Cost Analysis Overview

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Discuss the role of management accounting information in organisations’ pricing decisions. -------------------------------------------------

MBA Financial Management Practical Work Assignment
ID Numbers 11230
We hereby certify that the following piece of work complies with the Own Work Declaration form already issued and with the University’s Rules and Regulations relating to plagiarism and collusion, as listed in the Essential Information for Students and the MBA Course Handbook.

Overview

There are three major influences on organizations’ pricing decision: the customers’ preference through shaping the demand, the competitors’ actions through pricing or providing substitute goods and lastly the cost through affecting the supply (Horngren et al., 2003). Though the most important factor in setting the profit-maximizing sales price is the elasticity of demand in the market, cost of producing the goods or service determines whether or not a company wants to sell at the market price. Without an accurate allocation of costs to products/services, the company could not consistently make economically sound, fact-based decisions on pricing and then maximize its profitability.

There are a several ways in categorizing the cost of producing products or services. Based on the cost behavior, management accounting classifies cost into fixed and variable costs. In between there are semi-fixed and semi-variable costs. Due to direct relationship with the products’ volume, variable costs are easily allocated to the cost of a single unit. However, it is difficult to allocate the fixed cost to a single unit cost. Management accounting proposes a few cost allocation methods with different levels of sophistication and accuracy such as traditional costing system and activity based costing system. Each type of cost allocation results in different unit cost and thus in different pricing decision.

Pricing Decisions - CVP Analysis

In the long-run, the company must guarantee its revenues exceed its cost for survival. By providing the information of full cost of production as well as overhead costs, the management accounting system could help managers to know whether the sale prices are sufficient to cover all the cost and still provide the firm a reasonable rate of return. Depending on the level of the fixed cost as well as the products’ life span, the amount of excess in price to cost is different. Exhibit 1 illustrates the impact of those differences on three companies’ pricing strategies to achieve the same target profit.

As seen Exhibit 1, due to much higher fixed costs compared to company X, company Y would command a higher sale price to achieve the same target profit. For company Z, since it could sale more volume during its longer product life span, it could put lower sale price to achieve the same target profit as company X does. In practice, retail business has lower fixed costs and commands lower profit margin than automobile business that has higher fixed costs. Nevertheless, though airlines industry has high fixed cost, it still commands a relative low profit margin due to its long life span aircrafts.

When pricing the products/service using the marginal costing method as above, the managers also need to ensure the total unit sale could exceed the break-even point in a sale period to cover the full fixed cost. In case of company X, the break-even point would be

BEP = $100,000 / ($50 - $30) = 50,000 units.

Any increase in sale price results in a lower BEP but it may reduce the demand from...
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