LO 3 PLANNING AND DECISION MAKING

Management decision making is complex and requires knowledge of:

- management accounting principles and techniques

-organizational objectives and functions

- management techniques

- the relationship between an organization, its members and its environment

Principles of decision making:

- Making the right decision at the right time in the right place
- Right decision – can be made by analyzing the circumstances which relate to the decisions and
the purpose of making it.
- The right time – decision must be made at the appropriate time so that effective action can be
taken.
- The right place – ensures that decisions are made in the most effective location.

Levels of Decision making:

Decision making can be related to the hierarchy of an organization:

(a) Strategic decisions- are decisions made by the top management for the long term and these are
the basis for the organizations long term plans. Strategic decisions usually affect the whole
organization and involve a large amount of capital.
(b) Tactical decisions- are decisions made by the middle management and relates to the specialist
divisions within the organization. The divisions within an organization will depend upon :
- The nature of its activities
- The size
- The way it is structured
(c) Operating decisions- are decisions made by operating managers. They are made on a day-to-day
basis. It involves less capital investment then strategic and tactical decisions.

Stages of the decisions making process:

- Identifying the objectives of the organization

- Defining the purpose of the decision
- Identifying the potential course of action
- Obtaining the relevant information
- Evaluation of the options
- Making the appropriate decision
- Action- communicate to responsible people for carrying it out

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 - Review – carry out a review of events after the decision has been implemented

Decision making criteria

A decision maker has to make a number of criteria into account when making a decision. The decision
making criteria fall into two basic groups: quantitative and qualitative factors.

Quantitative factors

a. Profitability – commercial undertakings operate with maximization as a primary objective,

business decisions should be made with this objective in mind. The effect of a decision on
profitability is an important consideration.
b. Effect on cash flow – decisions involving the investment funds , affect the organisaitons cash
flow. Cash is a limited resource which places a severe restriction on management action.
c. Sales volume – this is very important in pricing decisions, decisions affecting the quality of a
product and decisions that affect a product or service availability.
d. Market share – in a highly competitive environment market share is considered as an important
factor. In such a situation the effect of a decision on a firm’s market share for a particular
product or service should be taken into account.
e. The time value of money- another important factor to consider in long-term decisions making is
the fact that money in the future is worth less than it is at present. Net present value and the
internal rate of return are widely used in long term decision making.
f. Efficiency – organisations operate with maximization of efficiency as an important objective, so
it is also an important factor, needs to be considered in decisions making.
g. Time taken to make a decision – one quantitative factor often overlooked in decision making is
how long it takes to make a decision than it takes to effect action from the present time.

Qualitative factors – factors which must be considered that cannot be expressed in measured units of
any kind. They include:

a. Competitors – some decisions, such as those affecting prices, conditions of trade, availability of
products and services, marketing, take overs and mergers and the quality of goods and services,
will result in competitors reacting to them, the likely reaction of competitors must be carefully
evaluated before such decisions are made.
b. Customers- many decisions made within organizations affect customers, such as marketing and
prices, product/service availability, product/service quality and the organization’s image.
c. Government – some decisions, particularly strategic ones, must take into account the attitude of
both central and local government.
d. Legal factors – the effect of laws on decisions must also be considered eg., the effect of the
relevant employment legislation must be taken into account when making decisions relating to
personnel matters.
e. Risk – decisions are made about the future based upon information available at the present
time. This means that there is always a risk that decisions may not work out as expected.

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 f. Staff morale – the effect of decisions on the morale of the workforce must always be
considered. Eg., decisions to close down part of an operation, discontinue a product line,
purchase products from outside instead of manufacturing etc.
g. Suppliers – suppliers must also be taken into account. An organisation which becomes
dependent upon just one or two suppliers becomes vulnerable if a supplier decides to change its
product rang or specification.
h. Flexibility – the environment is constantly changing. It is important that flexibility is considered
when making decisions.
i. Environment – it is important to evaluate the effect of a decision on the environment. Decisions
that affect pollution, noise etc., must take the environment into consideration.
j. Availability of information – a decision maker must consider whether sufficient information is
available to make a decision.

COSTING AND DECISION MAKING

While taking the decisions managers should have the information which is useful to them is detail
about what would be changed as a result of their decision ie., they need to know the relevant costs.

Relevant costs – are costs appropriate to aiding the making of specific management decisions.

Common costs – are those which will be the same in the future regardless of which option is
favoured, and they may be ignored. Eg., fixed overheads.

Opportunity costs – is the value of a benefit sacrificed in favour of an alternative course of action.
Eg., ceasing the construction of a range of products yielding a profit of P 25000 in favour of another
range of products yielding a profit of P 50000.

Sunk cost- these are cost that have already been incurred or committed and are not therefore
relevant costs. Eg., market research undertaken before deciding whether or not to proceed with a
project.

Incremental costs – the increase or decrease in costs as a result of one more or one less unit of
output. Eg., a company makes washing machines and decides to increase production from 200
machines a month 250 machines. The variable costs connected with this increase (material, labour,
direct overheads) would represent the incremental costs.

