Management Accounting

For Managers

Chapter 5
Pricing and Product
Pricing And Product Related
Related
Decision
Decisionsg and Product
Related Decision

Group Member
1) Mohd Shamsul Fahmi Bin Shamsudin 819915
2) Mohd Fahmi Bin Idris 820289
3) Nur Aeidah Binti Sabri 819439
4) Norita Binti Rasli 822130
5) Norazimah Binti Mohamad Tahir 819385

Cost Concept
for Decision
Making

Identifying Relevant Cost and

benefits
If

the total amount of a cost will be

the same regardless of the
alternative selected, then the
decision has no effect on the cost, so
the cost can be ignored
An avoidable cost is a cost that can
be eliminated by choosing one
alternative over another

Identifying Relevant Cost and

benefits
Avoidable

costs are relevant costs

Unavoidable costs are irrelevant costs
Two broad categories of costs are
never relevant in decisions, sunk
costs and future costs that do not
differ between the alternatives
Future costs that do not differ
between alternatives should also be
ignored

Different costs for different

purposes
costs

that are relevant in one

decision situation are not necessarily
relevant in another
Thus, each decision situation must be
carefully analyzed to isolate the
relevant costs.
Otherwise, irrelevant data may cloud
the situation and lead to a bad
decision.

An example of identifying
relevant costs and benefits
No

Item

Annual straight-line depreciation on car

[($24,000 original cost - $10,000
estimated resale value in 5 years)/5
years]

Cost of petrol ($2.70/gal 27 miles/gal)

Annual cost of auto insurance and license

Maintenance and repairs

Parking fees at school ($45/mo x 8mo)

Total average cost per mile

Annual cost of
fixed items

Cost per
Mile (based
on 10,000
miles per
year)

$ 2,800

$0.280
$0.100

$1,380

$0.138
$0.065

$360

$0.036
$0.619

*the distances are 230 miles x 2 (to and fro)

** if accident happens during the trip, the future insurance premium will be
affected, thus, the insurance premium will be a relevant cost. Otherwise, it is
not relevant.

An example of identifying
relevant costs and benefits
N
o

Item

Annual
cost of
fixed
items

Reduction in the resale value of car due

solely to wear and tear

Cost of round trip train ticket from Boston

to New York City

Benefit of relaxing and being able to

study during the train ride rather than
having to drive

Cost of putting the dog in a kennel while

gone

$40

Benefit of having a car available in New

York City

Hassle of Parking the car in New York City

Cost of parking the car in New York City

$0.026/mil
e
$104
-

$25/day

Relevant financial cost of driving to New York City

Petrol (460 miles x $0.100/mile)

$46.00

Maintenance and repairs (460miles x $0.065/mile)

$29.90

Reduction in the resale value of car due solely to wear

and tear (460 miles x $0.026/mile)

$11.96

Cost of parking the car in New York City (2 day x

$25/day)

$50.00

Total

$137.86
Relevant financial cost of taking the train to New York

Cost of round trip train ticket from Boston to New York

City

$104.00

Reconciling the total and

differential approaches
Situatio
Current
n with
Situati
the New
on
Machine
Units produced and sold

Differenti
al costs
and
benefits

5,000

5,000

Selling price per unit

$40

$40

$0

Direct materials cost per

unit

$14

$14

$0

Direct labour cost per unit

$8

$5

$15,000

Variable ovehead cost per

unit

$2

$2

$0

$62,000

$62,000

$0

$3,000

-$3,000

$18,000

$30,000

$12,000

Fixed costs, other

Fixed costs, rental of new
machine
Net Operating Income

Net Advantage of Renting the New Machine

Decrease in direct labour costs (5,000 units at a cost
savings of $3/unit)

$ 15,000

Increase in fixed expenses

-$3,000

Net annual cost savings from renting the new

machine

$12,000

Isolate relevant costs needs

First,

we considered all costs, both

those that were relevant and those
that were not
Second, we considered only the
relevant costs.
Rarely we will have enough
information available to prepare a
detailed income statement for both
alternatives.
Irrelevant costs may cause confusion

5.2
Pricing
Decision

To provide relevant information to managers and team who

make the decisions

Setting the price for an organization's product is one of the

most important decisions a manager faces and one of the
most crucial and difficult decisions afirm's manager has to
make.

