202 Ch 13 S08 S

# 202 Ch 13 S08 S - ACC 202 Intro to Management Accounting...

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Unformatted text preview: ACC 202 Intro to Management Accounting Chapter 13: Relevant Costs for Decision Making obj 1 Learning Objectives Identify relevant costs & benefits Should a product or segment be dropped or maintained? Prepare a make or buy analysis Should a special order be accepted? What is the most profitable use of a constrained resource? Should joint products be sold at splitoff or be processed further? Relevant & Irrelevant Costs Relevant costs: Irrelevant costs: Differ among alternatives Include avoidable costs (a cost that can be eliminated by choosing one alternative over another) Include unavoidable costs Include sunk costs Include future costs that do not differ between alternatives Relevant Cost Analysis: A TwoStep Process Step 1 Eliminate costs and benefits that do not differ between alternatives. Step 2 Use the remaining costs and benefits that do differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs. Identifying Relevant Costs Cynthia, a Boston student, is considering visiting her friend in New York. She can drive or take the train. By car it is 230 miles. Which alternative is less expensive? Automobile Costs (based on 10,000 miles driven per year) Annual Cost of Fixed Items \$ 2,800 1,380 360 Cost per Mile \$ 0.280 0.050 0.138 0.065 0.036 \$ 0.569 1 2 3 4 5 6 Annual straight-line depreciation on car Cost of gasoline Annual cost of auto insurance and license Maintenance and repairs Parking fees at school Total average cost \$45 per month 8 months \$1.60 per gallon 32 MPG \$18,000 cost \$4,000 salvage value 5 years Identifying Relevant Costs Automobile Costs (based on 10,000 miles driven per year) Annual Cost of Fixed Items \$ 2,800 1,380 360 Cost per Mile \$ 0.280 0.050 0.138 0.065 0.036 \$ 0.569 1 2 3 4 5 6 Annual straight-line depreciation on car Cost of gasoline Annual cost of auto insurance and license Maintenance and repairs Parking fees at school Total average cost 7 8 9 10 11 12 13 Some Additional Information Reduction in resale value of car per mile of wear Round-tip train fare Benefits of relaxing on train trip Cost of putting dog in kennel while gone Benefit of having car in New York Hassle of parking car in New York Per day cost of parking car in New York \$ 0.026 \$ 104 ???? \$ 40 ???? ???? \$ 25 Relevant or Irrelevant? Cost of the car Cost of insurance Cost of gasoline Cost of maintenance & repairs Cost of school parking Decrease in resale value Cost of train fare Benefit of relaxing on the train Cost of kennel stay Cost of parking in New York Benefit of having car in NY Problem finding parking in NY Identifying Relevant Costs From a financial standpoint, Cynthia would be better off taking the train to visit her friend. Some nonfinancial factors may influence her final decision. Relevant Financial Cost of Driving Gasoline (460 @ \$0.050 per mile) \$ 23.00 Maintenance (460 @ \$0.065 per mile) 29.90 Reduction in resale (460 @ \$0.026 per mile) 11.96 Parking in New York (2 days @ \$25 per day) 50.00 Total \$ 114.86 Relevant Financial Cost of Taking the Train Round-trip ticket \$ 104.00 Total vs. Differential Costs Management is considering getting a new laborsaving machine. Rent is \$3,000 per year. Data on annual sales and costs with and without the new machine follow: Current Situation \$ 200,000 70,000 40,000 10,000 120,000 80,000 62,000 62,000 18,000 Situation With New Machine \$ 200,000 70,000 25,000 10,000 105,000 95,000 62,000 3,000 65,000 30,000 Differential Costs and Benefits 15,000 15,000 (3,000) (3,000) 12,000 Sales (5,000 units @ \$40 per unit) Less variable expenses: Direct materials (5,000 units @ \$14 per unit) Direct labor (5,000 units @ \$8 and \$5 per unit) Variable overhead (5,000 units @ \$2 per unit) Total variable expenses Contribution margin Less fixed expense: Other Rent on new machine Total fixed expenses Net operating income \$ \$ Total vs. Differential Costs The only costs that differ between alternatives are the direct labor costs savings and the increase in fixed rental costs. Sales (5,000 units @ \$40 per unit) Less variable expenses: Direct materials (5,000 units @ \$14 per unit) Direct labor (5,000 units @ \$8 and \$5 per unit) Variable overhead (5,000 units @ \$2 per unit) Total variable expenses Contribution margin Less fixed expense: Other Rent on new machine Total fixed expenses Net operating income Current Situation \$ 200,000 70,000 40,000 10,000 120,000 80,000 62,000 62,000 18,000 Situation With New Machine \$ 200,000 70,000 25,000 10,000 105,000 95,000 62,000 3,000 65,000 30,000 Differential Costs and Benefits 15,000 15,000 (3,000) (3,000) 12,000 Efficiently analyze the situation. \$ \$ Look only at the costs and revenues that differ and arrive at the same solution. Net Advantage to Renting the New Machine Decrease in direct labor costs (5,000 units @ \$3 per unit) Increase in fixed rental expenses Net annual cost saving from renting the new machine \$ \$ 15,000 (3,000) 12,000 Total vs. Differential Costs The differential approach is desirable because: 1. Only rarely will enough information be available to prepare detailed income statements for both alternatives. 