Introductory

Management Accounting

Lecture 8

PRODUCT PRICING &

SPECIAL OPERATING DECISIONS

ChunLei Yang
 Lecture outline
• PRICING DECISIONS
– Optimal pricing using economic theory
– Cost plus pricing
– Contribution analysis and minimum price

• SPECIAL OPERATING DECISIONS

– Make or buy
– Keep or drop a product
– Special order
– Dealing with scarce resources
Pricing decisions
The Contribution of Management
Accounting

1. Calculate optimal price when demand

relationships and cost structures are
known

2. Cost plus pricing

3. Contribution analysis and minimum

price
 1. Optimal pricing using
economic theory
Start from the demand curve, the sales-price
relationship:
P Price (P) = 100 – 0.1
Quantity (Q)

@= £70 Q = 300
@= £60 Q = 400

Variable cost (V) = £30/unit

Q Fixed cost (F) = £8000

The price function (graphical expression) The price function (mathematical expression)
Identify the optimal point (graphical
inspection)
TR/TC Maximum Total costs
profit

25000

20000 Break
Profit even

15000 Total revenue

100Q – 0.1Q2

Break
10000 even

5000
Optimal
output

Production
100 200 300 400 500 600 700 800
level
 Identify the optimal point
(mathematical approach)
Total Revenue = PQ = 100Q – 0.1Q2
Total Cost = F + VQ = 8000 + 30Q
Profit = 100Q – 0.1Q2 – (8000 + 30Q)
 = 70Q – 0.1Q2 – 8000
d
0
Maximum profit, by calculus, will be where:
dQ
ie, any change in quantity will reduce profit
d
70 - 0.2Q 0
Q = 350 dQ
P = 65 (ie: 100 – 0.1x350) optimal price
OR,
Marginal Cost (MC)= Marginal Revenue dTR
(MR)
MR  100  0.2Q
Let MC=MR: dQ
30 = 100 – 0.2Q MC 
dTC
30
Q = 350 dQ
P = 65 (ie: 100 – 0.1x350) optimal price
 Difficulties with Optimal
Pricing
1. Estimating the demand function is
often very difficult
– Lack of experience
– Conditions and preferences changing

2. Non-price factors influence demand

– eg - advertising; quality

3. Assumed objective of profit

maximisation—does it always hold?
 2. Cost Plus Pricing
Useful when:
– demand difficult to predict
– one-off situations

Rational:
Need to cover costs in order to make a profit;

General method:
Base price on measurement of the appropriate
costs

Pricing Procedure:
Identify all costs (including allocated costs)
+) Add a profit %
Price
Cost plus pricing—Example
£
Direct manufacturing costs 12
Allocation of manufacturing overheads
5
___
= Total manufacturing costs 17

Allocation of non-manufacturing overheads

3
___
= Total cost
20

Profit margin (20%) 4

24/unit
___
 Problems with cost plus
pricing
1. Treatment of overheads
– fixed overheads don't vary
– methods of allocation arbitrary
(ie full cost plus ignores the principles of
relevant cost)
2. Adding a simple profit % will not be
consistent with maximising profit
3. Ignores demand conditions, hence
can lead to sub-optimal decisions
3. Contribution Margin & Minimum
Price
Contribution = P(Price) – VC(Variable cost)
Rationale
If P > V, then production and sale will generate a contribution
to fixed costs and profit
Virtue:
1. Takes account of relevant incremental costs (including
opportunity costs); ie., fixed costs are ignored here
2. Maximising contribution is consistent with maximising
profit
Problems:
1. Need to cover fixed costs in the long run  actual price
must be greater than the minimum
2. Customer expectations may be affected by low prices
3. Recognise potential limitations of fixed/variable analysis
Comments
4. This is a means of generating information for price
decisions rather than determining actual prices
5. VC is the MINIMUM (SHORT RUN) PRICE
 Summary
• Analysis of Revenues and Costs
– Economic Approach to Revenue
 OPTIMAL PRICING
– Cost Analysis
 COST PLUS
 CONTRIBUTION MARGIN

• Context of Pricing Decisions: Marketing and Other

factors

Need accounting analysis as well as

marketing information to determine
appropriate PRICING STRATEGY
2. Special Operating
Decisions
1) Make or buy
2) Keep or drop
3) Charge special order
4) Deal with scarce
resources
 Illustrative example-Ricon
and Sharp
Royle Ltd. has a factory producing two products:
“Ricon” and “Sharp”. Joint factory costs are allocated
based on production volume. Finished products are
transferred to a warehouse at another site, where all
the sales, distribution and administration functions are
located. Sales/distr./admin. costs are to be divided
equally between two products.
Production
Distribution
sales
R

Admin.
Illustrative example-Ricon and
Sharp
Ricon Sharp Total
Volume of production 10,000 5,000

/unit £000 /unit £000 £000

Price 10 15

Direct Manufacturing costs:

Fixed 10 15 25

Variable 2 6

Joint factory costs 45

Allocated units R+S
45,000/10,000+5,000

Selling/adm./dis allocated to 30
product

Net profit
 Questions/special
decisions:
1. A special order may be available for an extra 2,000 Ricon
Q: what price would make acceptance of this order
worthwhile? Special Order

2. Because Sharp is only just breaking even, should production be

terminated?
Keep or Drop
3. Other producers are willing to supply all R and S required at
prices of £7 and £13 respectively. If production ceases the
factory could be rented out for £35,000. Should the company
consider changing from production/sale to purchase/resale
(make or buy)?
Make or Buy
 Solution notes:
(1) To produce additional units of
Ricon costs:
Manufacturing Costs:

Fixed £1
variable £2
Factory £3
Selling etc £1.5
Total £7.5

Minimum price = price which covers incremental

cost of additional production

£2
Illustrative example-Ricon and
Sharp
Ritchie Sharp Total

Volume of production 10,000 5,000

/unit £000 /unit £000 £000

Price 10 15

Direct Manufacturing costs: 10,000/10,000

Fixed 1 10 3 15 25

variable 2 6
30,000/10,000

Joint factory costs 3 30 3 15 45

Allocated units R+S
(45,000/15,000)*10,000
45,000/10,000+5,000

Selling/adm./dis allocated 1.5 15 3 15 30

to product
Net profit 2.5/unit 0/unit
10-1-2-3-1.5=
 Solution notes:
(2)Cease production of Sharp
If S is no longer produced:

lose revenue of 75,000

save costs of:

Fixed manufacturing 15,000
Variable 30,000
Net effect -30,000

Contribution to joint costs would be lost=15000 + 15000

 Solution notes:
(3) Make or Buy
Purchase: R for £7 = £70,000
S for £13 = £65,000 £135,000
All production costs saved (FC+ VC+ Manu.OHs) £120,000
Rental income = £35,000
(so will be 155000 better off—relevant benefits)

 Net benefit from purchase £20,000

Other Factors:
• Continuity of Supply
• Quality issues
• Future Prices
• Costs of Changing Back
A quick question
000's

B appears to be making a loss, so

should be dropped. This statement is:

A. True
B. False
Should B be dropped-solution
notes
A B Drop B

Contribu 40 7 40
tion
Allocate (20) (30)
d (10)
fixed
costs
20 (3) 10

Net 17
benefit
Real World Perspectives
Make or Buy decisions in police services

"Competitive tendering of support services is part of

our plans to drive down costs so we can keep police
numbers high and ensure front-line officers have the
best possible support…. Core policing roles are not
being outsourced but we are asking the private
sector to show the Met where they could come in and
provide
" better police support services at a lower
cost."

Stephen Greenhalgh, London deputy mayor for

policing and crime, 2013

“The more money we can save and more efficient we

can get, the more officers we can devote to front-line
policing.”

Craig Mackey , Deputy Commissioner, 2013

Scarce Resources
 Scarce Resources:
Definition:
A resource of which a business has insufficient
supplies to accept all the opportunities expected
to give positive contributions--bottleneck

Decision making with scarce resources

• No scarce resource
• Single scarce resource
– use contribution per unit of scarce resource
• More than one scarce resource
– use linear programming (not examined)
 Real World Perspectives
The desirability of products in
retail operations

what is the scarce resource in a retail

operation?
Example: Masaccio Ltd -Has five possible products
A,B,C,D,E
Incurs total fixed costs = £175,000

Production: A B C D E

Selling Price 80 60 70 90 50
Variable Cost 40 39 40 82
44
Contribution 40 21 30 8 6

Hours of machine time 16 12 20 4

6
Demand 3000 4000 2500 2000 5000

Total Hours to meet demand 48,000 48,000 50,000

8,000 30,000
(184,000 hrs )
What is the optimal production
plan, in view of the scarce
resources?

Objective:
Maximise benefits (contribution) with limited
resources

Decision rule:
Rank products by their Contribution/limiting
factor
 Solution notes
RANKING PRODUCTS

Prod Contr. Hours C/H

Rank
A 40 16 2.50 1 ADBCE
B 21 12 1.75 3
C 30 20 1.50 4
D 8 4 2.00 2
E 6 6 1.00 5

Total Profit = Contribution - Fixed Costs

= 244,000 - 175,000
= 69,000

64,000hrs short, so won’t be able to produce E, and could only partially meet the demand of C [50,000-
(64,000-30,000)]=16,000hrs, therefore, contribution=
40*3000 +8*2000+21*4000+30*(16,000/50,000)*2500= 120,000+16,000+84,000+24,000=244,000
Or
2.5*48,000+2*8000+1.75*48,000+1.5*16,000=244,000
 Study checklist
 Competent students should by now:
• feel quite comfortable with the idea of relevant costing and be
able to use it to make a range of managerial decisions;
• understand the assumptions underlying each step of the
calculation;
• understand the strength and limitations of relevant costing
analysis.
 Review relevant lectures notes and examples pertaining to
relevant costing analysis
 Prepare for the next lecture on budgeting (Atrill and McLaney,
Chapter 6 and 7; Notes for Lecture 9 and 10, on BB)