Transcript class-8-master-embedx

CMA Part 2
Financial Decision Making
SU 10.1 – Marginal Analysis
• Review the Gleim Success Tip on page 295
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SU 10.1 – Marginal Analysis
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Accounting Costs vs. Economic Costs
Accounting Costs = Explicit cost, or those that are actual outlays of cash
The total amount of money or goods expended in an endeavor. It is money paid
out at some time in the past and recorded in journal entries and ledgers.
The economic cost of a decision depends on both the cost of the alternative
chosen and the benefit that the best alternative would have provided if chosen.
Economic cost differs from accounting cost because it includes opportunity cost.
– As an example, consider the economic cost of attending college. The accounting cost of
attending college includes tuition, room and board, books, food, and other incidental
expenditures while there. The opportunity cost of college also includes the salary or wage that
otherwise could be earning during the period. So for the two to four years an individual
spends in school, the opportunity cost includes the money that one could have been making
at the best possible job. The economic cost of college is the accounting cost plus the
opportunity cost.
– Thus, if attending college has a direct cost of $20,000 dollars a year for four years, and the lost
wages from not working during that period equals $25,000 dollars a year, then the total
economic cost of going to college would be $180,000 dollars ($20,000 x 4 years +
the interest of $20,000 for 4 years + $25,000 x 4 years).
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SU 10.1 – Marginal Analysis
• Explicit vs. Implicit Costs
– An explicit cost is a direct payment made to others in the
course of running a business, such as wage, rent and
materials.
– Implicit cost, also called an imputed cost, implied cost, or
notional cost, is the opportunity cost equal to what a firm
must give up in order to use factors which it neither
purchases nor hires.
Continued
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SU 10.1 – Marginal Analysis
• Implicit Costs
– Entrepreneurs opportunity costs are the most
important implicit cost.
– What else could you have done with the money
invested?
– Therefore a normal profit is an important implicit cost,
which often has to be “imputed”.
– So again, economic cost are “total” cost.
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SU 10.1 – Marginal Analysis
• Accounting vs. Economic Profit
 See Tutorial at http://www.khanacademy.org/economics-finance-domain/microeconomics/firmeconomic-profit/economic-profit-tutorial/v/economic-profit-vs-accounting-profit
• Accounting Profit = book income exceeds book
expenses
• Economic Profit = includes Accounting Profit + Implicit
costs
– Significantly higher
– Also called “Pure Profit”
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SU 10.1 – Marginal Analysis
• Relevant vs. Irrelevant Factors
– Focus should only be on the relevant revenues and cost.
Relevant transactions are established by:
• Being in the future. Past cost are sunk cost and are not relevant (in
decision making).
• Differing among possible alternative courses of action. If events
(transactions) are the same for choices considered, they are not
relevant and should not be factored in.
• Committed costs are not part of the decision making process
Continued
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SU 10.1 – Marginal Analysis
• Relevant transactions
• Be avoidable. If something is unavoidable it should not be
considered in the decision making process. Avoidable costs
(controllable = subject to Management decision / strategy)
• Be incremental. Fixed cost must be added as a certain
output level is reached.
• Focus should be on total relevant revenues and cost.
Common fallacy is to focus on unit data which may include
irrelevant cost.
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SU 10.1 – Marginal Analysis
• Marginal, Differential, or Incremental Analysis
– “Choices among courses of actions”
– See example on page 297
– Each of the items will both occur in the future and
be different between the courses of action
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SU 10.1 – Decision Making:
Applying Marginal Analysis
• Marginal / Differential / Incremental Analysis
– Problem in CMA will be an evaluation of choices among courses
of action
– What are the relevant and irrelevant costs?
– Quantitative analysis = ways in which revenues and costs vary
with the option chosen
– Focus on incremental revenue & costs, not total revenue & cost
 In the example  idle capacity (incremental impact)
– Compare marginal revenue and marginal cost (contribution
margin)
– Fixed costs have already been “absorbed”
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SU 10.1 – Marginal Analysis
• Quantitative analysis emphasizes the “ways” in
which revenues and costs vary with option
chosen.
– A useful measurement is to measure each option’s
contribution margin per unit of constraint.
Continued
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SU 10.1 – Marginal Analysis
• Constraints
– Any measure of activity (i.e. labor hours, machine hours, beds
occupied, etc.)
– Focus should be on most contribution margin per unit of
constraint.
– Goal is to use as much of the constraint as nec. to fill demand
for product or service with the highest contribution margin per
unit of constraint.
– See example on page 298
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SU 10.1 – Marginal Analysis
• Qualitative factors must be considered in marginal analysis and
include:
– Price discrimination
– Government contract pricing regulations
– Cannibalization between products (stealing market share from
yourself)
– Sales to a special customer
– Disinvestment effects on other product lines
– Outsourced product quality
– Employee moral
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SU 10.1 – Decision Making:
Applying Marginal Analysis
• Add-or-drop-a-segment decisions
– Disinvestment / capital budgeting decisions
– Marginal cost > Marginal revenue = Firm should disinvest
• Four steps to be taken
1.
2.
3.
4.
Identify fixed costs that will be eliminated if disinvesting
Determine the revenue needed to justify continuing operations
Establish the opportunity cost of funds that will be received
Determine whether the carrying amount of the asset = economic value. If
not revalue use market fair value and not carrying amount. Cost of idle
capacity is relevant cost.
