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Decision Making
and
Relevant Information
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Decision ModelsA decision model is a formal method of making a
choice, often involving both quantitative andqualitative analyses
Managers often use some variation of the Five-StepDecision-Making Process
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Five-Step Decision-Making Process
Step 1:
Obtain
Information
Step 5:
Evaluate
Performance
Step 4:
ImplementThe
Decision
Step 3:
ChooseAn
Alternative
Step 2:
Make
PredictionsAbout
Future
Costs
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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Relevant Cost Illustration
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Features of Relevant Information
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Irrelevance Historical costs are past costs that are irrelevant to
decision making
Also called Sunk Costs
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A Starting Point: Absorption-Based
Budgeted Income Statement
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Types of Information Quantitative factors are outcomes that can be
measured in numerical terms
Qualitative factors are outcomes that are difficult tomeasure accurately in numerical terms, such assatisfaction
Are just as important as quantitative factors even though
they are difficult to measure
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Terminology Incremental Cost the additional total cost incurred
for an activity
Differential Cost the difference in total cost between
two alternatives Incremental Revenue the additional total revenue
from an activity
Differential Revenue the difference in total revenue
between two alternatives
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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 OrdersAccepting or rejecting special orders when there is idle
production capacity and the special orders has nolong-run implications
Decision Rule: does the special order generateadditional operating income?
Yes accept
No reject Compares relevant revenues and relevant costs to
determine profitability
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Special Order Illustration
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Make-or-Buy Illustration
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Make-or-Buy Illustration, Extended
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Potential Problems with
Relevant-Cost AnalysisAvoid incorrect general assumptions about
information, especially:
All variable costs are relevant and all fixed costs areirrelevant
There are notable exceptions for both costs
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Potential Problems with
Relevant-Cost Analysis Problems with using unit-cost data:
Including irrelevant costs in error
Using the same unit-cost with different output levels Fixed costs per unit change with different levels of output
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Avoiding Potential Problems with
Relevant-Cost Analysis Focus on Total Revenues and Total Costs, not their
per-unit equivalents
Continually evaluate data to ensure that it meets therequirements of relevant information
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Insourcing vs. Outsourcing Insourcing producing goods or services within an
organization
Outsourcing purchasing goods or services from
outside vendorsAlso called the Make or Buy decision
Decision Rule: Select the that option will provide thefirm with the lowest cost, and therefore the highest
profit.
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Qualitative Factors Non-quantitative factors may be extremely important
in an evaluation process, yet do not show up directly incalculations:
Quality Requirements
Reputation of Outsourcer
Employee Morale
Logistical Considerations distance from plant, etc
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Opportunity Costs Opportunity Cost is the contribution to operating
income that is foregone by not using a limitedresource in its next-best alternative use How much profit did the firm lose out on by not selecting
this alternative?
Special type of Opportunity Cost: Holding Cost forInventory. Funds tied up in inventory are notavailable for investment elsewhere
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Product-Mix Decisions The decisions made by a company about which
products to sell and in what quantities
Decision Rule (with a constraint): choose the productthat produces the highest contribution margin per unitof the constraining resource
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Adding or Dropping Customers Decision Rule: Does adding or dropping a customer
add operating income to the firm?
Yes add or dont drop
No drop or dont add
Decision is based on profitability of the customer, nothow much revenue a customer generates
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Customer Profitability Analysis,
Illustrated
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Customer Profitability Analysis,
Extended
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Adding or Discontinuing
Branches or Segments
Decision Rule: Does adding or discontinuing a branchor segment add operating income to the firm?
Yes add or dont discontinue No discontinue or dont add
Decision is based on profitability of the branch orsegment, not how much revenue the branch orsegment generates
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Adding/Closing Offices or Segments,
Illustrated
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Equipment-Replacement Decisions Sometimes difficult due to amount of information at
hand that is irrelevant:
Cost, Accumulated Depreciation and Book Value ofexisting equipment
Any potential Gain or Loss on the transaction aFinancial Accounting phenomenon only
Decision Rule: Select the alternative that will generatethe highest operating income
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Equipment-Replacement Decisions,
Illustrated
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Equipment-Replacement Decisions,
Illustrated (Relevant Costs Only)
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Behavioral Implications Despite the quantitative nature of some aspects of
decision making, not all managers will choose the bestalternative for the firm
Managers could engage in self-serving behavior suchas delaying needed equipment maintenance in orderto meet their personal profitability quotas for bonusconsideration
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