Decision Making
February 8, 2017 | Author: Aashikkhan | Category: N/A
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DECISION MAKING
OVERVIEW Objective To identify relevant costs and appropriate techniques for decision-making and use them in various decision-making situations.
RELEVANT COSTS Definition Complications
SHORT RUN DECISIONS
DECISION MAKING
The decision-making cycle Information requirements Short run Long run
CVP ANALYSIS
INVESTMENT APPRAISAL
Contribution Breakeven chart P/V graph Calculations Assumptions Multi-product
Techniques ARR Payback NPV IRR Conclusion
Discontinuance Limiting factor Further processing Make or buy Accept or reject
In identifying decision-making as a major topic the Examiner has specifically referred to: relevant cost analysis limiting factors DCF allowing for uncertainty.
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DECISION MAKING
1
DECISION MAKING
1.1
The decision making cycle
Identify objectives
Identify alternative courses of action
Obtain information about alternatives Post Implementation review/audit Select one of the alternatives
Implement the decision
Compare actual results
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DECISION MAKING
1.2
Information requirements
Data requirements
Qualitative Effect on employees Opinions of customers Impact on local area eg pollution Political and economic factors eg possible change in tax rates Possible reaction of competitors
Quantitative
Monetary
Non-monetary
Costs Revenues
Resources required impact on market share
A decision should not be made without careful consideration of qualitative factors. 1.3
Short-run decision making
Short term decision making assumes that decisions previously made concerning fixed plant and equipment cannot be altered. Such decisions should therefore make best use of existing resources. Relevant costs must be considered. 1.4
Long-run decision making
In the long term new investment in plant and equipment may be considered. Looking further into the future requires consideration of the time value of money. Discounted cashflow techniques are therefore important for long-run decisions. 2
RELEVANT COSTS FOR DECISION MAKING
2.1
Definition
Relevant costs (and revenues) are those pertinent to a particular decision-making situation. They are: future avoidable incremental cash flows. They many also be opportunity costs.
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DECISION MAKING
Non-relevant costs include
sunk costs committed costs non-cashflows allocated apportioned absorbed recharged 2.2
Complications
2.2.1
Materials
Overheads
Materials needed for project
In stock
No alternative use
Use scrap value
Not in stock
Use current purchase price
Alternative use
Scarce
Use material cost plus lost contribution from alternative (opportunity cost)
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Not scarce
Use replacement cost
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DECISION MAKING
2.2.2
Labour
Labour needed for project
Already employed
No alternative work
Use current wage rate
Alternative work
Saved redundancy costs
No spare capacity
Spare capacity
Labour cost plus lost contribution
3
Hire new workers
Any incremental wages eg overtime premium
SHORT-RUN DECISIONS
Discontinuance (shutdown)
Limiting factor
Decisions
Further processing
Make or buy
Accept or reject an order
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DECISION MAKING
3.1
Discontinuance decisions
That is, whether to eliminate (shutdown) part of the business. 3.1.1
Decision criteria
Compare loss in revenue to savings in avoidable costs. 3.1.2
Qualitative factors
Adverse publicity regarding redundancies. Possible adverse reaction by investors – share price might fall. Effect on morale in remaining segments of the business. Lost synergy eg shared skills between divisions. Example 1
Decentro Ltd is a divisionalised company. Divisional results are as follows.
Sales Variable costs Specific fixed costs Apportioned head-office costs Profit/(loss)
Division X £ 50,000 (30,000) (12,000) (5,000) –––––– 3,000 ––––––
Division Y £ 30,000 (18,000) (10,000) (4,000) –––––– (2,000) ––––––
Division Z £ 40,000 (20,000) (10,000) (5,000) –––––– 5,000 ––––––
Required:
Determine whether or not Division Y should be closed. Solution Division Y £ Sales Variable costs –––––– Gross contribution Specific fixed costs –––––– Contribution towards head office costs –––––– It would appear that division Y should
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DECISION MAKING
3.2
Limiting factor decision
A factor other than sales limits the level of activity at which the company can operate. 3.2.1
Decision criteria
Maximise the contribution earned per unit of limiting factor. Example 2 A company produces two products with the following cost and revenue data per unit.
Selling price Variable cost Fixed cost Budgeted units
A £ 20 8 4
B £ 10 6 3
2,000
3,000
There are only 7,000 machine hours available to produce both A and B. A requires 4 hours per unit and B requires 1 hour per unit. Required:
Calculate the profit maximising product mix. Solution A £
B £
–—
–—
–—
–—
–—
–—
SP/unit Less VC/unit Contribution/unit Hours/unit Contribution/Unit of limiting factor Ranking Utilisation:
Hours available
Production plan
–—–—
–—–—
–—–—
–—–—
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DECISION MAKING
Example 3 Required:
As per Example 2 but we are able to sub-contract the products for an additional variable cost of £1 per unit for A and £0.50 per unit for B. Solution A £
B £
–—
–—
–—
–—
Contribution foregone/unit purchased (increase in VC/unit) Hours/unit Contribution forgone/unit of limiting factor Ranking for production Production and sales plan Hours available
Production and sales plan
–—–— –—–—
3.3
Further processing decision
Whether to sell at an intermediate point or to further process and sell at an enhanced value. 3.3.1
Decision criteria
We compare incremental revenues of further processing with the incremental costs of further processing.
