Lecture 5

Management Accounting

IBA 2005-2006
 Program

• Previous sessions covered cost accounting

concepts and cost management systems
• Chapter 14 & 15 deal with the use of accounting
information in decision making:
– Steps in decision making process
– Identifying relevant costs and benefits
– Analysis of special decisions
• Make or buy (outsourcing)
• Product-mix under capacity constraints
• Joint products: sell or process further
– Pricing decisions
– Target costing
 The decision-making process

1. Clarify the Problem

2. Specify the Criterion

3. Identify the Alternatives

Chapter 14

Quantitative
Analysis
4. Develop a Decision Model
Responsibility of
management 5. Collect the Data
accountant

Qualitative 6. Make a Decision

Considerations
 Role of accounting information (1)

• Linkages with information economics and

organizational economics:
– Statistical decision theory: representations of
preferences for decisions under uncertainty
(von Neumann & Morgenstern, 1944)
Chapter 14

– Bayesian statistics (expected values and

sensitivity analysis; see pp. 603-604)
• Conceptual framework:
– Decision-facilitating role of accounting
information
– Decision-influencing role of accounting
information
– Interdependent nature of the two roles
 Role of accounting information (2)

• Functions of decision-facilitating role of

accounting information:
– Reduce ex-ante uncertainty
– Improve judgment and decision-making
Chapter 14

• Functions of decision-influencing (control) role

of accounting information:
– Motivate, evaluate and reward
– Help to mitigate agency problems
• Interdependencies:
– Information and incentives are inextricably
linked!
 Decision-facilitating information

• Assumptions:
– Preferences are represented by a utility
function defined over a set of possible relevant
outcomes
– Decision-maker selects the action that
Chapter 14

maximizes his expected utility based on his

outcome beliefs given the information received
(ex-post choice)
– An (accounting) information system does not
have effects unless:
• some reports result in different outcome beliefs
• some differences in outcome beliefs result in different
actions
• the action differences affect the outcomes that occur
 Key information/measurement properties

• Posterior precision (informativeness) with

respect to outcome relevant events
• Relevance:
– correlation with outcome relevant events
Chapter 14

• Timeliness:
– reporting interval
– reporting delay
• Accuracy:
– precision
– freedom from bias
 Less accurate cost systems

• When and why to measure costs less accurately

to improve decision making?

• Three forms of less accurate cost systems:

1. Biased upward
Chapter 14

2. Biased downward
3. Costs defined less precisely than is possible
 1. Biased upward

• Why do some people set their watch 5 minutes

ahead?
– Even though they know that their watch shows biased
information, it helps them to overcome their
propensity to be late
Chapter 14

• Rationale in cost accounting to overstate

product costs:
– Positive effects on pricing decisions in competitive
situations
– Example in an apparel company: after having set
lenient labor time standards, labor costs increased
and overhead applied tended to be overstated.
Beneficial effect: protection against the tendency to
shave profit margins
 2. Biased downward

• Rationale in cost accounting to understate

product costs:
– Target costing (Chapter 15): cost standards based on
estimates of what an item should cost
– in a target costing system unfavorable variances do
not necessarily signify shirking or waste
Chapter 14

– other rationale: to stimulate the consumption of

services (e.g not allocate costs of supporting PC to
stimulate PC use)
 3. Costs defined less precisely than is possible
(1)

• Rationale:
– to focus attention on areas critical for
competitive advantage
– to reduce the occurrence of dysfunctional
behavior and effectively increase control
Chapter 14

• Example Textronix (electronics):

– support costs applied with a single cost driver:
number of components
– rationale: to encourage design engineers to focus
their attention on reducing the number of
components. With short life cycles, time to market is
important. Simple designs (fewer components
numbers) are critical to the success of Textronix
– as the number of cost drivers increases, managers
have more control over the allocation bases chosen
 3. Costs defined less precisely than is possible
(2)

• Increased discretion of managers being evaluated by the

cost system reduces the ability of the system to monitor
their behavior

• Benefits and costs of Activity-Based Costing:

$ Costs
Chapter 14

Benefits

• X optimum number of cost drivers

for decision-making (decision-
facilitating)
• Y optimum number of cost drivers
for both decision-making and
control (decision-influencing)
Net benefits (DM
only)
Y X # cost
drivers
Net benefits (DM +
control)
 Key features of relevant information

