Chapter VI: Accounting Information and Short-Term Decision Making PDF

**MODULE** **SECOND Semester, AY 2020-2021** **CHAPTER VI: ACCOUNTING INFORMATION AND SHORT-TERM DECISION MAKING** **7 steps of the decision-making process** 1. Identify the decision. 2. Gather relevant info. 3. Identify the alternatives. 4. Weigh the evidence. 5. Choose among the alter...

**MODULE** **SECOND Semester, AY 2020-2021** **CHAPTER VI: ACCOUNTING INFORMATION AND SHORT-TERM DECISION MAKING** **7 steps of the decision-making process** 1. Identify the decision. 2. Gather relevant info. 3. Identify the alternatives. 4. Weigh the evidence. 5. Choose among the alternatives. 6. Take action. 7. Review your decision. Step 1: Identify the decision You realize that you need to make a decision. Try to clearly define the nature of the decision you must make. This first step is very important. Step 2: Gather relevant information Collect some pertinent information before you make your decision: what information is needed, the best sources of information, and how to get it. This step involves both internal and external "work." Some information is internal: you'll seek it through a process of self-assessment. Other information is external: you'll find it online, in books, from other people, and from other sources. Step 3: Identify the alternatives As you collect information, you will probably identify several possible paths of action, or alternatives. You can also use your imagination and additional information to construct new alternatives. In this step, you will list all possible and desirable alternatives. Step 4: Weigh the evidence Draw on your information and emotions to imagine what it would be like if you carried out each of the alternatives to the end. Evaluate whether the need identified in Step 1 would be met or resolved through the use of each alternative. As you go through this difficult internal process, you'll begin to favor certain alternatives: those that seem to have a higher potential for reaching your goal. Finally, place the alternatives in a priority order, based upon your own value system. Step 5: Choose among alternatives Once you have weighed all the evidence, you are ready to select the alternative that seems to be the best one for you. You may even choose a combination of alternatives. Your choice in Step 5 may very likely be the same or similar to the alternative you placed at the top of your list at the end of Step 4. Step 6: Take action You're now ready to take some positive action by beginning to implement the alternative you chose in Step 5. Step 7: Review your decision & its consequences In this final step, consider the results of your decision and evaluate whether or not it has resolved the need you identified in Step 1. If the decision has not met the identified need, you may want to repeat certain steps of the process to make a new decision. For example, you might want to gather more detailed or somewhat different information or explore additional alternatives. **Elements of a decision** A quantitative decision problem involves six parts: a. An objective that can be quantified Sometimes referred to as \'choice criterion\' or \'objective function\', e.g. maximization of profit or minimization of total costs. b. Constraints Many decision problems have one or more constraints, e.g. limited raw materials, labor, etc. It is therefore common to find an objective that will maximize profits subject to defined constraints. c. A range of alternative courses of action under consideration. For example, in order to minimize the costs of a manufacturing operation, the available alternatives may be: i. to continue manufacturing as at present ii. to change the manufacturing method iii. to subcontract the work to a third party. iv. Forecasting of the incremental costs and benefits of each alternative course of action. d. Application of the decision criteria or objective function, e.g. the calculation of expected profit or contribution, and the ranking of alternatives. e. Choice of preferred alternatives. **Relevant costs for decision making** The costs which should be used for decision-making are often referred to as \"relevant costs\". CIMA defines relevant costs as \'costs appropriate to aiding the making of specific management decisions\'. To affect a decision a cost must be: d. Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are common to all alternatives that we may choose. e. Incremental: \' Meaning, expenditure which will be incurred or avoided as a result of making a decision. Any costs which would be incurred whether or not the decision is made are not said to be incremental to the decision. f. Cash flow: Expenses such as depreciation are not cash flows and are therefore not relevant. Similarly, the book value of existing equipment is irrelevant, but the disposal value is relevant. Other terms: g. Common costs: Costs which will be identical for all alternatives are irrelevant, e.g. rent or rates on a factory would be incurred whatever products are produced. h. Sunk costs: Another name for past costs, which are always irrelevant, e.g. dedicated fixed assets, development costs already incurred. f. Committed costs: A future cash outflow that will be incurred anyway, whatever decision is taken now, e.g. contracts already entered into which cannot be altered. Opportunity cost Relevant costs may also be expressed as opportunity costs. An opportunity cost is a benefit foregone by choosing one opportunity instead of