COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license. 1 Chapter 18 Activity Resource Usage Model and Tactical Decision Making

2 Study Objectives 1.Describe the tactical decision-making model. 2.Define the concept of relevant costs and revenues. 3.Explain how the activity resource usage model is used in assessing relevancy. 4.Apply the tactical decision-making concepts in a variety of business situations.

3 Tactical Decision Making Steps of the tactical decision making process 1.Recognize and define the problem. 2.Identify alternatives as possible solutions to the problem, and eliminate alternatives that are not feasible. 3.Identify the predicted costs and benefits associated with each feasible alternative. Eliminate the costs and benefits that are not relevant to the decision.

4 Tactical Decision Making 4.Compare the relevant costs and benefits for each alternative, and then relate each alternative to the overall strategic goals of the firm and other important qualitative factors. 5.Select the alternative with the greatest benefit which also supports the organization’s strategic objectives. Continued from previous slide

5 Each year 25 percent of the harvest by an apple processor is small and odd-shaped. These apples cannot be sold in the normal distribution channels and have simply been dumped in the orchards for fertilizer. What should the firm do with these apples? Step 1: Define the Problem Tactical Decision Making

6 Step 2: Identify Feasible Alternatives Tactical Decision Making Sell the apples to pig farmers. –Eliminate: not enough local farmers Bag the apples in five-pound bags and sell them to local supermarkets as seconds. –Feasible Rent a local canning facility and convert the apples to applesauce. –Feasible Rent a local canning facility and convert the apples to pie filling. –Eliminate: major capital investment required Continue with the current dumping practice. –Eliminate: status quo

7 Step 3: Identify Predicted Costs and Benefits; Eliminate Irrelevant Costs Tactical Decision Making Bagging Alternative 5 lbs of apples per bag Cost: $0.05 per pound for labor and materials (bags and ties) Revenue: $1.30 per bag Applesauce Alternative 6 lbs of apples to produce five 16- ounce cans of applesauce Cost: $0.40 per pound for rent, labor, apples, cans, and other materials Revenue: $0.78 per can

8 Step 4: Compare Relevant Costs and Relate to Strategic Goals Tactical Decision Making Bagging Alternative Revenue per lb$0.26 Cost per lb0.05 Net benefit per lb$0.21 Applesauce Alternative Revenue per lb$0.65 Cost per lb0.40 Net benefit per lb$0.25 Forward integration strategy Product differentiation strategy

9 Step 5: Select Best Alternative Tactical Decision Making The apple producer is reluctant to follow a forward integration strategy The bagging alternative should be chosen

10 Tactical Decision Making continued

11 Tactical Decision Making Continued from previous slide continued

12 Tactical Decision Making Continued from previous slide

13 Relevant Costs and Revenues Relevant costs –future costs that differ across alternatives Irrelevant Costs –Past costs: already incurred “sunk costs” are the same across alternatives; ignore

14 Relevancy, Cost Behavior, and the Activity Resource Usage Model Flexible Resources –Easily purchased in the amount needed –Purchased at the time of use Committed resources –Purchased before they are used

15 Relevancy, Cost Behavior, and the Activity Resource Usage Model Flexible resources –The activity resources demanded equal the resources supplied Demand changesrelevant Demand constantnot relevant

16 Relevancy, Cost Behavior, and the Activity Resource Usage Model Committed resources –Excess of supply over demand is unused capacity Demand increase < unused capacitynot relevant Demand increase > unused capacityrelevant Demand decrease Activity capacity reducedrelevant Activity capacity unchangednon relevant

17 Relevancy, Cost Behavior, and the Activity Resource Usage Model A company has five manufacturing engineers who supply a capacity of 10,000 engineering hours (2,000 hours each). The cost of this activity capacity is $250,000, or $25 per hour. The firm expects to use 9,000 hours. If the firm decides to reject a special order requiring 500 hours, the cost of engineering would be irrelevant.

