Study Unit 9
Decision Analysis and Risk Management
Objectives of the Class
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Use Marginal Analysis for Decision Making
Calculate effect on Operating Income of a Decision
Identify and describe qualitative factors
Identify the effects of changes in capacity
Impact of Income Taxes on Marginal Analysis
Recommend a course of action
Relation between Pricing and Supply / Demand
Target costing and Target pricing
Define Elastic and Inelastic Demand
Evaluate and recommend Pricing Strategies
Risk Assessment: financial / operational / strategic risks
Identify and explain the benefits of Risk Management
Decision Making: applying MA
• Relevant = be made in the future (not SUNK costs)
• Committed costs are not part of the decision making process
• Relevant = differ among the possible alternative courses of
action
• Relevant = avoidable costs (controllable = subject to
Management decision / strategy)
• Relevant = incremental (marginal or differential)  Relevant
Range (Pharma R&S, opening a new plant, packaging…)
• Be careful using UNIT revenue and cost
 Emphasis to be on TOTAL relevant revenues and costs
Marginal / Differential / Incremental Analysis
• Problem in CMA will be an evaluation of choices among courses of
action
• What are the relevant and irrelevant costs?
• Quant analysis = ways in which revenues and costs vary with the
option chosen (impact on bottom line = operating income)
• Example page 347  idle capacity (incremental impact)
• Compare Marginal revenue / Marginal Cost (contribution Margin) –
Fixed costs have already been “absorbed”
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Qualitative Factors to consider:
Pricing rules
Government Regulation
Cannibalization between products (stealing MS from yourself)
Outsourcing
Employee Morale
Decision Making
• Add-or-drop-a-segment decisions
• Disinvestment / capital budgeting decisions
• Marginal cost > Marginal revenue = Firm should disinvest
• 4 Steps to be taken:
1/ Identify fixed costs that will be eliminated if disinvesting
2/ Determine the revenue needed to justify continuing operations
3/ Establish the opportunity cost of funds that will be received
4/ Determine whether the carrying amount = economic value
(Assets). If not use market fair value and not carrying amount
• Special Orders = excess capacity
• Opportunity costs
• Variable costs (Contribution Margin)
Decision Making
• Make or Buy = insourcing or outsourcing (critical mass)
• Consider relevant costs to the investment decision
• Capacity constraint
• Product Mix
• Sell-or-Process Further Decisions
Price Elasticity of Demand
• Demand increases when Price goes down (in theory)
• Price of product and Quantity demanded are inversely related
• Price Elasticity of Demand = sensitivity
% change in Q / % change in P
• Most accurate way to calculate elasticity = ARC method
% Δ Q / % Δ P = [(Q1 – Q2) / (Q1+Q2) ] / [(P1 – P2) / (P1+P2)]
Example page 380 # 19
• Demand elasticity > 1 = elastic (small change in price = large change
in quantity)
• Elasticity = 1 (unitary elastic)
• Elasticity < 1 = perfectly inelastic (large change in price = small
change in quantity)
• Infinite = perfectly elastic (horizontal line) – Firm has no influence on
market price (pure competition)
• Equal to zero = perfectly inelastic (vertical line) – Consumer will pay
Pricing Theory
• Pricing Objectives: profit maximization / target margin /
forecasted volume / image (segmentation – positioning) /
stabilization
• Price-setting factors
• Supply & Demand = Economic (external factors)
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Type of market
Customer perceptions
Elasticity
Competition
• Internal Factors = Marketing / Strategy / Capacity / Financials
• Cartels = illegal practice except in international markets
• Cartel = collusive oligopoly
Pricing Theory
• Cost-based pricing differs from Target pricing (page 358)
• 4 basic formulas
• Target pricing
• Life cycle costing
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Market-based pricing
Competition-based pricing
New product pricing
Pricing by intermediaries
Price adjustments
Product-mix pricing
Illegal pricing
Exercise page 376
• Questions 10 to 12