UNIT 5

RELEVANCE, PRICING AND DECISION PROCESS

Contents
5.0Aims and Objectives
5.1 Introduction
5.2 The concept of relevance
5.3 Decision making
5.3.1 Short term decision
5.3.2 Relevant Costs and Relevant Costs
5.4 Product mix decision under capacity constraints
5.5 Pricing decisions
5.6 Summary
5.7 Self Test Questions
5.0 AIMS AND OBJECTIVES

After completing this unit, you should be able to understand:

 the concept of relevance
 the Short term decision making
 how Product mix decision under capacity constraints is computed
 the Pricing decisions

5.1 INTRODUCTION

Managers use both financial and nonfinancial quantitative information to analyze the effects of
past and potential business actions on their organization’s resources and profits. Although many
short-term business problems are unique and cannot be solved by following strict rules,
managers often had taken predictable actions when making decisions that will affect their
organizations in the short run. In this chapter, we describe those actions. It also explains how
managers use incremental analysis in making various types of short-term decisions.

5.2 THE CONCEPT OF RELEVANCE

It is the information that provided must be closely related or connected with decision process.
The information which is relevant for decision making is called relevant information.
Making decision is one of the basic functions of a manager. Managers are constantly faced with
problems of deciding what products to sell, whether to make or buy components or parts, what
prices to charge, what channels of distribution to use, whether to accept special orders at special
prices etc. Decision making is often a difficult task that is complicated by numerous alternatives
and massive amounts of data, only some of which may be relevant.
Every decision involves choosing best alternatives from at least two alternatives. In making a
decision, the costs and benefits of one alternative must be compared to the cost and benefits of
other alternatives. Costs that differ between alternatives are called relevant costs.
Distinguishing between relevant and irrelevant costs and benefits is critical for two reasons.
1. Irrelevant data can be ignored that can save decision makers tremendous amount of time
and effort.
2. Bad decisions can easily result irrelevant costs and benefits when analysing alternatives.
To be successful in decision making, managers must be able to tell the difference between
relevant and irrelevant data and must be able to correctly use the relevant data in analysing
alternatives. The purpose of learning this chapter is to develop these skills by illustrating their
use in a wide range of decision making situations.

5.3 DECISION MAKING

It means choosing the best alternative courses of action from two or more alternative courses of
actions. Managers frequently follow a method, called ‘a decision model’ for choosing different
courses of action. A decision model is a formal method for making choice, frequently involving
both quantitative and qualitative analysis. Shareholders would like managers to choose actions
that are in the best interest of shareholders. Management accountant works with managers by
presenting and analysing relevant data to guide decisions.
Decisions are of two types.
1. Short term decisions:-Decisions of less than one year example special order decision, make or
buy decision, and etc
2. Long term decisions:-Decisions of more than one year.

5.3.1 Short term decision

Many of the decisions that managers make affect their organization’s activities in the short run.
Those decisions are the focus of this chapter. In making short-run decisions, managers need
historical and estimated quantitative information that is both financial and nonfinancial in nature.
Such information should be relevant, timely, and presented in a format that is easy to use in
decision making.
Short-run decision analysis is the systematic examination of any decision whose effects will be
felt over the course of the next year. The decision analysis must take into account the
organization’s strategic plan and tactical objectives, the related costs and revenues, as well as any
relevant qualitative factors.
Although many business problems are unique and cannot be solved by following strict rules,
managers frequently take four predictable actions when making short-run decisions:
1. Discover a problem or need.
2. Identify all reasonable courses of action that can solve the problem or meet the need.
3. Prepare a thorough analysis of each possible solution, identifying its total costs, savings, and
other financial effects, as well as any qualitative factors.
4. Select the best course of action.
Later, managers review each decision to determine whether it produced the forecasted results by
examining how it was carried out and how it affected the organization. If results fell short, they
identify and prescribe corrective action. This post decision audit supplies feedback about the
results of the short-run decision. If the solution is not completely satisfactory or if the problem
remains, the management process begins again. In the course of a year, managers may make
many short-run decisions, such as whether to make a product or service or buy it from an outside
supplier, whether to accept a special order, whether to keep or drop an unprofitable segment, and
whether to sell a product as is or process it further. If resources are limited, they may also have to
decide on the most appropriate product mix. In making such decisions, managers analyze not
only quantitative factors relating to profitability and liquidity; they also analyze qualitative
factors. For example, the qualitative factors a bank might consider when deciding whether to
keep or eliminate a branch location include the following:
 Competition (Do our competitors have a branch office located here?)
 Economic conditions (Is the community growing?)
 Social issues (Will keeping this branch benefit the community we serve?)
 Product or service quality (Can we attract more business because of the quality of
service at this branch?)
 Timeliness (Does the branch promote customer service?)

