Fundamentals of Cost Analysis for Decision Making

Fundamentals of Cost Analysis for Decision Making
Now that you are comfortable with CVP analysis and the impact of fixed versus variable costs, we can extend the concepts and apply the theories to a multitude of business conditions. Chapter 4 McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives: 1. Use differential analysis to analyze decisions. 2. Understand how to apply differential analysis to pricing decisions. 3. Understand several approaches for establishing prices based on costs for long-run pricing decisions. This chapter begins by discussing differential analysis and then presents conditions that are conducive to the model. Most of us use differential analysis on a daily basis without even knowing we are implementing a management tool! 4. Understand how to apply differential analysis to production decisions. 5. Understand the theory of constraints. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Differential Analysis
LO1 Use differential analysis to analyze decisions. Differential Analysis The process of estimating revenues and costs of alternative actions available to decision makers and of comparing these estimates to the status quo. Short Run Now that you see the value of CVP analysis for decision-making, let’s move on to other decisions. In Chapter 1 we discussed differential costs and differential revenues. Today every decision that a manager makes requires comparing one or more proposed alternatives with the status quo. Differential analysis is the process of estimating revenues and costs of alternative actions and comparing these estimates to the status quo. Differential analysis is used for both short run decisions and long-run decisions. Short run is defined as the period over which capacity will be unchanged. The period of time over which capacity will be unchanged, usually one year. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Differential Costs Costs that change in response to an alternative course of action. Differential costs differ between actions. Remember from Chapter 1, differential costs differ between actions. In Chapter 1 Carmen was trying to decide whether she should expand her cookie operations or not. In Chapter 1 you looked at Carmen’s differential revenues and differential costs to determine if it was beneficial for Carmen to expand. If a cost is differential, or differs between alternatives, it is relevant to the decision making analysis. Differential costs are sometimes called relevant costs. If the cost does not differ between alternatives it is not relevant to the decision making analysis. Alternative A Alternative B McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Sunk Costs Costs incurred in the past that cannot be changed by present or future decisions. IT’S GONE TOO BAD An important category of cost to identify when making decisions includes costs that were incurred in the past and cannot be changed regardless of the decision made. These costs are called sunk costs and are not relevant for a decision. SO SAD A sunk cost is NOT relevant for making decisions. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Differential Analysis and Pricing Decisions
LO2 Understand how to apply differential analysis to pricing decisions. Variable costs Must always be covered. Fixed costs Differential analysis is useful for many decisions that managers make about pricing because it provides information about the likely impact of these decisions on profit. Variable costs must always be covered and fixed costs must be covered in the long run. Must be covered in the long run. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Full Cost and Pricing Decisions
Full cost of manufacturing and selling a product. Variable costs Necessary to manufacture and sell the product. and Fixed costs Variable costs are the costs necessary to manufacture and sell the product. Fixed costs relate to the capacity of the organization. The full cost of the product includes the variable cost necessary to make the product and the product’s share of the organization’s fixed cost. Share of organization’s fixed costs. Ultimately full costs must be recovered. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Short-run vs Long-run Variable costs Must always be covered. Must be included in both Short and Long-run Pricing Decisions Fixed costs Variable costs must always be covered and are critical for short run pricing decisions. Fixed cost must ultimately be recovered and impact long-run pricing decisions. Must be covered in the long run. Long-run Pricing Decisions McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Short-run vs Long-run Pricing Decisions
Year 1 Short-run Pricing Decision Long-run Pricing Decision Shorter than one year Longer than one year Pricing a one-time special order. Pricing a new product. For example, if a manager is pricing a one-time special order he asks: How much material is required for the order? But if the manager is pricing a new product he asks: Do I need a new plant? How much material is required? Do I need a new plant? McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Short-run Pricing Decisions:Special Orders
An order that will not affect other sales and is usually a one-time occurrence. Value of Option 1 Accept Special Order? Is Option > Option 2? Status Quo: Reject special offer Alternative: Accept special offer Value of Option 2 Option 1 Option 2 A special order is in order that will not affect other sales and is usually a onetime occurrence. The manager has two alternatives. One alternative is to reject the special order and maintain the status quo. Another alternative is to accept the special order. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Special Order
