26 - 1©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Chapter 26 Special Business Decisions and Capital Budgeting

26 - 2©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Identify the relevant information for a special business decision. Objective 1

26 - 3©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber It is expected future data that differs among alternatives. It is expected future data that differs among alternatives. Only relevant data affect decisions. Relevant Information for Decision Making n Relevant information has two distinguishing characteristics.

26 - 4©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Make five types of short-term special business decisions. Objective 2

26 - 5©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Special Sales Order n A. B. Fast is a manufacturer of automobile parts located in Texas. n Ordinarily A. B. Fast sells oil filters for $3.22 each. n R. Pino and Co., from Puerto Rico, has offered $35,400 for 20,000 oil filters, or $1.77 per filter.

26 - 6©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Special Sales Order n A. B. Fast’s manufacturing product cost is $2 per oil filter which includes variable manufacturing costs of $1.20 and fixed manufacturing overhead of $0.80. n Suppose that A. B. Fast made and sold 250,000 oil filters before considering the special order. n Should A. B. Fast accept the special order?

26 - 7©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Special Sales Order n The $1.77 offered price will not cover the $2 manufacturing cost. n However, the $1.77 price exceeds variable manufacturing costs by $.57 per unit. n Accepting the order will increase A. B. Fast’s contribution margin. n 20,000 units × $.57 contribution margin per unit = $11,400

26 - 8©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Dropping Products, Departments, Territories n Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil filters and 20,000 air cleaners). n Suppose that the company is considering dropping the air cleaner product line. n Revenues for the air cleaner product line are $41,000. n Should A. B. Fast drop the air cleaner line?

26 - 9©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Dropping Products, Departments, Territories n Variable selling and administrative expenses are $0.30 per unit. n Variable manufacturing expenses are $1.20 per unit. n Total fixed expenses are $335,000. n Total fixed expenses will continue even if the product line is dropped.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Product Line Oil Filters Air Cleaners Total Units 250,000 20, ,000 Sales$805,000$ 41,000$846,000 Variable expenses 375,000 30, ,000 Contribution margin$430,000$ 11,000$441,000 Fixed expenses 310,185 24, ,000 Operating income/(loss)$119,815($13,815)$106,000 Dropping Products, Departments, Territories

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Dropping Products, Departments, Territories n To measure product-line operating income, A. B. Fast allocates fixed expenses in proportion to the number of units sold. n Total fixed expenses are $335,000 ÷ 270,000 units, or $1.24 fixed unit cost. n Fixed expenses allocated to the air cleaner product line are 20,000 units × $1.24 per unit, or $24,815.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Oil Filters Alone Units 250,000 Sales$805,000 Variable expenses 375,000 Contribution margin 430,000 Fixed expenses 335,000 Operating income$ 95,000 Dropping Products, Departments, Territories

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Dropping Products, Departments, Territories n Suppose that the company employs a supervisor for $25,000. n This cost can be avoided if the company stops producing air cleaners. n Should the company stop producing air cleaners? n Yes! n $11,000 – $25,000 = ($14,000)

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Product Mix n Companies must decide which products to emphasize if certain constraints prevent unlimited production or sales. n Assume that A. B. Fast produces oil filters and windshield wipers. n The company has 2,000 machine hours available to produce these products.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Product Mix A. B. Fast can produce 5 oil filters in one hour or 8 windshield wipers. Product Oil Windshield Per Unit FiltersWipers Sales price$3.22$13.50 Variable expenses Contribution margin$1.72$ 1.50 Contribution margin ratio 53% 11%

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Product Mix Which product should A. B. Fast emphasize? Oil filters: $1.72 contribution margin per unit × 5 units per hour = $8.60 per machine hour Windshield wipers: $1.50 contribution margin per unit × 8 units per hour = $12.00 per machine hour

