses Br. 5,900,000 - Br. 5,900,000
Operating income Br. 1,000,000 Br. 100,000 Br. 1,100,000

The accountant’s role in decision making is primarily that of a technical expert on cost analysis,
i.e., collecting and reporting relevant information. However, many managers want the accountant
to recommend the proper decision; the final choice always rests with the operating executives.
Recommendation: Based on the relevant data, Samson Company should accept the special order
because it brings an additional income of Br. 100,000 for company and as a result the operating
income increase by 10% if the order had been accepted.
Income with special order Br. 1,100,000
Income without special order 1,000,000
Additional income if the order had been accepted Br. 100,000

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%NI = NI
NIo
Where : %NI = Percentage change in income.
NI = Change in income.
NIo = Income if the special order had not been accepted.
%NI = NI = Br. 100,000 = 0.1 or 10%
NIo Br. 1,000,000

Exhibit 2-3. The Incorrect Analysis

Without Special Incorrect effect With special
order of special order order
1,000,000 units 100,000 units 1,100,000 units
Sales Br. 20,000,000 Br. 1,300,000 Br. 21,300,000
Manufacturing COGs* 15,000,000 1,500,000 16,500,000
Gross margin Br. 5,000,000 Br. (200,000) Br. 4,800,000
Selling&administrative expenses 4,000,000 - 4,000,000
Operating income Br. 1,000,000 Br. (200,000) Br. 800,000
*COGs denote cost of goods sold.

Here above, the analysis treats the fixed manufacturing COGs as if it were variable. Refer the
effect of the special order on manufacturing COGs; it amounted to Br. 1,500,000 that include Br.
300,000 fixed cost. However, the special sales order would not affect the total fixed costs.
Example (2) Lucy Company has the capacity to produce 15,000 units per month. Current regular
production and sales are 10,000 units per month at a selling price of Br. 15 each. Based on the
current production level, the following costs are to be incurred per unit:
Direct materials Br. 5.00
Direct labor 3.00
Variable factory overhead (FOH) 0.75
Fixed FOH 1.50
Variable selling expense 0.25
Fixed administrative expense 1.00

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Lucy Company has received special order from a customer that wants to purchase 4,000 units at
Br. 10 each. There would be no selling expense in connection with this special order.
Instructions:
a. Should Lucy Company accepts or rejects the special order? Why or Why not? Assume that the
special order should not disturb regular business.
b. Suppose that the special order was for 8,000 units instead of 4,000 units. Thus, regular business
would be reduced by 3,000 units to accept the special order because production capacity
cannot be expanded in the short run. What would be the overall profit of the firm if it accepts
this order?
c. Refer the data given in requirement (b) above. At what selling price per unit from the customer
would the Lucy Company be economically indifferent between accepting and rejecting the
offer?

Solutions:
a. Here, the incremental costs (variable manufacturing costs) are the only relevant costs. The
special order would have no effect on the company’s variable selling expenses. Since the existing
fixed costs would not be affected by the order, they are not incremental costs and are therefore not
relevant. The incremental net operating income from accepting the special order can be computed
as follows:

Per unit Total

Incremental revenue Br. 10.00 Br. 40,000
Incremental costs:
Variable costs
Direct material 5.00 20,000
Direct labor 3.00 12,000
Factory overhead 0.75 3,000
Total variable costs Br. 8.75 Br. 35,000
Fixed costs 0
Total incremental costs Br. 35,000
Incremental net operating income Br. 5,000

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Accepting the special order will increase costs by Br. 8.75 per unit produced. The offered price of
Br. 10 per unit exceeds the Br.8.75 incremental variable costs, implying that the special order will
provide a positive contribution to profits. The contribution margin earned on the order will be Br.
1.25 per unit, so for the 4,000 units special order, the firm should be Br. 5,000 (Br. 1.25 x 4,000)
better off by accepting the special order.
Unit variable cost = 5 + 3 + 0.75 + 0.25 = Br. 9.00
Unit fixed costs = 1.50 + 1.00 = Br. 2.50
Total fixed costs = 2.50 x 10,000 = Br. 25,000
Income = Total sales – Total variable cost – Total fixed costs
Income (for 10,000 units of regular sale) = [10,000(15-9)] -25,000 = Br. 35, 000
Income with special order (for 14, 000unit) = 35,000 + 5,000 = Br. 40,000
Income without special order = 35,000
Advantage of accepting the special order Br. 5,000

b. In this case, the company has no sufficient capacity to produce the special order without
affecting normal sales. Therefore, the relevant costs to use in evaluating the special order include
an opportunity cost. The opportunity cost is the contribution margin forgone on regular sales.
The net relevant costs to accept the special order would now be the total of Br. 70,000 variable
manufacturing costs and a forgone contribution margin of Br. 18,000. The total cost of accepting
the special order, Br. 88,000, exceed the offered selling price of Br. 80,000.
Incremental revenue Br. 80,000
Incremental cost
• Variable costs * Br. 70,000
• Opportunity costs 18,000 88,000
Decremental net operating income Br (8,000)

