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Chapter 11 - Decision Making with a Strategic Emphasis
Chapter 11
Decision Making with a Strategic Emphasis
Learning Objectives
LO 11-1 Define the decision-making process and identify the types of cost information relevant for
decision making.
LO 11-2 Use relevant cost analysis and strategic analysis to make special-order decisions.
LO 11-3 Use relevant cost analysis and strategic analysis in the make, lease, or buy decision.
LO 11-4 Use relevant cost analysis and strategic analysis in the decision to sell before or after additional
processing.
LO 11-5 Use relevant cost analysis and strategic analysis in the decision to keep or drop products or
services.
LO 11-6 Use relevant cost analysis and strategic analysis to evaluate service and not-for-profit
organizations.
LO 11-7 Analyze the short-run product-mix decision.
LO 11-8 Discuss behavioral, implementation, and legal issues in decision making.
LO 11-9 Set up and solve in Excel a simple product-mix problem (appendix).
New in this Edition
One updated Real-World Focus (RWF) item, dealing with distortions and deceptions in decision-making
Three (3) new Real-World Focus (RWF) items: Sustainability—The Decision to Install Solar;
Amzaon.com—Insourcing of Retail Delivery Service; and, Sustainability—Choice of a New Auto
Increased use of Excel’s “Goal Seek” function for end-of-chapter exercises and problems
Shorter, crisper discussion of Predatory Pricing Practices
Teaching Suggestions
A key teaching point for this chapter is that the strategic issues can be more important than the calculation of
contribution margin or relevant cost to determine a preferred decision alternative. The approach I take is to first
introduce the concepts of relevant costs and decision making, and then to bring in the importance of the firm’s
strategy in determining the correct decision.
I typically cover Chapter 11 in two days. In the first day I present the fundamental concepts of
contribution/relevant cost decision making and cover one or more assignments from the following areas:
1. the special-order decision
2. the make, lease, or buy decision
3. the decision to sell at split-off or after additional processing
4. the decision to keep or drop a product line
5. evaluating programs, including not-for-profit programs
I do not stress the strategic approach on the first day, but concentrate instead on the fundamentals and problem
solving. The first day is mostly drill and practice in problem solving. I explain to the students that in this chapter
the concepts are simple but the application is sometimes difficultthat many students find they can understand the
chapter but have difficulty with some of the homework (and exam) problems. I tell them a key approach in this
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Chapter 11 - Decision Making with a Strategic Emphasis
chapter has to be practice, so that they see how to work a variety of different problems and develop confidence in
working these problems.
On the second day I focus on developing the strategic approach to decision making. I use one or more
exercises/problems to reinforce the point that relevant information for decision making includes both quantitative
(financial and non-financial) data as well as qualitative/strategic considerations. My main objective for the second
day is to leave the students with the idea that relevant cost/contribution margin decision analysis is only a part of
decision making, and that strategic considerations play an important part. Time permitting, and in the advanced
course, I present linear programming for the short-term product-mix decision; the Appendix to Chapter 11 shows
how to use the Solver Routine in Excel 2010 for this purpose.
Assignment Matrix
End-of-Chapter Exercises and Problems Chapter Learning Objectives Text Features
7th ed.
EOC
6th ed.
