1. 21-1 Preview of Chapter 21 Financial and Managerial Accounting Weygandt Kimmel Kieso

2. 21-2 Management Functions

3. 21-3 Management Hierarchy

4. 21-4 Strategic decisions … big choices of identity / direction. WHO / WHAT / WHERE … Who are we? Where are we heading? Complex and multi-dimensional. Often large dollars, a long-term impact … made by senior management. Tactical decisions … manage resources to achieve strategy. HOW … What is needed? Time-frame? Distinctive, within clearer boundaries. May involve significant resources, made by senior or middle managers. Operational decisions … routine and follow known rules. DO IT … How many? To what specification? These decisions involve more limited resources, shorter-term application, made by middle or first line managers. Decisions are broadly taken at 3 levels:

5. 21-5 Programmed Decisions: routine, “automatic” process. There are rules or guidelines to follow. Ex: Deciding to reorder office supplies. Non-programmed Decisions: unusual situations that have not been often addressed. No rules to follow since the decision is new. These decisions are made based on data, info, and manger’s intuition, and judgment. Ex: Should the firm invest in a new technology? Types of Decision Making

6. 21-6 The Proces of Making (rational) Decisions

7. 21-7   Decisions involve a choice among alternative actions.   Process used to identify the financial data that change under alternative courses of action. ► ► Both costs and revenues may vary or ► ► Only revenues may vary or ► ► Only costs may vary Incremental Analysis Approach

8. 21-8 Relevant cost Revenues or Costs that DIFFER between options Option 1: Buy a Honda Civic with a GPS … $20,500 Option 2: Buy Honda Civic without GPS … $ 21,000 Relevant cost is the $500 for a GPS Important concepts - incremental analysis:

9. 21-9 Opportunity cost. - - Potential benefit lost when you choose one thing over another … the “next best choice”. Opportunity costs of going away to college – full-time - include: * wages that could have been earned, * the value of any activities missed to study, * value of items that you could have bought with tuition money. Important concepts - incremental analysis:

10. 21-10 Sunk Costs. Cost that cannot be changed or avoided by any present or future choice. Money spent on a “non-refundable deposit”. Concert tickets already bought for this weekend. Important concepts - incremental analysis:

11. 21-11

12. 21-12 1. 1.Accept an order at a special price. Types of Incremental Analysis

13. 21-13   Obtain additional business by making a major price concession to a specific customer.   Assumes that sales of products in other markets are not affected by special order.   Assumes company is not operating at full capacity. Accept an Order at a Special Price

14. 21-14 Ex: Company makes 100,000 a blenders per month (80% cap.) Variable manufacturing costs … $8 per unit. Fixed mfg costs are $400,000, … $4 per unit. Blenders normally sell to retailers … $20 each. New customer wants an additional 2,000 blenders at $11 each. (Acceptance will not affect other sales of product). What should you do? What data is relevant? Accept an Order at a Special Price

15. 21-15   Fixed costs do not change since within existing capacity – thus fixed costs are not relevant.   Variable manufacturing costs and expected revenues change – thus both are relevant to the decision. Accept an Order at a Special Price

16. 21-16 Accept or Reject? You make a product that sells for $ 42. Your costs are $ 28 per unit … ( $ 18 variable & $ 10 fixed) Foreign company offers to buy 5,000 units at $ 25 ea. You will incur additional shipping costs of $ 1 per unit. Assuming you have excess operating capacity. Should you accept or reject this special order? Accept or Reject?

17. 21-17 1. 1.Accept an order at a special price. 2. 2.Make or buy parts or finished products. Types of Incremental Analysis

18. 21-18 Ex: Your annual costs to make 25,000 switches are: Make or Buy (Outsource or not) Should you outsource (buy) the switches at $ 8 ea. “What should you do?”

19. 21-19   Total cost to “make” switch is $1 higher per unit than “buy” price.   Must absorb at least $50,000 of fixed costs under either option. Make or Buy

20. 21-20 Make or Buy – Opportunity Cost Ex: If you buy the switches, you can use the “released” capacity to generate additional income of $38,000 by making a different product. So what ? This “lost” income is an additional “cost” of making switches.

21. 21-21 In a make-or-buy decision, relevant costs are: a.Manufacturing costs that will be saved. b. The purchase price of the units. c. Opportunity costs. d. All of the above. Review Question

22. 21-22 Should you make or buy “plug-in” cords for appliances you make. Your costs of making 166,000 the cords are as follows. Direct materials … $90,000 Variable overhead … $32,000 Direct labor ……… 20,000 Fixed overhead ……. 24,000 “Make” cords cost per unit = $1.00 ea. ($166,000 ÷ 166,000) “Buy” cords cost per unit = $0.90 ea. Buying cords, eliminates all variable costs and 1/4 of the fixed costs. (a)Prepare an analysis of whether company should make or buy the cords. (b)What if the released capacity will generate additional income of $5,000?

23. 21-23 (a) Prepare an incremental analysis showing whether the company should make or buy the electrical cords. You will incur $1,400 of added costs buying vs making cords.

24. 21-24 (b) Is your answer be different if the released capacity will generate additional income of $5,000? Yes, net income is increased by $3,600 buying vs making cords.