Incremental revenue = 10 x 8,000 = Br. 80,000

Variable costs = 8,000 (5 + 3 + 0.75) = Br. 70,000
Opportunity cost = 3,000 [15 – (5 + 3 + 0.75 + 0.25)] = Br. 18,000

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 WITHOUT EFFECT OF EFFECT OF WITH
SPECIAL SPECIAL ORDER SPECIAL SPECIAL
ORDER ON REGULAR ORDER 8,000 ORDER
10,000 units SALES 3,000 units units 15,000 units
Sales Br. 150,000 Br. 45,000 Br. 80,000 Br. 185,000
Variable expenses
Direct material Br. 50,000 Br. 15,000 Br. 40,000 B4. 75,000
Direct labor 30,000 9,000 24,000 45,000
Factory overhead 7,500 2,250 6,000 11,250
Selling 2,500 750 - 1,750
Total variable costs Br. 90,000 Br. 27,000 Br. 70,000 Br. 133,000

Contribution margin Br. 60,000 Br. 18,000 Br. 10,000 52,000

Fixed expenses
Factory overhead Br. 15,000 - - Br. 15,000
Administrative 10,000 - - 10,000

Total fixed expenses Br. 25,0 00 - - Br. 25,000

Operating income (loss) Br. 35,000 Br. 18,000 Br. 10,000 Br. 27,000

Note that special order would not require the Br. 0.25 variable selling expenses. The normal sales
however, require the Br. 0.25 variable selling expense
Recommendation. Lucy Company should not accept the special order because it has a net Br.
8,000 disadvantage.

The above analysis may be presented as tabulated here below:

Income with special order = Br. 27,000
Income without special order = 35,000
Disadvantage of accepting the special order Br. (8,000)

c. In requirement (b) above the company will be economically indifferent between accepting and
rejecting the special sales order if the contribution to profit from the special order equals a
contribution margin forgone from regular sales. Therefore, the offer “p” will make Lucy
Company equally attractive between two alternatives as computed here under:

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P (8,000) – 8,000 (8.75) = 18,000
P (8,000) = 18,000 + 70,000
P (8,000) = 88,000
P = 88,000
8,000
P = Br. 11
Thus, assuming an offer of Br. 11 instead of Br. 10, the company will be indifferent between
accepting and rejecting the special order in requirement (b) above.

2.2.1.2 Deletion or Addition of Products or Departments

Decisions relating to whether old product lines or other segments of a company should be
dropped and new ones added are among the most difficult that managers have to make. In such
decisions, many factors must be considered that are both qualitative and quantitative in nature.
Ultimately, however, any final decision to drop an old segment or to add a new one is going to
hinge primarily on the impact the decision will have on net operating income. To assess this
impact, it is necessary to make a careful analysis of the costs involved. To this end, let us try to
distinguish the difference between avoidable and unavoidable fixed expenses.

Fixed costs are divided into two categories, avoidable and unavoidable. Avoidable costs are costs
that will not continue if an ongoing operation is changed, deleted or eliminated. These costs are
relevant costs in decision-making. Examples of avoidable costs include departmental salaries and
other costs that could be avoided by not operating the specific department. Unavoidable costs
are costs that continue even if a subunit or an activity is eliminated and are not relevant for
decision. The reason for this is that such costs are not affected by a decision to delete a particular
activity. Unavoidable costs include many common costs, which are defined as those costs of
facilities and services that are shared by users. Examples are store depreciation, heating, air
conditioning, and general management expenses.

