ACCOUNTING FOR DECISION MAKING

Making decisions is one of the basic functions of a manager. To be successful in decision making, managers must
be able to perform differential analysis, which focuses on identifying the costs and benefits that differ between
alternatives.

DECISION MAKING: SIX KEY CONCEPTS

A. Key concept #1
 Every decision involves choosing from among at least two alternatives. Therefore, the first
step in decision-making is to define the alternatives being considered.

B. Key concept #2
 Once you have defined the alternatives, you need to identify the criteria for choosing
among them.
1. Relevant costs and relevant benefits should be considered when making
decisions.
2. Irrelevant costs and irrelevant benefits should be ignored when making
decisions.

C. Key concept #3
 The key to effective decision making is differential analysis—focusing on the future costs
and benefits that differ between the alternatives. Everything else is irrelevant and should
be ignored.
1. A future cost that differs between any two alternatives is known as a differential
cost. Differential costs are always relevant costs.
2. Future revenue that differs between any two alternatives is known as differential
revenue.
3. An incremental cost is an increase in cost between two alternatives.
4. An avoidable cost is a cost that can be eliminated by choosing one alternative
over another.

D. Key concept #4
 Sunk costs  are always irrelevant when choosing among alternatives.
1. A sunk cost is a cost that has already been incurred and cannot be changed
regardless of what a manager decides to do.

E. Key concept #5
 Future costs and benefits that do not differ between alternatives are irrelevant to the
decision-making process.

F. Key concept #6
 Opportunity costs also need to be considered when making decisions.
1. An opportunity cost is the potential benefit that is given up when one alternative
is selected over another.

BASIC STEPS IN DECISION MODEL

Decision Model is a formal method used by managers for making a choice. It often involves both
qualitative and quantitative analyses.

A. Identify the Problem. The typical short-term decision-making cases may involve questions on:

1. Whether to make or buy a part, sub-assembly, or product line (insourcing vs. outsourcing
cases);
2. Whether to accept or reject a special order or business proposal;
3. Whether to sell or process a product further;
4. Whether to continue operating or close a business segment;
5. Which is the best product mix considering capacity constraints;
6. How profit factors should be changed to achieve a profit goal;
7. How much price should be charged for the company’s product or services (pricing decisions).
B. Obtain Information and Make decisions

1. Qualitative and Quantitative Information

a. Qualitative Factors – outcomes that cannot easily and accurately be measured in numerical
terms.
b. Quantitative Factors – outcomes that can more easily be expressed in numerical terms.

2. Relevant Information – the information to be gathered should be relevant and related to the
decision-making case.

C. Identify and Evaluate the Alternative Courses of Action, then Choose the Best Alternative.

 Only relevant factors should be considered in evaluating the alternatives.

 As a general rule, the best alternative is the one that will give the organization the highest income
or lowest loss.

D. Implement the Decision

E. Evaluate the Performance of the Decision Implemented to Provide Feedback. This feedback can help
the decision maker in making better decisions in the future.

PRICING DECISIONS
Pricing Objectives
1. To maximize profit or target margin.
2. To meet the desired sales volume or market share.
3. To maintain a stable relationship between the company’s and the industry leaders’ prices.
4. To enhance the image that the company wants to project in the market.

Factors that Influence Product Pricing

A. Internal Factors
1. All the relevant costs in the value chain (from research and development to customer
service).
2. The company’s marketing objectives and its marketing mix strategy.
3. The company’s capacity.
 Peak-load-pricing – prices vary inversely with capacity usage. The company’s
products would be sold at higher prices if the company is not operating at full
capacity.
B. External Factors
1. The type of market where the products/services are sold.
 Perfect Competition – a firm can sell as much of a product as it can produce, all at
a single market price. Every firm in this market will charge the market price – if a
product is priced higher than the market price, nobody will buy; if priced lower,
the company would sacrifice profit.
 Imperfect Competition – a firm’s price will influence the quantity it sells. For
example, a company would have to reduce its prices to generate additional sales.
 Monopolistic Market – a monopolist is usually able to charge a higher price
because it has no competitors.
2. Demand and supply
3. Customers’ perception of value and price.
4. Price elasticity of demand – effect of price changes on sales volume.
 Highly Elastic Demand – small price increases cause large volume declines.
 Highly Inelastic Demand – prices have little or no effect on volume.
5. Legal requirements – both local and international laws
Some “Illegal” Pricing Schemes:
  Predatory Pricing – establishing prices so low to drive out competitions from the
market, so that once the predatory pricer no longer has significant competition, it
can dramatically raise prices.
 Discriminatory Pricing – charging different prices to different customers for the
same product or service.
 Collusive Pricing – companies conspire to restrict output and set artificial high
prices.
6. Competitors’ actions.

