Lecture 5: Decision making

Question 1

What two criteria make costs and revenues relevant

Answer 1

• Differ between alternative courses of action
• Affect future cash flows

Question 2

Name two reasons opportunity costs are relevant?

Answer 2

1. Costs of doing anything includes benefits that could have been obtained if that particular decision had not been taken
2. Opportunity costs are the foregone benefits form the next best alternative course of action and are always relevant

Question 3

What is relevant information for outsourcing decisions?

Answer 3

1. Which costs differ between insourcing and outsourcing options?
   - Avoidable costs in our own production
   - Outside purchase price
   - Incremental profit of next-best use of freed-up capacity if we outsource
2. Other considerations in outsourcing decisions
   - Lower quality control with outsourcing
   - Deterioration in employee morale due to outsourcing
   - Dependence on supplier

Question 4

Name two decision rules under capacity constraints?

Answer 4

• Maximize production of product with the highest contribution margin per unit of the constraining resource (not highest contribution margin per unit of the product)
• Once demand for that product is satisfied, produce as many units as possible of the other product

Question 5

What are short run pricing decisions?

Answer 5

• Short-run pricing decisions have a time horizon of less than one year and include decisions such as pricing a one-time-only special order with no long-run implications

Question 6

Name two long-run approaches?

Answer 6

1. Market based
2. Cost based

Question 7

What are long-run pricing decisions?

Answer 7

• Long-run pricing is a strategic decision designed to build long-run relationships with customers based on stable and predictable prices

Question 8

What is a market based long-run approach?

Answer 8

• Given what customers want and how competitors will react to what we do, what price should we charge
• Cost-leader usually sets the price, little price-discretion to firms

Question 9

What is a cost-based long-run pricing approach?

Answer 9

• Given what it costs us to make this product, what price should be charged to recoup costs and achieve a target return in investment?
• Firms determine costs to produce and sell the product
   Identify and charge reasonable markup
   Adjust markup as needed in response to market forces

Question 10

What are the 4 steps of target costing?

Answer 10

1. Determine price
2. Determine margin
3. Determine target cost (price – margin = target cost)
4. Adapt product design and production to stay within target cost

Question 11

What is cost-based pricing?

Answer 11

• Involves totaling costs of providing a product
• Then adding percentage to derive a selling price

Question 12

What are the four steps of cost-based (cost-plus) pricing?

Answer 12

1. Determine costs to produce and sell product
2. Identify reasonably return / markup
3. Add markup to the cost
4. Adjust markup as needed in response to market forces