Discuss the process of managerial decision-making and the factors involved.

Why learn to make managerial decisions based on costs?

The ability to make good decisions based on costs is a huge part of a manager’s job. Learning to understand which costs are relevant to a decision will help you to insure that the decisions you make use of the best available knowledge. Different costs will be important in different decisions, so practice is the key to learning how to navigate the process. Whether you need to figure out if you should keep or drop a product, make or buy components or sell or process further, we will take a look at what information may be important in your decision-making process!

Discuss the process of managerial decision-making and the factors involved.

As a manager you are forced to make countless decisions on a day to day basis, many of which have a lasting impact on the success of your company and its employees. Some decisions will require an analysis of the literal monetary costs and their relevance in the decision. Other choices will be made by examining the qualitative factors of the potential outcomes. Most decisions will require a balance of both. Knowing what to look for on both the quantitative and qualitative sides of each situation will help you as a manager make the decision that is best for your company and its employees.

Learning OUtcomes

• Explain the process of differential analysis

• Analyze qualitative factors that can also affect managerial decisions

Differential Analysis

Remember back to Module 11: Relevant Revenues and Costs where we discussed relevant and irrelevant costs and defined differential costs. We went into some discussion of differential analysis, but let’s take a closer look. Differential cost is defined as the difference in cost between any two alternative choices, so differential analysis will look at all possible scenarios to make a decision! Differential analysis involves looking at all possible scenarios of a decision, but ignoring some costs that are not relevant to the decision itself. We started talking in Module 11: Relevant Revenues and Costs, about costs that should not play in to the choices we need to make. We, as managers, simply need to focus on the costs and revenues that differ between the two choices. So, reviewing some key terms in the process is important:

1. Differential cost (relevant cost): the difference in cost between two choices.

2. Differential revenue (relevant benefits): the difference in revenue between two choices

3. Sunk cost: a cost that has already been incurred, so won’t be avoided no matter what decision is made.

4. Avoidable cost: a cost that CAN be eliminated depending on the decision made.

5. Opportunity cost: the potential benefit that is given up if an alternative decision is made.

So we need to ignore those things that remain constant, regardless of the decision we make. An example could be the rent paid on the building. It won’t matter whether you are making widget A, B or C, you still have to pay for the building, right? So rent would not be relevant to the decision regarding which product to make or sell. As managers, we need to look at all of the costs, and then determine which ones matter for the decision we are making. The relevant costs can differ for different decisions, so it is important to look at all of the costs involved, and look at each one independently for each decision! We will look at a variety of decisions in this module to help you practice your differential analysis skills!

Practice Questions

Qualitative Factors

Your boss just walked into your office and offered you a new position within the company! The money is great, including a 20 percent raise and a company car. The position includes 50 percent travel and at least 10 more hours per week than you are currently working. Oh, and you get to work from home, rather than coming into the office! You call your spouse and explain this great opportunity to him! He is less than excited, even with the raise in income. Why? Well, let’s look at the non-monetary components of this offer:

1. Less time at home with the additional hours and travel.

2. Home office reduces the commute time, but also takes up space in your home.

So, these are decisions that are called qualitative. They affect the quality of your life, rather than your bank account. Sometimes a decision that looks great from a financial standpoint, may cause quality changes that make the choice not as attractive. We talked a bit about this in our unit about a vacation or working. Sometimes, even with a loss of a week’s paycheck, the vacation is better! Qualitative decisions are different from quantitative decisions. Let’s first define those terms to clarify. Qualitative decisions are based more on the quality of a particular situation. For example, if you were planning to drive or fly when you go on your next vacation, you might not make your final decision based on which option is cheaper. Flying may have the qualitative advantage of being a quicker way to get to your destination, even though it costs more. On the other hand, driving may let you see many more sites on the way, even though it takes longer. So you can see, sometimes we have to look beyond the cost savings to other factors when we make our decisions. Quantitative decisions are just about the money. So, if it is cheaper to drive, and you are only concerned about the dollars spent, then you will drive! So let’s practice our skills.

Example

You are graduating from college, and would like to have a party for 50 of your closest friends. You are trying to decide between having your party at a restaurant, or making the meal at your home. Let's look at the details of each option to see what makes the most sense. Here are the details.

Option 1

Restaurant meal with one drink per guest: $30 x 50 guests = $1,500.00 Home meal with one drink per guest : $12 (groceries) x 50 guests = $600.00

Option 2

Savings to cook dinner at home $900.00 However, there are some qualitative advantages be to choosing the restaurant even though it costs more:

1. More time to talk with your friends if you have the meal prepared at the restaurant.

2. Less time involved if you go the restaurant, as you won’t have to cook and clean up after.

3. You won’t need to clean your house, after just finishing finals and doing all the cooking if you have the party at the restaurant.

So which would you pick?