Accounting for Business Decision Making
Evaluate Paul Pecos’ decision rule
Pecos Printers, Inc., just like other companies, must earn profit to stay in the game, afford inflation and keep its business operating. As founder and CEO of the Company, Mr. Paul Pecos wanted to earn and maximize its profit.
Pecos Printers, Inc. made a bold but good move in introducing new product in the market. PP7500 is a competitive product which may equal or exceed the competitors’. To strengthen the move, Pecos did right in strategizing market penetration by considering offering lower price to distributors.
Peco’s controller, Mr. Ledger, made an analysis of $295 unit cost composing of $245 variable cost and $50 fixed cost. It was mentioned that estimated total fixed cost for the year would amount to $475,000 with 15,000 projected production and 20,000 maximum production capacity.
Mr. Pecos-based PP7500’s selling price on Mr. Leger’s cost analysis. With the figures presented, he believed that to earn target income, the Company would need to sell the unit for $300 and up. However, there are certain points the Mr. Ledger failed to consider in analyzing the cost-volume-profit relationship.
The following are certain points Mr. Ledger was not able to consider:
475,000 fixed cost
At a level of up to 20,000 units produced, total fixed cost would not change.
In Mr. Ledger’s computation, estimated fixed cost is at $50 a unit. He based the computation at 9,500 ($475,000 divided by $50) production.
Fixed cost can be computed as follows:
Assuming that $475,000 fixed cost is spread out evenly during the year, fixed cost can be computed at $39,583.33 monthly or 31.6666 per unit*.
475,000 / 15,000** units = 31.6666 fixed cost per unit assumption: total 15,000 units to be produced during the year
Sale of a unit to at least $300
As a result of the over estimation of fixed cost per unit, the approved selling price by Mr. Pecos is higher. Unit cost is lower than previous estimation:
Mr. Ledger’s Computation
Total Cost per Unit
The Company could have accepted orders below $300, increase its sales volume and still generate profit. At a lower selling price, distributors would be enticed to purchase more units.
Evaluate Paul Pecos’ reaction to Ms. Goodperson’s sale
The move of Mr. Pecos to immediately terminate his Office Assistant Manager had been really drastic and de-motivating for other employees. Ms. Goodperson may even have a valid reason why she committed the transaction with the new distributor. He could have reevaluated cost-profit planning considering the number of units he could have sold.
With the previous cost analysis, the Company could have benefited with Ms. Goodperson’s move. And considering the large volume of Distributor’s order, it could have earned bigger profit. Below is the opportunity cost or lost benefit for not accepting potential sale:
300 and up sales price
290 sales price contracted by Ms. Goodperson
245 per unit)
Income sales orders the Company accepted
The Company could have earned an additional $31,500.00 income if Mr. Pecos accepted the committed sale made by his Office Assistant Manager.
Prepare a contribution margin income statement for the month
Based on Mr. Peco’s Decision
245 per unit)
Computed as follows:
Accepted Orders by Sam Smooth talk
Accepted Orders by Harry Hustler
Accepted Orders by Garry Giftofgab
Total Selling Price
Computed as follows of units
Recommended orders to accept:
Total amount of accepted order
Total Selling Price
Assumption that $475,000 fixed cost is spread out evenly during the year, thus, fixed cost per month is at $39,583.33.
Take note that the fixed cost amount did not changed for the month. This is because fixed cost do not change as volume changes. It will be incurred in spite of how many number of units will be produced at a certain level.
The second column (recommended portion) accepted sales order for those above 276.66 cost per unit. In the second column, total units sold increased from 925 units to 1,925 units.
Other recommendations to improve operations
The usefulness of cost-volume-profit analysis as a planning and deciding tool depends on Management’s estimates about future conditions. Manager’s attitude toward risk-return relationship influences decision of Company’s planned and target cost and income.
With this note, I would suggest serious reevaluation of Mr. Ledger’s analysis. Management’s assumption may make or break the Company’s success in budgeting its cost and maximizing profit. With previous illustration, we have shown how critical cost estimates can be in management’s analysis and decision. It can result to lost opportunity of earning higher income or higher sales volume.
Additional suggestion is for the Company to evaluate its capacity to provide commissions or incentives to its sales team or employee. It maybe a great motivation or drive for the employees to perform at their best capacity.
Another suggestion is to cascade a uniform sales price to the distributors. The distributors might compare its buying price with another distributor and those with higher price may demand adjustment to lower price. This could cause dispute or even loss of possible customers.
Support Computation for Requirement 3
Fixed Cost for the year
Variable Cost of units
Contribution Margin (following Mr. Pecos’ requirement – Sales price must be $300 and up) of units
SP per Unit
Variable Cost (925 units x $245)
Contribution Margin (Writer’s Recommendation to accept orders with SP $280 and up) of units
Variable Cost (1,925 units x $245)
Louderback, J.G. III, Holmen, J.S., Dominiak, G.F. (2000). Managerial Accounting,
Profit Planning (pp.29-58). South-Western College Publishing
Cost/Benefit Analysis: Evaluating Quantitatively Whether to Follow a Course of Action. (2007).
Retrieved August 14, 2007, at http://www.mindtools.com/pages/article/newTED_08.htm
Pajala, R.E. (1993). A Simple Profit Planning and Cost Management System for Small Sawmills.
Retrieved August 14, 2007, at http://www.extension.umn.edu/distribution/naturalresources/DD6075.html
Profit Planning (2004). Retrieved August 14, 2007, at http://www.frsconsultants.net/profit-planning.php
Cost Behavior. (2005). Retrieved August 14, 2007 from http://www.plu.edu/~mgtacctg/cost_behavior.htm
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