Cost-Revenue Analysis for Decision Making Chapter 30 Cost-Revenue Analysis for Decision Making Section 1: The Decision Process Section Objectives Explain the basic steps in the decision-making process. Prepare income statements using the absorption costing and direct costing methods. Using the contribution approach, analyze the profits of segments of a business. Determine relevant cost and revenue data for decision-making purposes. In Chapter 30 section 1, we will explain the basic steps in the decision-making process; prepare income statements using absorption costing and direct costing methods; analyze profits of segments of a business using the contribution approach; and determine relevant cost and revenue date for decision-making purposes. McGraw-Hill © 2009 The McGraw-Hill Companies, Inc. All rights reserved.

Explain the basic steps in the decision-making process. Objective 1 Explain the basic steps in the decision-making process. Our first objective is to explain the basic steps in the decision-making process.

The Decision-Making Process Define the problem. Identify workable alternatives. Determine relevant cost and revenue data. Evaluate the cost and revenue data. Consider appropriate nonfinancial factors. Make a decision. There are six steps involved in the decision making process. They are: Define the problem. Identify workable alternatives. Determine relevant cost and revenue data. Evaluate the cost and revenue data. Consider appropriate nonfinancial factors, and Make a decision.

Absorption Costing All manufacturing costs are included in the cost of goods manufactured. The value of ending inventory includes fixed costs. Under absorption costing, all manufacturing costs are included in the cost of goods manufactured. Also, the value of ending inventory includes fixed costs.

Objective 2 Prepare income statements using the absorption costing and direct costing methods. Our second objective is to prepare income statements using the absorption costing and direct costing methods.

Income Statement Using Absorption Costing White Manufacturing Corporation Income Statement Year Ended December 31, 2010 Sales (9,000 units sold @ $40) 360,000 Cost of Goods Sold Variable Manufacturing Costs (10,000 x $16) 160,000 Fixed Manufacturing Costs 50,000 Total Cost of Goods Mfgd. ($210,000/10,000 = $21/unit) 210,000 Less Finished Goods Inventory, Dec. 31 (1,000 x $21) 21,000 Costs of Goods Sold 189,000 Gross Profit on Sales 171,000 Selling and Administrative Expenses Variable Expenses (9,000 units @ $4) 36,000 Fixed Expenses 60,000 Total Selling and Administrative Expenses 96,000 Net Income 75,000 This example shows an income statement using absorption costing. Notice that fixed and variable manufacturing costs are included in the total cost of goods manufactured. Fixed and variable manufacturing costs are included

Direct Costing (also called Variable Costing) Only variable costs are included in the cost of goods manufactured. Fixed manufacturing costs are charged to expense during the period. Fixed manufacturing costs are not included in: Cost of goods sold, or Ending inventories. Direct costing is not acceptable for GAAP financial reporting purposes. Under direct costing, only variable costs are included in the cost of goods manufactured. Fixed manufacturing costs are charged to expense during the period. Fixed manufacturing costs are not included in either cost of goods sold or ending inventory. Finally, direct costing is not acceptable for generally accepted accounting principles financial reporting.

Direct Costing Manufacturing Margin: Marginal Income on Sales: Sales minus the variable cost of goods sold. Marginal Income on Sales: Manufacturing margin minus variable operating expenses. Under direct costing, manufacturing margin is sales minus the variable cost of goods sold. Marginal income on sales is the manufacturing margin minus variable operating expenses. Finally, net income is marginal income on sales minus fixed manufacturing costs and fixed selling and administrative expenses. Net Income: Marginal income on sales minus fixed manufacturing costs and fixed selling and administrative expenses.

Income Statement Using Direct Costing White Manufacturing Corporation Income Statement Year Ended December 31, 2010 Sales (9,000 units @ $40) 360,000 Cost of Goods Sold Variable Manufacturing Costs (10,000 units @ $16) 160,000 Less Finished Goods Inventory, Dec. 31 (1,000 @ $16) 16,000 Costs of Goods Sold 144,000 Manufacturing Margin 216,000 Variable Selling and Administrative Expenses (9000 units @ $4) 36,000 Marginal Income on Sales 180,000 Fixed Costs and Expenses Fixed Manufacturing Costs 50,000 Fixed Selling and Administrative Expenses 60,000 110,000 Net Income 70,000 In this example, we calculate manufacturing margin, marginal income on sale, and net income for White Manufacturing Corporation using direct costing. Notice that only variable manufacturing costs are included in the cost of goods sold calculation. Only variable manufacturing costs are included

Objective 3 Using the contribution approach, analyze the profits of segments of a business. The third objective of Chapter 30 is to analyze the profits of business segments using the contribution approach.

Contribution Margin Contribution margin is the excess of revenues over variable costs of the business segment. Profitability of a business segment is judged by its contribution toward covering common costs. Controllable fixed costs of each segment are deducted to determine the segment’s contribution to the overall profit. Common costs are not considered when computing the contribution margin. Contribution margin is defined as the excess of revenue over variable costs. Profitability of a business segment is judged by its contribution toward covering common costs. Controllable fixed costs of each segment are deducted to determine the segment’s contribution to overall profit. Finally, common costs are not considered when computing contribution margin.

What are controllable fixed costs? QUESTION: What are controllable fixed costs? Controllable fixed costs are costs that the segment manager can control. ANSWER: Controllable fixed costs are costs that the segment manager can control.

QUESTION: What are common costs? Common costs are costs not directly traceable to a specific segment of the business. ANSWER: Common costs are costs not directly traceable to a specific segment of the business.

Determine relevant cost and revenue data for decision-making purposes. Objective 4 Determine relevant cost and revenue data for decision-making purposes. The fourth objective of Chapter 30 is to determine relevant cost and revenue data for decision-making purposes.

