DECISION MAKING

Session Aim
The aim of this session is to enable you to use information to inform
management decisions
Learning Objectives
At the end of this session, you will be able to:

Analyse cost – volume – profit relationships

Evaluate cost reduction techniques

Evaluate pricing decisions

Cost-Volume-Profit Relationship
The principal purpose of this analysis is to improve management’s
understanding of the relationship between financial flows and the level of
operating activity

Decision making involves consideration of the combined effect on both cost

and revenue of changes in operations

The analysis is based on the relationship:

Profit = Revenues – Total Costs

Break-even Analysis
Total Revenue
Costs/Revenue Total Costs

Fixed Costs

Break-even Quantity Output/Sales

Break-even Analysis
Remember:

A higher price or lower price does not mean that break even will never be
reached

The BE point depends on the number of sales needed to generate revenue

to cover costs

The Break Even chart is NOT time related but based on the period covering
the fixed costs
Break-even Analysis
Higher prices might mean fewer sales to break-even but those sales may
take a longer time to achieve

Lower prices might encourage more customers but higher volume needed
before sufficient revenue generated to break-even
Cost Reduction Techniques
This is not the same as cost control – keeping costs within predetermined
limits

‘Cost reduction involves reducing costs from previous levels without adverse
impact on the quality of product/service being provided.’

[Source: Upchurch, A. (1998) Management Accounting – Principles & Practice, Financial Times Pitman Publishing]
Cost Reduction Techniques
Target Costing – starts with the price and works backwards to determine
the costs needed

Kaizen Costing – incremental, continual reduction (improvement). Like

target costing it involves target setting, associated with lean principles
Cost Reduction Techniques cont’
Value Chain Analysis – seeks to eliminate all activities which do not add
value. Examples:
- can function be achieved using less expensive methods/materials
- can some part or process be eliminated

Variety Reduction
Factors Affecting Pricing Policy

Price sensitivity Inflation

Price perception Uniqueness
Quality Incomes
Intermediaries Product range
Competitors Ethics
Suppliers Substitute products
Product Life Cycle
Growth

Maturity

Saturation - Decline
Markets and Competition
Price will be dependent on type of market:

Perfect
Competition
Monopoly
Oligopoly
Markets and Competition continued

Price leadership
Market penetration
Market skimming
Differential pricing
Sensitivity Analysis
Attempts to determine if changes in key variables will have a significant effect on business
results

For example:

will an increase in price result in a rise or fall in total revenue?

Pricing Approaches

Demand Based

Full Cost Plus

Marginal Cost Plus

Demand Based Pricing
Attempts to determine the relationship between price and demand for
particular product

‘Demand Curves’ plotted and used accordingly

Could be used to derive a profit or revenue maximising price (optimum

price)
Full Cost Plus Pricing
Traditional approach based on calculating the full cost of product
Percentage mark-up added to full cost for profit
Simple, quick and cheap method of pricing
Ensures costs covered providing normal capacity maintained

Disadvantages:
Price we set may not be competitive
May need to adjust prices to market and demand
Budgeted output volume needs to be established
Suitable basis for overhead absorption is needed
Marginal Cost Plus Pricing
Calculated by adding mark-up to marginal cost
Simple, easy and convenient method to use

Draws attention to contribution and its relationship with volume

Gives some flexibility in competitive situations