Decision Making

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

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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

 

Limiting factor

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.

Comments

  1. Hi there

    Do you have any examples where there are more than one limiting factors. For example both machine hours and labour hours?

    Thanks

    Regards

    • Hi Sabah,

      Please take a look at the post ‘Sales Mix Decision with Key factor and multiple constraints’ under the category ‘Decision Making’.

      In this example there is more than one limiting factor. While one of the factors play a key role the others act as constraints.

      Thanks

  2. Dear Sir,

    The information which was cited about decision making is simple to understand with your postures.

    Could you briefly provide some information regarding key factor?

    Thanking you sir,

    Ramu.

  3. Hi There,
    how come the units for product A which was first 500,be 180 units?pls clarify

    • @Grace

      There has been a typo in the question related to machine hours required per unit, this has been fixed now. Please let us know if you need further clarification.

      Thanks,
      VK

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