• Sunk (historical) costs may be helpful as a basis

for making predictions. However, past costs
themselves are always irrelevant when making
decisions
– Sunk costs can be relevant for control (decision-
Chapter 14

influencing)!
• Different alternatives can be compared by
examining differences in expected total future
revenues and costs
– Key questions: what difference will it make? what are
the opportunity costs?
• Pay attention to excess capacity
• Identify avoidable from unavoidable costs
• Due weight must be given to qualitative factors
 Two potential problems in relevant-cost
analysis

• Watch out for incorrect general assumptions,

like:
– all variable costs are relevant
– all fixed costs are irrelevant (within relevant
range only)
Chapter 14

• Misleading unit-cost data:

– fixed costs per unit at different output levels
– keep focusing on total revenues and total
costs
 Make versus Buy decisions (1)
• Example: costs of component Alpha (10,000 units)
Total Current Expected Expected
current cost per costs next cost per
costs unit year unit

Direct materials $ 80,000 $ 8.00 $80,000 $ 8.00

Direct labor 10,000 1.00 10,000 1.00

Chapter 14

Variable man. overhead 40,000 4.00 40,000 4.00

Mixed (variable and fixed)
overhead of materials 17,500 1.75 20,000 2.00
handling and setup a)

Fixed man overhead 30,000 3.00 30,000 3.00

$180,00
Total man costs $ 177,500 $ 17.75 $ 18.00
0
• Current year: 25 batches of 400 units; next year 50 batches of
200 units
a) current year: $5,000 + (# batches x $500)
a) next year $5,000 + (# batches x $300)
 Make versus Buy decisions (2)

• Suppose a manufacturer offers to sell 10,000 units of

Alpha next year for $ 16 per unit on whatever schedule
• Suppose the capacity now used to make Alpha will
become idle next year if the product is purchased and $
30,000 fixed overhead will continue to be incurred
• Assume that the $ 5,000 in clerical salaries to support
Chapter 14

setup, materials handling and purchasing will not be

incurred if production of Alpha is completely shut down
next year
• Would you accept this order?
 Make versus Buy decisions (3)

Total relevant Per-unit relevant

costs costs

Relevant costs Make Buy Make Buy

$160,00
Outside purchase of parts 0
$16
Chapter 14

Direct materials $80,000 $8

Direct labor 10,000 1

Variable MOH 40,000 4

Mixed materials
20,000 2
handling/setup
$150,0 $160,0
Total relevant costs 00 00
$15 $16
 Make versus Buy decisions (4)

• Suppose that, if the company accepts the offer from the

outside supplier, the best use of the available capacity is
to produce 5,000 units of Beta
• The estimates of the future revenues and costs of Beta
are the following:
Chapter 14

Additional future revenues

$80,000
Additional future costs:
Direct materials $30,000
Direct labor 5,000
Variable OH 15,000
Materials handling/setup 5,000

Additional future operating income

$25,000
 Make versus Buy decisions (5)

• Three alternatives:
1. Make Alpha and do not make Beta
2. Buy Alpha and do not make Beta
3. Buy Alpha and make Beta
Chapter 14

Total-alternatives approach to make-buy decisions

1. 2. 3.
Total incremental future costs of $150,000 $160,000 $160,00
making/buying Alpha 0
Excess of future revenues over 0 0 (25,000)
future costs from Beta
Total relevant costs under $150,000 $160,000 $135,00
total-alternatives approach 0
 Make versus Buy decisions (7)

Opportunity-cost approach to make-buy decisions

1. 2. 3.
Total incremental future costs of $150,000 $160,000 $160,00
making/buying Alpha 0
Opportunity cost: profit 25,000 25,000 0
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contribution foregone because

capacity will not be used to make
Beta as next-best alternative
Total relevant costs under $175,000 $185,000 $160,00
opportunity-cost approach 0

• This analysis emphasizes purely quantitative

considerations
• Strategic and qualitative factors should be considered as
well!
 Product-mix decisions under capacity constraints (1)

