CHAPTER 11

RELEVANT COSTS FOR NON-ROUTINE DECISION MAKING

(Identification of Relevant Costs)

Requirement 1
The relevant costs of a fishing trip would be:

Fuel and upkeep on boat per trip...................................... P25

Junk food consumed during trip*...................................... 8

Snagged fishing lures.......................................................    7
Total P40

* The junk food consumed during the trip may not be completely relevant. Even if Shin
were not going on the trip, he would still have to eat. The amount by which the cost of the
junk food exceeds the cost of the food he would otherwise consume would be the relevant
amount.

The other costs are sunk at the point at which the decision is made to go on another fishing trip.

Requirement 2
If he fishes for the same amount of time as he did on his last trip, all of his costs are likely to be
about the same as they were on his last trip. Therefore, it really doesn’t cost him anything to catch
the last fish. The costs are really incurred in order to be able to catch fish and would be the same
whether one, two, three, or a dozen fish were actually caught. Fishing, not catching fish, costs
money. All of the costs are basically fixed with respect to how many fish are actually caught
during any one fishing trip, except possibly the cost of snagged lures.

Requirement 3
In a decision of whether to give up fishing altogether, nearly all of the costs listed by Shin’s wife
are relevant. If he did not fish, he would not need to pay for boat moorage, new fishing gear, a
fishing license, fuel and upkeep, junk food, or snagged lures. In addition, he would be able to sell
his boat, the proceeds of which would be considered relevant in this decision. The original cost of
the boat, which is a sunk cost, would not be relevant.
These three requirements illustrate the slippery nature of costs. A cost that is relevant in one
situation can be irrelevant in the next. None of the costs are relevant when we compute the cost of
catching a particular fish; some of them are relevant when we compute the cost of a fishing trip;
and nearly all of them are relevant when we consider the cost of not giving up fishing. What is
even more confusing is that CG is correct; the average cost of a salmon is P167, even though the
cost of actually catching any one fish is essentially zero. It may not make sense from an economic
standpoint to have salmon fishing as a hobby, but as long as Shin is out in the boat fishing, he
might as well catch as many fish as he can.

(Dropping or Retaining a Segment)

Requirement 1
No, the housekeeping program should not be discontinued. It is actually generating a positive
program segment margin and is, of course, providing a valuable service to seniors. Computations
to support this conclusion follow:
 Contribution margin lost if the housekeeping program is dropped............................ P(80,000)
Fixed costs that can be avoided:
Liability insurance................................................................................................. P15,000
Program administrator’s salary.............................................................................  37,000   52,000
Decrease in net operating income for the organization as a whole........................... P(28,000)

Depreciation on the van is a sunk cost and the van has no salvage value since it would be donated
to another organization. The general administrative overhead is allocated and none of it would be
avoided if the program were dropped; thus it is not relevant to the decision.
The same result can be obtained with the alternative analysis below:
Difference: Net
Total If House- Operating Income
keeping Is Increase or
Current Total Dropped (Decrease)
Revenues................................................................................. P900,000 P660,000 P(240,000)
Variable expenses....................................................................  490,000  330,000    160,000
Contribution margin..................................................................  410,000  330,000    (80,000)
Fixed expenses:
Depreciation*....................................................................... 68,000 68,000 0
Liability insurance................................................................ 42,000 27,000 15,000
Program administrators’ salaries......................................... 115,000 78,000 37,000
General administrative overhead.........................................  180,000   180,000              0
Total fixed expenses.................................................................  405,000   353,000      52,000
Net operating income (loss)...................................................... P   5,000 P(23,000) P  (28,000)

*Includes pro-rated loss on disposal of the van if it is donated to a charity.

