pricing and short term decision making (edited)

7/21/2019 Pricing and Short Term Decision Making (Edited)

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Introduction to Management Accounting

Relevant Information forDecision Making with a Focus

on Pricing Decisions

Chapter 5



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.



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 ofdifference among the alternatives.

The Concept of Relevance



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.



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:

Accuracy and Relevance

QuantitativeQualitative



Cordell Company makes and

sells 1,000,000 seat covers.

Relevance of Alternate Income Statements

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 $ 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 180Factory 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



Cordell Company

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 $4,000Total 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 Approach

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 Approach

Cordell Company

Contribution Form of the Income Statement

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 expensesManufacturing $ 6,000

Selling and administrative 5,800 11,800

Operating income $ 2,000



Cordell Company makes and

sells 1,000,000 seat covers.

Special Sales Orders

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

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.

Accepting the special order:



Special Sales Order

Only variable manufacturing costs areaffected 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 $26Increase 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



Special Sales Order

Cordell Company

Contribution Form of the Income StatementFor the Year Ended December 31, 2007 (000)

Without Effect of With

special order special order special order

1,000,000 units Total Per Unit 1,100,000 unitsSales $40,000,000 $2,600,000 $26 $42,600,000

Less: Variable expenses

Manufacturing $24,000,000 $2,400,000 $24 $26,400,000

Selling and administrative 2,200,000 2,200,000

Total variable expenses 26,200,000 $2,400,000 $28,600,000

Contribution margin $13,800,000 $ 200,000 $14,000,000Less: Fixed expenses

Manufacturing $ 6,000,000 $6,000,000

Selling and administrative 5,800,000 5,800,000

Total fixed expenses 11,800,000 11,800,000

Operating income $ 2,000,000 $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 factory’s 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 Rs.2.50 per unit

Direct Labour Rs.1.00 per unitVariable expenses Rs.0.50 per unit

Fixed expenses Rs.1.00 per unit

Total cost 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 aconversion 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.

Price elasticity is the effect of

price changes on sales volume.

The firm must reduce prices

to generate additional sales.



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

Competitors’ actions

Customer demands

Predatory pricing Discriminatory pricing



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 basedon 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 $20.00

Variable costs:

Manufacturing $12.00 ($20.00 – $12.00) ÷ $12.00 = 66.67%Selling and administrative 1.10

Unit variable cost 13.10 ($20.00 – $13.10) ÷ $13.10 = 52.67%

Fixed costs:

Manufacturing $ 3.00

Selling and administrative 2.90Unit fixed costs 5.90

(3) Full Costs $19.00 ($20.00 – $19.00) ÷ $19.00 = 5.26%

Target operating income $ 1.00



Advantages of Contribution Margin Approach

The contribution margin approachoffers more detailed information.

This approach allows managers to prepare

price schedules at different volume levels.

Target pricing with full costing

presumes a given volume level.

This approach is sensitive to

cost-volume-profit relationships.



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.



Relevant Information for

Decision Making with a Focus

on Operational Decisions

Chapter 6

Introduction to Management Accounting



Opportunity, Outlay, and Differential Costs

Incremental cost are additional costs or reduced

benefits generated by the proposed alternative.

Differential cost is the difference intotal cost between two alternatives.

Differential revenue is the difference in

total revenue between two alternatives.

Incremental benefits are the additional revenues or reduced

costs generated by the proposed alternative.




An outlay cost requires a cash disbursement.

An opportunity cost is the maximum availablecontribution to profit forgone (or passed up) by

using limited resources for a particular purpose.

An incremental analysis is an analysis of the

additional costs and benefits of a proposed alternative.




Nantucket Nectars has three alternatives:

1. Increase production of Peach juice

2. Sell the machine

3. Produce a new drink Papaya Mango

Nantucket Nectars has a machine for

which it paid $100,000 and it is sitting idle.



Opportunity Cost

Revenue $500,000

Costs:

Outlay Costs 400,000Financial benefit before opportunity costs $100,000

Opportunity cost of machine 60,000

Net financial benefit $ 40,000

Sell machine for $50,000.

Peach Juice Contribution margin is $60,000.

