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Unformatted text preview: Module 16
Relevant Costs and Benefits for Decision Making
©Cambridge Business Publishers, 2009 Relevant and Irrelevant Costs
Future costs that Future costs that do differ among NOT differ among competing decision competing decision alternatives alternatives Primary focus is profit maximization Additional factors that must be considered Effects on longrun profit Nonquantitative factors Such as legal, ethical, social
©Cambridge Business Publishers, 2009 Revenues Relevant if they differ between alternatives Outlay costs Outlay costs require future expenditures of cash or other resources Relevant outlay costs Future Revenues and Outlay Costs Irrelevant outlay costs Outlay costs that do not differ between decisions ©Cambridge Business Publishers, 2009 Outlay costs that differ between decisions Sunk Costs
Result from past decisions that cannot be changed Sunk costs are NEVER relevant Sunk costs in decisions to replace a machine Can cause ethical dilemmas Cost of old machine Book value of old machine Managers often avoid disposing of old assets Disposing may create a loss on the income statement, making the manager’s performance look bad ©Cambridge Business Publishers, 2009 Disposal and Salvage Values Disposal value Amount of cash an old asset can be sold for at the time the new asset is purchased Relevant cash inflow Salvage value Obtained only if the replacement alternative is accepted Amount of cash an asset will bring at the end of its useful life if held to that time ©Cambridge Business Publishers, 2009 Opportunity Costs
Any benefit forgone as a result of rejecting one alternative in favor of another Always relevant when making decisions among competing alternatives ©Cambridge Business Publishers, 2009 Summary of Relevant and Irrelevant Costs
Only relevant costs are used in decision making. ©Cambridge Business Publishers, 2009 Example of Relevant and Irrelevant Costs
Trekker Tires manufacturers lawn mower tires. It produces and sells 10,000 tires annually at a selling price of $20 each. Management is evaluating the desirability of replacing the old assembly machine with a new machine. Data concerning the two machines: Old Machine Proposed Cost Estimated useful life
©Cambridge Business Publishers, 2009 $90,000 6 years Machine $80,000 4 years Continued Example of Relevant and Irrelevant Costs Continued
Unit level: Old Machine Direct materials $3.00 per unit Conversion $5.00 per unit Selling and distribution $1.00 per unit Batch level: Inspection and adjustment $500 per batch Batch size 1,000 Proposed Machine $3.00 per unit $3.50 per unit $1.00 per unit $400 per batch 1,000 Direct labor and variable manufacturing overhead required to convert raw materials into finished goods The old machine is two years old with a current disposal value of $35,000. The proposed machine has a zero salvage value. ©Cambridge Business Publishers, 2009 Continued Example of Relevant and Irrelevant Costs Continued
Unit level: Old Machine Direct materials $3.00 per unit Conversion $5.00 per unit Selling and distribution $1.00 per unit Batch level: Inspection and adjustment $500 per batch Batch size 1,000 Proposed Machine $3.00 per unit $3.50 per unit $1.00 per unit $400 per batch 1,000 •Difference in conversion costs •Disposal value of old machine •Difference in batch costs •Difference in depreciation
©Cambridge Business Publishers, 2009 Relevant Relevant •Direct material costs •Selling and distribution costs •Cost of old machine •Selling price of tires Irrelevant An approach to the analysis of relevant costs that focuses on costs that differ between alternative actions Preferred over an aggregate analysis when determining which of two alternatives is most profitable Benefits
Focuses on only items that differ Contains fewer items, making it easier and quicker to prepare Helps simplify complex situations Differential Analysis ©Cambridge Business Publishers, 2009 KonnectCo manufactures flash drives and sells them for €20 (euros). Management is considering 3 possible alternatives:
Proposed Change Expected Effect On Units Sold Changes in Profit Plans Example Alternative #1 Increase advertising budget by €1,000 Alternative #2 Increase unit selling price by €1 Alternative #3 Decrease unit selling price by €1 Sales increase by 300 units Sales decrease by 300 units Sales increase by 500 units, with direct labor for the last 200 units increasing by €1 each due to overtime ©Cambridge Business Publishers, 2009 Changes in Profit Plans Example continued
Current costs to produce flash drives are:
