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Analysis of Financial Statement.
Meet NO. Dates Chapter Topic Homework Assignment 1 08/22 13 Analysis of Financial Statement. 2 08/24 Using Connect – 6 Questions & LS for 60 Points. 3 08/29 Managerial Accounting Concepts and Principles. 4 08/31 Using Connect – 7 Questions & LS for 5 09/05 NO CLASS LABOR DAY 6 09/07 Job Order Costing and Analysis. 7 09/12 Atef Abuelaish

Process Costing and Analysis. 9 09/19
Meet NO. Dates Chapter Topic Homework Assignment 8 09/14 3 Process Costing and Analysis. 9 09/19 Using Connect – 7 Questions & LS for 60 Points. 10 09/21 REV. / EXAM 1 Chapters 1, 2, and 3. EXAM # 1 - Using Connect – 3 PARTS FOR 60 Points. In class room 11 09/26 4 Activity-Based Costing and Analysis. 12 09/28 13 10/03 5 Cost Behavior and Cost-Volume-Profit Analysis. 14 10/05 Atef Abuelaish

Variable Costing and Analysis.
Meet NO. Dates Chapter Topic Homework Assignment 15 10/10 6 Variable Costing and Analysis. 16 10/12 Using Connect – 7 Questions & LS for 60 Points. 17 10/17 Group Case 1 In class room 18 10/19 REV. Exam 2 Chapters 4, 5, and 6 EXAM # 2 - Using Connect – 3 PARTS FOR 60 Points. 19 10/24 7 Master Budget and Performance Planning 20 10/26 Atef Abuelaish

Flexible Budgets and Standard Costs.
Meet NO. Dates Chapter Topic Homework Assignment 21 10/31 8 Flexible Budgets and Standard Costs. 22 11/02 Using Connect – 6 Questions & LS for 60 Points 23 11/07 9 Performance Measurement and Responsibility Accounting. 24 11/09 Using Connect – 7 Questions & LS for 25 11/14 REV. Exam 3 Chapters 7, 8, and 9 EXAM # 3 - Using Connect – 3 PARTS FOR 60 Points. In class room 26 11/16 10 Relevant Costing for Managerial Decisions. Atef Abuelaish

Meet NO. Dates Chapter Topic Homework Assignment 27 11/21 10 Relevant Costing for Managerial Decisions. Using Connect – 8 Questions & LS for 60 Points. 28 11/23 11 Capital Budgeting and Investment Analysis. 29 11/28 Using Connect – 7 Questions & LS for 30 11/30 Group Case 2 In Class Room 31 12/05 REV. ALL CHAPTERS FOR FINAL EXAM 32 12/07 FINAL COURSE FINAL EXAM Chapters 01 – 11 & 13 Using Connect – 3 PARTS FOR 60 Points. In class room Atef Abuelaish

Performance Measurement and
Chapter 09 Performance Measurement and Atef Abuelaish

Performance Measurement and Responsibility Accounting
Chapter 09 Performance Measurement and Responsibility Accounting Atef Abuelaish

Common ways to decentralize organizations
Decentralization Common ways to decentralize organizations By Geography By Product line Companies are divided into smaller units, called divisions, segments, departments, or subunits, when they become too large to be managed effectively as a single unit. In these decentralized organizations, decisions are made by managers throughout the company rather than by a few top executives. Common ways to decentralize organizations are by geography or product line (also called brand). In this section we discuss the motivation for and the advantages and disadvantages of decentralization. In later sections of this PowerPoint presentation, we will look at performance measurement in decentralized organizations. Atef Abuelaish

Advantages of Decentralization
Providing lower-level managers with decision-making authority offers several advantages. Timely access to information Good training for employees Boosts employee morale and retention Enables top-level managers to focus on long-term strategy Many companies are so large and complex that they are broken into separate divisions for efficiency and/or effectiveness purposes. Providing lower-level managers with decision-making authority offers several advantages: Lower-level managers have timely access to detailed information about their departments. Providing lower-level managers with authority to make day-to-day decisions for their departments enables top-level managers to focus more on long-term strategy for the entire organization. Managing a division can be good training for employees who later might be promoted to top-level management. Having decision-making authority often boosts employee morale and retention. Atef Abuelaish

Disadvantages of Decentralization
Decentralization has potential disadvantages which organizations should consider: Department managers are too focused on own department Decisions of individual departments might conflict with one another Departments might duplicate certain activities Decentralization has potential disadvantages which organizations should consider: Because they are so focused on their own department, department managers might make decisions that do not reflect the organization’s overall strategy. When an organization has several departments, the decisions of individual departments might conflict with one another. Departments might duplicate certain activities, for example, payroll accounting or purchasing. Atef Abuelaish

Performance Evaluation
The accounting system provides information about resources used and outputs achieved. Managers use this information to control operations, appraise performance, allocate resources, and plan strategy. The type of accounting information provided depends on whether the department is a . . . Evaluated on ability to control costs. Cost center Evaluated on ability to generate revenues in excess of expenses. Profit center Evaluated on ability to generate return on investment in assets. Investment center All departments, whether production, sales, or service, use resources to achieve a desired output. If our decentralized accounting system is properly designed and implemented, we can control operations, appraise performance, allocate resources, and plan strategy. One of top management’s objectives for this type of system is to be able to allocate more resources to those departments who are performing at the highest level. Financial information used to evaluate a department depends on whether it is evaluated as a cost center, profit center, or investment center. Cost centers incur costs without directly generating revenues. Cost centers are evaluated on their ability to control costs. Profit center managers are judged on their ability to generate revenues in excess of the profit center’s costs. In addition to generating revenues and controlling costs, investment center managers make asset investment decisions and are evaluated based on the investment return on those investments. A responsibility accounting system can be set up to control costs and evaluate managers’ performance by assigning costs to the managers responsible for controlling them. We will look at responsibility accounting and cost control in the next section of this presentation. Atef Abuelaish

Controllable versus Uncontrollable Costs
A cost is controllable if a manager has the power to determine or at least significantly affect the amount incurred. Uncontrollable costs are not within the manager’s control or influence. A manager’s performance using responsibility accounting reports should be evaluated using costs that the manager can control. A cost is controllable if a manager has the power to determine or at least significantly affect the amount incurred. Uncontrollable costs are not within the manager’s control or influence. For example, department managers rarely control their own salaries. However, they can control or influence items such as the cost of supplies used in their department. Distinguishing between controllable and uncontrollable costs often depends on the level of management and the time period under analysis. For example, the cost of property insurance is usually not controllable at lower levels of management, especially in the short term. However, in the long term, management executives can make decisions to change insurance coverage contracts. All costs are controllable at some management level if the time period is sufficiently long. Supplies used in the manager’s department The department manager’s own salary Atef Abuelaish

Responsibility Accounting
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Responsibility Accounting System
An accounting system that provides information . . . Relating to the responsibilities of individual managers. To evaluate managers on controllable items. A responsibility accounting system uses the concept of controllable costs to evaluate a manager’s performance. Responsibility for controllable costs is clearly defined and performance is evaluated based on the ability to manage and control those costs. Prior to each reporting period, a company prepares plans that identify costs and expenses under each manager’s control. These responsibility accounting budgets are typically based on the flexible budgeting approach covered in chapter 8. P 1 Atef Abuelaish

Successful implementation of responsibility accounting may use organization charts with clear lines of authority and clearly defined levels of responsibility. A responsibility accounting system makes use of organizational charts to determine lines of authority and levels of responsibility. Performance reports for low-level management typically cover few controllable costs. Responsibility and control broaden for higher-level managers; therefore, their reports span a wider range of costs. The lines in this chart connecting the managerial positions reflect channels of authority. P 1 Atef Abuelaish

Responsibility Accounting Performance Reports
Amount of detail varies according to the level in the organization. The amount of detail in performance reports varies according to the level in the organization. The number of controllable costs reported varies across management levels. At lower levels, managers have limited responsibility and thus few controllable costs. Responsibility and control broaden for higher-level managers; therefore, their reports span a wider range of costs. In general, lower-level managers receive detailed reports, but the level of detail decreases at higher levels. Top management receives reports that are highly summarized. If a problem arises, top management can request greater detail to look into the problem. A store manager receives summarized information from each department. A department manager receives detailed reports. P 1 Atef Abuelaish

