CHAPTER 2

RELEVANT INFORMATION AND DECISION MAKING

After studying this chapter, you should be able to:
 Understand the role of accountants in special decisions

 Differentiate relevant costs and revenues from irrelevant costs and revenues in any decision
situation

 Distinguish between quantitative factors and qualitative factors in decisions

 Recognize how to make special order decision

 Know analysis of make or buy decisions

 Describe the key concept in choosing which among multiple products to produce when there are
capacity constraints

 Discuss the key factor managers must consider when adding or dropping product lines and
segments

 Explain why the book value of equipment is irrelevant in equipment replacement decisions

1.1. Introduction

During the last decade, increasing competition has forced many companies to refocus their resources and
to defend their core businesses against aggressors. In developing strategies to fight this war, managers
have generally reached a consensus on two strategic criteria. First, to win a battle, the focus of
organizations must be on delivering products and services in the manner most consistent with the desires
of customers. Second, no company can do all things well. The strategies managers devise in this
intensive struggle evolve from internal evaluations in which the managers identify the functions they
must do well to survive. These functions are regarded as core competencies and maintaining leadership
in these areas is regarded as vital. All other functions, although important to the organization, are
regarded as noncore functions. By intensely focusing on core functions, managers try to maintain a
competitive advantage. However, an undesirable consequence of focusing on only the core
competencies is that the quality and capabilities of the noncore functions can deteriorate. This
deterioration, in turn, can reduce a firm’s ability to attract customers to its products and services.
Outsourcing the noncore functions to firms that have core competencies in those functions frequently
solves the dilemma of maintaining a focus on core competencies while also maintaining excellence in
noncore functions. Managers are charged with the responsibility of managing organizational resources
effectively and efficiently relative to the organization’s goals and objectives. Making decisions about the
use of organizational resources is a key process in which managers fulfill this responsibility. Accounting
and finance professionals contribute to the decision-making process by providing expertise and
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 information.

Accounting information can improve, but not perfect, management understands of the
consequences of decision alternatives. To the extent that accounting information can reduce
management’s uncertainty about economic facts, outcomes, and relationships involved in various
courses of action, such information is valuable for decision-making purposes.

Many decisions can be made using relevant costing, which focuses managerial attention on a
decision’s relevant (or pertinent) facts. Relevant costing techniques are applied in virtually all
business decisions in both short-term and long-term contexts. This chapter examines their
application to several common types of business decisions: replacing an asset, outsourcing a product or
part, allocating scarce resources, determining the appropriate sales/production mix, and accepting
specially priced orders. In general these decisions require a consideration of costs and benefits that are
mismatched in time; that is, the cost is incurred currently but the benefit is derived in future periods. In
making a choice among the alternatives available, managers must consider all relevant costs and
revenues associated with each alternative

1.2. Information and the Decision Process

Decision making is the process of choosing the best course of action from alternatives available.
Decision model is a method used by managers for deciding among courses of action. Accounting
information (revenue and cost information) are basic inputs in to decision model. However, other
quantitative as well as qualitative information can also be used. In general information is divided in to
relevant and irrelevant information. Relevant information is information which is useful for decision
making where as irrelevant information is not useful for decision making since such information is
common for all alternatives. The management accountant’s role in the decision-making process is to
produce relevant information to the managers who make the decisions. Thus, the primary role of cost
accountant in decision process is to: decide what information is relevant to each decision problem, and
provide accurate and timely information (data).
Decision making process involves basically the following activities.
i. Identify and Define the Problem. The most important phase of decision-making process because all other
activities in the process depend on this phase. Incorrectly defined problems waste time and resources.
That is why it is usually said that defining a problem is solving half of the problem.

ii. Specify the Criterion. The phase in which the purpose of decision is to be made. Is the objective to
maximize profit, increase market share, minimize cost, or improve public service? For example, cost
minimization, increase the quality of product, maximize profit, etc.

