|
Lecture 9--Decision Making
Objective:
To examine some of the financial
tools that we can use to make decisions
9.0 Topics
 | benefit-cost analysis
|
| breakeven analysis
|
| contribution analysis
|
9.1 Introductory Points
| because financial resources are constrained, all of us must make financial choices |
| non-profit organizations cannot rely on the profit criterion because their purpose
is not to make a profit but to provide socially-valuable services |
| good decisions result from the intelligent consideration of a wide range of
alternatives |
| good decisions also result from avoiding some of the pitfalls associated with
financial numbers |
9.2 Benefit-Cost Analysis
| benefit-cost analysis quantifies the benefits the proposed activity will generate
(usually in monetary terms) and compares them to the associated costs |
| provides us with a way of distinguishing between competing activities |
9.3 Benefit-Cost Decision
Steps
1.Identify Benefits and Costs
-these include both the direct and indirect costs/benefits...we are interested in
the INCREMENTAL benefits/costs
2.Measure Benefits and Costs
-opportunity cost is an economic concept that refers to what else we could do with
those resources (i.e. put the money in the bank and earn interest)
-given that opportunity costs are often difficult to measure in the non-profit
sector, actual expenditures are often used as a measure of cost (plus perhaps indirect
costs associated with the alternative)
-benefits are also difficult to value because they consist of both the direct
receipts associated with an activity and the more difficult to value indirect benefits
-in cases where we are unable to attach a monetary value to certain benefits and
costs, the results are then simply stated in non-monetary terms (this is referred to as a
cost-effectiveness analysis)
3.Ranking Benefit-Cost Relationships
-different decision rules exist depending on if we are comparing similar/disimilar
projects and whether resources are constrained/not constrained
| |
Similar Projects (outcomes the same) |
Disimilar Projects |
| Constrained resources |
implement project that minimizes cost |
implement project that has largest absolute benefit |
| Un-constrained resources |
implement project with greatest benefit/cost ratio first |
implement project with greatest benefit/cost ratio first |
4.Analyzing Distributional
Affects
-equity considerations require us to ask as to the groups that will benefit from
the programs being introduced
-if equity is important to us, we might want to introduce programs that benefit
the most disadvantaged groups as long as they have positive benefits
5.Conducting a Sensitivity Analysis
-since financial decisions rely upon assumptions about the future, it is important
that we assess the sensitivity of our analysis to these assumptions
-sensitivity analysis helps us to articulate why we are comfortable with accepting
certain assumptions and not others by analyzing the effects associated with the
assumptions
9.4 Breakeven Analysis
| is a numerical technique that examines the relationships between fixed costs,
variable costs and breakeven volumes of activity |
| the starting assumption is that every activity will incur both fixed costs and
variable costs for every activity unit |
| the difference between the revenue generated by each activity unit and the variable
costs is referred to as the contribution margin |
| the contribution margin is the amount that is available to cover the fixed costs
associated with a particular project |
Breakeven Volume =
Fixed Costs
(Contribution Margin)
where contribution margin equals (Revenue per activity unit - Variable Cost per activity
unit)
| breakeven analysis is complicated when we have semi-variable costs such as teaching
salaries etc |
| to demonstrate these points we will return to the Almadina budgeting example from
the previous class |
9.5 Contribution Analysis
(this is a variation of the cost-benefit analysis described above)
| in this type of analysis we are trying to identify the incremental costs and
benefits associated with a particular project |
| the only factors that are relevant to a particular decision are those that will
change as a result of the decision (i.e. incremental revenues and incremental costs) |
| ***sunk costs (i.e. the amount previously paid for something is irrelevant) when
making a decision today*** |
9.6 The Mechanics of
Contribution Analysis
| list all the alternatives including the status quo |
| list all the incremental cash flows associated with each alternative (not
accounting revenues/expenses since these are based on accrual numbers) |
| choose the alternative with the highest positive or lowest negative cash flow |
9.7 Common Decision-Making
Errors
| including sunk costs |
| including total revenues as opposed to incremental revenues |
| ignoring the impact that the decisions of competitors will have on your analysis |
9.8 Generic Examples
| make or buy decision-->remember to only consider variable costs and not include
fixed costs (ie. overheads) in the decision |
| expand or contract decision-->identify costs that change with the decision
versus those that do not change |
| 