Managers must identify and assess the importance of all such qualitative factors, as well as
quantitative factors, when they make short-run decisions.
In the process of decision making the managers may follow the following five steps.
1. Gathering information
2. Making Prediction
3. Choosing an alternative from various alternatives.
4. Implementing the decision
5. Evaluating performance (provides feedback about actions taken in the previous step)
5.3.2 Relevant Costs and Relevant Costs
These are those expected future cost and expected future revenues that differ among the
alternative courses of action being considered.
Conditions for Decision Making
1. The information must be related to expected future cost and expected future revenues and
not the past costs and revenues. Because
a. Relevant costs and relevant revenues must occur in the future.
b. They must differ among the alternative courses of action.
2. The information must have different alternative courses of action. The information used for
decision making would be perfectly relevant and accurate.
 The concept of Relevance applies to numerous decision situations:
1. Special Order Decision
2. Adding or Dropping of product, service, department or any segment
3. Make or Buy Decision
4. Product Mix Decision under Capacity Constraints
1. SPECIAL ORDER DECISION
A Special order is a one- time order that is not considered part of the company’s normal
ongoing business. Managers must evaluate whether a special order should be accepted and if the
order is accepted, what is the price that should be charged.
Before making the decision to accept or reject the special order, one should take into account
the following points.
1. Capacity factor: It means whether the organisation is working with idle working capacity.
i.e., The company must have idle capacity
2. Profitability Factor: It should be profitable
3. The special order would not affect the regular business of the organisation. It must be
produced by using only idle resources and not regular resources.
4. The special order would not affect the fixed cost of the organisation. When organisation
produces goods with idle resources, fixed cost cannot be fully utilised.
5. It has no impact on selling (e.g., advertisement cost) and administrative expenses.
6. The special order should be made for short period.
7. For finding profitability of special order the organisation can follow Contribution approach
or Full cost Approach (Absorption Costing Method).
Example: 1
ABC Company has enough idle capacity to accept special order of 20,000 units at Birr 12 per
unit. The normal selling price of the product is Birr 20. Variable manufacturing cost equals Birr
9 per unit and the fixed cost is Birr 60,000. The company will not incur additional selling
expenses on the special order. Determine the effect of the special order on the net income of the
organisation.
Solution:
Particulars Birr/Unit Special Order Amount(in
Br) at 20,000 units

Sales 12 240,000 (12x 20,000)

Variable Cost 9 180,000 (9 x 20,000)

Contribution Margin 3 60,000 (240000-180000)

Fixed cost 0 0

Operating Income 3 60,000

Decision: We can accept the special order because the company’s total profitability increased
by Br. 60,000.
Example 2:
In the above example, if ABC Company’s capacity is 180,000 units per year and the operation
of current year indicates only 165000 units, what will be the decision if one of the customers of
ABC Company sent inquiry for special order of 20,000 units at Br.12 per unit? The normal
selling price of the product is Br.20. Variable manufacturing cost equals Br.9 per unit and the
fixed cost is Br.60, 000. ABC will not incur additional selling expenses.
Solution:
Find out Idle capacity of the company
Idle capacity=180,000 _165,000 =15,000
Since special order is more than idle capacity, the company should reject the order.
Example:3

