Module 5 - Decision Making - Mba Crash Course

MBA

Master of Business Administration

Crash Course

“To reach our greatest potential, we must set our sights clearly and embrace the unknown confidently”

The National Organization of Certified Public Accountants Riyadh Chapter, Kingdom of Saudi Arabia

An association of institutional, professionals, and OFWs Riyadh, Kingdom of Saudi Arabia

WHAT IS DECISION MAKING?

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DECISION MAKING Process of identifying problems and opportunities p pp and then resolving them! University of Leicester, 2603 Decision Making, 2002

Sequence of steps which if followed should lead to the best solution! R. Butler. Designing Organizations, pp.43/44, Routledge, 1991

WHAT IS A DECISION?

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DECISION A CHOICE made from available alternatives contributing to the achievement of organization’s objective. NATURE OF DECISION PURPOSEFUL CONSTRAINED

WHAT ARE THE TYPES OF DECISIONS?

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TYPES OF DECISIONS PROGRAMMED D i i Decisions that th t are made d routinely ti l or frequently NON-PROGRAMMED Decisions that are infrequent – strategic in nature

DECISION MAKING MODELS?

4

DECISION MAKING MODELS RATIONAL BOUNDED RATIONAL EVOLUTIONARY POLITICAL GARBAGE CAN

RATIONAL MODEL ORGANIZATIONAL GOALS PROBLEM IDENTIFICATION

PROVIDES CLEAR STRUCTURE, LOGICAL STEPS TO FOLLOW WHEN MAKING DECISION

ALTERNATIVE COURSES OF ACTION A1

A2

A3

A4

A5

CHOICE CRITERIA EVALUATION OF ALTERNATIVES CHOICE OF BEST IMPLEMENT

MONITOR AND EVALUATE

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BOUNDED RATIONAL BOUND RATIONALITY LIMIT NUMBER OF OPTIONS SATISFICING CONSIDERS CONSTRAINTS - Time Constraints Ti C i - Cost of Acquiring Information - Ambiguity of Objectives - Conflict of Objectives-Stakeholders

EVOLUTIONARY Revisiting and assessing different stages of rational model. Decision evolve from a complex pattern of feedback loop. Reduces risk R d i k off radical di l change. h Logical incrementalism.

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POLITICAL Considers stakeholders. Organization is pluralistic rather than unitary. Decision is an outcome of competition between different interests. interests Power is decision making resourceshort of supply.

GARBAGE CAN Organization is a collection of problems and solutions. Problems flow through the organization. Solution exists within the organization. organization In GARBAGE CAN SYSTEMS, decisions are often made by flight or oversight rather than by calculation! - Levitt and Nass

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WHAT ARE THE DRIVERS OF SUCCESS IN DECISION MAKING?

DRIVERS OF SUCCESS Lynley Sides of Sides and Associates

WHAT KIND OF ORGANIZATION STRATEGIC CONTEXT

LEADERSHIP

Best Executive Don't make very many decisions. They concentrate on what's important and delegate the rest."

Best Leader

Focus on creating strategy, developing the "decision making system," and making only the critical decisions or resolving exceptions.

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DRIVERS OF SUCCESS Lynley Sides of Sides and Associates

WHAT KIND OF ORGANIZATION STRATEGIC CONTEXT

LEADERSHIP CONSEQUENCES OF SENIOR MAGERS TOO INVOLVED IN DECISION MAKING

delayed decisions

employee frustration

lost productivity

inadequate leadership focus on their most critical responsibilities

under-utilization of middle management resources

DRIVERS OF SUCCESS Lynley Sides of Sides and Associates

EXPERIENCE Knowing WHATwhat KIND happened

LEARNING Knowing why OF ORGANIZATION STRATEGIC CONTEXT

it happened

LEADERSHIP ROLES PROCESS

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DRIVERS OF SUCCESS Lynley Sides of Sides and Associates

WHAT KIND OF ORGANIZATION STRATEGIC CONTEXT

LEADERSHIP ROLES PROCESS

TOOLS & TECHNOLOGY

MANAGEMENT AND CONTROLS

CHARACTERISTICS OF WELL MADE DECISIONS

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CHARACTERISTICS TIMELY

CLEAR

EVALUATED APPROPRIATELY UTILIZE LESSONS FROM PREVIOUS DECISIONS

GOOD LEADER VS. BAD LEADER Oliver Mouto of Epicentric

GOOD LEADER

“KNOWS WHEN TO PANIC”

BAD LEADER

“PANICS ALL THE TIME”

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DECISION MAKING IMPROVEMENTS IN GROWING COMPANIES

IMPROVEMENTS Personal decision making process and style consciously rather than sub-consciously. Good individual decision making skills are propagated through education and stated principles. Before making improvements, conduct unbiased evaluation of decision making at all levels of management and across functions functions. As company grows larger, put in place processes, roles, technologies and control systems.

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STRATEGIC DECISION MAKING

WHAT IS STRATEGY?

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STRATEGY Michael Porter, 1996

Creation of unique and valuable proposition involving different set of activities Creating fit among company’s activities. activities Setting yourself apart from competition.

WHAT ARE THE LEVELS OF STRATEGY?

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LEVELS OF STRATEGY CORPORATE STRATEGY - Strategic Issues - “What Business are we in? BUSINESS STRATEGY - How organization is going to p compete FUNCTIONAL STRATEGY - How do we support business level strategy?

