Relevant Information for Decision Making (Session 10)

Question 1

Process for Identifying and Analyzing Relevant Information

Answer 1

• Identify and Envision the problem
• Identify relevant quant information
• Identify relevant qualitative information
• Perform analyses
• Prioritize issues to arrive at a decision

Question 2

Types of Operating Decisions

Answer 2

• Keep or drop
• Insource or outsource (make or buy)
• Special orders
• Constrained resources
  -Product emphasis—multiple resource constraints and multiple products

Question 3

General rule for keep or drop decisions

Answer 3

Drop if Contribution margin < (Relevant fixed costs + Opportunity cost)

• Separate costs into fixed and variable components
• Variable costs are often avoidable and therefore relevant to the decision, whereas fixed costs usually include both avoidable and unavoidable
• Consider whether the cost is avoidable if we drop the product or segment or
  unavoidable whether we do or not.
• identify and estimate avoidable costs, by analyzing the nature of the cost and
  its relation to the two alternatives (keep or drop).

Question 4

Customer Profitability

Answer 4

A customer should be dropped if:

Customer CM < (Relevant FC + Opportunity Cost)

Question 5

Customer Profitability

Answer 5

Potential relevant costs:
* Avoidable costs of products manufactured or services provided
* Marketing, sales-order, and delivery costs
* Cost for equipment or other assets devoted to
particular customers
* Product technical support, warranty costs, and
product return handling
* Inventory carrying costs such as material
handling, warehousing, and insurance
* Avoidable administrative costs for labour,
facility, or other resources needed to satisfy
customer demands
* Alternative uses for capacity devoted to
customers

Question 6

Summary (Customer profitability)

Answer 6

1) Relevant Costs and Benefits
- CM lost if dropped
- FC avoided if dropped
- CM loss or gain on other products/segments

2) Irrelevant Costs
- Allocated common costs
- Sunk costs

3) Decision Role
- CM loss > FC avoided + contribution
margin gain on other products/
segments –> KEEP

CM lost < FC avoided + CM gain on other products/segments –> DROP

Question 7

Insource/Outsource (Make or Buy) Decisions

Answer 7

• Managers often must determine whether to
• make or buy a production input
• keep a business activity in-house or outsource the activity
• The general rule for making or buy decisions is:

Cost to outsource < Cost to insource

Or

Cost to outsource < (Relevant VC + Relevant FC + Opportunity cost)

Question 8

Quality and Outsourcing Decisions

Answer 8

• Product or service quality is often a major factor in outsourcing
  decisions.
• To ensure high quality, organizations typically negotiate outsourcing
  contracts that stipulate specific performance criteria, such as
  product specifications and timeliness.

Question 9

Summary (Make or Buy Decisions)

Answer 9

1) Relevant Costs and Benefits
- Cost of Purchase
- Saving on variable costs + avoidable
fixed costs
- Opportunity cost (contribution margin
gain from other projects)

2) Irrelevant Costs
- Unavoidable Fixed Costs
- Sunk Costs

3) Decision Rule
- Cost of purchase > Cost savings of not
making + opportunity cost (contribution
margin gain from other projects) –> MAKE

• Cost of purchase < Cost savings of not
  making + opportunity cost (contribution
  margin gain from other projects) –> BUY

Question 10

Special Order Decisions

Answer 10

A new customer (or an existing customer) may sometimes request a
special order with a lower selling price per unit.

• The general rule for special order decisions is:
  o Accept if Price > Relevant VC + Relevant FC + Opportunity cost
• If the special order replaces a portion of normal operations, then
  the opportunity cost of accepting the order must be included in
  incremental costs.

Question 11

Summary (Special Order Decisions)

Answer 11

1) Relevant Costs and Benefits
- Incremental revenues from the
order
- Incremental costs (including
variable and fixed costs) of
filling the order
- Opportunity cost of filling the
order

2) Irrelevant Costs
- Allocated common costs
- Sunk costs

3) Decision Rule
- Accept if
Incremental revenues > Total relevant costs
- Reject if
Incremental revenues < Total relevant costs

Question 12

Constrained Resource Decisions : Managers often face constraints such as:

Answer 12

• Production capacity constraints such
  as machine hours or limits on the availability of material inputs

-Limits on the quantities of outputs
that customers demand

Question 13

Constrained
Resource
Decisions - Managers need to determine which …

Answer 13

Managers need to determine which
products should first be allocated the
scarce resources.