• Special Orders when excess capacity
– No opportunity costs
– Accept order = Variable costs (Contribution Margin)
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SU 10.1 – Decision Making: Applying Marginal
Analysis
Practice Question 1
The cost incurred by Gleason for the market study is a(n)
A
Incremental cost.
B
Prime cost.
C
Opportunity cost.
D
Sunk cost.
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SU 10.1 – Decision Making: Applying Marginal
Analysis
Practice Question 1 Answer
Correct Answer: D
A sunk cost is a previously incurred cost that is the result of a past irrevocable
management decision. Nothing can be done in the future about sunk costs.
The market study cost is an example.
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SU 10.1 – Decision Making: Applying Marginal
Analysis
Practice Question 2
Assuming that Gleason elects to produce the frozen dessert, the profit
that would have been earned on the breakfast rolls is a(n)
A
Deferrable cost.
B
Sunk cost.
C
Avoidable cost.
D
Opportunity cost.
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SU 10.1 – Decision Making: Applying Marginal
Analysis
Practice Question 2 Answer
Correct Answer: D
An opportunity cost is the maximum return that could have been earned on
the next best alternative use of a resource. In this case, the lost profit on the
rolls is an opportunity cost.
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SU 10.1 – Decision Making: Applying Marginal
Analysis
Practice Question 3
If Hermo decides to supply power to Quigley, it wants to be compensated for the
decrease in the life of the plant and the appropriate variable costs. Hermo has
decided that the charge for the decreased life should be based on the original cost of
the plant calculated on a straight-line basis. The minimum annual amount that
Hermo would charge Quigley would be
A
$450,000
B
$630,000
C
$990,000
D
Some amount other than those given.
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SU 10.1 – Decision Making: Applying Marginal
Analysis
Practice Question 3 Answer
Correct Answer: B
The minimum charge would include any variable costs incurred plus
depreciation on a straight-line basis. Currently, variable costs are $360,000 at
60% of capacity ($1,800,000 × 20%). If Quigley purchases energy equal to an
additional 30% of capacity, it can be assumed that the increase in total
variable costs will be half of the variable costs for 60% of capacity, or
$180,000. Also, allocating $21,000,000 over 14 years results in an annual
depreciation of $1,500,000. Of this amount, 30% will relate to the capacity
sold. Thus, the depreciation charge to Quigley is $450,000 ($1,500,000 ×
30%). The total charge is $630,000 ($450,000 depreciation + $180,000 VC).
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SU 10.2 – Decision Making:
Special Orders
• Submitting Bids for the Lowest Selling price
– Bids should be at prices that meet or exceed
incremental cost
– Consideration must be given to quantitative vs.
qualitative factors
• Whether available capacity exists affects whether fixed costs
will be included in the lowest price
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SU 10.2 – Decision Making:
Special Orders
• Special Orders when excess capacity exists
– No opportunity cost is involved, because fixed cost are
already committed (fixed cost are irrelevant).
– Differential (marginal or incremental) cost must be
considered. If price meets or exceeds variable cost
the order should be considered)
See example on page 299
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SU 10.2 – Decision Making:
Special Orders
• Special Orders when no excess capacity exists
– Differential (marginal or incremental) cost must be
considered.
• Current production will be affected
Example on page
– Revenue, variable cost, and fixed cost of “displaced
production” are relevant.
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SU 10.2 – Decision Making: Special Orders
Practice Question 1
Production of a special order will increase gross profit when the
additional revenue from the special order is greater than
A
The direct materials and labor costs in producing the order.
B
The fixed costs incurred in producing the order.
C
The indirect costs of producing the order.
D
The marginal cost of producing the order.
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SU 10.2 – Decision Making: Special Orders
Practice Question 1 Answer
Correct Answer: D
Gross profit will increase if the incremental or marginal cost of producing the
order is less than the marginal revenue. Marginal cost equals the relevant
variable costs assuming fixed costs are not affected by the special order.
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SU 10.2 – Decision Making: Special Orders
Practice Question 2
When considering a special order that will enable a company to make use
of currently idle capacity, which of the following costs is irrelevant?
A
Materials.
B
Depreciation.
C
Direct labor.
D
Variable overhead.
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SU 10.2 – Decision Making: Special Orders
Practice Question 2 Answer
Correct Answer: B
Because depreciation will be expensed whether or not the company accepts
the special order, it is irrelevant to the decision. Only the variable costs are
relevant.
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SU 10.2 – Decision Making: Special Orders
Practice Question 3
Which of the following cost allocation methods is used to determine the
lowest price that can be quoted for a special order that will use idle
capacity within a production area?
A
Job order.
B
Process.
C
Variable.
D
Standard.
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SU 10.2 – Decision Making: Special Orders
Practice Question 3 Answer
Correct Answer: C
If idle capacity exists, the lowest feasible price for a special order is one
covering the variable cost. Variable costing considers fixed cost to be a period
cost, not a product cost. Fixed costs are not relevant to short-term inventory
costing with idle capacity because the fixed costs will be incurred whether or
not any production occurs. Any additional revenue in excess of the variable
costs will decrease losses or increase profits.
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SU 10.3 – Decision Making: Make or Buy
• Make or Buy = insourcing or outsourcing (critical mass)
– Not enough capacity outsource least efficient product
– Support services can be outsourced
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SU 10.3 – Decision Making: Make or Buy
• Firms focus should be on using its resources in the most efficient
and effective manner.
