L05-Special Decision Making Issues_1

L05-Special Decision Making Issues_1 - Topic 5: Topic 5:...

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Unformatted text preview: Topic 5: Topic 5: Special Decision Making Issues Introduction Introduction ► This chapter explores the decision­making process. ► It focuses on specific decisions such as accepting or rejecting a one­time­only special order, in­sourcing or outsourcing products or services, and replacing or keeping equipment. Structure of Lecture Structure of Lecture ► Decision Making Process ► Relevant costs ► Accepting/Rejecting a Special Order ► Make or Buy Decisions ► Opportunity costs and constraints ► Limited Resources ► Equipment Replacement decisions ► Add or drop a product ► Joint Costs Information and the Information and the Decision Process ► A decision model is a formal method for making a choice, often involving quantitative and qualitative analysis. Five­Step Decision Process Step 1 Gathering Information Step 2 Making Predictions 1 Step 3 Choosing an Alternative Step 4 Implementing the decision 2 3 4 5 Step 5 Evaluating Performance The Meaning of Relevance The Meaning of Relevance ► Relevant costs and relevant revenues are expected future costs and revenues that differ among alternative courses of action. ► Historical costs are irrelevant to a decision but are used as a basis for predicting future costs. ► Sunk costs are past costs which are unavoidable. The Meaning of Relevance The Meaning of Relevance ► Differential profit (net relevant profit) is the difference in total operating profit when choosing between two alternatives. ► Differential costs (net relevant costs) are the difference in total costs between two alternatives. Relevant Costs in Equipment Relevant Costs in Equipment Replacement Decision Which costs are not relevant to the decision to keep the old machine Which or replace it with a new, more efficient one? or • • • • • • • • • Old machine cost $4,200 when purchased Old machine has a book value of $2,100 Purchase price of a new machine is $7,000 New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3,500 and would allow one more year of productivity Power for either machine is expected to be $2.50 New machine will reduce labor costs by $0.50 per hour Expected level of output for next year is 2,000 units Relevant Costs in Equipment Relevant Costs in Equipment Replacement Decision Which costs are not relevant to the decision to keep the old machine Which or replace it with a new, more efficient one? or • • • • • • • • • Old machine cost $4,200 when purchased Old machine has a book value of $2,100 Purchase price of a new machine is $7,000 New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3,500 and would allow one more year of productivity Not relevant because Power for either machine is expected to be $2.50 of the zero salvage. New machine will reduce labor costs by $0.50 per hour Expected level of output for next year is 2,000 units Relevant Costs in Equipment Replacement Decision Which costs are not relevant to the decision to keep the old machine or Relevant or replace it with a new, more efficient one? because • • • • • • • • • • Old machine cost $4,200 when purchased the one year the Old machine has a book value of $2,100 relates to a Purchase price of a new machine is $7,000 relevant item. relevant New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3,500 and would allow one more year of productivity Power for either machine is expected to be $2.50 New machine will reduce labor costs by $0.50 per hour Expected level of output for next year is 2,000 units Relevant Costs in Equipment Relevant Costs in Equipment Replacement Decision Which costs are not relevant to the decision to keep the old machine Which or replace it with a new, more efficient one? or • • • • • • • • • Old machine cost $4,200 when purchased Old machine has a book value of $2,100 Purchase price of a new machine is $7,000 New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3,500 and would allow one more year of productivity output Relevant because the 2,000 unit Power for either machine is expected to be $2.50 is related to labor costs and savings. New machine will reduce labor costs by $0.50 per hour Expected level of output for next year is 2,000 units Relevant Costs in Equipment Relevant Costs in Equipment Replacement Decision So, the relevant costs are . . . • • • • • • • • • Old machine cost $4,200 when purchased Old machine has a book value of $2,100 Purchase price of a new machine is $7,000 New machine is expected to last one year New machine will have zero salvage value Repairs to old machine would be $3,500 and would allow one more year of productivity Power for either machine is expected to be $2.50 New machine will reduce labor costs by $0.50 per hour Expected level of output for next year is 2,000 units Relevant Cost Analysis in Equipment Replacement Decision Repair Old Machine Variable labor costs (2,000 hours x 1 year x $10) (2,000 hours x 1 year x $9.50) Fixed costs (1 year) Repair costs New machine Total Repair costs are lower by $2,500 $ Purchase New Machine 20,000 $ 19,000 $ 7,000 26,000 3,500 $ 23,500 Quantitative and Qualitative Quantitative and Qualitative Relevant Information ► Quantitative factors are outcomes that are measured in numerical terms: – Financial – Non­financial ► Qualitative factors are outcomes that cannot be measured in numerical terms. Analysis of Special Decisions Analysis of