Chapter 5

Relevant Information and Decision Making

Pricing Decisions

Course: Management Accounting

Nguyen Tan Binh/Horngren Management Accounting 1

 Objectives
1. Discriminate between relevant and irrelevant information for
making decisions
2. Relevance of Alternative Income Statements
3. Use the decision process to make business decisions
4. Decide to accept or reject a special order using the contribution
margin technique
5. Decide to add or delete a product line using relevant information
6. Compute a measure of product profitability when production is
constrained by a scarce resource
7. Discuss the factors that influence pricing decisions in practice
8. Compute a target sales price by various approaches and
compare the advantages and disadvantages of these approaches
9. Use target costing to decide whether to add a new product
10. Understand how relevant information is used when making
marketing decisions

Nguyen Tan Binh/Horngren Management Accounting 2

The Concept of Relevance

What information is relevant?

It depends on the decision being made.

Decision making essentially involves

choosing among several courses of action.

Management Accounting 5-3

The Concept of Relevance (cont.)

What is the accountant’s role in decision making?

It is primarily that of a technical expert on

financial analysis

The accountant helps managers focus on the

relevant information

Nguyen Tan Binh/Horngren Management Accounting 5-4

Relevant Information

Relevant information is the predicted future

costs and sales that will differ among the
alternatives.

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Relevance of Alternative Income Statements

Example:
 Sadaco Wood Company makes and sells
1,000,000 desks.
 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

Nguyen Tan Binh/Horngren Management Accounting 5-6

Relevance of Alternative Income Statements (cont.)

Sadaco wood company

Items Total Per unit
Units (desks) 1,000,000
Manufacturing cost 30,000,000 30
Direct material costs 14,000,000
Direct-labor costs 6,000,000

Nguyen Tan Binh/Horngren Management Accounting 5-7

Relevance of Alternative Income Statements (cont.)
Schedules of Predicted Costs
Schedules of Predicted Costs (in 1,000 of dollars)
Schedule 1: Variable Costs
Supplies (woods, hardwares, sandpaper, varnishes) 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

Nguyen Tan Binh/Horngren Management Accounting 5-8

Relevance of Alternative Income Statements (cont.)
Schedules of Predicted Costs (cont.)
Schedule 3: Selling Expenses
Variable costs:
Sales Commission $1,400
Shipping Expenses for products sold 600 $2,000
Fixed costs:
Advertising $1,400
Sales salaries 2,000
Other 600 $4,000
Total Selling Expenses $6,000

Schedule 4: Administrative Expenses

Variable costs:
Some clerical wages $160
Computer time rented 40 $200
Fixed costs:
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

Nguyen Tan Binh/Horngren Management Accounting 5-9

Relevance of Alternative Income Statements (cont.)
Absorption vs. 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.

Nguyen Tan Binh/Horngren Management Accounting 5 - 10

Relevance of Alternative Income Statements (cont.)
Absorption Approach
Sadaco wood Company
Absorption Form of the Income Statement
For the Year Ended December 31, 2021

Sales (in 1,000 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

Nguyen Tan Binh/Horngren Management Accounting 5 - 11

Relevance of Alternative Income Statements (cont.)
Contribution Approach
Sadaco wood Company
Contribution Form of the Income Statement
For the Year Ended December 31, 2021

Sales (in 1,000 of dollars) $40,000

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

Nguyen Tan Binh/Horngren Management Accounting 5 - 12

Comparing Absorption and Contribution Approaches

The absorption approach separates manufacturing costs

from non-manufacturing costs. It deducts manufacturing
costs from sales to compute a gross margin and then
deducts non-manufacturing costs to measure
profit/operating income. [like financial accounting]

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/operating income. [like
management accounting]

Nguyen Tan Binh/Horngren Management Accounting 5 - 13

The Decision Process
(A) (B)
(1)
Historical Information Other Information

(2) Predictions as Inputs

Prediction Method to Decision Model

(3) Decisions by Managers

Decision Model with Aid of Decision Model

(4)
Implementation and Evaluation

Feedback

Nguyen Tan Binh/Horngren Management Accounting 5 - 14

The Decision Process (cont.)

