module 5 - decision making - mba crash course
TRANSCRIPT
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MBAMBAMaster of Business Administration
Crash Course
An association of institutional, professionals, and OFWsRiyadh, Kingdom of Saudi Arabia
The National Organization of Certified Public AccountantsRiyadh Chapter, Kingdom of Saudi Arabia
“To reach our greatest potential, we must set our sights clearly and
embrace the unknown confidently”
WHATWHAT IS
DECISION MAKING?DECISION MAKING?
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DECISION MAKING
Process of identifying problems and opportunities
Sequence of steps which if
University of Leicester, 2603 Decision Making, 2002
p ppand then resolving them!
Sequence of steps which if followed should lead to the
best solution!R. Butler. Designing Organizations, pp.43/44, Routledge, 1991
WHAT IS AWHAT IS A DECISION?
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DECISION
A CHOICE made from available alternatives contributing to thealternatives contributing to the achievement of organization’s
objective.
NATURE OF DECISION
PURPOSEFULCONSTRAINED
WHAT ARE THEWHAT ARE THE TYPES OF
DECISIONS?DECISIONS?
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TYPES OF DECISIONS
PROGRAMMEDD i i th t d ti lDecisions that are made routinely or frequently
NON-PROGRAMMEDDecisions that are infrequentDecisions that are infrequent –strategic in nature
DECISION MAKINGDECISION MAKING MODELS?
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DECISION MAKING MODELS
RATIONAL
BOUNDED RATIONAL
EVOLUTIONARY
POLITICAL
GARBAGE CAN
RATIONAL MODEL
PROVIDES
ORGANIZATIONAL GOALS
PROBLEM IDENTIFICATION
PROVIDES CLEAR
STRUCTURE, LOGICAL STEPS TO
FOLLOW WHEN MAKING
ALTERNATIVE COURSES OF ACTION
EVALUATION OF ALTERNATIVES
CHOICE CRITERIA
A1 A2 A3 A4 A5
MAKING DECISION
CHOICE OF BEST
IMPLEMENT
MONITOR AND EVALUATE
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BOUNDED RATIONAL
BOUND RATIONALITY
LIMIT NUMBER OF OPTIONSLIMIT NUMBER OF OPTIONS
SATISFICING
CONSIDERS CONSTRAINTSTi C i- Time Constraints
- Cost of Acquiring Information- Ambiguity of Objectives- Conflict of Objectives-Stakeholders
EVOLUTIONARY
Revisiting and assessing different stages of rational model.
Decision evolve from a complex pattern of feedback loop.
R d i k f di l hReduces risk of radical change.
Logical incrementalism.
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POLITICAL
Considers stakeholders.
Organization is pluralistic rather thanOrganization is pluralistic rather than unitary.
Decision is an outcome of competition between different interestsinterests.
Power is decision making resource-short of supply.
GARBAGE CAN
Organization is a collection of problems and solutions.
Problems flow through the organization.
Solution exists within the organizationorganization.
In GARBAGE CAN SYSTEMS, decisions are often made by flight or oversight rather than by calculation!
- Levitt and Nass
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WHAT ARE THEWHAT ARE THE DRIVERS OF SUCCESS IN
DECISION MAKING?
DRIVERS OF SUCCESSLynley Sides of Sides and Associates
WHAT KIND OF ORGANIZATION STRATEGIC CONTEXT
LEADERSHIP
Best ExecutiveDon't make very many decisions. They concentrate on what's important and delegate the rest."
Best Executive
Best LeaderFocus on creating strategy, developing the "decision making system," and making only the critical decisions or resolving exceptions.
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DRIVERS OF SUCCESSLynley Sides of Sides and Associates
WHAT KIND OF ORGANIZATION STRATEGIC CONTEXT
LEADERSHIP
CONSEQUENCES OF SENIOR MAGERS TOO INVOLVED IN DECISION
delayed decisions
lost productivity
under-utilization of middle management resources
CONSEQUENCES OF SENIOR MAGERS TOO INVOLVED IN DECISION MAKING
employee frustration
inadequate leadership focus on their most critical responsibilities
DRIVERS OF SUCCESSLynley Sides of Sides and Associates
EXPERIENCE LEARNINGWHAT KIND OF ORGANIZATION
STRATEGIC CONTEXT
LEADERSHIP
EXPERIENCE LEARNINGKnowing what
happenedKnowing why it happened
ROLES
PROCESS
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DRIVERS OF SUCCESSLynley Sides of Sides and Associates
WHAT KIND OF ORGANIZATION STRATEGIC CONTEXT
LEADERSHIP
ROLES
PROCESS TOOLS & TECHNOLOGY
MANAGEMENT AND CONTROLS
CHARACTERISTICSCHARACTERISTICS OF WELL MADE
DECISIONS
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CHARACTERISTICS
TIMELY CLEAR
EVALUATED APPROPRIATELY
UTILIZE LESSONS FROM PREVIOUS DECISIONS
GOOD LEADER VS. BAD LEADER
GOOD BAD
Oliver Mouto of Epicentric
LEADER
“KNOWS WHEN TO
LEADER
“PANICS ALL THE TIME”PANIC” TIME”
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DECISION MAKINGDECISION MAKING IMPROVEMENTS IN
GROWING COMPANIES
IMPROVEMENTS
Personal decision making process and style consciously rather than sub-consciously.
Good individual decision making skills are propagated through education and stated principles.
Before making improvements, conduct unbiased evaluation of decision making at all levels of management and across functionslevels of management and across functions.
As company grows larger, put in place processes, roles, technologies and control systems.
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STRATEGIC DECISION MAKING
WHAT IS STRATEGY?
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STRATEGY
Creation of unique and valuable proposition involving different set
Michael Porter, 1996
proposition involving different set of activities
Creating fit among company’s activitiesactivities.
Setting yourself apart from competition.
WHAT ARE THE LEVELS OF STRATEGY?STRATEGY?
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LEVELS OF STRATEGY
CORPORATE STRATEGY- Strategic Issues- “What Business are we in?
BUSINESS STRATEGY- How organization is going to competep
FUNCTIONAL STRATEGY- How do we support business level strategy?
