Topic 7

Financial Decision Making

Chapter 15 in Core Text

Key points in this chapter :

Ñ        Types of Costs

Ñ        Short-term Business Decisions

Ñ        Long-term Business Decisions

Introduction

The management accountant provides both information and advice when decisions are made in business. There are special financial techniques, which assist business decisions in the short and long run. It is also important to realize that factors which cannot be accurately measured in monetary terms may also influence a decision. These factors are referred to as 'qualitative factors' e.g. the effect a decision may have on the morale and subsequent performance of the labour force will have an unquantifiable effect on future costs.

Types of Costs

It is important to know the various costs that managers should be aware of before taking crucial decisions. Some of these costs are:

Relevant costs

It is important to recognize those costs which are relevant to a decision in order to exclude non-relevant items from the decision's calculations. Decisions should be based on costs which will change as a result of the decision, and non-relevant costs must be excluded to simplify the data on which the decision is based. The term 'contribution' is significant in decision making since it expresses the incremental revenue earned as a result of the decision, less incremental costs - those extra costs incurred as a result of the decision. Clearly fixed costs which do not change as a result of a decision are not relevant and can be ignored when the decision is made, except in cases where the decision may make even the fixed costs variable.

Sunk costs

Sunk costs are costs which have been incurred before the decision point is reached and should not be allowed to influence the decision.  For example, a feasibility study concerning the installation of a computer, which is undertaken before the decision to install the computer is finalized, should not affect that decision. The cost of the feasibility study is a part of the total cost of making the decision.

Disposal costs

If a machine is to be replaced as a result of a decision, the scrap value of the machine may be less that it's carrying value in the books of the business, so that a book loss may be incurred by the disposal of the machine. This loss must not be allowed to influence the decision to install the new machine since logically the book loss represents past profits overstated because depreciation of the old machine was inadequate.

Non-cash costs

Costs which allocate, or provide for, other expenses which have already been spent cannot be considered in a decision. Depreciation is a provision to spread the cost of a machine over it's useful economic life, and is thus a book cost rather than a cost which concerns cash flowing out of the business.

 Opportunity cost

Decision making concerns the selection of one course of action from two or more alternatives, so that the opportunity cost of accepting one alternative may be the net cash flow foregone because the next best alternative is rejected. For example, investing scarce resources for Project A may mean that Project B cannot go ahead for lack of finance. Using scarce resources for Project A requires the sacrifice of profits that could have been earned from Project B.

The ripple effect

Organisations are complex systems and the effect of a decision may be felt in other parts of the organisation as a 'ripple' effect. For example, the effects caused by a change to costs or revenues following a decision may either harm or enhance products in other parts of the company. A decision to use a certain material in a new product may increase the quantity of that material purchased by the business so that a quantity discount is received which will in turn reduce the costs of other products which already use that material. A further example concerns the launch of a new brand which may, while gaining market share from rival products, also compete effectively with established products of the company thus reducing their sales.

Short-term Business Decisions

When management takes decisions within the scope of a short-term planning horizon it is usually reacting to changed circumstances or attempting to improve efficiency by adjusting or tuning it's present operations. Such decisions are taken within the parameters of existing production facilities, the need to maximize the return from limiting factors, and to apply the logic of relevant costs.

The optimum use of a limiting factor

A limiting factor is any factor which holds back a business from achieving a further improvement in it's performance. For example, scarcity of raw materials, skilled labor, financial resources or limited plant capacity. The optimum use of limiting factors concerns decisions to maximize the contribution from each unit of a scarce resource so that production will be concentrated on the most profitable plan of operations.

Make or buy decisions

A decision which is frequently taken in industry is to decide whether to make a component within the business or to buy it from an outside subcontractor. This decision must also ignore fixed costs and concentrate on the marginal costs of production (variable costs) because if a product is bought into the organisation, the saving concerns only the variable costs since fixed costs by definition will remain fixed whether the product is bought out or made in. Thus, the price offered by the subcontractor must be set against the variable costs of producing the product within the business.

 Long-term Business Decisions

These decisions are sometimes referred to as capital budgeting or capital investment appraisal. Funds for long-term investment are always scarce in business so the techniques of capital budgeting are designed to ensure that scarce investment resources are channeled into the most worthwhile long-term projects.

Methods of Investment Appraisal

The payback method

In this case, the payback is the period expressed in terms of the number of years which it takes the cash inflows from a capital investment project to equal the cash outflow. Competing projects are ranked according to the length of time it takes to repay the capital investment from cash flowing in. The project with the shortest payback period is deemed to be preferable.

The net present value method (NPV)

This is a discounted cash flow method of investment appraisal which is widely used in business. The technique is to discount cash outflows and inflows by a rate which represents the cost of capital of the business. If the present value of the cash inflows is greater that the present value of the cash outflows then the project is considered to be viable. If a choice must be made between alternatives, the project with the greatest net present value is the one that is selected.

Decision-Making                 Academic                     Homepage