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Decision making
1. DECISION MAKING
DECISION MAKING IS A FUNDAMENTAL PART OF MANAGEMENT.
THE SUCCESS OF ANY ORGANIZATION IS LARGELY DEPENDENT ON MANAGERS
BEING ABLE TO IDENTIFY OPPORTUNITIES, WHICH MAY BE OF ADVANTAGE TO
BUSINESS, OR TO REORGANIZE PROBLEMS AND MAKE THE MOST APPROPRIATE
DECISION.
TYPES OF DECISION:
SHORT TERM DECISIONS.
LONG TERM DECISIONS
SHORT TERM DECISIONS:
DECISIONS THAT DO NOT USUALLY REQUIRE SIGNIFICANT INCREASE
OR DECREASE IN CAPACITY-RELATED RESOURCES, SUCH AS FACTORY
SPACE, EQUIPMENT.
INVOLVE PERIOD OF LESS THAN ONE YEAR( MANY OVERHEADS
CONSIDERED FIXED)
SHORT TERM DECISIONS CAN BE CHANGED QUICKLY TO TAKE
ADVANTAGE OF BETTER OPPORTUNITIES.
EXAMPLES ARE , ACCEPT OR REJECT A SPECIAL ORDER, SELL OR
PROCESS FURTHER, MAKE OR BUY, PRICING ETC
LONG-TERM DECISIONS:
TENDS TO BE MORE STRATEGIC IN NATURE AND INVOLVE LARGE
OUTLAYS OR DECREASE IN CAPACITY RELATED RESOURCES.
THE EFFECT OF THESE DECISIONS TENDS TO BE MORE DIFFICULT TO
REVERSE AND MAY EXTEND FOR LONGER TIME PERIODS.
THESE DECISIONS INVOLVE CONSIDERATION FOR TIME VALUE OF
MONEY, BECAUSE IMPACT OF DECISION SPAN TO SEVERAL YEARS.
IN REALITY MANY OF SO CALLED SHORT TERM DECISIONS HAVE LONGER IMPLICATIONS
FOR EXAMPLE THE DECISION TO REDUCE PRODUCTION OF A PRODUCT BECAUSE OF
LIMITED CAPACITY MIGHT RESULT IN LONG-TERM LOSS OF CUSTOMERS AND
CONSEQUENTLY THE DECREASE IN PROFITS.
2. “ALL DECISIONS INVOLVE A CHOICE BETWEEN TWO OR MORE ALTERNATIVES.”
RELEVANT COSTING IS AN APPROACH THAT FOCUSES MANAGERIAL ATTENTION ON
A DECISION’S RELEVANT FACTS, i.e IN MAKING CHOICE AMONG ALTERNATIVES
MANAGER NEEDS TO CONSIDER ALL RELEVANT COST AND REVENUES ASSOCIATED
WITH EACH ALTERNATIVE IN THE CONTEXT OF BOTH LONG AND SHORT TERM
DECISION MAKING.
MOSTLY RELEVANT COSTS ARE VARIABLE COST ( AS FOCUS IS ON SHORT TERM
DECISION MAKING ), FIXED COST NORMALLY APPEARED FIXED FOR SHORT SPAN OF
TIME.
MANY BUSINESS DECISIONS CAN BE APPROACHED BY COMPARING THE
ALTERNATIVES IN TERMS OF THEIR DIFFERENTIAL (INCREMENTAL) COST AND
REVENUES. THEY ARE CALLED DIFFERENTIAL IN THE SENSE BECAUSE THEY ARE
THOSE COST AND REVENUE ITEMS THAT DIFFER AMONG ALTERNATIVES
DIFFERENTIAL COST SOME TIMES ALSO CALLED RELEVANT COST.
OPPORTUNITY COST, WHICH IS ALSO A RELEVANT COST, IS DEFINED AS THE
POTENTIAL BENEFIT THAT IS GIVEN UP WHEN ONE ALTERNATIVE IS CHOSEN OVER
ANOTHER.
AVOIDABLE COST , ARE THOSE COSTS THAT WILL NOT BE INCURRED IN THE
FUTURE IF A PARTICULAR DECISION IS MADE OR COST THAT CAN BE AVOIDED IF A
COMPANY TAKES A PARTICULAR DECISION. OBVIOUSLY A RELEVANT COST
UNAVOIDABLE COST ARE COSTS THAT WILL CONTINUE TO BE INCURRED, NO
MATTER WHICH DECISION ALTERNATIVE IS CHOSEN, THEREFORE ARE
CONSIDERED IRRELEVANT FOR DECISION MAKING PURPOSE.
