Short Term Decision Making Flashcards
Make-or-Buy Decision. Qualitative factors: (6)
- Quality of the product
- Reliability of the supplier
- Payment terms offered by the supplier
- Suppliers commitment to sustainability
- The loss of in-house knowledge
- Staff morale, if buying decision leads to reduced headcount
One-time decisions: Qualitative factors
The Mgt Acc will put together the cost for bidding for a 1-off contract.
Other factors:
- is the project in line with the strategic goals of the business
- is the business at full capacity, if not, what other opportunities are available to use this capacity
- the profile that winning this work may provide.
Service or product discontinuation: qualitative factors: (3)
- if one loss making product is discontinued, how does this affect the sale of other products
- how does this affect staff morale,
- what is the impact on consumers
Qualitative factors in product mix decisions: (3)
- are the products complementary?
- is there a requirement to produce a minimum level of something for legal or environmental reasons, or customer obligation
- does a minimum level of production of a certain unit need to be produced to satisfy strategic goals of the business.
Factors that influence product or service pricing decisions:
(6)
- price need to exceed costs in order to make a profit
- many products have a market price
- Cost-plus pricing = adding a percentage to the cost to ensure a profit
- Market penetration: it may be useful to accept a loss for a new product to gain market share.
- Onsolescence of a product: these are popular for a while and a maximum profit can be made. They then get sold at a cheap price, as they lose popularity or go out of date/ perish.
- sales of complementary products: for example printers are cheap, but the cartridges is where the profit is being made.
Types of short-term pricing methods for one-off projects:
- calculate the Relevant Cost
Or use - Cost-plus pricing (cost plus a margin)
What is Cost-plus pricing:
This is when you add a profit margin to the unit cost.
The unit cost can be calculated by using:
- absorption costing
- marginal costing or
- ABC
Formula to calculate Break-Even Point (BEP) Quantity:
BEP quantity = Fixed Costs / Contribution per unit
Simple BEP Revenue formula =
BEP Quantity * Selling Price
Calculating the BEP Revenue by using the (C/S) Ratio:
Fixed Costs /
(Contribution / Sales Price or Revenue)
What is the Margin of Safety?
It’s the ‘cushion’ between (a) how much needs to be sold to cover fixed costs and (b) how much is budgeted to be sold.
Whereby (a) is the BEP Revenue.
MoS= Budgeted Revenue -/- BEP Revenue
Margin of Safety percentage =
(Budgeted Rev -/- BEP Rev) /
Budgeted Rev
How to show BEP in a chart:
- Draw a line for:
* Total Revenue and a line for:
* Total Costs
The BEP is where they cross
What is Cost-Volume-Profit Analysis:
This chart shows the relationship between the costs of the business, the volume of sales, the impact these factors have on the profit of the business.
(It also includes the BEP and the budgeted volume)
It can be used to show the impact on profit by changing any of the variables (volume, costs, sales price)
What is Operational Gearing:
It reflects the proportion of fixed costs incurred in relation to its total cost.
= Fixed Costs / Total Costs
The higher the percentage the greater the operational gearing. (Which means high fixed costs)
A company with high operational gearing, tends to experience a higher break even point.
Formula to work out Target Profit:
= (Fixed Costs + Target Profit) / Contribution per unit
Limitations of Break Even Analysis: (3)
- Assumes a linear relationship between all costs and revenue.
Doesn’t take into account bulk discount for example. - It’s Volume Driven. Assuming that costs only change due to sales volume, which is often not the case.
- Model applies to single products or a mix, but assuming the mix will stay constant. This is unrealistic in a lot of cases.
How to overcome limitations of BE Analysis?
To use a spreadsheet, where you can flex budgets and update Sales Volumes, changes in prices, material usage etc. To show the new BEP.
Difference between uncertainty and risk:
Uncertainty = when future outcome is not known. There is no information available to evaluate how likely a range of outcomes might be.