Analysis of Special Order U-Develop Status Quo: Alternative: Reject Special Order Accept Special Order Difference Comparison of Totals Variable costs (1,000) (1,100) (100) Fixed costs (1,200) Operating profit $300 $400 $100 Sales revenue $2,500 $2,700 $200 Total contribution $1,500 $1,600 Back to U-Develop. The art teacher at the local high school asks U-Develop to allow students in the photography club to print 500 images for a special price of $.40 a print. U-Develop has idle capacity. This means that U-Develop has no additional long run costs associated with the special order. The special order is a short run pricing decision based on differential cost. The differential cost associated with the special order are the variable costs of the prints. Variable costs of the prints are $.20 per unit. A sales price of $.40 per unit minus variable costs of $.20 per unit results in an increase in operating profit before taxes of $.20 per unit, or $100 for 500 units. Notice the fixed costs of $1,200 to not change between alternatives. Alternative Presentation: Differential Analysis Differential operating profit (before taxes) $100 Differential sales, 500 at 40¢ $200 Less differential costs, 500 at 20¢ 100 McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Cost Analysis for Pricing
LO3 Understand several approaches for establishing prices based on costs for long-run pricing decisions. In the long run an organization must cover all variable and fixed costs – both manufacturing and selling. Life-cycle product costing and pricing In the long run an organization must cover variable and fixed cost. We will look at life-cycle and target costing. Target costing for Target pricing McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Life-cycle Product Costing and Pricing
Product life-cycle The time from initial research and development to the time that support to the customer ends. R&D Design Manufacturing Marketing Distribution & Customer Service (Disposal) Take Back Cradle Grave To Product life-cycle is the time from initial research and development of the product to the time that support to the customer ends and the product is disposed of. Life-cycle costing is concerned with covering costs in all categories of the lifecycle. To be profitable, companies must generate enough revenue to cover costs incurred in all categories of the value chain. Life-cycle Costing Concerned with covering costs in all categories of the life cycle. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Target Costing from Target Pricing
Target price: The price based on customers’ perceived value for the product and the price that competitors charge. What would a customer pay? How much profit do I need? Can I make it at this cost? Target costing is the concept of “price-based costing” instead of “cost-based pricing.” A target price is the estimated price for a product or service that potential customers will be willing to pay. A target cost is the estimated long-run cost of a product or service whose sale enables the company to achieve a targeted profit. Desired profit Target cost Target price McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Other Costing Issues Predatory Pricing: Practice of setting price below cost with the intent to drive competitors out of business. Dumping Exporting a product to another country at a price below domestic cost. Price Discrimination Practice of selling identical goods to different customers at different prices. Peak-load Pricing Practice of setting prices highest when the quantity demanded for the product approaches capacity. There are many issues related to pricing products. Some are legal and fair, some legal and unethical, others are illegal yet ethical, and several are both illegal and unethical. A few are mentioned in this chapter. These include, predatory pricing, dumping, price discrimination, peak-load pricing, and price fixing. Price Fixing Agreement among businesses to set prices at a particular level. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Differential Analysis for Production Decisions
LO4 Understand how to apply differential analysis to production decisions. Make or buy? Decision to make goods or services internally or purchase them externally. Add or drop a segment? Decision to add or drop a product line or close a business unit. We now apply our cost analysis concepts to production and operating decisions. Typical production and operating questions that managers often ask are: Should we make the product internally or buy it from an outside source? Should we add to or drop parts of our operations? Which products should we continue to produce and which should we drop? To make these decisions, the manager asks what costs and revenues will differ as a result of the choices made and which course of action would be the most profitable for the company? Product choice Decision on what products or services to offer (Product Mix). McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Make or Buy Decision to make goods or services internally or externally. Make or buy? Per Unit 100,000 prints Cost directly traceable Direct materials $0.05 $5,000 Direct labor 0.12 12,000 Variable manufacturing overhead 0.03 3,000 A make-or-by decision is any decision by a company to acquire goods or services internally or externally. The make-or-by decision is often part of the Company’s long-run strategy. Whether to rely on outsiders for a substantial amount of materials depends on both differential cost comparisons and other factors