Chapter Eleven

Decision Making and Relevant Information

Learning Objectives
The Five Step Decision Process

Relevant information
Opportunity costs Managing capacity constraints Managing customers Equipment replacement decisions

Reconciling decision making and performance evaluation

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Five-Step Decision-Making Process

Step 2: Make Predictions About Future Costs Step 3: Choose An Alternative Step 4: Implement The Decision

Step 1: Obtain Information

Step 5: Evaluate Performance

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 have to 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 two

alternatives

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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. 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,

Your opportunity cost of

attending college for one year is $20,000.

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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Making Decisions
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

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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 idle production capacity and the special orders would have no long-run implications

E.g., obtain additional business by making a major price

concession 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 additional operating income?
Yesaccept Noreject

Compare relevant revenues and costs to determine

profitability

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Special Order Example

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?
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Special Order Example

Fixed costs do not change thus are not relevant Variable manufacturing costs and expected revenues change

Are relevant to the decision

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Insourcing vs. Outsourcing Make 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 nonquantitative 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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Make or Buy Example

Baron Company incurs the following annual costs in producing
25,000 ignition switches for motor scooters

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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Make or Buy Example

Opportunity Cost a complete analysis must consider alternative uses for the capacity

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Make or Buy Opportunity Cost

Assume that by buying the switches, Baron Company can use the released capacity to generate additional income of $28,000.

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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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Product-Mix Decisions
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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Product-Mix Decisions
Compute contribution margin per unit of limited resource

Decision: Shift the sales mix to standard sets or increase

machine capacity

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Product-Mix Decisions
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 profitability of 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 Analysis Illustration

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Customer Profitability Analysis Results

Focus on relevant data

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Adding or Discontinuing Branches 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 or

segment add operating income to the firm?

Yesadd or dont discontinue Nodiscontinue or dont add

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Adding or Discontinuing Branches or Products

Considerations

Effect on related branches/product lines Fixed costs allocated to the eliminated product/branch must be absorbed

Net income may decrease when an unprofitable segment is eliminated

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Adding or Discontinuing Branches or Products - Example

Illustration: Martina Company manufactures three models of tennis rackets:

Profitable lines: Pro and Master Unprofitable line: Champ

What should management do?

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Adding or Discontinuing Branches or Products - Example

Prepare income statement after eliminating Champ product line

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

Total income is decreased by $10,000.

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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 relevant

Decision rule: Select the alternative that will generate

the highest operating income
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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 with Relevant Cost Analysis

Avoid incorrect general assumptions, especially:
All variable costs are relevant and all fixed costs are

irrelevant

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Potential Problems with Relevant 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 information

Weaknesses
Says nothing about the probability of outcomes Ignores relationships among variables

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Question
If an unprofitable segment is eliminated:
a. b. c. Net income will always increase. Variable expenses of the eliminated segment will have to be absorbed by other segments. Fixed expenses allocated to the eliminated segment will have to be absorbed by other segments. Net income will always decrease.

d.

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