4-1 Contribution Analysis for Decision Making C hapter 4 Prepared by Douglas Cloud Pepperdine University

4-2 1.Differentiate between relevant and irrelevant revenues and costs. 2.Organize relevant costs in a manner that clearly indicates how they differ under separate decision alternatives. 3.Discuss issues involved in predicting relevant costs. ObjectivesObjectives After studying this chapter, you should be able to: ContinuedContinued

4-3 4.Apply differential analysis to evaluate a variety of decision alternatives, including whether to make multiple changes in plans; to accept a special order; to make, buy, or outsource a product or service; or to sell a product or process further. 5.Determine how to allocate limited resources for the purpose of maximizing short-run profit. ObjectivesObjectives

4-4 Identifying Relevant Costs Costs and revenues that differ among decision alternatives Compare to indicate how they differ under each alternative Sunk costs are never relevant Focus on costs that differ among decision alternatives Organize them in a manner that clearly indicates how they differ under each alternative

4-5 Ace Welding Company Example Ace Welding Company manufacturers frames for Mountain and Touring bicycles. Mountain bicycle frames sell for $20 each, and Touring bicycle frames sell for $15 each. Annual production and sales total 10,000 Mountain bikes and 11,000 Touring bikes.

4-6 Ace Welding Company Example Unit Cost—Mountain Bicycle Unit level: Direct materials$3.00 per unit Conversion$5.00 per unit Selling and distribution$1.00 per unit Batch level: Inspection and adjustment$500 per batch (1,000 per batch)

4-7 Ace Welding Company Example Unit Cost—Touring Bicycle Unit level: Direct materials$2.50 per unit Conversion$3.50 per unit Selling and distribution$0.75 per unit Batch level: Inspection and adjustment$400 per batch (1,000 per batch)

4-8 What are conversion costs? All direct labor and variable manufacturing overhead required to convert raw materials into finished goods.

4-9 Ace Welding Company Example The Model I welding machine used in the manufacture of Mountain bicycle frames is two years old and has a remaining useful life of four years. It cost $90,000 when new and has an estimated salvage value of zero dollars. It has a current disposal value of $35,000.

4-10 Management is evaluating the desirability of replacing the Model I with a new Model II welding machine. The new machine cost $80,000, has a useful life of four years, and a predicted salvage value of zero. Ace Welding Company Example The new machine is expected to have a conversion cost of $4.00 per unit; inspection and adjustment cost are expected to be $300 per batch of 2,000; machine maintenance is expected to be $200 per year.

4-11 What is relevant?   Future revenues which are inflows of resources from the sale of goods or services are relevant if they differ between alternatives.   Outlay costs that require future expenditures of cash or other resources are relevant if they differ between alternatives.   Sunk cost are never relevant!   Disposal and salvage values may be relevant. Book value of the old assets is never relevant (expected tax reduction would be relevant).

4-12 Buy Model IIKeep Model I Total revenue$1,460,000$1,460,000 Mountain (10,000 x $20 x 4)$ 800,000 Touring (11,000 x $15 x 4) 660,000 Total$1,460,000 Both options are the same, so “Total revenue” is not relevant. Differential Analysis

4-13 Buy Model IIKeep Model I Direct materials $330,000$330,000 Mountain (10,000 x $3 x 4)$120,000 Touring (11,000 x $2.50 x 4) 110,000 Total$330,000 Differential Analysis Both options are the same, so “Direct materials” costs are not relevant.

