CHAPTER © jsnyderdesign / iStockphoto 8 USING ACCOUNTING INFORMATION TO MAKE MANAGERIAL DECISIONS

8 GOOD NEWS, BAD NEWS FOR C&C ► CISD wants 1,000 standard practice jerseys, with a couple of special modifications ► Bonadeo Embroidery wants to supply chenille letters at a low cost ► There are problems with the jersey fabric order at Bradley Textile Mills ► It looks like some sales territories are losing money and might need to be shut down What’s the real story on these issues?

IDENTIFYING RELEVANT INFORMATION Unit Unit 8.2Unit 8.3 © Tomwang112 / iStockphoto Unit 8.4 Unit 8.5

8 WHAT IS RELEVANT INFORMATION? ► Information that is directly related to the decision being made ► Information about something that will happen in the future ► Information that differs between alternatives

8 LET’S IDENTIFY RELEVANT INFORMATION AccordMazda 6Relevant? MSRP$25,405$23,370 MPG, City2721 MPG, highway3630 Warranty 36,000 miles, 36 months 36,000 miles, 36 months Leg room (front)42.5” Trunk capacity15.8 ft ft 3 ✖ ✖ ✔ ✔ ✔ ✔

8 SO WHEN IS A COST RELEVANT?

8 IMPORTANT TERMS TO KNOW ► Avoidable cost Cost associated with a particular alternative that will be eliminated if alternative is eliminated ► Unavoidable cost Cost that will continue regardless of the alternative selected

8 LET’S PRACTICE Is it cheaper to drive or to fly? You are getting ready to take a 500-mile trip and are trying to decide whether to drive or fly. You know that it costs you $1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just gotten wind of a special $65 round trip airfare.

8 LET’S PRACTICE Cost to DriveCost to Fly 500 $0.10/mile = $50$65 You are getting ready to take a 500-mile trip and are trying to decide whether to drive or fly. You know that it costs you $1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just gotten wind of a special $65 round trip airfare. But, that comparison includes irrelevant costs…

8 WATCH OUT FOR SUNK COSTS ► Sunk costs are NEVER relevant to a decision ► These costs have been incurred in the past and nothing you can do today can change them

8 A RELEVANT COST DECISION MODEL ► Identify the decision ► Identify the alternatives ► Identify the relevant revenues and costs ► Identify the qualitative issues to consider ► Identify the alternative with the greatest benefit or least cost

SPECIAL ORDER PRICING Unit Unit 8.2 Unit 8.3 © Tomwang112 / iStockphoto Unit 8.4 Unit 8.5

8 SPECIAL ORDER PRICING DECISIONS ► Sometimes a company may get an order from a customer asking for a “special price” that is less than the stated selling price ► Could be a grocery chain approaching Kleenex maker Kimberly-Clark to produce a “private label” facial tissue ► Sometimes the price requested appears to be less than the full product cost

8 WHY ACCEPT SPECIAL ORDER PRICING? ► For product made to customer specs ► For unusual order (quantity, packaging, means of delivery, etc.) ► For one-time job ► To utilize idle production facilities

8 QUALITATIVE ISSUES TO CONSIDER ► What precedent does this special order set for future jobs? ► How will regular customers react? ► Is there enough capacity to produce the order without reducing normal production?

8 What costs are relevant? Should Coopersmith accept the special order? Fixed costs will not change with the special order. Accepting the special order will result in an extra $80,000 in contribution ($8/barrel x 10,000 barrels), so ACCEPT IT! DM$5 DL2 VOH3 FOH9 $19 AN EXAMPLE… Coopersmith produces premium wooden barrels. A one liter barrel sells for $25, but a fancy Swiss ski resort has offered to buy 10,000 barrels for $18 each for its St. Bernard patrol. The barrel has the following product costs, based on annual production of 30,000 barrels: DM$5 ✔ DL2 ✔ VOH3 ✔ FOH9 ✖ $19$ 10

