copyright © 2013 pearson education, inc. publishing as prentice hall. relevant costs for short-term...

Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

Relevant Costs for Short-Term Decisions

Chapter 8

1


Objective 1Describe and identify information

relevant to short-term business decisions

2


How Managers Make Decisions

• Define business goals

• Identify alternative courses of action

• Gather and analyze relevant information

• Choose best alternative

• Implement decision

• Follow-up: Compare actual with anticipated results3


Relevant and Irrelevant Information

• Relevant – Expected future (cost and revenue) data– Differs among alternative courses of action– Is both quantitative and qualitative

• Irrelevant– Costs that do not differ between alternatives– Sunk costs – incurred in past and cannot be

changed

4


Relevant Nonfinancial Information

• Nonfinancial, or qualitative factors, also play a role in managers’ decisions.– laying off employees – outsourcing, reduced control over delivery time

and product quality– discounted prices to select customers

• Managers who ignore qualitative factors can make serious mistakes.

5


Six Short-Term Special Decisions

• Special sales orders

• Pricing

• Discontinuing products, departments, and stores

• Product mix

• Outsourcing (make or buy)

• Selling as is or processing further6


Keys to Making Short-Term Special Decisions

• Decisions approach– Relevant information approach or incremental

analysis approach

• Two keys in analyzing short-term special business decisions– Focus on relevant revenues, costs, and profits– Use contribution margin approach that separates

variable costs from fixed costs

7


Sustainability and Short-term Business Decisions

• View every decision as having an impact on– People– Planet– Profitability

• Timberland, “doing well and doing good”– Example: Employees given PTO to volunteer

• Costly

8


Objective 2Decide whether to accept a

special order

9


DECISION RULE: Do we have excess capacity available to fill this

order?

Yes

Consider further

No

Reject the special order

A customer requests a one-time order at a reduced sale price, often for a large quantity:

Special Order Considerations

10


Special Sales OrderDECISION RULE: Is the special reduced sales price high

enough to cover the incremental costs of filling the order? If revenues are

greater than expected cost

increaseAccept the

special order

If revenues are less than expected cost

increase


11


Special Sales OrderDECISION RULE:

Will the special order affect regular sales in the long run?

If no to these questions

Accept the special order

If yes to these questions


12


Incremental Analysis of SpecialSales Order, Exhibit 8-6

Expected increase in revenues—sale of 20,000 oil filters x $1.75 each $ 35,000

Expected increase in expenses—variable manufacturing costs:20,000 oil filters $1.20 each

(24,000)

Expected increase in operating income $ 11,000

13


Now turn to E8-16A

14


E8-16A1. Prepare an incremental analysis to determine whether

Collectible Cards should accept the special sales order assuming fixed costs would not be affected by the special order.

Would accept the special order because the cost per part to make it is only $0.30 per part versus the $0.40 per part selling price being offered by the buyer.

Variable costs: Direct Materials Direct Labor Variable Overhead

$0.130.060.11

Total Cost $0.30

15


E8-16A (cont.)2. Now assume that the Hall of Fame wants special hologram baseball

cards. Collectible Cards must spend $5,000 to develop this hologram, which will be useless after the special order is completed. Should Collectible Cards accept the special order under these circumstances? Show your analysis.

Expected increase in revenues—sale of 57,000 cards x $0.40 each $ 22,800

Expected increase in expenses—variable manufacturing costs:57,000 cards x $0.30 eachSpecial hologram cost

(17,100) (5,000)

Expected increase in operating income $ 700

16


Objective 3Describe and apply different approaches

to pricing

17


Regular Pricing Considerations

• What is our target profit?

• How much will customers pay?

• Are we a price-taker or a price-setter for this product?

