DECISION MAKING

- The function of selecting courses of action for the future

DECISION MODEL

- A formal method used b managers for making a choice. It often involves both quatitative and
qualitative analyses.

BASIC STEPS IN A DECISION MODEL

A. IDENTIFY THE PROBLEM

- The typical short-term decision-making cases may involve questions on:

1. whether to accept or reject a special order or business proposal;

2. whether to make or buy a part, sub-assembly, or product line (insourcing vs.

outsourcing);

3. whether to sell or process a product further;

4. whether to continue operating or close a business segment;

5. which is the best product-mix considering capacity constraints;

6. how profit factor should be changed to achieve a profit goal

7. how much price should be charged for the company’s product or services
( pricing decisions)

B. OBTAIN INFORMATION AND MAKE PREDICTIONS

1. QUALITATIVE AND QUANTITATIVE INFORMATION

a. Qualitative factors- outcomes that cannot easily and accurately be measured

in numerical terms

b. Quantitative factors- outcomes that can more easily be expressed in

numerical terms

2. RELEVANT INFORMATION- the information to be gathered should be relevant and

related to the decision-making case

a. Relevant cost and revenues-expected future costs and revenues that differ
among alternative courses of action

The following are relevant:

i. Differential costs- costs that are present in one alternative in a

decision-making case but are absent in whole or in part in another
alternative,
 ii. Avoidable costs- costs that can be eliminated in whole or in part when
one alternative is chosen over another in a decision making case

ii. Opportunity cost- refers to the contribution to income that is

foregone (or lost) when one action is taken over the next best
alternative course of action.

The following are irrelevant:

i. Sunk cost (or past cost)- cost that has already been incurred and
therefore cannot be avoided regardless of the alternative taken by the
decision maker.

Although Past (Sunk, Historical) costs are always irrelevant in

decision-making, they may serve as a basis for making predictions

ii. Future costs that do not differ between or among the alternatives
under consideration.

C. IDENTIFY AND EVALUATE THE ALTERNATIVE COURSES OF ACTION, THEN CHOOSE THE BEST
ALTERNATIVES

- Only relevant factors should be considered in evaluating the alternatives

- As a general rule, the best alternative is the one that will give the organization the
highest income (or lowest loss)

D. IMPLEMENT THE DECISION

E. EVALUATE THE PERFORMANCE OF THE DECISION IMPLEMENTED TO PROVIDE FEEDBACK

This feedback can help the decision maker in making better decisions in the future.

PRICING DECISIONS

PRICING OBJECTIVES

1. to maximize profit or target margin

2. to meet the desired sales volume or market share

3. to maintain a stable relationship between the company’s and the industry leaders’ prices

4. to enhance the image that the company wants to project in the market.

FACTORS THAT INFLUENCE PRODUCT PRICING

1. INTERNAL FACTORS

a. All relevant costs in the value chain (from research and development to customer
service).
b. The company’s marketing objectives, as well as its marketing mix strategy.
c The company’s capacity

Peak-load pricing- prices vary inversely with capacity usage. The company’s
products would be sold at higher prices if the company is not operating at full capacity.

EXTERNAL FACTORS

A. The type of market where the products/services are sold.

a. Perfect Competition-in this type of market, a firm can sell as much of a

product as it can produce, all at a single market price. Every firm in this market will
change the market price- if a product is priced higher than market price, nobody will
buy; if priced is lower, the company would sacrifice profit.

b. Imperfect Competition- the type of market wherein a firm’s price will

influence the quantity it sells. For example, a company would have to reduce its prices
to generate additional sales.

c. Monopolistic Market- a monopolistic is usually able to charge a higher price

because it has no competitors.

B. Demand and supply

C. Customer’s perception of value and price

D. Price elasticity of demand- the effect of price changes in sales volume

- Highly Elastic Demand- small price increases cause large volume declines

- Highly inelastic demand- prices have little or no effect on volume.

E. Legal Requirements-both local and international laws

SOME ILLEGAL PRICING SCHEMES

1. Predatory Pricing- establishing prices so low to drive out competitions from

the market, so that once the predatory pricer no longer has significant
competition, it can dramatically raise prices.

2. Discriminatory Pricing- charging different prices to different customary for the

same product or service.

3. Collusive Pricing- companies conspire to restrict output and set artificially

high prices.

F. COMPETITORS’ ACTIONS
PRICING METHODS

1. COST BASED PRICING- it starts with the determination of the cost, then a price is set so that
such price will recover all the costs in the value chain and provide a desired return on investment.

-Cost Plus Price

Price=Cost+ Markup

- Based on Total costs

Price= Total cost+ (Total cost X MU%)

-Based on Absorption Product Cost

Price= Absorption Product cost+ (Absorption product cost X MU%)

- Based on variable Manufacturing Cost

Price= Variable Manufacturing Cost+( Variable Manufacturing Cost+MU%)

- Based on Total Variable Cost

Price= Total variable Cost+ (Total Variable Cost X MU%

2. MARKET- BASED PRICING (OR BUYER-BASED PRICING)- prices are based on the products’
perceived value and competitors’ actions, rather than on the products/services costs.