EOC
Transition
6e to 7e
X = included in Connect
Est. Time
1. Decision-making process
2. Special-order decisions
3. Make, lease, or buy decisions
4. Sell before or after processing
5. Keep or drop decision
6. Service/NFP Programs Anal.
7. Short-term Product/Service Mix
8. Behavioral and legal issues
9. Using Excel: Product-Mix Prob.
Strategy
Service
International
Ethics
Sustainability
Brief Exercises
11-11 11-14 - X 10 min X
11-12 11-17 - X 5 min X
11-13 11-18 - X 5 min X
11-14 11-20 - X 10 min X
11-15 11-19 - X 10 min X
11-16 11-16 - X 10 min X
11-17 11-12 - X 10 min X
11-18 11-13 - X 5 min X
11-19 11-11 - X 5 min X
11-20 11-15 - - 5 min X
Exercises
11-21 11-29 - - 60 min X X X
11-22 11-21 - X 30 min X
11-23 11-22 - X 50 min. X
11-24 11-23 - X 30 min X X
11-25 11-24 - X 25 min X X
11-26 11-25 Revised X 50 min X
11-27 11-27 - X 45 min. X X
Continued on next page…
Chapter 11 Assignment Matrix—Continued
End-of-Chapter Exercises and Problems Chapter Learning Objectives Text Features
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Chapter 11 - Decision Making with a Strategic Emphasis
7th ed.
EOC
6th ed.
EOC
Transition
6e to 7e
X = included in Connect
Est. Time
1. Decision-making process
2. Special-order decisions
3. Make, lease, or buy decisions
4. Sell before or after processing
5. Keep or drop decision
6. Service/NFP Programs Anal.
7. Short-term Product/Service Mix
8. Behavioral and legal issues
9. Using Excel: Product-Mix Prob.
Strategy
Service
International
Ethics
Sustainability
11-28 11-26 - - 50 min. X X
11-29 11-28 - - 50 min X
11-30 11-30 Revised X 90 min X X X X X X
Problems
P11-31 P11-39 - - 90 min. X X X X X X
P11-32 P11-32 Revised - 45 min. X X X X
P11-33 P11-33 Revised - 60 min. X X X
P11-34 P11-34 Revised - 45 min X
P11-35 P11-31 - - 90 min X X X
P11-36 P11-35 - - 60 min X X X
P11-37 P11-37 Revised - 45 min X X X
P11-38 P11-38 - - 45 min X X X X X X
P11-39 P11-42 - - 60 min X X X
P11-40 P11-43 - - 75 min X X X
P11-41 P11-44 Revised - 60 min X X
P11-42 P11-46 - - 75 min X X X X
P11-43 P11-47 - - 45 min X X
P11-44 P11-36 - - 45 min X X X X X
P11-45 P11-48 - - 60 min X X X
P11-46 P11-40 - - 75 min X X X
P11-47 P11-41 - - 45 min X X
P11-48 P11-45 - - 60 min X X
Lecture Notes
A. The Decision-Making Process—see Text Exhibit 11.1. In deciding among alternative choices for a given
situation, managers employ the following five-step process. The first, and probably most important, step is to
consider the strategic issues regarding the decision context. This helps focus the decision maker on answering the
right question. The second step is to specify the criteria by which the decision is to be made. Often, a manager is
forced to think of multiple objectives, both the quantifiable short-term goals, and the more strategic long-term
goals. In the third step, a manager performs an analysis in which the relevant information is developed and
analyzed, using relevant cost analysis and strategic analysis. This step involves three sequential steps, the manager
identifies and collects relevant information about the decision, makes predictions about the relevant information,
and considers the strategic issues involved in the decision. Fourth, based on the cost analysis, the manager selects
the best alternative and implements it. In the fifth step, the manager evaluates the performance of the implemented
decision as it relates to future decisions.
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B. Relevant Cost Analysis—Basic Considerations:
1. Relevant Cost Information. Relevant costs are costs that will be incurred at some future time and
that differ for each option available to the decision maker. A relevant cost can either be variable or
fixed. Generally, variable costs are relevant for decision making because they differ for each
option and have not been committed. In contrast, fixed costs are often irrelevant, since typically
they do not differ for the options. Occasionally, some variable costs are not relevant and
sometimes, fixed costs can be relevant. However, there is more to the decision process than the
discovery of relevant costs. The manager must also consider the long-term, strategic issues.
2. Batch-Level Cost Drivers. Although most relevant costs for many decisions are variable, the
concept of variable costs does not mean only a cost tied to changes in the output level. A variable
cost varies directly with changes in a given cost driver, whether it is the number of products
produced, or the number of batches of product produced. In determining the costs that differ for
options, managers must consider variable costs in the broadest possible sense as those that might
vary at any level of manufacture (units of output, batches, and products).
