5 Short-Term Decisions and Accounting Information Prepared by Douglas Cloud Pepperdine University

After reading this chapter, you should be able to: Objectives Explain why decision making requires information not included in regular accounting reports. Determine what costs and revenues are relevant to decisions. Analyze the quantitative factors relevant to typical decisions. Explain the importance of complementary effects to decisions of a segment of a larger entity. After reading this chapter, you should be able to: Continued

Objectives Identify nonquantitative or long-term considerations that influence short-term decisions. Describe some of the legal constraints on managers’ decisions.

The Criterion for Short-term Decisions Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss). Two Subrules 1. The only revenues and costs that are relevant in making decisions are the expected future revenues and costs that will differ among the available choices. 2. Revenues and costs that have already been earned or incurred are irrelevant in making decisions. 11 4

Definitions Differential revenues and costs are the expected future revenues and costs that will differ among the choices that are available. Incremental revenues and costs are those differential revenues and costs that actually increase. 12 5

Definitions Sunk costs are costs that have already been incurred and therefore will be the same no matter which alternative a manager selects. Examples: Book value of equipment Original purchase price of building 13 6

Definitions An opportunity cost is the benefit lost by taking one action as opposed to another. Example: Rental income lost if facility is used for production. 14 7

Typical Short-Term Decisions Drop a Segment Make-or-Buy Joint Product Special Order Factors of Limited Supply Important: Short-term Perspective 9 9 16

Should the company accept the offer? Basic Example Gloucester Visuals recently manufactured 100 specialized workstation monitors for a customer that has since gone bankrupt. A rival company has offered to buy the monitors for $12,000. The cost to manufacture the monitors was $17,000. Should the company accept the offer?

Basic Example Differential revenues $12,000 Differential costs 0 Differential profit $12,000 Accept the offer!

Should the company accept the offer? Basic Example Third Alternative A competitor offers to pay $20,000 for the monitors provided that Gloucester disguises the original logo and makes a few other modifications. The production manager estimated the incremental cost of the modifications at $6,000. Should the company accept the offer?

Decision: Make modifications! Basic Example Third Alternative Differential revenues ($20,000 – $12,000) $8,000 Differential costs ($6,000 – $0) 6,000 Differential profit $2,000 Decision: Make modifications!

Comparison of the three methods Basic Example Comparison of the three methods Throw Out Monitors Sell Monitors As Is Rework and Sell Incremental revenue $0 $12,000 $20,000 Incremental costs 0 0 (6,000 ) Incremental profit (loss) $0 $12,000 $14,000

Activity-Based Estimates Using ABC helps managers focus on what activities change as a result of a decision.

Dropping a Segment Decision Sales $45,000 $40,000 $15,000 $100,000 Variable costs 25,000 18,000 11,000 54,000 Contribution margin $20,000 $22,000 $ 4,000 $ 46,000 Fixed costs: Direct–all avoidable (4,000 ) (3,400 ) (1,500 ) (8,900 ) Indirect (common), allocated on sales (9,450 ) (8,400 ) (3,150 ) (21,000 ) Income (loss) $ 6,550 $10,200 $ (650 ) $ 16,100 Clothing Shoes Jewelry Total Should Jewelry be eliminated? 10 10 17

Dropping a Segment Decision Genco’s analysis shows that dropping jewelry would reduce common costs by $1,000. If jewelry is dropped, the available space can be rented for $400 per month. Differential revenues: Lost sales from jewelry $15,000 New rent revenue 400 Net revenue lost $14,600 Differential costs: Variable costs saved on jewelry $11,000 Direct fixed costs saved 1,500 Indirect fixed costs saved 1,000 Total cost saving 13,500 Differential loss from dropping jewelry $ 1,100 Keep jewelry! 11 18 11

Complementary Effects Decision: Substitute Music for Jewelry Differential contribution margin— increase ($12,000 – $4,000) $8,000 Differential costs—increase in direct fixed costs ($2,700 – $1,500) 1,200 Differential profit favoring substitution $6,800

Complementary Effects Complementary effects happen when a change in the sale of one product might be accompanied by a change in the sale of another. Genco’s managers believe that some people coming to shop for music are also likely to buy clothing. After reviewing the results of market studies, the managers estimate that clothing sales will increase 7 percent if music is substituted for jewelry. 19 12

Complementary Effects Decision: Substitute Music for Jewelry Differential contribution margin: Increase due to selling music vs. jewelry $8,000 Increase due to higher clothing sales (7% x $20,000 contribution margin on current sales) 1,400 Net Increase in contribution margin $9,400 Differential costs—increase in direct fixed costs ($2,700 – $1,500) 1,200 Differential profit favoring substitution $8,200

Loss Leader A loss leader is a special case of complementary effects where a product or line shows a negative profit in the sense that its contribution margin does not cover its avoidable fixed costs. The manager of a local pizzeria prepares the income statement shown on Slide 5-20, based on a normal week, for the 11 a.m. to 2 p.m. period. All costs are incremental.

