Module 4
Responsibility Accounting and Segment Evaluation
Authority and responsibility must go together, one should not be present without the other. Authority
without responsibility is absolute power and absolute power corrupts absolutely. Responsibility without
authority is blind obedience, a plain servitude. Equationally, we could express that
Introduction
In a well- managed organization, responsibilities for specific functions among its employees are clearly
identified. A responsibility center is a specific unit of an organization assigned to a manager who is held
accountable for its operations and resources. Each manager’s performance is judged by how well he or
she manages those items under his or her control. In a budgeting program, each manager is assigned
responsibility for those items of revenues and costs in the budget that he or she is able to control. Each
manager is then held responsible for deviations between budgeted goals and actual results. This concept
known as Responsibility accounting is central to any effective profit planning and control system.
Authority = Responsibility
Fig. 4.1. Decision Levels in Centralization, Decentralization and Empowerment
Intended Learning Outcomes
At the end of this module, student should be able to:
1. Explain the importance of organizational structure to managerial reporting.
2. Elaborate the differences among centralization, decentralization and empowerment.
3. Distinguish authority, responsibility and accountability.
4. Discuss the different types of responsibility centers.
5. Explain the concept of controllability in relation to responsibility accounting.
6. Prepare a segment performance report.
7. Evaluation profit center’s performance using the segment margin analysis.
8. Evaluate investment center’s performance using the ROI, residual income, economic value added,
equity spread, and other segments assessment models.
Centralization, Decentralization, and Empowerment
Decisions forge organizations. Decisions may be fashioned in a centralized, decentralized or empowered
environment.
Centralized organization exists when decisions rest only to the top management. Decentralization
happens when the authority to make decisions is delegated to responsible officers in different
organizational units. Either decision model, centralization or decentralization, provides great results.
Managers have already realized they can produce more astounding results and accumulate more wealth by
doing things along with others. When top management rains, trusts, and delegates authority to capacitated
personnel operating decisions are made flexible, suitable, and faster leading to more satisfied and
delighted customers. These organizational attributes are needed to stay abreast and be relevant in a
competitive environment. This premise strengthens the practice of decentralization in managing large
organizations.
Figure 4.1 shown on the next page shows the basic difference among centralization, decentralization, and
empowerment in terms of the power to make organizational decisions.
Authority, Responsibility and Accountability
Authority is the power to do or not to do, give orders, give command, give instructions, or make
decisions.
As authority is shared to trusted men, responsibility must be performed in line with the principle of
accountability. The manner on how the authority is exercised and the effects of the acts performed to
fulfill a responsibility should be evaluated. This is the moving concept of accountability. Without it, there
would be no logical value of assessing how things are done and what have been done. Without
accountability, there would be no compelling reasons to evaluate performance fairly and objectively. In
an expanded equation, we could say:
Authority = Responsibility = Accountability
Authority and responsibility would loose their intrinsic meanings without accountability. It is in this
context that the power of individuals is harnessed, extolled, and recognized. This principle gives birth to
the powerful idea of providing a reward system in organizations.
Responsibility Centers
A responsibility center is a unit within the organization which has control over costs, revenues and /or
investment funds.
In a decentralized decision-making model, divisions, departments, segments, or units are considered
responsibility centers. Each center is managed by a responsible officer. A responsibility center could be
an investment center, profit center, revenue center, or a cost center.
An investment center manager decides on which strategic business opportunity should the company
undertake.
Responsibility is the duty to do or not to do an activity according to the order given.
A profit center manager controls both the generation of income and incurrence of costs.
Accountability is the answerability on the consequences of what had been done, undone, or had not been
done.
A revenue center manager controls the generation of revenue.
A cost center manager has a control or influence over the incurrence of costs.
The diagram on the next page shows the scope and relationships of these centers.
Figure 4.2 Responsibility Centers and Organizational Structure
The layer of emphasis normally speaks of the overall strategy adopted by the enterprise. Figures 4.4 to 4.6
is an illustration on how people would be assigned throughout the organizational structure.
Figure 4.4. Organizational Design with Emphasis on Functional Responsibility
In the hierarchical organizational design presented above, there are six levels starting from the corporate
headquarter chief to the division heads down to the workers. The perspective of the discussions that will
follow gears towards a holding company operating domestically or internationally. The corporate
headquarter is headed by the Chief Executive Officer. The holding company has divisional units that are
legally separate and independent from it. A division is managed by a President with his Vice-Presidents to
assist him in running the affairs of the business.
Organizational designs
Organizational strategy precedes structure. The overall corporate strategy defines the powers and duty to
be assigned to a division manager based on organizational priority or emphasis in a given period of
performance. A division is an investment center or a business segment having its separately defined
business and financing activities from that of the parent or controlling company. The first layer of
organizational emphasis, for example, may be on the functional areas, product lines, or geographical areas
as depicted in Figure 4.3.
This organizational design emphasizes the strength of functional areas such as finance, production,
marketing, sales, and administration. Hence, men are grouped along these lines and all other subsequent
or lower business units would subordinate their decisions, actions, and reports to the functional managers.
The lines of authority and responsibility will be delegated along these areas and performance shall be
assessed accordingly.
Figure 4.5. Organizational Design with Emphasis on Product Line Responsibility
Figure 4.3. Organizational Layer of Emphasis
This organizational design emphasizes the strategic importance of product lines such as consumer
products, industrial products, agro-tourism related products, health and health related services, and the
like. Further, the said product lines may be sub-categorized into a more detailed products groups such as
tree planting and land development, organic farming, herbal products, and wellness city for the agrotourism products.
Men shall be grouped along these lines and all other subsequent or lower business units would
subordinate their decisions, actions, and reports to the product line managers. The lines of powers and
duties will be delegated along these product lines areas and performances shall be evaluated accordingly.
Figure 4.7. Responsibility Centers and Performance Evaluation
Fig. 4.6 Organizational Design with Emphasis on Geographical Area of Responsibility
Performance Evaluation
The organizational design emphasizes the strategic importance of geographical areas such as northern
operations, southern operations, eastern operations, and the like. Further, the said geographical area of
operations sub-categorized into a more detailed areas such as region 1, region 2, and the like.
Accordingly, men shall be grouped along these lines and all other subsequent or lower business units
would subordinate their decisions, actions and reports to the product line managers. Authorities and
responsibilities will be delegated according to the areas of operations and performances shall be rewarded
accordingly.
It should be highlighted that in the creation of organizational designs the chief executive officer stays at
the top and the personnel at the bottom. The middle layers may be defined or rearranged according to the
strategies adopted by the organization.
A manager’s performance should be evaluated in line with the established objectives and standards of his
center. Different responsibility center managers should be evaluated differently inasmuch as their
authority, responsibility, and accountability vary from each other.
Performance evaluation (i.e., performance measurement, feedback) is a control issue. It may be
implemented before, during or after a process. Performance is assessed based on reports submitted to and
gathered by the manager. Therefore, an effective, reliable, timely, verifiable, and relevant reporting
system must be in place. Responsibility accounting reports may either be information reports or
performance reports.
Reports submitted by a responsibility center manager should segregate the controllable from the noncontrollable items. Managers’ performance should be measured for items they have control over with.
The techniques used in measuring managers’ performance are presented below:
Controllability and responsibility centers
Table 4.1. Basis of Evaluating Responsibility Centers
The span of authority given to a manager defines the area over which he has controls. Controllability
refers to the power of the manager to decide or influence the incurrence or non-incurrence of an item,
event or activity. This concept of controllability is extremely important in measuring a person’s
performance where it states that a manager should be evaluated only on matters that he controls.
A responsibility center manager has to understand the breadth and depth of his authority. The authority to
the manager should commensurate with the responsibility assigned to him. Consequently, he is
accountable to his actions or inaction. This model stresses the need to evaluate managerial performance.
Responsibility Center Manager
 Cost center manager
 Revenue center manager
 Profit center manager
 Investment center manager







Evaluation Techniques
Cost variance analysis
Revenue variance analysis
Segment margin analysis
Return on Investment (ROI)
Residual income model
Economic value added (EVA)
Equity spread, etc.
Cost center manager’s performance
A cost center manager has control or influence over the incurrence of non-incurrence of costs. The cost
center manager report should separate the controllable from the non-controllable costs and should
highlight the variances between the actual and budgeted costs.
Let us refer to the organizational chart shown in Fig. on page. Focus on department manager 2. He reports
to the Vice President for Product 2 and has 3 supervisors under him. An abbreviated example of a
department manager’s report is presented in Table 4.2 shown in the following page.
Variances are identified as either unfavorable (U) or favorable (F). Unfavorable variances indicate
excessive costs and should be avoided. Favorable variances mean savings, however, should also be
investigated.
The three (3) production supervisors have already submitted their respective reports to production
manager 2. The summary of these supervisors’ reports is captured in the departments manager’s report as
“cost center 1”, “cost center 2”, and “cost center 3” and included in the controllable items. The other
controllable costs are direct costs of operating department manager’s department. These items are
captured in the report of the Vice-President for Product 2 to be submitted to the Chief Operating Officer
as shown in Table 4.3 on page.
Table 4.2. Department Manager's Performance Report
X Corporation
Department Manager 2
September 9-15, 20CY
Controllable Costs
Cost center 1
Cost center 2
Cost center 3
Direct materials
Direct labor
Indirect materials
Fringe benefits
Factory supplies
Electricity and water
Telecommunications
Gas and oil
Repairs and maintenance
Supervisors' salaries
Miscelleneous
Total controllable costs
Noncontrollable Costs
Managers' salary
Depreciation expense
Rent expense
Allocated costs
Total noncontrollable costs
Performance Report
Actual
832,000
655,000
440,000
590,000
900,000
26,000
40,000
33,000
20,000
18,000
9,000
21,000
92,000
44,000
3,720,000
Budget
845,000.00
650,000.00
450,000.00
580,000.00
920,000.00
27,000.00
38,000.00
36,000.00
25,000.00
12,000.00
10,000.00
19,000.00
90,000.00
47,000.00
3,749,000.00
Variance (13,000.00)
5,000.00
(10,000.00)
10,000.00
(20,000.00)
(1,000.00)
2,000.00
(3,000.00)
(5,000.00)
6,000.00
(1,000.00)
2,000.00
2,000.00
(3,000.00)
(29,000.00)
70,000.00
90,000.00
22,000.00
66,000.00
248,000.00
66,000.00
95,000.00
26,000.00
66,000.00
253,000.00
4,000.00
(5,000.00)
(4,000.00)
(5,000.00)
U (F)
F
U
F
U
F
F
U
F
F
U
F
U
U
F
F
U
F
F
F
Table 4.3. Vice-President’s Performance Report
X Corporation
Vice-Presiden for Product 2
September 9-15, 20CY
Performance Report
Controllable Costs
Department Manager 1
Department Manager 2
Department Manager 3
Office Salaries
Fringe benefits
Supplies
Electricity and water
Telecommunications
Gas and oil
Miscelleneous
Total controllable costs
Actual
3,336,000
3,720,000
2,290,000
122,000
20,000
23,000
33,000
48,000
19,000
64,000
9,675,000
Budget
3,350,000.00
3,749,000.00
2,300,000.00
120,000.00
24,000.00
25,000.00
38,000.00
50,000.00
17,000.00
69,000.00
9,742,000.00
Noncontrollable Costs
VP Production Salary
Depreciation expense
Allocated costs
Total noncontrollable costs
80,000.00
300,000.00
466,000.00
846,000.00
80,000.00
300,000.00
466,000.00
846,000.00
Total Costs
10,521,000.00
Variance (14,000.00)
(29,000.00)
(10,000.00)
2,000.00
(4,000.00)
(2,000.00)
(5,000.00)
(2,000.00)
2,000.00
(5,000.00)
(67,000.00)
U (F)
F
F
F
U
F
F
F
F
U
F
F
-
10,588,000.00
(67,000.00)
F
Revenue Center Manager’s Performance
A revenue center manager has control or influence in generating revenue but not of costs. His
performance report should show the variances between actual revenue and budgeted revenue. When the
actual revenue is greater than budgeted revenue, there is a favorable revenue variance, and vice-versa. A
favorable variance at a blush maybe given a commensurate reward and recognition however should be
immediately evaluated for learning and further improvements. While an unfavorable variance should be
critically studied to avoid its recurrence.
Responsibility centers that are responsible in developing and maintaining sources of supply such as
sources of materials and labor may also be classified as revenue centers.
Profit Center Manager’s Performance
Total Costs
3,968,000.00
4,002,000.00
(34,000.00)
When presented in the VP for Product 2’s report, the department manager’s 2 report becomes only a “line
item”. In the same way, the report of the VP for Product 2 to the Chief Executive Officer will also be
presented in a single line. At the end of the reporting line, the Chief Executive Officer has only a page of
report summarizing the vital information in the organization.
A profit center manager has control over revenues and costs. his managerial performance is evaluated
based on controllable margin while the center’s performance is evaluated based on segment (or direct)
margin. The controllable margin and segment margin computations are presented below:
Table 4.4. Segment Margin
Contribution margin
Less: Controllable direct fixed costs and expenses
Controllable margin
Less: Noncontrollable direct fixed costs and expenses
Segment margin
P
P
x
x
x
x
x
Deduct the allocated (or indirect or unavoidable) fixed costs and expenses from the segment margin and
you will get the operating profit. The difference between controllable margin and segement margin is
fixed cost and expenses controllable not by the concerned manager but by others.
process. The benefit refers to the returns derived from investments while the cost refers to the amount
used in undertaking the opportunity.
The actual controllable margin and segment margin should be compared with the budgeted amounts to get
the variances and evaluate performances.
There are several models in evaluating investment center performance. Some of these are the return on
equity, return on investment (DuPont Model), residual income, economic value added, equity spread, total
shareholders return, and the market value added.
Sample Problem 4.1. Segment Performance
The Return on Investment (ROI)
Bajada Corporation has been experiencing negative operating results in the last six quarters. Its most
recent income statement is as follows:
The ROI is sometimes referred to as return on assets (ROA), or accounting rate of return (ARR). It is
computed as follows:
Sales
Less: Variable costs
Contribution margin
Less: Fixed costs
Profit
ROI = Segment Profit/ Segment Investment
P 6,300,000
3,474,000
2,826,000
2,906,000
P (80,000)
Take a second look, you will notice that the ROI is a measure of benefit over cost analysis. Benefit is
represented by the segment profit while the cost is the amount of the segment investment which is
preferred to be the assets employed in the division.
The higher the ROI, the better it will be for the business. The issue, therefore, is how to increase ROI.
Quantitatively speaking, ROI is increased by increasing profit and reducing investment, as follows:
The company operates three product lines which has the following related data:
Sales
Controllable direct fixed costs
Allocated fixed costs
Noncontrollable direct fixed costs
Variable cost ratio
Product 1
P 1,200,000
220,000
102,000
220,000
56%
Product 2
P 2,100,000
880,000
102,000
100,000
42%
Product 3
P 3,000,000
800,000
102,000
800,000
64%
Total
P 6,300,000
1,900,000
306,000
1,120,000
Required: Compute the segment margin for each of the product lines and of the corporation. Evaluate the
data.
Increase in ROI = Increase in Profit Decrease in Investment
The Du Pont Model
E. I. du Pont de Nemours and Company, commonly referred to as DuPOnt, an American chemical
company that has founded in July 1802 and is one of the world’s largest chemical company based on
market capitalization, evaluates the performance of its numerous business investments using an extended
ROI model as follows:
ROI = Profit / Net Sales x Net sales / Investment
ROI = Return on sales x Assets Turnover
Solutions/ Discussions:
 The segment margins of the three product lines are determined as follows:
Sales
- Variable costs
Contribution margin
- Controllable direct fixed costs
Controllable margin
- Noncontrollable direct fixed costs
Segment margin
- Allocated fixed costs
Profit (loss)
A
1,200,000
672,000
528,000
220,000
308,000
220,000
88,000
102,000
(14,000)
B
2,100,000
882,000
1,218,000
880,000
338,000
100,000
238,000
102,000
136,000
C
3,000,000
1,920,000
1,080,000
800,000
280,000
800,000
(520,000)
102,000
(622,000)
Total
6,300,000
3,474,000
2,826,000
1,900,000
926,000
1,120,000
(194,000)
306,000
(500,000)

Product line B registers the best performance in terms of peso amount amounting to a segment
margin of P 238,000 and margin return on sales of 11% (i.e., P 238,000/ P 2,100,000). Product
line C produces a negative segment margin of P 520,000. This product line does not contribute to
the overall profitability of the company but rather reduces the overall amount of the company’s
profit by the amount of its negative segment margin. Product line C, based on the computations
above, should be disposed.