Pricing is a profit planning exercise. Cost is one of the major

considerations in price determination of the product.
The main objectives in choosing and setting the price of a
product include the following:
- To maximize profit
-To meet target sales or market share
-To maintain a price that is stable in relation to
competitors' prices

3 MAJOR FACTORS WHICH INFLUENCE PRICING DECISION

Customers influence price through their

effect on the demand for a product or service,
based on factors such as quality and product
features

Competitors influence price through their

pricing schemes, product features, and
production volume

Costs influence prices because they affect

supply (the lower the cost, the greater the
quantity a firm is willing to supply)

Factors Affecting Pricing

Decision
Internal Factors in Pricing a Product
controllable by the company and, if necessary, can be
altered.
The cost of producing and marketing the product is
the main consideration in setting a price.
the company wants to make profits from the costs it
incurred. Marketing strategies, such as product
specifications, place of distribution, and ways or
promoting the product are carefully considered.
For example, product pricing may depend heavily on
the productivity of a manufacturing facility (e.g., how
much can be produced within a certain period of time)

Factors Affecting Pricing

Decision
External Factors in Pricing a Product

not controlled by the company but will impact pricing decisions.

1.Market competition -The type of market determines the

ability of a company in setting prices.Under perfect competition,
players have less to no control over price. It is set by the
market.Under monopolistic competition, a monopoly has the
power to set prices since there are no competitors.
2.Legal factors -Generally, pricing strategies that kill healthy
competition are prohibited by law.
3. The law of demand and supply -Generally, the higher the
demand, the higher the price sellers will charge. The higher the
supply is, the lower the price.

Pricing Methods
These 5 methods below are used to
determine the optimal price that a customer is
willing to pay for a product or service.
1. Cost-based
2. Value-based pricing
3. Competition-based
4. Penetration pricing
5. Price skimming

1. Cost-based pricing
Price is set by adding a certain mark-up above the
cost of producing and selling the product.
The goal of doing business is to maximize profits.
Cost-based pricing ensures that costs are fully
recovered and desired profits are met.
Cost-Plus Pricing Formula
-The price derived from applying mark-up over the
cost of the product is known ascost-plus price.
-Cost-Plus Price = Cost + Mark-up
The mark-up can be computed as a percentage of
total costs, product costs, variable manufacturing
costs, or total variable costs.

2.Value-based pricing

price is based on the value of the product as

perceived by the buyer rather than focusing
on costs
Unlike, cost-based pricing that places a
certain markup on top of costs incurred,
value-based pricing sets prices based on
the benefits provided by the product.
Suitable for Companies that offer products
with unique and distinguished features, as
well as highly customized products and
services

2.Value-based pricing
more applicable in situations where individual
quotes are given to individual orders or jobs.
Examples include: architectural design,
general repairs, car customization, and other
custom products and services.
Target Costing-When charging value-based
price, the seller still considers relevant costs.
Though mark-up is not directly computed on
the basis of cost, the selling price must be
enough to cover for the costs to be incurred.

3.Competition-based
pricing
pricing method that makes use of competitors'

prices for the same or similar product as basis in

setting a price.
Focus on information from the market rather than
production costs (cost-plus pricing) and product's
perceived value (value-based pricing).
The price of competing products is used as
benchmark. The business may sell its product at a
price above or below such benchmark.
Setting a price above the benchmark will result in
higher profit per unit but might result in less units
sold as customers would prefer products with lower
prices.
setting a price below the benchmark might result in
more units sold but will cause less profit per unit.

