Chapter 8: The Use of Cost Information in Managerial Decision-Making Process

Decisions And Decision-making Process

A decision is defined as a conscious choice between a large number of alternatives to achieve an objective or numbers of objectives. The qualities of a good decision is being effective, efficient, practical and being taken on time.

Decision making is simply the process of choosing the most appropriate alternative. Decision making is the basis of management. The common aspect of all management functions, from planning to audit, is decision making, which is an important factor while carrying out these functions. Thus, it has been observed that terms “management” and “decision making” have the same meaning and management is considered as a series of decision.

Decision-making problem basically involves three stages:

• Introducing all alternatives that may be the basis of the decision,
• Sorting alternatives through their significance,
• Selecting and evaluating the most optimal alternative

Types of Decision

It is possible to classify the decisions made by business managers from various perspectives. There are types of administrative decisions, types of decisions related to management levels, and types of decisions according to decision making conditions.

The Role of Cost Information in the Decision-Making Process

In the decision-making process, managers are in need of an information system that significantly affects the decision to be made. Information expected from the information system is generally related to sources of income regarding revenue and costs (expenses) regarding expenditures.

Information generated by expenditure or expense can often be monitored or minimized by the managers. Thus, information on expenses or costs provides a basis for the decision-making process in businesses.

Important Cost Concepts in Decision Making

Relevant Cost

Relevant costs are related to future decisions and they can change according to these decisions. Main features of relevant cost are as follows:

• are related to future
• can be changed among the alternatives
• are affected by the decisions

Sunk Cost

The sunk cost is excluded from future business decisions. Thus, it doesn’t need to be taken into consideration while decision making. In other words, all costs that do not qualify as relevant costs are called sunk costs.

Opportunity Cost

Opportunity cost is the value of benefit sacrificed in favor of an alternative course of action

Marginal Cost

Marginal cost is the additional cost incurred when making or producing (of a good or service) one additional unit. In other words, the change in total cost that arises from the quantity changes by one unit is called marginal cost.

Differential Cost

Differential cost is the increase in total cost in case one alternative is chosen among various alternatives. In other words, the differential cost is defined as the change in costs caused by the prediction of a change within the volume of activity.

Use of Cost Information in Profit Planning Decisions

A rational profit planning should be handled in business for the purpose of maximum profit. Profit planning is a managerial study that involves the careful consideration of the various factors that determine the profit and the necessary adjustments of these factors. There are many internal and external factors that determine the profit that a business will provide. We can list the essential factors that have a role in making a profit as follows:

• Price of the product (service) per unit
• Sales amount of the product (service)
• Variable cost of the product (service) per unit
• Total amount of fixed cost of the product (service)

Cost – Volume – Profit Analysis

To determine the potential future profit of a business, cost – volume – profit analysis method is used. Cost – Volume – Profit (CVP) Analysis is a method that is used by the management to make profit planning. This method analyzes the changes in profits in accordance with sales volume and changes between the cost of a product or service and its sales revenue. In other words, it is determining the effects of changes in the sales price, in variable and fixed costs on the activities of a business.

CVP Analysis Assumptions

• Expenses must be classified as fixed and variable.
• It must be assumed that total fixed expenses aren’t affected by the rise in the volume of activity and that variable expenses can change regarding the rise in the volume of activity.
• Since the sales price is supposed to be fixed, the total revenue function is accepted to be linear.
• It is assumed that there will be no change in the product mix in case multiple products are sold.
• It is assumed that the efficiency of production factors are constant.
• There is a complete synchronization between sales and inventories.
• Tangible fixed assets are constant despite various production volumes.
• Risks and uncertain conditions are ignored.
• No extraordinary income or expenditure has emerged.
• The analysis method is accepted as accurate for the short-term. Thus, it is implementable

Advantages and Disadvantages of CVP Analysis

• The advantages of CVP analysis for business managers are as follows:
• It determines the lowest amount of production that will prevent the business to make a loss.
• It determines the unit cost and the working capital needed in various amounts of production.
• It evaluates the implemented managerial policies by comparing the planned and the actual breakeven point.
• It helps to choose the most profitable production types and helps to generate product mix.
• It determines the lowest sale price of production.
• It determines the necessary activity volume to achieve profit targets.
• It determines the effects of the products, their selling prices, their costs and the changes in demand
• on profit.
• It determines the activity volume that will meet the new investments.
• It helps the decisions on products to be produced, investments to be made and the sales prices of
• the products.
• It determines the sales price that will meet the rise in activity volume.

