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Lecture 10

AYB225 - Lecture 10 Notes

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Queensland University of Technology

LECTURE 10 – DECISION MAKING INTRODUCTION TO DECISION MAKING Characteristics of Decision Information  Information accumulated for decision-making will include many characteristics, but also some that are specifically relevant to the decision-needs of managers. Cost Behaviour  Many of the decision-making techniques rely on a clear understanding of the behaviour of costs. o For example, CVP analysis is based entirely on the separation of costs into their fixed and variable categories. o Also review the pitfalls of incorrectly using unit costs. If the cost we are dealing with is a fixed cost, then for most decision-making issues (product pricing is an exception) per unit fixed costs should not be used - the total amount of the fixed costs is the appropriate item. Opportunity Cost  Opportunity cost is the revenue foregone by the next-best alternative being considered. Sunk Costs  These are costs which have been incurred in the past. They do not affect future costs and cannot be changed by any current or future action.  Sunk costs are never relevant costs. A common error when doing decision-making problems is to include sunk costs in the analysis. Marginal Costs  Marginal cost is the additional cost incurred to produce one additional unit. In accounting problems, marginal cost is frequently equated with variable cost. Relevant Costs  A cost is a relevant cost only if the cost differs across the different alternatives being considered. o Relevantcostsarealso describedas differentialorincremental costs.  If a particular total cost is the same in both alternatives being considered, that cost does not influencethedecision,andis thereforenotrelevant.  Whether an item is relevant or not depends on the particular decision being made. Therefore it is possible only to makeone definitiverule,and fortheremainderprovidebroadguidelines  Rule: o Pastcosts(sunkcosts)havealready been incurredandthereforeare never relevant  Guidelines: o Variablecosts are usually relevantcosts o Sometimes fixed costs are relevant, sometimes they are not. If you are considering two alternatives, and the total fixed costs are the same in each alternative, then fixed costs are not relevant. If they are different in the two alternatives,they arerelevant. Avoidable/Unavoidable Costs  This is usually of interest when the firm is considering changing from what it is currently doing.  If the cost will still be incurred if the firm makes the change, the cost is unavoidable.  If the cost is not incurred if the firm makes the change, it is avoidable. o This means that avoidable costs will be relevant costs, and unavoidable costs will not be relevant costs. o Frequently, but not always, the avoidable costs are the variable costs and the unavoidable costs are the fixed costs. Importance of the Contribution Margin  The contribution margin is an extremely important concept.  For many decisions (but as already stated, not all) the fixed costs will not change – they will be unavoidable. Therefore in many cases it is only necessary to consider whether the product/segment is contributing positively to the firm (i.e. has a positive contribution margin). o If so, it is unlikely that the firm will be better off by dropping that product or segment. o However, each decision situation is different, and you must always consider the facts related to a particular decision. Approaches to Quantitative Decision-Making Finance Economics Approach  A finance approach to decision-making applies discounted cash flow techniques (e.g. calculating the net present value of investment opportunities), taking into account the time value of money.  NPV analysis can be used for make-or-buy, add-or-drop, product mix decisions. o This approach provides a decision rule free from the limitations of many of the more traditional management accounting techniques. The Management Accounting Approach  Despite the superiority of the finance approach to decision-making, the management accounting approach has some value for short term decision-making  The decision-making techniques covered in the unit are: o CVP o Product mix o Add/drop product or segment o Special order pricing o Sell at split-off or process further In all cases care must be taken to collect all relevant quantitative data, and where appropriate, any qualitative data that is available. Often there is more than one way to approach a decision problem - Students would not be required to use a particular method. VARIOUS DECISION MAKING SITUATIONS Product Mix Decisions  Management must continually examine operating data and decide which combination of products offers the greatesttotal long-runpotentialforthefirm.  Where capacity constraints exist, the management accounting decision rule is that firms optimise income when theymaximisethecontributionmarginearnedper unitofconstrainingresource.  To select the most profitable mix, products are ranked by contribution margin per limiting factor and produced (subject to demand) until the scarce resource is used. The contribution margin per unit of scarce resource is calculatedas follows: o Calculatethecontributionmarginper unitinthe usualway. o Dividethecontributionmargin perunitby the numberofunitsofscarceresourcerequiredto produceoneunit. Lecture Example Example: A firm produces products X, Y and Z with contribution margins of $4, $5 and $10 respectively. Machine hours required for each of the products X, Y and Z are 1 hr, 1 hr and 5 hrs respectively. The firm faces a constraint in terms of machine hours. For a particular period, machine hours available are 5,000 hours, and demand for the products is: X 1,000 Y 3,000 Z 2,000 Howmanyunitsofeachproductwillthefirm produce? WORK EXAMPLE PAGE 3 HERE Make or Buy  The make or buy decision can be applied equally to products and services. For example, will the firm make a component partorbuy itfrom outside;willthe firm processitsown payroll(MAKE)oroutsourceit(BUY).  