STRATEGIC MANAGEMENT
PROCESSPROCESS
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STRATEGIC MANAGEMENT PROCESS
Scan External Environment-National-Global
Identify Strategic Factors-Opportunities-Threats Implement
Evaluate Current-Mission-Goals-Strategies
Global
Scan Internal
-Threats
Identify
Define New
-Mission-Goals-Strategies
Formulate Strategy-Corporate-Business-Functional
Implement Strategy via Change in:
-Leadership-Structure-HR-IT-Control Systems
SWOT
Environment-Core Competence-Synergy-Value Creation
Identify Strategic Factors-Strength-Weaknesses
y
SITUATION ANALYSIS
AND TOOLSAND TOOLS
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SITUATION ANALYSIS
Assessment of the strengthsAssessment of the strengths, weaknesses, opportunities, and
threats (SWOT) that affect organizational performance.
ASSESSMENT OF EXTERNAL ENVIRONMENT
PESTEL ANALYSIS
POLITICAL ECONOMIC
LEGAL SOCIALPESTEL
TECHNOLOGICAL
ENVIRONMENTAL
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ASSESSMENT OF EXTERNAL ENVIRONMENT
PORTER’S FIVE (5) FORCESPotential
New
Competitors’Rivalry
New Entrants
Threat of Substitute Products
Bargaining Power of Buyers
Bargaining Power of Suppliers
ASSESSMENT OF INTERNAL ENVIRONMENT
STRUCTURE
MCKINSEY 7S
FRAMEWORK
SHAREDVALUES
SYSTEMSSTRATEGY
SKILLS STYLE
STAFF
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ASSESSMENT OF INTERNAL ENVIRONMENT
VALUE CHAIN
FIRM INFRASTRUCTURE
HUMAN RESOURCE MANAGEMENT
TECHNOLOGY DEVELOPMENT
PROCUREMENT
InboundLogistics
Opera-tions
MarketingAnd
Sales
OutboundLogistics
ServiceSales
FORMULATINGFORMULATING CORPORATE
LEVEL STRATEGYS G
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• Specialize around limited strengths
• Seek ways to overcome weaknesses
• Withdraw if indications of sustained growth are
BUILD SELECTIVELY• Challenge for leadership
• Build selectively on strengths
• Reinforce Vulnerable
INVEST TO BUILD
GE/MCKINSEY GRID
SS
HIG
H
• Invest to grow at maximum digestible rate
• Concentrate effort on maintaining strength
PROTECT POSITION
sustained growth are lacking areas
• Look for ways to expand without high risk; otherwise minimize investment and rationalize operation
LIMITED EXPANSION OR HARVEST
ET A
TTR
AC
TIVE
NES
MED
IUM
• Protect existing program
• Concentrate investments in segments where profitability is good and risks are relatively low
SELECTIVITY/ MANAGE FOR
EARNINGS • Invest heavily in most attractive areas
• Build up ability to counter competition
• Emphasize profitability by raising productivity
BUILD SELECTIVELY
PROTECT/REFOCUSMANAGE FORDIVEST
MA
RK
E
BUSINESS STRENGTH
LOW
MEDIUM STRONGWEAK
• Manage for current earnings
• Concentrate on attractive segments
• Defined strengths
PROTECT/REFOCUS
• Protect position in most profitable segments
• Upgrade product line
• Minimize investment
MANAGE FOR EARNINGS
• Sell at time that will maximize cash value
• Cut fixed costs and avoid investments
DIVEST
BOSTON CONSULTING GROUP MATRIX
RELATIVE MARKET SHARE
LOWHIGH
QUESTION MARKSSTARS
T G
RO
WTH
RAT
E
HIG
H
QUESTION MARKS
CASH COW
STARS
DOGS
MA
RK
ET
LOW
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FORMULATINGFORMULATING BUSINESS LEVEL
STRATEGYS G
BUSINESS LEVEL STRATEGY
PORTER’S FIVE (5) FORCESPotential
New
Competitors’Rivalry
New Entrants
Threat of Substitute Products
Bargaining Power of Buyers
Bargaining Power of Suppliers
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BUSINESS LEVEL STRATEGY
COMPETITIVE STRATEGIES
COST LEADERSHIP
DIFFERENTIATION
FOCUS
BUSINESS LEVEL STRATEGY
PARTNERSHIP
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FORMULATINGFORMULATING FUNCTIONAL
LEVEL STRATEGYS G
FUNCTIONAL LEVEL STRATEGY
ACTION PLANS
IMPLEMENTATION
ACTION PLANS
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STRATEGYSTRATEGY IMPLEMENTATION
AND CONTROLCO O
STRATEGY IMPLEMENTATION & CONTROL
LEADERSHIP
Use PersuasionMotivate Employees
ENVIRONMENT
p yShape Culture/Values
STRUCTURAL DESIGNOrganization ChartCreate TeamsCentralization/ DecentralizationF iliti T k D i
HUMAN RESOURCESEmployee Recruitment & SelectionManage Transfers, promotion, trainingFirings/RecallsR
ATEG
Y
FOR
MA
NC
E
GA
NIZ
ATIO
N
Facilities, Task Design Firings/Recalls
INFORMATION & CONTROL SYSTEMS
Pay/Reward SystemBudget AllocationsIT SystemsProcedures
STR
PER
F
OR
G
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WHAT ISWHAT IS MANAGEMENT?
MANAGEMENT
a social process entailing WHAT KIND OF ORGANIZATION
p gresponsibility for the effective
economic planning and regulations of the enterprise in fulfillment of a given purposefulfillment of a given purpose
or objective.
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MANAGEMENT FUNCTIONS
PLANNING ORGANIZING
COORDI-NATING
CONTROL-LING
MOTIVATING
WHAT ISWHAT IS MANAGEMENT
CONTROL?CO O
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MANAGEMENT CONTROL
the process by which management ensures that the organization carries
WHAT KIND OF ORGANIZATION ensures that the organization carries
out its strategies.