8 Assume that the ski lodge requires special packaging that will cost Coopersmith $2 per barrel. Should Coopersmith accept the special order? DM$5 ✔ DL2 ✔ VOH3 ✔ FOH9 ✖ $19$ 10 VS&A2 ✔ $ 12 DM$5 ✔ DL2 ✔ VOH3 ✔ FOH9 ✖ $19$ 10 VS&A2 ✔ $ 12 AN EXAMPLE… Coopersmith produces premium wooden barrels. A one liter barrel sells for $25, but a fancy Swiss ski resort has offered to buy 10,000 barrels for $18 each for its St. Bernard patrol. The barrel has the following product costs, based on annual production of 30,000 barrels: Additional variable costs of $2/barrel will be incurred, thus the relevant cost per barrel is $12. The special order will result in an extra $60,000 in contribution margin: ($6/barrel x 10,000 barrels) ACCEPT IT!

8 RECAP OF SPECIAL ORDER PRICING ► Decision: Should we accept an order at a price less than normal selling price? ► Factors: differential income for the order ► Qualitative issues: affect on regular sales, expectation of continued special treatment ► Watch out: unavoidable fixed costs ► Decision Rule: as long as the special order covers differential costs and provides profit, accept the order

OUTSOURCING Unit Unit 8.2 Unit 8.3 © Tomwang112 / iStockphoto Unit 8.4 Unit 8.5

8 WHAT IS OUTSOURCING? ► Moving production outside the organization ► Offshoring is moving production to a foreign country (It may or may not be outsourcing) ► Outsourcing is a big trend in business today ► Sometimes referred to as a “make-or-buy” decisions (Do I make a component myself, or do I but it already fabricated from someone else?)

8 WHAT COSTS ARE RELEVANT? ► Price we have to pay to buy the component ► All avoidable costs we would incur to make the component ► Watch out for fixed overhead per unit; it may or may not be avoidable

8 DM$3 DL4 VOH1 FOH6 $14 Which costs are relevant? AN EXAMPLE… Thomas Company makes bicycles. It has always made its own tires but has recently received a bid from Tiny Tires, Inc. to supply the tires for $12 each. Thomas’s tire costs are shown below. Of the fixed overhead, 40% is related to plant occupancy costs that will continue even if tires are purchased from Tiny. Should Thomas make or buy the 5,000 tires it needs?

8 Which costs are relevant? DM$3 ✔ DL4 ✔ VOH1 ✔ FOH6 ✔ But only $3.60 $14 DM$3 DL4 VOH1 FOH6 $14 AN EXAMPLE… Thomas Company makes bicycles. It has always made its own tires but has recently received a bid from Tiny Tires, Inc. to supply the tires for $12 each. Thomas’s tire costs are shown below. Of the fixed overhead, 40% is related to plant occupancy costs that will continue even if tires are purchased from Tiny. Should Thomas make or buy the 5,000 tires it needs? So, the relevant cost to make a tire is only $11.60 $ 11.60

8 WHAT ABOUT OPPORTUNITY COSTS? ► Opportunity costs of using our facilities may be relevant ► What alternative uses of the capacity exist? ► Can we generate additional income by using the freed up facilities in some way?

8 WHAT IF… Suppose that if Thomas Company buys tires from Tiny, it could use the freed up manufacturing capacity to produce a new line of tricycles. The new tricycles are expected to generate $6,000 in net income. Should Thomas make or buy the 5,000 tires it needs? MakeBuy $11.60 × 5,000 = $58,000 $58,000 $12 x 5,000 = $60,000 Less new income ($6,000) $54,000

8 QUALITATIVE FACTORS TO CONSIDER… ► Relative net advantage given uncertainty of estimates (costs, risks, etc.) ► Reliability and number of sources of supply ► Ability to assure quality ► Future bargaining position with suppliers ► Perceptions regarding possible future price changes