3. Fixed Costs and Depreciation. A common misperception is that depreciation of existing facilities
is a relevant cost. Depreciation is a portion of a committed cost; therefore, it is sunk and irrelevant.
There is an exception to this rule: when tax effects are considered in decision-making. In this case,
depreciation has a positive value, since it’s an expense and it reduces taxable income.
4. Other Relevant Information: Opportunity Costs. Managers should include in their decision
process information such as the capacity usage of the plant. Capacity usage information is a
critical signal of the potential relevance of opportunity costs, the benefit lost when one chosen
option precludes the benefits from an alternative option. When opportunity costs are relevant, the
manager must consider the value of lost sales as well as the contribution form the new order or
new product. Another important factor is the time value of money that is relevant when deciding
among alternatives with cash flows over two years or more.
C. Strategic Analysis. Strategic information keeps the decision maker’s attention focused on the firm’s crucial
strategic goal. Failing to attend to the long-term, strategic factors could cause the firm to be less competitive in
the future. By identifying only relevant costs, the decision maker might fail to link the decision to the firm’s
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Chapter 11 - Decision Making with a Strategic Emphasis
strategy. A good indication of a manager’s failing to take a strategic approach is that the analysis will have a
product cost focus, while a strategic relevant cost analysis also addresses broad and difficult-to-measure strategic
issues.
D. Special-Order Decisions: Cost Analysis. The special-order decision occurs when a firm has a one-time
opportunity to sell a specific quantity of its product or service. It is called “special order” because it is typically
unexpected and non-recurring in nature. To make this special order decision, managers need critical information
about relevant costs, revenues, and any opportunity costs.
E. Special-Order Decisions: Strategic Analysis. The relevant cost analysis described in the previous section
provides a useful decision regarding the order’s profitability. However, for a full decision analysis, the firm
should also consider the strategic factors of capacity use, short-term vs. long-term pricing, the trend in variable
costs, and the use of activity-based costing. The relevant cost decision rule for special orders is intended only for
those infrequent situations when a special order can increase income. Done on a regular basis, relevant cost
pricing can erode normal pricing policies and lead to a loss on profitability for firms. Special order decisions
should not become the centerpiece of a firm’s strategy.
F. Make, Lease, or Buy Decisions: Cost Issues. The relevant cost information for the make-or-buy decision is
developed in a manner similar to that of the special order decision. The relevant cost information for making the
component consist of the short-term costs to manufacture it, ordinarily the variable manufacturing costs, which
would be saved if the part was purchased. These costs are compared to the purchase price for the part to determine
the appropriate decision. A similar question arises when a firm must choose between leasing or purchasing a piece
of equipment. Such decisions become ever more frequent as the cost and terms of the lease agreement become
more favorable.
G. Make, Lease, or Buy Decisions: Strategic Analysis. The make, lease, or buy decision often raises strategic
issues. Make, lease, or buy analysis has a key role in the decision to outsource by providing an analysis of the
relevant costs. Certain firms have taken the idea of outsourcing one step further, to what is called contract
manufacturing, in which another firm manufactures a portion of the first firm’s products. When one firm has
more capacity or expertise than another firm, contract manufacturing can be a cost-effective strategy for both
firms.
H. Sell Before or After Additional Processing: Cost Analysis. Another common decision concerns the option to
sell a product or service before an intermediate processing step or to add further processing and then selling the
product or service for a higher price. The analysis of features also is important for manufactures in determining
what to do with defective parts. The decision is whether the product should be sold with or without additional
processing. I use class time to distinguish between financial reporting uses of cost information (here, the need to
allocate joint production costs to outputs, so that the accountant can prepare financial statements—inventory on
the Balance Sheet, and Cost of Goods Sold on the Income Statement) versus the decision-use of cost information
(here, whether certain products should be sold at the spilt-off point or processed further and then sold). Again, the
decision process should begin (but not end) with a relevant cost analysis: which costs in the decision are
avoidable, and which are not? Added in the 6th edition was a discussion of the following terms:
joint production process
split-off point
joint production costs, and
separable processing costs
I. Sell Before or After Additional Processing: Strategic Analysis. Strategic concerns arise when considering
selling to discount stores, and whether doing so will affect sales in our markets.