that are not easily quantified, such as suppliers’ dependability and quality control. Let’s look at U-Develop’s cost to develop prints from film (nondigital) cameras. The current cost of developing 100,000 prints is $34,000. Costs directly traceable to the prints include direct materials, direct labor, variable manufacturing overhead and $4,000 of fixed manufacturing overhead. Costs not directly traceable, common costs, of $10,000, are allocated to the cost of the prints. The full cost of processing prints is $.34 per unit ($34,000 /100,000 units). Fixed manufacturing overhead 4,000 Common costs allocated to this product line 10,000 $34,000 McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Make or Buy, Continued. . . U-Develop 100,000 Prints Process Prints Outsource Processing Difference Direct Costs Direct Materials $5,000 $25,000a $20,000 Higher Labor 12,000 -0- Lower Variable Overhead 3,000 Fixed Overhead 4,000 Common Costs 10,000b Total Costs $34,000 $35,000 $1,000 U-Develop has received an offer from an outside developer to process prints for $.25 each. Differential cost, those costs that will differ between alternatives, the status quo and outsourcing, are materials, labor and variable overhead. These costs will be saved by outsourcing the processing of the prints. The direct fixed cost is the cost of leasing the machine to process the prints. If U-Develop stops processing the prints they do not have to lease the machine. Because this cost can be eliminated, it is also differential. The common costs, however, remain unchanged. Therefore, these costs should be omitted from the analysis. In addition, a differential cost is the $25,000 purchase price of the outsourcing. This analysis shows us that differential costs increase by $1,000 if U-Develop buys the prints. Therefore, the manager would decide to continue processing prints. Differential costs increase by $1,000, so reject alternative to buy. a 100,000 units purchased at $.25 = $25,000. b These common costs remain unchanged for these volumes. Because they do not change, they could be omitted from the analysis. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Make or Buy, Continued. . .
U-Develop 50,000 Prints Process Prints Outsource Processing Difference Direct Costs Direct Materials $2,500c $12,500d $10,000 Higher Labor 6,000 -0- Lower Variable Overhead 1,500 Fixed Overhead 4,000 Common Costs 10,000b Total Costs $24,000 $22,500 $1,500 Suppose U-Develop processes 50,000 prints a year. Doing the same differential analysis, we see that the differential costs decreased by $1,500 if U-Develop purchases the prints from the outside supplier. Why is it that at 100,000 prints it is cheaper to make the prints but at 50,000 prints it is cheaper to buy them outside? The common costs still remain unchanged and are still omitted from the analysis. The cost paid to the outside processor and the variable costs were reduced by half because volume was reduced by half. Remember, variable costs vary in total as activity changes. Notice, however, the $4,000 fixed overhead for renting the machine remains the same whether you develop 50,000 prints or 100,000 prints. Differential costs decrease by $1,500, so accept alternative to buy. b These common costs remain unchanged for these volumes. Because they do not change, they could be omitted from the analysis c 100,000 units purchased at $.25 = $25,000. d 50,000 units purchased at $.25 = $12,500. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Opportunity Cost of Making
U-Develop Make or Buy Analysis with Opportunity Cost Status Quo Alternative Process Prints Outsource Processing Difference Total Cost of 100,000 Prints $34,000 $35,000 $1,000 Highera Opportunity cost of using facilities to make covers 2,000 -0- Lowera Total costs, incl. opportunity cost $36,000 Recall from Chapter 2 that opportunity costs are the foregone benefit from the best alternative course of action. Suppose U-Develop could use the facilities to take passport and visa photos rather than processing prints. If that is the case, the total cost of processing 100,000 prints is $34,000 of outlay costs and $2,000 opportunity cost. The total cost of processing prints is $36,000. The cost to buy the prints from an outside developer is $35,000. In this case, U-Develop would choose to accept the offer from the outside developer. Differential costs decrease by $1,000, so accept the alternative. a These indicate whether the alternative is higher or lower than the status quo. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Add or Drop Add or drop a segment? Decision to add or drop a product line or close a business unit. Fourth Quarter Product Line Income Statement, U-Develop Less fixed costs: Total Prints Cameras Frames Sales revenue $80,000 $10,000 $50,000 $20,000 Cost of sales (all variables) 53,000 _ 8,000 30,000 15,000 Contribution margin $27,000 $2,000 $5,000 Rent 4,000 1,000 2,000 Salaries 5,000 2,500 1,500 Marketing and administrative _3,000 __500 _1,500 _1,000 Operating profit (loss) $15,000 $(500) $14,000 $1,500 Managers often must decide whether to add or drop a product line or close a business unit. Product lines or business units that were formerly profitable may no longer be profitable. In fact, Jamaal, the owner of U-Develop is looking at his product line income statement and sees that prints are no longer profitable. He is considering dropping prints. It appears to Jamaal, that operating profit would increase of $500 if he discontinued the prints. So Jamaal asks the accountant to do a differential analysis. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Add or Drop, Continued. . .
