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Introduction to Management Accounting

Chapter 5
Relevant Information for
Decision Making with a Focus
on Pricing Decisions

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
Managers 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.

Accuracy and Relevance

In the best of all possible worlds,
information used for decision
making would be perfectly
relevant and accurate.

Accuracy and Relevance The degree to which information is relevant or precise often depends on the degree to which it is: Qualitative Quantitative .

000.Relevance of Alternate Income Statements Cordell Company makes and sells 1.000 . or $30 per unit.000 Direct-labor costs are $ Total manufacturing cost is $30.000. Direct Material Costs are $14.000 seat covers.

sandpaper Materials-handling labor (forklift operators) Repairs on manufacturing equipment Power for factory Schedule 2: Fixed Costs Managers’ salaries in factory Factory employee training Factory picnic and holiday party Factory supervisory salaries Depreciation.400 3.000 $10.800 400 200 $ 400 180 20 1.600 300 100 $ 4.000 .Cordell Company Schedule 1: Variable Costs (in thousands of dollars) Supplies (lubricants. plant and equipment Property taxes on plant Insurance on plant Total indirect manufacturing costs $ 600 2. expendable tools.000 $ 6. coolants.

800 $ 2.Cordell Company Schedule 3: Selling Expenses (in thousands of dollars) Variable Sales Commission Shipping Expenses for products sold Fixed Advertising Sales salaries Other Total Selling Expenses Schedule 4: Administrative Expenses Variable Some clerical wages Computer time rented Fixed Office supplies Other salaries Depreciation on office facilities Public accounting fees Legal fees Other Total indirect manufacturing costs $1.400 2.000 .000 $4.000 600 $160 40 200 400 200 80 200 720 $2.400 600 $1.000 $200 1.000 $6.

000 10.000 2.000 $2.000 $ 14.000 .Absorption Approach Sales (in thousands of dollars) Less: Manufacturing costs of good sold Direct Materials Direct Labor Indirect Manufacturing (Schedule 1 plus 2) Gross Margin or Gross Profit Selling expenses (Schedule 3) Administrative expenses (Schedule 4) Total selling and administrative expenses Operating income $40.000 8.000 30.000 10.000 6.000 $ 6.

800 26.000 units) Less: Variable expenses Manufacturing Selling and administrative Contribution margin Less: Fixed expenses Manufacturing Selling and administrative Operating income $40.800 11.Contribution Approach Cordell Company Contribution Form of the Income Statement Sales (1.000 2.000 $24.000.000 5.000 .200 $13.200 $ 6.800 $ 2.

000.000 seat covers. Cordell is offered a special order of $26 per unit for 100. or $30 per unit. Total manufacturing cost is $30.Special Sales Orders Cordell Company makes and sells 1. .000.000.000 units.

would not affect Cordell’s regular business. 3. 2.Special Sales Order Accepting the special order: 1. would not require additional variable selling and administrative expenses. 4. . would use some otherwise idle manufacturing capacity. would not affect total fixed costs. 5. would not raise any antitrust issues.

000 ÷ 1. at a rate of $24 per unit ($24. All other variable costs and all fixed costs are unaffected and thus irrelevant. .000.Special Sales Order Only variable manufacturing costs are affected by this particular order.000 units).000.

Special Sales Order Special order sales price/unit Increase in manufacturing costs/unit Additional operating profit/unit $26 24 $ 2 Based on the preceding analysis.000 additional profit . should Cordell accept the order? $2 × 100.000 = $200.

000 $26 Sales Less: Variable expenses Manufacturing Selling and administrative Total variable expenses Contribution margin Less: Fixed expenses Manufacturing Selling and administrative Total fixed expenses Operating income $24.200.600.100.200.800.000 $ 200. 2007 (000) Without Effect of special order special order 1.000 $24 With special order 1.000 11.000 $6.000 $2.400.000 $14.000.800.000 $ 2.000 $2.000 units $42.800.000 2.000 units Total Per Unit $40.400.Special Sales Order Cordell Company Contribution Form of the Income Statement For the Year Ended December 31.000.000 $2.000 .600.200.000 $13.000 $2.000 5.400.000.000 $28.800.000 11.000 2.000 5.800.000 $ 6.000 $26.000.600.000.000.

As against the current price of Rs.1. The factory is currently operating at 60% level to meet its domestic demand.4. Order cannot be accepted in part.70 per unit which is less than the total cost of current production. The condition of the export order is that it has to be accepted in full. The cost break down is given below: Direct material Direct Labour Variable expenses Fixed expenses Total cost Rs.Example: Pieco Engineering company has received at once –off export order for its sole product that would require the use of half of the factory’s total capacity of 4 lakh units per annum.00 per unit Rs.00 per unit Rs.00 per unit The company has three options except for rejecting the offer: i.5. Accept the export order and cut back the domestic sales as necessary.00 per unit.2.6.50 per unit Rs.1. the export order offer is Rs.0.50 per unit Rs. .

