Slides adapted from Langfield-Smith et al., McGraw-Hill ACC602: Strategic Management Accounting Topic 5: Relevant Costs for Tactical Decision making Slides adapted from Langfield-Smith et al., McGraw-Hill Reference Chapter 19 (including appendix) from the recommended textbook

LEARNING OUTCOME: After the completion of this topic, you should be able to: Interpret the difference between tactical decisions and long term decisions. Compare contrast the steps in the decision – making process, and the management accountant’s role. Evaluate all relevant information in make or buy decision, add or delete a product or department, and for special order decisions. Validate the joint product costs in decisions about whether to sell a product or process it further. Formulate how incentives can influence the way that managers make decisions. 7/31/2018

The management accountant’s role in decision making To provide relevant information to managers and teams who make the decisions (about how to run their organisation) Tactical decisions Do not require significant capacity-related resource commitments (increasing or decreasing the resources such as factory space or equipment) Can be changed or reversed quickly – to take advantage of better opportunities (impact may be short term) Example: Accept or reject a one-off production special order Whether to sell or process further a joint product Focus on considering incremental revenues and costs that arise from each alternative 7/31/2018

Tend to be more strategic in nature Long-term decisions Tend to be more strategic in nature Involve increases or decreases in capacity-related resources More difficult to reverse and effects may extend over long time periods Examples: Closing a business unit Acquisition of automated computer equipment Introduction of new product line 7/31/2018

A model of the decision-making process The seven steps involved are: Step 1: Clarify the problem – decision to be made/ problem to be solved - Eg. Should you accept or reject the special order below the normal price (cont.) 7/31/2018

Step 2 Specify the decision criterion – upon which the decision will be made; often related to specific objective eg. Maximise profit, increase market share, minimise cost, etc 7/31/2018

Step 3 Identify alternative courses of action – possible (two or more options) Eg. If machine breaks down – repair, replace, regular maintenance, etc 7/31/2018

Step 4 Collect information about relevant costs and benefits Involves predictions about outcomes (costs and benefits) of various possible courses of action -need good understanding of what drives costs and factors that influence revenues The accountant needs to distinguish between relevant and irrelevant data 7/31/2018

Step 5 Compare the costs and benefits of each alternative course of action The accountant will prepare an analysis of the relevant costs and benefits for each possible course of action Must be matched with respect to decision criterion identified in step 2 (consider whether it is in line with the organisation objectives) 7/31/2018

Step 6 Select a course of action Managers will select the course of actions that best meets the decision criteria identified in Step 2 7/31/2018

Step 7 Evaluate the effectiveness of the decision - Whether the objectives were met or not -The main objective is to improve the future decisions 7/31/2018

Summary Quantitative Analysis - Steps 2-5 Qualitative considerations - Step 6 Primary responsibility of the management accountant – Steps 4 and 5 Management accountant participates (often as part of cross-functional management team) – Steps 1-7 7/31/2018

Characteristics of relevant information Different under competing courses of action Costs and benefits that are the same across all available courses of action need not be considered (because it will not make any difference in the decision) Relates to the future Consequences of decisions affect the future not the past, so only costs and benefits that relate to the future are relevant Sunk costs are ignored Costs that have already been incurred cannot be changed and are irrelevant Prediction of future costs may be based on past data (cont.) 7/31/2018

Characteristics of relevant information Timeliness versus accuracy Relevant information is only of value if it is available in time to be used in the decision-making process A trade-off may need to be made between the accuracy and timeliness of information (accurate information may take longer to produce) As accuracy improves, timeliness suffers (vice versa) More accurate information may take more time to produce Quantitative or qualitative Quantitative information can be expressed in numeric terms, such as dollars Qualitative information cannot be expressed effectively in numerical terms 7/31/2018

The importance of providing only relevant information Generating information is a costly process Requires time and effort Supplying irrelevant data to managers can lead to managers reading and processing the information, which is a waste of managerial resources Information overload decreases the effectiveness of decision making. 7/31/2018

Information for unique versus repetitive decisions Unique decisions Arise infrequently or only once (requires special analysis by the management accountant) Relevant information will often be found both inside and outside the organisation Relevant information is harder to generate Repetitive decisions Made over and over again Made at regular or irregular intervals May draw on a large amount of historical data readily available 7/31/2018

Identifying relevant costs and benefits: terminology (cont.) Two tests on relevant information: The cost or benefit relate to the future The costs or benefits differ between the alternatives 7/31/2018

Identifying relevant costs and benefits: terminology Incremental revenue The additional revenue that will be gained as a result of choosing one course of action over another relevant Incremental costs The additional costs that arise from choosing one course of action over another Out-of-pocket costs Those incremental costs that will be incurred if a particular course of action is selected (relevant) Sunk costs Costs that have already been incurred Irrelevant to any future decisions (do not affect any future cost and cannot be changed by any current or future action) Irrelevant to decisions Eg. Carrying amount of equipment, cost of inventory on hand (cont.)

