Module 5 - Decision Making - mba crash course

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MBAMBAMaster of Business Administration

Crash Course

An association of institutional, professionals, and OFWsRiyadh, Kingdom of Saudi Arabia

The National Organization of Certified Public AccountantsRiyadh Chapter, Kingdom of Saudi Arabia

“To reach our greatest potential, we must set our sights clearly and

embrace the unknown confidently”

WHATWHAT IS

DECISION MAKING?DECISION MAKING?

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DECISION MAKING

Process of identifying problems and opportunities

Sequence of steps which if

University of Leicester, 2603 Decision Making, 2002

p ppand then resolving them!

Sequence of steps which if followed should lead to the

best solution!R. Butler. Designing Organizations, pp.43/44, Routledge, 1991

WHAT IS AWHAT IS A DECISION?

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DECISION

A CHOICE made from available alternatives contributing to thealternatives contributing to the achievement of organization’s

objective.

NATURE OF DECISION

PURPOSEFULCONSTRAINED

WHAT ARE THEWHAT ARE THE TYPES OF

DECISIONS?DECISIONS?

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TYPES OF DECISIONS

PROGRAMMEDD i i th t d ti lDecisions that are made routinely or frequently

NON-PROGRAMMEDDecisions that are infrequentDecisions that are infrequent –strategic in nature

DECISION MAKINGDECISION MAKING MODELS?

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DECISION MAKING MODELS

RATIONAL

BOUNDED RATIONAL

EVOLUTIONARY

POLITICAL

GARBAGE CAN

RATIONAL MODEL

PROVIDES

ORGANIZATIONAL GOALS

PROBLEM IDENTIFICATION

PROVIDES CLEAR

STRUCTURE, LOGICAL STEPS TO

FOLLOW WHEN MAKING

ALTERNATIVE COURSES OF ACTION

EVALUATION OF ALTERNATIVES

CHOICE CRITERIA

A1 A2 A3 A4 A5

MAKING DECISION

CHOICE OF BEST

IMPLEMENT

MONITOR AND EVALUATE

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BOUNDED RATIONAL

BOUND RATIONALITY

LIMIT NUMBER OF OPTIONSLIMIT NUMBER OF OPTIONS

SATISFICING

CONSIDERS CONSTRAINTSTi C i- Time Constraints

- Cost of Acquiring Information- Ambiguity of Objectives- Conflict of Objectives-Stakeholders

EVOLUTIONARY

Revisiting and assessing different stages of rational model.

Decision evolve from a complex pattern of feedback loop.

R d i k f di l hReduces risk of radical change.

Logical incrementalism.

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POLITICAL

Considers stakeholders.

Organization is pluralistic rather thanOrganization is pluralistic rather than unitary.

Decision is an outcome of competition between different interestsinterests.

Power is decision making resource-short of supply.

GARBAGE CAN

Organization is a collection of problems and solutions.

Problems flow through the organization.

Solution exists within the organizationorganization.

In GARBAGE CAN SYSTEMS, decisions are often made by flight or oversight rather than by calculation!

- Levitt and Nass

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WHAT ARE THEWHAT ARE THE DRIVERS OF SUCCESS IN

DECISION MAKING?

DRIVERS OF SUCCESSLynley Sides of Sides and Associates

WHAT KIND OF ORGANIZATION STRATEGIC CONTEXT

LEADERSHIP

Best ExecutiveDon't make very many decisions. They concentrate on what's important and delegate the rest."

Best Executive

Best LeaderFocus on creating strategy, developing the "decision making system," and making only the critical decisions or resolving exceptions.

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LEADERSHIP

CONSEQUENCES OF SENIOR MAGERS TOO INVOLVED IN DECISION

delayed decisions

lost productivity

under-utilization of middle management resources

CONSEQUENCES OF SENIOR MAGERS TOO INVOLVED IN DECISION MAKING

employee frustration

inadequate leadership focus on their most critical responsibilities


EXPERIENCE LEARNINGWHAT KIND OF ORGANIZATION

STRATEGIC CONTEXT

LEADERSHIP

EXPERIENCE LEARNINGKnowing what

happenedKnowing why it happened

ROLES

PROCESS

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LEADERSHIP

ROLES

PROCESS TOOLS & TECHNOLOGY

MANAGEMENT AND CONTROLS

CHARACTERISTICSCHARACTERISTICS OF WELL MADE

DECISIONS

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CHARACTERISTICS

TIMELY CLEAR

EVALUATED APPROPRIATELY

UTILIZE LESSONS FROM PREVIOUS DECISIONS

GOOD LEADER VS. BAD LEADER

GOOD BAD

Oliver Mouto of Epicentric

LEADER

“KNOWS WHEN TO

LEADER

“PANICS ALL THE TIME”PANIC” TIME”

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DECISION MAKINGDECISION MAKING IMPROVEMENTS IN

GROWING COMPANIES

IMPROVEMENTS

Personal decision making process and style consciously rather than sub-consciously.

Good individual decision making skills are propagated through education and stated principles.

Before making improvements, conduct unbiased evaluation of decision making at all levels of management and across functionslevels of management and across functions.

As company grows larger, put in place processes, roles, technologies and control systems.

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STRATEGIC DECISION MAKING

WHAT IS STRATEGY?

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STRATEGY

Creation of unique and valuable proposition involving different set

Michael Porter, 1996

proposition involving different set of activities

Creating fit among company’s activitiesactivities.

Setting yourself apart from competition.

WHAT ARE THE LEVELS OF STRATEGY?STRATEGY?

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LEVELS OF STRATEGY

CORPORATE STRATEGY- Strategic Issues- “What Business are we in?