4-14 Keep Model IBuy Model II 10,000 x $4 x 4 Conversion costs are relevant. 10,000 x $5 x 4 Differential Analysis Conversion $160,000$200,000

4-15 Buy Model IIKeep Model I Conversion $160,000$200,000 Inspection and adjustment6,00020,000 Inspection and adjustment costs are relevant. Differential Analysis 5 x $300 x 410 x $500 x 4

4-16 Buy Model IIKeep Model I Conversion $160,000$200,000 Inspection and adjustment6,00020,000 Machine maintenance8009,600 Machine maintenance costs are relevant. Differential Analysis $200 x 4$200 x 12 x 4

4-17 Buy Model IIKeep Model I Conversion $160,000$200,000 Inspection and adjustment6,00020,000 Machine maintenance8009,600 Disposal of Model I(35,000) Disposal value of Model I is relevant to “buying the new machine.” Differential Analysis

4-18 Buy Model IIKeep Model I Conversion $160,000$200,000 Inspection and adjustment6,00020,000 Machine maintenance8009,600 Disposal of Model I(35,000) Cost of Model II80,000 Differential Analysis

4-19 Buy Model IIKeep Model I Conversion $160,000$200,000 Inspection and adjustment6,00020,000 Machine maintenance8009,600 Disposal of Model I(35,000) Cost of Model II 80,000 Total costs$211,800$229,600 Differential Analysis Advantage of replacement, $17,800

4-20 Advantages of Differential Cost Analysis Focusing on only those items that differ provides a clearer picture of the impact of the decision at hand. Because a differential analysis contains fewer items, it is easier and quicker to prepare. In complex situations, it is difficult to develop complete firm-wide statements to analyze all decision alternatives.

4-21 Cost Prediction Error What is a cost prediction error? It is the difference between a predicted future cost and the actual amount of the cost when it is incurred.

4-22 Differential Cost Analysis Mind Trek, Limited manufactures an electronic game sold for £22 per unit. Variable Costs per Unit Direct materials£ 5 Direct labor3 Manufacturing overhead2 Selling 2 Total£12 Direct materials£ 5 Direct labor3 Manufacturing overhead2 Selling 2 Total£12 Fixed Costs per Month Manufacturing overhead£30,000 Selling and administrative15,000 Total£45,000 Manufacturing overhead£30,000 Selling and administrative15,000 Total£45,000

4-23 Differential Cost Analysis Alternative Action #1: Increase the monthly advertising budget by £4,000, which should result in a 1,000 unit increase in monthly sales. Alternative Action #2: Increase the selling price by £3, which should result in a 2,000 unit decrease in monthly sales. Alternative Action #3: Decrease the selling price by £2, which should result in a 2,000 unit increase in monthly sales. However, the last 1,000 units would be produced during overtime, resulting in the direct labor cost increasing by £1 per unit.

4-24 Current Income Statement for Mind Trek, Limited Sales (5,000 units x £22)£110,000 Less variable costs: Direct materials (5,000 units x £5) £25,000 Direct labor (5,000 units x £3)15,000 Manufacturing overhead (5,000 x £2)10,000 Selling and administrative (5,000 x £2) 10,000(60,000) Contribution margin £ 50,000 Less fixed costs: Manufacturing overhead £30,000 Selling and administrative15,000 (45,000) Profit £ 5,000 Alternative Action #1: Increase the monthly advertising budget by £4,000, which should result in a 1,000 unit increase in monthly sales. Differential Cost Analysis

4-25 Restated Income Statement for Mind Trek, Limited Sales (6,000 units x £22)£132,000 Less variable costs: Direct materials (6,000 units x £5) £30,000 Direct labor (6,000 units x £3)18,000 Manufacturing overhead (6,000 x £2)12,000 Selling and administrative (6,000 x £2) 12,000 (72,000) Contribution margin £ 60,000 Less fixed costs: Manufacturing overhead £30,000 Selling and administrative19,000 (49,000) Profit £ 11,000 Differential Cost Analysis

4-26 A More Direct Approach Profit increase from increased sales: (1,000 additional unit sales x contribution margin of £10 per unit)£10,000 Profit decrease from increased advertising expenditures(4,000) Increase in monthly profit £ 6,000 Differential Cost Analysis

4-27 Alternative Action #2: Increase the selling price by £3, which should result in a 2,000 unit decrease in monthly sales. Differential Cost Analysis

4-28 Direct Approach Profit decrease from reduced sales: (2,000 lost unit sales x contribution margin of £10 per unit)£(20,000) Profit increase from increased selling price ([5,000 old unit sales - 2,000 lost unit sales] x £3 increase in unit selling price) 9,000 Decrease in monthly profits £(11,000) Differential Cost Analysis

