Short-term Decision Making Chapter 4 Short-term Decision Making

What is the CVP Model? Cost-volume-profit model (short-term) Use to explore relationships among costs, volumes, and profits Assumptions (linearity) Selling price is constant per unit Variable cost is constant per unit Fixed cost is constant in total Number of units produced = number of units sold

CVP Graph $ Total Revenue Profit area Total Cost Breakeven point Loss area Units produced and sold

How are the CVP Components Defined Mathematically? Total revenue SP * Q Total cost VC * Q + FC Breakeven (SP * Q – VC * Q) – FC = 0 Where, Q = quantity produced and sold

CVP Continued Contribution margin Target profit before taxes SP – VC Breakeven = CM * Q – FC = 0 Target profit before taxes CM * Q – FC = P Target profit after taxes CM * Q – FC = P/(1 – tax rate)

Contribution Margin Approach is a quicker way to calculate it? FC + P/CM = Q Contribution margin approach to determine target profit after taxes FC + (BTP/[1-tax rate])/CM = ATP

CVP Continued Change in selling price Change in variable cost Increase—decreases breakeven Decrease—increases breakeven Change in variable cost Increase—increases breakeven Decrease—decreases breakeven Change in fixed cost Change in tax rate No impact on breakeven

What are Product and Nonproduct Costs? Incurred in connection with buying or making the product Nonproduct costs Incurred in connection with selling the product and administering (running) the company

What are the 3 Types of Product Costs? Direct materials Traceable Worth the cost of tracing Direct labor Cost of employees making the product Manufacturing overhead Indirect costs of production (indirect materials, indirect labor, and other manufacturing costs)

What are the Activity Levels Associated with Costs? Unit-related Vary with units produced or sold Batch-related Vary with batches (groups) regardless of the number of units in the batch Product-sustaining Vary with the number of product lines Facility-sustaining Fixed or capacity costs

Types and Activity Levels Product Nonproduct Unit-related Materials Commissions Batch-related Set ups Ordering Product-sustaining Research & development Advertising Facility-sustaining Rental of equipment CEO salary

What are the 2 Characteristics of a Relevant Variable? Future The variable must occur in the future Different The variable must differ between the alternatives considered

Relevant Variables Continued Sunk costs Past, never relevant for decision making Opportunity costs Benefits foregone, always relevant for short-term decision making Incremental costs/revenues Additional cost/revenue, relevant if different between alternatives

What are the Types of Short-Term Decisions Considered? Accept-or-reject decisions Special order Base decision on incremental profit from the order Make-or-buy decisions Outsourcing Base decision on cost comparison between make and buy Keep-or-drop decisions Product mix Base decision on revenues lost versus costs saved

Lecture Example #1 1. A certain company sells its only product for $12 per unit. The variable costs to produce the product are $7 per unit and it costs approximately $1 per unit for selling and administrative costs. The fixed costs of production are $400,000 per period and the fixed selling and administrative costs are $200,000 per year. The company is subject to a 30 percent tax rate. Answer the following questions. a. What is the breakeven point in units? b. What is the breakeven point in dollars? c. How many units must be sold to earn a profit of $70,000 before tax? d. How many units must be sold to earn a profit of $70,000 after tax? e. If the variable costs increase 10 percent, what increase is necessary in selling price to maintain the same breakeven point in units? f. If the fixed costs increase, what is the effect on breakeven? On contribution margin per unit? g. If the tax rate increases, what is the effect on breakeven? On contribution margin per unit?

Lecture Example #1 Cont. Answer: a. SP = $12; VC = $8; CM = $4; FC = $600,000 $600,000/4 = 150,000 b. CM = $4; SP = $12; CM % = 33.3333% $600,000/33.3333% = $1,800,000 c. ($600,000 + $70,000)/4 = 167,500 d. $70,000/(1 - .3) = $100,000 ($600,000 + $100,000)/4 = 175,000 e. To maintain the same breakeven point, CM must remain the same. VC = $8.80; CM = $4; therefore SP = $12.80 f. If fixed costs increase, breakeven increases. Fixed costs do not affect contribution margin per unit. g. Tax rate increases do not affect breakeven or contribution margin per unit.