Example; A glass of orange juice may have a higher price in a classy restaurant than at the school
canteen.

-Target Price- the expected market price for a product/ service, considering the
consumers’ perceptions of value and competitors’ reactions.

Target Price- Target Profit= Target cost

-Target Costing- a company first determines the price ( the target priceor market price )
at which it can sell its product/service, and then design the product or service that can be
produced at the target cost to provide the target profit.

- Value Engineering- a means of reaching the target cost. It involves a systematic assessment of all
the aspects of the value chain costs of a product/service –from research and development,
design of the product, process design, production, marketing, distribution and customer service.
The objective is to minimize cost without sacrificing customer satisfaction.

Life-Cycle Costing- involves the determination of a product’s estimated revenues and expenses
over its expected life-cycle.

Life-Cycle
1. Research and development stage
2. Introduction stage
 3. Growth stage
4. Mature stage
5. Harvest or decline stage and final provision of customer support

Whole-Life Costs- composed of:

1. the life-cycle costs and
2. after purchase costs incurred by customers

Reduction of whole life cost provides benefits, both to the buyer and the seller.
Customers may pay a premium for a product with low after purchase costs.

3. COMPETTION- BASED PRICING

-price is based largely on competitors’ price

4. NEW PRODUCT PRICING 9INTRODUCTORY PRICE SETTING)

-Price Skimming- the introductory price is set at a very high level. The objective is to sell
to customers who are not concerned about price, so that the firm may recover its
research and development costs.

- Penetration Pricing-the introductory price is set at a very low level. The objective is to
gain deep market penetration quickly.

PRACTICAL EXERCISES

1. Peter Senen Supermarkets, Inc. operates a chain of three retail stores. For the year ended December
31, 2020, operating results for each store, before taxes and allocation of corporate overhead, were as
follows:

Store 1 Store 2 Store 3 Total

Sales P400,000 P320,000 P240,000 P960,000
Cost of Sales 224,000 184,000 152,000 560,000
Gross Margin P176,000 136,000 88,000 400,000
Operating Expenses
Variable Expenses 52,800 58,400 24,800 136,000
Fixed 56,000 48,000 40,000 144,000
Total P108,800 P106,400 P64,800 P280,000
Income before taxes P 67,200 P 29,600 P 23,200 P120,000

For the year ended December 31, 2020, corporation overhead was as follows:
Warehouse operations and depreciation P20,000
Delivery 28,000
Advertising 6,400
Main Office salaries and other expenses 25,600
Total corporation overhead P80,000
Delivery expenses vary with delivery-kilometers which is computed by multiplying the number of
deliveries to the distance (in kilometres) between the stores and the warehouse. The delivery statistics
for the year are as follows:

Distance (km) from the warehouse No. of deliveries Delivery-kilometers (DK)

Store 1 10 120 1,200
Store 2 20 40 800
Store 3 5 100 500
2,500
The company’s management has decided to expand one of the stores in a plan to increase sales by
P100,000. The contemplated expansion is expected to increase the store’s fixed operating costs by
P10,000 and to required 20 additional deliveries from the warehouse. Which store should be selected
for the prospective expansion?

Suggested Answer:
The store that will earn the highest incremental profit (considering relevant data) should be
selected for expansion.

Compute the Contribution Margin Ratio (CMR)

Store 1 Store 2 Store 3
Sales P400,000 P320,000 P240,000
Variable costs
Cost of sales P224,000 P184,000 P152,000
Operating expenses 52,800 58,400 24,800
Total variable cost P276,800 P242,400 P176,800
Contribution Margin P123,200 P 77,600 P 63,200
CMR ( CM/Sales) 30.80% 24.25% 26.33%

Compute Incremental Delivery Costs:

Delivery cost per = Total delivery costs = P28,000 = 11.20

Delivery kilometre Total delivery kilometres 2,500

Distance Additional deliveries Delivery kms Cost per DK Total Inc. Del. Costs
Store 1 10 20 200 P11.20 P2,240
Store 2 20 20 400 11.20 4,480
Store 3 5 20 100 11.20 1,120

Compute Incremental Profit, considering relevant data only.

Store 1 Store 2 Store 3

Incremental sales P100,000 P100,000 P100,000
X CMR 30.80% 24.25% 26.33%
Incremental CM P30,800 P24,250 P26,330
Less: Delivery costs 2,240 4,480 1,120
Incremental profit P28,560 P19,770 P25,210

Store 1 would earn the highest incremental profit. Hence this store must be selected for expansion.
2. JYD Corporation produces wood glue that is used by furniture manufacturers. The company normally
produces and sells 10,000 gallons of the glue each month. Petesy Glue is sold for P280 per gallon,
variable costs is P168 per gallon, fixed factory overhead cost total P460,000 per month, and the fixed
selling costs total P620,000 per month.

