LEARNING OBJECTIVES

2. LEARNING OBJECTIVES When you finish this chapter, you should be able to

3. LEARNING OBJECTIVES • Prepare differential analysis report for 6 special decisions. • Determine selling price under 3 cost conditions. • Calculate relative profitability in bottleneck production environment.

4. LEARNING OBJECTIVE 1 Prepare differential analysis report for 6 special decisions.

5. DIFFERENTIAL ANALYSIS LO 1 • Differential analysis looks at effects of different courses of action • Uses estimated revenues, costs • Focuses on relevant revenues, costs • Sunk costs are past costs that are not relevant

6. DIFFERENTIAL ANALYSIS LO 1 Focuses on effect of alternative courses of action on relevant revenues and costs

7. DIFFERENTIAL REVENUE LO 1 Increase or decrease in revenue derived from a particular course of action compared to an alternative

8. DIFFERENTIAL COSTS LO 1 Increase or decrease in costs derived from a particular course of action compared to an alternative

9. LO 1 6 SPECIAL DECISIONS • Lease or sell • Discontinue product, segment • Make or buy • Replace equipment • Process or sell • Accept business at special price

10. LO 1 LEASE OR SELL:Problem Statement Marcus has equipment to dispose of. Cost = $200,000 Accumulated depreciation = $120,000 Should Marcuslease($160,000 less $35,000 repairs, Taxes, etc.) Or sell ($100,000 less 6% commission) the equipment?

11. LO 1 LEASE OR SELL:Analysis Book value of equipment ($80,000) is a sunk cost and not considered. Analysis focuses on differential revenues and differential costs

12. LO 1 EXHIBIT 1 Decision: Lease alternative provides $31,000 more income.

13. LO 1 TO DISCONTINUE:Problem Statement Battle Creek Cereals produces & sells 3 cereals. Because Bran Flakes exhibits an operating loss, Battle Creek is considering discontinuing production, sale of the product. If fixed costs remain unchanged, Is this the right decision?

14. LO 1 EXHIBIT 3

15. LO 1 TO DISCONTINUE:Analysis Fixed costs do not relate to a particular product. We analyze the revenue and costs related to Bran Flakes alone to determine whether Bran Flakes contributes to covering fixed costs in making a discontinue decision.

16. LO 1 EXHIBIT 4 Decision: Discontinuing Bran Flakes would reduce overall profit by $15,000, the amount that Bran Flakes contributes to covering fixed costs.

17. LO 1 MAKE OR BUY:Problem Statement An automotive company has been buying a part for $240 that it now is considering producing. Cost of production includes Should the company make or buy?

18. LO 1 MAKE OR BUY:Analysis Focus the analysis on differential costs. If the automotive company has excess factory capacity, fixed costs are not relevant to the decision since they will not change.

19. LO 1 EXHIBIT 6 Decision: By including only relevant costs in the analysis, there is a cost savings of $28 per part from making the instrument panel.

20. LO 1 REPLACE EQUIPMENT:Problem Statement A manufacturer is considering replacing several old machines with a total book value, $100,000, remaining useful life, 5 years, with a new machine costing $250,000 less $25,000 proceeds from sale of old equipment. Variable costs with new machine will be reduced from $225,000 to $150,000. Should the company buy the new machine?

21. LO 1 REPLACE EQUIPMENT:Analysis Book value of equipment ($100,000) is a sunk cost and not considered. Relevant costs include cost savings of more efficient equipment, product quality.

22. LO 1 EXHIBIT 7 Decision: Efficiencies achieved with new machine will produce an annual savings of $30,000.

23. OPPORTUNITY COSTS LO 1 Measures the cost of an alternative choice that is foregone. Ex.: Suppose the net outlay ($225,000) were invested & earned 10% ($22,500). It would still be more beneficial to replace equipment($30,000).

24. LO 1 PROCESS OR SELL:Problem Statement A company can produce a 4,000 gallon batch of kerosene with a selling price of $.80 per gallon from 4,000 gallons of raw material costing $.60 per gallon. Alternatively, the company can continue processing the raw material into gasoline selling for $1.25 at an additional cost of $650 per batch and losing 20% of end product. Should the company process or sell?