4-29 Alternative Action #3: Decrease the selling price by £2, which should result in a 2,000 unit increase in monthly sales. However, the last 1,000 units would be produced during overtime, resulting in the direct labor cost increasing by £1 per unit. Differential Cost Analysis

4-30 Profit increase from increased sales if there were no changes in prices or costs: (2,000 increased unit sales x contribution margin of £10 per unit) £20,000 Profit decrease from reduced selling price ([5,000 old unit sales + 2,000 additional unit sales] x £2 decrease in unit selling price) (14,000) Profit decrease from increased direct labor cost of the last 1,000 units (1,000 units x £1 increase in unit direct labor costs) (1,000) Increase in monthly profits £ 5,000 Differential Cost Analysis Direct Approach

4-31 Special Orders A Brazilian distributor offers to place a special, one-time order for 1,000 units next month at a reduced price of £12 per unit. There will be no order-level costs. Mind Trek has sufficient production capacity to produce the additional units without reducing sales to the discount chain.

4-32 Increase in revenues (1,000 units x £12) £12,000 Increase in costs: Direct materials (1,000 x £5) £5,000 Direct labor (1,000 units x £3)3,000 Variable manufacturing overhead (1,000 units x £2) 2,000(10,000) Increase in profits £ 2,000 Accept the order Special Orders

4-33 What if the Brazilian distributor wanted Mind Trek to sign a multiyear contract to provide 1,000 units per month at £12 each? Direct materials £ 5.0 Direct labor3.0 Variable manufacturing overhead2.0 Variable selling and administrative2.0 Fixed manufacturing overhead (£30,000/6,000 units)5.0 Fixed selling and administrative ( £ 15,000/6,000 units) 2.5 Average full cost per unit £19.5 Importance of Time Span

4-34 Opportunity Costs What if Mind Trek were operating at capacity? Each unit sold to the Brazilian distributor could generate a £10 contribution from regular customers. Lost sales to regular customers (units) 1,000 Regular unit contribution margin x 10 Opportunity cost of accepting the special order £10,000 Because this opportunity exceeds the £2,000 contribution derived from the special order, management should reject the special order.

4-35OutsourcingOutsourcing Management no longer has to worry that invoices were sent out on time. Because of higher capacity, the external service provider eliminated delays in processing transactions. Vendor’s state-of-the-art system and experienced staff was able to inexpensively develop specialized reports. Med Resorts’ Unexpected Benefits Continued

4-36OutsourcingOutsourcing Med Resorts no longer needed to invest in software and hardware for billing and collections, not in related employee training. The improved performance of the accounts receivable portfolio and the investor contacts provided by the vendor enables Med Resorts to obtain more favorable financing. Med Resorts reduce the “hassles” that occasionally arise when dissatisfied customers refuse to pay their bills. Med Resorts’ Unexpected Benefits

4-37 Make or Buy? A Canadian manufacturer offers a one-year contract to supply Mind Trek with an electronic component at a cost of £2 per unit. If Mind Trek accepts the offer, it will be able to reduce: Material costs by 10 percent per unit Direct labor and variable factory overhead costs by 20 percent per unit. Fixed manufacturing overhead by £20,000 per year.

4-38 Make Buy Cost to buy (£2 x 5,000 x 12 months)£120,000 Cost to make: Direct materials (£5 x 0.10 x 60,000)£ 30,000 Direct labor (£3 x 0.20 x 60,000)36,000 Variable manufacturing overhead (£2 x 0.20 x 60,000)24,000 Fixed manufacturing overhead 20,000 Total£110,000£120,000 Advantage of making = £10,000 Make or Buy?

4-39 A Canadian manufacturer offers a one-year contract to supply Mind Trek with an electronic component at a cost of £2 per unit. What if the space currently used to manufacture the electronic component can be rented to a third party for £40,000 per year? Make or Buy?

