Managerial Accounting

ACC 3301, Managerial Accounting 1

Course Learning Outcomes for Unit IV

Upon completion of this unit, students should be able to:

7. Analyze problems in managerial decision-making regarding cost planning and control.
7.1 Demonstrate how incremental analysis is used in managerial decision-making.
7.2 Discuss various factors managers must consider when setting prices for products.

Required Unit Resources

Chapter 7: Incremental Analysis—Read the following sections:

• Decision-Making and Incremental Analysis
• Special Orders
• Make or Buy
• Sell or Process Further
• Repair, Retain, or Replace Equipment
• Eliminate Unprofitable Segment or Product

Chapter 8: Pricing—Read the following sections:

• Target Costing
• Cost-Plus and Variable-Cost Pricing
• Time-and-Material Pricing
• Transfer Prices

In order to access the following resources, click the links below.

Chapter 7 PowerPoint Presentation
PDF of Chapter 7 Presentation

Chapter 8 PowerPoint Presentation
PDF of Chapter 8 Presentation

Unit Lesson

Introduction

In Unit III, we focused mainly on the activity-based costing and cost-volume-profit analysis. In this unit, we will
shift our studies to incremental analysis and pricing. A manager has many tasks to do in their daily job. Some
of these tasks involve evaluating different options and choosing the best one based on cost factors. When
was the last time you had to decide between making dinner or going out to eat? When is the last time you had
to choose between buying a new car or getting your current one repaired? These are just a few examples of
how we are faced with incremental analysis decisions.

Relevant Costs

The key to making such decisions is understanding the differences between relevant and non-relevant costs.
Opportunity costs represent the benefit that could have been obtained by pursuing an alternative course of
action. For instance, assume that you give up a summer job that pays $5,000 and instead take summer
classes. The $5,000 would be viewed as an opportunity cost of attending summer school. Even though

UNIT IV STUDY GUIDE
Incremental Analysis and Pricing

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opportunity costs are not recorded in a company’s accounting records, they are important issues to consider
in business decisions. Unfortunately, they are sometimes not known at the time the decision is made.

Sunk costs, on the other hand, represent costs that have already been incurred and cannot be changed by
future actions. For instance, a company’s investment in a canned foods warehouse is a sunk cost. This cost
will not change regardless of whether the company rents out the warehouse, continues operations, or decides
to let the building go vacant. The only costs relevant to a decision are those that vary among the courses of
action being considered. Sunk costs are not considered relevant since they cannot be changed, regardless of
what decision is made.

When it comes to incremental analysis, there are many decisions to be considered. For instance, special
order decisions occur when a company receives large special orders to provide goods at less than regular
price. Most of the time, these orders are not from a company’s regular customers. The relevant costs in this
type of decision are the incremental revenues that will be earned and the incremental costs that will be
incurred by accepting the order. Incremental analysis is a useful tool in evaluating the effects of expected
short-term changes in revenue and costs. Managers should always be alert, however, to the long-run
implications of their actions.

Another type of incremental analysis involves make-or-buy decisions. In many manufacturing firms, the
company must decide whether to make a certain part required in the assembly of a good or buy the part from
outside suppliers. If the company is currently producing a part that could be purchased at a lower cost from
outsiders, profits may be increased by a decision to buy the part and utilize the company’s own manufacturing
resources for other purposes.

View the following video by accessing the Unit IV Additional Unit Resources folder in the unit.

To learn more about how to use incremental analysis for a make-or-buy decision, please view the Applied
Skills Video: How to Use Incremental Analysis Related to Make or Buy, and Consider Opportunity Cost video.
Once you click on the link, closed captioning can be accessed by clicking the “CC” button on the bottom right
of the video window, and a transcript can be accessed by clicking the “T” button next to the “CC” button.

Additionally, a common issue companies face is what to do with obsolete or defective products. Management
must decide whether to devote the resources to rebuild these units, sell them at a reduced price, or simply
scrap them. In the aviation industry, it is common for companies to rework parts that are found to be defective
instead of purchasing new ones. It certainly reduces overall manufacturing costs and overall waste.

Joint Product Decisions

Many firms produce multiple products from common raw materials and a shared production process.
Examples include oil refineries, lumber and steel mills, and meat processing companies. Products resulting
from a shared manufacturing process are termed joint products, and the manufacturing costs that relate to
these products as a group are called joint costs. In such manufacturing processes, two business issues arise.
One is how to allocate joint costs among the various types of products manufactured. The other type of
decision is whether some types of products should be processed further to create an even more valuable
finished good.

