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Chapter 6

Chapter 6. Relevant Information for Decision Making with a Focus on Operational Decisions. Chapter 6 Learning Objectives. When you have finished studying this chapter, you should be able to:

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Chapter 6

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  1. Chapter 6 Relevant Information for Decision Making with a Focus on Operational Decisions

  2. Chapter 6 Learning Objectives • When you have finished studying this chapter, you should be able to: • Use a differential analysis to examine income effects across alternatives and show that an opportunity-cost analysis yields identical results. • 2. Decide whether to make or to buy certain parts or products. • 3. Choose whether to add or delete a product line using relevant information.

  3. Chapter 6 Learning Objectives 4. Compute the optimal product mix when production is constrained by a scarce resource. 5. Decide whether to process a joint product beyond the split-off point. 6. Decide whether to keep or replace equipment. 7. Identify irrelevant and misspecified costs. 8. Discuss how performance measures can affect decision making.

  4. Learning Objective 1 Opportunity, Outlay, and Differential Costs and Analysis Differential cost is the difference in total cost between two alternatives. Differential revenue is the difference in total revenue between two alternatives. A differential analysis is a decision process that compares differential revenues and costs of alternatives.

  5. Opportunity, Outlay, and Differential Costs and Analysis Incremental costs are additional costs or reduced benefits generated by the proposed alternative. Incremental benefits are the additional revenues or reduced costs generated by the proposed alternative. Analyzing the differential costs between the existing situation and a proposed alternative is an incremental analysis.

  6. Opportunity, Outlay, and Differential Costs and Analysis An outlay cost requires a cash disbursement. If there are many alternative uses of resources, an incremental analysis can become cumbersome. Opportunity costs may be a viable option. An opportunity cost is the maximum available benefit forgone (or passed up) by using a resource that a company already owns or that it has already committed to purchase for a particular purpose.

  7. Opportunity, Outlay, and Differential Costs and Analysis Nantucket Nectars has a machine for which it paid $100,000 and it is sitting idle. • Nantucket Nectars has three alternatives: • Increase production of Peach juice • Sell the machine • 3. Produce a new drink Papaya Mango

  8. Opportunity, Outlay, and Differential Costs and Analysis Introducing Papaya Mango entails two types of costs, outlay costs and opportunity costs. Outlay costs include costs for items such as materials and labor. Opportunity cost is the maximum available benefit forgone (or passed up) by using such a resource for a particular purpose instead of the best alternative use.

  9. Opportunity, Outlay, and Differential Costs and Analysis Peach Juice Contribution margin is $60,000. 1 Sell machine for $50,000. 2 Produce Papaya Mango juice with projected sales of $500,000. 3 Suppose Nantucket Nectars will have total sales over the life cycle of Papaya Mango 100% Juice of $500,000. The production and marketing costs (outlay costs), excluding the cost of the machine, are $400,000. What is the net financial benefit from producing the Papaya Mango?

  10. Opportunity, Outlay, and Differential Costs and Analysis Revenues $500,000 Costs: Outlay costs 400,000 Financial benefit before opportunity costs $100,000 Opportunity cost of machine 60,000 Net financial benefit $ 40,000 Nantucket Nectars will gain $40,000 more financial benefit using the machine to make Papaya Mango than it would make using it for the next most profitable alternative.

  11. Learning Objective 2 Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier. Purchasing products or services from an outside supplier is called outsourcing. Managers apply relevant cost analysis to a variety of outsourcing decisions.

  12. Make-or-Buy Decisions Nantucket Nectars Company’s Cost of Making 12-ounce Bottles Direct material $ 60,000 $.06 Direct labor 20,000 .02 Variable factory overhead 40,000 .04 Fixed factory overhead 80,000 .08 Total costs $200,000 $.20 Another manufacturer offers to sell Nantucket Nectars the bottles for $.18. Should Nantucket Nectars make or buy the bottles?

  13. Make-or-Buy Example Perhaps Nantucket Nectars will eliminate $50,000 of fixed costs if the company buys the bottles instead of making them. For example, the company may be able to release a supervisor with a $50,000 salary. If the company buys the bottles, $50,000 of fixed overhead would be eliminated. Should Nantucket make or buy the bottles?

  14. Make Buy Total Per Bottle Total Per Bottle Purchase cost $180,000 $.18 Direct material $ 60,000 $.06 Direct labor 20,000 .02 Variable overhead 40,000 .04 Fixed OH avoided by not making 50,000 .05 0 0 Total relevant costs $170,000 $.17 $180,000 $.18 Difference in favor of making $ 10,000 $.01 Relevant Cost Comparison *Note that unavoidable fixed costs of $80,000 – $50,000 = $30,000 are irrelevant. Thus, the irrelevant costs per unit are $.08 – $.05 = $.03.