3.Competition-based pricing

In a perfectly competitive market, sellers almost

have no control over prices. It is solely determined
by the supply and demand, and products are sold
at themarket priceorgoing rate.
advantages of competition-based pricing is no
complex computations are required. Sellers simply
follow a market price, or a price set by market
leaders. In a highly competitive market, the
burden of price- based marketing is lifted.
Disadvantages- Additional efforts include
aggressive advertising, better customer support,
market saturation needed When sellers adopt the
same price as those charged by competitors,
certain marketing efforts must be made to attract
sales since price is not a major factor

4. Penetration pricing
Penetration pricing is a pricing method that
involves setting low prices with the
intention of quickly introducing a new
product to the market.
Penetration pricing aims to attract
customers away from competitors by
offering lower prices initially.
Once the product has been accepted and
has established its brand in the market,
prices may be increased to yield greater
profits.

4. Penetration pricing
gets the new product diffused into the market
quickly. However, when prices are set very low, it
results in low profit per unit and need the higher
volume of sales in order to sustain.
can help the business establish market
dominance. By setting low prices, possible
entrants will be discouraged in entering the
market. Current competitors may also be forced to
leave if they cannot keep up with low prices.
On the downside, by setting low prices might
cause customers to question the quality of the
product. Also, once prices are increased, buyers
may not be willing to make repeat purchases
anymore.

5. Price skimming

involves setting high initial prices to recover costs and

make huge profits in the early stages of the product's
life cycle. It is very common in technological markets
(mobile phones, gaming consoles such as Sony
Playstation and Microsoft X-box, etc.).
The goal is to sell as many units as possible to
customers who do not care much about price. Once the
amounts of cost have been recovered, prices may then
be lowered in order to expand sales.
Once the upper class market has been served, the price
is lowered to cater to a larger market. Those who were
not able to afford the product during its initial offering
will be able to buy it after subsequent price
adjustments. This results in a larger market share and
continuous sales.

5. Price skimming

The main advantage of price skimming is higher

profits in the early stages of the product's life
cycle. This is common in technological markets
where repeat purchase is uncommon.
Research and developments costs in technological
markets are high. These costs are recovered early
on by setting high selling prices. Also, customers
often associate high prices with good quality.
A business that adopts price skimming limits its
sales. Because of high initial price, sales volume is
restricted. Also, when the price is dropped later
on, customers might not be as excited as when
the product was first released.

Chapter 5 :
Product Mix Decision
Management Accounting for Managers

Meaning of Product Mix

Product
Product
Mix
Mix

-- Total
Total group
group of
of products
products
offered
offered by
by company
company
-Total
-Total assortment
assortment of
of
product
product and
and services
services
marketed
marketed by
by a
a company
company

Product
Product
Line
Line

Group
Group of
of closely
closely related
related
product
product items
items
-- Individual
Individual
products
products that
that are
are closely
closely
related
related in
in same
same way
way

Individual
Individual
Product
Product
Any
Any brand
brand or
or variant
variant of
of
a
brand
in
a
product
a brand in a product line
line

Characteristic of Product Mix

Width
Width

Length
Length

The
The Number
Number of
of
product
product lines
lines in
in
the
the product
product mix
mix

Depth
Depth

The
The number
number of
of
product
product in
in a
a
product
product line
line

How
How many
many
variants
variants offered
offered
of
of each
each product
product
line
line

Consistency
Consistency

The
The relatedness
relatedness
of
of the
the different
different
product
product line
line in
in a
a
product
product mix
mix

Product and Service Strategies- Product Mix Strategies

Add
Add New
New
Product
Product Lines
Lines

Delete
Delete Existing
Existing
Product
Product Lines
Lines

Branding
Branding
Strategies
Strategies

Product & Service Strategies (PLC)

Describe advancement of
products through identifiable
stages of their existence
Introduction >
Growth>Maturity>Decline
Diffusion Process describes
the adoption of an innovation
process over time