Differential Analysis U-Develop Status Quo: Alternative: Keep Prints Drop Prints Difference Less fixed costs: Sales revenue $80,000 $70,000 $10,000 decrease Cost of sales (all variables) 53,000 45,000 _8,000 Contribution margin $27,000 $25,000 $2,000 Salaries 5,000 4,000 1,000 Marketing and administrative _3,000 _2,750 __250 Operating profit (loss) $15,000 $14,250 $750 Rent The differential analysis shows that rent is not relevant for the decision. The rent must be paid whether the prints are dropped or not. Therefore, profits would decrease $750. Profits decrease $750 so keep prints. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Product Choice Decisions
Constraints Activities, resources, or policies that limit the attainment of an objective. Another common managerial decision is determining what products or services to offer. This choice directly affects costs and profits. By now you clearly understand contribution margin. Constraints are activities, resources or policies that limit the attainment of an objective. With a constrained resource, the important measure of profitability is not the contribution margin per unit of product, but the contribution margin per unit of scarce resource. Contribution margin per unit of scarce resource Contribution margin per unit of a particular input with limited availability. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Product Choice Decisions
U-Develop Revenue and Cost Information Metal Frames Wood Frames Price $50 $80 Less: Variable Costs per Unit Material 8 22 Labor 24 Overhead 4 Contribution Margin per Unit $30 Let’s look at the revenue and cost information for U-Develop’s metal and wood frames. Metal frames require a half hour of machine time and wood frames require an hour. The revenue and cost information indicates that both metal and wood frames have a contribution margin per unit of $30. Fixed manufacturing costs are $3,000 per month and fixed marketing and administrative costs are $1,500 per month. Are metal and wood frames equally profitable? Fixed manufacturing costs: $3,000 per month Fixed marketing and administrative costs: $1,500 per month McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Product Choice Decisions
U-Develop Revenue and Cost Information Per Unit Metal Frames Wood Frames Contribution Margin $30 Machine Hours Required .5 1 Contribution Margin per Machine Hour $60 If metal frames require half an hour of machine time U-Develop can produce two metal frames per hour. This means that even though the contribution margin per unit is $30, the contribution per machine hour is $60 for the metal frames. However, U-Develop can only produce one wood frame per hour. So the contribution margin per machine hour is $30 for wood frames. Metal Frames have a higher contribution margin per machine hour. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Example: Product Choice Decisions, Continued. . .
Suppose U-Develop has 200 machine hours per month available. Metal Frames Wood Frames Capacity 400 200 Contribution Margin per Unit $30 Total Contribution Margin $12,000 $6,000 Less: Fixed Manufacturing Costs 3,000 Less: Fixed M&A Costs 1,500 Operating Profit $7,500 $1,500 Machine hours is a constrained resource. Suppose U-Develop has 200 machine hours available per month. U-Develop can produce 400 metal frames for operating profit of $7,500. Only 200 wood frames can be produced for operating profit of $1,500. Selling metal frames will result in higher profits than selling wooden frames. McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

Theory of Constraints LO5 Understand the theory of constraints. Theory of Constraints Focuses on revenue and cost management when faced with bottlenecks Bottleneck Operation where the work required limits production. The bottleneck is the constraining resource The theory of constraints focuses on revenue and cost management when faced with bottlenecks. In essence, bottlenecks are constraints. Throughput Contribution Sales dollars minus direct materials costs and variables such as energy and piecework labor McGraw-Hill/Irwin Copyright ©2008 The McGraw-Hill Companies, Inc. All rights reserved.

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