Variable Costs per Unit
Direct materials €3 Direct labor Fixed Costs per Month 4 Manufacturing overhead Manufacturing overhead €20,000 2 Average monthly production Selling and administrative Selling and administrative
©Cambridge Business Publishers, 2009 and sales is 4,000 units
8,000 Changes in Profit Plans Example continued Alternative #1
Increase advertising by €1,000, with sales increasing by 300 units
Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = 10€
Profit increase from increased sales (300 units × €10) Profit decrease from increased advertising Increase in monthly profit
©Cambridge Business Publishers, 2009 €3,000. (1,000) €2,000. Alternative #2 Changes in Profit Plans Example continued Increase selling price by €1, with sales decreasing by 300 units
Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = 10€ Profit decrease from reduced sales (300 units × €10) Profit increase from increased selling price (3,700 units × €1) Increase in monthly profit
©Cambridge Business Publishers, 2009 €(3,000) 3,700. € 700. Changes in Profit Plans Example continued Alternative #3
Decrease selling price by €1, with sales increasing by 500 units, causing the last 200 units to incur overtime on direct labor costing €1 per unit more Unit contribution margin = €20 – (€3 + €4 + €2 + €1) = 10€
Profit increase from additional sales (500 units × (€19 – (€3 + €4 + €2 + €1)) Profit decrease from decreased selling price (4,000 units × €1) Profit decrease from overtime on 200 units (200 units × €1) Increase in monthly profit € 4,500. (4,000) (200) € 300. ©Cambridge Business Publishers, 2009 Changes in Profit Plans Example continued Alternatives #1 #2 #3 Increase in monthly profit Increase in monthly profit Increase in monthly profit The best option is alternative 1 because it results in the largest increase in profit.
©Cambridge Business Publishers, 2009 €2,000 € 700 € 300 Special Orders Occurs when a customer wants to buy merchandise or obtain services on a ‘one time’ basis at a price less than prices charged to other customers Usually involves a proposed purchase of a large volume of units
What is relevant? Sales revenue Variable production costs Additional costs to be incurred
©Cambridge Business Publishers, 2009 A customer offers to place a special, onetime order for 800 units at a reduced price of €16 per unit. KonnectCo has production capacity of 5,000 units and normally produces 4,200. KonnectCo will save 25% of its sales and administrative costs asa result. Should KonnectCo accept the order? Variable Costs per Unit Direct materials
KonnectCo’s Costs €3 Direct labor Special Order Example Fixed Costs per Month 4 Manufacturing overhead Manufacturing overhead €20,000 Selling and administrative 8,000
©Cambridge Business Publishers, 2009 2 continued Special Order Example continued
Increase in revenues (800 units × €16 ) Increase in costs Direct materials (800 × €3) Direct labor (800 × €4) Manufacturing overhead (800 × €2) Selling and administrative (800 × €1 × 75%) Increase in profits €2,400 3,200 1,600 600 €12,800. KonnectCo should accept the order since its profits will increase by €5,000. (7,800) € 5,000. The fixed portion of the selling and administrative costs remain at €8,000 no matter what level of activity. The special cost savings are for variable costs. ©Cambridge Business Publishers, 2009 Concerns with Special Orders Time span concerns Variable nature of longterm fixed costs Future year cost increases should be considered in multiyear special orders In the longrun, all costs, fixed and variable, should be considered relevant
Because they are subject to change over time Possible solutions Include a cost escalation clause in multiyear agreements Use full costs regardless of cost behavior patterns to approximate longrun variable costs ©Cambridge Business Publishers, 2009 Multiyear Special Order Example What if the customer wanted KonnectCo to sign a Full cost based on capacity Direct materials Direct labor Variable manufacturing overhead Variable selling and administrative Fixed manufacturing overhead (€20,000/5,000) Fixed selling and administrative (€8,000/5,000) Average full cost per unit multiyear contract to provide 800 units per month at €16 each? € 3.00 4.00 2.00 1.00 4.00 1.60 €15.60 KonnectCo should consider accepting a multiyear order based on full costs because €16 exceeds the full cost. ©Cambridge Business Publishers, 2009 What if KonnectCo were operating at capacity, its regular customers pay €20 per flash drive, and the special order customer wants to buy 800 units per month at €16 each? sales to regular customers (units) Lost 800.
