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Relevant Cost for Decision Making

DECISION MAKING

Decision making is the process of choosing the best course of action among the various alternative courses since if there is no choice, there is no decision to take. Generally, a decision always focuses on the future prediction. The aim of the decision maker is therefore to select the best course of action for the future. 

Relevant Costs

A cost that is relevant to a decision is called relevant cost. In an organization the decision maker just makes use of relevant costs. In other words, costs are relevant if they guide the executive towards the decision that harmonises with top management’s objectives. 

Differential Cost

Differential cost means the change in costs due to change in the level of activity or pattern or method of production. Simply, differential cost is the result of an alternative course of action.

 

COST CONCEPTS IN DECISION MAKING

Certain concepts which are generally used in the analysis of cost for decision making are listed below.

(i) Marginal cost                                              (vi) Replacement cost

(ii) Out of pocket cost                                     (vii) Avoidable and unavoidable costs

(iii) Differential costs                                       (viii) Imputed costs

(iv) Sunk costs                                                (ix) Relevant costs and irrelevant costs

(v) Opportunity costs

 

STEPS INVOLVED IN DECISION MAKING

The following steps are involved in decision making process.

(i) Problem identification

(ii) Identifying alternatives

(iii) Evaluating Quantitative factors

(iv) Examining Qualitative factors

(v) Obtaining further details if necessary

(vi) Selection of the best alternative.

 

AREAS OF DECISION MAKING

The executives of the organisation or the decision maker of the concern has to adopt the above steps in the following important areas of decision.

(i)                 Make or buy decisions

(ii)               Sell or process decisions

(iii)             Special order decisions

(iv)             Incremental analysis

(v)               Decision regarding further processing of joint/by products

(vi)             Sales mix decisions

(vii)           Additional shift decisions

(viii)         Adding or dropping product line decisions

(ix)             Plant closing down decisions

 

(i) Make or Buy Decisions. A firm may be producing some products, or tools or parts by itself. The same products or tools may be available from the outside suppliers. The management can take decision in this regard comparing the price that has to be paid and the saving that can be effected on cost.

(ii) Sell or Process Decisions. An organisation can sell its product when it has been part  processed or it  is sent for further process4lg before selling it. When a product passes various stages of manufacturing operation, it may be a marketable product at a number of different points along the way. Under this type of industrial sector, the company has an option to sell the product at various stages of completion. Under the sell or process decisions, incremental analysis guides the management to take correct decisions.

(iii)Special Order Decisions. Large Scale purchasers may place huge orders at a price less than the customer’s sale price on receiving a bulk order from the foreign companies. A decision has to be taken now whether to accept the order or to reject it. Such an order can prove beneficial to the company when it is working below full production capacity and the price offered results in incremental revenue which is higher than the differential costs.

(iv) Incremental Analysis. Incremental analysis refers to the changes in costs or revenue due to changes in the level of activity or pattern or method of production. Under the incremental analysis, the organisation has to get either incremental revenue and cost or decremental revenue and cost. Based upon the incremental revenue only, the management can take a decision.

(v) Decision Regarding Further Processing of Joint or By-product. Certain industries produce two or more products of almost more or less equal value which are simultaneously produced from the same manufacturing process and from the same raw material. They are known as joint products.

The term by-product refers to one or more products of relatively small value that are produced simultaneously with a product of greater value. Generally, the management has to take decision regarding further processing of joint products or by-products after the split off. This type of decision is taken on the basis of comparison of differential cost and incremental revenue.

(vi) Sales Mix Decisions. Sales mix is the ratio in which various products are produced and sold. Generally when an industry manufactures more than one product, it  as to face the problem of which product mix gives maximum profit. The best product mix is that which yields the maximum profit. Those products which give maximum contribution are to be retained and their production increased. Automatically sales is also increased. Based upon the results of p/v ratio and break even points only the organisation can take sales mix decisions.

(vii) Additional Shift Decisions. Any organisation, if it wants to go for the introduction of additional shift, incurs some additional cost. In this aspect, the additional cost should be compared with the additional revenue. So the management can take decision on the basis of the net effect on the profit earned by the company due to this additional shift.

(viii) Adding or Dropping Product Line Decisions. Some time, a manufacturing company may decide to add some new product or delete the existing product from the production line. In order to arrive at the correct decision in this regard, management has to find the profitable position of the company based upon the comparative analysis of differential cost and incremental revenue.

(ix) Plant Closing Down Decisions. Sometimes a manufacturing organisation should decide to close its business either on temporary basis or permanent basis. Closing down of business arises because closing is better than operating business at loss. In this situation, marginal costing assists the management to take suitable actions.