– In some cases if relevant production cost are less than outsourcing, should be
made in-house.
– Managers should consider only the relevant investment decision costs.
Consequently, some cost should be ignored:
• Sunk cost
• Costs not different between two alternatives
• Opportunity costs when idle capacity is available (but should be considered when capacity is
not available)
– Qualitative considerations should be given to quality of the outsourced
products and the reliability of the suppliers.
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SU 10.3 – Decision Making: Make or Buy
• When capacity exists fixed cost are considered irrelevant in
decision making process
– See example on page 301
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SU 10.3 – Decision Making: Make or Buy
• When capacity does not exist the differential (marginal or
incremental) costs must be considered.
– Revenue, variable and fixed costs are relevant in decision making process
– See example on page 301
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SU 10.3 – Decision Making: Make or Buy
• Capacity constraint
– Use marginal analysis
– Maximize CM
– Product mix
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SU 10.3 – Decision Making: Make or Buy
Practice Question 1
A company’s approach to an insourcing vs. outsourcing decision
A
Depends on whether the company is operating at or below normal
volume.
B
Involves an analysis of avoidable costs.
C
Should use absorption (full) costing.
D
Should use activity-based costing.
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SU 10.3 – Decision Making: Make or Buy
Practice Question 1 Answer
Correct Answer: B
Available resources should be used as efficiently as possible before
outsourcing. If the total relevant costs of production are less than the cost to
buy the item, it should be produced in-house. The relevant costs are those
that can be avoided.
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SU 10.3 – Decision Making: Make or Buy
Practice Question 2
In a make-versus-buy decision, the relevant costs include variable
manufacturing costs as well as
A
Factory management costs.
B
General office costs.
C
Avoidable fixed costs.
D
Depreciation costs.
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SU 10.3 – Decision Making: Make or Buy
Practice Question 2 Answer
Correct Answer: C
The relevant costs in a make-versus-buy decision are those that differ
between the two decision choices. These costs include any variable costs plus
any avoidable fixed costs. Avoidable fixed costs will not be incurred if the
“buy” decision is selected.
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SU 10.4 – Decision Making:
Other Situations
• Sell-or-Process-Further Decisions
– Determine whether to sell product at the split-off
point or process further
– Decision is based on difference between
incremental cost and incremental revenue
– Joint costs are irrelevant because they are sunk
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SU 10.4 – Decision Making:
Other Situations
• At split of point, then joint products acquire
different identities and costs thereafter are
separable.
– Joint cost - up to the split-off point
• Must be allocated since they can’t be traced
• Allocation methods include physical-measure-based
approach and market-based approach
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SU 10.4 – Decision Making:
Other Situations
• Physical-measure-based approach employs measures
such as volume, weight or linear measure.
• Market-based approaches include:
– Sales-value at split-off method
– Estimated net realizable value (NRV)
– Constant-gross-margin percentage NRV
– See examples on pages 302 - 304
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SU 10.4 – Decision Making:
Other Situations
• Add-or-Drop-a-Segment Decision
– Disinvestment decisions are opposite of capital
investment decisions
• Marginal cost of a project exceeds the marginal
revenue = disinvest
Continued
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SU 10.4 – Decision Making:
Other Situations
• Add-or-Drop-a-Segment Decision
– Four steps decision process
• Identify fixed cost that will be eliminated
• Determine revenue needed to justify continuing operations
(at least cover VC)
• Establish opportunity cost of funds
• Determine whether the carrying amount of assets is equal to
economic life. Also consider compare using fair value to
economic life.
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SU 10.4 – Decision Making:
Other Situations
• Add-or-Drop-a-Segment Decision
– When a company disinvest, excess capacity might
be available. Idle capacity is a relevant cost.
– See example on page 305
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SU 10.4 – Decision Making:
Other Situations
• Capacity Constraints and Product Mix
– Maximize the contribution margin per unit of the
constrained resource.
– Can be difficult with multiple constraints and requires
linear programing to solve.
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SU 10.4 – Decision Making: Other Situations
Practice Question 1
When a multiproduct plant operates at full capacity, quite often decisions must
be made as to which products to emphasize. These decisions are frequently
made with a short-run focus. In making such decisions, managers should select
products with the highest
A
Sales price per unit.
B
Individual unit contribution margin.
C
Sales volume potential.
D
Contribution margin per unit of the constraining resource.
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SU 10.4 – Decision Making: Other Situations
Practice Question 1 Answer
Correct Answer: D
In the short run, many costs are fixed. Hence, contribution margin (revenues
– all variable costs) becomes the best measure of profitability. Moreover,
certain resources are also fixed. Accordingly, when deciding which products to
produce at full capacity, the criterion should be the contribution margin per
unit of the most constrained resource. This approach maximizes total
contribution margin.
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SU 10.4 – Decision Making: Other Situations
Practice Question 2
In joint-product costing and analysis, which one of the following costs is relevant
when deciding the point at which a product should be sold to maximize profits?
A
Separable costs after the split-off point.
B
Joint costs to the split-off point.
C
Sales salaries for the period when the units were produced.
D
Purchase costs of the materials required for the joint products.
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SU 10.4 – Decision Making: Other Situations
Practice Question 2 Answer
Correct Answer: A
Joint products are created from processing a common input. Joint costs are
incurred prior to the split-off point and cannot be identified with a particular
joint product. As a result, joint costs are irrelevant to the timing of sale.
