Chapter 1 Decision-Making PDF

Chapter 1 Decision-Making Over the next ten chapters, our course of study will improve your competency in financial decision-making. The book spans subjects in accounting, finance, and engineering economics; take a few moments to review Figure 1.1 illustrating the ”road ahead” before we forge ahead...

Chapter 1 Decision-Making Over the next ten chapters, our course of study will improve your competency in financial decision-making. The book spans subjects in accounting, finance, and engineering economics; take a few moments to review Figure 1.1 illustrating the ”road ahead” before we forge ahead! Decision Making Financial Statements Time Value of Money (TVM) Part I Applications of TVM Comparing Alternatives Intellectual Property Part II Concept Mapping Probability and Risk Capital Budgeting Part III Leadership Figure 1.1: The road ahead: Ten learning modules grouped in three parts. 1.1 Three tactical challenges Much has been written about the subject of accounting, finance, and engineering economics and there are many informative textbooks about these subjects. Three challenges with this abundance of information are that: • There are a wide variety of topics to introduce, explain, study, and learn that pertain to the everyday life of an engineering manager. 1 • Readers of this textbook have a wide variety of prior experiences with finance; some may have already taken an accounting class while others may be entirely new to the subject. • The purchase of several di↵erent specialized books (accounting, finance, and engineering economics) results in underutilization when, in practice, we find we only need pieces and parts of any one of these books when beginning in this field. Topic variety is a reference selection challenge. There are so many existing textbooks that we could draw upon – my personal experience, years of work, actually, is with the works of Meigs and Meigs[1], McManus[2], Powers[3], and Wickes[4] – but methodical navigation requires an abundance of time (months!) devoted to each. Later in this introductory chapter we provide some perspectives the reader can adopt to facilitate mastery of so many topics. It is an easy read, so let’s go! 1.2 Three perspectives It is unreasonable to expect that we could simply outline several dozen concepts and expect that, through laborious exercise, the student will somehow recognize the fundamental premise of this course of study. Let’s fix that now. If you don’t remember anything else, the abstraction is to understand a transaction concept map shown in Figure 1.2. Figure 1.2 illustrates a simple, fundamental representation of the daily activities of a typical business; the cycle illustrates the role of accounting, information, and decisions central to the management of business. This diagram is highly simplified (and adopts the so-called internal perspective, as we shall soon see), so, of course we could have said “products or services” that result from managerial decisions, but hopefully you get the idea. And lots of things are missing from the diagram (the roles of investors, boards, etc.), but, in this simplified diagram, we underscore that at the most fundamental level: • Managerial decisions drive the conversion or use of assets into products, that ... • if are appealing to a market need lead to customer transactions, that ... • produce revenue and data to be converted into information, that ... • must be organized and communicated to managers to support decisionmaking. Pause for several moments to compare the itemized list above with the diagram below. Where might “ethics” issues enter and be a problem? Now, with Figure 1.2 in mind, is the interconnected nature of activities clear? Can you visualize the activities associated with each step that managers must lead to make things happen? If everything is so ”interconnected” then how do we characterize the activities and outcomes in a simple, understandable way? Let’s distill the process into three steps: • Adopt a transaction-based view of the business and ways to capture and communicate transaction activity. • Understand the engineering managers’ view of asset (cash, equipment, 2 Management Decisions Products Customer Transactions Information Data Analyze the Transaction Measure, Categorize & Record Synthesize and Report Accounting Figure 1.2: Role of accounting to provide support for managerial decisionmaking. facilities) management. • Examine the decision-making required to support and direct changes in business activity. A primary objective of this chapter is to explore these three perspectives with a special emphasis on decision making. 1.2.1 Transaction-based perspective Let’s examine the most fundamental – and hopefully common – business activity: transactions! Figure 1.3 helps focus the discussion. You can talk Sn+1 Product or Service Customer Transactions Supplier Sn S3 $ $$$$$$$ S2 Market Industry Figure 1.3: Transaction-based view of businesses, industries, and markets. strategy, dream about products you that think consumers might need, and organize focus groups to determine what end-users say they want, but unless your business is profitable (the revenue is greater than expenses) and solvent 3 (you can pay bills as they become due), you will never realize those aspirations. Profitability and solvency critically require that customers have a preference for your product and are willing to enter into a transaction with your business in which a product or service is exchanged for payment (i.e., buyers, not talkers). Better yet, we look for a series of ongoing transactions where a preference (over other suppliers) for your product and perceived value (see Figure 1.4) results in a transaction where the market price is far in excess of the cost of production (more on that later). Very simply, then, the “reality” $1.50 $1.00 $0.80 Market Value Cost of Production Target Price Figure 1.4: Identifying value in a transaction. of your “day-to-day” business can be characterized by customer transactions. An ability to appropriately capture, analyze, understand, and communicate those transactions is the foundation to knowing your business. Ideally the information provides actionable items and drives a transaction-based perspective. Items critical to long-term success (again, profitability and solvency) correlate directly to the magnitude (number of), type (pay now or pay later), and value (market preference) of periodic business transactions. Given that accounting is an information management system related to the analysis, measurement, and synthesis of transaction information, it should come as no surprise that the chapter to follow discusses accounting in more detail and the production of financial statements. To focus on business transactions means, of course, there must be some business transactions to examine, and an implicit assumption is that we are dealing with an ongoing concern, one that has been under way for a period of time – say, three years – and can be anticipated to be in operation for sometime in the future (at least five years). Such an assumption is essential for financial statements to have meaning year-to-year. Aspects of the business other than transactions warrant attention, too. These include fund-raising for the startup, investing for business expansion, and deciding to replace equipment. All involve transactions and play into a vibrant business; these will be identified later as investment activities. For now, our assumption of a transaction-based perspective implies a more simplistic “operational” scope. 