ACCA - P5 Study text - Emile Woolf INT

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Chapter 11: Economic, fiscal and environmental factors

possibly below marginal cost) in order to attract customers into the store, where

they will also buy other items as well as the low-priced items.

4.7 Going rate pricing

Many firms charge a price that is the ‘going rate’ in the market. This is a pricing

policy for ‘price followers’. Companies must often accept the going market price

when they produce a fairly standard product (or service) and they are not in a

particularly strong competitive position.

4.8 Target pricing

Target pricing has been described in an earlier chapter, in relation to target costing.

When a company develops a new product, it might decide during the design stage

of development what the price needs to be.

The decision about price may be based on a study of the existing market and prices

for similar products. A target price is the price that a company thinks it will have to

charge for a new product in order to be competitive in the market.

Having established a target price, the company can then establish a target cost. This

is the maximum amount that the new product must cost to make and sell, so that

the return on investment from the new product will be sufficient to justify its

development.

The designers of the product are then required to design the product so that it costs

no more than the target cost, and it can be sold for an appropriate return at the

target price.

Target costing is explained in more detail in a later chapter.

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Selling price decisions: MR = MC

 Strategy and sales price

 Establishing a formula for marginal revenue: MR

 The profit-maximising sales price

 Pricing decisions and sensitivity analysis

5 Selling price decisions: MR = MC

5.1 Strategy and sales prices

For established products, decisions about setting the sales price are usually made on

the basis of:

 adjusting the current price to allow for increases in costs or weakening sales

demand, or

 adjusting the price in response to price changes by competitors, or

 making competitive adjustments to the sales price.

A different situation arises when a sales price is decided for an entirely new product

or service, or for any other item where there is no direct competitor. When there is

no direct competitor for a product or service, it should be possible to decide on a

price to maximise profit, without any concern about how competitors will respond.

An examination question may therefore ask you to identify what the selling price

for an item should be if the company’s objective is to maximise profits. Typically,

there will be an estimate of the sales demand at different sales prices: the higher the

selling price, the lower the expected sales demand will be. It may be possible, form

information in the exam question, to establish a relationship between selling price

and sales demand in a mathematical formula.

Given further information about the variable cost of the item, the profit-maximising

sales quantity and price can be calculated using differentiation. This will be at the

price and quantity where the marginal revenue per extra unit sold (MR) equals the

marginal cost of sale (MC).

5.2 Establishing a formula for marginal revenue: MR

When a company is in a monopoly situation, it can set any selling price that it

wants, but sales demand will vary according to the price that is chosen. If there is a

linear relationship between estimated sales demand and sales price, you will be told

that for every $X increase or reduction in the sales price, the expected sales demand

will fall or rise by Y units.

Chapter 11: Economic, fiscal and environmental factors

For example, you may be told that a company is trying to decide the price for a new

and unique product, for which there is no competitor product. It has been estimated

that:

 at a price of $12 per unit, the expected annual sales demand would be 300,000

units

 however for every $0.50 increase or reduction in price, annual sales demand

would fall or increase by 2,000 units.

Formula for the relationship between sales price and sales quantity

From this information it is possible to derive a formula for the relationship between

the sales price and sales quantity. You should do this by calculating the sales price

at which sales demand will be 0 units.

In the example above, if the sales price is $12, sales demand is expected to be 300,000

units. For every $1 increase in the price, sales demand will fall by 4,000 units (=

2,000units/$0.50). The sales price at which demand will be 0 is therefore:

$12 + [(300,000/4,000) × $1] = $87.

A formula for the relationship between sales quantity (Q) and sales price (P) can be

stated in terms of the sales price.

P = 87 – (Q × 1/4000)

P = 87 – 0.00025Q

The value 1/4000 or 0.00025 is obtained from the relationship between changes in

the sales price and changes in the sales quantity (for every $1, quantity changes by

4,000 units).

Formula for total sales revenue

Total revenue (TR) is the sales quantity multiplied by the sales price per unit.

TR = P × Q

We already have a formula for P expressed in terms of Q. This can now be

substituted. In the example, we have:

TR = (87 – 0.00025Q) Q

TR = 87Q – 0.00025Q

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Formula for marginal revenue: MR

The formula for calculating marginal revenue is obtained by applying differential

calculus to the formula for total revenue. If you are not familiar with differential

calculus, you should learn the following technique:

(1) If total revenue (TR) = aQ – bQ

(2) Marginal revenue (MR) = a – [2b × Q]

In the example:

TR = 87Q – 0.00025 Q

MR = 87 – (2 × 0.00025Q) = 87 – 0.0005Q.

