Management's Decision-Making Process and Incremental Analysis

Chapter 7: Management's Decision-Making Process and Incremental Analysis

• Incremental Analysis: Focuses on analyzing the differences between alternatives that impact a company’s profitability.
• Steps in Management’s Decision-Making Process:
  • Identify the problem and assign responsibility
  • Determine and evaluate possible courses of action
  • Make a decision
  • Review results of the decision

Accounting's Role in Decision-Making

• Step 2: Provides relevant revenue and cost data for potential actions.
• Step 4: Prepares internal reports to review the actual impact of decisions.

Business Decisions

• Involve choices among alternative courses of action.
• Management typically considers:
  • Financial Information: Revenues and costs affecting overall profitability.
  • Nonfinancial Information: Employee turnover, environmental impact, company image.

Incremental Analysis Process

• Gather data, assess changes in costs and revenues for different alternatives.
• Basic Approach:
  1. Compare revenues for each option.
  2. Compare costs for each option.
  3. Determine net income (difference in revenues - costs).

Example of Incremental Analysis

• Alternative A vs. Alternative B:
  • Revenues: $125,000 (A), $110,000 (B)
  • Costs: $100,000 (A), $80,000 (B)
  • Net Income Increase/Decrease: (-$15,000 for A), +$20,000 for B.

Cost Concepts in Incremental Analysis

1. Relevant Costs and Revenues: Vary among alternatives and must be included.
2. Opportunity Cost: Potential benefits lost when choosing one alternative over another; always relevant.
3. Sunk Costs: Costs that cannot be altered by future decisions; irrelevant in incremental analysis.

Consideration of Qualitative Factors

• Factors affecting decisions that aren't easily quantifiable (e.g., employee morale, corporate social responsibility).

Activity-Based Costing (ABC)

• More accurately allocates overhead costs and is compatible with incremental analysis.

Common Decisions Using Incremental Analysis

• Accepting special orders, make-or-buy decisions, processing or selling products further, equipment decisions, segment elimination.

Detailed Examples

Special Orders

• Definition: An offer to provide goods/services at a price concession to a specific customer.
• Decision Rule: Accept if incremental revenue exceeds incremental costs, assuming regular sales are unaffected.

Example: Sunbelt's Special Order

• Offer: 2,000 blenders at $11 each.
• Costs: Variable cost of $8 per unit, fixed costs remain unchanged.
• Net Income Increase: Accept order; increases net income by $6,000.

Make or Buy Decisions

• Occur when evaluating whether to produce a component or purchase it.
• Opportunity Costs: If production capacity could generate income elsewhere, this must be considered.

Example: Baron Co.

• Buy Cost: $8 per switch versus producing for $9 per switch (considering avoided fixed costs).
• Net Analysis: It costs $25,000 more to buy than to make.

Elimination Decisions

• Assess the impact of eliminating unprofitable segments.
• Champ Line Example: Although Champ shows a loss, its fixed costs need to be allocated elsewhere, potentially hurting overall profitability if eliminated.

Chapter 8: Pricing Decisions and Target Costs

Pricing Factors

• Competitive Pressure: Market largely dictates prices based on supply and demand.
• Target Cost: Calculated as Market Price - Desired Profit.

Example: Slim Slicer by Mesa Company

• Market Price: $17.
• Desired Profit: 39% of the price = $10.37.
• Target Cost: $10.37.

Cost-Plus Pricing

• Formula: Total Costs + Markup = Target Selling Price.
• Limitations: Does not consider demand-side pricing factors; may set prices too low to cover fixed costs.

Chapter 9: Essentials of Effective Budgeting

Key Benefits of Budgeting

• Requires forward planning and sets clear objectives for performance evaluation.
• Creates early warning systems for potential issues and improves operational awareness.

Essentials of Effective Budgeting

1. Sound Organizational Structure: Defined authority and responsibilities.
2. Research and Analysis: Helps in establishing realistic goals.
3. Acceptance Across Management Levels: Critical for effectiveness.

Budgeting Process

• Involves data collection and coordination by a budget committee.
• Includes a sales forecast that drives all other budget components.

Direct Labor and Overhead Budgets

• Direct Labor Budget: Cost determined by the required output.
• Manufacturing Overhead Budget: Distinguishes between variable and fixed costs.

Cash Budget and Balance Sheet

• Cash Budget: Shows anticipated cash flow and liquidity status.
• Budgeted Balance Sheet: Projects financial position at budget period's end, developed using prior year’s figures and current year’s budgets.