Resources are obtained and used efficiently and effectively in the y yaccomplishment the company
objectives
GENERAL CONTROL MODEL
INPUT PROCESS OUTPUT
SIMPLE INPUT-OUTPUT PROCESS
FOUR ESSENTIAL CONDITIONS FOR A PROCESS TO BE CONTROLLED
Know what to achieve and set objectives.
Measure outputs and decide whether objectives are achievedMeasure outputs and decide whether objectives are achieved.
Predict effects of any action to alter or control the process.
Correct any deviation away from objectives.
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GENERAL CONTROL MODEL
INPUT PROCESS OUTPUT
COMPARATOR INTRODUCED
MEASURE OF OUTPUT
“If you cannot measure it,
how can you COMPA-how can you manage it”
OBJECTIVES
COMPARATOR
PREDICTIVE MODEL
INPUT PROCESS OUTPUT
MEASURE OF OUTPUT
PREDICTIVE MODEL OF THE
PROCESS
INFORMATION
COMPA-
OBJECTIVES
CORRECTIVE ACTION
COMPARATOR
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IMPLEMENTATION
INPUT PROCESS OUTPUT
MEASURE OF OUTPUT
PREDICTIVE MODEL OF THE
PROCESS
INFORMATION
COMPA-
IMPLEMENTATION OF ACTION
OBJECTIVES
CORRECTIVE ACTION
COMPARATOR
SINGLE-DOUBLE LOOPSET
THERMOSTAT TO 65OPLAN
RESET AT 70O
INCREASE
OPERATIONSET
THERMOSTAT AT 65O
FUEL SUPPLY TO EQUIPMENT
OUTPUT TEMP 65O
COMPARE-PLANMONITORING OUTPUT
INCREASE FUEL
CLO
SED LO
OPEN
LOO
VARIANCE - 3OOUTPUT
ACTIONACCEPT AT 65O
ALTER PLAN
OO
P
OP
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GENERAL APPLICATIONIDENTIFY OBJECTIVES
IDENTIFY COURSES OF ACTIONS
EVALUATE ALTERNATIVESEVALUATE ALTERNATIVES
SELECT ALTERNATIVES
COMPLETE LONG RANGE PLAN
IMPLEMENT LONG TERM PLAN-BUDGET
PLANNING
MONITOR : ACTUAL VS PLAN
VARIANCE ANALYSIS-INVESTIGATION CHANGE PLAN TO
MEET OBJECTIVESTAKE CORRECTIVE ACTION
CONTROL
MANAGEMENT CONTROL PROCESSES
M d Programming
INFORMALCOMMUNICATION
FORMALCOMMUNICATION
MemorandaMeetingsConversations
ProgrammingBudgetingReporting/Analysis
ACCOUNTING SYSTEM
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ACCOUNTING SYSTEMACCOUNTING
SYSTEM
FINANCIALACCOUNTING
MANAGEMENTACCOUNTING
Backward lookingSacrifice decision relevancy for objectivityGoverned by regulations
Decision & control relevanceFuture OrientatedDynamicNot subject to regulations
ROLE OF MGT ACCOUNTING
ANALYSIS OF PAST DECISION
PROVISION OF INFORMATION EXPLAINING CURRENT TRENDS
PROVISION OF INFORMATION FOR DECISION MAKING
PROVISION OF INFORMATION FOR PLANNING AND CONTROL
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MGT ACCOUNTING-FRAMEWORK
CONTROL OF OPERATION
DECISION MAKING
SYSTEMS
DATA CAPTURE SYSTEMS
CONTROLSYSTEMS
SHORT TERMDECISION MAKING
LONG TERMDECISION MAKING
BUDGETARYCONTROL
COSTCONTROL
BUDGETING
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BUDGET
A QUANTITATIVE STATEMENT, FOR DEFINED PERIOD OF
TIME, WHICH MAY INCLUDE PLANNED REVENUES, EXPENSES, ASSETS,
LIABILITIES AND CASHLIABILITIES AND CASH FLOWS.
PURPOSE OF BUDGET
TO COMPEL PLANNING – Action Plans for Long Range Plans.
TO COORDINATE ACTIVITIES
TO COMMUNICATE PLANS
TO MOTIVATE MANAGERS
TO CONTROL ACTIVITIES
TO EVALUATE PERFORMANCE OF MANAGERS
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STAGES IN BUDGETARY PROCESS
APPROVAL OF MASTER BUDGET
ON-GOING REVIEW
PREPARE INITIAL BUDGET
NEGOTIATION OF BUDGET
COORDINATE INITIAL BUDGET
ALTER/REMOVE INCONSISTENCIES
IDENTIFY KEY OBJECTIVES AND EXTERNAL CHANGES
DETERMINE KEY LIMITING FACTORS
PREPARE INITIAL SALES FORECASTS
PREPARE INITIAL BUDGET
BEHAVIORAL ISSUESBEHAVIORAL ISSUESIN
BUDGETING
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BEHAVIORAL ISSUES
TECHNICAL ISSUES OF BUDGETING ARE
Emannuel, Otley and Merchant
BUDGETING ARE STRAIGHTFORWARD WHEREAS BEHAVIORAL ISSUES ARE MUCH
MORE COMPLEX
BEHAVIORAL ISSUESMANAGEMENT USE OF BUDGETSMany managers considered budgetary information which they were provided was not very useful and frequently ignored –not very useful and frequently ignored –Dew and Gee (1973)
PARTICIPATIONParticipation in the budget-setting process improve the attitude of middle managers to the control process – Dew and Gee (1973)process Dew and Gee (1973)
BUDGET AS TARGETHighest level of performance is achieved by setting the most difficult specific goals as accepted by managers concerned – Hofstede (1968)
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BEHAVIORAL ISSUES
BUDGETS AS FORECASTSPeople introduce slacks in budget to achieve their targets easily –g yBroadbent and Cullen
USE OF BUDGET INUSE OF BUDGET IN PERFORMANCE EVALUATIONBudgetary control systems are often viewed very negatively
COSTINGCOSTING AND
BUDGETARY CONTROLCONTROL
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WHY MANAGERS NEED TO KNOW COSTS?