Step 1
Gather relevant information using historical
accounting information and other information
from outside the accounting system

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The Decision Process (cont.)

Step 2
Using the information gathered in Step 1,
formulate predictions of expected future
revenues or costs

Step 3
The predictions formulated in Step 2
to the decision model

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The Decision Process (cont.)

Step 4
The decisions made by managers, with the
aid of the decision model, are implemented
and evaluated

Feedback is used to make future adjustments

to the decision process

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Decision Model Defined

A decision model is any method used

for making a choice, sometimes
requiring prepare quantitative
procedures.

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Accuracy and Relevance

In the best of all possible worlds,

information used for decision making
would be perfectly relevant and accurate

Nguyen Tan Binh/Horngren Management Accounting 5 - 19

Accuracy and Relevance

The degree to which information is

relevant or accurate often depends
on the degree to which it is...

Qualitative Quantitative

Nguyen Tan Binh/Horngren Management Accounting 5 - 20

Special Sales Order Example
 Solo Company is offered a special order of
$13 per unit for 100,000 units.
 Should Solo accept the order?
 The first step is to gather relevant
information from Solo Company’s financial
statements.

Nguyen Tan Binh/Horngren Management Accounting 5 - 21

Special Sales Order Example (cont.)
Solo company
Order:
Units 100,000
Price 13
Income statement, 31/12/2020 Units $per unit Amount
Sales (1,000,000 units) 1,000,000 20 20,000,000
Less: Variable costs
Manufacturing 12 12,000,000
Selling and administrative 1,100,000
Contribution margin 6,900,000
Less: Fixed costs
Manufacturing 3,000,000
Selling and administrative 2,900,000
Operating income 1,000,000

Nguyen Tan Binh/Horngren Management Accounting 5 - 22

Special Sales Order Example (cont.)
 Only variable manufacturing costs are
affected by the particular order, at a rate of
$12 per unit ($12,000,000 ÷ 1,000,000
units)
 All other variable costs and all fixed costs are
unaffected and thus irrelevant.

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Special Sales Order Example (cont.)

Special order sales price/unit $13

Increase in manufacturing costs/unit 12
Additional operating profit/unit $ 1

Based on the preceding analysis, should

Solo accept the order?

Nguyen Tan Binh/Horngren Management Accounting 5 - 24

 Avoidable and Unavoidable Costs

Avoidable costs are costs that will not continue

if an ongoing operation is changed or deleted.

Unavoidable costs are costs that continue even

if an operation is stopped.

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 Department Store Example

Consider a discount department store

that has three major departments:
1. Groceries
2. General merchandise
3. Drugs

Nguyen Tan Binh/Horngren Management Accounting 5 - 26

Department Store Example (cont.)
Department
(in thousand) Total
Groceries General Drugs
Sales 1,000 800 100 1,900
Variable costs 800 560 60 1,420
Contribution margin 200 240 40 480
Fixed costs:
Avoidable 150 100 15 265
Unavoidable 60 100 20 180
Total fixed cost 210 200 35 445
Operating income (10) 40 5 35

Nguyen Tan Binh/Horngren Management Accounting 5 - 27

Department Store Example (cont.)
 For this example, assume first that the only
alternatives to be considered are dropping or
continuing the grocery department, which
shows a loss of $10 (thousand).
 Assume further that the total assets invested
would be unaffected by the decision.
 The vacated space would be idle and the
unavoidable costs would continue.

Nguyen Tan Binh/Horngren Management Accounting 5 - 28

Dropping Products, Departments, Territories

Before Change Total

Sales 1,900
Variable expenses 1,420
Contribution margin 480
Avoidable fixed expenses 265
Contribution to common
215
space and unavoidable costs
Unavoidable fixed expenses 180
Operating income 35

Nguyen Tan Binh/Horngren Management Accounting 5 - 29

Dropping Products, Departments, Territories (cont.)

Effect of Dropping Groceries

Sales 1,000
Variable expenses 800
Contribution margin 200
Avoidable fixed expenses 150
Contribution to common
50
space and unavoidable cost

Nguyen Tan Binh/Horngren Management Accounting 5 - 30

Dropping Products, Departments, Territories (cont.)