Requirement 2
To give the administrator of the entire organization a clearer picture of the financial viability of
each of the organization’s programs, the general administrative overhead should not be allocated.
It is a common cost that should be deducted from the total program segment margin. Following
the format for a segmented income statement, a better income statement would be:
Meals on
Total Home Nursing Wheels House-keeping
Revenues............................................................. P900,000 P260,000 P400,000 P240,000
Variable expenses................................................  490,000  120,000  210,000  160,000
Contribution margin..............................................  410,000  140,000  190,000    80,000
Traceable fixed expenses:
Depreciation..................................................... 68,000 8,000 40,000 20,000
Liability insurance............................................ 42,000 20,000 7,000 15,000
Program administrators’ salaries.....................  115,000    40,000    38,000    37,000
Total traceable fixed expenses.............................  225,000    68,000    85,000    72,000
Program segment margins...................................  185,000 P 72,000 P105,000 P  8,000
General administrative overhead..........................  180,000
Net operating income (loss).................................. P  5,000

(Special Order)

Requirement 1
Monthly profits would be increased by P9,000:
Total for 2,000
Per Unit Units
Incremental revenue........................................................................................................... P12.00 P24,000
Incremental costs:
Variable costs:
Direct materials......................................................................................................... 2.50 5,000
Direct labor............................................................................................................... 3.00 6,000
 Variable manufacturing overhead............................................................................. 0.50 1,000
Variable selling and administrative............................................................................    1.50    3,000
Total variable cost.......................................................................................................... P 7.50  15,000
Fixed costs:
None affected by the special order...........................................................................          0
Total incremental cost.........................................................................................................  15,000
Incremental net operating income....................................................................................... P 9,000

Requirement 2
The relevant cost is P1.50 (the variable selling and administrative costs). All other variable costs
are sunk, since the units have already been produced. The fixed costs would not be relevant, since
they would not be affected by the sale of leftover units.

(Make or Buy a Component)

The costs that are relevant in a make-or-buy decision are those costs that can be avoided as a
result of purchasing from the outside. The analysis for this exercise is:
Per Unit
Differential Costs 20,000 Units
Make Buy Make Buy
Cost of purchasing................................................................ P23.50 P470,000
Cost of making:
Direct materials................................................................ P 4.80 P96,000
Direct labor...................................................................... 7.00 140,000
Variable manufacturing overhead.................................... 3.20 64,000
Fixed manufacturing overhead........................................    4.00 *              80,000              
Total cost......................................................................... P19.00 P23.50 P380,000 P470,000
* The remaining P6 of fixed manufacturing overhead cost would not be relevant, since it will continue regardless of
whether the company makes or buys the parts.
The P150,000 rental value of the space being used to produce part R-3 represents an opportunity
cost of continuing to produce the part internally. Thus, the completed analysis would be:
Make Buy
Total cost, as above.................................................................................................... P380,000 P470,000
Rental value of the space (opportunity cost)................................................................  150,000             
Total cost, including opportunity cost........................................................................... P530,000 P470,000
Net advantage in favor of buying................................................................................. P60,000

Profits would increase by P60,000 if the outside supplier’s offer is accepted.

CHAPTER 12

QUANTITATIVE METHODS FOR DECISION MAKING

Introduction to Quantitative Analysis

This is a course about the use of quantitative methods to assist in decision making. The subject matter makes up
the discipline known as decision sciences, or you might hear it called management science or operations
research.

We will be covering a number of descriptive and prescriptive mathematical models that have proven useful to
managers, generally since World War II, although some of the models date back to the early 1900's.
Mathematical models are simply representations of reality that provide a framework for a scientific approach to
the study of managerial problems.

Models also help us gain insight into relationships such as the relationship that exists between an objective and a
constraint. For example, we will be using linear programming prescriptive models to represent the relationship
between a profit maximization objective and one or more limited resource constraints. Suppose a company
manufactures two products, X and Y. Product X has a profit contribution of $100 and Y $300. The
mathematical expression for maximizing profit is simply:

Maximize Profit = 100 X + 300 Y

What should this company do to maximize profit? That's right, make an infinite number of Y's! But the real
world presents constraints to every operation. Suppose that it takes 4 hours of labor to assemble an X, and 20
hours of labor to assemble each Y. If there are 140 hours of labor available in the next production period, we can
expand the problem as follows:

Maximize Profit = 100 X + 300 Y

Subject to Labor Constraint: 4 X + 20 Y < 140
The labor constraint equation uses numbers to represent the technological rate of resource consumption of the
two products (the coefficients of 4 and 20), as well as a less than or equal sign to put an upper limit on the 140
hour labor constraint. If we wanted to continue our strategy of making all Y's and no X's, we see that we could
make 7 Y's by using all of the 140 hours of labor.