STRATEGIC MANAGEMENT PROCESS

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STRATEGIC MANAGEMENT PROCESS Scan External Environment -National -Global Global

Evaluate Current -Mission -Goals -Strategies

Identify Strategic Factors -Opportunities -Threats Define New

SWOT

Scan Internal Environment -Core Competence -Synergy -Value Creation

-Mission -Goals -Strategies

Formulate Strategy -Corporate -Business -Functional

Identify Strategic Factors -Strength -Weaknesses

Implement Strategy via Change in: -Leadership -Structure -HR -IT -Control Systems y

SITUATION ANALYSIS AND TOOLS

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SITUATION ANALYSIS

Assessment of the strengths strengths, weaknesses, opportunities, and threats (SWOT) that affect organizational performance.

ASSESSMENT OF EXTERNAL ENVIRONMENT

PESTEL ANALYSIS

POLITICAL ECONOMIC

LEGAL

PESTEL

SOCIAL

ENVIRON TECHNO MENTAL LOGICAL

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ASSESSMENT OF EXTERNAL ENVIRONMENT

PORTER’S FIVE (5) FORCES Potential New Entrants

Threat of Substitute Products

Bargaining Power of Buyers

Competitors’ Rivalry

Bargaining Power of Suppliers

ASSESSMENT OF INTERNAL ENVIRONMENT STRUCTURE

SYSTEMS

STRATEGY

MCKINSEY 7S FRAMEWORK

SHARED VALUES

SKILLS

STYLE

STAFF

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ASSESSMENT OF INTERNAL ENVIRONMENT

VALUE CHAIN FIRM INFRASTRUCTURE HUMAN RESOURCE MANAGEMENT TECHNOLOGY DEVELOPMENT PROCUREMENT Inbound Logistics

Operations

Outbound Marketing And Logistics Sales

Service

FORMULATING CORPORATE LEVEL STRATEGY S G

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GE/MCKINSEY GRID HIGH MEDIUM

INVEST TO BUILD

• Invest to grow at maximum digestible rate

• Build selectively on strengths

• Concentrate effort on maintaining strength

• Reinforce Vulnerable areas

SELECTIVITY/ MANAGE FOR EARNINGS

LIMITED EXPANSION OR HARVEST • Look for ways to expand without high risk; otherwise minimize investment and rationalize operation

PROTECT POSITION

• Challenge for leadership

BUILD SELECTIVELY

• Protect existing program • Concentrate investments in segments where profitability is good and risks are relatively low

MANAGE FOR EARNINGS

DIVEST LOW

MARKE ET ATTRACTIVENES SS

BUILD SELECTIVELY • Specialize around limited strengths • Seek ways to overcome weaknesses • Withdraw if indications of sustained growth are lacking

• Sell at time that will maximize cash value

• Protect position in most profitable segments

• Cut fixed costs and avoid investments

• Upgrade product line

• Invest heavily in most attractive areas • Build up ability to counter competition • Emphasize profitability by raising productivity

PROTECT/REFOCUS • Manage for current earnings • Concentrate on attractive segments • Defined strengths

• Minimize investment

WEAK

STRONG

MEDIUM

BUSINESS STRENGTH

BOSTON CONSULTING GROUP MATRIX RELATIVE MARKET SHARE LOW

QUESTION MARKS

CASH COW

DOGS

HIGH

STARS

LOW

MARKET T GROWTH RATE

HIGH

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FORMULATING BUSINESS LEVEL S STRATEGY G

BUSINESS LEVEL STRATEGY

PORTER’S FIVE (5) FORCES Potential New Entrants

Threat of Substitute Products

Competitors’ Rivalry

Bargaining Power of Buyers

Bargaining Power of Suppliers

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BUSINESS LEVEL STRATEGY

COMPETITIVE STRATEGIES

DIFFERENTIATION COST LEADERSHIP FOCUS

BUSINESS LEVEL STRATEGY

PARTNERSHIP

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FORMULATING FUNCTIONAL LEVEL STRATEGY S G

FUNCTIONAL LEVEL STRATEGY

ACTION PLANS IMPLEMENTATION

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STRATEGY IMPLEMENTATION AND CONTROL CO O

STRATEGY IMPLEMENTATION & CONTROL ENVIRONMENT

ORG GANIZATION

STR RATEGY

9Use Persuasion 9Motivate Employees p y 9Shape Culture/Values

STRUCTURAL DESIGN

HUMAN RESOURCES

9 Organization Chart 9 Create Teams 9 Centralization/ Decentralization 9 Facilities, F iliti Task T k Design D i

9 Employee Recruitment & Selection 9 Manage Transfers, promotion, training 9 Firings/Recalls

INFORMATION & CONTROL SYSTEMS 9 9 9 9

PERF FORMANCE

LEADERSHIP

Pay/Reward System Budget Allocations IT Systems Procedures

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WHAT IS MANAGEMENT?

MANAGEMENT a social p process entailing g responsibility the effective WHAT KIND OF for ORGANIZATION economic planning and regulations of the enterprise in fulfillment of a given purpose or objective.

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MANAGEMENT FUNCTIONS

PLANNING

ORGANIZING

COORDINATING

CONTROLLING

MOTIVATING

WHAT IS MANAGEMENT CO CONTROL? O

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MANAGEMENT CONTROL the process by which management ensures that the organization carries out its strategies.

WHAT KIND OF ORGANIZATION Resources are obtained and used y and effectively y in the efficiently accomplishment the company objectives

GENERAL CONTROL MODEL SIMPLE INPUT-OUTPUT PROCESS INPUT

PROCESS

OUTPUT

FOUR ESSENTIAL CONDITIONS FOR A PROCESS TO BE CONTROLLED Know what to achieve and set objectives. Measure outputs and decide whether objectives are achieved. achieved Predict effects of any action to alter or control the process. Correct any deviation away from objectives.