2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical. Adding or Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment such as a product or a store. How should relevant costs be used in this type of decision? Adding or Dropping Segments Example: The popularity of digital watches has been declining. Lovell Company's digital watch line has not reported a profit for several years. Lovell is considering dropping this product line. Adding or Dropping Segments Contribution Margin Approach DECISION RULE Lovell should drop the digital watch segment only if overall profits would increase. This would only happen if the fixed cost savings exceed the lost contribution margin. Adding or Dropping Segments Segment Income Statement Digital Watches Sales Less: variable expenses Variable manufacturing costs Variable shipping costs Commissions Contribution margin Less: fixed expenses General factory overhead Salary of line manager Depreciation of equipment Advertising - direct Rent - factory space General admin. expenses Net operating loss \$ 500,000 \$ 120,000 5,000 75,000 200,000 \$ 300,000 \$ 60,000 90,000 50,000 100,000 70,000 30,000 400,000 \$ (100,000) Adding or Dropping Segments Investigation showed that total fixed general factory overhead and general administrative expenses would not be affected if the digital watch line is dropped. The fixed general factory overhead and general administrative expenses assigned to this product would be reallocated to other product lines. Adding or Dropping Segments Segment Income Statement Digital Watches Sales \$ 500,000 Less: variable expenses Variable manufacturing costs \$ 120,000 The equipment used to manufacture Variable shipping costs 5,000 digital watches has no resale Commissions 75,000 200,000 value or alternative use. Contribution margin \$ 300,000 Less: fixed expenses General factory overhead \$ 60,000 Salary of line manager 90,000 Depreciation of equipment 50,000 Should Lovell retain or drop Advertising - direct 100,000 the digital watch segment? Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss \$ (100,000) Contribution Margin Approach Contribution Margin Solution Contribution margin lost if digital watches are dropped Less fixed costs that can be avoided Salary of the line manager Advertising - direct Rent - factory space Net disadvantage \$ (300,000) \$ 90,000 100,000 70,000 \$ 260,000 (40,000) Comparative Income Approach The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment. Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales \$ 500,000 \$ \$ (500,000) Less variable expenses: Manufacturing expenses 120,000 120,000 Shipping 5,000 5,000 Commissions 75,000 75,000 Total variable expenses 200,000 200,000 Contribution margin 300,000 (300,000) Less fixed expenses: General factory overhead 60,000 Salary of line manager 90,000 Depreciation 50,000 If the digital watch Advertising - direct 100,000 line is dropped, the Rent - factory space 70,000 company gives up General admin. expenses 30,000 Total fixed expenses 400,000 its contribution Net operating loss \$ (100,000) margin. Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales \$ 500,000 \$ \$ (500,000) Less variable expenses: Manufacturing expenses 120,000 120,000 Shipping 5,000 5,000 Commissions 75,000 75,000 Total variable expenses 200,000 200,000 Contribution margin 300,000 (300,000) Less fixed expenses: General factory overhead 60,000 60,000 Salary of line manager 90,000 Depreciation 50,000 The general factory overhead Advertising - direct 100,000 Rent - factory space 70,000 would be the same, so this General admin. expenses 30,000 cost is irrelevant. Total fixed expenses 400,000 Net operating loss \$ (100,000) Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Sales \$ 500,000 \$ Less variable expenses: Lovell wouldn't need a Manufacturing expenses 120,000 manager for5,000 product -line the Shipping Commissions 75,000 anymore. Total variable expenses 200,000 Contribution margin 300,000 Less fixed expenses: General factory overhead 60,000 60,000 Salary of line manager 90,000 Depreciation 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 Total fixed expenses 400,000 Net operating loss \$ (100,000) Difference \$ (500,000) 120,000 5,000 75,000 200,000 (300,000) 90,000 Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales \$ 500,000 \$ \$ (500,000) Less variable expenses: If the digital watch line is dropped, the net -book value Manufacturing expenses 120,000 of the equipment would be written off. The 120,000 Shipping 5,000 5,000 depreciation that would have been taken will flow Commissions 75,000 75,000 Total variable expenses 200,000 200,000 through the income statement as a loss -instead. Contribution margin 300,000 (300,000) Less fixed expenses: General factory overhead 60,000 60,000 Salary of line manager 90,000 90,000 Depreciation 50,000 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 Total fixed expenses 400,000 Net operating loss \$ (100,000) Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Sales \$ 500,000 \$ Less variable expenses: Manufacturing expenses 120,000 Shipping 5,000 Commissions 75,000 Total variable expenses 200,000 Contribution margin 300,000 Less fixed expenses: General factory overhead 60,000 60,000 Salary of line manager 90,000 Depreciation 50,000 