STOCK VALUATION
SET SELLING PRICE
ASSESS PROFITABILITY
S S SSET STANDARDS
DIAGNOSE INEFFICIENCIES
COSTING AND BUDGETARY CONTROL
TO COMMUNICATE EFFECTIVELY, MANAGERS (NOT JUST ACCOUNTANTS) MUST FULLY UNDERSTAND
THE DIFFERENCES BETWEEN VARIOUS TYPES
OF COSTS, THEIR COMPUTATION AND USAGE!
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COST CLASSIFICATIONCOST CAN BE CLASSIFIED IN RELATION TO:
PRODUCT/SERVICEPRODUCT/SERVICE
LEVEL OF OUTPUT
DECISIONS
COST CLASSIFICATIONCOST CAN BE CLASSIFIED IN RELATION TO:
PRODUCT/SERVICE
DIRECT COST(Prime Cost)
Direct Materials- Raw materials
INDIRECT COST(Overhead Cost)
Indirect Materials-Lubricating oil, maintenance materials
Direct Labor-Work associated to product
Direct Expenses-Expenses associated to product
Indirect Labor-Factory Supervisor salary
Indirect Expenses- Factory Rent, Plant Insurance
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COST CLASSIFICATIONCOST CAN BE CLASSIFIED IN RELATION TO:
LEVEL OF OUTPUT
FIXED COST – cost that remains constant regardless of activity levels: Example – Rent, Director’s salary
$COST
OUTPUT
COST FIXED
COST CLASSIFICATIONCOST CAN BE CLASSIFIED IN RELATION TO:
LEVEL OF OUTPUT
VARIABLE COST – cost that vary at differing activity: Example – Direct Labor and materials.
$COST
Variable
OUTPUT
COST
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COST CLASSIFICATIONCOST CAN BE CLASSIFIED IN RELATION TO:
LEVEL OF OUTPUT
SEMI VARIABLE COST – cost that contain both fixed and variable elements: Example – electricity charge.
$COST
Variable
OUTPUT
COST
Fixed
COST CLASSIFICATIONCOST CAN BE CLASSIFIED IN RELATION TO:
LEVEL OF OUTPUT
STEPPED COSTS – fixed over a range and then jump to another level: Example – supervision costs.
$COST
OUTPUT
COST
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COST CLASSIFICATIONCOST CAN BE CLASSIFIED IN RELATION TO:
AS CONSEQUENCE OF DECISION(RELEVANT COST)(RELEVANT COST)
Costs that are results of decisions
PROCEDURE TOPROCEDURE TO DETERMINE
PRODUCT COSTPRODUCT COST
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PROCEDURE TO DETERMINE PRODUCT COST
CLASSIFY AND CODE
ALLOCATE OR APPORTION OVERHEADS TO COST
CENTERS
APPROTION SERVICES DEPARTMENT COST TO
PRODUCTION DEPT
ABSORB OVERHEAD COSTS INTO PRODUCTS
PROCEDURE TO DETERMINE PRODUCT COST
CLASSIFY AND CODE
CLASSIFY AND CODERefers to categorizing costs such as labor materials or overhead
ALLOCATE OR APPORTION
OVERHEADS TO COST CENTERS
APPORTION SERVICES
DEPARTMENT COST
as labor, materials or overhead.
COST CENTER CODE COST CENTER DESCRIPTION
01 Raw Materials02 Cleaners03 Personnel Department04 Warehouse
ABSORB OVERHEAD COSTS INTO PRODUCTS
DEPARTMENT COST TO PRODUCTION
DEPTEXPENSE CODE EXPENSE CATEGORY
001 Labor002 Salaries003 Fuel/Gas004 Supplies
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PROCEDURE TO DETERMINE PRODUCT COST
CLASSIFY AND CODE
ALLOCATE OVERHEADS TO COST CENTERS
ALLOCATE OR APPORTION
OVERHEADS TO COST CENTERS
APPORTION SERVICES
DEPARTMENT COST
Sharing costs between two or more cost centers
COST BASIS?????
Rent Floor Area
Wareho se Val e of iss es
ABSORB OVERHEAD COSTS INTO PRODUCTS
DEPARTMENT COST TO PRODUCTION
DEPTWarehouse Value of issues
Maintenance Hours WorkedMachine Value
Safety Officer No. of Employees
PROCEDURE TO DETERMINE PRODUCT COST
CLASSIFY AND CODE
APPORTION SERVICES DEPARTMENT COST
ALLOCATE OR APPORTION
OVERHEADS TO COST CENTERS
APPORTION SERVICES
DEPARTMENT COST
Allocating Service Department costs to Production Centers
DEPT TOT. COST
Whse $1,000 $375 $625Maint $ 800 $711 $ 89
PROD1 PROD2
ABSORB OVERHEAD COSTS INTO PRODUCTS
DEPARTMENT COST TO PRODUCTION
DEPT
Maint $ 800 $711 $ 89
Total $1,800 $1,086 $714
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PROCEDURE TO DETERMINE PRODUCT COST
CLASSIFY AND CODE
OVERHEAD ABSORPTION
Method of attaching overhead toALLOCATE OR
APPORTION OVERHEADS TO COST CENTERS
APPORTION SERVICES
DEPARTMENT COST
Method of attaching overhead to products/services using Overhead
Absorption Rates (OAR)
OAR = BUDGETED OVERHEADBUDGETED BASE
ABSORB OVERHEAD COSTS INTO PRODUCTS
DEPARTMENT COST TO PRODUCTION
DEPT
PROCEDURE TO DETERMINE PRODUCT COST
CLASSIFY AND CODE
OVERHEAD ABSORPTIONEXAMPLE:Given Budgeted Overhead = $ 300,000
ALLOCATE OR APPORTION
OVERHEADS TO COST CENTERS
APPORTION SERVICES
DEPARTMENT COST
gExpected Output = 37,500 unitsLabor Hours/Unit = 2Actual Output = 40,000Actual Labor Hours = 39,000Actual Overhead = $310,000
OAR = BUDGETED OVERHEADBUDGETED BASE
300,0002*37,500
OAR $ 4 l b h
ABSORB OVERHEAD COSTS INTO PRODUCTS
DEPARTMENT COST TO PRODUCTION
DEPTOAR = $ 4 per labor hour
Overhead Absorbed = Output* std content*OAR= 40,000 * 2 * 4= $ 320,000
Actual Overhead = $ 310,000
Over-Absorbed Overheads = $ 10,000
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PROCEDURE TO DETERMINE PRODUCT COST
CLASSIFY AND CODE
OVERHEAD ABSORPTIONFACTORS TO CONSIDER WHEN CHOOSING
OVERHEAD ABSORPTION RATES (OAR)
ALLOCATE OR APPORTION
OVERHEADS TO COST CENTERS
APPORTION SERVICES
DEPARTMENT COST
BASE - Reflect the workload characteristics of the department. It is preferable to use an OAR based on activity (e.g. labor hours) rather than one based on cost (e.g. wages paid).