the next best alternative. Example A company is considering publishing a limited edition book bound in a special leather. It has in stock the leather bought some years ago for \$1,000. To buy an equivalent quantity now would cost \$2,000. The company has no plans to use the leather for other purposes, although it has considered the possibilities: a. using it to cover desk furnishings, in replacement for other materials which could cost \$900 b. of selling it if a buyer could be found (the proceeds are unlikely to exceed \$800). In calculating the likely profit from the proposed book before deciding to go ahead with the project, the leather would not be costed at \$1,000. The cost was incurred in the past for some reason which is no longer relevant. The leather exists and could be used on the book without incurring any specific cost in doing so. In using the leather on the book, however, the company will lose the opportunity of either disposing of it for \$800 or of using it to save an outlay of \$900 on desk furnishings. The better of these alternatives, from the point of view of benefiting from the leather, is the latter. \"Lost opportunity\" cost of \$900 will therefore be included in the cost of the book for decision-making purposes. The relevant costs for decision purposes will be the sum of: i. \'avoidable outlay costs\', i.e. those costs which will be incurred only if the book project is approved, and will be avoided if it is not ii. the opportunity cost of the leather (not represented by any outlay cost in connection to the project). This total is a true representation of \'economic cost\'. **The assumptions in relevant costing** Some of the assumptions made in relevant costing are as follows: a. Cost behavior patterns are known, e.g. if a department closes down, the attributable fixed cost savings would be known. b. The amount of fixed costs, unit variable costs, sales price, and sales demand are known with certainty. c. The objective of decision-making in the short run is to maximize \'satisfaction\', which is often known as \'short-term profit\'. d. The information on which a decision is based is complete and reliable. **Price** is the value that is put on a product or service and is the result of a complex set of calculations, research and understanding and risk-taking ability. A pricing strategy takes into account segments, ability to pay, market conditions, competitor actions, trade margins and input costs, amongst others. It is targeted at the defined customers and against competitors. **Pricing** is the process whereby a business sets the price at which it will sell its products and services, and may be part of the business\'s marketing plan. **Pricing objectives** Pricing objectives are the preliminary goals and underlying framework your business sets to guide how you price a product or service. Pricing objectives are essential to consider when pinning down an ideal price point. You don't want to choose what you charge for a product or service at random. Without an objective, you\'re throwing prices at the wall and seeing what sticks. That\'s no way to do business. But landing on a pricing objective isn\'t always straightforward. And the one you go with typically rests on a variety of factors. Elements like timing, broader business goals, market position, and financial circumstances can all impact your decisions. **Why are pricing objectives important?** Price objectives help you align your pricing with your business goals. The way you price your products tells your customers the value of your products and labor. It can also be a critical part of your company values and brand identity. **Pricing Objectives vs. Pricing Strategy** While pricing objectives and pricing strategy are closely related, they are not the same. Pricing objectives are a framework. They can help you decide the primary motivation for your pricing decisions. *[Pricing strategy]* is a process that connects your pricing objectives to forces outside your business. These might include: - The state of your industry - Available stock and production resources - The stock market - Consumer demand - Market demand Both pricing objectives and strategy are important. Without a clear pricing strategy, your business could miss crucial opportunities. Without the right pricing objective, your business could lose direction and make the wrong decisions for your brand. Ultimately, your pricing objective will be specific to your company\'s needs and interests --- but there\'s a good chance it will revolve around some common ends. Here are some of the more prominent types of pricing objectives. **Types of Pricing Objectives** - Improving Retention - Maximizing Profit - Increasing Sales Volume - Competing With Similar Companies - Shifting Brand Image *[1. Improving Retention]* Customer retention is the sum of a company\'s efforts to keep its existing customers on board. It's an essential, cost-effective process that any growing business needs to prioritize. And implementing a strategy to improve yours often has a lot of layers. Doing the practice right involves aspects like: - Offering exemplary customer service - Investing in a solid customer success team - Creating customer loyalty programs But the avenues you can take to improve customer retention aren\'t limited to service --- and the impact pricing can have on retention is a testament to that. Maximizing retention is a popular pricing objective. If you choose to go this road, you may want