Chapter 20

How Managers Make Decisions

Define Business Goals
Identify Alternative Courses of Action
Gather and Analyze Relevant Information
Choose the best alternative

Relevant Information

Expected future data that differs among alternatives

Relevant Costs

Costs that are relevant to a particular decision.
- Occur in the future and differ between alternatives

Qualitative factors

Relevant qualitative factors have the same characteristics as relevant financial information.

Relevant Information Approach/Incremental Analysis Approach

Looks at how operating income would differ under each decision alternative, and leaves out information that does not pertain to the decision making process.

Two Keys to analyzing short-term special business decisions

Focus on relevant costs
Use a contribution margin approach that separates fixed costs from variable costs

Special Order Considerations

-Does the company have excess capacity to fill order?
-Will reduced sale price cover incremental costs? (price must be greater than variable costs to provide positive contribution margin) and cover fixed costs
-Will it affect regular sales?

Decision to Accept Special Order

-If expected increase in revenue exceeds increase in variable and fixed costs- Accept
-If expected increase in revenue is less than expected increase in variable and fixed costs- Reject

Regular Pricing Considerations

-What is target profit?
- How much will customers pay?
-Is the company a price-taker or a price setter?

Price-Taker

-Not an original product
-Intense competition
-Emphasizes target pricing

Price-Setter

-Unique product
-Less competition
-Cost-plus pricing

Target Full Product Cost

The total cost in developing, producing, and delivering a product or service

Target Full Cost Formula

Price-Taker
Revenue at market price (price per unit x number of units sold)-Desired profit = Target full cost
Revenue-Target full cost (COGS) = Net income (Desired Profit)

Cost-Plus Pricing

Price-Setter
Opposite of target pricing
Full cost+Profit = Cost-plus price

Constraint

A factor that restricts production or sale of a product

Dropping products, departments, or territories

-Does the product provide a positive contribution margin?
-Will fixed costs continue to exist?
-Will dropping the product affect sales of other products?
-What could the company do with the freed capacity?

Product Mix Considerations

-What constraints stop the company from making or displaying all units?
-Which products offer the highest contribution margin?- Emphasize the product with highest contribution margin
-Would emphasizing different products affect fixed costs?

Opportunity Cost

The benefit given up by not choosing an alternative course of action

Outsourcing Considerations

-How do the company's variable costs compare to outsourcing costs?
-Are any fixed costs avoidable?
-What could the company do with freed capacity?

Sell as is or process further

-If extra revenue exceeds cost of processing further- process
-If extra revenue is less- don't

Outsourcing

if the incremental cost of making a product exceeds the incremental cost of outsourcing, outsource.

Total Full Cost

Total fixed costs + total variable costs

Target Fixed Costs

Target full costs - variable costs