Identifying relevant costs and benefits: terminology (cont.) Opportunity costs The potential benefit give up when the choice of one action precludes a different action relevant Avoidable costs Costs that will not be incurred in the future if a particular decision is made (relevant) Unavoidable costs Costs that will continue to be incurred no matter which decision alternative is chosen Irrelevant to the decision 7/31/2018

Accept or reject a special order Whether or not to supply a customer with a single, one-off order for goods or services, at a special price Spare capacity occurs where equipment, labour or other inputs to production are not being utilised and, hence, are available for other purposes In situations of spare capacity If incremental revenues are greater than incremental costs, the order should be accepted, on financial grounds Allocated fixed costs should not be included Assumes that there are no alternative uses for the spare resources (cont.) 7/31/2018

Accept or reject a special order (cont.) If there is no spare capacity The analysis should take account of opportunity costs associated with the use of the limited capacity If the decision is not a one-off decision Pricing may need to be reviewed to cover facility costs If capacity is limited, then it may need to be increased to ensure that all profitable business can be accommodated Strategic issues Long-term strategic issues may include whether the decision to accept the special order will impact on the business’s reputation or relationships with existing customers (qualitative considerations) (cont.) 7/31/2018

Accept or reject a special order (cont.) Note: Cost savings is a benefit. 7/31/2018

Accept or reject a special order (cont.) 7/31/2018

Make or buy a product Involves the choice between whether the organisation produces a product itself, or purchases it from an external supplier Consider avoidable versus unavoidable costs Opportunity costs are often relevant Consider lost profits from using the capacity to make the product Strategic issues may include (qualitative considerations) Quality of the purchased product Delivery responsiveness, technical capabilities, labour relations and financial stability of the supplier Ability of the supplier to respect confidential information (cont.) 7/31/2018

Make or buy a product (cont.) 7/31/2018

Outsourcing decisions Outsourcing occurs when part of a manufacturing process, or another function normally undertaken within an organisation, is contracted to an outside business Tends to be a long-term decision rather than a tactical ‘make-or-buy’ decision Difficult and costly to reverse 7/31/2018

Add or delete a product, service or department Consider which costs and benefits will change if the decision is taken Has long-term implications Conventional accounting data that contains cost allocations should be treated with care Strategic issues (qualitative considerations) If we delete a product, will this affect sales of other products? Will we lose customers? Will it impact capacity? Will deleting a department impact on employee morale? (cont.) 7/31/2018

Add or delete a product, service or department (cont.) The following costs are avoidable: Food and beverages, wages ($20000), electricity and telephone, depreciation, supervisory salaries, insurance. The following costs are unavoidable: wages ($20000), and rent 7/31/2018

Add or delete a product, service or department (cont.) 7/31/2018

Add or delete a product, service or department Passengers may choose a different Airline Company if the club is eliminated. Therefore, lost contribution from decreased sale would be an opportunity cost 7/31/2018

Joint products: sell or process further Two or more products produced simultaneously from the one production process Cannot be separated prior to split-off Split-off point The stage in the production process when the joint products are identifiable as separate products Joint cost All manufacturing costs incurred in the production of joint products Relative sales method A method of allocating joint cost to joint products in proportion to their sales value at the split-off point (cont.) 7/31/2018

Joint products: sell or process further (cont.) 7/31/2018

Joint products: sell or process further 7/31/2018

Incentives for decision makers Managers typically make decisions that will maximise their reported performance and rewards Cost systems may be designed to explicitly encourage certain biases in decision making To encourage managers and employees to make certain decisions, systems must be designed with this in mind 7/31/2018

Pitfalls to avoid in using accounting data for decisions Ignore sunk costs Beware of using unitised fixed costs in decision making Example: Total Fixed cost is $5000, irrespective of whether 1000 units, 2000 units or 4000 units are produced But unit fixed cost would be as follows: $5000/1000 = $5 / unit $5000/2000 = $2.50/ unit $5000/4000 = $1.25/unit Beware of allocated fixed costs, but focus on identifying the avoidable costs Pay special attention to identifying and including opportunity costs in a decision analysis 7/31/2018

Summary Tactical decisions do not require significant changes in capacity and can be changed if better opportunities arise Relevant information will include quantitative and qualitative information, as well as consideration of strategic issues In decision analysis, incremental revenues and costs are usually the focus, and in some cases avoidable costs In special order and make-or-buy decisions, opportunity costs become relevant where there is no or limited spare capacity (cont.) 7/31/2018

Summary (cont.) Adding or deleting a product/department involves consideration of avoidable and unavoidable costs Processing joint products further requires consideration of incremental revenue and costs ABC systems may provide more accurate information for decisions than costs generated from conventional costing systems Management incentives can sometimes distort the collection and analysis of information in decisions Accounting data should be used carefully in decision analysis as it can be problematic 7/31/2018

Reference: Smith, L. (etal), 6th ed, “Management Accounting 6/e – Information for Managing and Creating Value. McGraw Hill. Australia.Pages 896-931 7/31/2018