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 30,000 Total fixed expenses 400,000 140,000 Net operating loss \$ (100,000) \$ (140,000) Difference \$ (500,000) 120,000 5,000 75,000 200,000 (300,000) 90,000 100,000 70,000 260,000 \$ (40,000) Beware of Allocated Fixed Costs Why should we keep the digital watch segment when it's showing a \$100,000 loss? Beware of Allocated Fixed Costs The answer lies in the way we allocate common fixed costs to our products. Beware of Allocated Fixed Costs Our allocations can make a segment look less profitable than it really is. The Make or Buy Decision A company carrying out more than one activity in the value chain is vertically integrated. A decision about performing an activity internally verses buying externally from a supplier is called a "make or buy" decision. Vertical Integration- Advantages Smoother flow of parts and materials Better quality control Realize profits Vertical Integration- Disadvantage Companies may fail to take advantage of suppliers who can create economies of scale advantage by pooling demand from numerous companies. Make or Buy Decision Example Essex Company manufactures part 4A that is used in one of its products. The unit product cost of this part is: Direct materials Direct labor Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Unit product cost \$ 9 5 1 3 2 10 \$ 30 Make or Buy Decision Example The special equipment used to manufacture part 4A has no resale value. The total amount of general factory overhead, which is allocated on the basis of direct labor hours, would be unaffected by this decision. The \$30 unit product cost is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of \$25 per part. Should we accept the supplier's offer? Make or Buy Decision Example Cost Per Unit Outside purchase price Direct materials Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost \$ 25 \$ 9 5 1 3 2 10 \$ 30 Cost of 20,000 Units Buy Make \$ 500,000 180,000 100,000 20,000 40,000 \$ 340,000 \$ 500,000 20,000 \$9 per unit = \$180,000 Make or Buy Decision Example Cost Per Unit Outside purchase price Direct materials Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost \$ 25 \$ 9 5 1 3 2 10 \$ 30 Cost of 20,000 Units Buy Make \$ 500,000 180,000 100,000 20,000 40,000 \$ 340,000 \$ 500,000 The special equipment has no resale value and is a sunk cost. Make or Buy Decision Example Cost Per Unit Outside purchase price Direct materials Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost \$ 25 \$ 9 5 1 3 2 10 \$ 30 Cost of 20,000 Units Buy Make \$ 500,000 180,000 100,000 20,000 40,000 \$ 340,000 \$ 500,000 Not avoidable; irrelevant. If the product is dropped, it will be reallocated to other products. Make or Buy Decision Example Cost Per Unit Outside purchase price Direct materials Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost \$ 25 \$ 9 5 1 3 2 10 \$ 30 Cost of 20,000 Units Buy Make \$ 500,000 180,000 100,000 20,000 40,000 \$ 340,000 \$ 500,000 Should we make or buy part 4A? Opportunity Costs Benefits foregone as a result of pursuing some course of action. Not actual dollar outlays Not recorded in the accounting system of an organization. How would this concept potentially relate to the Essex Company? Special Orders A special order is a one-time order that is not considered part of the company's normal ongoing business. When analyzing a special order only the incremental costs and benefits are relevant. Special Order Decision Example Jet, Inc. makes a single product whose normal selling price is \$20 per unit. A foreign distributor offers to purchase 3,000 units for \$10 per unit. This is a onetime order that would not affect the company's regular business. Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units. Should Jet accept the offer? Special Order Decision Example \$8 variable cost Special Order Decision Example If Jet accepts the offer, net operating income will increase by \$6,000. Increase in revenue (3,000 \$10) Increase in costs (3,000 \$8 variable cost) Increase in net income \$ 30,000 24,000 \$ 6,000 Note: This answer assumes that fixed costs are unaffected by the order and that variable marketing costs must be incurred on the special order. Utilization of a Constrained Resource When a limited resource of some type restricts the company's ability to satisfy demand, the company is said to have a constraint. The machine or process that is limiting overall output is called the bottleneck it is the constraint. Utilization of a Constrained Resource When a constraint exists, a company should select a product mix that maximizes the total contribution margin earned since fixed costs usually remain unchanged. A company should not necessarily promote those products that have the highest unit contribution margin. Rather, it should promote those products that earn the highest contribution margin in relation to the constraining resource. Utilization of a Constrained Resource Ensign Company produces two products and selected data is shown below: Utilization of a Constrained Resource Machine A1 is the constrained resource and is being used at 100% of its capacity. There is excess capacity on all other machines. Machine A1 has a capacity of 2,400 minutes per week. Should Ensign focus its efforts on Product 1 or 2? Quick Check How many units of each