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
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
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
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
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
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
Decision Process and
Role of Information
(1)
(2)
(3)
(4)
Historical
Other
(A)
(B)
information
information
Prediction method
Predictions as inputs
to decision model
Decision model
Decisions by managers with
the aid of the decision model
Implementation
and evaluation
Feedback
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5-7
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
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
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
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
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
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
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)
Less: Variable expenses
Manufacturing
Selling and administrative
Contribution margin
Less: Fixed expenses
Manufacturing
Selling and administrative
Operating income
$40,000
$24,000
2,200
$ 6,000
5,800
26,200
$13,800
11,800
$ 2,000
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5 - 14
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
Special Sales Order Example
Special order sales price/unit
Increase in manufacturing costs/unit
Additional operating profit/unit
$26
24
$ 2
Based on the preceding analysis,
should Cordell accept the order?
$2 × 100,000 = $200,000
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5 - 16
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
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Activity-Based Costing, Special
Orders, and Relevant Costs
What is the additional variable cost?
Additional unit-based variable
manufacturing cost, 100,000 × $18
Additional setup-based variable
manufacturing cost, 5 × $12,000
Total additional variable
manufacturing cost
$1,800,000
60,000
$1,860,000
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5 - 18
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
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
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
Department Store Example
Departments ($000)
General
Groceries Mdse.
Sales
Variable expenses
Contribution margin
Fixed expenses:
Avoidable
Unavoidable
Total fixed expenses
Operating income
Drugs
Total
$1,000
800
$ 200
$800
560
$240
$100
60
$ 40
$1,900
1,420
$ 480
$ 150
60
$ 210
$ (10)
$100
100
$200
$ 40
$ 15
20
$ 35
$ 5
$ 265
180
$ 445
$ 35
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5 - 22
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
Department Store Example
Store as a Whole ($000)
Sales
Variable expenses
Contribution margin
Avoidable fixed expenses
Profit contribution to
common space and
other unavoidable costs
Unavoidable expenses
Operating income
Total
Before
Change
Effect of
Dropping
Groceries
Total
After
Change
$1,900
1,420
$ 480
265
$1,000
800
$ 200
150
$900
620
$280
115
$ 215
180
$ 35
$
$165
180
$ (15)
$
50
0
50
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5 - 24
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
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
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
Optimal Use of Limited Resources
Club
Class
Selling price per seat
Variable costs per seat
Contribution margin per seat
Contribution margin ratio
$80
60
$20
25%
First
Class
$120
84
$ 36
30%
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5 - 28
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
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
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
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
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
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
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
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
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
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
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
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
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
5 - 41
Relationships of Costs to
Same Target Selling Prices
Target sales price
Variable costs:
Manufacturing
Selling and administrative
Unit variable cost
Fixed costs:
Manufacturing
Selling and administrative
Unit fixed costs
Target operating income
$20.00
$12.00
1.10
13.10
$ 3.00
2.90
5.90
$ 1.00
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5 - 42
Relationships of Costs to
Same Target Selling Prices
% of variable
manufacturing
costs:
($20.00 – $12.00) ÷ $12.00
= 66.67%
% of total
variable
costs:
($20.00 – $13.10) ÷ $13.10
= 52.67%
% 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
5 - 43
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
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
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
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
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
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
End of Chapter 5
©2005 Prentice Hall Business Publishing, Introduction to Management Accounting 13/e, Horngren/Sundem/Stratton
5 - 50