Lecture Example #2 2. A company has been approached by a supplier with an offer to provide 25,000 units of a production part for $9 per unit. If the company accepts the offer its direct materials costs are expected to decrease by 60 percent, its direct labor costs are expected to decrease by 30 percent, and its unit-related overhead is expected to decrease by 20 percent. A recent per unit cost report when 25,000 units were produced is shown below: Direct materials $10 Direct labor 2 Manufacturing overhead 8 Total cost $20 An analysis of manufacturing overhead reveals that overhead consists of unit-related and facility-sustaining overhead. Facility-sustaining overhead consists of depreciation and other fixed items and is approximately $150,000 per period. If the company accepts the supplier’s offer, it will use the released production facilities to produce another product with an expected contribution of $60,000 per period. Should the company accept or reject the supplier’s offer?

Lecture Example #2 Cont. Answer: Total overhead $8 * 25,000 = $200,000 Less facility-sustaining overhead 150,000 Unit-related overhead $ 50,000 Unit-related overhead per unit $50,000/25,000 = $2   Relevant variables Make Buy Direct materials $10.00 $ 4.00 ($10 * .4) Direct labor 2.00 1.40 ($2 * .7) Unit-related overhead 2.00 1.60 ($2 * .8) Purchase price -0- 9.00 Relevant cost per unit $14.00 $16.00 * Number of units 25,000 25,000 Total relevant unit cost $350,000 $400,000 Opportunity cost 60,000 -0- Total relevant cost $410,000 $400,000 BUY

Lecture Example #3 A company has been approached by a customer with an offer to buy 10,000 units of product but the customer wants a discount of 25 percent off the normal selling price. The company has the capacity to fill the customer’s order. A recent profit report is shown below: Sales (500,0000 units) $6,000,000 Cost of goods sold 4,200,000 Gross margin $1,800,000 Selling and administrative cost 1,000,000 Profit $ 800,000 Unit-related cost of goods sold is 40 percent of the current selling price while unit-related selling and administrative costs are 10 percent of the current selling price. To fill the customer’s order, one additional production run will be required at a cost of $6,000. An additional purchase order will be required at a cost of $500, and shipping costs to the customer will be $800. Should the company accept the customer’s order?

Lecture Example # 3 Cont. Answer: Current selling price = $6,000,000/500,000 = $12 Unit-related cost of goods sold = $12 * .4 = $4.80 Unit-related selling and administrative cost = $12 * .1 = $1.20 Proposed selling price = $12 * .75 = $9   Relevant variables Accept Reject Proposed selling price $9.00 $0.00 Cost of goods sold 4.80 0.00 Selling and administrative 1.20 0.00 Contribution margin $3.00 $0.00 * Number of units requested 10,000 10,000 Total contribution margin $30,000 $0 Additional batch costs: Production run ( 6,000) -0- Ordering ( 500) -0- Shipping ( 800) -0- Relevant profit $22,700 $0 ACCEPT

Lecture Example #4 4. A merchandising company currently sells three products—A, B, and C. Product profit reports for the last period are shown below: Product A Product B Product C Sales $100,000 $200,000 $150,000 Less: cost of goods sold 60,000 120,000 90,000 Gross margin 40,000 80,000 Less: selling and administrative costs 50,000 55,000 Profit ($10,000) $20,000 $5,000 A cost analysis reveals that cost of goods sold varies proportionately with sales (60%). Selling and administrative costs are $120,000 plus 10% of sales. The $120,000 of facility-sustaining selling and administrative cost will continue regardless of how many product lines the company maintains. Should the company keep or drop its existing product lines?

Lecture Example #4 Cont. Answer: If Product A is dropped: Revenues lost $100,000 Costs saved: Cost of goods sold $60,000 Selling & administrative 10,000 $70,000 Since the revenues lost exceed the costs saved, the company should keep Product A.