Question 14

Constrained
Resource
Decisions - The general rule for constrained resource
allocation decisions with only one constraint is:

Answer 14

Allocate scarce resources to
products with the highest
contribution margin per unit
of the constrained resource,
subject to qualitative
considerations.

Question 15

According to Theory of Constraints, managers will…

Answer 15

Managers will always face a constraint in their operations

Question 16

Constraints are…

Answer 16

Resource limitations and can be shortages of direct material or labour, or bottlenecks in the manufacturing process.

Question 17

A bottleneck is…

Answer 17

A bottleneck is any resource or process that limits overall capacity

Question 18

When resources are constrained…

Answer 18

We need to emphasize products and services that maximize the contribution margin per unit of constrained resources.

Question 19

The general rule for relaxing a short-term constraint for direct materials, direct labour, or capacity is that managers should…

Answer 19

be willing to pay not only what they are already paying but also some of or the entire contribution margin per unit of constrained resource. Their goal is to acquire added capacity, thereby eliminating the constraint.

Question 20

4 steps of Managing Constraints

Answer 20

1) Identify the constraint

2) Set the pace of manufacturing throughput or service delivery at the same pace as the bottleneck

3) Managers need to find improvements for the
bottleneck to increase throughput.

4) When this link is no longer a constraint, managers
identify the next constraint and repeat the process

Question 21

First option to Deal with Constraints

Answer 21

Emphasize products to maximize the
contribution margin within the
constraint

Question 22

Second option to deal with constraint

Answer 22

Relax the constraint by:

• Purchasing goods or services from an outside supplier.
• Increasing the speed and constancy of bottlenecks by operating them during breaks and meals.
• Increasing internal capacity by using overtime, outsourced labor or
  processes, and buying new equipment
• Redesigning products and processes to use existing capacity more
  efficiently.
• Offloading some products that use high-technology bottleneck
  resources to older, less-efficient equipment that performs the same
  task.

Question 23

What is the general rule for constrained resource decisions with one scarce resource?

Answer 23

The general rule for constrained resource decisions with one scarce resource is to first make only the product with the highest contribution margin per unit of the constrained
resource.

Question 24

Constrained Resource Decisions
(Multiple Scarce Resources)

Answer 24

1) Usually managers face more than
one constraint

2) Multiple constraints are easiest
to analyze using a quantitative
analysis technique known as
linear programming.

3) A problem formulated as a linear
programming problem contains
- an algebraic expression of the
company’s goal, known as the
objective function
(for example “maximize total
contribution margin” or “minimize
total costs”)
- a list of the constraints written as
inequalities

Question 25

Linear Programming Sequences

Answer 25

• DETERMINE THE CONTRIBUTION MARGIN
  FOR EACH PRODUCT AND LAY OUT THE
  OBJECTIVE (TARGET) FUNCTION TO BE
  MAXIMIZED.
• LIST THE AMOUNT OF CONSTRAINED
  RESOURCES REQUIRED PER PRODUCT
  AND THE TOTAL AMOUNT OF
  CONSTRAINED RESOURCE AVAILABLE
  (OFTEN MEASURED IN HOURS).
• SOLVE FOR THE OPTIMAL PRODUCT MIX,
  USING EXCEL SOLVER OR OTHER
  SOFTWARE
• INTERPRET THE OUTPUT.

Question 26

Constrained Resource Decisions
(Multiple Products; Multiple Constraints)

Answer 26

• Problems with multiple products, one scarce resource, and one constraint on customer demand for each product are easy to solve.
• The general rule is to make the product with the highest contribution margin
  per unit of the scarce resource:
  o until its customer demand is satisfied
  o then move to the product with the next highest contribution margin per unit of the scarce resource, etc.
• Problems with multiple products and multiple scarce resources are too
  cumbersome to solve by hand – Excel Solver is a useful tool here.

Question 27

Quality of Operating Decisions

Answer 27

• The quality of the information used in nonroutine operating
  decisions must be assessed.
  o There may be more information quality issues (and more uncertainty)
  in nonroutine decisions because of the irregularity of the decisions.

Question 28

Decision-maker bias

Answer 28

Sometimes, decision-makers are influenced
by predispositions for a course of action, which reduces their
ability to objectively and thoroughly analyze relevant information.

Question 29

When addressing any operating decision, managers should …

Answer 29

consider whether each option is consistent with the organization’s
strategies, vision, core competencies, and risk appetite.

Question 30

Three major factors that affect the quality of information for non-routine decisions

Answer 30

• Three major factors affect the quality of information for non-routine
  operating decisions:
  o business risk
  o information timeliness
  o analysis technique assumptions.