1. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 1

2. CHAPTER 8 Marketing Decisions © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 2

3. Learning Objectives Why is it important to understand cost behaviour in pricing and marketing decisions? How can cost–volume–profit (CVP) analysis be used to help answer “what if” questions related to sales volume and pricing? How is cost information used in setting prices? How can a company determine an optimal price for its products by considering demand volumes? What costs must a company include when setting a price for a one-time special order? How does a company determine a minimum transfer price between intercompany divisions? What cost information needs to be considered when a company is in the process of deciding to keep or drop a product line? © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 3

4. 4 Marketing Strategy Marketing is the business activity that aims to understand customer needs and satisfy those needs more effectively than competitors Sales mix  mix of products/services offered by the business Market segments  Defined by its unique characteristics Customer relationship management 4 Ps  Product, price, place, and promotion Decisions about product/service mix, customer mix, market segmentation, value and cost drivers, pricing, and distribution channels

5. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 5 Marketing and Accounting Accounting helps to answer What is the volume of products/services that we need to sell to maintain profitability? What sales mix will optimize our profitability? What alternative approaches to pricing can we adopt? How can we ensure we earn a profit over our costs? Should we keep or drop product lines that are underperforming?

6. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 6 Cost Behaviour Fixed costs  Do not change with increases in business activity Variable costs  increase or decrease in proportion to an increase or decrease in business activity Average costs  Total of both fixed and variable costs divided by the total number of units produced Step costs  Constant within a particular level of activity, but can increase when activity reaches a critical level Mixed costs  Have both fixed and variable components Marginal cost  Cost of producing one extra unit

7. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 7 Cost Behaviour: Fixed and Variable Costs

8. Cost–Volume–Profit (CVP) Analysis The relationship between changes in activity (the number of units sold) and changes in selling prices and costs (both fixed and variable) Relevant range is the volume of activity within which the business expects to be operating over the short term Sensitivity analysis is an approach to understanding how changes in one variable (such as price) affect other variables (such as volume) © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 8

9. Operating Profit Difference between revenue and costs (both fixed and variable) © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 9

10. CVP Analysis Working with contribution margin rather than operating profit Contribution margin (CM) is calculated by deducting the variable costs from the revenues for a product or service  Unit contribution margin (UCM) Contribution margin ratio (CM Ratio) is the contribution margin divided by the revenues © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 10

11. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 11 Breakeven Point The point at which total costs equal total revenue – there is neither a profit or loss or Breakeven in units = F/UCM = $200,000/$10 = 20,000 units or Breakeven in sales $ = F/CM ratio = $200,000/50% = $400,000

12. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 12 CVP Analysis Example Fixed costs $200,000 Variable costs $10 per unit Selling price $25 Total 20,000 units Operating Profit: P = Sx - (F + Vx) P = ($25 x 20,000) – [200,000 + ($10 x 20,000)] P = 500,000 – 400,000 P = $100,000

13. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 13 Breakeven Point Breakeven (in units): = Fixed costs/(Selling price per unit – variable costs per unit) = $200,000/ (20 – 10) = 20,000 units Breakeven (in $sales): = Fixed costs/CM Margin (Unit contribution as % of sales) = $200,000/50%* = $400,000 or 20,000 units @ $20 *Unit contribution is 20 – 10 = 10 As a % of sales 10/20 = 50% or 0.5

14. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 14 Target Profit (Variation on Breakeven) Units to sell: = Fixed costs + Profit/ (Selling price per unit – variable costs per unit) = 200,000 + 150,000/ (20 – 10) = 35,000 units Sales in dollars: = Fixed costs + Profit/CM Margin (Unit contribution as % of sales) = 200,000 + 150,000/0.50%* = $700,000 or 35,000 units @ $20 *Unit contribution is 20 – 10 = 10 As a % of sales 10/20 = 50% or 0.5

15. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 15 Breakeven Chart

16. Margin of Safety A measure of the difference between the anticipated and breakeven levels of activity Margin of safety (%) = Expected sales – Breakeven sales x 100 Expected sales © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 16

17. Margin of Safety Example Breakeven sales 20,000 units Anticipated sales 25,000 units Expected sales – Breakeven sales x 100 Expected sales Margin of safety = 25,000 – 20,000 x 100 20,000 = 20% © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 17