Special Decisions Let’s take a close look at some special decisions faced by many businesses. We just received a special order. Do you think we should accept it? Accept or Reject a Special Order Accept or Reject a Special Order ► A travel agency offers Worldwide Airways $150,000 for a round­trip flight from Hawaii to Japan on a jumbo jet. ► Worldwide usually gets $250,000 in revenue from this flight. ► The airlines is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency. ► The next screen shows cost data developed by managerial accountants at Worldwide. Accept or Reject a Special Order Accept or Reject a Special Order Worldwide will save about $5,000 in reservation and ticketing costs if the charter is accepted. Accept or Reject a Special Order Accept or Reject a Special Order Since the charter will contribute to fixed costs and Worldwide has idle capacity, the company should accept the flight. Accept or Reject a Special Order Accept or Reject a Special Order What if Worldwide had no excess capacity? If Worldwide adds the charter, it will have to cut its least profitable route that currently contributes $80,000 to fixed costs and profits. Should Worldwide still accept the charter? Accept or Reject a Special Order Accept or Reject a Special Order Worldwidehas no e ss capacity, so it should re ct the xce je Worldwide spe charte cial r. spe Accept or Reject a Special Order Accept or Reject a Special Order With excess capacity . . . Relevant costs usually will be the variable costs associated with the special order. Without excess capacity . . . Same as above but opportunity cost of using the firm’s facilities for the special order are also relevant. Potential Problems in Potential Problems in Relevant­Cost Analysis ► General assumptions: – Do not assume that all variable costs are relevant. – Do not assume that all fixed costs are irrelevant. ► Unit­cost data can potentially mislead decision makers: – Irrelevant costs are included. – The same unit costs are used at different output levels. In­sourcing versus Outsourcing In­sourcing versus Outsourcing ► Outsourcing is the process of purchasing goods and services from outside sellers rather than producing goods or providing services within the organisation, which is called in­sourcing. Make­or­Buy Decisions Make­or­Buy Decisions ► Decisions about whether to outsource or produce within the organisation are often called make­or­buy decisions. ► The most important factors in the make­or­ buy decision are quality, dependability of supplies, and costs. Outsource a Product or Service Outsource a Product or Service A decision concerning whether an item should be produced internally or purchased from an outside supplier is often called a “make or buy” decision. Let’s look at another decision faced by the management of Worldwide Airways. Outsource a Product or Service Outsource a Product or Service ► An Atlanta bakery has offered to supply the in­ flight desserts for 21¢ each. ► Here are Worldwide’s current cost for desserts: Outsource a Product or Service Outsource a Product or Service Not all of the allocated fixed costs will be saved if Worldwide purchases from the outside bakery. Outsource a Product or Service Outsource a Product or Service If Worldwide purchases the dessert for 21¢, it will only save 15¢ so Worldwide will have a loss of 6¢ per dessert purchased. Wow, that’s no deal! Opportunity Costs, Opportunity Costs, Outsourcing, and Constraints ► Opportunity cost is the contribution to profit that is foregone (rejected) by not using a limited resource in its next­best alternative use. ► Opportunity costs are not recorded in formal accounting records since they do not generate cash outlays. ► These costs also are not ordinarily incorporated into formal reports. Decisions Involving Limited Decisions Involving Limited Resources ► Firms often face the problem of deciding how limited resources are going to be used. ► Usually, fixed costs are not affected by this decision, so management can focus on maximizing total contribution margin. Let’s look at the Martin, Inc. example. Limited Resources Limited Resources Martin, Inc. produces two products and selected data is shown below: Limited Resources Limited Resources ► The lathe is the scarce resource because there is excess capacity on other machines. The lathe is being used at 100% of its capacity. ► The lathe capacity is 2,400 minutes per week. Should Martin focus its efforts on Webs or Highs? Limited Resources ► Decision criteria: Aim for the highest contribution margin per unit of the constraining factor. ► When multiple constraints exist, optimisation techniques such as linear programming can be used in making decisions. Limited Resources Limited Resources Martin, Inc. produces two products and selected data is shown below: Limited Resources Limited Resources Let’s calculate the contribution margin per unit of the scarce resource, the lathe. Limited Resources Limited Resources Let’s calculate the contribution margin per unit of the scarce resource, the lathe. Limited Resources Limited Resources Let’s calculate the contribution margin per unit of the scarce resource, the lathe. Highs should be emphasized. It is the more valuable use of the scarce resource the lathe, yielding a contribution margin of $30 per minute as opposed to $24 per minute for the Webs. Limited Resources Limited Resources Let’s calculate the contribution margin per unit of the scarce resource, the lathe. If there are