1

Differential Cost Analysis for Operating Decisions

CHAPTER 7

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in

part, except for use as permitted in a license distributed with a certain product or service or

otherwise on a password-protected website for classroom use.

PowerPoint Presentation by

LuAnn BeanProfessor of AccountingFlorida Institute of Technology

Managerial Accounting 11E

Maher/Stickney/Weil

2

CHAPTER GOALThis chapter explains how managers can use

differential analysis to examine the effects on profits. Differential analysis helps managers answer relevant questions such as:¯What activities differ between the alternatives?¯How does that difference affect costs and profits?

☼ ☼

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DIFFERENTIAL ANALYSIS: Definition

Is the analysis of differences among particular alternative

actions.

LO 1

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EXAMPLE: Ullman Educational Media

Ullman Educational Media (UEM) is a company that produces tutorial videos for primary and preschool use. UEM developed the following estimates:

LO 1

Continued

Units made and sold 800 per monthMaximum production and sales capacity 1,200 units per month

Selling price $ 30

UEM

5

ACTIVITY & COSTSUllman Educational Media provides the following

information about activities and costs:

LO 1

Continued

VC per unit FC per month

Manufacturing $ 17 $ 3,060Marketing and Administrative 5 1,740

Total costs $ 22 $4,800

UEM

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LO 1

EXHIBIT 7.2

UEM

Profit decreasesby $1,000.

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CASH FLOW

Differential analysis focuses on cash flow because ¯Cash is the medium of exchange in business¯Cash is a common objective measure of the costs

and benefits of alternatives

LO 1

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Pricing Decisions

LO 2

Customer

DemandsCompetitors’ Actions

Cost of Products

Will raising prices lose customers

to a competitor

or cause them to

substitute cheaper goods?

MANAGERS WANT TO KNOW!

Managers must consider

competitors actions both

nationally and internationally.

Internal focus on continuous improvements

is key to cutting costs.

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SPECIAL ORDERS

Ullman has an opportunity for a one-time only special order to sell 100 units at $25 each. The regular price is $28. Should they accept the special order?

LO 2MANAGERS WANT TO KNOW!UEM

Continued

10

LO 2

EXHIBIT 7.3Yes! Since

normal operations should be used to cover FC, not special

orders, this special order

adds $300 to the bottom line.

UEM

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LO 2

EXH

IBIT

7.5

Full cost, used for long run decisions, is the total

cost of producing and selling a unit.

UEM

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PRICING DECISIONSUse of full cost in pricing decisions is justified

because ¯In the long run, prices must cover all costs to

survive¯Long term contractual agreements must cover all

costs¯Prices in regulated industries are often based on

full cost¯Although full cost + profit may be used initially,

short term adjustments may reflect market conditions.

LO 2

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PRODUCT LIFE CYCLE: Definition

Covers the time from initial research and development to time support to customer is

withdrawn.

LO 2

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Predatory pricing: Definition

Is when a business deliberately prices below its costs to drive out competitors.

LO 2

Dumping: Definition

Occurs when a foreign company sells a product in the U.S. at a price below the

market value in the country of its creation.

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What is target cost?

Target cost is the target price less the target profit.

LO 3

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LO 3

EXH

IBIT

7.5

Value engineering is a systematic evaluation of

all aspects of the business.

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Customer cost ActivitiesCost to acquire customer Promote product; campaign to

win lost customers; run advertising campaign

Cost to provide goods and services Process order; deliver product; process returns

Cost to maintain customers Bill customers; process payments; issue refunds

Cost to retain customers Follow-up calls

USING ACTIVITY-BASED COSTING: Analyze Profitability

LO 4

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THEORY OF CONSTRAINTSThe theory of constraints (TOC) acknowledges

that businesses often have constraints or limits on what can be done. TOC encourages managers to identify where constraints arise and to develop methods to manage them. Three factors predominate:

1. Throughput contribution2. Investments3. Other operating costs

LO 6

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BOTTLENECK: Definition

Is an operation in which the work to be performed equals or exceeds the available capacity.

LO 6

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MANAGING THE BOTTLENECK

¯Recognize that the bottleneck resource determines throughput contribution of product

¯Search for, find bottleneck¯Resource with large quantities of inventory waiting to be

worked on¯Subordinate all non-bottleneck resources to the

bottleneck resource¯Increase bottleneck efficiency, capacity¯Repeat 4 steps for any new bottleneck

LO 6

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MAKE-OR-BUY

The make-or-buy decision is one where the firm must decide whether to meet its needs internally or to acquire goods or services externally. Both cost and non-quantitative factors are considered.

LO 7

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JOINT PRODUCTS

In some circumstances, multiple products can be produced from a single production process. The question for management is: What is the effect of additional processing/production on profits?

LO 8MANAGERS WANT TO KNOW!

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SPLITOFF POINT: Definition

Is the point up to which all costs are joint and after which additional processing costs are identified with other products.

