10-1 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Tactical Decision Making 12 PowerPresentation® prepared by David J. McConomy, Queen’s University

10-2 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Describe the tactical decision- making model. Explain how the activity resource usage model is used in assessing relevancy. Learning Objectives

10-3 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Apply the tactical decision-making concepts in a variety of management situations. Choose the optimal product mix when faced with one constrained resource. Learning Objectives (continued)

10-4 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Learning Objectives (continued) Explain the impact of cost on pricing decisions. Use linear programming to find the optimal solution to a problem of multiple constrained resources. (Appendix)

10-5 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Decision-Making Process Recognize and define the problem. Identify alternatives as possible solutions to the problem; eliminate alternatives that are clearly not feasible. Identify the costs and benefits associated with each feasible alternative. Classify costs and benefits as relevant or irrelevant and eliminate irrelevant ones from consideration.

10-6 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Decision-Making Process (continued) Total the relevant costs and benefits for each alternative. Assess the qualitative factors. Select the alternative with the greatest overall benefit.

10-7 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Relevant Costs Defined Costs that differ across alternatives Costs that deal with future courses of action

10-8 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Important: Short-term Perspective Some Types of Decisions Illustrated Make or Buy Keep or Drop Special Order Sell or Process Further Product Mix

10-9 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity Resource Usage Model and Assessing Relevancy a. Demand Changes b. Demand Constant Relevant Not Relevant Flexible Resources Resources Acquired as Needed

10-10 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity Resource Usage Model and Assessing Relevancy (continued) Committed Resources Acquired in Advance (Short Term) a. Demand Increase < Unused Capacity b. Demand Increase > Unused Capacity c. Demand Decrease (Permanent) 1. Activity Capacity Reduced 2. Activity Capacity Unchanged Not Relevant Relevant Not Relevant

10-11 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Activity Resource Usage Model and Assessing Relevancy (continued) Committed Resources Resources Acquired in Advance (Multiperiod Capacity) a. Demand Increase < Unused Capacity b. Demand Decrease (Permanent) c. Demand Increase > Unused Capacity Not Relevant Capital Decision

10-12 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Solution to Exercise Keep-or-Drop: A Segment Decision 1.Segmented income statement Product A Product B Total Sales$`100,000$250,000$350,000 Less: Variable exp. 50, , ,000 Contribution margin$ 50,000$105,000$155,000 Less: Direct fixed exp.* 60,000 60, ,000 Segment margin$ (10,000)$ 45,000$ 35,000 Less: Common fixed exp. 70,000 Operating income (loss)$ (35,000) ======= *Product A:100,000/350,000 x $70,000 = $20,000; $80,000 - $20,000 = $60,000 Product B: 250,000/350,000 x $70,000 = $50,000 $110,000 - $50,000 = $60,000

10-13 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Solution to Exercise Keep-or-Drop: A Segment Decision (continued) 2. AlternativesKeepDropDrop ADrop B BothBothKeep BKeep A Sales$350,000$ 0$275,000$150,000 Less: Variable exp. 195, ,500 75,000 Contribution margin$155,000 $ 0$115,500$ 75,000 Less: Direct fixed exp. 120, ,000 60,000 Segment margin$ 35,000$ 0$ 55,500$ 15,000 Less: Common fixed exp. 70,000 70,000 70,000 70,000 Operating income (loss)$ (35,000)$(70,000)$ (14,500)$ (55,000) ============= ============== Willem should drop product A unless the common fixed costs can be avoided if both products are dropped

10-14 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Solution to Exercise Special Order Decision 1.The company should not accept the offer because the additional revenue is less than the additional costs (assuming fixed overhead is allocated and will not increase with the special order): Incremental revenue per box$4.20 Incremental cost per box 4.25 Loss per box$0.05 Total loss: $0.05 x 5,000 = $250

10-15 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Solution to Exercise Special Order Decision (continued) 2. Costs associated with the layoff: Increase state UI premiums (0.01 x $1,460,000)$14,600 Notification costs ($25 x 20)500 Rehiring and retraining costs ($150 x 20) 3,000 Total$18,100 ====== The order should be accepted. The loss of $250 on the order is more than offset by the $18,100 savings by not laying off employees.

10-16 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Solution to Exercise Sell or Process Further 1.Sales$263,000 Costs 223,000 Operating income$ 40,000 ======= Process SellFurtherDifference 2.Revenues$40,000$75,000$35,000 Process cost 0 23,900 23,900 Operating income$40,000$ 51,100$ 11,100 ==================== The company should process Delta further as gross profit would increase by $11,100. (Note: Joint costs are irrelevant to this decision, as the company will incur them whether or not Delta is processed further.)

10-17 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. One Constrained Resource Jorgenson Company produces two types of gears: X and Y. Gear X has a contribution margin of $25 per unit and Gear Y has a unit contribution margin of $10. Each Gear must be notched by a special machine. The Company owns eight of these machines which can produce a total of 40,000 hours of machine time per year. The company can sell all that it produces of either model. The machine time required for Gear X is two hours per unit and for Gear Y is one half an hour per unit. How many of each model should be produced?

10-18 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. One Constrained Resource (continued) Answer: To maximize total contribution margin, select the product that yields the highest contribution margin per unit of scarce resource: Gear X: $25/2 = $12.50 per hour Economy: $10/.5 = $20.00 per hour Contribution for Gear X: 40,000 $12.50 = $500,000 Contribution for Gear Y: 40,000 $20.00 = $800,000 The Gear Y yields the highest CM per unit of scarce resource. Thus, 40,000/.5 = 80,000 units of Gear Y should be produced and none of Gear X.

10-19 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Two Approaches to Pricing 1. Cost-Based Pricing 2. Target Costing and Pricing

10-20 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. A Product Pricing Example Revenues$856,500 Cost of goods sold: Direct materials$489,750 Direct labour140,000 Overhead 84, ,750 Gross profit$142,750 Selling and administrative expenses 25,000 Operating income$117,750 =======

10-21 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Markup on COGS= (S & A expenses + Operating income) / COGS= ($25,000 + $117,750) / $713,750 = 0.20 Markup on direct materials = (DL + OH + S & A expenses + Oper. income) / Direct mater. = ($140,000 + $84,000 + $25,000 + $117,750) / $489,750 = Determining Markup Percentages

10-22 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Target Costing and Pricing Target costing is a method of determining the cost of a product or service based on the price (target price) that customers are willing to pay. This is also referred to as price-driven costing.

10-23 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Legal Aspects of Pricing There are certain issues that we must be aware of whenever we make pricing decisions: Predatory pricing Price Discrimination Price Gouging

10-24 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Multiple Constrained Resource To the Jorgenson Company example for a one constrained resource, add the following additional constraint: the market limits sales of GEAR Y to 60,000 units. Formulate the linear programming problem and solve using the graphical method Let X 1 = GEAR X, and X 2 = GEAR Y Formulation:Max CM = 25X X 2 Subject to:2X 1 +.5X 2 < 40,000 X 2 < 60,000

10-25 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Multiple Constrained Resource (continued) 80,000 60,000 A 20,000 D C B X X 2X +.5X < 20,000 X < 60,

10-26 Copyright © 2004 by Nelson, a division of Thomson Canada Limited. Multiple Constrained Resource (continued) Corner PointX 1 X 2 CM = 25X X 2 A000 B20,0000$500,000 C*5,00060,000$725,000 D060,000$600,000 * Point C is optimal The X 1 value of point C is found by substituting the second equation into the first one like so: 2X (60,000) = 40,000 2X 1 +30,000 = 40,000 2X 1 = 10,000 X 1 = 5,000