PRICING METHODS

1. Cost-Based Pricing - it starts with the determination of the cost, then a price is set so that such price
will recover all costs in the value chain and provide a desired return on investment.

Cost-Plus Price : Price = Cost + Markup

 Based on Total Costs

Price = Total cost + (Total Cost x MU%)
 Based on Absorption Product Cost
Price = Absorption product cost + (Absorption product cost x MU%)
 Based on Variable manufacturing Cost
Price = Variable manufacturing cost + (Variable manufacturing cost x MU%)
 Based on Total Variable Cost
Price = Total variable cost + (Total variable cost x MU%)

 MU% = markup percentage

2. Market-Based Pricing (or Buyer-Based pricing)

Prices are based on the products’ perceived value and competitors’ actions, rather than on the
products/services’ costs.

Example: A glass of orange juice may have a higher price in a classy restaurant than at the school
canteen.

 Target Price – the expected market price for a product/service, considering the
customers’ perception of value and competitors’ reactions.

Target price - Target profit = Target cost

 Target Costing – a company first determines the price (the target price or market price) at
which it can sell its product/service, and then design the product or service that can be
produced at the target cost to provide the target profit.

 Value Engineering – a means of reaching the target cost. It involves a systematic

assessment of all the aspects of the value chain costs of a product/service – from research
and development, design of the product, process design, production, marketing,
distribution, and customer service.
The objective is to minimize cost without sacrificing customer satisfaction.

 Life-Cycle Costing – involves the determination of a product’s estimated revenues and

expenses over its expected life-cycle.
Life Cycle:
1.Research and development stage
2.Introduction stage
3.Growth stage
4.Mature stage
5.Harvest or decline stage and final provision of customer support.
  Whole-Life Costs – composed of:
1.The life-cycle costs; and
2.After-purchase costs incurred by customers
 Reduction of whole life cost provides benefits, both to buyer and seller.
Customers may pay a premium for a product with low after-purchase costs.

3. Competition-Based Pricing
 Price is based largely on competitors’ prices.

4. New Product Pricing (Introductory Price Setting)

 Price Skimming – the introductory price is set at a very high level. The objective is to sell
to customers who are not concerned about price, so that the firm may recover its
research and development costs.
 Penetrating Pricing - the introductory price is set at a very low level. The objective is to
gain deep market penetration quickly.

SAMPLE PROBLEMS:

1. Make or Buy
ABC Co. presently manufactures all component parts of its product. The cost of one such part per
unit is as follows:
Materials P 6.00
Labor 5.50
Fixed overhead 2.00
Variable overhead 1.50
P15.00
A sub-contractor has offered to make this part for ABC Co. at a price of P13.50 per unit.
a. Should the company buy or continue to make the part?
b. Assume that if ABC Company accepts the offer, some of the facilities used to manufacture the
part could be used for the manufacture of other parts, thus saving P5,000 in relevant cost to
manufacture. The company needs 1,000 units of the component part per month. What decision
must ABC make and how much will be the cost difference?

Solution:
a. Unit relevant costs to make:
Materials P 6.00
Labor 5.50
Variable overhead 1.50
P13.00
Decision: The Company should continue making the part.

b. Unit relevant costs to make:

Materials P 6.00
Labor 5.50
Variable overhead 1.50
Total P13.00
x parts needed 1,000
Total relevant cost to manufacture P13,000
Relevant cost to buy
Total purchase costs (1,000 x P13.50) P13,500
Less cost savings 5,000 8,500
Cost savings if purchased P 4,500
2. Special Order

XYZ Company manufactures face mask. The projected income statement for the month of May
before any special order is as follows:

Total Per pack

Amount
Sales P400,000 P20
Cost of goods sold 320,000 16
Gross margin P 80,000 P4
Selling expenses 30,000 3
Operating income P 50,000 P1

Fixed costs included in above projected income statement are P80,000 in cost of goods sold and
P9,000 in selling expenses.