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Chapter 11 - Decision Making with a Strategic Emphasis
J. Profitability Analysis: Keep or Drop a Line—Cost Issues. An important aspect of management is the
regular review of product profitability. This review should address the following issues:
Which products are most profitable?
Are these products properly prices?
Which products should be promoted and advertised more aggressively?
Which product managers should rewarded?
K. Profitability Analysis: Keep or Drop a Line—Strategic Issues. In addition to the relevant cost analysis, the
decision to keep or drop a product line should include relevant strategic factors, such as the potential effects of the
loss of one product line on the sales of another. Other important factors include the potential effect on overall
employee morale and organizational effectiveness if a product line is dropped. Moreover, managers should
consider the sale growth potential of each product. A particularly important consideration is the extent of available
production capacity.
L. Profitability Analysis: Evaluating Programs—Cost Issues. Managers use the concept of relevant cost
analysis to measure the financial effectiveness of programs or projects sponsored by government and non-profit
organizations.
M. Multiple Products and Limited Resources. The preceding relevant cost analyses were simplified by using a
single product and assuming sufficient resources to meet all the demands. The analysis changes significantly with
two or more products and limited resources. A key element of the relevant cost analysis is the most profitable
sales mix for the two products. If there are no production constraints, the answer is clear, we manufacture what is
needed to meet demand for both products. However, when demand exceeds production capacity, management
must make some trade-offs about the quantity of each product to manufacture, and therefore, what demand is
unmet.
1. One Resource Constraint. When there is only one production constraint and excess demand, it is
generally best to focus production and sales on the product with the highest contribution per unit of scarce
resource. Of course, it is unlikely in a practical situation that a firm would be able to adopt the extreme
position of deleting one product and focusing entirely on the other. An optimal solution in this simplified
case can be determined graphically (that is, by determining the total contribution margin associated with
the “corner points” on a graph similar to the one depicted in Exhibit 11.19).
2. Two Resource Constraints. When the production process requires two or more production constraints, the
choice of sales mix involves a more complex analysis, and in contrast to one production constraint, the
solution can include both products. The analysis of sales mix and production constraints is a useful way
for managers to understand both how a difference in sales mix affects income and how production
limitations and capacities can significantly affect the proper determination of the most profitable sales mix.
When there are only two products, the optimal solution can be determined graphically (see text Exhibit
11.21, by choosing one of the “corner points” from the “feasible region”).
3. Using the Solver Routine in Excel: See the Appendix to the chapter for setting up and solving a
“constrained optimization” problem, similar to the product-mix problem discussed in the chapter. Of
particular interest is the “Sensitivity Report” that accompanies the optimal solution generated by Excel.
(See Exhibit 11A.4 for a sample report.)
N. Behavioral and Implementation Issues:
1. Consideration of Strategic Objectives. A well-known problem in business today is the tendency of
managers to focus on short-term goals and neglect the long-term strategic goals because their
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Chapter 11 - Decision Making with a Strategic Emphasis
compensation is based on short-term accounting measures. It is critical that relevant cost analysis be
supplemented by a careful consideration of the firm’s long-term strategic concerns. Without strategic
considerations, management could improperly use relevant cost analysis to achieve a short-term benefit
and potentially suffer a significant long-term loss.