Attract Customer via

awareness & interest
Induce customer, Educate,
Strengthen Channel, Build
availability, visibility &
pricing objectives

Individual
Individual Product
Product
Strategies
Strategies

Introduction
Introduction
Strategies
Strategies

Rapid Increase in
profitability
Length depends on nature
of product and competitive
reaction
Create unique positioning
Find ideal balance between
price and demand

Growth
Growth Strategies
Strategies

Generate Cash Flow

Hold Market Share
Steal Market Share
Increase Share of Customer

Maturity
Maturity
Strategies
Strategies

Market segment potential

Market position of the
product
Firms price and cost
structure
The rate of market
deterioration

Declining
Declining
Strategies
Strategies

Product & Service Strategies

Strategic Alternatives
either to increase or
decrease length of
product line

Product
Product Line
Line
Strategies
Strategies

Downward Stretch
Attempt to add products to
lower end product line
Upward Stretch Products
are added at the higher
end of product line
Two-way Stretch adding
product at both high and
low end of product
Line Filing Adding product
in different places within
product line to fill up gap
Cannibalisations Occurs
when new product takes
sales away from existing
products.

Line
Line Stretching
Stretching

Decreasing the product

line and consider to
deleting products when
- Not Successful
-Reach Decline stage
of PLC
-Long run product line
marketing cost too
high

Contraction
Contraction
Strategies
Strategies

Branding Strategies
Product
Product Mix
Mix
Branding
Branding
Strategies
Strategies

Individual
Individual
brand
brand name
name
strategy
strategy

Company
Company
name
name

Family
Family brand
brand
name
strategy
name strategy

Family
Family brands
brands
for
product
for product
name
name
Family
Family and
and
individual
individual
name
name

Branding Decisions
Product Category
Existing
New
Existing
Brand name
New

Line Extension

Brand
Extension

Multibrands

New brands

Diffusion Process by Customer

Original PLC Stages

PLC : Stages and characteristic

Chapter 5 :
Other Type Of Decisions
Management Accounting for Managers

What is a 'Make-Or-Buy Decision'

A make-or-buy decision is the act of choosing between
manufacturing a product in-house or purchasing it from an
external supplier. In a make-or-buy decision, the most
important factors to consider are part of quantitative analysis,
such as the associated costs of production and whether the
business has the capacity to produce at required levels.

BREAKING DOWN 'Make-Or-Buy Decision'

Also referred to as the outsourcing decision, the make-or-buy
decision compares the costs and benefits associated with
producing a necessary good or service internally to the costs
and benefits involved in hiring an outside supplier for the
resources in question. To compare costs accurately, all
aspects regarding the acquisition and storage of the items
must be considered.

The Make or Buy Decision: An

Example
Essex

Company manufactures part 4A that is

used in one of its products.
The unit product cost of this part is:
Direct materials
Direct labor
Variable overhead
Depreciation of special equip.
Supervisor's salary
General factory overhead
Unit product cost

9
5
1
3
2
10
$ 30

The Make or Buy Decision

The special equipment used to manufacture part

4A has no resale value.

The total amount of general factory overhead,

which is allocated on the basis of direct labor
hours, would be unaffected by this decision.

The $30 unit product cost is based on 20,000

parts produced each year.

An outside supplier has offered to provide the

20,000 parts at a cost of $25 per part.

Should we accept the suppliers offer?

The Make or Buy Decision

The
The avoidable
avoidable costs
costs associated
associated with
with making
making part
part 4A
4A include
include direct
direct

materials,
materials, direct
direct labor,
labor, variable
variable overhead,
overhead, and
and the
the supervisors
supervisors salary.
salary.

