Poor Decision Making in Business

Most people make decisions based on their current business performance.

They may estimate the costs to produce a contract they're pursuing at $10 variable costs per unit based on historical data. They put in a bid for $12 per unit to allow a $2 unit contribution (selling price per unit minus variable costs per unit).

Optimal decisions are guided by weighing the incremental benefit or costs associated with them.

The additional order volume from this prospective customer may result in far different costs than historically seen. If operating with unused production capacity, the true variable costs per unit may be closer to $8 instead of $10. If the new order volume would push the plant past its most efficiency operating capacity, the incremental costs to fulfill this contract may be closer to $14 variable costs per unit.

This misunderstanding of the true costs to produce the incremental volume associated with this contract can result in two scenarios:

1. Bidding too high - thus losing out on a profitable order to a competitor
2. Bidding too low - accepting a purchase order that will create losses

In the first scenario, we could have bid $9 per unit to win a profitable order as it would still have $1 unit contribution ($9 selling price less $8 variable costs per unit). Instead, we lose the bid to a competitor. In the second scenario, we should have bid closer to $15 per unit as we have a -$2 unit contribution ($12 selling price less $14 variable costs per unit).

Both scenarios results in the company being less profitable than what could have been achieved.

Simple profit & loss analysis using historical performance does not provide the insights required for profitable decisions.

Input costs such as raw materials, labor, and conversion costs change from period to period. The company could lose profits if the latest figures and expected future prices aren't accounted for. Depending on the company's current capacity, the same exact pricing and additional volume for a new contract should be accepted or rejected. This is because the incremental benefit must be weighed against the incremental cost. Unused capacity means fixed costs are spread over fewer units, so the business is likely to benefit from increased order volume. Operating near capacity may require additional investments to fulfill incremental volume, which may make that order unprofitable.

So how can we change our analysis to discover the true incremental cost or benefit to the business and ensure we make profitable decisions?

Marginal Analysis - The Key to Profitable Decisions

Marginal analysis is used to determine the incremental benefit or cost associated with changes in levels of activity.

Incremental benefit is the incremental revenue or costs savings from a change in activity level. Incremental costs are the additional costs incurred due to the change in activity level. When the incremental benefit outweigh the incremental costs, the option being evaluated is beneficial to pursue.

Volume tiered pricing is a example of how marginal analysis can be used to guide profitable decision making.

At 10,000 units purchased, our supplier gives us a 10% discount. But that discount increases to 15% for orders above 10,000 units. The gross cost per unit is $10 before any discounts are applied. 10,000 units cost us $90,000 with the 10% discount while 11,000 units costs us $93,500 with the 15% discount applied as seen below:

Most focus on the decrease in net cost per unit between the two scenarios, decreasing from $9.00 per unit at the 10% discount tier versus $8.50 per unit at the 15% discount tier.

While this is important to keep an eye on, marginal analysis focuses on the incremental change. The incremental costs view provides us more relevant information for decision making, especially if we have unused production capacity. To go from 10,000 units produced to 11,000 units, the additional 1,000 units only costs $3.50 per unit. This is useful to know, especially if we have unused production capacity. We may find it advantageous to offer a discount to win a new contract to increase our production volume. Our raw material costs are $3.50 per unit instead of our current $9.00 per unit. As long as the incremental revenue from the discount is higher than the incremental costs, we would increase our profits, even if our average selling price decreases.

What Information is Relevant to Decision Making?

Marginal revenue is the incremental revenue from the sale of additional units. Marginal cost is the incremental cost from the production of additional units. The marginal benefit or cost is marginal revenue (or cost savings) minus marginal cost. To determine the marginal benefit or cost, we have to include only relevant information for the decision at hand.

Revenues and costs must be future oriented and differ between options for them to be relevant to the decision.

Future oriented means it can change. Sunk costs are money already spent and cannot be recovered, thus are irrelevant to decision making. Examples of sunk costs include things like advertising. The money spent on advertising cannot be recovered, so it should be ignored. If a given decision required a change in future advertising spend, whether as an increase or decrease, that would be relevant and must be included in the analysis. Events and costs that have already occurred and cannot be recovered are irrelevant as they cannot be changed in the future.