4 1.2.2 Engineering management viewpoint Many stakeholders have an interest in the activities of a business. Since this Field Guide hopes to address those activities most likely to touch engineering students embarking on new managerial careers, the present work adopts the managerial viewpoint, as distinct from a regulatory, audit, and (to some extent) shareholder viewpoint. Principal stakeholders and the central role of the accounting system are shown below. Note the central role accounting plays All Stakeholders Financial statements Bank & agency reports Accounting System Tax returns Management & data reports Engineering Management Leadership Figure 1.5: Engineering management served by an accounting system (concept adapted from Meigs and Meigs[1], p. 7). in communication with stakeholders! We’ll talk more in Chapter 2 about the critical role of accounting in communicating business results; further, we’ll dispel any misunderstanding that accounting is the same as bookkeeping (for fun, try an Internet search of the phrase “accounting versus bookkeeping” – a recent search yields over 750,000 hits on this subject). Section 2.3 on page 23 explains further. What is the impact of taking a managerial perspective? How does this matter to this course of study? What is gained? Lost? How do current events play into the context of solutions? Consider and discuss the following statements in your study group: • Taxes are important and demand attention, but in the current work we do not venture beyond a simple understanding of how decisions can be impacted (or influenced) by tax considerations. The reasoning is that a typical engineering manager relies on the corporate tax department to help frame and present tax issues as a “boundary condition” or a project input parameter, with the idea that managers are not customarily tax accountants themselves. This Field Guide is therefore “light” in the 5 treatment of tax accounting except to the extent that taxes pertain to capital investment decisions. Many types of taxes are important, just not right now. • Regulatory matters have a significant bearing on many facets of a modern business, but as with tax accounting, the regulatory and audit function is not explored very deeply in the chapters ahead. Separate from the subject of ethics (which will appear to some degree later on in some case studies), this Field Guide lacks depth in the description of the audit function. There is no question that regulatory issues play an important role in decision-making, but, for now, we’ll keep these issues on the periphery of our discussions. • Stockholders are quite central to much of managerial thinking, but for the topics, tools, and skills we wish to center on in this book, we relegate stockholders as an environmental variable. Not a good thing to do in a more complete context of financial management, but for the time being we frame our world as having to simply meet established goals and objectives set for us by the stockholders through executive management, keeping stockholders at an “arm’s reach.” Do you think this assumption really has much day-to-day impact on the life of an engineering manager? Another way to distinguish between perspectives is to consider that there are internal and external users of information created by an organization. External users are normally indirectly related (auditors, regulators, lawyers, the press, etc.) to business operations and they will have a legitimate need for reliable information about past and planned activities taking the form of regular financial statements, the prospect of and contingency for lawsuits, or the planned purchase or sale of major assets. Returning to the needs of shareholders – external users of information – as investors in a company (and part owners, however small that fraction of ownership may be!) they would need financial information to decide whether they would like to own a bigger part of the company (buy more stock) or if the a↵airs of the company have become too risky (new products outside the core competencies of the management) for their portfolio and it is time to sell their holdings. Regulatory users are external users, too, as they are monitors of the activities of the company with bearing on managerial decision-making, but the regulators are part of the external context of business operations and are not the managers of the company. Labor unions might also have an interest in the prevailing wages of company employees, even though they are not directly responsible for setting company wages. In comparison, internal users of financial information are those individuals directly responsible for the operations and management of the company. Whether it is sales sta↵, marketing managers, human resources, purchasing agents, supply chain managers, or product development leadership, all have a direct impact on the success of the organization and need reliable financial information to be able to make informed decisions contributing to the efficiency and e↵ectiveness of the organization. Accountant career paths are another way to observe the di↵erence between 6 internal and external reporting, too. Management accounting attends to understanding, analyzing, and reporting information to internal decision makers while financial accounting has an external stakeholder focus. For the present work, we assume that internal engineering management information needs dominate, thus we set and accept a fairly narrow view of many key stakeholders. Over time, though, managers in practice do have many occasions where the importance of external users takes center stage, and that is not to be trivialized. Here, it is enough to tackle the intertwined, interdisciplinary, multifaceted nature of engineering management by bounding and limiting the environment in which we operate and make decisions. 