However, separable costs incurred after the split-off point are relevant
because, if incremental revenues exceed the separable costs, products should
be processed further, not sold at the split-off point.
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SU 10.5 – Price Elasticity of Demand
• Changes in “Quantity Demanded” (movement on
the curve)
– Demand is a schedule of the amounts of a good or
service that consumers are willing to purchase at various
prices during a period of time. It is a downward slope
(left to right).
– Price and quantity demanded are inversely related.
• See graph on page 306
– As prices fall, consumer buying power increases.
– Understand the substitution effect.
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SU 10.5 – Price Elasticity of Demand
• Changes in Demand (movement of the curve)
– Changes in one of the determinants of demand
results in a change in demand
– Greater population will result in greater demand
– See graph on page 306
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SU 10.5 – Price Elasticity of Demand
• Demand increases when price goes down in theory
• Price of product and quantity demanded are inversely
related
• Price Elasticity of Demand = Sensitivity
% change in Q
% change in P
• Elasticity describes the reaction to a change in price
from one level to another
• Because elasticity is always measured with a positive,
absolute value is used in the formula
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SU 10.5 – Price Elasticity of Demand
• Price elasticity of demand
Percent change in quantity demanded
Percent change in price
• Most accurate way to calculate elasticity = ARC
method
%ΔQ
%ΔP
=
[(Q1 – Q2) / (Q1+Q2) ]
[(P1 – P2) / (P1+P2)]
 See example on page 307
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SU 10.5 – Price Elasticity of Demand
• Elasticity > 1 relatively elastic
– Small change in price = large change in quantity
• Elasticity = 1 unitary elastic
– Single-unit change in price = single-unit change in quantity
• Elasticity < 1 perfectly inelastic
– Large change in price = small change in quantity
• Infinite perfectly elastic
– Horizontal line
– Firm has no influence on market price
– Pure competition
• Elasticity = 0 perfectly inelastic
– Vertical line
– Consumer will pay
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SU 10.5 – Price Elasticity of Demand
Practice Question 1
If the coefficient of elasticity is zero, then the consumer demand
for the product is said to be
A
Perfectly inelastic.
B
Perfectly elastic.
C
Unit inelastic.
D
Unit elastic.
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SU 10.5 – Price Elasticity of Demand
Practice Question 1 Answer
Correct Answer: A
When the coefficient of elasticity (percentage change in demand/change in
price) is less than one, demand is inelastic. When the coefficient is zero, the
demand is perfectly inelastic.
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SU 10.5 – Short-Run Profit Maximization
• Elasticity of demand measures how responsive a
products demand is to changes in its price level.
– When we have inelastic demand, a consumer will pay
almost any price for the good.
– Elastic demand therefore means that demand for the
product will vary when its price changes. Generally goods
which have elastic demand tend to have many substitutes,
so if the price of one good increases too much I will
substitute out towards a similar good which is cheaper.
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SU 10.5 – Short-Run Profit Maximization
• Calculating Price elasticity of demand
– Price elasticity of demand is calculated as the percentage change in quantity demanded
divided by the percentage change in price.
– There are a number of factors that can determine the price elasticity of demand for a
good or service.
– For example, the demand for luxury items tend to be more elastic than the demand for
necessities. For items that are essential, you tend to be less responsive to changes in
price. An example of this would be the demand for diamonds tends to be more price
elastic than the demand for electricity.
– Price elasticity of demand is also affected how large a percentage of your total income
an item is. We tend to be more elastic in regards to price changes for items that make up
a larger percentage of our incomes. For example, if the price of a pack of gum goes up
by 10%, I probably wouldn't even notice. On the other hand, if the price of a car I'm
considering purchasing goes up by 10%, I would definitely notice and I would probably
reconsider the purchase.
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SU 10.5 – Short-Run Profit Maximization
• A third factor that influences the price elasticity of demand is the time
frame allowed for response. We tend to be more responsive to changes in
price in the long run than in the short run. For example, if the price of gas
were to go up overnight to $10/gallon I would still have to put gas in my
car tomorrow morning because I have to go to work and I have to go to
school. But if the price of gas were to stay at $10/gallon for a year, then I
have more options. I could move closer to work, start carpooling, or trade
in my car for a hybrid with better gas mileage so that I don't have to buy as
much gas. So in the long run, demand tends to be more elastic than in the
short run.
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SU 10.5 – Short-Run Profit Maximization
Price Elasticity Example
Antoinette has a beauty salon. She services 100
customers per day. Her usual fee is $50. She wants to
expand her business. If she lowers her price (gives
everyone a coupon for $10 off), she expects to get an
extra 10 customers per day. Calculate the price
elasticity of demand. Did she make the correct
decision?
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SU 10.5 – Short-Run Profit Maximization
Price Elasticity Example Answer
A)
Percentage change in quantity demanded = 10% (100 customers increased to 110 customers)
B)
Percentage change in price = -20% ($50 reduced to $40)
A/B = 10%/-20% = -0.5
The price elasticity of demand for this service is -0.5, and a price elasticity of demand less than 1
means that a good is inelastic, meaning that quantity demanded is relatively unresponsive to a
change in price.
So you could argue that she made the wrong decision, as the price decrease did not greatly affect
demand. She might have been better choosing another strategy, such as better advertising or her
services.
You could also argue that she is reducing the price by 20% in return for a 10% increase in volume.