Responsibility Accounting Performance Reports
Exhibit 9.2 shows summarized performance reports for three management levels. The beverage department is a cost center, and its manager is responsible for controlling costs. This exhibit shows that costs under the control of the beverage department plant manager are totaled and included among the controllable costs of the VP of the Southeast region. Costs under the control of the VP are totaled and included among the controllable costs of the EVP of operations. In this way, responsibility accounting reports provide relevant information for each management level. A good responsibility accounting system makes every effort to provide relevant information to the right person (the one who controls the cost) at the right time (before a cost is out of control). P 1 Atef Abuelaish

Direct and Indirect Expenses
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Direct and Indirect Expenses
Direct expenses are incurred for the sole benefit of a specific department. Salary of employee who works in only one department. Indirect expenses benefit more than one department and are allocated among departments benefited. Direct expenses can be readily traced to one department. They are incurred for the sole benefit of one department. A good example of a direct expense is the salary of an employee who works in only one department. Indirect expenses cannot be traced to one department because they are incurred for the benefit of two or more departments. For example, if two or more departments share a single building, all enjoy the benefits of the expenses for rent, heat, and light. Since we cannot trace indirect expenses to individual departments, we must allocate them to departments on the basis of the relative benefits each department receives from the shared indirect expenses. Ideally, we allocate indirect expenses by using a cause-effect relation. Multiple departments share rent, electricity, and heat. C 1 Atef Abuelaish

Illustration of Indirect Expense Allocation, Exhibit 9.3
Classic Jewelry pays its janitorial service $800 per month to clean its store. Management allocates this cost to its three departments according to the floor space each occupies. Classic Jewelry has three departments in one store location, Jewelry, Watch repair, and China and silver. Janitorial services to clean the store cost $800 per month. Classic Jewelry allocates the $800 janitorial cost based on the square footage of each department. First, we add the square footage in each department to get a total of 4,000 square feet. Then, we divide the square footage in each department by this total to get the allocation percentages. Last, we multiply the allocation percentages times the janitorial cost of $800 to get the amount allocated to each department. For example, the allocation percentage for Jewelry is 2,400 square feet divided by 4,000 square feet, which equals 60 percent. Now, we multiply 60 percent times $800 to get the $480 that is allocated to the Jewelry Department. C 1 Atef Abuelaish

Allocation of Indirect Expenses
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Allocation of Indirect Expenses
Indirect expenses can be allocated to departments using a number of allocation bases. Some common indirect expenses and their allocation bases are: Indirect expenses can be allocated to departments using a number of allocation bases. Some common indirect expenses and their allocation bases are shown on your screen. P 2 Atef Abuelaish

Service Department Expenses
Service department costs are shared, indirect expenses that support the activities of two or more production departments. Commonly used bases to allocate service department expenses include: To generate revenues, operating departments require support services provided by departments such as personnel, payroll, and purchasing. Such service departments are typically evaluated as cost centers because they do not produce revenues. A departmental accounting system can accumulate and report costs incurred by each service department for this purpose. The system then allocates a service department’s expenses to operating departments benefiting from them. This slide shows some commonly used bases for allocating service department’s expenses to operating departments. The Classic Jewelry example used square footage as the allocation base. P 2 Atef Abuelaish

Departmental Income Statements
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Departmental Income Statements
Let’s prepare departmental income statements using the following steps: Accumulating revenues and direct expenses by department. Allocating indirect expenses across departments. Allocating service department expenses to operating departments. Preparing departmental income statements. Now that we have discussed direct expenses and the allocation of indirect expenses, we are ready to put our knowledge to work by preparing departmental income statements. These statements are the primary tool for evaluating departmental performance. Before we prepare the departmental income statements, we must determine the expenses for each department using the first three steps of the four-step process that you see on your screen. Step 1: Accumulating revenues and direct expenses by department. Step 2: Allocating indirect expenses across departments. Step 3: Allocating service department expenses to operating departments. Step 4: Preparing departmental income statements. P 3 Atef Abuelaish

Departmental Income Statements Step 1: Accumulating revenues and direct expenses by department
Revenues and/or Direct expenses are traced to each department without allocation. Revenues and Direct Expenses Revenues and Direct Expenses Direct Expenses Direct Expenses Service Dept. (Cost Center) General Office Service Dept. (Cost Center) Purchasing Step One is to accumulate revenues and direct expenses by department. Recall that direct expenses are incurred for the sole benefit of one department. Note that two of the departments on your screen, the Hardware department and the Housewares department, are both operating departments, and two, the General Office and the Purchasing departments, are service departments. Service departments may have direct expenses, but no revenue. After we have accumulated all of the expenses in the service departments, we will allocate the total from each service department to the operating departments. Operating Dept. (Profit Center) Hardware Operating Dept. (Profit Center) Housewares P 3 Atef Abuelaish

Departmental Income Statements Step 2: Allocating indirect expense across departments
Indirect expenses are allocated to all departments using appropriate allocation bases. Allocation Allocation Allocation Allocation Service Dept. (Cost Center) General Office Service Dept. (Cost Center) Purchasing Step Two is the allocation of indirect expenses across departments. Indirect expenses can included items such as depreciation, rent, advertising, and any other expenses that cannot be directly assigned to a department. Indirect expenses are first recorded in company accounts. Then, an allocation base is identified for each expense, and costs are allocated using a departmental expense allocation spreadsheet. Now each department has a combination of direct expenses and allocated expenses. Operating Dept. (Profit Center) Hardware Operating Dept. (Profit Center) Housewares P 3 Atef Abuelaish

Departmental Income Statements Step 3: Allocating service department expenses to operating departments Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to operating departments. Service Dept. (Cost Center) General Office Service Dept. (Cost Center) Purchasing Step Three is the allocation of service department expenses to operating departments. The total expense to be allocated from each service department is made up of the service department’s direct expenses from step one and the allocated expenses from step two. We will illustrate this three-step process using the Ames Hardware Company. Allocation Allocation Operating Dept. (Profit Center) Hardware Operating Dept. (Profit Center) Housewares P 3 Atef Abuelaish

Departmental Expense Allocation Spreadsheet
Step 1: Direct expenses are traced to service departments and sales departments without allocation. Ames Hardware Company sells two hammer models, regular (Sales Department One) and deluxe (Sales Department Two). The company has two service departments, Service Department One and Service Department Two. Each department has direct expenses for salaries and supplies. In Step 1, we trace these direct expenses to the individual departments without allocation. P 3 Atef Abuelaish

Of a total of 2,000 square feet, the service departments occupy 200 square feet each, Sales Department One occupies 600 square feet, and Sales Department Two occupies 1,000 square feet. In Step 2, we allocate the company’s indirect expenses, rent and utilities, to both the service and the sales departments based on floor space occupied. The total floor space is 2,000 square feet. Both service departments occupy 200 square feet, or 10 percent of the total for each service department. Sales department one occupies 600 square feet, or 30 percent of the total. Sales department two occupies 1,000 square feet, or 50 percent of the total. We allocate the indirect expenses by multiplying the allocation percentage for each department times the total indirect expenses. For example, we allocate rent to service department one by multiplying ten percent times the $10,000 total rent to get $1,000. Last, we total all expenses, both direct and indirect for each service department to prepare for the allocation in Step 3. The total for service department one is $2,200 and the total for service department two is $3,400. You should verify the numbers in the spreadsheet on your screen by working through the allocations for the remaining indirect expenses. Step 2: Indirect expenses are allocated to both the service and the sales departments based on floor space occupied. Ex. 200 sq ft 2000 sq ft P 3 X $10,000 = $1,000 Atef Abuelaish

Sales department one has $40,000 in sales and sales department two has $48,000 in sales. Total sales = $88,000 Step 3: Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to sales departments. (In this example, based on sales dollars for each department) In Step 3, we total the expenses for each service department and allocate the total to the operating departments. We will allocate the total expenses in service department one based on sales of the two sales departments, $40,000 for sales department one and $48,000 for sales department two. To begin the allocation, we add the sales for the two sales departments to get a total of $88,000. Then we divide the sales in each sales department by this total to get the allocation percentage. The sales department one allocation percentage is computed by dividing $40,000 by the $88,000 total. Last, we multiply the allocation percentage for each sales department times the $2,200 indirect cost of service department one to get the amounts allocated, $1,000 to sales department one and $1,200 to sales department two. Again, you should verify the numbers in the spreadsheet on your screen by working through the allocations for service department one. Ex. $40,000 sales dept. one $88,000 total sales P 3 X $2,200 = $1,000 Atef Abuelaish