  15. Make or Buy and the Use of Facilities Suppose Nantucket can use the released facilities in other manufacturing activities to produce a contribution to profits of $55,000, or can rent them out for $25,000. What are the alternatives?

  16. Make or Buy and the Use of Facilities (amounts in $000) Make Buy and leave facilities idle Buy and rent out facilities Buy and use facilities for other products Rent revenue $ — $ — $ 25 $ — Contribution from other products — — — 55 Variable cost of bottles (170) (180) (180) (180) Net relevant costs $(170) $(180) $(155) $(125)

  17. Deletion or Addition of Products, Services, or Departments Learning Objective 3 Often, existing businesses will want to expand or contract their operations to improve profitability. Decisions to add or to drop products or whether to add or to drop departments will use the same analysis: examining all the relevant costs and revenues. Relevant information plays an important role in decisions about adding or deleting products, services, or departments.

  18. Avoidable and Unavoidable Costs Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Unavoidable costs are costs that continue even if an operation is halted. Common costs are costs of facilities and services that are shared by users.

  19. Department Store Example Consider a discount department store that has three major departments: Groceries General merchandise Drugs

  20. Department Store Example Departments Total (amounts in $000) Drugs Groceries General Mdse. Sales $1,900 $1,000 $800 $100 Variable exp. 1,420 800 560 60 Contribution margin $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%) Fixed expenses: Avoidable $ 265 $ 150 $100 $ 15 Unavoidable 18060 100 20 Total fixed exp. $ 445 $ 210 $200 $ 35 Operating income$ 35 $ (10) $ 40 $ 5

  21. Department Store Example Assume that the only alternatives to be considered are dropping or continuing the grocery department, which has consistently shown an operating loss. Assume further that the total assets invested would be unaffected by the decision. The vacated space would be idle and the unavoidable costs would continue.

  22. Department Store Example Store as a Whole Total Before Change Effect of Dropping Groceries Total After Change (amounts in $000) Sales $1,900 $1,000 $900 Variable expenses 1,420 800 620 Contribution margin $ 480 $ 200 $280 Avoidable fixed expenses 265 150 115 Profit contribution to common space and other unavoidable costs $ 215 $ 50 $165 Unavoidable expenses 180 0 180 Operating income $ 35 $ 50 $ (15)

  23. Department Store Example Assume that the store could use the space made available by the dropping of groceries to expand the general merchandise department. This will increase sales by $50,000, generate a 30% contribution margin, and have avoidable fixed costs of $70,000. $80,000 – $50,000 = $30,000

  24. Department Store Example Store as a Whole Total Before Change Drop Groceries Expand General Merchandise Total After Change (amounts in $000) Sales $1,900 $1,000 $500 $1,400 Variable expenses 1,420 800350 970 Contribution margin $ 480 $ 200 $150 $ 430 Avoidable fixed expenses 265 150 70 185 Profit contribution to common space and other unavoidable costs$ 215 $ 50 $80 $245 Unavoidable expenses 180 0 0 180 Operating income $ 35 $ 50 $80 $ 65

  25. Department Store Example Relevant costs are not always variable. The key to decision making is not relying on a hard and fast rule about what to include and what to ignore. You must analyze all pertinent costs and revenues to determine what is and what is not relevant in the specific context. In this case, the relevant costs included the avoidable fixed costs.

  26. Department Store Example Nonfinancial information can influence decisions to add or delete products or departments, too. When deciding to delete a product or to close a plant, there are ethical considerations. How will the decision affect: Employees? Customers? Community?

  27. Optimal Use of Limited Resources Learning Objective 4 A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. Limiting factors include labor hours and machine hours that limit production (and hence sales) in manufacturing firms . . . and square feet of floor space or cubic meters of display space that limit sales in department stores.

  28. Optimal Use of Limited Resources Nike produces the Air Court tennis shoe and the Air Max running shoe. Assume that one factory is the only facility that produces the shoes, and Nike managers must decide how many shoes of each type to produce. Machine time is the measure of capacity in this factory, and there is a maximum of 10,000 hours of machine time. The factory can produce 10 pairs of Air Court shoes or 5 pairs of Air Max shoes in 1 hour of machine time.

  29. Optimal Use of Limited Resources Air Court Air Max Selling price per pair $80 $120 Variable costs per pair 60 84 Contribution margin per pair $20 $ 36 Contribution margin ratio 25% 30% Which is more profitable? If the limiting factor is demand, that is, pairs of shoes, the more profitable product is Air Max.

  30. Optimal Use of Limited Resources Air Max is the product with the higher contribution per unit. The sale of a pair of Air Court shoes adds $20 to profit. Why? The sale of a pair of Air Max shoes adds $36 to profit.

