alternative decisions in financial management

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ALTERNATIVE DECISIONSin

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When you have a choice between two or more alternatives and you have to select one,

you are making a decision

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A formal definition of decision making by Wikipedia.org

Decision making can be regarded as an outcome of mental processes leading to the selection of a course of action among several alternatives. Every decision making process produces a final choice. The output can be an action or an opinion of choice.

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Information and the Decision Process

A decision model is a formal method for making a choice, often involving quantitative and qualitative analysis.

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Five-Step Decision Process

Gather Information

Make Predictions

Choose an Alternative

Implement the Decision

Evaluate Performance

Step 1.

Step 2.

Step 3.

Step 4.

Step 5.

Historical CostsOther Information

Specific Predictions

Feed

back

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RELEVANT COST AND BENEFIT

C O S TB E N E F I T

Any decision must be evaluated under cost-benefit criteria

Only relevant cost and relevant revenues should be considered in making decisions

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The Meaning of RELEVANCE

Relevant costs and relevant revenues are expected future costs and revenues that differ among alternative courses of action.

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RELEVANCE continued…

DIFFERENTIAL COSTINCREMENTAL OR MARGINAL COSTOPPORTUNITY COST

Normally, the following are relevant costs:

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Differential costs - is the difference in cost items under two or more decision alternatives specifically two different projects or situations.

RELEVANCE continued…

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An example of differential cost would be of a company which is selling its products through distributors where they are paying a commission of Php16 million. Any alternate which costs lesser would be considered. Let us suppose that the company is planning to appoint salespersons to sell its products and cancels the contracts with distributors. In this case, the selling expense is expected to be Php12 million. There is cost differential of Php4 million (16 m - 12m). This a good sign but the risk would have to be considered for changing the channel of distribution. If there is low risk, it would be prudent to go for own arrangements for sales.

RELEVANCE continued…

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Differential costs must be compared to differential revenues. In case, switching over to direct sales bring additional revenues of Php2 million, it would increase the net benefit to Php6million. This would provide more comfort to the decision maker while considering a change in the distribution channel.

RELEVANCE continued…

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Incremental or marginal cost is a cost associated with producing an additional unit. In case of a university, it could be cost of admitting another student. Even operating a second shift is an example of incremental cost. It would be noted that the two decisions are not independent as second shift depends upon first shift. Incremental cost must be compared with incremental revenues to arrive at a decision.

RELEVANCE continued…

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RELEVANCE continued…

Opportunity Cost is a cost of opportunity foregone. Example: Eunice left FAMI which was paying her php30,000 per month and got admission in SWU. Monthly fee-charge in SWU is Php10,000 per month. For Eunice, this would be Php40,000 per month (Php10,000 + Php30,000).

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RELEVANCE continued…

Opportunity Cost example: Eyay has finished MBA-Ex from SWU and she got two offers, one of Php35,000 from an investment bank and another of Php25,000 for full time teaching staff in SWU. Another of her class-fellow, Maribel got the same offer from the same university. While Maribel would be happy to join the university, Eyay would not be happy as she would lose an opportunity to serve at the bank for Php35,000.

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IRRELEVANT COST

SUNK COSTS (past costs): Costs that already been incurred. They do not affect any future cost and cannot be changed by any current or future action.Common costs: Costs which will be identical for all alternatives, e.g. rent or rates on a factory would be incurred whatever products are produced. 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.

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Suppose, a piece of land has already been purchased by a company for a sum of Php30 million. Also suppose, the company has considered covering it with a wall which would cost Php2 million. While the sum of Php30 million is a sunk cost, the other of Php2 million is a future cost or out of pocket expenses, therefore it is relevant to decision: Whether to erect a wall now or postpone it for the next month, whether it should be two-meter or three-meter high, whether a wall is erected or not and, if erected, whether it is 2 or 3 meter, the sum of Php30 million for land would remain the same. It is a sunk cost and therefore irrelevant to the decision.

IRRELEVANT costs continued…

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OR

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MAKE OR BUY DECISIONS:

Decisions about whether to outsource or produce goods and services within the organization The most important factors in the make-or-buy decision are quality, dependability of supplies, and costs.

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MAKE OR BUY DECISIONS continued…

Hudierez & Co. manufactures bath accessories.Management is considering whether to produce a part it needs (#2) or use a part produced by Naya Enterprises.

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Hudierez & Co. has the following costs for 150,000 units of Part #2:Direct materials P 28,000 Direct labor 18,500 Mixed overhead 29,000 Variable overhead 15,000 Fixed overhead 30,000

Total P120,500

MAKE OR BUY DECISIONS continued…

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MAKE OR BUY DECISIONS continued…

Mixed overhead consists of material handling and setup costs.Hudierez & Co. produces the 150,000 units in 100 batches of 1,500 units each.Total material handling and setup costs equal fixed costs of P9,000 plus variable costs of P200 per batch.