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GENERAL CONTROL MODEL COMPARATOR INTRODUCED INPUT

PROCESS

“If you cannot measure it, how can you manage it”

OUTPUT

MEASURE OF OUTPUT COMPA COMPARATOR

OBJECTIVES

PREDICTIVE MODEL INPUT

PROCESS

OUTPUT

INFORMATION PREDICTIVE MODEL OF THE PROCESS

CORRECTIVE ACTION

MEASURE OF OUTPUT COMPA COMPARATOR

OBJECTIVES

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IMPLEMENTATION INPUT

PROCESS

OUTPUT

INFORMATION IMPLEMENTATION OF ACTION

PREDICTIVE MODEL OF THE PROCESS

MEASURE OF OUTPUT COMPA COMPARATOR

CORRECTIVE ACTION

OBJECTIVES

SINGLE-DOUBLE LOOP PLAN

OPERATION

SET THERMOSTAT TO 65O

SETSUPPLY FUEL THERMOSTAT TO EQUIPMENT AT 65O

RESET AT 70O

INCREASE FUEL

MONITORING OUTPUT

COMPARE-PLAN VARIANCE - 3O

OPEN LOO OP

CLOSED LO OOP

OUTPUT TEMP 65O

ACCEPT AT 65O ACTION ALTER PLAN

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GENERAL APPLICATION IDENTIFY OBJECTIVES IDENTIFY COURSES OF ACTIONS

PLANNING

EVALUATE ALTERNATIVES SELECT ALTERNATIVES COMPLETE LONG RANGE PLAN IMPLEMENT LONG TERM PLAN-BUDGET

CONTROL

MONITOR : ACTUAL VS PLAN VARIANCE ANALYSIS-INVESTIGATION TAKE CORRECTIVE ACTION

CHANGE PLAN TO MEET OBJECTIVES

MANAGEMENT CONTROL PROCESSES

INFORMAL COMMUNICATION Memoranda M d Meetings Conversations

FORMAL COMMUNICATION Programming Budgeting Reporting/Analysis

ACCOUNTING SYSTEM

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ACCOUNTING SYSTEM ACCOUNTING SYSTEM

FINANCIAL ACCOUNTING Backward looking Sacrifice decision relevancy for objectivity Governed by regulations

MANAGEMENT ACCOUNTING Decision & control relevance Future Orientated Dynamic Not subject to regulations

ROLE OF MGT ACCOUNTING ANALYSIS OF PAST DECISION PROVISION OF INFORMATION EXPLAINING CURRENT TRENDS PROVISION OF INFORMATION FOR DECISION MAKING PROVISION OF INFORMATION FOR PLANNING AND CONTROL

31

MGT ACCOUNTING-FRAMEWORK CONTROL OF OPERATION

DATA CAPTURE SYSTEMS

CONTROL SYSTEMS

DECISION MAKING SYSTEMS

BUDGETARY CONTROL

SHORT TERM DECISION MAKING

COST CONTROL

LONG TERM DECISION MAKING

BUDGETING

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BUDGET A QUANTITATIVE STATEMENT, FOR DEFINED PERIOD OF TIME, WHICH MAY INCLUDE PLANNED REVENUES, EXPENSES, ASSETS, LIABILITIES AND CASH FLOWS.

PURPOSE OF BUDGET TO COMPEL PLANNING – Action Plans for Long Range Plans. TO COORDINATE ACTIVITIES TO COMMUNICATE PLANS TO MOTIVATE MANAGERS TO CONTROL ACTIVITIES TO EVALUATE PERFORMANCE OF MANAGERS

33

STAGES IN BUDGETARY PROCESS ON-GOING REVIEW APPROVAL OF MASTER BUDGET ALTER/REMOVE INCONSISTENCIES COORDINATE INITIAL BUDGET NEGOTIATION OF BUDGET PREPARE INITIAL BUDGET PREPARE INITIAL SALES FORECASTS DETERMINE KEY LIMITING FACTORS IDENTIFY KEY OBJECTIVES AND EXTERNAL CHANGES

BEHAVIORAL ISSUES IN BUDGETING

34

BEHAVIORAL ISSUES Emannuel, Otley and Merchant

TECHNICAL ISSUES OF BUDGETING ARE STRAIGHTFORWARD WHEREAS BEHAVIORAL ISSUES ARE MUCH MORE COMPLEX

BEHAVIORAL ISSUES MANAGEMENT USE OF BUDGETS Many managers considered budgetary information which they were provided was not very useful and frequently ignored – Dew and Gee (1973) PARTICIPATION Participation in the budget-setting process improve the attitude of middle managers to the control process – Dew and Gee (1973) BUDGET AS TARGET Highest level of performance is achieved by setting the most difficult specific goals as accepted by managers concerned – Hofstede (1968)

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BEHAVIORAL ISSUES BUDGETS AS FORECASTS People introduce slacks in budget to achieve their targets g easily y– Broadbent and Cullen

USE OF BUDGET IN PERFORMANCE EVALUATION Budgetary control systems are often viewed very negatively

COSTING AND BUDGETARY CONTROL

36

WHY MANAGERS NEED TO KNOW COSTS? STOCK VALUATION SET SELLING PRICE ASSESS PROFITABILITY SET STANDARDS S S S DIAGNOSE INEFFICIENCIES

COSTING AND BUDGETARY CONTROL TO COMMUNICATE EFFECTIVELY, MANAGERS (NOT JUST ACCOUNTANTS) MUST FULLY UNDERSTAND THE DIFFERENCES BETWEEN VARIOUS TYPES OF COSTS, THEIR COMPUTATION AND USAGE!

