CMA Part 2 Financial Decision Making. Study Unit 9 - Decision Analysis and Risk Management Ronald Schmidt, CMA, CFM

Transcription

1 CMA Part 2 Financial Decision Making Study Unit 9 - Decision Analysis and Risk Management Ronald Schmidt, CMA, CFM

2 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

3 SU 9.1 Decision Making: Applying Marginal Analysis 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 = incremental cost of an additional unit of output is the same. Outside range incremental cost change. Be careful using UNIT revenue and cost Emphasis to be on TOTAL relevant revenues and costs

4 SU 9.1 Decision Making: Applying Marginal Analysis Marginal / Differential / Incremental Analysis Problem in CMA will be an evaluation of choices among courses of action What are the relevant and irrelevant costs? Quantitative analysis = ways in which revenues and costs vary with the option chosen. Focus on incremental rev & costs, not total rev & cost Example page 347 idle capacity (incremental impact) Compare Marginal revenue / Marginal Cost (contribution Margin) Fixed costs have already been absorbed

5 SU 9.1 Decision Making: Applying Marginal Analysis Qualitative Factors to consider: - Pricing rules - Government Regulation - Cannibalization between products (stealing market share from yourself) - Outsourcing - Employee Morale

6 SU 9.1 Decision Making: Applying Marginal Analysis 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 of the asset = economic value. If not revalue use market fair value and not carrying amount Cost of idle capacity is relevant cost. Special Orders when excess capacity No opportunity costs Accept order = Variable costs (Contribution Margin)

7 SU 9.1 Practice Question 1 The cost incurred by Gleason for the market study is a(n) A Incremental cost. B Prime cost. C Opportunity cost. D Sunk cost.

8 SU 9.1 Practice Question 1 Answer Correct Answer: D A sunk cost is a previously incurred cost that is the result of a past irrevocable management decision. Nothing can be done in the future about sunk costs. The market study cost is an example.

9 SU 9.1 Practice Question 2 Assuming that Gleason elects to produce the frozen dessert, the profit that would have been earned on the breakfast rolls is a(n) A Deferrable cost. B Sunk cost. C Avoidable cost. D Opportunity cost.

10 SU 9.1 Practice Question 2 Answer Correct Answer: D An opportunity cost is the maximum return that could have been earned on the next best alternative use of a resource. In this case, the lost profit on the rolls is an opportunity cost.

11 SU 9.1 Practice Question 3 If Hermo decides to supply power to Quigley, it wants to be compensated for the decrease in the life of the plant and the appropriate variable costs. Hermo has decided that the charge for the decreased life should be based on the original cost of the plant calculated on a straight-line basis. The minimum annual amount that Hermo would charge Quigley would be A $450,000 B $630,000 C $990,000 D Some amount other than those given.

12 SU 9.1 Practice Question 3 Answer Correct Answer: B The minimum charge would include any variable costs incurred plus depreciation on a straight-line basis. Currently, variable costs are $360,000 at 60% of capacity ($1,800,000 20%). If Quigley purchases energy equal to an additional 30% of capacity, it can be assumed that the increase in total variable costs will be half of the variable costs for 60% of capacity, or $180,000. Also, allocating $21,000,000 over 14 years results in an annual depreciation of $1,500,000. Of this amount, 30% will relate to the capacity sold. Thus, the depreciation charge to Quigley is $450,000 ($1,500,000 30%). The total charge is $630,000 ($450,000 depreciation + $180,000 VC).

13 SU Decision Making Special Orders Special Orders when excess capacity exists Differential (marginal or incremental) cost must be considered. Page 348 Special Orders when no excess capacity exists Differential (marginal or incremental) cost must be considered. Page 349

14 SU 9.2 Practice Question 1 Production of a special order will increase gross profit when the additional revenue from the special order is greater than A The direct materials and labor costs in producing the order. B The fixed costs incurred in producing the order. C D The indirect costs of producing the order. The marginal cost of producing the order.

15 SU 9.2 Practice Question 1 Answer Correct Answer: D Gross profit will increase if the incremental or marginal cost of producing the order is less than the marginal revenue. Marginal cost equals the relevant variable costs assuming fixed costs are not affected by the special order.

16 SU 9.2 Practice Question 2 When considering a special order that will enable a company to make use of currently idle capacity, which of the following costs is irrelevant? A Materials. B Depreciation. C Direct labor. D Variable overhead.

