CHAPTER 3

1. CHAPTER 3 Using Costs in Decision Making

2. Cost Classification Costs can be classified by: Financial reporting: product VS period costs Traceability: direct VS indirect costs Behavior: variable/fixed /mixed/step costs Other terms: incremental costs, sunk costs, opportunity costs, avoidable costs etc

3. Cost Categories Used in Financial Reporting

4. Common Cost Behavior Patterns Variable Costs: totalcosts changes in proportion to changes in quantity or activity. • E.g. DM, DL, & sales commissions. Fixed Costs: total costs do not change in response to changes in quantity or activity. • E.g. depreciation by straight line method, rent, and insurance etc. Mixed Costs: costs that have both variable and fixed elements. • E.g. a salesperson’s salary where he receives a base salary (fixed) plus commissions (variable). Step Costs: fixed for a range of output, but increase when upper bound of range is exceeded. • E.g. company adds second or third production shift, fixed costs related to supervisory salary, heat, light etc are expected to increase.

5. Practice How does the cost of your cell phone plan behavior? $0.50 per minute $10 monthly fee, $0.10 per minute $60 per month unlimited minutes $20 monthly fee up to 200 minutes; $40 monthly fee if 201 to 500 minutes; and $50 monthly fee if 501-1000 minutes.

6. Practice Matching questions #1

7. Other Useful Cost Definitions Incremental Cost—the cost of the next unit of production, sometimes referred to as the Marginal Cost Sunk costs—these are costs that have occurred and no current action or decision can change them

8. Other Useful Cost Definitions Relevant Costs—a cost that will change as a result of a decision Opportunity Costs—the maximum value forgone when a course of action is chosen Avoidable Costs—costs that can be avoided by taking a specific course of action

9. Summary of Cost Concepts • Sunk costs are never incremental or relevant i.e. Do not differ between alternatives • Avoidable costs are always incremental and relevant • Opportunity costs are also incremental and relevant

10. Review 1 Which of the following is often not an incremental cost? • Material • Labor • Variable overhead • Fixed overhead

11. Review 2 Opportunity costs are: • Never incremental costs • Always incremental costs • Sometimes sunk costs • Never avoidable costs Learning objective 2: Define sunk cost, avoidable cost, and opportunity cost, and understand how to use these concepts in analyzing decisions

12. Review 3 Which of the following costs should not be taken into consideration when making a decision? • Opportunity costs • Sunk costs • Relevant costs • Differential costs

13. “What Does This Product Cost?” Answer: Why do you want to know? • No single cost number is relevant for all decisions • Must find incremental information that is applicable to the decision - Some costs will change due to the decision, some will not - Only costs that change are relevant

14. Cost-Volume-Profit Analysis The Profit Equation Profit (NI) = SP(x) – VC(x) – TFC Where: x = Quantity of units produced and sold SP = Selling price per unit VC = Variable cost per unit TFC = Total fixed cost Fundamental to CVP analysis

15. Cost-Volume-Profit Analysis Break-Even Point # of units sold that allow the company cover its total costs, with a profit of zero. NI= SP(x) – VC(x) – TFC = 0 Break Even Unit (x0)=TFC/(SP-VC) Break-Even Sales= SP*x0 Units to realize target profit: Target Profit = SP(xt) – VC(xt) – TFC xt= (Target Profit + TFC)/(SP-VC) Target Sales= SP*xt

16. Gabby’s Wedding Cakes creates elaborate wedding cakes. Each cake sells for $500. The variable cost of baking the cakes is $200 and the fixed cost per month is $6,000 Exercise 1 • Calculate the break-even point in units • 2. How many cakes must be sold to earn a profit of $9,000?

17. At Winford Corp., the selling price per lawn mower is $120, variable cost per lawn mower is $55. Fixed costs are $130,000. Break-Even Point in units is? 1,000 units 1,083 units 2,000 units None of these Review 4

18. Break-Even Point

19. Practice Matching questions #2

20. Contribution Margin Difference between revenue and variable costs Contribution margin (CM): CM=Sales-TVC = SP(x) – VC(x) Unit contribution margin (Unit CM): Unit CM= SP– VC CM=Unit CM * x Unit CM measures the amount of incremental profit generated by selling an additional unit

21. At Winford Corp., the selling price per lawn mower is $120, variable cost per lawn mower is $55. Fixed costs are $130,000. Contribution Margin per unit is? $65 $75 $175 $30 Review 5

22. Contribution Margin Ratio The contribution margin ratio measures the amount of incremental profit generated by an additional dollar of sales Two methods to calculate the contribution margin ratio Contribution margin divided by sales revenue (Sales – TVC) / Sales Unit contribution margin divided by selling price (SP – VC) / SP

23. Exercise 2 Rhetorix, Inc. produces stereo speakers. The selling price per pair of speakers is $800. The variable cost of production is $300 and the fixed cost per month is $50,000. • Calculate the unit contribution margin associated with a pair of speakers • Calculate the contribution margin ratio for Rhetorix associated with a pair of speakers

24. Rhetorix, Inc. produces stereo speakers. The selling price per pair of speakers is $800. The variable cost of production is $300 and the fixed cost per month is $50,000. Exercise 3 • If the company sells five more speakers than planned, what is the expected effect on profit of selling the additional speakers? • If the company has sales that are $5,000 higher than expected, what is the expected effect on profit?

25. Variations in CVP Analysis • Pg 68-71 • Profit in percent • Impact of income tax • what-if analysis • Multiproduct firm

26. Analysis of Decisions Faced by Managers Four types of decisions that managers frequently face: • Make or buy (outsourcing) • Short-term product mix with constraints • Drop a product or not (death spiral) • Costing order (the floor price) Save 3&4 for later chapters

27. Make or Buy Decisions • A Case • Picture this: you are new at the job and you are eager to succeed. You go out and buy (after convincing your boss) a new machine for $1 million. It’s a highly specialized machine, built especially for your firm, with no resale value. • You plan to use this machine to produce a part that is used in every product the firm makes. • It will cost you, thanks to this new machine, only $4 per unit in variable costs and $1 in depreciation (fixed cost) to make the part.

28. Make or Buy Decisions • Case continued • Great!!...until a salesman from a very reputable firm comes to your office and offers to sell you the same part you are making, same quality, reliable delivery, etc. for $4.50 a part. Her company is willing to sign a long-term contract so the price is firm. • Questions: • Should you accept her offer (i.e., buy the part) or continue to make the part yourself? • Would your decision change if the fixed costs could be avoided by selling the machine at cost?

29. Make or Buy Decisions • Decision involves no incremental revenues; Analysis concentrates solely on incremental costs. • How much cost can be saved?

30. Make or Buy Decisions • Cost savings (avoidable cost) • Not all fixed cost are irrelevant. If they are avoidable, then they should be factored into the decision just like variable costs; • Labor costs, even for direct labor (variable) costs, could be unavoidable if workers cannot be laid off because existing labor contract. • An opportunity cost (benefit forgone by selecting one decision alternative over another) must also be considered in decision making.

31. Examples Chaps Company pg79-80 Anjlee’s Catering Services pg80-81 Practice 3-40 pg102

32. Short –Term Product Mix Decisions with Constraints • Constraining factor • Fred’s wood products pg87-89 • Harris Chemical pg89-93 • Group Case: Excel Solver • 3-67 pg114