4-40 Make Buy Cost to buy (£2 x [5,000 x 12 months)£120,000 Cost to make: Direct materials (£5 x 0.10 x 60,000)£ 30,000 Direct labor (£3 x 0.20 x 60,000)36,000 Variable manufacturing overhead (£2 x 0.20 x 60,000)24,000 Fixed manufacturing overhead 20,000 Opportunity cost of lost rent income 40,000 Total£150,000£120,000 Advantage of buying = £30,000 Make or Buy?

4-41 Sell or Further Process? Boston Rocking Company manufactures rocking chairs. Although the chairs are salable once assembled, Boston Rocking sands and paints all chairs before they are sold. Management wishes to know if this is the optimal selling point.

4-42 Per Chair Sell Sell After After Assembly Painting Selling price$40$75 Assembly costs(25)(25) Sanding and painting 0(12) Contribution margin$15$38 Advantage of painting, $23 Sell or Further Process?

4-43 Differential Analysis Increase in revenues: Sell after painting$75 Sell after assembly(40)$35 Additional costs of sanding and painting(12) Advantage of sanding and painting$23 Sell or Further Process?

4-44 Opportunity Cost Revenue after painting$75 Additional costs of sanding and painting$12 Opportunity cost of not selling after assembly40(52) Advantage of sanding and painting$23 Sell or Further Process?

4-45 Best Use of Limited Resources Delta Manufacturing Company produces three products: A, B, and C. A limitation of 120 machine hours for machine Z1 per week prevents Delta from meeting sales demand for these products. Which of the three products should Delta use machine Z1 to manufacture?

4-46 A B C Unit selling price$100$80 $50 Unit variable costs 90(50)(25) Unit contribution margin$ 10$30$25 At this point it appears that producing B is the best use of limited resources (machine hours of machine Z1) Best Use of Limited Resources

4-47 Machine hours per unit  2  2  1 Contribution margin per machine-hour$5$15$25 BEST Best Use of Limited Resources A B C Unit selling price$100$80 $50 Unit variable costs 90(50)(25) Unit contribution margin$ 10$30$25

4-48 BEST Click here for more proof Machine hours per unit  2  2  1 Contribution margin per machine-hour$5$15$25 Best Use of Limited Resources A B C Unit selling price$100$80 $50 Unit variable costs 90(50)(25) Unit contribution margin$ 10$30$25

4-49 Theory of Constraints   Management should identify the bottlenecks.   Management should schedule production to maximize the efficient use of the bottleneck resource.   Management should schedule production to avoid a buildup of inventory.   Management should work to eliminate bottlenecks.

4-50 Measure the utilization of bottleneck resources. Measure factory throughput. Not encourage the full utilization of nonbottleneck resources. Discourage the buildup of excess inventory. To support the theory of constraints, performance reports should: Theory of Constraints

4-51 Martin Company produces two products, A and B, in two departments, Assembly and Finishing. Product A has a unit contribution margin of $50, and product B has a unit contribution margin of $40. The demand for each product exceeds Martin’s capacity to produce. Pertinent Information Labor Hours per Unit Total Labor Hours Available per Week A B Assembly Department Finishing Department Linear Programming

B (units) | | | | | | A (units) Assembly Department constraint Finishing Department constraint Raw materials constraint Feasibility region Linear Programming

B (units) | | | | | | A (units) Feasibility region The “corners” Linear Programming

4-54 Optimal solution Recall that the contribution margins for A and B are $50 and $40, respectively. Value of Value of Objective Function Corner A B $50A + $40B = 100$ , , , ,000 Linear Programming

B (units) | | | | | | A (units) Feasibility area Optimal solution Linear Programming

4-56C hapter 4 The End

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4-58 Highest Selling Price Highest Contri- bution per Unit Highest Contri- bution per Unit of Constrain- ing Factor Machine hours available Machine hours per unit  2  2  1 Weekly production in units Unit contribution marginx $10x $30x $25 Total weekly contribution margin$600$1,800$3,000 Return