Mdc Lecture 6
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Management Decisions and Control 22421/0
Management Decisions and Control Lecture 6 Decision Process & Relevant Information 1
Lecture Objectives 1.
Introduction
3.
Qualitative and Quantitative Relevant Information
5.
The Accountants’ Role in Decision Making
7.
The Many Facets of Decision Making
9.
Common Decisions Confronting the Firm
11.
Guidelines for the Decision Making Process
13.
Examples
2 Management Decisions and Control 22421/0
Introduction In all forms of economic activity, decisions must be made. All firms, large, medium or small are confronted with a multitude of situations where a choice must be made from among a group of alternatives. The process of making this choice when confronted with a number of alternative courses of action is the process of decision making. To support decisions, managers develop a DECISION MODEL which is a formal method of evaluating both the quantitative and qualitative aspects of a decision.
3 Management Decisions and Control 22421/0
Qualitative and Quantitative Information
Quantitative factors are outcomes that are measured in numerical terms – monetary or some other physical measure such as units, hours etc.
Qualitative factors are outcomes that cannot be measured in numerical terms. For example, value of a trade name.
The Accountants’ Role in Decision Making A reasonable interpretation of the accountant’s role in decision making would be that he/she attempts to ‘attach costs and benefits’ to each alternative course of action being considered, and make recommendations based upon his/her acquired knowledge of the information used to quantify the costs and benefits of alternatives. 4 Management Decisions and Control 22421/0
Facets of Decision Making It should be quite obvious that there is much more than accounting or accounting information involved in the process of decision making. Although there are many stages in the decision process, the following three steps will be used to highlight the decision making process:
Isolate all foreseeable alternative course of action
Attempt to quantify the differences between alternatives
Presentation of the accumulated information with any recommendations to management, who are charged with the task of choosing from the available alternatives
The accountant should participate in all 3 steps, however, the quantification and presentation of financial information relevant to each decision can be said to be the major functions of the
Management Decisions and Control 22421/0
5
Common Decisions Confronting the Firm There are numerous situations where organisations will need to make decisions. Common situations include:
One-off special orders
In/out-sourcing products or services
Adding or dropping a product
Capacity issues
Product mix decision
Customer profitability
Each of these will be discussed. 6 Management Decisions and Control 22421/0
Guidelines The following are guidelines or policies that are used to determine what type of information should be used (is relevant to) the decision model:
Differs between alternatives
Is-future oriented (ie historical costs are not relevant
Timely
Includes opportunity costs
Uses output levels not unit information
Short run/long run
Includes both qualitative and quantitative data 7
Management Decisions and Control 22421/0
Example: Special Orders Assumptions: Idle production capacity (no capacity constraints) No long-run implications Information: Capacity: 48,000 towels per month Current sales level: 30,000 towels to retail outlets Cost data:
Material $6 (all variable) Labour $2 ($0.50 variable) Overhead $4 ($1 variable) Marketing $7 ($5 variable)
A hotel offers to buy 5,000 towels per month at $11 per towel for the next 3 months No subsequent sales to this customer is anticipated No marketing costs will be necessary for the 5,000 one-off special order Acceptance of this order is not expected to affect the selling price or the quantity of towels sold to regular customers 8
Management Decisions and Control 22421/0
Financi al Informa tion
Sales COGS GM Marketing Operating Profit
Total 600 000 360 000 240 000 210 000 30 000 Withoutspecial one-off order Per unit Total
Per Unit 20 12 8 7 1 Withone-off special order Total
Difference (5000units) Total
Sale Variable cost Manufacturing Marketing Total VC
Relevan t Informa tion
CM Fixed cost Manufacturing Marketing Total FC Operating income
Management Decisions and Control 22421/0
9
Pitfalls of Relevant-Cost Analysis
Not all variable cost are relevant - eg. the variable marketing cost of $5 per unit is not relevant because no marketing costs will be necessary for the 5,000 one-off special order
Not all fixed are irrelevant, eg. if the full capacity of 48,000 towels a month can only be achieved in three shifts of 16,000 towels per shift. The current demand of 30,000 towels can be met in 2 shifts (maximum production = 32,000 towels). Accepting this special order will increase production to 35,000 towels necessitating a third shift. Thus the extra 5,000 towels may increase fixed manufacturing costs.