18


Price-Taker vs Price-SetterPrice-Takers Price-Setters

Product lacks uniqueness Product is more unique

Heavy competition Less competition

Pricing approach emphasizes target costing

Pricing approach emphasizes cost-plus pricing

19


Target Costing – Exhibit 8-9

• Market price minus desired profit = target cost• Target Cost includes:

– Development cost – Marketing cost– Design cost – Delivery cost– Production cost – Service cost

20

Calculations TotalRevenue at market price 250,000 units x $3.00

price =$ 750,000

Less: Desired profit 10% x $1,000,000 of

assets(100,000)

Target total cost $650,000


Two potential outcomes when using target costing

1. Actual cost less than target total cost

2. Actual cost greater than target total cost

21


Other Strategies

• Increase sales– Use CVP analysis to compute target sales to achieve its target profit.

• Change or add to its product mix– Offer levels of the same product – Offer new items to the product mix with high CM– Remove items with the lowest CM

• Differentiate its products – (make it unique)– Branding– Quality– Service packs

22


Cost-Plus Pricing

• The opposite of the target-pricing approach– Starts with the company’s full costs – Adds the desired profit to determine a

cost-plus price

Total cost

Plus: Desired profit

Cost –plus price

23


Calculating Cost-Plus Price, Exhibit 8-12

If the current price is $3.00, can the company charge $3.20?

Total

Current variable costs 250,000 units x $1.50 per unit = $ 375,000Plus: Current fixed costs + 325,000Current total costs $700,000Plus: Desired profit 10% x $1,000,000 of assets + 100,000Target revenue $800,000Divided by number of units

÷ 250,000

Cost-plus price per unit $ 3.20

24


Pricing Decisions

DECISION RULE: How to Approach Pricing?

If company is a price-taker for the product:

Emphasize target costing approach

If the company is a price-setter for the product:

Emphasize cost-plus pricing approach

25


Now turn to E8-19A

26


E8-19A

1. Which approach to pricing should Smith Builders emphasize? Why?

– Target costing – Firm is a price taker, product lacks uniqueness and there is heavy competition

27


E8-19A (cont.)

2. Will Smith Builders be able to achieve its target profit levels? Show your computations.

The answer is no, the target cost is less than variable cost.

Calculations Total

Revenue at market price $ 206,000

Less: Desired Profit 14% of the variable cost $190,000

(26,600)

Target cost $ 179,400

28


E8-19A (cont.)

3. If Smith Builders upgrades, what will the new cost-plus price per home be? Should the company differentiate its product in this manner? Show your analysis.

Yes, they should customize – they will achieve their target profit levels with the cost-plus price.

Total

Current total costs ($190,000 + $18,000) $208,000Plus: Desired profit (14% x variable cost of $208,000) + 29,120Cost-plus price $237,120

29


Objective 4Decide whether to discontinue a

product, department, or store

30


Other Short-term Business Decisions Managers Face

• When to discontinue a product, department, or store

• How to factor constrained resources into product mix decisions

• When to make a product or outsource it

• When to sell as is or process further31


Considerations for Discontinuing Products, Departments or Stores, Exhibit 8-14

• Does product provide positive contribution margin?

32


Considerations for Discontinuing Products, Departments or Stores

• Will the total fixed costs continue to exist even if the product line is discontinued?

• Can any direct fixed costs of the product be avoided if the product line is discontinued?

• Can any direct fixed costs of the product be avoided if the product line is discontinued?

• Use incremental analysis for discontinuing a product

33


Discontinuing Products, Departments or Stores

DECISION RULE: Discontinue a product, department, or store?

If lost revenues from discontinuing a product, department, or store exceed the cost savings from discontinuing:

Do not discontinue

If total cost savings exceed the lost revenues from discontinuing a product, department, or store:

Discontinue

34


Now turn to E8-20A

35


E8-20A 1. Prepare an incremental analysis to show

whether Entertainment Plus should discontinue the DVD product line. Will discontinuing DVDs add $18,000 to operating income? Explain.

Expected decrease in revenues:Sale of DVDs $136,000

Expected decrease in expenses:Variable manufacturing expenses 86,000

Expected decrease in operating income $50,000

36


E8-20A (cont.)