to tailor your prices to retain the prestige of your product. At the same time, you don't want to raise prices to the point of alienating current customers. That generally translates to keeping prices relatively consistent. Pricing Objectives Examples: Retention Besides consistent pricing, there are other ways to make your pricing objectives customer-focused. Customer loyalty programs are often retention-focused. Pricing for your most loyal programs might involve pricing with upfront discounts in mind. It may also include relationship-driven benefits like: - Free shipping - Miles or point systems with rewards - Giveaways Another pricing objective example for retention is incentives. These are more common in service-oriented businesses. These incentives may mean that the price for a service goes down over time as a customer continues to use those services. Another way that you can use pricing to build long-term customer relationships is through product tie-ins. For example, For each video game console sale, the game company would offer select games at a discount. *[2. Maximizing Profit]* Maximizing profit is one of the most popular, conventional pricing objectives. And that makes sense --- it\'s not revolutionary to point out that businesses that don\'t make money rarely survive. Businesses that price for profit often do so by raising prices and cutting costs wherever possible. Ideally, they want to see significant improvements in return on investment (ROI). Pursuing this particular pricing objective often comes at the expense of sales volume or general revenue. Pricing Objectives Examples: Profit This pricing objective tends to manifest itself in a couple of different ways. In some cases, a business might want to maximize short-term profit. This might mean acquiring users without being too mindful of potential churn down the line. Or, a company will make long-term profit their objective --- In which case, it will price with more careful intention. Some businesses will use a formula to calculate the top price per unit. For example: Types of pricing objectives: Profit formula Cost of goods sold + Packaging cost = Product cost Other companies choose to increase the volume of units sold to increase total profit. This sometimes means a lower price per product. Another approach to profit-based pricing is basing your prices on your profit margin goal. This post includes details on how to calculate your profit margin. Profit-based price objectives can be a challenge because they need to flex with resource availability, how quickly products are selling, and more. *[3. Increasing Sales Volume]* Some companies set and change their pricing strategies to maximize conversions. These businesses set prices specifically to foster immediate, meaningful growth. In some cases, the endgame is getting a business off the ground --- carving out a piece of a market and settling in. In other cases, an already-established business might want to claim or maintain a specific share of its competitive landscape. They strategically adjust their prices to account for shifts and fluctuations that could alter their place in the market. And sometimes, companies might adjust their prices to make concentrated pushes to maximize their market share. In these cases, their pricing objectives are still set with intention --- but are a bit more indiscriminate than they\'d be otherwise. Pricing Objectives Examples: Conversion There are a few forms that sales-driven pricing objectives can take. One is bundling, where a business will group similar or complementary products together. They offer this \"bundle\" at a discount price. Conversion-driven pricing might also involve psychological pricing techniques. These techniques, like bracketing or charm pricing, use typical responses to set prices. Another conversion strategy is reframing an existing product. For example, say you are selling a SaaS product for \$120 a year. Instead of highlighting the total cost, you might present it as \"Just \$10 a month.\" This can make the price more attractive to buyers. Another example is presenting a standard product package alongside a premium or deluxe package. When placed beside the deluxe package, the standard option appears much more affordable. *[4. Competing With Similar Companies]* Sometimes a business needs to make a product or service more competitive within its broader market. Maybe, the sales volume that the company is raking in isn't what they\'d like it to be. Their company could also be losing out to lower or higher-priced options. Competitor-based pricing is common in saturated or competitive industries. It\'s also typical when a product doesn\'t have many unique features. Timing is essential with competitor pricing objectives. You\'ll also want access to real-time data so that you can adjust your pricing in alignment with your top competitors. Competitor-focused pricing objectives can help pull customers away from a competitor. They can also help a new business get traction with new customers. Pricing Objectives Examples: Competition Simply matching competitors\' prices is one of the more effective pricing objectives a business can pursue. This goal\'s underlying premise is relatively straightforward. It doesn\'t take much guesswork and effort to identify and mirror what competitor charges. But its simplicity doesn\'t necessarily undermine its efficacy. It can be an excellent way for businesses to gain a competitive edge within their industries. If