Management Accounting

GOMBA

PART 3
PRICING & MEASURING RELEVANT COSTS AND REVENUES FOR
DECISION- MAKING

Learning objectives:

• describe the different cost-plus pricing methods and target costing approach to pricing.
• distinguish between the relevant and irrelevant costs and revenues for short-term decisions.
• describe the opportunity cost concept.
• explain why different cost information is required for different purposes.
• appraise the importance of qualitative factors in decision-making.

3. Pricing and measuring relevant costs and revenues for decision-making

Casitos

Question 10 – Gamex, Ltd.

Question 11 – Plastex, Ltd. and Electomex, Ltd.
Examples
Question 12 – Pizzeria Venecia
Question 13 – PenínsulAIR
Casitos

Question 14 – Southwestern Company

Question 15 – Amsterdam Chocolate Company
Question 16 – Maria Salvador, Ltd.
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Question 10

(Adapted from Horngren et al. (2021) – “Cost Accounting: A Managerial Emphasis”, 17th Edition, Pearson Global Edition)

Gamex Ltd. manufactures game systems. Gamex has decided to create and market a new system with
wireless controls and excellent video graphics. Gamex’s managers are thinking of calling this system the
Yew. Based on past experience they expect the total life cycle of the Yew to be four years, with the
design phase taking about a year.

They budget the following costs for the Yew:

Total fixed costs Variable cost

over four years per unit
Year 1 R&D costs 6,590,000 € ---
Design costs 1,450,000 € ---
Years 2-4 Production 19,560,000 € 50€ per unit
Marketing & Distribution 5,242,000 € 10€ per unit
Customer service 2,900,000 € ---

Required:
1. Suppose the managers at Gamex price the Yew system at 110 € per unit. How many units do
they need to sell to break even?
2. The managers at Gamex are thinking of two alternative pricing strategies.
a. Sell the Yew at 110€ from the outset. At this price, they expect to sell 1,500,000 units
over its life cycle.
b. Boost the selling price of the Yew in year 2 when it first comes out to 240 € per unit. At
this price, they expect to sell 100,000 units in year 2. In year 3 and 4 drop the price to
110 € per unit. The managers expect to sell 1,200,000 units in years 3 and 4.
Which pricing strategy would you recommend? Explain.
3. What other factors should Gamex consider in choosing its pricing strategy?

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Measuring and reporting

SUSTAINABILITY

How can life-cycle analysis (LCA) be used to support an organization’s efforts to be more
sustainable?

Life Cycle Analysis (LCA) is a comprehensive analysis of a product or service’s impact across its
entire lifecycle. Recognizing the extent of the impact can be important in justifying changes.
Furthermore, because the analysis extends to suppliers and customers the effects of decisions in
one can be seen on the other. The economic and environmental costs of a product’s disposal will be
influenced by decisions made in the production of the raw materials. For example, if a
biodegradable alternative to rubber could be found for tires it would greatly reduce the economic
and environmental costs that the ultimate consumer (and society) bear in getting rid of old tires.
Similarly, LCA recognizes that an organization’s sustainability includes the sustainability of its
suppliers. In addition to the ethical issues of supporting suppliers that are damaging the
environment or mistreating people, connections to such suppliers can impose a significant risk on
the company.

Example

Prepare a life-cycle analysis for a smartphone.

Try to identify as many of the steps and inputs as possible, from inception to consumers using and
ultimately disposing of the phone (make assumptions where necessary).
At each stage, identify as many social and environmental impacts as you can.

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Question 11

A
For the next year, Plastex Ltd. has capacity to make 60,000 units of its plastic product. The variable
cost of production is 4 € per unit. Fixed costs per annum are budgeted at 120,000 €.
In the past prices have been set on a cost-plus basis, with 25% being added to the full cost per unit.
Overheads being absorbed on the assumption of full capacity utilization. As there is a depressed market,
it is now suggested that the market research survey would help to set a more profitable price for the
product.

The survey discloses the following:

Price per unit Anticipated demand

€ units
6.50 68,000
7.00 55,000
7.50 46,000
8.00 40,000
8.50 28,000
9.00 ------

Required:
1. If the cost plus 25% price were charged and the market survey proved reliable, what would be
the estimated profit for next year?
2. If the market survey proved reliable what would be the profit maximizing price?

B
Electromex, Ltd. wishes to capture 20% of the market for new type of heating equipment. Market
research has established that the selling price to achieve this volume is 375 € per unit. Calculate
the target cost for the new heating equipment, considering that the company’s target profit
margin for this type of product is 30%.

C
Explain both pricing strategies and discuss the difference between them.