SUNK COST, ARE COST INCURRED COST ARE IRRELEVANT FOR PRESENT AND
FUTURE DECISION MAKING, THATS WHY CALLED SUNK COST, THEY ARE ALSO
CONSIDERED AS IRRELEVANT COST. IT IS MIS THOUGHT THAT ALL FIXED COSTS
ARE SUNK COST THAT IS IRRELEVANT BUT THERE ARE NUMBER OF FIXED COST
WHICH ARE SUNK BUT IRRELEVANT, NOT SUNK BUT STILL IRRELEVANT, NOT SUNK
BUT RELEVANT.
FOR EXAMPLE:
DEPRECIATION (S.L.M) ON EQUIPMENT ALREADY PURCHASED
PRESIDENT SALARY WHICH WILL NOT CHANGE FOR BOTH ALTERNATIVES A
AND B.
SALARY OF SUPERVISOR WHO WILL BE RETAINED IF ALTERNATIVE A IS
TAKEN AND FIRED IN CASE OF ALTERNATIVE -B
3. SHORT TERM DECISIONS:
1. MAKE OR BUY DECISION
2. ACCEPT OR REJECT SPECIAL ORDER
3. CLOSING DEPARTMENT OR PRODUCT LINE.
MAKE OR BUY.
IN MAKE OR BUY DECISION AN ORGANIZATION IS FACED WITH THE CHOICE OF
WHETHER TO PRODUCE GOODS AND SERVICES ITSELF OR PURCHASES THEM
EXTERNAL SUPPLIER.
EXAMPLE:
JAMES BLACK IS WALLABY AIRLINES MANAGER OF IN FLIGHT SERVICES. HE SUPERVISES
THE AIR LINE FLIGHT ATTENDANTS AND ALL FIRMS FOOD AND BEVERAGES OPERATIONS.
BLACK HAS RECEIVED A CALL FROM SYDNEY BAKERY, WHICH HAS OFFERED TO
PRODUCE THE AIRLINE’S DESSERTS, FOR RS 21PER DESSERT, WHICH IS CURRENTLY
BACKED AND PACKAGED IN THE FLIGHT KITCHEN. AT FOLLOWING COST
VARIABLE COST COST PER DESSERT
DIRECT MATERIAL (FOOD AND PACKAGING)................. ……………………. RS 6.0
DIRECT LABOR……………………………………………………………………... RS 4.0
ELECTRICITY……………………………………………………………………….. RS 4.0
RS 14.0
FIXED COST (ALLOCATED TO PRODUCTS)
SUPERVISORY SALARY (FOUR SUPERVISOR’S EQUAL SALARY)…… RS 40,000
DEPRECIATION (KITCHEN EQUIPMENT)…………………………………... RS 70,000
IF DESSERT IS PURCHASED OUTSIDE, THE COMPANY CAN SAVE ONE SUPERVISORY
SALARY (AS NUMBER OF SUPERVISOR DECREASES) , IN ADDITION TO ALL VARIABLE COST.
REQUIRED: ADVICE JAMES BLACK, WHETHER TO PRODUCE ITS OWN DESSERT OR BUY
DESERT OUTSIDE, KEEPING IN MIND THE FLIGHT KITCHEN ‘S AVERAGE MONTHLY
VOLUME IS 10,000 DESSERT.
4. EXAMPLE-02
CONSIDERING THE SAME EXAMPLE AS ABOVE , SUPPOSE BY CHOOSING TO BUY DESSERT
FROM THE BAKERY THE KITCHEN COLD USE THE FREED-UP CAPACITY TO PRODUCE
ADDITIONAL MAIN COURSES. THESE COULD BE SOLD TO ANOTHER AIRLINE FOR RS 90,000
PER MONTH, IT IS ALSO ESTIMATED THAT THE ADDITIONAL COST ASSOCIATED WITH
USING THE FREED-UP CAPACITY AMOUNTING RS 65,000.
REQUIRED: AGAIN ADVICE BLACK.
EXAMPLE-03
WENDY GRANT , MANAGER OF TENNESSEE PLANT MANUFACTURING COMPRESSOR
COMPANY IS CONSIDERING DILLARD COMPRESSOR CORPORATIONS, OFFERS TO SUPPLY
50,000 COMPRESSORS AT RS 310 PER UNIT. LAST YEAR PLANT PRODUCED 50,000
COMPRESSORS; THE COMPANY INCURRED THE FOLLOWING COSTS.
