Introduction to Management Accounting Chapter 6 Relevant Information for Decision Making with a Focus on Operational Decisions

Make-or-Buy Decisions Case 1 Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier.

Make or Buy Decisions Direct material $ 60,000 $.06 Direct labor 20,000 .02 Variable factory overhead 40,000 .04 Fixed factory overhead 80,000 .08 Total costs $200,000 $.20 Nantucket Nectars Company’s Cost of Making 12-ounce Bottles

Make-or-Buy Example Another manufacturer offers to sell Nantucket the bottles for $.18. If the company buys the bottles, $50,000 of fixed overhead would be eliminated. Should Nantucket make or buy the bottles?

Relevant Cost Comparison Purchase cost $180,000 $.18 Direct material $ 60,000 $.06 Direct labor 20,000 .02 Variable overhead 40,000 .04 Fixed OH avoided by not making 50,000 .05 0 0 Total relevant costs $170,000 $.17 $180,000 $.18 Difference in favor of making $ 10,000 $.01 Total Per Bottle Make Buy

Make or Buy and the Use of Facilities Suppose Nantucket can use the released facilities in other manufacturing activities to produce a contribution to profits of $55,000, or can rent them out for $25,000. What are the alternatives?

Make or Buy and the Use of Facilities (000) Buy and rent out facilities Make Buy and leave facilities idle Buy and use facilities for other products Rent revenue $ — $ — $ 25 $ — Contribution from other products — — — 55 Variable cost of bottles (170) (180) (180) (180) Net relevant costs $(170) $(180) $(155) $(125)

Deletion or Addition of Products, Service, or Departments Case 2 Deletion or Addition of Products, Service, or Departments Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Unavoidable costs are costs that continue even if an operation is halted. Common costs are costs of facilities and services that are shared by users.

Department Store Example Consider a discount department store that has three major departments: Groceries General merchandise Drugs

Department Store Example Total Groceries General Mdse. Drugs Sales $1,900 $1,000 $800 $100 Variable expenses 1,420 800 560 60 Contribution margin $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%) Fixed expenses: Avoidable $ 265 $ 150 $100 $ 15 Unavoidable 180 60 100 20 Total fixed expenses $ 445 $ 210 $200 $ 35 Operating income $ 35 $ (10) $ 40 $ 5 ($000)

Department Store Example Assume that the only alternatives to be considered are dropping or continuing the grocery department, which has consistently shown an operating loss. Assume further that the total assets invested would be unaffected by the decision. The vacated space would be idle and the unavoidable costs would continue.

Department Store Example Store as a Whole ($000) Total Before Change Effect of Dropping Groceries Total After Change Sales $1,900 $1,000 $900 Variable expenses 1,420 800 620 Contribution margin $ 480 $ 200 $280 Avoidable fixed expenses 265 150 115 Profit contribution to common space and other unavoidable costs $ 215 $ 50 $165 Unavoidable expenses 180 0 180 Operating income $ 35 $ 50 $ (15)

Department Store Example Assume that the store could use the space made available by the dropping of groceries to expand the general merchandise department. Assume that the store could use the space made available by the dropping of groceries to expand the general merchandise department. This will increase sales by $500,000, generate a 30% contribution-margin, and have avoidable fixed costs of $70,000

Department Store Example Store as a Whole ($000) Total Before Change Drop Groceries Expand General Merchandise Total After Change Sales $1,900 $1,000 $500 $1,400 Variable expenses 1,420 800 350 970 Contribution margin $ 480 $ 200 $150 $ 430 Avoidable fixed expenses 265 150 70 185 Profit contribution to common space and other unavoidable costs $ 215 $ 50 $80 $245 Unavoidable expenses 180 0 0 180 Operating income $ 35 $ 50 $80 $ 65

Optimal Use of Limited Resources Case 3 Optimal Use of Limited Resources A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. Assume that the capacity of the facility is determined by machine time, and the maximum capacity is 10,000 machine hours The facility can produce 10 pairs of Air Court Shoes or 5 pairs of Air Max shoes per hour.

Optimal Use of Limited Resources Selling price per pair $80 $120 Variable costs per pair 60 84 Contribution margin per pair $20 $ 36 Contribution margin ratio 25% 30% Air Court Max

Optimal Use of Limited Resources Which is more profitable? If the limiting factor is demand, that is, pairs of shoes, the more profitable product is Air Max. Why?

Optimal Use of Limited Resources Air Max is the product with the higher contribution per unit. The sale of a pair of Air Court shoes adds $20 to profit. The sale of a pair of Air Max shoes adds $36 to profit.

Optimal Use of Limited Resources Suppose that demand for either shoe would fill the plant’s capacity. Now, capacity is the limiting factor. Which is more profitable? If the limiting factor is capacity, the more profitable product is Air Court. Why?