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SU 10.5 – Short-Run Profit Maximization
Price Elasticity Defined
A product with elasticity of 1.2 has elastic demand. What this means is that
for every 1% rise in the price, demand will fall by 1.2% (similarly, a 1% fall in
the price will lead to a 1.2% rise in demand).
The rule is:
Elasticity > 1 : elastic (% change in demand is greater than % change in price e.g. luxury
goods such as cars etc.)
Elasticity < 1 : inelastic (% change in demand is less than % change in price e.g. essential
goods such as food)
Elasticity = 1 : unitary elastic (% change in demand is equal to the % change in price)
Basically a firm producing an inelastic good can increase revenue by raising the price, as the
fall in demand is more than offset by the increased revenue on the remaining demand.
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SU 10.5 – Short-Run Profit Maximization
Price Elasticity Defined
• Infinite or perfectly elastic - If it were “perfectly” elastic,
demand would be infinite at all prices less than $3. A perfectly
elastic demand graph is a vertical line. And, when the price is
at $3, you can not tell from the graph what the demand is
since the line is vertical. The demand could be at any value.
• Perfectly price inelastic - means that the quantity demanded
will not change when price changes. Vertical demand curve
• Also, perfectly price elastic means if price changes, quantity
demanded changes totally, Horizontal Demand Curve
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SU 10.6 – Pricing Theory
• Pricing Objectives: profit maximization / target margin / forecasted
volume / image (segmentation – positioning) / stabilization
• Price-setting factors
– Supply & Demand = Economic (external factors)
•
•
•
•
Type of market
Customer perceptions
Elasticity
Competition
– Internal Factors
•
•
•
•
Marketing & Mix
Relevant cost
Strategy
Capacity
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SU 10.6 – Pricing Theory
• External Factors
– Type of market (pure competition, monopolistic,
oligopolistic or monopoly)
– Customer perceptions of price and value
– Price / demand relationship
– Competitors’ products, costs, prices and amount
supplied.
• Timing of demand
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SU 10.6 – Pricing Theory
• Cartels
– Illegal practice except in international markets
– Collusive oligopoly
– Restrict output & charge higher $$
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SU 10.6 – Pricing Theory
• Cost-based pricing differs from target pricing
– Four basic formulas
– Target pricing
– Life cycle costing
•
•
•
•
Market-based pricing - what the consumer will pay
Competition-based pricing - going rate & sealed bids
New product pricing - skimming & penetration pricing
Pricing by intermediaries - markups & downs
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SU 10.6 – Pricing Theory
• Price adjustments
–
–
–
–
–
–
–
Geographical pricing
Discounts & Allowances
Discriminatory pricing
Psychological pricing
Promotional pricing
Value Pricing
International pricing
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SU 10.6 – Pricing Theory
• Product-mix pricing
–
–
–
–
–
Product line
Optional product
Captive product
By-product
Product bundle
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SU 10.6 – Pricing Theory
• Illegal pricing
–
–
–
–
Pricing products below cost
Price discrimination among customers
Collusive pricing
Dumping
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SU 10.6 – Pricing Theory Practice Question 1
Several surveys point out that most managers use full product costs,
including unit fixed costs and unit variable costs, in developing cost-based
pricing. Which one of the following is associated with cost-based pricing?
A
Price stability.
B
Price justification.
C
Target pricing.
D
Fixed-cost recovery.
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SU 10.6 – Pricing Theory Practice Question 1 Answer
Correct Answer: C
A target price is the expected market price of a product, given the company’s
knowledge of its customers and competitors. Hence, under target pricing, the
sales price is known before the product is developed. Subtracting the unit
target profit margin determines the long-term unit target cost. If cost-cutting
measures do not permit the product to be made at or below the target cost,
it will be abandoned.
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SU 10.6 – Pricing Theory Practice Question 2
If a U.S. manufacturer’s price in the U.S. market is below an appropriate
measure of costs and the seller has a reasonable prospect of recovering the
resulting loss in the future through higher prices or a greater market share,
the seller has engaged in
A
Collusive pricing.
B
Dumping.
C
Predatory pricing.
D
Price discrimination.
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SU 10.6 – Pricing Theory Practice Question 2 Answer
Correct Answer: C
Predatory pricing is intentionally pricing below cost to eliminate competition
and reduce supply. Federal statutes and many state laws prohibit the practice.
The U.S. Supreme Court has held that pricing is predatory when two
conditions are met: (1) The seller’s price is below “an appropriate measure of
its costs,” and (2) it has a reasonable prospect of recovering the resulting loss
through higher prices or greater market share.
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SU 10.6 – Pricing Theory Practice Question 3
Which one of the following will occur in an organization that gives managers
throughout the organization maximum freedom to make decisions?
A
Individual managers regarding the managers of other segments as they do
external parties.
B
Two divisions of the organization having competing models that aim for the
same market segments.
C
Delays in securing approval for the introduction of new products.
D
Greater knowledge of the marketplace and improved service to customers.
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SU 10.6 – Pricing Theory Practice Question 3 Answer
Correct Answer: C
Decentralization is beneficial because it creates greater responsiveness to the
needs of local customers, suppliers, and employees. Managers at lower levels
are more knowledgeable about local markets and the needs of customers,
etc. A decentralized organization is also more likely to respond flexibly and
quickly to changing conditions, for example, by expediting the introduction of
new products. Furthermore, greater authority enhances managerial morale
and development. Disadvantages of decentralization include duplication of
effort and lack of goal congruence.