What are joint costs? Assume that Daisy Co. mixes together milk and cream. After joint manufacturing costs
of $3,000 have been incurred, this mixture separates into two viable products: ice cream and whipping cream.
How is the $3,000 in joint costs allocated between these products? While there is no right or wrong way to
allocate the joint costs, the most commonly used method is in proportion to the relative sales value of the
products produced.

Once joint costs can be separated, they have reached what is called the split-off point. At this point, each
product may be sold independently of the other, or it may be processed further. When we consider the Daisy
Co. example, the company may sell its ice cream and whipping cream after the split-off point without further
processing, or it may continue processing either of the products further. The decision of whether to sell the ice
cream and whipping cream or to continue processing them into something else is based on the incremental
costs and revenue expected after the split-off point.

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To learn more about joint product costs and the split-off profit, please view the video below. A transcript and
closed captioning are available once you access the video.

Joint Product Costs and the Splitoff Point video

Pricing

What type of pricing decisions are involved in managerial accounting? We all know that setting the price for a
company’s product or service is a very significant decision. It is also a very difficult process to manage due to
the number and variety of influences involved. The pricing decision arises in virtually all types of
organizations. Manufacturers set prices for the products they manufacture while merchandising firms set
prices for their goods. Service firms also establish prices for the services they provide, such as movie tickets,
hair salons, and insurance policies. Pricing a product or service that a company has sold for a long time may
be quite different from pricing a new product or service. Public utilities and cable companies face political
issues in pricing their products and services because their prices must adhere to certain governmental
regulations.

There are several ways to price a product. Managers must rely on a quick and straightforward method for
setting prices through cost-based pricing formulas. Even though market considerations may determine the
final product price, a cost-based pricing formula gives the manager a place to start. Most importantly, the cost
of a product or service provides a floor below which the price cannot be set in the long run. Although a
product may be initially set below cost, a product’s price ultimately must cover its costs in order for the firm to
remain in business. Even a nonprofit organization cannot forever price products or services below their costs.

Cost-plus pricing is based on the initial cost of a product or service plus a markup percentage that is applied
to it. The markup used would be based on all built-in costs plus a certain margin level that would cover excess
expenses related back to the company. The cost-plus method can be used effectively within an organization
as long as careful consideration is given to the cost factors built into the initial product or service. It is
imperative that price-setting managers understand that ultimately the price must cover all costs and normal
profit margin. Cost-plus pricing formulas establish a starting point in setting prices. Then, the price setter must
weigh market conditions, likely actions of competitors, and general business conditions. Thus, price setting
requires a constant interplay of market considerations and cost awareness.

Alternatively, target costing is the process of determining the maximum allowable cost for a new product and
then developing a prototype that can be profitably made for that maximum target cost figure. How is the target
cost computed? We have to start with the anticipated selling price and then deduct the desired profit:

Target cost = anticipated selling price – desired profit

Why is target costing used? It was developed in recognition of two important characteristics of markets and
costs. The first is based on the fact that many companies have less control over price than they would like to
think. The market determines price, and a company that attempts to ignore this does so at its peril. Thus, the
anticipated market price is taken as a given in target costing. The second thing to note is that most of a
product’s cost is determined in the design stage. Once a product is designed and has gone through
production, not much can be done to reduce its cost.

Most of the opportunities to lower the cost come from designing the product so that it is simple to make, uses
inexpensive parts, and is robust and reliable. If a firm has little control over market price and cost once the
product has started production, then it follows that the major opportunities for affecting profit come in the
design stage where valuable features that customers are willing to pay for can be added and where most of
the costs are really determined. The effort is concentrated in the designing and developing stages of the
product. The difference between target costing and other popular methods is significant. Instead of designing
a product and then finding out how much it costs, the target cost is set first and then the product is designed
so that the target cost is attained. What a great way to tackle costing issues!

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Suggested Unit Resources

In order to access the following resource, click the link below.

The following video will give you more insights into how the decision is made to accept or reject a special
order. A transcript and closed-captioning are available once you access the video.

Edspira. (2020, November 10). Accept or reject special order [Video]. cielo24.