BUSINESS STRATEGY- How organization is going to competep

FUNCTIONAL STRATEGY- How do we support business level strategy?

STRATEGIC MANAGEMENT

PROCESSPROCESS

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STRATEGIC MANAGEMENT PROCESS

Scan External Environment-National-Global

Identify Strategic Factors-Opportunities-Threats Implement

Evaluate Current-Mission-Goals-Strategies

Global

Scan Internal

-Threats

Identify

Define New

-Mission-Goals-Strategies

Formulate Strategy-Corporate-Business-Functional

Implement Strategy via Change in:

-Leadership-Structure-HR-IT-Control Systems

SWOT

Environment-Core Competence-Synergy-Value Creation

Identify Strategic Factors-Strength-Weaknesses

y

SITUATION ANALYSIS

AND TOOLSAND TOOLS

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SITUATION ANALYSIS

Assessment of the strengthsAssessment of the strengths, weaknesses, opportunities, and

threats (SWOT) that affect organizational performance.

ASSESSMENT OF EXTERNAL ENVIRONMENT

PESTEL ANALYSIS

POLITICAL ECONOMIC

LEGAL SOCIALPESTEL

TECHNOLOGICAL

ENVIRONMENTAL

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ASSESSMENT OF EXTERNAL ENVIRONMENT

PORTER’S FIVE (5) FORCESPotential

New

Competitors’Rivalry

New Entrants

Threat of Substitute Products

Bargaining Power of Buyers

Bargaining Power of Suppliers

ASSESSMENT OF INTERNAL ENVIRONMENT

STRUCTURE

MCKINSEY 7S

FRAMEWORK

SHAREDVALUES

SYSTEMSSTRATEGY

SKILLS STYLE

STAFF

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ASSESSMENT OF INTERNAL ENVIRONMENT

VALUE CHAIN

FIRM INFRASTRUCTURE

HUMAN RESOURCE MANAGEMENT

TECHNOLOGY DEVELOPMENT

PROCUREMENT

InboundLogistics

Opera-tions

MarketingAnd

Sales

OutboundLogistics

ServiceSales

FORMULATINGFORMULATING CORPORATE

LEVEL STRATEGYS G

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• Specialize around limited strengths

• Seek ways to overcome weaknesses

• Withdraw if indications of sustained growth are

BUILD SELECTIVELY• Challenge for leadership

• Build selectively on strengths

• Reinforce Vulnerable

INVEST TO BUILD

GE/MCKINSEY GRID

SS

HIG

H

• Invest to grow at maximum digestible rate

• Concentrate effort on maintaining strength

PROTECT POSITION

sustained growth are lacking areas

• Look for ways to expand without high risk; otherwise minimize investment and rationalize operation

LIMITED EXPANSION OR HARVEST

ET A

TTR

AC

TIVE

NES

MED

IUM

• Protect existing program

• Concentrate investments in segments where profitability is good and risks are relatively low

SELECTIVITY/ MANAGE FOR

EARNINGS • Invest heavily in most attractive areas

• Build up ability to counter competition

• Emphasize profitability by raising productivity

BUILD SELECTIVELY

PROTECT/REFOCUSMANAGE FORDIVEST

MA

RK

E

BUSINESS STRENGTH

LOW

MEDIUM STRONGWEAK

• Manage for current earnings

• Concentrate on attractive segments

• Defined strengths

PROTECT/REFOCUS

• Protect position in most profitable segments

• Upgrade product line

• Minimize investment

MANAGE FOR EARNINGS

• Sell at time that will maximize cash value

• Cut fixed costs and avoid investments

DIVEST

BOSTON CONSULTING GROUP MATRIX

RELATIVE MARKET SHARE

LOWHIGH

QUESTION MARKSSTARS

T G

RO

WTH

RAT

E

HIG

H

QUESTION MARKS

CASH COW

STARS

DOGS

MA

RK

ET

LOW

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FORMULATINGFORMULATING BUSINESS LEVEL

STRATEGYS G

BUSINESS LEVEL STRATEGY

PORTER’S FIVE (5) FORCESPotential

New

Competitors’Rivalry

New Entrants

Threat of Substitute Products

Bargaining Power of Buyers

Bargaining Power of Suppliers

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COMPETITIVE STRATEGIES

COST LEADERSHIP

DIFFERENTIATION

FOCUS


PARTNERSHIP

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FORMULATINGFORMULATING FUNCTIONAL

LEVEL STRATEGYS G

FUNCTIONAL LEVEL STRATEGY

ACTION PLANS

IMPLEMENTATION

ACTION PLANS

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STRATEGYSTRATEGY IMPLEMENTATION

AND CONTROLCO O

STRATEGY IMPLEMENTATION & CONTROL

LEADERSHIP

Use PersuasionMotivate Employees

ENVIRONMENT

p yShape Culture/Values

STRUCTURAL DESIGNOrganization ChartCreate TeamsCentralization/ DecentralizationF iliti T k D i

HUMAN RESOURCESEmployee Recruitment & SelectionManage Transfers, promotion, trainingFirings/RecallsR

ATEG

Y

FOR

MA

NC

E

GA

NIZ

ATIO

N

Facilities, Task Design Firings/Recalls

INFORMATION & CONTROL SYSTEMS

Pay/Reward SystemBudget AllocationsIT SystemsProcedures

STR

PER

F

OR

G

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WHAT ISWHAT IS MANAGEMENT?

MANAGEMENT

a social process entailing WHAT KIND OF ORGANIZATION

p gresponsibility for the effective

economic planning and regulations of the enterprise in fulfillment of a given purposefulfillment of a given purpose

or objective.

