Chapter 5

Relevant Information
and Decision
Making:
Marketing Decisions
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Learning Objective 1

Discriminate between relevant

and irrelevant information
for making decisions.

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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.

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 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.

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Relevant Information

Relevant information is the predicted

future costs and revenues that will
differ among the alternatives.

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Learning Objective 2

Use the decision process to

make business decisions.

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 The Decision Process
(A) (B)
(1)
Historical Information Other Information

(2) Predictions as Inputs

Prediction Method
to Decision Model

(3) Decisions by Managers

Decision Model
with Aid of Decision Model

(4)
Implementation and Evaluation

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

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 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.

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 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.

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Decision Model Defined

A decision model is any method used for

making a choice, sometimes requiring
elaborate quantitative procedures.

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Accuracy and Relevance

In the best of all possible worlds,

information used for decision
making would be perfectly
relevant and accurate.

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Accuracy and Relevance

The degree to which information is

relevant or precise often depends
on the degree to which it is...

Qualitative Quantitative

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Learning Objective 3

Decide to accept or reject a

special order using the
contribution margin
technique.

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 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.

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 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

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 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

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 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.

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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?

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Learning Objective 4

Decide to add or delete

a product line using
relevant information.

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 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.

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

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 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

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 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

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 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.

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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
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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

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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)

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Learning Objective 5

Compute a measure of product

profitability when production
is constrained by a scarce
resource.

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 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.

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 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.

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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%
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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?

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 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.

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 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.

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 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

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Learning Objective 6

Discuss the factors that influence

pricing decisions in practice.

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 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

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 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.

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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.

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

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Learning Objective 7

Compute a target sales price

by various approaches and
compare the advantages
and disadvantages of
these approaches.
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 Role of Costs in Pricing
Decisions
 Two pricing approaches used by companies
are:
1 Cost-plus pricing
2 Target costing

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 Target Sales Price
 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

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 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 13.10
Fixed costs:
Manufacturing $ 3.00
Selling and administrative 2.90
Unit fixed costs 5.90
Target operating income $ 1.00
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 Relationships of Costs to
Same Target Selling Prices
Markup percentages

% of variable
($20.00 – $12.00) ÷ $12.00
manufacturing
= 66.67%
costs:

% of total
($20.00 – $13.10) ÷ $13.10
variable
= 52.67%
costs:
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 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.

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Learning Objective 8

Use target costing to decide

whether to add a new product.

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 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 Automotive’s desired gross margin rate
is 30% on sales.
 The market conditions have established a
sales price of $200 per unit.

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 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

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 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

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Learning Objective 9

Understand how relevant

information is used when
making marketing decisions.

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 Marketing Decisions

Market Price = $200

Accountants and managers must have a thorough

understanding of relevant information, especially
costs, when making marketing decisions.

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End of Chapter 5

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