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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

Relevance of Alternate 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

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

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 Cordells 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


Increase in manufacturing costs/unit
Additional operating profit/unit

$26
24
$ 2

Based on the preceding analysis,


should Cordell accept the order?

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

Special Sales Order


Cordell Company
Contribution Form of the Income Statement
For the Year Ended December 31, 2007 (000)
Without
Effect of
special order
special order
1,000,000 units Total
Per Unit
$40,000,000 $2,600,000
$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

$24,000,000 $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

Rs.2.50 per unit


Rs.1.00 per unit
Rs.0.50 per unit
Rs.1.00 per unit
Rs.5.00 per unit

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

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.

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

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

$20.00
$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

Advantages of Contribution Margin Approach


The contribution margin approach
offers more detailed information.

This approach is sensitive to


cost-volume-profit relationships.
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


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. It tends to promote price stability.

6. It provides the most defensible basis


for justifying prices to all interested parties.

7. It simplifies pricing decisions.

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

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

Opportunity, Outlay, and Differential Costs


Differential cost is the difference in
total cost between two alternatives.
Differential revenue is the difference in
total revenue between two alternatives.
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.

Opportunity, Outlay, and Differential Costs


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

An outlay cost requires a cash disbursement.

Opportunity, Outlay, and Differential Costs


Nantucket Nectars has a machine for
which it paid $100,000 and it is sitting idle.

Nantucket Nectars has three alternatives:


1. Increase production of Peach juice
2. Sell the machine
3. Produce a new drink Papaya Mango

Opportunity Cost
Peach Juice Contribution margin is $60,000.

Sell machine for $50,000.


Produce Papaya Mango juice with projected sales of $500,000
With a total outlay cost of $400,000.

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

Managers often must decide whether to


produce a product or service within the
firm or purchase it from an outside supplier.

Make or Buy Decisions


Nantucket Nectars Companys Cost of Making 12ounce Bottles

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

Another manufacturer offers to sell


Nantucket the bottles for $.18.

If the company buys the bottles, $50,000


of fixed overhead would be eliminated.

Should Nantucket make or buy the bottles?

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
20,000
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

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
$55,000, or can rent them out for $25,000.

What are the alternatives?

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

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 halted.

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

Department Store Example

Departments
Groceries
Sales
Variable expenses
Contribution margin
Fixed expenses:
Avoidable
Unavoidable
Total fixed expenses
Operating income
($000)

General
Mdse.

Drugs

Total

$1,000
$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

Department Store Example


Assume that the only alternatives to be considered
are dropping or continuing the grocery department,
which has consistently shown an operating loss.

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.

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

$1,900
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

Department Store Example

Assume that the store could use the space


made available by the dropping of groceries
to expand the general merchandise department.

This will increase sales by $500,000,


generate a 30% contribution-margin,
and have avoidable fixed costs of $70,000.

Department Store Example


Store as a Whole ($000)

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

Optimal Use of Limited Resources


A firm manufactures five products using the same raw material. By examining
the following information and assuming the total demand for five units is
limited to 7,000 units, show which product(s) is/are to be chosen so that profit
can be maximized.
A
Demand (units)
Last years sales
Selling price per unit
Marginal cost per unit
Contribution per unit
Raw material required in Kgs.

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?

Optimal Use of Limited Resources

A limiting factor or scarce resource


restricts or constrains the production
or sale of a product or service.

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, and the
maximum capacity is 10,000 machine hours.

The facility can produce 10 pairs of Air Court


Shoes or 5 pairs of Air Max shoes per hour.

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, pairs


of shoes, the more profitable product is Air Max.

Optimal Use of Limited Resources


Air Max is the product with
the higher contribution per unit.

The sale of a pair of Air Court


shoes adds $20 to profit.

The sale of a pair of Air Max


shoes adds $36 to profit.

Optimal Use of Limited Resources


Suppose that demand for either shoe would fill the
plants capacity. Now, capacity is the limiting factor.
Which is more profitable?
If the limiting factor is capacity,
the more profitable product is Air Court.

Optimal Use of Limited Resources

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

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).

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