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MANAGEMENT FUNCTIONS

PLANNING ORGANIZING

COORDI-NATING

CONTROL-LING

MOTIVATING

WHAT ISWHAT IS MANAGEMENT

CONTROL?CO O

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MANAGEMENT CONTROL

the process by which management ensures that the organization carries

WHAT KIND OF ORGANIZATION ensures that the organization carries

out its strategies.

Resources are obtained and used efficiently and effectively in the y yaccomplishment the company

objectives

GENERAL CONTROL MODEL

INPUT PROCESS OUTPUT

SIMPLE INPUT-OUTPUT PROCESS

FOUR ESSENTIAL CONDITIONS FOR A PROCESS TO BE CONTROLLED

Know what to achieve and set objectives.

Measure outputs and decide whether objectives are achievedMeasure outputs and decide whether objectives are achieved.

Predict effects of any action to alter or control the process.

Correct any deviation away from objectives.

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GENERAL CONTROL MODEL


COMPARATOR INTRODUCED

MEASURE OF OUTPUT

“If you cannot measure it,

how can you COMPA-how can you manage it”

OBJECTIVES

COMPARATOR

PREDICTIVE MODEL


MEASURE OF OUTPUT

PREDICTIVE MODEL OF THE

PROCESS

INFORMATION

COMPA-

OBJECTIVES

CORRECTIVE ACTION

COMPARATOR

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IMPLEMENTATION


MEASURE OF OUTPUT

PREDICTIVE MODEL OF THE

PROCESS

INFORMATION

COMPA-

IMPLEMENTATION OF ACTION

OBJECTIVES

CORRECTIVE ACTION

COMPARATOR

SINGLE-DOUBLE LOOPSET

THERMOSTAT TO 65OPLAN

RESET AT 70O

INCREASE

OPERATIONSET

THERMOSTAT AT 65O

FUEL SUPPLY TO EQUIPMENT

OUTPUT TEMP 65O

COMPARE-PLANMONITORING OUTPUT

INCREASE FUEL

CLO

SED LO

OPEN

LOO

VARIANCE - 3OOUTPUT

ACTIONACCEPT AT 65O

ALTER PLAN

OO

P

OP

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GENERAL APPLICATIONIDENTIFY OBJECTIVES

IDENTIFY COURSES OF ACTIONS

EVALUATE ALTERNATIVESEVALUATE ALTERNATIVES

SELECT ALTERNATIVES

COMPLETE LONG RANGE PLAN

IMPLEMENT LONG TERM PLAN-BUDGET

PLANNING

MONITOR : ACTUAL VS PLAN

VARIANCE ANALYSIS-INVESTIGATION CHANGE PLAN TO

MEET OBJECTIVESTAKE CORRECTIVE ACTION

CONTROL

MANAGEMENT CONTROL PROCESSES

M d Programming

INFORMALCOMMUNICATION

FORMALCOMMUNICATION

MemorandaMeetingsConversations

ProgrammingBudgetingReporting/Analysis

ACCOUNTING SYSTEM

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ACCOUNTING SYSTEMACCOUNTING

SYSTEM

FINANCIALACCOUNTING

MANAGEMENTACCOUNTING

Backward lookingSacrifice decision relevancy for objectivityGoverned by regulations

Decision & control relevanceFuture OrientatedDynamicNot subject to regulations

ROLE OF MGT ACCOUNTING

ANALYSIS OF PAST DECISION

PROVISION OF INFORMATION EXPLAINING CURRENT TRENDS

PROVISION OF INFORMATION FOR DECISION MAKING

PROVISION OF INFORMATION FOR PLANNING AND CONTROL

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MGT ACCOUNTING-FRAMEWORK

CONTROL OF OPERATION

DECISION MAKING

SYSTEMS

DATA CAPTURE SYSTEMS

CONTROLSYSTEMS

SHORT TERMDECISION MAKING

LONG TERMDECISION MAKING

BUDGETARYCONTROL

COSTCONTROL

BUDGETING

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BUDGET

A QUANTITATIVE STATEMENT, FOR DEFINED PERIOD OF

TIME, WHICH MAY INCLUDE PLANNED REVENUES, EXPENSES, ASSETS,

LIABILITIES AND CASHLIABILITIES AND CASH FLOWS.

PURPOSE OF BUDGET

TO COMPEL PLANNING – Action Plans for Long Range Plans.

TO COORDINATE ACTIVITIES

TO COMMUNICATE PLANS

TO MOTIVATE MANAGERS

TO CONTROL ACTIVITIES

TO EVALUATE PERFORMANCE OF MANAGERS

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STAGES IN BUDGETARY PROCESS

APPROVAL OF MASTER BUDGET

ON-GOING REVIEW

PREPARE INITIAL BUDGET

NEGOTIATION OF BUDGET

COORDINATE INITIAL BUDGET

ALTER/REMOVE INCONSISTENCIES

IDENTIFY KEY OBJECTIVES AND EXTERNAL CHANGES

DETERMINE KEY LIMITING FACTORS

PREPARE INITIAL SALES FORECASTS

PREPARE INITIAL BUDGET

BEHAVIORAL ISSUESBEHAVIORAL ISSUESIN

BUDGETING

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BEHAVIORAL ISSUES

TECHNICAL ISSUES OF BUDGETING ARE

Emannuel, Otley and Merchant

BUDGETING ARE STRAIGHTFORWARD WHEREAS BEHAVIORAL ISSUES ARE MUCH

MORE COMPLEX

BEHAVIORAL ISSUESMANAGEMENT USE OF BUDGETSMany managers considered budgetary information which they were provided was not very useful and frequently ignored –not very useful and frequently ignored –Dew and Gee (1973)

PARTICIPATIONParticipation in the budget-setting process improve the attitude of middle managers to the control process – Dew and Gee (1973)process Dew and Gee (1973)

BUDGET AS TARGETHighest level of performance is achieved by setting the most difficult specific goals as accepted by managers concerned – Hofstede (1968)

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BEHAVIORAL ISSUES

BUDGETS AS FORECASTSPeople introduce slacks in budget to achieve their targets easily –g yBroadbent and Cullen

USE OF BUDGET INUSE OF BUDGET IN PERFORMANCE EVALUATIONBudgetary control systems are often viewed very negatively

COSTINGCOSTING AND

BUDGETARY CONTROLCONTROL

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WHY MANAGERS NEED TO KNOW COSTS?

