Pricing and Decision Support (Decision Making & Pricing)
Pricing and Decision-Making Support (Decision Making & Pricing)
Decision-making accounting: A practical introduction to management accounting and Differential Analysis for making critical financial decisions such as strategic pricing, product mix, and Make vs. Buy—Digital Salla.
- What is Differential Analysis and how to use it to compare alternatives?
- Identifying Relevant Costs vs. Irrelevant Costs.
- The trap of Sunk Costs and why most managers fall into it.
- The Concept of Opportunity Cost: The price of the road not taken.
- Strategic applications: Special Orders, Make vs. Buy, and Product Elimination.
- Pricing strategies: Cost-Plus Pricing vs. Target Costing.
1) The Concept of Decision-Making Accounting
Decision-Making Accounting is a branch of management accounting that focuses on providing the incremental data needed to choose between two or more courses of action. It relies on Differential Analysis, which only examines the elements that change between alternatives.
2) Relevant vs. Irrelevant Costs
For a cost to be Relevant to a decision, it must meet two criteria: (1) It must be a Future cost. (2) It must Differ between the alternatives.
3) Sunk Costs: The Psychological Trap
A Sunk Cost is a cost that has already been incurred and cannot be changed by any current or future decision.
- Example: $50,000 spent on a failed R&D project last year.
- Decision Logic: If spending another $10,000 will finish a project worth $15,000, you should do it. The $50,000 is irrelevant.
4) Opportunity Cost: The Invisible Factor
An Opportunity Cost is the benefit foregone when choosing one alternative over another. It is not recorded in the accounting books, but it is vital for the decision report.
- Example: If you use your warehouse for a new project, the opportunity cost is the rent you could have earned by leasing it to someone else.
5) Case Study: Accepting a Special Order
A customer offers to buy 1,000 units at $15 (Normal price is $25). Should you accept?
Financial Statements Template - Editable Word File
| Element | Value | Decision Rule |
|---|---|---|
| Incremental Revenue | +$15,000 | (1,000 units x $15) |
| Variable Manufacturing Cost | ($10,000) | (1,000 units x $10) |
| Additional Labeling Cost | ($1,000) | Specific to this order |
| Net Incremental Profit | +$4,000 | Accept (If idle capacity exists) |
6) Case Study: Make vs. Buy (Outsourcing)
Should you manufacture a component in-house for $20 or buy it for $18?
- Accounting Trap: The $20 “Make” cost includes $5 of allocated factory rent.
- Analysis: The Avoidable cost of making is only $15.
- Result: Making for $15 is better than buying for $18, even though the total unit cost looks higher in the books.
7) Strategic Pricing Models
Pricing is the most powerful lever for profit. FP&A supports this through two main models:
7.1 Cost-Plus Pricing
Cost + Desired Markup = Price.
Best for unique services or specialized contracts.
7.2 Target Costing (Market-In)
Market Price − Desired Profit = Target Cost.
Best for competitive consumer markets. If your cost is higher than the target, you must re-engineer the product.
8) Operational Controls & Readiness Checklist
To ensure your decision support is accurate:
Decision Quality Gate Checklist
- Are we using Contribution Margin logic instead of Gross Profit?
- Have all Sunk Costs been identified and removed from the model?
- Is the Opportunity Cost of using existing assets quantified?
- Have qualitative factors (Brand image, Quality control, Dependence on suppliers) been listed?
- Does the model include Sensitivity Analysis (What if sales are 10% lower)?
9) Common Errors and How to Prevent Them
- Focusing on Unitized Fixed Costs: Treating a share of the factory rent as a cost that will “Disappear” if a product is dropped.
- Ignoring the Long Term: Accepting a special low-price order today that might cannibalize your high-price market tomorrow.
- Over-reliance on Outsourcing: Choosing to “Buy” based on price alone but losing control over the supply chain and lead times.
- Ignoring Capacity Constraints: Making decisions based on unlimited resources.
10) Frequently Asked Questions
What are Relevant Costs?
Relevant costs are future costs that differ between alternatives. Examples include incremental materials, direct labor, and avoidable overhead.
Why should Sunk Costs be ignored?
Because they have already been spent. No future decision can change them, so they should not influence our choice between current options.
What is Target Costing?
It is a strategic pricing method that starts with the market price and subtracts the desired profit to determine the maximum cost allowed for production.
11) Conclusion
Mastering Decision-Making Accounting moves you from the back office to the Boardroom. By utilizing Differential Analysis, identifying Relevant Costs, and understanding Strategic Pricing, you provide management with the clarity to navigate complex choices with confidence. This role transforms you from a “Recorder of History” into a “Designer of the Future,” ensuring that every decision protects and enhances the entity’s profitability.
Action Step Now (30 minutes)
- Identify one underperforming product or service in your portfolio.
- Perform a Segment Margin analysis: Total Revenue − Avoidable Costs.
- If the margin is still negative, draft a “Product Elimination” vs. “Process Improvement” decision memo.