ACT503 Chap.10 Relevant Information and Decision Making
Relevant Information and Decision Making
Two tests in series, and both must pass
A relevant cost or revenue lies in the future and differs between the alternatives being considered. Both conditions are necessary and neither alone is sufficient.
Everything difficult here follows from the fact that the accounting system is not built to answer that question: it records what has happened, and it allocates costs that do not differ, so a unit cost taken from the ledger is almost never the right input to a decision. Most wrong answers fail at the second gate rather than the first, because an allocated overhead is a future cost and looks as though it qualifies.
Relevance also has nothing to do with size, and nothing to do with whether a cost is variable or fixed: a variable cost identical under both options fails, and a fixed cost that disappears under one option passes.
Five recurring shapes, and the planted figure in each
Almost every question in this area is a one time special order, a make or buy, an add or drop, a sell or process further, or a use of a constrained resource.
Recognising the shape tells you which figures to build and, more usefully, which figure has been planted to be discarded. In a special order the normal price is not a floor. In a make or buy the full unit cost is not comparable with a quotation. In a drop decision only the fixed costs that would actually stop being incurred are relevant, and the honest answer is often that only a small part of an apportioned block would.
In a sell or process further the joint cost never enters. And under a constraint the ranking is by contribution per unit of the scarce resource rather than per unit of product.
Opportunity cost, sunk cost, and the qualitative side
An opportunity cost is the contribution forgone from the best alternative use of a resource.
It lies in the future and differs between alternatives, so it passes both tests, and no accounting system records it because nothing was paid, which makes it both the most commonly omitted relevant item and the one most likely to reverse an answer. A sunk cost is an amount already committed that no current decision can change, and its size has no bearing on its irrelevance.
The published content pairs this chapter with sustainability considerations, which is a reminder that a relevant cost analysis compares quantified differences rather than giving a complete account of a decision, and a qualitative factor is only an argument when it is stated with a direction.
What this chapter covers
- 01
Future and different, the two relevance tests
- 02
Why an allocated cost fails the second test
- 03
Relevance against size, and against the variable and fixed pair
- 04
One time special orders and the price that is not a floor
- 05
Make or buy, and the avoidable part of a fixed block
- 06
Add or drop, and what avoidable actually means
- 07
Sell or process further, and why joint cost never enters
- 08
Constrained resources and contribution per unit of the constraint
- 09
Opportunity cost, sunk cost and the loss on disposal
Make or buy, with the allocated block separated
- 4Identify the relevant cost of making, separating the avoidable fixed element.
- 3Identify the relevant cost of buying, including the opportunity cost.
- 2State the decision and name the figure that would reverse it.
Key terms
- Relevant Cost
- A cost that lies in the future and differs between the alternatives under consideration. Both conditions are necessary, so a future cost that is identical under every option is irrelevant however large it is.
- Opportunity Cost
- The contribution forgone from the best alternative use of a resource. It passes both relevance tests and appears in no accounting record, because nothing was paid, which is why it is the most commonly omitted relevant item.
- Sunk Cost
- An amount already committed that no current decision can change. Its size has no bearing on its irrelevance, and the book value of an existing asset is the standard example.
- Avoidable Cost
- A cost that would genuinely stop being incurred if an alternative were chosen. In a drop or outsource decision only the avoidable part of an apportioned fixed block belongs in the comparison.
- Joint Cost
- A cost incurred before a split off point and therefore common to every product that emerges from it. It never belongs in a sell or process further comparison, however carefully it has been apportioned in the accounts.
- Constrained Resource
- A resource in short supply that limits output. Products are ranked by contribution per unit of that resource rather than by contribution per unit of product, and the two rankings frequently disagree.
- Incremental Cost
- The additional cost caused by taking one alternative rather than another. In a special order it is the cost the order adds, which is why a price below full unit cost can still be worth accepting.
Relevant Information and Decision Making FAQ
Is a fixed cost always irrelevant?
No, and neither is a variable cost always relevant. The two pairs from earlier in the course describe behaviour with respect to volume, while relevance describes behaviour with respect to a choice. A fixed supervisor salary that disappears if production stops passes both tests; a variable cost that is identical under both options fails the second.
Starting an answer by separating variable from fixed is the commonest way to lose the thread.
Why can I not compare a full unit cost with a supplier's quotation?
Because the unit cost from the costing system contains allocated fixed overhead that the decision will usually not change, so the comparison imports every irrelevant allocation at once. Rebuild the comparison from the costs that change, and say explicitly which portion of the fixed overhead is avoidable and which continues, rather than treating the whole block as one number.
What happens to the loss on disposal of an old machine?
It never enters the comparison as a figure. The accounts report the difference between carrying amount and proceeds as a loss, which mixes a sunk amount with a relevant one: the proceeds are relevant and the carrying amount is not. Split the loss before using anything from it, and say in one line that you have done so, because the exclusion should read as a decision rather than an omission.
How should the qualitative factors appear in the answer?
As a short list after the quantified recommendation, each stated with a direction. Something like this increases the risk that a single supplier can raise the price once the tooling is gone is an argument a marker can credit. A heading such as quality considerations is not an argument, and supplying the heading without the direction earns nothing.
Which product should be favoured when a resource is scarce?
Rank by contribution per unit of the scarce resource, which is frequently a different ordering from ranking by contribution per unit of product. A product earning sixty on three machine hours returns twenty an hour while one earning thirty on a single hour returns thirty, so if machine hours bind, the headline figure reverses the answer.
Exam move
Take any decision in front of you and write two columns with only the items that differ, then a single difference at the foot. Resist writing two full costings and subtracting them, because a full costing invites the reader to check lines that are irrelevant by construction. Beneath the table, name every item you excluded and the test it failed.
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