STOCK VALUATION

SET SELLING PRICE

ASSESS PROFITABILITY

S S SSET STANDARDS

DIAGNOSE INEFFICIENCIES

COSTING AND BUDGETARY CONTROL

TO COMMUNICATE EFFECTIVELY, MANAGERS (NOT JUST ACCOUNTANTS) MUST FULLY UNDERSTAND

THE DIFFERENCES BETWEEN VARIOUS TYPES

OF COSTS, THEIR COMPUTATION AND USAGE!

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COST CLASSIFICATIONCOST CAN BE CLASSIFIED IN RELATION TO:

PRODUCT/SERVICEPRODUCT/SERVICE

LEVEL OF OUTPUT

DECISIONS


PRODUCT/SERVICE

DIRECT COST(Prime Cost)

Direct Materials- Raw materials

INDIRECT COST(Overhead Cost)

Indirect Materials-Lubricating oil, maintenance materials

Direct Labor-Work associated to product

Direct Expenses-Expenses associated to product

Indirect Labor-Factory Supervisor salary

Indirect Expenses- Factory Rent, Plant Insurance

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LEVEL OF OUTPUT

FIXED COST – cost that remains constant regardless of activity levels: Example – Rent, Director’s salary

$COST

OUTPUT

COST FIXED


LEVEL OF OUTPUT

VARIABLE COST – cost that vary at differing activity: Example – Direct Labor and materials.

$COST

Variable

OUTPUT

COST

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LEVEL OF OUTPUT

SEMI VARIABLE COST – cost that contain both fixed and variable elements: Example – electricity charge.

$COST

Variable

OUTPUT

COST

Fixed


LEVEL OF OUTPUT

STEPPED COSTS – fixed over a range and then jump to another level: Example – supervision costs.

$COST

OUTPUT

COST

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AS CONSEQUENCE OF DECISION(RELEVANT COST)(RELEVANT COST)

Costs that are results of decisions

PROCEDURE TOPROCEDURE TO DETERMINE

PRODUCT COSTPRODUCT COST

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PROCEDURE TO DETERMINE PRODUCT COST

CLASSIFY AND CODE

ALLOCATE OR APPORTION OVERHEADS TO COST

CENTERS

APPROTION SERVICES DEPARTMENT COST TO

PRODUCTION DEPT

ABSORB OVERHEAD COSTS INTO PRODUCTS


CLASSIFY AND CODE

CLASSIFY AND CODERefers to categorizing costs such as labor materials or overhead

ALLOCATE OR APPORTION

OVERHEADS TO COST CENTERS

APPORTION SERVICES

DEPARTMENT COST

as labor, materials or overhead.

COST CENTER CODE COST CENTER DESCRIPTION

01 Raw Materials02 Cleaners03 Personnel Department04 Warehouse


DEPARTMENT COST TO PRODUCTION

DEPTEXPENSE CODE EXPENSE CATEGORY

001 Labor002 Salaries003 Fuel/Gas004 Supplies

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CLASSIFY AND CODE

ALLOCATE OVERHEADS TO COST CENTERS



APPORTION SERVICES

DEPARTMENT COST

Sharing costs between two or more cost centers

COST BASIS?????

Rent Floor Area

Wareho se Val e of iss es



DEPTWarehouse Value of issues

Maintenance Hours WorkedMachine Value

Safety Officer No. of Employees


CLASSIFY AND CODE

APPORTION SERVICES DEPARTMENT COST



APPORTION SERVICES

DEPARTMENT COST

Allocating Service Department costs to Production Centers

DEPT TOT. COST

Whse $1,000 $375 $625Maint $ 800 $711 $ 89

PROD1 PROD2



DEPT

Maint $ 800 $711 $ 89

Total $1,800 $1,086 $714

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CLASSIFY AND CODE

OVERHEAD ABSORPTION

Method of attaching overhead toALLOCATE OR

APPORTION OVERHEADS TO COST CENTERS

APPORTION SERVICES

DEPARTMENT COST

Method of attaching overhead to products/services using Overhead

Absorption Rates (OAR)

OAR = BUDGETED OVERHEADBUDGETED BASE



DEPT


CLASSIFY AND CODE

OVERHEAD ABSORPTIONEXAMPLE:Given Budgeted Overhead = $ 300,000



APPORTION SERVICES

DEPARTMENT COST

gExpected Output = 37,500 unitsLabor Hours/Unit = 2Actual Output = 40,000Actual Labor Hours = 39,000Actual Overhead = $310,000

OAR = BUDGETED OVERHEADBUDGETED BASE

300,0002*37,500

OAR $ 4 l b h



DEPTOAR = $ 4 per labor hour

Overhead Absorbed = Output* std content*OAR= 40,000 * 2 * 4= $ 320,000

Actual Overhead = $ 310,000

Over-Absorbed Overheads = $ 10,000

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CLASSIFY AND CODE

OVERHEAD ABSORPTIONFACTORS TO CONSIDER WHEN CHOOSING

OVERHEAD ABSORPTION RATES (OAR)



APPORTION SERVICES

DEPARTMENT COST

BASE - Reflect the workload characteristics of the department. It is preferable to use an OAR based on activity (e.g. labor hours) rather than one based on cost (e.g. wages paid).