• Example: garment manufacturer

– production of three types of shirts
– constraint: 200 machine hours per day

Basic Delux Super

e 13.00
Chapter 14

Selling price ($) 7.50 9.00

Variable cost of 6.00 7.00 7.00

production ($)
Fixed costs ($) 1.00 1.00 1.00

Machine hours to 0.6 2 3

complete one shirt
Demand per day 50 50 50
(shirts)
 Product-mix decisions under capacity constraints (2)

• The company is operating at full capacity and is

contemplating short-term adjustments to its
product-mix. Capacity is constrained: the
company must decide how best to deploy this
limited resource
Chapter 14

• Opportunity cost of producing one type of shirt

arises from not using machine hours producing
another type of shirt
• Decision rule under capacity constraint:
maximize the contribution per unit of capacity
– Therefore, the company should rank-order the
products by their contribution per machine hour (and
not by their contribution per unit!)
• Beware of fixed costs: they never enter the
analysis!
 Product-mix decisions under capacity constraints (3)

Basic Deluxe Super

Selling price ($) 7.50 9.00 13.00

Variable cost of production ($) 6.00 7.00 7.00

Contribution margin per shirt 1.50 2.00 6.00

Machine hours to complete one shirt 0.6 2 3

Chapter 14

Contribution margin per machine 2.50 1 2

hour ($)
Demand per day (shirts) 50 50 50

Production schedule (shirts) 50 10 50

X hours to complete one shirt 0.6 2 3

Hours consumed 30 20 150

#3 20 hours left: 10 Deluxe

#1 50 Basic: 30
hours #2 150 Super: 150
 Product-mix decisions under capacity constraints (4)

• If the garment manufacturer receives a special

order request, it would have to decide the
minimum price it would accept
• Because its production capacity is limited, the
company must cut back the production of some
other shirt to accept the order
Chapter 14

• Giving up the production of some profitable

product results in an opportunity cost equal to
the lost profit on the shirts that the company can
no longer make:
– The product with the lowest contribution per
hour should be sacrificed!
• The profit (contribution) lost on those products
would need to be covered by the price of the
special order
 Product-mix decisions under capacity constraints (5)

• Suppose a client wants to buy an additional 30 shirts

Super for $ 12.50 per shirt (not $ 13)
• Would you accept this order?
• What are the opportunity costs of producing and selling
these 30 extra shirts Super for $ 12.50 per shirt?
Chapter 14

• 30 shirts Super for $ 12.50; contribution margin per shirt

$ 5.50; contribution margin per machine hour $ 5.50/3 =
$ 1.83
• A machine hour for this order has a higher return than a
machine hour for producing Deluxe
• For the extra order 30 x 3 = 90 machine hours are
needed
• In the Deluxe production only 20 machine hours are used
• The maximum amount of Super shirts (for $ 12.50) that
can be produced is 6. The 2 machine hours left can be
used for producing 1 shirt Deluxe
 Product-mix decisions under capacity constraints (6)

Accept partial order:

• The 18 machine hours used for the extra order have a
contribution margin of 18 x $ 1.83 = $ 33; one shirt
Deluxe has a contribution margin of $2.
• The opportunity costs are: 18 hours x $ 1 = $ 18
• Thus, profit increases $ 15.
Chapter 14

Accept total order:

• The opportunity costs of 30 extra Super shirts are $ 160:
20 machine hours from the Deluxe production (20 x $ 1)
+
70 machine hours from the ‘normal’ Super shirt
production (70 x $ 2)
• By accepting the total order (30 Super shirts extra), profit
would increase: (30 x $ 5.50) - $ 160 = $ 5.
 Product-mix decisions under capacity constraints (7)

• Multiple constraints:
– Linear programming to solve product-mix
problem in presence of bottleneck (see
Appendix)
– Managing constraints:
Chapter 14

• outsourcing
• additional equipment
• parallel processing
• overtime
• eliminating non-value-added activities
 Joint products: sell or process further (1)

• Consider a joint production process resulting in

two or more products
• The point in the production process where the
joint products are identifiable as separate
products is called the split-off point
Chapter 14

Cocoa butter Example:

sales value
Joint Processing
$750 for
1,500 pounds of Cocoa Beans
Cocoa beans Joint Production
costing $500 process costing Split-off point
per ton $600 per ton
Cocoa powder Separable
sales value process
Total joint cost: $500 for costing
$1,100 per ton 500 pounds $800

