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Chapter 5
Relevant Information for
Decision Making with a Focus
on Pricing Decisions
Decision Model
A decision model
may also be simple.
Qualitative
Quantitative
Cordell Company
Schedule 1: Variable Costs (in thousands of dollars)
Supplies (lubricants, expendable tools, coolants, 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, plant and equipment
Property taxes on plant
Insurance on plant
Total indirect manufacturing costs
$ 600
2,800
400
200
$ 400
180
20
1,400
3,600
300
100
$ 4,000
$ 6,000
$10,000
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
600
$1,400
2,000
600
$160
40
200
400
200
80
200
720
$2,000
$4,000
$6,000
$200
1,800
$ 2,000
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
$ 14,000
6,000
10,000
30,000
10,000
$ 6,000
2,000
8,000
$2,000
Contribution Approach
Cordell Company
Contribution Form of the Income Statement
Sales (1,000,000 units)
Less: Variable expenses
Manufacturing
Selling and administrative
Contribution margin
Less: Fixed expenses
Manufacturing
Selling and administrative
Operating income
$40,000
$24,000
2,200
$ 6,000
5,800
26,200
$13,800
11,800
$ 2,000
$26
24
$ 2
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
$24,000,000 $2,400,000
2,200,000
26,200,000 $2,400,000
$13,800,000 $ 200,000
$ 6,000,000
5,800,000
11,800,000
$ 2,000,000
$24
With
special order
1,100,000 units
$42,600,000
$26,400,000
2,200,000
$28,600,000
$14,000,000
$6,000,000
5,800,000
11,800,000
$2,200,000
Example:
Pieco Engineering company has received at once off export order for its sole product that
would require the use of half of the factorys total capacity of 4 lakh units per annum. The
condition of the export order is that it has to be accepted in full. Order cannot be accepted
in part.
The factory is currently operating at 60% level to meet its domestic demand. As against
the current price of Rs.6.00 per unit, the export order offer is Rs.4.70 per unit which is less
than the total cost of current production. The cost break down is given below:
Direct material
Direct Labour
Variable expenses
Fixed expenses
Total cost
The company has three options except for rejecting the offer:
i. Accept the export order and cut back the domestic sales as necessary.
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. This will increase
fixed overheads by Rs.15,000 annually and additional amount of overtime work would
amount to Rs.40,000
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.2.00 per unit and appointing a supervisor at a salary of Rs.3,000
per month for checking the quality of the product and controlling operations at the
manufacturing unit.
Pricing Decisions
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).
Relationships of Costs to
Same Target Selling Prices
Alternative Markup Percentage to
Achieve Same Target Sales Price
$20.00
$12.00 ($20.00 $12.00) $12.00 = 66.67%
1.10
13.10 ($20.00 $13.10) $13.10 = 52.67%
$ 3.00
2.90
5.90
$19.00 ($20.00 $19.00) $19.00 = 5.26%
$ 1.00
Target Costing
Target Costing
Opportunity Cost
Peach Juice Contribution margin is $60,000.
Revenue
Costs:
Outlay Costs
Financial benefit before opportunity costs
Opportunity cost of machine
Net financial benefit
$500,000
400,000
$100,000
60,000
$ 40,000
Make-or-Buy Decisions
Direct material
Direct labor
Variable factory overhead
Fixed factory overhead
Total costs
$ 60,000
20,000
40,000
80,000
$200,000
$.06
.02
.04
.08
$.20
Make-or-Buy Example
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
20,000
40,000
$.06
.02
.04
50,000
$170,000
.05
$.17
$ 10,000
$.01
Total
Per Bottle
$180,000
$.18
0
$180,000
0
$.18
(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
Groceries
General merchandise
Drugs
Departments
Groceries
Sales
Variable expenses
Contribution margin
Fixed expenses:
Avoidable
Unavoidable
Total fixed expenses
Operating income
($000)
General
Mdse.
Drugs
Total
$1,000
$800
$100
800
560
60
$ 200 (20%) $240 (30%) $ 40 (40%)
$1,900
1,420
$ 480
$ 150
60
$ 210
(10)
$100
100
$200
$ 40
$ 15
20
$ 35
$ 5
$
$
265
180
445
35
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
$1,900
1,420
$ 480
265
$1,000
800
$ 200
150
$900
620
$280
115
$ 215
180
$ 35
$165
180
$ (15)
50
0
50
Total
After
Change
Total
Expand
Total
Before
Drop
General
After
Change Groceries Merchandise Change
Sales
$1,900
Variable expenses
1,420
Contribution margin
$ 480
Avoidable fixed expenses 265
Profit contribution to
common space and
other unavoidable costs $ 215
Unavoidable expenses
180
Operating income
$ 35
$1,000
800
$ 200
150
$
$
50
0
50
$500
350
$150
70
$1,400
970
$ 430
185
$80
0
$80
$245
180
$ 65
B
1,500
1,500
4.00
3.00
1.00
2
Products
C
D
2,500
1,600
2,500
1,500
3.50
1.50
2.00
1.25
1.50
0.25
8
3
E
2,000
2,000
1.00
0.75
0.25
5
2,200
2,000
3.00
2.50
0.50
2
If raw material is the scarce resource and only 5,000 Kgs. Of raw material is available
per annum, which product should get the priority?
Air
Court
Air
Max
$80
60
$20
25%
$120
84
$ 36
30%
Air Court
$20 contribution margin per pair 10,000 hours
= $2,000,000 contribution
Air Max:
$36 contribution margin per pair 10,000 hours
= $1,800,000 contribution