MANAGERIAL DECISION MAKING

INTRODUCTION
Decision-making is an integral part of modern management. Essentially, Rational or sound decision making is taken as primary function of management. Every manager takes hundreds and hundreds of decisions subconsciously or consciously making it as the key component in the role of a manager.

Decisions play important roles as they determine both organizational and managerial activities. A decision can be defined as a course of action purposely chosen from a set of alternatives to achieve organizational or managerial objectives or goals. Decision making process is continuous and indispensable component of managing any organization or business activities. Decisions are made to sustain the activities of all business activities and organizational functioning.

Decisions are made at every level of management to ensure organizational or business goals are achieved. Further, the decisions make up one of core functional values that every organization adopts and implements to ensure optimum growth and drivability in terms of services and or products offered

MANAGERIAL DECISION MAKING

COST INVOLVED IN DECISON MAKING

OPPORTUNITY COST Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone. It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. The opportunity cost is also the "cost" (as a lost benefit) of the forgone products after making a choice. Opportunity cost is a key concept in
economics, and has been described as expressing "the basic relationship

between scarcity and choice". The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[3] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.

SUNK COSTS sunk costs are retrospective (past) costs that have already been incurred and
cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken. Both retrospective and prospective costs may be either fixed (continuous for as long as the business is in operation and unaffected by output volume) or variable (dependent on volume) costs. Note, however, that many economists consider it a mistake to classify sunk costs as "fixed" or "variable." For example, if a firm sinks $1 million on an enterprise software installation, that cost is "sunk" because it was a one-time expense and cannot be recovered once spent.

MANAGERIAL DECISION MAKING

IMPUTED COST 1. In accounting, the expense of unreimbursed goods and services provided by one entity to another entity. 2. An expense that is borne indirectly. For example, paying cash for a car avoids the direct cost of interest payments to a lender, but it entails the imputed cost of lost income from having funds invested in the car rather than a more productive asset. Cost that is implied but not reflected in the financial reports of the firm; also called implicit cost. Imputed costs consist of the opportunity costs of time and capital that the manager has invested in producing the given quantity of production and the opportunity costs of making a particular choice among the alternatives being considered. Imputed cost, also referred to as opportunity cost, is a concept based on an economic theory, which basically states that to obtain anything one must give up something in return. For example, to get a full-time four year college education, one may need to forgo the opportunity of working full time and earning $20,000 US Dollars (USD) per year in that period. The $20,000 USD is the imputed cost. Among other concepts, the imputed cost concept is essential when computing economic profit. This is derived by taking the net accounting profit or loss and deducting the imputed cost.

MANAGERIAL DECISION MAKING

RELEVANT COST A relevant cost (also called avoidable cost or differential cost) is a cost that differs between alternatives being considered. It is often important for businesses to distinguish between relevant and irrelevant costs when analyzing alternatives because erroneously considering irrelevant costs can lead to unsound business decisions. Also, ignoring irrelevant data in analysis can save time and effort. Noncash items, such as depreciation and amortization, are frequently categorized as irrelevant costs, since they do not impact cash flows. Two common types of irrelevant costs are sunk costs and future costs that do not differ between alternatives. Sunk costs are unavoidable because they have already been incurred. Future costs that do not change between alternatives are also essentially unavoidable with respect to the alternatives being considered.

AVOIDABLE COST Definition of Avoidable Cost: A cost that can be avoided by not producing a particular good. For example, if you are building cars, an avoidable costs would be the raw materials. If you stopped producing a car, you would no longer have to pay for the raw materials such as steel and aluminum. However, other costs of a firm maybe unavoidable, at least in the short term. For example, the firm still has the fixed costs such as rent and paying some safety workers.

MANAGERIAL DECISION MAKING

CONTROLLABLE AND UNCONTROLLABLE COST

Controllable Cost are the costs which can be influenced by the action of a specified member of the undertaking. They are incurred in a particular responsibility centers can be influenced by the action of the executive heading that responsibility centre. For example: Direct labor cost, direct material cost, direct expenses controllable by the shop level management. These are the costs which can be influenced by the action of a specified member of an undertaking. A business organization is usually divided into number of responsibility centers and an executive heads each such centre. Controllable costs incurred in a particular responsibility centre can be influenced by the action of the executive heading that responsibility centre. For example, Direct costs comprising direct labor, direct material, direct expenses and some of the overheads are generally controllable by the shop level management.