The Make or Buy Decision

The
The depreciation
depreciation of
of the
the special
special equipment
equipment represents
represents aa sunk
sunk
cost.
cost. The
The equipment
equipment has
has no
no resale
resale value,
value, thus
thus its
its cost
cost and
and
associated
associated depreciation
depreciation are
are irrelevant
irrelevant to
to the
the decision.
decision.

The Make or Buy Decision

Not
Not avoidable;
avoidable; irrelevant.
irrelevant. IfIf the
the product
product is
is
dropped,
dropped, itit will
will be
be reallocated
reallocated to
to other
other products.
products.

The Make or Buy Decision

Should we make or buy part 4A? Given that the total

avoidable costs are less than the cost of buying the part,
Essex should continue to make the part.

Special Order
A special order is a one-time
order that is not considered
part of the companys normal
ongoing business.
When analyzing a special
order, only the incremental
costs and benefits are
relevant.
Since the existing fixed
manufacturing overhead costs
would not be affected by the
order, they are not relevant.

Special Orders
Jet, Inc. makes a single product whose normal selling
price is $20 per unit.

A foreign distributor offers to purchase 3,000 units for

$10 per unit.

This is a one-time order that would not affect the

companys regular business.

Annual capacity is 10,000 units, but Jet, Inc. is

currently producing and selling only 5,000 units.

Should Jet accept the offer?

Special Orders
Jet, Inc.
Contribution Income Statement
Revenue (5,000 $20)
$ 100,000
Variable costs:
Direct materials
$ 20,000
Direct labor
5,000
$8 variable cost
Manufacturing overhead
10,000
Marketing costs
5,000
Total variable costs
40,000
Contribution margin
60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs
20,000
Total fixed costs
48,000
Net operating income
$ 12,000

Special Orders
If Jet accepts the special order, the incremental revenue
will exceed the incremental costs. In other words, net
operating income will increase by $6,000. This
suggests that Jet should accept the order.
Increase in revenue (3,000 $10)
Increase in costs (3,000 $8 variable cost)
Increase in net income

$ 30,000
24,000
$ 6,000

Note: This answer assumes that the fixed costs are

unavoidable and that variable marketing costs must be
incurred on the special order.

Joint Product
In

some industries, a number of end

products are produced from a single raw
material input.
Two or more products produced from a
common input are called joint products.
The point in the manufacturing process
where each joint product can be
recognized as a separate product is
called the split-off point.

Joint Products
Oil

Joint
Input

Common
Production
Process

Gasoline

Chemicals

Split-Off
Point

For example,
in the petroleum
refining industry,
a large number
of products are
extracted from
crude oil,
including
gasoline, jet fuel,
home heating oil,
lubricants,
asphalt, and
various organic
chemicals.

Joint Products
Joint costs
are incurred
up to the
split-off point

Joint
Input

Common
Production
Process

Oil

Gasoline

Chemicals

Split-Off
Point

Separate
Processing

Final
Sale

Final
Sale

Separate
Processing

Separate
Product
Costs

Final
Sale

The Pitfalls of Allocation

Joint costs are traditionally
allocated among different
products at the split-off point.
A typical approach is to allocate
joint costs according to the
relative sales value of the end
products.
Although allocation is needed for
some purposes such as balance
sheet inventory valuation,
allocations of this kind are very
dangerous for decision making.

What are Keep or Drop Decisions?

A short-term decision of whether or not to

drop or continue one of the following:

Product line such as shoes at JCPenney, home

appliances at Best Buy
Product such as breakfast burritos at McDonalds,
Blue Moon beer at Hooters
Service line such as carpet installation by Home
Depot, textbook rentals at Follett book store
Service such as rental of DVDs by Netflix,
downloading of MP3s by Amazon
Segment such as a geographical division, retail
verses wholesale offerings, outpatient surgery in a
hospital, 3G cellular service

51

Relevant Amounts
Incremental
Revenue
The decline in revenue
from dropping

Incremental Cost
Savings
The variable cost
savings due to dropping
The direct fixed cost
savings due to
dropping

