PART 2

Financial Decision
Making
Section C. Decision Analysis and Risk Management
(25% Level C)
U.8

Prepared by: Sameh.Y.El-lithy. CMA,CIA. 1

 STUDY UNIT EIGHT
Decision Analysis and Risk Management

Introduction

Cost Classification for decision making

To facilitate management decision making and planning, the management accountant provides relevant, timely,
and accurate information at a reasonable cost. Relevance is the most critical of the decision-making concepts;
timeliness, accuracy, and cost are unimportant if the information is irrelevant.

Relevant Cost
The concept of relevant cost arises when the decision maker must choose between two or more options. To
determine which option is best, the decision maker must determine which option offers the highest benefit,
usually in dollars. Thus, the decision maker needs information on relevant costs.

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A relevant cost has two properties: (1) it differs for each decision option and (2) it will be incurred in the future. If
a cost is the same for each option, including it in the decision only wastes time and increases the possibility for
simple errors. Costs that have already been incurred or committed are irrelevant because there is no longer any
discretion about them.

Differential Cost & Incremental cost

A differential cost is a cost that differs for each decision option and is therefore relevant for the decision maker's
choice. In practice, another term are often used interchangeably with differential cost called Incremental cost
and it is the additional cost inherent in a given decision.
EXAMPLE: A company must choose between introducing two new product lines. The incremental choice of the
first option is the initial investment of $1.5 million; the incremental choice of the second option is the initial
investment of $1.8 million. The differential cost of the two choices is $300,000.

Opportunity Cost (Implicit cost)

Opportunity cost is the benefit lost when choosing one option precludes receiving the benefits from an
alternative option.
For example, if a sales manager chooses to forgo an order from a new customer to ensure that a current
customer's order is filled on time, the potential profit from the lost order is the manager's opportunity cost for this
decision.
The opposite of the opportunity cost is the outlay costs (explicit, accounting, or out-of-pocket costs) that require
actual cash disbursements.

Sunk Cost
Sunk costs are costs that have been incurred or committed in the past and are therefore irrelevant because the
decision maker no longer has discretion over them.
For example, if a company purchased a new machine without warranty that failed the next day, the purchase
price is irrelevant for the present decision to replace or to repair the machine.

Avoidable vs. Committed (establish the current level of operating capacity/ typically fixed costs)
Avoidable costs are those that may be eliminated by not engaging in an activity or by performing it more
efficiently. An example is direct materials cost, which can be saved by ceasing production.
Committed costs
• Committed costs are Costs which are governed mainly by
by past decisions that established the present
levels of operating and organizational capacity and which only change slowly in response to small
changes in capacity.
• Committed costs are those which are required as a result of past decisions and cannot be altered in the
short run.
• Committed costs arise from holding property, plant, and equipment.
Examples are insurance, real estate taxes, Long-term lease payments, and depreciation. They are by nature
long-term and cannot be reduced by lowering the short-term level of production.

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8.1.Cost-Volume-Profit (CVP) Analysis
In chapter 3 P.1 we discuss total revenues, total costs, and income. Cost-volume-profit (CVP)
analysis(also called breakeven analysis) is a powerful tool that helps managers understand the
relationships among cost, volume, and profit. CVP analysis focuses on how profits are affected by the
following five factors:
1. Selling prices.
2. Sales volume.
3. Unit variable costs.
4. Total fixed costs.
5. Mix of products sold.

Contribution income statement

The contribution income statement with per unit amounts is an integral part of breakeven analysis.
Every unit sold contributes a certain percentage of its sales revenue to covering fixed costs. Once
fixed costs are fully covered, all additional revenue contributes to profit.

Cost-Volume-Profit assumptions
The inherent simplifying assumptions of CVP analysis are the following:

a. Cost and revenue relationships are predictable and linear. These relationships are true over the
relevant range of activity and specified time span. For example, reductions in prices are not
necessary to increase revenues, and no learning curve effect operates to reduce unit variable labor
costs at higher output levels.

b. Total variable costs change proportionally with volume, but unit variable costs are constant over
the relevant range. Raw materials and direct labor are typically variable costs.

c. Changes in inventory are insignificant in amount.

d. Fixed costs remain constant over the relevant range of volume, but unit fixed costs vary indirectly
with volume. The classification of fixed versus variable can be affected by the time frame being
considered.

e. Unit selling prices and market conditions are constant.

f. Production equals sales.

g. The revenue (sales) mix is constant, or the firm makes and sells only one product.

h. All costs are either fixed or variable relative to a given cost object for a given time span. The longer
the time span, the more likely the cost is variable.

i. Technology and productive efficiency are constant.

j. Revenues and costs vary only with changes in physical unit volume. Hence, volume is the sole
revenue driver and cost driver.

