Relevant Information and Decision Making: Marketing Decisions

1. Relevant Informationand Decision Making:Marketing Decisions Chapter 5

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

3. What is Relevance? Accountants should use 2 criteria to determine whether information is relevant: 1. Information must be an expected future revenue or cost and... 2. it must have an element of difference among the alternatives.

4. What is Relevance? Relevant information is the predicted future costs and revenues that will differ among the alternatives.

5. 1. Special Sales Order Example Cordell Company makes and sells 1,000,000 seat covers. Total manufacturing cost is $30,000,000, or $30 per unit. Cordell is offered a special order of $26 per unit for 100,000 units.

6. Special Sales Order Example This order... 1. would not affect Cordell’s regular business. 2. would not affect total fixed costs. 3. would not require additional variable selling and administrative expenses. 4. would use some otherwise idle manufacturing capacity.

7. Cordell Company Contribution Form of the Income Statement For the Year Ended December 31, 2004 ($’000) Sales (1,000,000 units) $40,000 Less: Variable expenses Manufacturing $24,000 Selling and administrative 2,200 26,200 Contribution margin $13,800 Less: Fixed expenses Manufacturing $ 6,000 Selling and administrative 5,800 11,800 Operating income $ 2,000 Special Sales Order Example

8. Special Sales Order Example Only variable manufacturing costs are affected by this particular order, at a rate of $24 per unit ($24,000,000 ÷ 1,000,000 units). All other variable costs and all fixed costs are unaffected and thus irrelevant.

9. Special Sales Order Example Special order sales price/unit $26 Increase in manufacturing costs/unit 24 Additional operating profit/unit $ 2 Based on the preceding analysis, should Cordell accept the order? Yes $2 × 100,000 = $200,000

10. Activity-Based Costing, Special Orders, and Relevant Costs Suppose that Cordell examined its $24 million of variable manufacturing costs and determined that $18 million varied directly with the units produced, or $18 per unit, and $6 million relates to the set-up activity, or $12,000 per set-up. Assume that processing the additional 100,000 units will require 5 additional set-ups.

11. Activity-Based Costing, Special Orders, and Relevant Costs What is the additional variable cost? Additional unit-based variable manufacturing cost, 100,000 × $18 $1,800,000 Additional setup-based variable manufacturing cost, 5 × $12,000 60,000 Total additional variable manufacturing cost $1,860,000

12. 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.

13. 2. Adding/Dropping a Department/Product -A Department Store Example Consider a discount department store that has three major departments: Groceries General merchandise Drugs

14. Department Store Example Departments ($’000) Groceries General Mdse. Drugs Total Sales $1,000 $800 $100 $1,900 Variable expenses 800 560 60 1,420 Contribution margin $ 200 $240 $ 40 $ 480 Fixed expenses: Avoidable $ 150 $100 $ 15 $ 265 Unavoidable 60 100 20 180 Total fixed expenses $ 210 $200 $ 35 $ 445 Operating income $ (10) $ 40 $ 5 $ 35

15. 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.

16. Department Store Example Store as a Whole ($000) Total Before Change Effect of Dropping Groceries Total After Change Sales $1,900 $1,000 $900 Variable expenses 1,420 800 620 Contribution margin $ 480 $ 200 $280 Avoidable fixed expenses 265 150 115 Profit contribution to common space and other unavoidable costs $ 215 $ 50 $165 Unavoidable expenses 1800 180 Operating income $ 35 $ 50 $ (15)

17. Department Store Example Assume that the store could use the space made available by the dropping of groceries to expand the general merchandise department. This will increase sales by $500,000, generate a 30% contribution-margin, and have avoidable fixed costs of $70,000. $80,000 – $50,000 = $30,000

18. Department Store Example

19. 3. Optimal Use of Limited Resources A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. Assume that Grand Canyon Railway is considering converting its 100 economy- class seats to 50 first-class car seats.

20. Economy Class First Class Selling price per seat $80 $120 Variable costs per seat 60 84 Contribution margin per seat $20 $ 36 Contribution margin ratio 25% 30% Optimal Use of Limited Resources

21. Optimal Use of Limited Resources Which is more profitable? If no capacity constraints, i.e. customers have not reached maximum demand, first-class seats are more profitable. Why?

22. Optimal Use of Limited Resources The sale of a economy-class seat adds $20 to profit. The sale of a first-class seat adds $36 to profit.

23. Optimal Use of Limited Resources Now suppose there is enough demand to fill the car with passengers regardless of whether it has first-class or economy-class seats. Capacity is now the limiting factor.

