Decision Making

The need for a decision arises in business because a manager is faced with a problem
and alternative courses of action are available. In deciding which option to choose he
will need all the information which is relevant to his decision; and he must have some
criterion on the basis of which he can choose the best alternative. Some of the factors
affecting the decision may not be expressed in monetary value. Hence, the manager will
have to make 'qualitative' judgements, e.g. in deciding which of two personnel should be
promoted to a managerial position. A 'quantitative' decision, on the other hand, is
possible when the various factors, and relationships between them, are measurable.

Elements of a decision Making

A quantitative decision problem involves six parts:

A) An objective that can be quantified :

Sometimes referred to as 'choice criterion' or 'objective function', e.g.
maximisation of profit or minimisation of total costs.
B) Constraints:
Many decision problems have one or more constraints, e.g. limited raw
materials, labour, etc. It is therefore common to find an objective that will
maximise profits subject to defined constraints.

C) A range of alternative courses of action :

under consideration. For example, in order to minimise costs of a
manufacturing operation, the available alternatives may be:

i) to continue manufacturing as at present

ii) to change the manufacturing method
iii) to sub-contract the work to a third party.

D) Forecasting :

Forecasting of the incremental costs and benefits of each alternative course of action.

E) Application :

Application of the decision criteria or objective function, e.g. the calculation of expected
profit or contribution, and the ranking of alternatives.

F) Choice:

Choice of preferred alternatives.

Relevant Costs For
Decision Making

The costs which should be used for decision making are often referred to as "relevant
costs". CIMA defines relevant costs as 'costs appropriate to aiding the making of
specific management decisions'.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and
they are common to all alternatives that we may choose.

b) Incremental: ' Meaning, expenditure which will be incurred or avoided as a result of

making a decision. Any costs which would be incurred whether or not the decision is
made are not said to be incremental to the decision.

c) Cash flow: Expenses such as depreciation are not cash flows and are therefore not
relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal
value is relevant.

Other terms:

d) Common costs: Costs which will be identical for all alternatives are irrelevant, e.g.
rent or rates on a factory would be incurred whatever products are produced.

e) Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated
fixed assets, development costs already incurred.

f) Committed costs: A future cash outflow that will be incurred anyway, whatever
decision is taken now, e.g. contracts already entered into which cannot be altered.
What is a relevant cost or
benefit?
A relevant cost or benefit is one that will be affected by the decision. This means that
the following can be disregarded as they are irrelevant in the decision-making process:

 Fixed overheads. These will be incurred regardless of the decision.

 Notional costs. For example, notional rent - these costs are only a book exercise
and do not represent a real cash flow.
 Past or sunk costs. These have already happened, so they cannot be affected by
a future decision. It is vital to note that relevant costs are always future costs.
 Book values. Similar to sunk costs. For example, the price paid for stock in the
past is not a relevant cost to the decision.

1. Direct wages
Summary: There are two options. We can take the workers from their usual
department, where it would cost £32,000 to replace them. Or we could hire sub-
contractors to do the special order at a cost of £31,300.
Both of these costs are future costs that will be affected by the decision and are
therefore relevant. The choice between the two alternatives is relatively
straightforward - either incur a £32,000 cost or a £31,300 cost. As an accountant
you will want to minimise costs and will choose to hire the sub-contractors at
£31,300.
 
2. Supervisor costs
Summary: The supervisor's normal salary is £8,000 and this will be paid whether
or not we take on the special contract. This is a fixed cost to the business and is
unaffected by the decision. However, the £3,500 additional bonus is relevant as it
is dependent on the decision to take the special contract. In addition, if we take
the special contract we will not have to pay the £2,500 incentive payment.
Therefore, the net relevant cost to the business is £3,500 less £2,500 = £1,000.
 
3. General overheads
Summary: Regardless of the decision, general fixed overheads remain constant.
The apportioned rent, rates, power etc, will be incurred whether the special
contract is undertaken or not. Therefore, these are not relevant costs and can be
ignored for decision-making purposes. However, incremental overheads are
extra overheads, incurred as a direct result of undertaking the special project.
These could include additional costs for power or premises. They are relevant
costs to the project of £1,000.
 

4. Machine depreciation
Summary: The machine depreciation has been charged at £2,300 which is what
the accountant would normally charge for depreciation for this period of time. The
accountant will charge this time-based depreciation if we use the machine for the
special contract and also if we do not. It is only a book value and does not
represent a true cash flow to the business. Therefore it is not a relevant cost.
However, if we do take the special contract and use the machine, we will incur
maintenance costs of £500. These future costs are a direct result of the decision
and should be included within the costs.
Shutdown Problems
Shutdown problems involve the following types of decisions:

a) Whether or not to close down a factory, department, product line or other activity,
either because it is making losses or because it is too expensive to run.

b) If the decision is to shut down, whether the closure should be permanent or

temporary. Shutdown decisions often involve long term considerations, and capital
expenditures and revenues.

c) A shutdown should result in savings in annual operating costs for a number of years
in the future.

d) Closure results in release of some fixed assets for sale. Some assets might have a
small scrap value, but others, e.g. property, might have a substantial sale value.

e) Employees affected by the closure must be made redundant or relocated, perhaps

even offered early retirement. There will be lump sums payments involved which must
be taken into consideration. For example, suppose closure of a regional office results in
annual savings of $100,000, fixed assets sold off for $2 million, but redundancy
payments would be $3 million. The shutdown decision would involve an assessment of
the net capital cost of closure ($1 million) against the annual benefits ($100,000 per
annum).

It is possible for shutdown problems to be simplified into short run decisions, by making
one of the following assumptions

a) Fixed asset sales and redundancy costs would be negligible.

b) Income from fixed asset sales would match redundancy costs and so these items
would be self-cancelling.

In these circumstances the financial aspects of shutdown decisions would be based on

short run relevant costs.