Let X = 0, then
4 (0) + 20 Y = 140 gives
20 Y = 140 or

Y = 140/20 = 7

Solving for Profit, we get:

Profit = 100 (0) + 300 (7) = $2,100

But there is another alternative worth examining. We could make all X's and no Y's. Since X's require much less
labor, we can make 35 of them, at a profit of $3,500 - the better alternative. To be sure we have the best or
optimal solution that maximizes our profit criteria, we would need the mathematical model to check the profit
contribution of all other product mix combinations.

Obviously, this is a small problem that can be solved by observation. Imagine what the linear program problem
formulation looks like for an auto manufacturer which much select between perhaps 10 models of one make of
car subject to a multitude of labor, equipment, and market constraints. For these large problems we need a more
formal problem solving process.

The scientific approach to the study of managerial problems incorporates a problem solving process. The text
presents a seven-step process:

1. Identify and define the problem

2. Determine the set of alternative solutions

3. Determine the criterion or criteria that will be used to evaluate the alternatives.

4. Evaluate the alternatives (using an appropriate quantitative method or model).

5. Choose an alternative

6. Implement the selected alternative (the decision)

7. Evaluate the results and determine if a satisfactory solution has been obtained.

Decision-making is concerned with the first five steps and will be our focus through this course. The first three
steps are concerned with structuring the problem, and the next two with analysis. When the manager adds
qualitative considerations to the selection process, and follows through with implementation and evaluation, the
problem solving process is complete.
We will start off the course with descriptive models that describe outcomes for selected alternatives, and in that
manner assist the decision-maker in selecting between alternatives. These models include decision analysis,
forecasting, project management, and queuing or waiting line models.

For example, I hope you will enjoy the module on queuing or waiting lines simply because most of us probably
have "war stories" about waiting in lines some where at some time. Did you know that there are descriptive
models that predict how many customers will be standing in a given line, and for how long, given that we know
the customer arrival rate and system service rate inputs? In this module, we will introduce models that will
prove to you why banks and Disney utilize a single line/multiple server configuration to minimize waiting time
in line for their customers.

I hope you will also enjoy the forecasting module where simple mathematical techniques are used to discover
patterns such as trend and seasonality in our data. In the forecasting module, we drive home how important it is
to measure and report the reliability of a forecast - almost as important as the forecast itself.

The project management material helps us learn about the importance of focusing on critical activities, and on
the concept of slack resources. The decision analysis material we start with helps us appreciate the value that
can be placed on information as we study a model designed to help manager select between decisions when
faced with several state of nature scenarios.

The first prescriptive or optimization model that we will examine will be the classic economic order quantity
inventory model that has been used by managers to determine how much to order and when for the past 80
years. The model is prescriptive in the sense that we provide inputs such as demand, the cost to carry and the
cost to order inventory, and the model selects the order quantity alternative that minimizes total incremental
inventory cost.

We wrap up the course with linear and integer programming optimization models that select alternatives which
provide the best value for the problem criteria subject to structural and environmental constraints. An example
of an optimization problem was presented at the beginning of this section. Optimization models are very
powerful and are used to assist decision-makers in capital budgeting, project selection, resource allocation, and
scheduling and transportation problems.

Before we get started with our first module, Decision Analysis, you may want to load the CD-ROM that comes
with "The Management Scientist." I took a break to load my CD-ROM on my laptop at this point.

1. First, I broke open the seal and took out the CD-ROM (meaning I just bought the book!) and placed it in the
CD Drive in my personal computer.
Warning: As I proceeded with the installation steps below, I was warned to close any open applications before
proceeding with the installation. Since I had Word open, I stopped the installation, closed Word, then continued
with Step 2 below.
2. Next, following the installation instructions on page 2 of The Management Scientist, I clicked the Start button
in the Windows Task Bar and chose Run.

3. On the Command line, I typed D:\Setup (after noting to change "D" if my CD-ROM drive has a different
letter designation).

4. I then clicked the OK button (or press the Enter key).

5. I then followed the prompts of the installation.