Managerial accounting tool for business decision making chapter 07

Identify the relevant costs in accepting an order at a special price.. Identify the relevant costs in deciding whether to eliminate an unprofitable segment... Management’s Decision-Makin

Chapter 7-1

decision-2. Describe the concept of

incremental analysis

3. Identify the relevant

costs in accepting an order

at a special price

4. Identify the relevant

costs in a make-or-buy decision

6. Identify the relevant

costs to be considered in retaining or replacing

equipment

7. Identify the relevant

costs in deciding whether

to eliminate an unprofitable segment

Chapter

7-5

Preview of Chapter

Preview of Chapter

An important purpose of management accounting

is to provide managers with relevant information for decision making

All companies must make product decisions – to cut prices to increase market share, to produce a higher priced product, to change their product mix, etc

Management frequently uses a decision-making process called

process called incremental analysis.

Management’s Decision-Making

Process

Other Considerations

Other Considerations

Incremental analysis approach

How incremental analysis works

Qualitative factors Incremental analysis and ABC

Types of Incremental Analysis

Types of Incremental Analysis

Accept an order at a special price

Make or buy Sell or process further Retain or replace equipment

Eliminate an unprofitable segment

Chapter

7-7

Management’s Decision-Making Process

Management’s Decision-Making Process

Decision-making is an important management function that does not always follow a set pattern

Steps in management’s decision-making process:

Accounting helps management in making decisions by evaluating possible courses of action (step 2) and

reviewing results (step 4)

SO 1: Identify the steps in management’s decision-making process.

Illustration 7-1

Decisions vary in scope, urgency and importance.

Financial information includes revenues and costs

as well as their effect on profitability

Nonfinancial information relates to factors such as: the effect of the decision on employee

turnover, the environment, or company image

SO 1: Identify the steps in management’s decision-making process.

Financial data relevant to a decision are the data

that vary in the future among alternatives

Both costs and revenues may vary,

or

Only revenues may vary,

or

Only costs may vary

SO 2: Describe the concept of incremental analysis.

Chapter

7-10

Incremental Analysis Incremental Analysis

Process used to identify the financial data that change under alternative courses of action

Identifies the probable effects of decisions on future earnings

Involves estimates and uncertainty

Incremental analysis is also called differential analysis because it focuses on differences

SO 2: Describe the concept of incremental analysis.

Chapter

7-11

GATHERING DATA MAY INVOLVE:

MARKET ANALYSTS ENGINEERS

ACCOUNTANTS

NEED TO PRODUCE THE MOST

RELIABLE INFORMATION

AVAILABLE AT THE TIME THE

DECISION MUST BE MADE.

Incremental Analysis Incremental Analysis

Comparing alternative B to A, the net income differences

between the two are $15,000 with less net income under

alternative B However, a $20,000 incremental cost saving will

be realized with alternative B Thus, alternative B will produce

$5,000 more net income than A.

Chapter

7-13

How Incremental Analysis Works

How Incremental Analysis Works

Uses Three Important Cost Concepts:

SO 2: Describe the concept of incremental analysis.

Illustration 7-3

b Change under alternative courses of action

c Are mixed under alternative courses of action.

d No correct answer is given

Let’s Review

Let’s Review

SO 2: Describe the concept of incremental analysis.

Chapter

7-15

Types of Incremental Analysis Types of Incremental Analysis

Accept an order at a special price

Make or buy components or finished products

Sell products or process further

Retain or replace equipment

Eliminate an unprofitable business segment

Allocate limited resources

SO 2: Describe the concept of incremental analysis.

Chapter

7-16

Obtain additional business by making price concessions to a specific customer

Assumes sales of the product

in other markets would not be affected by this special order

Assumes company is notoperating at full capacity

SO 3: Identify the relevant costs in accepting an order at a special price.

Accept an Order at a Special Price

Accept an Order at a Special Price

Chapter

7-17

Accept an Order at a Special Price

Accept an Order at a Special Price

Mexico Co offers to buy a special order of 2,000

blenders at $11 per unit from Sunbelt

No effect on normal sales; sufficient plant capacity.

Operating at 80 percent capacity = 100,000 units.

Current fixed manufacturing costs = $400,000 or $4 per unit.

Variable manufacturing cost = $8 per unit.