ACTIVITY LEVEL - The level of activity used to set the base should be based on the normal



DEPTlevel of activity (not on a theoretical maximumcapacity).

DEPARTMENTAL RATES - It is preferable to use separate rates for each department.

COSTING METHODS

ABSORPTION COSTING

MARGINAL COSTING

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ABSORPTION COSTING

Fixed and variable costs are charged to the units

ADVANTAGES

Fixed costs are an inescapable – must be included in stock valuations.

"Total cost plus" pricing should ensure profit.

Stock Building Avoid a series of losses which willStock Building - Avoid a series of losses which will eventually be offset by profits when the goods are sold.

ADVANTAGES

MARGINAL COSTINGvariable costs are charged to cost units fixed costs attributable to the relevant period are written off in fall against the contribution

for that period

ADVANTAGESSimple to operate

No apportionment of fixed costs - subjective and time consuming exercise)

No under/over absorbed overheads.

Provides information relevant for short term decision making.

Fixed costs relate to time therefore it seems logical to write them off asFixed costs relate to time, therefore it seems logical to write them off as period costs.

Reflects cash flow more than absorption costing does

The cost to produce one extra unit is the marginal cost - realistic to value stock at this attributable cost.

Profit will vary with sales and is not distorted by changes in stock levels.

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ACTIVITY BASED MANAGEMENT

Focuses on the activities performed to provide the product/service improved value


provide the product/service improved value that is enjoyed by the customer and the profit

for the enterprise that created the value.

ABM will help companies to produce more efficiently, determine costs more accuratelyefficiently, determine costs more accurately and control and evaluate performance more

effectively

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Activity Based Costing (ABC) or ABM is a tool used to identify individual activities as fundamental cost objects.


j

Under ABC cost calculation is done for each individual activities & assign costs to objects like product/services on the basis of activities needed to produce product/services.

ABC focus on indirect costs (overheads), traces rather than allocates each expense category to particular cost object, makes indirect costs direct.

ADVANTAGES


Improves cost management & profitability by avoiding unwanted activitiesavoiding unwanted activities.

Helps in cost reduction & process improvement decisions in production activities.

Helps in product design decisions.

Provides support in planning & managing activities.

Helps in removing unwanted activities in production management.

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RESOURCESPeople, Materials,

Machines, Consumables, etc

How much resources an

activity requires?

RESOURCE COSTASSIGNMENT

RESOURCE DRIVERS

UNIT RESOURCE

ACTIVITIESProcesses: Selling,

Warehousing, Purchasing,

Assembly, etc

COSTOBJECTS

Products, Services, Customers, Market,

Channels, etc.

ACTIVITIES COSTASSIGNMENT

ACTIVITY DRIVERS

How much an object utilizes an

activity?

UNIT ACTIVITY

WHEN TO USE ABC?


When competition is stiffWhen competition is stiff.

When overheads are high

When product are diverse due to complexity, volume, & amount of labor.p y, ,

When cost of errors are high

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SHORT-TERM DECISION MAKING

TO ENSURE SURVIVAL OF THE ENTERPRISE

SHORT TERM DECISION MAKING

CONCERNED WITH LOOKING AT HOW ALTERNATIVE COURSES OF ACTION INFLUENCE THE FIRM’S

CASH FLOW

POWERFUL TOOL FOR SHORT TERM DECISION MAKING IS COST VOLUME PROFIT ANALYSIS (CVP)COST VOLUME PROFIT ANALYSIS

(CVP) IS ALSO KNOWN AS BREAK-EVEN ANALYSIS

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BUILDING A CVP MODEL


IMPACT OF VOLUME ON COSTSIMPACT OF VOLUME ON COSTS

IMPACT OF VOLUME ON PROFIT

CALCULATION OF BREAK-EVEN ON ENTERPRISE

CALCULATION OF VOLUME SALES TO ACHIEVE TARGET PROFIT


IMPACT OF VOLUME ON COSTSAs some costs are fixed, average cost per unit fall as

volume increases

Production 5,000 10,000 15,000

Variable Cost ($1per unit) 5,000 10,000 15,000

Fixed Cost 9,000 9,000 9,000

Total Cost 14,000 19,000 24,000

Cost Per Unit 2.80 1.90 1.60

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IMPACT OF VOLUME ON PROFIT

Production 5,000 10,000 15,000

Revenue ($ 2 per Unit) 10,000 20,000 30,000

LESS

Variable Cost ($1 per Unit) (5,000) (10,000) (15,000)

Fi d C t (9 000) (9 000) (9 000)Fixed Cost (9,000) (9,000) (9,000)

Cost Per Unit (4,000) 1,000 6,000


BREAK-EVEN POINT

BREAK-EVEN (IN UNITS) = TOTAL FIXED COSTS

CONTRIBUTION = SALES PRICE – VARIABLE COSTS

BREAK EVEN (IN UNITS) CONTRIBUTION PER UNIT

BREAK-EVEN (SALES) = TOTAL FIXED COSTS x SALES PRICE/UNITCONTRIBUTION PER UNITCONTRIBUTION PER UNIT

BREAK-EVEN + PROFIT = TOTAL FIXED COSTS + PROFITCONTRIBUTION PER UNIT

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MARGIN OF SAFETY RATIO

INDICATES BY HOW MUCH SALES MAY FALL BEFORE AN ENTERPRISE WILL SUFFER LOSS

% MARGIN OF SAFETY = EXPECTED SALES – BREAK EVEN SALESEXPECTED SALES

x 100%

BEFORE AN ENTERPRISE WILL SUFFER LOSS

% MARGIN OF SAFETY = 15,000 – 9,00015 000

x 100% = 40%15,000

THE SMALLER THE MARGIN OF SAFETY, THE GREATER IS THE RISK THAT THE ENTERPRISE’S

LEVEL OF ACTIVITY MAY FALL BELOW THE BREAK-EVEN POINT

DELETEDELETE OR

CONTINUE?

