©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Relevant Information and Decision Making: Marketing Decisions Chapter 5

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 1 Discriminate between relevant and irrelevant information for making decisions.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton The Concept of Relevance What information is relevant? It depends on the decision being made. Decision making is essentially choosing among several courses of action.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton What is Relevance? 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton What is Relevance? Relevant information is the predicted future costs and revenues that will differ among the alternatives.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 2 Apply the decision process to make business decisions.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 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)

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Decision Model Defined A decision model is any method used for making a choice, sometimes requiring elaborate quantitative procedures. elaborate quantitative procedures. A decision model may also be simple.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton In the best of all possible worlds, information used for decision making would be perfectly relevant and accurate. Accuracy and Relevance

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton The degree to which information is relevant or precise often depends on the degree to which it is: Accuracy and Relevance QuantitativeQualitative

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 3 Decide to accept or reject a special order using the contribution margin technique.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cordell Company makes and sells 1,000,000 seat covers. Special Sales Order Example 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Special Sales Order Example 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Special Sales Order Example Cordell Company Cordell Company Contribution Form of the Income Statement For the Year Ended December 31, 2004 (000) Sales (1,000,000 units)$40,000 Less: Variable expenses Manufacturing$24,000 Manufacturing$24,000 Selling and administrative 2,200 26,200 Selling and administrative 2,200 26,200 Contribution margin$13,800 Less: Fixed expenses Manufacturing$ 6,000 Manufacturing$ 6,000 Selling and administrative 5,800 11,800 Selling and administrative 5,800 11,800 Operating income$ 2,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Special Sales Order Example 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Special Sales Order Example 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

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Activity-Based Costing, Special Orders, and Relevant Costs Suppose that Cordell examined its $24 million of variable manufacturing costs and determined that $18 million varied directly with the units produced, or $18 per unit, and $6 million relates to the set-up activity, or $12,000 per set-up. Assume that processing the additional 100,000 units will require 5 additional set-ups.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Activity-Based Costing, Special Orders, and Relevant Costs What is the additional variable cost? Additional unit-based variable manufacturing cost, 100,000 × $18$1,800,000 manufacturing cost, 100,000 × $18$1,800,000 Additional setup-based variable manufacturing cost, 5 × $12,000 60,000 manufacturing cost, 5 × $12,000 60,000 Total additional variable manufacturing cost$1,860,000 manufacturing cost$1,860,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 4 Choose whether to add or delete a product line using relevant information.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Avoidable and Unavoidable Costs Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Unavoidable costs are costs that continue even if an operation is halted.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Department Store Example Groceries General merchandise Drugs Consider a discount department store that has three major departments:

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Department Store Example Sales$1,000$800$100$1,900 Variable expenses ,420 Contribution margin$ 200$240$ 40$ 480 Fixed expenses: Avoidable$ 150$100$ 15$ 265 Avoidable$ 150$100$ 15$ 265 Unavoidable Unavoidable Total fixed expenses$ 210$200$ 35$ 445 Operating income$ (10)$ 40$ 5$ 35 Departments ($000) GroceriesGeneralMdse.DrugsTotal

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Department Store Example Assume further that the total assets invested would be unaffected by the decision. The vacated space would be idle and the unavoidable costs would continue. For this example, assume first that the only alternatives to be considered are dropping or continuing the grocery department, which shows a loss of $10,000.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Department Store Example Sales$1,900$1,000$900 Variable expenses 1, Contribution margin$ 480$ 200$280 Avoidablefixed expenses Profit contribution to common space and common space and other unavoidable costs$ 215$ 50$165 other unavoidable costs$ 215$ 50$165 Unavoidable expenses Operating income$ 35$ 50$ (15) TotalBeforeChange Effect of DroppingGroceriesTotalAfterChange Store as a Whole ($000)

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Department Store Example Assume that the store could use the space made available by the dropping of groceries to expand the general merchandise department. This will increase sales by $50,000, generate a 30% contribution-margin, and have avoidable fixed costs of $70,000. $80,000 – $50,000 = $30,000

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 5 Compute a measure of product profitability when production is constrained by a scarce resource.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Optimal Use of Limited Resources Assume that Grand Canyon Railway is considering converting its 100 club-class seats to 50 first-class car seats. A limiting factor or scarce resource restricts or constrains the production or sale of a product or service.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Optimal Use of Limited Resources Selling price per seat$80$120 Variable costs per seat Contribution margin per seat$20$ 36 Contribution margin ratio 25% 30% ClubClassFirstClass

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Optimal Use of Limited Resources Which is more profitable? If sales are restricted by demand for only a limited number of seats, first-class seats are more profitable.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Optimal Use of Limited Resources The sale of a club-class seat adds $20 to profit. The sale of a first-class seat adds $36 to profit.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Optimal Use of Limited Resources Now suppose there is enough demand to fill the car with passengers regardless of whether it has first-class or club-class seats. Capacity is now the limiting factor.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Optimal Use of Limited Resources Which seats should the railroad emphasize? Club-class: $20 contribution margin per unit × 100 seats per car = $2,000 per car First-class: $36 contribution margin per seat × 50 seats per car = $1,800 per car

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 6 Identify the factors that influence pricing decisions in practice.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 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

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Pricing and Accounting Accountants seldom compute marginal revenue curves and marginal cost curves. They use estimates based on judgment. They examine selected volumes, not the range of possible volumes.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton General Influences on Pricing in Practice Legal requirements Competitors’ actions Customer demands Predatory pricing Discriminatory pricing

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 7 Compute a target sales price by various approaches, and compare the advantages and disadvantages of these approaches.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Cost-Plus Pricing It is setting prices by computing an average cost and adding a markup. Target prices can be based on a host of different markups that are in turn based on a host of different definitions of cost.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Target Sales Price 1)as a percentage of variable manufacturing costs 2)as a percentage of total variable costs 3)as a percentage of full costs 4)as a percentage of total manufacturing cost

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Relationships of Costs to Same Target Selling Prices Target sales price$20.00 Variable costs: Manufacturing$12.00 Selling and administrative 1.10 Unit variable cost Fixed costs: Manufacturing$ 3.00 Selling and administrative 2.90 Unit fixed costs 5.90 Target operating income$ 1.00

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Relationships of Costs to Same Target Selling Prices % of total variablecosts: ($20.00 – $13.10) ÷ $13.10 = 52.67% % of variable manufacturingcosts: ($20.00 – $12.00) ÷ $12.00 = 66.67% % of full costs: ($20.00 – $19.00) ÷ $19.00 = 5.26%

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Advantages of Total Manufacturing and Full-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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Advantages of Total Manufacturing and Full-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.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Learning Objective 8 Use target costing to decide whether to add a new product.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Costing Techniques Target costing sets a cost before the product is created or even designed. Value engineering is a cost-reduction technique, used primarily during design. Kaizen costing is the Japanese word for continuous improvement.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton Target Costing and Cost-Plus Pricing Compared Successful companies understand the market in which they operate and use the most appropriate pricing approach.

©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton End of Chapter 5