Risk: this relates to the variability in possible outcomes. There is an element of danger. Outcomes may be certain, but they are variable and there is a level of danger, which makes planning more difficult.
What external factors influence the outcome of Uncertain outcomes:
PESTEL
What is a pay-off table:
They enable a manager to consider multiple outcomes when there is uncertainty.
Each and every outcome is identified and evaluated in a pay-off table.
3 Attitudes towards risk:
- Maximin:
Are the pessimists, they choose the highest contribution out of the worst case scenarios. Maximum profit, but taking minimum risk.
These people are risk-adverse. - Maximax: is the optimist, who goes for maximum profit, using maximum risk
- Minimax regret: this person is risk averse and wants to achieve the minimum regret, when they select an option.
People who have this attitude, are risk-averse.
How to work out Minimax Regret for a decision:
The regret = the profit or loss made by buying the actual amount -/- the profit they would have had, if they had bought the correct amount for demand.
- Work out the opportunity cost they have missed out on, if they went for a different decision. By…
- Look at Row 1. Establish what the highest contribution could be and deduct the other contributions for the other options from this one. This is the Opportunity Cost (regret), that the company is missing out of, if it aims to sell less, while it could have sold more.
- Do this exercise for each row, creating a new table showing the opportunity cost for each option.
- Look at each column, select the highest regret in each column.
- The lowest value of regret out of these columns is going to give the best outcome. Least regret.
Difference between risk and uncertainty:
In both cases the future outcome is not known.
But when we talk about risk, the business does have the information to evaluate how likely a range of possible outcomes might be.
Risk:
A business can easily make reliable plans or decisions faced with risk.
This is more difficult when it regards uncertainty.
Probability is used to quantify the level of risk.
What is probability?
Evaluating a range of outcomes over a period and work out the probability for a range of outcomes in the future.
For example if in 3 month 100 items were sold and 9 months 200 items were sold. The probability that the company will sell 100 items = 0.25. While the probability that it sells 200 items is 0.75.
What is EV:
This is the Expected Value, based on a range of probabilities.
For example:
(25% prob to sell 100 items) + 75% prob to sell 200 items) = Expected Value of 175 items.
Decision trees, EV and Contribution:
Assume for the exam that the numbers in a decision tree relate to Contribution, unless otherwise stated.
Advantages (2) and limitations (3) of EV
Adv:
- it consolidates a range of data in one single figure, which helps planning and decision making.
- it is simple to use, if there is historical information available and if this information is likely to be representative for the future.
Limitations:
- it ignores the decision maker’s attitude towards risk.
- The EV is a risk neutral figure, while a risk taker may want to go for the highest possible outcome, while a risk averse person, may go for the safest option.
- the EV is a long run average and can’t be used as an expected outcome for a short period in the future. (For example, for Next Week.)
What is opportunity cost?
It is the income a company could have received if it had had enough products available to fill the demand.
Perfect v imperfect information:
A company can make better decisions and more profit, if decisions are based on perfect information, rather than on imperfect information.
What is Standard Deviation:
It’s the average amount of variability in a data set.
It tells you on average how far each of the possible variations of outcome lies from the Mean.
The Mean is the Average.
There is more risk, when the possible outcomes (the variabilities) are wider dispersed around the mean.
Standard deviations are only useful if compared to other standard deviations. They are not useful on their own.
Formula for Standard Deviation:
The square root of:
Sum (x-mean of x) squares /
n
x = each possible outcome
n is the number of values in the dataset
Why use the Standard Deviation?
To compare the outcomes of projects and decide which project is riskier (the one with the higher standard deviation).
What is the Coefficient of Variation?
It’s a statistical measure of the dispersion of data points in a data series, around the mean.
The coefficient of variation represents the ratio of the standard deviation to the mean.
Formula for Coefficient of Variation =
Standard Deviation /
Mean of the values
Answer in percent often
What is a decision tree:
It uses probabilities and Expected Value of an outcome at a given decision point.