Students have a tendency to use costs based on traditional cost categories (eg. full production costs), even though some production costs are not relevant (eg. fixed production costs) and some non-production costs are relevant. Rather the focus should be on what is the relevant cost: different costs for different purposes. 10
Management Decisions and Control 22421/0
Example: Outsourcing Decisions Outsourcing is the process of purchasing goods and services from outside vendors rather than producing the same goods or providing the same services internally. Example problem: Another manufacturer offers to sell El Cerrito 10,000 unit of a high density switchboard (HDS) for $16 per unit Should El Cerrito make or buy the Total HDS? Per Unit Direct Material Direct Manufacturing Labour Flexible Manufacturing O/H Capacity Costs Business Sustaining Costs Total Manufacturing Costs
80 000 10 000 40 000 20 000 30 000 180 000
8 1 4 2 3 18
Compared with full manufacturing costs, this offer seems attractive However, some costs are avoidable (relevant) and some are Management Decisions and Control 22421/0
11
Assumptions: Capacity costs (eg factory and machine rental) are avoidable if El Cerrito stops producing the component (note: this is different from special on-off, short-term decisions, where fixed costs are assumed to be irrelevant) The business sustaining costs ofnt$30,000 are unavoidable Tota l Releva Costs Pe r Unit RelevantCost RelevantItems Outside purchase of parts Direct material Direct labour Flexible manufacturing O/H Capacity cost Total relevant cost Differential cost
Make
Buy
Make
Buy
Recommendation: El Cerrito should: Apart from cost, other important factors in make-or-buy decisions are: Quality of the product Dependability of supplies 12 Note: also need to distinguish between lowest price suppliers and Management Decisions and Control 22421/0
Capacity Constraints and Opportunity Costs
The above solution is only valid if there is idle (excess) capacity
If the plant is producing at full capacity, there is also opportunity cost to take into account
Opportunity cost is the benefit in the next best alternative forgone
See El Cerrito example (above): Assume if instead of producing HDS, the plant can be used to make a regular switch (RS)
The contribution margin from producing RS is $25,000
The relevant cost of producing HDS is $175,000 (incremental costs $150,000 plus opportunity costs $25,000)
El Cerrito should buy HDS instead of making it because the cost of producing ($175,000) it is more than the purchase cost of $160,000 13
Management Decisions and Control 22421/0
Example: Product Mix Decisions Companies with capacity constraints must often decide which products to make and in what quantities. Example: Power Recreation assembles two engines: a snowmobile engine and a boat engine At first glance, boat engines appear Snow mobilemore profitable Boat than snowmobile engines Selling price 800 1000 Variable cost per unit 560 625 Contribution margin per unit 240 375 Contribution margin ratio 30% 37.5%
Power Recreation can sell as many engines as it produces Assume that only 600 machine-hours are available 14 It takes two hours to produce snowmobile and 5 hours to produce Management Decisions andengine Control 22421/0 boat
Example: Product Mix Decisions Snowmobile
Boat
Contribution margine per unit Machine hrs to produce 1 unit CM per machine hour Total CM for 600 machine/hrs Snowmobile engines contribute more profit per machine hour (which is the constraining factor) than boat engines. The price of snowmobile has to fall below $720 (equal to $560 incremental costs plus $150 opportunity costs) before Power Recreation would consider switching to producing boat engines.
15 Management Decisions and Control 22421/0
Example: Customer Profitability Analysis Customer profitability analysis for Allied West:
Sales COGS Material handling Equipment depreciation Rent Marketing support Purchase orders General administration Total operating costs Operating profit
Vogel
Brenner
Wisk
Total
500 000 37 000 41 000 10 000 14 000 11 000 13 000 20 000 479 000 21 000
300 000 220 000 18 000 6 000 8 000 9 000 7 000 12 000 280 000 20 000
4000 000 330 000 33 000 8 000 14 000 10 000 12 000 16 000 423 000 (23 000)
1 200 000 920 000 92 000 24 000 36 000 30 000 32 000 48 000 1 182 000 18 000
Should we stop doing business with Wisk as the financial information shows that trading with Wisk resulted in a loss?
16
Management Decisions and Control 22421/0
Relevant-cost analysis for Allied West dropping Wisk account: Depreciation is a sunk cost General administration costs are unavoidable. They are committed costs which will be incurred regardless of whether the company decides to drop Wisk or not:
Rent and depreciation are capacity costs General administration is a business sustaining cost
Amountof total revenueandcost KeepWisk account
DropWisk account
Incremental revenue (loss) &cost savingre: droppingWiskaccount
Sales COGS Material handling Depreciation Rent Marketing Purchase orders General administration Total operating costs Operating profit 17 Management Decisions and Control 22421/0
Summary Decision making is a matter of choosing between different courses of action. Cost and revenue analysis of the different courses of action are a necessity, as information inputs into the decision process. Only relevant costs will influence a decision. Relevant costs or differential costs, are those future costs which will be different under alternatives. Cost reports prepared for special decisions are not subject to any presentation rules, however, they should be prepared in a manner which discloses all relevant information and be easily interpreted by non-accountants.
