What you will learn to do: identify relevant information for short-term decision-making

Managerial decision-making often involves choosing among alternative courses of action.

From a financial perspective, this means making the choice that yields the highest amount of income or the one that results in the least amount of loss.

Managerial accountants often apply a concept called differential analysis to examine the benefits and costs associated with various options. The alternative selected is the one with the most favorable (or least unfavorable) financial impact. The evaluation includes only those costs that will change if one alternative is selected over another. Fixed costs or other costs that are constant for the two options are excluded from the analysis since they will not differentiate one choice from the other. Sunk costs, which are past expenditures that have already been incurred and cannot be recovered, are also ignored since the amount will be the same regardless of the alternative selected.

For example, the owner of a bed & breakfast inn in San Diego is considering converting an unused room on the first floor into a small gift shop or converting it to an additional guest room. It’s well situated for a gift shop, just off the main lobby, and for that reason, the owner thinks as a guest room it will only be occupied about 60% of the time. Also, she will only be able to charge $150, as opposed to the other upstairs rooms that bring in $225 a night.

If the room were a gift shop selling things like the thick linen sheets she uses on the beds, the heavy white cotton robes that hang in the closet, and the whole-bean coffee she serves at breakfast, all items that guests have expressed interest in buying, the owner estimates she could gross $4,000 per month, and the cost of the items will be about 40% of the retail value.

She makes this simple analysis using a standard housekeeping charge of $50 per occupied night that is based on a historical average:

We can easily see that from a profit standpoint, the gift shop is the better idea. But has she taken all costs into account? Are there any hidden costs? One-time costs? Are there any non-financial considerations? And what if she decides to postpone her decision? Is there any cost to that?

When you are done with this section, you will be able to:

• Identify relevant financial information
• Identify non-financial information
• Identify sunk costs and other irrelevant information
• Understand opportunity costs

Learning Activities

The learning activities for this section include the following:

• Reading: Financial Information
• Self Check: Financial Information
• Reading: Non-financial Information
• Self Check: Non-financial Information
• Reading: Irrelevant Information
• Self Check: Irrelevant Information
• Reading: Opportunity Costs
• Self Check: Opportunity Costs