ABSORPTION COSTING AND MARGINAL COSTING

Absorption costing and Marginal costing are costing techniques which are used for purposes of decision
making and control over costs and performance and they are applicable to all types of manufacturing
and service industries.

Absorption costing definition ‘’a principle where by fixed as well as variable costs are allotted to cost
units and total overheads are absorbed according to activity level’’

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Marginal costing definition ‘’A principle whereby variable costs are charged to cost units and the fixed
cost attributable to the relevant period is written off in full against the contribution for that period.’’

Contribution is the difference between sales value and the variable cost of those sales, expressed wither
in absolute terms or as a contribution per unit.’’

Contribution per unit= sales per unit – variable cost per unit.

Under marginal costing principles, fixed costs are written off in the period and closing stock is valued at
variable cost only. With, absorption costing, a share of fixed production cost is included in the value of
closing stock. Marginal costing principles are used for internal decision making purposes.

Profit statement using Marginal costing

Example: Beanland Ltd make a single product, the ‘’Beany’’ which sells for P 15 per unit. Opening stock
is zero and 10, 000 units are produced in the period. Variable costs (labour, material and expenses) are
P 10 per unit and fixed costs are P 37,500.

Calculate the profit at sales volumes of 5000, 7500 and 10,000 units

5000 units 7500 units 10 000 units

P P P P P P
sales 75000 112500 150000
Opening stock 0 0 0
variable production
cost 100000 100000 100000
closing stock -50,000 -25000 0
variable cost of sales 50000 75000 100000
contribution 25000 37500 50000
fixed costs 37500 37500 37500
Profit(loss) -12500 Nil 12500

Note: closing stock is valued at variable production cost, i.e., P 10 per unit, so at sales volumes of
5,000 units and production of 10,000 units, the closing stock value will therefore be 5000 units x P 10 =
50,000

Marginal costing Vs Absorption costing

The fundamental difference between marginal and absorption costing is the treatment of fixed
overheads.

Under marginal costing principles, fixed costs are written off in the period and closing stock is valued at
variable cost only. With absorption costing, a share of fixed production cost is included in the value of
closing stock.

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Referring back to out earlier work on Beanland Ltd, the results using the absorption costing method
would be as follows:

5000 units 7500 units 10 000 units

P P P P P P
sales 75000 112500 150000
Opening stock 0 0 0
variable production
cost 100000 100000 100000
Fixed production cost 37500 37500 37500
Closing stock (68,750) (34,375) 0
68750 103125 137500
Profit (Loss) 6250 9375 12500

Note:

Closing stocks are valued at variable plus fixed production cost, i.e.

= 100000 + 37500/10000 = P 13.75

(10,000 is the number of units products)

LIMITING FACTOR

Limiting factors refer to the constraints in availability of production resources (e.g. shortages in labor,
machine hours or materials) that prevent a business from maximizing its sale

Where Resources are limited

In marginal costing, the increase in profit arises from the increase in contribution and /or reduction in
fixed costs. Normally an organisation will concentrate on increasing contribution by selling those
products which produce the greatest contribution per unit. Sometimes, however, there is a limit to the
amount of resources available to the organisation, e.g., man hours, machine hours or raw materials. In
this event the organisation should concentrate on selling the product which produces the greatest
contribution per unit of limited resource.

For example, a company is able to produce 3 products and is planning its production mix for the
following period.

A B C

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 P P P
Selling Price per unit 10 12 16
Variable Cost per unit 4 7 14
Maximum demand (units) 1000 1000 1000
Labour – hours per unit 3 2 1

Obviously without a limiting factor it is best to sell as many items of A as possible, then B, then C.
However, labour is limited to 3,000 hours in the period.

In order to determine which products should be made, it is necessary to follow 5 steps:

Step 1: Calculate contribution per unit of product

A B C
P P P
Selling Price per unit 10 12 16
Variable Cost per unit 4 7 14
Contribution 6 5 2

Step 2: calculate contribution per unit of limited factor

A B C
P P P
Selling Price per unit 10 12 16
Variable Cost per unit 4 7 14
Contribution per unit 6 5 2
Contribution per labour hour 2 2.5 2
The contribution per limiting factor is:

A : 6/3 = P 2 contribution per labour hour

B: 5/2 = P 2.50 contribution per labour hour

C: 2/1= P 2 contribution per labour hour

Step 3: Rank the products based on highest contribution per labour hour

A B C
P P P
Selling Price per unit 10 12 16
Variable Cost per unit 4 7 14
Contribution per unit 6 5 2
Contribution per labour hour 2 2.5 2

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Rank 2 1 3

Step 4: Allocate the scarce resources to the highest-ranking product

Once the demand for the highest-ranking product has been satisfied, production should move on to the
next highest –ranking product and so on until the scarce resource is used up. Thus, here, the
organisation should concentrate first on producing B, then A, then C, maximising contribution relative to
the limited resource available.

Product Labour Units Contribution Total

hours Per unit contribution
P
B 2000 1000 5 5000
A 1000 500 6 3000
C - - - -
Total 3000 8000

Note: when there is only one resource that limits the activities or an organisation, optimal production
plan can be established by ranking production. When two or more resources are limited a technique
known as linear programming is used.