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Question 12 – Example
Example 5
Relevant Costs

Sofia, a Pizzeria Venecia’s manager, replaced the convection oven just six months ago. Today, Turbo
Ovens Manufacturing announced the availability of a new convection oven that cooks more quickly with
lower operating expenses. Sofia is considering the purchase of this faster, lower-operating cost
convection oven to replace the existing one they recently purchased. Selected information about the two
ovens is given below:
Existing New Turbo Oven
Original cost 60,000 € 50,000 €
Accumulated depreciation 5,000 € —
Current salvage value 40,000 € —
Remaining life 5 years 5 years
Annual operating expenses 10,000 € 7,500 €
Disposal value in 5 years 0 0

Required:
1. What costs are sunk? What costs are relevant? Explain.
2. From a financial point of view, should the Pizzeria purchase the new convection oven? Explain.
3. What other items should Sofia, as manager of the Pizzeria, consider when making this decision?

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 Example 5
Relevant Costs

Sofia, a Pizzeria manager, replaced the convection oven just six months ago. Today, Turbo Ovens
Manufacturing announced the availability of a new convection oven that cooks more quickly with lower
operating expenses. Sofia is considering the purchase of this faster, lower-operating cost convection
oven to replace the existing one they recently purchased. Selected information about the two ovens is
given below:
Existing New Turbo Oven
Original cost $60,000 $50,000
Accumulated depreciation $ 5,000 —
Current salvage value $40,000 —
Remaining life 5 years 5 years
Annual operating expenses $10,000 $ 7,500
Disposal value in 5 years $0 $0

Required:
1. What costs are sunk? What costs are relevant? Explain.
2. From a financial point of view, should the Pizzeria purchase the new convection oven? Explain.
3. What other items should Sofia, as manager of the Pizzeria, consider when making this
decision?

1.
Sunk costs include the original cost of the existing convection oven and the accompanying
accumulated depreciation.

Note that sunk cost are costs that are unavoidable (historical costs, as a result of past decisions)
and cannot be changed no matter what action is taken – therefore, irrelevant for decision making.

Relevant costs include:

Acquisition cost of the new Turbo oven.
Current disposal value of the existing convection oven.
Differences in annual operating expenses for the existing and the new Turbo oven.

Note that to identify relevant costs is important to focus on expected future costs that differ among
the alternatives.

2.
Net cash flows over 5 years with the new Turbo oven:

Cash inflow:
Decrease in annual operating expenses ($2,500 × 5) $ 12,500
Sale of the existing oven 40,000
Cash outflow:
Acquisition of the new Turbo oven (50,000)
Net cash inflow (outflow) $ 2,500

3.
Other items the manager should consider when making this decision include:
• The Turbo oven's reliability and efficiency is still unknown since it is a brand-new product.
• If the Turbo oven bakes faster as it claims, the Pizzeria may be able to increase sales due
to the quicker baking time.
• After purchasing another oven just six months prior, top management should consider the
Turbo oven option, but instead may question the decision-making ability of Sofia, the
current manager.
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Question 13 – Example
Example 6
Limited resources

PenínsulAIR operates scheduled commercial passenger flights between regional centres. The company’s
aircraft have three passenger classes: Club, Business and Economy. The available landing slots mean
that current passenger capacity is limited. The company has 16 aircrafts, each of which carries 125
passengers. Each aircraft makes five flights per day. The average flight is 500 miles.

Key demand and cost data are set out below:

Club Business Economy Total

Demand (passenger-miles per day) 1,000,000 3,500,000 2,000,000 6,500,000
Fares per passenger-mile 0.90 € 0.60 € 0.50 € ------
Variable costs per passenger mile 0.38 € 0.22 € 0.10 € ------

Fixed operating costs average 0.35 € per passenger-mile. How should the company arrange its aircraft
seating to maximise short-term profitability? Explain.

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 Example 6
Limited resources

Question 13 - Solution

PenínsulAIR operates scheduled commercial passenger flights between regional centres. The
company’s aircraft have three passenger classes: Club, Business and Economy. The available landing
slots mean that current passenger capacity is limited. The company has 16 aircrafts, each of which
carries 125 passengers. Each aircraft makes five flights per day. The average flight is 500 miles.

Key demand and cost data are set out below:

Club Business Economy Total

Demand (passenger-miles per day) 1,000,000 3,500,000 2,000,000 6,500,000
Fares per passenger-mile 0.90 € 0.60 € 0.50 € ------
Variable costs per passenger mile 0.38 € 0.22 € 0.10 € ------

Fixed operating costs average 0.35 € per passenger-mile. How should the company arrange its
aircraft seating to maximise short-term profitability? Explain.