5.3 The profit-maximising sales price

The profit-maximising sales price is the price at which MR = MC.

Formula for marginal cost: MC

The marginal cost per unit should be its variable cost.

In the example, suppose the variable cost per unit is $2.

The profit-maximising sales price is where:

MR = MC

87 – 0.0005Q = 2

85 = 0.0005Q

Q = 170,000.

P = 87 – 0.00025Q

So when Q = 170,000: P = 87 – (0.00025 × 170,000) = 87 – 42.50

P = 44.50.

Profit is maximised at a price of $44.50, when sales demand would be 170,000 units.

The contribution per unit would be $42.50, so total annual contribution would be

$7,225,000.

In this example, the profit-maximising price is a long way from the initial price of

$12 per unit that was considered.

The following example summarises the technique just described.

Example

A major hotel is planning a gala dinner, at which there will be up to 800 places

available. The initial idea was to charge $1,000 per person and at this price the hotel

would expect to sell 600 tickets. Market research suggests that for every $50 increase

or reduction in the ticket price, demand will fall or increase by 20.

The variable cost per person for the dinner will be $250, and the fixed costs

Chapter 11: Economic, fiscal and environmental factors

attributable to the event would be $240,000.

Required

If the hotel has a policy of maximising the profitability of such events, what price

per ticket should be charged for the dinner and what would be the total profit?

Answer

For every $1 change in price, the sales quantity would change by 20/50 = 0.4.

At a price of $1,000, sales quantity = 600.

Therefore the price at which the sales quantity would be 0 is:

1,000 + (600/0.4) = 1,000 + 1,500 = 2,500.

P = 2,500 – (50/20)Q

= 2,500 – 2.5Q

Total revenue TR = 2,500Q – 2.5Q

Marginal revenue MR = 2,500 – 5Q

Profit is maximised where MR = MC:

2,500 – 5Q = 250

5Q = 2,250

Q = 450

The sales price would be: 2,500 – (2.5 × 450) = 1,375.

Profit will be maximised by charging $1,375 per ticket, and the expected sales

quantity will be 450 tickets.

Sales revenue (450 × $1,375)

618,750

Variable costs (450 × $250)

112,500

Total contribution 506,250

Fixed costs 240,000

Profit from the event 266,250

5.4 Pricing decisions and sensitivity analysis

Sensitivity analysis for strategic planning was described in an earlier chapter. It can

be applied to strategic pricing decisions too.

In the previous example, suppose that the hotel management are not satisfied with a

profit of $266,250 from the gala dinner and are also would not be satisfied with sales

of only 450 tickets. It is therefore decided that the price should be kept at $1,000 so

that 600 tickets will be sold. However, management want to achieve a target profit

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of $300,000 from the event, and think that this could be achieved by reducing the

variable cost per person.

We can use sensitivity analysis to calculate what the maximum variable cost per

person should be if management are to achieve their target profit and sales quantity.

Required profit 300,000

Fixed costs 240,000

Required total contribution 540,000

If 600 tickets are sold, the contribution per unit would need to be $540,000/600 =

$900. To sell 600 tickets the price must be $1,000.

Therefore the maximum variable cost per person would have to be $1,000 – $900 =

$100.

This is $150 or 60% less than the current estimated variable cost of $250.

Paper P5

Advanced performance management

CHAPTER

Performance measurement

systems

Contents

1 Features of performance measurement systems

2 Information for performance measurement

3 Sources of information

4 Recording and processing methods. Management

reports

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Features of performance measurement systems

 What is a performance measurement system?

 The need for performance measurement

 Management accounting and performance measurement

 The analysis of costs

1 Features of performance measurement systems

1.1 What is a performance measurement system?

A performance measurement system is an integral part of a system of planning and

control.

 Planning targets clarify the objectives of the organisation. Corporate objectives

are converted into planning targets. Similarly, the objectives of strategic plans

are converted into planning targets. A target should be a clear statement of what

an entity wants to achieve within a specified period of time. Planning targets are

usually quantified, but may be expressed in qualitative terms.

 Measurements of performance (target and actual) help to improve

management’s understanding of processes and systems.

 Planning targets are set at strategic, tactical and operational management levels.

Using quantitative measures of performance makes it easier to set targets for

managers and the organisation as a whole.

