05 - Decision Making Flashcards
What is the learning outcome of the chapter on Decision Making?
- Explain relevant costs and cash flows.
- Explain make or buy decisions.
- Calculate the profit maximising product sales mix using limiting factor analysis.
What are relevant costs and revenues?
Costs and revenues appropriate to a specific management decision.
These are represented by future cash flows whose magnitude will vary depending upon the outcome of the management decision made.
If inventory is used, the relevant cost, used in the determination of the profitability of the transaction, would be the cost of replacing the inventory, not its original purchase price, which is a sunk cost.
What are irrelevant costs?
A good way to understand relevant costs and revenues is to think about examples of costs that will not be affected as a result of a decision.
- Past or sunk costs
- Future spending already committed by separate previous decisions
- Costs which are the same under each alternavtive course of action
Irrelevant cost - Past or sunk costs
A sunk cost is a cost that has already been incurred. The money has been spent and cannot be recovered. It has no further relevance to any decisions.
Example
For example, some obsolete inventory that cost $1,000 could be sold as scrap for $50. If the inventory has no further use then there is no point in rejecting the offer, even though the inventory cost much more than its selling price.
Irrelevant cost - Future spending already committed by separate previous decisions.
This is a variation on a sunk cost.
Example
- For example, an expensive item of equipment has been ordered for a project that has since been cancelled.
- If there is no other use for the equipment then it might as well be used for any other purpose even if a cheaper alternative could be obtained.
Irrelevant cost - Costs which are the same under each alternative course of action.
Only the incremental or differential cost between alternatives is relevant.
Example
- For example, suppose a car needs a service and one garage will charge $500 and another $510.
- The difference in price is only $10 and that is the only financial issue that needs to be taken into account.
Are decision makers rational?
Decision makers are not always rational.
For example, a ten year old PC that cost $1,000 when it was purchased might be stored away even though it is too old and slow to be of any real use.
The reason for that is the owner might feel that the PC cost too much to simply throw away. This is illogical because the asset’s real value is zero, but that is how the human mind can work.
How does the relevant range impact a decision?
The relevant range is also important.
It may be that a discount can be obtained for a large order, but if the order is too large to consider then it is irrelevant.
What is a limiting factor?
A limiting factor is any factor which is in scarce supply and which stops the organisation from expanding its activities further, that is, it limits the organisation’s activities.
What is a typical limiting factor for many trading organisations?
The limiting factor for many trading organisations is sales volume because they cannot sell as much as they would like.
However, other factors may also be limited, especially in the short term.
Example
For example, machine capacity or the supply of skilled labour may be limited for one or two periods until some action can be taken to alleviate the shortage.
The concept of contribution can be used to make decisions about the best use of a limited resource.
How do you make decisions involving a single limiting factor?
If an organisation is faced with a single limiting factor, for example machine capacity, it must ensure that a production plan is established which maximises the profit from the use of the available capacity.
Assuming that fixed costs remain constant, this is the same as saying that the contribution must be maximised from the use of the available capacity.
This decision rule can be stated as ‘maximising the contribution per unit of limiting factor’.
Describe in detail the process of maximising the contribution per unit of limiting factor.
- Determine whether there is a limiting factor
- Calculate the contribution created per product
- Calculate the contribution per unit of the limiting factor
- Rank the different products by their contribution per unit of the limiting factor.
- Maximise the production of each product according to their rank.
Make or buy decisions
Make or buy decisions are essentially an extension of the concept of identifying the relevant costs and revenues.
Many companies have discovered that they can choose between making goods for themselves and paying to have them manufactured by somebody else.
Example
- For example, many sportswear manufacturers do not own any factories.
- They design products and then pay an independent factory owner to undertake the manufacture.
Why is outsourcing attractive?
One of the attractions of an outsourcing arrangement is that they create flexibility.
If a manufacturer has its own factories and workforce then it will have to pay the fixed running costs and all of the wages that it has contracted for even if demand slumps and there are no sales.
If the work is passed over to a third party then the manufacturer can decide not to renew contracts.
This flexibility means that it could be sensible to pay slightly more to buy goods rather than make them.
What are some of the non-financial considerations of insourcing vs. outsourcing?
The biggest issue associated with buying instead of manufacturing goods is the loss of control over the manufacturing process.
The following risks exist:
- Quality may suffer as third-party manufacturers may not give the production the same care and attention.
- Bad publicity.
- For example, there have been many cases of major companies outsourcing production to factory owners who have used child labour or who have exploited third-world workers by underpaying them or forcing them to work in unpleasant conditions.
- Co-ordination and communication difficulties due to cultural or language related differences with offshore outsourcing firms.