Normal selling price = $20 per unit.

Based strictly on total cost of $12 per unit ($8 + $4),

reject offer as cost exceeds selling price of $11

SO 3: Identify the relevant costs in accepting an order at a special price.

Chapter

7-18

Accept an Order at a Special Price

Accept an Order at a Special Price

Within existing capacity, thus no change in fixed

costs, so they are not relevant for this decision

Total variable costs change – thus they are relevant

Revenue increases $22,000; variable costs increase

$16,000

Income increases by $6,000.

Accept the Special Order.

SO 3: Identify the relevant costs in accepting an order at a special price.

Illustration 7-4

Chapter

7-19

It costs a company $14 of variable costs and $6 of

fixed costs to produce product Z200 that sells for

$30 A foreign buyer offers to purchase 3,000 units

at $18 each If the special offer is accepted and

produced with unused capacity, net income will:

The decision to buy parts or services rather than

making them is called outsourcing

Example: Costs to produce 25,000 switches.

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 7-5

At first look, the switches should be purchased;

thus saving $1 per unit

Buying the switches eliminates all variable costs, but only $10,000 of fixed costs ($ 60,000

-10,000) = $50,000 of fixed cost will remain

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 7-5

Chapter

7-22

Make or Buy – Continued

Make or Buy – Continued

The relevant costs for incremental analysis are:

Baron Company will incur $25,000 additional cost if

switches are purchased

Continue to make switches.

SO 4: Identify the relevant costs in a make-or-buy decision.

Illustration 7-6

Assume Baron Company can use the newly available productive capacity from buying the switches to generate additional income of $28,000 by making another product.

If Baron makes the switches, this income is lost

SO 4: Identify the relevant costs in a make-or-buy decision.

Chapter

7-24

Make or Buy – Opportunity Cost Example Make or Buy – Opportunity Cost Example

SO 4: Identify the relevant costs in a make-or-buy decision.

This opportunity cost, the lost income, is added to the “Make” column as an additional

“cost” for comparative purposes

It is now advantageous to buy the switches.

Baron Company will be $3,000 better off.

Illustration 7-7

Chapter

7-25

In a make-or-buy decision, relevant costs are:

a Manufacturing costs that will be saved Manufacturing costs that will be saved

b The purchase price of the units

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Chapter

7-27

Sell or Process Further - Example

Sell or Process Further - Example

Single-Product Case

Cost to manufacture one unfinished table:

Selling price of unfinished unit is $50; unused capacity can be used to finish the tables to sell for $60

Relevant unit costs of finishing tables:

Direct materials increase $2; Direct labor increases $4.

Variable manufacturing overhead costs increase by $2.40

(60 percent of direct labor increase).

Fixed manufacturing costs will not increase.

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Illustration 7-8

Chapter

7-28

Sell or Process Further Sell or Process Further

Incremental revenues ($10) exceed incremental costs

($8.40); Income increases $1.60 per unit

Process further.

SO 5: Identify the relevant costs in determining whether

to sell or process materials further

Illustration 7-9

Chapter

7-29

Sell or Process Further

Sell or Process FurtherMultiple-Product Case

In many industries, a number of end-products are

produced from a single raw material and a common

production process

Multiple end-products are commonly called joint

products:

Petroleum – gasoline, lubricating oil, kerosene.

Meat Packing – meat, hides, bones.

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Joint costs are (for purposes of determining product cost)

allocated to individual products on the basis of relative sales value.

Joint costs are not relevant for any sell-or-process-further

decisions.

Joint product costs are sunk costs.

They have already been incurred and cannot be changed.

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Chapter

7-31

Sell or Process Further - Example

Sell or Process Further - ExampleMultiple-Product Case

Marais Creamery must decide whether to:

Sell cream and skim milk now,

orProcess each further before selling

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Illustration 7-10

Chapter

7-32

Sell or Process Further – Example Continued

Sell or Process Further – Example Continued

The daily cost and revenue data for Marais Creamery are:

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Illustration 7-11

Chapter

7-33

Sell or Process Further – Example Continued Sell or Process Further – Example Continued

Sell cream or process further into cottage cheese?

Do not process cream further:

To do so will incur an incremental loss of $2,000.