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SU 10.6 – Pricing Theory Practice Question 4
A proposed transfer price may be based upon the outlay cost. Outlay cost
plus opportunity cost is the
A
Retail price.
B
Price representing the cash outflows of the supplying division plus the
contribution to the supplying division from an outside sale.
C
Price usually set by an absorption-costing calculation.
D
Price set by charging for variable costs plus a lump sum or an additional
markup, but less than full markup.
77
SU 10.6 – Pricing Theory Practice Question 4 Answer
Correct Answer: B
At this price, the supplying division is indifferent as to whether it sells
internally or externally. Outlay cost plus opportunity cost therefore represents
a minimum acceptable price for a seller. However, no transfer price formula is
appropriate in all circumstances.
78
SU 10.6 – Practice Question 1
Finn Products, a start-up company, wants to use cost-based pricing for its only
product, a unique new video game. Finn expects to sell 10,000 units in the
upcoming year. Variable costs will be $65 per unit and annual fixed operating costs
(including depreciation) amount to $80,000. Finn’s balance sheet is as follows: If
Finn wants to earn a 20% return on equity, at what price should it sell the new
product?
A
$75.00
B
$78.60
C
$79.00
D
$81.00
79
SU 10.6 – Practice Question 1 Answer
Correct Answer: C
The net income Finn will require is calculated as follows:
Return on equity
Net income
=
=
=
=
Net income ÷ Equity
Equity × Return on equity
$300,000 × 20%
$60,000
The necessary selling price can then be derived:
Net income
=
[(Selling price – Variable costs) × Units sold] – Fixed costs
Selling price
=
(Net income + Fixed costs + Variable costs) ÷ Units sold
=
($60,000 + $80,000 + $650,000) ÷ 10,000
=
=
$790,000 ÷ 10,000
$79 per unit
80
SU 10.6 – Practice Question 2
Leader Industries is planning to introduce a new product, DMA. It is expected that
10,000 units of DMA will be sold. The full product cost per unit is $300. Invested
capital for this product amounts to $20 million. Leader’s target rate of return on
investment is 20%. The markup percentage for this product, based on operating
income as a percentage of full product cost, will be
A
42.9%
B
57.1%
C
133.3%
D
233.3%
81
SU 10.6 – Practice Question 2 Answer
Correct Answer: C
Leader’s required return is $4,000,000 ($20,000,000 invested capital × 20%).
Full product costs amount to $3,000,000 (10,000 units × $300). The markup
percentage on DMA is therefore 133.3% ($4,000,000 ÷ $3,000,000).
82
SU 9.3 – CVP Analysis – Basic Calculations
Question 3
A manufacturer contemplates a change in technology that would reduce
fixed costs from $800,000 to $700,000. However, the ratio of variable costs
to sales will increase from 68% to 80%. What will happen to breakeven level
of revenues?
A
B
C
D
Decrease by $301,470.50.
Decrease by $500,000.
Decrease by $1,812,500.
Increase by $1,000,000.
83
SU 9.3 – CVP Analysis – Basic Calculations
Question 3 Answer
Correct Answer: D
The original breakeven level was:
Breakeven point
= Fixed costs ÷ Contribution margin ratio
= $800,000 ÷ (1.0 – .68)
= $2,500,000
The new level is:
Breakeven point
= Fixed costs ÷ Contribution margin ratio
= $700,000 ÷ (1.0 – .80)
= $3,500,000
Thus, there is an increase of $1,000,000 ($3,500,000 – $2,500,000).
84
SU 9.4 – CVP Analysis – Target Income
Calculations
• Target Operating Income
Fixed costs + Target operating income
UCM
• Target Net Income
Fixed costs + Target net income / (1.0 – tax rate)
UCM
85
Computing Sales (Dollars) for a
Target Net Income
To convert target net income to before-tax
income, use the following formula:
Before-tax income =
Target net income
1 - tax rate
86
SU 9.4 – CVP Analysis – Target Income
Calculations Question 1
The data below pertain to the forecasts of XYZ Company for the upcoming year.
Total Cost
Unit Cost
$1,000,000
$25
Raw materials
160,000
4
Direct labor
280,000
7
80,000
2
Sales (40,000 units)
Factory overhead:
Variable
Fixed
Selling and general expenses:
360,000
Variable
120,000
Fixed
225,000
3
Continued
87
SU 9.4 – CVP Analysis – Target Income
Calculations Question 1
How many units does XYZ Company need to produce and
sell to make a before-tax profit of 10% of sales?
A.
65,000 units.
B.
36,562 units.
C.
90,000 units.
D.
25,000 units.
88
SU 9.4 – CVP Analysis – Target Income
Calculations Question 1 Answer
Correct Answer: C
Revenue minus variable and fixed expenses equals net income.
If X equals unit sales, revenue equals $25X, total variable expenses
equal $16X ($4 + $7 + $2 + $3), total fixed expenses equal $585,000
($360,000 + $225,000), and net income equals 10% of revenue. Hence, X
equals 90,000 units.
$25X - $16X -$585,000
=
$25X × 10%
6.5X
=
$585,000
X
=
90,000 units
89
SU 9.4 – CVP Analysis – Target Income
Calculations Question 2
The data below pertain to the forecasts of XYZ Company for the upcoming year.
