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Description of Integrated Analysis for Decision Making with Emphasis on Partial Budget and Enterprise Analysis

The discussion in these materials culminates with an emphasis on completing an analysis to support a decision, such as "is it more profitable for the business to continue to XXX, or would the business increase its profit by adopting the alternative of YYY".  This page suggests an overview of how such an analysis could be completed.  The assumption is that a document explaining the situation, analysis and decision will be the primary vehicle for describing the analysis, but a supplemental spreadsheet also will be developed to complete the calculations.

Goal

The discussion in the section about decision making and goals emphasizes that managers and other decision makers are likely to have multiple goals for the business, such as 1) maintaining, increasing, or maximizing profit, 2) increasing equity, 3) having the cash to pay obligations when they come due, 4) exposing the business to a reasonable level of risk, and 5) providing a safe work environment that offers rewarding, enjoyable experiences, and opportunity for professional and personal growth.  The analysis described on this page focuses on the goal of profit, despite the variety of common business goals.

Describe the Situation

An initial step in analyzing an alternative is to describe the current situation, the alternative, and why the alternative is being considered.  For example, "a crop farm generally hires a local firm to dry the farm's grain during wet fall harvests.  Would the business increase its profit by constructing and operating a drying system on the farm, rather than continuing to hire the drying service?"  A detailed description of the current situation and alternative also should be provided.  Continuing the example of the grain dryer, the description would indicate the types and quantities of grain being dried, the current cost of hiring the service, the cost of purchasing a drying system, the labor needed to operate the system, the projected cost of fuel, repairs, and electricity needed to operate the system, and the list goes on.  The details in the description provide the foundation for the quantitative portion of the analysis.

Specify a Decision Criterion

A critical point in the thought process is to state the circumstance that would cause the business to adopt the alternative, such as "the farm will breed its heifers and sell them as bred heifers as long as this alternative is projected to add $1500 to the farm's profit, after accounting for the additional labor required to raise and sell bred heifers".  This statement could be considered the decision criterion and will be used at the end of the analysis to make the decision. 

The decision criterion could also be accompanied with a brief statement indicating why the decision maker has established this particular criterion for this decision.  For example, "the managers not only want to be compensated for the additional time required to raise and sell bred heifers, but also want to be compensated for the additional market risk associated with selling breeding stock".  Clearly, the decision criterion reflects the decision maker's judgment.

Identify and Introduce an Analytical Method

Another important step is to indicate the analytical method.  Due to the assumed goal of determining profit, two common analytical tools are the enterprise analysis and a partial budget analysis.  The selected analytical method should not only be identified, but also briefly reviewed.  The explanation also should cite a reference to support the overview of the analytical method and a brief statement as to why that method is most appropriate for the problem being addressed,  The following examples may help illustrate this idea.

Example.  An enterprise analysis will be used in this decision because the decision maker wants to know whether the alternative would generate a profit. (This sentence would likely reflect the decision criterion).  An enterprise analysis identifies the revenue that would be generated and the costs that would be incurred if the alternative is adopted.  (Cite a reference that explains enterprise analysis.)  The difference between the revenue and the cost would be profit.

Example.  A partial budget analysis will be used in analyzing this decision because the decision maker wants to know whether adopting the alternative would increase profit.  A partial budget analysis identifies the positive and negative impacts of pursuing an alternative.  The positive impacts are further divided into new revenue that will result and costs that will be saved if the alternative is adopted.  The negative impacts include revenue that will NOT be received and costs that will be incurred if the alternative is adopted.  A partial budget analysis is appropriate in this situation because the decision maker wants to know whether adopting the alternative of YYY will change or impact the business profit.

It may also be helpful to provide a general outline of an enterprise analysis or partial budget as part of the overview of the analytical method.

Sample format of an Enterprise Analysis

Sample format of a Partial Budget Analysis

In some situations, the analysis may not focus on profit or change in profit; it might be that the alternative will not alter revenue.  In those instances, the focus is on cost.  Accordingly, an enterprise analysis may focus on cost; a partial budget may focus on change in cost.  For example, "the farm will produce hay for feed as long as it can do so for no more than $62 per ton".  Another example, "the business will purchase a new truck as long as it does not increase the cost per mile of operation by more than $.12".  In these situations, enterprise analysis and partial budget analysis are still appropriate.  The primary difference will be that cost will be emphasized, rather than profit.

In some situations, the decision maker may decide to prepare two enterprise analyses, rather than one partial budget analysis.  This is reasonable.  The overall result, if two enterprise analyses are prepared, would be determined by comparing the "profit" calculated for each enterprise.  However, the difference between the amount of profit for the two enterprises must be identical to the change in profit that would be calculated by preparing a partial budget.  If this is not the result, there is a mistake in the analysis.

Identify Needed Data

A final topic for this section of the document is to identify the data needed to conduct the analysis, such as fuel, hired labor, insurance, interest, and the list goes on.  The data should be detailed, such as what inputs will be used (or no longer used), what is the quantity of that input, what is the per unit price or cost of the input.  Listing sources for data will not only document this information for later use, but also help the decision makers assure they have not overlooked a factor that needs to be considered in making the decision. 

Conduct the Analysis

The data should then be entered into the spreadsheet in a format so it is easy to see the values and so the computer does the calculations.  Organizing the spreadsheet in this manner 1) documents the assumptions used in the analysis, 2) allows others to readily recognize what values were used, and 3) allows these values to be varied, with the spreadsheet rapidly completing the calculations using the alternative assumptions or values.

Note the list of inputs can be thought of as the "recipe" for producing the output, see https://www.ndsu.edu/pubweb/~saxowsky/frm&agbusmgt/ref_topics/prodtheoryintro.htm.