The assumptions under which CVP analysis operates primarily hinge on certainty.
However, many decisions must be made even though uncertainty exists. Assigning probabilities to
the various outcomes and sensitivity (“what-if”) analysis are important approaches to dealing with
uncertainty.

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Definitions
Breakeven point
The level of output at which total revenues equal total expenses; that is, the point at which operating
income is zero.

Margin of safety
A measure of risk. It is the excess of budgeted revenues over breakeven revenues (or budgeted units
over breakeven units).

Mixed costs(or semivariable costs)

Are costs with both fixed and variable elements.

Revenue (sales) mix

Is the composition of total revenues in terms of various products, i.e., the percentages of each
product included in total revenues. It is maintained for all volume changes.

Sensitivity analysis
examines the effect on the outcome of not achieving the original forecast or of changing an
assumption.

Unit contribution margin (UCM)

is the unit selling price minus the unit variable cost.

Formula for operating income can be stated as follows:

At the breakeven point, operating income is by definition $0 and so,

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EXAMPLE:
A product is sold for $200 per unit, with variable costs of $120 per unit and fixed costs of $2,000.
What is the breakeven point?
Operating income = Sales – Variable costs – Fixed costs
$0 = ($200 × Q) – ($120 × Q) – $2000
$80 × Q = $2,000
Q = 25 units
Price $200.00 100% $ 1.00
VC $120.00 60% $ 0.60
CM $80.00 40% $ 0.40
FC $2,000.00
CM% = CM/Price 40%
Q.Break=FC/CM 25

A simpler calculation is to divide fixed costs by the unit contribution margin (the unit contribution to
coverage of fixed costs).

In practice (because they have multiple products), companies usually calculate breakeven point
directly in terms of revenues using contribution margin percentages. Recall that in the GMAT
Success example,

That is, 40% of each dollar of revenue, or 40 cents, is contribution margin. To break even,
contribution margin must equal fixed costs of $2,000. To earn $2,000 of contribution margin, when $1
of revenue earns $0.40 of contribution margin, revenues must equal

The contribution income statement with per unit amounts is an integral part of breakeven
analysis.

$ Margin of safety =current Rev-BE.Rev @ 25 units = $5,000-$3,000

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While the breakeven point tells managers how much they must sell to avoid a loss, managers are
equally interested in how they will achieve the operating income targets underlying their strategies
and plans. In our example, selling 25 units at a price of $200 assures Emma that she will not lose
money if she rents the booth. This news is comforting, but we next describe how Emma determines
how much she needs to sell to achieve a targeted amount of operating income.

8.2.APPLICATIONS
1. Target operating income (TOI). An amount of operating income, either in dollars or as a
percentage of sales, is frequently required.

Assume the targeted operating income is $1,200, the question now, How many units must be sold
to generate enough CM to cover FC and TOI???

What is the revenue in $ required to generate $1200 TOI??

The revenues needed to earn an operating income of $1,200 can also be calculated directly by
recognizing (1) that $3,200 of contribution margin must be earned (fixed costs of $2,000 plus
operating income of $1,200) and (2) that $1 of revenue earns $0.40 (40 cents) of contribution margin.
To earn $3,200 of contribution margin, revenues must equal

A variation of this problem asks for net income (an after-tax amount) instead of operating income (a
pretax amount). In this case, the computation requires converting the target net income to target
operating income by dividing the target net income by one minus the income tax rate.

Target NI= TOI - (TOI x %T)

Target NI= TOI x (1 - T%)
Target OI= TNI / (1 - T%)
Since, TOI=Rev-VC-FC
thus, Rev-VC-FC= TNI / (1-T%)

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If the company requires $960 targeted net operating income, How many units must be sold to
generate enough CM to cover FC and TNI??? (Tax rate=40%)

To make net income evaluations, CVP calculations for target income must be stated in terms of target
net income instead of target operating income. For example, Emma may be interested in knowing the
quantity of units she must sell to earn a net income of $960, assuming an income tax rate of 40%.

In other words, to earn a target net income of $960, Emma’s target operating income
is $1,600.