24. Optimal Use of Limited Resources Which seats should the railroad emphasize? Economy-class: $20 contribution margin per unit × 100 seats per car = $2,000 per car First-class: $36 contribution margin per seat × 50 seats per car = $1,800per car

25. 4. Pricing Decisions 1. Setting the price of a new or refined product 2. Setting the price of products sold under private labels 3. Responding to a new price of a competitor 4. Pricing bids in both sealed and open bidding situations

26. Predatory pricing Discriminatory pricing General Influences onPricing in Practice Legal requirements Competitors’ actions Customer demands

27. 1. Cost-Plus Pricing It is setting prices by computing an average cost and adding a markup. Target prices can be based on a host of different markups that are in turn based on a host of different definitions of cost.

28. 1. Cost-Plus Pricing PRICE BASE COST

29. Target Sales Price • 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

30. Relationships of Costs toSame Target Selling Prices Target sales price $20.00 Variable costs: Manufacturing $12.00 Selling and administrative 1.10 Unit variable cost 13.10 Fixed costs: Manufacturing $ 3.00 Selling and administrative 2.90 Unit fixed costs 5.90 Target operating income $ 1.00

31. ($20.00 – $12.00) ÷ $12.00 = 66.67% % of variable manufacturing costs: % of total variable costs: ($20.00 – $13.10) ÷ $13.10 = 52.67% % of full costs: ($20.00 – $19.00) ÷ $19.00 = 5.26% Relationships of Costs to Same Target Selling Prices

32. Advantages of Contribution Margin Approach The contribution margin approach offers more detailed information. This approach allows managers to prepare price schedules at different volume levels. Target pricing with full costing presumes a given volume level.

33. Advantages of Total Manufacturing and Full-Cost Approaches. 1. In the long run, a firm must recover all costs to stay in business. 2. It may indicate what competitors might charge. 3. It meets the cost-benefit test. 4. It copes with uncertainty.

34. Advantages of Total Manufacturing and Full-Cost Approaches. 5. It tends to promote price stability. 6. It provides the most defensible basis for justifying prices to all interested parties. 7. It simplifies pricing decisions.

35. 2. Target costing Targetcosting sets a cost before the product is created or even designed. SELLING PRICE TARGET COST

36. 3. Cost reduction Value engineering is a cost-reduction technique, used primarily during design. Kaizen costingis the Japanese word for continuous improvement.

37. Exercise 5-A4 (Page 230) ABC uses target costing to aid in the final decision to release new products to production. A new product is being evaluated. Market research has surveyed the potential market for this product and believes that its unique features will generate a total demand over the product’s life of 70,000 units at an average price of $360.

38. Exercise 5-A4 (Contd.) The target costing team has members from market research, design, accounting & production engineering departments. The team has worked closely with key customers & suppliers. A value analysis of the product has determined that the total cost for the various value-chain functions using the existing process technology are:

39. Exercise 5-A4 (Contd.)

40. Exercise 5-A4 (Contd.) Management has a target contribution to profit percentage of 40% of sales. This contribution provides sufficient funds to cover corporate support costs, taxes & a reasonable profit.

41. Exercise 5-A4 (Contd.) Question 1: Should the new product be released to production? Explain. Revenue ($360 x 70,000) $25,200,000 Total cost over product life 16,600,000 Estimated contribution to profit $ 8,600,000 Desired (target) contribution to profit 40% x $25,200,000 $10,080,000 Deficiency in profit $ 1,480,000 The product should not be released to production.

42. Exercise 5-A4 (Contd.) Question 2: Approximately 70% of manufacturing costs for this product consists of materials and parts that are purchased from suppliers. Key suppliers on the target costing team have suggested process improvements that will reduce supplier cost by 20%. Should the new product be released to production? Explain.

43. Exercise 5-A4 (Contd.) Previous total estimated cost $16,600,000 Cost savings from suppliers .20 x .70 x $8,000,000 1,120,000 Revised total estimated cost $15,480,000 Revised total contribution to profit: $25,200,000 - $15,480,000 $ 9,720,000 Desired (target) contribution to profit $10,080,000 Deficiency in profit $ 360,000 The product should not be released to production.

44. Exercise 5-A4 (Contd.) Question 3: New process technology can be purchased at a cost of $220,000 that will reduce non-outsourced manufacturing costs by 25%. Assuming the supplier’s process improvements and new process technology are implemented, should the new product be released to production? Explain.

45. Exercise 5-A4 (Contd.) Previous revised total estimated cost from requirement 2. $15,480,000 Process improvement savings: .25 x .30 x $8,000,000 $600,000 Less cost of new technology 220,000380,000 Revised total estimated cost 15,100,000 Revised total contribution to profit: $25,200,000 - $15,100,000 $10,100,000 Desired (target) contribution to profit $10,080,000 Excess contribution to profit $ 20,000 The product should be released to production.

46. Exercises to try Page 231: 5-B1 (Special sales order) Page 232: 5-B3 (Dropping a product line) Page 232: 5-B4 (Cost-plus pricing v target costing)