11CHAPTER 132Decision Making3• Steps in decision making:–Define problem–Identify alternatives–Identify costs / benefits of alternatives–Compare relevant costs / benefits–Select alternative with:• Greatest benefit• Lowest cost4• Focus only on relevant costs & benefits–Everything else is irrelevant5Relevant Costs & Benefits6• Relevant costs & benefits are different between alternatives27• Assume you rent boat for $1,000/month• Harbor tour business vs fishing business:Fishing Tour DifferenceRevenue $8,000 $10,000 -$2,000Expenses -1,000 -4,000 3,000Rent -1,000 -1,000 ____0Profit $6,000 $5,000 $1,0008• Rent is same for both alternatives• You get same result if you ignore RentFishing Tour DifferenceRevenue $8,000 $10,000 -$2,000Expenses -1,000 -4,000 3,000Profit $7,000 $6,000 $1,000• Rent is not relevant9• No need to consider costs / benefits that are same– May mislead you• Also Relevant costs & benefits are future costs & benefits – Not sunk or historical costs10• E.g., Assume you own large painting for home– Paid $10,000• Moving & no room• Only offer is $8,000• Fact that you originally paid $10,000 is irrelevant – Original price is sunk cost11Opportunity Costs12• Opportunity Costs – Other revenue• Only available if one of alternatives is selected– Treated as cost of alternative that closes off additional revenue313• E.g., Assume you rented retail space• Choice: CD store vs Comic Book store • With Comic Book store only:– Can sublease part of space to vending machine operators• Additional $200 a month– This sublease not available with CD store alternative14• Lost revenue from vending machine sublease ($200)– Opportunity Cost of CD store– Added to other costs of CD store15CD Store Comic Book StoreDifferenceRevenue $10,000 $7,000 $3,000Expenses -5,000 -2,000 -3,000Sublease -200 _____0 ____-200Profit $4,800 $5,000 -$200• Lost sublease rent shown as cost for CD Store Alternative– Opportunity Cost16CD Store Comic Book StoreDifferenceRevenue $10,000 $7,000 $3,000Expenses -5,000 -2,000 -3,000Sublease _________200__-200Profit $5,000 $5,200 -$200• Can also show Opportunity as additional revenue17Other Important Factors18• We focus on quantitative– Qualitative factors• E.g., Should we outsource?– Supplier reliability– Quality control– Workforce morale– Robustness– Ability to resume production419• Time-value of money relevant– Ignore for now20General Example21• Assume you own Catalina cruise ship–Original Cost $4,000,000–20-year life–S/L Depreciation–Depreciation = $200,000/year–Operating Profit of $500,000/year–½ of ship not used for cruise business–Potential contract transport Scouts to Catalina for camping trips• Additional $15,00022• 2 alternate uses for unused ½ of ship–Figures exclude depreciation ($100K)• Freight business–Annual revenue = $70,000–Annual expenses = $10,000• Floating disco–Annual rents = $90,000–Annual expenses = $20,000–Boy Scouts will not patronize ship used as disco23• Cruise net profit irrelevant • Depreciation is irrelevant• Loss Boy Scout contract Opportunity Cost for DiscoFreight Disco DifferenceRevenue $70K $90K -$20KCash Expenses -$10K -$20K 10KOpportunity Cost ______ -$15K 15KOperating Profit $60K $55K $5K24• Boy Scout contract Additional Revenue for FreightFreight Disco DifferenceRevenue $70K $90K -$20KCash Expenses -$10K -$20K 10KOpportunity Cost$15K_____ 15KOperating Profit $75K $70K $5K525Special Orders26• Special Orders–Approached by potential customer•In area not normally served–Avoids cannibalization–Avoids price discrimination –Offers to buy product/service at price below your cost27• A, B, & C irrelevant • FC don’t change if sufficient capacity• VC could be differentDon’t Take Take DifferenceRev: A (A + a) aVCs: -B -(B+b) -bFCs _______-C __(C+c?) _____-c?Profit A – (B+C) (A+a)-(B+b+C+c?) a-(b+c?)• Overall cost is irrelevant– Already in business– Focus on effect of special order on OP28• E.g.,–Assume small airline takes passengers to resort island with deluxe conference center & hotel–Normal tourists take ferry for $50/passenger–Conference attendees take your jet & pay $700/passenger29• Passengers cost you $300/person–Trip costs you $3,000–Jet can carry 10 passengers–Typical trip sell 6 seats• 4 seats empty• Motel offers to buy empty seats for $100–Purchase on “Stand-By” basis–Won’t affect your current business30• $300/passenger cost irrelevant– Make $1,200 on each flight ($4,200 -$3,000)• Will special order hurt OP?• Accept if OP increases`Take Don’t Take DifferenceRevenue $400 $0 $400Expenses ___-0 -0 -0Profit $400 $0 $400631• With special orders, pay attention to capacity.– If you have excess capacity, taking special order does not cost you extra FC– If you don’t have enough current capacity, can you buy some extra capacity. That cost is a relevant cost.32• If – you don’t have enough current capacity, and – you can’t buy extra capacity,•Then you have to give up a current sale in order to take special order.• If you do this, your costs are the same whether you take the special order, but your revenue is different.– You are trading the current sales revenue for the lower special order sales revenue.33• E.g. Assume– Every unit has variable costs of $10 per unit, and fixed costs of $3 per unit.– You have no excess capacity.– You currently sell units for $20, and you get special order for 1,000 units at $15.• If you take the special order your costs are the same, you are trading sales prices. Costs are irrelevant. Only difference is:– 1,000 units x $20 = $20,000, and– 1,000 units x $15 = $15,000• You lose $5,00034Keep or Drop35• Keep or drop division/product• Firms prepare income statements–Include all costs of products / divisions–But, some FCs are not relevant•They don’t change36• Looks like dropping Gumby will save $50K• What are FCs?Barbie GI Joe Gumby TotalRevenue $600K $350K $250K $1,200KVCs -200K -100K -150K -450KFCs -300K -200K -150K -650KProfit $100K $50K -$50K $100K737• Rent is Common FC• Manager salary is Direct FCBarbie GI Joe Gumby TotalRevenue $600K $350K $250K $1,200KVCs -200K -100K -150K -450KSalary -100K -50K -50K -200KRent -200K -150K -100K -450KProfit $100K $50K -$50K $100K38• Rent is not relevant• Will make $50K more if
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