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LESSON -7
DECISION MAKING PROCESS
Before going through various stages of decision making process, we must essentially
understand the word ‘decision.’ This word has been derived from Latin word ‘decide re
‘and this mean ‘a cutting off ‘. This decision involves a cut of alternation between these that
are desirable.
The decision making is a process to arrive at a decision. “Shell et al” have defined decision
making as follows:
“Decision Making is a conscious human process is involving both individual and social
phenomenon based upon factual and value premises which includes with a choice of
behavioral activity from among one more alternatives with the intention of moving towards
some desired state is affairs”.
Thus decision-making is an act of one’s own mind upon an opinion or cause of action.
Decision making May takes places with or without recognizing that an opportunity for
decision making exists. The recognizing of such situation (problems) is the first element of
a decision making process.
There must be at least two alternations available to have a decision making situation. There
will be no decision making if only one course of action is available because there is nothing
to decide.
• Recognizing a problem:
Recognizing a problem is a real beginning of decision making process. Only when a problem
is recognized can the work toward its solution begin in a logical manner. The decision making
process begin with the recognition of a problem and the rush was on to determine what should
be done. A problem exist for a long time, it will be a problem only if it is recognized. In
typical situation like an overdrawn check, or exhausted supply of raw materials in a
manufacturing process, recognition of problem is obvious and immediate. Once we are aware
of the problem, we can solve it immediately
As we have already discussed, from the information external from the problem statement, the
objective function and constraints are formulated. A checklist may be useful for eliminating
error in problem formulation. Following is a sample checklist.
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We may find lot of alternation to a problem but they may be practical or impractical
alternations. An alternative may be infeasible for a variety of reasons such as violation of
fundamental law of science or require resources etc. After elimination only feasible
alternatives remain, and these became an input for further analysis.
It is very easy to select the criteria for choosing the best alternative. If the above five criteria
to a situation in which there were a number of alternation. It seems likely that the different
criteria would result in different decision. It may not the possible to minimize
unemployment without increasing expenditure of money at the same time. The
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disagreement between labor and management is collective bargaining wages and conditions
of employment reflect o disagreement over the criterion for selecting the best alternative.
After listing possible alternatives we have to weigh them without prejudice, no matte how it
is appealing or distasteful. While a suitable solution may solve the problem, it may not work
if resources are not available, if people won’t accept or if it causes new problem.
The following are some of the technologies used in decision making process.
1. Brain storming process
2. Linear programming.
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Linear Programming
Linear programming is a mathematical technique used in economics. This is to find
optimum objective function, subject to a set of constraints. The function must be linear in
order, for LP technique to use. This is to achieve the best allocation of its limited resources
such as money, materials, machines, spaces, time etc in a typical organization.
Sensitivity Analysis
The problem may be modeled using objective function. In reality there will be variation.
Suppose that you don’t know the value of a variable, but you have an idea of lowest
possible value and the highest possible value that it can take. A sensitivity analysis can be
performed to determine the sensitivity of the solution to change the parameters. Therefore
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1. The allowance increase or decrease refers to how much the objective function
decision variable coefficient can change without changing the values of any of the decision
variable.
2. The objective function value will change. If a coefficient changes, the
corresponding decision variable does not change.
3. 100% rule can be used to determine if a change in multiple objectives function
coefficients will change the value of the decision variable. Any combination of changes can
occur without a change in the solution, up to the total percentage, deviation does not exceed
100%
4. The decision variable coefficient is the effective numbers that is multiplied by
decision variable when the objective function is simplified, so that each decision variable
appears once.
5. How much reduced cost is more attractive the variable’s coefficient in the
objective functions, must be before the variable is worth using.
The shadow price in business applications is the maximum price that management is
willing to pay for an extra unit of a given limited source. The amount that the change in
objective function value is obtained by a change in constraint by one unit.
The shadow price is valid up to the allowance increase or decrease in the constraint. To
determine if a constraint is binding, compare final value with the constraint RHS. If the
constraint is non binding its shadow price is zero.
Simulation:
Simulation is a linear programming technique which assumes certainty and do not deal
with randomness by themselves. Procedure for maximizing or minimizing some objective
function, that contains random variables as follows;
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Fundamental approaches:
Fundamental approach is perhaps most commonly advocated by investment professionals.
The basic principle of fundamental is as follows
• There is an intrinsic value of security, which depend upon under lying economic
function.
• The intrinsic value can be established by analysis of fundamental factors of
company or industry.
• Prevailing market price will differ from intrinsic value.
• Sooner or later the market price may come in line with intrinsic value.
• Buying undervalued securities and selling overvalued securities, the investor get
superior return.
Psychological approaches:
This approach is based on the premise that stock price are guided by emotion rather than
reason.
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d. There are items which influence a decision but can not be accurately measuring in
monetary terms. There factors are called a qualitative factors. While making decision,
appropriate weight age must be given to the factor.
e. There are qualitative factors, which are non- financial, must be considered
carefully and must given appropriate weight age.
f. The cost and revenues will remain unaffected during the decision process, which
are called as irrelevant cost. Therefore relevant cost and relevant revenues differ among the
alternative course of action.
g. Relevant range is another concept in decision making. The fixed cost remains
fixed over a range of activity. This leads to cost behaviors e.g. fixed cost, variable cost,
semi variable cost. The cost behavior does not necessary to determine the relevant of cost.
h. In any business decision, the earnings must consider the effect of income taxes.