Optimal Use of Limited Resources Air Court $20 contribution margin per pair × 100,000 pairs = $2,000,000 contribution Air Max: $36 contribution margin per pair × 50,000 pairs = $1,800,000 contribution

Optimal Use of Limited Resources In retails stores, the limiting factor is often floor space. The focus is on products taking up less space or on using the space for shorter periods of time. Retail stores seek faster inventory turnover (the number of times the average inventory is sold per year).

Optimal Use of Limited Resources Faster inventory turnover makes the same product a more profitable use of space in a discount store. Retail Price $4.00 $3.50 Costs of Merchandise and other variable costs 3.00 3.00 Contribution to profit per unit $1.00 (25%) $ .50 (14%) Units sold per year 10,000 22,000 Total contribution to profit, assuming the same space allotment in both stores $10,000 11,000 Regular Department Store Discount Department Store

Case 4 Joint Product Costs Joint products have relatively significant sales values They are not separately identifiable as individual products until their split-off point. The split-off point is that juncture of manufacturing where the joint products become individually identifiable.

Joint Product Costs Separable costs are any costs beyond the split-off point. Joint costs are the costs of manufacturing joint products before the split-off point. Should Dow sell the products at the split-off point or process them further?

Joint Product Costs Suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process. The joint processing cost is $100,000. Both products are sold to the petroleum industry to be used as ingredients of gasoline.

Joint Product Costs Joint-processing cost is $100,000 1 million liters of X at a selling price of $.09 = $90,000 Joint-processing cost is $100,000 500,000 liters of Y at a selling price of $.06 = $30,000 Split-off point Total sales value at split-off is $120,000

Illustration of Sell or Process Further Suppose the 500,000 liters of Y can be processed further and sold to the plastics industry as product YA. The additional processing cost would be $.08 per liter for manufacturing and distribution, a total of $40,000. The net sales price of YA would be $.16 per liter, a total of $80,000.

Illustration of Sell or Process Further Sell at Split-off as Y Process Further and Sell as YA Difference Revenues $30,000 $80,000 $50,000 Separable costs beyond split-off @ $.08 – 40,000 40,000 Income effects $30,000 $40,000 $10,000

Equipment Replacement Case 5 Equipment Replacement

Book Value of Old Equipment Depreciation is the periodic allocation of the cost of equipment. The equipment’s book value (or net book value) is the original cost less accumulated depreciation.

Book Value of Old Equipment Suppose a $10,000 machine with a 10-year life span has depreciation of $1,000 per year. What is the book value at the end of 6 years? Original cost $10,000 Accumulated depreciation (6 × $1,000) 6,000 Book value $ 4,000

Keep or Replace the Old Machine? Original cost $10,000 $8,000 Useful life in years 10 4 Current age in years 6 0 Useful life remaining in years 4 4 Accumulated depreciation $ 6,000 0 Book value $ 4,000 N/A Disposal value (in cash) now $ 2,500 N/A Disposal value in 4 years 0 0 Annual cash operating costs $ 5,000 $3,000 Old Machine Replacement

Cost Comparison Cash operating costs $20,000 $12,000 $8,000 Old equipment (book value): Depreciation, or 4,000 – – Lump-sum write-off – 4,000 – Disposal value – (2,500) 2,500 New machine acquisition cost – 8,000 (8,000) Total costs $24,000 $21,500 $2,500 Difference Keep Replace Four Years Together

Relevance of Equipment Data A sunk cost is a cost already incurred and is irrelevant to the decision-making process. 4 commonly encountered items: Book value of old equipment Disposal value of old equipment Gain or loss on disposal Cost of new equipment

Relevance of Equipment Data The book value of old equipment is irrelevant because it is a past (historical) cost. Therefore, depreciation on old equipment is irrelevant.

Disposal Value of Old Equipment The disposal value of old equipment is relevant because it is an expected future inflow that usually differs among alternatives.

Gain or Loss on Disposal This is the difference between book value and disposal value. It is a meaningless combination of irrelevant (book value) and relevant items (disposal value). It is best to think of each separately.

Cost of New Equipment The cost of new equipment is relevant because it is an expected future outflow that will differ among alternatives.

Decision Making and Performance Evaluation Case 6 Decision Making and Performance Evaluation To motivate managers to make the right choice, the method used to evaluate performance should be consistent with the decision model. Consider the replacement decision where replacing a machine has a $2,500 advantage over keeping it.

Decision Making and Performance Evaluation Year 1 Years 2, 3, and 4 Keep Replace Keep Replace Cash operating costs $5,000 $3,000 $5,000 $3,000 Depreciation 1,000 2,000 1,000 2,000 Loss on disposal ($4,000 – $2,500) 0 $1,500 0 0 Total charges against revenue $6,000 $6,500 $6,000 $5,000

Decision Making and Performance Evaluation Performance is often measured by accounting income, consider the accounting income in the first year after replacement compared with that in years 2, 3, and 4. If the machine is kept rather than replaced, first-year costs will be $500 lower ($6,500 – $6,000), and first-year income will be $500 higher.