17 SU 9.2 Practice Question 2 Answer Correct Answer: B Because depreciation will be expensed whether or not the company accepts the special order, it is irrelevant to the decision. Only the variable costs are relevant.

18 SU 9.2 Practice Question 3 Which of the following cost allocation methods is used to determine the lowest price that can be quoted for a special order that will use idle capacity within a production area? A B C D Job order. Process. Variable. Standard.

19 SU 9.2 Practice Question 3 Answer Correct Answer: C If idle capacity exists, the lowest feasible price for a special order is one covering the variable cost. Variable costing considers fixed cost to be a period cost, not a product cost. Fixed costs are not relevant to short-term inventory costing with idle capacity because the fixed costs will be incurred whether or not any production occurs. Any additional revenue in excess of the variable costs will decrease losses or increase profits.

20 SU Decision Making Make or Buy Make or Buy = insourcing or outsourcing (critical mass) Not enough capacity Outsource least efficient product Support services can be outsourced. Consider relevant costs to the investment decision Key variable is total relevant costs, not all total costs. Sunk cost & Costs that do not change between choices are irrelevant. Opportunity costs are considered when at full capacity. Capacity constraint Use marginal analysis maximize CM Product Mix Sell-or-Process Further Decisions sell at split off point or process Joint cost of product is irrelevant. Based on relationship between incremental cost and revenue

21 SU 9.3 Practice Question 1 A company s approach to an insourcing vs. outsourcing decision A Depends on whether the company is operating at or below normal volume. B Involves an analysis of avoidable costs. C Should use absorption (full) costing. D Should use activity-based costing.

22 SU 9.3 Practice Question 1 Answer Correct Answer: B Available resources should be used as efficiently as possible before outsourcing. If the total relevant costs of production are less than the cost to buy the item, it should be produced inhouse. The relevant costs are those that can be avoided.

23 SU 9.3 Practice Question 2 In a make-versus-buy decision, the relevant costs include variable manufacturing costs as well as A B C D Factory management costs. General office costs. Avoidable fixed costs. Depreciation costs.

24 SU 9.3 Practice Question 2 Answer Correct Answer: C The relevant costs in a make-versus-buy decision are those that differ between the two decision choices. These costs include any variable costs plus any avoidable fixed costs. Avoidable fixed costs will not be incurred if the buy decision is selected.

25 SU 9.4 Decision Making Other Situations Capacity Constraints and Product Mix Maximize the contribution margin per unit of the constrained resource. Can be difficult with multiple constraints and requires linear programing to solve. Sell-or-Process-Further Decisions Determine whether to sell product at the split-off point or process further Decision is based on difference between incremental cost and incremental revenue

26 SU 9.4 Practice Question 1 When a multiproduct plant operates at full capacity, quite often decisions must be made as to which products to emphasize. These decisions are frequently made with a short-run focus. In making such decisions, managers should select products with the highest A B C D Sales price per unit. Individual unit contribution margin. Sales volume potential. Contribution margin per unit of the constraining resource.

27 SU 9.4 Practice Question 1 Answer Correct Answer: D In the short run, many costs are fixed. Hence, contribution margin (revenues all variable costs) becomes the best measure of profitability. Moreover, certain resources are also fixed. Accordingly, when deciding which products to produce at full capacity, the criterion should be the contribution margin per unit of the most constrained resource. This approach maximizes total contribution margin.

28 SU 9.4 Practice Question 2 In joint-product costing and analysis, which one of the following costs is relevant when deciding the point at which a product should be sold to maximize profits? A B C Separable costs after the split-off point. Joint costs to the split-off point. Sales salaries for the period when the units were produced. D Purchase costs of the materials required for the joint products.

29 SU 9.4 Practice Question 2 Answer Correct Answer: A Joint products are created from processing a common input. Joint costs are incurred prior to the split-off point and cannot be identified with a particular joint product. As a result, joint costs are irrelevant to the timing of sale. However, separable costs incurred after the split-off point are relevant because, if incremental revenues exceed the separable costs, products should be processed further, not sold at the split-off point.

30 SU 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

31 SU 9.5 Practice Question 1 If the coefficient of elasticity is zero, then the consumer demand for the product is said to be A Perfectly inelastic. B Perfectly elastic. C Unit inelastic. D Unit elastic.

