CHAPTER 2 RELEVANT INFORMATION AND DECISION MAKING
Making decisions is one of the basic functions of a manager. Managers are constantly faced with problems of
deciding what products to sell, 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. Decision making is often a
difficult task that is complicated by numerous alternatives and massive amounts of data, only some of which
may be relevant.
Every decision involves choosing from among at least two alternatives. In making a decision, the costs and
benefits of one alternative must be compared to the costs and benefits of other alternatives. Costs that differ
between alternatives are called relevant costs. Distinguishing between relevant and irrelevant costs and benefits
is critical for two reasons. First, irrelevant data can be ignored – saving decision makers tremendous amounts of
time and effort. Second, bad decisions can easily result from erroneously including irrelevant costs and benefits
when analyzing alternatives. To be successful in decision making, managers must be able to tell the difference
between relevant and irrelevant data and must be able to correctly use the relevant data in analyzing
alternatives.
Cost Concepts for Decision Making
Identifying Relevant Costs and Benefits
Only those costs and benefits that differ in total between alternatives are relevant in a decision. If a cost will be
the same regardless of the alternative selected, then the decision has no effect on the cost and it can be ignored.
For example, if you are trying to decide whether to go to a movie or to rent a videotape for the evening, the rent
on your apartment is irrelevant. Whether you go to a movie or rent a videotape, the rent on your apartment will
be exactly the same and is therefore irrelevant to the decision. On the other hand, the cost of the movie ticket
and the cost of renting the videotape would be relevant in the decision since they are avoidable costs.
An avoidable cost is a cost that can be eliminated in whole or in part by choosing one alternative over another.
By choosing the alternative of going to the movie, the cost of renting the videotape can be avoided. By choosing
the alternative of renting the videotape, the cost of the movie ticket can be avoided. Therefore, the cost of the
movie ticket and the cost of renting the videotape are both avoidable costs. On the other hand, the rent on the
apartment is not an avoidable cost of either alternative. You would continue to rent your apartment under either
alternative. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs.
Two broad categories of costs are never relevant in decisions. These irrelevant costs are:
1) Sunk costs.
2) Future costs that do not differ between the alternatives.
A sunk cost is a cost that has already been incurred and cannot be avoided regardless of what a manager
decides to do. Sunk costs are always the same, no matter what alternatives are being considered, and they are
therefore always irrelevant and should be ignored. On the other hand, future costs that do differ between
alternatives are relevant. For example, when deciding whether to go to a movie or rent a videotape, the cost of
buying a movie ticket and the cost of renting a videotape have not yet been incurred. These are future costs that
differ between the alternatives and therefore they are relevant.
In managerial accounting, the terms avoidable cost, differential cost, incremental cost, and relevant cost are
often used interchangeably. To identify the costs that are avoidable in a particular decision situation and are
therefore relevant, these steps should be followed:
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1) Eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of (a)
sunk costs and (b) future costs that do not differ between alternatives.
2) Use the remaining costs and benefits that do differ between alternatives in making the decision. The costs
that remain are the differential, or avoidable, costs.
Different Costs for Different Purposes
We need to recognize from the outset of our discussion that costs that are relevant in one decision situation are
not necessarily relevant in another. Simply put, this means that the manager needs different costs for different
purposes. For one purpose, a particular group of costs may be relevant; for another purpose, an entirely different
group of costs may be relevant. Thus, in each decision situation the data must be carefully examined to isolate
the relevant costs. Otherwise, there is the risk of being misled by irrelevant data.
An Example of Identifying Relevant Costs and Benefits
Cynthia is currently a student in an MBA program in Boston and would like to visit a friend in New York City
over the weekend. She is trying to decide whether to drive or take the train. Because she is on a tight budget,
she wants to carefully consider the costs of the two alternatives. If one alternative is far less expensive than the
other, that may be decisive in her choice. By car, the distance between her apartment in Boston and her friend’s
apartment in New York City is 230 miles. Cynthia has compiled the following list of items to consider:
Automobile Costs
Item Annual Cost per Mile
Cost of (based on
Fixed 10,000 miles
Items per year)
(a) Annual straight-line depreciation on car [($18,000 original cost - $4,000
estimated resale value in 5 years)/5 years] $2,800 $0.280
(b) Cost of gasoline ($1.60 per gallon / 32 miles per gallon) $0.050
(c) Annual cost of auto insurance and license $1,380 0.138
(d) Maintenance and repairs 0.065
(e) Parking fees at school ($45 per month x 8 months) $ 360 0.036
(f) Total average cost per mile $0.569
Additional Data
(g) Reduction in the resale value of car due solely to wear and tear $0.026 per mile
(h) Cost of round-trip Amtrak ticket from Boston to New York City $104
(i) Benefit of relaxing and being able to study during the train ride rather than having to ?
drive
(j) Cost of putting the dog in a kennel while gone $40
(k) Benefit of having a car available in New York City ?