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Outsourcing (Make or Buy) n A. B. Fast is considering the production of a part it needs, or using a model produced by C. D. Enterprise. n C. D. Enterprise offers to sell the part for $0.37. n Should A. B. Fast manufacture the part or buy it?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Outsourcing (Make or Buy) A. B. Fast has the following costs for 250,000 units of Part no. 4: Part no. 4 costs:Total Direct materials$ 40,000 Direct labor 20,000 Variable overhead 15,000 Fixed overhead 50,000 Total$125,000 $125,000 ÷ 250,000 units = $0.50/unit

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Outsourcing (Make or Buy) n Assume that by purchasing the part, A. B. Fast can avoid all variable manufacturing costs and reduce fixed costs by $15,000 (fixed costs will decrease to $35,000). n A. B. Fast should continue to manufacture the part. n Why?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Purchase cost (250,000 × $0.37)$ 92,500 Fixed costs that will continue 35,000 Total$127,500 The unit cost is then $0.51 ($127,500 ÷ 250,000). $127,500 – $125,000 = $2,500, which is the difference in favor of manufacturing the part. Outsourcing (Make or Buy)

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Best Use of Facilities n Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the facilities previously used to manufacture Part no. 4 to produce gasoline filters. n The expected annual profit contribution of the gasoline filters is $17,000. n What should A. B. Fast do?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Expected cost of obtaining 250,000 parts: Make part$125,000 Buy part and leave facilities idle$127,500 Buy part and use facilities for gas filters$110,500* *Cost of buying part: $127,500 less $17,000 contribution from gasoline filters. Best Use of Facilities

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sell As-Is Or Process Further n The sell as-is or process further is a decision whether to incur additional manufacturing costs and sell the inventory at a higher price, – or sell the inventory as-is at a lower price. n Suppose that A. B. Fast spends $500,000 to produce 250,000 oil filters. n A. B. Fast can sell these filters for $3.22 per filter, for a total of $805,000.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sell As-Is Or Process Further n Alternatively, A. B. Fast can further process these filters into super filters at an additional cost of $25,000, which is $0.10 per unit ($25,000 ÷ 250,000 = $0.10). n Super filters will sell for $3.52 per filter for a total of $880,000. n Should A. B. Fast process the filters into super filters?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sell As-Is Or Process Further n A. B. Fast should process further, because the $75,000 extra revenue ($880,000 – $805,000) outweighs the $25,000 cost of extra processing. n Extra sales revenue is $0.30 per filter. n Extra cost of additional processing is $0.10 per filter.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Sell As-Is Or Process Further Cost to produce 250,000 parts:$500,000 Sell these parts for $3.22 each:$805,000 Cost to process original parts further:$ 25,000 Sell these parts for $3.52 each:$880,000 Sales increase ($880,000 – $805,000)$ 75,000 Less processing cost 25,000 Net gain by processing further$ 50,000

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Explain the difference between correct analysis and incorrect analysis of a particular business decision. Objective 3

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Correct Analysis n A correct analysis of a business decision focuses on differences in revenues and expenses. n The contribution margin approach, which is based on variable costing, often is more useful for decision analysis. n It highlights how expenses and income are affected by sales volume.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Incorrect Analysis n The conventional approach to decision making, which is based on absorption costing, may mislead managers into treating a fixed cost as a variable cost. n Absorption costing treats fixed manufacturing overhead as part of the unit cost.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Use opportunity costs in decision making. Objective 4

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Opportunity Cost... – is the benefit that can be obtained from the next best course of action. n Opportunity cost is not an outlay cost, so it is not recorded in the accounting records. n Suppose that A. B. Fast is approached by a customer that needs 250,000 regular oil filters.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Opportunity Cost n The customer is willing to pay more than $3.22 per filter. n A. B. Fast’s managers can use the $855,000 ($880,000 – $25,000) opportunity cost of not further processing the oil filters to determine the sales price that will provide an equivalent income. n $855,000 ÷ 250,000 units = $3.42

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Use four capital budgeting models to make longer-term investment decisions. Objective 5

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Capital Budgeting... – is a formal means of analyzing long-range capital investment decisions. n The term describes budgeting for the acquisition of capital assets. n Capital assets are assets used for a long period of time.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Capital Budgeting n Capital budget models using net cash inflow from operations are: – payback – accounting rate of return – net present value – internal rate of return

