The Role of Management Accounting in the Firm’s Pricing Decisions
This paper is an essay about the role of management accounting in the pricing decisions of firms. This is a research type of essay paper, which makes use of journals and textbooks to show the actual application of management accounting in the firm’s final pricing decisions. The first part is intended for the background on management accounting, to give the readers a bird’s eye view of the topic. Then a slow interconnection of the topic to pricing issues is made as it approaches the middle part of the paper. The existing relationship between the two topics is then illustrated through presentations for further and clearer evaluation of the situation to the reader. This is also a way of showing how management accounting can affect a firm’s pricing decisions. On the last part, the topic is summarized to end the discussion and to give a clear conclusion for the readers.
Management Accounting
While other branches of accounting is concerned with the considerations of accounting information of business enterprises for the use of external decision makers, managerial accounting is focused on the realm of enterprise-related accounting information for the use of a different set of decision makers – the enterprise’s management itself. Therefore, managerial accounting is the branch of accounting thought and practice concerned on providing useful information to decision-makers within the enterprise. These decisions are related to the development of resources and the exploitation of the opportunities available for the enterprise.
The boundaries of managerial accounting are not rigid. One thing that managerial accounting and financial accounting have in common is their focus on the enterprise and its activities. Their difference, on the other hand, lies on the decision interests of the class or the decision makers that they served. Additionally, most of the decision models that have evolved for management use and for which accountants supply the necessary information inputs have been developed within the disciplines of managerial economics and managerial finance. These models are described as part of the managerial accounting due to its vital role in supplying the relevant information for decision-making. Without it, it would be hard to understand the models of management decision.
Management decisions can be divided into two types. They are the long run and the short-run decisions. Long-run decisions are defined as decisions whose outcomes commit the enterprise or have direct influence on its numerous future-period activities. The long run is thought of as a span of time sufficiently long for the planning, implementation and running of the enterprise’s significant project or program. Short-run decisions, on the other hand, are decisions whose outcomes commit the enterprise or directly influence its actions for perhaps only a year at most. The latitude available in the selection of short-run alternatives is restricted considerably by the commitments made by the enterprise in past long-run decisions.
Given the objective of profit maximization in the long-run, the success of the enterprise (management) in the long-run hinges on the ability of the management in the identification and implementation of the most promising product lines, projects, and programs within its capabilities, as well as its environmental and money-capital limitations. The active seeking of opportunities is the first requisite to success. It is done to assist, either in providing new and better products/services, or in the development of new and better means of production. The former requires at least some minimal level of involvement, in the research of present markets and consumer/industrial preferences, plus on the research on product development. On the other hand, the latter requires at least some involvement with industrial engineering as well as organizational, institutional, and behavioral research. All of these are essentially information- seeking activities contributed by specialists other than accountants. The accountants’ contribution comes into play in the selection of the most promising set among the identified alternatives. This is another important requisite to the enterprise’s success in the long run.
One essential feature of the opportunities (alternatives) in the long run is that they usually require considerable initial outlays of the enterprise’s limited money capital for implementation. These initial outlays include expenditures for things like long-lived assets to be employed in the program, legal fees, and further developmental and organizational research costs. Additional outlays are required when relating to several future periods. This enables the production of benefits in the form of cash inflows or lower total outlays compared to the programs they replace. Since long run programs generally require outlays of scarce money capital, the process of the selection of the best set among the available alternatives (opportunities) is usually referred to as capital budgeting.
This is where the role of the managerial accountant enters. Upon the decision maker’s discretion, he may perform not only the information-gathering step in the decision process but parts of the problem definition and evaluation steps as well. He also acts as the translator of the resource flows connected with a product, project, or program into financial or money flow implications.
Cost Behavior Analysis: A Flexible Tool
The discovery and application of cost and revenue behavior patterns are relevant in producing information for all types of management decisions. As noted earlier, one important task of managerial accounting is the association of financial (money) flows with the resource flows that are expected from various decision alternatives. Costs measured in money terms are associated with these alternatives in order to evaluate them in the context of the enterprise’s long-run goal, which is profit maximization.
The basis of associating these costs with particular decision alternatives is usually cost behavior patterns derived by the cost behavior analysis. A cost behavior pattern is a functional relationship between various activities or events that represent a decision alternative and the expected cost to be incurred in connection with that alternative. Cost behavior analysis, on the other hand, is the process of the discernment and the description of the forms of these cost behavior patterns.
How are cost behavior patterns used in managerial decision making? First, the cost-behavior implications of various activities and events are used in constructing an overall cost-function for a decision alternative or variable. Then the cost function (usually together with a revenue function) is manipulated to generate decision-relevant information about the alternative or variable.
Since most of the managerial decision making focuses on the production and sales of products and services, the frequent concern of accountants is on the use of cost behavior patterns in supplying information for decisions on production and sales. This type of application is called the cost-volume-profit analysis or break-even analysis. This is frequently used in practice and is the most appropriate context in acquainting the reader with the application of cost behavior patterns.
The Translation of the Actual Production Plans into Budgets
There are many kinds of activities involved in the operations planning and the control phases of the overall cycle of short-run management decision. These two phases are best described involving a series of steps. Each of these steps is necessary in accomplishing the purpose of each phase. Accounting takes a significant part for both phases.
The major steps involve in the planning phase of the decision cycle for the short-run includes: the assignment of goals to responsibility centers; the development of plans for the operations of each center; the translation of these plans into budgets, the coordination and combining of the different budgets (making of the master budget); and the final review and possible re-planning of the master budget.