TNI Q = FC + (TNI/1-T%) / $CM

The first step is to calculate the pretax operating income
=$960 ÷ 40%
=$1600
We need to cover $2000 FC plus $1600 OI , in total we need to cover $3,600

TNI Q = 3,600 / $80

=45 units
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Multiple products (or services) may be involved in calculating a breakeven point.
Specialty Cakes Inc. produces two types of cakes, a 2 lbs. round cake and a 3 lbs.
heartshaped cake. Total fixed costs for the firm are $94,000. Variable costs and sales data
for the two types of cakes are presented below.
2 lbs. 3 lbs.
Round Cake Heart-shape Cake
Selling price per unit $12 $20
Variable cost per unit $8 $15
Current sales (units) 10,000 15,000

We can calculate the breakeven volume for each of these products would be,
RC HS
CM $4.0 $5.0
units 10000 15000 25000
40% 60%
CM x sales mix $1.6 $3.0 $4.6

FC $94,000.0 20,434.78

Break even 8,173.91 12,260.87 20,434.78

Thus the breakeven will be 8,174 for round cakes and 12,261 for heart-shaped cakes.

If the product sales mix were to change to three heart-shaped cakes for each round cake, the
breakeven volume for each of these products would be

RC HS
CM $4.0 $5.0
units 6250 18750 25000
MIX 25% 75%
CM x sales mix $1.0 $3.8 $4.8

FC $94,000.0 19,789.47

Break even 4,947.37 14,842.11 19,789.47

If we multiply the mix % by the total breakeven we can arrive to 4,947 units for round cakes, and
14,842 for heart-shaped cakes.
Feedback: The correct answer is: 4,948 round cakes, 14,843 heart-shaped cakes.
The breakeven volume occurs when the contribution margin of the two types of cakes are equal to the fixed costs of $94,000. Assume that the product
mix is 3 heart-shaped cakes for each round cake, so heart-shaped cakes account for ¾ of the product mix and round cakes account for ¼ of the product
mix.
Unit contribution margin = price – variable cost per unit
Unit contribution margin, round cake = $12 - $8 = $4
Unit contribution margin, heat-shaped cake = $20 - $15 = $5
Let x = total volume, and an equation can be created to set contribution margins for the two cakes equal to total fixed costs, as follows:
(Contribution of round cakes)(product mix, rounds)(total volume) + (contribution of heart-shaped cakes)(product mix, hearts)(total volume) = total fixed
costs
($12 – $8)(1/4)x + ($20 – $15)(3/4)x = $94,000
$4x + $15x = $376,000
$19x = $376,000
x = 19,790 total cakes (actually, it’s 19,791 total cakes, since ¼(19,790) = 4,947.5 rounded to 4,948 for round cakes and ¾ (19,790) = 14,842.5 rounded
to 14,843 for heart-shaped cakes.
4,948 round cakes + 14,843 heart-shaped cakes = 19,791 total cakes

Prepared by: Sameh.Y.El-lithy. CMA,CIA. 9

 Self Assessment Quiz

Prepared by: Sameh.Y.El-lithy. CMA,CIA. 10

 CMA Exam Retired Questions
(1)209. CSO: 2C1a LOS: 2C1a
Breakeven quantity is defined as the volume of output at which revenues are equal to
a. marginal costs.
b. total costs.
c. variable costs.
d. fixed costs.

(2)211. CSO: 2C1b LOS: 2C1b

For the year just ended, Silverstone Company’s sales revenue was $450,000.
Silverstone’s fixed costs were $120,000 and its variable costs amounted to $270,000. For
the current year sales are forecasted at $500,000. If the fixed costs do not change,
Silverstone’s profits this year will be

a. $60,000.
b. $80,000.
c. $110,000.
d. $200,000.

(3)200. CSO: 2C1a LOS: 2C1a

All of the following are assumptions of cost-volume-profit analysis except
a. total fixed costs do not change with a change in volume.
b. revenues change proportionately with volume.
c. variable costs per unit change proportionately with volume.
d. sales mix for multi-product situations do not vary with volume changes.

(4)203. CSO: 2C1a LOS: 2C1g

Carson Inc. manufactures only one product and is preparing its budget for next year based on the
following information.
Selling price per unit $ 100
Variable costs per unit 75
Fixed costs 250,000
Effective tax rate 35%

If Carson wants to achieve a net income of $1.3 million next year, its sales must be

a. 62,000 units.
b. 70,200 units.
c. 80,000 units.
d. 90,000 units.

(5)213. CSO: 2C1b LOS: 2C1b

Wilkinson Company sells its single product for $30 per unit. The contribution margin
ratio is 45% and Wilkinson has fixed costs of $10,000 per month. If 3,000 units are sold
in the current month, Wilkinson’s income would be
a. $30,500.
b. $49,500.
c. $40,500.
d. $90,000.