37

COST CLASSIFICATION COST CAN BE CLASSIFIED IN RELATION TO:

PRODUCT/SERVICE LEVEL OF OUTPUT DECISIONS

COST CLASSIFICATION COST CAN BE CLASSIFIED IN RELATION TO:

PRODUCT/SERVICE DIRECT COST

INDIRECT COST

(Prime Cost)

(Overhead Cost)

Direct Materials - Raw materials Direct Labor -Work associated to product Direct Expenses -Expenses associated to product

Indirect Materials -Lubricating oil, maintenance materials Indirect Labor -Factory Supervisor salary Indirect Expenses - Factory Rent, Plant Insurance

38

COST CLASSIFICATION COST CAN BE CLASSIFIED IN RELATION TO:

LEVEL OF OUTPUT FIXED COST – cost that remains constant regardless of activity levels: Example – Rent, Director’s salary $ COST

FIXED

OUTPUT

COST CLASSIFICATION COST CAN BE CLASSIFIED IN RELATION TO:

LEVEL OF OUTPUT VARIABLE COST – cost that vary at differing activity: Example – Direct Labor and materials. $ COST

Variable

OUTPUT

39

COST CLASSIFICATION COST CAN BE CLASSIFIED IN RELATION TO:

LEVEL OF OUTPUT SEMI VARIABLE COST – cost that contain both fixed and variable elements: Example – electricity charge. $ COST

Variable

Fixed OUTPUT

COST CLASSIFICATION COST CAN BE CLASSIFIED IN RELATION TO:

LEVEL OF OUTPUT STEPPED COSTS – fixed over a range and then jump to another level: Example – supervision costs. $ COST

OUTPUT

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COST CLASSIFICATION COST CAN BE CLASSIFIED IN RELATION TO:

AS CONSEQUENCE OF DECISION (RELEVANT COST) Costs that are results of decisions

PROCEDURE TO DETERMINE PRODUCT COST

41

PROCEDURE TO DETERMINE PRODUCT COST

CLASSIFY AND CODE

ALLOCATE OR APPORTION OVERHEADS TO COST CENTERS

APPROTION SERVICES DEPARTMENT COST TO PRODUCTION DEPT

ABSORB OVERHEAD COSTS INTO PRODUCTS

PROCEDURE TO DETERMINE PRODUCT COST CLASSIFY AND CODE

CLASSIFY AND CODE Refers to categorizing costs such as labor, labor materials or overhead overhead.

ALLOCATE OR APPORTION OVERHEADS TO COST CENTERS

APPORTION SERVICES DEPARTMENT COST TO PRODUCTION DEPT

ABSORB OVERHEAD COSTS INTO PRODUCTS

COST CENTER CODE

COST CENTER DESCRIPTION

01 02 03 04

Raw Materials Cleaners Personnel Department Warehouse

EXPENSE CODE

EXPENSE CATEGORY

001 002 003 004

Labor Salaries Fuel/Gas Supplies

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PROCEDURE TO DETERMINE PRODUCT COST CLASSIFY AND CODE

ALLOCATE OR APPORTION OVERHEADS TO COST CENTERS

APPORTION SERVICES DEPARTMENT COST TO PRODUCTION DEPT

ABSORB OVERHEAD COSTS INTO PRODUCTS

ALLOCATE OVERHEADS TO COST CENTERS Sharing costs between two or more cost centers COST

BASIS?????

Rent

Floor Area

Wareho se Warehouse

Val e of iss Value issues es

Maintenance

Hours Worked Machine Value

Safety Officer

No. of Employees

PROCEDURE TO DETERMINE PRODUCT COST CLASSIFY AND CODE

ALLOCATE OR APPORTION OVERHEADS TO COST CENTERS

APPORTION SERVICES DEPARTMENT COST TO PRODUCTION DEPT

APPORTION SERVICES DEPARTMENT COST Allocating Service Department costs to Production Centers DEPT

TOT. COST

PROD1

PROD2

Whse Maint

$1,000 $ 800

$375 $711

$625 $ 89

Total

$1,800

$1,086

$714

ABSORB OVERHEAD COSTS INTO PRODUCTS

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PROCEDURE TO DETERMINE PRODUCT COST

OVERHEAD ABSORPTION

CLASSIFY AND CODE

ALLOCATE OR APPORTION OVERHEADS TO COST CENTERS

APPORTION SERVICES DEPARTMENT COST TO PRODUCTION DEPT

Method of attaching overhead to products/services using Overhead Absorption Rates (OAR)

OAR =

BUDGETED OVERHEAD BUDGETED BASE

ABSORB OVERHEAD COSTS INTO PRODUCTS

PROCEDURE TO DETERMINE PRODUCT COST CLASSIFY AND CODE

OVERHEAD ABSORPTION EXAMPLE: Given

ALLOCATE OR APPORTION OVERHEADS TO COST CENTERS

APPORTION SERVICES DEPARTMENT COST TO PRODUCTION DEPT

ABSORB OVERHEAD COSTS INTO PRODUCTS

OAR =

Budgeted g Overhead Expected Output Labor Hours/Unit Actual Output Actual Labor Hours Actual Overhead

= $ 300,000 = 37,500 units =2 = 40,000 = 39,000 = $310,000

BUDGETED OVERHEAD 300,000 BUDGETED BASE 2*37,500

OAR = $ 4 per labor l b hour h Overhead Absorbed = Output* std content*OAR = 40,000 * 2 * 4 = $ 320,000 Actual Overhead = $ 310,000 Over-Absorbed Overheads = $ 10,000

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PROCEDURE TO DETERMINE PRODUCT COST

OVERHEAD ABSORPTION

CLASSIFY AND CODE

FACTORS TO CONSIDER WHEN CHOOSING OVERHEAD ABSORPTION RATES (OAR)

ALLOCATE OR APPORTION OVERHEADS TO COST CENTERS

APPORTION SERVICES DEPARTMENT COST TO PRODUCTION DEPT

ABSORB OVERHEAD COSTS INTO PRODUCTS

BASE - Reflect the workload characteristics of the department. It is preferable to use an OAR based on activity (e.g. labor hours) rather than one based on cost (e.g. wages paid). ACTIVITY LEVEL - The level of activity used to set the base should be based on the normal level of activity (not on a theoretical maximum capacity).