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iii. Identify Possible Alternatives: Determining the possible alternatives is a critical step in the decision
process.

iv. Gathering Relevant Information. Information could be subjective or objective, internal or external to
the organization, historical (past) data, or future (expected) ones.

v. Making the Decision: Select the best alternative (course of action).

1.3. The Concept of Relevance

For information to be relevant, it must possess three characteristics: (1) be associated with the decision
under consideration, (2) be important to the decision maker, and (3) have a connection to or bearing on
some future endeavor.

Association with Decision

Costs or revenues are relevant when they are logically related to a decision and vary from one decision
alternative to another. Cost accountants can assist managers in determining which costs and revenues are
relevant to decisions at hand. To be relevant, a cost or revenue item must be differential or incremental.
An incremental revenue is the amount of revenue that differs across decision choices and incremental
cost (differential cost) is the amount of cost that varies across the decision choices.

To the extent possible and practical, relevant costing compares the incremental revenues and
incremental costs of alternative choices. Although incremental costs can be variable or fixed, a
general guideline is that most variable costs are relevant and most fixed costs are not. The logic of
this guideline is that as sales or production volume changes, within the relevant range, variable
costs change, but fixed costs do not change. As with most generalizations, some exceptions can occur
in the decision- making process.

The difference between the incremental revenue and the incremental cost of a particular alternative is
the positive or negative incremental benefit (incremental profit) of that course of action. Management
can compare the incremental benefits of alternatives to decide on the most profitable (or least costly)
alternative or set of alternatives.

Some relevant factors, such as sales commissions or prime costs of production, are easily identified and
quantified because they are integral parts of the accounting system. Other factors may be relevant and
quantifiable, but are not part of the accounting system. Such factors cannot be overlooked simply
because they may be more difficult to obtain or may require the use of estimates. For instance,
opportunity costs represent the benefits foregone because one course of action is chosen over another.
These costs are extremely important in decision making, but are not included in the accounting records.

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Importance to Decision Maker
The need for specific information depends on how important that information is relative to the
objectives that a manager wants to achieve. Moreover, if all other factors are equal, more precise
information is given greater weight in the decision-making process. However, if the information is
extremely important, but less precise, the manager must weigh importance against precision.

Bearing on the Future

Information can be based on past or present data, but is relevant only if it pertains to a future
decision choice. All managerial decisions are made to affect future events, so the information on
which decisions are based should reflect future conditions. The future may be the short run (two hours
from now or next month) or the long run (three years from now). Future costs are the only costs that can
be avoided, and a longer time horizon equates to more costs that are controllable, avoidable, and
relevant. Only information that has a bearing on future events is relevant in decision making.
Costs incurred in the past for the acquisition of an asset or resources are called sunk costs. They
cannot be changed, no matter what future course of action is taken because past expenditures are
not recoverable, regardless of current circumstances. Thus, the historical cost is not relevant to
the decision.

Example: Marina Company, a manufacturer of a line of ashtrays, is thinking of using aluminum instead
of copper in the manufacture of its product. Historical direct material cost was Br. 0.50 per unit. The
company expected future costs for aluminum is Br. 0.40 and it is unchanged for copper. Direct labor
cost were Br.0.80 per unit and will not be affected by the switch in materials.
The analysis in a nutshell is as follows:
Copper Aluminum Difference
Direct material Br. 0.50 Br. 0.40 Br. 0.10
Direct labor 0.80 0.80 -
In the foregoing analysis, the material cost (the expected future cost of copper compared with expected
future cost of aluminum) is the only relevant cost. The material cost met both criteria for relevant
information. That is, bearing on the future and an element of difference between the alternatives.
However, the direct labor cost will continue to be Br 0.80 per unit regardless of the material used. It is
irrelevant because the second criterion – an element of difference between the alternatives – is not met.

