FINANCIAL & MANAGERIAL ACCOUNTING for MBAs Peter D.

FINANCIAL & MANAGERIAL ACCOUNTING for MBAs Peter D.

FINANCIAL & MANAGERIAL ACCOUNTING for MBAs Peter D. EASTON Robert F. HALSEY Mary Lea McANALLY Al L. HARTGRAVES Wayne J. MORSE MODULE 17 Relevant Costs and Benefits for Decision Making Cambridge Business Publishers, 2018

5e Learning Objective 1 Distinguish between relevant and irrelevant revenues and costs. Cambridge Business Publishers, 2018 2 Relevant and Irrelevant Costs Relevant Irrelevant Future costs that differ among competing decision alternatives

Future costs that DO NOT differ among competing decision alternatives Primary focus is profit maximization Additional factors that must be considered Effects on long-run profit Nonquantitative factors Such as legal, ethical, social Cambridge Business Publishers, 2018 3 Future Revenues and Outlay Costs Revenues Relevant if they differ between alternatives Outlay costs Outlay costs require future expenditures of cash or

other resources Relevant outlay costs Outlay costs that differ between decisions Irrelevant outlay costs Outlay costs that do not differ between decisions Cambridge Business Publishers, 2018 4 Sunk Costs Result from past decisions that cannot be changed Sunk costs are NEVER relevant Sunk costs in decisions to replace a machine Cost of old machine Book value of old machine Can cause ethical dilemmas Managers often avoid disposing of old assets Disposing may create a loss on the income statement,

making the managers performance look bad Cambridge Business Publishers, 2018 5 Disposal and Salvage Values Disposal value Amount of cash an old asset can be sold for at the time the new asset is purchased Relevant cash inflow Obtained only if the replacement alternative is accepted Salvage value Amount of cash an asset will bring at the end of its useful life if held to that time Cambridge Business Publishers, 2018 6 Opportunity Costs

Any benefit forgone as a result of rejecting one alternative in favor of another Always relevant when making decisions among competing alternatives Cambridge Business Publishers, 2018 7 Summary of Relevant and Irrelevant Costs Remember that the deciding factor in whether or not a cost is relevant is if the cost differs among alternatives. Only relevant costs are used in decision making. Cambridge Business Publishers, 2018 8 Learning Objective 2

Analyze relevant costs and indicate how they differ under alternative decision scenarios. Cambridge Business Publishers, 2018 9 Relevant and Irrelevant Costs Example Trekker Tires manufacturers lawn mower tires. It produces and sells 10,000 tires annually at a selling price of $20 each. Management is evaluating the desirability of replacing the old assembly machine with a new machine. Data concerning the twoProposed machines: Old Machine Machine

Cost $90,000 $80,000 Estimated useful life 6 years 4 years Cambridge Business Publishers, 2018 10 Relevant and Irrelevant Costs Example Old Machine Unit level: Direct materials $3.00 per unit

Conversion $5.00 per unit Selling and distribution $1.00 per unit Batch level: Inspection and adjustment $500 per batch Batch size 1,000 Proposed Machine $3.00 per unit $3.50 per unit $1.00 per unit $400 per batch 1,000 Direct labor and variable manufacturing overhead required to convert raw materials into finished goods. The old machine is two years old with a current disposal value of $35,000. The proposed machine has a zero salvage value.

Cambridge Business Publishers, 2018 11 Relevant and Irrelevant Costs Example Old Machine Unit level: Direct materials $3.00 per unit Conversion $5.00 per unit Selling and distribution $1.00 per unit Batch level: Inspection and adjustment $500 per batch Batch size 1,000

Difference in conversion costs Disposal value of old machine Difference in batch costs Difference in depreciation Cambridge Business Publishers, 2018 Proposed Machine $3.00 per unit $3.50 per unit $1.00 per unit $400 per batch 1,000 Direct material costs

Selling and distribution costs Cost of old machine Selling price of tires 12 Differential Analysis An approach to the analysis of relevant costs that focuses on costs that differ between alternative actions Preferred over an aggregate analysis when determining which of two alternatives is most profitable Benefits Focuses on only items that differ Contains fewer items, making it easier and quicker to prepare Helps simplify complex situations Cambridge Business Publishers, 2018 13

