DB V

ACC 5301, Management Applications of Accounting 1

Course Learning Outcomes for Unit V Upon completion of this unit, students should be able to:

2. Apply accounting concepts to the creation of accounting information and reports. 2.3 Create accounting reports to make business decisions. 2.4 Use accounting data to make pricing decisions.

5. Discuss compliance requirements of accounting information.

5.2 Identify compliance and regulatory requirements related to product pricing.

Required Unit Resources Chapter 7: The Use of Cost Information in Management Decision Making, pp. 7-1 – 7-18 Chapter 8: Pricing Decisions, Customer Profitability Analysis, and Activity-Based Pricing, pp. 8-1 – 8- 13

Unit Lesson

Introduction Welcome to Unit V. We will be discussing how cost information is used to make business decisions and how product pricing decisions are made using various techniques. To begin our discussion, we will look at how accounting information is used in making decisions that involve choosing between alternatives such as expanding or removing operating locations, purchasing equipment, and more. Then we will expand our discussion to look at how prices are set using various accounting techniques.

Making Business Decisions In business, we often have to choose between various options. For example, we may need to determine if we should purchase Equipment A or Equipment B, make or buy components, close one of our locations, or expand our product line. When making these decisions, we focus on incremental analysis or the difference between incremental revenue and incremental expense. This means we look at the difference in revenue between two alternatives and the difference in expenses between two alternates to determine which alternative would generate the most profit for the company.

Two Alternatives In our first example, we will look at deciding between two alternative pieces of equipment. As you can see, each piece of equipment has a different amount of revenue that is generated and different costs associated with running that piece of equipment, which means each piece of equipment will generate a different amount of profit for the company. By doing this incremental analysis, we see that Equipment B, in this case, will generate almost $90,000 more profit for the company than Equipment A.

UNIT V STUDY GUIDE

Cost Information and Pricing

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Make or Buy Another example of a typical business decision using incremental analysis is to determine if the company should purchase a component or make it themselves. This is known as a make-or-buy decision. Let's go back to our computer manufacturer example that we have been using in this course. Let's say we want to decide if it is better to make the processor components ourselves or to purchase them from an outside vendor. In this example, we can see that it is less expensive to make the components than to purchase them. While we may be saving money on the materials, labor, variable overhead and some management salaries, the cost to purchase the components at the price quoted is too high to offset the savings by $120,000.

Close a Division In our third example, we will look at the decision to drop a product line or close a division. Again, going back to our computer manufacturer, let's see what would happen if we decide to drop our laptop division and only keep our desktop division. In this example, we are going to say that the laptop division is losing money and the initial response would be to close the division. In other words, why keep a division that does not make a profit. However, looking more closely at this analysis, if we close the laptop division, the overall net income for the company would drop by $4,500 in our incremental analysis. The reason for this is the laptop division is offsetting some of the very high fixed costs of the company. Therefore, even though the division as a unit is losing money, it is still generating income overall for the company to offset those high fixed costs. At this

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point, management may need to see how they can increase operating efficiency with the laptop division rather than just dropping the division.

We have spent a great deal of time looking at the numbers when making these important business decisions. However, as a manager, there are also qualitative considerations to take into account when making decisions. These decisions look at other factors that may affect business such as regular constraints, overall economic conditions, and even employee morale. For example, going back to our example to close the laptop division of our company, this would mean that employees would lose their jobs. How would this effect the desktop division employees? In other words, would their efficiency decline, would there be high turnover as employees look for other jobs in fear they too may lose their jobs? The point here is, as managers, you need to not only look at the numbers but also consider all of the effects on the company of a business decision.

