CHAPTER 23
Analysis for Decision Making
reviewing the chapter
Objective 1: Explain how managers make short-run decisions.
1.Short-run decision analysis is the systematic examination of any decision whose effects will be felt over the course of the next year. To perform this type of analysis, managers need both quantitative and qualitative information. The information should be relevant, timely, and presented in a format that is easy to use in decision making.
2.Short-run decision analysis is an important part of the management process.
a.Analyzing short-run decisions in the planning stage involves discovering a problem or need, identifying alternative courses of action to solve the problem or meet the need, analyzing the effects of each alternative on business operations, and selecting the best alternative. Short-run decisions should support the company’s strategic plan and tactical objectives and take into consideration not only quantitative factors, such as projected costs and revenues, but also qualitative factors, such as the competition, economic conditions, social issues, product or service quality, and timeliness.
b.In the performing stage, managers make and implement many decisions that affect their organization’s profitability and liquidity in the short run. For example, they may decide to accept a special order, to change the sales mix, or to outsource a product or service. All these decisions affect operations in the current period.
c.When managers evaluate performance they analyze each decision to determine if it produced the desired results, and, if necessary, they identify and prescribe corrective action.
d.Throughout the year managers prepare reports related to short-run decisions. In addition to developing budgets and compiling analyses of data that support their decisions, they issue reports that communicate the effects their decisions had on the organization.
Objective 2: Define incremental analysis, and describe how it applies to short-run decision analysis.
3.Incremental analysis (also referred to as differential analysis) is a technique used in decision analysis that helps managers compare alternative courses of action by focusing on the differences in projected revenues and costs. Only data that differ among the alternatives are included in the analysis. A cost that differs among alternatives is called a differential (or incremental) cost.
4.The first step in incremental analysis is to eliminate irrelevant revenues and costs—that is, those that do not differ among the alternatives. Also eliminated are sunk costs. A sunk cost is a cost that was incurred because of a previous decision and cannot be recovered through the current decision. Once all irrelevant revenues and costs have been identified, the incremental analysis can be prepared using only projected revenues and expenses that differ for each alternative.
5.Incremental analysis simplifies the evaluation of a decision and reduces the time needed to choose the best course of action. However, it is only one input to the final decision. Managers also need to consider other issues, such as opportunity costs, which are the revenues forfeited or lost when one alternative is chosen over another.
Objective 3: Apply incremental analysis to outsourcing decisions, special order decisions, segment profitability decisions, sales mix decisions involving constrained resources, and sell or process-further decisions.
6.Outsourcing is the use of suppliers outside the organization to perform services or produce goods that could be performed or produced internally. Make-or-buy decisions, which are decisions about whether to make a part internally or to buy it from an external supplier, often lead to outsourcing.
a.To focus their resources on their core competencies (i.e., the activities they perform best), many companies outsource nonvalue-adding activities, especially those that involve relatively low levels of skill (such as payroll processing or storage and distribution) or highly specialized knowledge (such as information management).
b.Incremental analysis of the costs and revenues associated with outsourcing a product or service as opposed to performing it internally helps managers identify the best alternative.
7.Special order decisions are decisions about whether to accept or reject special orders at prices below the normal market price. A special order should be accepted only if it maximizes operating income. Like all short-run decisions, a special order decision should support the organization’s strategic plan and tactical objectives and be based on the relevant costs and revenues, as well as qualitative factors.
a.One approach to analyzing a special order decision is to compare its price with the costs of producing, packaging, and shipping the order to see if a profit can be generated. Another approach is to prepare a bid price by calculating the minimum selling price for the special order; the bid price equals the relevant costs plus an estimated profit.
b.Qualitative factors that can influence a special order decision are the special order’s impact on sales to regular customers, its potential to lead the company into new sales areas, and the customer’s ability to maintain an ongoing relationship that includes good ordering and paying practices.
8.The objective of analyzing a decision about segment profitability is to identify segments that have a negative segment margin. A segment margin is a segment’s sales revenue minus its direct costs (direct variable costs and direct fixed costs traceable to the segment). These direct costs are avoidable costs because if management decides to drop the segment, they will be eliminated. If a segment has a positive segment margin (i.e., if the segment’s revenue is greater than its direct costs), the segment should be kept. If a segment has a negative segment margin (i.e., if its revenue is less than its direct costs), it should be dropped. Certain common costs are unavoidable and are excluded from the calculation of the segment margin. An analysis of segment profitability includes the preparation of a segmented income statement using variable costing to identify variable and fixed costs.
9.Sales mix decisions arise when limited resources, such as machine time or labor, restrict the types or quantities of products a company can manufacture. The objective of a sales mix decision is to select the alternative that maximizes the contribution margin per constrained resource. Incremental analysis of a sales mix decision involves two steps:
a.Calculate the contribution margin per unit for each product line affected by the constrained resource. The contribution margin per unit equals the selling price per unit less the variable costs per unit.
b.Calculate the contribution margin per unit of the constrained resource. The contribution margin per unit of the constrained resource equals the contribution margin per unit divided by the quantity of the constrained resource required per unit.