  31. Optimal Use of Limited Resources Suppose that demand for either shoe would exceed the plant’s capacity. Now, capacity is the limiting factor. Which is more profitable? If the limiting factor is capacity, the more profitable product is Air Court. Why?

  32. Optimal Use of Limited Resources Air Court Contribution margin per pair × 10,000 hours = $2,000,000 contribution Air Max: Contribution margin per pair × 10,000 hours = $1,800,000 contribution

  33. Optimal Use of Limited Resources In retail stores, the limiting factor is often floor space. The focus is on products taking up less space or on using the space for shorter periods of time. Retail stores seek faster inventory turnover (the number of times the average inventory is sold per year).

  34. Optimal Use of Limited Resources Faster inventory turnover makes the same product a more profitable use of space in a discount store. Regular Department Store Discount Department Store Retail Price $4.00 $3.50 Costs of merchandise and other variable costs 3.00 3.00 Contribution to profit per unit $1.00 (25%) $ .50 (14%) Units sold per year 10,000 22,000 Total contribution to profit, assuming the same space allotment in both stores $10,000 11,000

  35. Learning Objective 5 Joint Product Costs Joint products have relatively significant sales values. They are not separately identifiable as individual products until their split-off point. The split-off point is that juncture of manufacturing where the joint products become individually identifiable.

  36. Joint Product Costs Separable costs are any costs beyond the split-off point. Joint costs are the costs of manufacturing joint products before the split-off point. Examples of joint products include chemicals, lumber, flour, and the products of petroleum refining.

  37. Joint Product Costs Suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process. The joint processing cost is $100,000. Both products are sold to the petroleum industry to be used as ingredients of gasoline.

  38. Joint Product Costs

  39. Illustration of Sell or Process Further Suppose the 500,000 liters of Y can be processed further and sold to the plastics industry as product YA. The additional processing cost would be $.08 per liter for manufacturing and distribution, a total of $40,000. The net sales price of YA would be $.16 per liter, a total of $80,000.

  40. Illustration of Sell or Process Further Sell at Split-off as Y Process Further and Sell as YA Difference Revenues $30,000 $80,000 $50,000 Separable costs beyond split-off @ $.08 – 40,000 40,000 Income effects $30,000 $40,000 $10,000

  41. Learning Objective 6 Equipment Replacement The book value of equipment is not a relevant consideration in deciding whether to replace the equipment. Why? Because it is a past, not a future cost.

  42. Book Value of Old Equipment Depreciation is the periodic allocation of the cost of equipment. Accumulated depreciation is the sum of all depreciation charged to past periods. The equipment’s book value (or net bookvalue) is the original cost less accumulated depreciation.

  43. Book Value of Old Equipment Suppose a $10,000 machine with a 10-year life span has depreciation of $1,000 per year. What is the book value at the end of 6 years? Original cost $10,000 Accumulated depreciation (6 × $1,000) 6,000 Book value $ 4,000

  44. Old Machine Replacement Machine Original cost $10,000 $8,000 Useful life in years 10 4 Current age in years 6 0 Useful life remaining in years 4 4 Accumulated depreciation $ 6,000 0 Book value $ 4,000 N/A Disposal value (in cash) now $ 2,500 N/A Disposal value in 4 years 0 0 Annual cash operating costs $ 5,000 $3,000 Keep or Replace the Old Machine?

  45. Relevance of Equipment Data A sunk cost is a cost already incurred and is irrelevant to the decision-making process. 4 commonly encountered items: Book value of old equipment Disposal value of old equipment Gain or loss on disposal Cost of new equipment

  46. Relevance of Equipment Data The book value of old equipment is irrelevant because it is a past (historical) cost. Therefore, depreciation on old equipment is irrelevant. The disposal value of old equipment is relevant because it is an expected future inflow that usually differs among alternatives. The cost of new equipment is relevant because it is an expected future outflow that will differ among alternatives.

  47. Gain or Loss on Disposal This is the difference between book value and disposal value. It is a meaningless combination of irrelevant (book value) and relevant items (disposal value). It is best to think of each separately.

  48. Four Years Together Keep Replace Difference Cash operating costs $20,000 $12,000 $8,000 Old equipment (book value): Depreciation, or 4,000 – – Lump-sum write-off – 4,000 – Disposal value – (2,500) 2,500 New machine acquisition cost – 8,000 (8,000) Total costs $24,000 $21,500 $2,500 Cost Comparison

  49. Learning Objective 7 Irrelevant or Misspecified Costs The ability to recognize irrelevant costs is important to decision makers. Cost of obsolete inventory Book value of old equipment

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