1.4. Relevant Information for Specific Decisions

Managers routinely choose a course of action from alternatives that have been identified as feasible
solutions to problems. In so doing, managers weight the costs and benefits of these alternatives and
determine which course of action is best. Incremental revenues, costs, and benefits of all courses of

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action

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are measured against a baseline alternative. In making decisions, managers must provide for the
inclusion of any inherently non quantifiable considerations. Inclusion can be made by attempting to
quantify those items or by simply making instinctive value judgments about nonmonetary benefits and
costs.
In evaluating courses of action, managers should select the alternative that provides the highest
incremental benefit to the company. Rational decision-making behavior includes a comprehensive
evaluation of the monetary effects of all alternative courses of action. The chosen course of action
should be one that will make the business better off. Decision choices can be evaluated using relevant
costing techniques.

1.4.1. Special Order Decisions

One type of decision that affects output level is accepting or rejecting a special order. A special order is
a one-time order that is not considered part of the company’s normal ongoing business. In general, a
special order is profitable as long as the incremental revenue from the special order exceeds the
incremental costs of the order. Thus, conditions to consider in special-order decisions are: (i) Customers
must be from markets not ordinarily served by the company, and (ii) the company must operate below it
maximum productive capacity
Example: Consider the following details of the income statement, on absorption costing basis (that is,
both variable and fixed manufacturing costs are included in inventoriable costs and cost of goods sold),
of Samson Company for the year just ended December 31, 2014

Total per unit

Sales (1,000,000 units) Br 20,000,000 Br 20

Cost of Goods Sold 15,000,000 15
Gross Margin Br 5,000,000 Br. 5
Selling and Administrative Expenses 4,000,000 4
Operating Income Br. 1,000,000 Br. 1
Samson’s fixed manufacturing costs were Br 3 million and fixed selling and administrative expenses
were Br 2.9 million. Near the end of the year, Ethio Company offered Samson Br 13 per unit for
100,000-unit special order. The special order would not affect Samson‘s regular business in any way.
Furthermore, the special sales order would not affect total fixed costs and would not require any
additional variable selling and administrative expenses.
Required:

a) Should Samson accept or reject the special order?

b) Could the special-order affect Samson’s regular business?

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 1.4.2. Product Line Decisions
This is a decision relating to whether old product lines or other segments of a company should be
dropped and new ones added are among the most difficult decision that a manager has to make.
Operating results of multiproduct environments are often presented in a disaggregated format that shows
results for separate product lines within the organization or division. In reviewing these disaggregated
statements, managers must distinguish relevant from irrelevant information regarding individual product
lines. If all costs (variable and fixed) are allocated to product lines, a product line or segment may be
perceived to be operating at a loss when actually it is not. The commingling of relevant and irrelevant
information on the statements may cause such perceptions.
In classifying product line costs, managers should be aware that some costs may appear to be avoidable
but are actually not. For example, the salary of a supervisor working directly with a product line appears
to be an avoidable fixed cost if the product line is eliminated. However, if this individual has significant
experience, the supervisor is often retained and transferred to other areas of the company even if product
lines are cut. Determinations such as these needs to be made before costs can be appropriately classified
in product line elimination decisions.

For instance, mostly on add or delete decisions, fixed costs are divided into two categories, avoidable
and unavoidable. Avoidable costs are costs that will not continue if an ongoing operation is changed,
deleted or eliminated. These costs are relevant costs in decision making. Unavoidable costs are costs that
continue even if a subunit or an activity is eliminated and are not relevant for decision.

Example: Eyoha Department store has three major departments: groceries, general merchandise, and drugs.
Management is considering dropping groceries, which have consistently shown a net loss, as shown below on
statement of departments’ profitability analysis of Eyoha.

