Analytics for managerial decision making, Slides of Accounting

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Christopher J. Skousen; Larry M. Walther

Analytics for Managerial Decision

Making

Budgeting and Decision Making

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Larry M. Walther

Analytics for Managerial Decision

Making

Budgeting and Decision Making

Analytics for Managerial Decision Making

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Contents

Contents

Part 4 Analytics for Managerial Decision Making 7

1 Cost Characteristics and Decision-Making Ramifications 8 1.1 Sunk Costs VS. Relevant Costs 8 1.2 A Basic Illustration of Relevant Cost/Benefit Analysis 9 1.3 Complicating Factors 10

2 Business Decision Logic 11 2.1 Outsourcing 11 2.2 Outsourcing Illustration 13 2.3 Capacity Considerations in Outsourcing 14 2.4 Illustration of Capacity Considerations 14 2.5 Qualitative Issues in Outsourcing 15 2.6 Special Orders 16 2.7 Capacity Constraints and the Impact on Special Order Pricing 17 2.8 Discontinuing a Product, Department, or Project 17 2.9 The 80/20 Concept 19

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Contents

3 Capital Expenditure Decisions 21 3.1 Management Stewardship 22 3.2 Logic Justification of Capital Decisions 22

4 Compound Interest and Present Value 23 4.1 Compound Interest 23 4.2 Future Value of Annuities 25 4.3 Future Value of an Annuity Due 25 4.4 Future Value of an Ordinary Annuity 26 4.5 Present Value 27 4.6 Present Value of an Annuity Due 28 4.7 Present Value of an Ordinary Annuity 28 4.8 Electronic Spreadsheet Functions 28 4.9 Challenge Your Thinking 29

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Analytics for Managerial Decision Making

Part 4 Analytics for Managerial

Decision Making

Your goals for this “managerial analytics” chapter are to learn about:

• Cost characteristics and the impact on decisions.
• A general framework for making rational business decisions.
• Capital expenditure decisions.
• Compound interest and present value.
• Tools for evaluating capital projects.

Analytics for Managerial Decision Making

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Cost Characteristics and Decision-Making Ramifications

1 Cost Characteristics and

Decision-Making Ramifications

As a student, you can probably think of many things you wish you could do over. You may have taken an exam and regretted some stupid mistake. You knew the material but fumbled in your execution. Or, maybe you did not really know the material; your judgment about how much to study left you doomed from the start!

Business people will experience similar feelings. Perhaps inventory was shipped using costly overnight express when less expensive ground shipping would have worked as well. Perhaps parking lot lights were unnecessarily left on during daylight hours. Hundreds of examples can be cited, and management must be diligent to control against these types of business execution errors. Earlier chapters discussed numerous methods for monitoring and controlling against waste. Remember, each dollar wasted comes right off the bottom line. For a public company that is valued based on a multiple of reported income, a dollar wasted can translate into many times that in lost market value.

On a broader scale, business plans and decisions might be faulty from the outset. There is really no excuse for stepping into a business plan when it has little or no chance for success. This is akin to going into a tough exam without preparing. Regret is perhaps the only lasting outcome. The overall theme of this chapter is to impart knowledge about sound principles and methods that can be employed to make sound business decisions. These techniques won’t eliminate execution errors, but they will help you avoid many of the judgment errors that are all too common among failing businesses.

1.1 Sunk Costs VS. Relevant Costs

One of the first things to understand about sound business judgment is that a distinction must be made between sunk costs and relevant costs. There is an old adage that cautions against throwing good money after bad. This has to do with the concept of a sunk cost, and it is an appropriate warning. A sunk cost relates to the historical amount that has already been expended on a project or object. For example, you may have purchased an expensive shirt that was hopelessly shrunk in the dryer. Would you now attempt to buy a matching pair of pants because you had invested so much in the shirt? Obviously not. The amount you previously spent on the shirt is no longer relevant to your decision; it is a sunk cost and should not influence your future actions.