Step 3 (cont.): Service department total expenses (original direct expenses + allocated indirect expenses) are allocated to sales departments. (In this example, the allocation is based on number of employees.) Sales department one has 28 employees and sales department two has 40 employees. Total employees = 68 We will complete Step 3 by allocating the total expenses from service department two to each of the sales departments. We will allocate the total expenses in service department two based on the number of employees in each sales department, 28 employees for sales department one and 40 employees for sales department two. To begin the allocation, we add the employees for the two sales departments to get a total of 68 employees. Then, we divide the number of employees in each sales department by this total to get the allocation percentage. The sales department one allocation percentage is computed by dividing 28 employees by the 68 employee total. Last, we multiply the allocation percentage for each sales department times the $3,400 indirect cost of service department two to get the amounts allocated, $1,400 to sales department one and $2,000 to sales department two. Again, you should verify the numbers in the spreadsheet on your screen by working through the allocations for service department two. Now that we know the expenses, we can prepare departmental income statements. Ex. 28 employees sales dept. one 68 total employees P 3 X $3,400 = $1,400 Atef Abuelaish

Departmental Income Statements for Ames Hardware Company
Direct Expenses Allocated Indirect Expenses The departmental expense allocation spreadsheet can now be used to prepare performance reports. The service departments one and two, are cost centers, and their managers will be evaluated on their control of costs. This screen depicts the sales and the costs for each of the two operating departments, sales dept. one and sales dept. two. By subtracting the cost of goods sold for each sales department, we can calculate the gross profit generated in each department. Next, we see the operating expenses. Recall that salaries and supplies are direct expenses from Step 1, while rent and utilities are allocated expenses from Step 2. Next, we see the service department expenses that were allocated in Step 3. Adding all of the expenses and subtracting from gross profit, results in net income. You may refer back to the allocation spreadsheet to find the detail for our operating expenses and the total expenses of $12,100 for sales department one and $20,400 for sales department two. Allocated service dept. expenses P 3 Atef Abuelaish

Departmental Contribution to Overhead
Departmental revenue – Direct expenses = Departmental contribution to overhead Departmental contribution . . . Is used to evaluate departmental performance. Is not a function of arbitrary allocations of indirect expenses. Departmental contribution to overhead, is an important concept for managers. We subtract departmental direct expenses from departmental revenue to get departmental contribution to overhead. It is the amount that a department contributes to covering indirect expenses of the company. If the total of all the departments’ contribution is not sufficient to cover indirect costs, the company’s net income will be negative. If an individual department’s contribution is negative, it contributes nothing toward covering indirect costs and should be a candidate for elimination. Let’s redo the Ames Hardware Company’s departmental income statement so that we can see the contribution generated by each department. A department may be a candidate for elimination when its departmental contribution is negative. P 3 Atef Abuelaish

Departmental Contribution to Overhead
Departmental contributions to indirect expenses (overhead) are emphasized. Departmental contributions are positive so neither department is a candidate for elimination. Notice that the net income is still the same. The indirect expenses from Step Two and Step Three of the allocation are not allocated. Instead, they are deducted from the total contribution of the company to get net income. Only the direct expenses are deducted from gross profit to get departmental contribution. Now we can see exactly how much each sales department is contributing toward the indirect expenses of the company. Both of Ames Company’s sales departments have positive departmental contributions, so neither department is a candidate for elimination. P 3 Atef Abuelaish Net income for the company is still $17,500.

Evaluating Investment Center Performance
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Evaluating Investment Center Performance
Investment center managers are responsible for generating profit and for the investment of assets. They will be evaluated based on their ability to generate enough operating income to justify the investment in assets used to generate the operating income. Two performance measures are: Investment Center Return on Assets Investment Center Residual Income Investment center managers are responsible for generating profit and for the investment of assets. They will be evaluated based on their ability to generate enough operating income to justify the investment in assets used to generate the operating income. Typically, investment center managers are evaluated using performance measures that combine income and assets. Several of those measures will be described on the slides that follow including: Return on assets and residual income. Let’s take a look… A 1 Atef Abuelaish

1) Investment Center Return on Assets Invested (ROI)
Investment Center Net Income Investment Center Average Invested Assets An investment center’s performance is often evaluated using a measure called return on investment (ROI). ROI is defined as operating income divided by average invested assets. Consider the following data for Ztel, a company that operates two divisions: LCD and S-Phone. The LCD Division manufactures liquid crystal display (LCD) monitors and sells them for use in computers, cellular phones, and other products. The S-Phone division sells smartphones. Exhibit 9.17 shows current year income and assets for those divisions. Based on this information, we can determine the ROI or return on investment for each. The ROI for LCD is 21 percent, while the ROI for S-Phone is 23 percent. LCD Division earned more dollars of income, but it was less efficient in using its assets to generate income compared to S-Phone Division. LCD Division earned more dollars of income, but it was less efficient in using its assets to generate income compared to S-Phone Division. A 1 Atef Abuelaish

1) Investment Center Return on Assets Invested (ROI)
Return on investment (ROI) = Profit Margin Investment turnover × Investment center income Investment center sales Investment center sales Investment center average assets We can further examine investment center (division) performance by splitting return on investment into two measures: profit margin and investment turnover. Profit margin measures the income earned per dollar of sales. Investment turnover measures how efficiently an investment center generates sales from its invested assets. It is calculated as investment center sales divided by investment center average assets. Profit margin is expressed as a percentage, while investment turnover is interpreted as the number of times assets were converted into sales. Higher profit margin and higher investment turnover indicate better performance. To illustrate, consider Walt Disney Co., which reports results for two of its operating segments: Media Networks and Parks and Resorts. Disney's Media Networks division generates cents of profit for every dollar of sales, while its Parks and Resorts division generates cents of profit per dollar of sales. The Media Networks division (0.71 investment turnover) is slightly more efficient than the Parks and Resorts division (0.66 investment turnover) in using assets. Top management can use profit margin and investment turnover to evaluate the performance of division managers. The measures can also aid management when considering further investment in its divisions. Let’s review what you have learned in the following NEED-TO-KNOW Slide. A 2 Atef Abuelaish

2) Investment Center Residual Income
Investment Center Net Income Target Investment Center Net Income = – Another way to evaluate division performance is to compute investment center residual income. Residual income is the difference between the investment center net income and target investment center net income. The target investment center net income is the minimum rate of return on investment center invested assets. Exhibit 9.18: Let’s assume that the target net income for the LCD and S-Phone Divisions is 8 percent. When we compute the target investment center net income for each division and subtract it from net income, we see that the LCD division has a higher residual income. One of the real advantages of residual income is that it encourages managers to make profitable investments that might be rejected by managers whose performance is evaluated on the basis of ROI. This occurs when the ROI associated with an investment opportunity exceeds the company’s minimum required return, but is less than the ROI being earned by the division manager contemplating the investment. Regardless of the division’s current return on investment, its residual income will increase as long as the manager invests only in projects that exceed the company’s minimum required return. Let’s review what you have learned in the following NEED-TO-KNOW Slide. A 1 Atef Abuelaish

NEED-TO-KNOW The media division of a company reports income of $600,000, average invested assets of $7,500,000, and a target income of 6% of invested assets. Compute the division’s (a) return on investment and (b) residual income. Return on Investment (ROI) represents the earnings power of invested assets. Return on investment = Net Income Average Invested Assets $600,000 $7,500,000 8% The media division of a company reports income of $600,000, average invested assets of $7,500,000, and a target income of 6% of invested assets. Compute the division’s return on investment and residual income. Return on Investment (ROI) represents the earnings power of invested assets. It's calculated by taking net income and dividing by average invested assets. $600,000 divided by $7,500,000 is 8%. Every $1.00 of invested assets yields $.08 in net income. A 1 Atef Abuelaish

NEED-TO-KNOW The media division of a company reports income of $600,000, average invested assets of $7,500,000, and a target income of 6% of invested assets. Compute the division’s (a) return on investment and (b) residual income. Residual income is the amount earned above a targeted amount. Net income $600,000 Target income ($7,500,000 x .06) ,000 Residual income $150,000 Residual income is the amount earned above a targeted amount. Net income is $600,000. Targeted income is calculated as 6% of the average invested assets of $7,500,000, $450,000. Residual income is the amount earned above 6%, $150,000. A 1 Atef Abuelaish

