Decision Making Session 3

8/4/2019 Decision Making Session 3

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Relevant Information

and Decision Making:Marketing Decisions

Dr Rashmi Soni


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Discriminate between relevant

and irrelevant information

for making decisions.


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The Concept of Relevance

What information is relevant?

It depends on the decision being made.

Decision making essentially involveschoosing among several courses of action.


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The Concept of Relevance

What is the accountants role in decision making?

It is primarily that of a technical expert on

financial analysis.

The accountant helps managers focus on therelevant information.


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Relevant Information

Relevant information is the predicted

future costs and revenues that will

differ among the alternatives.


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Use the decision process to

make business decisions.


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The Decision Process

Historical Information Other Information

Prediction Method

Decision Model

Implementation and Evaluation

Predictions as Inputs

to Decision Model

Decisions by Managers

with Aid of Decision Model

Feedback

(1)

(2)

(3)

(4)

(A) (B)


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Gather relevant information using

historical accounting information and other

information from outside the accounting system.

Step 1


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Using the information gathered in Step 1,

formulate predictions of expected futurerevenues or expected future costs.

The predictions formulated in Step 2

to the decision model.

Step 3

Step 2


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The decisions made by managers, with the aid of

the decision model, are implemented and evaluated.

Feedback is used to make future adjustments

to the decision process.

Step 4


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Decision Model Defined

A decision model is any method used for

making a choice, sometimes requiring

elaborate quantitative procedures.


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In the best of all possible worlds,

information used for decisionmaking would be perfectly

relevant and accurate.

Accuracy and Relevance


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The degree to which information is

relevant or precise often depends

on the degree to which it is...

Accuracy and Relevance

QuantitativeQualitative


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Decide to accept or reject a

special order using thecontribution margin

technique.


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Special Sales Order Example

Solo Company

Income Statement

Year Ended December 31, 2002 (dollars 000)

Sales (1,000,000 units) $20,000

Less: Variable expenses

Manufacturing $12,000Selling and administrative 1,100 13,100

Contribution margin $ 6,900


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Solo Company

Income Statement

Year Ended December 31, 2002 (dollars 000)

Contribution margin $6,900

Less: Fixed expenses

Manufacturing $3,000Selling and administrative 2,900 5,900

Operating income $1,000


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Only variable manufacturing costs areaffected by the particular order, at a rate

of $12 per unit ($12,000,000 1,000,000units).

All other variable costs and all fixed costs

are unaffected and thus irrelevant.


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Special order sales price/unit $13

Increase in manufacturing costs/unit 12

Additional operating profit/unit $ 1

Based on the preceding analysis, should

Solo accept the order?


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Decide to add or delete

a product line usingrelevant information.


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Avoidable and Unavoidable Costs

Avoidable costs are costs that will notcontinue

if an ongoing operation is changed or deleted.

Unavoidable costs are costs that continue even

if an operation is halted.


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Department Store Example

Consider a department store that hasthree major departments:

1 Groceries

2 General merchandise

3 Drugs


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Department

General(000) Groceries Mdse. Drugs Total

Sales $1,000 $800 $100 $1,900

Variable expenses 800 560 60 1,420

Contribution margin $ 200 $240 $ 40 $ 480


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Department

General

(000) Groceries Mdse. Drugs TotalContribution margin $200 $240 $40 $480

Fixed expenses:

Avoidable $150 $100 $15 $265

Unavoidable 60 100 20 180Total $210 $200 $35 $445

Operating income $ (10) $ 40 $ 5 $ 35


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For this example, assume first that theonly alternatives to be considered aredropping or continuing the grocery

department, which shows a loss of$10,000.

Assume further that the total assets

invested would be unaffected by thedecision.

The vacated space would be idle and the

unavoidable costs would continue.


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Dropping Products, Departments,Territories

Total Before Change

Sales $1,900,000

Variable expenses 1,420,000

Contribution margin 480,000

Avoidable fixed expenses 265,000

Contribution to common

space and unavoidable costs $ 215,000Unavoidable fixed expenses 180,000

Operating income $ 35,000


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Dropping Products, Departments,

TerritoriesEffect of Dropping Groceries

Sales $1,000,000

Variable expenses 800,000Contribution margin 200,000

Avoidable fixed expenses 150,000

Contribution to commonspace and unavoidable cost $ 50,000


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Dropping Products, Departments,

TerritoriesTotal After Change

Sales $900,000Variable expenses 620,000Contribution margin 280,000Avoidable fixed expenses 115,000Contribution to common

space and unavoidable costs $165,000Unavoidable fixed expenses 180,000Operating income $ (15,000)


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Compute a measure of product

profitability when production

is constrained by a scarce

resource.