DEPARTMENTAL RATES - It is preferable to use separate rates for each department.

COSTING METHODS ABSORPTION COSTING

MARGINAL COSTING

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ABSORPTION COSTING Fixed and variable costs are charged to the units

ADVANTAGES Fixed costs are an inescapable – must be included in stock valuations. "Total cost plus" pricing should ensure profit. Stock Building - Avoid a series of losses which will eventually be offset by profits when the goods are sold.

MARGINAL COSTING variable costs are charged to cost units fixed costs attributable to the relevant period are written off in fall against the contribution for that period Simple to operate

ADVANTAGES

No apportionment of fixed costs - subjective and time consuming exercise) No under/over absorbed overheads. Provides information relevant for short term decision making. Fixed costs relate to time time, therefore it seems logical to write them off as period costs. Reflects cash flow more than absorption costing does The cost to produce one extra unit is the marginal cost - realistic to value stock at this attributable cost. Profit will vary with sales and is not distorted by changes in stock levels.

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ACTIVITY BASED MANAGEMENT

ACTIVITY BASED MANAGEMENT Focuses on the activities performed to provide the product/service improved value that is enjoyed by the customer and the profit for the enterprise that created the value. ABM will help companies to produce more efficiently, determine costs more accurately and control and evaluate performance more effectively

47

ACTIVITY BASED MANAGEMENT Activity Based Costing (ABC) or ABM is a tool used to identify individual activities as fundamental cost objects. j Under ABC cost calculation is done for each individual activities & assign costs to objects like product/services on the basis of activities needed to produce product/services. ABC focus on indirect costs (overheads), traces rather than allocates each expense category to particular cost object, makes indirect costs direct.

ACTIVITY BASED MANAGEMENT ADVANTAGES Improves cost management & profitability by avoiding unwanted activities. activities Helps in cost reduction & process improvement decisions in production activities. Helps in product design decisions. Provides support in planning & managing activities. Helps in removing unwanted activities in production management.

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ACTIVITY BASED MANAGEMENT People, Materials, Machines, Consumables, etc

RESOURCES

RESOURCE COST ASSIGNMENT

Processes: Selling, Warehousing, Purchasing, Assembly, etc

RESOURCE DRIVERS

UNIT RESOURCE

ACTIVITY DRIVERS

UNIT ACTIVITY

ACTIVITIES

ACTIVITIES COST ASSIGNMENT

Products, Services, Customers, Market, Channels, etc.

How much resources an activity requires?

COST OBJECTS

How much an object utilizes an activity?

ACTIVITY BASED MANAGEMENT WHEN TO USE ABC? stiff When competition is stiff. When overheads are high When product are diverse due to p y, volume,, & amount of labor. complexity, When cost of errors are high

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SHORT-TERM DECISION MAKING

SHORT TERM DECISION MAKING TO ENSURE SURVIVAL OF THE ENTERPRISE CONCERNED WITH LOOKING AT HOW ALTERNATIVE COURSES OF ACTION INFLUENCE THE FIRM’S CASH FLOW POWERFUL TOOL FOR SHORT TERM DECISION MAKING IS COST VOLUME PROFIT ANALYSIS (CVP) COST VOLUME PROFIT ANALYSIS (CVP) IS ALSO KNOWN AS BREAK-EVEN ANALYSIS

50

SHORT TERM DECISION MAKING BUILDING A CVP MODEL IMPACT OF VOLUME ON COSTS IMPACT OF VOLUME ON PROFIT CALCULATION OF BREAK-EVEN ON ENTERPRISE CALCULATION OF VOLUME SALES TO ACHIEVE TARGET PROFIT

SHORT TERM DECISION MAKING IMPACT OF VOLUME ON COSTS As some costs are fixed, average cost per unit fall as volume increases Production

5,000

10,000

15,000

Variable Cost ($1per unit)

5,000

10,000

15,000

Fixed Cost

9,000

9,000

9,000

Total Cost

14,000

19,000

24,000

2.80

1.90

1.60

Cost Per Unit

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SHORT TERM DECISION MAKING IMPACT OF VOLUME ON PROFIT

Production

5,000

10,000

15,000

10,000

20,000

30,000

Variable Cost ($1 per Unit)

(5,000)

(10,000)

(15,000)

Fi d Cost Fixed C t

(9 000) (9,000)

(9 000) (9,000)

(9 000) (9,000)

Cost Per Unit

(4,000)

1,000

6,000

Revenue ($ 2 per Unit) LESS

SHORT TERM DECISION MAKING BREAK-EVEN POINT BREAK-EVEN BREAK EVEN (IN UNITS) =

TOTAL FIXED COSTS CONTRIBUTION PER UNIT

CONTRIBUTION = SALES PRICE – VARIABLE COSTS

BREAK-EVEN (SALES) = TOTAL FIXED COSTS x SALES PRICE/UNIT CONTRIBUTION PER UNIT BREAK-EVEN + PROFIT =

TOTAL FIXED COSTS + PROFIT CONTRIBUTION PER UNIT

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SHORT TERM DECISION MAKING MARGIN OF SAFETY RATIO INDICATES BY HOW MUCH SALES MAY FALL BEFORE AN ENTERPRISE WILL SUFFER LOSS % MARGIN OF SAFETY = EXPECTED SALES – BREAK EVEN SALES x 100% EXPECTED SALES

% MARGIN OF SAFETY =

15,000 – 9,000 x 100% 15 000 15,000

= 40%

THE SMALLER THE MARGIN OF SAFETY, THE GREATER IS THE RISK THAT THE ENTERPRISE’S LEVEL OF ACTIVITY MAY FALL BELOW THE BREAKEVEN POINT

DELETE OR CONTINUE?