After the determination of the best feasible one among the available production plans presented, a financial representation of that plan is prepared. This is called the budget, which is the operating plan for a certain period, expressed in money terms. Accountants take the role of assistance in the formulation of budgets. This process consists of the combination of the individual unit resource requirements (based on a selected plan), with the assigned goal on the production activity. The process of budgeting relies heavily on the predictions of the cost behavior patterns.
The Master Budget
After the formulation of the budgets for all of the lowest-level responsibility centers, a process involving the combination of the said unit budgets into budgets for the higher-level responsibility centers follows. The lower-level centers are part of the higher-level ones. Then after that combination, they are put together finally to form a coordinated whole. That is what they call the master budget. It consists of a coordinated set of financial estimates for the budget period. This includes the balance sheet, income statement, and other statements deemed to be useful for the said budget.
The master budget differs from the budgets of high-level responsibility areas, it is not a “summing up” of the budgets of the lower-levels. Instead, it allows for the financial consequences of the various conflicting, major activities like production and sales.
The Final Review of the Master Budget and the Replanning
The master budget serves as a means for checking all of the individual plans. This is due to the fact that it is where the different plans for all of the activities of an enterprise is integrated, and expressed in financial terms. It does not pinpoint any potential production bottlenecks and other defects on the technical planning. However, it is useful in other ways. One case is on the careless seeking of the optimal plans for operation. The lack of rigor may not be discernible in their individual budgets due to this situation. Nevertheless, the result will turn out to be a less-than-satisfactory estimated income figure, after the combination of the budgets into the master budget.
On the other hand, certain adaptation forms are considered desirable in case the master budget turn out to be ineffective. It should only happen before the start of the operations. The exact adaptation form depends on the cause of the poor outcome. If the foreseeable cause lies either on the lack of rigorous planning on the part of the responsibility centers, or on the selection of overambitious goals by the management, a reiteration of the entire planning process is needed. For the first case, more attention must be dedicated for the selection process of the best (least-cost) plans for each subunit. While for the second case, goals that are more realistic must be assigned throughout.
On the other hand, if the cause of the frustration is beyond the management’s control in the short-run, the problem becomes a matter to be considered in the long run by the management. That is, if it is due to some identifiable internal or external constraint. Even though the initial operational plan is a failure, it is not necessarily abandoned, unless adaptation could lead to a better plan under the circumstances.
Pricing of Products and Services
Pricing involves a delicate act of balancing. The higher the prices are, the more revenue earned per unit sold. However, this will drive down the unit sales. One difficult problem here is the actual setting of prices in its exact amount in order to maximize profits. In general, however, the mark-up over cost for those products, whose customers are least sensitive to price, should be the highest. In particular, the demand for such products is termed as being price inelastic.
Managers often rely on cost-plus formulas in setting their target prices. In the approach of absorption costing, the cost base is the absorption costing unit product cost, while the mark-up is computed to cover both non-manufacturing costs as well as to provide an adequate investment return. However, costs will not be covered here and there will be no adequate return on investment unless the unit sales forecast used in the cost-plus formula is accurate. If through the application of the cost-plus formula resulted in a price that is too high, the unit sales forecast will be unattainable.
Some companies, however, make use of a different approach for pricing. Instead of starting with costs and determine the prices afterwards, they start first with the prices and then determine the allowable costs. Companies using the target costing approach used the new product’s anticipated features as well as the prices of the existing products in the market, as their basis to estimate the likeness of the new product’s market price. In order to arrive at the product’s target cost, they subtract the desired profit from the estimated market price. Thus, the responsibility of ensuring that the actual cost of the new product should not exceed the target cost is given to the team of design and development.
Conclusion
Managers have to make decisions, whether it be in the allocation of its limited resources, on pricing products, whether to drop a product line or not, or on the way of organizing its product and process. These decisions are based on information as its source. If the source (the information) turns out to be good, the decision will also turn out to be a better result. Nowadays, there is the emphasis of computer specialists on the “systems” nature of information and decisions. They argued that the way of the data development, summarization, and presentation determines the way a situation is viewed. In turn, it also determines the actions to be taken. Accounting reports, therefore, are the major source of performance information and the only source regarding the profitability information of a company. However, due to its service extended to external groups, it has not focused enough on its task of supporting managers in their full range decisions. Accuracy and validity in representing the companies’ activities are also compromised for uniformity and simplicity in its external reporting. This will further mislead the managers, resulting into the development of inappropriate strategies, which in turn, will also result into bad decisions.
A recent development solves this problem. This is the activity-based costing, which provides the management the opportunity to bring the overhead allocations into line, with the way the plant actually operates. The activities (which cause the costs) are identified in order for the products (which cause the activities) to pay for them. The activity-based costing is not considered as a radical or dramatic change. Instead, it is defined as a subtle, fine-tuning. It has the potential of improving the usefulness of accounting significantly, as a decision support system for the strategic move of the manager in rebuilding its competitiveness.
, editor of Management Accounting and director of NAA research, summarize the developments in activity-based costing. He also states that activity accounting is a technique for better understanding of costs. Therefore, every company should make improvements with the use of the activity-based costing concept. The estimation of the potential costs of running a business is difficult with the use of inaccurate information. Activity-Based Costing, therefore, is an offering of opportunity made by the accountants. Every company who wish to improve their accounting reports’ accuracy should take this in modeling their company.
References
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