ACTIVITY LEVEL - The level of activity used to set the base should be based on the normal
ABSORB OVERHEAD COSTS INTO PRODUCTS
DEPARTMENT COST TO PRODUCTION
DEPTlevel of activity (not on a theoretical maximumcapacity).
DEPARTMENTAL RATES - It is preferable to use separate rates for each department.
COSTING METHODS
ABSORPTION COSTING
MARGINAL COSTING
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ABSORPTION COSTING
Fixed and variable costs are charged to the units
ADVANTAGES
Fixed costs are an inescapable – must be included in stock valuations.
"Total cost plus" pricing should ensure profit.
Stock Building Avoid a series of losses which willStock Building - Avoid a series of losses which will eventually be offset by profits when the goods are sold.
ADVANTAGES
MARGINAL COSTINGvariable costs are charged to cost units fixed costs attributable to the relevant period are written off in fall against the contribution
for that period
ADVANTAGESSimple to operate
No apportionment of fixed costs - subjective and time consuming exercise)
No under/over absorbed overheads.
Provides information relevant for short term decision making.
Fixed costs relate to time therefore it seems logical to write them off asFixed costs relate to time, therefore it seems logical to write them off as period costs.
Reflects cash flow more than absorption costing does
The cost to produce one extra unit is the marginal cost - realistic to value stock at this attributable cost.
Profit will vary with sales and is not distorted by changes in stock levels.
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ACTIVITY BASED MANAGEMENT
Focuses on the activities performed to provide the product/service improved value
ACTIVITY BASED MANAGEMENT
provide the product/service improved value that is enjoyed by the customer and the profit
for the enterprise that created the value.
ABM will help companies to produce more efficiently, determine costs more accuratelyefficiently, determine costs more accurately and control and evaluate performance more
effectively
48
Activity Based Costing (ABC) or ABM is a tool used to identify individual activities as fundamental cost objects.
ACTIVITY BASED MANAGEMENT
j
Under ABC cost calculation is done for each individual activities & assign costs to objects like product/services on the basis of activities needed to produce product/services.
ABC focus on indirect costs (overheads), traces rather than allocates each expense category to particular cost object, makes indirect costs direct.
ADVANTAGES
ACTIVITY BASED MANAGEMENT
Improves cost management & profitability by avoiding unwanted activitiesavoiding unwanted activities.
Helps in cost reduction & process improvement decisions in production activities.
Helps in product design decisions.
Provides support in planning & managing activities.
Helps in removing unwanted activities in production management.
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ACTIVITY BASED MANAGEMENT
RESOURCESPeople, Materials,
Machines, Consumables, etc
How much resources an
activity requires?
RESOURCE COSTASSIGNMENT
RESOURCE DRIVERS
UNIT RESOURCE
ACTIVITIESProcesses: Selling,
Warehousing, Purchasing,
Assembly, etc
COSTOBJECTS
Products, Services, Customers, Market,
Channels, etc.
ACTIVITIES COSTASSIGNMENT
ACTIVITY DRIVERS
How much an object utilizes an
activity?
UNIT ACTIVITY
WHEN TO USE ABC?
ACTIVITY BASED MANAGEMENT
When competition is stiffWhen competition is stiff.
When overheads are high
When product are diverse due to complexity, volume, & amount of labor.p y, ,
When cost of errors are high
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SHORT-TERM DECISION MAKING
TO ENSURE SURVIVAL OF THE ENTERPRISE
SHORT TERM DECISION MAKING
CONCERNED WITH LOOKING AT HOW ALTERNATIVE COURSES OF ACTION INFLUENCE THE FIRM’S
CASH FLOW
POWERFUL TOOL FOR SHORT TERM DECISION MAKING IS COST VOLUME PROFIT ANALYSIS (CVP)COST VOLUME PROFIT ANALYSIS
(CVP) IS ALSO KNOWN AS BREAK-EVEN ANALYSIS
51
BUILDING A CVP MODEL
SHORT TERM DECISION MAKING
IMPACT OF VOLUME ON COSTSIMPACT OF VOLUME ON COSTS
IMPACT OF VOLUME ON PROFIT
CALCULATION OF BREAK-EVEN ON ENTERPRISE
CALCULATION OF VOLUME SALES TO ACHIEVE TARGET PROFIT
SHORT TERM DECISION MAKING
IMPACT OF VOLUME ON COSTSAs some costs are fixed, average cost per unit fall as
volume increases
Production 5,000 10,000 15,000
Variable Cost ($1per unit) 5,000 10,000 15,000
Fixed Cost 9,000 9,000 9,000
Total Cost 14,000 19,000 24,000
Cost Per Unit 2.80 1.90 1.60
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SHORT TERM DECISION MAKING
IMPACT OF VOLUME ON PROFIT
Production 5,000 10,000 15,000
Revenue ($ 2 per Unit) 10,000 20,000 30,000
LESS
Variable Cost ($1 per Unit) (5,000) (10,000) (15,000)
Fi d C t (9 000) (9 000) (9 000)Fixed Cost (9,000) (9,000) (9,000)
Cost Per Unit (4,000) 1,000 6,000
SHORT TERM DECISION MAKING
BREAK-EVEN POINT
BREAK-EVEN (IN UNITS) = TOTAL FIXED COSTS
CONTRIBUTION = SALES PRICE – VARIABLE COSTS
BREAK EVEN (IN UNITS) CONTRIBUTION PER UNIT
BREAK-EVEN (SALES) = TOTAL FIXED COSTS x SALES PRICE/UNITCONTRIBUTION PER UNITCONTRIBUTION PER UNIT
BREAK-EVEN + PROFIT = TOTAL FIXED COSTS + PROFITCONTRIBUTION PER UNIT
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SHORT TERM DECISION MAKING
MARGIN OF SAFETY RATIO
INDICATES BY HOW MUCH SALES MAY FALL BEFORE AN ENTERPRISE WILL SUFFER LOSS
% MARGIN OF SAFETY = EXPECTED SALES – BREAK EVEN SALESEXPECTED SALES
x 100%
BEFORE AN ENTERPRISE WILL SUFFER LOSS
% MARGIN OF SAFETY = 15,000 – 9,00015 000
x 100% = 40%15,000
THE SMALLER THE MARGIN OF SAFETY, THE GREATER IS THE RISK THAT THE ENTERPRISE’S
LEVEL OF ACTIVITY MAY FALL BELOW THE BREAK-EVEN POINT
DELETEDELETE OR
CONTINUE?