For example, suppose Home State Bank has been approved to provide and service four ATMs at
a special event. The event sponsors want the fee reduced to $0.50 per ATM transaction. At past
special events, ATM use has averaged 2,000 transactions per machine. Home State Bank has
located four idle ATMs and determined the following additional information:
ATM Cost Data for Annual Use of One Machine (400,000 Transactions)
Direct materials $0.10
Direct labor 0.05
Variable overhead 0.20
Fixed overhead ($100,000 / 400,000) 0.25
Advertising ($60,000 /400,000) 0.15
Other fixed selling and administrative expenses
($120,000 _ 400,000) 0.30
Cost per transaction $1.05
Regular fee per transaction $1.50
Should Home State Bank accept the special event offer?
An incremental analysis of the decision in the contribution margin report shows the contribution
margin for Home State Bank’s operations both with and without the special order. Fixed costs
are not included because the only costs affected by the order are direct materials, direct labor,
and variable overhead.
 Price and relevant cost comparison: The net result of accepting the special order is a
$1,200 increase in contribution margin (and, correspondingly, in operating income).
Home State Bank
Special Order Decision
Incremental Analysis
Difference in
Favor of
Without With Accepting
Order Order Order
Sales $2,400,000 $2,404,000 $ 4,000
Less variable costs:
Direct materials $ 160,000 $ 160,800 ($ 800)
Direct labor 80,000 80,400 (400)
Variable overhead 320,000 321,600 (1,600)
Total variable costs $ 560,000 $ 562,800 ($ 2,800)
Contribution margin $1,840,000 $1,841,200 $ 1,200
The analysis reveals that Home State Bank should accept the special order. The $1,200 increase
is verified by the following incremental analysis:
Special order sales [(2,000 transactions x 4) x $0.50] = $4,000
Less variable costs:
Direct materials (8,000 transactions x $0.10) = $ 800
Direct labor (8,000 transactions x $0.05) = 400
Variable overhead (8,000 transactions x $0.20) = 1,600
Total variable costs 2,800
Special order contribution margin $1,200
2. ADDING OR DROPPING OF PRODUCT,SERVICE OR DEPARTMENT
Decisions relating to whether old product lines or other segments of a company should be
dropped and new ones added are among the most difficult that a manager has to make. In such
decisions, many qualitative and quantitative factors must be considered. However any final
decision to drop an old segment or to add a new one depends primarily on operating income. To
assess this impact, costs must be carefully analysed.
1. Avoidable Cost: It is the cost that can be eliminated in whole or in part by choosing one
alternative over another. I e, Costs that will not continue if an ongoing operation is changed
or dropped. E.g. salary, advertisement, insurance etc. Avoidable costs are relevant costs.
2. Unavoidable Cost: It is the cost that will continue even if an ongoing operation is changed
or dropped. E.g. fixed costs and common costs. Unavoidable costs are irrelevant costs.
Two broad categories of cost are never relevant in decisions. These irrelevant costs are:
i) Sunk Costs: It is a cost that has already been incurred and cannot be avoided regardless
of what a manager decides to do. They are always same and therefore irrelevant and should
be ignored.
ii) Future costs that do not differ between alternatives.
Example 4:
XY Company wants to evaluate the potential elimination of Division ‘C’. The basic
information regarding cost and revenue is as flows:
Particulars Division ‘A’ & Division ‘C’ (in Birr) Total (in Birr)
‘B’ (in Birr)
Sales 90, 000 10,000 100,000

Variable Cost 35,000 5,000 40,000

 Contribution margin 55,000 5,000 60,000

Allocated fixed cost 37,000 11,000 48,000

Unallocated fixed cost 8,000 _ _

1. What will be the increase or decrease in profit by eliminating division ‘C’ if all costs to
Division ‘C’ are avoidable?
2. Should the company eliminate Division ‘C’?
Solution:
Particulars Before elimination Division ‘C’ After elimination
Sales 100,000 10,000 90,000

Variable Cost 40,000 5,000 35,000

Contribution 60,000 5,000 55,000

Allocated FC + 56,000 11,000 45,000

Unallocated FC (48,000+8,000) (37,000+8,000)

Net Income before 4,000 6,000 10,000

tax

Decision: Division ‘C’ should be eliminated because the organization’s Net Income
increased by 6,000 Birr (that is, from 4,000 to 10,000) as a result of elimination of Division
‘C’.
3. MAKE OR BUY DECISION
Make or buy decision is also called In sourcing or Outsourcing decision.