On the other hand, the disadvantages of CVP analysis are listed as follows:

• The variable and fixed cost classification used in CVP analysis may not reflect the truth. This can make the managers take wrong decisions.
• Most of the fixed cost factors have the feature of semi-variable cost. This can be ignored in the analysis.
• It is assumed that the total revenue and total cost are linear. In fact, this relationship is not linear or is about to be linear in most businesses.
• The errors in the analysis can be caused due to market conditions.
• If numerous products are produced, the determination of their contribution to total sales will be hard.
• This may cause errors in the results of the analysis.
• As a product contributes the production of other products, a great number of production is made.
• Thus, there would be difficulties in determining the cost of the products.

Break-Even Point

In cost – volume – profit relationships, “break-even point” which is also called “dead point” is the analysis of the level at which the business will make a profit. Break-even point refers to the amount of production that does not result in profit or loss as a result of the activities of the business. However, if sales are made above this point, the business will start to make a profit whereas a loss will be experienced if sales are made below the break-even point.

Use of Cost Information in Pricing Decisions

Pricing can be defined as the process of determining the sales value of the products or services produced and sold by the business at the point of the property exchange. There is a close relationship between pricing policies and practices and the objectives of the business for maintaining itself and making a profit.

Factors Affecting the Pricing Decisions

How companies price their products or services are mainly based on supply and demand for products and services. However, on supply and demand,there areeffects of customers, competitors, costs and political and legal regulations. For this reason, businesses should take these four factors into consideration while making pricing decisions.

Pricing Strategies

As in all businesses pricing decisions are one of the critical decisions affecting the success of production businesses. In the past, while production businesses were generally using pricing strategies based on costs, today consumer associations, social organizations and competition conditions play a significant role in pricing decisions.

A wide variety of strategies are used in pricing. However, in general, pricing strategies are divided into two groups as pricing strategies of existing products and new products.

Use of Cost Information in Other Various Management Decisions

The Use of Cost Information in Investment Decisions

Production businesses are businesses that use advanced technology in production processes and have to follow technology closely. Accordingly, they allocate shares in their budgets so as to purchase new equipment and machines or to renovate the current ones. The decision to renew the machines is one of the managerial decisions that cost-volume-profit analysis is implemented. In the case of the renewal of current equipment and machinery, the cost of loss due to the disposal of the outdated machine has to be compared with the cost savings of the machine to be purchased. Thus, the issue should be approached within the framework of the current cost analysis.

The Use of Cost Information in the Decision of Ceasing or Breakdown of a Product

In some cases, managers may end up with the production of all the products, services or may have a breakdown. The profitability of that product needs to be analyzed in order to decide whether to continue the production of a product or not. Therefore, when deciding whether to continue the production of any product, it is analyzed if the product meets its direct expenses or if it has a contribution to the common expenses. The production of a product or a service that causes loss is not even a matter of discussion unless it has a strategic purpose.

The Use of Cost Information in the Decision of Producing New Products

Throughout the process of deciding on the launch of a new product, the cost should be considered as well as its benefits to society. Differential costs of a new product should also be carefully analyzed. Cash inflows of the newly launched product haveto be higher than the cash outflows for producing this product.

The Use of Cost Information While Accepting a Special Sales Price

Production businesses may sometimes be proposed an offer to sell the products at a price which is lower than the standard sales price. This offer can be accepted if the production business has unutilized spare capacities or in case the proposed price meets at least the variable costs whether it is related to a new market.

The Use of Cost Information in Determining the Appropriate Product Mix

Referring to the contribution margins in determining the most appropriate product mix will provide significant benefits to the managers while making decisions in production businesses that produce more than one product or service. When creating the product mix, the information gathered from the costvolume-profit analysis of the profitability of various products while evaluating together with production and sales conditions, will enable to determine to most appropriate product mix.

The Use of Cost Information in the Decisions of Outsourcing

Production businesses can get subcontractors to carry on some services which are out of their production field. In addition to services such as cleaning, security, automation, technical unit, catering service or staff transportation, production businesses may prefer outsourcing in marketing and advertising services. The most significant factor while making this decision is the cost. However, besides the cost, factors such as quality, timing, reducing the risk, keeping up with technology and efficiency should also be taken into consideration.