Management Accounting (chapter 5)

Slide 1: Relevant Information and Decision Making: Marketing Decisions Chapter 5 ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5-1

Slide 2: 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 5-2

Slide 3: 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 5-3

Slide 4: What is Relevance? Accountants should use two criteria to determine whether information is relevant: 1. Information must be an expected revenue or cost and... 2. it must have an element of difference among the alternatives. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5-4

Slide 5: 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 5-5

Slide 6: 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 5-6

Slide 7: Decision Process and Role of Information (1) Historical Other (A) (B) information information (2) Predictions as inputs Prediction method to decision model (3) Decisions by managers with Decision model the aid of the decision model (4) Implementation and evaluation Feedback ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5-7

Slide 8: Decision Model Defined A decision model is any method used for making a choice, sometimes requiring elaborate quantitative procedures. A decision model may also be simple. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5-8

Slide 9: Accuracy and Relevance In the best of all possible worlds, information used for decision making would be perfectly relevant and accurate. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5-9

Slide 10: Accuracy and Relevance The degree to which information is relevant or precise often depends on the degree to which it is: Qualitative Quantitative ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 10

Slide 11: 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 5 - 11

Slide 12: Special Sales Order Example Cordell Company makes and sells 1,000,000 seat covers. Total manufacturing cost is $30,000,000, or $30 per unit. Cordell is offered a special order of $26 per unit for 100,000 units. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 12

Slide 13: 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 5 - 13

Slide 14: Special Sales Order Example 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 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 ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 14

Slide 15: 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 5 - 15

Slide 16: 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 5 - 16

Slide 17: 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 5 - 17

Slide 18: 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 Additional setup-based variable manufacturing cost, 5 × $12,000 60,000 Total additional variable manufacturing cost $1,860,000 ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 18

Slide 19: 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 5 - 19

Slide 20: 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 5 - 20

Slide 21: Department Store Example Consider a discount department store that has three major departments: Groceries General merchandise Drugs ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 21

Slide 22: Department Store Example Departments ($000) General Groceries Mdse. Drugs Total Sales $1,000 $800 $100 $1,900 Variable expenses 800 560 60 1,420 Contribution margin $ 200 $240 $ 40 $ 480 Fixed expenses: Avoidable $ 150 $100 $ 15 $ 265 Unavoidable 60 100 20 180 Total fixed expenses $ 210 $200 $ 35 $ 445 Operating income $ (10) $ 40 $5 $ 35 ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 22

Slide 23: Department Store Example 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. 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. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 23

Slide 24: Department Store Example Store as a Whole ($000) Total Effect of Total Before Dropping After Change Groceries Change Sales $1,900 $1,000 $900 Variable expenses 1,420 800 620 Contribution margin $ 480 $ 200 $280 Avoidable fixed expenses 265 150 115 Profit contribution to common space and other unavoidable costs $ 215 $ 50 $165 Unavoidable expenses 180 0 180 Operating income $ 35 $ 50 $ (15) ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 24

Slide 25: 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 5 - 25

Slide 26: 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 5 - 26

Slide 27: Optimal Use of Limited Resources A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. Assume that Grand Canyon Railway is considering converting its 100 club-class seats to 50 first-class car seats. ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 27

Slide 28: Optimal Use of Limited Resources Club First Class Class Selling price per seat $80 $120 Variable costs per seat 60 84 Contribution margin per seat $20 $ 36 Contribution margin ratio 25% 30% ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 28

Slide 29: 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 5 - 29

Slide 30: 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 5 - 30

Slide 31: 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 5 - 31

Slide 32: 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 5 - 32

Slide 33: 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 5 - 33

Slide 34: 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 5 - 34

Slide 35: 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 5 - 35

Slide 36: 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 5 - 36

Slide 37: 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 5 - 37

Slide 38: General Influences on Pricing in Practice Legal requirements Predatory pricing Discriminatory pricing Competitors’ actions Customer demands ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 38

Slide 39: 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 5 - 39

Slide 40: 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 5 - 40

Slide 41: Target Sales Price 1) as a percentage of variable manufacturing costs 1) as a percentage of total variable costs 1) as a percentage of full costs 1) as a percentage of total manufacturing cost ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 41

Slide 42: 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 13.10 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 5 - 42

Slide 43: Relationships of Costs to Same Target Selling Prices % of variable ($20.00 – $12.00) ÷ $12.00 manufacturing = 66.67% costs: % of total ($20.00 – $13.10) ÷ $13.10 variable = 52.67% costs: % of full ($20.00 – $19.00) ÷ $19.00 costs: = 5.26% ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 43

Slide 44: 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 5 - 44

Slide 45: 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 5 - 45

Slide 46: 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 5 - 46

Slide 47: 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 5 - 47

Slide 48: 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 5 - 48

Slide 49: 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 5 - 49

Slide 50: End of Chapter 5 ©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton 5 - 50