This will increase fixed overheads by Rs.15.000 Option III: Appoint a sub-contractor to manufacture the additional requirement and meet the domestic and export requirement in full by supplying the raw materials. paying a conversion charge @ Rs.000 annually and additional amount of overtime work would amount to Rs.2.Option II: Remove the capacity constraint by installing necessary balancing equipment and also by working overtime to meet both domestic as well as export demand.000 per month for checking the quality of the product and controlling operations at the manufacturing unit.40.00 per unit and appointing a supervisor at a salary of Rs.3. .

Setting the price of products sold under private labels 3. Responding to a new price of a competitor 4. Setting the price of a new or refined product 2. Pricing bids in both sealed and open bidding situations .Pricing Decisions 1.

The Concept of Pricing In perfect competition. Marginal cost is the additional cost resulting from producing and selling one additional unit. all competing firms sell the same type of product at the same price. . Marginal revenue is the additional revenue resulting from the sale of one additional unit.

The Concept of Pricing In imperfect competition. Price elasticity is the effect of price changes on sales volume. 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. .

Pricing and Accounting Accountants seldom compute marginal revenue curves and marginal cost curves. not the range of possible volumes. . They use estimates based on judgment. They examine selected volumes.

General Influences on Pricing in Practice Legal requirements Predatory pricing Discriminatory pricing Competitors’ actions Customer demands .

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. .

Target Sales Price 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 .

10 13.00 = 5.67% $ 3.00 .00 ($20.00) ÷ $12.10 ($20.67% 1.00 – $13.00 2.00 ($20.00 – $19.Relationships of Costs to Same Target Selling Prices Alternative Markup Percentage to Achieve Same Target Sales Price Target sales price Variable costs: Manufacturing Selling and administrative Unit variable cost Fixed costs: Manufacturing Selling and administrative Unit fixed costs (3) Full Costs Target operating income $20.26% $ 1.10) ÷ $13.00 – $12.00 = 66.00 $12.10 = 52.90 $19.00) ÷ $19.90 5.

Advantages of Contribution Margin Approach The contribution margin approach offers more detailed information. This approach is sensitive to cost-volume-profit relationships. . Target pricing with full costing presumes a given volume level. This approach allows managers to prepare price schedules at different volume levels.

In the long run. .Advantages of Absorption-Cost Approaches 1. a firm must recover all costs to stay in business. 4. It copes with uncertainty. It may indicate what competitors might charge. 2. 3. It meets the cost-benefit test.

6.Advantages of Absorption-Cost Approaches 5. It simplifies pricing decisions. It tends to promote price stability. . 7. It provides the most defensible basis for justifying prices to all interested parties.

Value engineering is a cost-reduction technique.Target Costing Target costing sets a cost before the product is created or even designed. Kaizen costing is the Japanese word for continuous improvement. used primarily during design. .

Target Costing Successful companies understand the market in which they operate and use the most appropriate pricing approach. .

Introduction to Management Accounting Chapter 6 Relevant Information for Decision Making with a Focus on Operational Decisions .

. Incremental cost are additional costs or reduced benefits generated by the proposed alternative. Incremental benefits are the additional revenues or reduced costs generated by the proposed alternative. Outlay. Differential revenue is the difference in total revenue between two alternatives.Opportunity. and Differential Costs Differential cost is the difference in total cost between two alternatives.

Outlay. An opportunity cost is the maximum available contribution to profit forgone (or passed up) by using limited resources for a particular purpose. and Differential Costs An incremental analysis is an analysis of the additional costs and benefits of a proposed alternative. An outlay cost requires a cash disbursement. .Opportunity.

Increase production of Peach juice 2. Nantucket Nectars has three alternatives: 1. Produce a new drink Papaya Mango . Sell the machine 3.Opportunity.000 and it is sitting idle. Outlay. and Differential Costs Nantucket Nectars has a machine for which it paid $100.

000 60.000 $ With a total outlay cost of $400.000 .Opportunity Cost Peach Juice Contribution margin is $60. Sell machine for $50.000 $ 40.000 400.000. Revenue Costs: Outlay Costs Financial benefit before opportunity costs Opportunity cost of machine Net financial benefit $500. Produce Papaya Mango juice with projected sales of $500.

.Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier.

000 40.000 20.02 .06 .000 $200.20 .08 $.000 $.04 .000 80.Make or Buy Decisions Nantucket Nectars Company’s Cost of Making 12ounce Bottles Direct material Direct labor Variable factory overhead Fixed factory overhead Total costs $ 60.

If the company buys the bottles. Should Nantucket make or buy the bottles? .000 of fixed overhead would be eliminated. $50.Make-or-Buy Example Another manufacturer offers to sell Nantucket the bottles for $.18.

18 0 $180.06 .000 40.02 .Relevant Cost Comparison Buy Make Total Purchase cost Direct material Direct labor Variable overhead Fixed OH avoided by not making Total relevant costs Difference in favor of making Per Bottle $ 60.000 20.17 $ 10.01 Total Per Bottle $180.05 $.000 $.000 $.18 .000 0 $.04 50.000 $170.000 .000 $.