Departments
Groceries General merchandise Drugs Total
Sales Br. 100,000 Br. 8,0000 Br. 10,000 Br.190,000

Variable CGS & Expenses

80,000 56000 6,000 142,000
Contribution margin Br. 20,000 Br. 24000 Br. 4,000 Br. 48,000
Fixed_Expenses:
Avoidable Br. 15,000 Br. 10,000 Br. 1,500 Br. 26,500

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 6,000 10,000 2,000 18,000
Unavoidable
Total fixed expenses Br.21,000 Br. 20,000 Br.3,500 Br. 44,500
Operating income (loss) Br. (1,000) Br.4,000 Br. 500 Br. 3,500

Required:
a) Which alternative would be recommended if the only alternatives to be considered are dropping or
continuing the grocery department? Assume that the total assets would be unaffected by the decision and
the space made available by dropping groceries would remain idle.
b) Refer the income statement presented above. Assume that the space made available by dropping
groceries could be used to expand the general merchandise department. The space would be occupied by
merchandise that increase sales by Br. 50,000, generate a 30% contribution margin percentage and have
additional avoidable fixed costs of Br.7, 000. Should Eyoha discontinue grocery and expand
merchandise department?
1.4.3. Optimal Use of Scarce Resources Decisions (Product Mix Decisions)

Managers are frequently confronted with the short-run problem of making the best use of scarce
resources that are essential to production activity, but are available only in limited quantity. Scarce
resources create constraints on producing goods or providing services and can include machine hours,
skilled labor hours, raw materials, and production capacity and other inputs. Management may, in the
long run, obtain a greater quantity of a scarce resource. For instance, additional machines could be
purchased to increase availability of machine hours. However, in the short run, management must make
the most efficient use of the scarce resources it has currently.

Determining the best use of a scarce resource requires managerial recognition of company objectives. If
the objective is to maximize company profits, a scarce resource is best used to produce and sell the
product having the highest contribution margin per unit of the scarce resource. This strategy assumes
that the company is faced with only one scarce resource. A scarce resource or a limiting factor refers to
any factor that restrict or constraint the production or sale of a product or service.

Example: Jimma Computers manufactured two products, desktop computer and notebook computer.
The Company’s scarce resource is a data chip that it purchases from a supplier. Each desktop computer
requires one chip and each notebook computer requires three chips. Currently, the firm has access to
only 5,100 chips per month to make either desktop or notebook computers or some combination of both.
Demand is above 5,100 units per month for both products and there is no variable selling or
administrative costs related to either product. The desktop’s Br. 650 selling price less its Br. 545 variable
cost provides a contribution margin of Br. 105 per unit. The notebook’s contribution margin per unit is
Br.180 (Br.900 selling price minus Br.720 variable cost). Fixed annual overhead related to these two
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product lines totals Br. 6,570,000 and is allocated to products for purposes of inventory valuation. Fixed
overhead, however, does not change with production levels within the relevant range

Instructions: on the bases of the above information which product is more profitable and on which
products should the firm spend its resources?

1.4.4. Make or Buy (In source or out sourcing) decision

A concern with subcontracting or outsourcing has dominated business in recent years as the cost of
providing goods and services in-house is increasingly compared to the cost of purchasing goods on the
open market. Thus, a daily question faced by managers is whether the right components and services
will be available at the right time to ensure that production can occur. Additionally, the inputs must be of
the appropriate quality and obtainable at a reasonable price. Traditionally, companies ensured
themselves of service and part availability and quality by controlling all functions internally. However,
there is a growing trend toward “outsourcing” (buying) a greater percentage of required materials,
components, and services.

This outsourcing decision (make-or-buy decision) is made only after an analysis that compares internal
production and opportunity costs with purchase cost and assesses the best uses of available facilities.
Consideration of an in source (make) option implies that the company has available capacity for that
purpose or has considered the cost of obtaining the necessary capacity. The make versus buy decision
should be based on which alternative is less costly on a relevant cost basis; that is, taking into account
only future, incremental cash flows. In other words, in a make or buy situation with no limiting factors,
the relevant costs for the decision are the differential costs between the two options.

