Differential Analysis: The Key to Decision Making Chapter 10

Differential Analysis: The Key to Decision Making Chapter 10 Introduction to ManagerialAccounting, Brewer, Garrison,Noreen Power Points fromwebsite - adapted by Cynthia Fortin, CPA, CMA http://highered.mheducation.com/sites/0078025419/student_view0/chapter12/index.html

relevant Costs and benefits that differbetween alternatives Costs that are avoidable

Incremental : addedcosts or revenues • Differential : difference of costs and revenue between alternatives

Keys to Successful Decision-Making • only on relevant costs • 2. Ignoresunk costs and future • costs and benefits that do not • differ between the alternatives.

3. Consider qualitative information is vital to decision-making.

Different Costs for Different Purposes Costs that are relevant in one decision situation may not be relevant in another context.

Each decision situation requires the manager to examine the data at hand and isolate the relevant costs.

Differential Cost Advantages 1. Only rarely will enoughinformation be available to prepare detailed income statements for both alternatives.

Differential Cost Advantages 2. Mingling irrelevant costs withrelevant costs may causeconfusion and distract attentionaway from the information that is really critical.

Keep Segments Drop or • Calculate Contribution margin that would disappear if segment is dropped. Put results as negative. • 2. Calculate fixed costs that would disappear if segment is dropped. • 3. Add (1) to (2). If result is negative • 4. Evaluate significant qualitative consequences. keep

Keep Segments Drop or • Calculate Contribution margin that would disappear if segment is dropped. Put results as negative. • 2. Calculate fixed costs that would disappear • if segment is dropped. • 3. Add (1) to (2). If result is negative • 4. Evaluate significant qualitative consequences. keep.

Illustration The management of Bayside Company is considering whether one of the departments in its retail stores should be eliminated. The contribution margin in the department is $150,000 per year. Fixed expenses allocated to the department are $130,000 per year. It is estimated that $120,000 of these fixed expenses will be eliminated if the department is discontinued. Part (a) Which costs are irrelevant to this decision? The common fixed costs of $10,000 (or $130,000 - $120,000) are irrelevant to this decision.

Part (b) If the department is eliminated, what will be the impact on the company’s overall net operating income? CM that would be lost if department is discontinued $(150,000) Less fixed costs that can be avoided if department is discontinued 120,000 Increase (decrease) in net operating income (30,000) Based on this information alone, because the company’s net operating income would decrease by $30,000 per year, management should this department. keep

Make or Buy • Outsourcing: • Purchasing goods or services from outside vendor or supplier. • Insourcing: • Producing goods or services withinan organization • May require expanding to increase capacity

Calculate total amount to pay supplier. • Calculate total differential costs if company chooses to make. • Calculate difference between the 2 options. • Select lowest cost option. • Analyze qualitative factors

Qualitative factors • Logistical considerations • distance from plant

Qualitative factors • Dependanceon supplier can increase risk:

Qualitative factors

Make or BuyAnalysis Idle space (caused by outsourcing) that has no alternative has an opportunity cost of $ 0.

No longterm implications • There is existing idle capacity • Usually the price is lower than the regular product • There are variable and fixed relevant costs incurred

Company must decide if the decision creates incremental net operating income • Fixed costs are sunk costs, therefore irrelevant • Absorption costing is not appropriate in the decision

Calculate total revenue generated by special order • Calculate total incremental costs • (1) – (2) => if positive acceptthe order

Qualitative factors • Will this impact regular customers? • Is there potential future business?

Utilization of a constrained resource Effectively managing the constraint is the key to success.

Theory of Constraints Only actions that strengthen the weakest link in the “chain” improve the process. 2. Allow the weakest link to set the tempo. 3. Focus on improving the weakest link. 1. Identify the weakest link. 4. Recognize that the weakest linkis stronger.

Utilization of a constrainedresource • Calculate each product’s Contribution Margin (CM) per unit. • Identify constraining resource and the quantity of that resource that is consumed by the unit. • Divide (CM) by unit of constrained resource.

Utilization of a constrainedresource 4. Rank products from highest CM to lowest CM. 5. The CM must be viewed in relation to the amount of the constrained resource each product requires.

Managing Constraints • Increase the capacity of a bottleneck, called relaxing constraint, such as: • Working overtime on the bottleneck. • Subcontracting some of the processing that would be done at the bottleneck. • Investing in additional machines at the bottleneck.

Managing Constraints • 4. Shifting workers from non-bottleneck processes to the bottleneck. • 5. Focusing business process improvement efforts on the bottleneck. • 6. Reducing defective units processed through the bottleneck.

Quick Check  Colonial Heritage makes reproduction colonial furniture from select hardwoods. The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand? a. Yes b. No

Quick Check  Colonial Heritage makes reproduction colonial furniture from select hardwoods. The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand? a. Yes b. No (2  600) + (10  100 ) = 2,200 > 2,000

Quick Check  The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits? a. 500 chairs and 100 tables b. 600 chairs and 80 tables c. 500 chairs and 80 tables d. 600 chairs and 100 tables

Quick Check  As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood? a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero

Quick Check  As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood? a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero The additional wood would be used to make tables. In this use, each board foot of additional wood will allow the company to earn an additional $20 of contribution margin and profit.

Sell or Process furtherJoint Product Costs and Contribution Margin When 2 or more products are produced from a common input. Split-off point is when the diffferent products are separated.

Joint Products Petroleum refining industry, a large number of products are extracted from crude oil: gasoline, jet fuel, home heating oil, lubricants, asphalt, and various organic chemicals. Oil Common Production Process Joint Input Gasoline Chemicals Split-Off Point

Joint Products Joint costs are incurred up to the split-off point Final Sale Separate Processing Oil Common Production Process Joint Input Final Sale Gasoline Separate Processing Final Sale Chemicals Separate Product Costs Split-Off Point

or Processfurther Joint costs are irrelevant From the split-off point they cannot be avoided. Joint costs are common and should not be included in making decisions

or Processfurther 1.Sales value if processed further minus Sales value at the split-off point. 2. Cost of further processing beyond the split-off point. 3. (1) – (2). If positive then Process further

Differential Analysis: The Key to Decision Making Chapter 10