Learning Objective 3 Apply differential analysis to evaluate changes in profit plans. Cambridge Business Publishers, 2018 14 Changes in Profit Plans Example Proposed Change Expected Effect on Units Sold KonnectCo manufactures flash drives and sells them for Increase advertising by Sales increase by 300 units Alternative

#1 Management 20 (euros). is considering 3 possible 1,000 alternatives: Alternative #2 Increase unit selling price by 1 Sales decrease by 300 units Alternative #3 Decrease unit selling price by 1 Sales increase by 500 units, with direct labor for the last

200 units increasing by 1 each due to overtime Cambridge Business Publishers, 2018 15 Changes in Profit Plans Example Variable Costs per Unit Direct materials 3 Direct labor 4 Manufacturing overhead 2 Selling and administrative1 Fixed Costs per Month Manufacturing overhead 20,000 Selling and administrative8,000 Current costs to produce flash drives are:

Average monthly production and sales is 4,000 units. Cambridge Business Publishers, 2018 16 Changes in Profit Plans Example Alternative #1 Unit contribution margin = 20 (3 + 4 + 2 + 1) = 10 Increase advertising Differential by 1,000,Analysis with sales increasing by 300Profit unitsincrease from increased sales (300 units 10) Profit decrease from increased advertising Increase in monthly profit Cambridge Business Publishers, 2018

3,000. (1,000) 2,000. 17 Changes in Profit Plans Example Alternative #2 Unit contribution margin = 20 (3 + 4 + 2 + 1) = 10 Differential Analysis Increase selling by 1, with sales decreasing by 300 units Profit decrease from reduced sales (300 units 10) Profit increase from increased selling price (3,700 units 1) Increase in monthly profit

Cambridge Business Publishers, 2018 (3,000) 3,700. 700. 18 Changes in Profit Plans Example Alternative #3 Unit contribution margin = 20 (3 + 4 + 2 + 1) = 10 Decrease selling by 1, with sales increasing by 500 units, Differential Analysis causing the last 200 units to incur overtime on direct Profit increase

sales labor costing 1from peradditional unit more 500 units (19 (3 + 4 + 2 + 1)) Profit decrease from decreased selling price (4,000 units 1) Profit decrease from overtime on 200 units (200 units 1) Increase in monthly profit Cambridge Business Publishers, 2018 4,500. (4,000) (200) 300. 19

Changes in Profit Plans Example Alternatives #1 Increase monthly profit 2,000 #2 Increase monthly profit 700 #3 Increase monthly profit 300 The best option is Alternative #1 because it results in the largest increase in profit. Cambridge Business Publishers, 2018 20 Learning Objective 4

Apply differential analysis to evaluate whether to accept a special order. Cambridge Business Publishers, 2018 21 Special Orders Occurs when a customer wants to buy merchandise or obtain services on a one time basis at a price less than prices charged to other customers Usually involves a proposed purchase of a large volume of unitsWhat is relevant? Sales revenue Variable production costs Additional costs to be incurred Cambridge Business Publishers, 2018

22 Special Order Example A customer offers to place a special, one-time order for 800 units at a reduced price of 16 per unit. KonnectCo has production capacity of 5,000 units and normally produces 4,200. KonnectCo KonnectCos Costs will save 25% of its variable sales and administrative costs as a result. Should KonnectCo order? Fixed Costs per Month Variable Costs per Unitaccept the Direct materials 3

Direct labor 4 Manufacturing overhead 2 Selling and administrative1 Cambridge Business Publishers, 2018 Manufacturing overhead 20,000 Selling and administrative8,000 23 Special Order Example Differential Analysis Increase in revenues (800 units 16) Increase in costs Direct materials (800 3) Direct labor (800 4) Manufacturing overhead (800 2) Selling and administrative (800 1 75%) Increase in profits