Pricing Decisions Special Orders Looking at the idea of how incremental analysis can be used in pricing decisions, we will look at the concept of special orders. This is a common pricing decision companies often make to determine the cost of accepting a special order. A special order is when a company accepts an order that is outside of what the business normally produces, and that order does not affect the production of its normal products (Jiambalvo, 2020). For example, our computer manufacturer is considering accepting a special order for a special price to make laptops with additional memory. In order to determine if this special order is worth the additional revenue, the computer manufacturer will use an incremental analysis. First, the company needs to look at the revenue that would be gained if it produced the special order laptops. In this case, the additional revenue would be $1,000,000. Then the company needs to look at the additional costs associated with making these special order computers. Since the computers need additional memory, there is an added cost of $500,000 for the parts. Then the company needs to account for the salaries of the workers that will be needed to assemble these computers, which would be $390,000. Finally, there is additional overhead associated with making these special order computers of $250,000. Overall, once this incremental analysis is complete this special order would wind

(Jiambalvo, 2020)

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up costing the company $140,000. Consequently, the company should reject the special order or renegotiate the selling price. Another important issue related to product pricing relates to basic economics. For example, as the demand for the product increases, the supply on hand will decrease, and this will drive up the price of the product. We see this all of the time during the holiday season. The price of a child's toy may be $29.99, but as the demand for that toy increases and stores run out of stock (or supply) of the toy, the price of that same toy will increase drastically. In other words, you may find it online for $150.00 when its original selling price was much less. This is the effect of a limited supply and a high demand. Knowing the demand for a product is often difficult for managers. In our previous example, the company was out of stock (or supply), driving up the price; however, it may go the other way, and that same $29.99 toy that managers thought was going to be a big seller winds up not selling at all, and they are overstocked in inventory. This would mean that in order to sell the toy, they would need to lower the price to $19.99. In this example, the supply (or stock) was greater than the demand, so the price needs to be lowered to sell the product.

Cost-Plus Pricing Due to the uncertainty related to pricing, many companies use cost-plus pricing. In other words, companies start with an estimate of the product's cost and then add on a reasonable amount of profit. For example, if it costs the company $1,000 to make a computer, then the company marks it up 30% to sell it for $1,300. This seems like a good way to ensure costs are covered and the company makes a reasonable profit. The challenge is to determine what the appropriate amount of markup is for the product. If it is too high of a markup, no one will buy the product; too low, the company estimates may have been incorrect, and selling price may not cover the actual cost (Jiambalvo, 2019).

Target Costing Target costing is an overall way used to determine the product features, price, cost, and design that will provide the company with the most profit. In this costing method, the company looks first at the selling price of the product based on its features and then subtracts out the profit needed on that product to arrive at the target cost for the product (Jiambalvo, 2019). Again, looking at our computer manufacturing company, let's say the engineers develop a new computer with unique features that should sell for $3,500. Then the company calculates the profit it wants to make on this new product. This leaves a target cost for the new product that the company needs to meet. In other words, using this example, the cost to make the new product needs to be $2,450.

Activity-Based Pricing In activity-based pricing, customers are given separate prices for additional services that accompany the product. Using our computer manufacturing company, customers would be charged a per-item fee for each additional service associated with the sale of the computer. As an example, customers may be charged an ordering or packing fee.

Conclusion In this unit, we have looked at making common business decisions using accounting data. For example, we looked at deciding between two products, deciding if it is more cost effective to make or buy a product, and deciding if a company should close a division. In addition to looking at how accounting data is used to make common business decisions, we also looked at pricing decisions. Some of these decisions included accepting special orders, cost-plus pricing, target costing, and activity-based pricing.

Reference

(Jiambalvo, 2020)

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Jiambalvo, J. (2020). Managerial accounting (7th ed.). Wiley.

https://bookshelf.vitalsource.com/#/books/9781119577706

Suggested Unit Resources View the following videos by accessing the Unit V Additional Unit Resources folder in the unit. The video Method: Incremental Analysis will discuss how managers make decisions looking at cost data. You can access a transcript for this video by hovering over the PDF button at the bottom of the video and then clicking on the word “Transcript.” Alternatively, you can click on the “cc” button at the bottom of the video to turn on closed captions. The video Zappos: Pricing will discuss pricing practices within a company. You can access a transcript for this video by hovering over the PDF button at the bottom of the video and then clicking on the word “Transcript.” Alternatively, you can click on the “cc” button at the bottom of the video to turn on closed captions.

Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. After watching both videos in the Suggested Unit Resources, you may want to view the Chapter 7 Flash Cards and the Chapter 8 Flash Cards found in the Additional Unit Resources folder to reinforce the material presented in this unit.