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Optimal Use of Limited

Resources A limiting factor or scarce resource

restricts or constrains the production or

sale of a product or service. The order to be accepted is the one that

makes the biggest total profit contribution

per unit of the limiting factor.


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Key Factor / Limiting Factor -

* The factor of production which in short supply is called askey factor or limiting factor.

* The decision regarding profitability of the product in suchsituation is based upon profitability of key factor

* Profitability of the key factor =

Contribution per unit / Key Fcator

* Higher the profitability of key factor, better theproduct


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Main key factors

(1) Sales in unit - Check Contribution per unit - higherbetter

(2) Sales in Rs - Check P/V ratio - higher better

(3) Raw Material - Check profitability of raw material -

higher better

(4) Time / Labour / Capacity - Check profitability of labour -higher better


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Product Profitability Example

Constrained by a Scarce Resource Assume that a company has two products:

a plain cellular phone and a fancier cellular

phone with many special features.


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Plant workers can make 3 plain phones

in one hour or1 fancy phone.

Product

Plain Fancy

Per Unit Phone Phone

Selling price $80 $120

Variable costs 64 84Contribution margin $16 $ 36

Contribution margin ratio 20% 30%

Product Profitability ExampleConstrained by a Scarce Resource


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Which product is more profitable?

If sales are restricted by demand for only

a limited number of phones, fancy

phones are more profitable.

Why?


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Product Profitability Example

Constrained by a Scarce Resource

The sale of a plain phone adds

$16 to profit.

The sale of a fancy phone adds$36 to profit.


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Now suppose annual demand for phonesof both types is more than the company

can produce in the next year. Productive capacity is the limiting factor

because only 10,000 hours of capacity are

available.


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Which product should the company emphasize?

Plain phone:$16 contribution margin per unit 3 units per hour

= 48 per hour

Fancy phone:

$36 contribution margin per unit 1 unit per hour

= $36 per hour


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Discuss the factors that influence

pricing decisions in practice.


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Pricing Decisions

Among the many pricing decisions to bemade are:

setting the price of a new or refinedproduct

setting the price of products sold underprivate labels

responding to a new price of a competitor

pricing bids in both sealed and openbidding situations


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The Concept of Pricing

Inperfect competition, a firm can sell as

much of a product as it can produce,all at a single market price.

In imperfect competition, the price a firmcharges for a unit will influence the

quantity of units it sells.


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The Concept of Pricing

Marginal costis the additional cost resulting

from producing one additional unit.

Marginal revenue is the additional revenue

resulting from the sale of one additional unit.

Price elasticity is the effect of price changes

on sales volume.


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Influences on Pricing

Several factors interact to shape themarket in which managers make pricing

decisions: legal requirements

competitors actions

customer demands


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Compute a target sales price

by various approaches


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Role of Costs in Pricing

Decisions Two pricing approaches used by

companies are:

1 Cost-plus pricing2 Target costing


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Target Sales Price

There are four popular markup formulasfor pricing:

1 As a percentage of variable manufacturingcosts

2 As a percentage of total variable costs

3 As a percentage of full costs

4 As a percentage of total manufacturingcost


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Relationships of Costs toSame Target Selling Prices

Target sales price $20.00Variable costs:

Manufacturing $12.00Selling and administrative 1.10

Unit variable cost 13.10Fixed costs:

Manufacturing $ 3.00Selling and administrative 2.90Unit fixed costs 5.90Target operating income $ 1.00


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Relationships of Costs toSame Target Selling Prices

Markup percentages

% of variable

manufacturing

costs:

($20.00$12.00) $12.00= 66.67%

% of totalvariable

costs:

($20.00$13.10) $13.10

= 52.67%


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Costing Techniques

Target costing sets a cost before the

product is created or even designed.

Value engineering is a cost-reduction

technique, used primarily during design.

Kaizen costing is the Japanese word for

continuous improvement.


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Use target costing to decide

whether to add a new product.


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Target Costing and

Cost-Plus Pricing Compared Suppose that ITT Automotive receives an

invitation to bid from Ford on the anti-lock

braking systems. The current manufacturing cost is $154.

ITT Automotives desired gross margin

rate is 30% on sales. The market conditions have established a

sales price of $200 per unit.


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Target Costing and

Cost-Plus Pricing Compared

What is the bid price using cost-plus pricing?

Bid price = Cost Cost % = $154 0.7

Bid price = $220


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Target Costing and

Cost-Plus Pricing Compared

Target cost = Market price Cost %

= $200 0.7

Target cost = $140

Bid price = Market price = $200

What is the bid price using target costing?


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Thanks

Decision Making Session 3

Documents

Transcript of Decision Making Session 3