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(6)201. CSO: 2C1a LOS: 2C1g
Ace Manufacturing plans to produce two products, Product C and Product F, during the next year,
with the following characteristics.

Product C Product F
Selling price per unit $10 $15
Variable cost per unit $8 $10
Expected sales (units) 20,000 5,000

Total projected fixed costs for the company are $30,000. Assume that the product mix would be the
same at the breakeven point as at the expected level of sales of both products. What is the projected
number of units (rounded) of Product C to be sold at the breakeven point?

a. 2,308 units.
b. 9,231 units.
c. 11,538 units.
d. 15,000 units.

(7)204. CSO: 2C1a LOS: 2C1g

MetalCraft produces three inexpensive socket wrench sets that are popular with do-it yourselfers.
Budgeted information for the upcoming year is as follows.

Total fixed costs for the socket wrench product line is $961,000. If the company’s actual experience
remains consistent with the estimated sales volume percentage distribution, and the firm desires to
generate total operating income of $161,200, how many Model No. 153 socket sets will MetalCraft
have to sell?

a. 26,000.
b. 54,300.
c. 155,000.
d. 181,000.

(8)208. CSO: 2C1a LOS: 2C1g

Zipper Company invested $300,000 in a new machine to produce cones for the textile industry.
Zipper’s variable costs are 30% of the selling price, and its fixed costs are $600,000. Zipper has an
effective income tax rate of 40%. The amount of sales required to earn an 8% after-tax return on its
investment would be

a. $891,429.
b. $914,286.
c. $2,080,000.
d. $2,133,333.

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(9)210. CSO: 2C1a LOS: 2C1b
Eagle Brand Inc. produces two products. Data regarding these products are presented
below.
Product X Product Y
Selling price per unit $100 $130
Variable costs per unit $80 $100
Raw materials used per unit 4 lbs. 10 lbs.

Eagle Brand has 1,000 lbs. of raw materials which can be used to produce Products X and
Y.
Which one of the alternatives below should Eagle Brand accept in order to maximize
contribution margin?
a. 100 units of product Y.
b. 250 units of product X.
c. 200 units of product X and 20 units of product Y.
d. 200 units of product X and 50 units of product Y.

(10)212. CSO: 2C1b LOS: 2C1f

Breeze Company has a contribution margin of $4,000 and fixed costs of $1,000. If the
total contribution margin increases by $1,000, operating profit would
a. decrease by $1,000.
b. increase by more than $1,000.
c. increase by $1,000.
d. remain unchanged.

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 Answers CMA Exam Retired Questions
1.209. B
2.211. B
3.200. C
4.203. D
5.213. A
6.201. B
7.204. B
8.208. B
9.210. B
10.212. C

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DECISION MAKING AND MARGINAL ANALYSIS
The typical problem for which marginal analysis can be used involves choices among courses of
action.

a. Quantitative analysis emphasizes the ways in which revenues and costs vary with the option
chosen. Thus, the focus is on incremental revenues and costs, not the totals of all revenues and
costs for the given option.

b. EXAMPLE: A firm produces a product for which it incurs the following unit costs:
Direct materials $2.00
Direct labor 3.00
Variable overhead .50
Fixed overhead .50
Total cost $6.00
1) The product normally sells for $10 per unit. An application of marginal analysis is necessary if a
foreign buyer, who has never before been a customer, offers to pay $5.60 per unit for a special
order of the firm’s product.
a) The immediate reaction might be to refuse the offer because the selling price is less than the
average cost of production.
2) However, marginal analysis results in a different decision. Assuming that the firm has idle
capacity, only the additional costs should be considered.
a) In this example, the only marginal costs are for direct materials, direct labor, and variable
overhead. No additional fixed overhead costs would be incurred.
b) Because marginal revenue (the $5.60 selling price) exceeds marginal costs ($2 materials + $3
labor + $.50 variable OH = $5.50 per unit), accepting the special order will be profitable.
3) If a competitor bids $5.80 per unit, the firm can still profitably accept the special order while
underbidding the competitor by setting a price below $5.80 per unit but above $5.50 per unit.
2. Caution always must be used in applying marginal analysis because of the many qualitative factors
involved.
a. Qualitative factors include
1) Special price concessions place the firm in violation of the price discrimination provisions of the
Robinson-Patman Act of 1936.
2) Government contract pricing regulations apply.
3) Sales to a special customer affect sales in the firm’s regular market.
4) Regular customers learn of a special price and demand equal terms.

