Decision Making and Relevant Information

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Decision Making andRelevant Information

• Chapter 11

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Overview

• Decisions
• Relevant information
• Examples of common decisions
• Opportunity costs
• Capacity constraints
• Replace equipment
• Comprehensive example

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Information and theDecision Process
A decision model is a formal method for making a
choice, often involving quantitative and
qualitative analysis.
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Five-Step Decision Process
Historical Costs Other Information
Gather Information
Step 1.
Make Predictions
Step 2.
Specific Predictions
Choose an Alternative
Step 3.
Feedback
Implement the Decision
Step 4.
Evaluate Performance
Step 5.
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Differentiate relevant from irrelevant costs and
revenues in decision situations.
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The Meaning of Relevance
Relevant costs and relevant revenues are expected
future costs and revenues that differ among
alternative courses of action.
Historical costs
Sunk costs
Differential income
Differential costs
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Quantitative and QualitativeRelevant Information
Quantitative factors
Financial
Nonfinancial
Qualitative factors
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One-Time-OnlySpecial Order Example
Profit is made if the incremental revenue exceeds
incremental costs.
If excess capacity exists, then relevant cost
generally equals variable cost to make special
order. Will marketing costs change?
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Two Potential Problems inRelevant-Cost Analysis
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Incorrect general assumptions
Misleading unit-cost data
All variable costs are relevant.
Include irrelevant costs.
All fixed costs are irrelevant.
Use same unit costs at different output levels.
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Outsourcing versus Insourcing
Outsourcing is purchasing goods and services
from outside vendors.
Insourcing is producing goods or providing
services within the organization.
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Make-or-Buy Decisions
This is a very common (frequent) decision made by
most organizations.
Purchase managers report three important
factors (1) Quality (2) Supplier
dependability (3) Cost
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Make-or-Buy Decisions
In making a make-or-buy decision it is often
times useful and quick to compare the cost to
outsource versus the costs saved if you outsource.
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Opportunity Costs andOutsourcing
Opportunity cost is the contribution to
income that is forgone (rejected) by not using
a limited resource in its next-best alternative
use.
Generally, opportunity cost is the benefit
foregone by not choosing the next best
alternative.
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Opportunity Costs andOutsourcing
Many decisions have an opportunity cost. What is
the opportunity cost for making the decision to
come to class today? Give an example of a
decision that had no or zero opportunity cost.
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Capacity Constraints
Deciding which products to produce when there are
capacity constraints.
Answer Produce/sell product(s) with the highest
CM/unit of constraint!
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Product-Mix DecisionsUnder Capacity Constraints
Per unit Product 2 Product 3 Sales
price 2.11 14.50 Variable expenses
0.41 13.90 Contribution margin 1.70
0.60 Contribution margin ratio 81
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Bismark Co. has 3,000 machine-hours available.
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Product-Mix DecisionsUnder Capacity Constraints
One unit of Prod. 2 requires 7 machine-hours.
One unit of Prod. 3 requires 2 machine-hours.
What is the contribution of each product per
machine-hour?
Product 2 1.70 7 0.24 Product 3 0.60
2 0.30
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From a company economic Perspective, the book
value of equipment is irrelevant
in equipment-replacement decisions.
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Conflicts can arise between the decision
model used by a manager and the performance
evaluation model used to evaluate the manager.
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Decisions andPerformance Evaluation
What is the journal entry to sell the existing
machine?
Cash 14,000 Accumulated Depreciation
50,000 Loss on Disposal 16,000
Machine 80,000
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Decisions andPerformance Evaluation
In the real world would the manager replace the
machine?
An important factor in replacement decisions is
the managers perceptions of whether the decision
model is consistent with how the managers
performance is judged.
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Decisions andPerformance Evaluation
Top management faces a challenge that
is, making sure that the performance-evaluation mo
del of subordinate managers is consistent with
the decision model.
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Anatomy of a Decision Buy a used versus lease a
new car

• Example of decision--See spread sheet analysis.
• Quantitative and qualitative analysisyou are
  only part way done with analysis after the
  quantitative analysis. Use this as a benchmark
  against the qualitative factors.
• What qualitative factors have I missed (left out
  of) in my quantitative analysis?

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End of Chapter 11