Decision making is a key function of managers which involves choosing between alternatives. There are various types of decisions faced by managers. Below are a few examples
a) Make or buy a product
b) Accept or reject an order
c) Shutdown or continue operations of a plant
d) Introduce a new product or not
Relevant Information for decision making
Not all information pertaining to a decision may be relevant. Relevancy of information for a decision depends on the type of decision being made. Therefore a critical step in decision making is to identify relevant costs and revenues.
Relevant costs need to possess both the following two characteristics:
a) Futurity – Historical (past) costs are not relevant for a decision. Only predicted future costs are relevant.
b) Change – Costs are relevant only if they change between decision alternatives.
Decision making costs
The following are the different types of decision making costs
|Type of cost||Definition||Relevancy|
|Outlay cost||Costs which involve actual outflow of funds||Relevant|
|Notional cost||Costs which do not involve outflow of fundsExample: Rent paid on own land||Relevant|
|Opportunity cost||Profit foregone by not choosing the next best alternative||Relevant|
|Sunk cost / Historical cost||Costs that are already incurred||Irrelevant|
A scarce resource which restricts the output generated or sales volume achieved is called a limiting factor. Limiting factors could be raw material, labor hours, machine hours, money etc. In decisions involving limiting factors contribution approach can be used i.e. contribution per unit of the limiting factor. For instance a unit making multiple products has limited availability of machine hours, the product mix is made based on the contribution per machine hour of the products.
Sales Mix Decision with limiting factor – Example:
X Ltd manufactures three products A, B and C on the same plant. Details about the products are as follows:
A B C
Selling Price per unit ($ ) 30 40 25
Variable Cost per unit ($ ) 15 25 15
Contribution per unit ($ ) 15 15 10
Machine hours required per unit 5 3 3
Maximum demand (units) 500 200 300
The plant can be run only for 3000 hours per month.
The Managing Director wants to know the optimum sales mix.
Step 1 : Product prioritization based on contribution per unit of the key factor
A B C
Selling Price per unit 30 40 25
Variable Cost per unit 15 25 15
Contribution per unit (X) 15 15 10
Machine hours required per unit (Y) 5 3 3
Contribution per machine hour (X / Y) 3 5 3.3
Priority III I II
Step 2: Sales mix based on product prioritization and demand constraints
Product Units Machine hours required Balance M.Hours
B 200 600 (200 x 3) 2400 (3000 – 600)
C 300 1500 (300 x 5) 900 (2400 -1500)
A 180 (900 /5) 900 —
It may be noted that machine hours available are insufficient to meet demand for product A. Therefore only 180 units of product A could be manufactured with the left out 900 hours after manufacturing the maximum possible units of Products B and C.