Tactical Decision Making CHAPTER Tactical Decision Making

After studying this chapter, you should be able to: Objectives 1. Describe the tactical decision-making model. 2. Explain how the activity resource usage model is used in assessing relevancy. 3. Apply tactical decision-making concepts in a variety of business situations. 4. Choose the optimal product mix when faced with one constrained resource. 5. Explain the impact of cost of pricing decisions. After studying this chapter, you should be able to:

Objectives 6. Use linear programming to find the optimal solution to a problem of multiple constrained resources. (Appendix)

Model for Making Tactical Decisions Step 1. Recognize and define the problem. Increase capacity for warehousing and production. Step 2. Identify alternatives as possible solutions to the problem; eliminate alternatives that are clearly not feasible. Build new facility Lease larger facility; sublease current facility Lease additional facility Lease warehouse space Buy shafts and brushings; free up needed space Continued

Model for Making Tactical Decisions Step 3. Identify the costs and benefits associated with each feasible alternative. Classify costs and benefits as relevant or irrelevant, and eliminate irrelevant ones from consideration. Lease warehouse space: Variable production costs $345,000 Warehouse lease 135,000 Buy shafts and bushings externally: Purchase price $460,000 Continued

Model for Making Tactical Decisions Step 4. Total the relevant costs and benefits for each alternative. Lease warehouse space: Variable production costs $345,000 Warehouse lease 135,000 Total $480,000 Buy shafts and bushings externally: Purchase price $460,000 Differential cost $ 20,000 Continued

Model for Making Tactical Decisions Step 5. Assess qualitative factors. Quality of shafts and brushing is significantly lower Quality of external suppliers Reliability of external suppliers Price stability Labor relations and community image Not reliable Step 6. Make the decision. Continue to produce shafts and bushings internally; lease warehouse

Relevant Costs Defined Relevant costs are future costs that differ across alternatives. A cost must not only be a future cost but most also differ between alternatives.

Flexible resources can be easily purchased in the amount needed and at the time of use… like electricity.

Committed resources are purchased before they are used, such as salaried employees.

Activity Resource Usage Model and Assessing Relevancy Flexible Resources a. Demand Changes Relevant b. Demand Constant Not Relevant

Supply – Demand = Unused Capacity Activity Resource Usage Model and Assessing Relevancy Committed Resources (Short-Term) Supply – Demand = Unused Capacity a.. Demand Increased < Unused Capacity Not relevant b. Demand Increased > Unused Capacity Relevant c. Demand Decease (Permanent) Activity Capacity Reduced Relevant Activity Capacity Unchanged Not Relevant

Supply – Demand = Unused Capacity Activity Resource Usage Model and Assessing Relevancy Committed Resources (Multiperiod Capacity) Supply – Demand = Unused Capacity a.. Demand Increased < Unused Capacity Not relevant b. Demand Decreased (Permanent) Relevant c. Demand Increase > Unused Capacity Capital Decision

Illustrative Examples of Relevant Cost Applications Make or Buy Keep or Drop Special Order Sell or Process Further Product Mix Important: Short-term Perspective

Make or Buy Swasey Manufacturing currently produces an electronic component used in one of its printers. Swasey must produce 10,000 of these parts. The firm has been approached by a supplier who offers to build the component to Swasey’s specifications for $4.75 per unit.

Enough material is on hand to make 5,000 parts. Make or Buy The full absorption cost for the 10,000 parts is computed as follows: Total Cost Unit Cost Rental of equipment $12,000 $1.20 Equipment depreciation 2,000 0.20 Direct materials 10,000 1.00 Direct labor 20,000 2.00 Variable overhead 8,000 0.80 General fixed overhead 30,000 3.00 Total $82,000 $8.20 Enough material is on hand to make 5,000 parts.

Make or Buy The cost to make or buy 5,000 units follows: Alternatives Differential Make Buy Cost to Make Rental of equipment $12,000 ------- $12,000 Direct materials 5,000 ------- 5,000 Direct labor 20,000 ------- 20,000 Variable overhead 8,000 ------- 8,000 Purchase cost ------- $47,500 -47,500 Receiving Dept. labor ------- 8,500 - 8,500 Total $45,000 $56,000 $-11,000 Make

Keep-or-Drop Decisions Norton Materials, Inc. produces concrete blocks, bricks, and roofing tile. The controller prepared the following income statements: Blocks Bricks Tile Total Sales revenue $500 $800 $150 $1,450 Less: Variable expenses 250 480 140 870 Contribution margin $250 $320 $ 30 $ 580 Less direct fixed expenses: Advertising $ 10 $ 10 $ 10 $ 30 Salaries 37 40 35 112 Depreciation 53 40 10 103 Total $100 $ 90 $ 55 $ 245 Segment margin $150 $230 $- 45 $ 335 Less: Common fixed exp. 125 Operating income $ 210

Keep-or-Drop Decisions Differential Keep Drop Amount to Keep Sales $150 ---- $150 Less: Variable expenses 140 ---- 140 Contribution margin $ 10 ---- $ 10 Less: Advertising -10 ---- -10 Cost of supervision -35 ---- -35 Total relevant benefit (loss) $- 35 $ 0 $- 35 Preliminary figures indicate that the tile segment should be dropped!