Instant cocoa mix

sales value
$2,000 for
500 pounds
 Joint products: sell or process further (2)

Allocation of joint costs: Relative-Sales-Value method

Allocation
Joint Sales value Relative of joint
costs Joint products at Split-off proportion costs

Cocoa butter $ 750 60% $ 660

$ 1,100
Cocoa powder $ 500 40% $ 440
Chapter 14

$ 1,250 100% $ 1,100

• Cocoa butter is sold at the end of the joint processing

• Cocoa powder may be sold now or processed into instant
cocoa mix. Further processing costs of $800 (separable
processing costs) will be incurred if the company elects
to make instant cocoa mix
 Joint products: sell or process further (3)

Per-unit
Total basis
basis
Sales value of instant cocoa
$ 2,000 $ 4.00
mix

Sales value of cocoa powder $ 500 $ 1.00

Chapter 14

Incremental revenue $ 1,500 $ 3.00

Less: separable processing

$ 800 $ 1.60
costs
Net benefit of further
$ 700 $ 1.40
processing

• The cocoa powder should be processed into cocoa mix

• The allocation of joint costs ($ 1,100) is irrelevant!
 Role of product costs in pricing

• Understanding how to analyze product costs is

important for making pricing decisions:
– At most firms whose managers make
decisions about establishing or accepting a
price for their products, managers need to
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make decisions about, for example, whether

they should offer discounts for large orders
or to valued customers
– Even when prices are set by overall market
supply and demand forces and the firm has
little or no influence on product prices,
management still has to decide the best mix
of products to manufacture and sell
 Four major influences on pricing decisions

•Customer demand: Management must consider

customers’ demand for their product, which
reflects the price that customers are willing to
pay for the product
•Actions of competitors: When pricing its product,
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management must consider the likely pricing

decisions and product design decisions of
competing firms
•Costs: No organization or industry can price its
product below total production costs indefinitely
•Political, legal, and image-related issues:
Management must consider the way the public
perceives the firm and must adhere to certain
laws when setting prices
 Short-and Long-term Pricing Considerations

• Managers must consider both the short-term

and long-term consequences of their decisions
• The costs of many resources committed to
activities are likely to be committed costs in the
short-term because firms cannot easily alter the
Chapter 15

capacities made available for many production

and support activities
– So for short-term decisions, it is important to pay
special attention to whether surplus capacity is
available for additional production, or whether
shortages of available capacity limit additional
production alternatives
• Decisions about whether to introduce new
products or eliminate existing products have
long-term consequences
 Ability to influence prices (1)

• We also classify decisions based on whether the

firm can influence the price of its products
– If the firm is one of a large number of firms in an
industry, and if there is little to distinguish the
products of different firms from each other:
• Economic theory states that prices will be set by
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the aggregate market forces of supply and demand

• No single firm can influence prices significantly by
its own decisions
• The result will be similar if prices are set by one or
more large firms leading an industry, while a smaller
firm on the fringe must match the prices set by the
industry leaders
• Such a firm is a price taker, and it chooses its
product mix given the prices set in the
marketplace for its products
 Ability to influence prices (2)

• In contrast, firms in an industry with relatively

little competition, who enjoy large market
shares and exercise leadership in an industry,
must decide what prices to set for their
products
• Firms in industries in which products are highly
Chapter 15

customized or otherwise differentiated from

each other (because of special features,
characteristics, or customer service) also need
to set the prices for their differentiated
products
• Such firms are price setters; they announce
their prices, customers place orders, and
production follows
 Short-term decisions for price takers
• A price taker should produce and sell as much as
it can of all products whose costs are less than
industry prices
• Although this may appear to be a simple decision
rule, two important considerations complicate
matters:
Chapter 15