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Example (1) Eyoha Department Store has three major departments: groceries, general
merchandise, and drugs. Management is considering dropping groceries, which have
consistently shown a net loss. The following table reports the present annual net income (in
thousands).
DEPARTMENTS
Groceries General merchandise Drugs Total
Sales Br. 1,000 Br. 800 Br. 100 1,900
Variable COGS* & Expenses 800 560 60 1,420
Contribution margin Br. 200 Br. 240 Br. 40 Br. 480
Fixed expenses
Avoidable Br. 150 Br. 100 Br. 15 Br. 265
Unavoidable 60 100 20 180
Trial fixed expenses Br. 210 Br. 200 Br. 35 Br. 445
Operating income (loss) Br. (10) Br. 40 Br. 5 Br. 35
*COGS denote cost of goods sold.
Instructions:
a. Which alternative would you recommend if the only alternatives to be considered are
dropping or continuing the grocery department? Assume that the total assets would be
unaffected by the decision and the space made available by dropping groceries would
remain idle.
b. Refer the income statement presented above. However, assume that the space made
available by dropping groceries could be used to expand the general merchandise
department. The space would be occupied by merchandise that would increase sales by Br.
500,000, generate a 30% contribution margin percentage and have additional avoidable
fixed costs of Br. 70,000. Should Eyoha discontinue grocery and expand merchandise
department?
a)
A B A–B
Total before Effect of dropping Total after change
change grocery
Sales Br. 1,900 Br. 1,000 Br. 900
Variable COGS and Expenses 1,420 800 620
Contribution margin Br. 480 Br. 200 Br. 280
Fixed expenses
Avoidable Br. 265 Br. 150 Br. 115
Unavoidable 180 - 180
Total fixed expenses Br. 445 Br. 150 Br. 295
Operating income (loss) Br. 35 Br. 50 Br. (15)

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 Income with grocery department = Br. 35,000
Loss assuming grocery is eliminated = (15,000)
Disadvantage of discontinuing grocery = Br. (50,000)
Notice that all of the grocery’s variable expenses are avoidable. If the grocery department is
discontinued, the Br. 60,000 of the fixed expenses will continue. Eyoha Department Store will
incur these expenses regardless of its decision about that particular department.
Recommendation: Dropping grocery and leaving the vacated facilities idle would be worse. Groceries
bring in contribution margin of Br. 200,000, which is Br. 50,000 more than the Br. 150,000 fixed expenses
that would be saved by closing the grocery department.
b)

A B C (A – B) + C
Total before E f f ec t o f E f f ect o f Total
ch an g e Dropping Expanding after
Groceries Ge n e r a l Change
Merchandise
Sales Br. 1,900 Br. 1000 Br. 500 Br. 1,400
Variable COGS and Expense 1 ,4 2 0 800 350 970
Contribution margin Br. 480 Br. 200 Br. 150 Br. 430
Fixed expenses
Avoidable Br. 265 Br. 150 Br. 70 Br. 185
Unavoidable 180 - 180
-
Total fixed expenses Br. 445 Br. 150 Br. 70 Br. 365
Operating income (loss) Br. 35 Br. 50 Br. 80 Br. 65

Effect of expanding general merchandise:

Incremental revenue = Br. 500,000
Incremental cost
Variable cost = (1-0.30) x 500,000 = (350,000)
Fixed cost = (70,000)…..(420, 000)
Incremental income Br. 80,000
N.B. All birrs in the exhibit above are in thousands.
Recommendation: The conclusion in (a) will be correct if and only if the space made available by
dropping grocery would be idle. As the above analysis shows, dropping grocery and using the

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vacated space to expand general merchandise is recommendable. The Br. 80,000 increase in
operating income of general merchandise more than offset the Br. 50,000 decline fro eliminating
groceries, providing an overall increase in operating income of Br. 30,000, i.e., Br. 65,000 less Br.
35,000.

2.2.1.3 Optimal Use of Limited Resources

Managers are routinely faced with the problem of deciding how scarce resources are going to be
utilized. A scarce resource or a limiting factor refers to any factor that restrict or constraint the
production or sale of a product or service. It include the following, among others, labor hours,
machine hours, square feet of floor space, cubic meters of display space .A department store, for
example, has a limited amount of floor space and therefore cannot stock every product that may
be available. A manufacturing firm has a limited number of machine- hours and a limited number
of direct labor-hours at its disposal. When capacity becomes pressed because of scarce resource,
the firm is said to have a constraint.

When a plant that makes more than one product is operating at capacity, managers often must
decide which orders to accept. The contribution margin technique also applies here, because the
product to be emphasized or the order to be accepted is the one that makes the biggest total profit
contribution per unit of the limiting factor. Fixed cost are usually unaffected by such choices.