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DECISION MAKING
Example 4
Selling prices C D E F G H
Conversion costs (variable) C → F £6/unit D → G £6/unit E → H £6/unit
: £5/unit : £7/unit : £8/unit : £10/unit : £14/unit : £22/unit
Conversion costs (fixed) £10,000
Refining operation F
C Input
Joint process
G
D
H
E Budgeted units/demand C/F D/G E/H
4,000 2,000 1,000
Required:
Determine which products should be further processed. Solution Incremental costs/revenues Revenue/unit Less VC/unit
C/F £
D/G £
E/H £
–—
–—–
–—
–—–—
–—–—
Total £
Contribution/unit –— Budgeted units –—–—
Total contribution Less Fixed cost –—–— Change in profit –––––– Conclusion:
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3.4
Make or buy decision
Whether to make a product in house or to purchase that product from an outside supplier. 3.4.1
Decision criteria
Compare the marginal cost of making with the purchase cost of buying in. Example 5 Product K is currently produced in house a £15/unit of which £6/kg is fixed. The cost of purchasing this product from a contractor is £10/unit. Required:
Determine whether the product should be made in-house. Solution Product K £ Marginal cost of making Marginal cost of buying in (purchase price) –—–— Decision –—–—
3.5
Accept or reject an order
3.5.1
Decision criteria
Are the relevant costs of the decision less or greater than the suggested revenue? An application of relevant cost analysis. Example 6 A material P in stock, which is used on the product to be produced is already used as a substitute for another material Q in common usage. Material Q can be purchased for £4.00/kg and conversion costs required to P are £2.00/kg. Alternatively P could be sold for scrap at £1.50/kg. Required:
Determine the relevant cost of the 3 kg of P required for the product.
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DECISION MAKING
Solution Decision Analysis
Revenue/unit £
Either sell for scrap Or substitute for material Q –—–— Choose to substitute as the next best alternative. Relevant cost of 3 kg of material P –—–—
Example 7 Skilled labour needed to fulfil the order would be specially recruited for £50,000. Unskilled labour would be transferred from another department where it is paid £30,000. Half is currently idle. The other half generates a contribution of £5,000. Required:
Calculate the relevant labour cost of the order. Solution £ Skilled labour Unskilled Idle workers – no incremental cost Working – labour cost + opportunity cost –––––– Relevant cost –––––– 4
COST VOLUME PROFIT ANALYSIS (CVP)
4.1
Contribution
£ X (X) (X) ––– X –––
Revenue Variable production costs Variable non-production costs Contribution
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DECISION MAKING
4.2
Breakeven charts
Breakeven point occurs where: Total contribution = Total fixed costs.
£
Total revenue
Total costs
Fixed costs
Units
Breakeven point OR
£
Total revenue
Total costs Total variable costs
Units
Breakeven point
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DECISION MAKING
4.3
Profit/volume graphs
Profit £
Total profit
+
0
Units or revenue
–
Breakeven point
Fixed costs
4.4
Calculations
Contribution per unit = Unit selling price – Unit variable costs Profit = (Sales volume × Contribution per unit) – Fixed costs Breakeven sales volume =
Fixed costs Contribution per unit
Margin of safety = Actual or budgeted sales – Breakeven sales Sales volume to achieve a target profit =
C/S ratio =
Contribution per unit Selling price per unit
Breakeven sales revenue = 4.5
Fixed costs + Target profit Contribution per unit
Fixed costs C/S ratio
Assumptions
All costs can be split into fixed and variable. Fixed costs are constant. Variable cost per unit is constant. Selling price per unit is constant. Stock levels are constant (ie sales = production). CVP analysis is therefore only useful within a limited range of activity.
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DECISION MAKING
4.6
Multi-product
4.6.1
Assumption CVP analysis can be extended to multi-product situations if a predetermined sales mix is held to be constant.
4.6.2
Calculation Calculate a weighted average contribution per unit to depict average revenues and average costs for the given sales mix. Use breakeven formulae as for single product analysis. Number of units calculated will be in total therefore split in mix ratio to state in terms of individual products.
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DECISION MAKING
5
INVESTMENT APPRAISAL
5.1
Techniques
The methods learnt in Paper 3 and Paper 8 are also examinable in Paper 9. Accounting rate of return (ARR) . Payback period Net present value (NPV) Internal rate of return (IRR) . 5.2
Accounting rate of return
Average annual net profit × 100 Initial investment OR
Average annual net profit × 100 Average investment
Where average investment =
5.2.1
Cost + scrap 2
Advantages
5.2.2
Disadvantages
Easily calculated.
