Decision Making and Relevant Information

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A decision model is a formal method of making a choice, often involving both quantitative and qualitative analyses Managers often use some variation of the FiveStep Decision-Making Process

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Step 1: Obtain Information

Step 2: Make Predictions About Future Costs

Step 3: Choose An Alternative

Step 4: Implement The Decision

Step 5: Evaluate Performance

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Relevant Information has two characteristics:

It occurs in the future It differs among the alternative courses of action

Relevant Costs expected future costs Relevant Revenues expected future revenues

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 2009 Pearson Prentice Hall. All rights reserved.

 2009 Pearson Prentice Hall. All rights reserved.

Historical costs are past costs that are irrelevant to decision making

Also called Sunk Costs

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 2009 Pearson Prentice Hall. All rights reserved.

Quantitative factors are outcomes that can be measured in numerical terms Qualitative factors are outcomes that are difficult to measure accurately in numerical terms, such as satisfaction

Are just as important as quantitative factors even though they are difficult to measure

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Incremental Cost the additional total cost incurred for an activity Differential Cost the difference in total cost between two alternatives Incremental Revenue the additional total revenue from an activity Differential Revenue the difference in total revenue between two alternatives

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One-Time-Only Special Orders Insourcing vs. Outsourcing Make or Buy Product-Mix Customer Profitability Branch / Segment: Adding or Discontinuing Equipment Replacement

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Accepting or rejecting special orders when there is idle production capacity and the special orders has no long-run implications Decision Rule: does the special order generate additional operating income?

Yes accept No reject

Compares relevant revenues and relevant costs to determine profitability

 2009 Pearson Prentice Hall. All rights reserved.

 2009 Pearson Prentice Hall. All rights reserved.

 2009 Pearson Prentice Hall. All rights reserved.

Avoid incorrect general assumptions about information, especially:

All variable costs are relevant and all fixed costs are irrelevant There are notable exceptions for both costs

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Problems with using unit-cost data:

Including irrelevant costs in error Using the same unit-cost with different output levels
Fixed costs per unit change with different levels of

output

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Focus on Total Revenues and Total Costs, not their per-unit equivalents Continually evaluate data to ensure that it meets the requirements of relevant information

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Insourcing producing goods or services within an organization Outsourcing purchasing goods or services from outside vendors Also called the Make or Buy decision Decision Rule: Select the that option will provide the firm with the lowest cost, and therefore the highest profit.

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Non-quantitative factors may be extremely important in an evaluation process, yet do not show up directly in calculations:

Quality Requirements Reputation of Outsourcer Employee Morale Logistical Considerations distance from plant, etc

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Opportunity Cost is the contribution to operating income that is foregone by not using a limited resource in its next-best alternative use

How much profit did the firm lose out on by not selecting this alternative?

Special type of Opportunity Cost: Holding Cost for Inventory. Funds tied up in inventory are not available for investment elsewhere

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The decisions made by a company about which products to sell and in what quantities Decision Rule (with a constraint): choose the product that produces the highest contribution margin per unit of the constraining resource

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Decision Rule: Does adding or dropping a customer add operating income to the firm?

Yes add or dont drop No drop or dont add

Decision is based on profitability of the customer, not how much revenue a customer generates

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 2009 Pearson Prentice Hall. All rights reserved.

 2009 Pearson Prentice Hall. All rights reserved.

Decision Rule: Does adding or discontinuing a branch or segment add operating income to the firm?

Yes add or dont discontinue No discontinue or dont add

Decision is based on profitability of the branch or segment, not how much revenue the branch or segment generates
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 2009 Pearson Prentice Hall. All rights reserved.

Sometimes difficult due to amount of information at hand that is irrelevant:

Cost, Accumulated Depreciation and Book Value of existing equipment Any potential Gain or Loss on the transaction a Financial Accounting phenomenon only

Decision Rule: Select the alternative that will generate the highest operating income

2009 Pearson Prentice Hall. All rights reserved.

 2009 Pearson Prentice Hall. All rights reserved.

 2009 Pearson Prentice Hall. All rights reserved.

Despite the quantitative nature of some aspects of decision making, not all managers will choose the best alternative for the firm Managers could engage in self-serving behavior such as delaying needed equipment maintenance in order to meet their personal profitability quotas for bonus consideration

2009 Pearson Prentice Hall. All rights reserved.