Introduction to Management Accounting
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 1
Introduction to Management Accounting
Chapter 5
Relevant Information for
Decision Making with a Focus
on Pricing Decisions
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 2
Learning
Objective 1
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 3
The Concept of Relevance
Accountants 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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 4
Learning
Objective 2
(1)
(2)
(3)
(4)
Decision Process and Role of Information
Historical
Other
(A)
(B)
information
information
Prediction method
Predictions as inputs
to decision model
Decision model
Decisions by managers with
the aid of the decision model
Implementation
and evaluation
Feedback
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 5
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 6
Accuracy and Relevance
In the best of all possible worlds,
information used for decision
making would be perfectly
relevant and accurate.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 7
Accuracy and Relevance
The degree to which information is
relevant or precise often depends
on the degree to which it is:
Qualitative
Quantitative
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 8
Learning
Objective 3
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
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 9
Absorption Approach
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
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 10
Absorption Approach
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
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 11
Contribution 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
Internal (management accounting) reporting that
emphasizes the distinction between variable and
fixed costs for the purpose of better decision making.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 12
Contribution Approach
Cordell Company
Contribution Form of the Income Statement
For the Year Ended December 31, 2007 (000)
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
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 13
Learning
Objective 4
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 14
Special Sales Order
Accepting the special 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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 15
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 16
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
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 17
Special Sales Order
Cordell Company
Contribution Form of the Income Statement
For the Year Ended December 31, 2007 (000)
Without
special order
1,000,000 units
$40,000,000
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
2,200,000
26,200,000
$13,800,000
$ 6,000,000
5,800,000
11,800,000
$ 2,000,000
Effect of
special order
Total
Per Unit
$2,600,000
$26
With
special order
1,100,000 units
$42,600,000
$2,400,000
$26,400,000
2,200,000
$28,600,000
$14,000,000
$2,400,000
$ 200,000
$24
$6,000,000
5,800,000
11,800,000
$2,200,000
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 18
Activity-Based Costing, Special Orders, and
Relevant Costs
Cordell examined its $24 million of variable manufacturing costs
and discovered two significant activities and related cost drivers:
$21million of processing activity that varies directly with units
produced ($14 million of direct materials, $6 million of direct
labor, and $1 million of variable manufacturing overhead) at a
rate of $21 per unit and $3 million of setup activity that varies
with the number of production setups.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 19
Activity-Based Costing, Special Orders,
and Relevant Costs
Assume that processing the additional
100,000 units will require only 5 set-ups.
What is the additional variable cost
Using ABC costing?
Additional unit-based variable manufacturing cost, 100,000 × $21
Additional setup-based variable manufacturing cost, 5 × $6,000
Total additional variable manufacturing cost
$2,100,000
30,000
$2,130,000
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 20
Learning
Objective 5
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
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 21
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 22
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 23
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 24
Learning
Objective 6
General Influences on Pricing in Practice
Legal requirements
Predatory pricing
Discriminatory pricing
Competitors’ actions
Customer demands
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 25
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 26
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 27
Advantages of Absorption-Cost Pricing
The absorption-cost approach assumes all costs are
variable (even if some are fixed in the short run).
This approach meets the cost-benefit test. It is too
expensive to conduct cost-volume-tests on all products.
This approach copes with the uncertainty
of the demand curve.
Target pricing with full costing
presumes a given volume level.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 28
Learning
Objective 7
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
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 29
Relationships of Costs to
Same Target Selling Prices
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
Alternative Markup Percentage to
Achieve Same Target Sales Price
$20.00 ($20.00 – $12.00) ÷ $12.00 = 66.67%
$12.00
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
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 30
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 31
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 32
Learning
Objective 8
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.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 33
Target Costing
Successful companies understand
the market in which they operate
and use the most appropriate
pricing approach.
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 34
The End
End of Chapter 5
©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 5 - 35