Chapter 11 - Decision making and Relevant Information

5/27/2018 Chapter 11 - Decision making and Relevant Information

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Chapter Eleven

Decision Making and RelevantInformation


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The Five Step Decision Process

Relevant information

Opportunity costs

Managing capacity constraints

Managing customers

Equipment replacement decisions Reconciling decision making and performance evaluation

Learning Objectives


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Five-Step Decision-Making Process

Step 1:

Obtain

Information

Step 5:

Evaluate

Performance

Step 4:

Implement

The

Decision

Step 3:

Choose

An

Alternative

Step 2:

Make

Predictions

About

FutureCosts

Feedback


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Relevance

Relevant information has two characteristics:

It occurs in the future

It differs among the alternative courses of action

Relevant costs - expected future costs

Relevant revenues - expected future revenues


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Types of Information

Appropriate weight must be given to qualitative factors and

quantitative non-financial factors

Outcomes that are difficult to measure accurately in

numerical terms

E.g., effects on employee turnover, customer

satisfaction, the environment, product cannibalization,

overall company image, etc.


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Relevant Information

What relevant information would AmEx need to haveto offer this deal?


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Relevance Terminology

Incremental cost/revenue The additional total cost/revenue incurred for an activity

Differential cost/revenue

The difference in total cost/revenue between twoalternatives


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Relevant Cost Illustration


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Sunk Costs

Sunk costs have already occurred and can not be changed

Are excluded from analysis

May be helpful as a basis for making predictions

However, past costs are irrelevant when making

decisions


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Opportunity Costs

Opportunity costs are the contribution to income that is

foregone by not using a limited resource in its next best

alternative

How much profit did the firm lose out on by not

selecting this alternative?

E.g., holding cost for inventoryfunds tied up in

inventory are not available for investment elsewhere


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Opportunity and Sunk Costs

Opportunity Cost: potential

benefit given up when one

alternative is selected

Example: If you were

not attending college,

you could earn $20,000

per year.

Your opportunity cost of

attending college for one

year is $20,000.

Sunk Costs: Costs incurred in

the past that cannot be changed

Example: You bought an

automobile that cost $12,000

two years ago.

The $12,000 cost is sunk

because whether you drive,

park, trade, or sell it, you

cannot change the cost.


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Relevant Cash Flows Analyses

Sunk Costs .. N

Opportunity Costs ... Y

Side Effects/Erosion.. Y

Financing Costs.... N

Tax Effects ... Y


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Managing Capacity Constraints - Resources are always

limited

Floor space for a retail firm

Raw materials, direct labor hours, or machine

capacity for a manufacturing firm

Management must decide which products to make and sell

to maximize net income

Making Decisions


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Types of Decisions

One-time-only special orders

Insourcing vs. outsourcing/Make or buy

Product mix

Customer profitability

Branch/segment: adding or discontinuing

Equipment replacement


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One Time Only Special Orders

Decision: Accept/reject special orders when there is idleproduction capacity and the special orders would have no

long-run implications

E.g., obtain additional business by making a major priceconcession to a specific customer

Key Assumptions

1. Sales in other markets or with other customers will not

be affected

2. Company is not operating at full capacity


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Special Orders

Decision rule: Does the special order generate additionaloperating income?

Yesaccept

Noreject

Compare relevantrevenues and costs to determine

profitability


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Sunbelt Company produces 100,000 automatic blenders per

month, which is 80 percent of plant capacity.

Variable manufacturing costs are $8 per unit.

Fixed costs are $400,000, or $4 per unit.

The blenders are sold to retailers at $20 each.

Sunbelt has an offer from Mexico Co. to purchase an additional

2,000 blenders at $11 per unit. Acceptance would not affect

normal sales of the product.

What should management do?

Special Order Example


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Fixed costsdo not changethus are not relevant

Variable manufacturing costsand expected revenues change

Arerelevantto the decision

Special Order Example


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Insourcing vs. OutsourcingMake or Buy

Insourcing

Producing goods or services within an organization

Outsourcing

Purchasing goods or services from an outside vendor

Decision rule: Select the option that will provide the

lowest cost, and highest profit, not withstanding non-

quantitative factors


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Insourcing or Outsourcing

Potential non-quantitative factors:

Quality

Reputation of outsourcer

Employee morale

Customer requirements/expectations

Logistical considerationsdistance from plant


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Baron Company incurs the following annual costs in producing25,000 ignition switches for motor scooters

Make or Buy Example

They can purchase the ignition switches at $8/unit but must

absorb $50,000 of fixed costs even if they buy

What should management do?