3 Types of events in a decision tree:
- A decision point (a free choice)
- An outcome point (there is uncertainty and one of the outcome may happen)
- An end point (final financial outcome.
4 steps in a decision tree:
1) identify all separate options
2) ensure the correct chronology of events and include cashflow when it occurs
3) construct the tree
4) enter cashflows. Do not offset any amounts
Adv and Disadv of using decision trees:
Adv:
- frequently used, because they are easy to follow.
- all options can be seen on the decision tree, so a decision maker can consider the combinations and base a decision on other factors, like minimising losses.
Disadv:
- the EV is an average that might arise, not an exact figure.
- th EV will only arise if the decision is repeated many times.
- the probabilities are likely to be unreliable
- there are non financial factors that can’t be shown in the tree, that may be important to the decision.
4 Short-term finance solutions to cover a cash deficit:
1) Bank Overtdraft
2) Short term loan
3) Extend Trade Payables or reduce Trade Receivables
4) Debt factoring
Adv/Disadv Short Term Loans:
Adv:
- K. In a good fin position to be able to be approved for a short term loan.
- funds available quickly
- the bank can’t ask for the money back earlier than the agreement says.
- it’s a private agreement
- fixed rate, not a variable rate. So you’ll know what the monthly cost is going to be.
Disadv:
- you need to pay interest, even if you don’t use the full amount.
- interest rates are high currently, because even the BofK rate is 5.25%. Because loan is unsecured.
- sometimes loan needs to be repaid in one big chunk at the end.
Overdraft: adv and Disadv.
Adv:
- you only pay interest over what you borrow.
- instant access to the funds
- once arranged, it can just be used easily
- Disadv:
- comes with a variable rate, so unsure about monthly cost
- the bank is allowed to stop the arrange any time
- if the overdraft gets exceeded, the penalties could be high
Trade payables:
- 2 adv
- 5 disadv
Adv:
- no interest for paying late
- it’s flexible
Disadv:
- it may damage relationship with suppliers
- suppliers may think business is in financial difficulties
- late payment may result in penalties
- the facility can be stopped by supplier at any time
- it may be expensive if supplier offers early payment discounts.
Debt factoring :
3 adv
4 disadv
Adv
- cash instantly available
- reduces trade receivables, as factoring companies more focussed on getting customers to pay on time
- cost savings, as credit control outsourced
Disadv:
- factoring comp may diamanté relationship with customer
- customer may think that company is in financial difficulties
- the factor few can be high
- less control or overview over credit collection
Operating Cycle
= Inventory days
+ Receivable days
- Payable days
Inventory days = the total
Of:
- Raw materials from arrival to production.
- Work in progress from production to finished goods
- finished goods until they have been sold
Inventory is calculated using the formula:
Raw materials inventory / purchases throughout the year x
365
Receivables Days =
(Total balance of receivables now / annual credit sales) x
365
Payable days:
Current outstanding payables /
Annual credit purchases (or cost of sales) x
365
How to manage Working Capital: Aggressive
- Low Receivable Days
- Low inventory days
- High Payable Days
- Steady growth in sales revenue
How to manage Working Capital:
Conservative
- for company with rapid growth:
- high receivable days
- high inventory days, in order to react to changes in demand quickly
- low payable days, don’t have the confidence from suppliers yet
- rapid sales growth
Short term fin v long term fin
Short term:
- flexible
- cheaper
Long term:
- provides security
- fixed rate often
How to use a decision tree to work out if Market Research is worthwhile carrying out:
- Calculatr EV for options other than market research.
- Draw the market research part and work out the EV of the second part of the tree, thenoart with the decisions.
- Then based on the EVs. Decide what option you would go for in each scenario.
- Then go back to the market research bit and work out EV for that part, which is your final EV to take into consideration what option to go for. (A)
- the cost of the market research must be less than the difference between the best EV without using MR and the EV of the MR (A).