In sourcing: It is the process of producing goods and services within the organisation.
Outsourcing: It is the process of purchasing goods and services from outside vendors or
suppliers.
Decisions about whether a producer of goods and services will in source or outsource are called
Make or Buy decision.
Sometimes qualitative factors direct management’s Making or buys decision. For e.g. Dell
computer buys the Pentium chip for its personal computers from Intel because it does not have
the know-how and technology to make the chip itself. Coca-cola does not outsource the
manufacture of its concentrate to safeguard its formula and retain control of the product.
A company has to take the decision in the following circumstances.
1. Buy certain parts or sub-assemblies from outside suppliers
2. Use available capacity to produce the parts or sub-assembles within the company (factory).
In this situation, the following relevant information should be considered for taking
decision.
i. Potential use of available capacity
ii. Quantitative factors must be evaluated in the decision process.
iii. Differential cost approach should be considered.
Differential cost: - Decisions involve choosing between alternatives. In business decision, each
alternative will have costs and benefits of the other available alternatives. A difference in costs
between any two alternatives is known as Differential cost.
Example 5:
XY Company needs 20,000 units of certain parts in the production. The company estimated the
cost to make the parts is as follows:
Direct Materials : 3 Birr per Unit
Direct Labour : 10.5 Birr per Unit
Variable Cost : 4 Birr per Unit
Fixed Cost : 5 Birr per Unit
Total Cost : 22.5 Birr per Unit
The Company can buy the parts from GK Company for Birr 21 per Unit. 60% of the Fixed Cost
will continue regardless of what decision is made. What is the differential cost for make or buy
decision?

Solution:
Particulars To make (In Birr) To buy (In Birr)

Purchase price _ 21

Direct material 3 _

Direct Labour 10.5 _

Variable cost 4 _

Fixed Cost 2 (Birr 3 ignored) _

Total Relevant Cost 19.5 Birr per Unit 21 Birr Per Unit

Therefore, we accept Make Decision and reject Buy Decision.

Note: 60% of 5 (FC) = 3 is irrelevant because it incurred under both alternatives. The remaining
40% (2) is relevant cost.

4. PRODUCT MIX DECISION UNDER CAPACITY CONSTRAINTS

Managers are routinely faced with the problem of deciding how constrained resources are going
to be utilised. For example, a department store has a limited amount of floor space and therefore
cannot stock every product that may be available.
A manufacture has a limited number of machine-hours and a limited number of direct
labour-hours at its disposal. When a limited resource of same type restricts the company’s
ability to satisfy demand, the company is said to have a constraint.
Since the company cannot fully satisfy demand, the manager must decide how the constrained
resource should be used. Fixed costs are usually unaffected by such choices, so the course of
action that will maximise the company’s total contribution margin ordinarily be selected.
In this section, we examine how the concept of Relevance applies to product-mix decisions, the
decisions by companies about how much of each product to sell. These decisions frequently
have a short-run focus because the level of capacity can only be expanded in the long run.
Sometimes a company faces the following situations.
1. Full capacity is being utilised; i.e., there is no idle capacity.
2. Demand is in excess of company’s production capacity; i.e., high amount of demand for the
production or the company can sell as much as possible.
3. Output is restricted by some limited factors such as shortage of materials, labour, factory
space etc.
In this situation the company will face the problem for deciding the best product-mix and
earning operating profit. The only solution is assessment of product-mix that gives best profit.

