Decision Making

Management 122
Michael Williams

Decision Making
9 simple rules for making all decisions
Differential costs and revenues
Outsourcing
Sell or process further
Drop a product
Special order

Nine steps for decision

making
1. Make sure you fully understand the economic environment.
2. Identify the precise nature of the decision.
3. Identify your objectives.
4. Identify the economic effects of your decision.
5. Make sure youve seen the intangible as well as the tangible
effects of the decision.
6. Aggregate all of the effects and determine the choice that
maximizes the objective.
7. What do you need to know that you dont?
8. Make sure youve answered the question that needs
answering.
9. Communicate your findings.

Differential costs and revenues

This is involved in step 4.
You need to identify which costs and revenues
are affected by the decision.
Only costs and revenues that change across
alternative choices are relevant to the analysis.
These are called differential costs/revenues.
Any non-differential costs/revenues should be
ignored when doing the analysis in step 6.

Types of non-differential costs

Sunk costs: resources already spent that cant
be gotten back, regardless of what you do.
R&D for an unpromising drug.
A PhD in a field with poor job opportunities.

Ancillary costs: anticipated costs that will

occur regardless of the decision.
The cost of janitorial service for a pricing
decision.
Rent on a store for a decision on hours of
operation.

Types of differential costs

Incremental costs: these relate to cost drivers
affected by the decision.
Play-Doh has a limited number of colors. Adding colors
would increase various costs, such as batch setup and
tooling costs and packaging costs.

Opportunity costs: choosing X prevents you from

choosing Y. In this case, the benefit of Y is lost to you
and is effectively a cost of X.
When an earthquake hits, a local construction firm has
many job offers for reconstruction work. Unfortunately,
it only has enough tools and skilled workers to accept a
few.

Outsourcing

Organizations (not just businesses) need a lot

of services to function, such as accounting,
information systems, and janitorial services.

Manufacturing firms that produce final

products need intermediate products to make
them (such as engines for airplanes).

These entities can do one of two things:

Produce the services or intermediate goods

themselves.
Buy the services or intermediate goods from
someone else. (Outsourcing)

Outsourcing (cont.)
Outsourcing to a specialty provider has the
following benefits:
Greater expertise
Economies of scale (cheaper)

Outsourcing has the following costs:

Less control over the work (lower quality)
Profit markup by the supplier (more
expensive)

Outsourcing (cont.)
To make the decision to outsource an existing
activity, you need to identify differential costs.
Existing costs that are driven by the activity
can be eliminated. These provide differential
cost savings.
The supplier will charge you for the
outsourced product. This is a differential cost
increase.
There could be other differential costs of
outsourcing, such as shipping the product
from the supplier.

Outsourcing and breakeven

Outsourcing has two effects. Fixed costs
go down and variable costs go up.
The balance in this tradeoff depends on
volume.
At high volume, outsourcing is too costly.
At low volume, outsourcing is attractive.
There is a breakeven volume at which
total cost is the same.

Outsourcing and breakeven (cont.)

Recall the breakeven formula from CVP.
Vbe = F / M.
Now do this using differential costs.
Vbe = Fdiff / Mdiff.
Vbe = Fdiff / (Pdiff Cdiff).
Vbe = (Fout Fin) / (Cin Cout).
If volume is less than Vbe, then outsource.
If volume exceeds Vbe, then keep in house.

Sell or process further

This is similar to outsourcing, but at the
other end of the production chain.
A company that makes an intermediate
good can elect to sell it as is or add a
manufacturing step to make a more
valuable refined product.
An oil company can sell its crude oil or
build a refinery and convert it into
gasoline and other petroleum products.

Drop a product
If you stop making/selling a product, then you will
lose the revenue youre getting from it.
Dropping a product can provide a variety of
differential cost savings:
All variable costs
Many fixed costs that are product-specific
Opportunity costs from tying up resources that can
now be used for other products

In addition, you might get more or less sales of

your other products (substitutes or complements).

Special order
Companies typically offer a standard price for
their products.
What do you do if someone asks for a discount
price on a large order?
If you are operating at capacity, you say no.
If you have excess capacity, then you might
consider it.
Generally, the only differential costs are variable
costs (but not always).
In that case, the order is profitable if the price
exceeds the variable cost per unit.

Inventory
A company must decide how much
inventory to maintain and how often to
replenish it.
Inventory management involves a set of
tradeoffs.
If inventory is too high, then
valuable resources are idle (and thus
unprofitable),
there is a risk of obsolescence or
shrinkage.

If inventory is too low, then stockouts can

Inventory (cont.)
A standard technique for optimizing inventory is the
EOQ (economic order quantity) model.
There are two types of differential costs:
Costs of ordering or creating a batch of inventory (P)
Costs of carrying a unit of inventory over time (S)

Note that P does not include the cost of the

inventory itself (which must occur however often
we order it)
If inventory is sold or consumed at a steady rate (a
total of A per unit of time), the optimal batch size is
Q = (2AP/S)1/2