12,800. 2,400 3,200 1,600 600 (7,800) 5,000. KonnectCo should accept the order since its profits will increase by 5,000. The fixed portion of the selling and administrative costs remain at 8,000 no matter what level of activity. The special cost savings are for variable costs. Cambridge Business Publishers, 2018 24 Concerns with Special Orders Time span concerns Future year cost increases should be considered in

multiyear special orders Variable nature of long-term fixed costs In the long-run, all costs, fixed and variable, should be considered relevant Because they are subject to change over time Possible solutions Include a cost escalation clause in multiyear agreements Use full costs regardless of cost behavior patterns to approximate long-run variable costs Cambridge Business Publishers, 2018 25 Multiyear Special Order Example Full cost based on capacity Direct materials 3.00 Direct labor 4.00

manufacturing overhead 2.00 WhatVariable if the customer wanted KonnectCo to sign a multiyear Variable selling and administrative 0.75 contract to provide 800 units per month at 16 each? Fixed manufacturing overhead (20,000 / 5,000) 4.00 Fixed selling and administrative (8,000 / 5,000)

1.60 Average full cost per unit 15.35 KonnectCo should consider accepting a multiyear order based on full costs because 16 exceeds the full cost. Cambridge Business Publishers, 2018 26 Special Order with Opportunity Costs Example Lost sales to regular customers (units) 800. Regular unit contribution margin What if KonnectCo operating at capacity, its regular [20 (3 + 4 + were 2 + 1)]

10. customers pay 20 per flashthe drive, andorder the special order Opportunity cost of accepting special (8,000) Increasewants in profitto if special order accepted customer buy 800 units per month at 16 each?

[16 (3 + 4 + 2 + .75)] 5,000. Net decrease in profit is special order accepted (3,000) KonnectCos profits would decrease by 3,000 if the special order is accepted if operating at capacity. Cambridge Business Publishers, 2018 27 Qualitative Considerations of Special Orders Impact on regular customers Potential long-term benefits from the special order customer Trying to establish a customer relationship Legal factors Does the buyer compete with regular customers? Cambridge Business Publishers, 2015

28 Learning Objective 5 Apply differential analysis to evaluate outsourcing decisions. Cambridge Business Publishers, 2018 29 Outsourcing Outsourcing is the procurement of services, products, components from an external source. Possible reasons for outsourcing include: Cambridge Business Publishers, 2018 30

Outsourcing Example KonnectCos Costs Variable Costs per Unit Direct materials 3 Direct labor 4 Manufacturing overhead 2 Selling and administrative1 Fixed Costs per Month Manufacturing overhead 20,000 Selling and administrative8,000 A manufacturer has offered to supply KonnectCo with all the flash drives it needs for one year at a cost of 9 each. If accepted, KonnectCo could eliminate production supervisor salaries that currently cost 1,000 per month. Normal production is 4,200 units each month. Should KonnectCo outsource? Cambridge Business Publishers, 2018 31

Outsourcing Example Cost to buy (9 4,200 12 months) Cost to make: Direct materials (3 4,200 12) Direct labor (4 4,200 12) Variable manufacturing overhead (2 4,200 12) There are no relevant revenues Fixed manufacturing overhead (1,000 12) Total Advantage of buying 453,600 151,200 201,600 100,800 in outsourcing decisions. 12,000

465,600 465,600 12,000 KonnectCo should consider outsourcing as profits will be higher by 12,000. Cambridge Business Publishers, 2018 32 Outsourcing Example Cost to buy (9 4,200 12 months) 453,600 Cost to make: Directspace materials (3 4,200used 12) to manufacture can 151,200 If the

currently be rented Direct labor (4 4,200 12) 201,600 forVariable 15,000 per year, what(2 should do? manufacturing overhead 4,200 KonnectCo 12) 100,800 Fixed manufacturing overhead (1,000 12) 12,000 Opportunity cost of lost rental income if manufactured 15,000 . Total 480,600 453,600

Advantage of buying 27,000 KonnectCo should consider outsourcing to increase profits by 27,000. Cambridge Business Publishers, 2018 33 Learning Objective 6 Apply differential analysis to evaluate whether to sell or further process a product. Cambridge Business Publishers, 2018 34 Sell or Process Further Decisions Key issue is to determine a products most advantageous selling point for products salable

at various stages of completion Decision is whether To sell the product as is Process the product further to sell for a higher selling price Two types of decisions Single products Joint products Cambridge Business Publishers, 2018 35 Sell or Process Further Decision Example StackEm manufactures assembled, ready-to-paint book shelves for $18 each and sells them for $30 each. Painting the shelves would increase the total cost of a shelf to $23, but Increase in revenues: StackEm

could then sell them for $38 each. What should Revenue per shelf if painted $38 StackEm do?shelf if sold without paint Revenue per 30 $ 8. Additional costs of painting ($23 $18) Advantage of painting for each shelf (5) $ 3. StackEm should paint the shelves as profit increases by $3 per shelf. Cambridge Business Publishers, 2018 36 Joint Product Cost Decisions