8 RECAP OF OUTSOURCING DECISION ► Decision: Do you make a component in house or buy it from an outsider? ► Factors: avoidable costs to make, purchase price, alternative uses of facility ► Qualitative issues: supplier reliability and quality, theft of intellectual property, transfer or technological risk ► Watch out: non-differential fixed costs ► Decision Rule: If purchase price is less than avoidable costs, buy from outside

ALLOCATING CONSTRAINED RESOURCES Unit Unit 8.2Unit 8.3 Unit 8.4 © Tomwang112 / iStockphoto Unit 8.5

8 CONSTRAINED RESOURCE ALLOCATION ► Most businesses face some constraint in terms of available resources ► We need a way to decide how to allocate those scarce resources across the business ► Focus on the highest contribution margin per unit of scarce resource

8 BannersKites Sales Price$ 12$ 15 Variable Costs$ 9$ 14 CM/unit$ 3 $ 1 Machine hours/unit1 hour0.25 hour CM/machine hour$ 3 $ 4 BannersKites Sales Price$ 12$ 15 Variable Costs$ 9$ 14 CM/unit$ 3 $ 1 AN EXAMPLE (Exercise 8-14) Wendy’s Windy Things manufactures kites and banners. This month Wendy has orders for 3,000 Valentine banners and Easter 1,200 kites. Wendy only has 1,000 sewing machine hours available.

8 WHAT SHOULD WENDY PRODUCE? 1.As many kites as she can sell 1000 kites x.25 hours = 250 hours How many hours are left? 1,000 – 250 = 750 hours 2.Produce as many banners as she can with remaining hours X banners x 1 hour = 750 hours X = 750 banners

8 RECAP OF CONSTRAINED RESOURCE ALLOCATION DECISION ► Decision: How should we allocate a scarce resource across all products? ► Factors: scarce resource, CM per unit of scarce resource, demand for products ► Qualitative factors: customer preferences for products, customer service issues ► Watch out: CM per unit of product ► Decision Rule: Make the product with the highest contribution margin per unit of scarce resource

KEEPING OR ELIMINATING OPERATIONS Unit Unit 8.2Unit 8.3Unit 8.4 © Tomwang112 / iStockphoto Unit 8.5

8 MAKING THE OPERATIONS DECISION ► How do we know when to add or drop a portion of operations? ► Decision should be based on relevant costs of those operations ► A lot of costs that a company incurs support the entire company, not a specific segment; these common costs are often allocated to segments and are the ones that cause the problems

8 WHAT IS RELEVANT TO THE DECISION? ► All direct costs associated with the segment Variable costs Direct avoidable fixed costs ► Calculate the segment margin Revenues – Variable Costs – Avoidable Fixed Costs ► Watch out for allocated common fixed costs

8 TOTALSDept. ADept. BDept. C Sales$ 65,000$20,000$15,000$30,000 COGS Variable29,0004,00010,00015,000 Direct Fixed9,0002,0001,0006,000 S, G, & A Variable9,0002,0004,0003,000 Direct Fixed4,0001,0002,0001,000 Common FC13,0004,0003,0006,000 Net Income$ 1,000$ 7,000$ (5,000)$ (1,000) AN EXAMPLE… If we eliminate departments B and C, what revenues and costs will disappear?

8 AN EXAMPLE… TOTALSDept. ADept. BDept. C Sales$ 65,000$20,000$15,000$30,000 Variable COGS29,0004,00010,00015,000 S, G, & A9,0002,0004,0003,000 Product CM27,00014,0001,00012,000 Avoidable FC COGS9,0002,0001,0006,000 S, G, & A4,0001,0002,0001,000 Segment Margin$ 14,000$ 11,000 $ (2,000)$ 5,000 Department C is contributing $5,000 in segment margin to cover common fixed costs. Do not drop this department.

8 RECAP OF PRODUCT LINE DECISION ► Decision: Should we keep an existing segment that appears to have a net loss? ► Factors: contribution margin, segment margin, direct fixed costs ► Qualitative issues: customer relations, preferences ► Watch out: allocated common fixed costs ► Decision Rule: If segment margin is positive, keep the segment