(l) Hassle of parking the car in New York City ?
(m) Cost of parking the car in New York City $25 per day
Which costs and benefits are relevant in this decision? Remember, only those costs and benefits that differ between
alternatives are relevant. Everything else is irrelevant and can be ignored.
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Start at the top of the list with item (a): the original cost of the car is a sunk cost. This cost has already been incurred and
therefore can never differ between alternatives. Consequently, it is irrelevant and can be ignored. The same is true of the
accounting depreciation of $2,800 per year, which simply spreads the sunk cost across a number of years.
Move down the list to item (b): the cost of gasoline consumed by driving to New York City. This would clearly be a
relevant cost in this decision. If Cynthia takes the train, this cost would not be incurred. Hence, the cost differs between
alternatives and is therefore
relevant.
Item (c), the annual cost of auto insurance and license, is not relevant. Whether Cynthia takes the train or drives on this
particular trip, her annual auto insurance premium and her auto license fee will remain the same.
Item (d), the cost of maintenance and repairs, is relevant. While maintenance and repair costs have a large random
component, over the long run they should be more or less proportional to the amount of miles the car is driven. Thus, the
average cost of $0.065 per
mile is a reasonable estimate to use.
Item (e), the monthly fee that Cynthia pays to park at her school during the academic year, would not be relevant in the
decision of how to get to New York City. Regardless of which alternative she selects—driving or taking the train—she
will still need to pay for parking at school.
Item (f) is the total average cost of $0.569 per mile. As discussed above, some elements of this total are relevant, but some
are not relevant. Since it contains some irrelevant costs, it would be incorrect to estimate the cost of driving to New York
City and back by simply multiplying the $0.569 by 460 miles (230 miles each way x 2). This erroneous approach would
yield a cost of driving of $261.74. Unfortunately, such mistakes are often made in both personal life and in business.
Since the total cost is stated on a per-mile basis, people are easily misled. Often people think that if the cost is stated as
$0.569 per mile, the cost of driving 100 miles is $56.90. But it is not. Many of the costs included in the $0.569 cost per
mile are sunk and/or fixed and will not increase if the car is driven another 100 miles. The $0.569 is an average cost, not
an incremental cost. Beware of such unitized costs (i.e., costs stated in terms of a dollar amount per unit, per mile, per
direct labor-hour, per machine-hour, and so on)—they are often misleading.
Item (g), the decline in the resale value of the car that occurs as a consequence of driving more miles, is relevant in the
decision. Because she uses the car, its resale value declines. Eventually, she will be able to get less for the car when she
sells it or trades it in on another car. This reduction in resale value is a real cost of using the car that should be taken into
account. The reduction in resale value of an asset through use or over time is often called real or economic depreciation.
This is different from accounting depreciation, which attempts to match the sunk cost of the asset with the periods that
benefit from that cost.
Item (h), the $104 cost of a round-trip ticket on Amtrak, is clearly relevant in this decision. If she drives, she would not
have to buy the ticket.
Item (i) is relevant to the decision, even if it is difficult to put a dollar value on relaxing and being able to study while on
the train. It is relevant because it is a benefit that is available under one alternative but not under the other.
Item (j), the cost of putting Cynthia’s dog in the kennel while she is gone, is clearly irrelevant in this decision. Whether
she takes the train or drives to New York City, she will still need to put her dog in a kennel.
Like item (i), items (k) and (l) are relevant to the decision even if it is difficult to measure their dollar impacts.
Item (m), the cost of parking in New York City, is relevant to the decision. Bringing together all of the relevant data,
Cynthia would estimate the relative costs of driving and taking the train as follows:
Relevant financial cost of driving to New York City:
Gasoline (460 miles at $0.050 per mile) $ 23.00
Maintenance and repairs (460 miles @ $0.065 per mile) 29.90
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Reduction in the resale value of car due solely to wear and tear 11.96
(460 miles @ $0.026 per mile)
Cost of parking the car in New York City (2 days @ $25 per day) 50.00
Total $114.86
Relevant financial cost of taking the train to New York City:
Cost of round-trip Amtrak ticket from Boston to New York City $104.00
What should Cynthia do? From a purely financial standpoint, it would be cheaper by $10.86 ($114.86 - $104.00) to take
the train than to drive. Cynthia has to decide if the convenience of having a car in New York City outweighs the additional
cost and the disadvantages of being unable to relax and study on the train and the hassle of finding parking in the city.
