Essay on Costs and Decision Making

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Chapter 14 - Decision Making: Relevant Costs and Benefits

CHAPTER 14
Decision Making: Relevant Costs and Benefits
ANSWERS TO REVIEW QUESTIONS
14-1

The seven steps in the decision-making process are as follows:
Clarify the decision
Specify the criterion
Identify the alternatives
Develop a decision model
Collect the data
Select an alternative
Evaluate decision effectiveness

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The managerial accountant’s role in the decision-making process is to participate as a proactive member of the management team, and, in particular, to provide information relevant to the decision.

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A quantitative analysis is expressed in numerical terms. A qualitative analysis focuses on the factors in a decision problem that cannot be expressed effectively in numerical terms.

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A decision model is a simplified representation of the choice problem. Unnecessary details are stripped away, and the most important elements of the problem are highlighted. 14-1

Chapter 14 - Decision Making: Relevant Costs and Benefits

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The result of a quantitative analysis is that one alternative is preferred over the nextbest alternative by some numerical amount, such as profit. The amount by which the best alternative dominates the second-best alternative establishes a “price” on the sum total of the qualitative characteristics that might favor the second-best alternative. Suppose, for example, that a hospital’s board of directors is considering establishing an outpatient clinic in one of the two suburban communities. The quantitative analysis of the decision suggests that site A will be more cost effective for the clinic than site B. Assume that the annual cost of running the clinic at site A will be $50,000 less than the annual cost of running the clinic at site B. Now suppose that the board of directors feels that various qualitative considerations indicate that it would be preferable to locate the clinic at site B. For example, site B might be in an economically depressed area, where it is important to bring better-quality health care to the community. Now the board of directors can put a price on these qualitative advantages to locating the clinic at site B. If the board of directors believes that the qualitative benefits at site B outweigh the $50,000 quantitative advantage at site A, then they should locate the clinic at site B.

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Relevant information is pertinent to a decision problem. Accurate information is precise. Timely information is available to the decision maker in time to make the decision. Objective information need not be relevant or accurate. For example, several people may agree that the interest rate in the coming year in a local community will be 10 percent. However, this information may not be accurate, since that prediction may prove to be wrong. Moreover, information about the interest rate may not be pertinent to a decision about where to locate a new branch bank within the community.

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Two important criteria that must be satisfied in order for information to be relevant are as follows:
(1) Relevant cost or benefit information must involve a future event. In other words, the information must have a bearing on the future.
(2) Relevant information must involve costs or benefits that differ among the alternatives. Costs or benefits that are the same across all of the available alternatives have no bearing on the decision.

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The book value of an asset is its acquisition cost less its accumulated depreciation.
The book value is not a relevant cost because it is a sunk cost. It occurred in the past and has no bearing on the future.

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Chapter 14 - Decision Making: Relevant Costs and Benefits

14-9

The book value of inventory, like the book value of any asset, is not a relevant cost.
The inventory’s book value is based on its acquisition cost or its production cost and is, therefore, a sunk cost. It has no bearing on any…