25. 21-25 1. 1.Accept an order at a special price. 2. 2.Make or buy component parts or finished products. 3. 3.Sell or process further. Types of Incremental Analysis

26. 21-26   You have option to sell product at a given point in production or to process further and sell at a higher price.   Decision Rule: Process further as long as the incremental revenue from processing exceeds the incremental processing costs. Sell or Process Further

27. 21-27 Sell or Process Further … Single Product Ex: You make tables. Your cost to make an unfinished table is $35. The selling price per unfinished unit is $50. You have unused capacity that can be used to finish the tables and sell them at $60 per unit. Process further $: Direct materials will increase … + $ 2 Direct labor costs will increase … + $ 4. Variable overhead will increase … ?? + $ 2.40 (60% of direct labor). No increase is anticipated in fixed overhead.

28. 21-28 Should Woodmasters sell or process further. Should you sell or process further? The incremental analysis on a per unit basis is as follows. Sell or Process Further … Single Product

29. 21-29 Joint product situation for DairyCo. Cream and skim milk result from the processing of raw milk. Joint product costs are sunk costs and thus not relevant to the sell-or-process further decision. Sell or Process Further … Multiple Products

30. 21-30 Cost and revenue data per day for cream. Determine whether DairyCo should just sell the cream … or process it further into cottage cheese. Sell or Process Further … Multiple Products

31. 21-31 Marais should or should not process the cream further? Analysis of whether to sell cream or process into cottage cheese. DairyCo “should” … or … “should not” process the cream further? Sell or Process Further - Multiple Products

32. 21-32 Cost and revenue data per day for skim milk. Determine whether DairyCo should sell the skim milk or process it further into condensed milk. Sell or Process Further … Multiple Products

33. 21-33 Marais should or should not process the milk further? Analysis of whether to sell skim milk or process into condensed milk. Sell or Process Further – Multiple Products

34. 21-34 The decision rule is a sell-or-process-further decision: Process further as long as the incremental revenue from processing exceeds: a.Incremental processing costs. b. Variable processing costs. c. Fixed processing costs. d. No correct answer is given. Review Question

35. 21-35 1. 1.Accept an order at a special price. 2. 2.Make or buy component parts or finished products. 3. 3.Sell or process further them further 4. 4.Repair, retain, or replace equipment. Types of Incremental Analysis

36. 21-36 Decision: Replace old machine with new. Old machine originally cost $110,000. Book value is $40,000. It has a remaining useful life of four years ( @ depreciation rate of $70,000 per year). New machine costs $120,000. Expected salvage value after 4-year useful life is zero. New machine will decrease variable mfg costs from $640,000 to $500,000 The old machine can be sold for $5,000. Repair, Retain, or Replace Equipment

37. 21-37 Additional Considerations   Book value of old machine does not affect decision. (Book Value calculation = Asset Cost - Accumulated Depreciation) ► ► Book value is a sunk cost. ► ► Costs which cannot be changed by future decisions (sunk cost) are not relevant in incremental analysis.   However, any trade-in allowance or cash disposal value of the existing asset is relevant. Repair, Retain, or Replace Equipment

38. 21-38 Retain or Replace? Prepare the incremental analysis for the four-year period. Repair, Retain, or Replace Equipment REPLACE Machine KEEP Machine

39. 21-39 1. 1.Accept an order at a special price. 2. 2.Make or buy component parts or finished products. 3. 3.Sell or process further them further 4. 4.Repair, retain, or replace equipment. 5. 5.Eliminate unprofitable business segment or product(s). Types of Incremental Analysis

40. 21-40   Key: Focus on Relevant Costs.   Consider effect on related product lines.   Fixed costs allocated to the unprofitable segment must be absorbed by the other segments.   Net income may decrease when an unprofitable segment is eliminated.   Decision Rule: Retain the segment unless fixed costs eliminated exceed contribution margin lost. Eliminate an Unprofitable Segment

41. 21-41 Illustration: Company makes 3 models of tennis rackets:   Profitable lines: Pro and Master   Unprofitable line: Champ Should Champ be eliminated? Eliminate an Unprofitable Segment

42. 21-42 Prepare income data after eliminating Champ product line. Assume fixed costs are allocated 2/3 to Pro and 1/3 to Master. Total income is changed by $10,000. Eliminate an Unprofitable Segment

43. 21-43 Incremental analysis of Champ provided the same results: Do Not Eliminate Champ Eliminate an Unprofitable Segment

44. 21-44 If an unprofitable segment is eliminated: a.Net income will always increase. b. Variable expenses of the eliminated segment will have to be absorbed by other segments. c. Fixed expenses allocated to the eliminated segment will have to be absorbed by other segments. d. Net income will always decrease. Review Question

45. 21-45 Company makes accessories including hats and scarves. Sales of hats & scarves = 400,000, Variable expenses = 310,000, Fixed expenses = 120,000, for a net loss = 30,000. If company eliminates hats and scarves, 20,000 of fixed costs will remain. Should company eliminate hats and scarves.

46. 21-46   Potential effects of decision on existing employees and the community.   Cost of lost morale that might result.   Cost of (potentially) “lost sales”. Qualitative (vs “Quantitative”) Factors Other Considerations in Decision-Making