Make-or-Buy Decisions (Insourcing vs. Outsourcing)

a. The firm should use available resources as efficiently as possible before outsourcing. Often, an
array of products can be produced efficiently if production capacity is available.
1) If not enough capacity is available to produce all products, those that are produced least
efficiently should be outsourced (or capacity should be expanded).
b. In a make-or-buy decision, the manager considers only the costs relevant to the investment
decision. If the total relevant costs of production are less than the cost to buy the item, it should be
insourced.
1) The key variable is total relevant costs, not all total costs.
2) Sunk costs are irrelevant. Hence, a production plant’s cost of repairs last year is irrelevant to this
year’s make-or-buy decision. The carrying amount of old equipment is another example.
3) Costs that do not differ between two alternatives should be ignored because they are not
relevant to the decision being made.
4) Opportunity costs must be considered when idle capacity is not available.

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They are of primary importance because they represent the forgone opportunities of the firm.
c. EXAMPLE: Should a company make or buy an item?
Make Buy
Total variable cost $10
Allocation of fixed cost 5
Total unit costs $15 $13
1) If the plant has excess capacity, the decision should be to produce the item. Total variable cost
($10) is less than the purchase price.
a) However, if the plant is running at capacity, the opportunity cost of displaced production becomes
a relevant cost that might alter the decision in favor of purchasing the item from a supplier.
2) The firm also should consider the qualitative aspects of the decision. For example, will product
quality be as high if a component is outsourced than if produced internally? Also, how reliable are the
suppliers?

Capacity Constraints and Product Mix

a. Marginal analysis also applies to decisions about which products and services to sell and in what
quantities given the known demand and resource limitations.
1) For example, if the firm can sell as much as it can produce and has a single resource constraint,
the decision rule is to maximize the contribution margin per unit of the constrained resource.
a) However, given multiple constraints, the decision is more difficult. In that case, sophisticated
techniques such as linear programming must be used.

Disinvestment decisions are the opposite of capital budgeting decisions, i.e., to terminate an
operation, product or product line, business segment, branch, or major customer rather than start
one.
a. In general, if the marginal cost of a project exceeds the marginal revenue, the firm should
disinvest.
b. Four steps should be taken in making a disinvestment decision:
1) Identify fixed costs that will be eliminated by the disinvestment decision, e.g., insurance on
equipment used.
2) Determine the revenue needed to justify continuing operations. In the short run, this amount
should at least equal the variable cost of production or continued service.
3) Establish the opportunity cost of funds that will be received upon disinvestment .
4) Determine whether the carrying amount of the assets is equal to their economic value. If not,
reevaluate the decision using current fair value rather than the carrying amount.
c. When a firm disinvests, excess capacity exists unless another project uses this capacity
immediately. The cost of idle capacity should be treated as a relevant cost.

Sell or Process Further Decisions

a. In determining whether to sell a product at the split-off point or process the item further at
additional cost, the joint cost of the product is irrelevant because it is a sunk cost.
b. The sell-or-process decision should be based on the relationship between the incremental costs
(the cost of additional processing) and the incremental revenues (the benefits received).

If the decision is between selling the product “as-is” or processing it further, presumably in order to
sell it for a higher price, the decision is based on the incremental operating income that is
attainable beyond the “as-is” point. This kind of situation may be encountered when dealing with
joint costs or obsolete inventory.

Joint Costs
A joint cost is the cost of a production process that yields more than one product. For example, the
processing of petroleum yields crude oil, gas and raw liquid propane gas. The further processing of the
crude oil may yield heating oil, lubricating oil and various petrochemicals. With joint costs, the place in
the production process where the various products become individually identifiable is called the
splitoff point. Costs incurred up to the splitoff point are joint costs. Costs incurred after the splitoff
point are separable costs.

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The products of a joint manufacturing process may have value at the splitoff point, and they may
also have greater value if processed further as separate products. The decision needs to be made as
to whether they will be sold at the splitoff point, or whether they will be processed further and then
sold.
When joint costs have already been incurred for a product, management making a decision to process
further or sell at the splitoff point should not even consider the joint costs or the portion of those joint
costs that have been allocated to the individual products. This is because these are sunk costs. The
only factors that are relevant are incremental revenues and costs. The increased revenues attainable
by processing further should be balanced against the increased costs to process further. The increase
in net operating income as a result of the additional processing is the only basis for the decision.

