Managerial CH5

Copyright © 2014 Pearson Education 5-1
Chapter 5
Relevant Information for

Decision Making with a Focus
on Pricing Decisions

Chapter 5 Learning Objectives
When you have finished studying this chapter, you
should be able to:
1. Discriminate between relevant and irrelevant

information for making decisions.
2. Apply the decision process to make business

decisions.
3. Construct absorption and contribution-margin

income statements, and identify their relevance for
decision making.
4. Decide to accept or reject a special order using the

contribution-margin approach.
Chapter 5 Learning Objectives
5. Explain why pricing decisions depend on the

characteristics of the market.
6. Identify the factors that influence pricing decisions

in practice.
7. Compute a sales price by various methods, and

compare the advantages and disadvantages of these
methods.
8. Use target costing to decide whether to add a new

product.

Learning
Objective 1 The Concept of Relevance
Relevant information depends

on the decision being made.
Decision making is choosing

among several courses of action.
Relevant information is the predicted future costs

and revenues that differ among the alternatives.

The Concept of Relevance
Accountants should use two

criteria to determine whether
information is relevant:
1. Information must be an
expected revenue or cost and...
2. it must have an element of

difference among the alternatives.

Decision Model
A decision model is any

method used for making a
choice, sometimes requiring
elaborate quantitative
procedures. A decision model
may also be simple.
You will be able to focus on

relevant information—the
predicted future differences
between alternatives—in any
decision.

Learning Decision Process and Role of
Objective 2
Information
(1) Historical Other

(A) (B)
information information
(2) Predictions as inputs

Prediction method
to decision model
(3) Decisions by managers with

Decision model the aid of the decision model
(4) Implementation
and evaluation
Feedback
Accuracy and Relevance
In the best of all possible worlds,

information used for decision making
would be perfectly relevant and accurate.
The degree to which information is

relevant or precise often depends on the
degree to which it is:
Qualitative Quantitative
(Subjective) (Financial)

Learning Relevance of Alternate
Objective 3
Income Statements
Cordell Company makes and

sells 1,000,000 seat covers.
Total manufacturing cost is

$30,000,000, or $30 per unit.
Direct material costs are $14,000,000

Direct-labor costs are $6,000,000
Copyright © 2014 Pearson Education 5 - 10

Schedules of Predicted Costs
Schedule 1: Variable Costs (in thousands of dollars)

Supplies (lubricants, expendable tools, coolants, sandpaper) $ 600
Materials-handling labor (forklift operators) 2,800
Repairs on manufacturing equipment 400
Power for factory 200 $ 4,000
Schedule 2: Fixed Costs

Managers’ salaries in factory $ 400
Factory employee training 180
Factory picnic and holiday party 20
Factory supervisory salaries 1,400
Depreciation, plant, and equipment 3,600
Property taxes on plant 300
Insurance on plant 100 $ 6,000
Total indirect manufacturing costs $10,000

Schedules of Predicted Costs
Schedule 3: Selling Expenses (in thousands of dollars)
Variable
Sales Commission $1,400
Shipping Expenses for products sold 600 $2,000
Fixed
Advertising $1,400
Sales salaries 2,000
Other 600 $4,000
Total Selling Expenses $6,000
Schedule 4: Administrative Expenses

Variable
Some clerical wages $160
Computer time rented 40 $200
Fixed
Office supplies 200
Other salaries 400
Depreciation on office facilities 200
Public accounting fees 80
Legal fees 200
Other 720 1,800
Total indirect manufacturing costs $ 2,000

Absorption versus
Contribution Approach
Absorption costing considers all indirect

manufacturing costs (both variable and fixed)
to be product (inventoriable) costs that become
an expense in the form of manufacturing cost
of goods sold only as sales occur.
Contribution costing is an internal (management

accounting) reporting method that emphasizes
the distinction between variable and fixed costs
for the purpose of better decision making.

Absorption Approach
Cordell Company
Absorption Form of the Income Statement
For the Year Ended December 31, 20X1
Sales (in thousands of dollars) $40,000

Less: Manufacturing costs of good sold
Direct Materials $ 14,000
Direct Labor 6,000
Indirect Manufacturing (Schedule 1 plus 2) 10,000 30,000
Gross Margin or Gross Profit 10,000
Selling expenses (Schedule 3) $ 6,000
Administrative expenses (Schedule 4) 2,000
Total selling and administrative expenses 8,000
Operating income $2,000

Contribution-Margin Approach
Cordell Company
Contribution Form of the Income Statement
For the Year Ended December 31, 20X1
Sales (1,000,000 units) $40,000

Less: Variable expenses
Manufacturing $24,000
Selling and administrative 2,200 26,200
Contribution margin $13,800
Less: Fixed expenses
Manufacturing $ 6,000
Selling and administrative 5,800 11,800
Operating income $ 2,000

Comparing Absorption and
Contribution Approaches
The absorption approach separates manufacturing

costs from nonmanufacturing costs. It deducts
manufacturing costs from sales to compute a
gross margin and then deducts nonmanufacturing
costs to measure profit.
The contribution approach separates fixed costs

from variable costs. It deducts variable costs
from sales to compute a contribution margin and
then deducts fixed costs to measure profit.

