CHAPTER 11
Decision Making
and
Relevant Information
Decision Models
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 Five-Step Decision-Making Process
Five-Step
Decision-Making Process
Relevance
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
Irrelevance
Historical costs are past costs that are irrelevant to decision making
Also called Sunk Costs
Types of Information
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
Terminology
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
Types of Decisions
One-Time-Only Special Orders
Insourcing vs. Outsourcing
Make or Buy
Product-Mix
Customer Profitability
Branch / Segment: Adding or Discontinuing
Equipment Replacement
One-Time-Only Special Orders
Accepting or rejecting special orders when there is idle production capacity and the special orders have no long-run implications
Decision Rule: does the special order generate additional operating income?
Yes – accept
No – reject
One-Time-Only Special Orders
Compares relevant revenues and relevant costs to determine profitability
Potential Problems with
Relevant-Cost Analysis
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
Potential Problems with
Relevant-Cost Analysis
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
Avoiding Potential Problems with
Relevant-Cost Analysis
Focus on Total Revenues and Total Costs, not their per-unit equivalents
Continually evaluate data to ensure that they meet the requirements of relevant information
Insourcing vs. Outsourcing
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 option that will provide the firm with the lowest cost, and therefore the highest profit.
Qualitative Factors
Nonquantitative 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.
Opportunity Costs
Opportunity Cost is the contribution to operating income that is forgone 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
Product-Mix Decisions
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
Adding or Dropping Customers
Decision Rule: Does adding or dropping a customer add operating income to the firm?
Yes – add or don’t drop
No – drop or don’t add
Decision is based on profitability of the customer, not how much revenue a customer generates
Adding or Discontinuing
Branches or Segments
Decision Rule: Does adding or discontinuing a branch or segment add operating income to the firm?
Yes – add or don’t discontinue
No – discontinue or don’t add
Decision is based on profitability of the branch or segment, not how much revenue the branch or segment generates
Equipment-Replacement Decisions
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
Behavioral Implications
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