For example, the costs of in-house production of a computer processing service that averages 10,000
transactions per month are calculated as Br. 25,000 per month. This comprises Br.0.50 per transaction
for stationery and Br. 2 per transaction for labor. In addition, there is a Br. 10,000 charge from head
office as the share of the depreciation charge for equipment. An independent computer bureau has
tendered a fixed price of Br. 20,000 per month.

Based on this information, stationery and labor costs are variable costs that are both avoidable if
processing is outsourced. The depreciation charge is likely to be a fixed cost to the business irrespective
of the outsourcing decision. It is therefore unavoidable. The fixed outsourcing cost will only be incurred
if outsourcing takes place.

The relevant costs for each alternative can be compared as shown in Table 6.1 below. The Br. 10,000
share of depreciation costs is not relevant as it is unavoidable. The relevant costs for this decision are

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therefore those shown in Table 6.2

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Based on relevant costs, there would be a Br. 5,000 per month saving by outsourcing the computer
processing service.

Table 1 Relevant costs – make versus buy

Cost to make Cost to buy

Stationery 10,000 @ Br. 0.50 Br. 5,000

Labour 10,000 @ Br. 2 20,000
Share of depreciation costs 10,000 10,000
Outsourcing cost 20,000
Total relevant cost Br. 35,000 Br. 30,000

Table 2Relevant costs – make versus buy, simplified

Relevant cost to makeRelevant cost to buy
Stationery 10,000 @ Br. 0.50 Br. 5,000
Labour 10,000 @ Br. 2 20,000
Outsourcing cost 20,000
Total relevant cost Br. 25,000 Br. 20,000

Note that relevant information for make or buy decision includes both quantitative and qualitative
factors. Such as:
Quantitative Factors
Buy Make
 the amount paid to supplier  variable costs incurred to produce the
component
 transportation costs  special equipment to produce the
product
 costs incurred to process  hire additional supervisory personnel
the part upon receipt to assist with making the product

Qualitative Factors
 Advantage of long term  The quality of the product is decided

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 relationship with suppliers to be controlled
 Possibility of shortage of  If the purchase price is likely to rise
material or labor for making due to increased demand in the
the component market, it becomes uneconomical to
Buy
 Uninterrupted supply of  Where the technical know-how is to
requisite quality from reliable be kept secret and not to be passed
supplies on
to the suppliers

1.4.5. Keep or Replace Equipment Decisions

The usefulness of plant assets may be impaired long before they are considered to be worn out.
Equipment may be no longer being efficient for the purpose for which it is used. On the other hand, the
equipment may not have reached the point of complete inadequacy. Decisions to replace usable plants
assets should be based on studies of relevant costs. The relevant costs are the future costs of continuing
to use the equipment versus replacement. The book values of the plant assets being replaced are sunk
costs and are irrelevant.

As for example, assume that a business is considered disposing of several identical machines having a
total book value of Birr 1,000,000 and an estimated remaining life of five years. The old machines can
be sold for Birr 25,000. They can be replaced by a single high-speed machine at a cost of Birr 250,000.
The new machine has an estimated useful life of five years and no residual value. Analyses
indicate an estimated annual reduction in variable manufacturing costs from Birr 225,000, with the old
machine to Birr 150,000 with the new machine. No other changes in the manufacturing costs or the
operating expenses are expected. The relevant costs are summarized in the differential report are as
follows: Proposal for Replacement Equipment (Differential Analysis Report – Replacement
Equipment):
Annual variable costs of present equipment (a) Birr 225,000
Annual variable costs - new equipment (b) 150,000
Annual differential decrease in cost(c= a-b) Birr 75,000
Number of years applicable (d) 5
Total differential decrease in cost (e=cxd) Birr 375,000
Proceed from sales of present equipment (f) 25,000
total (g =e+f) Birr 4, 00,000

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Cost of new equipment (h) 2, 50,000

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 Net differential decreases in cost, 5-year total (i =g+h) Birr 1, 50,000
So, annual net differential decreases in cost – new equipment (i÷d) Birr 30,000

Additional factors are often involved in equipment replacement decisions. For example, differences
between the remaining useful life of the old equipment and the estimated life of the new equipment
could exist. In addition, the new equipment might improve the overall quality of the product, resulting in
an increase in sales volume. Other factors that could be significant include the time value of money and
other uses for the cash needed to purchase the new equipment.