000. What are the alternatives? .000.Make or Buy and the Use of Facilities Suppose Nantucket can use the released facilities in other manufacturing activities to produce a contribution to profits of $55. or can rent them out for $25.

Make or Buy and the Use of Facilities (000) Make Buy and leave facilities idle Rent revenue Contribution from other products Variable cost of bottles Net relevant costs $ — $ — $ 25 $ — — (170) $(170) — (180) $(180) — (180) $(155) 55 (180) $(125) Buy and rent out facilities Buy and use facilities for other products .

Unavoidable costs are costs that continue even if an operation is halted. .Avoidable and Unavoidable Costs Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Common costs are costs of facilities and services that are shared by users.

Department Store Example Consider a discount department store that has three major departments: Groceries General merchandise Drugs .

000 $800 $100 800 560 60 $ 200 (20%) $240 (30%) $ 40 (40%) $1.420 $ 480 $ 150 60 $ 210 (10) $ $100 100 $200 $ 40 $ 15 20 $ 35 $ 5 $ $ 265 180 445 35 .900 1.Department Store Example Departments Groceries Sales Variable expenses Contribution margin Fixed expenses: Avoidable Unavoidable Total fixed expenses Operating income ($000) General Mdse. Drugs Total $1.

Department Store Example Assume that the only alternatives to be considered are dropping or continuing the grocery department. Assume further that the total assets invested would be unaffected by the decision. which has consistently shown an operating loss. . The vacated space would be idle and the unavoidable costs would continue.

900 1.000 800 $ 200 150 $900 620 $280 115 $ 215 180 $ 35 $ $165 180 $ (15) $ 50 0 50 Total After Change .Department Store Example Store as a Whole ($000) Sales Variable expenses Contribution margin Avoidable fixed expenses Profit contribution to common space and other unavoidable costs Unavoidable expenses Operating income Total Before Change Effect of Dropping Groceries $1.420 $ 480 265 $1.

Department Store Example Assume that the store could use the space made available by the dropping of groceries to expand the general merchandise department.000. .000. generate a 30% contribution-margin. This will increase sales by $500. and have avoidable fixed costs of $70.

420 Contribution margin $ 480 Avoidable fixed expenses 265 Profit contribution to common space and other unavoidable costs $ 215 Unavoidable expenses 180 Operating income $ 35 $1.900 Variable expenses 1.000 800 $ 200 150 $ $ 50 0 50 $500 350 $150 70 $1.400 970 $ 430 185 $80 0 $80 $245 180 $ 65 .Department Store Example Store as a Whole ($000) Total Expand Total Before Drop General After Change Groceries Merchandise Change Sales $1.

500 4.000 3.25 5 2.00 1.50 2.00 3.500 1.500 3. which product should get the priority? .500 1.600 2. Of raw material is available per annum.50 0.50 0.000 1.000 Kgs. B 1.000 units.25 8 3 E 2.200 2.50 2 If raw material is the scarce resource and only 5. By examining the following information and assuming the total demand for five units is limited to 7.00 2.25 1.00 2 Products C D 2.00 0.00 1.75 0.000 2. show which product(s) is/are to be chosen so that profit can be maximized.50 1.500 1. A Demand (units) Last years sales Selling price per unit Marginal cost per unit Contribution per unit Raw material required in Kgs.Optimal Use of Limited Resources A firm manufactures five products using the same raw material.

Optimal Use of Limited Resources A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. .

and the maximum capacity is 10.Optimal Use of Limited Resources Nike produces two different athletic shoes. . Air Court and Air Max. These are produced by one production facility. Assume that the capacity of the facility is determined by machine time. The facility can produce 10 pairs of Air Court Shoes or 5 pairs of Air Max shoes per hour.000 machine hours.

Optimal Use of Limited Resources Selling price per pair Variable costs per pair Contribution margin per pair Contribution margin ratio Air Court Air Max $80 60 $20 25% $120 84 $ 36 30% .

Optimal Use of Limited Resources Which is more profitable? If the limiting factor is demand. that is. the more profitable product is Air Max. . pairs of shoes.

The sale of a pair of Air Max shoes adds $36 to profit. The sale of a pair of Air Court shoes adds $20 to profit. .Optimal Use of Limited Resources Air Max is the product with the higher contribution per unit.

capacity is the limiting factor. Which is more profitable? If the limiting factor is capacity. .Optimal Use of Limited Resources Suppose that demand for either shoe would fill the plant’s capacity. Now. the more profitable product is Air Court.

000 hours = $2.000 contribution Air Max: $36 contribution margin per pair × 10.000.000 hours = $1.800.Optimal Use of Limited Resources Air Court $20 contribution margin per pair × 10.000 contribution .

Optimal Use of Limited Resources In retails stores. the limiting factor is often floor space. The focus is on products taking up less space or on using the space for shorter periods of time. . Retail stores seek faster inventory turnover (the number of times the average inventory is sold per year).