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DELETE OR CONTINUE? ABSORPTION COSTING BASIS A

B

170 000 170,000

100 000 100,000

150 000 150,000

420 000 420,000

DIRECT MATERIALS

30,000

25,000

35,000

90,000

DIRECT LABOR

20,000

25,000

24,000

69,000

VARIABLE OVERHEAD

40,000

30,000

20,000

90,000

APPROTIONED FIXED OVERHEAD

30,000

35,000

34,000

99,000

120 000 120,000

115 000 115,000

113 000 113,000

348 000 348,000

50,000

(15,000)

37,000

72,000

SALES

TOTAL FACTORY COSTS GROSS PROFIT

C

TOTAL

LESS : SELLING ADMINISTRATIVE EXPENSES

40,000

GROSS PROFIT

32,000

DELETE OR CONTINUE? MARGINAL COSTING APPROACH A SALES

B

C

TOTAL

170 000 170,000

100 000 100,000

150 000 150,000

420 000 420,000

DIRECT MATERIALS

30,000

25,000

35,000

90,000

DIRECT LABOR

20,000

25,000

24,000

69,000

VARIABLE FACTORY OVERHEAD

40,000

30,000

20,000

90,000

2,000

1,000

1,500

4,500

TOTAL FACTORY COSTS

92,000

81,000

80,500

253,500

CONTRIBUTION

78 000 78,000

19 000 19,000

69 500 69,500

166 500 166,500

VARIABLE SELLING & ADM

LESS : FIXED FACTORY OVERHEAD

99,000

LESS : SELLING ADMINISTRATIVE EXPENSES

35,500

NET PROFIT

32,000

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MAKE OR BUY?

MAKE OR BUY? EXTERNAL SUPPLIER OFFER = $800 Direct labor = 200 Direct materials = 400 Variable Overhead = 100 Fixed Overhead = 300 TOTAL COST =1,000 If fixed costs are unavoidable, and therefore not relevant, the appropriate comparison is as follows: Direct labor = Direct materials = Variable Overhead = TOTAL COST =

200 400 100 700

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QUALITATIVE CONSIDERATIONS

QUALITATIVE CONSIDERATIONS ¾ COMPETITORS ¾ CUSTOMERS ¾ LABOR – MORALE, TRAINING, AVIALBAILITY ¾ LEGAL CONSTRAINTS ¾ ENVIRONMENT ¾ MANAGEMENT CONTROL ¾ LEARNING CURVE

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LONG -TERM DECISION MAKING

LONG TERM INVESTMENT ¾ EXPANSION Adding to fixed assets to achieve greater level of service

¾ MODERNIZATION Level of service is the same but cost of service is reduced

¾ CHANGE OF METHOD USED Stimulated by change in cost of providing service

¾ REPLACEMENT Cheaper to replace equipment than to repair

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FINANCIAL METHODS OF INVESTMENT APPRAISAL

INVESTMENT APPRAISAL PAYBACK

INTERNAL RATE OF RETURN

CAPITAL INVESTMENT APPRAISAL

NET PRESENT VALUE

DISCOUNTED PAYBACK

ACCOUNTING RATE OF RETURN

58

PAYBACK MEASURES THE NUMBER OF YEARS TO RECOVER THE ORIGINAL INVESTMENT FROM NET CASH FLOW RESULTING FROM A PROJECT PROJECT A INVESTMENT

PROJECT B

1,000

1,000

Cash Cumm

Cash Cumm

Year 1

200

200

Year 2

250

450

100

100

Year 3

150

600

150

250

Year 4

150

750

150

400

Year 5

150

900

150

550

Year 6

100

1,000

200

750

Year 7

100

Year 8

150

900

100

1,000

Year 9

100

Year 10

100

Project A Payback 6 Years j B Payback y Project 8 Years

PAYBACK ADVANTAGES Calculation is simple Cash Flow at risk – shortest possible time Quickest Restoration off liquidity li idit position. iti Acknowledge that uncertainty increases with time.

DISADVANTAGES Ignores receipts g p at end of payback period. No account is taken of the time value of money. Expected overall profitability is not considered.