Solution:

Company’s capacity = 16 aircrafts x 125 pass. X 5 flights x 500 miles = 5,000,000 miles

Demand (miles per day) = 6,500,000 miles

Club Business Economy

price 0.90 € 0.60 € 0.50 €
variable cost 0.38 € 0.22 € 0.10 €
contribution margin 0.52 € 0.38 € 0.40 €
1st 3rd 2nd

Therefore:

Club 1,000,000 (20% club)

Economy 2,000,000 (40% economy)
Business 2,000,000 (40% business)
5,000,000

The aircraft seating should be:

25 places club
50 places economy
50 places business
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Question 14

Southwestern Company needs 1,000 motors in its manufacture of automobiles. It can buy the motors
from Jinx Motors for 1,250€ each. Southwestern’s plant can manufacture the motors for the following
costs per unit:

Direct materials 500 €

Direct manufacturing labor 250 €
Variable manufacturing overhead 200 €
Fixed manufacturing overhead 350 €
Total 1,300 €

If Southwestern buys the motors from Jinx, 70% of the fixed manufacturing overhead applied will not
be avoided.

Required:
1. Should the company make or buy the motors?
2. What additional factors should Southwestern consider in deciding whether or not to make or buy
the motors?

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Question 15

The management accountant for the Amsterdam Chocolate Company has prepared the following
income statement for the most current year (Euros):

Chocolate Other Candy Fudge Total

Sales 40,000 25,000 35,000 100,000
Cost of goods sold 26,000 15,000 19,000 60,000
Contribution margin 14,000 10,000 16,000 40,000
Delivery and ordering costs 2,000 3,000 2,000 7,000
Rent (per sq. foot used) 3,000 3,000 2,000 8,000
Allocated corporate costs 5,000 5,000 5,000 15,000
Corporate profit 4,000 (1,000) 7,000 10,000

Required:
1. Do you recommend discontinuing the Other Candy product line? Why or why not?
2. If the Chocolate product line had been discontinued, corporate profits for the current year would
have decreased by what amount?

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Question 16

Maria Salvador, Ltd. produces clothing for the luxury market. The company has only one supplier
since they use a special fabric. They have a contract with a company for the whole output – a
maximum of 7,700 m2 of the fabric per week, at a selling price of 25 €/m2. Maria Salvador, Ltd. has the
following demand, selling price and costs for its products:

Scarves Blouses Skirts

Demand (units per week) 1,000 2,000 1,500
Selling price per unit 50 € 90 € 125 €
Fabric per unit (m2) 1 2 3
Direct labor hours per unit 0.25 0.50 0.50
Packing costs per unit 5€ 7€ 7€

Fixed costs are 22,500 € per week for a five-day working week and 400 direct labor hours per day are
available at 10€ per hour.

Required:
Identify the most profitable weekly production plan and compute the profit for that plan.

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Question 16/B

Maria Salvador, Ltd. produces clothing for the luxury market. The company has only one supplier
since they use a special fabric. They have a contract with a company for the whole output – a
maximum of 10,000 m2 of the fabric per week, at a selling price of 25 €/m2. Maria Salvador, Ltd. has
the following demand, selling price and costs for its products:

Scarves Blouses Skirts

Demand (units per week) 1,000 2,000 1,500
Selling price per unit 50 € 90 € 125 €
Fabric per unit (m2) 1 2 3
Direct labor hours per unit 0.25 0.50 0.50
Packing costs per unit 5€ 7€ 7€

Fixed costs are 22,500 € per week for a five-day working week and 350 direct labor hours per day are
available at 10€ per hour.

Required:
Identify the most profitable weekly production plan and compute the profit for that plan.

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Question 16/C

Maria Salvador, Ltd. produces clothing for the luxury market. The company has only one supplier
since they use a special fabric. They have a contract with a company for the whole output – a
maximum of 7,700 m2 of the fabric per week, at a selling price of 25 €/m2. Maria Salvador, Ltd. has the
following demand, selling price and costs for its products:

Scarves Blouses Skirts

Demand (units per week) 1,000 2,000 1,500
Selling price per unit 50 € 90 € 125 €
Fabric per unit (m2) 1 2 3
Direct labor hours per unit 0.25 0.50 0.50
Packing costs per unit 5€ 7€ 7€

Fixed costs are 22,500 € per week for a five-day working week and 350 direct labor hours per day
are available at 10€ per hour.

Required:
Identify the most profitable weekly production plan and compute the profit for that plan.

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