Any revenues and costs that differ between available options are relevant and are to be included in marginal analysis. Any that remain unchanged no matter what option is ultimately selected, such as fixed costs remaining the same regardless as to what the product mix ends up being, should be excluded from the analysis because they have no financial implications.

Typically, relevant revenues are easy to determine and see how they differ between options. Relevant costs on the other hand can be more difficult to determine what is and is not relevant for marginal analysis.

To help shed some light on how costs can differ and whether they factor into marginal analysis, we'll cover 3 broad examples:

• Differential and Incremental costs
• Avoidable and Unavoidable costs
• Economic versus Accounting Costs

Differential and Incremental Costs

Costs that differ between options are considered differential costs.

An example of differential costs are changing a product mix. We have the capacity to produce either 200 additional units of Product A or 100 additional units of Product B. The costs that differ between these options such as the difference in variable manufacturing costs (direct materials, direct labor, variable overhead) as well as any changes to fixed costs would be considered differential costs.

Incremental costs are the costs associated with changes in activity levels.

For example, a special one-time order increases production volume. The incremental costs for this order would be the additional variable manufacturing costs from higher levels of production volume. Fixed costs would be irrelevant as they would remain unchanged whether or not we accepted the special one-time order or not for this example.

Both differential and incremental costs would be relevant to decision making and are to be included in marginal analysis.

Avoidable and Unavoidable Costs

Avoidable and unavoidable costs are existing costs that may or may not continue into the future.

Avoidable costs are any costs that we can choose to no longer incur if we pursue a given option.

These are relevant to decision making. An example of this is the direct material costs related to Product B. If we choose to no longer produce Product B, those direct material costs would cease to occur in the future.

Unavoidable costs will continue to occur no matter what option we choose to pursue.

These are irrelevant to decision making as the cost is the same no matter what. An example of this is fixed costs. It doesn't matter if we produce 100% of Product A or B or any combination in between. The fixed costs would remain unchanged and should be excluded from the analysis.

Economic and Accounting Costs

This final area focuses on quantifying the financial implications of options forgone and not found on financial statements. This is crucial as it helps us determine whether the options we've chosen are the best options available to maximize future performance.

Accounting costs are those easily found on your financial reports.

They are identified and accounted for on your production statements, profit & loss statements, cash flow statement, balance sheet, etc. If we choose to invest in more machinery to increase our production capacity, we would see the cost as a cash outflow on the cash flow statement and as depreciation on the profit & loss statement.

Economic costs on the other hand cannot be found within your financial results.

These are the costs of benefits forgone from selecting one option over another. This is known as an opportunity cost. Resource are scarce so not all options can be pursued at any given time. Manufacturers must ensure they are putting their limited resources to their best use to increase future performance.

Our investment in additional machinery to increase production capacity produces $100,000 additional annual profit. We chose to pursue this investment over investing in a new product line, which could have resulted in $125,000 of additional annual profit. The opportunity cost in this scenario would be $25k ($125k profit from new product line forgone minus $100k profit from additional production capacity). In theory, we are $25k worse off by increasing our production capacity instead of investing in the new product line.

There may have been good reasons for opting for the production capacity increase over the new product line investment, such as execution risk, that may have made the new product line investment too risky to pursue at this time. Regardless, we want to capture what could have been possible in order to ensure we are making decisions that balance risk with maximizing profits and cash flows.

What to Expect Next

Our next article is going to dive deeper into costs and how they are used in decision making.

This will help you identify the costs to include or exclude in marginal analysis for specific situations to give you better information to guide decision making. The week after that will focus on specific examples of decisions that can be made using marginal analysis to increase your manufacturing company's profits. We'll wrap up by showing the financial implications of changes in output levels and how more volume doesn't always translate into higher profits.

You can watch videos and read newsletters all day, but nothing beats looking at your own numbers. If you're ready to stop guessing and start implementing a clear financial strategy that puts more profit in your pocket, then it's time for my 1:1 Financial Clarity Assessment. We'll deep-dive into your company's financials to pinpoint the exact levers you need to pull for immediate, actionable improvements.

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