Uncontrollable Cost are the costs which cannot be influenced by the action of a specified member of the undertaking. For example: a foreman in charge of a tool room can only control costs pertaining to the same department and the matters which come directly under his control, not the costs apportioned to other department. The expenditure which is controllable by an individual may be uncontrollable by another individual. Costs which cannot be influenced by the action of a specified member of an undertaking are known as uncontrollable costs. For example, expenditure incurred by, say, the Tool Room is controllable by the foreman in charge of that section but the share of the tool-room expenditure which is apportioned to a machine shop is not to be controlled by the machine shop foreman

MANAGERIAL DECISION MAKING

REPLACEMENT COST
The cost to replace the assets of a company or a property of the same or equal value. The replacement cost asset of a company could be a building, stocks, accounts receivable or liens. This cost can change depending on changes in market value. Also referred to as the price that will have to be paid to replace an existing asset with a similar asset. The amount it would cost to replace an asset at current prices. If the cost of replacing an asset in its current physical condition is lower than the cost of replacing the asset so as to obtain the level of services enjoyed when the asset was bought, then the asset is in poor condition and the firm would probably not want to replace it.

NORMAL AND ABNORMAL COST

Normal cost refers to the cost, at a given level of output in the conditions in which that level of output is normally attained. Abnormal cost is a cost which is not normally incurred at a given level of output in the conditions in which that level of output is normally attained. Normal Cost are the normal or regular costs which are incurred in the normal conditions during the normal operations of the organization. Example: repairs, maintenance, salaries paid to employees. Abnormal Cost are the costs which are unusual or irregular which are not incurred due to abnormal situation s of the operations or productions. Example: destruction due to fire, shut down of machinery, lock outs, etc.

MANAGERIAL DECISION MAKING

MARGINAL COSTING
In economics and finance, marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good. If the good being produced is infinitely divisible, so the size of a marginal cost will change with volume, as a non-linear and nonproportional cost function includes the following:

variable terms dependent to volume, constant terms independent to volume and occurring with the respective lot size, jump fix cost increase or decrease dependent to steps of volume increase

Definition of 'Marginal Cost of Production'

1.Change in total cost that comes from making or producing one additional item. The purpose of analyzing marginal cost is to determine at what point an

organization can achieve economies of scale. The calculation is most often used among manufacturers as a means of isolating an optimum production level.

2.The increase or decrease in a firm's total cost of production as a changing production by one unit

result of

MANAGERIAL DECISION MAKING

FEATURES OF MARGINAL COSTING:

It is a method of recoding costs and reporting profits. It involves ascertaining marginal costs which is the difference of fixed cost and variable cost. The operating costs are differentiated into fixed costs and Variable costs. Semi variable costs are also divided in the Individual components of fixed cost and variable cost. Fixed costs which remain constant regardless of the volume of production do not find place in the product cost determination and inventory valuation. Fixed costs are treated as period charge and are written off to the profit and loss account in the period incurred. Only variable costs are taken into consideration while Computing the product cost. Prices of products are based on variable cost only. Marginal contribution decides the profitability of the Products.

MANAGERIAL DECISION MAKING

ADVANTAGES OF MARGINAL COSTING 1.Decision regarding pricing:Any price change has an immediate effect on PVR, BEP and margin of safety. It is generally said that the effect of a price reduction is always to reduce the P/V ratio, to raise the break- even point, and to shorten the margin of safety.

Pricing decision may be based on mainly 3 considerations:

Percentage of profit on total cost: in this method, the market condition and competitiveness will not be taken care of.

Percentage of profit on selling cost: the profit on sale suffers the limitations of market conditions ,competitiveness and difficulty of price fixation in case of multiple products.

Return on investment. Of all, this is considered to be the best method because the investment takes care of all the aspects of net fixed assets and net working capital employed for earning the profit.