VARIABLE COST
DIRECT MATERIAL (100 PER UNIT) ……………………………… RS 5,000,000
DIRECT LABOR (120 PER UNIT)…………………………………… RS 6,000,000
VARIABLE OVERHEAD ( 80 PER UNIT)………………………….. RS 4,000,000
TOTAL VARIABLE COST…………………………………………… RS 15,000,000
FIXED COSTS
DEPRECIATION OF BUILDING…………………………………….. RS 600,000
DEPRECIATION OF EQUIPMENT…………………………………. RS 800,000
SUPERVISORY SALARIES………………………………………….. RS 500,000
OTHER …………………………………………………………………. RS 350,000
TOTAL FIXED COST……………………………………………….. RS 2,250,000
TOTAL COST……………………………………………………………. RS 17,250,000
REQUIRED:
1. ADVICE WENDY, WHETHER TO MANUFACTURE COMPRESSOR OR TO BUY IT FROM
DILLARD.
2. SUPPOSE TENNESSEE PLANT IS CURRENTLY SPENDING 500,000 PER YEAR TO RENT
SPACE FOR MANUFACTURING METAL SHELVING UNITS THAT ARE USED IN THE
REFRIGERATION UNITS, IF IT DISCONTINUES PRODUCTION OF COMPRESSORS, THE
COMPANY WILL MOVE THE SHELVING TO SPACE CURRENTLY OCCUPIED BY THE
COMPRESSOR OPERATION. WILL WENDY CONSIDER THIS AS RELEVANT COST, IF
YES WHAT WILL BE HIS DECISION, NOW .
5. ACCEPT OR REJECT SPECIAL ORDER:
IN SPECIAL ORDER DECISION, MANAGERS ARE FACED WITH DECIDING WHETHER
OR NOT TO SUPPLY A CUSTOMER WITH A SINGLE ONE-OFF ORDER FOR GOODS OR
SERVICES AT A SPECIAL PRICE.
THE INCREMENTAL COST ASSOCIATED WITH THE DECISION WILL OFTEN BE THE
DIRECT COST OF PRODUCING THE PRODUCT FOR THE SPECIAL ORDER
SOME TIMES COST OF SPECIAL EQUIPMENT OR OTHER ACTIVITIES RELATED TO
SPECIAL ORDER ARE ALSO INCLUDED.
EXAMPLE:
JIM WRIGHT WALLABY AIRLINES OPERATION MANAGER HAS BEEN APPROACHED BY A
JAPANESE TOURIST AGENCY WHICH HAS REQUESTED A ONE-OFF SPECIAL FLIGHT. THE
TOURIST AGENCY HAS OFFERED WALLABY AIRLINES RS 150,000 FOR A ROUND TRIP
FLIGHT BETWEEN JAPAN AND HAWAII. THE AIR LINE DOES NOT USUALLY FLY THIS
ROUTE. JIM RIGHT KNOWS THAT WALLABY AIR LINES HAVE A JUMBO JET IDLE AT THE
TIME THE AGENCY REQUIRES THE SPECIAL FLIGHT TO HELP MAKE THIS DECISION
WRIGHT ASK ACCOUNTANT TO PROVIDE COST ESTIMATES OF THE SAME DISTANCE AS
THE SPECIAL FLIGHT
VARIABLE COST OF FLIGHT RS 90,000
FIXED COST ALLOCATED TO FLIGHT: RS 100,000
THE VARIABLE COST COVER RESERVATIONS AND TICKETING COSTS, AIR CRAFT FUEL,
MAINTENANCE, FLIGHT CREW COST, FLIGHT MEAL ETC. THE FIXED COST INCLUDES
AIRCRAFT DEPRECIATION, MAINTENANCE AND DEPRECIATION OF FACILITIES AND
ADMINISTRATIVE COSTS.
REQUIRED:
1. ADVICE WRIGHT TO ACCEPT OR REJECT THIS OFFER, KEEPING IN MIND THE AIR
LINE CAN SAVE RS 5,000 PER FLIGHT IN RESPECT OF RESERVATION AND TICKETING
COST.
2. ASSUME THAT THERE IS NO IDLE CAPACITY, AND IN ORDER TO FLY THE CHARTER
BETWEEN JAPAN AND HAWAII , THE AIR LINE HAS TO CANCEL AN AVAILABLE
FLIGHT , WHICH IS CONTRIBUTING RS 80,000 TOWARDS COVERING THE AIR LINE
FIXED COST.
6. CLOSING DEPARTMENT OR PRODUCT LINE:
THE DECISION TO ELIMINATE A PRODUCT OR DEPARTMENT INVOLVES
CONSIDERING WHICH COSTS AND BENEFITS WILL DISAPPEAR IF DECISION IS
TAKEN.
UNDERSTANDING THE DIFFERENCE BETWEEN ALLOCATED FIXED COST AND DIRECT
FIXED COST IS VERY CRUCIAL.
LOSS OF CONTRIBUTION MARGIN OF THE DROPPED PRODUCT APPEARED AS
OPPORTUNITY COST.