Investment Center Profit Margin and Investment Turnover
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Investment Center Profit Margin and Investment Turnover
Return on investment (ROI) = Profit Margin Investment turnover × Investment center income Investment center sales Investment center sales Investment center average assets We can further examine investment center (division) performance by splitting return on investment into two measures: profit margin and investment turnover. Profit margin measures the income earned per dollar of sales. Investment turnover measures how efficiently an investment center generates sales from its invested assets. It is calculated as investment center sales divided by investment center average assets. Profit margin is expressed as a percentage, while investment turnover is interpreted as the number of times assets were converted into sales. Higher profit margin and higher investment turnover indicate better performance. To illustrate, consider Walt Disney Co., which reports results for two of its operating segments: Media Networks and Parks and Resorts. Disney's Media Networks division generates cents of profit for every dollar of sales, while its Parks and Resorts division generates cents of profit per dollar of sales. The Media Networks division (0.71 investment turnover) is slightly more efficient than the Parks and Resorts division (0.66 investment turnover) in using assets. Top management can use profit margin and investment turnover to evaluate the performance of division managers. The measures can also aid management when considering further investment in its divisions. Let’s review what you have learned in the following NEED-TO-KNOW Slide. Media Networks ROI = 23.78% Parks and Resorts ROI= 10.4% A 2 Atef Abuelaish

NEED-TO-KNOW A division reports sales of $50,000, income of $2,000, and average invested assets of $10,000. Compute the division’s (a) profit margin, (b) investment turnover, and (c) return on investment. Profit margin measures the income earned per dollar of sales. Profit margin = Net Income Sales $2,000 $50,000 4% A division reports sales of $50,000, income of $2,000, and average invested assets of $10,000. Compute the division’s (a) profit margin, (b) investment turnover, and (c) return on investment. sales. Profit margin measures the income earned per dollar of sales. It's calculated by taking net income and dividing by Net income of $2,000 divided by $50,000 in sales is 4%. $0.04 of every $1.00 of sales is profit. A 2 Atef Abuelaish

Need to Know (24-2b) NEED-TO-KNOW
A division reports sales of $50,000, income of $2,000, and average invested assets of $10,000. Compute the division’s (a) profit margin, (b) investment turnover, and (c) return on investment. Investment turnover measures how efficiently an investment center generates sales from its invested assets. Investment turnover = Sales Average Invested Assets $50,000 $10,000 5 Investment turnover measures how efficiently an investment center generate sales from its invested assets. It's calculated by taking sales and dividing by average invested assets. $50,000 in sales divided by average invested assets of $10,000 is an investment turnover of 5. Every $1.00 of invested assets yields $5.00 in sales. A 2 Atef Abuelaish

NEED-TO-KNOW Need to Know (24-2c)
A division reports sales of $50,000, income of $2,000, and average invested assets of $10,000. Compute the division’s (a) profit margin, (b) investment turnover, and (c) return on investment. Return on Investment (ROI) represents the earnings power of invested assets. Return on investment = Net Income Average Invested Assets $2,000 $10,000 20% Return on investment represents the earnings power of invested assets. It's calculated by taking net income and dividing by the average invested assets. Net income of $2,000 divided by average invested assets of $10,000 is a return on investment of 20%. A 2 Atef Abuelaish

NEED-TO-KNOW Need to Know (24-2d)
A division reports sales of $50,000, income of $2,000, and average invested assets of $10,000. Compute the division’s (a) profit margin, (b) investment turnover, and (c) return on investment. Return on Investment (ROI) represents the earnings power of invested assets. Return on investment = Profit Margin x Investment Turnover Net Income = Net Income Sales Average Invested Assets Sales Average Invested Assets 20% = % x An alternative way to calculate return on investment is to take the profit margin and multiply by the investment turnover. Because if we divide by sales in the profit margin and multiply by sales in the investment turnover, we're left with net income divided by average invested assets. The 20% return on investment is equal to the 4% profit margin multiplied by the investment turnover of 5. A 2 Atef Abuelaish

Nonfinancial Performance Evaluation Measures
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Balanced Scorecard Collects information on several key performance indicators within each of the four perspectives. Customer Perspective How do our customers see us? Performance Indicators Innovation/Learning How can we continually improve and create value? Internal Processes In which activities must we excel? A balanced scorecard consists of an integrated set of performance measures that are derived from and support a company’s vision and strategy. The balanced scorecard is used to assess company and division manager performance. The balanced scorecard requires managers to think of their company from four perspectives: 1. customer perspective: What do customers think of us? 2. internal processes: Which of our operations are critical to meeting customer needs? 3. innovation and learning: How can we improve? 4. financial: What do our owners think of us? In the balanced scorecard approach, we continually develop indicators that help us analyze or answer questions such as: how do we appear to our owners; how do we appear to our customers; what kind of continual innovation and learning is taking place; and which processes within the organization are excellent and which need improvement? The key sequence of events in the balanced scorecard approach is that learning improves business processes. Improved business processes translate to improved customer satisfaction. When we have a high degree of customer satisfaction, we have improved financial results. Financial Perspective How do we look to the firm’s owners? A 3 Atef Abuelaish

Global View L’Oreal is an international cosmetics company incorporated in France. With multiple brands and operations in over 100 countries, the company uses concepts of departmental accounting and controllable costs to evaluate performance. A recent annual report shows the following for the major divisions in L’Oreal’s cosmetics branch: L’Oreal is an international cosmetics company incorporated in France. With multiple brands and operations in over 100 countries, the company uses concepts of departmental accounting and controllable costs to evaluate performance. A portion of a recent L’Oreal annual report is shown on your screen. L’Oreal’s non-allocated costs include costs that are not controllable by division managers, including fundamental research and development and costs of service operations like insurance and banking. Excluding noncontrollable costs enables L’Oreal to prepare more meaningful division performance evaluations. L’Oreal’s non-allocated costs include costs that are not controllable by division managers. Excluding noncontrollable costs enables L’Oreal to prepare more meaningful division performance evaluations. Atef Abuelaish

Cycle Time and Cycle Efficiency
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Process Time + Inspection Time + Move Time + Wait Time
Cycle Time and Cycle Efficiency A metric that measures the time involved in manufacturing a product. Order Received Production Started Goods Shipped Process Time + Inspection Time + Move Time + Wait Time Manufacturing Cycle Time Total time is the elapsed time from when a customer order is received to when the completed order is shipped. The manufacturing cycle time is the amount of time required to turn raw materials into completed products. This includes process time, inspection time, move time, and wait time. Process time is the time spent producing the product and it is the only value-added activity of the four components of cycle time because it is the only activity in cycle time that adds value to the product form the customer’s perspective. Total Time Process time is the time spent producing the product and it is the only value-added time! A 4 Atef Abuelaish

Cycle Time and Cycle Efficiency
Order Received Production Started Goods Shipped Process Time + Inspection Time + Move Time + Wait Time Manufacturing Cycle Time Companies strive to reduce non-value-added time to improve cycle efficiency (CE), which is a measure of production efficiency. Cycle efficiency (CE) is computed by dividing value-added time by cycle (throughput) time. A CE less than one indicates that non-value-added time is present in the production process and they need to evaluate it to identify ways to reduce non-value-added activities. Total Time Cycle Efficiency Value-added time Cycle time = A 4 Atef Abuelaish

Chapter 10 Relevant Costing for Atef Abuelaish

Relevant Costing for Managerial Decisions
Chapter 10 Relevant Costing for Managerial Decisions Atef Abuelaish

Describe the importance of relevant costs for short-term decisions.
10-C1: Describe the importance of relevant costs for short-term decisions. Atef Abuelaish

Decision Making Decision making involves five steps:
Define the decision task. Identify alternative courses of action. Collect relevant information on alternatives. Select the preferred course of action. Analyze and assess decisions made. These five steps represent an orderly, structured decision-making process that will lead to better decisions. First, we need to clearly define the decision task and consider all feasible alternatives. Next, we need to gather information. Some of the information might not be relevant, so we need to discard that information and concentrate on using only relevant information to select the best alternative. After the decision is made, we should review the outcome in an effort to become even better decision makers in the future. Atef Abuelaish