MANAGERIAL DECISION MAKING

2. Decision regarding optimum product mix: Marginal costing helps the management in deciding the most profitable productmix.the product-mix which yields the maximum possible profits is the optimum product mix.

3.Decision regarding special offer/discontinue product: This decision is mainly concerned in adding or discontinuing marginal unit. The management has to decide whether to Increase or decrease in the production of a unit Add or continue or discontinue a product Accept or reject a specific order Add, continue or discontinue a specific department.

Thus by analyzing the marginal costs, management can decide whether to increase or decrease the production of the article and so on.

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MANAGERIAL DECISION MAKING

DIFFERENTIAL COSTING
Differential cost is the difference between the cost of two alternative decisions, or of a change in output levels. The concept is used to reach decisions about which alternatives to pursue, and which to drop. The concept can be particularly useful in step costing situations, where producing one additional unit of output may require a substantial additional cost A differential cost can be a variable cost, a fixed cost, or a mix of the two there is no differentiation between these types of costs, since the emphasis is on the gross difference between the costs of the alternatives or change in output. Since a differential cost is only used for management decision making, there is no accounting entry for it. Differential cost is a business term that refers to the difference in costs for a business when choosing between two alternatives. It is an important tool in the decision-making process for businesses looking to make possible changes to a business model. Closely associated with marginal, a term favoured by economists, it can refer to either fixed or variable costs. The relevance of these costs is obvious when judged alongside of differential revenue to give businesses a perspective on the positives or negatives of a decision.

Definition
Differential cost is the aggregate of change in fixed cost and variable cost which takes place due to the adoption of alternative course of action or change in the volume of output

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MANAGERIAL DECISION MAKING

CHARACTERISTICS OF DIFFERENTIAL COSTING

In order to ascertain the differential costs, only total cost is Needed and not cost per unit.

Existing level is taken to be the base for comparison with some Future or forecasted level. Differential cost is the economists concept of marginal cost.

It may be referred to as incremental cost when the difference in Cost is due to increase in the level of production and detrimental costs when difference in cost is due to decrease in the level of production.

It does not form part of the accounting records, but may be Incorporated in budgets.

Cost analysis because it can be worked out on the method of absorption costing or standing costing.

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MANAGERIAL DECISION MAKING

Uses of Differential Costing in policy decisions like:

1. The introduction of a new plant. 2. Make or buy decisions. 3. Lease or buy decisions. 4. Discontinuing a product, suspending or closing down a Segment of the business. 5. The profitability of a change in product mix. 6. Acceptance of an offer at a lower selling price. 7. Change in the methods of production. 8. The determination of the most profitable levels of production and price. 9. Submitting tenders. 10. The determination of price at which raw materials can be Purchased. 11. Equipment replacement decisions. 12. The profitability or otherwise of further processing. 13. The opening of a new sales area or territory.

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MANAGERIAL DECISION MAKING

DIFFERENCES BETWEEN MARGINAL AND DIFFERENTIAL COST Differential Cost Analysis Marginal Costing Analysis

It is a costing technique used for decision-making purpose with the use of differential revenue and differential cost The differential costing can be applied in varied alternative proposals hence the scope is wider. The differential costing uses the accounting information and it can only be part of accounting system. The main analytical tools used in differential costing are, incremental/ decremented cost, incremental revenue and incremental/ detrimental profit The differential costing can be used for short-term, medium-term and long-term decision-making

It is a technique used in ascertaining the marginal cost and effect on changes in profit due to changes in volume The scope of marginal costing is comparatively lesser.

