Chapter 23: Decisions and Information

Managerial Decision Making Process The decision-making process in managerial accounting involves five key steps: 1. Define the Decision: Clearly state the problem or decision to be made. 2. Identify Alternatives: Determine the possible courses of action. 3. Collect Relevant Information and Evaluate Alternatives: Gather financial and non-financial data, focusing on information that directly impacts the decision. 4. Select the Course of Action: Choose the best alternative based on the evaluation. 5. Analyze and Assess Decisions Made: Review the outcomes to ensure that the decision met the intended objectives and refine future decision-making processes. Relevant Costs and Benefits Relevant costs and benefits are crucial for making short-term decisions and involve understanding the following key concepts: • • • Incremental Revenues: The additional revenues generated by choosing one option over another. Incremental Costs: Also known as differential or avoidable costs, these are the additional costs incurred by selecting one option over another. Incremental Income: This is calculated as incremental revenues minus incremental costs. The best decision typically maximizes incremental income. Types of Costs in Decision-Making Understanding which costs are relevant is essential for accurate decision-making: 1. Sunk Costs: o Costs that have already been incurred due to past decisions and cannot be changed. o They are irrelevant for current decision-making because they do not affect future costs or benefits. o Examples: Previously paid amounts or depreciation of an existing asset. 2. Out-of-Pocket Costs: o Costs that require a future cash outlay. o These are relevant to decisions as they directly impact future cash flows. o Example: The future cost of replacing equipment. 3. Opportunity Costs: o The potential benefit lost when one alternative is chosen over another. Though not recorded in accounting records, opportunity costs are relevant for decision-making as they reflect the true cost of choosing one option. o Example: Wages lost by choosing to attend a class instead of working. 4. Avoidable Costs: o Costs that can be avoided if a particular decision is made. o They are always relevant because they represent savings that could be realized by selecting one alternative. o Example: Labor costs that could be eliminated if a job is automated. o Decision Example: Sell or Process Further Scenario: Georgia Co. has two options for its harvested peanuts: • • Option 1: Sell the peanuts as is for $35,000. Option 2: Process the peanuts into peanut butter, which would cost an additional $25,000 and result in total revenues of $55,000. Analysis of Relevant Costs and Revenues: • • • • Revenue from selling as is: $35,000 (relevant) Revenue from processing further: $55,000 (relevant) Cost of harvesting: $20,000 (irrelevant for the decision since it is already incurred and remains the same regardless of the option chosen—it is a sunk cost). Additional cost to process: $25,000 (relevant, as it is only incurred if the peanuts are processed further). Incremental Analysis: • • • Incremental Revenue: $55,000 (from processing) - $35,000 (from selling as is) = $20,000 Incremental Cost: Additional processing cost = $25,000 Incremental Income: $20,000 - $25,000 = - $5,000 Conclusion: The decision should be to sell the peanuts as is because processing further would result in a negative incremental income of $5,000, making it less profitable.