6. Decision Making Techniques Flashcards
When looking at costs and benefits for any kind of decisio making what is the key thing to remember?
Use only RELEVANT costs (and sometimes income) in the calculations.
What is relevant depends on the decision being considered, but will always be simply the COSTS OR INCOME THAT WILL CHANGE according to the outcome of the decision.
eg. If a new machine is being considered and both old and new hav the same maintenance costs then that’s ignored.
Since relevant costs will always be those affected by the decision they must always be costs that can occur IN THE FUTURE. (Past costs that are not relevant are sometimes known as ‘sunk’ costs)
Be careful also not to be swayed by NOTIONAL COSTS, like depreciation, that are based on past activities. Wea re really only interested in income and costs that are based on FUTURE FLOWS OF CASH
When looking at costs and benefits for any kind of decisio making what are the 3 criteria to use to pick out RELEVANT COSTS?
- FUTURE
Not past transactions that cannot be changed - INCREMENTAL
The ‘Extra’ cost or income that derives directly from the decision being considered. - CASH FLOWS
Movements of ‘Real money’, not notional book entries like depreciation
Relevant costs for decision making:
Opportunity cost
This is the income avoided by the course of action taken and is a relevant cost.
Ie the income that could have been generated by using the resource in a different way.
Applies to labour as well as materials - the contribution being lost
The general concept of relevant costing fits in with what ?
.. the application of marginal costing
MINIMUM PRICING
.
OUTSOURCING (MAKE or BUY)
Remember decision may be hard to reverse. (eg. skilled staff, specialised equipment are involved)
Variable costs - variable production costs are saved. Variable non-production costs (eg selling) are not.
Fixed costs - Saved only if they releate entirely to the product under consideration of outsourcing.
Other issues -
- Price ..needs guaranteed and future increases within agreed limits.
- Quality ..needs specified
- Supply ..continuity must be guaranteed and timely deliveries.
- Commercial sensitivity ..secret formula, or co may want to protect brand by implying its products are not made by anyone else.
LIMITING FACTOR DECISIONS
Need to know how to:
- Deal wth a combo of limitations
- Product choice when there are limited resources
Material or labour shortage / limited prod capacity.
- LIMITING FACTOR DECISIONS (more than 1 LF)
With limiting factor decisions where there is more than one limiting factor - The issue that MOST constrains the output is called?
How do you deal with?
The binding contsraint
- LIMITING FACTOR DECISIONS (how to plan production)
Product choice when there are limited resources.
What are the steps?
NB: Procedure is based on the idea of opportunity cost. By choosing the products with the highest CPU we ensure the opportunity cost is minimised.
- Using marginal costing, calculate the ‘CONTRIBUTION P/U’ for each product.
- Identify the limited resource and how much required for each product.
Divide the Contribution per unit from step 1 by the quantity required of the LF (for eah prduct)
This gives the ‘CONTRIBUTION P/U of LIMITING FACTOR’ - Rank the products and allocate the resource accordingly.
Downsides of limiting factor selection of best products
If you suspend production of a product and you have customers who need that and like to buy everything from one supplier might go elsewhere.
When doing limiting factor analysis what tricks to watch out for?
Being given different labour costs for each product but also being told they’re on fixed contracts .. this means labour is a fixed cost and shouldn’t be included in the marginal cost when calculating the contribution of that product.
Break even point in units?
Break even point in £sales
Target profit?
Fixed costs / Contribution per Unit
Fixed costs / Contribution per £ of sales *
- Take the total £contribution/£sales for the period and just use it as a decimal in the above equation (ie don’t multiply by 100 to get a %)
For target profit just add the Profit on to the Fixed costs and use in the equations above
Margin of safety
Measures how far budgeted sales are from the BE level. (ofter calculated as a % in order to show what % drop wuld result in zero profit)
(Budgeted sales - Break even Sales) / Budgeted sales (* 100)
A company with higher fixed costs and lower variable costs …
… might be said to have a riskier cost structure … working from the margin of safety % being lower
Need to clarify depreciation in decision making.
Beginning of Decision making techniques chapter osborne says ‘notional book entries’ are not ‘relevant costs’ …. but example on page 206/7 includes additional depreciation calculating additional profit for a change in face cream
.
Make sure can take an operating statement and draw up a marginal format OS from it.
MOS will prob have 4 columns across:
Item ; Product 1 ; Product 2; Total
Down the side (for EACH column):
start with Sales
then the Marginal/Variable costs (include var S&D)
Contribution
Then for the TOTAL column only:
Fixed costs (1 or more rows)
Operating Profit/(Loss)
What to remember if considering outsourcing production abroad
Currency movements
price stability
Quality control
AUTOMATION basics
- Big outlay on buying/leasing machinery, and subsequently maintaining and operating
- Reduction in labour costs.
This may mean Fixed costs incease and Variable decrease. This can therefore change the cost structure to a RISKIER one which is MORE SENSITIVE to changes in volume of output.
AUTOMATION calcs:
1 of 2: Redraft an income statement.
(Probably along with BE and RONA in order to establish that the new automation may increase OP but also will be riskier/more sensitive to change in volume)
.
AUTOMATION calcs:
2 of 2: Use Discounted cash flows to establish NPV of the Automation
(in contrast to Redrafting an income statement here we are concerned only with cash flows)
- Ignore costs that are the same in both cases!!
- Ignore non-cash like depreciation
- Include both capital and revenue receipts & pmts
(Need to be able to pick out correct data & discard red herrings)
Corporate Social Responsibility & Ethical considerations
Profit is main driver for decisions but it is not the only consideration. Corporate decisions have wide-ranging consequences and these must be considered also.
Orgs are becoming increasingly aware of responsibility to ALL stakeholders , (not just shareholders) and to society as a whole.
Consumers will boycott businesses that do not seem to be acting fairly ref social/environmental issues so often in best interest of the org as wel as society as a whole
- Automation means job losses.
- Make or Buy affect current workforce. Loss of local jobs affect communities as well as local businesses that rely on the Org and it’s employees for trade.
Also must consider clean up costs and environmental factors where appropriate. - Oversees outsourcing - may be ethical considerations regarding working conditions and fair pay.
- Automation affects employees but also could be considerations regarding energy consumption and sustainability.
Return on Additional Investment %
This is the return on additional NCAs bought for the new scenario.
(I got confused and was using net additional costs)