In terms of individual segment manager’s performance, the manager of product line B still
registers the best performance posting a controllable margin of 16% (i.e., P 338,000/ P 2,100,000)
compared to that of product line C’s manager of 9% (i.e., P 280,000 / P 3,000,000) and that of
product line A’s manager of 3% (i.e., P 308,000/ P 1,200,000)
Investment Center Manager’s Performance
The investment center manager has authority to decide over which investment opportunity should be
considered and pour in the funds for investments. As such, their performance is evaluated based on the
results of investments. The cost-benefit criterion plays a vital role in the investment selection decision
This model encourages investment center managers to wisely take investment only for those which are of
relevance to their operations. This will result to efficiency in allocating investment funds. Only those
investment of which the investment center manager has control and use in operations shall be included in
the ROI determination.
Sample Problem 8.2. Return on Investment
Frances Beau Corporation’s balance sheet indicates that the company has P 5,000,000 investment in
operating assets. In 20CY, Frances Beau earned P 1,100,000 of profit on P 11,000,000 of sales.
Required: Determine the following for Frances Beau:
1. Profit margin for 20CY
2. Assets turnover for 20CY.
3. Return on investment for 20CY.
4. ROI under each of the following independent assumptions:
a. Sales increase from P 5 million to P 6 million and profit increase from P 1,100,000 to P
1,300,000
b. Sales remain constant, costs and expenses decrease while profit increases by P
400,000.
c. The amount of investment is decreased by P 400,000 without affecting the profit.
Solutions/ Discussions:
1. Profit margin or return on sales is computed as follows:
Profit margin = Profit / Net sales = P 1,100,000 / P 11,000,000 = P 10%
2. The assets turnover is determined as follows:
Assets turnover = Net sales/ assets = P 11 million / P 5 million = 2.2.
3. ROI = Return on sales x Assets turnover = 10% x 2.2. = 22%
Or ROI may be computed directly as
ROI = Profit / Average assets used = P 1,100,000/ P 5,000,000 = 22%
4.a. ROI = P 1,300,000 / P 6,000,000 = 21.67%
4.b. ROI = (P 1,100,000 + P 400,000) / P 5,000,000 = 30%
The investment base used in computing the minimum income is to the amount agreed upon by the
corporate headquarter and the investment center manager. The imputed interest rate is to be determined
by the corporate headquarter management. Normally, the imputed interest rate is based on the prevailing
market rate form which the business generates profit without accepting a high business risk. The imputed
rate is ordinarily the pre-tax cost of capital, and in principle, should reflect the degree of risk of the
reporting responsibility center. If the residual income is positive, the performance is above standard and
is, therefore, favorable.
Residual income is considered superior than the ROI because it considers two levels of assessments, the
compliance to minimum return and the size of the excess return over the same minimum return.
4.c. ROI = P 1,100,000 / P 4,600,000 = 23.91%
Sample Problem 4.3 Residual Income
The ROI and its limitations
The use of ROI has several limitations. Significant differences in the amount of investment from one
project to another and the difference in the life of the asset used in investment opportunities may render
the use of ROI difficult to apply. To highlight these limitations, consider the following:
Return on investment
Amount of investment
Life of assets in years
Company A
20%
P 1 billion
15 years
Company B
40%
P 1 million
2 years
Tom Corporation gathered the following data relative to Northern Division’s performance:
Net sales
P 12,000,000
Costs and expenses
11,000,000
Average operating assets
5,000,000
Desired minimum (or imputed) rate
of return established by management
15%
Average industry rate of return
28%
Income tax rate
40%
Compute the Northern Division’s residual income.
Using the ROI model, Company B is better BUT
Solutions/ Discussions:
The size matters…
Using the ROI, company B manager with 40% ROI would be better off than that of company A manager
with 20% ROI. However, considering the amount of investment supervised by each manager respectively,
we could easily say that managing a million worth of business (e.g., Company B) is a lot much easier than
managing a billion worth of business resources (e.g., Company A).

Segment profit (P 12 million – P 11 million)
Less: Minimum income (P 5 million x 15%)
Residual income

The average industry rate of return, though may be considered in setting the minimum desired
rate of return, is different from the minimum rate of return.

The desired minimum income is normally expressed in amount before tax, hence, it is compared
with operating income or segment profit.

Since the residual income of a division is positive, the division has met the expectations or
standards set by top management in terms of profitability and is therefore considered acceptable.
P 1,000,000
750,000
P 250,000
The asset life also matters…
Also, considering the life span of the assets used, company B’s performance is an utter dismay because
only 80% of the investment would be recovered in 2 years, which is the life of the investment, given a
40% ROI per annum. This performance falls short of recovering the entire amount of investment over its
operational life. Whereas company A has a total return of 300% (e.g., 20% x 15 years) which means
investment in company A is recoverable three times and is indeed better than the 80% recovery rate of
company B.
The special assignment matters…
ROI model may not also be the most suitable method in evaluating the performance of an excellent
manager who is assigned to make a business turnaround performance, say to deliver a profitable
performance of a previously unprofitable operations.
The Residual Income Model
The limitations encountered in applying the ROI is improved by the residual income model that uses
amount as a basis of evaluating the acceptance of a prospective investment or the performance of an
investment project. The residual income is computed as follows:
Segment income
Less: Minimum income
Residual income
P x
x (Investment x Implied Interest rate)
P x
The segment income is income expressed before tax. Segment income also refers to earnings before
interest and tax (e.g., EBIT) or the operating profit. Minimum income is sometimes labeled as imputed
income, implied income, implicit income or desired income.
Economic Value Added
The economic value added (EVA) is a more specific after-tax version of residual income. It represents the
business unit’s true economic profit because a change in the cost of equity capital is implicit in the cost of
capital. the cost of equity is an opportunity cost, that is, the return that could have been obtained with the
best alternative investment having similar risk. The EVA is computed as follows
Operating Profit After Tax (EBIT x after tax rate)
Less: Minimum income (Investment x Weighted Average Cost of Capital)
Economic value added
Px
x
Px
The operating profit after tax (OPAT) is computed by multiplying the earnings before interest and taxes
(EBIT) by the after-tax rate (i.e., 1-Tax rate). The weighted average cost of capital is computed after tax.
EVA measures the marginal benefit obtained by using resources in relation to the business of increasing
shareholders’ value. Some adjustments in EBIT are needed such as research and development (R&D)
costs which are capitalized and amortized over 5 years. The true economic depreciation rather than the
accounting depreciation used for tax purposes is to be used in computing the EVA.
Sample Problem 4.4. Economic Value Added
Global Holdings operates Star Corporation, a division in electronics industry, and provided you the
following data with regard to the division’s 20CY performance:
Divisional income before interest and taxes
Interest expense
Tax rate
Weighted average cost of capital
Average total assets
Carrying amount
Current value
Average current liabilities
P 200 million
P 60 million
40%
12%
References used:
P 90 million
P 120 million
P 40 million
Agamata, Franklin T. Management Services 2019 Edition. GIC Enterprises & Co., Inc, 2019
Cabrera, Ma. Elenita B. Management Accounting Concepts and Applications. GIC Enterprises &
Co., Inc, 2014
Required: Economic value added (EVA) assuming the investment base is:
1. Market value of long-term financing.
2. Carrying amount of long term financing.
3. Market value of total assets.
4. Carrying amount of total assets
Solutions / Discussions:
1. Investment base is the market value of long-term financing.
OPAT (P 200 million x 60%)
Less: Minimum return on market value of long-term financing
[ ( P 120 million – P 40 million) 12%]
Economic value added
P 120.00 million
P9.60 million
P 110.40 million
2. Investment base is the carrying amount of long-term financing.
OPAT
Less: Minimum return on carrying amount of long-term financing
[ ( P 90 million – P 40 million) 12%]
Economic value added
P 120.00 million
P 6.00 million
P 114.00 million
3. Investment base is the market value of the total asset
OPAT
Less: Minimum return on market value of long-term assets
(P 120 million x 12%)
Economic value added
P 120.00 million
P 14.40 million
P 105.60 million
4. Investment base is the carrying amount of the total asset
OPAT
Less: Minimum return on carrying amount of long-term assets
(P 90 million x 12%)
Economic value added
P 120.00 million
P 10.80 million
P 109.20 million
The economic value added is a measure of the management effectiveness in increasing investor’s value.
The best investment base to use is the market value of the long-term financing. The market value is used
to reflect the true amount of investment and the exercise prudence in the process. also, long-term
financing is used to isolate the interest of the true investors from the short-term ones. Maximizing the
interest of long-term investors, both creditors and owners, are the real intentions of enterprise
management.
Other investment center evaluation models
Other divisional evaluation models are equity spread, total shareholders’ return and market value added.
The equity spread, like the EVA, is also a straightforward method for measuring managerial
performance regarding creation of shareholder value. It is computed as follows:
Table 4.7. Equity Spread
Shareholders’ equity – beginning
x (Return on equity – Cost of equity rate)
Equity spread
The market value added is the difference between the market value of the equity (i.e., market price x
shares outstanding) and the equity supplied by the shareholders.
P
x
x%
P x
Total shareholder’s return equals the change in the stock price plus dividends per share divided by the
initial stock price.
Responsibility Accounting - Activity with
Solution
Read and understand each problem carefully.
* Required
3.
How much is the residual income? *
1 point
Mark only one oval.
P 100,000
P 270,000
P 300,000
P 330,000
4.
How much is the return on investment? *
Mark only one oval.
1.
What is the total contribution to corporate profits generated by Division B
before allocation of central corporate expenses?
*
1 point
135%
Mark only one oval.
150%
200%
P 18,000
P 20,000
P 30,000
P 150,000
2.
What is the contribution margin of Division A? *
Mark only one oval.
P 90,000
P 115,000
P 235,000
P 265,000
75%
1 point
1 point
5.
For Segment B, net income as a percentage of sales is *
1 point
9.
8.00%
6.00%
6.67%
20%
4.00%
20.8%
10.00%
7.5%
For Segment C, net income as a percentage of sales is *
1 point
10.
5.00%
6.00%
6.67%
20.8%
4.00%
20%
20.00%
7.5%
For Segment C, the turnover of investment is *
1 point
11.
For Segment B, the minimum peso ROI is *
3.0
P 30,000
1.5
P 6,750
2.5
P 4,800
4.0
P 120,000
For Segment D, the turnover of investment is *
Mark only one oval.
1 point
1 point
Mark only one oval.
Mark only one oval.
8.
For Segment B, ROI is *
Mark only one oval.
Mark only one oval.
7.
1 point
Mark only one oval.
Mark only one oval.
6.
For Segment A, ROI is *
1 point
12.
For Segment C, the minimum peso ROI is *
Mark only one oval.
3.0
P 30,000
1.5
P 6,750
2.5
P 4,800
4.0
P 120,000
1 point
13.
Assume that the minimum peso ROI is P 6,750 for Segment C. The
minimum percentage of ROI is
*
1 point
Module 5
Transfer Pricing
Mark only one oval.
20%
Introduction
6%
A problem common to most companies operating with decentralized segments is that of placing a fair
value of exchange of goods and services between segments within the company – the problem of Transfer
pricing.
15%
10%
Option 5
14.
In Segment D, the minimum percentage of ROI is *
1 point
When goods or services are transferred from one unit of an organization to another, the transaction is
recorded in the accounting records. In the days when all companies were small and management was
centralized, accountants transferred goods and services from one cost center to another at the cost of
production. Today many companies are giant conglomerates having multiple divisions. Simply
transferring goods and services at cost no longer serves the needs of these decentralized organizations.
The problems revolve around the question of what transfer price to charge between the segments.
Intended Learning Objectives:
Mark only one oval.
By the end of this module, students should be able to:
20%





6%
15%
10%

15.
In Segment D, the residual income is *
1 point
Mark only one oval.
Explain the rationale of transfer pricing
Define transfer price
Differentiate arm’s length transactions from the related party transactions
Explain the importance of transfer pricing to segment reporting
Identify the various transfer prices, their proper applications, and explain their importance to
segment evaluation
Evaluate various multinational transfer pricing options for the overall corporate objective.
Related Parties
Transfer pricing happens when two or more legally independent but related companies transact with each
other.
P 2,250
The related companies may be
P 9,000





P (30,000)
P0
a wholly-owned company,
subsidiary,
affiliate,
special purpose entity, or
a business enterprise however created having legal existence to conduct commercial and other
activities.
Figure 5.1. The Related Parties
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Parent Company
Forms
A Company
(affiliate)
C Company
(subsidiary)
B Company
(affiliate)
D Company
(subsidiary)
E Company
(affiliate)
F Company
(wholly-owned entity)
Related-party transaction - any transaction entered into by the parent company with any of its related
entities or entered into by any two or more of its related parties.
The issue of transfer pricing occurs when an independent unit sells to or buys from another independent
unit within the same business conglomerate. This is an issue of interdependence. Since independent
business unit managers have the authority to decide on how they run their business operations, they deal
with external suppliers and customers and also with affiliated divisions (e.g., internally independent
business units) as well.
Cost-based transfer price


Selling division, buying division, and parent company
Whenever there is an interdivisional transaction, there are at least three (3) independent but related parties
affected thereto;



the selling division,
the buying division, and
the parent company.

Negotiated transfer price
Say, Asian Holdings Corporation (parent company) has several related companies operating
independently from each other. Two of its related companies are the Packaging Company and the
Consumer Products Company. The Packaging Company (selling division) sells packaging materials to
Consumer Products Company (buying division). The central issue is: What transfer price is to be used in
the interdivisional transaction?



Asian Holdings Corporation

<
AT WHAT TRANSFER PRICE?
Consumer Products Company
(Buying Division)



When the overall goal of the organization prevails over that of the divisional goals, it is called
goal congruence.
When the entity goal of the division prevails over the overall organization goals, it is called
suboptimization.
Managerial effort is the extent to which a manager attempts to accomplish a goal. Goal congruence and
managerial effort are managerial motivation. Motivation is the desire to attain a specific goal (goal
congruence) and the commitment to accomplish the goal (managerial effort).
Transfer Prices
Transfer price is an artificial price used to record interdivisional transactions of goods or services and
correspondingly evaluate divisional performance in line with the overall objective of the enterprise.
Transfer pricing may be a market-based pricing, cost-based pricing, negotiated pricing, arbitrary
pricing, or dual pricing.
Market price



The best transfer price.
Because individual business units or segments have to compete with the rest of the world, they
have to beat or conform with the prevailing market price to stay competitive.
They have to follow the market rules in the capitalistic model of a free enterprise system.
set by the management in the corporate headquarters.
Its strength is anchored on the premise that the entire corporate organization has to promote its
overall goals (optimization) over and above that of the division’s goals (suboptimization).
On the contrary, it does not jibe well with the very principle of decentralization where authority is
given to division managers to make decisions with regard to their operations.
Dual pricing
Goal Congruence and Suboptimization
Another issue on transfer pricing arises when the entity goal of the transacting division center runs in
conflict with the overall goal of the organization.
may occur when segments are free to determine the prices at which they buy and sell internally.
especially appropriate when market prices are subject to rapid fluctuations.
reflects the best bargain price acceptable to the selling and buying divisions without adversely
sacrificing their respective interests.
Arbitrary transfer pricing


Fig. 5.2. The Transfer Price Environment
Packaging Company
(Selling division)
equals cost plus a lump sum or a markup percentage.
Cost may either be standard or actual cost.
o Standard cost has the advantage of isolating variances.
o Actual cost gives the selling division a little incentive to control costs.
 Actual cost-based transfer pricing does not promote long-term manufacturing
efficiencies.
does not give motivation on the part of the buying division since the costs incurred by the selling
division may not reflect the best possible performance in the market which is adversely
transferred to the buying division.





used when the selling and buying divisions, use two (2) different prices in recording their intercompany transfers.
For example, the selling division records the transfer at market prices as if the sale is made to
outside customers, while the buying division records the purchases at variable cost of production.
o Each division’s performance would improve using the dual pricing scheme. In a sense, the
variable costs would be the relevant price for decision-making purposes but the
segment’s performance is evaluated based on market prices.
In this pricing model, the sum of the profits of the individual divisions would be greater than the
overall profit of the organization.
This model reduces managerial efforts to control costs.
The seller is assured of a high price, and the buyer is assured of an artificially low price.
This is rarely used in practice because division managers are assured of a good segment
performance and may not exert much effort to report higher segment margin.
Sample Problem 5.1. Basic Transfer Prices
Great Flowers Holdings, Inc., has two independent divisions, Asian Enterprises and Malayan
Corporation, that conduct business in the same country. Asian Enterprises produces product “Cute” of
which Malayan Corporation buys from an external supplier at P 80 per piece. The relevant production
data of Asian Enterprises is as follows:
Variable production costs
Allocated factory overhead
P 66
15
Required: Determine the profit for Asian Enterprise, Malayan Corporation, and Great Flowers, Inc., if an
interdivisional transfer of goods occurred under each of the following transfer prices:
1. Market price of P 80.
2. Variable production costs of P 66.
3. Negotiated price of P 73.
4. Dual pricing.
Solutions/ Discussions:
 The profit of the concerned companies is computed as follows:
Asian Enterprise (Seller)
Malayan Corporation (Buyer)
1. Transfer price is market price at P 80.
Transfer price
P 80
Market price
- Var. prod. Cost
66
- Transfer price
Profit
P 14
Profit
2. Transfer price is variable production costs of P 66.
Transfer price
P 66
Market price
- Var. prod. Cost
66
- Transfer price
Profit
P Profit
3. Transfer price is negotiated price of P 73.
Transfer price
P 73
Market price
- Var. prod. Cost
66
- Transfer price
Profit
P 7
Profit
4. Transfer price is dual prices
Transfer price
P 80
Market price
- Var. prod. Cost
66
- Transfer price
Profit
P 14
Profit

from its selling division as long as the incremental costs of producing the goods is lower than the
cost of buying the same from an outside supplier. This decision would produce overall savings,
regardless of the transfer price used in recording the interdivisional transaction, and would be
beneficial for the overall operations of the holdings company.
Great Flowers Holdings, Inc.
(Parent Company)
P 80 Market price
80 - Var. prod. Costs
P - Profit
P 80
66
P 14
P 80 Market price
66 - Var. prod. Costs
P 14 Profit
P 80
66
P 14
P 80 Market price
73 - Var. prod. Costs
P 7 Profit
P 80
66
P 14
P 80 Market price
66 - Var. prod. Costs
P 14 Profit
P 80
66
P 14
If the transfer price is based on costs, the buying division registers all the profit of P 14, reports
higher return on investment, or residual income, or EVA, and the buying division manager would
have a higher chance of getting more rewards and recognition, assuming all things are the same
on all divisions.