Pandemic problem due to Covid-19 arose and the furniture manufacturers that buy the bulk of Petesy
Glue have caused the monthly sales of JYD Corporation to temporarily decrease to only 15% of its
normal monthly volume. JYD Corporation’s management expects that the pandemic problem will last for
about 2 months, after which sales of Petesy Glue should return to normal. However, due to the dramatic
drop in the sales level, JYD Corporation’s management is considering to close down its plant during the
two- month period that the pandemic is on-going.

If JYD Corporation will temporarily shut down its operation, it is expected that the fixed factory
overhead costs can be reduced to P340,000 per month and that the fixed selling costs can be reduced by
P62,000 per month. Start-up costs at the end of the shut-down period would total P56,000. JYD
Corporation uses the Just-in Time system, so no inventories are on hand.

Required:
1. Determine the shutdown point in units
2. At the sales level of only 30% of the normal volume, should the company continue operating
or shut down temporarily for two months?

Suggested Answer

1. A shutdown point in units is the number of units that must be sold so that the company will be
indifferent between continuing or discontinuing operations. If the actual sales volume is equal to the
shut-down point, the loss to be incurred would be the same whether the plant is shut down or not.

The shutdown point (SDP) in units can be computed as follows:

SDP in units = Fixed costs under continued operations- shutdown costs

Contribution margin per unit

Fixed costs under continued operations (for 2 months)

Factory overhead (P460,000X 2 months) P 920,000
Selling costs (P620,000 X 2 months) 1,240 000
Total P 2,160,000
Less: shutdown costs*
Factory overhead (P340,000 X 2 months) P680,000
Selling costs ( P620,000-62,000) X 2 months 1,116,000
Star-up costs 56,000 1,852,000
Difference P 308,000
Divide by CM per units (280-P168) 112
Shutdown point in units 2,750 units

*Shutdown costs- costs that the company will incur if shut down its operation

Continuing operating with sales of 2,750 units

 Contribution margin ( 2,750 X P112) P308,000
Less; fixed costs 2,160,000
Loss P 1,852,000
Shutdown for two months:
Contribution margin P -0-
Less: shutdown costs 1,852,000
Loss P1,852,000

2. The shutdown point may be used as a guide in making a decision whether to continue operating or
shut down temporarily.

If the expected sales during the period under consideration (two months in this case) is greater than
the shutdown point (30% or 3,000 units for two months in this case, is greater than the shutdown point
of 2,750 units), the company should continue operating.

At a sales level of 3,000 units, the loss to be incurred if the company continues to operate is less
than the loss to be incurred if the company shuts down operating

Loss at sales level of 3,000 units:

Contribution margin (3,000 X P112) P336,000
Less: Fixed costs for two months 2,160,000
Loss P1,824,000

Loss if the company shuts down

(equal to the shutdown cost) P1,852,000

3. Peter Senen Realty, Inc. manages five (5) townhouses in Quezon City. The summary income
statements of the townhouses are as follows (in million pesos):

Townhouse 1 2 3 4 5
Rental Income P15,000 P18,150 P35,205 P28,170 P15,975
Expenses 12,000 19,500 39,000 36,000 19,500
Profit (loss) P 3,000 (P 1,350) ( P3,795) (P 7,830) (P 3,525)

When the company president saw the income statements, he was dismayed that only Townhouse 1 is
earning profit. Because of this, he is considering to sell Townhouse 2 and 5 and continue operating
Townhouse 1 only. But before making his final decision, he consulted the company’s accountant first
and instructed him to conduct further analysis and give a recommendation as to which townhouse
should really be sold.

The accountant’s study revealed that included in the total expenses is P18,000,000 of corporate
overhead allocated to the townhouses based on rental income. The company will continue to incur this
corporate overhead regardless of whether any of the townhouses is sold.

Required:
1. Determine which of the townhouse(s) should be sold?
2. If the appropriate townhouses were sold, what would be the increase or decrease in the total
income?
Suggested Answer:

1. The allocated corporate overhead is irrelevant, so it should be deducted from the

expenses. The balance on the avoidable expenses should be compared with the rental income. If
the townhouse’s rental income is less than its avoidable expenses. Such townhouses should be
sold

T-1 T-2 T-3 T-4 T-5 Total

Rental Income P15,000 P18,150 P35,205 P28,170 P15,975 P112,500
Expenses 12,000 19,500 39,000 36,000 19,500 126,000
Less: Unavoidable
OH 2,400 2,904 5,633 4,507 2,556 18,000
Avoidable Exp. P9,600 P16,596 P33,367 P31,493 P16,944 P108,000
Townhouse
Margin P5,400 P1,554 P 1,838 ( P3,323) (P 969) P 4,500

Based on the above analysis, Townhouse 4 and 5 should be sold because their margin is
negative.

2. If townhouse 4 and 5 are sold, their negative margin would be zero. The eliminated negative
margin would represent the increase in income.
Townhouse 4 loss P3,333
Townhouse 5 loss 969
Increase in total profit P4,302