32 SU 9.5 Practice Question 1 Answer Correct Answer: A When the coefficient of elasticity (percentage change in demand/change in price) is less than one, demand is inelastic. When the coefficient is zero, the demand is perfectly inelastic.

33 SU 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 & Mix Relevant cost Strategy Capacity

34 SU Pricing Theory External Factors Type of market (pure competition, monopolistic, oligopolistic or monopoly) Customer perceptions of price and value Price / demand relationship Competitors products, costs, prices and amount supplied. Timing of demand Cartels = illegal practice except in international markets Cartel = collusive oligopoly restrict output, charge higher $$

35 SU Pricing Theory Cost-based pricing differs from Target pricing (page 358) 4 basic formulas Target pricing Life cycle costing Market-based pricing What consumer will pay Competition-based pricing Going rate & Sealed bids New product pricing Skimming & Penetration pricing Pricing by intermediaries Markups & downs Price adjustments Geographical pricing Discounts & Allowances Discriminatory pricing Psychological pricing Promotional pricing Value Pricing International pricing

36 SU Pricing Theory Product-mix pricing Product line Optional product Captive product By-product Product bundle Illegal pricing Pricing products below cost Price discrimination among customers Collusive pricing Dumping

37 SU Pricing Theory Exercise page 376 Questions 10 to 12

38 SU 9.6 Practice Question 1 Several surveys point out that most managers use full product costs, including unit fixed costs and unit variable costs, in developing cost-based pricing. Which one of the following is associated with cost-based pricing? A B C D Price stability. Price justification. Target pricing. Fixed-cost recovery.

39 SU 9.6 Practice Question 1 Answer Correct Answer: C A target price is the expected market price of a product, given the company s knowledge of its customers and competitors. Hence, under target pricing, the sales price is known before the product is developed. Subtracting the unit target profit margin determines the long-term unit target cost. If cost-cutting measures do not permit the product to be made at or below the target cost, it will be abandoned.

40 SU 9.6 Practice Question 2 If a U.S. manufacturer s price in the U.S. market is below an appropriate measure of costs and the seller has a reasonable prospect of recovering the resulting loss in the future through higher prices or a greater market share, the seller has engaged in A Collusive pricing. B Dumping. C Predatory pricing. D Price discrimination.

41 SU 9.6 Practice Question 2 Answer Correct Answer: C Predatory pricing is intentionally pricing below cost to eliminate competition and reduce supply. Federal statutes and many state laws prohibit the practice. The U.S. Supreme Court has held that pricing is predatory when two conditions are met: (1) The seller s price is below an appropriate measure of its costs, and (2) it has a reasonable prospect of recovering the resulting loss through higher prices or greater market share.

42 SU 9.6 Practice Question 3 Which one of the following will occur in an organization that gives managers throughout the organization maximum freedom to make decisions? A B C D Individual managers regarding the managers of other segments as they do external parties. Two divisions of the organization having competing models that aim for the same market segments. Delays in securing approval for the introduction of new products. Greater knowledge of the marketplace and improved service to customers.

43 SU 9.6 Practice Question 3 Answer Correct Answer: C Decentralization is beneficial because it creates greater responsiveness to the needs of local customers, suppliers, and employees. Managers at lower levels are more knowledgeable about local markets and the needs of customers, etc. A decentralized organization is also more likely to respond flexibly and quickly to changing conditions, for example, by expediting the introduction of new products. Furthermore, greater authority enhances managerial morale and development. Disadvantages of decentralization include duplication of effort and lack of goal congruence.

44 SU 9.6 Practice Question 4 A proposed transfer price may be based upon the outlay cost. Outlay cost plus opportunity cost is the A B C D Retail price. Price representing the cash outflows of the supplying division plus the contribution to the supplying division from an outside sale. Price usually set by an absorption-costing calculation. Price set by charging for variable costs plus a lump sum or an additional markup, but less than full markup.

45 SU 9.6 Practice Question 4 Answer Correct Answer: B At this price, the supplying division is indifferent as to whether it sells internally or externally. Outlay cost plus opportunity cost therefore represents a minimum acceptable price for a seller. However, no transfer price formula is appropriate in all circumstances.

