Chapter12

Chapter12 - Identifying Relevant Costs Identifying A...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Identifying Relevant Costs Identifying A relevant cost is a cost that differs between alternatives. relevant is An avoidable cost can be eliminated (in whole or in part) by An choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. costs. Two broad categories of costs are never relevant in any Two decision and include: Sunk costs. Future costs that do not differ between the Future do alternatives. alternatives. Relevant Cost Analysis: A TwoRelevant Step 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. Total and Differential Cost Approaches Total The management of a company is considering a new labour-saving machine that rents for $3,000 per year. Data about the company’s annual sales and costs with and without the new machine are: Sales (5,000 units @ $40 per unit) Less variable expenses: Direct materials (5,000 units @ $14 per unit) Direct labour (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 Situation W ith New Machine $ 200,000 Differential Costs and Benefits - 70,000 40,000 10,000 120,000 80,000 70,000 25,000 10,000 105,000 95,000 15,000 15,000 62,000 62,000 18,000 62,000 3,000 65,000 30,000 (3,000) (3,000) 12,000 $ $ Total and Differential Cost Approaches Total As you see, the only costs that differ between the alternatives are the direct labour 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 labour (5,000 units @ $8 and $5 per unit) V ariable 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 S ituation W ith New Machine $ 200,000 Differential Costs and Benefits - 70,000 40,000 10,000 120,000 80,000 70,000 25,000 10,000 105,000 95,000 15,000 15,000 62,000 3,000 65,000 30,000 (3,000) (3,000) 12,000 We can efficiently analyze the decision by62,000 looking at the different costs and revenues and 62,000 $ 18,000 arrive at the same solution. Net Advantage to Renting the New Machine Decrease in direct labour costs (5,000 units @ $3 per unit) I ncrease in fixed rental expenses Net annual cost saving from renting the new machine $ $ 15,000 (3,000) 12,000 $ Total and Differential Cost Approaches Total Using the differential approach is desirable for two reasons: 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/Dropping Segments Adding/Dropping One of the most important decisions managers make is whether to One add or drop a business segment such as a product or a store. add Due to the declining popularity of digital watches, Lovell Due Company’s digital watch line has not reported a profit for several years. Lovell is considering dropping this product line. several DECISION RULE DECISION RULE Lovell should drop the digital watch segment only if its profit Lovell should drop the digital watch segment only if its profit Lovell Lovell would increase. This would only happen if the fixed cost would increase. This would only happen if the fixed cost savings exceed tthe lost contribution margin.. savings exceed he lost contribution margin exceed exceed Adding/Dropping Segments Adding/Dropping 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 $ 60,000 90,000 50,000 100,000 70,000 30,000 200,000 $ 300,000 400,000 $ (100,000) A Contribution Margin Approach Contribution 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) Comparative Income Approach Solution Keep Drop Digital Digital W atches W atches 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) The Make or Buy Decision The When a company is involved in more than When one activity in the entire value chain, it is vertically integrated. A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier is called a “make or buy” decision. decision. The Make or Buy Decision: An Example The Essex Company manufactures part 4A Essex that is used in one of its products. that The unit product cost of this part is: Direct materials Direct labour Variable overhead Depreciation of special equip. Supervisor's salary General factory overhead Unit product cost $ 9 5 1 3 2 10 $ 30 The Make or Buy Decision The The special equipment used to manufacture The part 4A has no resale value. part The total amount of general factory overhead, The which is allocated on the basis of direct labour hours, would be unaffected by this decision. hours, The $30 unit product cost is based on 20,000 The parts produced each year. parts An outside supplier has offered to provide the An 20,000 parts at a cost of $25 per part. 20,000 Should we accept the supplier’s offer? Opportunity Cost Opportunity An opportunity cost is the benefit that is opportunity is foregone as a result of pursuing some course of action. of Opportunity costs are not actual dollar outlays Opportunity and are not recorded in the formal accounts of an organization. of How would this concept potentially relate to the How Essex Company? Essex Key Terms and Concepts Key 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 Orders Special Jet, Inc. makes a single product whose Jet, normal selling price is $20 per unit. normal A foreign distributor offers to purchase foreign 3,000 units for $10 per unit. This is a one-time order that would not This affect the company’s regular business. affect Annual capacity is 10,000 units, but Jet, Annual Inc. is currently producing and selling only 5,000 units. only Should Jet accept the offer? Key Terms and Concepts Key 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: An Example Resource: Ensign Company produces two products and Ensign selected data is shown below: selected Utilization of a Constrained Resource Resource Machine A1 is the constrained resource Machine and is being used at 100% of its capacity. There is excess capacity on all other There machines. Machine A1 has a capacity of 2,400 Machine minutes per week. minutes Should Ensign focus its efforts on Should Product 1 or 2? Product Managing Constraints Managing Finding ways to process more units through a resource