1.2.3 Emphasis on decision-making We noted at the end of the last section that an important role of engineering management is to make decisions; however, up to this point it has been assumed we know what “decision-making” really means! Decision-making is often confused and treated synonymously with problem solving and, to some extent, critical thinking skills. Does the di↵erence matter? Are we just playing with words? Or is there a structural di↵erence that can help guide development and learning specifically related to the financial a↵airs of an organization? This section briefly underscores managerial decision-making as the impetus for much of the information we collect, analyze, and communicate; further, we identify decision-making as just one part of the much larger problem-solving process. Daily living gives us many examples to observe the gap between “what should be” and “what is.” While this sets the stage for spotting a “problem” in many cases, absent any process for filtering problems by degree of severity, the domain of problems that confront us would be unbounded! It is therefore useful to narrow thinking (at least in the corporate world) around those important problems that motivate time and energy to investigate the situation in detail. Let’s clarify with a specific example illustrated in Figure 1.6. In this example we suggest that a corporate strategic advantage can be gained by creating intellectual capital though the development of product patents, but a problem may be that competitors might already have defensible claims. The process of identifying existing or similar patent claims requires only a simple search of the US Patent and Trademark Office (USTPO) database. Claims retrieved from a keyword search of the USTPO database can be compared against our idea for a patent claim we think is unique. In this situation, let us assume our idea is for a highly fragmented market with a high degree of competition between suppliers. We would want to check if there are patent claims similar to ours to avoid the problem of patent infringement. The problem-solving process involves an iterative search of the database, harvesting select information from the database to examine, and then using this information to decide if the product attributes we have in mind are unique. Absent any claims from the database we might consider “similar” to our own ideas, we then decide to proceed with our plans to launch a new product. If we 7 Idea for a patent claim Search USPTO database for a “patent claim” A match? No Yes Related? Yes Draft a new claim to test Modify the claim to test No Add claim to patent claims Figure 1.6: A perspective on the patent claim search decision-making process. are wrong, there is the probability of financial impact on operations through legal expenses, fines, and losses in divestment of a product line. While the idea for the product may have come from, say, marketing, the engineering manager plays a critical risk mitigation role on the management team. In this corporate growth problem, the choice of core competence to develop (intellectual capital), sources (and legitimacy) of data, the interpretation of that data, and the logic underpinning risk management involve a wide variety of factors contributing to problem definition and decision-making. We can’t say that one is more important than the other. Is it better to identify the “right” problem and make poor choices in solving it, or to optimize the solution to the wrong problem? This example is similar to many others one might confront in practice and emphasizes the subtle role decision-making plays in problem-solving: 1. The product launch problem is important and involves an engineering decision among options (in this case, regarding “freedom to operate” in a marketplace). 2. There is a large body of information available and we use analysis tools to identify and refine that subset of information to establish a choice of action. 3. The interdisciplinary nature of the problem (presumably involving lawyers, among other professionals) and an iterative solution helps refine the course of action. 4. Some risk of corporate financial exposure exists and decisions must be made about the probability of that risk. Problem definition and decision-making are intertwined; for many engineering managers, then, problems present themselves in a variety of ways and must be reduced to a tractable form, a problem-solving strategy crafted, and 8 decision-making undertaken to optimize corporate resources. Accountability follows decision-making and defines managerial success or failure. Leaders must be as good at identifying the right problems as they are good decisionmakers. While we attend to both issues in the course of study covered by this book, the abbreviated nature of this course does, however, place an emphasis on engineering decision-making. The successful financial decision-maker is one who embraces and finds delight in the problem-solving process, a person who has some comfort level with ambiguity and interdisciplinary activity. Many times the cause of the problem emerges when working through many iterations of the problem definition, in which there is a pattern to relevant changes. And it is most gratifying to find the outcome that explains all the facts. It’s sort of like a mystery novel! The reality is that such gratification is hard to come by, so we have to be content with success in the art of decision-making. We really do not understand the problem completely, yet still manage to make a decision that satisfies most of our criteria. Saundra Lipe and Sharon Beasley[5](page 37) emphasize the concept of decision-making: “decision making is a purposeful, goal-directed e↵ort applied in a systematic way to make a choice among alternatives. It is action to achieve a foreseen result, which is preceded by reflection and judgment to appraise the situation, and by a thoughtful, deliberate choice of what should be done.” Decision-making, then, is influenced by many factors – among them “perception” – but we suggest here that many of these skills can be acquired over time. Let’s summarize six aspects of decision-making: 1. Outcomes or required outputs must be established. 2. Within the context of an organization or project, the outcomes of required outputs must be prioritized. 3. A set of (actionable) alternatives must be identified or developed. 4. Each of the proposed alternatives must be examined with respect to objectives (and their priorities). 5. A tentative decision is an alternative that appears to provide all the objectives. 6. Decisive actions are taken, and additional actions are taken to prevent any adverse consequences, thus avoiding another round of problem analysis and decision making. And, it is easy say, for instance, in item 1 that “outputs must be established,” but how do we go about it? The start of a very long answer begins by looking at the context of decision-making, the topic of the next section. 1.3 Financial frame of reference Among the more frustrating responses to the student inquiry “How do I ...?” is the response “It depends.” This fails the test of didactic rigor learned over the students’ prior years of college engineering training yet is so common in 9