Chapter 2 - Decision-making Techniques Flashcards
What is a relevant cost?
A future incremental cash flow
What are the tests that a cost must pass to be relevant?
It must be:
- Future
- Incremental
- Cash flow
What is the relevant cost of materials?
- Is there material in inventory? - No = current purchase price, Yes = go to step 2.
- Is it currently used elsewhere in the business? No = scrap/resale value, Yes = go to step 3.
- Can it be replaced? No = contribution/opportunity cost, Yes = current purchase price.
What is the relevant cost of labour?
- Is labour at full capacity? No = zero (no extra cost), Yes = go to step 2.
- Could we hire more staff? No = lost sales proceeds less saving in material costs, Yes = cost of hiring more staff OR overtime cost
What is the relevant cost of machines and other non-current assets?
The lower of: - Replacement cost (new machine) OR - the higher of: a) net realisable value (sold) b) economic value in business (kept)
What is the opportunity cost?
The benefit foregone by choosing one course or action instead of the next best alternative
How do you work out contribution per unit?
Selling price per unit - Variable cost per unit
What is the contribution sales ratio?
Contribution / sales
How do you work out total contribution?
Number of units sold X contribution per unit
What does total contribution equal?
Fixed costs
How do you calculate fixed costs?
= Total contribution thus:
Number of units sold X contribution per unit
How do you calculate the breakeven point in units?
Fixed costs / contribution sales ratio
How do you calculate the breakeven revenue?
Fixed costs / contribution sales ratio
What is the margin of safety?
A measure of how much sales would need to drop by before a loss is made
How do you calculate the margin of safety in units?
Budgeted sales units - breakeven sales units
How do you calculate the margin of safety in percent?
(Budgeted sales units - breakeven sales units) / budgeted sales units
What is the calculation for units sold to achieve target profit?
(Fixed costs + Target profit) / Contribution per unit
What does the profit/volume charge show?
The relationship between sales volume and profit.
What are the assumptions of breakeven analysis?
- Constant fixed costs at any output level
- Constant variable cost per unit and constant selling price per unit
- No change in inventory levels
What does a multi-product breakeven analysis assume?
- A constant product mix, OR
- All products have identical c/s ratios
What is the calculation for units (bags) sold to breakeven?
Fixed costs / Contribution part standard mix
How do you calculate breakeven revenue for multi-products?
Fixed costs / contribution sales ratio per standard mix(bag)
What are the steps for the calculation of margin of safety for multi-products?
- Calculate the average contribution per mix
- Calculate the breakeven revenue
- Calculate the margin of safety
What are the steps for determining the optimal production plan with one limiting factor?
- Identify what the limiting factor is
- Calculate the contribution per unit of limiting factor
- Rank the products according to the contribution per unit of limiting factor
- State the optimum production plan
What are the steps for limiting factor analysis for make or buy decisions?
- Identify what the limiting factor is
- Calculate the contribution per unit of limiting factor for each product where there is no external alternative. For products where there is an external alternative compare the internal variable cost of making the item with the buying in price, then divide this difference by the amount of limiting factor per unit to give the “saving from making per unit of limiting factor”
- Rank the products according to the contribution per unit of limiting factor or saving per unit of limiting factor
- State the optimum production plan
What are the steps for linear programming where there is more than one limiting factor?
- Define the variables (label e.g. x,y,z)
- Establish the constraints (equation for each constraint)
- Define the objective function (write an equation that explains what you are trying to achieve)
What are the steps for solving a linear programme problem graphically?
- Plot the constraints on a graph
- Identify the feasible region
- Plot the objective function
- Determine the optimal solution
What is the shadow price?
How much more is it worth paying (over current price) in order to obtain more of a particular resource.
How is the shadow price usually measured?
The increase in contribution if one or more unit of the resource is obtained
How do you calculate the shadow price of a scarce resource?
- add one to its constraint that you are trying to find
- rework the solution using simultaneous equations
What is ‘slack’?
The surplus or spare capacity of a particular constraint. The slack for the constraints forming the optimal solution is always nil. For other constraints the slack is the difference between their current usage and their maximum ability.
What factors influence prices?
Demand Quality Marketing Competition Inflation
What is price elasticity?
% change in demand / % change in price
What does the price elasticity of demand (PED) measure?