18 Management Decisions and Control 22421/0
Management Decisions and Control Lecture 6 Decision Process & Relevant Information 1
Lecture Objectives 1.
Introduction
3.
Qualitative and Quantitative Relevant Information
5.
The Accountants’ Role in Decision Making
7.
The Many Facets of Decision Making
9.
Common Decisions Confronting the Firm
11.
Guidelines for the Decision Making Process
13.
Examples
2 Management Decisions and Control 22421/0
Introduction In all forms of economic activity, decisions must be made. All firms, large, medium or small are confronted with a multitude of situations where a choice must be made from among a group of alternatives. The process of making this choice when confronted with a number of alternative courses of action is the process of decision making. To support decisions, managers develop a DECISION MODEL which is a formal method of evaluating both the quantitative and qualitative aspects of a decision.
3 Management Decisions and Control 22421/0
Qualitative and Quantitative Information
Quantitative factors are outcomes that are measured in numerical terms – monetary or some other physical measure such as units, hours etc.
Qualitative factors are outcomes that cannot be measured in numerical terms. For example, value of a trade name.
The Accountants’ Role in Decision Making A reasonable interpretation of the accountant’s role in decision making would be that he/she attempts to ‘attach costs and benefits’ to each alternative course of action being considered, and make recommendations based upon his/her acquired knowledge of the information used to quantify the costs and benefits of alternatives. 4 Management Decisions and Control 22421/0
Facets of Decision Making It should be quite obvious that there is much more than accounting or accounting information involved in the process of decision making. Although there are many stages in the decision process, the following three steps will be used to highlight the decision making process:
Isolate all foreseeable alternative course of action
Attempt to quantify the differences between alternatives
Presentation of the accumulated information with any recommendations to management, who are charged with the task of choosing from the available alternatives
The accountant should participate in all 3 steps, however, the quantification and presentation of financial information relevant to each decision can be said to be the major functions of the
Management Decisions and Control 22421/0
5
Common Decisions Confronting the Firm There are numerous situations where organisations will need to make decisions. Common situations include:
One-off special orders
In/out-sourcing products or services
Adding or dropping a product
Capacity issues
Product mix decision
Customer profitability
Each of these will be discussed. 6 Management Decisions and Control 22421/0
Guidelines The following are guidelines or policies that are used to determine what type of information should be used (is relevant to) the decision model:
Differs between alternatives
Is-future oriented (ie historical costs are not relevant
Timely
Includes opportunity costs
Uses output levels not unit information
Short run/long run
Includes both qualitative and quantitative data 7
Management Decisions and Control 22421/0
Example: Special Orders Assumptions: Idle production capacity (no capacity constraints) No long-run implications Information: Capacity: 48,000 towels per month Current sales level: 30,000 towels to retail outlets Cost data:
Material $6 (all variable) Labour $2 ($0.50 variable) Overhead $4 ($1 variable) Marketing $7 ($5 variable)
A hotel offers to buy 5,000 towels per month at $11 per towel for the next 3 months No subsequent sales to this customer is anticipated No marketing costs will be necessary for the 5,000 one-off special order Acceptance of this order is not expected to affect the selling price or the quantity of towels sold to regular customers 8
Management Decisions and Control 22421/0
Financi al Informa tion
Sales COGS GM Marketing Operating Profit
Total 600 000 360 000 240 000 210 000 30 000 Withoutspecial one-off order Per unit Total
Per Unit 20 12 8 7 1 Withone-off special order Total
Difference (5000units) Total
Sale Variable cost Manufacturing Marketing Total VC
Relevan t Informa tion
CM Fixed cost Manufacturing Marketing Total FC Operating income
Management Decisions and Control 22421/0
9
Pitfalls of Relevant-Cost Analysis
Not all variable cost are relevant - eg. the variable marketing cost of $5 per unit is not relevant because no marketing costs will be necessary for the 5,000 one-off special order
Not all fixed are irrelevant, eg. if the full capacity of 48,000 towels a month can only be achieved in three shifts of 16,000 towels per shift. The current demand of 30,000 towels can be met in 2 shifts (maximum production = 32,000 towels). Accepting this special order will increase production to 35,000 towels necessitating a third shift. Thus the extra 5,000 towels may increase fixed manufacturing costs.