Topics that Will Likely Need Additional Explanation

Much of the analysis will be easy to understand, such as quantity of input used, cost per unit of input, quantity of output used, and price per unit of output.  Fuel, hired labor, feed, seed, fertilizer, and land rent are easy examples in production agriculture.  Other economic or managerial topics, however, warrant additional comment.

Depreciation -- Many of the decisions involve alternatives that have a useful life beyond one production period, such as a decision to purchase a combine, a grain drying system, or a building.  As discussed in other sections, the concept of depreciation is a means by which managers and other decision makers allocate the cost of such an item against the output the item is used to produced during a production period.

See https://www.ndsu.edu/pubweb/~saxowsky/frm&agbusmgt/ref_topics/Depreciation.htm.

Opportunity cost -- All resources have a cost, including resources owned by the business owner.  Even though the business does not have to make a cash payment to a supplier, the decision maker still wants (needs?) to impose a cost on the use of owned resources as a means of assuring the business is generating not only enough revenue to pay all suppliers, but also to reward the business owner for the assets the business owner contributes to the business. Easy examples of owned resources would be the business owner's time (labor), equity (capital), and land.

Despite the usual definition of opportunity cost, it may be helpful to consider opportunity cost as the amount of income the owners want in return for using their own resources in the business.

See https://www.ndsu.edu/pubweb/~saxowsky/frm&agbusmgt/ref_topics/opportunitycost2010.htm.

Cash outflow for debt service -- If the alternative being analyzed involves a major investment, the manager may need to borrow from a lender and repay the debt over time. The debt will incur an interest expense.  It also will require repayment of the principal.  It is important that the analysis recognizes the interest is an expense, but that all cash outflows (such as principal payments) are not expenses.

Example.  The business is considering a $100,000 investment with a useful life of 12 years.  The owners have $35,000 cash and will borrow $65,000.  The lender will charge 7% annual interest and expect the loan to be repaid in 5 years (annual payment  at end of year, constant principal, declining interest).  The business owners impose a 5% charge on the capital they invest in the business.  In this example, the initial amount of owner capital (equity) is $35,000, but this amount changes each year due to principal payments and depreciation.

Table to Illustrate Difference between Cost and Cash Outflow based on Borrowed Capital

The depreciation and interest on loan are explicit costs that accountants recognize.  The payment to the bank is a cash outflow, but only the interest portion is a cost.  The principal portion of the payment to the bank is not a cost, even though it is a cash outflow.  The opportunity cost on equity is primarily a consideration for the business owners; this is the amount of earnings they want in return for having their capital (equity) invested in this $100,000 item.

Remember, all costs do not require cash outflows (e.g., depreciation and opportunity cost), and all cash outflows are not costs (e.g., principal portion of payment to bank).

This table illustrates how a supplemental table can be developed in support of the analysis.  It is not uncommon to also need a depreciation schedule for an analysis that uses several depreciable items, such as a line of field equipment for a crop enterprise.

See https://www.ndsu.edu/pubweb/~saxowsky/frm&agbusmgt/ref_topics/costvcashoutflow.htm.

Present value of future earnings -- As discussed in another section (see time value of money), the value of money received in the future will have less value than a cash payment of the same amount that is today.  This "discount" is due to

1) opportunity cost (if I had the money today I could invest it now and earn some interest),

2) risk (will I actually receive the future payment),

3) inflation (it will take more cash in the future to buy the same item as today due to rising prices), and

4) preference to consume today (I want it now rather than in the future).

Many of the decisions being analyzed, especially those that involve an investment with a useful life beyond one year, involves receiving income in future years.  These future payments are needed to justify the expenditure at this time, but those future inflows will have less value.  This factor needs to be considered in analyzing the overall return of an investment.

The following table summarizes the annual income, cost and profit for an investment that has a useful life of 7 years.  These numbers may have been drawn from a series of enterprise analyses (perhaps, one for each year).  In this example, the business will want to invest no more than $48,500 in this alternative; that is, the value of an asset is the present value of its future earnings.

Example of Present Value of Profit Earned by

Adopting an Alternative

Note that this example and the following example incorporate a risk element into the analysis without much discussion.

The next example illustrates a summary of an analysis that assesses whether an alternative is less expensive than the current practice.  These numbers may have been drawn from a series of enterprise analyses (perhaps two per year), or a series of partial budget analyses (perhaps one for each year).  In this case, the managers would want to pay no more than $35,100 for this "cost saving" investment.

Example of Present Value of Cost Saved by

Adopting an Alternative

See https://www.ndsu.edu/pubweb/~saxowsky/frm&agbusmgt/ref_topics/timevalue.htm.

Explain the Analysis, Interpret the Results, and Make the Decision

Now that the analysis has been conducted and the spreadsheet(s) has been prepared, the decision maker will want to explain the analysis, especially the key assumptions and the most important components or items.  The decision maker also needs to interpret the "bottom line" and relate it back to the decision criterion stated at the beginning of the analysis.  Finally, the decision maker will recommend a decision based on the results of the analysis, such as "adopt the alternative because ..." or "do not adopt the alternative because ..."

Summary

The focus of this page has been on a multi-step process to analyze the profitability of an alternative by using either an enterprise analysis (what is the profit) or a partial budget analysis (what will be the change in profit).  Specifying and applying a decision criterion clarifies the question the decision maker is focusing on.  Additional economic concepts, such as depreciation, opportunity cost, cost v. cash outflow, and time value of money, also impact these analyses and thus need to be applied when appropriate.

Last Updated November 6, 2010

Email: David.Saxowsky@ndsu.edu

This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.

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