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Transcript of Chapter 11final
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Decision Makingand
Relevant Information
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Decision ModelsA 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
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Five-Step Decision-Making Process
Step 1:Obtain
Information
Step 5:Evaluate
Performance
Step 4:Implement
TheDecision
Step 3:Choose
AnAlternative
Step 2:Make
PredictionsAboutFutureCosts
Feedback
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RelevanceRelevant Information has two characteristics:
It occurs in the futureIt differs among the alternative courses of
actionRelevant Costs – expected future costsRelevant Revenues – expected future
revenues
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Relevant Cost Illustration
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Features of Relevant Information
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IrrelevanceHistorical costs are past costs that are
irrelevant to decision makingAlso called Sunk Costs
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A Starting Point: Absorption-Based Budgeted Income Statement
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Types of InformationQuantitative factors are outcomes that can be
measured in numerical termsQualitative factors are outcomes that are
difficult to measure accurately in numerical terms, such as satisfactionAre just as important as quantitative factors
even though they are difficult to measure
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TerminologyIncremental Cost – the additional total cost
incurred for an activityDifferential Cost – the difference in total cost
between two alternativesIncremental Revenue – the additional total
revenue from an activityDifferential Revenue – the difference in total
revenue between two alternatives
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Types of DecisionsOne-Time-Only Special OrdersInsourcing vs. OutsourcingMake or BuyProduct-Mix Customer ProfitabilityBranch / Segment: Adding or DiscontinuingEquipment Replacement
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One-Time-Only Special OrdersAccepting 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 – acceptNo – reject
Compares relevant revenues and relevant costs to determine profitability
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Special Order Illustration
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Make-or-Buy Illustration
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Make-or-Buy Illustration, Extended
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Potential Problems with Relevant-Cost AnalysisAvoid 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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Potential Problems with Relevant-Cost AnalysisProblems with using unit-cost data:
Including irrelevant costs in errorUsing the same unit-cost with different output
levels Fixed costs per unit change with different levels of
output
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Avoiding Potential Problems with Relevant-Cost AnalysisFocus on Total Revenues and Total Costs, not
their per-unit equivalentsContinually evaluate data to ensure that it
meets the requirements of relevant information
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Insourcing vs. OutsourcingInsourcing – producing goods or services
within an organizationOutsourcing – purchasing goods or services
from outside vendorsAlso called the “Make or Buy” decisionDecision Rule: Select the that option will
provide the firm with the lowest cost, and therefore the highest profit.
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Qualitative FactorsNon-quantitative factors may be extremely
important in an evaluation process, yet do not show up directly in calculations:Quality RequirementsReputation of OutsourcerEmployee MoraleLogistical Considerations – distance from plant,
etc
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Opportunity CostsOpportunity Cost is the contribution to
operating income that is foregone by not using a limited resource in it’s 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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Product-Mix DecisionsThe decisions made by a company about
which products to sell and in what quantitiesDecision Rule (with a constraint): choose the
product that produces the highest contribution margin per unit of the constraining resource
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Adding or Dropping CustomersDecision Rule: Does adding or dropping a
customer add operating income to the firm?Yes – add or don’t dropNo – drop or don’t add
Decision is based on profitability of the customer, not how much revenue a customer generates
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Customer Profitability Analysis, Illustrated
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Customer Profitability Analysis, Extended
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Adding or DiscontinuingBranches or SegmentsDecision Rule: Does adding or discontinuing
a branch or segment add operating income to the firm?Yes – add or don’t discontinueNo – discontinue or don’t add
Decision is based on profitability of the branch or segment, not how much revenue the branch or segment generates
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Adding/Closing Offices or Segments, Illustrated
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Equipment-Replacement DecisionsSometimes difficult due to amount of
information at hand that is irrelevant:Cost, Accumulated Depreciation and Book
Value of existing equipmentAny potential Gain or Loss on the transaction –
a Financial Accounting phenomenon onlyDecision Rule: Select the alternative that will
generate the highest operating income
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Equipment-Replacement Decisions, Illustrated
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Equipment-Replacement Decisions, Illustrated (Relevant Costs Only)
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Behavioral ImplicationsDespite 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
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