Chapter 5: Relevant Information for Decision Making with a Focus on
Pricing Decisions
Discernment between relevant and irrelevant information for making decisions:
To be relevant to a particular decision, a cost (or revenue) must meet two criteria:
1. Information must be an expected revenue or cost and...
2. It must have an element of difference among the alternatives.
Decision Process:
Any method used
for making a choice
historical data
Form the
accounting
system
decision
model
predictions
Other data
from outside
accounting
system
implemention
and
evaluations
decisions
Feed back
Accuracy and Relevance:
Accountants often trade off relevance versus accuracy. Precise but irrelevant information is
worthless for decision making .imprecise but relevant information can be quite useful.
Don't consider any quantitative information only, Qualitative information may be more
important than qualitative information in many decisions.
Absorption and contribution margin income statement, and identify their
relevance for decision making:
v. manu. Cost
Absorption approach :
Sales
-
-
Dm----vc
+DL----vc
+OH----vc
fc
contribution margin:
Sales
-
Total manufacturing cost
+ v. sellin and
admi. cost
Total variable costs
Contribution margin
- Fixed cost
Gross margin
Selling and administrative cost
Operating income
Operating income
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Absorption method:
a costing approach that consider all indirect manufacturing costs (both variable
and fixed) to be product ( inventorial ) costs that become an expense in the form of
manufacturing cost of goods sold as sales occur.
Contribution method:
A method of internal management accounting reporting that emphasizes the
distinctions between variable and fixed costs for the purpose of better decision making.
The major difference between the absorption and contribution margin for the
income statement is that:
The CM format focus on cost behavior (variable and fixed), whereas the absorption
format reports costs by business functions ( manufacturing vs nonmanufacturing).
The CM makes it easier for managers to evaluate the effects of the changes in volume on
income and thus it is suitable for shorter decision making.
Special Sales Orders
Definition: a one-time order often at a reduced price

While thinking of accepting the SO or not , the management must consider
few things :
1. Does the company have excess (idle) capacity available to till SO?
2. SO shouldn't affect the company's normal operations.
3. Will the reduced Selling price be higher enough to cover the incremental costs of
filling the order (Vc + extra Fc).
vc
fc
Man
always relevant
mosty irrelevant
selling
relevant (but watch it)
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Decision rule
if expected increase in
revnue exceed expected
increase in relevant cost
(vc+fc)
Accept SO
if expected increase in revnue
less than expected increase in
relevant cost (vc+fc)
Reject SO
Example:
Cordell Company makes and sells 1,000,000 seat covers. Total manufacturing cost is
$30,000,000, or $30 per unit (30,000,000÷1,000,000).
Suppose that Cordell is offered a special order of $26 per unit for 100,000 units. and that
special order:
1. Wouldn't affect total fixed costs.
2. Wouldn't require any additional variable selling and administrative expenses.
3. Would use some idle manufacturing capacity.
If :





the sales = 40,000,000
variable manufacturing = 24,000,000
variable selling and administrative =2,200,000
fixed manufacturing = 6,000,000
fixed selling and administrative = 5,800,000
 Should Cordell Company accept the special order or not? Why?
The solution:
The contribution margin approach must be used, and in all managerial
decisions the usage of gross margin will be misleading as it combines FC and VC
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This problem can be solved by focusing on relevant information:
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.
Special order sales price/unit
$26
Increase in manufacturing costs/unit
$ 24
Additional operating profit/unit
$2
So the company should accept the special order as there is $2 × 100,000 = $200,000
additional profit.
Summary
When you look at so decisions, you should look at how much revenue the SO
will bring in and how much costs would have incurred to cover this SO.
But watch that these incremental costs would be mostly variable costs as fixed
costs would be covered by normal operations, but if there is any additional FC,
there should be considered while accepting SO
Pricing decisions
Pricing decisions must be made regarding:
1. Setting the price of a new or refined product.
2. Setting the price of products sold under private labels.
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3. Responding to a new price of a competitor.
4. Pricing bids in both sealed and open bidding situations.
Pricing decisions depend on the characteristics of the market a firm focuses on:
In perfect competition, all competing firms sell the same type of product at the
same price.
 The firm should produce up to the point where: MC=MR
Marginal cost (MC) is the additional cost resulting from producing and selling one additional
unit.
Marginal revenue (MR) is the additional revenue resulting from the sale of one additional
unit.
In imperfect competition, the price a firm charges for a unit will affect the
quantity of units it sells.
 The effect of prices changes on sales volume is called (price elasticity).
General Influences on Pricing:
1. Legal requirements:
a. Predatory pricing: a company establishes prices so low that competitors
are driven out of the market so that the predatory price has no significant
competition and the company can then raises prices dramatically.
b. Discriminatory pricing: charging different types to different customers for
the same product or service.
2. Competitors’ actions
3. Customer demands:
If customers believe a price is too high they may turn to other resources for the
product or service.
Cost-Plus Pricing
Setting prices by computing an average cost and adding a markup (the amount by which
sales price exceeds cost).

It can be computed :
1) as a percentage of variable manufacturing costs
2) as a percentage of total variable costs
3) as a percentage of total manufacturing cost
4) as a percentage of full costs
the first two formulas are consistent with the contribution margin approach , while the last
two formulas are consistent with the absorption costing approach.
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

Advantages of contribution margin Approach:
1. It offers more detailed information
2. It's sensitive to cost – volume- profit analysis
3. It allows managers to prepare price schedules at different volume
levels
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.
5. It tends to promote price stability.
6. It simplifies pricing decisions.
Target Costing
Target costing takes a product market price as given and determines the maximum cost that
the company can spend to make the product before the product is created or even
designed.

We can reduce costs via:
1. Value engineering is a cost-reduction technique, used primarily during design that
uses information about a value chain functions that satisfy customer needs while
reducing costs.
2. Kaizen costing is the Japanese word for continuous improvement.
Example:
Bennett builders build 1500 square-foot starter tract homes in the last growing suburbs of
Atlanta land. Land and labor are cheap, and competition among developers is fierce
(strong). The homes are cookie- cutter, with any upgrades added by the buyer after the sale.
Bennett's developed sub-lot are as follows:
Land
$54,000
Construction
$122,000
Landscaping
$5,000
Variable market cost
$3,000
Bennett builders would like to earn a profit of %15 of the variable cost of each home sale,
similar homes offered by competing builders sell for $200,000 each.
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Q1: what approach to pricing should Bennett builder emphasize? Why?
Target pricing … as there is a serve competition in the market and it's not a
unique product (cookie cutter).
Q2: will Bennett builders be able to achieve their target profit levels?
Market price of similar homes
200,000
Less: target profit (15%*184,000)
(27,600)
Target cost
172,400
No, as our actual cost is 184,000.
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