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Decision Making

Management 122
Michael Williams

Nine steps for decision


making
1. Make sure you fully understand the economic environment.
2. Identify the precise nature of the decision.
3. Identify your objectives.
4. Identify the economic effects of your decision.
5. Make sure youve seen the intangible as well as the tangible
effects of the decision.
6. Aggregate all of the effects and determine the choice that
maximizes the objective.
7. What do you need to know that you dont?
8. Make sure youve answered the question that needs
answering.
9. Communicate your findings.

Cost-Volume-Profit
This is an analytical approach used to
model a firms activities.
It involves simplifying assumptions,
specifically that all costs are fixed or
variable.
It can be useful for making a variety of
business decisions.
The nicest feature of CVP is its linearity,
making the math very easy.

The Nature of Costs


Controlling costs is a key objective of any
company.
To control costs, you must understand costs.
Accountants try to identify cost drivers. These are
economic activities that cause costs to increase.
A lot of decisions involve tradeoff between the
costs driven by activities and the benefits they
provide (revenue).

Fixed and variable costs


The most common cost driver is volume.
Volume is the amount of product (in # units) you produce
(manufacturer) or sell (merchandiser).
Costs that are driven by volume are called variable costs.
Total variable cost = (Cost/unit) x Volume
Costs that are independent of volume are called fixed costs.
Step costs are a complication. We can usually treat them as
fixed costs, but only so long as we stay on a single step.

Profit
The main objective of any company is to maximize its
profit.
Profit () = Revenue Cost.
Revenue = Price (P) x Volume (V).
Cost = Var. cost/unit (C) x V + Fixed cost (F)
= PV (CV + F).
= (P C) V F.

Contribution margin
The contribution margin is the first part of the profit
equation.
Contribution margin = (P C) V.
This is how much the volume contributes towards the
profit of the company.
Contribution margin per unit (M) is P C. This is how
much profit increases if you increase volume by one unit.
= MV F.

CVP analysis
= MV F

This formula expresses the fundamental


relationship between the Cost (in M and F), the
Volume (V), and the Profit ().

CVP analysis uses this equation, by plugging in


estimated values for all but one of these
variables and determining the unknown
variable.

Break-even / target profit


A common use of CVP is to determine the volume needed to
achieve a specific profit level.
In this case, M, and F are estimated. V is the unknown.
= MV F.
V = ( + F) / M.
Often, the target profit is zero (how depressing). In this
case, V is called the break-even point.
V = F / M.

CVP in decision making


The break-even/target profit analysis can be used
to decide whether to get into a business.
You need to forecast sales demand and decide
what profit makes the project worthwhile.
The CVP model is also useful for analyzing
decisions about different techniques/strategies
with different fixed/variable costs.
It can also be used for pricing decisions.

CVP example
Ralphs is considering a new store location. It
expects fixed costs to be $2m / year and average
contribution margin per customer to be $10. How
many customers must Ralphs anticipate, for the
new store to break even?
V = F / M = $2 m / $10 = 200,000 per year.
What if Ralphs requires a $500,000 profit each year?
V = ( + F) / M = $2.5 m / $10 = 250,000.