After Change Total

Sales 900
Variable expenses 620
Contribution margin 280
Avoidable fixed expenses 115
Contribution to common
165
space and unavoidable costs
Unavoidable fixed expenses 180
Operating income (15)

Nguyen Tan Binh/Horngren Management Accounting 5 - 31

Dropping Products, Departments, Territories (cont.)

Total Less Total

INCOME STATEMENT
Before Groceries After
Sales 1,900 1,000 900
Variable expenses 1,420 800 620
Contribution margin 480 200 280
Avoidable fixed expenses 265 150 115
Contribution to common
215 50 165
space and unavoidable costs
Unavoidable fixed expenses 180 180
Operating income 35 (15)

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Optimal Use of Limited Resources
 A limiting factor or scarce resource restricts or
constrains the production or sale of a product or
service.
 The order to be accepted is the one that makes
the biggest total profit contribution per unit of
the limiting factor.

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 Product Profitability Example
Constrained by a Scarce Resource

 Assume that a company has two products:

 a plain cellular phone, and
 a fancier cellular phone with many special
features.
 Workers can make 3 plain phones in one
hour or 1 fancy phone

Nguyen Tan Binh/Horngren Management Accounting 5 - 34

 Product Profitability Example
Constrained by a Scarce Resource (cont.)

Phone Company Product

Per Unit Plain Fancy
Selling price 80 120
Variable costs 64 84
Contribution 16 36
Contribution ratio 20% 30%

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 Product Profitability Example
Constrained by a Scarce Resource (cont.)

Which product is more profitable?

If sales are restricted by demand for only
a limited number of phones, fancy
phones are more profitable. Why?

Because:
 The sale of a plain phone adds $16 to profit
 The sale of a fancy phone adds $36 to profit

Nguyen Tan Binh/Horngren Management Accounting 5 - 36

 Product Profitability Example
Constrained by a Scarce Resource (cont.)
 Now suppose annual demand for phones
of both types is more than the company
can produce in the next year
 Productive capacity is the limiting factor
because only 10,000 hours of capacity
are available
 Which product should the company
emphasize?

Nguyen Tan Binh/Horngren Management Accounting 5 - 37

 Product Profitability Example
Constrained by a Scarce Resource (cont.)

Plain phone:
$16 contribution margin per unit
× 3 units per hour = $48 per hour

Fancy phone:
$36 contribution margin per unit
× 1 unit per hour = $36 per hour

Nguyen Tan Binh/Horngren Management Accounting 5 - 38

 Pricing Decisions
Among the many pricing decisions to be made
are:
 setting the price of a new or refined product
 setting the price of products sold under
private labels
 responding to a new price of a competitor
 pricing bids in both sealed and open bidding
situations

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 The Concept of Pricing
In perfect competition, a firm can sell as much of
a product as it can produce, all at
a single market price
[sell the same type of product at the same price]

Marginal cost (MC) is the additional cost resulting

from producing one additional unit.

Marginal revenue (MR) is the additional revenue

resulting from the sale of one additional unit

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 The Concept of Pricing (cont.)

In imperfect competition, the price a firm

charges for a unit will influence the
quantity of units it sells.

Price elasticity is the effect of price changes

on sales volume.

The firm must reduce prices to generate

additional sales.

Nguyen Tan Binh/Horngren Management Accounting 5 - 41

 MR = MC and Maximize Profit
Price 131
Total Average Average Average Marginal Price = Total
product Fixed cost Variable cost Total cost cost Marginal Revenue Profit
(Output) (AFC) (AVC) (ATC) (MC) (MR) (Loss)
1 100.0 90.0 190 90 131 (59)
2 50.0 85.0 135 80 131 (8)
3 33.3 80.0 113 70 131 53
4 25.0 75.0 100 60 131 124
5 20.0 74.0 94 70 131 185
6 16.7 75.0 92 80 131 236
7 14.3 77.1 91 90 131 277
8 12.5 81.3 94 110 131 298
9 11.1 86.7 98 130 131 299
10 10.0 93.0 103 150 131 280

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 MR = MC and Maximize Profit (cont.)

