CHAPTER Prepared by: Jerry Zdril, CGA Tools for Business Decision-Making Third Canadian Edition MANAGERIAL ACCOUNTING Weygandt-Kimmel-Kieso-Aly 7

CHAPTER Prepared by: Jerry Zdril, CGA Study Objectives 1. Identify the steps in management’s decision-making process. 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. 5. Identify the relevant costs in deciding whether to sell or process materials further. 6. Identify the relevant costs in deciding whether to retain or replace equipment. 7. Identify the relevant costs in deciding whether to eliminate an unprofitable segment. 8. Determine the sales mix when a company has limited resources. 7 Incremental Analysis 7

CHAPTER 7 Management’s Decision-Making Process  Does not always follow a set pattern or process Decisions vary in scope Decisions vary in urgency and importance  However some steps can be identified: 3 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Management’s Decision-Making Process  Considers both financial and non-financial information Financial information Revenues and costs Overall profitability Nonfinancial information Effect of decision on employee turnover Environment Overall image of company 4 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review The decision making process normally includes: a. identify, determine, make a decision and review results. b. selecting the best deal or offer. c. analyses of sunk costs in order to choose the best alternative. d. Both b. and c. 5 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review: Solution The decision making process normally includes: a. identify, determine, make a decision and review results. b. selecting the best deal or offer. c. analyses of sunk costs in order to choose the best alternative. d. Both b. and c. 6 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Management’s Decision-Making Incremental Analysis Approach  Decisions involve a choice among alternative actions  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  Incremental Analysis: Process to identify financial data that change under alternative actions Identifies probable effects of decisions on future earnings 7 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Management’s Decision-Making How Incremental Analysis Works – Example  Alternative B is being compared to Alternative A Incremental revenue is $15,000 less under Alternative B Incremental cost savings of $20,000 is realized Alternative B produces $5,000 more net income Alternative Alternative Net Income A B Increase (Decrease) Revenues $125,000 $110,000 $(15,000) Costs 100,000 80,000 20,000 Net income $25,000 $30,000 $5,000 8 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Management’s Decision Making How Incremental Analysis Works  Relevant cost: In incremental analysis, the only factors to be considered are: (1) those costs and revenues that are different for each alternative, and (2) those costs and revenues that will occur in the future.  Opportunity cost: In choosing to take one action, the company must often give up the opportunity to benefit from some other action. This lost benefit is called an opportunity cost.  Sunk cost: Costs that have already been incurred and will not be changed or avoided by any future decision are called sunk costs. Sunk costs are not relevant costs. 9 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review When making decisions, a general rule would be a. fixed costs are always relevant. b. variable (unit-level) costs are always irrelevant. c. future costs and revenues are always relevant. d. future revenues and costs which differ are always relevant. 10 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review: Solution When making decisions, a general rule would be a. fixed costs are always relevant. b. variable (unit-level) costs are always irrelevant. c. future costs and revenues are always relevant. d. future revenues and costs which differ are always relevant. 11 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Management’s Decision-Making Types of Incremental Analysis 1. Accept an order at a special price 2. Make or buy component parts or finished products 3. Sell products or process further 4. Retain or replace equipment 5. Eliminate or retain an unprofitable business segment 6. Allocate limited resources 12 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Accept an Order at a Special Price  Obtain additional business by making price concessions  Assumes sales of the products in other markets would not be affected by special order  Assumes company is not operating at full capacity 13 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Accept an Order at a Special Price – Example  Customer 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% capacity = 100,000 units Current fixed manufacturing costs = $400,000 or $4 per unit Variable manufacturing cost = $8 per unit Normal selling prince = $20 per unit  Based strictly on total cost of $12 per unit ($8 + $4), reject offer as cost exceeds selling price of $11 14 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Accept an Order at a Special Price – Example: Continued  No change in fixed costs since within existing capacity – thus fixed costs are not relevant  Only total variable costs change – thus they are relevant  Revenue increases $22,000; variable costs increase by $16,000;  Thus, net income increases $6,000 Decision: Accept the offer. Income will increase by $6, Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review Of several types of decisions that involve incremental analysis, the most common are: a. accept an order at a special price. b. make or buy component parts. c. sell products or process further. d. all of the above. 