Pricing
Establishment of the selling price for their product is one of the most critical decisions that a company
will make. If the price is too high, the company runs the risk of not selling enough product and losing
money. If the price is too low, there is the risk that the company will not cover all of its costs and will
also lose money.

This decision is even more critical for start-up companies as they usually do not have a large cash
reserve to cover any mistakes in the short-term.
In general, the price of a product or service is dependent upon its demand and supply.

The three major influences on a price are the “three Cs”:

• Customers. Customers’ desire for the product and their willingness to pay for it constitutes demand.
When a product is in high demand, its supply becomes limited, and the price is driven up.
• Competitors. Prices charged by competitors for substitute products affect the demand for a
company’s product. If a competitor’s price is significantly below the market price, demand for the
output of a company in the same market will be decreased. The company may be forced to lower its
price to stay in business.
• Costs. Costs of production affect supply. The lower the cost, the higher the profit, and the more
product the company will be willing to supply. Relevant costs include the costs of all the value-chain
business functions. To review, these are: research and development; design of products, services or
processes; production; marketing; distribution; and customer service

How do short-run pricing decisions differ from long-run pricing decisions?

Short-run pricing decisions focus on a period of less than one year and have no long-run implications.
Long-run pricing decisions focus on a time horizon of one year or longer. The time horizon appropriate
to a decision on pricing dictates which costs are relevant, how costs are managed, and the profit that
needs to be earned.

Short-Run Pricing
Short-run pricing is opportunistic and more responsive to changes in demand than long-run
pricing.
In short-run pricing decisions, fixed costs are frequently irrelevant, because they cannot be changed in
the short term. The cost of a special order will be only the variable costs associated with its
production, since the fixed costs will not increase because of the special order.
Availability of production capacity plays an important part in short-term pricing, as well. If a company
has unused capacity, it will be more likely to price its products aggressively in order to make use of
that capacity than it would be if it were operating at 100% capacity. Another consideration in short-
run pricing is competitors and what they are bidding. If bidding on a one-time special order, the
company would want to bid a price that covers its incremental costs but is lower than competing bids.

Long-Run Pricing
To determine a long-run price that will be stable over time and also earn the desired long-run return,
a company must know its long-run costs, including all costs involved in the production and sale of the
product. This incorporates fixed costs and indirect manufacturing costs.
There are two approaches to setting long-run prices: (1) a market-based approach, or (2) a cost-
based approach, also called cost-plus. The market-based approach starts with the customer and
competitor, and then looks at costs. The cost-based approach looks first at costs and considers

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customers and competitors secondarily. Which strategy an individual company uses generally depends
on what type of market the company is operating in.

The Market-Based Approach

The market-based approach focuses on what the customers want and how competitors will react to
what the company does. Companies operating in competitive markets, such as oil and gas, use this
approach.
In a competitive market, one company’s products or services are very similar to another company’s,
so an individual company has no influence over the price to charge. Each company accepts the market
price.

Target pricing is an important form of market-based pricing. A target price is a price based on
knowledge of customer perception of the value of the product or service and what customers are
willing to pay, as well as knowledge of competitors’ responses.
Steps in establishing a target price and a target cost are:
1) The company develops a new product that meets the needs of potential customers.
2) The company estimates the price that potential customers will be willing to pay, based on
customers’ perceived value for the product, as well as projected sales at that price. Prices that
customers will be willing to pay and projected sales come from marketing department input, which
may be determined through market research or other marketing techniques.
Pricing would also be based on expected responses from competitors. This information could come
from competitors’ customers, suppliers and employees. Or it may be derived by means of reverse
engineering, which is the process of taking apart competitors’ products and analyzing them to
determine design, materials and technology used.
3) The target price then determines what the target cost per unit needs to be in order to earn the
target operating income per unit. The target cost per unit is the target price minus the target
operating income per unit.
Calculation of the target cost must include all future costs, both variable and fixed. But the target cost
is only that: a target to shoot for. The target cost may be lower than the company’s actual current
costs. The company must then find ways to reduce costs such as seeking cost concessions from
suppliers.
4) Value engineering is performed, which is an evaluation of all the business functions in the value
chain with the objective of reducing costs while satisfying customer needs. This may lead to design
improvements, materials specification changes or modifications in manufacturing methods.
In value engineering, management distinguishes between a value-added cost and a non-value-
added cost. If a value-added cost were eliminated, it would reduce the product’s value, or
usefulness, to customers. Since value-added costs cannot be eliminated, value engineering seeks to
reduce their costs by improving efficiency.
On the other hand, if a non-value-added cost were eliminated, it would not reduce the value or
utility of the product. A non-value-added cost is a cost the customer is not willing to pay for. Examples
of non-value-added costs are costs for expediting, re-work and repair; and these are costs that can be
reduced through improvements to the manufacturing process.
Locked-in costs must also be recognized in value engineering. For example, direct materials costs
per unit are locked in (or designed in) at an early stage in the development of a product, and they
are difficult to reduce later. Scrap and re-work costs may be locked in by a faulty design. For example,
in the software industry, costly and difficult-to-fix errors that appear during coding and testing are
already locked in by bad design at the beginning. The costs may not have been incurred yet, but they
will be. If the costs have not been locked in early, costs can be reduced right up to the time they are
incurred, and the costs may be reduced by improved operating efficiency and productivity measures.
However, when locked in costs are a factor, the key to reducing them is in the product design, and
value engineering must focus on making innovations and modifications at this early stage.