In such kind of decision, the contribution margin technique must be used wisely. Managers
sometimes mistakenly favor those products with the biggest contribution margin or gross margin
per sales birr, without regard to scarce resources.
Example (1): Wajo Company has two products: a plain cellular phone and a fancier cellular phone
with many special features. Unit data follow:

Plain Phone Fancy Phone

Selling price Br.80 Br.120
Variable costs 64 84
Contribution margin Br.16 Br.36
Contribution margin ratio 20% 30%

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Instructions:
a. Which product is more profitable? On which should the firm spend its resources? Assume
that sales are restricted by demand for only a limited number of phones.
b. Now suppose that annual demand for phones of both types is more than the company can
produce in the next year and the major constraint is the availability of time on a processing
machine. Plain Phone requires one hour of processing on the machine, Fancy Phone
requires three hours of processing. Which product is more profitable? Assume that only
10, 000 machine hours of capacity are available.

Solution:
a. Under this circumstance, the limiting factor is units of sale. Thus, the more profitable product is
the one with the higher contribution margin per unit. The fancier cellular phone appears to be
more profitable than the plain phone. It has Br.36 per unit contribution margin as compared to
Br.16 per unit for the plain model, and it has a 30% CM ratio as compared to 20% for the plain
model.
To maximize total contribution margin, a firm should not necessarily promote those products
that have the highest contribution margins. Rather, total contribution margin will be
maximized by promoting those products or accepting those that provide the highest unit
contribution margin in relation to scarce resources of the firm.
b. In requirement (b) above, for instance, the productive capacity is the limiting factor because
only 10, 000hours of capacity is available. To answer this question, the manager should
look at the contribution per unit of the scarce resource. This figure is computed by dividing
the contribution margin for a unit of product by the amount of the scarce resource it
requires. These calculations are carried out below for the plain and fancy phones.
Model
Plain Phone Fancy Phone
Contribution margin (CM) per unit (a) Br.16 Br.36
Machine hours required per unit (b) 1 hour 3 hours
CM per unit of the scarce resource (a÷b) Br.16 per machine Br. 12 per machine
hour hour

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With this data in hand, it is easy to decide which product is less profitable and should be de-
emphasized. Each hours of processing time on the machine that is devoted to the plain phone
results in an increase of Br.16 in contribution margin and profits. The comparable figure for the
fancier phone is only Br.12 per hour. Therefore, the plain model should be emphasized in this
situation. Even though the fancier model has the larger per unit contribution margin and the
larger CM ratio, the plain model provides the larger contribution margin in relation to scarce
resource.

2.2.2 Production Decisions

This part and the preceding one illustrate relevant costs for many types of decisions. Does this
mean that each decision requires a different approach to identifying relevant costs? No. The
fundamental principle in all decision situations is that relevant costs are future costs that differ
among alternatives. The principle is simple, but its application is not always straightforward.

Managers must have tools at their disposal to assist them in distinguishing relevant and irrelevant
costs so that the latter can be eliminated from the decisions framework.

What costs are relevant in decision-making? The answer is easy. Any future cost that makes a
difference between decisions alternative is relevant for decision purpose. All costs are considered
relevant, except
a) Sunk costs. A sunk cost is a cost that has already been incurred and that cannot be
avoided regardless of which course of action a manager may decide to take. As such, sunk
costs have no relevance to future events and must be ignored in decision-making.
b) Future costs that do not differ between the alternatives at hand.

Relevant costs are avoidable costs. An avoidable cost can be defined as cost that can be eliminated
as a result of choosing one alternative over another in a decision-making situation.

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In management accounting, the term avoidable is synonymous with differential cost. These terms
are frequently used interchangeably. To identify the costs that are avoidable (differential) in a
particular decision situation, the manager’s approach to cost analysis should include the following
steps:
• Assemble all of the costs associated with each alternative being considered.
• Eliminate those costs that are sunk.
• Eliminate those that do not differ between alternatives.
• Make a decision based on the remaining costs. These costs will be the differential or
avoidable costs, and hence the costs relevant to the decision to be made.

2.2.2.1 Make or Buy Decisions

Managers in manufacturing companies are often faced with the problem whether to manufacture
a component used in manufacturing a product or to purchase from the outside. Production of
such basic materials as screws, nails, washers, sheet metal and so on is not usually economical
owing to specialization and returns to scale. These materials can almost always be acquired more
cheaply from outside suppliers. But for many materials, such as subassemblies and special parts,
it is not always clear which is least costly means of acquisition. The cost and management
accounting system assist managers in arriving at a correct decision by presenting suitable analysis
of the cost of production and comparing it with the purchase price of the product.

