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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
Product-Mix Decisions
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Compute contribution margin per unit of limited resource
Decision: Shift the sales mix to standard sets or increasemachine capacity
Product-Mix Decisions
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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.
Product-Mix Decisions
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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