The Cost-Based Approach

The cost-based approach focuses on what it costs to manufacture the product and the price necessary
to both recoup the company’s investment and achieve a desired return on its investment. It is used in
a market where there is product differentiation, such as automobile manufacturing.
A company using this method calculates the cost of production and then adds a markup. This markup
is a percentage of the cost of production. The company may use whatever it wants as the cost of
production, but the most common costs to use are:

Prepared by: Sameh.Y.El-lithy. CMA,CIA. 18

1) Total cost,
2) Absorption manufacturing costs,
3) Variable manufacturing costs, or
4) Total Variable costs.

Government Contracts, the CASB, and Cost Plus Pricing

In 1970, the US Congress established the Cost Accounting Standards Board (CASB) to achieve
uniformity and consistency in cost accounting standards for contracts and subcontracts with the US
government. The CASB established standards regarding cost measurement, assignment and allocation
in contracts with the US government. The standards are applicable only to contracts greater than
$500,000.
This was a result of the fact that often the US had paid large amounts for simple products because of
contracts that were negotiated as cost plus, and the suppliers had been very liberal in their
interpretation of what was a cost.
Cost-Plus and Target Pricing Used Together
In a market where there is product differentiation, companies would be more likely to consider both
the market and the costs – giving equal emphasis to both strategies.
Sales prices set by cost-plus pricing are prospective prices only. In the above example, ABC’s price for
widgets was determined to be $825 per unit. However, ABC operates in a fairly competitive market,
and customer and competitor reactions to this price may require a price reduction to $780 per unit.
This will reduce the markup percentage to only 4%, unless costs are reduced. ABC will need to employ
the value engineering described under target pricing in order to reduce its costs if it expects to
produce the widgets at its required rate of return.
Target pricing used alone reduces the need to go back and forth between setting a cost-plus price,
then evaluating that price in light of customer preferences and competitor responses, then calculating
a target cost. Instead, target pricing begins with the customer preferences and competitor responses.
The market and the market price then motivate managers to reduce costs to achieve the target cost.
If they are not able to reduce costs sufficiently, the company must either redesign the product or
accept a smaller profit margin.

Life-Cycle Product Costing

The product life cycle is the time from the initial research and development on a product to the point
when the company no longer offers customer servicing and support for the product.
Life-cycle costing tracks and accumulates all the costs of each product all the way through the value
chain. Other terms for life-cycle costing are “cradle-to-grave costing” and “wombto-tomb costing.” A
product’s life cycle usually spans several years.
Life-cycle budgeted costs are used in pricing decisions because they incorporate costs that might not
otherwise be considered. If costs for research and development and other nonproduction costs such as
marketing, distribution and customer service are significant, it is essential to include them in the
product’s cost along with the direct manufacturing costs.
The price set is the price that will maximize life-cycle operating income. A company may decide to
bring the new product out at an exceptionally high or exceptionally low price and then adjust the price
later. A life-cycle budget will incorporate this strategy. Target pricing and target costing often utilize
life-cycle costing in order to develop life-cycle budgets for products that estimate costs and revenues
over the entire life of the product.

Other Considerations in Price Setting

Price discrimination is the practice of charging different prices for the same product to different
customers. An example of this is in the airline industry, where a carrier will charge a lower rate if
someone stays over a Saturday night. This usually separates business travelers (whose demand is
inelastic) from pleasure travelers (whose demand is elastic) and charges them different prices
depending on the elasticity of their demand.
Peak-load pricing involves charging a higher price for the same product or service at times when
demand is the greatest. This also reflects supply and demand, because prices charged when capacity
is most in demand will represent what competing customers are willing to pay.
When excess capacity is available, prices are lower. This pricing method is used in the
telecommunications, electric utility and travel industries.