In make or buy decisions, the appropriate means of analysis is to compare the relevant cost of
buying the part with the relevant cots of making the part. Here relevant cost of buying the
component is typically the amount paid to supplier. It may also include transportation costs
incurred to get the component to the company’s plant and costs incurred to process the part upon
receipt.

The relevant cost of making the component is often the variable costs incurred to produce the
component. In some cases, however, the company will need to acquire special equipment to
produce the product or will hire additional supervisory personnel to assist with making the

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product. These incremental fixed costs will be part of the relevant cost of making the part. The
alternative chosen make or buy, is typically the one with the lowest cost.

In the final decision regarding make or buy qualitative factors, besides the quantitative data,
should be considered as part of the decision.

In make or buy decision, the following qualitative factors, besides the quantitative considerations
may favor the decision to “buy”:
➢ Advantage of long-term relationship with suppliers.
➢ Possibility of shortage of material or labor for making the component.
➢ Uninterrupted supply of requisite quality from reliable suppliers.
➢ The internal demand for the product under consideration is small and, as such, it is no use
to set up manufacturing facilities for it and so forth.
On the contrary, the following qualitative factors may favor the decision “to make”:
➢ The quality of the product is decided to be controlled.
➢ If the purchase price is likely to rise due to increased demand in the market, it becomes
uneconomical to buy.
➢ Where the technical know-how is to be kept secret and not to be passed on to the suppliers and so
on.
Example (1) Great Company manufactures 60, 000 units of part XL-40 each year for use on its
production line. The following are the costs of making part XL-40:

Total Costs Cost per

60, 000 units unit
Direct material Br. 480, 000 Br.8
Direct labor 360, 000 6
Variable factory overhead (FOH) 180, 000 3
Fixed FOH 360, 000 6
Total manufacturing costs Br. 1, 380, 000 Br.23

Another manufacturer has offered to sell the same part to Great for Br.21 each. The fixed overhead
consists of depreciation, property taxes, insurance, and supervisory salaries. The entire fixed

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overhead would continue if the Great Company bought the component except that the cost of Br.
120, 000 pertaining to some supervisory and custodial personnel could be avoided.

Instructions:
a) Should the parts be made or bought? Assume that the capacity now used to make parts
internally will become idle if the pats are purchased?
b) Assume that the capacity now used to make parts will be either (i) be rented to near by
manufacturer for Br. 60, 000 for the year or (ii) be used to make another product that will
yield a profit contribution of Br. 250,000 per year. Should the company purchase them from
the outside supplier?
Solutions:

a) To approach the decision from a financial point of view, the manager must focus on the
relevant or differential costs. The differential cost can be obtained by eliminating from the
cost data those costs that are not avoidable –that is, by eliminating the sunk costs and the
future costs that will continue regardless of whether the parts XL-40 are produced internally or
purchased from outside.
Thus, the relevant cost computation follows:
COST TO MAKE COST TO BUY
Per Unit Total Per Unit Total
Direct materials Br.8.00 Br.480, 000
Direct labor 6.00 360, 000
Variable FOH 3.00 180, 000
Fixed FOH, avoidable 2.00 120, 000 _______ ___________
Total cost Br. 19.00 Br. 1, 140, 000 Br.21.00 Br.1, 260, 000

Here above, the analysis shows that the variable costs of producing the part XL-40 (materials,
labor, and variable overhead) are differential costs. All these variable costs, therefore, can be
avoided or eliminated by buying the part from the outside supplier.

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Again, are only the variable costs relevant? No. Perhaps Br. 120, 000 of the total fixed factory
overhead cost is avoidable by purchasing the component part from outside, then it too will be a
differential cost and relevant to the decision. Therefore, the decision should be made by
comparing the total of all variable costs and the avoidable fixed factory overhead against the total
purchase price- that is, cost to buy.

Recommendation: Great Company should reject the outside supplier’s offer because it costs Br.2
less per unit to continue to make the part XL-40. This is a total of Br.120, 000 net advantages.
Relevant Costs Per Unit
Cost to buy Br.21.00
Cost to make 19.00
Advantage of making the part internally Br. 2.00

Total advantage = Br. 2.00 x 60, 000 units=Br. 120, 000

b) If the space now being used to produce the part would otherwise be idle, then Great should
continue to produce its own XL-40and the supplier’s offer should be rejected, as stated
above. Idle space that has no alternative use has an opportunity cost of zero.

