A note on "relevant information for decision making terms" in advanced management accounting study
Briefly describe the
following relevant information for decision making terms in advanced management
accounting study
(Terms used in
Chapter 10)
1. Relevant costs and
relevant revenues
2. Differential cost
3. Relevant qualitative
factors
4. Potential problems in
relevant-cost analysis
5. Make-or-buy decisions
6. Opportunity costs,
outsourcing and capacity constraints
7. Carrying costs of
stock
8. Customer
profitability and relevant costs
9. Irrelevance of sunk
cost and book value
Relevant-cost
analysis supports short-term decisions by comparing only the future cash flows
that change between alternatives. It avoids decisions being distorted by
allocated overheads, historical costs, or accounting book values.
Core relevant-cost concepts
1.
Relevant costs and
relevant revenues
These are future costs and revenues that will differ depending on which option
management chooses. A cost or revenue that is identical under all alternatives
is irrelevant because it cannot affect the choice. Relevant costs are normally
incremental/avoidable cash flows.
2.
Differential cost
Differential cost is the difference in total cost between two alternatives; it
is also called incremental or avoidable cost when it arises from choosing one
option rather than another. For example, if outsourcing costs $120,000 and
internal production creates avoidable costs of $95,000, the $25,000 difference
favours making—before considering capacity opportunity costs.
3.
Relevant
qualitative factors
Important non-financial factors may override a narrow cost comparison. These
include supplier quality and reliability, delivery lead times, loss of
technical know-how, intellectual-property risk, employee morale or
redundancies, customer service, strategic dependence on a supplier, and
flexibility to respond to demand changes. A make-or-buy decision should
therefore combine relevant-cost data with these operational and strategic
considerations.
Limitations and pitfalls
4.
Potential problems
in relevant-cost analysis
Common problems include:
o Using full absorbed product costs, including
unavoidable fixed overhead, instead of avoidable future cash flows
o Omitting opportunity costs where scarce
capacity has an alternative profitable use
o Making inaccurate forecasts about volumes,
prices, quality failures, or supplier performance
o Treating a short-term decision as if it had
no long-term strategic consequences
o Ignoring qualitative factors that are
difficult to quantify
o Assuming fixed costs are unavoidable when
some can actually be removed, or assuming they are avoidable when they are
committed
5.
Irrelevance of
sunk cost and book value
A sunk cost is a past cost that has already been incurred and cannot be
changed, such as prior development expenditure or the original cost of old
machinery. Book value—original cost less accumulated depreciation—is generally
also historical and non-cash, so it is irrelevant. However, a machine’s future
resale/disposal value is relevant because it is a future cash inflow that can
differ between alternatives.
Sourcing and capacity
6.
Make-or-buy
decisions
Management should make internally when the relevant cost of internal production
is lower than the relevant cost of purchasing externally; otherwise it should
buy. Relevant make costs usually include direct materials, direct labour,
variable overhead, avoidable fixed costs, and any opportunity cost of capacity.
Relevant buy costs include supplier price, inspection, transport, receiving,
contract-management, and any necessary inventory or quality-control costs.
7.
Opportunity costs,
outsourcing and capacity constraints
Opportunity cost is the contribution or benefit forgone from the next-best use
of a scarce resource. It is not normally recorded in financial accounts, but it
is economically relevant. If the business has idle capacity, using it to make a
component usually has no capacity opportunity cost. If capacity is fully used,
making a component may sacrifice contribution from another product; that
forgone contribution must be added to the cost of making before comparing it
with outsourcing.
Inventory and customer decisions
8.
Carrying costs of
stock
Carrying, or holding, costs are the costs of keeping inventory over time. They
include:
o Opportunity cost of capital tied up in stock
or inventory-financing interest
o Warehouse rent, utilities, handling, and
inventory administration
o Insurance and applicable taxes
o Obsolescence, deterioration, damage, theft,
and shrinkage risks
These costs matter in decisions about order quantity, supplier arrangements,
safety stock, and whether to hold stock internally or let suppliers hold it.
9.
Customer
profitability and relevant costs
Customer profitability assesses revenue from an individual customer or customer
segment less the costs attributable to serving them. Beyond product cost,
relevant customer-specific costs can include sales commissions, account-manager
time, order processing, bespoke packaging, deliveries, returns, customer
service, promotional support, warehousing, and credit collection.
Activity-based costing can improve this analysis by tracing costs through
customer-related activities and cost drivers.
A customer with
high sales revenue may still be unprofitable if they require frequent small
orders, special handling, heavy support, long credit terms, or high returns.
The management response need not be to drop the customer: it may instead
redesign service, introduce minimum-order quantities, alter pricing, or
renegotiate terms.
** also study the videos on this topic: video 1; video 2; video 3.
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