Advanced Management Accounting
Week 6 Part II
Strategic Profitability Analysis
Instructor: Zhihong Wang, PhD
Strategic Profitability Analysis
Strategic Analysis of Operating Income
Strategic analysis: link strategy to the sources of operating-income
increases
1) The Growth component measures the change in operating
income attributable solely to the change in quantity of
output sold between years.
2) The Price-recovery component measures the change in
operating income attributable solely to changes in prices of
inputs and outputs between years.
3) The Productivity component measures the change in costs
attributable to a change in the quantity of inputs used in
current year relative to the quantity of inputs that would have
been used in the prior year to produce the current year output.
Example
UST produces a microchip CX1. The company implemented key elements of its
cos-leadership strategy in 2021 and generated the following data
2020 2021
Analysis of Growth Component
Revenue Effect of Growth
Revenue Actual Units of Actual Units of Prior
Effect = Output Sold in _ Output Sold in X Period
of the Current the Prior Selling
Growth Period Period Price
Revenue Effect of Growth =
(1,150,000 – 1,000,000) x $23 = $3,450,000 F
Analysis of Growth Component
Cost Effect of Growth for Variable Costs
Cost Effect Units of Input Actual Units of Prior
of Growth = Required to Produce _ Input Used to X Period
for Variable Current Output in the Produce Prior Input
Costs Prior Period Period Output Price
Cost effect of growth for variable costs
= (3,000,000 x (1,150,000/1,000,000) – 3,000,000) x $1.40
= $630,000 U
Analysis of Growth Component
COST EFFECT OF GROWTH FOR FIXED COSTS
Cost
Effect Actual Units of Actual Units Prior
Of capacity in of Capacity Period
Growth = Prior Period to in the X Price
For Produce Current Prior per unit
Fixed Period Output Period of
Costs capacity
UST has adequate capacity to process the raw materials inputs for both years.
Cost effect of growth for fixed costs=
(3,750,000 sq cm – 3,750,000 sq cm) X $4.28 =0
Analysis of Growth Component
In Summary:
Revenue effect of growth 3,450,000 F
Cost effect of growth
Direct material costs 630,000 U
Conversion costs 0 630,000 U
Changes in operating income due to growth 2,820,000 F
Analysis of Price Recovery Component
Revenue Effect of Price Recovery
Revenue
Effect Current
Current Period Prior Period Period
Of = X
Selling Price Selling Price Units
Price-
Recovery Sold
Revenue effect of price recovery= ($22 - $23) X 1,150,000 = $1,140,000 U
Analysis of Price Recovery Component
Cost Effect of Price Recovery for Variable Costs
Cost Units of
Effect Input
Of required to
Price- Current Period Prior Period produce
= X Current
Recovery Input Price Input Price
for Period’s
Variable Output in
Costs the Prior
Period
Cost effect of price recovery for variable costs=
($1.50 - $1.40) X 3,450,000 = $345,000 U
Analysis of Price Recovery Component
Cost Effect of Price Recovery for Fixed Costs
Cost
Effect Actual Units of
Of Current Period Prior Period Capacity on
Price- = Price per Unit Price per Unit X Prior Period to
Recovery of Capacity of Capacity Produce
for Fixed Current
Costs Period’s Output
Cost effect of price recovery for fixed costs=
($4.35 - $4.28) X 3,750,000 = $262,500 U
Analysis of Price Recovery Component
In Summary:
Revenue Effect of Price Recovery 1,150,000 U
Cost effect of price recovery
Direct material costs 345,000 U
Conversion costs 262,500 U 607,500 U
Changes in operating income due to price recovery 1,757,500 U
Analysis of Productivity Component
Cost effect of Productivity for Variable Costs
Cost
Actual Units of Units of Input
Effect
Input used to Required to
Of Input Price in
= Produce Produce Current X
Productivity Current Period
Current Period Period’s Output
for Variable
Output in Prior Period
Costs
Cost effect of productivity for variable costs=
(2,900,000 – 3,450,000) X $1.50 = $825,000 F
Analysis of Productivity Component
Cost effect of Productivity for Fixed Costs
Assuming adequate current capacity:
Cost
Actual Actual Units of
Effect
Units of Capacity in Prior Price Per Unit of
Of
= Capacity in Period to X Capacity in
Productivity
Current Produce Current Current Period
for Fixed
Period Period’s Output
Costs
Cost effect of Productivity for fixed costs=
(3,500,000 – 3,750,000) X $4.35 = $1,087,500 F
Analysis of Productivity Component
In Summary:
Cost Effect of Productivity
Direct material costs 825,000 F
Conversion costs 1,087,500 F
Changes in operating income due to productivity 1,912,500 F
Conclusion
Consistent with a cost-leadership strategy, the productivity gains of
$1,912,500 in 2017 were a big part of the increase in operating income
for prior year to current year.
In-Class Exercise
When analyzing the change in operating income, the strategy component of
price-recovery will increase when ________.
A) capacity is reduced
B) market share is increased
C) selling prices are increased
D) more units are sold
In-Class Exercise
12-34 As a result of implementing the cost leadership strategy, Scott Company has reduced
manufacturing capacity and lowered the selling price of their major product to gain market share.
Information about the current period (2021) and last period (2020) follows.
2020 2021
Conversion costs in each year depend on production capacity defined in terms of kits that can be
processed. Selling and customer-service costs depend on the number of customers that Scott can support.
Scott has 140 customers in 2020 and 160 customers in 2021.
1. Calculate operating income of Scott Company for 2020 and 2021.
2. Calculate the growth, price-recovery, and productivity components that explain the change in operating
income from 2020 to 2021. What do these components indicate?
Pricing Decisions
Factors that Affect Pricing Decisions
How companies price a product or service ultimately
depends on the demand and supply for it.
• Customers: influence price through their effect on the
demand for a product or service.
• Competitors: influence price through their technologies,
plant capacities, and operating strategies which affect their
costs.
• Costs: influence prices because they affect supply. The
lower the cost of producing a product, the greater the
quantity a firm is willing to supply.
Cost Allocation for Pricing
• Recall that indirect costs of a particular cost object are
costs that are related to that cost object but cannot be
traced to it in an economically feasible (cost-effective) way.
• These costs often comprise a large percentage of the
overall costs assigned to cost objects.
• Cost allocations and product profitability analyses affect
the products promoted by a company. To increase profits,
managers focus on high-margin products.
Purposes of Cost Allocation
Long-Run Pricing
Long-run pricing is a strategic decision designed to build long-run
relationships with customers based on stable and predictable
prices. Managers prefer a stable price because it reduces the
need for continuous monitoring of prices, improves planning and
builds long-run buyer-seller relationships.
• The MARKET-BASED APPROACH asks: Given what our
customers want and how competitors will react to what we do,
what price should we charge?
• The COST-BASED APPROACH asks: Given what it costs us
to make this product, what price should we charge that will
recoup our costs and achieve a target return on investment?
In-Class Exercise
1) In a perfectly competitive market, which of the following is a primary factor
influencing pricing decisions?
A) cost of production
B) availability of raw materials in the market
C) information on competitor's cost structure
D) value customers place on product
2) In a noncompetitive environment, the key factor affecting pricing decisions is
the ________.
A) customer's willingness to pay
B) price charged for alternative products
C) information on competitor's cost structure
D) minimum price acceptable to the firm