In business decision making, sunk costs should be ignored. Instead, the focus should be on relevant costs. Relevant items are those where future costs and revenues are expected to differ for the alternative decisions under consideration. The objective will be to identify the decision yielding the best incremental outcome as it relates to relevant costs/benefits.

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Cost Characteristics and Decision-Making Ramifications

Your head is likely swimming in information based on this comprehensive analysis. Although it is more descriptive of the entirety of the two alternatives, it is unnecessarily confusing. Bears repeating that decision making should be driven only by relevant costs/benefits – those that differ among the alternatives! To toss in the extraneous data may help describe the situation, but it is of no benefit in attempting to guide decisions.

In one sense, Dillaway was lucky. The insurance proceeds were more than enough to put Dillaway back in operation. Many times, a favorable outcome cannot be identified. Each potential decision leads to a negative result. Nevertheless, decisions must be made. As a result, proper incremental analysis often centers on choosing the option of least incremental harm or loss.

1.3 Complicating Factors

Relevant costs/benefits are rarely so obvious as illustrated for Dillaway. Suppose the local truck dealer offered Dillaway a third option: A $27,000 trade-in allowance toward a new truck costing $80,000. The incremental cost of this option is $53,000 ($80,000–$27,000). This is obviously more costly than either of the other two options. But, Dillaway would have a brand new truck. As a result, Dillaway must now begin to consider other qualitative factors beyond those evident in the incremental cost analysis. This is often the case in business decision making. Rarely are two (or more) options under consideration driven only by quantifiable mathematics. Managers must be mindful of the impacts of decisions on production capacity, customers, employees, and other qualitative factors.

Therefore, as you develop your awareness of the analytical techniques presented throughout this chapter, please keep in mind that they are based on concrete textbook illustrations and logic. However, your ultimate success in business will depend upon adapting these sound conceptual approaches in a business world that is filled with uncertain and abstract problems. Do not assume that analytical methods can be used to solve all business problems, but do not abandon them in favor of wild guess work!

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Business Decision Logic

2 Business Decision Logic

It is virtually impossible to develop a listing of every type of business decision you will confront. Classic examples include whether to outsource or not, when to accept special orders, and whether to discontinue a product or project. Although each of these examples will be considered in more detail, what is most important is for you to develop a general frame of reference for business decision making. In general, that approach requires identification of decision alternatives, logging relevant costs/benefits of each choice, evaluating qualitative issues, and selecting the most desirable option based on judgmental balancing of quantitative and qualitative factors. As you reflect on this process, recognize that it begins with judgment (what are the alternatives?) and ends with judgment (which alternative presents the best blend of quantitative and qualitative factors). Analytics support decision making, but they do not supplant judgment.

2.1 Outsourcing

Companies must frequently choose between using outside vendors/suppliers or producing a good or service internally. Outsourcing occurs across many functional areas. For instance, some companies outsource data processing, tech support, payroll services, and similar operational aspects of running a business. Manufacturing companies also may find it advantageous to outsource certain aspects of production (frequently termed the “make or buy” decision). Further, some companies (e.g., certain high profile sporting apparel companies) have broad product lines, but actually produce no tangible goods. They instead focus on branding/marketing and outsource all of the actual manufacturing. Outsourcing has been around for decades, but it has received increased media/political attention with the increase in global trade. Tax, regulation, and cost factors can vary considerably from one global region to another. As a result, companies must constantly assess the opportunities for improved results via outsourcing.

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Business Decision Logic

2.2 Outsourcing Illustration

Pilot Corporation produces software for handheld global positioning systems. The software provides a robust tool for navigational support and mapping. It is used by airline pilots, mariners, and others. Because these applications are often of critical importance, Pilot maintains a tech support department that is available around the clock to answer questions that are received via e-mail, phone, and IM. The annual budget for the tech support department is shown below. Direct labor to staff the tech support department consists of three persons always available during each 8-hour shift, at an hourly rate of $ per hour (3 persons per shift × 8 hours per shift × 3 shifts per day × 365 days per year × $12 per hour = $315,360). The utilities and maintenance are fixed, but would be avoided if the unit were shut down. The building is leased under a long-term contract, and the rent is unavoidable. Phone and computer equipment is leased under a flat rate contract, but the agreement is cancelable without penalty. The annual depreciation charge on furniture and fixtures reflects a cost allocation of expenditures made in prior years.