The marginal costing system can be included into accounting system

In marginal costing, the main analytical tools are, P/V ratio, Breakeven point, contribution, CVP analysis etc

The marginal costing is mainly used for short-term and medium-term decision-making

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MANAGERIAL DECISION MAKING

ILLUSTRATION 1. PRICING
EVALUATE ALTERNATIVE RESPONSES TO PRICE CHANGES The accounts of a company are expected to reveal a profit of Rs.14,00,000 after charging fixed costs of Rs.10,00,000 for the year ended 31 st march, 2004. The selling price of the product is Rs.50 per unit and variable cost per unit is Rs. 20. Market investigations suggest the following responses to the price changes: Alternative I II III Selling price reduced by 5% 7% 10% Quantity sold increases by 10% 20% 25%

Evaluate these alternatives and state which of the alternatives on profitability, consideration, should be adopted for the forthcoming year. SOLUTION Statement for evaluating three alternatives on profitability consideration Particulars alternatives I II III Rs. Rs. Rs. A. Selling price per unit (WN 1) 47.50 46.50 45.00 B. Less : Variable cost per unit 20.00 20.00 20.00

C. D.

Contribution per unit (A-B) Revised quantity of units to be sold (WN 4)

27.50 88,000

26.50 96,000

25.00 1,00,000

E.

Total contribution (C*D)

24,20,000

25,44,000

25,00.000

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MANAGERIAL DECISION MAKING

Recommendation: An alternative of the above 3 alternatives on profitability consideration clearly shows that alternative II is the best as it gives maximum contribution and hence profitability; therefore this alternative should be adopted. Working notes 1) Selling price per unit I : Rs.50-5% of 50 = Rs.47.50 II : Rs.50-7% of 50 = Rs.46.50 III : Rs.50-10% of 50 = Rs.45.00 2) Contribution per unit Contribution=selling price per unit-variable cost per unit =Rs.50-20 =Rs.30 3) Expected quality of units to be sold: Profit Add: fixed cost Total contribution 14, 00,000 10, 00,000 24,00,000

Quantity of units sold = total contribution/contribution per unit =24, 00,000/30 =80,000 units 4) Revised quantity of units sold: Alternative I II III Units to be sold 80,000 units + 10% of 80,000 units 80,000 units + 20% of 80,000 units 80,000 units + 25% of 80,000 units Units 88,000 96,000 1,00,000

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MANAGERIAL DECISION MAKING

2. KEY FACTOR
From the following data, which product would you recommend to be manufactured in a factory, time being the key factor.(time) Per unit of product direct material direct labor(Rs 1 per hr) Variable overhead( Rs 2 per hr) Selling price Standard time to produce A 24 2 4 100 2 hrs B 14 13 6 110 3 hrs

SOLUTION: CONTRIBUTION ANALYSIS Particulars Sales Less: variable costs Direct material Direct labour Variable overheads Contribution Standard time Contribution per standard hour Ranking: Product A is better 24 2 4 30 70 2 hrs 70/2 =35 14 13 6 33 77 3 hrs 77/3 =25.67

A 100

B 110

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MANAGERIAL DECISION MAKING

3. PRODUCT MIX
2 PRODUCTS, 3 MIXES From the following data you are required to present. 1) The marginal cost of product X and Y and the contribution per unit . 2) The total contribution and profits resulting from each of the suggested sales mixtures. Particulars Direct materials Direct materials Direct wages Direct wages Product X Y X Y Per unit Rs. 10.50 8.50 3.00 2.00

Variable expenses 100% of direct wages per product. Fixed expenses (total) Rs. 800 Sales price X Rs.20.50 Y Rs.14.50 Suggested sales mixes Alternatives X A B C 100 150 200 No. of units Y 200 150 100

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MANAGERIAL DECISION MAKING

SOLUTION 1) Marginal cost and contribution Particulars Direct materials Direct wages Variable expenses (100% of direct wages) Marginal cost per unit Selling price per unit Less : marginal cost Contribution per unit 16.50 20.50 16.50 4.00 12.50 14.50 12.50 2.00 Product X 10.50 3.00 3.00 Product Y 8.50 2.00 2.00

2) Contribution & profits of sales mix Sales Mix (A) Particulars Contribution from 100 units of product X @ Rs.4 Contribution from 200 units of product Y @ Rs.2 Total contribution Less : fixed expenses Profit Rs. 400 400 800 800 nil

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MANAGERIAL DECISION MAKING

Sales mix (B) Particulars Contribution from 150 units of product X @ Rs.4 Contribution from 150 units of product Y @ Rs.2 Total contribution Less : fixed expenses Profit Rs. 600 300 900 800 100

Sales Mix (C) Particulars Contribution from 200 units of product X @ Rs.4 Contribution from 100 units of product Y @ Rs.2 Total contribution Less : fixed expenses Profit Rs. 800 200 1000 800 200

3) Advice Mix C should be adopted because it gives the maximum contribution and profit.