46 SU 9.7 Pricing - Calculations

47 SU 9.7 Practice Question 1 Finn Products, a start-up company, wants to use cost-based pricing for its only product, a unique new video game. Finn expects to sell 10,000 units in the upcoming year. Variable costs will be $65 per unit and annual fixed operating costs (including depreciation) amount to $80,000. Finn s balance sheet is as follows: If Finn wants to earn a 20% return on equity, at what price should it sell the new product? A $75.00 B $78.60 C $79.00 D $81.00

48 SU 9.7 Practice Question 1 Answer Correct Answer: C The net income Finn will require is calculated as follows: Return on equity = Net income Equity Net income = Equity Return on equity = $300,000 20% = $60,000 The necessary selling price can then be derived: Net income = [(Selling price Variable costs) Units sold] Fixed costs Selling price = (Net income + Fixed costs + Variable costs) Units sold = ($60,000 + $80,000 + $650,000) 10,000 = $790,000 10,000 = $79 per unit

49 SU 9.7 Practice Question 2 Leader Industries is planning to introduce a new product, DMA. It is expected that 10,000 units of DMA will be sold. The full product cost per unit is $300. Invested capital for this product amounts to $20 million. Leader s target rate of return on investment is 20%. The markup percentage for this product, based on operating income as a percentage of full product cost, will be A 42.9% B 57.1% C 133.3% D 233.3%

50 SU 9.7 Practice Question 2 Answer Correct Answer: C Leader s required return is $4,000,000 ($20,000,000 invested capital 20%). Full product costs amount to $3,000,000 (10,000 units $300). The markup percentage on DMA is therefore 133.3% ($4,000,000 $3,000,000).

51 SU Risk Management 4 Types of Risk: Hazard risks insurable Financial risks interest rates Operational risks procedural failure Strategic risks global, political and regulatory Volatility and Time Capital adequacy = solvency (cash flows) / liquidity (reserves) Risk = severity of consequences + likelihood of occurrence 5 strategies for Risk response: Risk avoidance End the activity that establishes the risk Risk retention Acceptance of risk. Self insurance Risk reduction - Mitigation Risk sharing Moving risk to 3 rd party Insurance, hedging, JV Risk exploitation Deliberately entering to pursue high return.

52 SU Risk Management Residual risk The risk that remains after the effects of avoidance, sharing, or mitigation efforts. Inherent risk The risk that arises for the activity itself. 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 Risk appetite

53 SU Risk Management Hazard risk management Insurance Financial risk management Hedging Sinking funds Rigid policies (maturity matching) Qualitative risk assessment tools Identification Ranking Mapping Quantitative risk assessment tools Value at risk (VaR) Page 364

54 SU Risk Management

55 SU 9.8 Practice Question 1 The risk associated with a project will increase in direct proportion to all of the following the: A Duration of the project. B Volatility of the cash flows associated with the project. C Uncertainty surrounding the impact of Federal regulation on the project. D Capital adequacy of the organization.

56 SU 9.8 Practice Question 1 Answer Correct Answer: D Capital adequacy is a term normally used in connection with financial institutions. A bank must be able to pay those depositors that demand their money on a given day and still be able to make new loans. Capital adequacy can be discussed in terms of solvency (the ability to pay longterm obligations as they mature), liquidity (the ability to pay for day-to-day ongoing operations), reserves (the specific amount a bank must have on hand to pay depositors), or sufficient capital.

57 SU 9.8 Practice Question 2 All of the following are potential benefits of risk management A Lower cost of capital. B Efficient allocation of resources. C Flexibility in responding to unforeseen circumstances. D Reduced inherent risk.

58 SU 9.8 Practice Question 2 Answer Correct Answer: D Inherent risk is the risk of an activity that arises from the activity itself. For example, uranium prospecting is inherently riskier than retailing.

59 SU 9.8 Practice Question 3 Which one of the following calculations does employ statistical techniques such as the normal distribution? A Cash flow at risk. B Earnings distribution. C Value at risk. D Capital adequacy.

60 SU 9.8 Practice Question 3 Answer Correct Answer: D Capital adequacy is a term normally used in connection with financial institutions. A bank must be able to pay those depositors that demand their money on a given day and still be able to make new loans. Capital adequacy can be discussed in terms of solvency (the ability to pay longterm obligations as they mature), liquidity (the ability to pay for day-to-day ongoing operations), reserves (the specific amount a bank must have on hand to pay depositors), or sufficient capital.