Managerial Accounting Basics Organization charts show the interrelationships of activities and the delegation of authority and responsibility within the company.

The Proces of Making (rational) Decisions

Incremental Analysis Approach Decisions involve a choice among alternative actions. Process used to identify the financial data that change under alternative courses of action. Both costs and revenues may vary or Only revenues may vary or Only costs may vary

Types of Decision Making Programmed Decisions: routine, “automatic” process. There are rules or guidelines to follow. Ex: Deciding to reorder office supplies. Non-programmed Decisions: unusual situations that have not been often addressed. No rules to follow since the decision is new. These decisions are made based on data, info, and manger’s intuition, and judgment. Ex: Should the firm invest in a new technology?

Decisions are broadly taken at 3 levels: Strategic decisions … broad choices of identity / direction. WHO / WHAT / WHERE … Who are we? Where are we heading? Often large dollars, a long-term impact … made by senior management. Tactical decisions … manage resources to achieve strategy. HOW … What is needed? When? Distinctive, within clearer boundaries. May involve significant resources, made by senior or middle managers. Operational decisions … routine and follow known rules. DO IT … How many? To what specs? Decisions involve more limited resources, shorter-term application, made by middle or first line managers.

Relevant cost is the $500 for a GPS Important concepts - incremental analysis: Relevant cost Revenues or Costs that DIFFER between options Option 1: Buy a Honda Civic with a GPS … $20,500 Option 2: Buy Honda Civic without GPS … $ 21,000 Relevant cost is the $500 for a GPS

Opportunity cost. Important concepts - incremental analysis: Potential benefit lost when you choose one thing over another … the “next best choice”. Opportunity costs of going away to college – full-time - include: * wages that could have been earned, * the value of any activities missed to study, * value of items that you could have bought with tuition money.

Sunk Costs. Important concepts - incremental analysis: Cost that cannot be changed or avoided by any present or future choice. Money spent on a “non-refundable deposit”. Concert tickets already bought for this weekend.

Types of Incremental Analysis Accept an order at a special price.

Accept an Order at a Special Price Obtain additional business by making a major price concession to a specific customer. Assumes that sales of products in other markets are not affected by special order. Assumes company is not operating at full capacity.

Accept an Order at a Special Price Ex: Company makes 100,000 a blenders per month (80% cap.) Variable manufacturing costs … $8 per unit. Fixed mfg costs are $400,000, … $4 per unit. Blenders normally sell to retailers … $20 each. New customer wants 2,000 blenders at $11 each. (Acceptance will not affect other sales of product). What should you do? What data is relevant?

Variable manufacturing costs … $8 per unit. Fixed mfg costs are $400,000, … $4 per unit. New customer wants 2,000 blenders at $11 each. Fixed costs do not change since within existing capacity – thus fixed costs are not relevant. Variable manufacturing costs and expected revenues change – thus both are relevant to the decision.

You make a product that sells for $42. Your costs are $28 per unit … ($18 variable & $10 fixed) Foreign company offers to buy 5,000 units at $25 ea. You will incur additional shipping costs of $1 per unit. Assuming you have excess operating capacity. Should you accept or reject this special order? Accept or Reject? Accept or Reject?

Types of Incremental Analysis Accept an order at a special price. Make or buy parts or finished products.

Make or Buy (Outsource or not) Ex: Your annual costs to make 25,000 switches are: Should you outsource (buy) the switches at $8 ea.

Make or Buy Total cost to “make” switch is $1 higher per unit than “buy” price. Must absorb at least $50,000 of fixed costs under either option.

Make or Buy – Opportunity Cost Ex: If you buy the switches, you can use the “released” capacity to generate additional income of $38,000 by making a different product. So what ? This “lost” income is an additional “cost” of making switches.

Should you make or buy “plug-in” cords for appliances you produce. Your costs of making 166,000 cords are as follows. Direct materials … $90,000 Variable overhead … $32,000 Direct labor ……… 20,000 Fixed overhead ……. 24,000 $166,000 “Make” cords cost per unit = $1.00 ea. ($166,000 ÷ 166,000) “Buy” cords cost per unit = $0.90 ea. Buying cords, eliminates all variable costs and 1/4 of the fixed costs.