COST CATEGORIES.
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irrelevant are usually sunk cost. Following important points with regard to should be kept
in varies while making decision.
a. Sunk cost cannot be recovered.
b. These irrelevant. But all irrelevant cost is not sunk cost.
c. Suck cost represents behavior to exit. A firm incurred heavy expenses on R&D, but
it will be difficult to decide to exit market even if it sees good opportunities our side.
d. Sunk cost may be useful for analyzing the market, as in the case of exports.
e. Sunk cost is distinct from economic loss.
9. Opportunity cost: Opportunity cost is the measure of benefits forgone for adopting a
specific course of action. This is the most important factor to be considered in decision
making. This cost is relevant in a situation where the resource is scarce. The opportunity
cost of something in terms of an opportunity forgone. The opportunity cost need not be
assessed in monetary terms. Opportunity cost is not incorporated into formal financial
accounting records.
Cost-Volume-Profit relationship:
The relationship of analysis can be presented in the following ways:
1. Formulae
2. Reports or statements.
3. Charts- such as breakeven chart. Etc.
Formulae: This method involves finding out different values by the use of marginal cost
equalize.
(i.e) = sales – (fixed cost +variable cost) = profit,
Sales – variable cost = fixed cost +profit.
S – v = f+p.
Or p/v ratio = (sales- marginal cost of sales) / sales.
That means the point where operating income equals zero. Or at a point where total
revenue is equal to total cost.
BEP units = F.Cost/Contribution per unit.
The break even points in dollars can be found by using the formula:
Fixed cost /contribution margin percentage.
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It is necessary to know the following costing terminologies before taking up the detailed
study of CVP analysis.
Marginal costing:
CIMA defines the marginal costing “as the accounting system in which variable cost are
charged to cost units and fixed cost of the period are written off in full against the
aggregate contribution. Its special value is in decision making”. The marginal costing is a
technique which uses data to reveal the true relationship of costs- volume – profit. This is
not a method of costing like process costing or standard costing.
Under this system, the cost is analyzed into two categories; one is fixed cost and the other
is variable cost. Fixed cost will be written off against contribution. The Excess of
contribution over fixed cost is profit or net margin. Emphasis will be given only to
increase total contribution.
Fixed cost:
This cost remains constant for a period of time or over a range of volume of sales of
production. For examples rent is a fixed expense. The expenses will be increased for a
period of time irrespective of volume of production.
Variable cost:
The variable cost changes directly in proportion with volume. Variable cost per unit of
production remains constant irrespective of change in out put. Total variable cost changes
with the changes in volume of output.
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Variable cost includes Cost of direct material, direct labors and direct overhead expenses.
Variable cost per unit can be arrived at either by deciding total variable cost by number of
units produced or by dividing change in cost by change in volume.
Marginal cost:
CIMA defines marginal cost as “the cost of one unit of product or service which would be
avoided if that unit were not produced or provided”.
Following terms are very essential to understand Cost Volume Profit relationship
Sales mix:
This is the total sales revenue of various products, i.e, the percentage of each product
added to from total revenue. The same will be maintained for all volume changes. This is
also called as revenue mix.
Operating income:
Operating income = sales – variable cost – fixed cost. This operating income is zero at
break even point.
P/V Ratio:
The profit / volume ratio expressed the relationship between contribution and sales. This is
expressed as a percentage of sales value. The statement that P/V ratio is 40% means the
contribution is 40$; if the size of the sale is 100$. P/V ratio remains same as all levels of
output. P/V ratio is also called a marginal income ratio or contribution of sale or variable
profit ratio. This is my be expressed as
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This will lead to improvement of margin of safety. This will increase the gap of sale at
specified level of activity and sales at BEP.
Breakeven chart:
Breakeven chart is the pictorial expression of relationship of cost-volume-profit.
Breakeven chart demonstrates importance of fixed cost in the operation of an organization.
Soundness of business can be measured by M.O.S. This is very helpful to take decision to
reduce price, to face competition.
The profit is the concern of the management. Margin of safety indicates how much present
output is able to keep the business away from the breakeven point. Therefore management
is always giving importance to improve the margin of safety. The margin of safety can be
improved by following the steps.
Increase in selling price; in certain cases, it is not possible to increase the sale volume. The
sale price can be increased to improve the margin of safety
Increase in sale volume: If the sale volume increases the sale at BEP and present sale
increase. The margin of safety also increases.
Total cost line and total sales line intersect in graphical presentation of cost / volume /
profit relationship. That point of intersection is called breakeven point.
Margin of safety
The margin of safety is the difference between actual out put or sales and output sales at
breakeven point. This is expressed in percentage of sales.
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Sales in 0 10 20 30 40
Units
Sales
Revenue $0 $100 $200 $300 $400
Variable
Cost 0 $ 50 $100 $150 $200
Fixed
Cost $100 $100 $100 $100
Operating
Income ($50) $0 $50 $100
Operating leverage:
The operating leverage is a measure of how the growth of revenue turns into growth in
operating income. Generally contribution margin is a measure of operating leverage The
higher contribution margin increase with sales. If contribution is a fixed quality, it does
not change with sales.
Another point we have to remember is the operating expenses consists of fixed cost and
variable costs. If the variable cost is equal to operating expense then the operating margin
would be constant as sales grow.
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