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Payback... – is the length of time it takes to recover, in net cash inflows from operations, the dollars of capital outlays. n An increase in cash could result from an increase in revenues, a decrease in expenses, or a combination of the two.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Payback Example n Assume that A. B. Fast is considering the purchase of a machine for $200,000, with an estimated useful life of 8 years, and zero predicted residual value. n Managers expect use of the machine to generate $40,000 of net cash inflows from operations per year.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Payback Example n How long would it take to recover the investment? n $200,000 ÷ $40,000 = 5 years n 5 years is the payback period.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Payback Example n When cash flows are uneven, calculations must take a cumulative form. n Cash inflows must be accumulated until the amount invested is recovered. n Suppose that the machine will produce net cash inflows of $90,000 in Year 1, $70,000 in Year 2, and $30,000 in Years 3 through 8.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Payback Example n What is the payback period? n Years 1, 2, and 3 together bring in $190,000. n Recovery of the amount invested occurs during Year 4. n Recovery is 3 years + $10,000. n 3 years + ($10,000 ÷ $30,000) = 3 years and 4 months

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accounting Rate of Return... – measures profitability. n It measures the average return over the life of the asset. n It is computed by dividing average annual operating income by the average amount of investment in the asset.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accounting Rate of Return Example n Assume that a machine costs $200,000, has no residual value, and has a useful life of 8 years. n How much is the straight-line depreciation per year? n $25,000 n Management expects the machine to generate annual net cash inflows of $40,000.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Accounting Rate of Return Example n How much is the average operating income? n $40,000 – $25,000 = $15,000 n How much is the average investment? n $200,000 ÷ 2 = $100,000 n What is the accounting rate of return? n $15,000 ÷ $100,000 = 15%

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Discounted Cash-Flow Models n Discounted cash-flow models take into account the time value of money. n The time value of money means that a dollar invested today can earn income and become greater in the future. n These methods take those future values and discount them (deduct interest) back to the present.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Net Present Value n The (NPV) method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present. n The amount of interest deducted is determined by the desired rate of return. n This rate of return is called the discount rate, hurdle rate, required rate of return, or cost of capital.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Net Present Value Example n A. B. Fast is considering an investment of $450,000. n This proposed investment will yield periodic net cash inflows of $225,000, $230,000, and $210,000 over its life. n A. B. Fast expects a return of 16%. n Should the investment be made?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Net Present Value Example Periods Amount PV Factor Present Value 0 ($450,000)1.000 ($450,000) 1225, , , , , ,610 Total PV of net cash inflows$499,450 Net present value of project$ 49,450

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Internal Rate of Return... – is another model using discounted cash flows. n The internal rate of return (IRR) is the rate of return that a company can expect to earn by investing in a project. n The higher the IRR, the more desirable the investment.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Internal Rate of Return n The IRR is the rate of return at which the net present value equals zero. n Investment = Expected annual net cash inflow × PV annuity factor n Investment ÷ Expected annual net cash inflow = PV annuity factor

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Internal Rate of Return Example n Assume that A. B. Fast is considering investing $500,000 in a project that will yield net cash inflows of $152,725 per year over its 5-year life. n What is the IRR of this project? n $500,000 ÷ $152,725 = (PV annuity factor)

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Internal Rate of Return Example n The annuity table shows that is in the 16% column for a 5-period row in this example. n Therefore, 16% is the internal rate of return of this project. n If the minimum desired rate of return is 16% or less, A.B. Fast should undertake this project.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Compare and contrast popular capital budgeting methods. Objective 6

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Comparison of Capital Budgeting Models n The discounted cash-flow models, net present value, and internal rate of return are conceptually superior to the payback and accounting rate of return models. n Strengths of the payback include: n It is easy to calculate, highlights risks, and is based on cash flows.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber Comparison of Capital Budgeting Models n Its weaknesses are that it ignores cash flows beyond the payback, the time value of money, and profitability. n The strength of the accounting rate of return is that it is based on profitability. n Its weakness is that it ignores the time value of money.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber End of Chapter 26