If the transfer price is based on negotiated pricing, both the selling and the buying divisions have
share on the transaction profit, report higher return on investment, or residual income, or EVA,
and have an equal chance of being considered in the next round or promotions or giving of
rewards, assuming all things are the same among the divisions.

If the transfer price is based on dual pricing, both the selling and the buying divisions record
profit at P 14, report much higher return on investment, or residual income, or EVA, and have an
equal chance of being considered in the next round or promotions or giving of rewards, assuming
all things are the same among the divisions.

The allocated factory overhead is not considered in the computation of divisional profit for
performance purposes because it is not reflective of the controllable performance and it does not
change regardless of the option to buy the product from an outside supplier or from a relative
division.

The transfer pricing policy is normally set by the top management. The segment’s goal is also relevant but
the overall goal of the organization is paramount.
The other factors that are considered in setting the transfer price are
 excess capacity,
 opportunity cost of the transfer transaction,
 international tax issues (e.g., income taxes, sales taxes, value-added taxes inventory and payroll
taxes, and other governmental charges), and
 other international issues such as foreign exchange rate fluctuations and limitations on transfers
of profits outside the host country.
The challenge in setting the minimum transfer price is of interest both to the selling and buying divisions.
In the perspective of the selling division, the minimum transfer price (MTP) is as follows:

With excess capacity
MTP = Regular Incremental Cost + Opportunity Cost – Savings
If the transfer price is the market price, the selling division reports all the profit of P 14 and
thereupon reports higher return on investment, or residual income, or EVA. The selling division
manager has a higher chance of getting more rewards such as job bonuses, bonuses, and other
perks and privileges, assuming all things are the same in all divisions.


Minimum transfer prices

Without excess capacity
MTP = Regular Sales Price + Other Incremental Cost + Opportunity Cost – Savings
Regular incremental costs include that of variable production costs, incremental overhead, and regular
marketing, selling and administration expenses. Other incremental costs pertain to those aside from the
regular incremental costs.
When there is no excess capacity, the minimum transfer price starts from the regular sales price which
already includes the regular incremental costs of production and sales, fixed overhead which should be
transferred and charged to the buying division, and regular contribution margin which becomes an
opportunity costs if the regular sales are sacrificed in lieu of accepting the order of the buying division.
Sample Problem 5.2. Minimum Transfer Price
It should had been immediately noticed the transfer price is not relevant in the perspective of the
parent company. First, because the divisions are in the same country and therefore is covered by
the same taxation laws and regulations. Second, the transfer price is an input cost and a revenue
involving the same amount, therefore is only a transfer payment and has no impact on the overall
performance of the parent company. If in the case, the transacting divisions are covered by
different set of tax rules and regulations, although located in the same country however have
varying tax impacts, the change in the tax effects should be considered in the analysis in the
parent company.
Overall, the profit of Great Flowers Holdings, Inc., remains the same at P 14, despite the
differences in the transfer price used by the transacting divisions. Following the doctrine of goal
congruence, a holding company should continue advising its buying division to buy the goods
Coco Division of Lubi Corporation produces “bales” of coconut brooms that are used in various
commercial applications. The bales sells for an average of P 20 each and Coco Division has the capacity
to produce 10,000 bales per month. Consumer Products Division of Lubi Corporation uses approximately
2,000 bales of brooms each month in its production of various household gadgets. The operating
information for Coco Division at its present level of operations (8,000 bales per month) follows:
Sales (all external)
P 160,000
Variable costs per bale:
Production
5
Selling
2
General and administrative expenses
1
Fixed costs per bale (based on a 10,000 unit capacity)
Production
2
Selling
3
General and administrative expenses
4
Consumer Products Division currently pays P 15 per bale for coconut broom obtained from its external
supplier.
Required: Determine the following:
1. Minimum transfer price.
2. Minimum transfer price, assuming the Consumer Products Division needs 3,500 bales.
3. Minimum transfer price, assuming the Consumer Products Division needs 4,400 bales but is willing to
pick up the goods from the factory resulting to a saving in selling expenses of P 1.30 per bale.
China
P 300
120
Unit sales price
Unit variable production costs
Domestic price of material “22n4”
Tax rate
Solutions/ Discussions:
Philippines
P 580
80
250
30%
60%
1. with excess capacity
Min. Transfer Price = Incremental costs + Opportunity costs – Savings = P 8.00
The incremental costs include variable production and expenses (e.g., P 5 + P 2 + 1)
World Holdings, Inc., is entertaining the possibility of the China Division supplying the product “22n4”
needs of the Philippine Division. The China Division has enough capacity to accommodate the possible
demand of the Philippine Division, and its local and other international market would not be affected by
its contemplated sales to the Philippine Division. If ever the transfer pushes through, shipping charges,
freight, custom duties, and other incremental and similar costs of transactions would be P 40 per unit.
2. with no excess capacity
Min. Transfer Price = Regular sales price + Other incremental costs + Opportunity costs - Savings
= P 20 + P 0.8571 = P 20.8571
The opportunity cost is the lost contribution margin on regular sales P 3,000 (e.g., 3,500 units – 2,000
units) x P 2 = P 3,000), and if spread over the 3,500 units ordered would be P 0.8571 per unit.
3. Min. Transfer Price = (P 20 – P 1.30) + 1.20 = P 19.90
The opportunity cost is the lost contribution margin on regular sales P 3,000 [e.g., (4,400 units – 2,000
units) x P 2 = P 4,800], and if spread over the 4,000 units ordered would be P 1.20 per unit.
Transfer Price for Services
Departments of many large organizations may sell services for customers and for each other internally.
The department performing the services to a second department generates revenues from such activity.
The same transfer is the second department’s purchase of services. For example, a company typically bill
administrative services, such as computer processing, accounting, payroll and personnel to the
departments they support. In each of the cases, equitable transfer prices must be established to appraise
the department’s performance for its own return on invested capital.
The following steps may be followed in setting transfer price for services:
1. Identify the different departments contributing various services.
2. Evaluate the corresponding skill and experience of personnel involved in delivering services.
3. Estimate the cost involved in providing the service. Factors such as time requirements,
qualifications, cost of the facilities needed to provide the service should be considered.
4. Adopt one or any of the principles applied to the transfer of products discussed in this module.
Multinational Transfer Pricing
Multinational transfer pricing applies when the transacting divisions are addressed or located in different
countries of operations.
In multinational transfer pricing, the objectives of the holdings company govern to minimize costs and
maximize profit. Costs are minimized if the internal costs of producing the goods are lower than the costs
of acquiring the goods externally.
A special focus of multinational transfer pricing is the analysis on international tax effects incurred or
paid by the parent or holding company to the host countries. The holding company would endeavor to
reduce the overall tax payments by striking the best transfer price that would result to the lowest total tax
payments to be made. Also, to record the shipping expenses in the country having lower applicable tax
rates.
Sample Problem 5.3. Multinational Transfer Pricing
World Holdings Inc., has two international divisions, one operating in the Philippines and the other is
operating in China. The China Division produces product “22n4” which is a material used by the
Philippines Division. The divisions are operating independently and below are the selected data on their
operations:
Required: Determine the overall profit of World
the shipping and related costs, are as follows:
Options
Transfer price
1
P 300
2
P 300
3
P 120
4
P 120
5
P 250
6
holdings, Inc., if the transfer price and the recording of
Shipping costs to be recorded by
China Division
Philippine Division
Philippine Division
China Division
Philippine Division
The 6th option is for the Philippine Division buys the materials locally and the China Division sells the
goods in the domestic market.
Solutions/ Discussions

The computations of the consolidated net profit shall be as follows:
1
Consolidate profit before tax
(P 580 – P 120 – P 40 – P 80)
(P 300 – P 120) + (P 580 – P 80 – P 250)
China tax paid
(P 300 – P 120 – P 40) 60%
(P 300 – P 120) 60%
(P 120– P 120) 60%
(P 120 – P 120 – P 40) 60%
(P 250 – P 120) 60%
(P 300 – P 120) 60%
Philippine tax paid
(P 580 – P 300 – P 80) 30%
(P 580 – P 300 – P 40 - P 80) 30%
(P 580 – P 120 – P 40 - P 80) 30%
(P 580 – P 120 – P 80) 30%
(P 580 – P 250 – P 40 - P 80) 30%
(P 580 – P 250 – P 80) 30%
Consolidated profit

P 340
2
P 340
3
4
P 340
5
P 340
6
P 340
P 430
(84)
(108)
0
24
(78)
(108)
(60)
(48)
(102)
(114)
(63)
P 196.50
P 184.50
P 238.50
P 250.00
P 199.00
(75)
P 247.00
Based on the analysis above, the best transfer price for the overall goal congruence of the
enterprise is option no. 3 which would result to the highest profit after taxes of P 250.00. That is,
set the transfer price at P 120 and the China Division would absorb the cost of shipping and
related expenses.
The field of multinational transfer pricing has already attracted the attention of regulatory agencies,
international standard-setting firms, and entities articulating the advantages and wisdom of recording
transactions on a pure arm’s-length transactions basis.
Transfer Pricing
Additional Notes
Quality Management Measurements
Feedback and performance evaluation are important in effecting managing. Feedback regarding
managerial performance may take the form of financial and nonfinancial measures that may be internally
and externally generated. Some examples of financial and external measures are stock price, industry
average on return on equity, return on assets, and return on sales, debt-to-equity ratio, and price - earnings
ratio. Examples of internal and financial measures are cost variances, return on investment, residual
income, breakeven point, breakeven time, return on sales, and other financial ratios.
Breakeven time is the point where the cumulative discounted cash inflows from investment equals the
cost of investment.
Nonfinancial measures are important in a modern, quality-oriented organizations. Emphasis is made on
kaizen or continuous improvement, value-chain analysis, process innovation (or reengineering), process
mapping where standards are geared towards process analyses and not on absolute costs benchmarks.
Examples of external nonfinancial measures are customer satisfaction, market share, number of sales
returns, delivery performances, and competitive rank. Examples of internal nonfinancial measures are set
up time, retooling, rework, outgoing product quality, new product development time, manufacturing cycle
time, and productivity rate.
Product development time pertains to the period where the product is conceptualized, designed,
approved, and the prototype made and readied for commercial production. As customer tastes,
preferences, needs and wants change now more frequently, product life cycle shortens and the quickness
of addressing customer wants, etc becomes a critical factor in a business growth and relevance.
Manufacturing cycle time refers to a period where the materials from suppliers are received, stocked,
checked processed, and prepared for delivery to customers. To improve manufacturing cycle time, nonvalue added activities should be eliminated, therefore, production gets faster, costs diminishes, and
customers will be served on time. Partial Productivity rate is a measure of output (finished goods) over
process input (e.g., materials, labor hours).
Balanced scorecard uses multiple measures in determining as to whether a manager is achieving
objectives at the expense of others. The scorecard approach is a goal congruence tool that informs
managers about the factors that top management believes to be important. For example, the value of
improving operating results at the expense of new product development could be evaluated using the
scorecard approach. A typical scorecard includes measures in four categories:
 Learning and growth perspectives;
 Internal business processes perspectives;
 Customer satisfaction perspectives; and
 Financial perspectives.
References:
Agamata, Franklin T. Management Services 2019 Edition. GIC Enterprises & Co., Inc, 2019
Cabrera, Ma. Elenita B. Management Accounting Concepts and Applications. GIC Enterprises & Co., Inc,
2014
Illustrative Problem 1
The Lewis Company has two divisions, Production and Marketing. Production manufactures designer
pants, which it sells to both the Marketing Division and to other retailers (to the latter under a different
brand name). Marketing operates numerous pants stores, and it sells both Lewis pants and other bands.
The following facts also pertain to the Lewis Company:
 Sales price to retailers if sold by Production: P 380 per pair.
 Variable cost to produce: P 190 per pair.