Regular unit contribution margin (€20 – (€3 + €4 + €2 + €1)) Opportunity cost of accepting the special order Increase in profit if special order accepted (€16 – (€3 + €4 + €2 + €1)) Net decrease in profit is special order accepted € 10. (8,000) 4,800. (€3,200) Special Order with Opportunity Costs Example KonnectCo’s profits would decrease by €3,200 if the special order were accepted if operating at capacity. ©Cambridge Business Publishers, 2009 Impact on regular customers Potential longterm benefits from the special order customer Trying to establish a customer Qualitative Considerations of Special Orders Legal factors
customers? relationship Does the buyer compete with regular ©Cambridge Business Publishers, 2009 Outsourcing is the procurement of services, products, components from an external source
Reasons for Outsourcing Outsourcing ©Cambridge Business Publishers, 2009 Source as cited by Easton, et.al, Financial & Managerial Accounting for MBAs, 2e: 8th Annual Outsourcing Index: Money Matters, “Outsourcing Essentials, Vol.3, No. 4, Winter 2005 A manufacturer has offered to supply KonnectCo with all the flash drives it needs for one year at a cost of €9 each. If accepted, KonnectCo could eliminate production supervisor salaries that currently cost $1,000 per month. Normal production is 4,200 units each month. Should KonnectCo outsource? KonnectCo’s Costs Fixed Costs per Month Manufacturing overhead
©Cambridge Business Publishers, 2009 Outsourcing Example Direct materials €3 Direct labor Variable Costs per Unit €20,000 4 Manufacturing overhead
continued Outsourcing Example Continued
There are no relevant revenues in outsourcing decisions.
Cost to buy (€9 × 4,200 × 12 months) Cost to make: Direct materials (€3 × 4,200 × 12) Direct labor (€4 × 4,200 × 12) Variable manufacturing overhead (€2 × 4,200 × 12) Fixed manufacturing overhead (€1,000 × 12) . €453,600 €151,200 201,600 100,800 . 12,000 Total €465,600 €453,600 KonnectCo should consider outsourcing as profits will be Advantage of buying higher by $12,000. € 12,000
©Cambridge Business Publishers, 2009 Outsourcing Example Continued
If the space currently used to manufacture can be rented for €15,000 per year, what should KonnectCo do?
€ 151,200 201,600 100,800 12,000 15,000 € 480,600 0 €453,600 € 27,000 Cost to buy (€9 × 4,200 × 12 months) Cost to make: Direct materials (€3 × 4,200 × 12) Direct labor (€4 × 4,200 × 12) €453,600 Variable manufacturing overhead (€2 × 4,200 × 12) Fixed manufacturing overhead (€1,000 × 12) Opportunity cost of lost rental income if manufactured Total Advantage of buying KonnectCo should consider outsourcing to increase profits by $27,000. ©Cambridge Business Publishers, 2009 Sell or Process Further Decisions
Key issue is to determine a product’s most advantageous selling point for products salable at various stages of completion Decision is whether Two types of decisions To sell the product ‘as is’ Process the product further to sell for a higher selling price Single products Joint products ©Cambridge Business Publishers, 2009 Sell or Process Further Decision Example
Stack’Em manufactures assembled, readytopaint book shelves for $18 each and sells them for $30 each. Painting the shelves would increase the total cost of a shelf to $23, but Stack’Em could then sell them for $38 each. What should Stack’Em do? Increase in revenues: Revenue per shelf is painted Revenue per shelf if sold without paint Additional costs of painting ($23 – $18) Advantage of painting for each shelf $38 30 $ 8. (5) $ 3. Stack’Em should paint the shelves as profit increases by $3 per shelf. ©Cambridge Business Publishers, 2009 Joint Product Cost Decisions What are joint products? Splitoff point Two or more products simultaneously produced by a single process from a common set of inputs The point in the process where the joint product becomes separately identifiable Costs incurred