When making decisions, sunk costs are irrelevant. Types of Costs Relevant Cost: Future or expected cost that will change as a result of a decision. Sunk Cost: A cost that has already been incurred. When making decisions, sunk costs are irrelevant. Differential Cost: The difference between one alternative and another. Opportunity Cost: The potential earnings or benefits that are given up because a certain course of action is taken. Relevant costs are future or expected costs that will change as a result of a decision. A sunk cost is a cost that has already been incurred. When making decisions, sunk costs are considered irrelevant. Differential cost is the difference between one alternative and another. Finally, opportunity cost is the potential earnings or benefits that are given up because a certain course of action is taken.

Opportunity Cost Dilemma Decision Opportunity Cost To purchase equipment or invest in securities. Purchase equipment. Amount of interest or dividends received on securities if they had been purchased. In this example, the dilemma is whether to purchase equipment or invest in securities. If equipment is purchased, the opportunity cost is the amount of interest or dividends that could have been received if the securities had been purchased.

Cost-Revenue Analysis for Decision Making Chapter 30 Cost-Revenue Analysis for Decision Making Section 2: Cost-Revenue Analysis Section Objectives In the final section of Chapter 30 we will apply an appropriate decision process in three situations. Pricing products in special cases. Deciding whether to purchase new equipment, and deciding whether to make or buy a part. Apply an appropriate decision process in three situations: Pricing products in special cases. Deciding whether to purchase new equipment. Deciding whether to make or buy a part. McGraw-Hill © 2009 The McGraw-Hill Companies, Inc. All rights reserved.

Apply An Appropriate Decision Process In Three Situations: Objective 5 Apply An Appropriate Decision Process In Three Situations: Pricing products in special cases. Deciding whether to purchase new equipment. Deciding whether to make or to buy a part. Our fifth objective is to apply an appropriate decision process in the situations that follow on the next several slides.

Product Pricing in Special Situations Direct costing is often useful in setting prices and considering purchase offers in special situations. I better talk to accounting about this? Direct costing is often useful in setting prices and considering purchase offers in special situations.

Product Pricing in Special Situations Customer offers to buy 1,000 units at $25 per unit. The order will require $1 per unit in shipping costs. Management’s Analysis using Absorption Costing: Manufacturing costs ($210,000 ÷ 10,000 units) $21.00 Selling and administrative costs ($96,000 ÷ 9,000 units) 10.67 Total average cost per unit * $31.67 Management’s Analysis using Direct Costing: Variable manufacturing costs $16.00 Variable selling and administrative expenses 4.00 Variable costs per unit $20.00 Additional shipping cost 1.00 In this example, a customer offers to buy 1,000 units at $25 per unit. The order will require $1 per unit in shipping costs. Under direct costing, there is a potential profit of $4 per unit. Potential Profit $25 - $21 = $4 per unit Total variable cost per unit $21.00 * Includes fixed costs, which are not relevant in this situation.

Product Pricing in Special Situations Management needs to consider all relevant factors when analyzing special pricing situations: Does the company have sufficient manufacturing capacity? Will the special order jeopardize sales to existing customers? Do federal laws prohibit price differentials? Management needs to consider all relevant factors when analyzing special pricing situations. Those relevant factors include: Does the company have sufficient manufacturing capacity? Will the special order jeopardize sales to existing customers? Do federal laws prohibit price differentials?

Purchasing New Equipment The net income under each alternative must be calculated and compared. When making the decision to purchase new equipment, net income under each alternative must be calculated and compared.

Purchasing New Equipment SUS Industries Inc. is considering the purchase of new machinery. If Machine If Machine Differential Is Not Purchased Is Purchased Annual Sales $350,000 $350,000 Variable costs Materials $120,000 $120,000 Labor 100,000 90,000 ($10,000) Manufacturing overhead 30,000 30,000 Total variable costs $250,000 $240,000 Contribution margin $100,000 $110,000 10,000 Fixed costs 19,000 22,000* (3,000) Net Income $ 81,000 $ 88,000 $ 7,000 Income would increase by $7,000 per year. In this example SUS Industries Incorporated is considering the purchase of new machinery. If the machine is not purchased, net income will earned is $81,000. If the machine is purchased, net income will increase $88,000. Therefore, the income differential shows in increase of $7,000 in net income if the machine is purchased. * Includes depreciation for the new machine and effects of other changes in fixed costs.

Purchasing New Equipment Before purchasing the new equipment however, management needs to consider all relevant factors, including: Employee morale, and Product quality with the new machine. Before purchasing the new equipment, management needs to consider all relevant factors, including: Employee morale, and Product quality with the new machine.

Making or Buying a Part Fixed manufacturing overhead costs are not considered because they remain the same whether the part is purchased or made. When making the decision to make or buy a new part, fixed manufacturing overhead costs are not considered because they remain the same whether the part is purchased or made.

Making or Buying a Part SUS Industries Inc. is weighing the alternatives of buying a part from an outside vendor, or making the part themselves. Cost to purchase part $16.00 Cost to manufacture part Variable costs only Materials $8.00 Labor (1/4 hour at $16 per hour) 4.00 Manufacturing overhead (1/4 hour at $8 per hour) 2.00 14.00 Differential cost (savings per unit if part is manufactured) $ 2.00 Number of parts per year x 20,000 Total annual savings $40,000 In this example, SUS Industries Incorporated is weighing the alternatives of buying a part from an outside vendor, or making the part themselves. The cost to purchase the part is $16 per unit, while the cost to manufacture the part is $14 per unit. Therefore, there is a differential cost savings of $2 per unit if the part is manufactured. This translate into an annual savings of $40,000.

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