In general, in deciding whether to replace or keep existing equipment, four commonly encountered
items considered in relevance:
i. Book value of old equipment: irrelevant, because it is a past (historical) cost. Therefore, depreciation
on old equipment irrelevant.
ii. Disposal value of old equipment: relevant, because it is an expected future inflow that usually differs
among alternatives.
iii. Gain or loss on disposal: this is the algebraic difference between book value and disposal value. It is
therefore, a meaningless combination of irrelevant and relevant items. Consequently, it is best to
think of each separately.
iv. Cost of new equipment: relevant, because it is an expected future outflow that will differ among
alternatives. Therefore, depreciation on new equipment is relevant.

1.5. Pricing Decisions

Companies are constantly making product and service pricing decision. These are strategic decision that
affects the quantity produced and sold, and therefore cost and revenues. To make these decisions,
managers need to understand cost behavior pattern and cost drivers. They can then evaluate demand at
different prices and manage costs across the value chain and over a products life cycle to achieve
profitability.
Major influences on pricing decision
How companies prices a product or a service ultimately depends on the demand and supply of it. Three
influences on demand and supply are:-
i. Customers: - customer influences price through their effect on the demand for a product or
services, based on factors such as the features of a product and its quality.
ii. Competitors: when there are competitors, knowledge of rivals’ technology, plant capacity,
and operating policies enables a company to estimate its competitors’ costs-valuable
information in setting its own prices.

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 iii. Costs – costs influence prices because they affect supply. As companies supply more product
the cost of producing each additional unit initially declines but then eventually increase
managers who understand the cost of producing their company’s product set polices that
make the products attractive to customers. In computing the relevant costs for a pricing
decision, the manager must consider relevant costs in all business functions of the value
chain.

Costing and pricing for the short run

Short-run pricing decisions typically have a time horizon of less than a year and include decision such as
(a) pricing one time only special order with no long run implications and (b) adjusting product mix and
output volume in a competitive market.
Company’s short run pricing decisions need identify a sufficiently low price at which company would
still make a profit and assumed that (a) company has access to extra capacity and (b) a competitor with
an efficient plant and idle capacity was likely to make a low bid. However, short run pricing does not
always work this way. Companies may experience strong demand for their products in the short-run, but
they may have limited capacity. In these cases, companies strategically increase prices in the short run to
as much as the market will bear.
In general, short run pricing decisions are responses to short-run demand and supply condition, and the
relevant costs are only those costs that will change in the short run.

Costing and pricing for the long run

Long run pricing decisions have a time horizon of a year or longer and include pricing a product in a
major market in which there is some see way in setting price. Two key differences affect pricing for the
long run versus the short run:-
1. Costs that are often irrelevant for short run pricing decisions, such as fixed costs that cannot be
changed, are generally relevant in the long run because cost can be altered in the long run.
2. Profit margins in the long run pricing decision are often set to earn a reasonable return on
investment. Short run is opportunistic, prices are decreased when demand is weak and increased
when demand is strong.
Long run pricing is a strategic decision desired to build long run relationship with customers based on
stable and predictable prices. But to change a stable price and earn the target long run return, a company
must, over the long run, know and manage its costs of supplying product to customers. Thus, relevant
costs for long run pricing decision include all future fixed and variable costs.

