Chapter 5

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

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

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.

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

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

7. The Decision Process (A) (B) (1) Historical Information Other Information Predictions as Inputs to Decision Model (2) Prediction Method (3) Decisions by Managers with Aid of Decision Model Decision Model (4) Implementation and Evaluation Feedback

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

9. 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.

10. 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.

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

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

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

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

15. 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 Company’s financial statements.

16. 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

17. 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

18. 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.

19. 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?

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

21. 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.

22. Department Store Example • Consider a discount department store that has three major departments: • Groceries • General merchandise • Drugs

23. Department Store Example 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

24. Department Store Example Department General (000) Groceries Mdse. Drugs Total Contribution margin $200 $240 $40 $480 Fixed expenses: Avoidable $150 $100 $15 $265 Unavoidable 60 100 20 180 Total $210 $200 $35 $445 Operating income $ (10) $ 40 $ 5 $ 35

25. 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.

26. 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

27. 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

28. 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)

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

30. 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 biggesttotal profit contribution per unit of the limiting factor.

31. Product Profitability ExampleConstrained by a Scarce Resource • Assume that a company has two products: a plain cellular phone (C&W) and a fancier cellular phone (Digicel) with many special features.

32. Product Profitability ExampleConstrained by a Scarce Resource Plant workers can make 3 plain phones in one hour or 1 fancy phone. Product Plain Fancy Per UnitPhonePhone Selling price $80 $120 Variable costs 64 84 Contribution margin $16 $ 36 Contribution margin ratio 20% 30%

33. Product Profitability ExampleConstrained 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?

34. 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.

35. Product Profitability ExampleConstrained 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.

36. 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 = $36per hour

37. End of Chapter 5