Fixed costs: P 2,000,000 per month.
 Production is operating far below its capacity.
 Sales price to customers if sold by Marketing: P 500 per pair.
 Variable marketing costs: 5 percent of sales price.
Marketing has decided to reduce the sales price of Lewis pants. The company’s variable manufacturing
and marketing costs are differential to this decision, whereas fixed manufacturing and marketing costs are
not.
a. What is the minimum price that can be charged for the pants and still cover differential
manufacturing and marketing costs?
b. What is the appropriate transfer price for this decision?
c. What if the transfer price were set at P 380? What effect would this have on the minimum price
set by the marketing manager?
d. How would you answer to questions a and b change if the Production Division had been
operating at full capacity?
Solution: Lewis Company
a. From the company’s perspective, the minimum price would be the variable cost of producing and
marketing the goods. It would solve for this minimum price as follows:
Let X =
minimum transfer price
X =
190 + 0.05X
=
190
0.95
=
P 200
The minimum price the company should accept is P 200. If the company were centralized, we
would expect this information to be conveyed to the manager of Marketing, who would be
instructed not to set a price below P 200.
b. The transfer price that correctly informs the marketing manager about the differential costs of
manufacturing is P 190. Production is operating below capacity, so there is no opportunity cost of
transferring internally.
c. If the production manager set the price at P 380, the marketing manager would solve for the
minimum price:
Let X1 =
minimum price
X1 =
P 380 + 0.05X1
P 380
=
0.95
=
P 400
So the marketing manager sets the price in excess of P 400 per pair, when, in fact prices greater
than P 200 would have generated a positive contribution margin from the production and sale of
pants.
d. For question a:
If production is operating at full capacity, the minimum price is
X1 =
P 380 + 0.05X1
0.95X1 =
P 380
X1 =
P 400
Transfer price ≥ Variable cost per unit + Total contribution margin on lost sales
Number of units transferred
For question b:
If Production Division had been operating at capacity, there would have been an implicit
opportunity cost of internal transfer. Production would have foregone a sale in the wholesale
market to make the internal transfer. The implicit opportunity cost to the company is the lost
contribution margin (P 380 – P 190 = P 190) form not selling the wholesale market.
Thus, if Production had sufficient sales in the wholesale market so that it would have had to
forego those sales to transfer internally, the transfer price should have been
Differential Cost to Production + Implicit Opportunity Cost to Company if Goods are
Transferred Internally
= P 190 + P 190
= P 380
Since there is enough idle capacity to fill the entire order from the Motor Division, there are no
lost outside sales. And since the variable cost per unit is P 21, the lowest acceptable transfer price
as far as the selling division is concerned is also P 21.
Transfer price ≥ P 21 + P
0 = P 21
21,000
b. The Motor Division can buy a similar transformer from an outside supplier for P 38. Therefore,
the Motor Division would be unwilling to pay more than P 38 per transformer.
Transfer price ≥ Cost of buying from outside supplier = P 38
c. Combining the requirements of both the selling division and the buying division, the acceptable
range of transfer prices in this situation is:
Illustrative Problem 2
NY Company’s Electrical Division produces a high-quality transformer. Sales and cost data on the
transformer follow:
Selling price per unit on the outside market
Variable costs per unit
Fixed costs per unit (based on capacity)
Capacity in units
P 40
P 21
P 9
60,000
NY Company has a Motor Division that would like to begin purchasing this transformer from the
Electrical Division. The Motor Division is currently purchasing 10,000 transformers each year from
another company at a cost of P 38 per transformer. NY Company evaluates its division managers on the
basis of divisional profits.
Required:
1. Assume that the Electrical Division is now selling only 50,000 transformers each year to outside
customers.
a. From the standpoint of the Electrical Division, what is the lowest acceptable transfer
price for transformers sold to the Motor Division?
b. From the standpoint of the Motor Division, what is the highest acceptable transfer price
for transformers acquired from the Electrical Division?
c. If left free to negotiate without interference, would you expect the division managers to
voluntarily agree to the transfer of 10,000 transformers from the Electrical Division to the
Motor Division? Why or why not?
d. From the standpoint of the entire company, should a transfer take place? Why or why
not?
2. Assume that the Electrical Division is now selling all of the transformers it can produce to outside
customers.
a. From the standpoint of the Electrical Division, what is the lowest acceptable transfer
price for transformers sold to the Motor Division?
b. From the standpoint of the Motor Division, what is the highest acceptable transfer price
for transformers acquired from the Electrical Division?
c. If left free to negotiate without interference, would you expect the division managers to
voluntarily agree to the transfer of 10,000 transformers from the Electrical Division to the
Motor Division? Why or why not?
d. From the standpoint of the entire company, should a transfer take place? Why or why
not?
Solution:
Requirement 1
a. The lowest acceptable transfer price from the perspective of the selling division, the Electrical
Division, is given by the following formula:
P 21 ≤ Transfer Price ≤ P 38
Assuming that the managers understand their own businesses and that they are cooperative, they
should be able to agree on a transfer price within this range and the transfer should take place.
d. From the standpoint of the entire company, the transfer should take place. The cost of the
transformers transferred is only P 21 and the company saves the P 38 cost of the transformers
purchased from the outside supplier.
Requirement 2
a. Each of the 10,000 units transferred to the Motor Division must displace a sale to an outsider at a
price of P 40. Therefore, the selling division would demand a transfer price of at least P 40. This
can also be computed using the formula for the lowest acceptable transfer price as follows:
Transfer price ≥ P 21 + (P 40 – P 21) x 10,000
10,000
= P 21 + (P 40 – P 21) = P 40
b. As before, the Motor Division would be unwilling to pay more than P 38 per transformer.
c. The requirements of the selling and buying divisions in this instance are incompatible. The selling
division must have a price of at least P 40 whereas the buying division will not pay more than P
38. An agreement to transfer the transformers is extremely unlikely.
d. From the standpoint of the entire company, the transfer should not take place. By transferring a
transformer internally, the company gives up revenue of P 40 and saves P 38, for a loss of P 2.
Multinational Transfer Pricing
Transfer pricing is used worldwide to control the flow of goods and services between segments of
organizations. However, the objective of transfer pricing change when a multinational corporation is
involved and the goods and services being transferred must cross international borders. The objectives of
international transfer pricing focus on minimizing taxes, duties, and tariffs, foreign exchange risks along
with enhancing a company’s competitive position and improving its relation with foreign government.
Corporations may change a transfer price that will reduce its total tax bill or that will strengthen a foreign
subsidiary. For example, a division in a high-income-tax-rate country produces a subcomponent for
another division in a low-income tax rate country. By setting a low transfer price, most of the profit from
the production can be recognized in the low-income-tax-rate country, thereby minimizing taxes. On the
other hand, items manufactured by divisions in a low-income-tax-rate country and transferred to a
division in a high-income-tax-rate country should have a high transfer price to minimize taxes.
Sometimes import duties offset income tax effects. Usually import duties are based on the price paid for
an item, whether bought from an outside company or transferred to another division. Therefore, low
transfer prices will be used to lessen the import duties.
Managers should be sensitive to the geographics, political and economic circumstances in which they are
operating, and set transfer price in such a way as to optimize total company performance and at the same
time conform with the laws in various countries where they operate.
Module 6
Nonroutine Operating Decisions
Intended Learning Outcomes:
At the end of the module, you should be able to:
 Differentiate strategic, tactical and operational decisions.
 Differentiate routinary from non-routinary decisions
 Discuss the difference between the relevant costs from irrelevant costs in decision making
 Give examples of nonroutine operating decisions
 Present relevant costs and quantitative analysis in various situations involving nonroutine
operating decisions.
Introduction
Managers must constantly make decisions. In making these decisions, they must estimate how each
decision could affect operating income. The management accountant’s role in this process is to supply
information on changes in cost and revenues to facilitate the decision process. How does accountant
decide which information to present?
Managers often select the course of action that maximizes expected operating income over the period
affected by the decision. To do this, they analyze relevant information. Relevant information is the
expected future data that differ among alternative courses of action.
In decision making, revenue and costs are often the key factors. These revenues and costs of one
alternative must be compared against the revenues and cost of other alternatives as one step in the
decision making process. The problem is that some costs associated with an alternative may not be
relevant to the decision to be made. A relevant cost can be defined as a cost that is applicable to a
particular decision in the sense that it will have a bearing on which alternative the manager selects.
Decision Viewpoints
Decisions drive things to happen or not to happen. Decisions are made in all facets of our life. Decisions
make us. We are who we are because we have decided to be who we are.
Decisions are made in all segments of organizational units. Decisions make an organization.
Decisions may be strategic, tactical or operational. Strategic decisions have long-term effects, its focus is
growth and stability, and it is concerned of meeting the needs of institutional investors. Tactical decisions
are regularly made to impact medium-term organizational activities. Its focus is profitability and liquidity
and it is concerned with customer’s satisfaction. Operational decisions are made on a daily basis where
the judgment call of a supervisor is at its greatest value. Most of the developed science of management
accounting is based on strategic and tactical decisions.
Strategic and tactical decisions are compared below.
Table 6.1. Strategic v. Tactical Decisions
Comparison of Strategic and Tactical Decisions
Variables
Strategic Decisions
Tactical Decisions
Time-effects
Long-term
Medium-term and short-term
Concerned management level
Top executives
Middle and supervisory
managers
Primary interests served
Financial investors (i.e., owners
Customers
and creditors)
Focus
Stability and growth
Profitability and liquidity
Management accounting
Capital budgeting
Standard costing
techniques used
Responsibility accounting
Short-term budgeting
Cost-volume-profit analysis
Variance analysis
Nonroutine operating decisions
Frequency
Nonrepetitive
Repetitive (routinary) and
nonrepetitive (non-routinary)
The nonroutine operating decisions
Scrap or rework a defective unit?
Nonroutine operating decisions are not covered by standard operating policies (SOPs) normally codified
in a manual. Repetitive or routinary transactions are the ones covered by SOPs. Examples are policies on
expense approval, collections from customers, issuance of checks, receipts of purchases, warehousing and
inventory management, selecting, hiring, and training of personnel, and other regular (ordinary,
repetitive) transactions.
Nonroutine operating decisions have effects on the profitability but have no visible or direct impact on the
long-term stability and strategy of an organization. Profitability is the core driver in making nonroutine
operating decisions.
Determining the indifference point
money and tax effects are not considered)
Choose the alternative that gives the highest shortterm profitability
Indifference point is where the outcomes of the
alternatives are the same
In making these decisions, the guiding principle is always to maximize profitability.
Make or Buy a Component or Part? … an Insourcing vs. Outsourcing issue…
Relevant costs
A product is composed of different parts. Not all parts of the product are manufactured by a company. A
part may be outsourced from a supplier based on the following reasons:
1. Lack of technology, man labor hours, machine hours, systems expertise, or financing.
2. Savings or discontinuance of unprofitable segment operations.
3. Legal or cultural limitations, or,
4. Strategic business relations.
Relevant costs are those used in making a decision. If a cost is not used in a specific situation that needs
to be decided upon, that cost is irrelevant in that situation. A decisional situation needs specific sets of
relevant costs. a cost that is relevant in a particular decision may be irrelevant in another.
The total relevant costs of each option should be taken when deciding to make or buy a part. Whichever
option gives a lower relevant cost would be a better alternative, assuming no other quantitative and
qualitative factors are to be considered.
Relevant costs have two (2) important features – differential and future-oriented.
Sample Problem 6.1. Make or Buy a Part
Differential costs (or incremental costs) change from one alternative to another. In making a decision, you
have at least two (2) alternatives or options. If a cost differs from one option to another, that cost is
differential. Incremental costs refer to those that increase in costs from one option to another. The normal
examples of incremental costs are direct materials, direct labor, variable overhead and variable expenses.
Avoidable fixed overhead may also be an incremental cost.
Toblerone Corporation manufactures part X-24 for use in its production cycle. The cost per unit for
10,000 units of part X-24 are as follows:
In making decisions, multifarious qualitative variables are also considered. Sometimes, they are more
important than the measurable ones. However, qualitative variable are not included in this discussion.
Direct materials
Materials handling costs (20%)
Direct labor
Variable overhead
Fixed overhead
Total
Future costs are referred to as planned costs, budgeted costs, projected costs, or estimated costs. Future
costs are yet to be incurred in upcoming activities. If a cost is not a future cost, it is automatically not
relevant.
P 6.00
1.20
20.00
5.00
11.00
P 43.20
A cost to be relevant must be both differential and future cost. Sunk cost (or past costs, historical cost)
cannot be changed further, cannot be incurred in the future, and could not be relevant in decision-making.
Ferrero Company has offered to sell Toblerone Corporation 10,000 units of part X-24 for P 40 per unit.
Nonroutine operating decisions use relevant costs and as such is sometimes referred to as relevant costing,
incremental costing, or differential costing.
If Toblerone accepts Ferrero’s offer, P 4 of the fixed overhead per unit could be eliminated. The materials
handling costs pertaining to the cost of receiving and inspecting of incoming materials and other
components are not included in the overhead.
Application of Relevant Costing
Relevant costing is applied in all possible situations where standard operating policies are not applicable.
However, only the following decision situations are to be illustrated and discussed in this chapter:
Nonroutine Operating Situations
Make or buy (insource or outsource) a component
or part?
Accept or reject a special sales order?
Drop or continue a segment or division?
Sell-as-is or process further a completed product?
Continue or temporarily shutdown operations?
What is the winning bid price, highest or lowest?
Optimization of scarce resources
Sell now or later a product
Replace or retain an old asset?
Decision Guidelines
Least-cost analysis, whichever option results to a
lower relevant cost is better
If there is an incremental profit, accept
If the segment margin is positive, continue. But
also consider the complementary effects.
If there is profit from further processing, then
process further.
If sales are greater than the shut down point, better
continue operating.
Focus on the incremental costs.
Prioritize the product that gives the highest
contribution margin on the limited resource.
If the expected increase in sales is greater than the
incremental cost of storage and other relevant costs,
then sell later.
If the net cash inflows are greater than the net
outflows, replace the asset. (here the time value of
If the part is outsourced from an outside supplier, one-half of the released facilities could be used to
produce a new product. Citrus, which is expected to generate a contribution margin of P 90,000 a year.
Additionally, savings of P 15,000 are expected if the parts are purchased outside. The other half of the
released facilities could be rented out for P 60,000 per annum.
Ferrero Company requires that equipment be leased to meet the order of Toblerone Corporation. The
equipment rental cost of P 80,000 shall be charged to the buying company.
Required: For Toblerone Corporation:
1. What alternative is better, make or buy the part and by how much is its advantage?
2. Indifference price of the two alternatives.
3. Purchase price to have a savings of P 10.00 per part.
4. The sunk cost (or irrelevant cost) in the decision of making or buying part.
Solutions/ Discussions:

The tabulated relevant costs of making and buying the part are as follows:
Computations
Purchase price
Direct materials
Materials handling costs
P 6.60 x 20%
Direct labor
Variable overhead
Avoidable fixed overhead
Savings if the part is bought
P 15,000/10,000
Rental income from released facilities
P 60,000/10,000
Contribution margin from a new product
P 90,000/10,000
Rental expense if the part is bought
P 80,000/10,000
Total relevant costs
Savings per unit if the parts are made
Total savings if the parts are made 10,000 x P 3.30
Unit Costs
To MAKE To BUY
P 40.00
P 6.00
1.20
8.00 (P 40.00 x 20%)
20.00
5.00
4.00
(1.50)
(6.00)
(9.00)
8.00
P 36.20 P 39.50
P 3.30
P 33,000

Variable production costs (e.g., direct materials, direct labor, and variable overhead) are
incremental costs, differential cost, and are relevant costs.

Avoidable fixed overhead costs are also relevant cost since they vary from one option to another.
If a part is manufactured, the avoidable fixed cost is still incurred; but if the part is purchased, it is
avoided.

Unavoidable fixed overhead cannot be avoided regardless of decisions made whether make or
buy. It does not change, it is irrelevant.

Materials handling costs apply to both materials and other items being purchased. The rate used
in the allocation of the material handling costs is constant but the amount allocated to various
departments differs depending on the base amount of items purchased. This makes the materials
handling costs relevant for the make or buy short-term decision.

Savings from parts bought, rental income from released facilities, and contribution margin from a
new product all happen when the part is bought. They are all inflows, either in the form of
savings or additional income, and as such are deducted from the costs of buying.

Variable and fixed selling and administrative expenses are not considered in the analysis because
they are not affected by the decisions; they will not change, and are irrelevant in the decision on
hand.

Based on the quantitative analysis above, it is advisable for Toblerone Corporation to make the
part.
2. The indifference price of the alternatives make or buy is computed as follows:
Unit cost to make
Added (Deducted) back to the relevant costs to buy,
except for the purchase price and related handling costs:
Rental expenses
Contribution margin from a new product
Rental income from released facilities
Savings if the part is bought
Purchase price and handling costs
Purchase price from the supplier P 44.70 / 120%
P 36.20
(8.00)
9.00
6.00
1.50
P 44.70
P 37.25
The handling costs is 20% of the purchase price.
3. The purchase price with a P 10 – saving per part shall be computed as follows:
Gross purchases price including handling costs
Required savings
Gross purchase price with savings
Net purchase price P 34.70 / 120%
P 44.70
(10.00)
P 34.70
P 28.917
4. The sunk cost in the decision to make or buy the part shall be the unavoidable fixed costs of P 7.00
(e.g. P 11 – P 4) or a total of P 70,000 (e.g., 10,000 x P 7)
Accept or Reject a Special Sales Order… Is there an incremental profit?
This pertains to a special sales order outside of the regular sales. In deciding whether to accept or reject a
special sales order, the paramount consideration is incremental profit, which is normally determined as:
Incremental revenue
Incremental costs
Incremental profit (loss)
Px
(x)
P x
The following factors are to be considered in the decision to accept or reject a special order:
 Is unnecessary competition created?
If the acceptance of the special sales order creates an unnecessary competition to the regular
product sales, the special sales order is normally rejected. But if the special sales order is accepted
and regular sales are lost due to the acceptance of a special sales order, the lost contribution
margin thereof becomes an opportunity cost that should be deducted from the incremental profit
of accepting the special order.
Normally, a regular market is distinguished from a special market in that one is domestic and the
other foreign. Or, the products, regular product or special product, can be visibly identified for
each other through marks, color, or other distinguishing features.