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DISCOUNTED PAYBACK Money received today is worth more than the money received next year due to the following factors:

™ Opportunity to invest ™ Obtain a return

DISCOUNTED PAYBACK Example Money received now : Year 0 = 100 If invested i t d att 10% At end of year 1 At end of year 2

: 100 = 110 : 100 = 121

To convert the cash flow at end of each year in today’s value At end of year 1 At end of year 2

: 100/110 = 0.909 : 100/121 = 0.826

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DISCOUNTED PAYBACK Example: ABC Company investigated the possibility of investing in a new project and the following has been obtained: TOTAL COST OF PROJECT

500,000

EXPECTED NET CASH FLOW Year 1

20,000

Year 2

50,000

Year 3

100,000

Year 4

200,000

Year 5

300,000

Year 6

30,000

NET RETURN

700,000 200,000

DISCOUNTED PAYBACK Example: Assuming a rate of interest of 8%, calculate the project’s overall return using the following methods: PAYBACK Year

0

Net Cash Flow

Cumm. Net Cash Flow

(500,000) (500,000)

DISCOUNTED PAYBACK Discount Factors

Present Value at 8%

Cumm. Net Cash Flow

1.0000 (500,000) (500,000)

1

20,000 (480,000)

0.9259

18,518 (481,482)

2

50,000 ((430,000))

0.8573

42,865 ((438,617))

3

100,000 (330,000)

0.7938

79,380 (359,237)

4

200,000 (130,000)

0.7350

147,000 (212,237)

5

300,000

170,000

0.6860

205,800

(6,437)

6

30,000

200,000

0.6302

18,906

12,469

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DISCOUNTED PAYBACK ADVANTAGES Easy to understand Not too difficult to compute

DISADVANTAGES Difficult to estimate the amount of timing of installment of original investment.

Focuses on cash recovery of an investment.

Difficult to estimate the amount and timing of future net cash receipts and other payments.

Cash received now maybe worth more than the cash received in the future.

Not easy to determine an appropriate rate of interest.

Takes into account more of net cash flow

Net cash flow received after payback period are ignored.

ACCOUNTING RATE OF RETURN Compares the profit generated by the project with the original cost of investment

Considers Profit Flows rather than Cash Flows

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ACCOUNTING RATE OF RETURN

A.R.R. =

Average Annual Return X 100 Average Capital Invested

Average Annual Return =

Total Expected Profit Projects Life

Average Capital Invested = Value of working capital + half the cost of investment in fixed assets

ACCOUNTING RATE OF RETURN PROJECT A 450

INVESTMENT Cash

Depr

Profit

Year 1

100

90

10

Year 2

200

90

110

Year 3

100

90

10

Year 4

100

90

10

Year 5

220

90

130

TOTAL

450

270

Average

225

54

A.R.R =

54 X 100% 225

A.R.R = 24%

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ACCOUNTING RATE OF RETURN ADVANTAGES Compatible with similar accounting ratio used in financial accounting. Relatively easy to understand

DISADVANTAGES Net profit can be subject to different definition. Not always clear whether original cost of investment to be used.

Not difficult to compute

Use of residual value, the higher the residual value, the lower the ARR.

Draws attention to the notion of overall profit.

Method does not give what is acceptable rate of return. Does not take into account the time value of money

NET PRESENT VALUE (NPV)

The Cash Received today is preferable to cash receivable in the future

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NET PRESENT VALUE (NPV) Example: MBA3 Company is considering two capital investment project. The company expects a rate of return of 10% per annum. Details are as follows: PROJECT

1

2

3 YEARS

5 YEARS

100,000

100,000

Year 1

20,000

10,000

Year 2

80 000 80,000

40 000 40,000

Year 3

40,000

ESTIMATED LIFE PROJECT COST ESTIMATED CASH FLOW

40,000

Year 4

40,000

Year 5

20,000

NET PRESENT VALUE (NPV) PROJECT APPRAISAL PROJECT 1

PROJECT

Net Cash Flow

Discount Factor 10%

PROJECT 2 Present Value

Net Cash Flow

Discount Factor 10%

Present Value

Year 1

20,000

0.9091

18,182

10,000

0.9091

9,091

Year 2

80,000

0.8264

66,112

40,000

0.8264

33,056

Year 3

40,000

0.7513

30,052

40,000

0.7513

30,052

40,000

0.6830

27,320

20,000

0.6209

Year 4 Year 5

12,418

TOTAL PRESENT VALUE

114,346

111,937

LESS: INITIAL COST

100,000

100,000

14,346

11,937

NET PRESENT VALUE

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NET PRESENT VALUE THREE RULES If NPV = 0; You would be indifferent to the investment If NPV = Negative; Project fails to generate sufficient funds to cover the cost of capital If NPV = Positive; Project generates a return greater than the cost of capital and should be considered.

NET PRESENT VALUE ADVANTAGES Using cash flow emphasize liquidity Different accounting policies are not relevant Time value of money is taken into account Easy to compare the NPV of different projects, to reject projects that do not have acceptable NPV

DISADVANTAGES Difficulties in estimating the initial cost of the p project j and time periods in which installment can be paid back. Difficult to estimate accurately the net cash flow Not easy to select appropriate i t rate t off interest. i t t

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INTERNAL RATE OF RETURN

An alternative method of investment appraisal pp based on discounted net cash flow It answers the question: What rate of return would be required to ensure that the total NPV equals total initial cost?

INTERNAL RATE OF RETURN Example: ABC Company is considering to invest 50,000 in a new project. The project’s net cash flow is as follows:

Year 1 Year 2 Year 3 Year 4

= 7,000 = 25,000 = 30,000 = 5 5,000 000

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INTERNAL RATE OF RETURN NET CASH FLOW

PROJECT

AT 10% Discount Factor 10%

AT 15%

Present Value

Discount Factor 15%

Present Value

Year 1

7,000

0.9091

6,364

0.8696

6,087

Year 2

25 000 25,000

0 8264 0.8264

20 660 20,660

0 7561 0.7561

18 903 18,903

Year 3

30,000

0.7513

22,539

0.6575

19,725

Year 4

5,000

0.6830

3,415

0.5718

2,859

TOTAL PRESENT VALUE

52,978

LESS: INITIAL COST

50,000

50,000

2,978

(2,426)

NET PRESENT VALUE

47,574

Safest Discounting g Factor: IRR = Positive Rate + {Positive NPV/(Positive NPV+Negative NPV)}*Range of rates IRR = 10% + {2,978/(2978+2426)}*(15% - 10%) IRR = 12.76%

Note: negative sign of Negative NPV is ignored

INTERNAL RATE OF RETURN ADVANTAGES Care has to be taken in estimating the initial cost of the project. Emphasis is placed on liquidity Attention is given to the timing of net cash flows Appropriate rate of return does not have to be calculated.

