© The McGraw-Hill Companies, Inc., Operating cycle decision-making YOU ARE HERE! Special order decisions Discontinue product line decisions Make or buy decisions Chapter 5 Short-Tem Operating Decisions Indifference point decisions Sell or process further decisions

© The McGraw-Hill Companies, Inc., PART TWO: PLANNING Chapter 5 - Short-Term Operating Decisions

© The McGraw-Hill Companies, Inc., CHAPTER 5 LEARNING OBJECTIVES L.O.1: Describe a relevant variable analysis for making short-term operating decisions. L.O.2: Use a relevant variable analysis to analyze a special order accept-or-reject decisions. L.O.3: Employ a relevant variable analysis to assess a make-or-buy decision. L.O.4: Apply a relevant variable analysis to solve sell-now-or-process-further and sell-later decisions.

© The McGraw-Hill Companies, Inc., CHAPTER 5 LEARNING OBJECTIVES L.O.5: Use a relevant variable analysis to analyze decisions to discontinue a product line. L.O.6: Apply the indifference point concept to assess short-term operating decisions. L.O.7: (Appendix) Determine product mix in a scarce resource environment.

© The McGraw-Hill Companies, Inc., Operating Strategic Short-term WHAT IS A SHORT-TERM OPERATING DECISION? Long-term planning Day to day operations Unanticipated and unplanned

© The McGraw-Hill Companies, Inc., sAssumes current capacity is fixed since, in the short-term, a company cannot increase its physical capacity. sDecisions not planned as part of the management cycle; ad hoc opportunities or issues that must be addressed in a timely manner. sUnique decisions - each decision must be analyzed as a distinct opportunity. SHORT-TERM OPERATING DECISION vs. OTHER OPERATING DECISIONS

© The McGraw-Hill Companies, Inc., UNDERSTANDING TYPES OF COSTS COMPANIES INCUR The key to making short-term operating decisions is understanding the types of costs a business incurs and which variables are relevant. Nonproduct costs Product costs Cost to acquire products or to make products Costs not related to acquiring or making products

© The McGraw-Hill Companies, Inc., UNDERSTANDING TYPES OF COSTS COMPANIES INCUR Product costs Merchandiser Manufacturer Costs incurred to purchase and receive the product Costs incurred to make the product Direct materials Direct labor Manufacturing overhead Insurance Purchase price of product Freight

© The McGraw-Hill Companies, Inc., UNDERSTANDING TYPES OF COSTS COMPANIES INCUR Nonproduct costs Costs incurred to sell the products Costs incur to administer the business Executive salaries Income taxes Rent on office space Sales salaries and commissions Advertising Delivery

© The McGraw-Hill Companies, Inc., PAUSE AND REFLECT If Procter & Gamble rents warehouse space for its finished products, is this rent a nonproduct or product cost? Why? Typically, we would call rent for finished products a nonproduct cost. However, since storing inventory is part of the conversion cycle, we could define it as a product cost. Typically, we would call rent for finished products a nonproduct cost. However, since storing inventory is part of the conversion cycle, we could define it as a product cost.

© The McGraw-Hill Companies, Inc., UNDERSTANDING TYPES OF COSTS COMPANIES INCUR A company must understand the cost behavior of all of its costs to determine if it is relevant in a given situation. sUnit-related costs sBatch-related costs sProduct (or customer) sustaining costs sFacility-sustaining costs Is this a fixed cost? Is this a variable cost? Is this a mixed cost? Activity levels studied for cost behavior

© The McGraw-Hill Companies, Inc., PAUSE AND REFLECT Identify each of the following costs as unit- related, batch-related, product (customer) - sustaining, or facility-sustaining: tFreight paid per unit ordered tFreight paid per order tCost incurred to service Customer A tCosts incurred to hire a new CEO Freight paid per unit is a unit- related cost; freight paid per order is a batch-related cost; cost incurred to service customers is a product (customer)-sustaining cost; and costs incurred to hire a new CEO are facility sustaining costs. Freight paid per unit is a unit- related cost; freight paid per order is a batch-related cost; cost incurred to service customers is a product (customer)-sustaining cost; and costs incurred to hire a new CEO are facility sustaining costs.

© The McGraw-Hill Companies, Inc., A cost or revenue that will occur in the future and that differs among alternatives considered. WHAT IS A RELEVANT VARIABLE? Focus for short- term decision making

© The McGraw-Hill Companies, Inc., Past cost Irrelevant SUNK COSTS

© The McGraw-Hill Companies, Inc., The cost of this bridge is not relevant to the decision to replace it with another bridge. SUNK COST EXAMPLE

© The McGraw-Hill Companies, Inc., Forgone benefits of the next best alternative OPPORTUNITY COSTS An opportunity set represents the set of alternatives available to decision-makers; thus, by choosing one alternative over another, economic benefits are given up on the alternative not chosen. Thus, opportunity costs are always relevant costs.