LO 8

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ADD OR DROP

Managers must decide when to add or drop products; when to open or abandon sales territories. The differential principle involved can be stated:

If differential revenue from selling exceeds differential costs of product, the product is profitable and the firm should continue production.

LO 9MANAGERS WANT TO KNOW!

Click the button to skip Example

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INVENTORY MANAGEMENT

Inventory has a direct affect on profit and must be carefully managed. Key questions for managers are:

1. How many units should be on hand for use or sale?

2. How often should the firm order an item and what is the optimal order size?

LO 10MANAGERS WANT TO KNOW!

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JUST-IN-TIME (JIT)

JIT is a philosophy, not a tool, that dovetails with total quality management (TQM) in that TQM requires reliable processing systems and disallows defective units. Flexible manufacturing that reduces both setup and inventory levels also enhances JIT.

LO 10

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LINEAR PROGRAMMING

¯Linear programming: (a) finds the product mix that will maximize profits given the constraints, (b) provides opportunity costs of constraints, and (c) allows for sensitivity analysis.

LO 11

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ECONOMIC ORDER QUANTITY (EOQ)

¯The economic order quantity (EOQ) model is a mathematical model that gives the optimal amount of goods to order when demand reduces inventory to a level called the “reorder point.”

LO 12

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Capital Expenditure Decisions

CHAPTER 8

Managerial Accounting 11E

Maher/Stickney/Weil

PowerPoint Presentation by

LuAnn BeanProfessor of AccountingFlorida Institute of Technology

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in

part, except for use as permitted in a license distributed with a certain product or service or

otherwise on a password-protected website for classroom use.

30

CHAPTER GOALThis chapter explains how the differential

principle applies to long-term decisions where the focus is on changes in operating capacity over several future time periods. Present value analysis, also called discounted cash flow (DCF), provides analysts with the appropriate technique.

☼ ☼

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1Explain the reasoning behind the separation of the investing and financing aspects of making long-term decisions.

LEARNING OBJECTIVE

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CAPITAL BUDGETING: Definition

Involves deciding which long-term investments to take

involving capital (long-term) assets.

LO 1

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2Explain the role of capital expenditure decisions in the strategic planning process.

LEARNING OBJECTIVE

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STRATEGIC PLANNING

In strategic planning, an organization decides on major programs and the resources to devote to them. Strategic planning provides the context for capital expenditure decisions.

LO 2

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BENEFITS: Long-Term Investments

¯Reducing potential to make mistakes improves product

¯Making goods, delivering services that competitors cannot

¯Reducing cycle time to make product¯Permanently reducing costs to provide such an

advantage that competitors cannot afford to enter market

LO 2

Click the button to skip Exercise 6

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EXERCISE 6

Press “Enter” or click left mouse button for answer.

“If an investment does not fit with an organization’s strategic plan, it is probably not a good idea, even if the net present value (NPV) is positive.” Under what conditions would

this statement be true? False?

LO 2

The statement is generally true for projects that fit the strategic plan. In certain special cases, a firm might depart from its strategic plan.

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Environmental accounting presents a major challenge for companies. What are

some of the benefits?Benefits include

providing cash flow benefits by reducing fines, legal costs and

cleanups.

LO 2

MANAGERIAL APPLICATION

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3Describe the steps of the net present value method for making long-term decisions using discounted cash flows, and explain the effect of income taxes on cash flows.

LEARNING OBJECTIVE

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DISCOUNTED CASH FLOW (DCF): Definition

Aids in evaluating investments involving cash flows over time

where there is a significant difference between cash payment

and receipt.

LO 3

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What is the discount rate?

The discount rate is the interest rate that analysts

use in computing the present value of future

cash flows.

LO 3

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ELEMENTS OF DISCOUNT RATE

The choice of a discount rate should consider the following¯A pure rate of interest that reflects the productive

capability of capital assets¯A risk factor reflecting the riskiness of the project¯An increase reflecting inflation expected to occur

over the life of the project.

LO 3

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RISK-FREE RATE: Definition

Is the pure interest rate plusexpected inflation.

LO 3

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What is the realinterest rate?

The real interest rate is the pure interest rate plus a premium for risk but no

increase for inflation.

LO 3

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NOMINAL INTEREST RATE: Definition

Includes all three factors: pure interest, risk premium, and

expected inflation.

LO 3

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If the present value of future cash inflows exceeds the present value offuture cash outflows for a proposal, The firm should accept the project

with the largest NPV.Reject any negative PV.

LO 3

DECISION RULEEstimate the amounts of future cash inflows and future cash outflows in each period foreach alternative

Discount the future cash flows to the present using the project’s discount rate.

