5 Managerial Decision Making

Find the relevant differences

Managers make short-term choices among alternatives such as accepting a one-time order, making or buying a component, or keeping or dropping a product line. A sound decision compares the relevant revenues and costs of each option rather than relying only on the amounts shown in an accounting report.

Relevant information is future-oriented and differs between alternatives. Amounts that remain the same regardless of the choice do not affect which option is better.

Classify costs and benefits

Differential (incremental) costs and revenues are the amounts that change between options. An avoidable cost can be eliminated by choosing an alternative, so it is relevant when it differs between options. Some fixed costs are avoidable, but many short-term fixed costs continue either way.

An opportunity cost is the benefit given up by choosing one option instead of the next-best alternative. It may not appear in accounting records, but it belongs in the analysis. Sunk costs have already been incurred and cannot be changed by the current decision, so they are irrelevant to it.

Do not decide whether a cost matters from its label alone. A fixed cost can be relevant if it can be avoided, while a variable cost already incurred may be sunk. Focus on what will change in the future.

Evaluate a special order

For a one-time order offered below the usual selling price, compare its additional revenue with its additional costs. With idle capacity, regular sales may be unaffected, and existing fixed costs that will not change are generally excluded. If capacity is full, include the contribution margin lost from regular sales displaced by the order, as well as any extra costs required to fulfill it.

For example, a company with idle capacity receives an offer for an order of $1{,}000$ units at $\$18$ each. Variable production cost is $\$12$ per unit, special packaging adds $\$1$ per unit, and the order requires a setup cost of $\$2{,}000$.

On these facts, accepting the order improves short-term income. If the order displaces regular sales, subtract the contribution margin those sales would have earned before deciding.

Compare making with buying

Compare the avoidable cost of making a component with the purchase price, adjusted for any other benefits or costs of either option. Include relevant materials, labor, variable overhead, avoidable fixed costs, delivery or inspection costs, and opportunity costs. Exclude allocated fixed costs that will continue either way. Also consider whether outsourcing frees capacity for more profitable work.

For example, making $10{,}000$ components costs $\$7$ per unit in variable costs and $\$15{,}000$ in avoidable fixed costs:

A supplier offers the components for $\$8.20$ each:

If quality, delivery, and other effects are comparable, and making the components has no additional opportunity benefit, buying saves $\$3{,}000$. Unavoidable factory overhead should not be added to the cost of making merely because it is allocated to the component.

Decide whether to keep or drop a segment

A segment may appear unprofitable after common fixed costs are allocated to it. Instead, compare the contribution margin that would be lost if the segment were dropped with the avoidable fixed costs that would be saved. Dropping a segment improves income only when the avoidable costs saved, together with any other benefits, exceed the contribution margin and other benefits lost.

For example, a product line earns a contribution margin of $\$40{,}000$ and has $\$30{,}000$ of avoidable fixed costs. Dropping it would reduce income by $\$10{,}000$ before considering other effects. Allocated headquarters costs that continue after the line closes do not count as savings.

Consider qualitative effects and avoid pitfalls

Financial comparisons do not capture every consequence. Consider product quality, supplier reliability, customer relationships, effects on employees, legal or contractual obligations, reputation, and whether the choice supports the company’s longer-term strategy. A low supplier bid, for example, may be unattractive if unreliable delivery threatens customer orders.

Common pitfalls include:

• Including sunk costs because they were large or because management wants to recover them.

• Treating all fixed costs as irrelevant, or assuming all allocated fixed costs will disappear when a segment closes.

• Ignoring opportunity costs, capacity constraints, or sales displaced by a special order.

• Comparing average or full cost per unit instead of the amounts that change between alternatives.

• Treating the numerical result as the only consideration and overlooking qualitative effects.

Follow a practical decision process

Use this process to organize a short-term decision:

1. State the alternatives and the decision period.

2. Identify future revenues, costs, and benefits that differ between the options.

3. Remove sunk costs and amounts that remain unchanged; add opportunity costs.

4. Compare the net financial effect of each option.

5. Assess qualitative consequences and test important assumptions, such as whether capacity is available or fixed costs are truly avoidable.

6. Choose the alternative with the strongest overall benefit, not merely the lowest reported cost.

The analysis depends on relevant future differences. Special-order decisions turn on incremental costs, capacity, and displaced sales; make-or-buy decisions compare avoidable production costs with purchase costs and opportunity benefits; and keep-or-drop decisions weigh lost contribution margin against costs actually saved. Combine the financial analysis with qualitative judgment, and do not let sunk costs or arbitrary allocations distort the choice.

• differential costs and revenues

• make-or-buy decision