Total Cost
Unit Cost
$1,000,000
$25
Raw materials
160,000
4
Direct labor
280,000
7
80,000
2
Sales (40,000 units)
Factory overhead:
Variable
Fixed
Selling and general expenses:
360,000
Variable
120,000
Fixed
225,000
3
Continued
90
SU 9.4 – CVP Analysis – Target Income
Calculations Question 2
Assuming that XYZ Company sells 80,000 units, what is the
maximum that can be paid for an advertising campaign while still
breaking even?
A.
$135,000
B.
$1,015,000
C.
$535,000
D.
$695,000
91
SU 9.4 – CVP Analysis – Target Income
Calculations Question 2 Answer
Correct Answer: A
The company will break even when net income equals zero. Net income is equal to
revenue minus variable expenses and fixed expenses, including advertising. Thus, if X
equals advertising cost, the equation is
80,000)($25) – (80,000)($16) – $585,000 – X
=
0
$2,000,000 – $1,280,000 – $585,000 – X
=
0
X
=
$135,000
92
SU 9.4 – CVP Analysis – Target Income
Calculations Question 3
For one of its divisions, Buona Fortuna Company has fixed costs of $300,000
and a variable-cost percentage equal to 60% of its $10 per unit selling price. It
would like to earn a pre-tax income of $90,000 per year from the division.
How many units will Buona Fortuna have to sell to earn a pre-tax income of
$90,000 per year?
A
65,000 units.
B
75,000 units.
C
77,250 units.
D
97,500 units.
93
SU 9.4 – CVP Analysis – Target Income
Calculations Question 3 Answer
Correct Answer: D
Buona Fortuna’s unit contribution margin is $4 ($10 unit price – $6 unit variable cost).
By treating desired profit as an additional fixed cost, the target unit sales can be
calculated as follows:
Target unit sales = (Fixed costs + Target operating income) ÷ UCM
= ($300,000 + $90,000) ÷ $4
= 97,500
94
Computing a Multiproduct
Break-Even Point
• The CVP formulas can be modified for use when a company sells
more than one product.
• The unit contribution margin is replaced with the contribution
margin for a composite unit.
• A composite unit is composed of specific numbers of each product
in proportion to the product sales mix.
• Sales mix is the ratio of the volumes of the various products.
95
SU 9.5 – CVP Analysis – Multi-Product
Calculations
• Multiple Products (or Services)
– S = FC + VC = Calculated Weighted Average Contribution
Margin
96
SU 9.5 – CVP Analysis – Multi-Product
Calculations
• Choice of Product decisions – When resources are
limited companies have to choose which products to
produce
• A breakeven analysis of the point where the same
operating income or loss will result
97
SU 9.5 – CVP Analysis – Multi-Product
Calculations
• Special Orders (usually lower price than std.)
– The assumption are that idle capacity is sufficient to
manufacture extra units of a special order.
98
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 1
Moorehead Manufacturing Company produces two products for which the data
presented to the right have been tabulated. Fixed manufacturing cost is applied
at a rate of $1.00 per machine hour. The sales manager has had a $160,000
increase in the budget allotment for advertising and wants to apply the money
to the most profitable product. The products are not substitutes for one
another in the eyes of the company’s customers.
Per Unit
XY-7
BD-4
Selling price
$4.00
$3.00
Variable manufacturing cost
2.00
1.50
Fixed manufacturing cost
.75
.20
Variable selling cost
1.00
1.00
Continued
99
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 1
Suppose Moorehead has only 100,000 machine hours that can be made
available to produce additional units of XY-7 and BD-4. If the potential increase
in sales units for either product resulting from advertising is far in excess of this
production capacity, which product should be advertised and what is the
estimated increase in contribution margin earned?
A
Product XY-7 should be produced, yielding a contribution margin of $75,000.
B
Product XY-7 should be produced, yielding a contribution margin of $133,333.
C
Product BD-4 should be produced, yielding a contribution margin of $187,500.
D
Product BD-4 should be produced, yielding a contribution margin of $250,000.
100
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 1 Answer
Correct Answer: D
The machine hours are a scarce resource that must be allocated to the product(s) in a
proportion that maximizes the total CM. Given that potential additional sales of either product
are in excess of production capacity, only the product with the greater CM per unit of scarce
resource should be produced. XY-7 requires .75 hours; BD-4 requires .2 hours of machine time
(given fixed manufacturing cost applied at $1 per machine hour of $.75 for XY-7 and $.20 for BD4). XY-7 has a CM of $1.33 per machine hour ($1 UCM ÷ .75 hours), and BD-4 has a CM of
$2.50 per machine hour ($.50 ÷ .2 hours). Thus, only BD-4 should be produced, yielding a CM
of $250,000 (100,000 × $2.50). The key to the analysis is CM per unit of scarce resource.
Incorrect Answers:
A: Product XY-7 actually has a CM of $133,333, which is lower than the $250,000 CM for product BD-4.
B: Product BD-4 has a higher CM at $250,000.
C: Product BD-4 has a CM of $250,000.
101
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 2
Product A accounts for 75% of a company’s total sales revenue and has
a variable cost equal to 60% of its selling price. Product B accounts for
25% of total sales revenue and has a variable cost equal to 85% of its
selling price. What is the breakeven point given fixed costs of
$150,000?
A
$375,000
B
$444,444
C
$500,000
D
$545,455
102
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 2 Answer
Correct Answer: B
Using the relationship: sales = total variable costs + total fixed costs, the combined breakeven
point can be calculated as follows:
S
S
=
=
0.75S(0.60) + 0.25S(0.85) + $150,000
0.45S + 0.2125S + $150,000
S – 0.6625S
=
$150,000
0.3375S
S
=
=
$150,000
$444,444
Incorrect Answers:
A: This amount is based on the contribution margin of Product A only rather than a weighted average.
