Analytics for Managerial Decision Making
Cost Characteristics and Decision-Making Ramifications
As a student, you can probably think of many things you wish you could do over. You may have taken an exam and regretted some stupid mistake. You knew the material but fumbled in your execution. Or, maybe you did not really know the material; your judgment about how much to study left you doomed from the start!
Business people will experience similar feelings. Perhaps inventory was shipped using costly overnight express when less expensive ground shipping would have worked as well. Perhaps parking lot lights were unnecessarily left on during daylight hours. Hundreds of examples can be cited, and management must be diligent to control against these types of business execution errors. Earlier chapters discussed numerous methods for monitoring and controlling against waste. Remember, each dollar wasted comes right off the bottom line. For a public company that is valued based on a multiple of reported income, a dollar wasted can translate into many times that in lost market value.
On a broader scale, business plans and decisions might be faulty from the outset. There is really no excuse for stepping into a business plan when it has little or no chance for success. This is akin to going into a tough exam without preparing. Regret is perhaps the only lasting outcome. The overall theme of this chapter is to impart knowledge about sound principles and methods that can be employed to make sound business decisions. These techniques won't eliminate execution errors, but they will help you avoid many of the judgment errors that are all too common among failing businesses.
Sunk Costs VS. Relevant Costs
One of the first things to understand about sound business judgment is that a distinction must be made between sunk costs and relevant costs. There is an old adage that cautions against throwing good money after bad. This has to do with the concept of a sunk cost, and it is an appropriate warning. A sunk cost relates to the historical amount that has already been expended on a project or object. For example, you may have purchased an expensive shirt that was hopelessly shrunk in the dryer. Would you now attempt to buy a matching pair of pants because you had invested so much in the shirt? Obviously not. The amount you previously spent on the shirt is no longer relevant to your decision; it is a sunk cost and should not influence your future actions.
In business decision making, sunk costs should be ignored. Instead, the focus should be on relevant costs. Relevant items are those where future costs and revenues are expected to differ for the alternative decisions under consideration. The objective will be to identify the decision yielding the best incremental outcome as it relates to relevant costs/benefits.
A Basic Illustration of Relevant Cost/Benefit Analysis
During a recent ice storm, Dillaway Company's delivery truck was involved in a traffic accident. The truck originally cost $60,000, and was 40% depreciated. An insurance company has provided Dillaway $30,000 for the damages that were incurred. Dillaway took the truck to a local dealer who offered two options: (a) repair the truck for $24,000, or (b) buy the truck "as is, where is" for $10,000. Dillaway has found an undamaged, but otherwise identical, used truck for sale on the internet for $32,000 what decision is in order?
The truck's original cost of $60,000 is sunk, and irrelevant to the decision process. The degree to which it is depreciated is equally irrelevant. The financial statement "gain" that would be reported on a sale is irrelevant. The $30,000 received from the insurance company is the same whether the truck is sold or repaired; because it does not vary among the two alternatives it is irrelevant (i.e., it is not necessary to factor it into the decision process). All that matters is to note that the truck can be repaired for $24,000, or the truck can be sold for $10,000 and a similar one purchased for $32,000. in the former case, Dillaway is up and running for $24,000; in the later, Dillaway is up and running for $22,000 ($32,000-$10,000). it seems clear that the better option is to sell the damaged truck and buy the one for sale on the internet.
The logic implied by the preceding discussion is to focus on incremental items that differ between the alternatives. The same conclusion can be reached by a more comprehensive analysis of all costs and benefits. The following portrays one such analysis. This analysis also supports sale and replacement because the income and cash flow impacts are $2,000 better than with the repair option:
Your head is likely swimming in information based on this comprehensive analysis. Although it is more descriptive of the entirety of the two alternatives, it is unnecessarily confusing. Bears repeating that decision making should be driven only by relevant costs/benefits - those that differ among the alternatives! To toss in the extraneous data may help describe the situation, but it is of no benefit in attempting to guide decisions.
In one sense, Dillaway was lucky. The insurance proceeds were more than enough to put Dillaway back in operation. Many times, a favorable outcome cannot be identified. Each potential decision leads to a negative result. Nevertheless, decisions must be made. As a result, proper incremental analysis often centers on choosing the option of least incremental harm or loss.
Relevant costs/benefits are rarely so obvious as illustrated for Dillaway. Suppose the local truck dealer offered Dillaway a third option: A $27,000 trade-in allowance toward a new truck costing $80,000. The incremental cost of this option is $53,000 ($80,000-$27,000). This is obviously more costly than either of the other two options. But, Dillaway would have a brand new truck. As a result, Dillaway must now begin to consider other qualitative factors beyond those evident in the incremental cost analysis. This is often the case in business decision making. Rarely are two (or more) options under consideration driven only by quantifiable mathematics. Managers must be mindful of the impacts of decisions on production capacity, customers, employees, and other qualitative factors.
Therefore, as you develop your awareness of the analytical techniques presented throughout this chapter, please keep in mind that they are based on concrete textbook illustrations and logic. However, your ultimate success in business will depend upon adapting these sound conceptual approaches in a business world that is filled with uncertain and abstract problems. Do not assume that analytical methods can be used to solve all business problems, but do not abandon them in favor of wild guess work!