But what if the space now being used to produce the part would not sit idle rather could be used
for some other purpose? In that case, the space would have an opportunity cost that would have
to be considered in assessing the desirability of the supplier’s offer. What would this opportunity
cost be? It would be the segment margin that could be derived from the best alternative use of the
space. Therefore, the use of the idle facilities may change our previous decision in requirement (a)
above.
Assuming the space now being used to produce part XL-40 would be
i) Rented to a nearby manufacture for Br. 60, 000 per annum or
ii) Used to produce other product that contributes a profit of Br. 250, 000 per year, the
relevant cost computation follows:

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 Make Buy and Buy and Buy and
Leave Rent out Produce Other
Facility Idle Product
Cost to obtain parts Br. 1, 140,000 Br. 1, 260, 000 Br.1, 260, 000 Br. 1, 260, 0000
Contribution from other products - - (250, 000)
Rent revenue - - (60, 000) -
Net relevant costs Br. 1, 140, 000 Br. 1, 260, 000 Br.1, 200, 000 Br.1, 010, 000

Great company would be better off through accepting the supplier’s offer and to using the
available facility to produce the new product line. This move has the least net relevant cost of Br.
1,010,000.
Example (2) Assume that a division of Leranso Company makes an electric component for its
speakers. The management is trying to decide whether the division of the company should
manufacture this component part or purchase it from another manufacturer.
The following are production costs for 100,000 units of the component for the forth-coming year.
Direct material Br.500, 000
Direct labor 200,000
Factory overhead
Indirect labor Br. 32,000
Supplies 90,000
Allocated occupancy costs 50,000 172,000
Total cost Br.872, 000

A small local company has offered to supply the components at a price of Br.7.80 each. If the
division discontinued the production of its components it would save two thirds of the supplies
cost and Br.22, 000 of indirect labor cost. All other overhead costs would continue regardless of
the decision made.

Instruction: Should the parts be made or bought? Assume that the capacity now used to make the
parts will become idle if they are purchased from outside.
Solution:
In this case Br.10, 000 of indirect labor cost and the Br.50, 000 allocated occupancy costs are
unavoidable costs. That is, a total of Br. 60,000 fixed overhead costs cannot be eliminated

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irrespective of the decision made. Therefore, these costs are irrelevant for the decision making at
hand. The relevant costs can be computed as follows.

COST TO MAKE COST TO BUY

Unit Total Unit Total
Direct material Br. 5.00 Br. 500,000
Direct labor 2.00 200,000
Factory overhead
Indirect labor 0.22 22,000
Supplies 0.60 60,000
Occupancy costs - - ______ _________
Total cost Br.7.82 Br.782, 000 Br.7.80 Br.780,000

Leranso should purchase the component from the supplier because the form saves Br. 2,000 by
purchasing the component.
Net relevant cost to make Br. 782,000
Net relevant cost to buy 780,000
Advantage of purchasing the part from outside Br. 2,000

2.2.2.2 Joint Product Decisions: Sell or Process Further

Often a firm manufactures several different products from a common input and a common
production process. In some cases of such multiple product processing, only one product is of
major importance. The other products are incidental to production. For example, processing of log
in a wood industry produces lumber and saw dust where the latter is produced incidentally. In
other cases, several products of comparable value or importance emerge from a single process.
For example, gasoline, jet fuel, and lubricants all result from petroleum refining. The accountant
classifies multiple products according to their relative importance. The principal product is called
the main product. Incidental products of lesser value are usually called by – products. Products of
nearly equal value are usually called joint products, or co-products.
When two or more manufactured products have relatively significant sales values and are not
separately identifiable as individual products until their split off, they are called joint products.
• Split –off point- is the juncture in manufacturing where the joint products become
individually identifiable.

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 • The costs of manufacturing joint products before the split – off are called joint costs. The
costs of further processing beyond the split-off are separable costs.
Firms that produce several end products from a common input are faced with the problem of
deciding whether it is more advantageous to sell the products at split- off point or process them
further. When such a choice is available, managers must be familiar with the relevant cost and
revenue data to reach a correct decision.