C: This amount is based on half of the required sales at B’s contribution margin.
D: This amount is based on an unweighted average of the two contribution margins.
103
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 3
Von Stutgatt International’s breakeven point is 8,000 racing bicycles and
12,000 5-speed bicycles. If the selling price and variable costs are $570 and
$200 for a racer, and $180 and $90 for a 5-speed respectively, what is the
weighted-average contribution margin?
A
$100
B
$145
C
$179
D
$202
104
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 3 Answer
Correct Answer: D
Contribution margin equals selling price minus variable costs.
The product contribution margins are:
= $370
Racer:
$570 – $200
= $90
5-Speed:
$180 – $90
The sales mix is:
Racer:
8,000 ÷ (8,000 + 12,000) = 40%
5-Speed:
12,000 ÷ (8,000 + 12,000) = 60%
Multiply the CM by the sales mix for each product, and add the results.
Weighted-average CM = ($370 × 40%) + ($90 × 60%)
= $148 + $54
= $202
105
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 3 Answer
Incorrect Answers:
A: The sales mix dictates how much of the total CM will come from sales of each
product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the
UCM for racers must be added to 60% of the UCM for 5-speeds to get the weightedaverage CM.
B: The sales mix dictates how much of the total CM will come from sales of each
product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the
UCM for racers must be added to 60% of the UCM for 5-speeds to get the weightedaverage CM.
C: The sales mix dictates how much of the total CM will come from sales of each
product. Unit sales are attributable 40% to racers and 60% to 5-speeds, so 40% of the
UCM for racers must be added to 60% of the UCM for 5-speeds to get the weightedaverage CM.
106
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 4
Catfur Company has fixed costs of $300,000. It produces two products, X and Y.
Product X has a variable cost percentage equal to 60% of its $10 per unit selling price.
Product Y has a variable cost percentage equal to 70% of its $30 selling price. For the
past several years, sales of Product X have averaged 66% of the sales of Product Y.
That ratio is not expected to change. What is Catfur’s breakeven point in dollars?
A
$300,000
B
$750,000
C
$857,142
D
$942,857
107
SU 9.5 – CVP Analysis – Multi-Product
Calculations Question 4 Answer
Correct Answer: D
A helpful approach in a multiproduct situation is to make calculations based on the
composite unit, i.e., 2 units of Product X and 3 units of Product Y (a 66% ratio). The
selling price of this composite unit is $110 [(2 × $10) + (3 × $30)]. The UCM of the
composite unit is $35 {[2 × ($10 – $6)] + [3 × ($30 – $21)]}. Consequently, the
breakeven point in composite units is 8,571.43 ($300,000 FC ÷ $35 UCM), and the
breakeven point in sales dollars is $942,857 (8,571.43 × $110).
Incorrect Answers:
A: This amount equals the fixed costs.
B: This amount assumes a 40% contribution margin ratio.
C: This amount assumes a 35% contribution margin ratio.
108
CMA Part 2
Financial Decision Making
Essays
•
•
•
•
This section provides a great opportunity to earn partial credit
Be sure to show your work and assumptions
Expect 3-6 questions for each essay scenario
You can scroll between questions and scenarios within the
essay section of the exam
• Helps to determine how much time you will need for
responses
Essay Exam Strategies
•
•
•
•
•
•
•
•
Pay close attention to verbs
E.g., if it says compare or contrast, don’t define something
Read the entire question to understand all requirements
You may have more than one requirement, for example:
“Define abc and interpret its applicability to xyz.”
Grammar and writing skills
Focus is on use of standard English, organization and clarity
Graders are looking for effective writing skills
Essay Exam Strategies
•
•
•
•
Be brief and to the point
It’s ok to use bullet points
Do not leave a questions blank
If short on time, at least write an outline of your main
points
• Graders are looking to give you points, not take them away
• Make it as easy as possible for graders to give you points!
Essay Exam Information
• Type your responses into a text box
• Similar to MS Word, but with more simple
functionality
• Effective January 2013, the spreadsheet tool is
no longer being used on the CMA exam
• Be sure to use all of the time available to you
IMA Essay Webinar Highlights
• Here are highlights from webinar.
– Roughly 75% of points come from multiple choice, essay only accounts for
25% of points.
– There are two essay questions for each section of the CMA exam. Each
question will have 3-6 parts that must be answered.
– Be sure you skim all essay parts before begin answering. This will help you
survey how much time to spend on each question from the beginning. Some
will be easy, just asking for a definition. Some will require calculations. Show
all your work. Even if your answer is wrong, showing your work will give you
partial credit.
– Be sure to answer the question correctly. If the question asks you to compare
or contrast something, don't define it. That is not what they are looking for.
IMA Essay Webinar Highlights
• They don't deduct for wrong answers. Once you get the maximum
points for this part, the grader moves on. You don't get more points
for embellishing.
• Don't embellish. Be direct. Be simple. Use bullet points. Show your
work, including calculations. Use proper grammar and English. Then
move on to the next question.
• Practice answering essays online. This will get you used to how to
type calculations and make bullet points.
• Use ALL the time you have on your essay questions, even if you pull
time from your multiple choice section.
• The more you study, the better you will do. It is as simple as that.