2. Predatory Pricing Practices. The Robinson-Patman Act, administered by the FTC, addresses pricing that
could substantially damage the competition in an industry. This is called predatory pricing, and it occurs
when a company has set prices below cost and planned later to raise prices to recover the losses from lower
prices. This law is relevant for short-term and long-term pricing since it could require a firm to justify
significant price cuts.
3. Replacement of Variable Costs with Fixed Costs. Another potential incentive associated with relevant
cost analysis is for managers to replace variable costs with fixed costs. This might happen if mid-level
managers realize that because they rely on relevant cost analysis, upper management tends to overlook
fixed costs. Management’s proper goal is to maximize contribution margin and to minimize fixed operating
costs at the same time. Managers must not forget to develop methods to manage fixed costs.
4. Proper Identification of Relevant Factors. Another possible problem area of cost analysis is that
managers can fail to properly identify relevant costs. In particular, untrained managers commonly include
irrelevant, sunk costs into their decision-making. Similarly, many managers fail to see that allocated fixed
costs are irrelevant. It is easier for these managers to see the fixed cost as irrelevant when it is given in a
single sum.
Advanced Lecture Notes
The illustrations developed in this chapter have assumed that each of the cost and revenue factors in the relevant
cost analysis is known with certainty. In some situations this can be a very unrealistic assumption, as for example,
for new companies, new products, seasonal products, and so on. Rather than to simply calculate the cost and/or
income under each decision alternative based on approximated values, managers often prefer to incorporate the
uncertainty directly into the analysis. Techniques have been developed to deal with this matter; they include
simulation and analytical modeling, which are explained in the teaching notes at the end of Chapter 9 (CVP
analysis) in this guide.
Another technique for handling uncertainty is to use a probability modeling approach, as explained in the note
below. This approach is also used in Chapter 12 (Capital Budgeting) and in the appendix of Chapter 15 to
illustrate the application of the method for investigating standard cost variances under conditions of uncertainty.
Modeling of Uncertainty in Relevant Cost Analysis
To illustrate the application of probability modeling, we consider again the example of the QUICK COPY lease or
buy decision developed in this chapter. Now suppose QUICK COPY is uncertain that the annual demand will be
6,000,000 copies, and wants to formally include this uncertainty in the analysis. The first step is to have
management describe their uncertainty in a graph; suppose what you get from this is shown in Exhibit 1. The
graph shows that management expects the number of copies will be between 4,000,000 and 8,000,000 copies and
there is a 30% chance it will be between four and six million, and a 70% chance it will be between six and eight
million copies.
Since we know from the analysis in the chapter that QUICK COPY should purchase rather than lease the copy
machine if the demand for the number of copies exceeds the indifference point of 5,000,000 copies, and since
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Chapter 11 - Decision Making with a Strategic Emphasis
there is a 70% probability that the demand for copies will exceed six million copies, we can say that the
probability is at least 70% that QUICK COPY will have less cost if it purchases the new machine.
We can also give the manager a pretty good idea of expected income assuming the purchase of the machine, as
follows. First, we assume that the average price per copy is $.06, the average cost of paper per copy is $.01, and
the expected labor and other operating costs are expected to be $48,000. (Note that this information was irrelevant
for the decision about lease or purchase, since the decision would not affect price, paper cost or operating costs).
Second, with the idea that since the probability is 30% that sales will be between four and six million copies, we
say the probability is 30% that sales will be exactly five million copies (the mid-point) to simplify the analysis
(and similarly, the probability is 70% that sales will be seven million copies). Then, expected income can be found
by calculating the expected value for each of the two possible outcomes (5 or 7 million sales of copies).
Expected Income = Expected contribution less Fixed Operating Costs (Labor, Service
Contract, Depreciation)
Exhibit 1: Probabilities for QUICK COPY
This expected value calculation shows that QUICK COPY can expect income of $132,000, assuming the purchase
of the copier and given management's probabilistic estimate of demand. This information can be used by
management in choosing whether to lease or to buy the new machine, in planning expenditures for the coming
year, and in obtaining financing for the new machine.
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