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MANAGERIAL DECISION MAKING

4. OPTIMUM LEVEL
OPTIMUM CAPACITY LEVEL Jay and Vijay company is at present operating at 60% capacity producing at the rate of 10000 units a month- a single product sells for 9.00 a unit. for the year 2003 the results have been as follows: Particulars Sales: 120000 units at 9 per unit Cost of sales: Direct material Direct labor Variable overheads Fixed manufacturing overheads Gross profit Selling expenses Fixed Variable Administrative expenses Fixed Profit Rs Rs 1080000 180000 360000 90000 135000

765000 315000

50000 36000

22000

108000 207000

Although the company is operating at a net high profit at a plant capacity of 60%, it is a fact that if the price unit could be reduced by 20%, the value of the sales would increase to 180000units per year with an increase in the fixed manufacturing overheads of 9000 per year. If sales price could be reduced by 331/2 the volume of sale should increase to full capacity (2000000)units with increase in expenses at 60% levels as follows; manufacturing overheads 11000 fixed selling expenses 2000 fixed administrative expenses 6000 you are required to

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MANAGERIAL DECISION MAKING

1. prepare a comparative statement showing net income under the three alternative profit volume relationships and 2. compute the break even sales point in each SOLUTION: statement of net income Particulars Per Rs unit
Sales 9 7.20 6 Less: variable cost Direct material Direct labor Variable o/h Variable selling Contribution Less; fixed expenses Selling Manufacturing Admin. expen. Profit/loss 1050000 1296000 1200000

120000 Rs units

180000 Rs units

20000 units

1.50 2 0.75 0.35

180000 360000 90000 36000

666000 414000

270000 540000 135000 54000

999000 297000

300000 600000 150000 60000

1110000 90000

50000 135000 22000

207000 207000

50000 144000 22000

216000 81000

25000 146000 28000

226000 136000

Therefore the present activity at 60 % capacity (of 20000) units is better, as it gives maximum profit of 207000 break even sales = fixed cost x sales contribution for 120000 units = 207000x 1080000 =540000 414000 for 180000 units = 216000 x 1296000 = 942545 297000 for 200000 units = 226000 x 1200000 = 3013333 90000

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MANAGERIAL DECISION MAKING

5. COST CONTROL
MECHANIZATION & LABOR INCENTIVES The present output details of a manufacturing department are as follows; Average output per week Sales value of output = 48000 units from 160 employees = 600000

Contribution made by output toward fixed expenses and profit = 240000

The board of directors plan to introduce more mechanization into the department at a capital cost of 160000. The effect of this will be to reduce the number of employees to 120, and increasing the output per individual employee by 60% . To provide the necessary incentive to achieve the increased output, he board intends to offer a 1 5 increase on the piece of work rate of 1 per unit for every 2 5 increase in average individual output achieved.

To sell the increased output, it will be necessary to decrease the selling price by 4 %.Calculate the extra weekly contribution resulting from the proposed change and evaluate for the boards information, the desirability of introducing the change.

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MANAGERIAL DECISION MAKING

SOLUTION: Statement of extra weekly contribution

Expected sales unit 57600 Particulars Sales value: (57600 x 12) Marginal costs (excluding wages) (57600 x 6.50) Wages: (57600 x 1.30) Total marginal cost: Marginal contribution Less: present contribution Increase in contribution (per week) 374400 74880 449280 241920 241920 240000 1920 691200

Evaluation since the mechanization has resulted in the increase of contribution to the extent of 1920 per week, therefore the proposed change should be accepted.