Arbitrary target ARR.
Easily understood %.
Ignores time value of money.
Similar to ROCE used by analysts for company appraisal.
Profits are subjective. A % measure – does not show the absolute gain to shareholders.
Use of ARR will not lead to investment decisions which maximise shareholder wealth. 5.3
Payback period
The time it takes for the cash inflows from a project to equal the cash outflows.
5.3.1
Advantages
5.3.2
Easily calculated. Easily understood. Uses objective cashflows. Maximises liquidity. Favours low risk projects.
Disadvantages
Ignores cashflows after the payback period. Ignores time value of money. Ignores project profitability. Arbitrary target payback period.
Use of payback will not lead to maximisation of shareholder wealth.
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DECISION MAKING
5.4
NPV
The present value of cash inflows less the present value of cash outflows.
5.4.1
Advantages
5.4.2
Takes into account the time value of money.
Disadvantages
Difficult to calculate. Difficult to explain to nonaccountants.
Uses objective cashflows. An absolute measure of gain to shareholders.
NPV shows the increase in shareholder wealth from undertaking a project. Use of NPV will lead to maximisation of shareholder wealth. 5.5
IRR
The discount rate at which NPV = 0.
5.5.1
Advantages
5.5.2
Takes into account the time value of money. Uses objective cashflows. Easily understood %.
Disadvantages
Difficult to calculate. Some projects have multiple IRR’s. a % measure – does not show the absolute gain to shareholders. Not reliable where projects are mutually exclusive.
Use of IRR will not lead to investment decisions which maximise shareholder wealth. 5.6
Conclusion
NPV is the only reliable method of project appraisal. It is superior to ARR, payback and IRR. It is also superior to ROI and RI used by divisional managers for project appraisal.
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DECISION MAKING
FOCUS
You should now be able to discuss the decision making process and the information needed for decision making deal with various short-run decisions, identifying the relevant costs in each scenario use and discuss CVP analysis and investment appraisal methods .
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DECISION MAKING
EXAMPLE SOLUTIONS Solution 1 – Discontinuance
Division Y £ 30,000 (18,000) –––––– 12,000 (10,000) –––––– 2,000 ––––––
Sales Variable costs Gross contribution Specific fixed costs Contribution towards head office costs
It would appear that division Y should remain open as it makes a positive contribution towards head office costs. This assumes that total head office costs will remain the same if division Y closes ie they are unavoidable. Solution 2 – Limiting factor
SP/unit Less VC/unit Contribution/unit Hours/unit Contribution/Unit of limiting factor Ranking
Utilisation:
Hours available
A £
B £
20 8 –— 12 4 –— 3 –—
10 6 –— 4 1 –— 4 –—
2
1
Production plan
7,000 (3,000) @ 1 hr/unit –—–—
Product B 3,000 units –—–—
4,000 (4,000) @ 4 hrs/unit –—–—
Product A 1,000 units –—–—
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DECISION MAKING
Solution 3 – Purchase alternative
Contribution foregone/unit purchased (increase in VC/unit) Hours/unit Contribution forgone/unit of limiting factor Ranking for production
A £
B £
1.00 4 –— 0.25 –—
0.50 1 –— 0.50 –—
2
1
Production and sales plan
Hours available
Production and sales plan
7,000 (3,000) –—–— (4,000) –—–—
Product B produced = 3,000 units
@ 1 hr/unit @ 4 hrs/unit
Product A produced = 1,000 units Product A bought in (remainder) 1,000 units
Solution 4 – Further processing
Incremental costs/revenues Revenue/unit Less VC/unit Contribution/unit Budgeted units
C/F £
D/G £
E/H £
5 (6) –— (1) –— Do not further process
7 (6) –—– 1
14 (6) –— 8
2,000 –—–— 2,000
1,000 –—–— 8,000
Total contribution Less Fixed cost
Using quantitative data only the decision appears marginal.
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Total £
–—–— 10,000 (10,000) –—–— 0 ––––––
DECISION MAKING
Solution 5 – Make or buy
Product K £ Marginal cost of making (15 – 6) Marginal cost of buying in (purchase price)
9 10 –—–— Make –—–—
Decision Solution 6 – Relevant cost analysis
Decision Analysis
Revenue/unit £
Either sell for scrap Or substitute for material Q (4 – 2) =
1.50 2.00 –—–—
Choose to substitute as the next best alternative. Relevant cost of 3 kg of material P = 3 × 2 =
£6.00 –—–—
Solution 7 – Relevant labour cost
£ Skilled labour Unskilled Idle workers – no incremental cost Working – labour cost + opportunity cost (15,000 + 5,000) Relevant cost
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50,000 Nil 20,000 –––––– 70,000 ––––––
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