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MAKE OR BUY DECISIONS continued…

What is the cost per unit for Part #2?P120,500 ÷ 150,000 units = P0.8033/unitNaya Enterprises offers to sell the same part for P0.55.Should Hudierez & Co. manufacture the part or buy it from Naya Enterprises?

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The answer depends on the difference in expected future costs between the alternatives.Hudierez & Co. anticipates that next year the 150,000 units of Part #2 expected to be sold will be manufactured in 150 batches of 1,000 units each.

MAKE OR BUY DECISIONS continued…

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Variable costs per batch are expected to decrease to P100. Hudierez & Co. plans to continue to produce 150,000 next year at the same variable manufacturing costs per unit as this year.Fixed costs are expected to remain the same as this year.

MAKE OR BUY DECISIONS continued…

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What is the variable manufacturing cost per unit?Direct material P28,000

Direct labor 18,500 Variable overhead 15,000 Total P61,500P61,500 ÷ 150,000 = P0.41 per unit

MAKE OR BUY DECISIONS continued…

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Expected relevant cost to make Part #2:Manufacturing P61,500 Material handling and setups 15,000* Total relevant cost to makeP76,500 *150 × P100 = P15,000Cost to buy: (150,000 × P0.55)P82,500Hudierez & Co. will save P6,000 by making the part.

MAKE OR BUY DECISIONS continued…

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Now assume that the P9,000 in fixed clerical salaries to support material handling and setup will not be incurred if Part #2 is purchased from Naya Enterprises.Should Hudierez & Co. buy the part or make the part?

MAKE OR BUY DECISIONS continued…

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Relevant cost to make:Variable P76,500 Fixed 9,000 Total P85,500Cost to buy: P82,500

MAKE OR BUY DECISIONS continued…

Hudierez would save P3,000 by buying the part.

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Product-Mix Decisions Under Capacity Constraints

What product should be emphasized to maximize operating income in the face of capacity constraints?Orlanes & Co. produces Product #2 and Product #3.The company has 3,000 machine hours available to produce these products.

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Decision criteria:Aim for the highest contribution margin per unit of the constraining factor.When multiple constraints exist, optimization techniques such as linear programming can be used in making decisions.

Product-Mix Decisions Under Capacity Constraints

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Per unit Product #2 Product #3 Sales price P 101.28 P 696.00 Variable expenses 19.68 667.20 Contribution margin P 81.60 P 28.80Contribution margin ratio 81% 4%

Product-Mix Decisions Under Capacity Constraints

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One unit of Prod. #2 requires 7 machine hours.One unit of Prod. #3 requires 2 machine hours.What is the contribution of each product per machine hour?Product #2: P 81.60 ÷ 7 = P 11.66Product #3: P 28.80 ÷ 2 = P 14.40

Product-Mix Decisions Under Capacity Constraints

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Which product should be emphasized?The product with the highest contribution margin per unit of the constraining resource.

Product-Mix Decisions Under Capacity Constraints

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I N V E S T OR NOT TO

INVEST

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Equipment-Replacement Decisions (invest in new machine)

Assume that Cabrera & Co. is considering replacing a cutting machine with a newer model.The new machine is more efficient than the old machine.Revenues will be unaffected.

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Existing Replacement Machine Machine

Original cost P80,000 P105,000 Useful life 4 years 4 yearsAccumulated depreciation P50,000 Book value P30,000

Disposal price P14,000 Annual costs P46,000 P 10,000

Equipment-Replacement Decisions (invest in new machine)

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Ignoring the time value of money and income taxes, should Cabrera replace the existing machine?Yes!The cost savings per year are P36,000. The cost savings over a 4-year period will be P36,000 × 4 = P144,000.

Equipment-Replacement Decisions (invest in new machine)

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Investment = P105,000 – P14,000 = P91,000 P144,000 – P91,000 = P53,000 advantage of the replacement machine.

Equipment-Replacement Decisions (invest in new machine)

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Renting vs. Buying

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Renting vs. Buying

Maintenance and repair are the landlord’s responsibilityYou are under contract for one year or less (more if you choose)No taxes an insurance costs to you

Advantages of renting:

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Renting vs. Buying

You are not the owner of your home.Your rent might increase.You might not be able to renew your rental contract and then you will have to find a new place to live.You are essentially paying your landlord’s mortgage.

Disadvantages of renting:

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Renting vs. Buying

You will not obtain a tax deduction for your rent payments, while mortgage interest is tax deductible.

Disadvantages of renting:

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Renting vs. Buying

Build equityBorrow against equityIncreased value means a good investmentThe home is yours when the mortgage is paid in fullIncome tax reductions

Advantages of buying:

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Renting vs. Buying

Can you think of any disadvantages of owning your home?

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