© The McGraw-Hill Companies, Inc., ECONOMIC FRAMEWORK: SHORT-TERM DECISION MAKING B? A? A or B? D? C ? C or D? B? A? C ? I give up! Which alternative increases operating income the most?

© The McGraw-Hill Companies, Inc., Alt. AAlt. B Revenue1,1001,000 Labor Materials Incremental Profit ILLUSTRATION OF INCREMENTAL ANALYSIS Focus only on those revenues and costs that differ among alternatives

© The McGraw-Hill Companies, Inc., sIdentify alternative actions. sDetermine decision-relevant variables (revenues and costs). sDetermine incremental effect of each alternative on operating income. sChoose the alternative that produces the highest incremental operating income. STEPS IN APPLYING INCREMENTAL ANALYSIS

© The McGraw-Hill Companies, Inc., tSpecial order decisions tMake-or-buy decisions tAdd or delete a product line decisions EXAMPLES OF SHORT-TERM DECISIONS

© The McGraw-Hill Companies, Inc., I need 300 airplane engines each $200 below normal selling price! ? SPECIAL ORDER DECISIONS WESTSTAR ENGINES Customer initiated order

© The McGraw-Hill Companies, Inc., sAccept special order if the relevant profit is positive. sReject special order if the relevant profit is negative. OPERATING DECISION RULE: SPECIAL ORDERS

© The McGraw-Hill Companies, Inc., The Weststar company manufacturers and sells short-block engines. Budgeted sales and cost data for the year are as follow: Sales price $800,000 Variable costs 450,000 Contribution margin 350,000 Fixed costs 200,000 Net income $150,000 WESTSTAR ENGINES SPECIAL ORDERS

© The McGraw-Hill Companies, Inc., sA special order has been received from a company in Germany for 300 engines at a selling price of $600 each. sWeststar has the plant capacity to accept the order. sIf accepted, Weststar will incur additional shipping costs of $50 per engine, but fixed costs will remain unchanged.. Sales price$800,000 Variable costs 450,000 Contribution margin 350,000 Fixed costs 200,000 Net income$150,000 Budgeted data - sales of 1,000 engines Variable cost per unit = $450 WESTSTAR ENGINES SPECIAL ORDERS Variable cost per unit = $450

© The McGraw-Hill Companies, Inc., WESTSTAR ENGINES SPECIAL ORDERS Incremental revenues: Special order of $600 each 180,000 Incremental costs: Variable costs ($450/unit) (135,000) Additional variable costs of special order ($50/unit) (15,000) Incremental contribution margin 30,000

© The McGraw-Hill Companies, Inc., PAUSE AND REFLECT If Wal-Mart approaches Procter & Gamble with a large order and requests a bid, what quantitative and qualitative factors should Procter & Gamble consider? If P&G has the capacity, it should consider the incremental costs to fill the order and the profit needed. P&G should also consider whether giving Wal-Mart a special price will affect the prices offered to others, and how this short-term offer will affect long-term pricing. If P&G has the capacity, it should consider the incremental costs to fill the order and the profit needed. P&G should also consider whether giving Wal-Mart a special price will affect the prices offered to others, and how this short-term offer will affect long-term pricing.

© The McGraw-Hill Companies, Inc., ? OR MAKE OR BUY DECISION HD Motorcycle Corporation MAKE MOTORCYCLES BUY MOTORCYLES Outsourcing decisions

© The McGraw-Hill Companies, Inc., OPERATING DECISION RULE: MAKE OR BUY sMake product internally if the relevant cost of making the item is less than the relevant cost of buying externally. sBuy an item externally if the relevant cost of buying the item is less than the relevant cost of making the item.

© The McGraw-Hill Companies, Inc., HD Corporation manufactures and sells motorcycles to dealers throughout the country. Based on a production level of 12,000 motorcycles, the cost to produce its most popular model of motorcycle is shown below: Direct materials $1,500 Direct labor $1,200 Unit-variable overhead $800 Fixed overhead $2,000 HD CORPORATION: MAKE OR BUY

© The McGraw-Hill Companies, Inc., sAn offer has been received from California Motors to supply the motorcycle engines for $1,900 per engine. sIf accepted, HD estimates the following cost reductions: materials (50%), labor (60%), variable overhead (20%). sIf accepted, fixed costs are not expected to change in total. Direct materials $1,500 Direct labor $1,200 Unit-variable overhead $800 Fixed overhead $2,000 HD CORPORATION: MAKE OR BUY

© The McGraw-Hill Companies, Inc., Incremental costs: Make Buy Direct materials $1,500 $750 Direct labor 1, Variable-unit overhead Purchase price of engines 1,900 Incremental cost $3,500 $3,770 HD CORPORATION: MAKE OR BUY Cost to make is cheaper than to buy