Relevant Costs Costs that are applicable to a particular decision.
Three types of costs that are pertinent to the discussion of relevant costs are: Sunk costs Out-of-pocket costs Opportunity costs. Costs that are applicable to a particular decision. Costs that should have a bearing on which alternative a manager selects. Costs that are avoidable. Future costs that differ between alternatives. Relevant costs are future costs that differ between alternatives. A relevant cost is a cost that will be incurred if an alternative is selected but avoided if the alternative is rejected. For example, if you are deciding between walking to class and driving to class, the cost of gasoline would be a relevant cost. There are three types of costs that are pertinent to our discussion of relevant costs: sunk costs, out-of-pocket costs, and opportunity costs. Let’s take a closer look at these costs… Atef Abuelaish

C 1 Relevant Costs Sunk costs are the result of past decisions and cannot be changed by any current or future decisions. Sunk costs are irrelevant to current or future decisions. Out-of-pocket costs are future outlays of cash associated with a particular decision. Out-of-pocket costs are relevant to decisions. Sunk costs cannot be changed by any decision we make as they have been incurred in the past and cannot possibly differ between any alternative that we might currently choose. Sunk costs should not be considered in the decision process. For example, if you bought an automobile two years ago for $15,000, that amount is a sunk cost. Whether you drive the car, park it, trade it, or sell it, the $15,000 cost will not change. An out-of-pocket cost is a future outlay of cash associated with a particular decision alternative. Out-of-pocket costs are relevant costs as they are future costs that differ between alternatives. For example, in considering the decision to take a vacation or stay at home, you will have travel costs (out-of-pocket costs) only if you choose a vacation. Opportunity costs are the potential benefits that are given up when one alternative is selected over another. Opportunity costs are not actual dollar outlays; however, they may impact our decisions. For example, the opportunity cost of attending college is the lost salary that you could have earned by working. Besides relevant costs, management must also consider the relevant benefits associated with a decision. Relevant benefits refer to the additional or incremental revenue generated by selecting a particular course of action over another. Opportunity costs are the potential benefits given up when one alternative is selected over another. Opportunity costs are relevant to decisions. Management must also consider relevant benefits. Atef Abuelaish 69

Evaluate short-term managerial decisions using relevant costs.
10-A1: Evaluate short-term managerial decisions using relevant costs. Atef Abuelaish

Accepting Additional Business
The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur if the company decides to accept the new business. FasTrac currently sells 100,000 units of its product. They are operating at 80% of full capacity. The company has per unit and annual total sales and costs as shown in the following contribution margin income statement. On occasion, we may have the opportunity to accept additional business. We should make the decision to accept or reject the additional business using incremental revenues and incremental costs. Some of our costs may not change if we accept additional business. Those costs are not relevant as they do not differ between the alternatives: accept or reject the additional business. FasTrac makes 100,000 units of a single product that normally sells for $10.00 per unit. They are currently operating at its normal level of 80% of full capacity. Total cost to make one unit is $9.00, resulting in a $1.00 profit per unit. Atef Abuelaish

A current buyer of FasTrac’s products wants to purchase additional units of its product and export them to another country. This buyer offers to buy 10,000 units of the product at $8.50 per unit, or $1.50 less than the current price. The offer price is low, but FasTrac is considering the proposal because this sale would be several times larger than any single previous sale and it would use idle capacity. Should FasTrac accept the offer? A current buyer of FasTrac’s products wants to purchase additional units of its product and export them to another country. This buyer offers to buy 10,000 units of the product at $8.50 per unit, or $1.50 less than the current price. The offer price is low, but FasTrac is considering the proposal because this sale would be several times larger than any single previous sale and it would use idle capacity. Should FasTrac accept this special order? Atef Abuelaish

Identify relevant costs and apply them to managerial decisions.
10-P1: Identify relevant costs and apply them to managerial decisions. Atef Abuelaish

To determine whether to accept or reject this order, management needs to know whether accepting the offer will increase net income. FasTrac should accept the offer. To determine whether to accept or reject this order, management needs to know whether accepting the offer will increase net income. We can see from this analysis that the additional business at $8.50 per unit will increase income by $20,000. Let’s look at the reasons why this is the case. To correctly make its decision, FasTrac must analyze the costs of this potential new business differently. The $9.00 historical cost per unit is not necessarily the incremental cost of this order. If we decide to accept this one-time special order, revenue will increase by $85,000 (10,000 units at $8.50 per unit). The variable manufacturing costs to produce this order will be the same as for FasTrac's normal business --$3.50 per unit for direct materials, $2.20 per unit for direct labor, and $0.50 per unit for variable overhead. * Selling expenses for this order will be $0.20 per unit, which is lower than FasTrac's normal business. * Fixed overhead expenses will not change whether this order is accepted or not. * This order will incur incremental administrative expenses of $1,000 for clerical work. These are additional fixed costs due to this order. By comparing incremental revenue of $85,000 with the total incremental costs of $65,000, we see why the income from the additional business is $20,000. Now we can make the correct decision to accept the additional business. Atef Abuelaish

Need to Know 10.1 P 1 A company receives a special order for 200 units that requires stamping the buyer’s name on each unit, yielding an additional fixed cost of $400 to its normal costs. Without the order, the company is operating at 75% of capacity and produces 7,500 units of product at the costs below. The company's normal selling price is $22 per unit. The sales price for the special order is $18 per unit. Costs Variable Fixed costs (7,500 costs per units) unit Direct materials $37,500 $5.00 Direct labor 60,000 $8.00 Overhead (30% variable) 20,000 $0.80 $14,000 Selling expenses (60% variable) 25,000 $2.00 $10,000 The special order will not affect normal unit sales and will not increase fixed overhead and selling expenses. Variable selling expenses on the special order are reduced to one-half the normal amount. Should the company accept the special order? In order for the special order to be accepted, it must 1) increase net income; the incremental revenue must exceed the incremental expense, and 2) not adversely impact normal sales. Need-to-Know 10.1 A company receives a special order for 200 units that requires stamping the buyer’s name on each unit, yielding an additional fixed cost of $400 to its normal costs. Without the order, the company is operating at 75% of capacity and produces 7,500 units of product at the costs below. The company's normal selling price is $22 per unit. The sales price for the special order is $18 per unit. The special order will not affect normal unit sales and will not increase fixed overhead and selling expenses. Variable selling expenses on the special order are reduced to one-half the normal amount. Should the company accept the special order? First we need to determine which costs are variable, costs that will increase on a per unit basis, and which costs are fixed. Direct materials are variable costs. $37,500 divided by 7,500 units is a variable cost per unit of $5. Direct labor is also a variable cost. $60,000 divided by 7,500 units is a variable cost per unit of $8. 30% of the overhead is variable. 30% of $20,000 is $6,000. $6,000 divided by 7,500 units is a variable cost per unit of $0.80. The remaining 70%, $14,000, is a fixed cost. Selling expenses: 60% are variable. 60% of $25,000 is $15,000. $15,000 divided by 7,500 units is a variable cost per unit of $2. The remaining 40%, $10,000, is a fixed cost. So, now, we can look at the profitability of the additional 200 units. In order for the special order to be accepted, it must increase net income; the incremental revenue must exceed the incremental expense, and the special order must not adversely impact normal sales. Atef Abuelaish

Need to Know 10.1 P 1 A company receives a special order for 200 units that requires stamping the buyer’s name on each unit, yielding an additional fixed cost of $400 to its normal costs. Without the order, the company is operating at 75% of capacity and produces 7,500 units of product at the costs below. The company's normal selling price is $22 per unit. The sales price for the special order is $18 per unit. Costs Variable Fixed costs (7,500 costs per units) unit Direct materials $37,500 $5.00 Direct labor 60,000 $8.00 Overhead (30% variable) 20,000 $0.80 $14,000 Selling expenses (60% variable) 25,000 $2.00 $10,000 The special order will not affect normal unit sales and will not increase fixed overhead and selling expenses. Variable selling expenses on the special order are reduced to one-half the normal amount. Should the company accept the special order? Incremental revenues (200 units x $18.00) $3,600 Direct materials (200 units x $5.00) $1,000 Need-to-Know 10.1 The incremental revenue for this order, 200 units at $18 per unit, $3,600. The incremental costs will include direct materials: 200 units at $5 per unit, $1,000; Direct labor, 200 units at $8 per unit, $1,600; the variable portion of the overhead, 200 units at $0.80 per unit, $160; variable selling expenses, 200 units multiplied by the $2 per unit multiplied by 50%, as the as the variable selling expenses are reduced to one-half the normal amount, $200. The special order will also have additional fixed cost for the stamping of $400. Total incremental expenses are $3,360. Net income will increase by $240. So yes, the company should accept the special order. Direct labor (200 units x $8.00) 1,600 Overhead (30% variable) (200 units x $0.80) 160 Selling expenses (60% variable) (200 units x $2.00 x 50%) 200 Additional fixed costs (Stamping costs) 400 Total incremental expenses 3,360 Net income increases by: $240 Yes, the company should accept the special order. Atef Abuelaish