(a) Prepare an incremental analysis showing whether the company should make or buy the electrical cords. You will incur $1,400 of added costs buying vs making cords.

Net income increased by $3,600 buy vs make cords. (b) Is your answer be different if the released capacity will generate additional income of $5,000? Net income increased by $3,600 buy vs make cords.

Types of Incremental Analysis Accept an order at a special price. Make or buy component parts or finished products. Sell or process further.

Sell or Process Further You have option to sell product at a given point in production or to process further and sell at a higher price. Decision Rule: Process further as long as the incremental revenue from processing exceeds the incremental processing costs.

Sell or Process Further … Single Product Ex: You make tables. Your cost to make an unfinished table is $35. The selling price per unfinished unit is $50. You have unused capacity that can be used to finish the tables and sell them at $60 per unit. To process further: Direct materials will increase … + 2.00 Direct labor costs will increase … + 4.00 Variable overhead will increase … + 2.40 No increase is anticipated in fixed overhead.

Sell or Process Further … Single Product The incremental analysis on a per unit basis is as follows. Should you sell or process further? Should Woodmasters sell or process further.

Sell or Process Further … Multiple Products Joint product situation for DairyCo. Cream and skim milk result from the processing of raw milk. Joint product costs are sunk costs and thus not relevant to the sell-or-process further decision.

Sell or Process Further … Multiple Products Cost and revenue data per day for cream. Determine whether DairyCo should just sell the cream … or process it further into cottage cheese.

Sell or Process Further - Multiple Products Analysis of whether to sell cream or process into cottage cheese. Marais should or should not process the cream further? DairyCo “should” … or … “should not” process the cream further?

Sell or Process Further … Multiple Products Cost and revenue data per day for skim milk. Determine whether DairyCo should sell the skim milk or process it further into condensed milk.

Sell or Process Further – Multiple Products Analysis of whether to sell skim milk or process into condensed milk. Marais should or should not process the milk further? Marais should or should not process the milk further?

Types of Incremental Analysis Accept an order at a special price. Make or buy component parts or finished products. Sell or process further them further Repair, retain, or replace equipment.

Repair, Retain, or Replace Equipment Decision: Replace old machine with new. Old machine originally cost $110,000. Book value is $40,000. It has a remaining useful life of four years (@ depreciation rate of $70,000 per year). New machine costs $120,000. Expected salvage value after 4-year useful life is zero. New machine will decrease variable mfg costs from $640,000 to $500,000 The old machine can be sold for $5,000.

Repair, Retain, or Replace Equipment Additional Considerations Book value of old machine does not affect decision. (Book Value calculation = Asset Cost - Accumulated Depreciation) Book value is a sunk cost. Costs which cannot be changed by future decisions (sunk cost) are not relevant in incremental analysis. However, any trade-in allowance or cash disposal value of the existing asset is relevant.

Repair, Retain, or Replace Equipment Prepare the incremental analysis for the four-year period. KEEP Machine REPLACE Machine Retain or Replace? Retain or Replace?

Types of Incremental Analysis Accept an order at a special price. Make or buy component parts or finished products. Sell or process further them further Repair, retain, or replace equipment. Eliminate unprofitable business segment or product(s).

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 contribution margin lost.

Should Champ be eliminated? Eliminate an Unprofitable Segment Illustration: Company makes 3 models of tennis rackets: Profitable lines: Pro and Master Unprofitable line: Champ Should Champ be eliminated?

Eliminate an Unprofitable Segment Prepare income data after eliminating Champ product line. Assume fixed costs are allocated 2/3 to Pro and 1/3 to Master. Total income is changed by $10,000.

Eliminate an Unprofitable Segment Incremental analysis of Champ provided the same results: Do Not Eliminate Champ

Company makes accessories including hats and scarves. Sales of hats & scarves = 400,000, Variable expenses = 310,000, Fixed expenses = 120,000, for a net loss = 30,000. If company eliminates hats and scarves, 20,000 of fixed costs will remain. Should company eliminate hats and scarves.

Qualitative (vs “Quantitative”) Factors Other Considerations in Decision-Making Qualitative (vs “Quantitative”) Factors Potential effects of decision on existing employees and the community. Cost of lost morale that might result. Cost of (potentially) “lost sales”.