Keep-or-Drop Decisions Tom Blackburn determines that dropping the tile section will reduce sales in all sections as follows: $50,000 for blocks, $64,000 for bricks, and $150,000 for roofing tile. His summary in thousands is shown below: Differential Keep Drop Amount to Keep Sales $1,450 $1,186.0 $264.0 Less: Variable expenses 870 666.6 203.4 Contribution margin $ 580 $ 519.4 $ 60.6 Less: Advertising -30 -20.0 -10.0 Cost of supervision -112 -77.0 -35.0 Total $ 438 $ 422.4 $ 15.6 Keep roofing tile segment!

Alternate Use of Facilities Keep-or-Drop Decisions Alternate Use of Facilities The marketing manager sees the market for floor tile as stronger and less competitive than roof tile. He submits the following figures for floor tile sales: Sales $100,000 Less: Variable expenses 40,000 Contribution margin $ 60,000 Less: Direct fixed expenses 55,000 Segment margin $ 5,000

Alternate Use of Facilities Keep-or-Drop Decisions Alternate Use of Facilities Drop and Differential Keep Replace Amount to Keep Sales $1,450 $1,286.00 $164.00 Less: Variable expenses 870 706.60 163.40 Contribution margin $ 580 $ 579.40 $ 0.60 $1,450 – $150 –$50 – $64 + $100 $870 – $140 – $25 – $38.40 + $40 Decision: Continue making roof tile!

Special-Order Decisions An ice cream company is operating at 80 percent of its productive capacity (20 million half gallon units). The unit costs associated with producing and selling 16 million units are shown on the next slide.

Special-Order Decisions Variable costs: Dairy ingredients $ 0.70 Sugar 0.10 Flavoring 0.15 Direct labor 0.25 Packaging 0.20 Commissions 0.02 Distribution 0.03 Other 0.05 Total variable costs $ 1.50 Wholesale price = $2.00 Total fixed costs 0.097 Total costs $1.597

Special-Order Decisions An ice cream distributor from a geographic region not normally served by the company has offered to buy two million units at $1.55 per unit, provided its own label can be attached to the product. The distributor has agreed to pay the transportation cost.

Special-Order Decisions Variable costs: Dairy ingredients $0.70 Sugar 0.10 Flavoring 0.15 Direct labor 0.25 Packaging 0.20 Commissions 0.02 Distribution 0.03 Other 0.05 Total variable costs $1.50 Which costs are irrelevant? $1.45 Total fixed costs 0.097 Total costs $1.597

Special-Order Decisions Accept the offer ($0.10 x 2,000,000 = $200,000 more profit). Variable costs: Dairy ingredients $ 0.70 Sugar 0.10 Flavoring 0.15 Direct labor 0.25 Packaging 0.20 Commissions 0.02 Distribution 0.03 Other 0.05 Total variable costs $ 1.50 Which costs are irrelevant? $1.45 Total fixed costs 0.097 Total cost $1.597

Sell or Further Process Yield at Split-Off Further Processing Grade A 800 lb Sell for $0.40 lb Bagged 120 Bags Cost $0.05/Bag Sell for $1.30/Bag Joint Cost $300 Grade B 600 lb Applesauce 500 16-oz Cans Cost $0.10/lb Sell for $0.75 can Grade C 600 lb

Sell or Further Process Process Differential Amount Further Sell to Process Further Revenues $450 $150 $300 Processing cost 120 ---- 120 Total $330 $150 $180 Further process!

Two Approaches to Pricing 1. Cost-Based Pricing 2. Target Costing and Pricing

Cost-Based Pricing Revenues $856,500 Cost of goods sold: Direct materials $489,750 Direct labor 140,000 Overhead 84,000 713,750 Gross profit $142,750 Selling and administrative expenses 25,000 Operating income $117,750

Determining Markup Percentages 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 = 0.749

Determining Markup Percentages Direct materials (computer components, etc.) $100,000 Direct labor (100 x 6 hours x $15) 9,000 Overhead (60 percent of direct labor cost) 5,400 Estimated cost of goods sold $114,400 Plus 20 percent markup of COGS 22,880 Bid price $137,280

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 referred to as price-driven costing.

Legal Aspects of Pricing Predatory pricing. The practice of setting prices below cost for the purpose of injuring or eliminating competitors. Price discrimination. Charging different prices to different customers for essentially the same product. The Robinson-Patman Act is the most potent weapon against price discrimination, but it doesn’t cover services and intangibles.

Linear Programming The maximum demand for Gear X is 15,000 units and the maximum demand for Gear Y is 40,000 units. The contribution margin for X is $25 and for Y is $10. Z = $25X x $10Y Two machine hours are used for each unit of Gear X, and 0.5 machine hour is used for a unit of Gear Y. 2X + 0.5Y  40,000

Linear Programming Max. Z = $25X x $10Y Subject to: 2X + 0.5Y  40,000

Machine Hours Constraint 80 – 75 – 70 – 65 – 60 – 55 – 50 – 45 – 40 – 35 – 30 – 25 – 20 – 15 – 10 – 5 – 0 – Machine Hours Constraint 2X + 0.5Y  40,000 Demand Constraint X  15,000 A B C D E Demand Constraint Y  40,000 Feasibility Region | | | | | 5 10 15 20 25

Linear Programming Corner Point X-Value Y-Value Z = $25X + $10Y B 15 0 375 C 15 20 575 D 10 40 650 E 0 40 400 Manufacture 10,000 units of Gear X and 40,000 of Gear Y.

Chapter Seventeen The End