There are different decisions that managers need to make as part of business management. For example, on whether to close a factory, whether to outsource or make their own components, determining on what price charge for goods and services or what price to charge for special orders.
Management accountants would be gathering information and collecting data for such decisions. The nature of the decision making has following characteristics:
Forward looking. Being concerned with what WILL happen rather then what HAS happened.
One-off decisions. We deal with problems that are unique.
Data availability. Some data may be specially obtained.
Net cash flow. Managers need to know what impact of the costs of the decision will have on the cashflow and future cash flow.
Relevant costs. Costs and revenues that are nor related to the project are excluded from the analysis (fixed costs are normally ignored)
Opportunity costs. These are the benefits that would be forgone or lost by taking the decision.
Probability testing. Because majority of the decisions are about the future and speculative it is beneficial to conduct some probability testing and it involves calculating the expected value of the particular project or proposal.
Example of probability testing
Source: Dyson J, 2010, "Accounting for non-accounting students", Pearsons Education UK
Types of costs
When making decisions on projects the direct and indirect costs may not be relevant. We need to focus on the fixed and variable costs. Fixed costs are those that are likely to remain unchanged, and variable costs move proportionate to the activity.
Relevant costs are those that are likely to be affected by a particular decision. Non-relevant costs are those which are not likely to be affected by a particular decision ( such as fixed costs).
Avoidable costs are those that may be saved by not taking a particular decision. Non-avoidable costs will still be incurred if the decision was taken.
Sunk costs are those that already have been incurred as a result of previous decisions and can be excluded from the decision making analysis.
Committed costs arise from decision that has already been taken although the event has not yet take place. If we commit, for example to increase capacity we will increase capacity expenditure. Then the costs become sunk costs when the decision take place.
Opportunity cost is the measure of the benefit that would be lost if one decision was taken over another.
Types of decisions
Shutdown decisions
From time to time managers may need to take 'closure' decisions, for example, closing store, factory or department. It happens when a segment or product becomes unprofitable. A product may not be profitable but make contributions towards the fixed costs of the company, however, shutdown of one product may affect sale of other products. These decisions often require staff to be made redundant.
Make or buy decisions
These decisions require management to determine whether to manufacture internally or purchase externally. These decisions are known as 'outsourcing'. The principle is that the business should be doing what they are doing best and employ others to do other activities. Business should concentrate on their main business objectives. Sometimes outsourcing may seem cheaper, but not always. It may not be possible to obtain exactly what we want or delays in receiving goods from suppliers. These issues could hold the company's own production and prove more expensive.
For example a company may make their own product with the following cost:
Direct Material - £5
Direct labour - £4
Variable overhead - £3
Total variable cost - £12
Fixed costs - £8000 per month
1000 components needed per month
What would be the best decision if a supplier offered to manufacture for £18?
First we would need to calculate the cost of manufacturing of the component internally. The variable cost of each unit is given, but some fixed costs need to be taken into account. The fixed costs monthly activity may vary.
The manufacturing cost of 1000 units would be:
Total variable cost ( 1000 X £12) £12,000
Associated fixed costs £8,000
Total cost £20,000
Total unit cost £20
This indicates that for 1000 units it would be cheaper to make the item internally. However, if the quantities were higher, it would be cheaper to make them internally. To make the cost the same of £18, the company would need to make 1334 units. However, because only 1000 units is needed it is cheaper to outsource the items externally.
We need to ensure that the data is reliable, the product supplied meet our expectations, the supplier is reliable, potentially needing another supplier in case of emergency, how stable would the price of £18 be and how easy it would be to be able to switch to internal manufacture.
Pricing decisions
These are very important decisions to make for managers. There are external prices and transfer prices.
External pricing are based on either market price or on cost. Market based pricing are set in highly competitive markets. Businesses have to base their selling price on what is being charged in the market. Tight controls must be ,therefore, be exercised over costs, otherwise there will be no returns and profits.
Sometimes prices have effect on the numbers of units sold and it depends on the frequency of purchase.
Cost based pricing
Below variable costs - would be used when entity tries to establish a new product on the market or an attempt is being made to drive out the competitors, or even as a 'loss leader' encourage other goods to be bought. Price at this level could only be sustained for a short time period.
At variable costs - it may be used to launch new product, to drive out competition, in different market conditions or as a 'loss leader'. This price could be held for sometime but ultimately some contribution would need to cover the fixed costs.
At total production costs - it will include the unit direct costs and share of the production overheads. Price at this level could be held for sometime, maybe when demand is low, but eventually the business would need to cover its non-production overheads to make a profit.
At total cost - this will include the units direct costs and share of the production and non-production overheads. Such prices could be held for a very long time, perhaps during recession, but eventually some profit would need to be earned.
At cost plus - it would be either the total production cost or the total cost. The 'plus' element would be the addition to the cost to allow non-production overhead and profit and for profit alone. These are options for profit making entity.
Transfer pricing
In large organisations it is quite common for one segment to trade with another segment. What is the 'revenue' for one segment, it is the 'expenditure' to another. It does matter what charges are placed and invoiced between different segments. This is because some segments are given a great degree of autonomy. For example a segment A fixes its transfer price based on 'cost plus' basis - £10 per unit. But segment B can purchase it elsewhere at £8 per unit, but it might not be beneficial to the entity as a whole for segment B to source externally. There are various transfer pricing that can be adopted:
- Market price. Price similar to the price offered externally.
- Adjusted market price. Market prices are reduced to encourage segments to trade with each other.
- Total cost or total cost plus. Transfer price based on total cost will incur the direct costs plus share of the production overheads and non-production overheads. Total cost plus method allows for some profit and these may encourage suboptimisation.
- At variable cost or variable cost plus. The variable cost does not encourage segments to trade but incentive percentage may provide incentive for contribution to fixed costs. These may be very attractive to the 'receiving' segments.
- At negotiated price. it involves a bargain between the segments based on combination of the market price and cost and this method could be highly successful.
- Opportunity cost - it comprises two elements, first standard variable cost in the supplying segment and second, the entities opportunity cost resulting from the transaction.
Special orders decisions
For special orders a potential client would be expected to pay lower price then standard and receive some favourable treatment. It would depend on the capacity but and the minimum price would generally equal the extra cost of accepting the order. The extra costs may be variable costs and prices would be very competitive. It would allow to maintain the surplus capacity. Generally the higher the price, the higher the risk that customer would reject the quotation.
Conclusion
An important role of management accountant is to support management decisions. The information may provide much historical data, but we need to deal with future so often these are speculations. Therefore, there needs to be a suitable level of skill and judgment when collecting the information. These need to be accurate and relevant.
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