What is not relevant

Allocated fixed costs
Often called common costs
Consists of overhead costs that a company allocates
or divides up amongst several units that use the
costs

How to Make Keep or Drop

Decisions

52

If the decline in revenue < incremental cost savings

Drop the product/product line, unless
qualitative characteristics impact the decision
If the decline in revenue > incremental cost savings
Do not drop the product/product line, unless
qualitative characteristics impact the decision
If the decline in revenue = incremental cost savings
Use qualitative characteristics to assess

Beware of Allocated Fixed

Costs
Dropping a
product/service/line/segment that has
a net loss often creates a bigger loss
Referred to as the Cost Allocation
Death Spiral Because not
Why should we
keep the ice
cream segment?
It shows a loss?

all costs will

disappear
when we
allocate costs
to products.

Our allocations
can make a
segment look less
profitable than it
really is.

Keep or Drop Example

Take Outs has three product lines in its retail stores: snacks,
salads, and sandwiches. The allocated fixed costs are unavoidable.
Results of July follow:

Units sold
Revenue
Variable costs
Direct fixed costs
Allocated fixed
costs
Operating income

Snacks

Salads

Sandwiche
s

Total

800
1,200
2,400
4,400
$49,600 $52,800 $67,200 $169,600
19,200
26,400
33,600 79,200
10,000
14,000
13,000 37,000
16,000
$4,400

18,000
($5,600)

16,000
$4,600

50,000
$3,400

Demand of snacks is expected to increase by 10% if salads

are dropped. Prepare an incremental analysis.

54

Keep or Drop Example

Data reproduced:

Units sold
Revenue
Variable costs
Direct fixed costs
Allocated fixed costs
Operating income

Snacks

800
$49,600
19,200
10,000
16,000
$4,400

Salads

1,200
$52,800
26,400
14,000
18,000
($5,600)

Sandwiches

cont.
Total

2,400
4,400
$67,200 $169,600
33,600
79,200
13,000
37,000
16,000
50,000
$4,600
$3,400

Incremental decline in salad revenue

($52,800)
Incremental variable cost savings - salads
26,400
Incremental direct fixed costs savings salads
14,000
Incremental snack revenue (10% x $49,600)
4,960
Incremental variable costs snacks (10% x $19,200)
Original profit +/- Change in profit = New profit
(1,920)
New profit
= $3,400
- $9,360
$5,960 loss
55
Incremental
decrease
in profit
if drop =
salads

Sell or Process Further

Joint costs are irrelevant in decisions
regarding what to do with a product from
the split-off point forward. Therefore, these
costs should not be allocated to end
products for decision-making purposes.
With respect to sell or process further
decisions, it is profitable to continue
processing a joint product after the split-off
point so long as the incremental revenue
from such processing exceeds the
incremental processing costs incurred after
the split-off point.

Sell or Process Further: An Example

Sawmill,

Inc. cuts logs from which unfinished

lumber and sawdust are the immediate joint
products.

Unfinished lumber is sold as is or processed

further into finished lumber.

Sawdust can also be sold as is to gardening

wholesalers or processed further into prestologs.

Sell or Process Further

Data about Sawmills joint products includes:

Sales value at the split-off point

Sales value after further processing
Allocated joint product costs
Cost of further processing

Per Log
Lumber
Sawdust
$
140
$
40
270
176
50

50
24
20

Sell or Process Further

Sell or Process Further

Analysis of Sell or Process Further
Per Log
Lumber

Sales value after further processing

Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing

270
140
130
50
80

Sawdust

50
40
10
20
(10)

Sell or Process Further

Analysis of Sell or Process Further
Per Log
Lumber

Sales value after further processing

Sales value at the split-off point
Incremental revenue
Cost of further processing
Profit (loss) from further processing

270
140
130
50
80

The lumber should be processed

further and the sawdust should be
sold at the split-off point.

Sawdust

50
40
10
20
(10)