16 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review: Solution Of several types of decisions that involve incremental analysis, the most common are: a. accept an order at a special price. b. make or buy component parts. c. sell products or process further. d. all of the above. 17 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Make or Buy - Example  Outsourcing: The decision to buy parts or services rather than making them  Baron Co. incurs the following costs to make 25,000 switches:  Switches can be purchased for $8 per switch ($200,000) Eliminates all variable costs and $10,000 of fixed costs; however, $50,000 of fixed costs remain Direct materials $ 50,000 Direct labour 75,000 Variable manufacturing overhead 40,000 Fixed manufacturing overhead 60,000 Total manufacturing costs $225,000 Total cost per unit ($225,000 ÷ 25,000) $ Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Make or Buy – Example: Continued  Based on analysis of costs under both alternatives: Purchasing adds $25,000 to cost of switches MakeBuyIncremental Cost (Saving) Direct materials$50,000$ 0$50,000 Direct labour75,000$ 075,000 Variable manufacturing costs40,000$ 040,000 Fixed manufacturing costs60,00050,00010,000 Purchase price (25,000 x $8) 200,000(200,000) Total Annual Cost225,000$250,000($25,000) Decision: Continue to make switches. 19 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Opportunity Costs Baron Company – Example: Continued  Opportunity cost – the potential benefit that may be obtained from following an alternative course of action  Example: Assume that buying the switches allows Baron to use the released capacity to generate $28,000 additional income. 20 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Make Buy Costs and Saving Total annual cost $225,000 $250,000 $(25,000) Opportunity cost 28, ,000 Total cost $253,000 $250,000 $ 3,000 Decision: Based on the analysis, Baron should buy the switches as the company will earn an additional $3,000 in Net Income.  Thus, the $28,000 lost income is an additional cost of making the switches Incremental Analysis Opportunity Costs Baron Company – Example: Continued 21 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review In a make-or-buy decision, the relevant costs are: a. the manufacturing costs that will be saved. b. the purchase price of the units. c. opportunity costs. d. all of the above. 22 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review: Solution In a make-or-buy decision, the relevant costs are: a. the manufacturing costs that will be saved. b. the purchase price of the units. c. opportunity costs. d. all of the above. 23 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Sell or Process Further  Manufacturers may have to decide, at a given point in production, whether to sell now or to process further and sell at a higher price later  Decision Rule: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs 24 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Sell or Process Further Single-Product Case  Cost to manufacture one unfinished table: Direct materials $15 Direct labour 10 Variable manufacturing overhead 6 Fixed manufacturing overhead 4 Manufacturing cost per unit $35 Selling price of unfinished unit is $50  Unused capacity is available to enable the company to finish the tables Selling price of finished unit is $60 25 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Relevant unit costs of finishing tables: Direct materials increase $2 Direct labour increase $4 Variable manufacturing overhead costs increase by $2.40 (60% of direct labour increase) Fixed manufacturing costs will not increase Incremental Analysis Sell or Process Further Single-Product Case: Continued 26 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Decision: Process further. Incremental revenue ($10) exceeds incremental processing costs ($8.40); income increases $1.60 per unit. Sales per unit Cost per unit Direct materials Direct labour Variable manufacturing overhead Fixed manufacturing overhead Total Net income per unit Sell $ $35.00 $15.00 Process Further $ $43.40 $16.60 Incremental Revenue and Costs $10.00 (2.00) (4.00) (2.40) $(8.40) $1.60 Incremental Analysis Sell or Process Further Single-Product Case: Continued 27 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Especially appropriate when multiple products are produced simultaneously  Many end-products are produced from a single raw material and a common production process  Joint products – multiple end products Petroleum – gasoline, lubricating oil, kerosene