Students have a tendency to use costs based on traditional cost categories (eg. full production costs), even though some production costs are not relevant (eg. fixed production costs) and some non-production costs are relevant. Rather the focus should be on what is the relevant cost: different costs for different purposes. 10
Management Decisions and Control 22421/0
Example: Outsourcing Decisions Outsourcing is the process of purchasing goods and services from outside vendors rather than producing the same goods or providing the same services internally. Example problem: Another manufacturer offers to sell El Cerrito 10,000 unit of a high density switchboard (HDS) for $16 per unit Should El Cerrito make or buy the Total HDS? Per Unit Direct Material Direct Manufacturing Labour Flexible Manufacturing O/H Capacity Costs Business Sustaining Costs Total Manufacturing Costs
80 000 10 000 40 000 20 000 30 000 180 000
8 1 4 2 3 18
Compared with full manufacturing costs, this offer seems attractive However, some costs are avoidable (relevant) and some are Management Decisions and Control 22421/0
11
Assumptions: Capacity costs (eg factory and machine rental) are avoidable if El Cerrito stops producing the component (note: this is different from special on-off, short-term decisions, where fixed costs are assumed to be irrelevant) The business sustaining costs ofnt$30,000 are unavoidable Tota l Releva Costs Pe r Unit RelevantCost RelevantItems Outside purchase of parts Direct material Direct labour Flexible manufacturing O/H Capacity cost Total relevant cost Differential cost
Make
Buy
Make
Buy
Recommendation: El Cerrito should: Apart from cost, other important factors in make-or-buy decisions are: Quality of the product Dependability of supplies 12 Note: also need to distinguish between lowest price suppliers and Management Decisions and Control 22421/0
Capacity Constraints and Opportunity Costs
The above solution is only valid if there is idle (excess) capacity
If the plant is producing at full capacity, there is also opportunity cost to take into account
Opportunity cost is the benefit in the next best alternative forgone
See El Cerrito example (above): Assume if instead of producing HDS, the plant can be used to make a regular switch (RS)
The contribution margin from producing RS is $25,000
The relevant cost of producing HDS is $175,000 (incremental costs $150,000 plus opportunity costs $25,000)
El Cerrito should buy HDS instead of making it because the cost of producing ($175,000) it is more than the purchase cost of $160,000 13
Management Decisions and Control 22421/0
Example: Product Mix Decisions Companies with capacity constraints must often decide which products to make and in what quantities. Example: Power Recreation assembles two engines: a snowmobile engine and a boat engine At first glance, boat engines appear Snow mobilemore profitable Boat than snowmobile engines Selling price 800 1000 Variable cost per unit 560 625 Contribution margin per unit 240 375 Contribution margin ratio 30% 37.5%
Power Recreation can sell as many engines as it produces Assume that only 600 machine-hours are available 14 It takes two hours to produce snowmobile and 5 hours to produce Management Decisions andengine Control 22421/0 boat
Example: Product Mix Decisions Snowmobile
Boat
Contribution margine per unit Machine hrs to produce 1 unit CM per machine hour Total CM for 600 machine/hrs Snowmobile engines contribute more profit per machine hour (which is the constraining factor) than boat engines. The price of snowmobile has to fall below $720 (equal to $560 incremental costs plus $150 opportunity costs) before Power Recreation would consider switching to producing boat engines.
15 Management Decisions and Control 22421/0
Example: Customer Profitability Analysis Customer profitability analysis for Allied West:
Sales COGS Material handling Equipment depreciation Rent Marketing support Purchase orders General administration Total operating costs Operating profit
Vogel
Brenner
Wisk
Total
500 000 37 000 41 000 10 000 14 000 11 000 13 000 20 000 479 000 21 000
300 000 220 000 18 000 6 000 8 000 9 000 7 000 12 000 280 000 20 000
4000 000 330 000 33 000 8 000 14 000 10 000 12 000 16 000 423 000 (23 000)
1 200 000 920 000 92 000 24 000 36 000 30 000 32 000 48 000 1 182 000 18 000
Should we stop doing business with Wisk as the financial information shows that trading with Wisk resulted in a loss?
16
Management Decisions and Control 22421/0
Relevant-cost analysis for Allied West dropping Wisk account: Depreciation is a sunk cost General administration costs are unavoidable. They are committed costs which will be incurred regardless of whether the company decides to drop Wisk or not:
Rent and depreciation are capacity costs General administration is a business sustaining cost
Amountof total revenueandcost KeepWisk account
DropWisk account
Incremental revenue (loss) &cost savingre: droppingWiskaccount
Sales COGS Material handling Depreciation Rent Marketing Purchase orders General administration Total operating costs Operating profit 17 Management Decisions and Control 22421/0
Summary Decision making is a matter of choosing between different courses of action. Cost and revenue analysis of the different courses of action are a necessity, as information inputs into the decision process. Only relevant costs will influence a decision. Relevant costs or differential costs, are those future costs which will be different under alternatives. Cost reports prepared for special decisions are not subject to any presentation rules, however, they should be prepared in a manner which discloses all relevant information and be easily interpreted by non-accountants.
18 Management Decisions and Control 22421/0
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