The Decision Making Process
Chapter Four
Syllabus topic 1, "Introduction to Management Accounting – Meaning, Nature, Scope, Functions, Decision Making Process, Financial Accounting V/s Management Accounting"
Pages 7 to 8 of 162
In one line
A decision is made in six steps, and the management accountant supplies the figures for four of them.
The six steps
| Step | What happens | Whose step |
|---|---|---|
| 1 | Define the problem or the objective | Management, with the accountant |
| 2 | Identify the alternative courses of action | Management |
| 3 | Collect the data relevant to each alternative | The accountant |
| 4 | Evaluate the alternatives against the objective | The accountant presents, management judges |
| 5 | Select the course of action | Management alone |
| 6 | Implement, and review the outcome against what was expected | Management, with the accountant on the review |
Step three is where the subject lives
"Relevant" is the word to understand, and it has a technical meaning.
| A cost is relevant if | Example |
|---|---|
| It is a future cost | The rent of a warehouse not yet taken |
| It differs between the alternatives | Material that one design uses and another does not |
A cost that is already incurred is irrelevant, however large. A cost that is the same under every alternative is irrelevant, however necessary.
So a decision is taken on differential figures, not on total figures, and the accountant's first task is to strip out everything that does not differ.
Worked, and it is short on purpose
A company can make a component or buy it. Making it costs materials Rs 40, labour Rs 30 and variable overhead Rs 10 a unit, and it absorbs Rs 25 a unit of fixed factory overhead that the company incurs whatever it does. The component can be bought at Rs 90.
| Make, Rs | Buy, Rs | |
|---|---|---|
| Materials | 40 | nil |
| Labour | 30 | nil |
| Variable overhead | 10 | nil |
| Purchase price | nil | 90 |
| Relevant cost a unit | 80 | 90 |
Making is cheaper by Rs 10 a unit.
The fixed overhead of Rs 25 is nowhere in the statement, because the company bears it under both alternatives. Include it and the answer reverses: making would appear to cost Rs 105 against Rs 90, and the company would buy a component it can make more cheaply. That single omission is what step three exists to enforce.
Where the review closes the loop
Step six is not decoration. Comparing what happened with what was expected does two things: it corrects the course while there is still time, and it tells the accountant how good the estimates in step three were. A firm that never reviews never learns whose forecasts to trust.
What it does NOT mean
The steps are not always sequential. Evaluating one alternative often reveals another, and the process goes back to step two.
Not every decision needs all six. A routine reorder is decided by a rule, and the rule was itself the outcome of a decision once taken.
The Decision Making Process
The figures do not decide. They narrow the choice; judgment on matters not in figures does the rest.
Quick revision
| Six steps | Define, identify alternatives, collect relevant data, evaluate, select, implement and review |
| The accountant's steps | Three and four, and the review in six |
| A relevant cost is | Future and differs between the alternatives |
| Two costs to exclude | Sunk costs and costs common to all alternatives |
| Whose step is five | Management's alone |
Test yourself
- List the six steps.
- What two tests must a cost pass to be relevant?
- In the make-or-buy example, why is the fixed overhead excluded?
- Which step belongs to management alone?
- What does step six give the accountant?
Answer in one sentence
1. Define the problem, identify the alternatives, collect the relevant data, evaluate the alternatives, select a course, and implement and review it.
2. It must be a future cost and it must differ between the alternatives.
3. Because the company incurs it whether it makes or buys, so it does not differ, and including it reverses the answer.
4. Step five, selecting the course of action.
5. A measure of how good the estimates in step three were, and so of whose forecasts to trust next time.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.