Chapter 7

The Decision-Making Process

 The decision making process involves 5 steps
1. Identify the decision problem. We begin the decision process by identifying the
decision problem presented to us.
2. Determine the decision alternatives. This is a critical step because the remainder of
the decision process hinges on the decision alternatives (solutions) identified here.
3. Evaluate the costs and benefits of the alternatives. We must evaluate the costs and
benefits of each alternative. We may use a differential analysis (or incremental
analysis) by analyzing the differences (relevant) in costs and benefits among the
alternatives.
4. Make the decision. In addition to the numerical analysis performed, managers should
incorporate a variety of other factors, such as strategic issues, quality considerations,
legal and ethical issues, and the like before making the final decision.
5. Review the results of the decision. The final step in the decision-making process is to
review the results of the decision to determine if we made the right choice. If needed,
corrective action or adjustments can be made going forward.

Relevant versus Irrelevant Costs

 Relevant Costs have the potential to influence a decision
o Two criteria for a Relevant Cost
 Occurs in the future
 Differs between decision alternatives
o Relevant costs are also called:
 Differential costs
 Incremental costs
 Avoidable costs
 Irrelevant Costs are those that will not influence a decision
o Two categories
 Sunk costs which have already been incurred and cannot be avoided
 Costs that do not differ between alternatives and therefore are never
relevant to a decision

Opportunity Costs and Capacity

 Opportunity cost: the foregone benefit that is given up when one alternative is selected
over another
 Capacity: a measure of the limit placed on specific resources
o At full capacity, adding additional work requires giving up a portion of existing
work,
 The benefit of existing work given up is an opportunity cost
o With idle capacity, additional work can be added without sacrificing existing
work.
 No opportunity cost

Special Order Decisions

  A one-time order that is outside the scope of normal sales
Make or Buy
 A decision to perform a particular activity or function in-house or purchase from an
outside supplier. Also, could be called insourcing versus outsourcing.
 Key Questions:
o How much will costs and revenue change?
o Are there opportunity costs associated with either alternative?
o Are there other qualitative factors to consider?
Keep or Drop
 Managers must sometimes decide whether to eliminate a particular division or segment of
the business.
 Key Questions:
o How much will total revenue and total costs change if the segment is eliminated?
o Will other segments or product lines be affected?
o Are there opportunity costs associated with keeping the segment?
o Are there other qualitative factors to consider?
Sell-or-Process Further Decisions
 Business are often faced with the decision to sell a product “as is” or add additional
features (refine) to it so that it can be sold for a higher price
o As a general rule, we only process further if incremental revenues exceed
incremental costs
Prioritizing Products with Constrained Resources
 When a limited resource restricts a company’s ability to satisfy demand, the company is
said to have a constrained resource, also known as a bottleneck
 To maximize profits in the short run, a company with a bottleneck must prioritize the
products or services so as to maximize contribution margin per unit of the constrained
resource
 The focus is on contribution margin because fixed costs will not change in the short run
and are therefore irrelevant

Chapter 8

Budgets
 Budget: a comprehensive financial plan for achieving the financial and operational goals
of an organization

Master Budget
Sales Budget
 The starting point for preparing the master budget.
 Forecasts unit sales for each period
 The forecast of unit sales might come from one of the following sources:
o Last periods actual sales
o Research on overall industry trends
o Input from top management about overall sales objectives
o Planned marketing activities
Budgeted Unit Sales x Budgeted Sales Price = Budgeted Sales Revenue

Production Budget
 The production budget is directly related to the sales budget and to the quantity the
company wants to have on hand at the beginning and end of each period.

Budgeted Unit Sales + Budgeted End FG INV – Budgeted Beg FG INV = Budgeted Production
Units

Raw Materials Purchases Budget

 Next, we must determine the quantity of raw material to purchase to use for the
production budget. Budgeted raw material purchases will depend on budgeted
production needs and on planned levels of beginning and ending raw materials
inventory
RM Needed for Production + Budgeted End RM Inv – Budgeted Beg RM Inv = Budgeted RM
Purchases

Direct Labor Budget

 Next, we can prepare a budget to show how much direct labor is required to support
budgeted production levels
Budgeted Production x Direct Labor Required per Unit x Direct Labor Rate = Total Budgeted
(Units) Direct Labor

Budgeted Cost of Goods Sold

Budgeted Unit Sales x Budgeted manufacturing cost per unit = Budgeted COGS

Budgeted Income Statement

Budget Sales Revenue
Less: Budgeted COGS
Equal: Budgeted Gross Margin
Less: Budgeted Selling and Administrative Expenses
Equals: Budgeted Net Operating Income

Cash Budget
Beg Cash + Budgeted Cash – Budgeted Cash +/- Cash Borrowed or = End Cash
Receipts Payments Repaid
 The Cash Budget consists of three sections:
o Budgeted cash receipts (also called collections)
 Based on sales budget
o Budgeted cash payments (also called disbursements)
 Based on operating expense budgets
o Cash borrowed or repaid (also called Financing)

Budgeting in Non-Manufacturing Firms

 The primary operating budget for a merchandiser is a merchandise purchases budget.
 Since a merchandising company does not manufacture, it does not have raw materials,
direct labor, and manufacturing overhead budgets
Budgeted Sales + Budgeted End – Budgeted Beg = Budgeted Merchandise Purchases
Merchandise Inv Merchandise Inv