The relationship between the price charged and the corresponding level of demand
What happens if there is a negative sign on the price elasticity of demand?
The negative sign is ignored
What does it mean if the PED is <1?
Demand is inelastic
What does is mean if PED is >1?
Demand is elastic
What is the straight line demand equation?
P=a-bQ
P= price a = price when Q=0 b= change in price / change in quantity Q = quantity demanded
What is the equation for total cost function?
TC=a+bQ
TC = total cost a = fixed cost b = variable cost per unit Q = quantity
When is profit maximised?
When: marginal revenue = marginal cost
What is the equation for marginal revenue?
MR = a-2bQ
What does the tabular approach assume?
That only sales volumes given in the question can be achieved
What are some of the impacts of increased production activity?
Sales price is usually reduced
Lower quality products
Damage the brand issues
What is the cost-plus approach?
It involves identifying costs then adding a markup so that the desired profit margin is achieved.
What is the marginal cost?
The variable cost of the item
What is the full absorption cost?
Variable and fixed costs
What is skimming?
Initially charging high prices, generally to recover high up-front costs, then gradually lowering the price as the produce becomes mature
When is skimming used?
- New and different products
- Products that have a short life cycle
- High prices are expected to generate high initial cash flows
- Barriers to entry limit competition
- Demand and price sensitivity of demand to price are unknown
What is penetration?
Initially set low initial price to aim for high volumes and a large market share is gained quickly. High volumes will reduce the unit cost of production
In what situations is penetration used?
- High elasticity of demand so that demand is very sensitive to price
- Significant economies of scale
- Discouraging competitors when other barriers to entry are low
- If organisations want products to have a short introduction stage and enter growth and maturity stages quickly
What is a complementary product?
A product sold in conjunction with another product
What is a product line.
A range of products being produced
What is volume discounting?
The price charged depends upon the volume purchased
What is the relevant cost?
Incorporating opportunity costs as well as basic incremental costs
What is pricing discrimination?
A different price is charged in different market segments due to different price/demand relationships in each segment
What are the different ways in which a market can be segmented?
- time of day
- age of consumer
- geographical market
- type of consumer
What is a make or buy decision?
It involves comparing the costs and benefits of carrying out an activity internally or buying it in from an external source.
What are the non-financial perspectives considered in make or buy decisions?
- Quantity
- Reliability
- Strategic importance
- Confidentiality
- Expertise
- Loss of control
What ‘other decisions’ can relevant costs be used for?
- Shut down
- One-off contracts
- Further processing of joint products
How can uncertainty be reduced?
Research:
- reaction of focus groups
- market research to obtain more certainty about likely demand levels
- mystery shopping to assess likely competitor reactions
What does simulation involve?
Identifying a number of different possible outcomes that may arise if the project goes ahead.
How do you get the expected value?
Identify the possible outcomes (x) and their associated probabilities (p), then multiply each outcome by its probability and adding all of the results together ((sum of)px)
Who used expected values?
Risk neutral decision makers
What are the benefits of expected values?
- Quantification if a risky situation
- Indication of long term effects
What are the problems with expected values?
- Can only be calculated if you can identify each future possible outcome and it’s probability
- A long run average so only applies if facing a situation which will be repeated may times
- Ignores risk
What does sensitivity analysis involve?
Seeing how much the estimates used to make the original decisions can change before the decision changes. The less they can change, the more sensitive the decision becomes. (“What if” analysis)
What is maximax regret?
Maximising the maximum achievable result (risk seekers)
What is maximin regret?
Maximising the minimum achievable results (risk adverse)
What is minimax regret?
Maximum regret fir making the wrong decision (risk adversity based on opportunity cost)
What is a decision tree?
A pictorial method of showing a sequence of interrelated decisions and their expected outcomes. Decision trees can incorporate both the probabilities of, and values of, expected outcomes.
What are the types of key point in the decision tree?
- Decision points
- Outcome points
What is a decision point on a decision tree?
What a decision has to be made
What is an outcome point on a decision tree?
Where an outcome based on probabilities happens
What does a square represent in a decision tree?
A decision point
What does a circle represent on a decision tree?
An outcome point
What is the value of imperfect information?
The amount you are willing to pay for the information (e.g. research)
What is the value of perfect information?
Expected Value (with perfect information) - Expected Value (without perfect information)
