Using Accounting Data for Managerial Decisions

Using Accounting Data for Managerial Decisions

One of the main purposes of costing various goods, services and production activities is to provide information that is useful for decisions. However, a firm's formal cost accounting system is general purpose in nature. It is not designed for some specific decision that may come along. What costs and revenues are relevant for a specific decision will depend very much on the nature of the decision to be made. This implies that, when faced with a specific decision, a manager must examine each component of the costs reported by the firm's costing system and make a judgment whether that cost is relevant, or not relevant, for the specific decision in hand. Costs that are not relevant must be removed. Additionally, depending upon how the decision is framed, some costs that are usually not included in a firm's costing system must be added. These costs to be added are typically in the nature of "opportunity costs." Blind acceptance of cost data that is routinely produced by the firm's accounting system will often lead to bad decisions.

The basic principle underlying Relevant Information is the following:

For information to be relevant, it has to satisfy two conditions:

1. It should relate to a cost or benefit that will be incurred or received in the future.

2. It should differ across alternatives under consideration.

This seems really simple but is difficult to follow in practice. The following more detailed application of the above principles in a general context should be kept in mind when modifying the data produced by the firm's formal cost accounting system:

1) Costs that do not change with the alternatives under consideration (i.e. fixed costs or unavoidable costs) are irrelevant and should be removed.

2) Sunk costs are irrelevant for decisions and should be removed.

3) Opportunity costs, appropriately calculated, are always relevant and should be added.

4) Hidden benefits that arise from enhancing the revenues or decreasing the costs of other departments should be added.

5) It may be misleading to compare the profitability of various goods on the basis of their contribution margins alone. The capacity constraints under which the firm may be operating need to be taken into account. If a single scarce resource in the firm constrains its choices, the most profitable product is the one that has the highest contribution per unit of that scarce resource.

The above principles are illustrated below.

Fixed