Direct labor Utilities and maintenance Building rent Phone/computer leasing Annual depreciation of furniture and fixtures

$ 315, 40, 120, 60, 100, $ 635,

Pilot has been approached by Chandra Corporation, a leading provider of independent tech support services. Chandra has offered to provide a turn-key tech support solution at the rate of $12 per support event. Pilot estimates that it generates about 50,000 support events per year. Chandra’s proposal to Pilot notes that the total expected cost of $600,000 (50,000 events × $12 per event) is less than the amount currently budgeted for tech support. However, a correct analysis for Pilot focuses only on the relevant items (following). Even if Chandra is engaged to provide the support services, building rent will continue to be incurred (it is not relevant to the decision). The cost of furniture and fixtures is a sunk cost (it is not relevant to the decision). The total cost of relevant items is much less than the $600,000 indicated by Chandra’s proposal. Therefore, the quantitative analysis suggests that Pilot should continue to provide its own tech support in the near future. After all, why spend $600,000 to avoid $415,360 of cost? Once the building lease matures, the furniture and fixtures are in need of replacement, or if tech support volume drops off, Chandra’s proposal might be worthy of reconsideration.

Direct labor Utilities and maintenance Building rent Phone/computer leasing Annual depreciation of furniture and fixtures

$ 315, 40, 120, 60, 100, $ 415,

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Business Decision Logic

2.3 Capacity Considerations in Outsourcing

Outsourcing analysis is made more complicated if a business is operating at capacity. If outsourcing will free up capacity to be used on other services or products, then the contribution margin associated with the additional services or products also becomes a relevant item in the decision process. In other words, if a company continues to manufacture a product in lieu of outsourcing, it foregoes the chance to produce the alternative product. The loss of this opportunity has a cost that must be considered in the final decision. Accountants (and economists and others) may use the term “opportunity cost” to describe the cost of foregone opportunities. It is appropriate to factor opportunity costs into any outsourcing analysis.

2.4 Illustration of Capacity Considerations

Mueller Building Systems manufactures customized steel components that are sold in kits for the do-it- yourself rancher. The kits include all of the parts necessary to easily construct metal barns of various shapes and sizes. Mueller’s products are very popular and its USA manufacturing plants have been running at full capacity. In an effort to free up capacity, Mueller contracted with Zhang Manufacturing of China to produce all roof truss components to be included in the final kits. The capacity that was released by the outsourcing decision enabled a 10% increase in the total number of kits that were produced and sold. Mueller’s accounting department prepared the following analysis that was used as a basis for negotiating the contract with Zhang:

Direct labor to produce trusses Direct material to produce trusses Variable factory overhead to produce trusses Avoidable fixed factory overhead to produce trusses Relevant costs to produce trusses Contribution margin associated with 10% increase in kit production Maximum amount to spend (including transportation) for purchased trusses

$ 3,800, 4,000, 2,000, 1,000, $ 10,800, 3,000, $ 13,800,

Notice that the analysis reveals that Mueller will reduce costs by only $10,800,000 via outsourcing, but can easily spend more than this on purchasing the same units. This results because the freed capacity will be used to produce additional contribution margin that would otherwise be foregone.

One must be very careful to fully capture the true cost of outsourcing. Oftentimes, the costs of placing and tracking orders, freight, customs fees, commissions, or other costs can be overlooked in the analysis. Likewise, if outsourcing results in employee layoffs, expect increases in unemployment taxes, potential acceleration of pension costs, and other costs that should not be ignored in the quantitative analysis. Finally, a situation like that faced by Mueller may indicate the need for additional capital expenditures to increase overall capacity. Capital budgeting decisions are covered later in this chapter.

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Business Decision Logic

2.6 Special Orders

A business may receive a special order at a price that is significantly different from the normal pricing scheme. The quantitative analysis will focus on the contribution margin associated with the special order. In other words, it must be determined whether the special order sales price exceeds the variable production and selling costs associated with the special order.