Produce Papaya Mango juice with projected sales of $500,000

With a total outlay cost of $400,000.



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

Direct material $ 60,000 $.06

Direct labor 20,000 .02

Variable factory overhead 40,000 .04

Fixed factory overhead 80,000 .08

Total costs $200,000 $.20

Nantucket Nectars Company’s Cost of Making 12-ounce Bottles



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

Purchase cost $180,000 $.18

Direct material $ 60,000 $.06

Direct labor 20,000 .02

Variable overhead 40,000 .04

Fixed OH avoided by

not making 50,000 .05 0 0

Total relevant costs $170,000 $.17 $180,000 $.18Difference in favor

of making $ 10,000 $.01

Total Per Bottle Total Per Bottle

Make Buy



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

Rent revenue $ — $ — $ 25 $ —

Contribution from

other products — — — 55

Variable cost of bottles (170) (180) (180) (180)Net relevant costs $(170) $(180) $(155) $(125)

Make

Buy and

leave

facilities

idle

Buy and

rent out

facilities

Buy and use

facilities

for other

products(000)



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.

Avoidable and Unavoidable Costs

Common costs are costs of facilities and

services that are shared by users.



Groceries

General merchandise

Drugs

Consider a discount department store

that has three major departments:

Department Store Example



Sales $1,000 $800 $100 $1,900Variable expenses 800 560 60 1,420

Contribution margin $ 200 (20%) $240 (30%) $ 40 (40%) $ 480

Fixed expenses:

Avoidable $ 150 $100 $ 15 $ 265

Unavoidable 60 100 20 180Total fixed expenses $ 210 $200 $ 35 $ 445

Operating income (10) $ 40 $ 5 $ 35

DepartmentsGroceries

GeneralMdse. Drugs Total


($000)



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.

Assume that the only alternatives to be considered

are dropping or continuing the grocery department,

which has consistently shown an operating loss.




Sales $1,900 $1,000 $900

Variable expenses 1,420 800 620

Contribution margin $ 480 $ 200 $280

Avoidable fixed expenses 265 150 115

Profit contribution to

common space andother unavoidable costs $ 215 $ 50 $165

Unavoidable expenses 180 0 180

Operating income $ 35 $ 50 $ (15)

TotalBeforeChange

Effect ofDroppingGroceries

TotalAfter

Change

Store as a Whole ($000)




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.




Sales $1,900 $1,000 $500 $1,400

Variable expenses 1,420 800 350 970

Contribution margin $ 480 $ 200 $150 $ 430

Avoidable fixed expenses 265 150 70 185

Profit contribution to

common space andother unavoidable costs $ 215 $ 50 $80 $245

Unavoidable expenses 180 0 0 180

Operating income $ 35 $ 50 $80 $ 65

TotalBeforeChange

DropGroceries

TotalAfter

Change

Store as a Whole ($000)ExpandGeneral

Merchandise




Optimal Use of Limited Resources

A firm manufactures five products using the same raw material. By examiningthe 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.

Products

A B C D EDemand (units) 1,500 2,500 1,600 2,000 2,200

Last years sales 1,500 2,500 1,500 2,000 2,000

Selling price per unit 4.00 3.50 1.50 1.00 3.00

Marginal cost per unit 3.00 2.00 1.25 0.75 2.50

Contribution per unit 1.00 1.50 0.25 0.25 0.50Raw material required in Kgs. 2 8 3 5 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?



A limiting factor or scarce resource

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





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.

Nike produces two different athletic shoes,

Air Court and Air Max.

These are produced by one production facility.



Selling price per pair $80 $120

Variable costs per pair 60 84

Contribution margin per pair $20 $ 36

Contribution margin ratio 25% 30%

AirCourt

AirMax




Which is more profitable?

If the limiting factor is demand, that is, pairs

of shoes, the more profitable product is Air Max.





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.

Air Max is the product with

the higher contribution per unit.



Suppose that demand for either shoe would fill the

plant’s capacity. Now, capacity is the limiting factor.


Which is more profitable?

If the limiting factor is capacity,

the more profitable product is Air Court.




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




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).

pricing and short term decision making (edited)

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