Management Accounting - Pricing and profitability analysis, Capital investment decisions, Divisional performance

Topics Covered:
  - Pricing and profitability analysis
  - Capital investment decisions
  - Divisional performance
Note: These slides provide a brief recap and do not replace the lecture slides and seminar examples. For detailed study, refer to the following weeks:
  - Week 7 for Pricing decisions and profitability analysis
  - Weeks 8 and 9 for Capital investment decisions
  - Week 20 for Divisional Performance materials

General Application:
  - Accounting information is critical for pricing decisions, particularly in:
    - Organisations with customised or differentiated products
    - Market-leading companies with the discretion to set prices
Influence of Cost Information:
  - Pricing in these firms is influenced directly by:
    - The cost of the product
    - The actions of competitors
    - Customer perceived value
Price Takers vs. Price Setters:
  - Price Takers:
    - Firms with little influence over selling prices, reliant on market forces
  - Price Setters:
    - Firms with some discretion in price settings based on product characteristics

Context of Firms: Differences in roles according to pricing strategies:
- Price setters: Use cost information as a key input for pricing decisions
- Price takers: Require cost information to optimize product mix
Situational Classifications:
  - Price-setting firm:
    - Short run pricing decisions
    - Long run pricing decisions
  - Price-taking firm:
    - Short run product mix decisions
    - Long run product mix decisions

Cost-Plus Pricing:
  - Formula:
    - Price = cost per unit + chosen mark up
  - When using cost-plus pricing, the options available are:
    - Actual or standard cost
    - Marginal or full cost
    - Relevant cost
Target Costing:
  - Opposite of cost-plus pricing. Begins with the selling price; calculate target cost:
    - Formula:
    - $ext{Target Cost} = ext{Selling Price} - ext{Desired Profit Margin}$
  - Aim is to keep future costs below target cost.

Variables Influencing Pricing Decisions:
  - Pricing policies consider many variables, including:
    - Price-skimming policy
    - Penetration pricing policy

Stages of Product Life Cycle:
  - Introductory Stage: Influence pricing on future demand; a strategy to discourage market entry
  - Growth Stage: Sales expansion, dynamic pricing adjustments
  - Maturity Stage: Use of promotions to stimulate demand
  - Decline Stage: Replacement by superior products

Current Trends: Movement from product profitability to customer profitability analysis via activity-based costing.
Objective:
- Identify key customer classes for targeted pricing strategies
- Calculate customer attributable costs.

Example of Setting Selling Price:
Albany’s product cost analysis:
  - Direct Materials:
    - Material 1: £10 (4kg at £2.5/kg)
    - Material 2: £7 (1kg at £7/kg)
  - Direct Labour: £13 (2 hours at £6.50/hour)
  - Fixed Overheads: £7 (2 hours at £3.5/hour)
  - Total Cost Calculation:
    - $ext{Total Cost} = £10 + £7 + £13 + £7 = £37$
Calculation Requirement:
- Calculate prices using different bases and discuss advantages/disadvantages.

Marginal (Variable) Costs:
  - Formula:
    - $ext{Price} = ext{Variable Cost} imes (1 + 0.20) = 30 imes (1 + 0.20) = £36$
  - Advantages: Avoids arbitrary allocations, identifies short-term relevant costs
  - Disadvantages: Ignores price-demand relationships
Total Cost (Full Cost):
  - Formula:
    - $ext{Price} = ext{Total Cost} imes (1 + 0.20) = 37 imes (1 + 0.20) = £44.40$
  - Advantages: Reduces risk of fixed costs not being covered
  - Disadvantages: May involve arbitrary allocations, ignores price-demand relationship.

Overview: When an organization decides to invest in capital—such as equipment, buildings, or technology—it is usually making expenditures now (spending money now) that are anticipated to generate returns or advantages over a period in the future.
Key distinction:
- Short-term decisions: Usually within a 1-year horizon
- Capital investment decisions: Require a longer period to recoup costs.

Four Common Methods:
  - Net Present Value (NPV)
  - Internal Rate of Return (IRR)
  - Payback Period
  - Accounting Rate of Return (ARR)
Time Value of Money:
- NPV and IRR include the time value of money; ARR and Payback do not.

Definition: Present value of net cash inflows minus the initial investment outlay.
Positive NPV: Accept; Negative NPV: Reject; Zero NPV: Indifferent.

Investment Example:
A company is evaluating a project with an expected life of 3 years and an investment outlay of £1m. The opportunity cost of capital is 10%. The net cash inflows for Project A are as follows:
    - Year 1: £300,000
    - Year 2: £1,000,000
    - Year 3: £400,000
NPV Calculation:
- NPV = £300,000/1.10 + £1,000,000/1.10² + £400,000/1.10³ - £1,000,000 = £399,700
Present Value Calculation with Discounts:
  - Year 1: £272,730
  - Year 2: £826,400
  - Year 3: £300,520
  - Total NPV: £399,650

Project B Example:
  - Investment outlay £1m, cash inflows of £600,000 per year.
  - Use of Annuity Table:
  - Discount factor for 10% over 3 years = 2.487
  - $ext{PV} = 600,000 imes 2.487 = 1,492,200$
  - NPV:
    - $ext{NPV} = 1,492,200 - 1,000,000 = £492,200$

Definition:
- represents the true interest rate earned on an investment over the course of its economic life.
- sometimes referred to as the discounted rate of return.

Example:
- Project with net cash inflows as with previous examples to find IRR via trial and error.
Calculation Process:
- Test different discount rates and find where NPV switches from positive to negative.

Definition: Time required to recover initial cash outlay.
Cash Flow Information: Projects A and B to be evaluated based on cash flows provided.

Definition: Average profit divided by average investment, representing profitability.
Formula:
- $ext{ARR} = rac{ ext{Average Annual Profits}}{ ext{Average Investment}}$

Projects Evaluation: A, B, C profitability calculations based on provided profits and initial investments.

Overview: Divisionalization as a means for organizational effectiveness; potential misalignments in interests may occur.
Performance Measurement: Importance of financial and non-financial measures to ensure effective evaluation.