BBACCT2102Chap012 - 12-1 Chapter12 Differential Analysis...

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Unformatted text preview: 12-1 Chapter 12 Differential Analysis: The Key to Decision Making 12-2 Relevant Costs and Benefits A relevant cost is a cost that differs between alternatives. A relevant benefit is a benefit that differs between alternatives. 12-3 Identifying Relevant Costs An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. Two broad categories of costs are never relevant in any decision. They include: Sunk costs. A future cost that does not differ between the alternatives. 12-4 Decision Making: A Two­Step Process Step 1 Eliminate costs and benefits that do not differ between alternatives. Step 2 Use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs. 12-5 Total and Differential Cost Approaches The management of a company is considering a new labor 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 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 Situation With 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 $ $ 12-6 Total and Differential Cost Approaches 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. 12-7 Adding/Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment. Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess this impact, it is necessary to carefully analyze the costs. 12-8 Adding/Dropping Segments Due to the declining popularity of digital watches, Lovell Company’s digital watch line has not reported a profit for several years. Lovell is considering discontinuing this product line. 12-9 A Contribution Margin Approach DECISION RULE Lovell should drop the digital watch segment only if its profit would increase. Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped. 12-10 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 $ 60,000 90,000 50,000 100,000 70,000 30,000 200,000 $ 300,000 400,000 $ (100,000) 12-11 Adding/Dropping Segments Segment Income Statement Digital Watches Sales $ 500,000 Less: variable expenses An investigation has revealed that the fixed An investigation has revealed that the fixed Variable manufacturing costs and fixed general $ 120,000 general factory overhead and fixed general general factory overhead Variable shipping costs 5,000 administrative expenses will not be affected by administrative expenses will not be affected by Commissions 75,000 200,000 dropping the digital watch line. The fixed general Contributionthe digital watch line. The fixed general $ 300,000 dropping margin Less: fixed expenses and general administrative factory overhead and general administrative factory overhead General factory overhead $ 60,000 expenses assigned to this product would be expenses manager Salary of line assigned to this product would be 90,000 reallocated to other product lines. reallocated to other product lines. Depreciation of equipment 50,000 Advertising - direct 100,000 Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss $ (100,000) 12-12 Adding/Dropping Segments Segment Income Statement Digital Watches Sales $ 500,000 Less: variable expenses The equipment used to manufacture The equipment used to manufacture Variable manufacturing costs $ 120,000 digital watches has no resale Variable shipping costs 5,000 digital watches has no resale Commissions or alternative use. 75,000 200,000 value or alternative use. value Contribution margin $ 300,000 Less: fixed expenses General factory overhead $ 60,000 Salary of line manager 90,000 Should Lovell retain or drop Should Depreciation of equipment Lovell retain or drop 50,000 Advertising - direct the digital watch segment? 100,000 the digital watch segment? Rent - factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss $ (100,000) 12-13 A 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) 12-14 Comparative Income Approach The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment. Let’s look at this second approach. 12-15 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) 12-16 The Make or Buy Decision When a company is involved in more than 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. 12-17 The Make or Buy Decision: An Example ssex 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 12-18 The Make or Buy Decision • 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? Should we accept the supplier’s offer? 12-19 The Make or Buy Decision Cost Per Unit Outside purchase price $ 25 Direct materials (20,000 units) Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost $ 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? Given that the total avoidable costs are less than the cost of buying the part, Essex should continue to make the part. 12-20 Key Terms and Concepts 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. Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant. 12-21 Special Orders 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? 12-22 Special Orders $8 variable cost 12-23 Special Orders If Jet accepts the special order, the incremental revenue will exceed the incremental costs. In other words, net operating income will increase by $6,000. This suggests that Jet should accept the order. Increase Increase Increase in revenue (3,000 × $10) in costs (3,000 × $8 variable cost) in net income $ 30,000 24,000 $ 6,000 Note: This answer assumes that the fixed costs are unavoidable and that variable marketing costs must be incurred on the special order. 12-24 Key Terms and Concepts 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. 12-25 Utilization of a Constrained Resource • Fixed costs are usually unaffected in these situations, so the product mix that maximizes the company’s total contribution margin should ordinarily be selected. • A company should not necessarily promote those products that have the highest unit contribution margins. • Rather, total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest contribution margin in relation to the constraining resource. 12-26 Utilization of a Constrained Resource: An Example Ensign Company produces two products and selected data are shown below: 12-27 Utilization of a Constrained Resource: An Example • 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 Should Ensign focus its efforts on Product 1 or Product 2? Product 1 or Product 2? 12-28 Utilization of a Constrained Resource The key is the contribution margin per unit of the constrained resource. Ensign should emphasize Product 2 because it generates a contribution margin of $30 per minute of the constrained resource relative to $24 per minute for Product 1. 12-29 Utilization of a Constrained Resource The key is the contribution margin per unit of the constrained resource. Ensign can maximize its contribution margin Ensign can maximize its contribution margin by first producing Product 2 to meet customer by first producing Product 2 to meet customer demand and then using any remaining demand and then using any remaining capacity to produce Product 1. The capacity to produce Product 1. The calculations would be performed as follows. calculations would be performed as follows. 12-30 Utilization of a Constrained Resource Let’s see how this plan would work. Alloting Our Constrained Resource (Machine A1) Alloting Our Constrained Resource (Machine A1) Weekly demand for Product 2 Weekly demand for Product 2 Time required per unit Time required per unit Total time required to make Total time required to make Product 2 Product 2 Total time available Total time available Time used to make Product 2 Time used to make Product 2 Time available for Product 1 Time available for Product 1 Time required per unit Time required per unit Production of Product 1 Production of Product 1 × × 2,200 2,200 0.50 0.50 units units min. min. 1,100 min. 1,100 min. ÷ ÷ 2,400 2,400 1,100 1,100 1,300 1,300 1.00 1.00 1,300 1,300 min. min. min. min. min. min. min. min. units units 12-31 Utilization of a Constrained Resource According to the plan, we will produce 2,200 units of Product 2 and 1,300 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. 12-32 Joint Costs • In some industries, a number of end products are produced from a single raw material input. • Two or more products produced from a common input are called joint products. joint products • The point in the manufacturing process where each joint product can be recognized as a separate product is called the split­off point. split­off point 12-33 Joint Products Joint costs are incurred up to the split-off point Joint Input Common Production Process Oil Gasoline Chemicals Split-Off Point Separate Processing Final Sale Final Sale Separate Processing Separate Product Costs Final Sale 12-34 Sell or Process Further: An Example • 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 wholesalers or processed further into “presto­ logs.” logs.” 12-35 Sell or Process Further 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 Sawdust $ 140 $ 40 270 176 50 50 24 20 12-36 Sell or Process Further 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 The lumber should be processed further and the sawdust should be sold at the split-off point. Sawdust $ $ 50 40 10 20 (10) ...
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