CHAPTER 11 and appendix RELEVANT COSTS With LINEAR PROGRAMMING

WHAT ARE RELEVANT COSTS? COSTS THAT WILL BE DIFFERENT WITH A DIFFERENT DECISION FOR EXAMPLE: YOU PLAN TO DRIVE TO SAN FRANCISCO FOR A ONE DAY MEETING YOU CAN DRIVE YOUR CAR OR RENT A CAR WHAT COSTS ARE RELEVANT?

RELEVANT COSTS WITH DRIVING YOUR OWN CAR WEAR AND TEAR ON YOUR CAR

RELEVANT COSTS WITH RENTING A CAR RENTAL FEE THE INCONVIENCE OF OBTAINING AND RETURNING THE RENTAL CAR

IRRELEVANT COSTS TAXES ON YOUR CAR INSURANCE (UNLESS YOU THINK ONE ALTERNATIVE IS SAFER THAN THE OTHER) PARKING IN SAN FRANCISCO GASOLINE

HOW TO ANALYZE USE AN INCREMENTAL (DIFFERENTIAL) ANALYSIS, I.E., CONSIDER ONLY THOSE COSTS THAT WILL BE DIFFERENT. USE A BROAD (TOTAL) ANALYSIS, I.E., ESTIMATE THE TOTAL COSTS UNDER EACH ALTERNATIVE

PITFALLS OF ALLOCATIONS ALLOCATIONS MAY LEAD TO BAD FINANCIAL DECISIONS BECAUSE THEY MAY INDICATE THAT A SEGMENT IS NOT PROFITABLE BUT THE ELIMINATION OF THE SEGMENT MAY REDUCE OVERALL PROFITS

IRRELEVANT INFORMATION Past information Fixed Costs

TWO THINGS TO CONSIDER What will you get, and What will you give up (cost)

TWO EXAMPLES OF DECISIONS One-Time-Only Special Orders Make or Buy Decisions / Outsourcing

ONE-TIME-ONLY SPECIAL ORDERS (from text) Your mfg. costs are: Variable Costs Fixed Costs Total Costs Materials$ $6.00 Labor 0.50 $ Overhead Total$7.50 $4.50 $12.00 Your normal price is $18. You received an order from a foreign company for 2,000 units at a price of $11. You have never dealt with this company or expect to again. This sale will not affect any of your other sales.

WHAT SHOULD YOU CONSIDER? Only the variable costs of $7.50 and Capacity: Can you produce the goods for this order without affecting production of any other goods?

MAKE OR BUY DECISIONS / OUTSOURCING Outsourcing may change some fixed costs to variable costs or it may change some variable costs to fixed costs. BUT It will provide greater flexibility

MAKE OR BUY EXAMPLE (revised from text) CURRENT SITUATION » Cost per Unit Direct materials $8 Direct labor 1 Variable overhead 4 Mat. handling & setup 2 Fixed overhead 3 Total$18

OUTSIDE OFFER Someone offers to produce all we need for $16 each. Should we outsource? Assume that we can not use the fixed capacity in any productive way. NO! Our cost of producing an additional unit is only $15, the $3 fixed cost is irrelevant. Assume that we can use the fixed capacity in a productive way. It is as valuable for another purpose. THE FIXED COST is not relevant but THE CONTRIBUTION AVAILABLE FROM THE CAPACITY GIVEN UP IS RELEVANT.

EXERCISE You are trying to decide whether to rent or buy a home for your family of four. What financial information is relevant? Which choice provides the greater flexibility? What subjective variables should be considered? How can you compare these two opportunities when you include subjective variables?

CHAPTER 11 APPENDIX LINEAR PROGRAMMING

WHAT IS LINEAR PROGRAMMING? A technique to determine the optimal combination of products to produce. You need to know: –The input requirements of each product –The contribution from each product –The constraints

EXAMPLE (Modified from text) You can produce snowmobile engines (SE) or boat engines (BE). SEs use 2 hours of Assembly time and 1 hour of Testing time. BEs us 5 hours of Assembly time and 0.5 hours of Testing time. The contribution margin of a SE is $240 and the contribution margin of a ME is $375. There are 600 hours available in Assembly and 120 hours available in Testing.

ANALYSIS We can produce no more than 300 SEs in Assembly or 120 in Testing. We can produce no more than 120 BEs in Assembly or 240 in Testing. Determine the feasible combinations

GRAPHICALLY BE SE feasible area testing depart. constraint assembly dept. constraint

ADD IN OBJECTIVE FUNCTION We want to maximize profits To do this, we need to maximize contribution Contribution of SE is $ 240 and of BE is $ 375. That is a ratio of 0.64 to Add the objective function to the graph

GRAPHICALLY BE SE feasible area testing depart. constraint assembly dept. constraint

OPTIMAL PRODUCTION LEVEL Where the two constraints cross. ALGEBRAICALLY 2 SE + 5 BE = SE BE = 120 SE = 75 BE = 90

EXERCISE You produce Xs and Ys. An X takes 2 hrs. in dept. 1 and 3 hrs. in dept. 2. A Y takes 3 hrs. in dept. 1 and 1 hr. in dept. 2. There are 90 hours available in dept. 1 and 60 hrs. in dept. 2 The contribution margin of an X is $4 and a Y is $1.

SOLVE GRAPHICALLY Y X feasible area Dept. 2 constraint dept. 1 constraint 20 45

SOLUTION Produce only Xs.

WHAT DOES THE ACCOUNTANT HAVE TO DO WITH THIS? The accountant will have to estimate the contribution margin. The accountant may obtain the information on the constraints We will see later the further use of the idea of constraints