Do we have an idle capacity? Is there an alternative use of the capacity?
If there is no alternative use of capacity, the incremental profit (loss) is the difference between
incremental sales and incremental costs and expenses.
If there is an alternative use of the capacity, the best benefit that may be derived from such should
be deducted from the incremental profit to get the net advantage or disadvantage from accepting
the special sales order.
A tabulated summary of accept or reject a special order analysis is presented in the following table.
Table 6.1. Pro-Forma Analysis for Special Sales Order in Relation to Idle Capacity
Accept or reject a special sales order
With idle or without idle capacity
Situations
No alternative use of capacity
With idle
Incremental sales
Px
capacity
Incremental costs
(x)
Incremental profit (loss) P x
With alternative use of capacity
Incremental sales
Px
Incremental costs
(x)
Incremental profit (loss)
Px
Opportunity costs (benefit lost)
from the alternative use of
capacity
(x)
Advantage (disadvantage) of accepting
the special sales order
Px
The opportunity costs here refer to the net benefit
that could have been derived from another
alternative had the special sales order not been
accepted.
Examples of opportunity costs are:
 Rented income, or
 New contribution margin from producing
a new product
No idle capacity
Incremental sales
Px
Incremental costs
(x)
Incremental profit (loss) P x
Incremental sales
Incremental costs
Incremental profit (loss)
Opportunity costs, net of
best benefit foregone
from alternative use of
capacity
Advantage (disadvantage) of
accepting the special sales
order
Px
(x)
Px
(x)
P x
4. Incremental CM
CM lost from regular sales (2,000 units x P 45)
Net increase in profit from accepting the special sales
P 420,000
(90,000)
P 330,000
The regular UCM is P 45. The CM lost from regular sales out of accepting the special sales order
is an opportunity cost to be deducted from the incremental contribution margin to determine the
net increase in profit in the business operations.
Sample Problem 6.2. Accept or Reject a Special Sales Order
The manufacturing capacity of NorthWind Corporation’s facilities is 50,000 units of product a year. A
summary of operating results for the year end December 31, 2019 is as follows:
Total
P 3,800,000
2,090,000
1,710,000
900,000
810,000
P 420,000
(600,000)
P 480,000
Still, the incremental profit or loss from accepting the special sales order is compared with the net
benefit derived from an alternative use of the facility, in this case, the contribution margin from a
new product. Inasmuch as the profit from producing a new product is greater than the profit from
accepting the special sales order, the special sales order should be rejected and the new product
be produced.
The opportunity costs here refers to the lost
contribution margin from regular sales or from
the best use of the sacrificed capacity.
Sales (38,000 units)
Less: Variable costs and expenses
Contribution margin
Less: Fixed costs and expenses
Operating income
3. Incremental CM (12,000 x P 35)
CM from a new product
Net advantage of rejecting the special order
Per Unit
P 100.00
55.00
P 45.00
A distributor company has offered to buy 12,000 units at P90 per unit in the following year. Assume that
all of the corporation’s costs next year would be at the same levels and rates as in the prior year.
Required: Should NorthWind Corporation accept or reject the special sales order? (Consider the
following cases independently.)
1. The corporation has no alternative use of the idle capacity.
2. The corporation can rent out the idle capacity for P 200,000.
3. The corporation can use the idle capacity to produce a new product that could contribute a P
600,000 contribution margin.
4. If the special order is accepted, 2,000 units of regular sales are expected to be lost.
5. Assuming a distributor has ordered 16,000 units and the corporation has to sacrifice some of its
regular customers to accommodate the special order.
5. Incremental CM (16,000 units x P 35)
Lost contribution margin (4,000 units x P 45)
Net incremental profit
P 560,000
(180,000)
P 380,000
The UCM of the special order is still P 35 (i.e., P 90 – P 55). The 16,000 units ordered on a
special basis is more than the idle capacity of 12,000 units (i.e., 50,000 units – 38,000 units of
regular sales). To accept the special order, 4,000 units of regular sales should be sacrificed (i.e.,
16,000 units – 12,000 units). Accordingly, the contribution margin of the 4,000-unit regular sales
would be lost. Hence, it is deducted from the income arising from special sales.
Continue or drop a business segment…
A business segment represents a division, product line, department or business unit. Depending on what it
intends to describe, segment margin is sometimes labeled as division margin, product margin, or
department margin. If the segment margin is positive, it means that the segment is contributing to the
overall profitability of the organization. If you drop the segment, the overall profitability of the business
will be diminished by the amount of the positive segment margin.
Companies fold up there segment operations for strategic, operating, or financial reasons. Strategically, an
enterprise folds up its business segment when it is consolidating its business either vertically or
horizontally. Financially, business segments are closed to raise funds and finance more profitable
segments. Operationally, an enterprise closes a segment to avoid recurring losses from the segment’s
normal operating activities.
Solutions/ Discussions:
1. Incremental sales (12,000 units x P 90)
Incremental costs (12,000 units x P 55)
Incremental profit
P 1,080,000
660,000
P 420,000
The incremental costs here refer to variable costs and expenses. The unit variable costs is P 55
(i.e., P 2,090,000/ 38,000 units).
In this situation, the profitability of a segment is measured by its segment margin. If its segment margin is
positive, it contributes to the overall profitability of the enterprise and should be continues, assuming
there is no alternative use of the released facilities if the segment is discontinued. If there is an alternative
use of the released facilities, compare the segment margin from the net benefit of its best alternative use.
If the segment margin is still greater, then continue. Otherwise, discontinue the division and better
undertake the alternative use of the facilities.
Principally, the segment margin is determined as follows:
The total fixed costs and expenses are assumed to be the same whether the special order is
accepted or not, and, therefore, are irrelevant in the analysis.
2. Incremental CM (12,000 x P 35)
Rent income if the facility is rented out
Net advantage of accepting the special order
P 420,000
(200,000)
P 220,000
The incremental UCM is P 35 (i.e., P 90 – P 55). The benefit that could be derived from the
alternative use of the facility, in this case rental income, is compared with the incremental profit
from accepting the special order. Since the incremental income from accepting the special sales
order is greater than renting out the facility by P 220,000, it is more advantageous for the business
to accept the special sales order.
Contribution margin
Less: Avoidable fixed costs and expenses
Segment margin
P x
x
P x
Alternatively, segment margin is computed as shown below:
Pro-Forma
Marginal Income Statement
Sales
Less: Variable costs of goods sold
Manufacturing margin
Less: Variable selling and administrative expenses
Contribution margin
Less: Controllable direct fixed costs and expenses
Controllable margin
Less: Non-controllable direct fixed costs and expenses
Segment (direct margin)
Less: Indirect (allocated) fixed costs and expenses
Operating income
Px
x
x
x
x
x
x
x
x (focus here)
x
Px
Sample Problem 6.3. Drop or Continue a Division – 1
Francis Company plans to discontinue a division with a P 200,000 contribution to overhead. Overhead
allocated to the division is P 500,000, of which P 50,000 cannot be eliminated. Should Francis Company
discontinue the division?
Solutions/ Discussions:
 The controllable segment margin is computed as follows:
Contribution margin
Less: Avoidable fixed costs (P 500,000 – P 50,000)
Controllable segment margin

c. Decrease in profit due to lost positive segment margin of product 1
40% increase in the CM of product 2 (P 400,000 x 40%)
Net increase in overall profit
P (80,000)
160,000
P 80,000
d. Contribution margin
Avoidable fixed costs
20% decrease in CM of product 2 (P 400,000 x 20%)
Net increase in the overall profit
P 120,000
(80,000)
P (200,000)
P 180,000
(60,000)
Alternatively, the analysis may be made in “total approach” as follows (amounts in thousands):
Product A
Sales
-Variable costs
Contribution margin
- Avoidable fixed costs
Segment margin
- Allocated fixed costs
Profit (loss)
Increase (decrease) in profit
P 300
120
180
100
80
200
P (120)
Product B
P 600
200
400
100
300
200
P 100
Total
P 900
320
580
200
380
400
P (20)
a
P 600
200
400
100
300
400
(100)
P (80)
Total Profit Analysis
b
C
d
P 600 P 840
P 480
200
280
160
400
560
320
100
100
140
300
460
180
340
400
400
(40)
60
(220)
P (20) P 80
P (200)
Sell-as-is or process further a product… Is there an incremental profit?
P 200,000
450,000
P (250,000)
The division should be discontinued because it has a negative controllable segment margin. If the
division margin is dropped, the loss is eliminated and the overall profit of the enterprise will
increase by P 250,000.
Sample Problem 6.4. Drop or Continue a Division – 2
Samal Company produces and sells two products with the following income statement data in 2019 (in
pesos)
Goods undergo several conversion processes from original source to final consumption. For example,
eggs may be hatched to chicks, chicks may be raised to hens, hens may be sold live or may be retained to
become layers, chickens may be sold live or otherwise, or may be sold, chopped or cooked. In each
conversion process, the business has an opportunity to sell now or sell after further processing. If the
product is processed further, the unit sales price is expected to increase. However, there is also a cost for
subsequent processing (i.e., cost of further processing, upgrading cost, or cost of additional processing)
which is an incremental costs.
Again, focus on the incremental profit. If the incremental sales are greater than the incremental costs of
further processing, it is advisable to process further the product to maximize profit. The joint production
costs (or common costs) and all other costs of preceding processes are considered irrelevant in deciding
whether to sell now or process further.
Sample Problem 6.5. Sell-As-Is or Process Further a Product – 1
Sales
- Variable costs
Contribution margin
- Avoidable fixed costs
Segment margin
- Allocated fixed costs
Profit (loss)
Product A
P 300
120
180
100
80
200
(120)
Product B
P 600
200
400
100
300
200
100
Total
P 900
320
580
200
380
400
(20)
Required: Assuming all things shall be constant in the following business period, except as provided
below, determine the effect of the following independent cases to the overall profit of the enterprise.
1. Product A is dropped.
2. Product A is dropped and 15% of the allocated fixed cost is eliminated.
3. Product A is dropped and the released facility is used to produce and sell 40% more of Product 2.
4. Product A is discontinued and 40% of the product’s avoidable fixed costs would remain with a
corresponding 20% decrease in the sales of product 2.
Solutions/ Discussions:
a. Decrease in profit due to lost positive segment margin of product 1
P (80,000)
b. Decrease in profit due to lost positive segment margin of product 1
15% drop in allocated fixed cost (P 400,000 x 15%)
Net decrease in overall profit
P (80,000)
60,000
P (20,000)
Tarlac Corporation produces three (3) main products. Its production and costs data are given below:
Unit sales price after further processing
Unit sales price before further processing
Costs of separate (further) processing
Units produced and sold
Total joint costs, P 1,400,000
X
P 300
250
120,000
2,000
Y
P 550
530
65,000
4,000
Z
P 220
190
190,000
7,500
Which of the products should be processed further?
Solutions/ Discussions:

The incremental (decremental) profit of further processing per product is presented below:
Incremental sales (2,000 units x P 50)
(4,000 units x P 20)
(7,500 units x P 30)
Incremental costs
Increase (decrease) in profit
X
P 100,000
Y
Z
P 80,000
(120,000)
P (20,000)
(65,000)
P 15,000
P 225,000
(190,000)
P 35,000




Products Y and Z should be processed further to maximize profit while product X should be sold
now or at split-off point.
Incremental sales equal increase in unit sales price times the number of units sold. The unit sales
price normally increases after further processing.
Incremental costs are those incurred in the act of processing further the product.
The total joint cost is irrelevant in this decision because it does not change regardless of selling
the products at split-off pint or processing further.
Sample Problem 6.6. Sell-As-Is or Process Further a Product – 2
Cyclone Corporation produces three products at segregation point, Kah, Mooh, and Tey. These These
products could be processed further then later sold at higher sales value. The total joint cost in
manufacturing these three products was P 3 million. The data below were made available by the
accounting and production personnel:
Production and sales
Unit sales price at split-off point
Unit sales price after further processing
Unit variable costs of subsequent processing
during rainy days. Also, there are months in a year where businesses in a given economy experience
slowdowns caused by natural, cultural, or environmental conditions of the place where the business
operates. During slack seasons, businesses incur operating losses. Hence, management may contemplate
temporarily stopping its operations to avoid losses.
Yet, if operations are temporarily shut down, the business will still incur a loss because of the shutdown
costs. Costs incurred even after operations temporarily stopped are called as shutdown costs. Examples
are salaries of remaining executives and skeletal personnel, security, insurance, rental, interests,
depreciation, property taxes, advertising, and similar unavoidable costs. On top of it, the business will
incur restart-up costs once it resumes its operations. Restart-up costs include costs of rehiring and
retraining personnel, refueling, aligning, and returning machineries and equipment, and refurbishing the
plant. Either way, continue or shut down, the business will have a loss. It is a choice between two evils. In
this case, you have to choose the lesser evil. The guideline is, “which option will give a lesser amount of
loss?”
Technically, if continuing the operations will result to sales greater than the shut down point, it is better to
continue operating and be spared of more losses from discontinuing operations.
Kah
Mooh
Tey
10,000 units 40,000 units 50,000 units
P 80
P 100
P 200
90
120
230
8
18
27
Shutdown point is the level of operations where the loss from continuing is equal to the loss from
discontinuing (i.e., shut down costs). Expressed mathematically we have,
If product Kah is processed further, an equipment should be rented at a cost of P 12,000. To process
further product Mooh an outside contractor will be engaged for an amount of P 90,000 because the
company has no available space and manpower for its subsequent processing. Product Tey could be
subsequently processed by using idle machine and manpower time within the company. The total set-up
cost of subsequently processing product Tey is P 120,000.
Required:
1. Which product should be processed further to maximize profit?
2. To maximize profit, what is the minimum sales price for product Kah that should be set after it is
processed further?
Where:
Loss from continuing
=
loss from discontinuing
Loss from continuing
Loss from discontinuing
=
=
(CM – FC)
(0 - Shutdown costs)
At shutdown point:
(CM-FC)
QS (UCM) – FC
QS (UCM)
where:
=
=
=
(O – SDC)
(O – SDC)
FC – SDC
CM – Contribution margin
FC – Fixed costs
SDC – Shutdown costs
UCM – Unit contribution margin
QS – Quantity sold
Solutions/ Discussions:
Therefore, shutdown point equals:
QS
1. The increase or decrease in short-term profit shall be determined as follows:
Kah
Incremental unit sales price
Incremental unit variable costs
Incremental unit contribution margin
x units sold
Incremental contribution margin
Incremental fixed costs
Incremental (decremental) profit
P
(
10
8)
2
10,000
P 20,000
(12,000)
P 8,000
Mooh
P
20
(
18)
2
40,000
P 80,000
(90,000)
P (10,000)
Tey
P
30
27)
3
50,000
P 150,000
(120,000)
P 30,000
(
The incremental unit price is the difference in unit sales price at split-off point and after further
processing. The total incremental costs include the incremental variable costs and incremental fixed costs.
the common cost is a sunk costs and is irrelevant in this decision analysis.
Products Kah and Tey should be processed further and product Mooh should be sold at split-off point.
2. The minimum unit sales price for product Kah after further processing should be:
Unit sales price at split-off point
P 80.00
Unit variable costs of subsequent processing
8.00
Incremental fixed costs (P 12,000 / 10,000)
1.20
Minimum sales price after further processing
P 89.20
Continue operations or shut down … It is only temporary!
Demands for products vary due to seasonal, cyclical or random variations. Products manufactured for
Christmas season may not be highly saleable in other months. Summer clothes are not greatly saleable
=
FC – SDC
UCM
Sample Problem 6.7. Shut Down or Continue Operations
FAT Company produces and sells 140,000 units monthly except for the months of July and August when
the number of units sold normally decline to 10,000 units per month. Management contemplates of
temporarily shutting down operations in the months of July and August with the belief that the business
will be spared of more losses during those periods. If the business temporarily shuts down, security and
maintenance amounting to P 220,000 per month would still be incurred. Restarting the operations will
cost the business P 300,000 for mobilization and other costs. The business incurs a total of P 24 million
annual fixed costs allocated evenly over a 12 – month period. This fixed cost is expected to drop by 60%
during the months the operations are shut down.
Other sales and costs data are as follows:
Unit sales price
Unit variable production costs
Unit variable expenses
Required:
1. How much is the total shutdown cost?
2. What is the shutdown point?
3. Should the business continue or shut down?
P 300
140
40
If production of this engine were discontinued, the production capacity would be idle and the supervisor
would be laid off. When asked to bid on the next contract for this engine, what should be the minimum
bid price?
Solutions/ Discussions:
1. The shutdown costs of P 2,340,000 is determined as follows:
Allocated fixed costs (P 24 million x 2/12 x 40%)
Security and insurance (P 220,000 x 2 months)
Restart-up cost
Shutdown cost
P 1,600,000
440,000
300,000
P 2,340,000
Solutions/ Discussions

The minimum price should at least be equal to the incremental cost of manufacturing.
Direct materials
P 300,000
Direct labor
190,000
Supervisor’s salary
40,000
Fringe benefits on direct labor
19,000
Incremental costs/ Minimum price
P 549,000

The depreciation and rent expenses are unavoidable costs whether the contract is obtained or not.
They are constant regardless of alternatives, they are therefore irrelevant.
2. The total fixed cost in the months of July and August if the operations are continued is P 4
million (i.e., P 24 million x 2/12). The unit contribution margin is P 120 (i.e., P 300 – P 180).
Therefore, the shut down point is 13,834, computed as follows:
Shutdown point = P 4,000,000 – P 2,340,000 / P 120 = 13,833.33 units (say 13,834 units)
To prove, we have:
Contribution margin (13,833.33 x P 120)
Less: Fixed costs and expenses
Loss from continuing the operations
Shutdown costs
P 1,660,000
4,000,000
P (2,340,000)
P 2,340,000
Shutdown point is where the loss from continuing equals the shutdown costs.
3. Continue or shutdown?
Contribution margin (10,000 units x 2 mos. x P 120)
Less: Fixed costs and expenses
Loss from continuing the operations
Less: Shutdown costs
Advantage of continuing the operations
P 2,400,000
4,000,000
(1,600,000)
(2,340,000)
P 740,000
Alternatively, the P 740,000 may be computed as follows, [eg. (20,000 – 13,833) x P 120].
Bid price … maximize or minimize?
Sample Problem 6.9. Maximum Bid Price – 2
Frank Dean Company has its own cafeteria with the following annual costs:
Food
P 2,300,000
Labor
820,000
Overhead
550,000
Total
P 3,670,000
The overhead is 30% fixed. Of the fixed overhead, P 72,000 go to the salary of the cafeteria supervisor.
The remainder of the fixed overhead has been allocated from total company overhead. Assuming the
cafeteria supervisor remains and that Frank Dean continues to pay the supervisor’s salary, what is the
maximum cost Frank Dean would be willing to pay an outside firm to service the cafeteria?
Solutions/ Discussions:

Pricing is an important part in economic transactions. It is more important when participating in a bidding
process to get a contract or secure a project. The process of bidding could vary depending on the practices
and circumstances of the bidding process. bidding could be done through public auction, or through
sealed bidding or through whispering one’s bid (e.g., “bulungan”) as practiced by some domestic fish
dealers.
Now, assume that you are operating in a purely competitive business environment. In this case, the
concept of incremental costing is of importance. If you are in a construction business and are bidding for
a construction contract, you have to submit the minimum bid price to win the contract. The minimum bid
price should not be less than your incremental costs. If you are bidding for the acquisition of an important
item or object, you have to submit the highest bid to win.
Generally, the minimum bid price is computed as follows:
The incremental cost of operating the cafeteria is the maximum price that the company should be
willing to pay an outside canteen operator. The incremental cost is P 3,505,000 computed as
follows:
Food
Labor
Variable overhead (P 550,000 x70%)
Incremental costs/ Maximum price

P 2,300,000
820,000
385,000
P 3,505,000
The salary of the cafeteria supervisor is irrelevant in the analysis because it will still be incurred
regardless of who operates the cafeteria. The remaining fixed overhead is allocated and is,
therefore, definitely irrelevant because the total allocated overhead would not change regardless
of the option chosen.
Optimization of scarce resources … profit per limiting resource
Minimum bid price = Incremental costs + Opportunity costs – Savings
The opportunity costs refer to the highest possible benefit that may be derived from the best alternative
use of capacity.
Sample Problem 6.8. Minimum Bid Price – 1
Continental Systems, Inc., manufactures car engines for industrial users. The cost of a particular car
engine the company manufactures is shown below:
Direct materials
P 300,000
Direct labor
190,000
Overhead:
Supervisor’s salary
40,000
Fringe benefits on direct labor
19,000
Depreciation
50,000
Rent
10,000
Total costs
P 609,000
Wherever and whoever you are, resources will always be limited. We live in a world of scarcity.
Businesses are saddled with the reality that operations are to be done in an environment of scarce
resources. Although, the level of resource scarcity varies from one organization to another, still, the
challenge to management is to produce extraordinary results from scarce resources. Money, machine
hours, direct labor hours, supply of materials, and technology are subject to scarcity.
To optimize scarce resources, sales and production should be allotted to a product that gives the highest
profit per scarce resource. If the scarce resource is direct labor hour, then product the product that gives
the highest contribution margin per direct labor hour. The CM per hour is computed as follows:
Unit contribution margin
/ Hours per unit
Contribution margin per hour
Px
x hrs.
Px
UCM
x Units per hour
CM per hour
Px
x
Px
4. As much as possible, use all your resources in producing the product that has the highest CM per
hour unless such product has market limitation. In such case, after satisfying all the market need
of the product that has the highest CM per hour, produce and sell the product that has the next
highest CM per hour, and so on.
Sample Problem 6.10. Maximization of Scarce Resources
Panay Corporation has 52,000 available machine hours and has a fixed overhead rate of P 4 per hour. It is
considering to produce two popular products with the following production and costs data:
Dragon Ball
P 70
11
25
18
20,000
Cost if purchased from outside supplier
Direct materials
Direct labor
Factory overhead at P 9 per hour
Annual demand in units
3. Sensitivity analysis – e.g., change in unit direct material cost. The unit direct materials of
Samurai X decreases by P 12 (i.e., P 22 – P 10). This means that the unit variable cost decreases
and, correspondingly, the unit contribution margin increases by P 12. The new contribution
margin per hour is determined below:
Samurai X
P 105
22
38
27
15,000
Required:
1. Assuming that there is no market limitation, which product should Panay Corporation produce?
2. Considering the market limits, how would Panay Corporation use its limited machine hours to
maximize profit?
3. Assuming that the unit direct materials cost of Samurai X decreases to P 10 and considering the
market limit, how would the limited machine hours be used to maximize profit?
Solutions/ Discussions:
1. No market limit. The product to be produced and sold should give the highest contribution
margin per machine hour. The unit sales price to be used shall be the unit price offered by
competitors.
Other relevant data not readily given by the problem are computed and presented below:
Number of hours per unit
(P 18 per unit / P 9 per hour)
Fixed overhead per unit
(P 4 per hr. x 2 hrs. per unit)
Variable factory overhead
P 18 – P 8)
The 52,000 machine hours will be used to produce 20,000 units of Dragon Ball and 4,000 units of
Samurai X to maximize profit. Take note, Dragon Ball has a market limit of 20,000 units.
Dragon Ball
2 hrs.
Samurai X
3 hrs.
P 8
P 12
(P 4 per hr. x 3 hrs. per unit)
P 10
P 15
(P 27 – P 12)
Unit contribution margin
/ No. of hrs. per unit
Contribution margin per hour
Rank
Dragon Ball Samurai X
P 24
P 42
2 hrs
3 hrs.
P 12
14
(2)
(1)
The 52,000 machine hours would be used as follows:
Rank 1
Rank 2
Total
Product
Samurai X
Dragon Ball
Units
15,000
3,500
Hours per unit
3 hrs.
2 hrs.
Total hours
45,000
7,000 (squeezing balance)
52,000
This time Samurai X has a higher CM per hour and is therefore to be prioritized. The 52,000 machine
hours shall be used to produce 15,000 units of Samurai X and 3,500 units of Dragon Ball to maximize
profit.
Sell Now or Later… which is more profitable?
There are instances where the sales price of a product is expected to increase as it ages. Examples of these
are fashion clothes, wines, artifacts, paintings, historical items, jewelries, and land. If the product is not
sold now, it will be secured and, sometimes, stored in a special place. Keeping the product would entail
storage costs, maintenance costs, and opportunity costs of the money locked in the product. If the
expected incremental sales is greater than the incremental costs of keeping the product, then sell it later.
(P 27 per unit/ P 9 per hr.)
Sample Problem 6.11. Sell Now or Later
Tashima Corporation has 12,000 units of product Laos, a high-end men’s wear, in storage. This product is
now out-of-fad but is expected to regain market acceptance in the next 10 months. The total cost of
producing the product is P 240,000, sixty percent of which is variable. It is now kept in a special storage
of which the company pays monthly rental of P 8,000.
The contribution margin per hour is computed below:
Unit sales price
Unit direct materials cost
Direct labor
Variable factory overhead
Unit contribution margin
/ No. of hrs. per unit
Contribution margin per hour
Rank
Dragon Ball
P 70
(11)
(25)
(10)
24
2 hrs.
P 12
(1)
Samurai X
P 105
(22)
(38)
(15)
30
3 hrs.
P 10
(2)
The product has a regular sales price of P 20 per unit but is expected to be sold at P 14 per unit when
fashion acceptability recovers. A merchandiser has offered to buy all the 12,000 units of product Laos at a
price of P 8 per unit who will be picking up the products in the company’s storage.
Should the company sell now or sell the products later?
Solutions/ Discussions:

Sales (12,000 x P 8)
Storage costs (P 8,000 x 10 mos.)
Incremental profit
Net advantage
Panay Corporation should produce and sell Dragon Ball because it has a higher contribution
margin per hour. It should use all its 52,000 machine hours to produce 26,00 units (i.e., 52,000
hrs. / 2 hrs.) of Dragon Ball.
2. With market limits. Given the market limitations as provided in the problem, the 52,000
machine hours would be used as follows:
Rank 1
Rank 2
Product
Dragon Ball
Samurai X
Units
20,000
4,000
Hours per unit
2 hrs.
3 hrs.
Total hours
40,000
12,000 (squeezing balance)
The relevant costs analysis is presented below:
Sell Now
P 96,000
96,000
P 8,000
Sell Later
P 168,000 (12,000 x P 14)
(80,000)
P 88,000

The company should be advised to sell its products now due to its net benefit of P 8,000 over the
alternative of selling the products later.

The costs of producing products, variable and fixed, are irrelevant costs in this decision-making
situation. These costs are already sunk, past, and unavoidable regardless of decision to make.
Replace or retain an asset … what is the net cash flow?
Solutions/ Discussions:
Over time, assets age. Normally, assets deteriorate or become dysfunctional while others appreciate in
value. Those that deteriorate or become dysfunctional are eventually replaced. Those that become
obsolete due to technological advances would have to be discarded.
The issue here is “when the asset is still functionally useful and has not yet reached its point of
technological or physical obsolescence, should management retain or replace the old asset now?”
Maintenance-wise, the old asset needs higher budget than the new one. If the asset is replaced, there is an
immediate outflow of cash. However, there would be savings that are expected to be derived from a
reduced operating expenses of maintaining the new asset compared with that of the old asset. Also, there
is a possible inflow from the current salvage value of the old asset. If the net cash flow is positive,
meaning, the cash inflows are greater than the cash outflow over the life of the asset, then it is advisable
to replace the old asset and generate net benefit over its useful life.

The income from cafeteria operations and vending machines should be compared and determine
which alternative is more advantageous.
Income from vending machine (P 2,200,000 x 140% x 15%)
Income from cafeteria operations:
Contribution margin (P 2,200,000 x 55%)
P 1,210,000
Less: Fixed costs
980,000
Net advantage of vending machines
P 462,000
230,000
P 232,000
Scrap or rework a defective unit
We do this analysis under the assumption that the useful life of the new asset, compared to the old asset,
is equal, without considering the time value of money and effects of taxes.
There are products that do not meet the standard production specifications. Some of these products are
defective which could be sold as scrap or could be reworked and sold later at a higher value. In deciding
whether to sell as scrap or rework, the profit from reworking should be compared with the profit of selling
as scrap without regard to the past costs of producing the product.
Sample Problem 6.12. Retain or replace an old asset -1
Sample Problem 6.14. Scrap or Rework
Pink Industries, Inc., has an opportunity to acquire a new equipment to replace one of its existing
equipment. The following data are gathered relative to the new and old assets.
A company has 5,000 obsolete cutting supplies carried in inventory at a manufacturing cost of P 40 per
unit. If the toys are reworked for P8 per unit, they could be sold for P 12 per unit. If the toys are scrapped,
they could be sold for a total of P 15,800.
Book value
Purchase price
Life in years
Salvage value - current
Salvage value – after 5 years
Variable operating expenses
Old
P 700,000
5 years
50,000
None
1,300,000
New
P 1,200,000
5 years
None
1,000,000
Should the company retain or replace its old equipment?
Solutions/ Discussions:

The net cash inflows is determined as follows:
Savings (P 300,000 x 5 yrs.)
Salvage value of old equipment
Purchase price of new equipment
Net cash inflows in favor of replacing (5 years)


P 1,500,000
50,000
(1,200,000)
P 350,000
It is advisable to replace the old equipment now and generate a net benefit of P 350,000 over a
period of 5 years. It should be noted that the time value of money and tax effects are not included
in the analysis.
mak
The book value of the old equipment is a sunk cost, unavoidable, and is irrelevant in the decisionmaking.
Sample Problem 6.13. Retain or Replace an Old Asset – 2
Boondat operates a cafeteria for its employees. The operations of the cafeteria requires fixed costs of P
980,000 per month and variable costs at 45% of sales. Cafeteria sales currently average P 2,200,000 per
month. the company has the opportunity to replace the cafeteria with vending machines. Gross customer
spending at the vending machines is estimated to be 40% greater than the current sales because the
machines are available at all hours. By replacing the cafeteria with vending machines, the company would
receive 15% of the gross customer spending and avoid all cafeteria costs.
Should Boondat retain its cafeteria operations or sell using vending machines?
Required:
1. Should the company sell the cutting supplies as scrap or rework it?
2. What is the sunk cost in the decision to be made?
Solutions/ Discussions:
1. Incremental revenue from reworking (5,000 units x P 12)
Incremental costs of reworking (5,000 units x P 8)
Incremental profit from reworking
Incremental profit from selling as scrap
Net advantage of reworking
P 60,000
40,000
20,000
(15,800)
P 4,200
The manufacturing costs of producing the product are irrelevant cost in this decision situation.
Those costs will not change and will remain constant regardless of decision to make.
2. The sunk cost in this decision is the manufacturing cost of P 200,000 (e.g., 5,000 x P 40). These
costs, either variable or fixed manufacturing costs, have been incurred, can no longer be changed,
and are irrelevant.
Indifference point … whatever decision, the results are equal
Indifference point is where the outcome of alternatives is the same. So, regardless of choices the manager
makes, he will arrive at the same profit or loss. Examples of indifference point computations are the
breakeven point, shutdown point, economic order quantity, and internal rate of return. A special
application of indifference point is to be discussed here.
Sample Problem 6.15. Indifference Point
Charm Motors employs 30 sales personnel to market an office equipment. The average equipment sells
for P 350,000 and the company is currently paying 8% commission to its salespersons. It is considering a
scheme of paying its sales persons a flat rate of P 7,000 per month plus 3% commission on sales made.
What is the amount of sales that would produce the same total compensation paid to sales persons?
Solutions/ Discussions:

Module 7
Product Pricing and Profit Analysis
The indifference point is computed as follows:
Let
x =
units sold
350,000 x
=
total sales
Commission 1 =
8% (350,000x)
Commission 2 =
2% (350,000x) + 210,000 *
= 28,000 x
= 7,000x + 270,00
(*210,000 = 7,000 per month x 30 sales personnel)
At indifference point:
Commission 1 =
Commission 2
28,000 x
21,000 x
x
x
=
=
=
=
7,000x + 270,000
210,000
210,000/21,000
10 units
Total sales
=
=
P 350,000 (10 units)
P 3,500,000
At the end of the module, student should be able to:
 Understand the importance of pricing as a business strategy.
 Illustrate the different models of product pricing.
 Use the different cost-based pricing techniques and compute the mark-up rate.
 Identify cost-based from non-cost based costs and expenses.
 Relate product pricing to profitability.
 Calculate the sales price variance, sales quantity variance, cost price variance, cost quantity
variance, sales mix variance and final sales volume variance.
 Explain the general causes of sales and cost variances affecting profit.
Product Pricing
The operating profit or loss is not only affected by cost and expenses, but also by sales. Sales are affected
by volume and unit sales price. The number of units sold is something not directly controlled by manager
but is influenced by various market factors such as general financial and economic conditions,
technological developments, changes in customer’s needs and wants, competition, and other forces in the
market place.
To prove the indifference point of sales, we have:
Commission 1 =
8% (P 3,500,000)
= P 280,000
Commission 2 =
2% (P 3,500,000) + P 210,000 = P 280,000
References used:
Agamata, Franklin T. Management Services 2019 Edition. GIC Enterprises & Co., Inc, 2019
Cabrera, Ma. Elenita B. Management Accounting Concepts and Applications. GIC Enterprises & Co., Inc,
2014
Let us deal with competition as a force that influences the number of units sold. Among the variables of
competition is price. Product pricing is a delicate, technical and strategic matter. If your product is priced
too exorbitantly, the market would repudiate it. If the product is priced too low, it may stir strong
reactions from competitors that may lead to strenuous and unfavorable operational circumstances. Or, if
the product is priced too low, customers may consider the product cheap and not worth their utility and
possession.
Still, pricing a product is a decision that directly affects the profitability of business operations. This field
of business management has been truly more of an art than science. A sales price is determined by a host
of factors that even experienced companies have been continually monitoring to influence price trends
which are affected not only by competition but by changing customer wants and needs, governmental
regulations, changes in technology, and other external economic factors, to name a few. Because of this,
the field of product pricing has generated various pricing models.
Pricing Models
Setting the price of a product could be done in different perspectives, such as:

Traditional pricing
o Economist’s model
o Premium pricing (perception –based prestige pricing)
o Controlled market-based pricing

Strategic pricing
o Target pricing
o Life-cycle-based pricing
o Penetration-based pricing
o Skimming-based pricing
o Predatory pricing
o Loss leader pricing
o Product bundling
o Pricing with additional features

Tactical pricing
o Time pricing
o Material-based pricing
o Distress pricing
o Transfer pricing
o Cost-based pricing
Solutions/ Discussions:
Traditional Pricing Models
The traditional pricing models follow the basic methods of determining a unit-sales price.