25. LO 1 PROCESS OR SELL:Analysis Initial raw material cost will be incurred in both alternatives & is not considered. Differential revenues from 2 alternatives are only relevant issues.

26. LO 1 EXHIBIT 8 Decision: Processing further will result in an additional $150 per batch after considering product loss & additional costs.

27. LO 1 SPECIAL BUSINESS:Problem Statement A company currently produces 10,000 basketballs on average each month, although the factory has a capacity of `12,500 basketballs. Variable costs are $12.50, fixed costs are $7.50, and domestic selling price is $30. An offer to sell 5,000 additional basketballs for $18 to a foreign buyer & produced over 3 months is considered. Should the company accept the business?

28. LO 1 SPECIAL BUSINESS:Analysis The company has excess capacity and can produce additional product without incurring additional fixed costs. Whether differential revenue covers relevant costs and produces income is the issue.

29. LO 1 EXHIBIT 9 Decision: This special business should be accepted because the additional revenue covers the variables costs & increases income.

30. LEARNING OBJECTIVE 2 Determine selling price under 3 cost conditions.

31. ROLE OF COST CONCEPT LO 2 Uses “cost +” to set selling price that provides sufficient profit.

32. LO 2 3 COST DETERMINANTS • Total cost concept • Markup added to total cost • Product cost concept • Markup added to product costs • Variable cost concept • Markup added to variable costs

33. COST INFORMATION LO 2 *per unit

34. MARKUP FORMULA:Total Cost LO 2 Markup % = Desired profit / Total cost

35. BASIC INFORMATION:Total Cost LO 2 A manufacturer wants to earn a 20% return on assets valued at $800,000. 100,000 calculators will be produced.

36. SELLING PRICE UNDER TOTAL COST LO 2 Desired profit (800,000 * 20%) $160,000 Selling price {$16.70 + (160,000/100,000)} $18.30 CHECK: (100,000 * $18.30) - $1,670,000 = $1,830,000 – 1,670,000 = $160,000

37. CALCULATING MARKUP:Total Cost LO 2 Markup % Desired profit / Total cost = $160,000 / $1,670,000 = 9.6%

38. MARKUP FORMULA:Product Cost LO 2 Markup % = (Desired profit + Selling, Administrative expense) / Manufacturing cost

39. BASIC INFORMATION:Product Cost LO 2

40. CALCULATING MARKUP:Product Cost LO 2 Markup % = (Desired profit + Selling, Administrative expense) / Manufacturing cost {$160,000 + ($1.50*100,000) + $20,000} / $1,500,000 22%

41. SELLING PRICE UNDER PRODUCT COST LO 2 Desired profit (800,000 * 20%) $160,000 Selling price {$15.00 + ($15 * 22%)} $18.30 CHECK: {100,000 * ($15 + $3.30)} = $18.30

42. MARKUP FORMULA:Variable Cost LO 2 Markup % = (Desired profit + Total fixed costs) / Variable costs

43. BASIC INFORMATION:Product Cost LO 2

44. CALCULATING MARKUP:Variable Cost LO 2 Markup % = (Desired profit + Total fixed costs) / Variable costs {$160,000 + $50,000 + $20,000} / $1,600,000 14.4%

45. SELLING PRICE UNDER PRODUCT COST LO 2 Desired profit (800,000 * 20%) $160,000 Selling price {$16.00 + ($16 * 14.4%)} $18.30 CHECK: {100,000 * ($16 + $2.30)} = $18.30

46. LO 2 OTHER COST CONCEPTS • Activity based costing • Identifies, traces costs to specific activities • Target cost concept • Combines market-based pricing with cost containment • Variable cost concept • Markup added to variable costs

47. LO 2 EXHIBIT 10

48. LEARNING OBJECTIVE 3 Calculate relative profitability in bottleneck production environment.

49. PRODUCTION BOTTLENECKS LO 3 A production bottleneck (constraint) occurs at a point in the production process where demand exceeds the ability to produce the product. Theory of constraints attempts to reduce influence of bottlenecks.

50. ANALYZING PROFIT IN BOTTLENECK LO 3 CM suggests large wrench most profitable BUT Small wrench produces most bottleneck profit.