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Long run pricing approaches
Two different approaches for pricing decision using product cost information are:-
1. Market based approach
2. Cost based/cost plus approach

1. Market based pricing

Market based pricing approach starts by management asking, given that our customers want and how
our competitors will react to what we do, what price should we charge?
Companies operating in a very competitive market, for example, commodities such as steel, oil, and
natural gas, use the market-based pricing. An important form of market-based pricing is target pricing.
Target price is the estimated price for a product or service that potential customers will be willing to
pay. This estimate is based on an understanding of customer’s perceived value for a product or service
and how competitors will price competing product or service.
Hence, target operating income is the operating income that a company wants to earn on each unit of a
product or service sold and target price leads to a target cost, target cost per unit is the estimated long
run cost per unit of a product or service that, when sold at the target price, enables the company to
achieve the target operating income.
Thus, Target price - Target operating income = Target cost

Implementing target pricing and target costing

In developing target prices and target cost companies may require to follow the following five steps:
 Develop a product that satisfy the needs of potential customers
 Choose a target price based on customer’s perceived value for the product and the price
competitors charge, and target operating income per unit.
 Drive a target cost per unit by subtracting the target operating income per unit from the target price
 Perform cost analysis to analyze which aspects of a product or service to target for cost reduction.
 Perform value engineering to achieve target cost. Value engineering is a systematic evaluation of
all aspect of the value chain business function with the objective of reducing cost while
satisfying customers’ needs. Value engineering can result in improvement in product design,
change in material specification, and modification in process method. In this case, Costs can be
value adding or non-value adding. Value adding costs are costs that costumers perceive as adding
utility or value while non value adding cost that do not add value to the product and to

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customers.

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Example:Astel Company is a manufacturer of personal computer .Astel expects its competitors to lower
prices of PC. Astels management believes that it must respond by reducing price by 20% from Br. 1000
per unit to Br.800 per unit. At this low price, Astels marketing manager forecast an increase in annual
sales from 150,000 to 200,000 units. Astel management wants a 10% target operating income on sales
revenue. The total production cost at the moment for 150,000 units is Br. 135 million.
Required compute
a) The total target revenue
b) Total target operating income
c) Target operating income per unit
d) Current target cost per unit
Solution
a) Total target revenue ═ target price per unit x target annual unit sold
═ Br.800 per unit x 200,000 units ═ Br.160, 000,000
b) Total target operating income═ target rate x Total target revenue
═ 10% x Br.160, 000,000═ Br.16, 000,000
c) Target operating income per unit═ Total target operating income/ annual unit sold
═ Br.16, 000,000/200,000 units ═ Br.80
d) Current cost per unit═ target price per unit less target operating income per unit
═ Br.800 per unit - Br.80 ═ Br.720

2. Cost-plus pricing
Accounting information may be used in pricing decisions, particularly where the firm is a market leader
or price-maker. In these cases, firms may adopt cost-plus pricing, in which a margin is added to the total
product/service cost in order to determine the selling price. In many organizations, however, prices are
set by market leaders and competition requires that prices follow the market (i.e. the firms are price-
takers). Nevertheless, even in those cases an understanding of cost helps in making management
decisions about what product/services to produce, how many units to make and whether the price that
exists in the market warrants the business risk involved in any decision to sell in that market. An
understanding of the firm’s marketing strategy is therefore, essential in using cost information for
pricing decisions.

In the long term, the prices that businesses charge must cover all of its costs. If it is unable to do so, it
will make losses and may not survive. For every product/service, the full cost must be calculated, to
which the

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desired profit margin is added. Full cost includes an allocation to each product/service of all the costs of
the business, including producing and delivering a good or service, and all its marketing, selling, finance
and administration costs.
The general formula for setting a cost based price adds a markup component to the cost base to
determine the prospective selling price. One way to determine the markup percentage is to choose a
markup to earn a target rate of return on investment.
The target rate of return on investment is the target annul operating income that an organization aims to
achieve divided by invested capital (asset)
i.e. TRR = T a r g e t operating income
Invested capital
Therefore, Target operating income=TRR*Invested capital