prior to the splitoff point Are sunk costs and never relevant to joint product decisions or to process further decisions Cows are joint products. Joint costs ©Cambridge Business Publishers, 2009 Use of Limited Resources Managers should decide how to best use limited resources to accomplish organizational goals. Sometimes results in a product mix decision, i.e., which product should be produced with the limited resource? Examples of limited resources Limited capacity Limited labor hours due to lack of skilled labor Limited materials due to supply limitations Limited machine hours ©Cambridge Business Publishers, 2009 Wilson Sports produces two models of baseball bats using white ash wood. Due to weather problems, wood supply is limited and Wilson is able to obtain only 24,000 board feet of white ash. Which bat should Wilson produce given the following information? B asic D eluxe B at s B at s $75 $54 34 25 $41 $29 3.40 2.20
continued Use of Limited Resources Single Constraint Example ©Cambridge Business Publishers, 2009 U nit selling pr ice U nit var iable cost s U nit cont r ibut ion mar gin N umber of boar d feet of wood needed per bat Determine the contribution margin per board foot for each product: B asic
U nit cont r ibut ion mar gin N umber of boar d feet of wood needed per bat 3.40 2.20 Cont r ibut ion mar gin per boar d foot : $12.06 $13.1 $41 ÷ 3.40 = 8 D$29 ÷ 2.20 = eluxe bats generate $12.06 of profit for every board foot of white ash wood used, while basic bats generate $13.18. Basic bats should be produced. ©Cambridge Business Publishers, 2009 Use of Limited Resources Single Constraint Example D eluxe B at s B at s $41 $29 Assume that Wilson Sports must produce at least 2,000 of each model to remain competitive. With the same material constraint of 24,000 board feet of white ash, how much will total contribution margin be when profit is maximized under the constraint? Deluxe – contribution per board foot: $41/3.40 = $12.06 Basic – contribution per board foot: $29/2.20 = $13.18 Use of Limited Resources Multiple Constraint Example Produce more basic bats since they generate more contribution to profit per board foot than do the deluxe bats. ©Cambridge Business Publishers, 2009 continued Subtract the board foot to be used for the minimum units of the least profitable product from available wood: 24,000. F eet to be used for minimum deluxe bats (3.4 × ( 6,800) 2,000) Determine the number of basic bats to be produced . R emaining feet to be used for basic bats 17,200 A vailable boar d feet Use of Limited Resources Single Constraint Example with the remaining board feet: Contribution margin generated: Contribution margin generated: N umber of basic bats to be p r oduced ( 17,200 ÷ 2.20) = 7,818 $ 82,000 226,722 C ontr ibution fr om D eluxe bats ($41 × 2,000) C ontr ibution fr om Basic bats ($29 × ©Cambridge Business Publishers, 2009 7,818) Theory of Constraints States that Every process has a bottleneck, and Production cannot take place faster than it is processed through the bottleneck Goal is to maximize throughput in a Throughput is sales revenue minus direct constrained environment
materials cost A bottleneck is a constraining resource.
©Cambridge Business Publishers, 2009 Management’s Role in Bottlenecks
Management should…. Identify the bottlenecks Schedule production to maximize the efficient use of the bottleneck resource Schedule production to avoid a buildup of inventory Work to eliminate bottlenecks ©Cambridge Business Publishers, 2009 Theory of Constraints
To support the theory of constraints, performance reports should: Measure the utilization of bottleneck resources Measure factory throughput Not encourage the full utilization of nonbottleneck resources Discourage the buildup of excess inventory ©Cambridge Business Publishers, 2009 ...
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- Spring '10
- Decision Making