18 Relevancy, Cost Behavior, and the Activity Resource Usage Model The firm can purchase a component that will drop the demand from engineering hours from 9,000 to 7,000. Since engineering activity capacity is acquired in chunks of 2,000, the company can lay off one engineer or reassign the engineer to another plant.

19 Relevancy, Cost Behavior, and the Activity Resource Usage Model

20 Illustrative Examples of Tactical Decision Making Assumptions of C-V-P Analysis 1.The analysis assumes a linear revenue function and a linear cost function. 2.The analysis assumes that price, total fixed costs, and unit variable costs can be accurately identified and remain constant over the relevant range. 3.The analysis assumes that what is produced is sold. 4.For multiple-product analysis, the sales mix is assumed to be known. 5.The selling price and costs are assumed to be known with certainty.

21 Illustrative Examples of Tactical Decision Making Common Decisions –Make or Buy –Keep or Drop –Special Order –Sell or Process Further Cost analysis informed by –Activity-based cost management system –Functional-based cost management system

22 Talmage Company produces a mechanical part used in one of its engines. (Talmage produces engines for snowblowers.) An outside supplier has offered to sell a part (Part 34B) for $4.75. The company normally produces 100,000 units of the part each year. Make-or-Buy Decision Illustrative Examples of Tactical Decision Making Flexible resources: Using materials Using direct labor Moving materials Providing power Inspecting products Committed resources: Providing supervision Moving materials Inspecting products Setting up equipment

23 Illustrative Examples of Tactical Decision Making Make-or-Buy Decision ABC: buy the part

24 Illustrative Examples of Tactical Decision Making Make-or-Buy Decision Functional: make the part

25 Illustrative Examples of Tactical Decision Making Keep-or-Drop Decision If a segment is dropped only the traceable revenues and costs should vanish ABC classifications provide information on traceable costs Drop?

26 Dropping the product saves $45,000! Illustrative Examples of Tactical Decision Making Keep-or-Drop Decision

27 Accept or reject a special order Illustrative Examples of Tactical Decision Making Polarcreme, Inc., an ice-cream company, is operating at 80 percent of its 20 million half-gallon capacity. A distributor from another geographic region offered to buy 2 million units of premium ice cream at $1.75 per unit. Distributor will provide their own label and pay transportation costs. This sale is not subject to a sales commission. Impact of special order on non-unit level activities: Purchase ordersincrease10,000 Receiving ordersincrease20,000 Setupsincrease13

28 Special order unit revenue$1.75 Unit-level variable costs: Dairy ingredients$0.70 Sugar0.10 Flavoring0.15 Direct labor0.25 Packaging Commissions Distribution0.03 Other 0.05 Unit-level costs$1.450 Non-unit-level variable costs for special order Purchasing ($8 × 10,000) ÷ 2M Receiving ($6 × 20,000) ÷ 2M0.060 Setting up ($8,000 × 13) ÷ 2M0.052 Non-unit-level costs Net benefit per unit on special order$0.148 Accept or reject a special order Illustrative Examples of Tactical Decision Making

29 Joint products have common processes and costs of production up to a split-off point. Sell or Process Further Illustrative Examples of Tactical Decision Making Joint products with common processes and common costs Decision: Sell “Grade A” tomatoes as produce or process into hot sauce. 1 lb tomatoes yields 1 bottle of hot sauce. Revenue at split-off1,000 lb × $0.40 Revenue from hot sauce1,000 bottles × $1.50 Costs to process into hot sauce$1,000

30 Differential Amount SellProcess Furtherto Process Further Revenues$400$1,500$1,100 Processing costs ,000 1,000 Total$400$ 500$ 100 Sell or Process Further Illustrative Examples of Tactical Decision Making Process further

COST MANAGEMENT Accounting & Control Hansen▪Mowen▪Guan COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. Cengage Learning and South-Western are trademarks used herein under license. 31 End Chapter 19