Study Unit 9 Decision Analysis and Risk Management

Objectives of the Class 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&D, 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” 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) 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 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

Risk Management COSO Framework 4 Types of Risk: Hazard risks Financial risks Operational risks Strategic risks Capital adequacy = solvency (cash flows) / liquidity (reserves) Risk = severity of consequences + likelihood of occurrence 5 strategies for Risk response: Risk avoidance Risk retention Risk reduction Risk sharing Risk exploitation

Risk Management Residual risk vs. inherent risk Benefits: -Efficient use of resources -Fewer surprises -Reassuring investors 5 Key Steps in Risk Management Process 1/ Identify risks 2/ Assess risks 3/ Prioritize risks 4/ Formulate risk responses 5/ Monitor risk responses Value at risk (VaR) = normal distribution

COSO Framework 4 Risk Categories: -Strategic -Operational -Reporting -Compliance 8 Components of an ERM Program: -Internal Environment -Objective setting -Event identification -Risk assessment -Risk response -Control activities -Information and Communication -Monitoring