Decision Analysis
What you must know
Decision analysis tests whether you can isolate relevant information. Relevant costs and revenues are future, incremental, and differ between alternatives. Everything else-sunk costs, allocated common fixed costs, book depreciation on existing assets-is a distraction. Core topics: special-order pricing, make-or-buy, keep-or-drop a segment, sell-or-process-further, constrained-resource allocation, CVP analysis (breakeven in units = fixed costs ÷ unit contribution margin; in dollars = fixed costs ÷ contribution margin ratio), target profit, margin of safety, degree of operating leverage (contribution margin ÷ operating income), and pricing approaches (cost-plus, target costing, value-based).
Traps that show up
- Including allocated fixed overhead in a make-or-buy or special-order decision. If the cost does not change, it is irrelevant.
- Ranking products by contribution margin per unit when a bottleneck exists-rank by contribution margin per unit of the constrained resource.
- Forgetting opportunity cost: using a facility for one product forfeits contribution from another.
- Treating unavoidable fixed costs as avoidable when dropping a segment.
- Mixing up contribution margin and gross margin.
Worked example
Two products share a machine limited to 10,000 hours. Product A: CM $6/unit, 2 hours per unit → $3.00 per machine hour. Product B: CM $9/unit, 4 hours per unit → $2.25 per machine hour. Despite the higher unit CM, B is wrong for a bottleneck; prioritize A. If demand for A is only 4,000 units (8,000 hours), fill the remaining 2,000 hours with B.
Rule of thumb
Ask two questions of every cost: Does it change? and Does it differ between alternatives? Only if both answers are yes does it belong in the analysis.