Loss Leader Pizza Soft Drinks Total Sales (200 pizzas @ $1.80) $360 $100 $460 Variable costs 120 40 160 Contribution margin $240 $ 60 $300 Wages of part-time employees 80 Income $220

Loss Leader Pizza Soft Drinks Total Sales $ 720 $ 0 $720 Variable costs 240a 100b 340 Contribution margin $480a $(100) $380 Wages of part-time employees ($80 + $40) 120 Income $260 a Variable costs computed at the same rate as before, one-third or 33 1/3% of selling price. b Variable costs computed as two and one-half times the previous costs.

Make-or-Buy Decision Total Cost Unit Cost Assume the following cost data relate to the decision to produce 12,000 units of a product or buy from external source: Rental of equipment $15,000 $1.25 Equip. depreciation 3,000 .25 Direct materials 12,000 1.00 Direct labor 24,000 2.00 Variable overhead 9,000 .75 Fixed overhead 36,000 3.00 Total $99,000 $8.25 Total Cost Unit Cost The purchase price from an outside vendor is $5.50 per unit. 13 13 20

Decision: Manufacture parts in-house Make-or-Buy Decision Differential Make Buy Cost to Make Rental of equip. $15,000 ---- $15,000 Direct materials 12,000 ---- 12,000 Direct labor 24,000 ---- 24,000 Variable overhead 9,000 ---- 9,000 Purchase cost $66,000 $(66,000 ) Relevant costs $60,000 $66,000 $(6,000 ) Decision: Manufacture parts in-house The cost to make is $5.00 per unit. The price to buy is $5.50 per unit. 14 14 21

Make-or-Buy Decision Qualitative issues: Quality of purchased components Timely delivery Potential price increases 24 15

Joint Products When a single manufacturing process invariably produces two or more separate products, the products are called joint products. QBT, a chemical company, operates a joint process that results in two products. Each 1,000 pounds of material yields 600 pounds of Alpha and 400 pounds of Omega. 25 16

Joint Products Alpha Omega Selling price at split-off $1,200 $1,600 Selling price after additional processing $3,600 $2,000 Costs of additional processing, all variable $900 $500 17 17 26

Joint Products Alpha Omega Differential revenues $2,400 $ 400 Differential costs 900 500 Differential profits $1,500 $(100 ) Decisions: Process Alpha further and sell Omega at the split-off point 17 27 18

Special Order Example Per Unit Total Sales (60,000 units) $15 $900,000 Manufacturing costs: Materials $4 $240,000 Direct labor 3 180,000 Overhead (1/3 variable) 6 360,000 Total $13 780,000 Gross margin $120,000 Selling and admin. expenses 80,000 Operating income $ 40,000 Per Unit Total Should the company sell a special on-time order for 20,000 at $10 per unit to a company in a new market? 19

Decision: Accept special order Special Order Example Per Unit Total Differential revenues (20,000 units) $10 $200,000 Differential costs: Materials $4 $80,000 Direct labor 3 60,000 Variable overhead 2 40,000 Total $9 180,000 Incremental profit favoring acceptance $ 20,000 Decision: Accept special order 20

Special Order Example Differential revenues: : New revenues (20,000 units) $200,000 Lost revenues (5,000 units x $15) (75,000 ) Total differential revenues $125,000 Differential costs: Costs of special order $180,000 Costs from not making regular sales: Variable manufacturing cost 5,000 x $9 ($4 + $3 + $2) (45,000 ) Commissions (5,000 x $0.30) (1,500 ) Total differential costs 133,500 Differential loss, favoring rejecting order $ (8,500 ) 21

Resource Constraint Selling price $10 $6 Variable cost 6 4 Drive Chip Modem Chip Selling price $10 $6 Variable cost 6 4 Contribution margin $ 4 $2 Number of units that can be made per MH 60 150 Which product should be processed assuming only 100 machine hours are available? 22

Resource Constraint Number of units that can be made per MH 60 150 Contribution margin per unit x $4 x $2 Contribution margin per machine hour $240 $300 Drive Chip Modem Chip Decision: Produce modem chips 23

Decision Making Under Environmental Constraints Antitrust laws forbid actions that might substantially reduce competition. Anti-dumping laws address aspects of unfair competition in international trade. 33 24

Decision Making Under Environmental Constraints The Sherman Act, Clayton Act, Robinson-Patman Act, and the statutes of many states prohibit predatory pricing. Predatory pricing is pricing below cost in the short term to drive competitors out of business and eventually to raise prices. 34 25

Decision Making Under Environmental Constraints The Robinson-Patman Act forbids charging different prices to different customers unless there are intrinsic cost differences in serving the different customers; in other words, this act forbids discriminatory pricing. The Federal Trade Commission (FTC) is the regulatory agency responsible for enforcing the act. 35 26

Decision Making Under Environmental Constraints Anti-dumping laws prevent unfair competitive practices in international trade by prohibiting a company in one country from selling its products in another country at less than fair value. The International Trade Administration, part of the Commerce Department, deals with charges of dumping in the United States. 36 27

Chapter 5 The End