To illustrate, assume that Lunker Lures Company produces the popular Rippin’ Rogue pictured at right. The “cost” to produce a Rippin’ Rogue is $1.10, consisting of $0.20 direct materials, $0.40 direct labor, and $0.50 factory overhead. The overhead is 30% variable and 70% fixed cost allocation. Lunker Lures are sold to retailers across the country through an established network of manufacturers’ representatives who are paid $0.10 for each lure sold in their respective territories.

Lunker Lures has been approached by Walleye Pro Fishing World to produce a special run of 1,000, units. These lures would be sold under the Walleye Wiggler brand name and would not otherwise compete with sales of Rippin’ Rogues. Walleye Pro Fishing World’s offer is priced at $1.00 per unit. Lunker Lures is obligated to pay its representatives half of the normal rep fee for such private label transactions. On the surface it appears that Lunker Lures should not accept this order. After all, the offer is priced below the noted cost of production. However, so long as Walleye Wigglers do not compete with sales of Rippin’ Rogues, and Lunker Lures has plenty capacity to produce lures without increasing fixed costs, profit will be enhanced by $200,000 ($0.20 × 1,000,000) by accepting the order. The following analysis focuses on the relevant items in reaching this conclusion:

Selling price per unit Direct material per unit Direct labor per unit Variable factory overhead per unit ($0.50 X 30%) Manufacturing margin Variable selling costs (50% of normal) Contribution margin

$ 0.

$ 1.

$ 0.

$ 0.

Note: Aggregate fixed costs will be the same whether the special order is accepted or not. The per unit allocation of fixed costs is not relevant.

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Business Decision Logic

2.7 Capacity Constraints and the Impact on Special Order Pricing

A potential error in special order pricing is acceptance of special orders offering the highest contribution margin per dollar of sales, while ignoring capacity constraints. Notice that the special order for Walleye Wigglers offered a 20% contribution margin ($0.20/$1.00). Suppose Bass Pro Fishing World also placed a special order for a Bass Buzzer lure, and that special order afforded a 30% margin on a $1.00 per unit selling price. At first glance, one would assume that the Bass Pro Fishing World would represent the better choice. But, what if you were also informed that remaining plant capacity would allow production of either 1,000,000 Walleye Wigglers or 600,000 Bass Buzzers? Now, the total contribution margin on the Wiggler is $200,000 (1,000,000 units × $0.20) while the total contribution on the Buzzer is $180,000 (600,000 × 30%). The better choice is to go with the Wiggler, as that option maximizes the total contribution margin. This important distinction gives consideration to the fact that producing a few units (with a high per-unit contribution margin) may be less profitable than producing many units (with a low per-unit contribution margin). Contribution margin analysis should never be divorced from consideration of factors that limit its generation! The goal will be to optimize the total contribution margin, not the per unit contribution margin.

2.8 Discontinuing a Product, Department, or Project

One of the more difficult decisions management must make is when to abandon a business unit that is performing poorly. Such decisions can have far reaching effects on the company, shareholder perceptions about management, employees, and suppliers. The tools of Enterprise Performance Evaluation chapter provided insight into performance evaluation methods that are helpful in identifying lagging sectors, and the preceding chapter showed how misuse of absorption costing information can invoke a series of successive product discontinuation decisions that bring about a downward business spiral. So, what analytical methods should be employed to support a final decision to pull the plug on a business unit?

Management should not merely conclude that any unit generating a net loss is to be eliminated! This is an all too common error made by those who lack sufficient accounting knowledge to look beyond the bottom line. Sometimes, eliminating a unit with a loss can reduce overall performance. Consider that some fixed costs identified with a discontinued unit may continue and must be absorbed by other units. This creates a potential domino effect where each falling unit pushes down the next. Instead, the appropriate analysis is to compare company wide net income “with” and “without” the unit targeted for elimination.

