The wide availability of personal computers encourages more managers to apply cost volume profit analysis
Computers can quickly make the computations for changes in the assumptions identifying proposed projects e.g. computer spreadsheets allow managers to determine the most profitable combination of selling process, variable and fixed cost volume. A manager enters into the computer various numbers for price and cost in an equation based on CVP relationships to yield target income for each combination because of a computers speed and accuracy in providing this information the manager can select the most profitable actions
Limitations of CVP Analysis
The use of the basic CVP model is only relevant to planning and decision-making in an activity range in which the basic cost and revenue behaviour assumptions are valid. Outside the relevant range, CVP techniques may still be applied so long as the varying cost and revenue behaviour patterns are taken into consideration.
However, the limitations o CVP analysis are actually its assumptions, which do not hold outside the relevant range!
Nature of Decision-making
Decision-making may fall into any of the following categories
- Short run operational decisions
- Short run tactical decisions
- Longer term strategic planning decisions
Short run operational decisions are made in relation to the achievement of short-term output requirements. A decision may be made to work overtime in a department in order to have a job completed in accordance with a scheduled delivery date to the customer. Such decisions are aimed at ensuring that the current business plan is achieved
Short run tactical decisions are related to specific events which management wish to decide upon and which will change the future operation of the business in some way. Its time horizon is short and it is usually the next 12 months
Longer term strategic planning is more concerned with the overall direction of the business plan. It may have a time horizon of 5 to 10 years. For example should a decision be made to install a fully automated production line to replace existing labour intensive machine process. These decisions require consideration of factors such ass
- The level of market likely to be available in future
- An estimation of changing price levels
- The timing of cash flows in relation to the decision
- The degree of uncertainty estimated in relation to data used in the evaluation of the situation
- The strategy which competitors are likely to implement
- The cost of capital or target rate of return
The decision making cycle
Steps in decision-making cycle are:
- Clearly define the objective, which is to be the focus of the decision. This is important in order that the decision makers have a well-defined problem which has to be solved and not a vague idea which lacks clarity.
- Consider the alternative strategies available to the satisfactory attainment of the objective. This is important in order that the final decision agreed upon has taken account of all relevant possibilities.
- Gather relevant information in order to compare alternative strategies in quantifiable terms. This may require considerable thought and effort in order to ensure that all relevant data are obtained.
- Consider the qualitative factors, which are likely to influence the decision. This is important as an element in decision making. There may be non-quantifiable costs and benefits, which lead to the final choice of strategy being other than that giving the highest quantifiable return.
- Compare the alternative strategies using both quantitative and qualitative data and then make a final decision.
- Re-evaluate your decision; determine if you are achieving the objectives and if not, repeat the process.
Relevant costs and decision-making
The relevance of costs will depend upon the purpose for which they are being used. Relevance is related to future decisions
The relevance of costs in decision-making is related to whether they are avoidable in relation to the decision made or if they are unavoidable, in that they will remain irrespective of the decision taken.
Relevant costs in decision-making are therefore said to be incremental and future costs relating to the decision to be made. Costs are incremental if they will result in a difference e.g. avoidable costs result in reduced cots if they are avoided. Future costs are those costs that have not yet been incurred i.e. they are not sunk costs or committed costs. This is explained further in this text.
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