A special order offering to buy 2,000 packs for P17 each was made to XYZ. No additional selling
expenses will be incurred if the special order is accepted. The company has the capacity to
manufacture 2,000 more packs.

As a result of the special order, how much would be the increase (decrease) in the operating income
of the company?

Solution:
Increase in sales (2,000 x P17) P34,000
Less: increase in variable cost of sales:
Total costs of sales P320,000
Less: fixed portion 80,000
Cost of sales, variable P240,000
Divided by units sold 20,000
Unit variable cost of sales P12.00
Multiply by units ordered 2,000 24,000
Increase in operating income P10,000

3. Sell or process a product further

The production manager of DEF Corporation is at a loss on what to do with 10,000 units of defective
product on stock which cost the company P25,000 to produce. Two proposals submitted for his
consideration are as follows:
a. Sell the product as scrap for P2.00 per unit; or
b. Rework the units at a cost of P12,500 and then sell them for P5.00 per unit.

How much will be the net advantage or disadvantage to the company if proposal b (rework the
nunits) is followed?

Solution:
Revenue after reworking (10,000 x P5) P50,000
Less cost of reworking 12,500
Amount recoverable after reworking P37,500
Amount recoverable if sold as scrap (10,000 x P2) 20,000
Net advantage of reworking P17,500
4. Continue operating or close a business segment
The operating results of MNO Inc. by division for the previous year are summarized below.
Unavoidable company headquarters’ costs of P1,540,000 included in the total costs have been
distributed to the divisions on the basis of sales revenue. The remaining portion of the total costs
have been incurred at the divisional level and can be avoided if a division is shut down.

MNO Inc.
Operating Results
For the year ended December 31, 2019
(P000 omitted)

Divisions
Total North South East West
Sales revenue P6,600 P 990 P2,640 P 990 P 1,980
Total costs 6,226 572 2,090 1,276 2,288
Profit (loss) P 374 P 418 P 550 P (286) P (308)

What division, if any should be shut down due to failure to recover divisional costs?

Solution:
 The North and South divisions show a profit after the allocation and should not be shut
down.
 The allocation percentage for headquarters is 23.33% (P1,540,000/P6,600,000).
 Only East should be shut down as shown by the following computation:

East West
Loss P(286) P(308)
Allocated costs:
0.2333 x P990 231
0.2333 x P1,980 462
Divisional profit (loss) P(55) P154

5. Best product mix considering capacity constraints

OPQ Co. has available production capacity of P150,000 hours. This facility can be used to produce
three products in any combination. Total fixed costs is P135,000. The other pertinent data are as
follows:

Products
A B C
Selling price P7.50 P22.50 P4.50
Variable costs 6.75 11.50 1.50
Units of capacity required a unit 1 10 2
(hours)
Market limitations (units) none 3,000 30,000

a. Which is the best combination of products?

b. How much is the net profit associated with the best combination of products?

Solution:

Products
A B C
Selling price P7.50 P22.50 P4.50
Less: Variable costs 6.75 11.50 1.50
 Contribution margin P0.75 11.00 P3.00
Divided by Units of capacity required 1 10 2
a unit (hours)
Contribution margin per unit of P0.75 P1.10 P1.50
capacity
Hours needed Units to be made

Product combination:
Product C 60,000 30,000
Product B 30,000 3,000
Product A 60,000 60,000
Total available capacity (hours) 150,000

b. Profit from best combination

Contribution margin of best product combination:

Product A (60,000 x P0.75) P 45,000

Product B (3,000 x P11,00) 33,000
Product C (30,000 x P3.00) 90,000
Total contribution margin P168,000
Less: Total fixed costs 135,000
Net profit from operations P 33,000

6. How much price should be charged for the company’s product or services (pricing decisions).

I. NCO Company incurs the following costs in producing and selling 5,000 units of product V19 each
year:

Production costs:
Variable (materials, labor and overhead) P7.00
Fixed (based on 5,000 units produced) 3.00
Selling and administrative costs:
Variable 1.00
Fixed (based on 5,000 units produced) 2.00
a. Assume the company uses the absorption approach to cost-plus pricing and desires a
markup of 40 percent. What is the target selling price?
b. Assume that the company uses the contribution approach to cost-plus pricing and
desires a markup of 75 percent. What is the target selling price?