Make or Buy Decisions P 1 Incremental costs are important in the decision to make a product or purchase it from a supplier. The cost to produce an item must include: (1) direct materials, (2) direct labor, and (3) incremental overhead. We should not use the predetermined overhead application rate to determine product cost in the decision. The managerial decision to make or buy a component is common. The “Make or Buy” decision involves the question of whether it is more economical to produce some goods internally or purchase them from an outside supplier. We will again concentrate on incremental costs for this decision. Incremental costs will include the direct materials cost, the direct labor cost and the incremental overhead incurred. We must be careful not to use the historical predetermined overhead application rate to determine the product cost that will be used in the decision. Atef Abuelaish

Make or Buy Decisions P 1 FasTrac currently makes Part 417, assigning overhead at 100 percent of direct labor cost, with the following unit cost: FasTrac is now making Part 417, which is a component part in its final product. As shown on your screen, the unit cost of the part includes direct material, direct labor, and factory overhead. Currently, FasTrac’s normal predetermined overhead application rate is 100% of direct labor cost. Normal, predetermined overhead application rate is 100% of direct labor cost. Atef Abuelaish

Continue to make the part! less than the purchase price of $1.20.
Make or Buy Decisions FasTrac can buy Part 417 from a supplier for $ How much overhead do we have to eliminate before we should buy this part? Assume management computes an incremental overhead rate of $0.20 per unit if it makes the part. . . Continue to make the part! An outside supplier offers to make Part 417, and sell it to FasTrac for $1.20 per unit. We know that $1.20 is less than FasTrac’s $1.45 unit cost. Should FasTrac stop making the part and buy it from the outside supplier for $1.20 per unit? We know that FasTrac will avoid the direct material cost and the direct labor cost if it buys the part instead of making it. But that total is only $ FasTrac cannot afford to pay $1.20 per unit if it will only avoid $0.95 per unit. It must also be able to avoid some of the factory overhead. How much overhead does FasTrac avoid in order to justify buying the part? FasTrac must be able to eliminate (avoid) a minimum of $0.25 per unit ($1.20-$0.95) in factory overhead costs to justify buying the part. If the avoidable amount of factory overhead per unit is greater than $0.25, FasTrac should buy the part instead of making it. On the other hand, if the avoidable amount of factory overhead per unit is less than $0.25, then FasTrac should continue making the part. In this instance, assume management computes an incremental overhead rate of $0.20 per unit if it makes the part. Based on the per unit analysis on this slide, it is cheaper to make the part than to buy it. To make the correct make or buy decision, we must always determine the relevant (avoidable) costs of making the part and then compare these avoidable costs to the outside purchase cost. In almost all make or buy decisions, a significant amount of the factory overhead will be unavoidable, and therefore irrelevant to the decision as it will be the same for either alternative. ? We must eliminate $0.25 per unit ($ $0.95) of overhead, to make the total cost of making the component less than the purchase price of $1.20. Atef Abuelaish

Need to Know 10.2 P 1 A company currently buys a key part for a product it manufactures. The company buys the part for $5 per unit and believes it can make the part for $1.50 per unit for direct materials and $2.50 per unit for direct labor. The company allocates overhead costs at the rate of 50% of direct labor. Incremental overhead costs to make this part are $0.75 per unit. Should the company make or buy the part? (per unit) Make Buy Direct materials $1.50 Direct labor 2.50 Overhead 0.75 Cost to buy the part $5.00 Total $4.75 $5.00 The company should make the part, because the $4.75 cost to make is less than the $5.00 cost to buy. Need-to-Know 10.2 A company currently buys a key part for a product it manufactures. The company buys the part for $5 per unit and believes it can make the part for $1.50 per unit for direct materials and $2.50 per unit for direct labor. The company allocates overhead costs at the rate of 50% of direct labor. Incremental overhead costs to make this part are $0.75 per unit. Should the company make or buy the part? The costs to make the part include: Direct materials, $1.50 per unit; Direct labor, $2.50 per unit, and variable overhead, $0.75 per unit. The cost to buy the part is $5.00 per unit. The total cost to make each unit is $4.75, which is $0.25 less per unit than the cost to buy the units. The company should make the part. Atef Abuelaish

Scrap or Rework P 1 Often in manufacturing processes, we have products that do not pass inspection. We can either sell them as is, or rework them to improve the quality. As long as rework costs are recovered through sale of the product, and rework does not interfere with normal production, we should rework rather than scrap. Often in manufacturing processes, we have products that do not pass inspection. We can either sell them as is, or rework them to improve the quality. Once reworked, the products will likely be sold for a higher price. The decision to rework or sell as is should be based on incremental revenues and incremental costs. The costs of manufacturing the product up to the inspection point are sunk and therefore irrelevant. Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered so they are irrelevant. Atef Abuelaish

Should FasTrac scrap or rework?
Example: FasTrac has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $0.40 each or reworked at an additional cost of $0.80 per unit. If reworked, the units can be sold for the normal selling price of $1.50 each. Reworking the defective units will prevent the production of 10,000 new units that would also sell for $1.50. Let’s look at an example of a scrap or rework decision… Let’ assume that FasTrac has 10,000 defective units of a product that have already cost $1 per unit to manufacture. They can be sold as is for $0.40 per unit, or reworked and sold for $ The cost of reworking the defective units is $0.80 each. The $1.00 per unit original cost to make the defective units is a sunk cost and irrelevant to the decision. FasTrac does not have the capacity to rework the defective units and continue with its normal production. Reworking the defective units will prevent the production of 10,000 new units that would also sell for $1.50. What should FasTrac do? Should FasTrac scrap or rework? Atef Abuelaish

Decision: FasTrac should scrap the units now.
Scrap or Rework P 1 10,000 units × $0.40 per unit ($.50 per unit) 10,000 units × $1.50 per unit Sale of the 10,000 defective units as is for $0.40 will generate incremental income of $4,000. Reworking and selling each unit for $1.50 will generate $15,000. The total cost to rework the 10,000 defective units at $0.80 each will be $8,000. We must also include the opportunity cost of the 10,000 units of regular production that would be prevented by the rework. The regular units sell for $1.50 each and cost $1.00 per unit to make. We give up the opportunity to earn this $5,000 if we rework the defective units. FasTrac should sell the defective units as is for $4,000, as the net return is $2,000 higher than reworking the defective units. Note that if FasTrac does not include the opportunity cost of the displaced regular production, the company will make an incorrect decision to rework the defective product. Failing to include the opportunity cost of $5,000, the rework option would have shown an income of $7,000 instead of $2,000, mistakenly making reworking appear more favorable than scrapping. 10,000 units × $0.80 per unit 10,000 units × ($ $1.00) per unit Decision: FasTrac should scrap the units now. Atef Abuelaish

Sell or Process Further
Businesses are often faced with the decision to sell partially completed products as is or to process them further for sale as other products. As a general rule, we process further only if incremental revenues exceed incremental costs. Example: FasTrac has 40,000 units of partially finished product Q. Processing costs to date are $30,000. The 40,000 unfinished units can be sold as is, for $50,000 or they can be processed further to produce finished products X, Y, and Z. Processing the units further will cost an additional $80,000 and will yield total revenues of $150,000. Many products can be sold in an unfinished state, or processed further into a finished product that will sell for a higher price. The decision to sell or process should be based on incremental revenues and incremental costs. The costs of manufacturing the product up to the sell or process decision point are sunk and therefore irrelevant. FasTrac has 40,000 partially completed units of product Q that can be sold for a total of $50,000. FasTrac also has the option of further processing the 40,000 units of product Q to obtain products X, Y, and Z. Processing the units further will cost an additional $80,000 and will yield total revenues of $100,000. What should FasTrac do? First, we need some additional information that is on the next slide before we can make a decision. FasTrac must decide whether the added revenues from selling finished products X, Y, and Z , exceed the costs of finishing them. . . Atef Abuelaish

