Decision Making

INTRODUCTION

Accountants have an important role in the preparation of relevant data for decision making purposes.

For decision making purposes information is required which is relevant to the particular decision under consideration.  In all decisions there must be a “status quo” (or position the decision making entity will be in if no decision is taken) and an alternative position (or several alternative positions) which will result as a direct consequence of the decision to be taken.  Relevant information is that which relates to the differences between the basic, or status quo outcome and the alternatives.  Therefore the decision should be appraised by making a comparison of the financial effects between the two sets of outcomes.  Information concerning events which are common to all outcomes possibilities may be ignored as such events are not decision variables.  The decision variables are not to be measured by the historic costs utilised in regular management accounting reports as the historic costs relate to past transactions and not, therefore, decision variables for the purpose of any current decision.  Past transactions are common to all future or current actions and as such are events which are common to all outcomes hence they may be ignored.  Relevant information concerns future incremental (or avoidable) costs and revenues (as these can be altered by the current decisions) as well as current opportunity values of existing assets.

Hence the figures incorporated in regularly produced management accounting reports are generally based on past actions and are not to be used for decision making which is concerned with current and future alternative actions. However, frequently, the figures used in the regularly produced statements will be a good first approximation for the values which should be attributed to the relevant decision variables – but this cannot be relied upon to be always the case.

Relevant costs for decision making purposes are:

  • Opportunity costs of existing assets or past expenditure.

Assets currently held as a result of past expenditure bestow benefits to the owner.  It is not the past expenditure which bestows the benefits but the current ownership of the asset and benefits can be measured only by considering the uses to which the asset can be put.  Hence for decision making purposes the historic cost is irrelevant as it is the measurement of a past transaction and it does not measure the current benefit derivable from the asset.  If a current asset is used for one purpose then its alternative use will be foregone – for the purposes of deciding whether it is worthwhile to forego this alternative use then the benefits which would be derived from that use should be attributed to the asset as its opportunity cost.  Opportunity cost is therefore the net revenue which avoidable as a result of the decision.

 

  • Incremental, attributable future costs.

Future costs may be relevant but the essential point is that the future costs be avoidable as a result of the decision.  If accepting a decision incurs (or saves) a cost and rejecting the decision does incur (or saves) a cost and rejecting the decision does incur (or save) that cost then the cost is a decision variable.  However care must be taken to ensure that only truly avoidable costs are included as relevant, and all truly avoidable costs are treated as relevant – apportioned fixed overhead is not relevant but actual changes in total fixed overhead are relevant to the decision which would cause the change.

These are the types of cost which are relevant for decision making but the actual application of the concept depends upon the precise decision to be made.  There is no such thing as the costs for decision purposes which can be applied to an asset on a regular basis – there are instead a variety of relevant costs depending upon the nature of the decision to be made.  Thus figures used in routinely produced statements are not useful for decision making purposes as relevant information is situation dependant.

THE PRACTICAL USE OF RELEVANT COSTS

There are a number of specific areas where accountants can use the concept of relevant costs and these will be illustrated now: – (a) Make or buy decisions

  • Joint product decision i.e. sell or reprocess
  • Special orders
  • Key factor decisions
  • Addition/discontinuance of products
  • Pricing
  • Continue/close down decisions

 

Make or Buy Decisions

A common type of decision is a make-buy decision in which the decision maker chooses between buying an item or manufacturing it e.g. should a furniture manufacturer buy in seat cushions or should they try and manufacture them themselves.

The decision may not simply be for tangible products but could be a service facility e.g. sub contract out computer services of use own personnel.  Regardless of the type of make-buy decisions the analytical process is the same.  Managers attempt to isolate the costs relevant to the decision at hand.

Joint Product Decision I.E. Sell Or Reprocess

In general joint product decisions can be categorised as those affecting single products and those affecting the entire group.  Allocated joint costs are not relevant to the former decision but are to the latter.

Special Orders

Often a company is faced with a decision to take on special orders or “one off” orders which have different characteristics than on going orders.  Each order should therefore be evaluated based on costs relevant to the situation.

However it would be wrong simply to judge the special order on its quantitative merits along.  There are a number of side effects which should be carefully considered in conjunction with the above?

  • Will acceptance result in further orders from this customer and if I charge this price of RWF7 am I stuck to it?
  • What effect will this reduced price have on other customers. Will they demand price decreases or are they likely to turn elsewhere for their business?
  • By accepting the special order could I be losing out on other more profitable work elsewhere?
  • How long will this spare capacity last?

These are just a few of the problems created by this decision and these may very well in the end outweigh the financial advantages computed as per above.

 

  • Key Factor Decisions

Contribution Per Key Factors

Sometimes a decision has to be made on whether to produce one product or another.  This happens when a multi-product plant is operating at capacity and a decision has to be made as to which orders to accept i.e. the production capacity is the limiting factor.

The contribution approach supplies the data for a proper decision, because the decision is determined by the product that makes the largest total contribution to profit.  The objective is to maximise total profits which depend on getting the highest contribution margin per unit of the constraining factor.

