Relevant Cost for Decision Making

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Concept of Decision Making

In a business organization, decision making is both a habit as well as process. In this process of decision making, one needs to opt for the best course of action from other possible alternatives. While selecting the best action for tomorrow, one may often make use of various techniques, tools and perceptions. A right decision helps a maker to have a secured future.

Concept of Relevant Cost

These relevant costs have a direct relevance to the decision making process. Such costs have a direct effect on the cash flow of a business organization. Costs which guide the organization towards their preferred decision are known as Relevant Costs.

Various types of costs in Decision Making

There are various costs which play a significant role in the decision making process of an organization. Among this, differential costs have a major effect on the decision making of the company. These costs are the changes which result once a change in method or activity takes place. These are the results of a different course of action.

Other than the differential costs, there are various other cost concepts which are involved in the decision making process. These costs are-

  • Opportunity Costs
  • Imputed Costs
  • Replacement Costs
  • Marginal Costs
  • Sunk Costs
  • Out-of-pocket costs
  • Avoidable and Unavoidable Costs
  • Relevant and irrelevant Costs

What are the steps to make effective decision?

Each of the steps in decision making process is supported by various tools and techniques of their own. The important steps are as follows-

  1. Identifying the problem:

Deciding on factors like what the actual problem is, why it occurred, how is it affecting, why it needs to be solved, etc.

  1. Gather necessary information

Collect necessary information which will help in problem solving process. One can use tools like ‘Check Sheets’.

  1. Identification of alternatives

Know what the other possible course of action are which may help in future.

  1. Judging the qualitative factors

This will ensure that all consequences of a particular business decision are deeply considered.

  1. Determining the quantitative factors

These are the numerical basis for any decision making in a business. These are based on statistical and quantifiable analysis of data.

  1. Choose the best alternative

A decision maker needs to make use of his judgmental abilities and principles while choosing the best alternative.

  1. Execution of the decision

This decision now needs to be implied into activities either individually or along with other staffs.

  1. Evaluating the derived results

Once this decision is implied check whether there are suitable results or they need any further corrections.

Areas involving Decision Making

Once these necessary steps are taken, the organization has to adopt them in the below important areas-

  1. Making or purchasing decisions

The products or tools that a firm produces or the part it produces is often available with outside suppliers too. The organization’s management can decide this by comparing the paid prices with that of its saving that can be applied on the cost.

  1. Selling or processing decisions

It depends on the firm whether they want to sell a product once it is partially processed or even sell it only when it gets fully processed. Since this product goes through various manufacturing stages, it can be used for selling at various points. Now this allows the company to decide about the area where the product’s selling will be more effective.

  1. Analyzing the increment

Such an analysis determines the changes in the revenue and costs incurred due to change in the activity or method of production. This analysis will depict whether there has been a profitable cost and revenue or decreasing revenue and cost. It is only on the basis of incremental revenue can the management make a further decision.

  1. Decisions on Special Order

On the receipt of a huge order from international companies, large scale buyers often make bulk orders at a lower value than that of their customer’s buying price. The organization needs to decide whether to proceed with the order or decline it at once. It may consider accepting this offer if it finds that the revenue generated is more than that of those differential costs.

  1. Joint or by-product process decisions

Companies often manufacture two or more products of more or less same value with same manufacturing process and raw materials. It is these products which are known as Joint products.

By-products are goods with smaller value which are manufactured simultaneously with a product of larger value. Once these are split, the organization needs to decide about proceeding with its processing by comparing its incremental revenue with its differential cost.

  1. Decisions on Sales Mix

The ratio in which products are manufactured and sold is known as sales mix. An organization fails to decide which product mix yields maximum profit when it produces more than one good at a time.

Once it is decided which is the more profitable one, it is bound to have increased production to generate sales. And once this sell rises, increased profits come naturally.

  1. Product line decisions

Often a company may decide of introducing a new product or simply remove an existing product. To plan this out, a comparative analysis needs to be done on incremental revenue and differential costs. This will help in deciding which is more profitable for the business.

  1. Decisions on additional shift

Once the company decides to have additional shift, it incurs additional costs as well. The company needs to decide whether it will proceed with the introduction of additional shifts after comparing its additional revenue with its additional cost incurred.

  1. Decisions on closing down

Once the management goes through marginal costs of the company, they need to decide whether it is better to run its operations or simply shut down the plant. This is done at a time when the company goes through losses for a long period of time. They further need to decide whether it will be a temporary shutdown or a permanent one.

 

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