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 An illustration for MR and MC
Total Revenue (TR) = P × Q [Price × Quantity]
Marginal revenue is another important measure. Marginal revenue is the revenue
obtained from the last unit sold. This is computed by taking the change in
total revenue divided by the change in quantity.

MR = Change in TR/Change in Q

For competitive firms, marginal revenue isn't very interesting. If all units are sold
for the market price, then marginal revenue will simply be the market price.
In the table below, you can see that the marginal revenue is constant for
all cakes sold-$6. From that information, and by remembering that we are talking
about a competitive market, we can easily tell that the market price for cakes is $6.
So the last cake will be sold for $6 as long as the market price remains constant.
Competitive firms have a constant MR curve.
A cake sold for $6 is $6 of additional revenue.

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 An illustration for MR and MC (cont.)
Price $6.0
Total Marginal Fixed Variable Total Average Marginal
Bakers Cakes
revenue Revennue cost cost cost Total cost cost
(Labor) (Q) (TR) (MR=TR/Q) (FC) (VC) (TC=FC+VC) (ATC=TC/Q) (MC=TC/Q)
1 20 120 6.00 200 50 250 12.50 2.56
2 38 228 6.00 200 100 300 7.89 2.78
3 56 336 6.00 200 150 350 6.25 2.78
4 73 438 6.00 200 200 400 5.48 2.94
6 104 624 6.00 200 300 500 4.81 3.23
8 132 792 6.00 200 400 600 4.55 3.57
10 158 948 6.00 200 500 700 4.43 3.85
13 191 1,146 6.00 200 650 850 4.45 4.55
16 220 1,320 6.00 200 800 1,000 4.55 5.17
20 250 1,500 6.00 200 1,000 1,200 4.80 6.67
25 277 1,662 6.00 200 1,250 1,450 5.23 9.26
30 300 1,800 6.00 200 1,500 1,700 5.67 10.87

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 An illustration for MR and MC (cont.)

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 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.

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 Influences on Pricing
Several factors interact to shape the market
in which managers make pricing decisions:
 legal requirements
 competitors’ actions
 customer demands

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 Role of Costs in Pricing Decisions

Two pricing approaches used by

companies are:
1. Cost-plus pricing
2. Target costing

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 Target Sales Price
There are four popular markup 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

Nguyen Tan Binh/Horngren Management Accounting 5 - 50

 Relationships of Costs to Same Target
Selling Prices
Target sales price $20.0
Variable costs:
Manufacturing 12.0
Selling and administrative 1.1
Unit variable cost 13.1
Fixed costs:
Manufacturing 3.0
Selling and administrative 2.9
Unit fixed costs 5.9
Target operating income 1.0
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 Relationships of Costs to Same Target
Selling Prices (cont.)

Markup percentages

Percentages of variable manufacturing costs:

($20.0 – $12.0) ÷ $12.0 = 66.7%
Percentages of total variable costs:
($20.0 – $13.1) ÷ $13.1 = 52.7%

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 Costing Techniques

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

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 Target Costing and
Cost-Plus Pricing Compared
 Suppose that ITT Automotive receives an
invitation to bid from Ford on the anti-lock
braking systems
 The current manufacturing cost is $154
 ITT Automotive’s desired gross margin
rate is 30% on sales (cost of good sold is
70% on sales)
 The market conditions have established a
sales price of $200 per unit

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 Target Costing and
Cost-Plus Pricing Compared (cont.)

What is the bid price using cost-plus pricing?

Bid price = Cost ÷ Cost % = $154 ÷ 0.7

Bid price = $220

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 Target Costing and
Cost-Plus Pricing Compared (cont.)

What is the bid price using target costing?

Target cost = Market price × Cost %

= $200 × 0.7

Target cost = $140

Bid price = Market price = $200

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 Marketing Decisions

Market Price = $200

Accountants and managers must have a thorough

understanding of relevant information, especially
costs, when making marketing decisions

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