DISADVANTAGES Sometime not easy to understand. Difficult to determine which of the two suitable rates to adopt unless computer is used. Gives only approximate rate of return. In complex situations, it can give misleading results.

Clear % of ROI

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WHAT TOOL TO USE? NOTES Firms often use a combination of methods. Payback P b k is i used d to t screen projects, j t then th NPV or IRR is used for a more rigorous appraisal. ARR is the least popular primary appraisal method. method Al methods are heavily reliant on the quantity and quality of data.

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PRICING

PRICING SETTING PRICE TOO HIGH ¾ Lost Customers ¾ Fall in Market Share ¾ Low revenues – unable to cover cost SETTING PRICE TOO LOW ¾ Price War ¾ Unable to cover total cost ¾ Customer’s perception of quality

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PRICING ISSUES Ineffective pricing often results from these key issues:

Lack of Pricing Strategy Many firms know their customers' wants and needs, but no solid understanding of customers' price sensitivity. Are customers willing to pay more, or would any price increase drive them to the competition? Intelligent customer by price sensiti sensitivity c stomer segmentation b it is often underutilized, Understanding the goal - to maximize revenues, margins or sales (AND other factors to effective pricing strategy.

PRICING ISSUES Ineffective pricing often results from these key issues:

Lack of Scenario Planning “WHAT IF” scenario planning is performed in an ad hoc manner, or not at all; consequence is either paralysis, or reactive/panic decision-making.

Lack of Pricing Process Pricing decisions are often made by a single individual in a firm, or by an understaffed and overworked pricing group. Pricing can be performed quite well if these individuals are armed with exceptional intuition and knowledge.

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PRICING MAJOR FACTORS TO CONSIDER WHEN DEVELOPING PRICING STRATEGY Corporate Objectives - ROI, Profit, Payback Period Marketing Objectives Degree of risk Response of competitors Corporate image Cost/Volume relationship

PRICING 2006 Gartner Research report

1% improvement in price translated to an 11% increase in profitability. By contrast, % improvement p o e e t in fixed ed costs or o in variable a ab e 1% costs only increases profitability by 3% and 7%, respectively.

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PRICING COST PLUS PRICING Adding a mark-up to the product’s cost in order to arrive at a selling price

BUT WHICH COST SHOULD BE USED? Full Cost Marginal Cost Minimum/Relevant Cost

PRICING ECONOMIST PRICING MODEL Lower Selling Price generates Larger Volume of Sales PRICE B Demand Curve A

DEMAND

Profit is maximized where Marginal Revenue = Marginal Cost

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PRICING ECONOMIST PRICING MODEL Problems with Economist Model I assumes demand d d curve is i known k It Total cost and marginal cost can be derived after analysis, judgment and arbitrary allocation Demand is not only influenced by price Not all firms are profit maximizers

PRICING PRICING NEW PRODUCTS/SERVICES SKIMMING setting sett g high g p price ce to ea earn supe super p profit. o t Buyers are price insensitive Substitute are not available High price acts as sign of quality There are barriers to entry Cost of smaller volume are not disproportionate

74

PRICING PRICING NEW PRODUCTS/SERVICES PENETRATION setting low price to attract high volume sales Buyers are price sensitive Substitute are available Low price is deterrent to new entrants Cost reductions can be effected through volume.

PRICING PRICING OBJECTIVES Current profit maximization Current revenue maximization – increase market share. Maximize quantity – Units sold Maximize profit margin Quality Leadership Partial Cost recovery Survival Status Quo – price stabilization to avoid price wars

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PRICING JOBBER AND HOOLEY STUDY Stage of Market Evolution Pricing Objectives Emerging

Growth

Mature

Decline

Profit Maximization

41.3

40.9

38.8

41.8

Market Share Attainment

11.9

16.8

17.7

15.2

Maximize current sales revenue

13.0

5.7

9.4

12.4

q cash flow Ensure adequate

17.4

8.7

5.6

9.8

Target profit Attainment

16.3

27.8

28.4

20.7

PRICING JOBBER AND HOOLEY STUDY BY SIZE OF FIRM Pi i Pricing Objectives Obj ti

Below 2.5 M

2.5 to 20

Above 20

Profit Maximization

45.3

44.9

39.2

Market Share Attainment

13.0

16.0

22.3

Maximize current sales revenue

9.7

11.1

8.6

Ensure adequate cash flow

13.9

6.3

5.5

Target profit Attainment

22.3

27.0

32.7

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PRICING JOBBER AND HOOLEY STUDY 45

40.2%

40 35 26.0%

30 25 16.6%

20 15

8.0%

9.1%

10 5 0

Ensure Adequate Cash Flow

Maximize Current Revenue

Market Share Attainment

Target Profit Attainment

Profit Maximization

PRICING THE NEED FOR BETTER PRICING Increasingly complex markets and business model – Globalization of business organization and product proliferation Increased sophistication of purchasers. Proliferation of pricing entities and competitive alternatives – Technological advances drives increase in d di i i channels. h l Increase in quantity of enterprise data – Use of ERP, Supply Chain Management, etc.

77

CASE STUDY

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