Very often where labour is the constraining factor one is asked to indicate possible methods of providing the estimated missing productive capacity which would include the following:

  • Recruit and train additional personnel.
  • Resort to employing existing labour on an overtime basis. During the overtime periods, a premium would be paid which would have to be more than offset by the additional contribution.  Also to be considered is whether fixed costs and variable overhead will change as a result of the extended use of personnel and facilities.  In addition, the effect of the overtime on labour efficiency should be considered.
  • The production might be contracted out to another manufacturer. In this case the main factor would be the external contract price which would have to be included in the contribution analysis. (d) Install a second shift.

 

  • Addition/Discontinuance Of Products

The various reasons for adding or discontinuing products to a company’s range are usually to increase profits or reduce the losses.  Provided that no fixed investment is required then the incremental analysis should provide a solution.

Pricing

Pricing Decisions: Long Run And Short Run

Pricing a product is one of the most difficult areas for management decision.  There are basically two aspects of the problem: – (a) Long-run pricing policy and Short-run pricing policy.

 

Long-run pricing policy

The objective in the long run of a company is to maximise profit.  Basically this boils down to maximising the difference between: –

  • Total Revenue = units x price and
  • Total costs = (units x variable costs) + fixed costs.

In many firms today the pricing policy is quite often simply to add a margin to total cost giving a sales figure.  This COST PLUS PRICING can be seriously in error for it fails to take into account the effect of that decision on sales volume.  It may be possible to reduce prices and increase profits if the volume is sufficiently elastic in relation to price changes or it may not affect volume and therefore decrease profits.  Sufficient to stress that pricing policies should not be reviewed in isolation.

When comparing the effect on unit sales of varying prices what is critical is the contribution margin since fixed costs are unaffected by volume changes.  The aim of contribution pricing is to maximise contribution and therefore profits at the same time.

However, there are a number of dangers inherent in this approach: –

  • Fixed costs are only fixed within the RELEVANT RANGE OF ACTIVITY. Once outside this range then we must take account of the impact of the pricing decision on fixed costs.  (Example below illustrates this point in a short run context.)
  • In the long run all costs will vary.

These two dangers should lead to caution in using a rigid classification of costs.

  • By concentrating on contribution management could lose sight of the long term problem of covering fixed costs. This often happens when management allow a short run price which slightly exceeds marginal cost to become the long run price. (See (c) Special Orders above).

Short run pricing policy

In the short term a company can accept orders at a price above marginal cost but below normal full cost provided there is surplus capacity available in the factory and that it does not displace other more profitable work or affect the relationship that the company has with its present customers who may well ask for price reductions as well.  This type of marginal cost pricing is used in the public sector a great deal e.g. railway cheap fares in off-peak periods, electricity cheaper off peak usage etc.

The conclusion should not be reached that all variable costs are relevant and that all fixed costs are irrelevant.  This approach over-simplifies the problem as all costs become variable in the long run.

Certain costs may be variable but because of the nature of the decision to be made become irrelevant.  Furthermore fixed costs are often affected by a decision.  For example the decision to buy (or not to buy) a second car is usually influenced by the fixed costs that go with the second car.

If the length of time under consideration is long enough no cost is fixed.  Yet decisions often have to be made in conditions where the length of time is short enough for costs to be fixed.

Fixed costs should therefore, be considered when they are expected to be altered either immediately or in the future by the decision at hand.

MARKET VULNERABILITY ANALYSIS

Price Competition and Volume Shortfalls

A simple examination of a firm’s cost structure will show how vulnerable it is to market changes in the downward direction.

In particular a businessman with a high variable cost is vulnerable to price competition from competitors who have a low variable cost per unit.  They will still be generating a contribution at a price below his variable cost, so that he must sell each unit at a gross loss to compete.

However in conditions of low demand for the product where the price is maintained (i.e. where price reductions will not generate increased demand) the business with the low variable costs and high fixed costs will fare worse.  This is because volume shortfalls at a high contribution per unit have a greater impact on profit than at a low contribution per unit.  The business with the low variable cost will usually have high fixed costs with the result that volume shortfalls quickly give rise to losses.

CONTINUE/CLOSE DOWN DECISIONS

A similar decision to the addition/discontinuance of products is the decision whether to continue or close down a department/business.  Again the relevant costs in the decision are the AVOIDABLE COSTS.

DECISION MAKING INVOLVING A SINGLE LIMITING FACTOR

 “A limiting factor is any factor that is in scarce supply and that prevents the organisation from expanding its activities further, i.e. it limits the organisation’s activities”

 For many organisations, the limiting factor is sales because they simply cannot sell as many units as they would like. Therefore, their ability to expand is restricted or limited.

But other factors may also be limited (and this is especially the case in the short term). For example, machine capacity, raw materials or the supply of skilled labour may be limited for the period (or until some remedial action resolves the situation)

If an organisation is facing a situation involving a single limiting factor (i.e. where only one resource is in short supply), then it must ensure that a production plan is established that maximises the organisation’s profit using the available capacity of this resource.

Assuming that fixed costs remain constant, this is the same as saying that that the contribution must be maximised from the use of the scarce resource. The profit of an organisation in this situation will be maximised by maximising the contribution per unit of the limiting factor. This is the decision rule that must be followed.

 

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