© The McGraw-Hill Companies, Inc., PAUSE AND REFLECT If HD Corporation decides to buy the engines from California Motors Corporation and could then reuse the engine manufacturing space to make motor scooters that would produce $400/unit in incremental profit, how would this change the make/buy analysis? Reusing the space to make a more profitable product is an opportunity cost of choosing to continue to make the engines because HD is precluded from making the scooters. It could also be viewed as a reduction of the cost to buy the engines. Reusing the space to make a more profitable product is an opportunity cost of choosing to continue to make the engines because HD is precluded from making the scooters. It could also be viewed as a reduction of the cost to buy the engines.

© The McGraw-Hill Companies, Inc., Make Buy Direct materials $1,500 $750 Direct labor 1, Variable-unit overhead Purchase price of engines 1,900 Current incremental cost $3,500 $3,770 Opportunity cost of making scooter 400 Revised incremental cost $3,900 $3,770 HD CORPORATION: MAKE OR BUY Incremental costs: Now cheaper to buy

© The McGraw-Hill Companies, Inc., Joint costs of processing to split-off point $$$$ Split-off point Joint products Raw Materials SELL NOW OR PROCESS FURTHER DECISION

© The McGraw-Hill Companies, Inc., OPERATING DECISION RULE: SELL OR PROCESS FURTHER sProcess a product further if the relevant profit after processing is greater than the relevant profit before further processing. sDo not process a product further if the relevant profit before further processing is greater than the relevant profit after further processing.

© The McGraw-Hill Companies, Inc., SELL NOW OR PROCESS FURTHER DECISION $$$$ Chemical Raw Materials Chemical A Chemical B Sunk cost at the time sell or process decision made Chemical A Additional process cost $2/gallon Chemical B Additional process cost $4/gallon Selling price $15 Cost $8 Profit $7 Selling price $15 Incremental cost $4 Incremental Profit $11 Selling price at split-off point $10

© The McGraw-Hill Companies, Inc., DISCONTINUING A PRODUCT LINE Jason Enterprises Special Roast Regular Roast Premium Roast Should the unprofitable special roast coffee be discontinued?

© The McGraw-Hill Companies, Inc., OPERATING DECISION RULE: DISCONTINUING A PRODUCT LINE sDo not drop the product line if the relevant revenue lost exceeds the relevant costs saved from the discontinuance. sDrop a product line if the relevant revenue lost is less than the relevant costs saved from the discontinuance.

© The McGraw-Hill Companies, Inc., Sales (cases) 5,000 4,000 6,000 15,000 Sales Variable costs of sales Variable selling costs Fixed costs Operating profit $355, ,000 35, ,000 $6,500 $332, ,800 39, ,000 ($23,640) $786, , , ,000 $17,900 $1,473, , , , SpecialPremium Total Regular Positive contribution margin on special roast = $76,360 JASON ENTERPRISES: DISCONTINUANCE OF PRODUCT LINE Should we discontinue the unprofitable special roast line?

© The McGraw-Hill Companies, Inc., Sales (cases) 5,000 6,000 11,000 Sales Variable costs of sales Variable selling costs Fixed costs Operating profit $355, ,000 35, ,000 ($43,500) $786, , , ,000 ($32,100) $1,141, , , ,000 ($75,600) Premium Total Regular JASON ENTERPRISES: DISCONTINUANCE OF PRODUCT LINE Fixed costs do not go away; there is $76,360 less contribution margin to cover them

© The McGraw-Hill Companies, Inc., PAUSE AND REFLECT In 1997, Procter & Gamble discontinued its Duncan Hines line. What quantitative and qualitative factors do you think led Procter & Gamble to this decision? P&G determined that it could make a higher profit by focusing on its main product lines. In addition, it probably considered its marketing strategy and how it would be affected by having fewer, more closely related products. P&G determined that it could make a higher profit by focusing on its main product lines. In addition, it probably considered its marketing strategy and how it would be affected by having fewer, more closely related products.

© The McGraw-Hill Companies, Inc., INDIFFERENCE POINT ANALYSIS Some short-term decisions must be decided on volume. Indifference point analysis compares the cost equations of two alternatives to derive an indifferent point - the volume point where choosing either alternative costs the same. Who cares? I’m indifferent!

© The McGraw-Hill Companies, Inc., INDIFFERENCE POINT ANALYSIS Assume that S & H Products is evaluating two ordering systems. System A costs $1,000 per order while System B costs $12,000 per month plus $200 per order. The indifference point is calculated as follows: $1,000X = $12,000 + $200X $800X = $12,000 x = 15 orders/month In excess of 15 orders, S & H should choose the system with the lower variable costs. This would be System B because the per order costs are only $200.