Applying the formula, we have:
The Economist’s model
Elasticity of demand
This pricing model is based on the principle of scarcity of resources and rationality of men. It anchors on
the universal and basic laws of supply and demand which state that as the demand for a product increases,
the price correspondingly increases, and vice-versa. Likewise, if the supply for a product increases or
exceeds the market needs, the price correspondingly decreases, and vice-versa. Pricing in this model is
fundamentally based on the reaction of the market. The change in price in relation to the change in the
level of demand and supply could either be elastic or inelastic. There is demand elasticity if a minimal
change in price greatly affects the demand of a product. And there is demand inelasticity if a minimal
change in price significantly changes the demand of a product.
Fig. 11.1. Elasticity of Demand
Elasticity of demand = Percentage of change in quantity demanded
Percentage of change in price
Theoretically, if the level of demand and supply does not change, price remains constant.
=
=
=

Percentage in Quantity Demanded
Percentage
in Unit Sales Price
-28.57% / 18.18%
- 1.57
The -1.57 elasticity rate means that product Mozz is considerably elastic with the change in its
selling price. Stating more concretely, for every 1% change in price, the quantity demanded
inversely changes by -1.57%.
Premium Pricing (or perception – based pricing)
This pricing model resides on the psychology of the market participants. If a product offers good utility
and value, buyers are willing to pay for more. That is, their satisfaction is heightened. Otherwise, if the
product offers inferior value and use, the market would absorb the product if the price is lowered.
Reversing the perspective, we could say that if the price of a product is high, the value and utility (i.e.,
quality) of that product is also high, and vice-versa. This reversed-market analysis led to the development
of product branding, product differentiation, and similar marketing models.
Note that there is a negative relationship, or negative correlation, between price and demand. As price
decreases, the level of quantity demanded tends to increase, and vice-versa. Given the downward or
negative, slope of the demand curve in relation to price, the negative sign in the numerator has the effect
of making the outcome positive, simply to more conveniently represent the relationship.
Controlled-market-based pricing
If the elasticity of demand is greater than 1, demand is considered elastic. This means that a reduction in
price would increase demand considerably. And if the elasticity of demand is less than 1, demand is
considered inelastic. This means that if price increases, the demand for the product would decline.
Strategic Pricing Models
The importance of knowing the elasticity of demand is emphasized when critically pricing a product in
periods of hard business adjustments. For example, when cost inflation is higher than sales price inflation
and the product’s demand elasticity is positive, it would not advisable for an enterprise to increase its
sales price to level off the increase in cost prices because an unnecessary increase in sales price would
adversely affect its units sold resulting to lower revenues and consequently lower profit.
In this model, the company looks at the market, determines the prevailing market price, establishes its
desired profit, then computes the should be amount of cost to be incurred in producing and selling a
product. Once the cost is determined, processes, activities, systems are established accordingly to produce
a product not in excess of the determined cost, otherwise, the profit will suffer. Costs become targets for
improvement. To improve costs means to reduce it. To reduce costs, continuous improvements are
needed. This model, like the life-cycle costing, is in line with the trend of increasing efficiency,
productivity and competitiveness for long-term survival.
Factors Affecting Price Elasticity
There are multitudes of variables affecting price elasticity. Some of the most considered factors affecting
price elasticity are as follows:







Target Pricing
Life-cycle-based pricing
Here, a price is established that would be applicable over the life-span of a product. The price is
determined by dividing the total costs (i.e., locked-in costs and operational costs) over the total estimated
units to be produced and sold.
Market definition
Competition and product availability
Substitute products
Complementary products
Disposable income
Product necessity
Consumer habits
The life stages of a product are normally divided into four, namely: infancy (or start-up) stage, growth
stage, expansion stage, and maturity/ decline stage. In the life-cycle-based pricing, another stage is
included which is the pre-infancy (or conception stage). This stage precedes the infancy stage. During this
pre-infancy stage, strategic decisions are made and costs are locked-in. Locked-in costs (or designed-in
costs) are not yet incurred but are expected to be incurred in the future, as caused by decisions made
during the infancy stage. To effectively reduce costs, locked-in costs should be minimized.
Sample Problem 7.1 Demand Elasticity
The following results were tabulated with respect to the relationship of changes in price and units sold
with respect to product “Mozz”:
P0
P1
Sales price
P100 P 120
Quantity sold
2,000
1,500
= Change
Required: Determine the elasticity of demand.
This product pricing model based its prices on government regulations or implied agreements among key
players in the market. Gas and oil companies, mining companies, and utility companies use this model.
P 20
(500)
Average
P 110
1,750
Percentage
18.18%
28.57
Life-cycle-based pricing includes all costs relative to a product. These are costs in research and
development, design, production, marketing, distribution, and customer services. A significant portion of
a product’s life-cycle costs are incurred even before the start of commercial operations. And ignoring the
effects of these costs incurred and committed prior to commercial production would understate the true
amount of costs and may lead to lower sales price and reduced profitability.
One of the pre-commercial expenditures that has a great impact on operational costs is the cost of design.
An excellent product design that meets customer’s acceptance effectively puts in place efficient and
economical manufacturing system that brings lesser costs relative to retraining, retooling, production
setups, spoilage, and design changes after production has started.
widespread market acceptance. Penetration pricing is most applicable in a buyers market where the
behavior of the market is significantly influenced by buyers than by sellers.
Problem Sample 7.2. Life-cycle based pricing
King Lion Company is contemplating to introduce a product which is expected to be sold in the market
for five years. The product feasibility has been prepared and the following data were presented.
Life-cycle stage
Infancy and pre-infancy
Growth
Expansion
Maturity and decline
Total
Costs
P 20,000,000
8,000,000
5,000,000
1,000,000
P 34,000,000
This pricing model is applicable in a seller’s market. This market is difficult to enter due to some entry
barriers such as great amount of investment requirement, need for a high-level of technological
applications, and presence of only a few sellers in the market. At this instance, the seller influences the
level of pricing and normally sets the price at a higher level. This pricing model gives more protection to
sellers than that of the penetration pricing.
Production
50,000
250,000
500,000
200,000
1,000,000
Predatory (or anti-competition) pricing
The company would like to apply the life-cycle based costing and price its product based on the strategic
life-cycle costs. It is studying the pricing strategy it has to adopt under each of the following schemes:
Life-cycle stage
Infancy and pre-infancy
Growth
Expansion
Maturity and decline
Scheme 1
20% higher
500% higher
1,000% higher
10% higher
Scheme 2
1,000% higher
1,000% higher
800% higher
10% higher
Loss leader pricing applies when there is a main product with subsequent sales of parts and services. The
main product is priced at a very low price that sometimes is lower than the cost of producing it but
company would recover later by selling unique parts, consumables, rendering highly technical services
that are priced at a much higher amount. Examples are low-priced computer printer with high-priced
cartridges, low-priced gadget with high-priced supplies (e.g. razor as the main product and razor blades as
the “extra” or supplies), and free or very low cost of installing phone connection with relatively expensive
monthly fees.
Required: Determine for each of the schemes mentioned above the following:
1. Life-cycle costs per unit.
2. Unit sales prices under each scheme for each life cycle stages.
3. Product life-cycle profit under each pricing scheme.
Solutions/ Discussions:
1. The life-cycle cost per unit is computed as follows:
Pricing with Additional Features
Life-cycle cost per unit = P 34,000,000 / 1,000,000 = P 34.00
2. The unit sales price under each scheme for each life cycle stages would be:
Scheme 1
Computations
Unit sales price
P 34 x 120%
P 40.80
P 34 x 600%
204.00
P 34 x 1,100%
374.00
P 34 x 110%
37.40
Scheme 2
Computations
Unit sales price
P 34 x 1,100%
P 374.00
P 34 x 1,100%
374.00
P 34 x 900%
306.00
P 34 x 110%
37.40
3. The product life-cycle profit for each pricing scheme would be
Life-cycle
Infancy and pre-infancy
Growth
Expansion
Maturity and decline
Total product sales
- Total product costs
Profit
Production
50,000
250,000
500,000
200,000
Scheme 1
Unit sales
price
P 40.80
204.00
374.00
37.40
Amount
(000’s)
P 2,040
51,000
187,000
7,480
247,520
34.00
P 213,520
Production
50,000
250,000
500,000
200,000
Scheme 2
Unit sales
price
P 374.00
374.00
306.00
37.40
In this model, a company sets a very low price purposely to gain greater share of and ultimately control
the market. The price set is so low that ordinary producers and sellers would not dare follow to avoid
incurrence and recurrence of operational loss. This pricing model drives away operationally inefficient
and financially insufficient players who do not have the critical financial string to absorb operational
losses and maintain their market presence. This technique is considered not conducive to a healthy trade
and developmental business environment. Other countries have laws against predatory pricing.
Loss Leader Pricing
It is also estimated that all units produced would be sold.
Life-cycle stage
Infancy and pre-infancy
Growth
Expansion
Maturity and decline
Skimming Pricing
Amount
(000’s)
P 18,700
93,500
153,000
7,480
272,680
34,000
P 238,680
Main products are sometimes sold with additional features or “ extras” . With the “extras” on the product,
the price of the product would logically change. At what price level depends on the acceptability of the
additional features to the customers, whether the “extras” add value to their use of the product or not.
Product Bundling
Product bundling is packaging the interrelated products together to make a complete set and offered to
customers at a temptingly low price. This technically sets the average price and margin for all the
products included in the bundle. It has the advantage of selling slow moving products and still maintain
the desired overall financial performance of an enterprise. It also has an advantage of creating savings in
product handling, packaging, and invoicing costs.
Bundling is proven to be successful when used to matured products and customer loyalty is already high.
However, issues are to be handled on the reaction of competitors on the bundling policy and the
customers reactions when products are unbundled later.
Tactical Pricing

Time pricing. This pricing model considers time as the basis in setting a price. This applies to
professionals (such as lawyers, accountants, doctors, consultants)and non-professionals (such as
repairmen and technicians) alike.

Materials-based pricing–In this model, price is based on the expected amount of materials to be
used. For example, construction companies estimate contract prices substantially based on
materials to be used in a given construction project.
Apparently, Scheme 2 would bring more profit to the enterprise and therefore would be the better
strategic option.
Penetration Pricing
This pricing model is applied when a company wants to enter a market where entry is relatively easy due
to minimal amount of investment needed, absence of high-level technological requirements, and a market
not controlled by one or few players. To penetrate a market, pricing is se at a lower level to gain



Distress (or incremental) pricing – This pricing techniques is used when there is an idle
capacity, competition is very stiff, and businesses have to sell hard their products to at least
breakeven. In this case, sales price is based not on the regular production costs but on relevant
(i.e., incremental) costs to produce and sell a product. Here, profitability is subordinated to
recoverability of cost and sustainability of operations.
Sales price
=
Cost-based + Markup
where:
Markup
=
Cost-based x Markup ratio
markup
Markup ratio =
= non-cost based + profit
Markup / Cost-based
or:
Markup ratio =
(Non-cost-based + Profit) / Cost-based
Transfer pricing- This pricing model applies when there is an inter-company oriented-divisional
transfer of products between affiliated companies and company or divisional managers are
evaluated based on their operating performances. Transfer prices may be based on market, cost,
negotiated prices, arbitrary or dual prices.
To illustrate, let us assume the data given on sample problem 1 below:
Cost-based pricing – This pricing model rationalizes that price equals cost plus markup. This
model is explained more in the next three pages.
The Accounting Department of Baguio Corporation has assembled the following data relative to product
Cold:
Sample Problem 7.3. Sales Price Setting Using Cost-Based Model
Cost-based Pricing
This is a traditional and simple technique of setting a sales price. You only have to determine the costs of
producing a product and operating a business, then add your desired profit and you will arrive at a sales
price. This relationship is depicted below:
Costs (and expenses)
Add: Profit
Sales price
Px
x
Px
Costs have different meanings. A cost may pertain to materials costs, prime costs, conversion costs, total
production costs, variable production costs, variable costs and expenses, total costs and expenses or any
other definition of cost. Because of this, sales price is restated as follows:
Cost-based
Add: Markup
Sales price
P x (as defined)
x (includes profit plus non-cost-based)
Px
Cost-based is anchored to the definition of cost. If the sales price is based on absorption cost, then the cost
based pricing includes the costs of materials, labor, variable overhead, and fixed overhead. If the cost is
defined as prime cost, then the cost-based is the sum of direct materials and direct labor.
The company wants a 20% return on its investment of P 3 million. It expects to sell 40,000 units of cold
in the coming period.
Required: Determine the (a) unit sales price and (b) markup percentage of product cost assuming that the
cost-based model is used:
1. Absorption method
2. Contribution margin (or marginal costing) method
3. Prime cost
4. Conversion cost
5. Material cost
Solutions/ Discussions:

Non-cost based refers to all other costs and expenses not included in the cost-based. If the cost-based is
prime cost, the non-cost-based includes variable overhead, fixed overhead, variable expenses and fixed
expenses. To emphasize, consider the classification of costs and expenses below, either as cost-based or
non-cost-based, in relation to cost-based pricing analysis:
Costs and Expenses
Materials
Labor
Variable overhead
Fixed overhead
Px
x
x
x

x
Basically, the sales price is computed in details as follows:
Direct materials
Direct labor
Variable overhead
Fixed overhead
Variable expenses
Fixed expenses
Total costs and expenses
Add: Profit (P 3 million x 20% / 40,000 units)
Unit sales price
Cost is defined as
Prime Cost
Absorption cost
Cost-based
Cost-based
Non-cost based
Variable expenses
x
The determination of cost-based and non-cost based depends on the definition of cost used in the pricing
model.
Markup does not only refer to profit. It is the sum of profit and non-cost based. Markup is computed by
multiplying cost-based with markup ratio. Markup ratio is markup over cost-based. The summary of this
mathematical relationship is given on the next page:
Per Unit
P 10.00
20.00
5.00
6.00
5.00
4.00
P 50.00
15.00
P 65.00
The sales prices under various cost definitions are:
Non-cost based
Fixed expenses
Per Unit
P 10.00
20.00
5.00
6.00
5.00
4.00
P 50.00
Direct materials
Direct labor
Variable overhead
Fixed overhead
Variable expenses
Fixed expenses
Total costs and expenses
Cost-based
Markup*
(P 41 x 58.54%)
(P 40 x 62.50%)
(P 30 x 116.67%)
(P 25 x 160.00%)
(P 10 x 550.00%)
Unit sales price
(1)
P 41.00
(3)
P 30.00
(4)
P 25.00
(5)
P 10.00
24.00
25.00
35.00
40.00
P 65.00
__________________________________
Markup = Cost-based x markup ratio
(2)
P 40.00
P 65.00
P 65.00
P 65.00
55.00
P 65.00

Markup ratio is profit plus non-cost based divided by cost-based. The markup ratios are
calculated below:
Profit
Non-cost based
(P 50 – P 41)
(P 50 – P 40)
(P 50 – P 30)
(P 50 – P 25)
(P 50 – P 10)
Markup
/ Cost-based
Markup ratio
Absorption
cost
P 15.00
Marginal
cost
P 15.00
Prime
cost
P 15.00
Conversion
cost
P 15.00
Material
cost
P 15.00
The Sales Variances
The net sales variance is composed of the sales price variance and sales quantity variance. These
variances are computed as follows:
9.00
10.00
20.00
25.00
24.00
41.00
58.54%
25.00
40.00
62.50%
35.00
30.00
116.67%
40.00
25.00
160.00%
SPV
=
(USPTY – USPLY) QSTY
=
USP x QSTY
SQV
=
(QSTY – QSLY) USPLY
=
Q x USPLY
where: SPV
=
Sales price variance
SQV
=
Sales quantity variance
USPTY
=
Unit sales price this year (i.e., actual price)
USPLY
=
Unit sales price last year (i.e., standard price)
QSTY
=
Quantity sold this year (i.e., actual quantity)
QSLY
=
Quantity sold last year (i.e., standard quantity)
40.00
55.00
10.00
550.00%
___________________________________________________
(*Non-cost based= Total costs and expenses (i.e., P 50) less cost-based)

