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.
7.
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.
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:
Cost of Investment
Annual 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.
Payback Period
=
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:
Project’s Average Annual
Net Income
Average Investment Cost
Average investment in a proposed capital investment is calculated as follows:
Accounting Rate of Return
=
 Total Investment  Residual Value 
Average Investment Cost = 
 + Residual Value
2


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.