What are joint products? Two or more products simultaneously produced by a single process from a common set of inputs Split-off point The point in the process where the joint product becomes separately identifiable Joint costs Costs incurred prior to the split-off point Are sunk costs and never relevant to joint product decisions or to process further decisions Cambridge Business Publishers, 2018 37 Learning Objective 7 Allocate limited resources for purposes of maximizing short-run profit.

Cambridge Business Publishers, 2018 38 Use of Limited Resources Managers should decide how to best use limited resources to accomplish organizational goals. Sometimes results in a product mix decision, i.e., which product should be produced with the limited resource? Examples of limited resources Limited capacity Limited labor hours due to lack of skilled labor Limited materials due to supply limitations Limited machine hours Cambridge Business Publishers, 2018

39 Use of Limited Resources Single ConstraintExample Wilson Sports produces two models of baseball bats using white ash wood. Due to weather problems, wood supply is limited and Wilson is able to obtain only 24,000 board feet of white ash. Which bat should Wilson produce given the following Deluxe Basic Bats Bats information? Unit selling price Unit variable costs Unit contribution margin Number of board feet of wood needed per bat

Cambridge Business Publishers, 2018 $75 34 $41 3.40 $54 25 $29 2.20 40 Use of Limited Resources Single ConstraintExample Unit contribution margin Determine thefeet contribution Number of board

of wood neededmargin per bat Contribution margin per board foot: each product. $41 / 3.40 = $29 / 2.20 = per Deluxe Basic Bats Bats $41 $29 board 3.40foot for2.20 $12.06 $13.18 Deluxe bats generate $12.06 of profit for every board foot

of white ash wood used, while basic bats generate $13.18. Therefore, basic bats should be produced. Cambridge Business Publishers, 2018 41 Use of Limited Resources Multiple ConstraintExample Assume that Wilson Sports must produce at least 2,000 of each model to remain competitive. With the same material constraint of 24,000 board feet of white ash, how much will total contribution be when profit is Deluxe: Contribution per board margin foot: $41/3.40 = $12.06

maximized under the constraint? Basic: Contribution per board foot: $29/2.20 = $13.18 Produce more basic bats since they generate more contribution to profit per board foot than do the deluxe bats. Cambridge Business Publishers, 2018 42 Use of Limited Resources Multiple ConstraintExample Available board feet Feet to be used for minimum deluxe bats (3.4 2,000) Remaining feet to be used for basic bats 24,000. (6,800) 17,200.

Subtract the board foot to be used for the minimum units of Determine the number of basic bats to be produced with the the least profitable product from available wood: remaining board feet: Number of basic bats to be produced (17,200 / 2.20) = 7,818 Contribution margin generated: Contribution margin from deluxe bats ($41 2,000) Contribution margin from basic bats ($29 7,818) Total contribution margin Cambridge Business Publishers, 2018 $ 82,000 226,722 $308,722 43 Theory of Constraints

States that Every process has a bottleneck, and Production cannot take place faster than it is processed through the bottleneck Goal is to maximize throughput in a constrained environment Throughput is sales revenue minus direct materials cost A bottleneck is a constraining resource. Cambridge Business Publishers, 2018 44 Managements Role in Bottlenecks Management should Identify the bottlenecks Schedule production to maximize the efficient use of the bottleneck resource Schedule production to avoid a buildup of inventory

Work to eliminate bottlenecks Cambridge Business Publishers, 2018 45 Theory of Constraints To support the theory of constraints, performance reports should: Measure the utilization of bottleneck resources Measure factory throughput Not encourage the full utilization of non-bottleneck resources Discourage the buildup of excess inventory Cambridge Business Publishers, 2018 46 The End

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