Managerial decision making involves choosing between alternative courses of action. Although the managerial decision-making process varies by the type of decision, it normally involves the following steps: o
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Step 1. Identify the objective of the decision, which is normally maximizing income. Step 2. Identify alternative courses of action. Step 3. Gather information and perform a differential analysis. Step 4. Make a decision. Step 5. Review, analyze, and assess the results of the decision.
Differential analysis, sometimes called incremental analysis, analyzes differential revenues and costs in order to determine the differential impact on income of two alternative courses of action. o
Differential revenue is the amount of increase or decrease in revenue
that is expected from a course of action compared to an alternative. Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared to an alternative. Differential income (loss) is the difference between the differential revenue and differential costs. Differential income indicates that a decision is expected to increase income. A differential loss indicates that a decision is expected to decrease income.
The differential analysis is prepared in three columns, where positive amounts indicate the effect is to increase income and negative amounts indicate the effect is to decrease income. o
The first column is the revenues, costs, and income for maintaining floor space for tables (Alternative 1). The second column is the revenues, costs, and income for using that floor space for a salad bar (Alternative 2). The third column is the difference between the revenue, costs, and income of one alternative over the other.
In this chapter, differential analysis is illustrated for the following common decisions: o o o
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Leasing or selling equipment Discontinuing an unprofitable segment Manufacturing or purchasing a needed part Replacing fixed assets Selling a product or processing further Accepting additional business at a special price
Management may lease or sell a piece of equipment that is no longer needed. In making a decision, differential analysis can be used. Only the differential revenues and differential costs associated with the lease-or-sell decision are included in the differential analysis. o
The book value of the equipment is a sunk cost and is not considered in the differential analysis. Sunk costs are costs that have been incurred in the past, cannot be recouped, and are not relevant to future decisions.
A product, department, branch, territory, or other segment of a business may be generating losses. As a result, management may consider discontinuing (eliminating) the product or segment. Discontinuing the product or segment usually eliminates all of the product’s or segment’s variable costs such as direct materials direct labor, variable factory overhead, and sales commissions. However, fixed costs such as depreciation, insurance, and property taxes may not be eliminated. o
Thus, it is possible for total company income to decrease rather than increase if the unprofitable product or segment is discontinued.
Companies that manufacture products made up of components that are assembled into a final product, such as automobile manufacturers, must decide whether to make a part or purchase it from a supplier. Differential analysis can be used to decide whether to make or buy a part.
The usefulness of a fixed asset may decrease before it is worn out as it may be less efficient. Differential analysis can be used for decisions to replace fixed assets such as equipment and machinery. o
The analysis normally focuses on the costs of continuing to use the old equipment versus replacing the equipment. The book value of the old equipment is a sunk cost and, thus, is irrelevant.
During manufacturing, a product normally progresses through various stages or processes. In some cases, a product can be sold at an intermediate stage of production, or it can be processed further and then sold. Differential analysis can be used to describe whether to sell a product at an intermediate stage or to process it further. o o
In doing so, the differential revenues and costs from further processing are compared. The costs of producing the intermediate product do not change, regardless of whether the intermediate product is sold or processed further.
A company may be offered the opportunity to sell its products at prices other than normal prices. o
For example, an exporter may offer to sell a company’s products overseas at special discount prices.
Differential analysis can be used to decide whether to accept business at a special price. o
The differential revenue from accepting the additional business is compared to the differential costs of producing and delivering the product to the customer.
If the company is operating at less than full capacity, then the additional production does not increase fixed manufacturing costs. – However, selling and administrative expenses may change because of the additional business.
Setting Normal Product Selling Prices (slide 1 of 3)
The normal selling price is the target selling price to be achieved in the long term. The normal selling price must be set high enough to cover all costs and expenses (fixed and variable) and provide a reasonable profit.
Setting Normal Product Selling Prices (slide 2 of 3)
Managers can use one of two market methods to determine selling price: o
Demand-based concept The demand-based concept sets the price according to the demand for the product. – If there is high demand for the product, then the price is set high. – Likewise, if there is low demand for the product, then the price is set low.
Competition-based concept The competition-based concept sets the price according to the price offered by competitors.
Step 1. Estimate the total product costs as follows:
Step 2. Estimate the total selling and administrative expenses. Step 3. Divide the total product cost by the number of units expected to be produced and sold to determine the total product cost per unit, computed as follows:
A production bottleneck (or constraint) is a point in the manufacturing process where the demand for the company’s product exceeds the ability to produce the product. The theory of constraints (TOC) is a manufacturing strategy that focuses on reducing the influence of bottlenecks on production processes. When a company has a production bottleneck in its production process, it should attempt to maximize its profits, subject to the production bottleneck. o
Activity-based costing (ABC) identifies and traces costs and expenses to activities and then to specific products. The ABC method is an alternative approach for allocating factory overhead when there are diverse products and processes. ABC uses multiple factory overhead rates based on activities. o o
The allocation of factory overhead affects the accuracy of product costs. In turn, product costs are used for decisions such as establishing product price and determining whether to discontinue a product line. Using an inappropriate factory overhead allocation method can lead to distorted product costs.
Under the total cost concept, manufacturing cost plus the selling and administrative expenses are included in the total cost per unit. The markup per unit is then computed and added to the total cost per unit to determine the normal selling price.