10.A sell or process-further decision is a decision about whether to sell a joint product at the split-off point or to sell it after further processing. Joint products are two or more products, made from a common material or process, that cannot be identified as separate products during some or all of the production process. Only at a specific point, called the split-off point, do joint products become separate and identifiable. At that point, a company may decide to sell the product as is, or it may decide to process it into another form for sale to a different market. The objective of a sell or process-further decision is to select the alternative that maximizes operating income.
Objective 4: Identify the types of projected costs and revenues used to evaluate alternatives for capital investment.
11.Capital investment decisions are decisions about when and how much to spend on capital facilities and other long-term projects. Capital investment analysis (also called capital budgeting) is the process of identifying the need for a capital investment, analyzing courses of action to meet that need, preparing reports for managers, choosing the best alternative, and allocating funds among competing needs. Decisions about capital investments are among the most significant decisions that management must make. Personnel from all parts of an organization participate in this decision-making process.
12.Managers use a variety of measures to estimate the benefits to be derived from a proposed capital investment.
a.Net income and net cash inflows: Estimating the net income that a capital investment will produce is one way of measuring its benefits. A more widely used measure is projected cash flow. Net cash inflows are the balance of increases in projected cash receipts over increases in projected cash payments. They are used when the analysis involves cash receipts. When the analysis involves only cash outlays, cost savings are used as the measure.
b.Equal versus unequal cash flows: Projected cash flows may be the same for each year of an asset’s life, or they may vary from year to year. Unequal cash flows are common and must be analyzed for each year of the asset’s life.
c.Carrying value of assets: Carrying value (also referred to as book value)is the undepreciated portion of the original cost of a fixed asset. When analyzing a decision to replace an old asset, carrying value is irrelevant because it is a past, or historical, cost. However, net proceeds from the asset’s sale or disposal are relevant.
d.Depreciation expense and income taxes: Depreciation is a noncash expense requiring no cash outlay during the period. However, because depreciation expense is deductible when determining income taxes, it can result in significant savings. Thus, depreciation expense is relevant to evaluations based on after-tax cash flows.
e.Disposal or residual values: Proceeds from the sale of an old asset are current cash inflows and are relevant to evaluating a proposed capital investment. Projected disposal or residual values of replacement equipment are also relevant because they represent future cash inflows and usually differ among alternatives.
Objective 5: Apply the concept of the time value of money.
13.A key question in capital investment analysis is how to measure the return on a fixed asset. When the asset that is being considered has a long useful life, managers usually analyze the cash flows that it will generate in terms of the time value of money. The time value of money is the concept that cash flows of equal dollar amounts separated by an interval of time have different present values because of the effect of compound interest. The notions of interest, present value, future value, and ordinary annuity are all related to the time value of money.
14.Interest is the cost associated with the use of money for a specific period of time. Simple interest is the interest cost for one or more periods when the amount on which the interest is computed stays the same from period to period. Compound interest is the interest cost for two or more periods when the amount on which interest is computed changes in each period to include all interest paid in previous periods.
15.Future value is the amount an investment will be worth at a future date if invested today at compound interest. Present value is the amount that must be invested today at a given rate of compound interest to produce a given future value.
16.When you calculate the present value of equal amounts equally spaced over time, you are calculating the present value of an ordinary annuity. An ordinary annuity is a series of equal payments or receipts that will begin one time period from the current period.
Objective 6: Use the net present value method to analyze capital investment proposals.
17.A significant advantage of the net present value method is that it incorporates the time value of money into the analysis of proposed capital investments. Future cash inflows and outflows are discounted by the company’s minimum required rate of return to determine their present values. (The minimum rate of return should at least equal the company’s average cost of capital, which is the weighted-average rate of return a company must pay to its long-term creditors and shareholders for the use of their funds.) The present values are added together, and the amount of the initial investment is subtracted from the total. If the net present value is positive—that is, if the total of the discounted net cash inflows exceeds the initial cash investment—the rate of return on the investment will exceed the company’s minimum rate of return, and the project can be accepted. The project can also be accepted if the net present value is zero, since this also meets the minimum rate of return. If the net present value is negative, the project should be rejected.
Objective 7: Use the payback period method and the accounting rate-of-return method to analyze capital investment proposals.
18.The payback period method of evaluating a capital investment focuses on the minimum length of time needed to recover the initial investment. When two or more investment alternatives are being considered, the one with the shortest payback period should be selected. The payback period is computed as follows:
Payback Period / = / Cost of InvestmentAnnual Net Cash Inflows
The projected annual net cash inflows are found by determining the increase in cash revenue resulting from the investment and subtracting the cash expenses. The advantage of the payback period method is that it is easy to understand and apply. Its disadvantages are that it does not measure profitability; it ignores the time value of money; and by disregarding cash flows after the payback period is reached, it fails to consider long-term returns on the investment.
19.The accounting rate-of-return method focuses on the financial reporting effects of a capital investment rather than on the investment’s cash flows. It uses two variables to measure performance: estimated annual net income from the project and average cost of the investment. The basic equation is as follows:
Accounting Rate of Return / = / Project’s Average Annual Net IncomeAverage Investment Cost
Average investment in a proposed capital investment is calculated as follows:
If the rate of return is higher than the desired minimum rate, management should think seriously about making the investment. Like the payback period method, the accounting rate-of-return method is easy to apply and understand. Its disadvantages are that it averages net income over the life of the investment, it is unreliable if estimated annual income differs from year to year, it ignores cash flows, and it does not consider the time value of money.