– First, managers must decide which costs are relevant to

the short-term product mix decision
• Should all the product costs be considered?
• Should only those costs that vary in the short-term
be considered?
– Second, in the short-term, managers may have little
flexibility to alter the capacities of the firm’s resources:
• The available equipment capacity may limit the
ability of a firm to produce and sell more products
whose costs are lower than their prices
 Economic pricing model (1)
• Introductory textbooks in economics usually
analyze the profit maximization decision by a
firm in terms of the choice of a quantity to
produce. In turn, the quantity choice determines
the product price in the marketplace
• Economists present the quantity choice in terms
Chapter 15

of equating marginal revenue and marginal cost

– Marginal revenue is defined as the increase in revenue
corresponding to a unit increase in the quantity
produced/sold
– Marginal cost is the increase in cost for a unit increase
in the quantity produced and sold
– If marginal revenue is greater than marginal cost, then
increasing the quantity by one unit will increase profit
– If marginal revenue is less than the marginal cost, then
it is possible to increase profit by decreasing production
 Economic pricing model (2)

Dollars Profit is maximized where

per unit marginal cost equals
marginal revenue, resulting
in price p* and quantity q*
Chapter 15

p*

Marginal Demand
cost

Marginal
revenue Quantity made
and sold
q*
 Limitations of economic pricing model

1. Firm’s demand and marginal revenue curves are

difficult to determine with precision
2. The marginal cost, marginal revenue paradigm is
not valid for all forms of market organization
3. Cost accounting systems are not designed to
Chapter 15

measure the marginal changes in cost incurred

as production and sales increase by unit. To
measure marginal cost would entail a very
costly information system
 Role of accounting product costs in pricing
Optimal Decisions Suboptimal Decisions

Economic pricing model Cost-based pricing

Sophisticated decision Simplified decision

model and information model and information
requirements requirements
Chapter 15

Marginal-cost and Accounting product-

marginal-revenue data cost data

More costly Less costly

The best approach, in terms of costs and

benefits, typically lies between the extremes.
 Cost-plus pricing

Price = cost + (markup percentage × cost)

Chapter 15

Four cost bases:

• Absorption manufacturing cost
• Total cost
• Variable manufacturing cost
• Total variable cost
 Absorption-Cost pricing formula

Advantages:
– In the long run, the price must cover all costs and a
normal profit margin
– Absorption-cost and total-cost pricing formulas
provide a justifiable price that tends to be perceived
as equitable by all parties
Chapter 15

– When a company’s competitors have similar

operations and cost structures, cost-plus pricing
based on full costs gives management an idea of how
competitors may set prices
– Absorption-cost information is provided by a firm’s
cost-accounting system, because it is required for
external financial reporting
• Disadvantage:
– Absorption-cost and total-cost pricing formulas
obscure the cost behavior pattern of the firm
 Variable-Cost pricing formula

Advantages:
– Variable-cost data do not obscure the cost behavior
pattern by unitizing fixed costs and making
them appear variable
– Variable-cost data do not require allocation of
common fixed costs to individual product lines
Chapter 15

• Disadvantage:
– Managers may perceive the variable cost of a
product or service as the ‘price floor’
– Fixed costs may be overlooked in pricing decisions,
resulting in prices that are too low to cover total
costs
 The markup rate (1)

Return-on-investment (ROI) pricing:

Markup Profit required
Total annual costs not
percentage to achieve +
included in cost base
applied to target ROI
=
cost base in Cost-base per unit
cost-plus Annual volume X used in cost-plus
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formula pricing formula

• Disadvantages target ROI:

– ROI pricing uses the same cost of capital for all
assets
• discussion for next sessions
– ROI pricing can make a company unresponsive to the
actions of competitors; it encourages an inward
viewpoint by the company
 The markup rate (2)

• Just as prices depend on demand conditions,

markups increase with the strength of
demand:
– If more customers demand more of a product, then
the firm is able to command a higher markup
Chapter 15

• Markups also depend on the elasticity of

demand:
– Demand is said to be elastic if customers are very
sensitive to the price, that is, if a small increase in
the price results in a large decrease in the demand
– Markups are smaller when demand is more elastic
• Markups also fluctuate with the intensity of
competition
– If competition is intense, it is more difficult for a firm
to sustain a price much higher than its incremental
costs
 The markup rate (3)

• Firms decide on markups for strategic reasons:

– A firm may choose a low markup for a new product to
penetrate the market and win over market share
from an established product of a competing firm
– Many internet businesses have adopted the strategy
of setting low prices to build the business, acquire a
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brand name, build a loyal customer base, and garner

market share
– In contrast to this penetration pricing strategy, firms
sometimes employ a skimming price strategy, as in
the audio and video equipment industry, where
initially a higher price is charged to customers who
are willing to pay more for the privilege of possessing
the latest technological innovations
 Determining a bid price