2. Assume that Entertainment Plus can avoid $20,000 of fixed expenses by discontinuing the DVD product line (these costs are direct fixed costs of the DVD product line). Prepare an incremental analysis to show whether Entertainment Plus should stop selling DVDs.

37

Expected decrease in revenues:Sale of DVDs $136,000

Expected decrease in expenses:Variable manufacturing expenses $86,000Direct fixed expenses $20,000Expected decrease in total expenses 106,000

Expected decrease in operating income $30,000


E8-20A (cont.)3. Now, assume that all $68,000 of fixed costs assigned to DVDs are direct

fixed costs and can be avoided if the company stops selling DVDs. However, marketing has concluded that Blu-ray disc sales would be adversely affected by discontinuing the DVD line . Blu-ray disc production and sales would decline 10%. What should the company do?

38

Expected decrease in revenues:Sale of DVDs $136,000Sale of Blu-rays 14,300 $150,300

Expected decrease in expenses:Variable manufacturing expenses $86,000Direct fixed expenses $68,000Expected decrease in total expenses 154,000

Expected increase in operating income $3,700


Objective 5Factor resource constraints into product

mix decisions

39


Product Mix Considerations – Example from pages 477 - 479

Data Per UnitShirts Jeans

Sale priceLess: Variable expenses

Contribution marginContribution margin ratio:

Product A —Product B —

40

$30 $60(12) (48)$18 $12

60%20%

$18 ÷ $30$12 ÷ $60


Product Mix Considerations – Exhibit 8-18

Shirts Jeans(1) Units that can be produced each machine hour

10 20

(2) Contribution margin per unit x $18 x $12Contribution margin per machine hour (1) x (2)

$ 180 $ 240

Available capacity—number of machine hours x 2,000 x 2,000Total contribution margin at full capacity $360,000 $480,000

41


Product MixDECISION RULE:

Which product to emphasize?Emphasize the product with the highest contribution margin per

unit of constraint

42


Product Mix When Demand Is Limited or Fixed Costs Change

• What if demand is limited, due to competition or other factors? [In this example, company has demand for only 30,000 jeans, which consume in total 1,500 hours (30,000 jeans/20 jeans per hour)]

• What if fixed costs are different when a different product mix is emphasized?

Example Shirts Jeans

Contribution margin per machine hour $ 180 $ 240Machine hours devoted to product x 500 x 1,500

Total contribution margin at full capacity $90,000 $360,000

43


Now turn to E8-22A

44


E8-22A What product mix will maximize operating income?

Get FitProduct Mix Analysis

Deluxe RegularSale price per unitVariable costs per unitContribution margin per unit

Units produced with equivalent number of machine hours

Contribution margin for equivalentnumber of machine hours

45


E8-22A What product mix will maximize operating income?

Get FitProduct Mix Analysis

Deluxe RegularSale price per unit $1,010 $560Variable costs per unit 781a 427b

Contribution margin per unit 229 133

Units produced with equivalent number of machine hours × 1 × 3

Contribution margin for equivalentnumber of machine hours $ 229 $399

a ($310 + $ 88 + $264 + $119)b ($90 + $184 + $ 88 + $ 65)

Get Fit should produce only the Regular model.

46


Objective 6Analyze outsourcing (make-or-buy)

decisions

47


Outsourcing (Make or Buy) Considerations

• To buy a product or service or produce it in-house

• The heart of the decisions : how best to use available resources – How do our variable costs compare to the

outsourcing cost?– Are any fixed costs avoidable if we outsource?– What could we do with the freed capacity?

48


OutsourcingDECISION RULE:

Should the company outsource?