Managersconsidermakeorbuydecisionsforvariousreasons,suchas: o to reducecosts o to useorfreeupcapacity o to improvequality ordelivery  The quantitativeanalysisconsistsof identifying: o Coststo buy o Coststo make o Selecting the lower cost option, though a firm is unlikely to change from one option to the other if the optimal is only marginally superior. LectureExample Our firm currently makes a component, and requires 30,000 for the coming year’s production. Another supplier has offered the part at a delivered price of $3 per unit. It would cost us $3,000 to check purchased units for quality. Our unit costs for the past year were: DM $1.25 DL .60 Var OH .50 Fixed OH $1.00 $3.35 If the component was bought, fixed overhead would be reduced by $6,000, the cost of leasing specialised equipment. The space vacated by the equipment can be rented for $4,000 for the year. Consider relevant costs only. Which option is cheaper, and by how much? What is the correct decision? WORK EXAMPLE ON PAGE 4 HERE. Indifference Point  Theanalysis aboveisof limitedusefulnessunlessthefirm alwaysproduces30,000 units.  Amore generaldecisionrulecouldbeobtained by using the“pointofindifference”. Thistechniqueisusefulwhere theoptionsbeingconsidered includecombinationsoffixedandvariablecosts,as isthecase here: o Costsofmakearefixed$6,000 +variable$2.35 unit o Coststo buyarefixed-$1,000 +variable$3unit  The point of indifference is the level of activity where the firm is indifferent between two options being considered. Thefirm wouldbeindifferent atthe pointwhereprofitsorcostsarethe sameunder both.  At the point of indifference, any fixed costs are covered, which means that if activity is above the point of indifference, the firm incurs additional variable costs only, and no additional fixed costs. It is therefore possible to concludethatthefirm willalwaysprefer: o Thelowervariablecostoptionifactivityis abovethe pointof difference o Thelower fixedcostoptionif activity is belowthe pointif indifference  In thisexample,“make” hasthelowervariable costthereforewouldbe selected foractivity above thepointofindifference. “Buy” hasthehighervariablecostandthe lowerfixedcostandwouldbe selected for activitybelowthe pointofindifference. Calculatingthe IndifferencePoint WORKEXAMPLEPAGE5HERE  The qualitativeanalysisinvolvesconsideringfactorssuch asthefollowing: o Buying increases uncertainty,inparticularwithrespecttotimelyavailabilityofthecomponentorservice o Buying also surrenderscontrolover product andservicedesign,qualityetc. o Effectonemployeemorale if adecisionto buymeansputtingoff staff o Considerationre useofcapacity. Ifwe aregoingto changeto“make” do we havethe capacity? Ifwemove to“buy”,whatuseisto bemadeofexistingcapacity? etc. o Isthereaneedforparticular expertiseor specialisedequipment? o Customerexpectations, inparticularifwecurrently “make” andaregoingto changeto “buy” o If buying, analysis will have been made on a quoted price. How likely is it that the supplier will continue to supply atthatprice? o Howreliableisthesupplierwith respectto correcting faulty items? o Position of the firm after the period considered in the analysis. Most management accounting analyses of this type are not into perpetuity, and therefore the firm must consider the cost of converting back to "make" ifthe"buy"optiondoesnotcontinueto beoptimal. Add/Drop Products/Segments  In thissectionweconsidertechniques usedto decidewhetherthefirm should: o Add a product/segment or retain existing number of products/segments, OR o Drop a product/segment or retain existing number of products/segments  Firms will benefit by the timely identification of products or entire business segments (i.e. an entire department/section/division)whichshouldbeeliminatedorextended(added).  The discussion in this section focuses on dropping (as distinct from adding) an item however similar principles applyto adding productsorsegments.  Ideally, management should have access to data which would signal a product-line or service-line in trouble, such as: o decreasingmarketshare o reportsofasuperiorcompetitiveproduct o consistentloweringofsalespriceto maintainsales  While firms must be on the look-out for "non-performing" products, a product or service should not be discontinuedmerely because itreports alossonthefirm’ssegmentfinancialreports. o The loss could result from allocated costs (usually, but not always, fixed costs) that will not be avoided by eliminating the product, and therefore those costs are irrelevant to a decision about whether to drop the product.  If, as isoften thecase, fixedcostswillnotbereduced bydroppingthe product,thenfixedcosts arenotrelevant,and thedecisionrule is iftheproduct has apositivecontributionmargin,do not droptheproduct. LECTURE EXAMPLE The managing director of Wallaby Airlines is concerned about the profitability of its World Hoppers Club (extract from profit statementshownbelow)and isconsideringclosingitdown: Questions: (a) Shouldtheclubclose? (b) Howmuchworse/betteroffwouldWallaby Airlines beif theclubclosed? Revenue 200,000 Lessvariablecosts: Food 70,000 Personnelwages 40,000 Electricity 25,000 135,000 CONTRIBUTIONMARGIN 65,000 Lessfixedcosts: Depreciationonfurniture 30,000 Supervisor'ssalaries 20,000 Insurance 5,000 Rent 10,000 General administrative 10,000 75,000 Netloss 10,000 Analysisofthefirm revealsthefollowing: (1) If the Club was closed, some staff would be dismissed and others would be transferred to another section. This wouldresult in areductionofhalfthestaffcostsineach salary type (personneland supervisors) above. (2) Rent and general administrative costs have been allocated to the Club. The total amount of these items would not change ifthe Clubwasclosed. (3) Allothercostswill beavoided ifthe Clubiscloseddown. WORK EXAMPLE ON PAGE 7 HERE  Where the quantitative decision is in favour of dropping the product or division, a final decision should not be made withoutconsideringqualitative factors suchas: o theeffectonotherproducts(e.g.customersmay preferto buy from asuppliercarrying allproductlines) o alternative useofspace o effectonthefirm'simage o effectonemployeemorale o potentialopenings forcompetitors o flexibility to re-introducethe product if futurecircumstanceschange Product Pricing Special Order Pricing  The assumption behind this decision-making situation is that existing sales will continue. In such a case, fixed costs will only be relevant if they would increase because of the additional production required. Otherwise fixed costs willbecoveredbyregularsales at the normalprice,and so canbe ignored.  In the following example the fixed costs are relevant, but in many cases of special-order pricing the only relevant costswill bethevariablecostsassociatedwiththespecialorder Thequestionwill be phrased eitheras: (1) what priceshouldwecharge forthespecialorder?,or
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