Here, the decision whether to sell or process further will be taken by comparing the additional
cost of processing with the incremental revenue obtainable from the product processed further.
This decision will not be influenced either by the size of the joint cost or the portion of the joint
cost allocated to the product which is to be processed further. Thus, joint product costs are
irrelevant in decision regarding what to do with a product from the split-off point forward, the
joint product costs have already been incurred and therefore are sunk costs. However, allocation
of joint product costs is need for some purposes, such as balance sheet inventory valuation. In case
joint products are on hand at the end of an accounting period, some value must be assigned to
them. To do so, joint product costs must be allocated to specific units of inventory.
• As a general rule, it will always be profitable to continue processing a joint product after
the split –off point so long as the incremental revenue from such processing exceeds the
incremental costs.
Example (1) GREAT Co. uses a common direct material R that has a joint product cost of Br.
16,000 and yields 6,000 pounds of product X selling for Br. 3 per pound and 4,000 pounds of
product Y selling for Br. 3.50 per pound. Product X can be processed further into XP at an
additional cost of Br. 8,000, and product Y can be processed further into YP at an additional cost of
Br. 6,000. The new products, XP and YP, can then be sold for Br. 4 and Br. 6 per pound,
respectively.
Instruction: Which product (s) should be sold at split off and which should be sold after
processed further? Why? Assume no loss of input in further processing.
Solution:
Product XP

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 Sales revenue (6,000 x Br 4) Br. 24, 000
Less: Sales value at split- off (6,000 x Br. 3) 18, 000
Additional sales revenue Br. 6, 000
Less: separable costs 8, 000
Disadvantage (loss) of processing further Br. (2, 000)

Product YP
Sales revenue (4,000 x Br 6) Br. 24, 000
Less: Sales value at split- off (4,000 x Br. 3.50) 14, 000
Additional sales revenue Br. 10, 000
Less: separable costs 6, 000
Advantage of processing further Br. 4, 000

Comment: From this analysis, a manager would correctly conclude that product X should be sold
at the split –off and product Y should be processed into product YP. The joint product cost of Br.
16,000 should not be used to reach this decision. Rather, the analysis should be limited to the
difference between the incremental revenue and the incremental (separable) cost.
Example (2) UNITED Chemical Company produces three chemical products, x, y and z, as a
result of a particular joint process. The joint process cost is Br. 105,000. This includes raw material
costs and the cost of processing to the point where these joint products go their separate ways.
These products were processed further and sold as follows:

CHEMICAL ADDITIONAL PROCESSING

PRODUCTS SALES COSTS
X Br. 260,000 Br. 220,000
Y 330,000 300,000
Z 175,000 100,000

The company has had an opportunity to sell at split-off directly to other processors. If that
alternative had been selected, sales would have been: X, Br. 56,000, Y, Br. 28,000 and Z, Br. 54,000.
The company expects to operate at the same level of production and sales in the forth-coming
year.
Consider all the available information, and assume that all costs incurred after split-off are
variable.
Instruction:

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 a. Which products should be processed further and which should be sold at split-off?
a. Could the company increase operating income by altering its processing decisions? If so,
what would be the expected overall operating income?
Solutions:
a.
Products Sales AtSales After Incremental Incremental Difference
split-off
Further Revenue Cost Separable
Process cost
X Br. 56,000 Br. 260,000 Br. 204,000 Br. 220,000 Br, (16,000)
Y 28,000 330,000 302,000 300,000 2,000
Z 54,000 175,000 121,000 100,000 21,000
Comment: The above analysis shows that X should be sold at Split-off and Y and Z should be sold
after processed further. Further processing Y and Z have an advantage of Br. 2,000 and Br. 21,000,
respectively. On the other hand, processing X beyond split-off point has a net Br. 16,000
disadvantage.

b. (i) Operating income (OI) with the current processing decision

OI= Total sales - (Joint Cost + Separable costs)
Operating income = (260,000+330,000+175,000)-(105,000+220,000+300,000+100,000)
= Br. 40,000
(ii) Operating income (OI) with the recommended processing decision.
OI = (56,000+330,000+175,000)-(105,000+300,000+100,000)
= Br. 56,000
Increase in operating income = Br. 56,000-Br. 40,000
= Br. 16,000
This analysis also shows that the recommended processing decision has a net Br. 16,000
advantage, which equals the disadvantage of processing X further.

2.2.2.3 Keep or Replace Equipment Decisions

Care must be taken to select only the data that are relevant for a decision whether to replace or
keep the old equipment. In such kind of decision, the book value of the old equipment is not a
relevant consideration, for instance.

