ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 18 Professor Jeff Yu

Review: Relevant Cost Analysis A Two-Step Process:  Step 1: Eliminate costs and benefits that DO NOT differ between alternatives. Two broad categories of costs are NEVER relevant in decision making: (1) Sunk costs; (2) Future costs that do not differ between alternatives.  Step 2: Use the remaining costs and benefits that DO differ between alternatives in making the decision.

Review: equipment replacement decision In deciding whether to replace or keep existing equipment, consider the following relevant costs:  Purchase or rental costs of new equipment  Disposal value of old equipment  Cost savings from using the more efficient new equipment instead of the old equipment

Review: Decision to Add/Drop Segments Relevant factors to consider: (1)Segment margin (2)The interaction between segments Recall: Common fixed costs are unavoidable, hence irrelevant in the decision. Traceable fixed costs are avoidable.

Review: Transfer Pricing decision Buyer: Max. transfer price = best price from outside suppliers Seller: Min. transfer price = VC per unit + Opportunity cost per unit Opportunity cost per unit = Total CM on lost sales / # of units transferred (1)If idle capacity = 0, then opportunity cost per unit = CM per unit, minimum transfer price = Market price (2) If idle capacity >= units transferred, then opportunity cost per unit = 0, minimum transfer price = VC per unit (3) If 0< idle capacity <= units transferred, then min. transfer price = w*VC per unit + (1-w)*Market price where the weight: w = idle capacity ÷ units transferred.

Similar to Transfer pricing: With ample idle capacity... Relevant costs usually will be the variable costs associated with the special order, plus any special processing cost or costs of special tools required. Without enough idle capacity... Relevant costs: the costs above, plus the opportunity cost of using the firm’s facilities for the special order. Review: Decision to Accept/Reject a Special Order

“Make or Buy” Decision The basic make-or-buy question is whether a company should make its own parts to be used in its products or buy them from vendors. DECISION RULE  Step 1: calculate the relevant costs of making each unit of the part after eliminating sunk costs and future costs that do not differ between making or buying the parts.  Step 2: Compare the unit cost calculated from step 1 with the price offered by outside suppliers. Note: watch out for any relevant opportunity costs.

Essex manufactures part 4A that is currently used in one of its products. The unit cost to make this part is: The equipment used to make part 4A has no resale value and no alternative use. General overhead is allocated regardless of Essex making or buying part 4A. The $30 total unit cost is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part. Should we accept the supplier’s offer? Practice Problem

Motor Company manufactures 10,000 units of Part M-l each year for use in its production. The following total costs were reported last year: Valve Company has offered to sell Motor 10,000 units of Part M-l for $18 per unit. If Motor accepts the offer, some of the facilities presently used to manufacture Part M-l could be rented to a third party at an annual rental of $25,000. Additionally, $4 per unit of the fixed overhead applied to Part M-l would be eliminated. Q: Should Motor Company accept Valve Company's offer, and why? Direct Materials$20,000 Direct Labor55,000 Variable MOH45,000 Fixed MOH70,000

Optimal Use of Limited Resources W We have a limited number of machine hours in which to produce our products. How much of each product should we produce? Let’s take a look at another decision faced by many firms:

A limited (constrained) resource is an item essential to production, but available only in a limited quantity. As a result, the production (or sale) of a product (or service) is constrained. When facing a limited resource constraint, the firm will maximize profit to produce the product with the highest contribution margin PER UNIT OF SCARCE RESOURCE rather than the product with the highest CM per unit. Optimal Use of Limited Resources

A company has two products: a plain cellular phone and a fancier cellular phone with many special features: PlainFancy PhonePhone Selling price $ 80 $ 120 VC per unit CM per unit CM ratio 20% 30% Suppose annual demand for phones of both types is unlimited, and managers identified labor hours to be the limited resource: only 10,000 hours are available next year. If in one hour plant workers can make either three plain phones or one fancy phone, which phone should be produced to maximize the profit? Practice Problem

Croson Co. produces 3 products with the following data: ABC price3242 VC/unit MH/unit945 Q: If machine hour is constrained and demand for all 3 products is unlimited, in which order of priority will you produce these 3 products? Practice Problem

Wood Co. produces 3 products with the following data: ABC price VC/unit LH/unit162 If only 1,800 labor hours (LH) are available next month and only 800 units of each product can be sold each month, what is the maximum amount of contribution margin that Wood Co. can generate next month? Practice Problem

Two or more products produced from a common input are called joint products. The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point. Joint costs are costs incurred up to the split-off point and are usually allocated to the end products proportionate to their sales value. Costs incurred after the point of split-off are called Separate Product Costs. Joint Products & Joint Costs

Joint Products Example Separate Processing Separate Processing Final Sale Final Sale Final Sale Joint Input Common Production Process JointCosts Oil Gasoline Chemicals Separate Product Costs Split-OffPoint

Decision: Sell or Process Further? Managers frequently face decisions of whether to sell joint products at split-off or to process some products further. The decision to process further (beyond the split-off point) should be made based on each product’s incremental costs and incremental revenues ONLY! Decision Rule: process further only when the incremental revenue from such processing exceeds the incremental processing cost incurred after the split-off point. Joint costs are irrelevant to the decision. Why?

Cocoa beans costing $500 per ton Joint Production process costing $600 per ton Cocoa butter sales value $750 for 1,500 pounds Cocoa powder sales value $500 for 500 pounds Separate process costing $800 Instant cocoa mix sales value $2,000 for 500 pounds Total joint cost: $1,100 per ton Split-off point Q: Should the cocoa powder be sold now or processed into instant cocoa mix? Practice Problem

Dodd Co. makes 2 joint products with the following data: ProductXY Allocated joint costs$14,000$21,000 Sales value at split-off point--$30,000 Costs of further processing$23,500$16,900 Sales value after further processing$45,500$47,500 Q: (1) what is the profit (loss) from processing Y further? (2) If managers decide to sell 1,000 units of product X at the split-off point, what should be the minimum selling price? Practice Problem

For Next Class  Review Present Value concepts  Start Capital Budgeting  Attempt the assigned HW problems.

WACC Co. produces 3 products with the following data: ABC Machine hours required for each unit523 Price per unit Variable cost per unit If only 1,300 machine hours are available next month and only 200 units of each product can be sold each month, what is the maximum amount of contribution margin that WACC Co. can generate next month? Homework Problem