Meat Packing – meat, hides, bones Incremental Analysis Sell or Process Further Multiple-Product Case 28 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Joint costs all costs incurred prior to split-off point allocate to individual products based on relative sales value  Sunk costs already incurred and cannot be changed Irrelevant for sell or process further decisions  Joint costs are sunk costs for sell or process further decisions. Incremental Analysis Sell or Process Further Multiple-Product Case: Continued 29 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Sell cream and skim milk or Process them further before selling Marais Creamery Decision – Example Incremental Analysis Sell or Process Further Multiple-Product Case: Continued 30 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Sell cream or process further into cottage cheese? Joint cost allocated to cream $9,000 Processing cream into cottage cheese $10,000 Expected revenue per day: Cream $19,000 Cottage cheese$27,000 Incremental Analysis Sell or Process Further Multiple-Product Case: Continued Marais Creamery Decision – Example 31 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Decision: Do not process the cream further. Incremental revenue ($8,000) is less than incremental costs ($10,000); income decreases by $2,000. Process Incremental Sell Further Revenue and Costs Sales per day $19,000 $27,000 $ 8,000 Cost per day Processing cream into cottage cheese ,000 (10,000) $19,000 $17,000 $ (2,000) Incremental Analysis Sell or Process Further Multiple-Product Case: Continued Marais Creamery Decision – Example 32 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Sell skim milk or process further into condensed milk? Joint cost allocated to skim milk $5,000 Processing skim milk into condensed milk $8,000 Expected revenue per day: Skim milk $11,000 Condensed milk $26,000 Incremental Analysis Sell or Process Further Multiple-Product Case: Continued Marais Creamery Decision – Example 33 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Decision: Process the skim milk further. Incremental revenue ($15,000) exceeds incremental costs ($8,000); Income increases by $7,000. Process Incremental Sell Further Revenue and Costs Sales per day $11,000 $26,000 $ 15,000 Cost per day Processing skim milk into condensed milk ,000 ( 8,000) $11,000 $18,000 $ 7,000 Marais Creamery Decision – Example Incremental Analysis Sell or Process Further Multiple-Product Case: Continued 34 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review The decision rule in a sell or process further decision is to process further as long as the incremental revenue from processing is more than the: a. incremental processing costs. b. variable processing costs. c. fixed processing costs. d. no correct answer given. 35 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review: Solution The decision rule in a sell or process further decision is to process further as long as the incremental revenue from processing is more than the: a. incremental processing costs. b. variable processing costs. c. fixed processing costs. d. no correct answer given. 36 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Retain or Replace Equipment – Example  Assessment of replacement of a factory machine:  Variable costs: Decrease from $160,000 to $125,000 annually Old Machine New Machine Book value $40,000 Cost of new machine $120,000 Remaining useful life 4 years 4 years Scrap value Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Retain Replace Revenue or Costs Variable manufacturing costs $640,000 a $500,000 b $140,000 New machine cost 120,000 (120,000) Total $640,000 $620,000 $20,000 a (4 years x $160,000) b (4 years x $125,000) Decision: Replace equipment. Lower variable manufacturing costs more than offsets the cost of new equipment. The book value of the old machine does not affect the decision. Incremental Analysis Retain or Replace Equipment – Example: Continued 38 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review  What is the salvage value of old equipment considered to be? a. A relevant cost b. A non-incremental cost c. An opportunity cost d. A cost that is not differential 39 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review: Solution  What is the salvage value of old equipment considered to be? a. A relevant cost b. A non-incremental cost c. An opportunity cost d. A cost that is not differential 40 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis 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 41 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Manufactures three models of tennis racquets: Profitable lines: Pro and Master Unprofitable line: Champ  Condensed Income Statement data: Should Champ line be eliminated? Pro Master Champ Total $100,000 Sales $800,000 $300,000 $100,000 $1,200,000 90,000 Variable expenses 520, ,000 90, ,000 10,000 Contribution margin 280,000 90,000 10, ,000 30,000 Fixed expenses 80,000 50,000 30, ,000 $(20,000) Net income $200,000 $40,000 $(20,000) $ 220,000 Incremental Analysis Eliminate an Unprofitable Segment Martina Company – Example 42 