you don\'t want to match competitor pricing, another way to go is to choose a higher price. This can give the impression of a better product. Another competitive approach to pricing objectives is market-penetration pricing. You might do this if you\'ve recently added a new and powerful feature or started to use higher-quality materials. *[5. Shifting Brand Image]* Pricing has a significant impact on how consumers perceive a business. Ideally, higher prices create an air of prestige and luxury, while lower ones signal value. But public perception doesn\'t always shake out how companies want it to. If your pricing objectives center on brand equity, creating a long-term strategy is important. While some pricing approaches can fluctuate, consistency matters. Brand-focused pricing needs to appeal to your target audience. Certain prices or pricing models might leave a business with an image it\'s not particularly happy with. In those instances, companies might look to raise or lower prices to capture and project fresh brand identities. That might mean changing to branding that your target consumers will be receptive to. Pricing Objectives Examples: Brand Awareness High brand equity can lead a brand to price its products much higher than competitors in the same niche. Another option is to start with a high price for limited-edition or new products. Then, once you establish brand equity you can lower the price to increase sales volume. If your pricing objectives are brand-focused, keep a close eye on competitors in your industry. You may need to set your price at a certain level to convey quality, and durability, or to stand out from the crowd. For example, Apple products tend to be more expensive than some competitors in consumer electronics. They do this with unique product features and a strong brand identity. **Types of pricing methods** The pricing methods can be defined as the techniques to decide the final price of goods and services by taking different factors, such as cost of production, the demand of the product, competition in the market, the life cycle of a product, and the vision of the organization. There are two broad categories of pricing methods, such as cost-oriented methods and market-oriented methods. These main categories have various subcategories depending on multiple factors. 1. Cost-oriented pricing method 2. Market-oriented pricing method **A. Cost-oriented methods:** Cost-oriented or cost-based pricing method is the purest form of pricing method. In this pricing method, a certain percentage of the desired profit is added to the cost of the product to obtain the final price of the product. The cost of the product is the total cost spent on the production of the product. The followings are the different sub-categories of cost-oriented pricing methods. *[1. Cost Plus Pricing:]* The cost-plus pricing method is the simplest, and the price of goods using this method is determined by following the most basic idea behind the concept of business. The idea is that a businessman produces and sells a product to generate profit from it. The price of goods using a cost-plus pricing method is determined by adding the unit cost of production with a certain percentage of the value. The advantage of using this method is that it covers all the costs of production and provide a consistent return on investment, whereas, the disadvantages of using this method is that it does not take into consideration the consumer of the product and the competition in the market. *[2. Mark-up pricing:]* Mark up pricing can be determined by adding the cost of a product with a certain percentage of markup to determine the final price of goods or services. The markup value of a product is the amount of profit the company wants to earn by selling the product. To determine the markup price of a product, the company first should specify the exact total cost of production of a product and mark up value. The formula to calculate the markup pricing is as follows: Markup pricing = Production cost + markup cost The formula to calculate the markup value is as follows: Markup value = Unit Cost / 1 -- Desired Return on Sales The advantage of using a markup pricing method is the easiness of the calculation of the final price of the product. Moreover, because of its simplicity, most companies use this method to decide the final price of goods and services. Therefore, there are very few chances that the difference between the price of the goods will take place. That means all companies will sell a product at a similar price. However, there are a few disadvantages also associated with this pricing method is that while deciding the price of the product companies ignore the demand of the product in the market and the competition in the market, which are two important factors in deciding the price of goods. *[3. Target return pricing:]* Target return pricing is a type of pricing method in which companies plan to achieve a certain level of return on investment by selling a particular quantity of goods. The formula to calculate target return pricing is as follows: Target Return pricing = Unit Cost + (Desired Return \* Invested Capital) / Unit Sales The advantage of using target return pricing is that it is easy to calculate and understand. Moreover, with target return pricing, the company can decide the level of effort of the whole team as a unit required to generate a certain percentage of profit. The limitation associated with the target return pricing method is the accuracy to calculate the estimated amount of sales. 