54
DELETE OR CONTINUE?
SALES
A B C TOTAL
170 000 100 000 150 000 420 000
ABSORPTION COSTING BASIS
SALES 170,000 100,000 150,000 420,000
DIRECT MATERIALS 30,000 25,000 35,000 90,000
DIRECT LABOR 20,000 25,000 24,000 69,000
VARIABLE OVERHEAD 40,000 30,000 20,000 90,000
APPROTIONED FIXED OVERHEAD 30,000 35,000 34,000 99,000
TOTAL FACTORY COSTS 120 000 115 000 113 000 348 000TOTAL FACTORY COSTS 120,000 115,000 113,000 348,000
GROSS PROFIT 50,000 (15,000) 37,000 72,000
LESS : SELLING ADMINISTRATIVE EXPENSES 40,000
GROSS PROFIT 32,000
DELETE OR CONTINUE?MARGINAL COSTING APPROACH
SALES
A B C TOTAL
170 000 100 000 150 000 420 000SALES 170,000 100,000 150,000 420,000
DIRECT MATERIALS 30,000 25,000 35,000 90,000
DIRECT LABOR 20,000 25,000 24,000 69,000
VARIABLE FACTORY OVERHEAD 40,000 30,000 20,000 90,000
VARIABLE SELLING & ADM 2,000 1,000 1,500 4,500
TOTAL FACTORY COSTS 92,000 81,000 80,500 253,500
CONTRIBUTION 78 000 19 000 69 500 166 500CONTRIBUTION 78,000 19,000 69,500 166,500
LESS : FIXED FACTORY OVERHEAD 99,000
LESS : SELLING ADMINISTRATIVE EXPENSES 35,500
NET PROFIT 32,000
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MAKEMAKE OR
BUY?
MAKE OR BUY?
EXTERNAL SUPPLIER OFFER = $800
Direct labor = 200Direct materials = 400Direct materials = 400Variable Overhead = 100Fixed Overhead = 300TOTAL COST =1,000
If fixed costs are unavoidable, and therefore not relevant, the appropriate comparison is as follows:
Direct labor = 200Direct materials = 400Variable Overhead = 100TOTAL COST = 700
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QUALITATIVEQUALITATIVE CONSIDERATIONS
QUALITATIVE CONSIDERATIONSCOMPETITORS
CUSTOMERS
LABOR – MORALE, TRAINING, AVIALBAILITY
LEGAL CONSTRAINTS
ENVIRONMENTENVIRONMENT
MANAGEMENT CONTROL
LEARNING CURVE
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LONG -TERM DECISION MAKING
LONG TERM INVESTMENT
EXPANSIONAdding to fixed assets to achieve greater level of service
MODERNIZATIONLevel of service is the same but cost of service is reduced
CHANGE OF METHOD USEDStimulated by change in cost of providing serviceStimulated by change in cost of providing service
REPLACEMENTCheaper to replace equipment than to repair
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FINANCIALFINANCIAL METHODS OF INVESTMENT APPRAISAL
INVESTMENT APPRAISAL
PAYBACK
DISCOUNTEDPAYBACK
INTERNALRATE OF RETURN CAPITAL
INVESTMENTAPPRAISAL
ACCOUNTINGRATE OFRETURN
NETPRESENT
VALUE
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PAYBACKMEASURES THE NUMBER OF YEARS TO
RECOVER THE ORIGINAL INVESTMENT FROM NET CASH FLOW RESULTING FROM A PROJECT
PROJECT A PROJECT BINVESTMENT 1,000 1,000
Cash Cumm Cash CummYear 1 200 200Year 2 250 450 100 100Year 3 150 600 150 250Year 4 150 750 150 400
Project A Payback 6 Years
Project B Payback Year 5 150 900 150 550Year 6 100 1,000 200 750Year 7 100 150 900Year 8 100 1,000Year 9 100Year 10 100
j y8 Years
PAYBACK
ADVANTAGES DISADVANTAGES
Calculation is simple Ignores receipts at
Cash Flow at risk –shortest possible time
Quickest Restoration f li idit iti
g pend of payback period.
No account is taken of the time value of money.
of liquidity position.
Acknowledge that uncertainty increases with time.
Expected overall profitability is not considered.
