Relevant Information for Decision Making (Session 10) Flashcards
Process for Identifying and Analyzing Relevant Information
- Identify and Envision the problem
- Identify relevant quant information
- Identify relevant qualitative information
- Perform analyses
- Prioritize issues to arrive at a decision
Types of Operating Decisions
- Keep or drop
- Insource or outsource (make or buy)
- Special orders
- Constrained resources
-Product emphasis—multiple resource constraints and multiple products
General rule for keep or drop decisions
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).
Customer Profitability
A customer should be dropped if:
Customer CM < (Relevant FC + Opportunity Cost)
Customer Profitability
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
Summary (Customer profitability)
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
Insource/Outsource (Make or Buy) Decisions
- 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)
Quality and Outsourcing Decisions
- 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.
Summary (Make or Buy Decisions)
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
Special Order Decisions
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.
Summary (Special Order Decisions)
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
Constrained Resource Decisions : Managers often face constraints such as:
- Production capacity constraints such
as machine hours or limits on the availability of material inputs
-Limits on the quantities of outputs
that customers demand
Constrained
Resource
Decisions - Managers need to determine which …
Managers need to determine which
products should first be allocated the
scarce resources.
Constrained
Resource
Decisions - The general rule for constrained resource
allocation decisions with only one constraint is:
Allocate scarce resources to
products with the highest
contribution margin per unit
of the constrained resource,
subject to qualitative
considerations.
According to Theory of Constraints, managers will…
Managers will always face a constraint in their operations
Constraints are…
Resource limitations and can be shortages of direct material or labour, or bottlenecks in the manufacturing process.
A bottleneck is…
A bottleneck is any resource or process that limits overall capacity
When resources are constrained…
We need to emphasize products and services that maximize the contribution margin per unit of constrained resources.
The general rule for relaxing a short-term constraint for direct materials, direct labour, or capacity is that managers should…
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.
4 steps of Managing Constraints
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
First option to Deal with Constraints
Emphasize products to maximize the
contribution margin within the
constraint
Second option to deal with constraint
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.
What is the general rule for constrained resource decisions with one scarce resource?
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.
Constrained Resource Decisions
(Multiple Scarce Resources)
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
Linear Programming Sequences
- 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.
Constrained Resource Decisions
(Multiple Products; Multiple Constraints)
- 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.
Quality of Operating Decisions
- 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.
Decision-maker bias
Sometimes, decision-makers are influenced
by predispositions for a course of action, which reduces their
ability to objectively and thoroughly analyze relevant information.
When addressing any operating decision, managers should …
consider whether each option is consistent with the organization’s
strategies, vision, core competencies, and risk appetite.
Three major factors that affect the quality of information for non-routine decisions
- Three major factors affect the quality of information for non-routine
operating decisions:
o business risk
o information timeliness
o analysis technique assumptions.