4\. Break-Even pricing: Let me explain to you what is the breakeven point before we get to break-even pricing. The breakeven point is a point where a company is neither generating profit nor losing any money. That means the total revenue generated is enough that it covers all the fixed as well as variable costs of the production of goods or services. Click here if you want to learn more about the breakeven point and breakeven analysis. It is easy to understand breakeven pricing after learning about the breakeven point. The breakeven price is the price decided by the company to cover all fixed and variable costs incurred in the business. That means the company plans to reach the breakeven point as soon as possible. So that they neither make a profit nor a loss. *[5. Early cash recovery Pricing:]* The early cash recovery pricing method is concerned with the early recovery of total investment in the business. This pricing strategy is adopted by those businesses who are aware of the short life of the market or when they are dealing with fashion-related products or products which are technology sensitive. For example, the life of smartphones is concise because every few months, a new smartphone with updated features is introduced in the market. Because of this, the lifespan of smartphones is very short in the market. Sometimes, small or new companies also use this pricing method when they enter the market with a new concept or idea. They want to recover their investment before a large company comes the market with lower prices and give fierce competition to small companies. To avoid such situations, these companies decide the final cost of their products in such a way so that they can maximize their revenue generation in a short period. Because of this reason, the price of a new product is usually quite high, and after some time, you can buy the same product from the same or different companies at lower prices. **B. Market-Oriented Pricing Methods** The market-oriented pricing method or market-based pricing method is also known as a competition-oriented pricing method. The cost of goods and services is decided as per the current conditions of the market in a market-oriented pricing method. That means companies determine the price of the goods and services by taking into consideration the cost of the product and services of their competitors. They determine the price either the same as the price of their competitor or close to the amount of the products of their competitor. The market-oriented pricing method can be divided into different sub-categories. The followings are the sub-categories of market-oriented methods *[1. Perceived Value Pricing]* The perceived value pricing method works on the image of the product in the eyes of its customers. Most companies decide the price of their product depending on its value perceived by customers. Customers will be willing to pay a high price if they think highly of the product. Various factors are considered in deciding the perceived value pricing such as the image of the brand, the trustworthiness of the brand or company, the reputation of the supplier, customer support services, the warranty of a product, and the previous experience of customers. Take the example of Apple's product. The company charges high prices for its products and customers pay any amount charged by the company willingly because of the reputation of the brand and the experience of customers with Apple's products. The benefit of adopting the perceived value pricing method is the increased amount of profit, whereas the limitations of using this method are that it makes customers suspicious that the company might have hiked its price and the company might miss price-conscious customers. It is good to adopt this method only if a company is offering price-worth features and qualities in the product. *[2. Sealed bid Pricing]* Sealed bid pricing is different from other types of pricing methods. The sealed bid pricing method is used in case of large orders. The seller submits sealed bid pricing to get the contract or work. This type of pricing method is used to get the agreement of a job from big industries or the government. Let us understand how a sealed bid pricing method works. The government or a large organization advertises the bulk of products for a particular work. In response to this advertisement, different organizations submit a sealed quotation or bid. The buyer selects the seller with the lowest prices and excellent services. The buyer expects his job to be done at the lowest price. Therefore, to win the contract, the seller is required to anticipate the bid value of its competitors and sends in the cost more economical than their value. *[3. Differentiated Pricing]* Differentiated pricing is the pricing where the same product or service is sold at different prices. The difference in the cost of the product or service is made based on various factors. Based on these factors, differentiated pricing is further divided into four different categories. The followings are the subcategories of differentiated pricing A. [Discount Pricing] B. [Competitors' parity method] C. [Premium Pricing] **Objectives of pricing methods:** - Maximum Profit Generation and return on investment. - To increase market share and strengthen the position in the market. - To make better use of competitive positioning. - Give competition to the competitors. - Long life of the company in the market. - Attain price stability. **Factors influencing Pricing**  A. **Internal Factors** 1. **Organizational Factors:** Pricing decisions occur on two levels in the organization. Overall price strategy is dealt with by top executives. They determine the basic ranges that the product falls into in terms of market segments. The actual mechanics of pricing are dealt with at lower levels in the firm and focus on individual product strategies. Usually, some combination of production and marketing specialists are involved in choosing the price. 