Learning
Objective 4 Special Sales Orders
Cordell Company makes and

sells 1,000,000 seat covers.
Total manufacturing cost is

$30,000,000, or $30 per unit.
Cordell is offered a special order

of $26 per unit for 100,000 units.

Special Sales Order
Accepting the special order:
1. would not affect Cordell’s regular business.

2. would not raise any antitrust issues.
3. would not affect total fixed costs.
4. would not require additional variable selling and
administrative expenses.
5. would use some otherwise idle manufacturing capacity.

Special Sales Order
Only variable manufacturing costs are

affected by this particular order, at a rate of
$24 per unit ($24,000,000 ÷ 1,000,000 units).
All other variable costs and all fixed

costs are unaffected and thus irrelevant.

Special Sales Order
Special order sales price/unit $26

Increase in manufacturing costs/unit 24
Additional operating profit/unit $ 2
Based on the preceding analysis,

should Cordell accept the order?
$2 × 100,000 = $200,000 additional profit

Incorrect Analysis: Misuse of Unit Cost
Faulty cost analysis can occur by misinterpreting

unit fixed costs, especially with an absorption
approach. For instance, Cordell’s managers might
erroneously use the $30 @ unit manufacturing
cost under the absorption approach.

Incorrect Analysis: Misuse of Unit Cost
The incorrect prediction of a $3 million increase

in costs results from multiplying 100,000 units by
$30. The fallacy in this approach is that it treats
a fixed cost (fixed manufacturing cost) as if it
were variable.
Avoid the mistake of using total unit costs as a

basis for predicting how total costs will behave.
Unit costs are useful for predicting variable costs,
but can be misleading when used to predict fixed
costs.

Confusion of Variable and Fixed Costs
The typical cost accounting system serves

two purposes simultaneously:
(1) planning and control and
(2) product costing.
The total fixed cost for planning and control
purposes can be graphed as a lump sum:

Activity-Based Costing, Special Orders,
and Relevant Costs
Cordell examined its $24 million of variable

manufacturing costs and discovered two
significant activities and related cost drivers:
$21 million of processing activity that varies

directly with units produced ($14 million DM,
$6 million DL, and $1 million of variable MO)
at a rate of $21 per unit.
. . . and $3 million of setup activity that varies

with the number of production setups.
Confusion of Variable and Fixed Costs
For product-costing purposes, however, it is easy

to misinterpret the fixed unit manufacturing
cost—to act as if these fixed costs behave as if
they are variable costs, which is contrary to
fixed-cost behavior:

Activity-Based Costing, Special
Orders, and Relevant Costs
Assume that processing the additional

100,000 units will require only 5 set-ups.
What is the additional variable cost

using ABC costing?
Unit-based variable cost, 100,000 × $21 $2,100,000

Setup-based variable cost, 5 × $6,000 30,000
Total additional variable cost $2,130,000

Learning
Objective 5 Pricing Decisions
1. Setting the price of a new or refined product

2. Setting the price of products sold under
private labels
3. Responding to a new price of a competitor
4. Pricing bids in both sealed and open
bidding situations

The Concept of Pricing
In perfect competition, all competing

firms sell the same type of
product at the same price.
Marginal cost is the additional cost resulting

from producing and selling one additional unit.
Marginal revenue is the additional revenue

resulting from the sale of one additional unit.

The Concept of Pricing
In imperfect competition, the price a

firm charges for a unit will influence
the quantity of units it sells.
The firm must reduce prices

to generate additional sales.
Price elasticity is the effect of

price changes on sales volume.
Pricing and Accounting
Accountants seldom compute marginal

revenue curves and marginal cost curves.
They use estimates based on judgment.
They examine selected volumes,

not the range of possible volumes.

Learning
Objective 6 Influences on Pricing in Practice
Legal requirements provide

protection from:
Predatory pricing Discriminatory pricing
Competitors’ actions
Customer demands

Influences on Pricing in Practice –
Legal Requirements
Predatory pricing: Establishing prices so low

That they drive competitors out of the market.
The predatory pricer then has no significant
competition and can raise prices
dramatically.
Discriminatory pricing: Charging different

prices to different customers for the same
product or service.