Example 6:
PQ Power Company manufactures two types of engines known as Snow and Boat. The
following information belongs to these products:
Particulars Snow Boat
Selling Price per Unit Birr 800 Birr 1000

Variable Cost per Unit Birr 560 Birr 625

Estimated sales Unit 200 Units 200 Units

Fixed Cost: Birr 20,000
The Company’s plant capacity is 1200 machine hours per year for assembling engines. The
company is suffering with machine hours to meet the demand. It takes two machine hours to
produce one Snow engine and five machine hours to produce one Boat engine. Compute the
optimal product mix.
Solution:

Step 1. Determining the rank.

Particulars Boat (in Birr) Snow (in Birr)

Selling Price per Unit 1000 800

Variable Cost per Unit 625 560

Contribution Margin per Unit 375 240

Machine Hour per Unit 5 Hours 2 Hours

Contribution Margin per 75 120

machine hour
Rank 2 1

Step 2. Determining maximum product mix.

Rank Products Per Unit Total Machine Available Product Mix

Hours Hrs Machine
Hrs
I Snow 2 400 (2 x 200) 400 200 Units ( 400/2)

II Boat 5 1000 (5 x 200) 800 160 Units (800/5)

Total 1400 1200 360 Units (actual

production units)

5.4 PRICING DECISION

The price of a product or service is the outcome of the interaction between demand and supply.
Therefore pricing decisions mainly based on how demand and supply are expected to be
affected.
Pricing decisions are management decisions about what to charge for the products and services
that companies deliver. These decisions affect the quality of product sold and hence product
revenues.
There are three main factors influencing on demand and supply- customers, competitors and
costs.
1. Customers:
Customers influence prices through their effect on demand. Companies must always examine
pricing decisions through the eyes of their customers. Too high a price may cause customers to
reject a company’s product.
2. Competitors:
No business operates in a vacuum. Companies must therefore always be mindful of the actions
of their competitors. Rival’s technology, plant capacity, operating policies etc. able to estimate
competitor’s costs, which is valuable information in setting prices. A business without a rival
can set higher prices.
Competition spans international borders. Hence, costs and pricing decisions are also affected by
fluctuations in the exchange rates of different countries currencies. For example, if the Yen
weakens against the Dollar, Japanese products become cheaper in terms of dollar and can be
priced more competitively in global market.
3. Costs:
Costs influence prices because they affect supply. Understanding the costs of delivering
products enables companies to set price that make products attractive to customers while
maximising companies ‘operating income.
There are two types of pricing decisions (Time Horizon of pricing decision).
1. Short Run Pricing Decision
Decisions have a time horizon of less than one year are called Short run pricing decisions such
as
i) pricing one-time only(special order) with no long run implications
ii) adjusting product-mix and output volume in a competitive market
2. Long Run Pricing Decision
They have a time-horizon of a year or longer for fixing the price of the product. Examples of
such industries are extracting oil, mining etc. This approach prefers stable prices rather than
fluctuations and earns the desired long run return. This stable price also improves planning and
builds long run buyers-sellers relationship.
Long run pricing decisions can be made on the basis of market based and cost based pricing.
a. Market Based: - This pricing starts by asking, what our customers want and show our
competitors will react to what we do, what price should we charge?
b. Cost Based (Cost-Plus):- This pricing starts by asking, what does it cost us to make this
product, and hence what price should we charge that will recoup our costs and achieve a
desired return on investment?

5.5 SUMMARY

Information to be relevant for decision making, the two conditions that must be are:
The information must be related to expected future cost and expected future revenues and not
the past costs and revenues. Moreover the information must have different alternative courses of
action. The information used for decision making would be perfectly relevant and accurate.
The concept of Relevance applies to numerous decision situations such as: Special Order
Decision, Adding or Dropping of product, service, department or any segment, Make or Buy
Decision, Product Mix Decision under Capacity Constraints.
5.6 SELF TEST QUETIONS

Problem 1
Sample Company has received an order for Product EZ at a special selling price of $26 per unit
(suggested retail price is $30). This order is over and above normal production, and budgeted
production and sales targets for the year have already been exceeded. Capacity exists to satisfy
the special order. No selling costs will be incurred in connection with this order. Unit costs to
manufacture and sell Product EZ are as follows: direct materials, $7.00; direct labor, $10.00;
variable overhead, $8.00; fixed manufacturing costs, $5.00; variable selling costs, $3.00; and
fixed general and administrative costs, $9.00. Should Sample Company accept the order?
Solution
Variable Costs to Produce Product EZ
Direct materials $ 7.00
Direct labor 10.00
Variable overhead 8.00
Total variable costs to produce $25.00
Sample Company should accept the special order because the offered price exceeds the variable
manufacturing costs.