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In deciding whether to replace or keep existing equipment, four commonly encountered items
differ in relevance:
(i) Book value of old equipment: Irrelevant, because it is a past (historical) Cost. Therefore,
depreciation on old equipments irrelevant.
(ii) Disposal value of old equipment: Relevant, because it is an expected future inflow that
usually differs among alternatives.
(iii) Gain or loss on disposal: This is the algebraic difference between book value and
disposal value. It is therefore, a meaningless combination of irrelevant and relevant
items. Consequently, it is best to think of each separately.
(iv) Cost of new equipment: Relevant, because it is an expected future outflow that will
differ among alternatives. Therefore depreciation on new equipment is relevant.

Example (1) Consider the data regarding Success co. photocopying requirements:
Old Proposed
Equipment Replacement
Equipment
Useful life, in years 5 3
Current age, in years 2 0
Useful life remaining, in years 3 3
Original cost Br. 25,000 Br. 15,000
Accumulated depreciation 10,000 0
Book value 15,000 Not acquired yet
Disposal value (in cash) now 3,000 Not acquired yet
Disposal value in 2 years 0 0
Annual cash operating costs for power,
maintenance, toner and supplies Br. 14,000 Br.7, 500

The administrator is trying to decide whether to replace the old equipment. Because of rapid
changes in technology, he expects the replacement equipment to have only a three-year useful life.
Ignore the effects of taxes.
Instruction: Should SUCCESS keep or replace the old equipment? Compute the difference in total
cost over the next 3-years under both alternatives, that is, keeping the original or replacing it with
the new machine.

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Solution:
THREE YEARS TAKEN TOGETHER
OLD EQUIPMENT NEW EQUIPMENT
Cost of new equipment - Br. 15,000
Disposal Value - (3,000)
Cash operating costs Br. 42,000 22,500
Net relevant costs Br. 42,000 Br. 34,500
Recommendation: Replacing the old equipment has a net Br. 7,500 advantage (Br.42, 000 less Br.
34,500)
Example (2) Awash Co. has just today paid for and installed a special machine for polishing cars
at one of its several outlets. It is the first day of the company's fiscal year.

The machine cost, Br. 20,000. Its annual cash operating costs total Br. 15,000, exclusive of
depreciation. The machine will have a 4-year useful life and a zero terminal disposal price.
After the machine has been used for a day, a machine salesperson offers a different machine that
promises to do the same job at a yearly cash operating cost of Br. 9,000, exclusive of depreciation.
The new machine will cost Br. 24,000 cash, installed. The "old" machine is unique and can be sold
outright for only Br. 10,000 minus Br. 2000 removal cost. The new machine, like the old one, will
have a 4-year useful life and zero terminal disposal prices.

Sales, all in cash, will be Br. 150,000 annually, and other cash costs will be Br. 110,000 annually,
regardless of this decision.

Instructions:
(a) Prepare a summary income statement covering the next four years under both alternatives
(when the new machine is not purchased and when the new machine is purchased). What
is the cumulative difference in operating income for the 4 years taken together?
(b) Determine the desirability of purchasing the new machine using only relevant costs in your
analysis?
Solutions:
Two different approaches may be used to solve such kinds of problems for decision-making
purposes.

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 (i) Comparative income approach. This approach includes both relevant and irrelevant
costs. When the comparative income approach is used, the net operating income for
reach alternative is computed and compared. All revenues and costs are considered-
even those that are the same for each alternative.
(ii) Differential analysis. In this approach, only revenues and costs that differ among the
alternatives are considered.
N.B. The end-result- a correct decision - will be the same regardless of which method is used.
a) Comparative income approach.
AWASH Company
comparative INCOME STATEMENT
for the next 4 years together
OLD MACHINE NEW MACHINE
Sales Br. 600,000 Br. 600,000
Cash operating costs (60,000) (36,000)
Other cash costs (440,000) (440,000)
Depreciation (20,000) (24,000)
Loss on disposal _______- (12,000)
Income Br. 80,000 Br. 88,000

Comment: The above analysis (which includes both relevant and irrelevant items) shows Br. 8000
cumulative difference in operating income for the 4 years taken together. Ignoring income taxes
and the time value of money, the purchase of the new machine appears to be a favorable.
b) Differential analysis
Four years taken together
Old machine New machine
Cost of new equipment - Br. 24,000
Disposal value - (8,000)
Cash operating costs Br. 60,000 36,000
Net relevant costs Br. 60,000 Br. 52,000

When differential analysis is used, the focus is on cash flows. The investment decision is based on
the difference between the net cash inflows and the net cash outflows. Regardless of which
method is used; the net cash advantage will always be the same. Net cash advantage in favor of
replacing old machine is Br. 8,000 as shown above using differential analysis.

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