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DISCOUNTED PAYBACK
Money received today is worth more than the money received next year due to the following
factors:
Opportunity to invest
Obtain a return
DISCOUNTED PAYBACK
ExampleMoney received now : Year 0 = 100If i t d t 10%If invested at 10%At end of year 1 : 100 = 110At end of year 2 : 100 = 121
To convert the cash flow at end of each year in today’s value
At end of year 1 : 100/110 = 0.909At end of year 2 : 100/121 = 0.826
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DISCOUNTED PAYBACKExample: ABC Company investigated the possibility of investing in a new project and the following has been obtained:
TOTAL COST OF PROJECT 500,000TOTAL COST OF PROJECT 500,000
EXPECTED NET CASH FLOW
Year 1 20,000
Year 2 50,000
Year 3 100,000
Year 4 200,000Year 4 200,000
Year 5 300,000
Year 6 30,000 700,000
NET RETURN 200,000
DISCOUNTED PAYBACKExample: Assuming a rate of interest of 8%, calculate the project’s overall return using the following methods:
PAYBACK DISCOUNTED PAYBACK
Year Net Cash Flow
Cumm. Net
Cash Flow
Discount Factors
Present Value at
8%
Cumm. Net
Cash Flow
0 (500,000) (500,000) 1.0000 (500,000) (500,000)
1 20,000 (480,000) 0.9259 18,518 (481,482)
2 50,000 (430,000) 0.8573 42,865 (438,617)( ) ( )
3 100,000 (330,000) 0.7938 79,380 (359,237)
4 200,000 (130,000) 0.7350 147,000 (212,237)
5 300,000 170,000 0.6860 205,800 (6,437)
6 30,000 200,000 0.6302 18,906 12,469
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DISCOUNTED PAYBACK
ADVANTAGES DISADVANTAGES
Easy to understand Difficult to estimate the amount of timing of
Not too difficult to compute
Focuses on cash recovery of an investment.
amount of timing of installment of original investment.
Difficult to estimate the amount and timing of future net cash receipts and other payments.
Cash received now maybe worth more than the cash received in the future.
Takes into account more of net cash flow
Not easy to determine an appropriate rate of interest.
Net cash flow received after payback period are ignored.
ACCOUNTING RATE OF RETURN
Compares the profit generated by the project with the original cost of investmentwith the original cost of investment
Considers Profit Flows rather than Cash Flows
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ACCOUNTING RATE OF RETURN
A.R.R. = Average Annual ReturnAverage Capital Invested
X 100Average Capital Invested
Average Annual Return = Total Expected ProfitProjects Life
Average Capital Invested = Value of working capital + half the cost of
investment in fixed assets
ACCOUNTING RATE OF RETURN
PROJECT AINVESTMENT 450
Cash Depr Profit 54Cash Depr ProfitYear 1 100 90 10Year 2 200 90 110Year 3 100 90 10Year 4 100 90 10Year 5 220 90 130TOTAL 450 270
A.R.R = 54225 X 100%
A.R.R = 24%
Average 225 54
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ACCOUNTING RATE OF RETURN
ADVANTAGES DISADVANTAGES
Compatible with similar Net profit can be subject to different definition.
accounting ratio used in financial accounting.
Relatively easy to understand
Not difficult to compute
Not always clear whether original cost of investment to be used.
Use of residual value, the higher the residual value, the lower the ARR.
Draws attention to the notion of overall profit.
Method does not give what is acceptable rate of return.
Does not take into account the time value of money
NET PRESENT VALUE (NPV)
The Cash Received today is preferable to cash receivable in the
futurefuture
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NET PRESENT VALUE (NPV)
Example: MBA3 Company is considering two capital investment project. The company expects a rate of return of 10% per annum. Details are as follows:
PROJECT 1 2
ESTIMATED LIFE 3 YEARS 5 YEARS
PROJECT COST 100,000 100,000
ESTIMATED CASH FLOW
Year 1 20,000 10,000
Year 2 80 000 40 000Year 2 80,000 40,000
Year 3 40,000 40,000
Year 4 40,000
Year 5 20,000
NET PRESENT VALUE (NPV)
PROJECT APPRAISAL
PROJECTPROJECT 1 PROJECT 2
Net Cash Flow
Discount Factor 10%
Present Value
Net Cash Flow
Discount Factor 10%
Present Value
Year 1 20,000 0.9091 18,182 10,000 0.9091 9,091
Year 2 80,000 0.8264 66,112 40,000 0.8264 33,056
Year 3 40,000 0.7513 30,052 40,000 0.7513 30,052
Year 4 40,000 0.6830 27,320
Year 5 20,000 0.6209 12,418TOTAL PRESENT VALUE 114,346 111,937LESS: INITIAL COST 100,000 100,000NET PRESENT VALUE 14,346 11,937
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NET PRESENT VALUE
THREE RULES
If NPV = 0; You would be indifferent to the investment
If NPV = Negative; Project fails to generate sufficient funds to cover the cost of capital
If NPV = Positive; Project generates a return greater than the cost of capital and should be considered.
NET PRESENT VALUE
ADVANTAGES DISADVANTAGES
Using cash flow Difficulties in estimating the initial cost of the project and
emphasize liquidity
Different accounting policies are not relevant
Time value of money is taken into account
p jtime periods in which installment can be paid back.
Difficult to estimate accurately the net cash flow
Not easy to select i t t f i t tEasy to compare the NPV
of different projects, to reject projects that do not have acceptable NPV
appropriate rate of interest.
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INTERNAL RATE OF RETURN
An alternative method of investment appraisal based ppon discounted net cash flow
It answers the question:What rate of return would beWhat rate of return would be required to ensure that the total NPV equals total initial
cost?
INTERNAL RATE OF RETURN
Example: ABC Company is considering to invest 50,000 in a new project. The project’s net cash flow is as follows:
Year 1 = 7,000Year 2 = 25,000Year 3 = 30,000Year 4 = 5 000Year 4 = 5,000
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INTERNAL RATE OF RETURN
PROJECT NET CASH FLOW
AT 10% AT 15%
Discount Factor 10%
Present Value
Discount Factor 15%
Present Value
Year 1 7,000 0.9091 6,364 0.8696 6,087
Year 2 25 000 0 8264 20 660 0 7561 18 903Year 2 25,000 0.8264 20,660 0.7561 18,903
Year 3 30,000 0.7513 22,539 0.6575 19,725
Year 4 5,000 0.6830 3,415 0.5718 2,859TOTAL PRESENT VALUE 52,978 47,574LESS: INITIAL COST 50,000 50,000NET PRESENT VALUE 2,978 (2,426)
Safest Discounting Factor:gIRR = Positive Rate + {Positive NPV/(Positive NPV+Negative NPV)}*Range of rates
IRR = 10% + {2,978/(2978+2426)}*(15% - 10%)
IRR = 12.76%
Note: negative sign of Negative NPV is ignored
INTERNAL RATE OF RETURN
ADVANTAGES DISADVANTAGES
Care has to be taken in Sometime not easy to understand.
estimating the initial cost of the project.
