Relevant Information and Decision Making: Marketing Decisions

Dr Rashmi Soni

Discriminate between relevant and irrelevant information for making decisions.

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.

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 the relevant information.

Relevant Information

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

Use the decision process to make business decisions.

The Decision Process

(A) (1) (B)

Historical Information

Other Information Predictions as Inputs to Decision Model Decisions by Managers with Aid of Decision Model

(2)

Prediction Method

(3)

Decision Model

(4)

Implementation and Evaluation Feedback

The Decision Process

Step 1 Gather relevant information using historical accounting information and other information from outside the accounting system.

The Decision Process

Step 2 Using the information gathered in Step 1, formulate predictions of expected future revenues or expected future costs.

Step 3
The predictions formulated in Step 2 to the decision model.

The Decision Process

Step 4 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.

Decision Model Defined

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

Accuracy and Relevance

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...

Qualitative

Quantitative

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

Special Sales Order Example

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

Special Sales Order Example

Solo Company Income Statement Year Ended December 31, 2002 (dollars 000) Sales (1,000,000 units) Less: Variable expenses Manufacturing $12,000 Selling and administrative 1,100 Contribution margin $20,000

13,100 $ 6,900

Special Sales Order Example

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

5,900 $1,000

Special Sales Order Example

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

Special Sales Order Example

Special order sales price/unit Increase in manufacturing costs/unit Additional operating profit/unit $13 12 $ 1

Based on the preceding analysis, should Solo accept the order?

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. Unavoidable costs are costs that continue even if an operation is halted.

Department Store Example

2
3

Consider a department store that has three major departments: Groceries General merchandise Drugs

Department Store Example

Department General (000) Groceries Mdse. Drugs Sales $1,000 $800 $100 Variable expenses 800 560 60 Contribution margin $ 200 $240 $ 40

Total $1,900 1,420 $ 480

Department Store Example

Department General (000) Groceries Mdse. Drugs Contribution margin $200 $240 $40 Fixed expenses: Avoidable $150 $100 $15 Unavoidable 60 100 20 Total $210 $200 $35 Operating income $ (10) $ 40 $ 5

Total $480 $265 180 $445 $ 35

Department Store Example

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. Assume further that the total assets invested would be unaffected by the decision. The vacated space would be idle and the unavoidable costs would continue.

Dropping Products, Departments, Territories

Total Before Change Sales Variable expenses Contribution margin Avoidable fixed expenses Contribution to common space and unavoidable costs Unavoidable fixed expenses Operating income $1,900,000 1,420,000 480,000 265,000 $ 215,000 180,000 $ 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 Variable expenses Contribution margin Avoidable fixed expenses Contribution to common space and unavoidable costs Unavoidable fixed expenses Operating income $900,000 620,000 280,000 115,000 $165,000 180,000 $ (15,000)

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

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.

Key Factor / Limiting Factor * The factor of production which in short supply is called as

key factor or limiting factor. * The decision regarding profitability of the product in such situation is based upon profitability of key factor

* Profitability of the key factor =

Contribution per unit / Key Fcator

* Higher the profitability of key factor, better the product

Main key factors

(1)

Sales in unit - Check Contribution per unit - higher better

(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

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.

Product Profitability Example Constrained by a Scarce Resource

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 64 84 Contribution margin $16 $ 36 Contribution margin ratio 20% 30%

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

Now suppose annual demand for phones of 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.

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

Discuss the factors that influence pricing decisions in practice.

Pricing Decisions

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

Several factors interact to shape the market in which managers make pricing decisions: legal requirements competitors actions customer demands

Compute a target sales price by various approaches

Role of Costs in Pricing Decisions

Two pricing approaches used by companies are: Cost-plus pricing Target costing

Target Sales Price

2 3 4

There are four popular markup formulas for pricing: As a percentage of variable manufacturing costs As a percentage of total variable costs As a percentage of full costs As a percentage of total manufacturing cost

Relationships of Costs to Same Target Selling Prices

Target sales price Variable costs: Manufacturing Selling and administrative Unit variable cost Fixed costs: Manufacturing Selling and administrative Unit fixed costs Target operating income $20.00

$12.00 1.10
13.10 $ 3.00 2.90 5.90 $ 1.00

Relationships of Costs to Same Target Selling Prices

Markup percentages % of variable manufacturing costs: % of total variable costs: ($20.00 $12.00) $12.00 = 66.67%

($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.

Use target costing to decide whether to add a new product.

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.

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

What is the bid price using target costing? Target cost = Market price Cost % = $200 0.7 Target cost = $140 Bid price = Market price = $200

Thanks