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MANAGERIAL DECISION MAKING

6. DISCONTINUE PRODUCT
DISCONTINUE A pen manufacturer makes an average net profit of Rs. 25.00 per pen on a selling price of Rs. 143.00 by producing and selling 60,000 pens, or 60% of the potential capacity. His cost of sales is : RS. Direct materials Direct wages Works overhead (50% fixed) Sales overhead (25% veriable) 35.00 15.50 62.50 8.00

During the current year he intends to produce the same number of pens but anticipates that his fixed charges will go up by 10%while rates of direct labour and direct material will be increase by 8% and 6% respectively. But he has no option of increasing the sales price. Under this situation, he obtains an offer for a further 20% of his capacity. What minimum will you recommend for acceptance to ensure the manufacturer an overall profit of Rs. 16,73,000.

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MANAGERIAL DECISION MAKING

Solution:
Particulars 60,000 units Amtrs. Per pen rs. Direct materials Direct wages Prime cost Works overhead Fixed Variable Works cost Selling overhead Fixed Variable Cost of sales profit Total sales 3,60,000 1,20,000 6.00 2.00 3,96,000 1,60,000 91,66,500 16,73,000 4.95 2.00 114.58 20.91 18,75,000 31.25 18,75,000 31.25 66,00,000 110.00 20,62,500 25,00,000 86,10,500 25.78 31.25 107.63 21,00,000 35.00 7,50,000 12.50 29,68,000 10,80,000 40,48,000 80,000 units Amtrs. Per pen rs. 37.10 13.50 50.60

28,50,000 47.50

70,80,000 118.00 15,00,000 25.00 85,80,000 143.00

1,08,39,500 135.49

Minimum price recommended will be Rs. 135.49 per pen.

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MANAGERIAL DECISION MAKING

7. SPECIAL ORDER
Export order The cost sheet of a product is as follows Particulars Direct material Direct wages Factory overheads Fixed Variable Administrative expenses Selling and distribution expenses Fixed Variable Cost of sales Per unit 10 5 01 02

00.50 01 21

The selling per unit is 25. The above cost information is for an output of 50000 units, whereas the capacity of the firm is 60000 units. A foreign customer is desirous of buying 10000 units at a price of 19 per unit. The extra cost of exporting the product is 0.50 per unit. You are required to advice the manufacturer whether the order should be accepted?

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MANAGERIAL DECISION MAKING

SOLUTION: Particulars 50000 units Rs Sales (50000x25) (10000x19) Total sales Variable costs Direct material Direct wages Cost of exports Factory overheads Selling and distribution Total variable cost Contribution Fixed costs Factory overhead Administration Selling and distribution Total fixed costs Profit 50000 75000 25000 150000 200000 1 1.5 0.5 3 4 50000 75000 25000 150000 205000 0.83 1.25 0.42 2.50 3.42 100000 50000 900000 350000 2 1 18 7 500000 250000 10 5 600000 300000 5000 120000 60000 10 5 0.08 2 1 1250000 25 1250000 Per unit 60000 units Rs 1250000 190000 1440000 24 Per unit

1085000 18.08 355000 592

If the export order is accepted, profit increases from 200000 to 205000 i.e. By 5000 and therefore it should be accepted by the manufacturer.

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CONCLUSION
Decisions play important roles as they determine both organizational and managerial activities. A decision can be defined as a course of action purposely chosen from a set of alternatives to achieve organizational or managerial objectives or goals. Decision making process is continuous and indispensable component of managing any organization or business activities. Decisions are made to sustain the activities of all business activities and organizational functioning.

Decisions are made at every level of management to ensure organizational or business goals are achieved. Further, the decisions make up one of core functional values that every organization adopts and implements to ensure optimum growth and drivability in terms of services and or products offered

The nature of the decision-making process within an organization is influenced by its culture and structure, and a number of theoretical models have been developed. Decision theory can be used to assist in the process of decision making. Specific techniques used in decision making include heuristics and decision trees. Computer systems designed to assist managerial decision making are known as decision support systems

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BIBLIOGRAPHY
http://aboutfinancialmatters.blogspot.in http://www.careerride.com http://www.managementstudyguide.com www.accountingcoach.com http://www.referenceforbusiness.com

BOOKS REFERRED Advanced Cost Accounting- Varsha Ainapure

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