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Unformatted text preview: BCOR 2000 Chapter 12M Relevant Costs for Decision Making CH 12M Game Plan:
1. Relevant Costs and Benefits 2. Adding / Dropping Product Lines / Segments 3. Vertical Integration Make or Buy Decisions 4. Marketing Accept `Special' Orders 5. Producing under Constrained Resources 6. Production Joint Product Costs and Selling or Processing Further Decisions Relevant Costs and Benefits Costs that differ between alternatives are relevant costs Avoidable costs can be eliminated partially or completely by choosing one alternative over another (these are relevant) Irrelevant costs should be ignored: Sunk Costs already incurred and cannot be avoided Future costs that do not differ between alternatives Relevant Costs Example Adding/Dropping Segments Context: manager is deciding whether to add or drop a business segment (e.g., product or geographic), specific plant, or store. DECISION RULE using contribution approach, companies should drop segments only if overall profit increases. E.g., if fixed cost savings exceed lost contribution margin from dropping segment. Ex: Due to ing popularity of digital watches, Lovell Co.'s digital watch line hasn't reported a profit for several years. Lovell considers dropping the product line. Adding/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) 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 $ 90,000 Advertising - direct 100,000 Rent - factory space 70,000 Net disadvantage $ (300,000) 260,000 $ (40,000) Moral of the story: Beware of allocated fixed costs Make or Buy Context: Should company make or buy product or component? Related to outsourcing & vertical integration. Companies are vertically integrated if involved in 1+ activity in the value chain Advantages of vertical integration: control flow of parts, control quality, realize profits of entire process Advantages of external suppliers: By pooling demand they may be able to provide higher quality at lower cost Make or Buy (outsourcing) Baron Co. incurs the following costs to make 25,000 switches: Switches can be purchased for $8 per switch ($200K). Should Baron make or buy? What if $10,000 of fixed costs could be eliminated? (avoidable fixed cost) Make or Buy Baron example
Make Direct materials $ 50,000 Direct labor 75,000 Variable manufacturing costs 40,000 Fixed manufacturing costs 60,000 Purchase price -0Total annual cost $225,000 Buy $ -0-0-050,000 200,000 $250,000 Net Income Increase (Decrease) $ 50,000 75,000 40,000 10,000 (200,000) $ (25,000) Buying adds $25K to cost of switches, so continue to make switches What are the nonfinancial considerations? Opportunity Costs Opportunity costs = economic benefits forgone as a result of pursuing a course of action By choosing one alternative, sacrifice benefits of other alternative(s) In Make or Buy, opportunity costs could be represented by income-generating activities associated with use of facilities when not used for production if company chooses to buy Special Orders
Special Order = a one-time order not considered part of company's normal ongoing business Decision Rule: Consider only incremental costs and benefits Existing costs and benefits are irrelevant when deciding whether to accept special order Is incremental revenue > incremental cost? Is production at capacity? Impacts on `normal' business? Ex: Jet, Inc. Special Orders Jet, Inc. makes a single product whose normal selling price is $20 per unit. A foreign distributor offers to purchase 3K units for $10 per unit. This is a one-time order that would not affect the company's regular business. Annual capacity is 10K units, but Jet, Inc. is currently producing and selling only 5K units. Should Jet accept the offer? Special Orders $8 variable cost Special Orders 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 Key assumptions: Fixed costs are unaffected by the order Variable marketing costs must be incurred on the special order. Quick Check Northern Optical ordinarily sells the X-lens for $50. The variable production cost is $10, the fixed production cost is $18 per unit, and the variable selling cost is $1. A customer requests a special order for 10K units of the X-lens to be imprinted with the customer's logo. This special order would not involve any selling costs, but Northern Optical would have to purchase an imprinting machine for $50,000.
(Continued ...) What is the rock bottom minimum price below which Northern Optical should not go in its negotiations with the customer? In other words, below what price would Northern Optical actually be losing money on the sale? There is ample idle capacity to fulfill the order and the imprinting machine has no further use after this order. Quick Check a. $50 b. $10 c. $15 d. $29 Constrained Resources A company has a constraint when a limited resource restricts its ability to satisfy demand Managers must decide best use of resource E.g.: Machine hours, floor space, direct labor A bottleneck is the machine or process that is limiting overall output Rule to follow: Maximize the contribution margin per unit of constrained resource Ex: Ex: Utilization of a Constrained Resource
Ensign Company produces two products and selected data are shown below (Machine A1 is bottleneck): Utilization of a Constrained Resource Machine A1 is constrained resource and is being Machine A1 is constrained resource and is being used at 100% of capacity. used at 100% of capacity. There is excess capacity on all other machines. There is excess capacity on all other machines. Machine A1 has a capacity of 2,400 minutes per Machine A1 has a capacity of 2,400 minutes per week. week. Should Ensign focus its efforts on Product 1 or Product 2? Quick Check How many units of each product can be processed through Machine A1 in one minute? Product 1 Product 2 a. b. c. d. 1 unit 1 unit 2 units 2 units 0.5 unit 2.0 units 1.0 unit 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
Determine the CM per unit of the constrained resource: Therefore, 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
How would we implement the plan?
Alloting the 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 Joint Product Costs and the Decision to Sell or Process Further 2+ products that are produced from a common input are called Joint Products Split-off point = point in mfg process at which joint products are recognized as distinct products Joint Costs are costs incurred up to the split-off point though allocation of these costs are needed for B/S valuation, they are irrelevant for decisions to sell or process further Ex: Sell or Process Further Sawmill, Inc. cuts logs from which unfinished Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint lumber and sawdust are the immediate joint products. products. Unfinished lumber is sold "as is" or processed Unfinished lumber is sold "as is" or processed further into finished lumber. further into finished lumber. Sawdust can also be sold "as is" to gardening Sawdust can also be sold "as is" to gardening wholesalers or processed further into "presto-logs." wholesalers or processed further into "presto-logs." Decision rule: If incremental revenue > incremental Decision rule: If incremental revenue > incremental costs, then process further costs, then process further Sell or Process Further
Data about Sawmill's joint products includes:
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
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) Since incremental costs > incremental revenues for Sawdust, sell and do not process further Chapter 12M Exercises / Problems E12M-14 (Add or Drop Segment) E12M-9 (Make or Buy) E12M-4 (Special Order) E12M-11 (Constrained Resource) P12M-17 (Sell or Process Further) ...
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- Spring '07