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CASH FLOW VARIETIES

¯Initial cash flows: ¯Occur at beginning of project

¯Periodic cash flows¯Occur during life of project

¯Terminal cash flows¯Occur at end of project

LO 3

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EXAMPLE: JEP Realty Syndicators

JEP Reality Syndicators, Inc. (JEP) is considering acquisition of computer hardware with a 5-year life. Disposal of current hardware occurs in Year 0 with no gain or loss and no tax consequences.

LO 3

Continued

Cost $ 100,000

Market value of present equipment $ 10,000

Scrap value $ 5,000

JEP

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LO 3

EXHIBIT 8.1Projected cash flows over life of

project.

JEP

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LO 3

EXHIBIT 8.2

JEP

Depreciation is subtracted before

tax

Year 0 & Year 1

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LO 3

EXHIBIT 8.2

JEP

Pretax net cash inflow (outflow) – tax payable

= Net cash inflow (outflow) X PV factor

(12%) = NPV

Year 0 & Year 1

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JEP

EXHIBIT 8.2

+ + + + +=

LO 3

Projected cash flows over life

of project is positive $12,469.

>>>ACCEPT

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WARNING! The only time analysisneed recognize working capital occurs

when cash sits idle as conditionof investment.

LO 3

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4Explain how spreadsheets help the analyst to conduct sensitivity analyses of capital budgeting.

LEARNING OBJECTIVE

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THREE ESTIMATES for Calculating NPV

The calculation of NPV for a proposed project requires three types of projections¯Amount of future cash flows¯Timing of future cash flows¯Discount rate

Note: errors in predicting amounts of future cash flows will likely have the largest impact.

LO 4

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LO 4JEP

EXHIBIT 8.3

= $350,000 in revenues

+ + + +

Base case

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LO 4JEP

EXHIBIT 8.3

+ + + ++

Amount of future cash flows

= $344,000in revenues,

less than projected

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LO 4JEP

EXHIBIT 8.3

= $350,000 in revenues, not received as expected.

+

Timing of future cash flows

+++

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LO 4JEP

EXHIBIT 8.3

+ + +

Discount rate changed to 13%

+ = $350,000 in revenues, but discount rate changed.

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Which change had the greatesteffect on NPV?

LO 4

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5Describe the internal rate of return method of assessing investment alternatives.

LEARNING OBJECTIVE

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INTERNAL RATE OF RETURN (IRR): Definition

Is the discount rate that equates the NPV of the series to 0.

(Also called the time-adjusted rate of return.)

LO 5

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LO 5

DECISION RULE

Net Present Value Method Internal Rate of Return Method1. Compute the investment’s net present value, using the organization’s cost of capital adjusted for project-specific risk as the discount rate (hurdle rate).2. Undertake the investment if its net present value is positive. Reject the investment if its net presentvalue is negative.

1. Compute the investment’s internal rate of return.2. Undertake the investment if its internal rate of return is equal to or greater than the organization’s cost of capital adjusted for project-specific risk (hurdle rate). If not, reject the investment.

The decision to accept or reject an investment proposal can be made using either the internal rate of return method or the net present value method under most circumstances.

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LO 5

EXHIBIT 8.4

JEP’s hurdle rate

is 12%. Should they accept this project?

JEP

Click the button to skip Exercise 15

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EXERCISE 15

Press “Enter” or click left mouse button for answer.

Some people claim, “The IRR is more difficult to compute than the NPV of a project. The IRR method can never give

a better answer then the NPV method.” Why do you suppose that so many people use the IRR method?

LO 5

The IRR decision is easier because it is easier to compare (and understand) interest rates (IRR) than to compare net present values

(NPV).

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6Explain why analysts will need more than cash flow analysis to justify or reject an investment.

LEARNING OBJECTIVE

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JUSTIFYING INVESTMENTSInvestments in computer-integrated manufacturing are

often difficult because of difficulties in applying discounted cash flow methods ¯Hurdle rate too high

¯Should be cost of capital¯Bias toward incremental projects¯Uncertainty about operating cash flows¯Exclusion of benefits that are difficult to quantify

¯More flexibility¯Shorter cycle and lead times¯Reduction of non-value-added costs

LO 6

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LONG-TERM INVESTMENTS

Three types of long term capital investments are: ¯Replacement and minor improvements¯Expansion¯Strategic moves

LO 6

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7 Explain why the capital investment process requires audits.

LEARNING OBJECTIVE

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AUDITINGAuditing to compare estimates of capital

budgeting projects to actual results provides advantages: ¯Audits identify which estimates were wrong to

correct in future¯Managers can use audits to reward good planning¯Audits create environment that removes the

temptation to inflate estimates and benefits

LO 7

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8 Identify the behavioral issues involved in capital budgeting.

LEARNING OBJECTIVE

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BEHAVIORAL ISSUES

Planners have a desire to implement a project, meet performance measures. This can influence their objectivity in making estimates. Additionally, conflicts may arise between criteria used to evaluate individualprojects and criteria used to evaluate an organization’s overall or unit performance.

LO 8