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  If Champ is eliminated, allocate its $30,000 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) Pro Master Total Sales $800,000 $300,000 $1,100,000 Variable expenses 520, , ,000 Contribution margin 280,000 90, ,000 Fixed expenses 100,000 60, ,000 Net income $180,000 $ 30,000 $ 210,000 Incremental Analysis Eliminate an Unprofitable Segment Martina Company – Example: Continued 43 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Incremental analysis of Champ provides the same results Incremental Continue Eliminate Revenue and Costs Sales $100,000 $ $(100,000) Variable expenses 90, ,000 Contribution margin 10, (10,000) Fixed expenses 30,000 30, Net income $(20,000) $(30,000) $ (10,000) Decision: Do not eliminate Champ.  Decrease in net income is due to Champ’s contribution margin of $10,000 that will not be realized if the segment is discontinued Incremental Analysis Eliminate an Unprofitable Segment Martina Company – Example: Continued 44 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review  How should that portion of fixed costs that are unavoidable be handled when making a decision on whether to eliminate an unprofitable segment? a. They should be subtracted from the contribution margin and if that results in a net loss, the segment should be eliminated. b. They should not be considered as they are not relevant. c. They should be allocated to other segments. If that causes a loss in another segment, that segment should be eliminated as well. d. Fixed costs are never relevant. 45 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review: Solution  How should that portion of fixed costs that are unavoidable be handled when making a decision on whether to eliminate an unprofitable segment? a. They should be subtracted from the contribution margin and if that results in a net loss, the segment should be eliminated. b. They should not be considered as they are not relevant. c. They should be allocated to other segments. If that causes a loss in another segment, that segment should be eliminated as well. d. Fixed costs are never relevant. 46 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Allocate Limited Resources  Resources are always limited floor space for a retail firm raw material, direct labour hours, or machine capacity for a manufacturing firm  Management must decide which products to make and sell to maximize net income 47 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Produces standard and deluxe pen and pencil sets  Limiting resource – 3,600 machine hours per month  Deluxe set has higher contribution margin: $8  Standard set takes fewer machine hours per unit Deluxe set Standard set Contribution margin per unit $8 $6 Machine hours required 0.4 per unit 0.2 per unit Incremental Analysis Allocate Limited Resources Collins Company – Example 48 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Must calculate contribution margin per unit of limited resource  Standard sets have higher contribution margin per unit of limited resources Decision: Shift sales mix to standard sets or increase machine capacity. Deluxe Sets Standard Sets Contribution margin per unit (a) $8 $6 Machine hours required (b) ÷ 0.4 ÷ 0.2 Contribution margin per unit of limited resource [(a) ÷ (b)] $ 20 $ 30 Incremental Analysis Allocate Limited Resources Collins Company – Example: Continued 49 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7  Alternative: Increase machine capacity from 3,600 to 4,200 hours  To maximize net income, all 600 hours should be used to produce standard sets. Produce Produce Deluxe SetsStandard Sets Machine hours (a) Contribution margin per unit of limited resource (b) $20 $30 Contribution margin [(a) x (b)] $12,000 $18,000 Incremental Analysis Allocate Limited Resources Collins Company – Example: Continued 50 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Incremental Analysis Theory of Constraints  Approach used to identify and manage constraints so as to achieve company goals  Requires identification of constraints  Continual attempts to reduce or eliminate constraints 51 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Management’s Decision-Making Other Considerations  Qualitative factors Potential effects of decision on employees and community Low morale Employee turnover  Incremental Analysis and Activity-Based Costing Completely consistent with each other ABC better identifies relevant costs resulting in better incremental analysis 52 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review Which of the following is not a qualitative factor? a. Employee satisfaction b. Quality control process c. Customer satisfaction d. Cost of labour per unit 53 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 7 Let’s Review: Solution Which of the following is not a qualitative factor? a. Employee satisfaction b. Quality control process c. Customer satisfaction d. Cost of labour per unit 54 Copyright John Wiley & Sons Canada, Ltd.

CHAPTER 55 7 Copyright © 2012 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein. Copyright Copyright John Wiley & Sons Canada, Ltd.