Sell or Process Further
Sell as Product Q Process Further into Products X, Y, and Z Incremental revenue $50,000 $150,000 Incremental cost (80,000) Incremental income $70,000 Decision: FasTrac should process further; by doing so, it will earn an additional $20,000 of income ($70,000 – $50,000). The incremental income from processing further is $70,000. This is greater than the incremental income of $50,000 that would be earned from selling Product Q as is. Therefore, FasTrac should process further; by doing so, it will earn an additional $20,000 of income ($70,000 – $50,000). Notice that the $30,000 of previously incurred manufacturing costs are excluded from the analysis. These costs are sunk, and they are not relevant to the decision. The incremental revenue from selling Product Q as is ($50,000) is properly included. It is the opportunity cost associated with processing further. The $30,000 of previously incurred manufacturing costs are excluded from the analysis. These costs are sunk, and they are not relevant to the decision! Atef Abuelaish

Need-to-Know 10.3 P 1 For each of the two independent scenarios below, determine whether the company should sell the partially completed product as is or process it further into other saleable products. 1. $10,000 of manufacturing costs have been incurred to produce Product Alpha. Alpha can be sold as is for $30,000 or processed further into two separate products, BB and CC. The further processing will cost $15,000, and products BB and CC can be sold for total revenues of $60,000. 2. $5,000 of manufacturing costs have been incurred to produce Product Delta. Delta can be sold as is for $150,000 or processed further into two separate products, YY and ZZ. The further processing will cost $75,000, and Products YY and ZZ can be sold for total revenues of $200,000. Need-to-Know 10.3 For each of the two independent scenarios below, determine whether the company should sell the partially completed product as is or process it further into other saleable products. Atef Abuelaish

Need-to-Know 10.3 P 1 1. $10,000 of manufacturing costs have been incurred to produce Product Alpha. Alpha can be sold as is for $30,000 or processed further into two separate products, BB and CC. The further processing will cost $15,000, and products BB and CC can be sold for total revenues of $60,000. Alpha Sell as is Process Further Incremental revenue $30,000 $60,000 Incremental cost (15,000) Incremental income $30,000 $45,000 Alpha should be processed further; doing so will yield an extra $15,000 ($45,000 - $30,000) of income. 2. $5,000 of manufacturing costs have been incurred to produce Product Delta. Delta can be sold as is for $150,000 or processed further into two separate products, YY and ZZ. The further processing will cost $75,000, and Products YY and ZZ can be sold for total revenues of $200,000. Delta Sell as is Process Further Incremental revenue $150,000 $200,000 Incremental cost (75,000) Need-to-Know 10.3 1. $10,000 of manufacturing costs have been incurred to produce Product Alpha. Alpha can be sold as is for $30,000 or processed further into two separate products, BB and CC. The further processing will cost $15,000, and products BB and CC can be sold for total revenues of $60,000. The incremental revenue is $30,000 if we sell the products as is. If the units are processed further, they can be sold for $60,000. There is no incremental cost if we sell the products as is. If we process the units further, the additional cost will be $15,000. The incremental income if we sell the units as is, $30,000, vs. $45,000 if the units are processed further. Alpha should be processed further; doing so will yield an extra $15,000 ($45,000 - $30,000) of income. 2. $5,000 of manufacturing costs have been incurred to produce Product Delta. Delta can be sold as is for $150,000 or processed further into two separate products, YY and ZZ. The further processing will cost $75,000, and Products YY and ZZ can be sold for total revenues of $200,000. If we sell the units as is, incremental revenue is $150,000. If they're processed further, incremental revenue is $200,000. There is no additional cost if we sell the units as is. The incremental cost if the units are processed further is $75,000. Incremental income if we sell the units as is, $150,000, vs. incremental income if the units are processed further, $125,000. Delta should be sold as is; doing so will yield an extra $25,000 ($150,000 - $125,000) of income. Incremental income $150,000 $125,000 Delta should be sold as is; doing so will yield an extra $25,000 ($150,000 - $125,000) of income. Atef Abuelaish

P 1 Sales Mix Selection When a company sells a variety of products, some are likely to be more profitable than others. Management concentrates sales efforts on more profitable products. If production facilities or other factors are limited, producing more of one product usually means producing less of others. In this case, management must identify the most profitable combination, or sales mix of products. Management focuses on the contribution margin per unit of scarce resource. All businesses face constraints that affect production and sales decisions. They must make decisions to best utilize constrained resources. When a company sells a variety of products, some are likely to be more profitable than others. Management concentrates sales efforts on more profitable products. If production facilities or other factors are limited, producing more of one product usually means producing less of others. In this case, management must identify the most profitable combination, or sales mix of products. Management focuses on the contribution margin per unit of scarce resource. Let’s look at an example. Atef Abuelaish

Sales Mix Selection (w/ limited resources)
Example: FasTrac makes and sells two products, A and B using the same machines. A and B have the following selling prices and variable costs per unit: Per unit Product A Product B Selling price $5.00 $7.50 Variable costs 3.50 5.50 However, it takes one hour to produce one unit of Product A, while it takes two hours to produce one unit of Product B. We need to figure each product’s contribution margin per machine hour. (a) (b) (a) Times (b) FasTrac produces Product A and Product B. The selling prices and variable costs of each product are shown in the top table. In the bottom table, Product A is shown to have a contribution margin of $1.50 per unit and Product B has a contribution margin of $2.00 per unit. If each product requires the same time to make, and the demand is unlimited for each product, FasTrac should produce only Product B because it has the higher contribution per unit. However, it takes one hour to produce one unit of Product A, while it takes two hours to produce one unit of Product B. If we divide the contribution per unit by the hours required to produce each unit, we find that we generate more contribution per hour if we make Product A, even though its unit contribution is less. If demand for Products A and B is unlimited, we should produce as many units of Product A as possible, even if that means producing no Product B. By producing Product A, we make $1.50 contribution margin per machine hour worked, which is higher than the $1.00 contribution margin per machine hour that Product B generates. If demand for Product A is limited, we should produce Product A first, until we satisfy the sales demand; thereafter, we should use any remaining machine time to produce Product B. Decision: Even though Product A’s unit contribution is less, it has a higher contribution margin per machine hour. FasTrac should produce more Product A! Atef Abuelaish

Need-to-Know 10.4 P 1 A company produces two products, Gamma and Omega. Gamma sells for $10 per unit and Omega sells for $12.50 per unit. Variable costs are $7 per unit of Gamma and $8 per unit of Omega. The company has a capacity of 5,000 machine hours per month. Gamma uses 1 machine hour per unit, and Omega uses 3 machine hours per unit. 1. Compute the contribution margin per machine hour for each product. 2. Assume demand for Gamma is limited to 3,800 units per month, and demand for Omega is limited to 1,000 units per month. How many units of Gamma and Omega should the company produce, and what will be the total contribution margin from this sales mix? (per unit) Gamma Omega Sales $10.00 $12.50 Variable costs (7.00) (8.00) Contribution margin per unit $3.00 $4.50 Machine hours per unit 1 3 Contribution margin per machine hour $3.00 $1.50 Total machine hours available 5,000 Need-to-Know 10.4 A company produces two products, Gamma and Omega. Gamma sells for $10 per unit and Omega sells for $12.50 per unit. Variable costs are $7 per unit of Gamma and $8 per unit of Omega. The company has a capacity of 5,000 machine hours per month. Gamma uses 1 machine hour per unit, and Omega uses 3 machine hours per unit. 1. Compute the contribution margin per machine hour for each product. Contribution margin per unit is equal to sales: $10.00 per unit for Gamma, and $12.50 per unit for Omega; minus variable costs; $7.00 per unit for Gamma and $8.00 per unit for Omega. Contribution margin is $3.00 per unit for Gamma and $4.50 per unit for Omega. At first glance, it may look like the production of Omega is more profitable, but we need to consider the limiting resources, in this case machine hours. It only takes one machine hour to produce 1 unit of Gamma, generating $3.00 in contribution margin per machine hour. It takes 3 machine hours to produce each unit of Omega; the contribution margin per machine hour is only $1.50. 2. Assume demand for Gamma is limited to 3,800 units per month, and demand for Omega is limited to 1,000 units per month. How many units of Gamma and Omega should the company produce, and what will be the total contribution margin from this sales mix? With the 5,000 available machine hours, the company should choose to produce the units with the highest contribution margin per machine hour, Gamma, producing as many units as the market demands. The market demand for Gamma is 3,800 units per month, which will require 3,800 machine hours (1 hour per unit). With the remaining 1,200 machine hours, the company should produce the less profitable units, Omega. 1,200 machine hours divided by 3 MHs per unit will allow the production of 400 units of Omega. Machine hours used for production of Gamma (3,800 units x 1 MH per unit) 3,800 Machine hours available for production of Omega 1,200 Machine hours used for production of Omega (1,200 MHs / 3 MH per unit = 400 units) 1,200 Remaining machine hours Atef Abuelaish