If the incremental costs of making exceed the incremental costs of

outsourcing:

Outsource

If the incremental costs of making are less than the incremental costs

of outsourcing:

Do not outsource

49


Now turn to E8-25A

50


E8-25A1. Given the same cost structure, should OptiSystems make or

buy the switch?OptiSystems

Incremental Analysis for Outsourcing Decision

Make Unit Buy UnitCost to Make Minus Cost

to Buy

Variable cost per unit:Direct materials

Direct laborVariable overheadPurchase price from outsider

Variable cost per unit

51


E8-25A1. Given the same cost structure, should OptiSystems make or

buy the switch?OptiSystems

Incremental Analysis for Outsourcing Decision

Make Unit Buy UnitCost to Make Minus Cost

to Buy

Variable cost per unit:Direct materials $ 10.00a $

—$ 10.00

Direct labor 2.50b — 2.50Variable overhead 3.00c — 3.00Purchase price from outsider — 17.00 (17.00)

Variable cost per unit $15.50 $17.00 $ (1.50)

a $720,000 / 72,000 = $10.00/unitb $180,000 / 72,000 = $2.50/unitc $216,000 / 72,000 = $3.00/unit

52


E8-25A (cont.)

2. Now, assume that OptiSystems can avoid $100,000 of fixed costs a year by outsourcing production. In addition, because sales are increasing, OptiSystems needs 77,000 switches a year rather than 72,000. What should OptiSystems do now?

Make switches Buy switches

Variable cost per unit (from part 1) × Units neededTotal variable costsFixed costs

Total relevant costs

53


E8-25A (cont.)

2. Now, assume that OptiSystems can avoid $100,000 of fixed costs a year by outsourcing production. In addition, because sales are increasing, OptiSystems needs 77,000 switches a year rather than 72,000. What should OptiSystems do now?

Make switches Buy switches

Variable cost per unit (from part 1) $ 15.50 $ 17.00 × Units needed 77,000 77,000Total variable costs $ 1,193,500 1,309,000Fixed costs 468,000 368,000*

Total relevant costs $1,661,500 $1,677,000

*($468,000 − $100,000 avoidable)54


E8-25A (cont.)

3. Given the last scenario, what is the most OptiSystems would be willing to pay to outsource the switches?

Cost if making switches = Cost of outsourcing switches

* Where x = outsourcing cost per switch55

($15.50 × 77,000) + $468,000 = (x)* (77,000) + $368,000

Variable costs + fixed costs = Variable costs + fixed costs

$1,193,500 + $468,000 = 77,000x + $368,000

$1,293,500 = 77,000x

$16.80(rounded) = x


Objective 7Make sell as-is or process further

decisions

56


Sell As-Is or Process Further Considerations

• How much revenue is generated if we sell the product as is?

• How much revenue is generated if we sell the product after processing it further?

• How much will it cost to process the product further?

57


Analysis for Sell As Is or Process Further Decision – Exhibit 8-25

Sell As-Is ProcessFurther

Additional Revenue/(Cos

ts) from Processing

FurtherExpected revenue from selling 50,000 quarts of regular olive oilat $5.00 per quart

$250,000

Expected revenue from selling 50,000 quarts of gourmet dipping oil at $7.00 per quart

$350,000 $100,000

Additional costs of $0.75 per quart to convert 50,000 quarts of plain olive oil into gourmet dipping oil

(37,500) (37,500)

Total net benefit $250,000 $312,500 $62,500

58


Sell As-Is or Process FurtherDECISION RULE:

Sell as-is or process further?

If extra revenue (from processing further) exceeds extra cost of

processing further:

Process further

If extra revenue (from processing further) is less than extra cost of

processing further:

Sell as is

59


Now turn to E8-28A

60


E8-28ASell as is

(gallons)

Process

further

Sales revenue per unit $ 6.00 $ 0.50

Additional process costs per unit - packaging (0.10) (0.05)

Additional process costs per unit - fruit (0.00) (0.15)

Net benefit per unit $ 5.90 $ 0.30

Number of units produced per batch × 600 × 12,800

Net benefit per batch $3,540 $ 3,840

61


End of Chapter 8

62

copyright © 2013 pearson education, inc. publishing as prentice hall. relevant costs for short-term...

Documents

pearson education

prentice hall

special order considerations

shortterm business decisions

managers decisions

relevant revenues

onetime order

shortterm decisions