5 - 1 Chapter 5 Relevant Information and Decision Making: Marketing Decisions

5 - 2 Learning Objective 1 Discriminate between relevant and irrelevant information for making decisions.

5 - 3 The Concept of Relevance What information is relevant? It depends on the decision being made. Decision making essentially involves choosing among several courses of action.

5 - 4 The Concept of Relevance What is the accountant’s role in decision making? It is primarily that of a technical expert on financial analysis. The accountant helps managers focus on the relevant information.

5 - 5 Relevant Information Relevant information is the predicted future costs and revenues that will differ among the alternatives.

5 - 6 Learning Objective 2 Use the decision process to make business decisions.

5 - 7 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)

5 - 8 The Decision Process Gather relevant information using historical accounting information and other information from outside the accounting system. Step 1

5 - 9 The Decision Process Using the information gathered in Step 1, formulate predictions of expected future revenues or expected future costs. The predictions formulated in Step 2 to the decision model. Step 3 Step 2

The Decision Process 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

Decision Model Defined A decision model is any method used for making a choice, sometimes requiring elaborate quantitative procedures.

In the best of all possible worlds, information used for decision making would be perfectly relevant and accurate. In the best of all possible worlds, information used for decision making would be perfectly relevant and accurate. Accuracy and Relevance

The degree to which information is relevant or precise often depends on the degree to which it is... The degree to which information is relevant or precise often depends on the degree to which it is... Accuracy and Relevance Quantitative Qualitative

Learning Objective 3 Decide to accept or reject a special order using the contribution margin technique.

Special Sales Order Example l Solo Company is offered a special order of $13 per unit for 100,000 units. l Should Solo accept the order? l The first step is to gather relevant information from Solo Company’s financial statements.

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$12,000 Selling and administrative 1,100 13,100 Contribution margin$ 6,900

Special Sales Order Example Solo Company Income Statement Year Ended December 31, 2002 (dollars 000) Contribution margin$6,900 Less: Fixed expenses Manufacturing$3,000 Selling and administrative 2,900 5,900 Operating income$1,000

Special Sales Order Example l Only variable manufacturing costs are affected by the particular order, at a rate of $12 per unit ($12,000,000 ÷ 1,000,000 units). l All other variable costs and all fixed costs are unaffected and thus irrelevant.

Special Sales Order Example 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?

Learning Objective 4 Decide to add or delete a product line using relevant information.

Avoidable and Unavoidable Costs Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Unavoidable costs are costs that continue even if an operation is halted.

Department Store Example l Consider a discount department store that has three major departments: 1 Groceries 2 General merchandise 3 Drugs

Department Store Example Department General (000) Groceries Mdse. Drugs Total Sales$1,000$800$100$1,900 Variable expenses ,420 Contribution margin$ 200$240$ 40$ 480

Department Store Example Department General (000) Groceries Mdse. Drugs Total Contribution margin$200$240$40$480 Fixed expenses: Avoidable$150$100$15$265 Unavoidable Total$210$200$35$445 Operating income$ (10)$ 40$ 5$ 35

Department Store Example l For this example, assume first that the only alternatives to be considered are dropping or continuing the grocery department, which shows a loss of $10,000. l Assume further that the total assets invested would be unaffected by the decision. l The vacated space would be idle and the unavoidable costs would continue.

Dropping Products, Departments, Territories Total Before Change Sales$1,900,000 Variable expenses 1,420,000 Contribution margin 480,000 Avoidable fixed expenses 265,000 Contribution to common space and unavoidable costs$ 215,000 Unavoidable fixed expenses 180,000 Operating income$ 35,000

Dropping Products, Departments, Territories Effect of Dropping Groceries Sales$1,000,000 Variable expenses 800,000 Contribution margin 200,000 Avoidable fixed expenses 150,000 Contribution to common space and unavoidable cost$ 50,000

Dropping Products, Departments, Territories Total After Change Sales$900,000 Variable expenses 620,000 Contribution margin 280,000 Avoidable fixed expenses 115,000 Contribution to common space and unavoidable costs$165,000 Unavoidable fixed expenses 180,000 Operating income$ (15,000)

Learning Objective 5 Compute a measure of product profitability when production is constrained by a scarce resource.

Optimal Use of Limited Resources l A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. l The order to be accepted is the one that makes the biggest total profit contribution per unit of the limiting factor.

Product Profitability Example Constrained by a Scarce Resource l Assume that a company has two products: a plain cellular phone and a fancier cellular phone with many special features.

Plant workers can make 3 plain phones in one hour or 1 fancy phone. Product Plain Fancy Per Unit Phone Phone Selling price$80$120 Variable costs Contribution margin$16$ 36 Contribution margin ratio 20% 30% Product Profitability Example Constrained by a Scarce Resource

Product Profitability Example Constrained by a Scarce Resource Which product is more profitable? If sales are restricted by demand for only a limited number of phones, fancy phones are more profitable. Why?

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.

Product Profitability Example Constrained by a Scarce Resource l Now suppose annual demand for phones of both types is more than the company can produce in the next year. l Productive capacity is the limiting factor because only 10,000 hours of capacity are available.

Product Profitability Example Constrained by a Scarce Resource 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

Learning Objective 6 Discuss the factors that influence pricing decisions in practice.

Pricing Decisions l Among the many pricing decisions to be made are: – setting the price of a new or refined product – setting the price of products sold under private labels – responding to a new price of a competitor – pricing bids in both sealed and open bidding situations

The Concept of Pricing In perfect 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 firm charges for a unit will influence the quantity of units it sells.

The Concept of Pricing Marginal cost is 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.

Influences on Pricing l Several factors interact to shape the market in which managers make pricing decisions: – legal requirements – competitors’ actions – customer demands

Learning Objective 7 Compute a target sales price by various approaches and compare the advantages and disadvantages of these approaches.

Role of Costs in Pricing Decisions l Two pricing approaches used by companies are: 1 Cost-plus pricing 2 Target costing

Target Sales Price l There are four popular markup formulas for pricing: 1 As a percentage of variable manufacturing costs 2 As a percentage of total variable costs 3 As a percentage of full costs 4 As a percentage of total manufacturing cost

Relationships of Costs to Same Target Selling Prices Target sales price$20.00 Variable costs: Manufacturing$12.00 Selling and administrative 1.10 Unit variable cost Fixed costs: Manufacturing$ 3.00 Selling and administrative 2.90 Unit fixed costs 5.90 Target operating income$ 1.00

Relationships of Costs to Same Target Selling Prices Markup percentages % of variable manufacturing costs: ($20.00 – $12.00) ÷ $12.00 = 66.67% % of total variable costs: ($20.00 – $13.10) ÷ $13.10 = 52.67%

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.

Learning Objective 8 Use target costing to decide whether to add a new product.

Target Costing and Cost-Plus Pricing Compared l Suppose that ITT Automotive receives an invitation to bid from Ford on the anti-lock braking systems. l The current manufacturing cost is $154. l ITT Automotive’s desired gross margin rate is 30% on sales. l The market conditions have established a sales price of $200 per unit.

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

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?

Learning Objective 9 Understand how relevant information is used when making marketing decisions.

Marketing Decisions Accountants and managers must have a thorough understanding of relevant information, especially costs, when making marketing decisions. Market Price = $200

End of Chapter 5