bottleneck At the bottleneck itself: • Improve the process Improve • Add overtime or another shift Add • Hire new workers or acquire more machines more • Subcontract production Subcontract • Reduce amount of defective units produced units • Add workers transferred from Add non-bottleneck departments non-bottleneck Joint Costs Joint In some industries, a number of end In products are produced from a single raw material input. material Two or more products produced from a Two common input are called joint products. joint The point in the manufacturing process The where each joint product can be recognized as a separate product is called the split-off point. point. Joint Products Joint Joint Costs Joint Input Common Production Process Oil Gasoline Chemicals Split-Off Point Separate Processing Final Sale Final Sale Separate Processing Separate Product Costs Final Sale Sell or Process Further Sell Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward. forward. It will always be profitable to continue processing a It joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs incurred after the split-off point. split-off Sell or Process Further: An Example Example Sawmill, Inc. cuts logs from which unfinished Sawmill, lumber and sawdust are the immediate joint products. products. Unfinished lumber is sold “as is” or processed Unfinished further into finished lumber. further Sawdust can also be sold “as is” to gardening Sawdust wholesalers or processed further into “presto-logs.” wholesalers Sell or Process Further Sell Data about Sawmill’s joint products includes: Sales value at the split-off point Sales value after further processing Allocated joint product costs Cost of further processing Per Log Lumber S awdust $ 140 $ 40 270 176 50 50 24 20 Sell or Process Further Sell Analysis of Sell or Process Further Per Log Lumber 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 Sawdust $ $ 50 40 10 20 (10) Setting a Target Selling Price Setting Here is information provided by the management of Ritter Company. Direct materials Direct labour Variable manufacturing overhead Fixed manufacturing overhead Variable S & A expenses Fixed S & A expenses Per Unit $ 6 4 3 Total $ 70,000 2 60,000 Assuming Ritter will produce and sell 10,000 Assuming units of the new product, and that Ritter typically uses a 50% markup percentage, let’s determine the unit product cost. the Setting a Target Selling Price Setting Direct materials Direct labour Variable manufacturing overhead Fixed manufacturing overhead Unit product cost Per Unit $ 6 4 3 7 $ 20 ($70,000 ÷ 10,000 units = $7 per unit) Ritter has a policy of marking up unit product costs by 50%. Let’s calculate the target selling price. Setting a Target Selling Price Setting Ritter would establish a target selling price to cover selling, general, and administrative expenses and contribute to profit $30 per unit. Direct materials Direct labour Variable manufacturing overhead Fixed manufacturing overhead Unit product cost 50% markup Target selling price Per Unit $ 6 4 3 7 $ 20 10 $ 30 Determining the Markup Percentage Percentage The markup percentage can be based on an industry “rule of thumb,” company tradition, or it can be explicitly calculated. The equation to calculate the markup percentage is: Markup % on absorption cost = (Required ROI × Investment) + SG&A expenses Unit sales × Unit product cost Determining the Markup Percentage Percentage Let’s assume that Ritter must invest $100,000 in the Let’s assume that Ritter must invest $100,000 in the Let’s Let’s product and market 10,000 units of product each product and market 10,000 units of product each year. The company requires a 20% ROI on all year. The company requires a 20% ROI on all iinvestments. Let’s determine Ritter’s markup nvestments. Let’s determine Ritter’s markup percentage on absorption cost. percentage on absorption cost. percentage percentage Determining the Markup Percentage Percentage Markup % (20% × $100,000) + ($2 × 10,000 + $60,000) on absorption = 10,000 × $20 cost Variable SG&A per unit Total fixed SG&A Markup % on absorption cost = ($20,000 + $80,000) $200,000 = 50% Target Costing Target Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be made for that maximum target cost figure. The equation for determining the target price is shown below: Target cost = Anticipated selling price – Desired profit Reasons for Using Target Costing Costing Two characteristics of prices and product costs: 1. The market (i.e., supply and demand) determines price 2. Most of the cost of a product is determined in the design stage Target costing was developed in recognition of Target costing was developed in recognition of Target Target these two characteristics. tthese two characteristics. these hese Target Costing Target Handy Appliance feels there is a niche for a hand Handy Appliance feels there is a niche for a hand Handy Handy mixer with certain features. The Marketing mixer with certain features. The Marketing Department believes that a price of $30 would be Department believes that a price of $30 would be about right and that about 40,000 mixers could be about right and that about 40,000 mixers could be sold. An investment of $2,000,000 is required to gear sold. An investment of $2,000,000 is required to gear up for production. The company requires a 15% ROI up for production. The company requires a 15% ROI on invested funds. on invested funds. on on Target Costing Target Projected sales (40,000 units × $30) Desired profit ($2,000,000 × 15%) Target cost for 40,000 mixers $ 1,200,000 300,000 $ 900,000 Target cost per mixer ($900,000 ÷ 40,000) $ 22.50 Each functional area within Handy Appliance would be responsible for keeping its actual costs within the target established for that area. Homework Homework Extra Practice Exercises: 12-8 to 12-12, 12-19 Questions? Jason.Gonsalves@Humber.ca ...
View Full Document

Ask a homework question - tutors are online