Solution

a. Variable production cost P 7.00

Fixed production cost 3.00
Total P10.00
Add markup (P10 x 40%) 4.00
Target selling price P14.00

b. Variable production cost P 7.00

Variable selling and administrative 1.00
Total P 8.00
Add markup (P8 x 75%) 6.00
Target selling price P14.00

II. ECQ Company produces and sells 25,000 units of product X each year. The company incurs the
following unit costs at the 25,000-unit level of activity:

Direct materials P16.00

Direct labor 10.00
Variable overhead 4.00
Fixed overhead 13.00
 Variable selling and administrative expense 6.00
Fixed selling and administrative expense 8.00
What is the “floor” which the company should not go, even in special pricing decisions?

Solution:
Direct materials P16.00
Direct labor 10.00
Variable overhead 4.00
Variable selling and administrative expense 6.00
Total P36.00

III. GCQ Company estimates that the following costs and activity would be associated with the
manufacture and sale of product Y:

Number of units monthly 40,000

Required investment in assets P 800,000
Cost to manufacture one unit 25
Selling and administrative expenses, monthly 600,000
If the company uses the absorption approach to cost-plus pricing and desires a 15% ROI,
what is the required markup for product Y?
Solution:

Operating income (P800,000 x 15%) P120,000

Expenses 600,000
Contribution margin P720,000

Production cost (40,000 x P25) P1,000,000

Markup = P720,000/1,000,000
= 72%

IV. IUDA Co. wants to introduce a new product. To compete effectively, the product could not be
priced
at more than P30. The company requires a 25 percent return on investment on all new products. In
order to produce and sell 40,000 units each year, the company would need to make an investment
of P600,000. Selling and administrative expenses would total P400,000 per year. What is the target
cost to manufacture one unit of the new product?

Solution:
Estimated sales (40,000 x P30) P1,200,000
Less: Estimated gross profit:
Net income (P600,000 x 25%) P150,000
Selling and administrative expenses 400,000 550,000
Target cost of sales P 650,000
Divided by units to be sold 40,000
Target cost per unit P 16.25
Problem Set

A. ABC Company makes 27,000 units of a certain component each year for use of its production line. The
cost per unit for the component at this level of activity is as follows:
Direct materials P 4.20
Direct labor 12.00
Variable factory overhead 5.80
Fixed factory overhead 6.50

ABC Company has received an offer from an outside supplier who is willing to provide 27,000 units of
this component each year at a price of P25 per component.

Required:

1. Assume that there is no other use for the facilities now being used to produce the component.
If ABC Company continues to make the components, how much higher or lower will net
income be than if the components are purchased from the outside supplier?
2. Assume that the facilities now being used to produce the component could be rented to
another company for P64,800 per year if the component were purchased from the outside
supplier. Under these conditions, if the company continued to make the component, how
much higher or lower will net income be than if the component were purchased from the
outside supplier?
3. Suppose the conditions are the same in question 1, at what price per unit charged by the
outside supplier would ABC Co. be economically indifferent between making the component or
buying it from the outside?
4. Assume that if the component is purchased from the outside supplier, P35,100 of annual fixed
factory overhead could be avoided and the facilities now being used to make the component
could be rented to another company for P64,800 per year. If ABC chooses to buy the
component from the outside supplier under these conditions, how much is the change in the
annual net income due to accepting the offer?
5. Suppose the conditions are the same as in question 4, and the number of units of this
component used each year can change. What would be the quantity of units of this component
used per year that would make ABC economically indifferent between making or buying the
component?

