Chapter 4 Short-Term Decision Making Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Day One Short Term Decisions – pg. 101 Cost-Volume-Profit Analysis & Breakeven point – pgs Learning Objective 2 – Explain the purpose of, and perform, cost-volume- profit (CVP) analysis

Short-Term Decisions Assume that capacity is fixed  A company cannot increase its physical capacity to operate by building new facilities, adding a shift of workers, or relocating Short-term operating decisions are ad-hoc  They cannot be planned during the normal planning process Short-term operating decisions are unique  Each decision must be analyzed as a distinct opportunity A model is a representation of reality  They help organize and sort information –decision making tools

4-4 What is the CVP Model? Cost-volume-profit model (short-term)  Use to explore relationships among costs, volumes, and profits  Valuable planning tool because management must assess whether the company can sell a given product in sufficient volume to cover the costs  Simplifies reality to make predictions without considering every factor

What is the CVP Model? (cont.) Assumptions (linear relationships)  Selling price is constant per unit sold  Variable cost is constant per unit purchased or made  Fixed cost is constant in total  Number of units produced = number of units sold  Sales mix is constant The activity driver is the number of units produced and sold

4-6 CVP Graph Breakeven point Loss area Profit area Units produced and sold $ Total Revenue Total Cost

4-7 How are the CVP Components Defined Mathematically? Total revenue – selling price * units sold  SP * Q Total cost – variable cost * units produced (purchased) + fixed costs  VC * Q + FC Breakeven – total revenue = total costs, profit=0  (SP * Q – VC * Q) – FC = 0 Where, Q = quantity produced and sold

4-8 CVP Continued Contribution margin  SP – VC  Breakeven = CM * Q – FC = 0 Target profit before taxes  CM * Q – FC = P Target profit after taxes  CM * Q – FC = P/(1 – tax rate)

4-9 Sensitivity Analysis The process of changing the key variables (but not the assumptions) in CVP analysis Change in selling price  Increase—decreases breakeven  Decrease—increases breakeven Change in variable cost  Increase—increases breakeven  Decrease—decreases breakeven Change in fixed cost  Increase—increases breakeven  Decrease—decreases breakeven Change in tax rate  No impact on breakeven

Example A certain company sells its only product for $10 per unit. The variable costs to produce the product are $3 per unit and it costs approximately $1 per unit for selling and administrative costs. The fixed costs of production re $400,000 per period while the fixed selling and administrative costs are $200,000 per period. The company is subject to a 20 percent tax rate. 4-10

Example cont. a)What is the breakeven point in units? b)What is the breakeven point in dollars? c)How many units must be sold to earn a profit of $72,000 before tax? d)How many units must be sold to earn a profit of $72,000 after tax? e)If the variable costs increase 10 percent, what increase is necessary in selling price to maintain the same breakeven point in units? f)If the fixed costs increase, what is the effect on breakeven? On contribution margin per unit? g)If the tax rate increases, what is the effect on breakeven? On contribution margin per unit? 4-11

Review Review –pages E 4.1, E 4.2, E 4.3, E 4.4, E 4.5, E 4.6, E 4.7, E 4.8, P

What are Product and Nonproduct Costs? Nonproduct costs  Incurred in connection with selling the revenue and expenditure process Associated with selling the product and administering (running) the company  Selling (marketing) costs – salaries/commissions paid to salespeople, maintaining delivery vehicles, advertising costs, etc.  Administrating costs – salaries paid to execs, rent on office space, income taxes paid on profits, etc.

4-14 What are Product and Nonproduct Costs? Product costs  Incurred in connection with the conversion process Associated with obtaining or producing the product  Merchandising firm – costs incurred to purchase and receive the product Cost of product + cost of freight + cost of insurance  Manufacturing firm – cost incurred to make the product Direct materials, direct labor, manufacturing overhead

4-15 What are the 3 Types of Product Costs? Direct materials  Cost of the primary materials  Traceable and worth the cost of tracing Direct labor  Cost of laborers making the product Manufacturing overhead  All manufacturing costs that are not classified as direct materials or direct labor  (indirect materials, indirect labor, utilities, rent, depreciation, etc)

More Costs Depreciation – When a company uses long- term assets, it must spread the cost out over the period the assets are used NOT relevant in short-term decision making Examples: Depreciation on a delivery truck used to get product to customers = selling cost Depreciation on production machinery = product cost

4-17 What are the Activity Levels Associated with Costs? Unit-related  Vary with units produced or sold Batch-related  Vary with batches (groups) regardless of the number of units in the batch Product-sustaining  Vary with the number of product lines regardless of the number of units or batches associated with the product line Facility-sustaining  Costs incurred to maintain operating capacity, these costs do not vary in the short-term

4-18 Types and Activity Levels ProductNonproduct Unit-relatedMaterialsCommissions Batch-relatedSet upsOrdering Product- sustaining Research & development Advertising Facility- sustaining Rental of equipment CEO salary

4-19 What are the 2 Characteristics of a Relevant Variable? Future  The variable must occur in the future Different  The variable must differ between the alternatives considered

4-20 Relevant Variables Continued Sunk costs  Past cost, never relevant for short-term decision making Opportunity costs  Benefits foregone, always relevant for decision making Incremental costs/revenues  Additional cost/revenue, associated with a decision, relevant if the amount differs among alternatives

Review Pages E 4.10, E 4.11, E 4.12

4-22 What are the Types of Short-Term Decisions Considered? Accept-or-reject decisions  The company must determine whether to sell products to a customer at a reduced price  Base decision on incremental profit associated with the order  Special order

4-23 What are the Types of Short-Term Decisions Considered? Make-or-buy decisions  The company must determine whether to outsource a particular activity  Base decision on cost comparison between make and buy  Outsourcing

4-24 What are the Types of Short-Term Decisions Considered? Keep-or-drop decisions  The company must determine whether to keep a seemingly unprofitable product  Base decision on revenues lost versus costs saved  Product mix

Example A company has been approached by a customer with an offer to buy 10,000 units of product but the customer wants a 25% discount off the normal selling price of $12. Unit-related cost of goods sold is $4.80 while unit-related selling costs are $1.20. To fill the customer’s order, one additional production run at a cost of $6,000 will be needed. In addition, an additional purchase order will be required at a cost of $500 and shipping to the customer will be $800. The company has the capacity to fill the customer’s order without interrupting normal sales. Should the company accept the order? 4-25

Answer AcceptReject Selling price$9 ($12 * 0.75)$0 Cost of goods sold$4.80$0 Unit selling$1.20$0 Contribution margin$3.00$0 Number of units10,0000 Total contribution margin$30,000$0 Less: production run$6,000$0 Less: purchase order$500$0 Less: shipping$800$0 Profit on order$22,

Another example Product AProduct BProduct C Sales$100,000$200,000$150,000 Cost of goods sold 60,000120,00090,000 Gross margin40,00080,00060,000 Selling and administrative 50,00060,00055,000 Product profit($10,000)20,0005,000 A merchandising company sells 3 products. A recent profit report is shown below. 4-27

Another example continued A cost analysis reveals the cost of goods sold varies proportionately with sales (60%). However, selling and administrative costs are both facility-sustaining ($120,000) and unit- related (10% of sales). The facility sustaining costs will remain regardless of what happens to these product lines. Should the company keep or drop Product A? 4-28

Answer Revenues lost if Product A is dropped: $100,000 Costs saved if Product A Is dropped: Cost of goods sold (60%) 60,000 Unit-related selling (10%) 10,000 70,000 Excess revenues lost over cost saved: $30,000 Keep Product A 4-29

Review Page 121 E 4.13, E 4.14, E 4.16