Published On:Sunday, 27 November 2011
Posted by Muhammad Atif Saeed
SHORT TERM DECISION MAKING
SHORT TERM DECISION MAKING
“The beginning of wisdom in using accounting for decision-making is a clear understanding that the relevant costs and revenues are those which as between the alternatives being considered are expected to be different in the future. It has taken accountants a long time to grasp this essential point.”
Costs: Resources sacrificed to achieve a specific objective, such as manufacturing a particular product, or providing a client a particular service.
Sunk costs: These are costs that were incurred in the past. Sunk costs are irrelevant for decisions, because they cannot be changed.
Opportunity cost: The profit foregone by selecting one alternative over another. It is the net return that could be realized if a resource were put to its next best use. It is “what we give up” from “the road not taken.”
Relevant costs: These are costs that are relevant with respect to a particular decision. A relevant cost for a particular decision is one that changes if an alternative course of action is taken. Relevant costs are also called differential costs.
Incremental cost
Cost which is specifically incurred by following a course of action and which is avoidable if such action is not taken. Variable cost of production
Non-incremental cost
These are costs which will not be affected by the decision at hand. Non-incremental costs are non-relevant costs because they are not related to the decision at hand (Fixed Cost)
Relevant Costing
Introduction: -
A management decision involves predictions of costs & revenues. Only the costs and revenues that will differ among alternative actions are relevant to the decision. The role of historical data is to aid the prediction of future data. But historical data may not be relevant to the management decision itself. Qualitative factors may be decisive in many cases, but to reduce the number of such factors to be judged, accountants usually try to express many decision factors as possible in quantitative terms.
Meaning of Relevant Costs: -
Relevant costs represent those future costs that will be changed by a particular decision. While irrelevant costs are those costs that will not be affected by a decision. In the short run, if the relevant revenues exceed the relevant costs then it will be worthwhile accepting the decision. Therefore relevant costs playa major role in the decision-making process of an organization. A particular cost can be relevant in one situation but irrelevant in another, the important point to note is that relevant costs represent those future costs that will be changed by a particular decision, while irrelevant costs are those costs that will not be affected by that decision. We shall now see what are relevant costs and revenues for decision-making process. In summary relevant information concerns:
Other Important Terminologies : -
Relevant costs are costs appropriate to aiding the making of specific management decisions. Actually, to affect a decision a cost must be:
Future: Past costs are irrelevant as they are not affected them by future decisions & decisions should be made as to what is best now.
Incremental: This refers to additional revenue or expenditure, which may appear as a result of our decision-making.
(A cash flow - Such charges as depreciation may be future but do not represent cash flows and, as such, are not relevant.)
Sunk costs: Past costs, not relevant for decision making
Committed costs: This is future in nature but which arise from past decisions, perhaps as the result of a contract.
Incremental cost:- Cost which is specifically incurred by following a course of action and which is avoidable if such action is not taken. Variable cost of production
Non-incremental cost:- These are costs which will not be affected by the decision at hand. Non-incremental costs are non-relevant costs because they are not related to the decision at hand (Fixed Cost)
Opportunity Cost:-It is defined in the CIMA terminology as “ the value of the benefit sacrificed when one course of action is chosen, in preference to an alternative. The opportunity cost is represented by the forgone potential benefit from the best rejected course of action”
Relevant Cost :-A relevant cost is a cost that is pertinent to a particular decision. The cost appropriate to specific Management decision. A relevant cost possesses two important characteristics:
- It must be a future cost.
- It must differ between decision alternatives