product can be processed through Machine A1 in one minute? Product 1 Product 2 a. 1 unit 0.5 unit b. 1 unit 2.0 units c. 2 units 1.0 unit d. 2 units 0.5 unit Quick Check What generates more profit for the company, using one minute of machine A1 to process Product 1 or using one minute of machine A1 to process Product 2? a. Product 1 b. Product 2 c. They both would generate the same profit. d. Cannot be determined. Utilization of a Constrained Resource The key is the contribution margin per unit of the constrained resource. Product 2 should be emphasized. Provides more valuable use of the constrained resource machine A1, yielding a contribution margin of \$30 per minute as opposed to \$24 for Product 1. Utilization of a Constrained Resource The key is the contribution margin per unit of the constrained resource. If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use remaining capacity to make Product 1. Utilization of a Constrained Resource How would this plan work? Alloting Our Constrained Resource (Machine A1) Weekly demand for Product 2 Time required per unit Total time required to make Product 2 2,200 units 0.50 min. 1,100 min. Utilization of a Constrained Resource How would this plan work? Alloting Our Constrained Resource (Machine A1) Weekly demand for Product 2 Time required per unit Total time required to make Product 2 Total time available Time used to make Product 2 Time available for Product 1 2,200 units 0.50 min. 1,100 min. 2,400 min. 1,100 min. 1,300 min. Utilization of a Constrained Resource How would this plan work? Alloting Our Constrained Resource (Machine A1) Weekly demand for Product 2 Time required per unit Total time required to make Product 2 Total time available Time used to make Product 2 Time available for Product 1 Time required per unit Production of Product 1 2,200 units 0.50 min. 1,100 min. 2,400 1,100 1,300 1.00 1,300 min. min. min. min. units Utilization of a Constrained Resource According to the plan, we will produce 2,200 units of Product 2 and 1,300 units of Product 1. Our contribution margin looks like this. Production and sales (units) Contribution margin per unit Total contribution margin Product 1 1,300 \$ 24 \$ 31,200 Product 2 2,200 \$ 15 \$ 33,000 The total contribution margin for Ensign is \$64,200. Managing Constraints Find ways to process more units through a resource bottleneck At the bottleneck: Improve the process Add overtime or another shift Hire new workers or acquire more machines Subcontract production Reduce amount of defective units produced Add workers transferred from non-bottleneck departments Joint Costs Sometimes, several end products can be produced from a single raw material input. Two or more products produced from a common input are called joint products. The point in the manufacturing process where each joint product can be recognized as a separate product is called the splitoff point. Joint Products Oil Joint Input Common Production Process Gasoline Chemicals Split-Off Point Joint Products Joint Costs Common Production Process Oil Separate Processing Final Sale Joint Input Gasoline Final Sale Chemicals Separate Processing Final Sale Split-Off Point Separate Product Costs The Pitfalls of Allocation Joint costs are often allocated to end products on the basis of the relative sales value of each product or on some other basis. Although allocation is needed for some purposes such as balance sheet inventory valuation, allocations of this kind are very dangerous for decision making. Sell or Process Further Joint costs are irrelevant in decisions regarding what to do with a product from the splitoff point forward. It will always be profitable to continue processing a joint product after the splitoff point as long as the incremental revenue exceeds the incremental processing costs incurred after the splitoff point. Sell or Process Further Example Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint products. Unfinished lumber is sold "as is" or processed further into finished lumber. Sawdust can also be sold "as is" to gardening wholesalers or processed further into "presto logs." Sell or Process Further Example Data about Sawmill's joint products: Per Log Lumber Sawdust \$ 140 \$ 40 270 176 50 50 24 20 Sales value at the split-off point Sales value after further processing Allocated joint product costs Cost of further processing Sell or Process Further Example Analysis of Sell or Process Further Per Log Lumber Sawdust Sales value after further processing Sales value at the split-off point Incremental revenue \$ 270 140 130 \$ 50 40 10 Sell or Process Further Example Analysis of Sell or Process Further Per Log Lumber Sawdust Sales value after further processing Sales value at the split-off point Incremental revenue Cost of further processing Profit (loss) from further processing \$ \$ 270 140 130 50 80 \$ \$ 50 40 10 20 (10) Sell or Process Further Example Analysis of Sell or Process Further Per Log Lumber Sawdust Sales value after further processing Sales value at the split-off point Incremental revenue Cost of further processing Profit (loss) from further processing \$ \$ 270 140 130 50 80 \$ \$ 50 40 10 20 (10) We should process the lumber further and sell the sawdust "as is." ...
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