Reconciling the Total and Differential Approaches
Oak Harbor Woodworks is considering a new labor-saving machine that rents for $3,000 per year. The machine will be
used on the company’s butcher block production line. Data concerning the company’s annual sales and costs of butcher
blocks with and without the new machine are shown below:
Current Situation
Situation with the New
Machine
Units produced and sold 5,000 5,000
Selling price per unit $40 $40
Direct materials cost per unit $14 $14
Direct labor cost per unit $8 $5
Variable overhead cost per unit $2 $2
Fixed costs, other $62,000 $62,000
Fixed costs, rental of new machine — $3,000
Given the annual sales and the price and cost data above, the net operating income for the product under the two
alternatives can be computed as shown on the next page. Note that the net operating income is $12,000 higher with the
new machine, so that is the better alternative. Note also that the $12,000 advantage for the new machine can be obtained
in two different ways. It is the difference between the $30,000 net operating income with the new machine and the
$18,000 net operating income for the current situation. It is also the sum of the differential costs and benefits as shown in
the last column on the next page.
Current Situation Differential
Situation with the New Costs and
Machine Benefits
Sales (5,000 units @ $40 per unit) $200,000 $200,000 $0
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 0
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 0
Total variable expenses 120,000 105,000
Contribution margin 80,000 95,000
Less fixed expenses:
Other 62,000 62,000 0
Rent of new machine 0 3,000 (3,000)
Total fixed expenses 62,000 65,000 ______
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Net operating income $ 18,000 $ 30,000 $12,000
A positive number in the Differential Costs and Benefits column indicates that the difference between the alternatives
favors the new machine; a negative number indicates that the difference favors the current situation. A zero in that column
simply means that the total amount for the item is exactly the same for both alternatives. Thus, since the difference in the
net operating incomes equals the sum of the differences for the individual items, any cost or benefit that is the same for
both alternatives will have no impact on which alternative is preferred. This is the reason that costs and benefits that do
not differ between alternatives are irrelevant and can be ignored. If we properly account for them, they will cancel out
when we compare the alternatives.
We could have arrived at the same solution much more quickly by ignoring altogether the irrelevant costs and benefits.
The selling price per unit and the number of units sold do not differ between the alternatives. Therefore, the total sales
revenues are exactly the same for the two alternatives as shown above. Since the sales revenues are exactly the same,
they have no effect on the difference in net operating income between the two alternatives. That is shown in the last
column, which shows a $0 differential benefit.
The direct materials cost per unit, the variable overhead cost per unit, and the number of units produced and sold do
not differ between the alternatives. Consequently, the direct materials cost and the variable overhead cost will be the
same for the two alternatives and can be ignored.
The “other” fixed expenses do not differ between the alternatives, so they can be ignored as well.
Indeed, the only costs that do differ between the alternatives are direct labor costs and the fixed rental cost of the new
machine. Hence, the two alternatives can be compared based only on these relevant costs:
Net advantage to renting the new machine:
Decrease in direct labor costs (5,000 units at a cost savings of $3 per unit) $15,000
Increase in fixed expenses (3,000)
Net annual cost savings from renting the new machine $12,000
If we focus on just the relevant costs and benefits, we get exactly the same answer as when we listed all of the costs and
benefits — including those that do not differ between the alternatives and hence are irrelevant. We get the same answer
because the only costs and benefits that matter in the final comparison of the net operating incomes are those that differ
between the two alternatives and hence are not zero in the last column. Those two relevant costs are both listed in the
above analysis showing the net advantage to renting the new machine.
Why Isolate Relevant Costs?
In the preceding example, we used two different approaches to analyze the alternatives. First, we considered all costs,
both those that were relevant and those that were not; and second, we considered only the relevant costs. We obtained the
same answer under both approaches. It would be natural to ask, “Why bother to isolate relevant costs when total costs will
do the job just as well?” Isolating relevant costs is desirable for at least two reasons.
First, only rarely will enough information be available to prepare a detailed income statement for both alternatives such as
we have done in the preceding examples. Assume, for example, that you are called on to make a decision relating to a
portion of a single operation of a multi departmental, multiproduct company. Under these circumstances, it would be
virtually impossible to prepare an income statement of any type. You would have to rely on your ability to recognize
which costs are relevant and which are not in order
to assemble the data necessary to make a decision.
Second, mingling irrelevant costs with relevant costs may cause confusion and distract attention from the information that
is really critical. Furthermore, the danger always exists that an irrelevant piece of data may be used improperly, resulting
in an incorrect decision. The best approach is to ignore irrelevant data and base the decision entirely on relevant data.
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Relevant cost analysis, combined with the contribution approach to the income statement, provides a powerful tool for
making decisions.