18. Breakeven with Multiple Products Product A: 60% sales mixProduct B: 40% sales mix Selling price$30$15 Variable costs$12$7 Contribution per unit $1860% x $18 + $10.80 $840% x $8 = $3.20 Breakeven $200,000 $200,000 = 14,286 units (both Products A & B) $10.80+$3.20 $14 Units by product to breakeven 14,286 x 0.6 = 8,572 14,286 x 0.4 = 5,714 Sales8,572 @ $30 =$257,1605,714 @ $15$85,710 Variable costs@ $12102,864@ $739,998 Contribution$154,296$45,712 Total contribution $200,008 © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 1st Cdn Ed., Ch 8 Weighting the sales and contribution margins of each product For example: Fixed costs $200,000

19. Operating Leverage Refers to the mix of fixed and variable costs in a business Demonstration of Operating Leverage © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 19

20. Operating Leverage Example Company ACompany B Sales200,000 @ $1.50$300,000200,000 units @ $1.50 $300,000 Variable costs90 cents per unit 180,00030 cents per unit 60,000 Contribution60 cents per unit 120,000$1.20 per unit240,000 Fixed costs100,000220,000 Profit$20,000 Breakeven point $100,000/$0.60166,667 units $250,000 $220,000/$1.20183,333 units $275,000 Higher risk Contribution from 50,000 units sold (after breakeven) 50,000 @ $0.60$30,00050,000 @ $1.20$60,000 Higher return © 2012 John Wiley & Sons, Ltd, Accounting for Managers, 1st Cdn Ed., Ch 8 Two company’s sell the same product at same price with same profits. Only the mix of variable and fixed costs is different

21. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 21 Assumptions of CVP Analysis Costs can be clearly segregated between fixed and variable The behaviour of costs is linear Changes in costs occur only because of changes in the number of units sold or the level of service provided A single product/service or a product/service mix remains constant CVP analysis applies only to the relevant range CVP analysis has a short-term focus and cannot really be used as a long-term planning tool

22. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 22 Alternative Approaches to Pricing Cost-plus pricing  Margin is added to the total product/service cost to establish the selling price

23. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 23 Alternative Approaches to Pricing Target Rate of Return Pricing  Estimates the fixed and working capital investment required for the business, and takes into account the need to generate an adequate return on that investment to satisfy shareholders Market Pricing  Base its pricing on the competitive market price adjusted to take into account quality, product features, and extended services that may be offered with the product

24. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 24 Determining the Optimum Selling Price Point at which profit is maximized Contribution at Different Activity Levels

25. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 25 Special Pricing Decisions Occur when a company has some available capacity or downtime with which to process an order that is outside its normal operations One-time special orders at a price below the price that the product usually sells for in the market As fixed costs remain constant irrespective of volume, the selling price must cover the variable costs of a special order in order for it to make a positive contribution to recovering some of the fixed costs of the business

26. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 26 Special Pricing Decisions Business must have spare capacity that has no alternative use, and the fixed costs must be unavoidable in the short term. Consider long term marketing implications: 1. The future selling price may be affected by accepting a special order if competitors adopt similar pricing tactics. 2. Customers who receive or become aware of a special selling price may expect a similar low price in the future. 3. Accepting this order may prevent the firm from accepting a more profitable order at a higher price if one subsequently comes along.

27. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 27 Special Pricing Decisions Example Revenue 17,000 @ $30$510,000 Variable costs 17,000 @ $10 170,000 Contribution 340,000 Fixed costs 200,000 Net profit 140,000 Accepting an order of 3,000 units @ $12 will increase profits by 3,000 x (12 – 10) = $6,000

28. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 28 Transfer Pricing Transfers between business units based on  Market price to external customers  Marginal cost of making the product  Full cost of producing the goods or services, including fixed and variable costs but excluding any profit margin  Full cost of the goods or services plus a mark-up  Negotiated price General guideline for setting a transfer price Minimum transfer price = Incremental costs + Opportunity costs

29. Decisions to Keep or Drop a Product Line Separate fixed costs into unavoidable business wide costs and avoidable segment-specific costs Unavoidable costs are often allocated by an arbitrary method to each business unit or market segment, although these costs are able to be influenced only at the corporate level. Avoidable costs are identifiable with and are able to be influenced by decisions made at the business-unit level. © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 29

30. Decisions to Keep or Drop a Product Line © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 30 Personal tax returns market segment clients contributed $7,000 toward the unavoidable overhead. If this segment was discontinued, the profit of the practice would fall by $7,000 to $18,000

31. Conclusions Cost concepts Cost behaviour Cost–volume–profit (CVP) analysis Alternative approaches to pricing Optimizing prices Special order decisions Deciding to keep or drop a product line © 2013 John Wiley & Sons, Ltd, Accounting for Managers, 1Ce, Ch 8 31