no other considerations, the best plan would If be to produce to meet current demand for Highs and then use any capacity that remains to make Webs. then Limited Resources Limited Resources Let’s see how this plan would work. Limited Resources Limited Resources According to the plan, Martin will produce 2,200 Highs and 1,300 Webs. Martin’s contribution margin looks like this. The total contribution margin for Martin, Inc. is $64,200. Any other combination would result in less contribution. Any less Add or Drop a Service, Add or Drop a Service, Product, or Department One of the most important decisions managers make is whether to add or drop a product, service or department. Let’s look at how the concept of relevant costs should be used in such a decision. Add or Drop a Product Add or Drop a Product Due to the declining popularity of digital watches, Swick Company’s digital watch line has not reported a profit for several years. An income statement for last year is shown on the next screen. Add or Drop a Product Add or Drop a Product Add or Drop a Product Add or Drop a Product If the digital watch line is dropped, the fixed general factory overhead and general administrative expenses will be allocated to other product lines because they are not avoidable. Add or Drop a Product Add or Drop a Product The equipment used to manufacture digital The watches has no resale value or alternative use. watches Add or Drop a Product Add or Drop a Product Should Swick retain or drop the digital watch segment? Add or Drop a Product Add or Drop a Product Add or Drop a Product Add or Drop a Product Summary Summary DECISION RULE Swick should drop the digital watch segment Swick only if its fixed cost savings exceed lost contribution margin. contribution Joint­Cost Basics Joint­Cost Basics ► Joint costs are the costs of a single production process that yields multiple products simultaneously. ► Industries abound in which a single production process simultaneously yields two or more products. Joint­Cost Basics Joint­Cost Basics Tomatoes Tomato juice Tomato sauce Tomato paste Joint­Cost Basics Joint­Cost Basics Coal Gas Benzyl Tar Split­off Point Split­off Point ► The split­off point is the juncture in the production process where one or more products in a joint­cost setting become separately identifiable. ► Separable costs are all costs (manufacturing, marketing, distribution, etc.) incurred beyond the split­off point that are assignable to one or more individual products. Joint Processing of Cocoa Bean Cocoa beans Cocoa costing $500 per ton Joint Production process costing $600 per ton Total joint cost: $1,100 per ton Cocoa butter sales value $750 for 1,500 pounds Split-off point Cocoa powder sales value $500 for 500 pounds Separable process costing $800 Instant cocoa mix sales value mix sales $2,000 for 500 pounds Why Allocate Joint Products? Why Allocate Joint Products? ► 1. 2. 3. 4. 5. The purposes for allocating joint costs to products include: Stock costing Cost reimbursement contracts Insurance settlements Rate regulation Litigation Joint Products Joint Products Relative Sales Value Method Joint Products Joint Products Relative Sales Value Method $750 ÷ $1,250 = 60% Joint Products Joint Products Relative Sales Value Method 60% × $1,100 = $660 Joint Products Joint Products Relative Sales Value Method Sell Intermediate Products Or Sell Intermediate Products Or Process Them Further? National Wood Products has a sawmill in Georgia. The mill has a monthly capacity of 4,700 mbf (1,000 board feet). For a month of production, the mill acquires logs and cuts them into two grades of lumber (1,000 mbf of Grade A Standard and 3,000 mbf of Grade B Standard) at a cost of $1,400,000. The Grade A Standard can be further processed into Grade A Special lumber at an additional cost of $100,000. Forecasted Sales Price information is as follows: Sell Intermediate Products Or Sell Intermediate Products Or Process Them Further? National Wood Products has a decision to make. They can choose Option 1 and produce 1,000mbf of Grade A Standard and 3,000 mbf of Grade B Standard. Alternatively, Option 2 allows them to produce 1,000 mbf of Grade A Special and 3,000 mbf of Grade B Standard. Which option should National Wood Products choose? Note: The decision hinges on making an accurate determination of which option provides the highest Net Realizable Value. Sell Intermediate Products Or Sell Intermediate Products Or Process Them Further? Net realizable value (NRV) = Sales value - further processing costs after split off Option 2 obviously has Option the higher NRV and is the option of choice. the Maximizing The Profit Of Joint Product Processes Computing the NRV of each set of products provides a comparison of each product’s sales revenues to cost after split-off What is RELEVANT? Allocation of the sawmill’s $1,400,000 joint processing costs Revenues from processing beyond the split-off and any expenditures for additional processing NO YES Irrelevance of Joint Costs Irrelevance of Joint Costs for Decision Making ► Joint costs incurred up to the split­off point are past (sunk) costs irrelevant to the decision to sell a joint (or main) product at the split­off point or to process it further. Other Issues in Decision Making Other Issues in Decision Making Pitfalls to Avoid Sunk costs. Allocated fixed costs. Unitized fixed costs. Opportunity costs. End of Topic 5 End of Topic 5 ...
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