Influences on Pricing in Practice -
Competitors’ Actions
Competitors usually react to the price changes

of their rivals. Companies gather information
regarding a rival’s capacity, technology, and
operating policies.
A manager’s expectations of competitors’

reactions and of the overall effects of price
changes on an industry’s demand heavily
influence pricing policies.

Influences on Pricing in Practice -
Customer Demands
Managers recognize the needs of customers, and

pricing is no exception.
If customers believe a price is too high, they

may turn to other sources for the product,
substitute a different product, or decide to
produce the item themselves.

Learning
Objective 7
Compute Sales Prices by Various
Approaches
To achieve a desired operating income,
managers will examine relationships of costs
to selling price and set formulas for pricing:
1) as a percentage of variable manufacturing costs
2) as a percentage of total variable costs
3) as a percentage of full costs
4) as a percentage of total manufacturing cost

Cost-Plus Pricing
Setting prices by computing an

average cost and adding a markup (the
amount by which sales price exceeds cost).
Target prices can be based on a host of

different markups that are in turn based
on a host of different definitions of cost.

Advantages of Contribution
Approach in Cost-Plus Pricing
The contribution margin approach

offers more detailed information.
This approach is sensitive to

cost-volume-profit relationships.

Advantages of Contribution
Approach in Cost-Plus Pricing
This approach allows managers to prepare

price schedules at different volume levels.
Target pricing with full costing

presumes a given volume level.

Advantages of Absorption-Cost
Approaches in Cost-Plus Pricing
1. In the long run, a firm must recover

all costs to stay in business.
2. It may indicate what

competitors might charge.
3. It meets the cost-benefit test.
4. It copes with uncertainty.

Advantages of Absorption-Cost
Approaches
5. Tends to promote price stability.
6. Provides the most defensible basis for

justifying prices to all interested parties.
7. Simplifies pricing decisions.

Learning
Objective 8 Target Costing
Target costing sets a cost before the

product is created or even designed.
Value engineering is a cost-reduction

technique, used primarily during design.
Kaizen costing is the Japanese

word for continuous improvement.
Target Costing
Use target costing to decide whether

to add a new product.
Successful companies understand

the market in which they operate
and use the most appropriate
pricing approach.

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Copyright © 2014 Pearson Education 5-1

Relevant Information for

Copyright © 2014 Pearson Education 5-2

1. Discriminate between relevant and irrelevant

2. Apply the decision process to make business

3. Construct absorption and contribution-margin

4. Decide to accept or reject a special order using the

5. Explain why pricing decisions depend on the

6. Identify the factors that influence pricing decisions

7. Compute a sales price by various methods, and

8. Use target costing to decide whether to add a new

Copyright © 2014 Pearson Education 5-4

Relevant information depends

Decision making is choosing

Relevant information is the predicted future costs

Copyright © 2014 Pearson Education 5-5

Accountants should use two

2. it must have an element of

Copyright © 2014 Pearson Education 5-6

A decision model is any

You will be able to focus on

Copyright © 2014 Pearson Education 5-7

(1) Historical Other

(2) Predictions as inputs

(3) Decisions by managers with

In the best of all possible worlds,

The degree to which information is

Copyright © 2014 Pearson Education 5-9

Cordell Company makes and

Total manufacturing cost is

Direct material costs are $14,000,000

Copyright © 2014 Pearson Education 5 - 10

Schedule 1: Variable Costs (in thousands of dollars)

Schedule 2: Fixed Costs

Total indirect manufacturing costs $10,000

Copyright © 2014 Pearson Education 5 - 11

Schedule 4: Administrative Expenses

Copyright © 2014 Pearson Education 5 - 12

Absorption costing considers all indirect

Contribution costing is an internal (management

Copyright © 2014 Pearson Education 5 - 13

Sales (in thousands of dollars) $40,000

Operating income $2,000

Copyright © 2014 Pearson Education 5 - 14

Sales (1,000,000 units) $40,000

Copyright © 2014 Pearson Education 5 - 15

The absorption approach separates manufacturing

The contribution approach separates fixed costs

Copyright © 2014 Pearson Education 5 - 16

Cordell Company makes and

Total manufacturing cost is

Cordell is offered a special order

Copyright © 2014 Pearson Education 5 - 17

Accepting the special order:

1. would not affect Cordell’s regular business.

Copyright © 2014 Pearson Education 5 - 18

Only variable manufacturing costs are

All other variable costs and all fixed

Copyright © 2014 Pearson Education 5 - 19

Special order sales price/unit $26

Based on the preceding analysis,

$2 × 100,000 = $200,000 additional profit

Copyright © 2014 Pearson Education 5 - 20

Faulty cost analysis can occur by misinterpreting