 In a well-designed performance management system, all planning targets are

consistent with each other, at the strategic, tactical and operational levels.

 When the business environment is changing, a performance measurement

system should provide for the continual re-assessment of planning targets, so

that targets can be altered as necessary to meet the changing circumstances.

 Actual performance, at the strategic, tactical and operational levels should be

measured and monitored. Comparing actual performance with targets provides

useful control information. Differences between actual performance and targets

can be analysed, to establish the causes. Where appropriate, action can be taken

to improve performance by dealing with the causes of the poor performance.

 Performance measures also make it possible to compare the performance of

different organisations or different divisions within the same organisation.

 Performance measurement systems promote accountability of the organisation

to its stakeholders.

 A performance management system may be linked to a system of rewarding

individuals for the successful achievement of planning targets.

1.2 The need for performance measurement

Every managed organisation needs a system of performance measurement.

Chapter 12: Performance measurement systems

 Managers need to understand what they should be trying to achieve. A sense of

purpose and direction is provided by plans (strategies, budgets, operational

plans and so on), and for each plan there should be objectives and targets.

Setting targets for achievement (performance targets) is an essential part of

planning.

 Managers also need to know whether they are successful. The information they

need is provided by comparing:

- their actual results or performance with the performance target, and

- the performance target with the current forecast of what performance will be.

Targets, forecasts and actual performance should be measured, in order to compare

them. Ideally measures of performance should be quantified values (financial or

non-financial measures), because numerical measures of performance are easier to

compare than non-quantified (‘qualitative’) measures.

The benefits of performance measurement systems

The advantages of having a formal system of performance measurement can be

summarised as follows:

 A well-structured system of performance measurement clarifies the objectives of

the organisation, and shows how departments, work groups and individuals

within the organisation contribute to the achievement of those objectives.

 It establishes agreed measures of activity, based on key success factors.

 It helps to provide a better understanding of the processes within the

organisation, and what each should be trying to achieve.

 It provides a system for comparing the performance of different organisations or

departments.

 The system establishes performance targets for the organisation’s managers,

over a suitable time period for achievement.

1.3 Management accounting and performance measurement

Management accounting is an important element in performance measurement

systems. Many performance targets are financial in nature, such as achieving targets

for return on capital, profits and sales revenue and targets for keeping expenditure

under control.

However, a performance measurement system uses a wide range of targets at the

strategic, tactical and operational level. Many of these are non-financial targets, and

not all targets are quantifiable.

Clearly, a comprehensive management accounting system should therefore provide

information for setting targets and measuring actual performance at all levels. It

should also provide non-financial information as well as financial information.

If a management accounting system cannot provide all this information to

management, managers will have to rely on other information systems in addition

to the management accounting system. An entity might then have several different

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information systems, which is probably inefficient and less effective than a fully co-

ordinated management information system.

1.4 The analysis of costs

The analysis of costs is a core feature of management accounting. A management

accounting system must be capable of providing reliable and relevant information

about costs for purposes of planning, setting targets, performance measurement and

control.

 A management accounting system must be able to analyse how costs should

vary with changes in activity. Understanding cost behaviour is important for

planning decisions as well as for analysing actual performance.

 A management accounting system must also be able to report actual

performance in a way that identifies the managers who are responsible for the

costs or revenues. The controllability of costs and performance is also a key

issue. Controllability is considered in more detail in the next section.

 A management accounting system should also provide information that enables

managers to assess performance. Performance can be assessed by:

- comparing actual performance with the targets

- comparing current forecasts with the original targets

- looking at trends and changes in performance over time

- comparing performance with other entities (benchmarking).

 Information about performance should also make a distinction between what is

significant (material) and what is unimportant (immaterial).

Assessing trends

Performance reports may show the changes in performance over a period of time,

such as annual growth in sales and profits. The value of measuring changes in a

measure of performance over time is that it helps managers to identify trends. When

there is an upward or downward trend over time, it might be appropriate to assume

that the trend is likely to continue unless action is taken to try changing it.

Materiality

Performance reports should help managers to identify the aspects of performance

that appear significant or material. Reports may therefore highlight exceptional or

material results. For example:

 Long reports usually begin with an executive summary, where the key aspects of

performance are summarised.

 ‘Reporting by exception’ might be used to report results to management. This is

a form of reporting in which only exceptional results are brought to

management’s attention.

ACCA - P5 Study text - Emile Woolf INT - 2010

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