PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 7 Incremental Analysis for Short-Term Decision Making

7- 3 Steps in the Decision-Making Process

7- 4 Relevant versus Irrelevant Costs and Benefits Relevant Costs have the potential to influence a decision. Relevant costs are also called differential costs, incremental costs, or avoidable costs. Two Criteria for a Relevant Cost 1. Occurs in the future 2. Differs between decision alternatives

7- 5 Relevant versus Irrelevant Costs and Benefits are Irrelevant costs are those that will not influence a decision. Costs that have been incurred in the past. (sunk costs) Costs that are the same regardless of the alternative chosen.

7- 6 An opportunity cost is the benefit that is given up when one alternative is selected over another. At full capacity, adding additional work requires giving up a portion of the existing work. The benefit of the existing work given up is an opportunity cost. With idle capacity, additional work may be added without sacrificing existing work. There is no opportunity cost to the additional work. Opportunity Costs and Capacity Considerations

7- 7 A special order is a one-time order that is outside the scope of normal sales. Special-Order Decisions When analyzing a special order, only the incremental costs and benefits are relevant.

7- 8 Special-Order Decisions A major university has asked Mattel to make a special University Barbie, dressed in a sporty outfit with the school’s logo and colors. The university bookstore has offered to buy 25,000 of these dolls at a price of $7.00 each. Mattel has the capacity to fill the order without affecting production of other Barbie products, which are normally sold to toy stores and discount chains for $9.00 each. More Information

7- 9 Special-Order Decisions Mattel estimates that its unit cost to produce the University Barbie will be: Should Mattel accept the special order?

7- 10 The special order will result in a profit of $2.00 per doll and a total profit of $50,000. Note that fixed costs are excluded because they are irrelevant to the decision. Incremental Analysis (with Excess Capacity)

7- 11 Make-or-Buy Decisions A decision to perform a particular activity or function in-house or purchase from an outside supplier has traditionally been called a make-or- buy decision, but could also be called an insourcing versus outsourcing decision. Key Questions 1.What costs will change? 2.Are there opportunity costs associated with either alternative? 3.Are there other qualitative factors to consider?

7- 12 Managers must sometimes decide whether to eliminate a particular division or segment of the business. These decisions are called keep-or-drop decisions or continue-or-discontinue decisions. Key Questions 1.How much will total revenue and total costs change? 2.Will other segments or product lines be affected? 3.Are there opportunity costs associated with keeping the segment? 4.Are there other qualitative factors to consider? Decisions to Keep-or-Drop Segments

7- 13 Sell-or-Process Further Decisions Businesses are often faced with the decision to sell a product “as is” or refine it so that it can be sold for a higher price., As a general rule, we process further only if incremental revenues exceed incremental costs. Costs of manufacturing the product up to the sell-or- process decision point are sunk and therefore irrelevant.

7- 14 Summary of Incremental Analysis Common Rules for Analyzing Relevant Costs and Benefits: Relevant costs and benefits occur in the future and differ between alternatives. Variable costs are usually relevant to the decision because they vary with the number of units produced or sold. Fixed costs may not be relevant because they do not change with the number of units produced or sold. Fixed costs that are directly related to the decision may be avoidable and thus relevant. Opportunity costs are the lost benefit of choosing one alternative over another. These costs are relevant and occur when capacity is reached or resources are constrained. The quantitative analysis provides a starting point for making decisions, but must be balanced against qualitative factors such as quality considerations, customer loyalty, and other factors.

7- 15 Prioritizing Products with Constrained Resources When a limited resource restricts a company’s ability to satisfy demand, the company is said to have a constrained resource that is referred to as a bottleneck. To maximize profits in the short run, a company with a bottleneck must prioritize its products or services so as to maximize contribution margin per unit of the constrained resource. The focus is on contribution margin because fixed costs will not change in the short run, and are not relevant.

7- 16 End of Chapter 7