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Illustration 7-12

Chapter

7-34

Sell or Process Further

Sell or Process Further

Sell skim milk or process further into condensed milk?

Marais should process the skim milk:

To do so will increase net income by $7,000.

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Illustration 7-13

Chapter

7-35

The decision rule in a sell-or-process-further decision

is process further as long as the incremental revenue

from processing exceeds:

a Incremental processing costs Incremental processing costs

b Variable processing costs

c Fixed processing costs.

d No correct answer is given.

Let’s Review

Let’s Review

SO 5: Identify the relevant costs in determining whether

to sell or process materials further.

Chapter

7-36

Retain or Replace Equipment

Retain or Replace Equipment

Management must decide whether a company should continue to use an asset or replace it

machine:

Variable costs:

Decrease from $160,000

to $125,000 annually

SO 6: Identify the relevant costs to be considered in

retaining or replacing equipment.

Old Machine New Machine Book value $40,000

Cost $120,000

Remaining useful life Four years Four years

Scrap value - 0 - 0

-Chapter

7-37

Retain or Replace Equipment - Example Retain or Replace Equipment - Example

more than offset cost of new equipment.

The book value of the old machine does not affect the

However, any trade-in allowance or cash disposal value of

the old asset is relevant.

SO 6: Identify the relevant costs to be considered in

retaining or replacing equipment.

Illustration 7-14

Chapter

7-38

In a decision to retain or replace equipment, the book

value of the old equipment is a/an:

a Opportunity cost Opportunity cost

SO 6: Identify the relevant costs to be considered in

retaining or replacing equipment.

Chapter

7-39

Eliminate an Unprofitable Segment

Eliminate an Unprofitable Segment

Should the company eliminate an unprofitable

segment?

Key: Focus on relevant costs

Consider effect on related product lines

Fixed costs allocated to the unprofitable segment

must be absorbed by the other segments

Net income may decrease when an unprofitable

segment is eliminated

Decision Rule:

Retain the segment unless fixed costs eliminated

exceed the contribution margin lost

SO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.

Chapter

7-40

Eliminate an Unprofitable Segment - Example Eliminate an Unprofitable Segment - Example

Martina Company manufactures three models of tennis

racquets: Profitable lines: Pro and Master Unprofitable line:

Champ

Condensed income statement data:

Should the Champ line be eliminated?

SO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.

Illustration 7-15

Chapter

7-41

Eliminate an Unprofitable Segment - Example Eliminate an Unprofitable Segment - Example

If Champ is eliminated, must allocate its $30,000

share of fixed costs: 2/3 to Pro and 1/3 to Master.Revised income statement data:

Total income has decreased by $10,000 ($220,000 -

$210,000)

SO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.

Illustration 7-16

Chapter

7-42

Eliminate an Unprofitable Segment - Example

Eliminate an Unprofitable Segment - Example

Incremental analysis of Champ provides the same

results:

Decision: Do not eliminate Champ

SO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment.

Illustration 7-17

Chapter

7-43

If an unprofitable segment is eliminated:

a Net income will always increase Net income will always increase

b Variable expenses of the eliminated segment will

have to be absorbed by other segments

c Fixed expenses allocated to the eliminated

segment will have to be absorbed by other segments.

d Net income will always decrease.

Let’s Review

Let’s Review

SO 7: Identify the relevant costs in deciding whether

to eliminate an unprofitable segment

Chapter

7-44

Other Considerations in Decision Making Other Considerations in Decision Making

Many decisions involving incremental analysis have

important qualitative features that must be

considered in addition to the quantitative factors

Example – cost of lost morale due to outsourcing or eliminating a plant

Incremental analysis is completely consistent with

activity-based costing (ABC)

ABC often results in better identification of relevant costs and, thus, better incremental analysis

Chapter

7-45

All About You

All About You About You

What is a Degree Worth?

Over a life time of work, college graduates earn an average of $500,000 more than associate degree holders and $900,000 more than high-school

graduates

Tuition costs about $8,655 a year to attend a public four-year college and about $1,359 for a public two year institution

About 600,000 students drop out

of four-year colleges each year

Chapter

7-46

All About You

All About You About You

What is a Degree Worth?

You are working two jobs, your grades are suffering, you feel depressed: Should you drop out of school?

Is it better to stay in school even if you only take one class each semester?