Problem 2

Box Company has purchased packing cartons from an outside supplier at a cost of $1.25 per
carton.
 The supplier has just informed Box Company that it is raising the price 20 percent, to
$1.50 per carton, effective immediately.
 Box Company has idle machinery that could be adjusted to produce the cartons.
 Annual production and usage would be 20,000 cartons. The company estimates the cost
of direct materials at $0.84 per carton. Workers, who will be paid $8.00 per hour, can
process 20 cartons per hour ($0.40 per carton).
 The cost of variable overhead will be $4 per direct labour hour, and 1,000 direct labour
hours will be required.
 Fixed overhead includes $4,000 of depreciation per year and $6,000 of other fixed costs.
 The company has space and machinery to produce the cartons; the machines are
currently idle and will continue to be idle if the cartons are purchased.

Should Box Company continue to outsource the cartons?

Solution
Box Company
Outsourcing Decision
Incremental Analysis
Difference in
Favor of
Make Outsource Make
Direct materials
(20,000 x $0.84) $16,800 — ($16,800)
Direct labor
(20,000 x $0.40) 8,000 — (8,000)
Variable overhead
(l,000 hours x$4) 4,000 — (4,000)
Purchase price
(20,000 x $1.50) — $30,000 30,000
Totals $28,800 $30,000 $ 1,200
Neither the machinery nor the required factory space has any other use, the depreciation costs
and other fixed overhead costs are the same for both alternatives; therefore, they are not relevant
to the decision. The cost of making the needed cartons is $28,800. The cost of buying 20,000
cartons at the increased purchase price will be $30,000. Since the company would save $1,200
by making the cartons, management will decide to make the cartons.
Problem 3

Surf, Inc., makes three kinds of surfboards, but it has a limited number of machine hours
available to make them. Product line data are as follows:
Fiberglass Plastic Graphite
Machine hours per unit 4 1 2
Selling price per unit $1,500 $800 $1,300
Variable manufacturing cost per unit 500 200 800
Variable selling costs per unit 200 350 200
In what order should the surfboard product lines be produced?
Solution
Fiberglass Plastic Graphite
Selling price per unit $1,500 $800 $1,300
Less variable costs
Manufacturing $ 500 $200 $ 800
Selling 200 350 200
Total unit variable costs $ 700 $550 $1,000
Contribution margin per unit (A) $ 800 $250 $ 300
Machine hours per unit (B) /4 /1 /2
Contr. margin per machine hour (A / B) $ 200 $250 $ 150
Surf, Inc., should produce plastic surfboards first, then fiberglass surfboards, and finally graphite
surfboards.
Problem 4:
Sample Company is evaluating its two divisions, East Division and West Division. Data for East
Division include sales of $500,000, variable costs of $250,000, and fixed costs of $400,000, 50
percent of which are traceable to the division. West Division’s data for the same period include
sales of $600,000, variable costs of $350,000, and fixed costs of $450,000, 60 percent of which
are traceable to the division.
Should either division be considered for elimination?
Solution
East Division West Division Total Company
Sales $ 500,000 $ 600,000 $1,100,000
Less variable costs 250,000 350,000 600,000
Contribution margin $ 250,000 $ 250,000 $ 500,000
Less direct fixed costs 200,000 270,000 470,000
Divisional income $ 50,000 ($ 20,000) $ 30,000
Less common fixed costs 380,000
Operating income (loss) ($ 350,000)
The company should keep East Division because it is profitable. West Division does not seem to
be profitable and should be considered for elimination. The home office and its very heavy
overhead costs are causing the company’s loss.