Notice that the sales price remains the same regardless of the cost-based used. This is correct
because the purpose of setting the markup ratio is not to change the sales price, neither to change
the profit but to expedite and simplify the determination of the unit sales price. There are
variations in the definition of cost-based inasmuch as the process of accumulating and the timing
of accumulating accounting data vary from a company to another. Some companies can instantly
determine cost-data on materials while others can quickly assemble data on conversion costs, or
other costs data. This explains why cost-based is defined differently.
The Cost of Sales Variances
CPV
=
(UCPTY – UCPLY) QSTY
=
UCP x QSTY
CQV
=
(QSTY – QSLY) UCPLY
=
Q x UCP
Gross Profit Variation Analysis
where:
Profitability is determined not only to measure a department’s performance but that of a manager as well.
It serves as a feedback information on the what and why of operating performance, productivity and
profitability wise. It gives a glimpse on what happened to the business operations. It is also an indicator in
identifying excellent managerial techniques to sustain organizational effectiveness and in determining
causes of operational failures.
The first line of profitability is measured by the gross profit under the absorption costing method and
contribution margin using the variable costing method. The gross profit variance analysis is illustrated in
this chapter. The contribution margin variance analysis follows the pattern of analyzing the gross profit
variations.
Gross profit is the difference of sales and cost of goods sold. Ergo, a change in gross profit is caused by a
change in sales and cost of goods sold. Sales is a factor of number of units sold and sales price. Therefore,
a change in sales, which causes a change in gross profit, is affected by a change in units sold and unit
sales price.
Similarly, cost of goods sold is a factor of units sold and unit cost. Therefore, a change in cost, which also
causes a change in gross profit, is affected by a change in units sold and unit cost price. This relationship
is presented on the next page.
Sales
Cost of goods sold
Gross profit
P x
x
P x
(quantity sold x unit sales price)
(quantity sold x unit cost price)
This Year
P x
x
P x
Actual
Last Year
P x
x
P x
Standard
=
Cost price variance
CQV
=
Cost quantity variance
UCPTY
=
Unit cost price this year (i.e., actual price)
QSTY
=
Quantity sold this year (i.e., actual quantity)
QSLY
=
Quantity sold last year (i.e., standard quantity)
The Gross Profit Variances
The gross profit variance is normally accounted for following the sources and operational classification of
variances as follows:
Sales variances:
Sales price variance
Sales quantity variance
Px
x
P x
Cost of goods sold variances:
Cost price variance
x
Cost quantity variance
x
Gross profit variance
x
P x
The gross profit variance may also be classified as price factor and quantity factor (i.e., volume factor):
A gross profit variance is a difference between the actual gross profit and a base gross profit. Normally,
the base gross profit is the gross profit in the last year. The base in computing the gross profit variance
may also be the budgeted data, industry averages, or a chief competitor’s data. For purposes of our
illustration, we will use the last year’s data as the basis of computing a gross profit variance. The gross
profit variance may be summarized as follows:
Sales
Less: Cost of goods sold
Gross profit
Data treated as
CPV
Net Variance
P x
x
P x
Price factor:
Sales price variance
Px
Cost price variance
x
P x
Net price variance
Quantity factor:
Sales quantity variance
x
Cost quantity variance
x
Net quantity variance
x
Gross profit variance
P x
(You may also say that gross profit is affected by at least three major variables – unit sales price, unit
cost price, and unit sold)
Notice that the quantity variance, both for sales quantity variance and cost quantity variance, are based on
the same quantities. Hence, when used in analysis, the term quantity variance refers to the net quantity
variance, which in this case is P 120,000 favorable.
2. 3-way variance analysis
The gross profit variance analysis follows the direct materials variance analysis
Notice the formula used in the computing sales and cost variances follow the same pattern as used in the
direct materials price variance and quantity variance, discussed and reviewed below.
When using the 3-way analysis, the “joint variance” is included in the analysis on top of the basic price
and quantity variances, as follows:
Price variances:
Materials Price Variance = (Actual Unit Price – Standard Unit Price) x Actual Quantity Sold
Materials Quantity Variance = (Actual Quantity – Standard Quantity) x Standard Unit Price
If:
Actual unit price
=
Unit sales price this year
Standard unit price
=
Unit sales price last year
Actual quantity
=
Standard quantity
=
(P 5 U x 22,000 units)
P (220,000) U
110,000 U
P (330,000) U
Sales quantity variance (3,000 F x P 120)
360,000 F
Cost quantity variance (3,000 UF x P 80)
240,000 U
120,000 F
Joint variances:
Quantity sold last year
By substitution, we have the sales variances as:
USP x QSTY
SQV = (QSTY – QSLY) USPLY =
[P (10) U x 22,000 units]
Cost price variance
Quantity variance:
Quantity sold this year
SPV = (USPTY – USPLY) QSTY =
Sales price variance
Joint sales price-quantity variance [P (10) U x 3,000 F]
(30,000) U
Joint cost price-quantity variance [P 5 U x 3,000 UF)
15,000 U
Net decrease in gross profit
Q x USPLY
(The analysis of cost variances follow the patterns as that of the sales analysis.)
The variances are normally identified as U for unfavorable and F for favorable.
45,000 U
P (255,000) U
Contribution margin variance analysis
To illustrate the applications of these formula, let us consider the following:
The procedures used in analyzing contribution margin variance follows that of the gross profit variance
analysis.
Sample Problem 7.4. Basic gross profit variance analysis
Sample Problem 7.5 Contribution Margin Variance Analysis
The management of Triple Star Corporation is analyzing the factors that cause an increase in its gross
profit in 2020. The information shown below is assembled for this purpose.
The comparative partial income statement of Crispy Corporation in 2019 and 2020 is shown below.
Sales
Less: Cost of goods sold
Gross profit
Units sold
Unit sales price
Unit cost price
2019
2020
P 2,640,000
1,760,000
P 880,000
22,000
P 120.00
P 80.00
P 2,750,000
2,125,000
P 625,000
25,000
P 110.00
P 85.00
Increase
(Decrease)
P 110,000
365,000
P (255,000)
3,000
P (10.00)
P 5.00
Crispy Corporation
Comparative Income Statement Data
For the Years Ended, December 31, 2019 and 2020
(in thousands)
Sales
Less: Variable costs
Contribution margin
Units sold
Unit sales price
Unit variable costs
Analyze the gross profit variation, using the:
1. 2-way variance analysis.
2. 3-2ay analysis
Solutions/ Discussions:
1. 2-way variance analysis.
The variances are calculated as follows (refer to formula guidelines on page ):
Price variance:
Sales price variance
[P (10) UF x 25,000 units]
Cost price variance
(P 5 UF x 25,000 units)

125,000 U
P 96,000
52,000
P 44,000
4,000
P 24
13
The contribution margin variances are computed and presented below:
Sales variances:
P (375,000) U
Sales price variance
[P (1) UF x 4,000 units]
Sales quantity variance (400 F x P 24)
Sales quantity variance (3,000 F x P 120)
360,000 F
Cost quantity variance (3,000 UF x P 80)
240,000 U
Gross profit variance
P 90,000
54,000
P 36,000
3,600
P 25
15
Increase
(Decrease)
P 6,000
(2,000)
P 8,000
400
(1)
(2)
Solutions/Discussions:
Quantity variance:
Net quantity variance
2020
Analyze the contribution margin variance analysis using the 2-way analysis.
P (250,000) U
Net price variance
2019
P (4,000) UF
10,000 F
P 6,000 F
Variable cost variances:
120,000 F
P (255,000) U
Variable cost price variance [(2)F x 4,000 units)
(8,000) F
Variable cost quantity variance (400 F x P 15)
6,000 UF
Net contribution margin variance
(2,000) F
P 8,000 F
Gross Profit Variance Analysis... Only a variance rate is given
Solutions/ Discussions:
At times data are not all available. The unit sales price, unit cost price and units sold may not be given on
their absolute values but are given in terms of percentage change. The variances to be computed shall be
the same, but the procedural computations are slightly reconfigured.
Sales price variance
Sales this year
- Sales this year at unit sales prices last year
(P 2,340,000/ 90%)
Sales quantity variance:
Sales this year at unit sales prices last year
- Sales last year
Cost price variance
Cost this year
- Cost this year at unit cost prices last year
Cost quantity variance:
Cost this year at unit cost prices last year
- Cost last year
Gross profit variance
The sales variances may also be analyzed as follows:
Sales this year
=
QSTY x USPTY
Sales price variance
Applied sales this year =
QSTY x USPLY
Sales quantity variance
Sales last year
=
QSLY x USPLY
The sales this year and sales last year are normally available. The item to be calculated is the amount of
sales this year at unit sales prices last year. To compute this amount we have to know a sales variance
ratio. A sales variance ratio given may be a sales price variance ratio or a sales quantity variance ratio.
For example, say the last year’s unit sales price is P 200 and it increase by P 40 this year, then, the sales
price variance ratio is 20% (i.e., P 40/P 200). Assume again that the units sold last year was 40,000 units
and decreases to 44,000, then, the sales quantity variance ratio is 10% (i.e., 4,000/40,000 where 4,000 =
44,000 less 40,000).
The sales this year at sales prices last year (STY @ USPLY) is calculated as follows:
If the given is
1. Sales price variance rate
2. Sales quantity variance rate
Then,
: STY @ USPLY = Sales this year / (1 + Sales price variance ratio)
: STY @ USPLY = Sales last year x (1 + Sales quantity variance ratio)
=
QSTY x UCPTY
Cost price variance
Applied cost this year
=
QSTY x UCPLY
Cost last year
=
QSLY x UCPLY
Cost quantity variance
The cost this year and cost last year are normally available. The item to be calculated is the amount of
cost of goods sold this year at unit sales prices last year. To compute this amount we have to know a cost
variance ratio. A cost variance ratio given may be a cost price variance ratio or a cost quantity variance
ratio.
The cost this year at cost prices last year (CTY @ UCPLY) is calculated as follows:
If the given is
1. Cost price variance rate
2. Cost quantity variance rate
Then,
: CTY @ UCPLY = Cost this year / (1 + Cost price variance ratio)
: CTY @ UCPLY = Cost last year x (1 + Cost quantity variance ratio)
To illustrate, assume the following:
Sample Problem 7.6. Gross profit variance analysis with only a variance ratio given.
Arabian Corporation decreased its sales price by 10% in 2020 as compared with 2019. Its gross profit data
are provided below.
2,600,000
(1)
P 2,600,000
2,000,000
(2)
P 1,911,000
1,820,000
P 1,820,000
1,400,000
P (260,000) U
600,000 F
(3)
91,000 U
(4)
420,000 U
P 171,000 U
(1) The sales price rate is given, so the computation starts from the sales price variance. Since the sales
price variance rate is given at 10% decrease, then, STY @ USPLY = Sales this year / 90% (i.e., P
2,340,000/ 90%).
(2) Consequently, the sales quantity variance is computed by getting the difference between the STY at
USPLY and sales last year. Inasmuch as the sales quantity variance is already taken, the sales quantity
variance ratio may not be determined, as follows:
Sales quantity variance rate
The cost variance are analyzed as follows:
Cost this year
P 2,340,000
=
=
=
Sales quantity variance/ Sales last year
P 600,000 F/ P 2,000,000
30% F (Increase)
A favorable sales quantity variance indicates the quantity sold this year is greater than the quantity sold
last year.
(3) The quantity variance rate applies to both sales and cost of goods sold. Since the quantity variance rate
is determined to be 30% increase, then the cost quantity variance may now be computed. In the
computation of cost quantity variance, the CTY @ UCLY is unknown. This may now be calculated as,
CTY @ UCPLY = Cost last year x 130%. This gives us an amount of P 1,820,000. The cost quantity
variance is now determined at P 420,000 U (i.e., P 1,800,000 – P 1,400,000) and the cost price variance is
subsequently computed at P 91,000 U (i.e., P 1,911,000 – P 1,820,000)
After computing the cost price variance, the cost price variance rate may now be calculated as follows:
Cost price variance rate
=
Cost price variance / CTY @ UCPLY
=
P 91,000 U / P 1,820,000
=
5% UF (Increase)
An unfavorable cost price variance means that cost price this year is greater than the cost prices last year.
As such, there is an increase in unit cost price.
(4) By using the sales price variance of P 260,000 unfavorable, we can check the percentage change in
sales price as follows:
Sales price variance rate = Sales price variance/ STY @ USPLY
= P 260,000 U / P 2,600,000 = 10% UF (Decrease)
An unfavorable sales price variance indicates that the sales price this year decreases compared that of last
year.
Sales
Less: Cost of goods sold
Gross profit
Compute the gross profit variances.
2019
P 2,000,000
1,400,000
P 600,000
2020
P 2,340,000
1,911,000
P 429,000
Change +(-)
P 340,000
511,000
P (171,000)
(5) The given variance rate indicates where to start the variance analysis. From the first computation of
variance, the implied variance rates of prices and quantity may be determined as follows:
Variance rates
a. Sales price variance rate
b. Sales quantity variance rate
c. Cost price variance rate
Formulas
Sales price variance / STY @ USPLY
Sales quantity variance / Sales last year
Cost price variance / CTY @ UCLY
b. Cost quantity variance rate
Cost quantity variance / Cost last year
Cost price variance =
UCP x QSTY
A = (P 1) F x 20,000 units
=
B = P 2 U x 22,000 units
=
C = 0 x 13,000 units
=
Net cost price variance
Sales mix variance:
Gross profit this year at UGP last year
A = (20,000 units x P 3)*
=
B = (22,000 units x P 2)
=
C = (13,000 units x P 4)
=
Total
- Gross profit this year @ Average unit gross
profit last year (55,000 units x P 2.69565)**
Net sales mix variance
Sales yield variance
Gross profit this year @ Average unit gross
profit last year
- Gross profit last year
Net sales yield variance
Net gross profit variance
where: STY @ USPLY also means Applied Sales This Year
CTY @ UCLY also means Applied Cost This Year
Multi-Product Gross Profit Variances
In many instances, companies operate in a multi-product sales operations. In this case, the net quantity
variance may be divided into sales mix variance and sales yield variance. The sales yield variance is
sometimes called as the final sales volume variance. The sales price variance and the cost price variance
computations will still be the same.
In a sales mix analysis, the following variance computations constitute the accounting for gross profit
variation:
Sales price variance =
USP x QSTY
Cost price variance =
UCP x QSTY
Sales mix variance:
Gross profit this year at UGP last year
- Gross profit this year @ Average unit
gross profit last year
Sales mix variance
Sales yield variance (Final sales volume variance)
Gross profit this year @ Average unit gross
profit last year
- Gross profit last year
Sales yield variance
Net gross profit variance
Px
x
Px
x
x
x
x
x
P x
Sample Problem 7.7. Multi-Product Profit Variances
Android Corporation sells three products – A, B, and C. The sales, cost of goods sold, and gross profit of
the three products in 2019 and 2020 are given below.
Costs
A (8,000 units x P 8)
B (26,000 units x P 4)
C (12,000 units x P 10)
A (8,000 units x P 5)
A (26,000 units x P 2)
A (12,000 units x P 6)
Gross profit (46,000 x P 2.69565)
2019
P 64,000
104,000
120,000
288,000
40,000
52,000
72,000
164,000
P 124,000
(20,000 units x P 6)
(22,000 units x P 5)
(13,000 units x P 12)
(20,000 units x P 4)
(22,000 units x P 4)
(13,000 units x P 6)
(55,000 units x P 2.32727)
2020
P 120,000
110,000
156,000
386,000
80,000
88,000
78,000
246,000
P 140,000
Solutions/ Discussions:
 The change in gross profit variance to be analyzed is:
Gross profit this year
P 140,000
Less: Gross profit last year
124,000
Increase in gross profit
P 16,000 F

148,261
7,739 F
148,261
124,000
24,261 F
P 16,000 F
P (40,000) U
22,000 F
26,000 F
P 8,000 F
The sales mix variance may be alternatively computed as follows:
(a)
Product
A
B
C
b
Actual
Qty. sold
(c)
Actual qty. sold at
standard sales mix
20,000 (55,000 x 8/46) = 9,565
22,000 (55,000 x 26/46) = 31,087
13,000 (55,000 x 12/46) = 14,348
55,000
Net sales mix variance
(d= b-c)
Mix Var
(F) UF
10,435 F
(9,087) U
(1,348) U
E
Unit gross
profit last
year
P3
2
4
(f = d x e)
Mix Variance in
pesos – F (UF)
P 31,305 F
(18,174) U
(5,392) U
P 7,739 F
The total units sold in 2012 is 55,000 units (i.e., 20,000 + 22,000 + 13,000). The fractions 8/46,
26/46, and 12/46 were developed based on the standard sales mix last year (where A = 8,000
units, B = 26,000 units, and C = 12,000 units). The third column (quantity sold this year at
standard sales mix) determines the expected quantity sold based on standard sales mix of the last
year. If the actual quantity sold per product is greater than the actual quantity at standard sales
mix, the mix variance is unfavorable, otherwise, the mix variance is favorable.

The sales yield variance may be alternatively computed as follows:
Quantity sold this year
55,000 units
- Quantity sold last year
46,000
Yield variance in units
9,000 F
x Average unit gross profit last year
P 2.69565
Yield variance in pesos
P 24,261 F

The sum of the sales mix variance and the sales yield variance is the net quantity variance:
Quantity variance = Q x Unit gross profit rate last year
A
=
12,000 F x P 3
P 36,000 F
B
=
(4,000) U x P 2
(8,000)U
C
=
1,000 F x P 4
4,000 F
Net quantity variance
P 32,000 F
The increase in gross profit is analyzed as follows:
Sales price variance =
USP x QSTY
A = (P 2) U x 20,000 units
=
B = P 1 F x 22,000 units
=
C = P 2 F x 13,000 units
=
Net sales price variance
60,000
44,000
52,000
156,000
You may refer to our previous discussions on sales price variance and cost price variance in sample
problem no. 1 for the formula guidelines.
Required: Compute the sales price variance, cost price variance, sales mix variance, and sales yield
variance.

24,000 U
* UGP last year = USP last year – UC last year
e.g., Product A (P 8 – P 5)
P3
Product B (P 4 – P 2)
2
Product C (P 10 – P 6)
4
** UGP last year = GP last year/ Total units sold last year
= P 124,000 / (8,000 +26,000 + 12,000)
= P 2.69565
To illustrate the applications of the above formulas, let us consider the following sample problem.
Sales
(20,000) F
44,000 U
0