Emphasis is placed on liquidity
Attention is given to the timing of net cash flows
Difficult to determine which of the two suitable rates to adopt unless computer is used.
Gives only approximate rate of return.timing of net cash flows
Appropriate rate of return does not have to be calculated.
Clear % of ROI
In complex situations, it can give misleading results.
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WHATWHAT TOOL
TO USE?
NOTES
Firms often use a combination of methods.
P b k i d t j t thPayback is used to screen projects, then NPV or IRR is used for a more rigorous appraisal.
ARR is the least popular primary appraisal methodmethod.
Al methods are heavily reliant on the quantity and quality of data.
70
PRICING
PRICING
SETTING PRICE TOO HIGH
SETTING PRICE TOO LOW
Lost CustomersFall in Market ShareLow revenues – unable to cover cost
Price WarUnable to cover total costCustomer’s perception of quality
71
PRICING ISSUESIneffective pricing often results from these key issues:
Lack of Pricing Strategy
Many firms know their customers' wants and needs, but no solid understanding of customers' price sensitivity.
Are customers willing to pay more, or would any price increase drive them to the competition?
Intelligent c stomer segmentation b price sensiti it isIntelligent customer segmentation by price sensitivity is often underutilized,
Understanding the goal - to maximize revenues, margins or sales (AND other factors to effective pricing strategy.
PRICING ISSUESIneffective pricing often results from these key issues:
Lack of Scenario Planning“WHAT IF” scenario planning is performed in an ad hoc manner, or not at all; consequence is either paralysis, or reactive/panic decision-making.
Pricing decisions are often made by a single individual in a
Lack of Pricing ProcessPricing decisions are often made by a single individual in a firm, or by an understaffed and overworked pricing group. Pricing can be performed quite well if these individuals are armed with exceptional intuition and knowledge.
72
PRICING
Corporate Objectives
MAJOR FACTORS TO CONSIDER WHEN DEVELOPING PRICING STRATEGY
Corporate Objectives- ROI, Profit, Payback Period
Marketing Objectives
Degree of risk
Response of competitors
Corporate image
Cost/Volume relationship
PRICING
1% improvement in price translated to an
2006 Gartner Research report
1% improvement in price translated to an 11% increase in profitability.
By contrast,
1% improvement in fixed costs or in variable % p o e e t ed costs o a ab ecosts only increases profitability by 3% and 7%, respectively.
73
PRICING
COST PLUS PRICINGAdding a mark-up to the product’s cost in order
to arrive at a selling priceto arrive at a selling price
BUT WHICH COST SHOULD BE USED?
Full Cost
Marginal Cost
Minimum/Relevant Cost
PRICING
ECONOMIST PRICING MODELLower Selling Price generates
Larger Volume of SalesLarger Volume of Sales
A
PRICEB
Demand Curve
Profit is maximized where Marginal Revenue = Marginal Cost
DEMAND
74
PRICING
ECONOMIST PRICING MODELProblems with Economist Model
I d d i kIt assumes demand curve is known
Total cost and marginal cost can be derived after analysis, judgment and arbitrary allocation
Demand is not only influenced by priceDemand is not only influenced by price
Not all firms are profit maximizers
PRICING
PRICING NEW PRODUCTS/SERVICESSKIMMING
setting high price to earn super profit.sett g g p ce to ea supe p o t
Buyers are price insensitive
Substitute are not available
High price acts as sign of quality
There are barriers to entry
Cost of smaller volume are not disproportionate
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PRICING
PRICING NEW PRODUCTS/SERVICESPENETRATION
setting low price to attract high volume salessetting low price to attract high volume sales
Buyers are price sensitive
Substitute are available
Low price is deterrent to new entrantsLow price is deterrent to new entrants
Cost reductions can be effected through volume.
PRICING
PRICING OBJECTIVESCurrent profit maximization
Current revenue maximization – increase market share.
Maximize quantity – Units sold
Maximize profit margin
Quality Leadership
Partial Cost recovery
Survival
Status Quo – price stabilization to avoid price wars
76
PRICING
JOBBER AND HOOLEY STUDY
Pricing ObjectivesStage of Market Evolution
Pricing ObjectivesEmerging Growth Mature Decline
Profit Maximization 41.3 40.9 38.8 41.8
Market Share Attainment 11.9 16.8 17.7 15.2
Maximize current sales revenue 13.0 5.7 9.4 12.4
Ensure adequate cash flow 17.4 8.7 5.6 9.8q
Target profit Attainment 16.3 27.8 28.4 20.7
PRICING
JOBBER AND HOOLEY STUDY
P i i Obj ti
BY SIZE OF FIRM
Pricing Objectives Below 2.5 M 2.5 to 20 Above 20
Profit Maximization 45.3 44.9 39.2
Market Share Attainment 13.0 16.0 22.3
Maximize current sales revenue 9.7 11.1 8.6
Ensure adequate cash flow 13.9 6.3 5.5
Target profit Attainment 22.3 27.0 32.7
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PRICING
JOBBER AND HOOLEY STUDY
4045 40.2%
2025303540
16.6%
26.0%
05
1015
Ensure AdequateCash Flow
8.0%
Maximize CurrentRevenue
9.1%
Market ShareAttainment
TargetProfitAttainment
ProfitMaximization
PRICING
THE NEED FOR BETTER PRICING
Increasingly complex markets and business model Globalization of businessmodel – Globalization of business organization and product proliferation
Increased sophistication of purchasers.
Proliferation of pricing entities and competitive alternatives – Technological
d d i i i h ladvances drives increase in channels.
Increase in quantity of enterprise data – Use of ERP, Supply Chain Management, etc.
78
CASE STUDY