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 Self Assessment Quiz

Prepared by: Sameh.Y.El-lithy. CMA,CIA. 20

211. CSO: 2C1b LOS: 2C1b
For the year just ended, Silverstone Company’s sales revenue was $450,000. Silverstone’s fixed costs
were $120,000 and its variable costs amounted to $270,000. For the current year sales are forecasted at
$500,000. If the fixed costs do not change, Silverstone’s profits this year will be

a. $60,000.
b. $80,000.
c. $110,000.
d. $200,000.

214. CSO: 2C1c LOS: 2C1i

Cervine Corporation makes motors for various products. Operating data and unit cost information for
its products are presented below

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Cervine has 40,000 productive machine hours available. What is the maximum total
contribution margin that Cervine can generate in the coming year?
a. $665,000.
b. $689,992.
c. $850,000.
d. $980,000.

226. CSO: 2C2a LOS: 2C2d

Refrigerator Company manufactures ice-makers for installation in refrigerators. The costs per unit, for
20,000 units of ice-makers, are as follows.

Cool Compartments Inc. has offered to sell 20,000 ice-makers to Refrigerator Company for $28 per
unit. If Refrigerator accepts Cool Compartments’ offer the plant would be idled and fixed overhead
amounting to $6 per unit could be eliminated. The total relevant costs associated with the manufacture
of ice-makers amount to
a. $480,000.
b. $560,000.
c. $600,000.
d. $680,000.

227. CSO: 2C2b LOS: 2C2f

Edwards Products has just developed a new product with a manufacturing cost of $30.
The Marketing Director has identified three marketing approaches for this new product.

Approach X Set a selling price of $36 and have the firm’s sales staff sell the product at a 10%
commission with no advertising program. Estimated annual sales would be 10,000 units.

Approach Y Set a selling price of $38, have the firm’s sales staff sell the product at a 10%
commission, and back them up with a $30,000 advertising program. Estimated annual sales would be
12,000 units.

Approach Z Rely on wholesalers to handle the product. Edwards would sell the new product to the
wholesalers at $32 per unit and incur no selling expenses. Estimated annual sales would be 14,000
units.

Rank the three alternatives in order of net profit, from highest net profit to lowest.
a. X, Y, Z.
b. Y, Z, X.
c. Z, X, Y.
d. Z, Y, X.

Prepared by: Sameh.Y.El-lithy. CMA,CIA. 22

Condensed monthly operating income data for Korbin, Inc., for May follows

Additional information regarding Korbin’s operations follows:

• One-fourth of each store’s direct fixed costs would continue if either store is closed.
• Korbin allocates common fixed costs to each store on the basis of sales dollars.
• Management estimates that closing the Suburban Store would result in a 10% decrease in the Urban
Store’s sales, while closing the Urban Store would not affect the Suburban Store’s sales.
• The operating results for May are representative of all months.

[1149] Gleim #: 9.1.5 -- Source: CMA 694 4-25

(Refers to Fact Pattern #123)
A decision by Korbin to close the Suburban Store would result in a monthly increase (decrease) in
Korbin’s operating income of
A. $(10,800)
B. $(6,000)
C. $(1,200)
D. $4,000

[1150] Gleim #: 9.1.6 -- Source: CMA 694 4-26

(Refers to Fact Pattern #123)
Korbin is considering a promotional campaign at the Suburban Store that would not affect the Urban
Store. Increasing annual promotional expense at the Suburban Store by $60,000 in order to increase
this store’s sales by 10% would result in a monthly increase (decrease) in Korbin’s operating income
during the year (rounded) of
A. $(5,000)
B. $(1,400)
C. $487
D. $7,000

Prepared by: Sameh.Y.El-lithy. CMA,CIA. 23

[1151] Gleim #: 9.1.7 -- Source: CMA 694 4-27
(Refers to Fact Pattern #123)
One-half of the Suburban Store’s dollar sales are from items sold at variable cost to attract customers
to the store. Korbin is considering the deletion of these items, a move that would reduce the Suburban
Store’s direct fixed expenses by 15% and result in a 20% loss of Suburban Store’s remaining sales
volume. This change would not affect the Urban Store. A decision by Korbin to eliminate the items
sold at cost would result in a monthly increase (decrease) in Korbin’s operating income of
A. $(5,200)
B. $(1,200)
C. $(7,200)
D. $2,000

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