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DELETE OR CONTINUE?

SALES

A B C TOTAL

170 000 100 000 150 000 420 000

ABSORPTION COSTING BASIS

SALES 170,000 100,000 150,000 420,000

DIRECT MATERIALS 30,000 25,000 35,000 90,000

DIRECT LABOR 20,000 25,000 24,000 69,000

VARIABLE OVERHEAD 40,000 30,000 20,000 90,000

APPROTIONED FIXED OVERHEAD 30,000 35,000 34,000 99,000

TOTAL FACTORY COSTS 120 000 115 000 113 000 348 000TOTAL FACTORY COSTS 120,000 115,000 113,000 348,000

GROSS PROFIT 50,000 (15,000) 37,000 72,000

LESS : SELLING ADMINISTRATIVE EXPENSES 40,000

GROSS PROFIT 32,000

DELETE OR CONTINUE?MARGINAL COSTING APPROACH

SALES

A B C TOTAL

170 000 100 000 150 000 420 000SALES 170,000 100,000 150,000 420,000

DIRECT MATERIALS 30,000 25,000 35,000 90,000

DIRECT LABOR 20,000 25,000 24,000 69,000

VARIABLE FACTORY OVERHEAD 40,000 30,000 20,000 90,000

VARIABLE SELLING & ADM 2,000 1,000 1,500 4,500

TOTAL FACTORY COSTS 92,000 81,000 80,500 253,500

CONTRIBUTION 78 000 19 000 69 500 166 500CONTRIBUTION 78,000 19,000 69,500 166,500

LESS : FIXED FACTORY OVERHEAD 99,000

LESS : SELLING ADMINISTRATIVE EXPENSES 35,500

NET PROFIT 32,000

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MAKEMAKE OR

BUY?

MAKE OR BUY?

EXTERNAL SUPPLIER OFFER = $800

Direct labor = 200Direct materials = 400Direct materials = 400Variable Overhead = 100Fixed Overhead = 300TOTAL COST =1,000

If fixed costs are unavoidable, and therefore not relevant, the appropriate comparison is as follows:

Direct labor = 200Direct materials = 400Variable Overhead = 100TOTAL COST = 700

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QUALITATIVEQUALITATIVE CONSIDERATIONS

QUALITATIVE CONSIDERATIONSCOMPETITORS

CUSTOMERS

LABOR – MORALE, TRAINING, AVIALBAILITY

LEGAL CONSTRAINTS

ENVIRONMENTENVIRONMENT

MANAGEMENT CONTROL

LEARNING CURVE

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LONG -TERM DECISION MAKING

LONG TERM INVESTMENT

EXPANSIONAdding to fixed assets to achieve greater level of service

MODERNIZATIONLevel of service is the same but cost of service is reduced

CHANGE OF METHOD USEDStimulated by change in cost of providing serviceStimulated by change in cost of providing service

REPLACEMENTCheaper to replace equipment than to repair

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FINANCIALFINANCIAL METHODS OF INVESTMENT APPRAISAL

INVESTMENT APPRAISAL

PAYBACK

DISCOUNTEDPAYBACK

INTERNALRATE OF RETURN CAPITAL

INVESTMENTAPPRAISAL

ACCOUNTINGRATE OFRETURN

NETPRESENT

VALUE

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PAYBACKMEASURES THE NUMBER OF YEARS TO

RECOVER THE ORIGINAL INVESTMENT FROM NET CASH FLOW RESULTING FROM A PROJECT

PROJECT A PROJECT BINVESTMENT 1,000 1,000

Cash Cumm Cash CummYear 1 200 200Year 2 250 450 100 100Year 3 150 600 150 250Year 4 150 750 150 400

Project A Payback 6 Years

Project B Payback Year 5 150 900 150 550Year 6 100 1,000 200 750Year 7 100 150 900Year 8 100 1,000Year 9 100Year 10 100

j y8 Years

PAYBACK

ADVANTAGES DISADVANTAGES

Calculation is simple Ignores receipts at

Cash Flow at risk –shortest possible time

Quickest Restoration f li idit iti

g pend of payback period.

No account is taken of the time value of money.

of liquidity position.

Acknowledge that uncertainty increases with time.

Expected overall profitability is not considered.

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DISCOUNTED PAYBACK

Money received today is worth more than the money received next year due to the following

factors:

Opportunity to invest

Obtain a return

DISCOUNTED PAYBACK

ExampleMoney received now : Year 0 = 100If i t d t 10%If invested at 10%At end of year 1 : 100 = 110At end of year 2 : 100 = 121

To convert the cash flow at end of each year in today’s value

At end of year 1 : 100/110 = 0.909At end of year 2 : 100/121 = 0.826

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DISCOUNTED PAYBACKExample: ABC Company investigated the possibility of investing in a new project and the following has been obtained:

TOTAL COST OF PROJECT 500,000TOTAL COST OF PROJECT 500,000

EXPECTED NET CASH FLOW

Year 1 20,000

Year 2 50,000

Year 3 100,000

Year 4 200,000Year 4 200,000

Year 5 300,000

Year 6 30,000 700,000

NET RETURN 200,000

DISCOUNTED PAYBACKExample: Assuming a rate of interest of 8%, calculate the project’s overall return using the following methods:

PAYBACK DISCOUNTED PAYBACK

Year Net Cash Flow

Cumm. Net

Cash Flow

Discount Factors

Present Value at

8%

Cumm. Net

Cash Flow

0 (500,000) (500,000) 1.0000 (500,000) (500,000)

1 20,000 (480,000) 0.9259 18,518 (481,482)

2 50,000 (430,000) 0.8573 42,865 (438,617)( ) ( )

3 100,000 (330,000) 0.7938 79,380 (359,237)

4 200,000 (130,000) 0.7350 147,000 (212,237)

5 300,000 170,000 0.6860 205,800 (6,437)

6 30,000 200,000 0.6302 18,906 12,469

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DISCOUNTED PAYBACK


Easy to understand Difficult to estimate the amount of timing of

Not too difficult to compute

Focuses on cash recovery of an investment.

amount of timing of installment of original investment.

Difficult to estimate the amount and timing of future net cash receipts and other payments.

Cash received now maybe worth more than the cash received in the future.

Takes into account more of net cash flow

Not easy to determine an appropriate rate of interest.

Net cash flow received after payback period are ignored.

ACCOUNTING RATE OF RETURN

Compares the profit generated by the project with the original cost of investmentwith the original cost of investment

Considers Profit Flows rather than Cash Flows

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A.R.R. = Average Annual ReturnAverage Capital Invested

X 100Average Capital Invested

Average Annual Return = Total Expected ProfitProjects Life

Average Capital Invested = Value of working capital + half the cost of

investment in fixed assets


PROJECT AINVESTMENT 450

Cash Depr Profit 54Cash Depr ProfitYear 1 100 90 10Year 2 200 90 110Year 3 100 90 10Year 4 100 90 10Year 5 220 90 130TOTAL 450 270

A.R.R = 54225 X 100%

A.R.R = 24%

Average 225 54

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Compatible with similar Net profit can be subject to different definition.

accounting ratio used in financial accounting.

Relatively easy to understand

Not difficult to compute

Not always clear whether original cost of investment to be used.

Use of residual value, the higher the residual value, the lower the ARR.

Draws attention to the notion of overall profit.

Method does not give what is acceptable rate of return.

Does not take into account the time value of money

NET PRESENT VALUE (NPV)

The Cash Received today is preferable to cash receivable in the

futurefuture

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Example: MBA3 Company is considering two capital investment project. The company expects a rate of return of 10% per annum. Details are as follows:

PROJECT 1 2

ESTIMATED LIFE 3 YEARS 5 YEARS

PROJECT COST 100,000 100,000

ESTIMATED CASH FLOW

Year 1 20,000 10,000

Year 2 80 000 40 000Year 2 80,000 40,000

Year 3 40,000 40,000

Year 4 40,000

Year 5 20,000


PROJECT APPRAISAL

PROJECTPROJECT 1 PROJECT 2

Net Cash Flow

Discount Factor 10%

Present Value

Net Cash Flow

Discount Factor 10%

Present Value

Year 1 20,000 0.9091 18,182 10,000 0.9091 9,091

Year 2 80,000 0.8264 66,112 40,000 0.8264 33,056

Year 3 40,000 0.7513 30,052 40,000 0.7513 30,052

Year 4 40,000 0.6830 27,320

Year 5 20,000 0.6209 12,418TOTAL PRESENT VALUE 114,346 111,937LESS: INITIAL COST 100,000 100,000NET PRESENT VALUE 14,346 11,937

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NET PRESENT VALUE

THREE RULES

If NPV = 0; You would be indifferent to the investment

If NPV = Negative; Project fails to generate sufficient funds to cover the cost of capital

If NPV = Positive; Project generates a return greater than the cost of capital and should be considered.

NET PRESENT VALUE


Using cash flow Difficulties in estimating the initial cost of the project and

emphasize liquidity

Different accounting policies are not relevant

Time value of money is taken into account

p jtime periods in which installment can be paid back.

Difficult to estimate accurately the net cash flow

Not easy to select i t t f i t tEasy to compare the NPV

of different projects, to reject projects that do not have acceptable NPV

appropriate rate of interest.

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INTERNAL RATE OF RETURN

An alternative method of investment appraisal based ppon discounted net cash flow

It answers the question:What rate of return would beWhat rate of return would be required to ensure that the total NPV equals total initial

cost?


Example: ABC Company is considering to invest 50,000 in a new project. The project’s net cash flow is as follows:

Year 1 = 7,000Year 2 = 25,000Year 3 = 30,000Year 4 = 5 000Year 4 = 5,000

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PROJECT NET CASH FLOW

AT 10% AT 15%

Discount Factor 10%

Present Value

Discount Factor 15%

Present Value

Year 1 7,000 0.9091 6,364 0.8696 6,087

Year 2 25 000 0 8264 20 660 0 7561 18 903Year 2 25,000 0.8264 20,660 0.7561 18,903

Year 3 30,000 0.7513 22,539 0.6575 19,725

Year 4 5,000 0.6830 3,415 0.5718 2,859TOTAL PRESENT VALUE 52,978 47,574LESS: INITIAL COST 50,000 50,000NET PRESENT VALUE 2,978 (2,426)

Safest Discounting Factor:gIRR = Positive Rate + {Positive NPV/(Positive NPV+Negative NPV)}*Range of rates

IRR = 10% + {2,978/(2978+2426)}*(15% - 10%)

IRR = 12.76%

Note: negative sign of Negative NPV is ignored



Care has to be taken in Sometime not easy to understand.

estimating the initial cost of the project.

