Chapter 8: We have got to make some decisions

Managers make decisions continuously every day they are at work.  The focus of this chapter hones in on different ways managers can look at the facts (as factual as their accounts permit) and weigh up the pros and cons and decide which way they will proceed.  Some decisions will be relatively every day and therefore considered short terms,  moving into longer term…….a little harder to undo, see results or recover from if the worst comes to worst.  Then there is the big one, sinking capital into a venture, a decision which could potentially make or break a company.  These are long terms decisions and as with most matters dealing with capital (think home loans contracts etc), relatively permanent or unable to be undone. 

Focus on what is relevant

A students comment were quoted on the weekly slides about their confusion as to why only consider costs which are relevant to their decision as they believed all costs involved would be relevant.  Prior to reading the whole chapter I just thought well that kind of just goes without saying, doesn’t it? What the author is trying to articulate is the we need to focus and concentrate on only those factors that differ from the rest, or may result in a different outcome – why put unnecessary effort into thinking about costs which are going to be incurred which ever way a company decides to go.  I can’t help but picture a pool table with a heap of balls, once they are sunk…….just ignore them, they are done and dusted.  Similarly with sunk costs, we need to disregard them as they don’t have any bearing left on the game we are currently playing.

Avoidance is another methodology used is all risk assessment, which making decisions in business is – assessing a risk; elimination, avoidance, control etc.  If we can avoid a particular cost or risk, then this is definitely relevant to be thrown into the mix.

Additionally, how long it will take to pay back and investment and get into the safe zone will need to be taken into account and weight up. 

Everything is limited, Time value for money

Opportunity cost – like in a previous chapter, this must be examined as to whether a potential decision is the best use of a resource?  Yes, time is limited for everything, everyday.  All resources within a company have a shelf life and I actually think it is obvious that if a resource needs to be replaced or upgraded due to a decisions that this then most certainly relevant in weighing up the said decision.  The benefits that may be reaped from a change are also very relevant and have to be considered.  Nothing stands still so we need to make the most out of every opportunity.

I think the whole section on time value for money can be condensed down into inflation.  What Nan and Pop paid for a burger back in the day will always be nominal when compared with what we pay today.

Focusing on contribution

As the author states in the course text, this is one of most important concepts in this entire course.  I always get a picture of a wallet whenever I hear contribution margin – the amount of money that will be put into our wallet to pay the bills, being fixed costs (not to mention profit etc).  As contribution margin will inevitably determine whether or not whether or not we can stay pay out bills, it is of course paramount tohave products/services with the biggest contribution margins possible.

What I am confused about is why a company would even think about anything with a negative CM.  The chapter that which mentions not to disregard negative CM makes me think I am missing something big or I have misunderstood the concept of CM.  I simply don’t understand why a business would keep on producing something which is costing them money?

Decisions with just two constraints

Broadly speaking, product mix is about determining what products to choose when taking into account factors such as resources and contribution margin.  What products or services are going to be included in the business to inevitably add as much value to an entity?  I think that anyone who has ever been in business, past or present will be governed by the two constraints emphasised in this chapter, supply and demand!   The message in this section is how to make decisions to capitals on making the most of what you have got.  If the main constraint is resources – focus on breaking down your options into comparable items, weighing up products that can stretch out the resource, and with the greatest CM.  Get the most bang for your buck!

DCF, IRR , NPV and ARR

Each of these methods is a different way of looking at a decision from another angle.  They all have their weaknesses and strengths but above all it is apparent to me that they need to be used in conjunction with each other to provide managers with a balanced view of the potential outcome of a decision.

In my first SPA I mentioned that a business’ reality is not only the numbers recorded the accounts, but also the qualitative goings on.   These realities are critical to decisions and must be considered.

Accounts record a business’ past and inturn are to best tools to calculate and inform managers of what is to be expected moving forward……to the best of anyone’s ability to predict the future anyway.