Session 5: Costs and Decision Making Flashcards
What kinds of costs are relevant to decision making?
Costs must be future, incremental, and involve cash flows.
FUTURE: Decision today cannot change the past and so only future costs are relevant. Past costs = sunk costs
and are not relevant e.g. the cost of preparing a
sales quote. Opportunity costs reflect future
alternatives foregone and are always relevant.
INCREMENTAL: Only those costs that will, or can be, changed by the decision are relevant. Irreversibly committed costs are not relevant e.g. fixed costs generally not incremental to decision making in short term. Avoidable costs are relevant.
CASH FLOWS: • Non-cash P&L costs based on accounting conventions are not relevant e.g. depreciation.
What are the 5 major decision-making types in Management Accounting?
- Product prioritization decisions (no constraints)
- Product discontinuation decisions
- The “special order - minimum possible quote” decision: “YSL marketing”
- Make or buy (outsourcing) decisions
- Pricing Decisions
What are the financial and qualitative elements to bear in mind for Make or Buy (Outsourcing) Decisions?
• Financially, we simply compare the incremental costs of
manufacturing to the alternative outsourcing cost
• Most also consider qualitative factors e.g.
– Outsourcing likely reduces FCs / operational leverage
– Quality?
– Differentiation opportunity lost?
– Reliability (of supply, of price)?
– Lead times (impact on inventories)?
– Customer reaction?
– Employee morale?
– Confidentiality (e.g. loss of know-how)?
What are the none different types of pricing strategy + three relevant inputs?
'Relevant Cost' Cost Plus Customer Profitability Market Skimming Market Penetration Discrimination Volume Discount Complementary Products Product Line (consistency or inconsistency)
Demand Curve
Competition
Business Strategy
What is relevant cost pricing?
Relevant cost is a managerial accounting term that describes avoidable costs that are incurred only when making specific business decisions. The concept of relevant cost is used to eliminate unnecessary data that could complicate the decision-making process. As an example, relevant cost is used to determine whether to sell or keep a business unit. The opposite of a relevant cost is a sunk cost, which has already been incurred regardless of the outcome of the current decision.
KEY TAKEAWAYS
Relevant costs are only the costs that will be affected by the specific management decision being considered.
The opposite of a relevant cost is a sunk cost.
Management uses relevant costs in decision making, such as whether to close a business unit, whether to make or buy parts or labor, and whether to accept a customer’s last minute or special orders.
• Sets the minimum price in short term to cover relevant
incremental costs e.g. where unused capacity
• Can incorporate opportunity costs as well as basic
incremental costs. e.g. “YSL Marketing” case
What is cost plus pricing?
Variable cost-plus pricing is a pricing method whereby the selling price is established by adding a markup to total variable costs. The expectation is that the markup will contribute to meeting all or a part of the fixed costs and yield some level of profit. Variable cost-plus pricing is particularly useful in competitive scenarios, such as contract bidding, but it is not suitable in situations where fixed costs are a major component of total costs.
Variable cost-plus pricing is not suitable for a company that has significant fixed costs or fixed costs that increase if more units are produced; any markup on the variable costs on top of the fixed costs per unit might result in an unsustainable price for the product.
• Very common approach. Cost plus a % markup.
• Usually full [absorption] cost i.e. fixed and variable
cost. Addresses long-term profitability.
• Supplemented with Target Costing approach.
What is customer profitability pricing?
e.g. utilisation of ‘loss leaders’ to maximise overall level
of profitable customer relationships
What is market skimming (aka price skimming)?
Price skimming is a product pricing strategy by which a firm charges the highest initial price that customers will pay and then lowers it over time. As the demand of the first customers is satisfied and competition enters the market, the firm lowers the price to attract another, more price-sensitive segment of the population. The skimming strategy gets its name from “skimming” successive layers of cream, or customer segments, as prices are lowered over time.
KEY TAKEAWAYS
Price skimming is a product pricing strategy by which a firm charges the highest initial price that customers will pay and then lowers it over time.
As the demand of the first customers is satisfied and competition enters the market, the firm lowers the price to attract another, more price-sensitive segment of the population.
This approach contrasts with the penetration pricing model, which focuses on releasing a lower-priced product to grab as much market share as possible.
What is market penetration pricing (aka penetration pricing)?
Penetration pricing is a marketing strategy used by businesses to attract customers to a new product or service by offering a lower price during its initial offering. The lower price helps a new product or service penetrate the market and attract customers away from competitors. Market penetration pricing relies on the strategy of using low prices initially to make a wide number of customers aware of a new product.
The goal of a price penetration strategy is to entice customers to try a new product and build market share with the hope of keeping the new customers once prices rise back to normal levels. Penetration pricing examples include an online news website offering one month free for a subscription-based service or a bank offering a free checking account for six months.
KEY TAKEAWAYS
Penetration pricing is a strategy used by businesses to attract customers to a new product or service by offering a lower price initially.
The lower price helps a new product or service penetrate the market and attract customers away from competitors.
Penetration pricing comes with the risk that new customers may choose the brand initially, but once prices increase, switch to a competitor.
What is discrimination pricing?
Price discrimination is a selling strategy that charges customers different prices for the same product or service based on what the seller thinks they can get the customer to agree to. In pure price discrimination, the seller charges each customer the maximum price he or she will pay. In more common forms of price discrimination, the seller places customers in groups based on certain attributes and charges each group a different price. With price discrimination, a seller charges customers a different fee for the same product or service.
With first-degree discrimination, the company charges the maximum possible price for each unit consumed.
Second-degree discrimination involves discounts for products or services bought in bulk, while third-degree discrimination reflects different prices for different consumer groups.
- A different price is charged in different market segments to exploit different price/demand relationships.
- Market segment based on demographics (student; OAP); time (peak/offpeak) ; geography (home market; export market)
What is volume discount pricing?
• The price charged depends upon the volume purchased.
• Larger volumes have lower unit prices and smaller
volumes have higher unit prices. This strategy is
widespread in commodity markets.
What is complementary product pricing?
• If your product is sold in conjunction with another product e.g. fish and chips; the price of the complementary product needs to
be allowed for when setting your price.
• May create opportunities e.g. pricing of car optional extras
What is product line pricing?
- E.g. a fabric manufacturer may produce nylon, cotton and silk sheets. The price charged must fit in with the other products on the line, so the cotton sheets will have a lower price than the silk sheets, but a higher price than the nylon sheets
- Similarly, pricing and brands (as much as products) may be used to address different customer segments e.g. car models