Let illustrate a cost – plus pricing formula on top company. Assume top’s engineers have redesigned
product CD into 2CD and that top uses a 12% markup on the full unit cost of the product in developing
the prospective selling price. The target product 2CD profitability for 2000 is as follows:

Estimated total amounts Estimated total amount

for 200,000 units (1) per unit (2) = (1)  200,000
Revenues Bir 160,000,000 Bir 800
Cost of goods sold 108,000,000 540
Operating costs 36,000,000 180
Total cost of product Bir 144,000,000 720
Operating income 16,000,000 Bir 80

Suppose that top’s target rate of return on investment is 18% and 2CD’s capital investment is Bir 96
million. The target annual operating income for 2CD is:
Invested capital ……………………………….. Bir 96,000,000
Target rate of return on investment……………. 18%
Target Annual Operating income [0.18 Bir 96mln]…Bir17,280,000
Target operating income per unit of 2A
[Bir17,280,000  200,000 units]....................Bir 86.40

This calculation indicates that top needs to earn a target operating income of Bir86.40 on each unit of
2A. The mark up of Bir 86.40 expressed as a percentage of the full production cost per unit of Bir720
equals 12% (Bir 86.40 Bir 720]

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 Thus the prospective selling price of product 2A is Bir806.40 (Full unit cost of 2A,
Bir 720 plus the markup component of 12% (0.12 Bir 720=Bir 86.40).
1.6. Review Questions

WORKOUT QUESTIONS

1) Belt and Braces Ltd makes a single product which sells for Br 20. It has a full cost of Br 15
which is made up as follows:

Direct Material Br 4
Direct Labor 6
Variable Overhead 2
General Fixed Overhead 3
Br. 15

The labor force is currently working at 90% of capacity and so there is a spare capacity for 2,000
units. A customer has approached the company with a request for the manufacture of a special
order of 2,000 units for which he is willing to pay Br. 25,000. Assess whether the contract should
be accepted or not.

2) Buster Ltd makes four components, W, X, Y and Z, for which costs in the forthcoming year are
expected to be as follows.

Attributable fixed cost per annum and other fixed costs are as follows:

Incurred as a direct consequence of making WWXYZ Br 1,000

Incurred(units)
Production as a direct consequence of making X 1,000 2,000 5,000
4,000 3,000
Unit variable
Incurred as costs Direct
a direct consequence of making Y 6,000
materials Direct labor
Incurred
Variable as a direct
production consequence of making Z
overheads Br. 4 Br 5 8,000
Br 2 Br 4
Other fixed costs (committed) 30,000 8 9 4 6
Total fixed costs 2312 Br 50,000
Br 14Br
A subcontractor has offered to supply units of W, X, Y17Br
and 7Br
Z for12Br 12, Br 21, Br 10, and Br 14
respectively.

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 Required: Decide whether Buster Ltd should make or buy the components and mention some
qualitative factors to be considered by Buster Ltd in decision making.

3) Great Company manufacturers 60,000 units of part XL – 40:

Total costs Cost per

60,000 units unit

Direct material Br 480,000 Br 8

Direct labor 360,000 6
Variable factory overhead (FOH) 180,000 3
Fixed FOH 360,000 6
Total manufacturing costs Br 1,380,000 Br 23

Another manufacturer has offered to sell the same part to Great for Br 21 each. The fixed
overhead consists of depreciation, property taxes, insurance, and supervisory salaries. The entire
fixed overhead would continue if the Great Company bought the component except that the cost
of Br 120,000 pertaining to some supervisory and custodial personnel could be avoided.

Required:

a. Should the parts be made or bought? Assume that the capacity now used to make parts internally
will become idle if the pats are purchased?
b. Assume that the capacity now used to make parts will be either (i) be rented to nearby
manufacturer for Br 60,000 for the year or (ii) be used to make another product that will yield a
profit contribution of Br 250,000 per year. Should the company purchase them from the outside
supplier?

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