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Business Decision Logic

Management is quite concerned about the Golf Department. It has had plenty of time to flourish, but has never turned a profit. Further, no one at Casa de Deportes, including the Golf Department manager, believes this situation is apt to change anytime soon. The accounting department was asked to prepare a report of the overall financial impacts if Golf is discontinued. In preparing the “without golf ” report, it was learned that only 70% of the General and Administrative costs would be eliminated, rent and depreciation would continue to be incurred, and utilities would be reduced by only half. The selling costs would be completely eliminated. The unavoidable costs from the golf department are assumed to be shifted equally to the other departments (although other allocation methods could be used, the overall conclusions would not change). The income report “without golf ” appears as follows:

Fishing Hunting Camping Golf Total Sales Variable expenses Contribution margin Less fixed costs: General/administrative Selling Rent Utilities Depreciation Total fixed costs Net income (loss)

$ 6,000, 3,600, $ 2,400, $ 630, 1,200, 333, 46, 63, $ 2,273, $ 126,

$ 8,000, 4,800, $ 3,200, $ 830, 1,600, 333, 46, 48, $ 2,858, $ 341,

$ 4,000, 2,400, $ 1,600, $ 430, 800, 333, 46, 73, $ 1,683, $ (83,334)

$ -

$ - $ -

$ - $ -

$18,000, 10,800, $ 7,200, $ 1,890, 3,600, 1,000, 140, 185, $ 6,815, $ 385,

Obviously, discontinuing the Golf Department will not help the overall situation. The reallocation of unavoidable costs not only reduces overall profitability, but it also paints the Camping Department in a precarious light. Further, this analysis does not take into account potential sales reductions in other departments that might occur from reductions in overall store traffic (e.g., a “golfing only” customer might nevertheless buy an occasional flashlight from the camping department, etc.). Another factor not included above are the incremental costs from closing a department (e.g., inventory write-offs, increased unemployment compensation costs for laid off workers, etc.). As you can see, the decision to discontinue a product, department, or project is far more complex than it might at first seem.

2.9 The 80/20 Concept

Many businesses have broad product lines and large customer bases. However, an in-depth evaluation is likely to reveal that a significant portion of its success is centered around a narrow set of products, customers, and services. The remainder of the business activity may be very marginal. For example, a technology-based business may find that some of its lowest-volume customers consume the largest amount of the tech support staff ’s time (due to customer inexperience with the product) while the large volume customers require almost no assistance with the company’s product.

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Business Decision Logic

It requires a great deal of business discipline to “abandon” a product, customer, or service, but such decisions can actually contribute to business success. Consider the following quote from ITW, a large and successful corporation that embraces the 80/20 concept:

“A key element of the Company’s business strategy is its continuous 80/20 business process for both existing businesses and new acquisitions. The basic concept of this 80/20 business process is to focus on what is most important (the 20% of the items which account for 80% of the value) and to spend less time and resources on the less important (the 80% of the items which account for 20% of the value). The Company’s operations use this 80/20 business process to simplify and focus on the key parts of their business, and as a result, reduce complexity that often disguises what is truly important. The Company’s 700 operations utilize the 80/20 process in various aspects of its business. Common applications of the 80/20 business process include:

• Simplifying manufactured product lines by reducing the number of products offered by combining the features of similar products, outsourcing products or, as a last resort, eliminating products.
• Simplifying the customer base by focusing on the 80/20 customers and finding different ways to serve the 20/80 customers.
• Simplifying the supplier base by partnering with key 80/20 suppliers and reducing the number of 20/80 suppliers.
• Designing business processes and systems around the key 80/20 activities.

The result of the application of this 80/20 business process is that the Company improves its operating and financial performance. These 80/20 efforts often result in restructuring projects that reduce costs and improve margins. Corporate management works closely with those business units that have operating results below expectations to help the unit apply this 80/20 business process and improve their results.”

Some contend that this approach results in sacrificing long-term opportunities to enhance short-term profitability. For instance, a “small and inexperienced” customer that is abandoned today might eventually grow to be a major player. As a result, the 80/20 philosophy is not always the optimum strategy and good business judgment should always be exercised in the decision-making process.