B. DEF Company has been producing two bearings, component B12 and B18, for use in production. Data
regarding these two components are as follows:

B12 B18
Machine hours required per unit 2.5 3.0
Standard cost per units:
Direct materials P2.25 P3.75
Direct labor 4.00 4.50
Manufacturing overhead:
Variable, applied on the basis of direct labor hours 2.00 2.25
Fixed, applied on the basis of machine hours 3.75 4.50
P12.00 P15.00

DEF’s annual requirement for these components is 8,000 units of B12 and 11,000 units of B18.
Recently, DEF’s management decided to devote additional machine time to other product lines
resulting in only 41,000 machine hours per year that can be dedicated to the production of the
bearings. An outside supplier has offered to sell DEF the annual supply of the bearings at prices of
 P11.25 for B12 and P13.50 for B18. DEF wants to schedule the otherwise idle 41,000 machine hours to
produce bearings o that the company can minimize its cost (maximize its net benefit).
Required:
6. What is the net benefit (loss) per machine hour that would result if DEF Company accepts the
supplier’s offer of P13.50 per unit for component B18?
7. How many of each component be purchased or manufactured to maximize net benefits?
8. Without prejudice to item 6 and 7, assume that DEF Company’s idle capacity of 41,000
machine hours has a traceable avoidable annual fixed cost of P44,000 that will continue if the
capacity is not used. What is the maximum price DEF would be willing to pay a supplier for
component B18?

C. Condensed monthly operating income data for Cosmo Inc. for November 2019 is presented below.

Total Mall Store Town Store

Sales P200,000 P 80,000 P120,000
Variable costs 116,000 32,000 84,000
Contribution margin P 84,000 P 48,000 P 36,000
Direct fixed expenses 60,000 20,000 40,000
Segment margin P 24,000 P 28,000 P (4,000)
Common fixed expenses 10,000 4,000 6,000
Operating income P 14,000 P 24,000 P(10,000)

Additional information:
 One-fourth of each store’s direct fixed expenses would continue through December 31, 2020, if
either store was closed.
 Common fixed expenses are allocated on the basis of sales pesos.
 Management estimates that closing the Town Store would result in a ten percent decrease in
Mall Store sales, while closing the Mall Store would not affect Town Store sales.
 The operating results for November 2019 are representative of all months.

Required:
9. What is the effect on the monthly operating income during 2020 if the Town Store would be
closed?
10. Cosmo is considering a promotional campaign at the Town Store that would not affect the
Mall Store. if annual promotional expenses at the Town Store will be increased by P60,000
(which is expected to increase sales by ten percent), what is the effect on the monthly
operating income during 2020?
11. One-half of Town Store’s peso sales are from items sold at variable cost to attract customers
to the store. Cosmo is considering the deletion of this items, a move that would reduce the
Town’s direct expenses by 15% and result in the loss of 20% of the remaining Town’s sales
volume. This change would not affect the Mall Store. What is the effect on the operating
income of the company if the items sold at cost are eliminated?

D. A firm needs two component parts, X and Y. which can be manufactured or purchased. in producing
the parts, factory overhead is applied at P1.00 per standard machine hour. The fixed capacity costs,
which will remain unchanged whether the parts will be produced or purchased, represent 50% of the
applied overhead. Total hours available for production is 45,000 hours. Standard costs and other
information for the two component parts used by the firm are presented below.

Part X Part Y
Direct materials P0.50 P12.00
Direct labor 1.50 7.00
Factory overhead 6.00 3.00
Unit standard costs P8.00 P22.00
Units needed per year 9,000 12,000
Machine hours per unit 6 3
 12. How much is the relevant unit production costs that should be considered in the decision to
schedule the 45,000 hours available machine time in order to realize the maximum potential
cost savings?
13. If the allocation of machine time is based on potential cost savings per machine hour, what is
the best combination of parts that should be produced?

E. The Yellow Company has the capacity to manufacture 20,000 units per month. However, present plans
call for monthly production and sales of 15,000 units at P21.00 each. Costs per unit are as follows:
Direct materials P 7.00
Direct labor 4.20
Variable factory overhead 1.05
Fixed factory overhead 2.10
Variable marketing expenses 0.35
Fixed administrative expenses 1.40
P16.10
14. Assuming that Yellow Co. accepted a special order for 5,000 units at P15.00 per unit, how
much will be the increase or decrease in the contribution margin?
15. How much will be the unit cost figure for purpose of costing inventory if the company shall
use direct costing?
16. Assuming that the regular sales price is reduced to P19 resulting in a 10% increase in sales
volume, how much will be the effect in the monthly contribution margin?