Emphasis is placed on liquidity

Attention is given to the timing of net cash flows

Difficult to determine which of the two suitable rates to adopt unless computer is used.

Gives only approximate rate of return.timing of net cash flows

Appropriate rate of return does not have to be calculated.

Clear % of ROI

In complex situations, it can give misleading results.

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WHATWHAT TOOL

TO USE?

NOTES

Firms often use a combination of methods.

P b k i d t j t thPayback is used to screen projects, then NPV or IRR is used for a more rigorous appraisal.

ARR is the least popular primary appraisal methodmethod.

Al methods are heavily reliant on the quantity and quality of data.

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PRICING

PRICING

SETTING PRICE TOO HIGH

SETTING PRICE TOO LOW

Lost CustomersFall in Market ShareLow revenues – unable to cover cost

Price WarUnable to cover total costCustomer’s perception of quality

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PRICING ISSUESIneffective pricing often results from these key issues:

Lack of Pricing Strategy

Many firms know their customers' wants and needs, but no solid understanding of customers' price sensitivity.

Are customers willing to pay more, or would any price increase drive them to the competition?

Intelligent c stomer segmentation b price sensiti it isIntelligent customer segmentation by price sensitivity is often underutilized,

Understanding the goal - to maximize revenues, margins or sales (AND other factors to effective pricing strategy.

PRICING ISSUESIneffective pricing often results from these key issues:

Lack of Scenario Planning“WHAT IF” scenario planning is performed in an ad hoc manner, or not at all; consequence is either paralysis, or reactive/panic decision-making.

Pricing decisions are often made by a single individual in a

Lack of Pricing ProcessPricing decisions are often made by a single individual in a firm, or by an understaffed and overworked pricing group. Pricing can be performed quite well if these individuals are armed with exceptional intuition and knowledge.

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PRICING

Corporate Objectives

MAJOR FACTORS TO CONSIDER WHEN DEVELOPING PRICING STRATEGY

Corporate Objectives- ROI, Profit, Payback Period

Marketing Objectives

Degree of risk

Response of competitors

Corporate image

Cost/Volume relationship

PRICING

1% improvement in price translated to an

2006 Gartner Research report

1% improvement in price translated to an 11% increase in profitability.

By contrast,

1% improvement in fixed costs or in variable % p o e e t ed costs o a ab ecosts only increases profitability by 3% and 7%, respectively.

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PRICING

COST PLUS PRICINGAdding a mark-up to the product’s cost in order

to arrive at a selling priceto arrive at a selling price

BUT WHICH COST SHOULD BE USED?

Full Cost

Marginal Cost

Minimum/Relevant Cost

PRICING

ECONOMIST PRICING MODELLower Selling Price generates

Larger Volume of SalesLarger Volume of Sales

A

PRICEB

Demand Curve

Profit is maximized where Marginal Revenue = Marginal Cost

DEMAND

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PRICING

ECONOMIST PRICING MODELProblems with Economist Model

I d d i kIt assumes demand curve is known

Total cost and marginal cost can be derived after analysis, judgment and arbitrary allocation

Demand is not only influenced by priceDemand is not only influenced by price

Not all firms are profit maximizers

PRICING

PRICING NEW PRODUCTS/SERVICESSKIMMING

setting high price to earn super profit.sett g g p ce to ea supe p o t

Buyers are price insensitive

Substitute are not available

High price acts as sign of quality

There are barriers to entry

Cost of smaller volume are not disproportionate

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PRICING

PRICING NEW PRODUCTS/SERVICESPENETRATION

setting low price to attract high volume salessetting low price to attract high volume sales

Buyers are price sensitive

Substitute are available

Low price is deterrent to new entrantsLow price is deterrent to new entrants

Cost reductions can be effected through volume.

PRICING

PRICING OBJECTIVESCurrent profit maximization

Current revenue maximization – increase market share.

Maximize quantity – Units sold

Maximize profit margin

Quality Leadership

Partial Cost recovery

Survival

Status Quo – price stabilization to avoid price wars

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PRICING

JOBBER AND HOOLEY STUDY

Pricing ObjectivesStage of Market Evolution

Pricing ObjectivesEmerging Growth Mature Decline

Profit Maximization 41.3 40.9 38.8 41.8

Market Share Attainment 11.9 16.8 17.7 15.2

Maximize current sales revenue 13.0 5.7 9.4 12.4

Ensure adequate cash flow 17.4 8.7 5.6 9.8q

Target profit Attainment 16.3 27.8 28.4 20.7

PRICING


P i i Obj ti

BY SIZE OF FIRM

Pricing Objectives Below 2.5 M 2.5 to 20 Above 20

Profit Maximization 45.3 44.9 39.2

Market Share Attainment 13.0 16.0 22.3

Maximize current sales revenue 9.7 11.1 8.6

Ensure adequate cash flow 13.9 6.3 5.5

Target profit Attainment 22.3 27.0 32.7

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PRICING


4045 40.2%

2025303540

16.6%

26.0%

05

1015

Ensure AdequateCash Flow

8.0%

Maximize CurrentRevenue

9.1%

Market ShareAttainment

TargetProfitAttainment

ProfitMaximization

PRICING

THE NEED FOR BETTER PRICING

Increasingly complex markets and business model Globalization of businessmodel – Globalization of business organization and product proliferation

Increased sophistication of purchasers.

Proliferation of pricing entities and competitive alternatives – Technological

d d i i i h ladvances drives increase in channels.

Increase in quantity of enterprise data – Use of ERP, Supply Chain Management, etc.

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CASE STUDY

Module 5 - Decision Making - mba crash course

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