2. **Marketing Mix** Marketing experts view price as only one of the many important elements of the marketing mix. A shift in any one of the elements has an immediate effect on the other three---Production, Promotion, and Distribution. In some industries, a firm may use price reduction as a marketing technique. Other firms may raise prices as a deliberate strategy to build a high-prestige product line. In either case, the effort will not succeed unless the price change is combined with a total marketing strategy that supports it. A firm that raises its prices may add a more impressive-looking package and may begin a new advertising campaign. 3. **Product Differentiation** The price of the product also depends upon the characteristics of the product. In order to attract customers, different characteristics are added to the product, such as quality, size, color, attractive package, alternative uses, etc. Generally, customers pay more prices for a product that is of the new style, fashion, better package, etc. 4. **Cost of the Product:** The cost and price of a product are closely related. The most important factor is the cost of production. In deciding to market a product, a firm may try to decide what prices are realistic, considering current demand and competition in the market. The product ultimately goes to the public and their capacity to pay will fix the cost, otherwise, the product would be flapped in the market. 5. **Objectives of the Firm:** A firm may have various objectives and pricing contributes its share in achieving such goals. Firms may pursue a variety of value-oriented objectives, such as maximizing sales revenue, maximizing market share, maximizing customer volume, minimizing customer volume, maintaining an image, maintaining stable prices, etc. Pricing policy should be established only after proper considerations of the objectives of the firm. B. **External Factors:** 1. **Demand:** The market demand for a product or service obviously has a big impact on pricing. Since demand is affected by factors like the number and size of competitors, the prospective buyers, their capacity and willingness to pay, their preference, etc. are taken into account while fixing the price. A firm can determine the expected price in a few test markets by trying different prices in different markets and comparing the results with a controlled market in which the price is not altered. If the demand for the product is inelastic, high prices may be fixed. On the other hand, if demand is elastic, the firm should not fix high prices, rather it should fix lower prices than that of the competitors. 2. **Competition:** Competitive conditions affect pricing decisions. Competition is a crucial factor in price determination. A firm can fix the price equal to or lower than that of the competitors, provided the quality of the product, in no case, is lower than that of the competitors. 3. **Suppliers:** Suppliers of raw materials and other goods can have a significant effect on the price of a product. If the price of cotton goes up, the increase is passed on by suppliers to manufacturers. Manufacturers, in turn, pass it on to consumers. Sometimes, however, when a manufacturer appears to be making large profits on a particular product, suppliers will attempt to make profits by charging more for their supplies. In other words, the price of a finished product is intimately linked with the price of the raw materials. Scarcity or abundance of the raw materials also determines to price. 4. **Economic Conditions:** The inflationary or deflationary tendency affects pricing. In a recession period, the prices are reduced to a sizeable extent to maintain the level of turnover. On the other hand, *the prices are increased in the boom period to cover the increasing cost of production and distribution*. To meet the changes in demand, price, etc. Several pricing decisions are available: - Prices can be boosted to protect profits against rising costs, - Price protection systems can be developed to link the price on delivery to current costs, - Emphasis can be shifted from sales volume to profit margin and cost reduction etc. 5. **Buyers:** The various consumers and businesses that buy a company's products or services may have an influence on the pricing decision. *Their nature and behavior for the purchase of a particular product, brand, service, etc. affect pricing when their number is large.* 6. **Government:** Price discretion is also affected by the price control by the government through the enactment of legislation when it is thought proper to arrest the inflationary trend in the prices of certain products*. The prices cannot be fixed higher, as the government keeps a close watch on pricing in the private sector.* Marketers obviously can exercise substantial control over the internal factors, while they have little, if any, control over the external ones.