• Assume that the full costs for a special order are

estimated to be $28,500 consisting of:
– $ 8,400 of direct materials
– $ 9,900 of direct labor
– $10,200 of support activity costs, consisting of:
• $ 3,400 of supervision
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• $ 3,700 of batch related expenses

• $ 3,100 of business sustaining expenses
• Assume that the company has decided the markup
percentage is normally to be 40% of full costs
• If the bid request came from a regular customer, the bid
price would have been $ 39,900
= 1.40 x $ 28,500
• But for this special order from a new customer, what is
the minimum acceptable price?
 Available surplus capacity

• The company’s incremental costs of filling the order will

be $ 22,000 (material, direct labor, batch related
expenses)
• The costs of supervision and business-sustaining support
activities will not increase if excess capacity of these
resources is available to meet the production needs of
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the order
• The price that the company should bid must cover the
incremental costs for the job to be profitable
– In other words, the minimum acceptable price is $
22,000 since surplus production capacity is available
(no opportunity cost in accepting an additional
order!)
• The company would likely add a profit margin above
incremental costs and make the bid price something
higher than $ 22,000, depending on competitive and
demand conditions
 No available surplus capacity (1)

• If surplus machine capacity is not available, the

company will have to incur additional costs to acquire
the needed capacity
• Companies often meet such short-term capacity
requirements by operating its plant overtime
– Paying its supervisors overtime wages
Chapter 15

– Incurring additional expenditures for heating,

lighting, cleaning, and security
• More machine maintenance and plant engineering
activities will be necessary
– Experience has shown that the incidence of machine
breakdowns increases during the overtime shift
• Under its machinery leasing contract, the company also
incurs additional rental costs for the extra use of
machines when it adds an overtime shift
 No available surplus capacity (2)

• Assume management estimates the order would cause:

– $5,100 of incremental supervision costs (including
overtime premium)
– $5,400 of incremental business-sustaining costs
• Thus, the total cost of overtime required to manufacture
customized tools for the order is $ 10,500 ($ 5,100 + $
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5,400)
• Therefore, the minimum acceptable price in this case is
$ 32,500 ($ 22,000 + $ 10,500)
– The actual price will depend on the amount of
markup charged over the incremental costs
• In case the special order substitutes ‘normal’
production, it is also appropriate to include in the price
an estimate of the opportunity cost (= lost contribution)
associated with the job (see Case 15-48)
 Target costing (1)

Target cost = Target price per unit – Target profit per unit
Chapter 15

• The target costing process is a system of profit

planning and cost management that is price
led, customer focused, design centred, and
cross-functional
• Target costing initiates cost management at
the earliest stages of product development and
 

applies it throughout the product life cycle by

actively involving the entire value chain
 Target costing (2)

Target Costing vs Standard Costing

Characteristic Target Costing Traditional Standard Costing

When applied During the Planning and Design  Applied during the Production 

Stage of the product's life cycle Stage of the product's life cycle
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Approach Involves a proactive Cost  Involves a reactive Cost 

Planning Approach where  Control Approach during 
pricing is considered prior to  production
production 
Type of Industry  Assembly Oriented Industries  Process­Oriented Industries like 
Best­Suited like electronics and automotive  chemicals and steel 
(Variety, medium to small  (Continuous production)
volume production)
 Target costing (3)

Locked-in (or designed-in): costs that have not yet been

incurred but which, based on decisions that have
already been made, will be incurred in the future.
Typically 80% of product costs are locked-in during the
production stage
Cumulative Costs per Unit

e
st Curv
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- i n C o
Locked
e
enc
r
cur e
n v
s t-I Cur
Co

R&D and Manufacturing Mkt., Dist.,

Design & Cust. Services
 Differences in pricing practices
Rankings of factors used to price products (1 most important)
US Japan Ireland UK
Market 2 1 1 1
based
Cost based 1 2 2 2
Full cost 1 n.a. 1 1
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Variable 2 n.a. 2 2
cost

Use of value engineering and designers in cost management
Australia Japan UK
% use 24 58 29
% involvement 25 46 32
of designers