©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Introduction to Management Accounting

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Introduction to Management Accounting Relevant Information for Decision Making with a Focus on Pricing Decisions Chapter 5

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Company has five different pricing plans It uses a contribution margin approach to develop its pricing plans

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Another example is Maison & Jardin a Wine Spectator Excellence Award restaurant near Orlando that sells wine at five different prices Glass Special Restaurant bottle Take-out bottle Case How do they determine the prices?

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler The Concept of Relevance Relevant information depends on the decision being made. Decision making is choosing among several courses of action. Learning Objective 1 Relevant information is the predicted future costs and revenues that differ among the alternatives.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Accountants should use two criteria to determine whether information is relevant: 1. Information must be an expected revenue or cost and it must have an element of difference among the alternatives. The Concept of Relevance

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Decision Process and Role of Information Prediction method Predictions as inputs to decision model Decision model Decisions by managers with the aid of the decision model Implementation and evaluation Feedback HistoricalinformationOtherinformation(A)(B) (4) (3) (2) (1) Learning Objective 2

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Decision Model A decision model is any method used for making a choice, sometimes requiring elaborate quantitative procedures. A decision model may also be simple.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler In the best of all possible worlds, information used for decision making would be perfectly relevant and accurate. Accuracy and Relevance

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler The degree to which information is relevant or precise often depends on the degree to which it is: Accuracy and Relevance Quantitative Qualitative

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cordell Company makes and sells 1,000,000 seat covers. Relevance of Alternate Income Statements Total manufacturing cost is. $30,000,000, or $30 per unit. Direct Material Costs are $14,000,000 Direct-labor costs are $6,000,000 Learning Objective 3

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Absorption Approach Schedule 1: Variable Costs (in thousands of dollars) Supplies (lubricants, expendable tools, coolants, sandpaper$ 600 Materials-handling labor (forklift operators)2,800 Repairs on manufacturing equipment 400 Power for factory 200$ 4,000 Schedule 2: Fixed Costs Managers’ salaries in factory$ 400 Factory employee training 180 Factory picnic and holiday party 20 Factory supervisory salaries 1,400 Depreciation, plant and equipment 3,600 Property taxes on plant 300 Insurance on plant 100 $ 6,000 Total indirect manufacturing costs$10,000

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Absorption Approach Schedule 3: Selling Expenses (in thousands of dollars) Variable Sales Commission$1,400 Shipping Expenses for products sold 600 $2,000 Fixed Advertising $1,400 Sales salaries 2,000 Other 600 $4,000 Total Selling Expenses $6,000 Schedule 4: Administrative Expenses Variable Some clerical wages $160 Computer time rented 40 $200 Fixed Office supplies 200 Other salaries 400 Depreciation on office facilities 200 Public accounting fees 80 Legal fees 200 Other 720 1,800 Total indirect manufacturing costs $ 2,000

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Contribution Approach Sales (in thousands of dollars)$40,000 Less: Manufacturing costs of good sold Direct Materials $ 14,000 Direct Labor 6,000 Indirect Manufacturing (Schedule 1 plus 2) 10,000 30,000 Gross Margin or Gross Profit 10,000 Selling expenses (Schedule 3) $ 6,000 Administrative expenses (Schedule 4) 2,000 Total selling and administrative expenses 8,000 Operating income $2,000 Internal (management accounting) reporting that emphasizes the distinction between variable and fixed costs for the purpose of better decision making.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Contribution Approach Cordell Company Contribution Form of the Income Statement For the Year Ended December 31, 2007 (000) Sales (1,000,000 units)$40,000 Less: Variable expenses Manufacturing$24,000 Selling and administrative 2,200 26,200 Contribution margin$13,800 Less: Fixed expenses Manufacturing$ 6,000 Selling and administrative 5,800 11,800 Operating income$ 2,000

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cordell Company makes and sells 1,000,000 seat covers. Special Sales Orders Total manufacturing cost is $30,000,000, or $30 per unit. Cordell is offered a special order of $26 per unit for 100,000 units. Learning Objective 4

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Special Sales Order 1 1. would not affect Cordell’s regular business. 2. would not raise any antitrust issues. 3. would not affect total fixed costs. 4. would not require additional variable selling and administrative expenses.. 5. would use some otherwise idle manufacturing capacity. Accepting the special order:

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Special Sales Order Only variable manufacturing costs are affected by this particular order, at a rate of $24 per unit ($24,000,000 ÷ 1,000,000 units). All other variable costs and all fixed costs are unaffected and thus irrelevant.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Special Sales Order Special order sales price/unit$26 Increase in manufacturing costs/unit 24 Additional operating profit/unit$ 2 Based on the preceding analysis, should Cordell accept the order? $2 × 100,000 = $200,000 additional profit

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Special Sales Order Cordell Company Contribution Form of the Income Statement For the Year Ended December 31, 2007 (000) Without Effect of With special order special order special order 1,000,000 units Total Per Unit 1,100,000 units Sales $40,000,000$2,600,000 $26$42,600,000 Less: Variable expenses Manufacturing $24,000,000 $2,400,000 $24$26,400,000 Selling and administrative 2,200,000 2,200,000 Total variable expenses 26,200,000$2,400,000$28,600,000 Contribution margin$13,800,000$ 200,000$14,000,000 Less: Fixed expenses Manufacturing$ 6,000,000 $6,000,000 Selling and administrative 5,800,000 5,800,000 Total fixed expenses 11,800,000 11,800,000 Operating income$ 2,000,000 $2,200,000

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Pricing Decisions 1. Setting the price of a new or refined product 2. Setting the price of products sold under private labels 3. Responding to a new price of a competitor 4. Pricing bids in both sealed and open bidding situations Learning Objective 5

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler The Concept of Pricing In perfect competition, all competing firms sell the same type of product at the same price. Marginal cost is the additional cost resulting from producing and selling one additional unit. Marginal revenue is the additional revenue resulting from the sale of one additional unit.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler The Concept of Pricing In imperfect competition, the price a firm charges for a unit will influence the quantity of units it sells. Price elasticity is the effect of price changes on sales volume. The firm must reduce prices to generate additional sales.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Pricing and Accounting Accountants seldom compute marginal revenue curves and marginal cost curves. t. They use estimates based on judgment. They examine selected volumes, not the range of possible volumes.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler General Influences on Pricing in Practice Legal requirements Competitors’ actions Customer demands Predatory pricingDiscriminatory pricing Learning Objective 6

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Cost-Plus Pricing Setting prices by computing an average cost and adding a markup (the amount by which sales price exceeds cost). Target prices can be based on a host of different markups that are in turn based on a host of different definitions of cost.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Advantages of Contribution Margin Approach The contribution margin approach. offers more detailed information. This approach allows managers to prepare price schedules at different volume levels. Target pricing with full costing presumes a given volume level. This approach is sensitive to cost-volume-profit relationships.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Advantages of Absorption-Cost Pricing The absorption-cost approach assumes all costs are variable (even if some are fixed in the short run). This approach copes with the uncertainty of the demand curve. Target pricing with full costing presumes a given volume level. This approach meets the cost-benefit test. It is too s. expensive to conduct cost-volume-tests on all products.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Target Sales Price 1) 1)as a percentage of variable manufacturing costs 2) 2)as a percentage of total variable costs 3) 3)as a percentage of full costs 4) 4)as a percentage of total manufacturing cost Learning Objective 7

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Relationships of Costs to Same Target Selling Prices Alternative Markup Percentage to Achieve Same Target Sales Price Target sales price$20.00 ($20.00 – $12.00) ÷ $12.00 = 66.67% Variable costs: Manufacturing$12.00 Selling and administrative 1.10 Unit variable cost ($20.00 – $13.10) ÷ $13.10 = 52.67% Fixed costs: Manufacturing$ 3.00 Selling and administrative 2.90 Unit fixed costs 5.90 (3) Full Costs$19.00 ($20.00 – $19.00) ÷ $19.00 = 5.26% Target operating income$ 1.00

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Advantages of Absorption-Cost Approaches 1. In the long run, a firm must recover all costs to stay in business. 2. It may indicate what competitors might charge. 3. It meets the cost-benefit test. 4. It copes with uncertainty.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Advantages of Absorption-Cost Approaches 5. It tends to promote price stability. 6. It provides the most defensible basis. for justifying prices to all interested parties.. 7. It simplifies pricing decisions.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Target Costing Target costing sets a cost before the product is created or even designed. Value engineering is a cost-reduction gn. technique, used primarily during design. Kaizen costing is the Japanese word for continuous improvement. Learning Objective 8

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler Target Costing Successful companies understand the market in which they operate and use the most appropriate pricing approach.

©2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler End of Chapter 5 The End