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Opportunity Cost a complete analysis must consideralternative uses for the capacity

Make or Buy Example


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Assume that by buying the switches, Baron Company can use

the released capacity to generate additional income of

$28,000.

Make or Buy Opportunity Cost


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Product-Mix Decisions

Which products to sell and in what quantities

Decision rule (with a constraint): Choose the product that

produces the highest contribution margin per unit of the

constraining resource


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Collins Company manufactures deluxe and standard pen and

pencil sets. The constraining resource is machine capacity,

which is 3,600 hours per month.

Relevant data follows



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Compute contribution margin per unit of limited resource

Decision: Shift the sales mix to standard sets or increasemachine capacity



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Assume Collins is able to increase machine capacity from

3,600 hours to 4,200 hours.

The additional 600 hours could be used to produce either

the standard or deluxe sets.

Determine the total contribution margin for each alternative.



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Adding or Dropping Customers

Decision is based on profitabilityof the customer, not how

much revenue a customer generates

Decision rule: Does adding or not dropping a customer add

income to the firm?

Yesadd or dont drop

Nodrop or dont add


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Customer Profitability AnalysisIllustration


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Customer Profitability AnalysisResults

Focus on

relevantdata


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Adding or DiscontinuingBranches or Products

Decision is based on profitability of the branch or product,

not how much revenue it generates (similar to a customer)

Decision rule: Does adding or discontinuing a branch orsegment add operating income to the firm?

Yesadd or dont discontinue

Nodiscontinue or dont add


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Considerations

Effect on related branches/product lines

Fixed costs allocated to the eliminatedproduct/branch must be absorbed

Net income may decrease when an unprofitable

segment is eliminated

Adding or DiscontinuingBranches or Products


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Illustration: Martina Company manufactures three models

of tennis rackets:

Profitable lines: Pro and Master

Unprofitable line: Champ

What should

management do?

Adding or DiscontinuingBranches or Products - Example


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Total income is decreased by $10,000.

Prepare income statement after eliminating Champ product line

Assume fixed costs are allocated 2/3 to Pro and 1/3 to Master

Adding or DiscontinuingBranches or Products - Example


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Equipment Replacement Decisions

Ignore irrelevant information Equipment cost, accumulated depreciation, and book

value of existing equipment

Book value is a sunk cost Any potential gain or loss on the transactiona

financial accounting phenomenon only

Trade-in or salvage values are relevantDecision rule: Select the alternative that will generate

the highest operating income

E i t R l t D i i


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Equipment Replacement Decisions,Illustrated (All Costs)


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Equipment Replacement Decisions,Illustrated (Relevant Costs Only)


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Potential Problems withRelevant Cost Analysis

Avoid incorrect general assumptions, especially:

All variable costs are relevant and all fixed costs are

irrelevant

P t ti l P bl ith


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Potential Problems withRelevant Cost Analysis

Problems with using unit cost data:

Using the same unit cost with different output levels

Fixed costs per unit change with different levels of

output


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Behavioral Implications

Goal Congruence

Not all managers will choose the best alternative for

the firm

E.g., Delaying equipment maintenance in order to

meet profit quotas


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Decision Analyses

Scenario Analysis

Consider best case, worst case and most likely case

when forecasting the future

Sensitivity Analysis

Shows how changes in a single input variable will affect

results

Each variable is fixed except one

Answers what if questions


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Limitations of Scenario Analysis

Considers only a few possible outcomes

Assumes perfectly correlated inputs

All bad values occur together and all good values

occur together


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Sensitivity Analysis

Strengths

Provides an indication of stand-alone risk

Identifies dangerous variables

Gives some breakeven informationWeaknesses

Says nothing about the probability of outcomes

Ignores relationships among variables


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a. Net income will always increase.

b. Variable expenses of the eliminated segment willhave to be absorbed by other segments.

c. Fixed expenses allocated to the eliminated

segment will have to be absorbed by other

segments.

d. Net income will always decrease.

If an unprofitable segment is eliminated:

Question

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Chapter 11 - Decision making and Relevant Information

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