Need-to-Know 10.4 P 1 A company produces two products, Gamma and Omega. Gamma sells for $10 per unit and Omega sells for $12.50 per unit. Variable costs are $7 per unit of Gamma and $8 per unit of Omega. The company has a capacity of 5,000 machine hours per month. Gamma uses 1 machine hour per unit, and Omega uses 3 machine hours per unit. 1. Compute the contribution margin per machine hour for each product. 2. Assume demand for Gamma is limited to 3,800 units per month, and demand for Omega is limited to 1,000 units per month. How many units of Gamma and Omega should the company produce, and what will be the total contribution margin from this sales mix? (per unit) Gamma Omega Sales $10.00 $12.50 Variable costs (7.00) (8.00) Contribution margin per unit $3.00 $4.50 Machine hours per unit 1 3 Contribution margin per machine hour $3.00 $1.50 Contribution margin (calculated on a per unit basis) Gamma 3,800 units x $3.00 contribution margin per unit $11,400 Need-to-Know 10.4 At this sales mix, 3,800 units of Gamma, each contributing $3.00 per unit is a total contribution margin of $11,400 for Gamma, and 400 units of Omega, each contributing $4.50 per unit is a total contribution margin of $1,800 for Omega. Total contribution margin is $13,200. We can prove this answer by calculating the contribution margin per machine hour. While producing Gamma, the machines run for 3,800 hours generating a contribution margin of $3.00 per machine hour, $11,400. While producing Omega, the machines run 1,200 hours generating a contribution margin of $1.50 per machine hour, $1,800. Total contribution margin, $13,200. Omega 400 units x $4.50 contribution margin per unit 1,800 Total contribution margin $13,200 Contribution margin (calculated on a per machine hour basis) Gamma 3,800 machine hours x $3.00 contribution margin per machine hour $11,400 Omega 1,200 machine hours x $1.50 contribution margin per machine hour 1,800 Total contribution margin $13,200 Atef Abuelaish

Let’s take a closer look at the division’s expenses...
Segment Elimination A segment is a candidate for elimination if its revenues are less than its avoidable expenses. Avoidable expenses are amounts the company would not incur if it eliminated the segment. FasTrac is considering eliminating its Treadmill Division because it reported a $500 operating loss for the recent year… Managers should consider eliminating poorly performing segments. A segment may be a division, territory, store, or product line. You have no doubt seen a segment eliminated. It might have been a large segment such as an automobile or it may have been a much smaller segment such as a store or restaurant closing. How should we make segment elimination decisions? Let’s look at an example from FasTrac whose Treadmill Division’s total expenses are greater than its sales. Let’s take a closer look at the division’s expenses... Atef Abuelaish

Segment Elimination Exhibit 10.11 P 1
Here we see the total costs in the Treadmill Division. To make the correct decision, we need to know the amount of costs that will be avoided (saved) if we eliminate the Treadmill Division. A segment is a candidate for elimination only if its revenues are less than its avoidable costs. If we eliminate the Treadmill Division, we will avoid total costs of $41,800. The last column in the table shows the unavoidable expenses of the division. The $6,500 of expenses shown in this column, are unavoidable and would be incurred even if the Treadmill Division is discontinued. These costs are irrelevant to the decision because they are the same for either alternative. Let’s focus on Avoidable expenses and revenues… Atef Abuelaish

Do not eliminate the Treadmill Division!
Segment Elimination P 1 Because this division’s sales are $47,800, eliminating the division would reduce FasTrac’s income by $6,000 ($47,800-$41,800). The Treadmill Division’s sale revenue is greater than its avoidable expenses by $6,000. If FasTrac eliminates the Treadmill Division, the company’s income will be $6,000 less. We would have made an incorrect decision using total costs. Remember-we must compare avoidable expenses to sales revenue to make the correct decision. Do not eliminate the Treadmill Division! Atef Abuelaish

Need-to-Know 10.5 P 1 A bike maker is considering eliminating its tandem bike division because it operates at a loss of $6,000 per year. Sales for the year total $40,000, and the company reports the costs for this division as shown below. Should the tandem bike division be eliminated? Avoidable Expenses Unavoidable Expenses Cost of goods sold $30,000 Direct expenses 8,000 Indirect expenses 2,500 $3,000 Service department costs 250 2,250 Total $40,750 $5,250 Keep Tandem Division Eliminate Tandem Division Sales $40,000 $0 Total costs and expenses 46,000 5,250 Net income (loss) ($6,000) ($5,250) Quantitative Analysis: Total avoidable costs of $40,750 are greater than the division’s sales of $40,000, suggesting the division should be eliminated. Need-to-Know 10.5 A bike maker is considering eliminating its tandem bike division because it operates at a loss of $6,000 per year. Sales for the year total $40,000, and the company reports the costs for this division as shown below. Should the tandem bike division be eliminated? If the tandem division is kept, sales of $40,000 minus total costs and expenses, both the avoidable and unavoidable expenses of $46,000 is an operating loss of $6,000. If the division is eliminated, sales will be $0, but the unavoidable expenses of $5,250 will remain. The operating loss is $5,250. Based on this information alone, the tandem division should be eliminated. It makes sense to give up $40,000 in revenues if, in doing so, you can avoid $40,750 in expenses. You are $750 better off. Of course, other factors might be relevant. For example, are sales expected to increase in the future? Does the sale of tandem bikes help sales of other types of products? Other factors might be relevant, since the shortfall in sales ($750) is low. For example, are sales expected to increase in the future? Does the sale of tandem bikes help sales of other types of products? Atef Abuelaish

Keep or Replace Equipment
FasTrac can purchase a new machine for $100,000 and receive $25,000 in return for trading in an old machine with a market value of $25,000. The new machine will reduce manufacturing costs by $18,000 per year. Businesses periodically must decide whether to keep using equipment or replace it. For example, FasTrac has a piece of manufacturing equipment with a book value (cost minus accumulated depreciation) of $20,000 and a remaining useful life of four years. At the end of four years the equipment will have a salvage value of zero. The market value of the equipment is currently $25,000. FasTrac can purchase a new machine for $100,000 and receive $25,000 in return for trading in its old machine. The new machine will reduce FasTrac’s variable manufacturing costs by $18,000 per year over the four-year life of the new machine. FasTrac’s incremental analysis is shown in this slide. FasTrac should not replace the old equipment with this newer version as it will decrease income by $3,000. *18,000 x 4 years Decision: FasTrac should not replace the old equipment with this newer version as it will decrease income by $3,000! Atef Abuelaish

Determine product selling price based on total costs.
10-A2: Determine product selling price based on total costs. Atef Abuelaish

Setting Product Price A 2 There are several methods to help management in setting prices for their products. The cost-plus methods are probably the most common, where management adds a markup to cost to reach a target price. The total cost method, is described below. Four Steps: Step 1: Determine total costs Total costs = Production (DM, DL & OH) costs + Nonproduction (selling and admin) costs Step 2: Determine total cost per unit Total cost per unit = Total costs ÷ Total units expected to be produced and sold Relevant costs are useful to management in determining prices for special short-term decisions. But longer run pricing decisions of management need to cover both variable and fixed costs, and yield a profit. There are several methods to help management in setting prices. The cost-plus methods are probably the most common, where management adds a markup to cost to reach a target price. The total cost method, where management sets price equal to the product’s total costs plus a desired profit on the product is described on this slide. It is a four-step process: Step 1: Determine total costs. The formula to determine this is: Total costs will equal Production costs that include (direct materials, direct labor, and overhead) and then we add Nonproduction costs including (selling and &administrative costs). Step 2: Determine total cost per unit. The formula is: Total cost per unit is equal to Total costs divided by Total units expected to be produced and sold Step 3: We need to determine the dollar markup per unit. The formula for this is Markup per unit is equal to Total cost per unit times the Markup percentage. Where the markup percentage is equal to the desired profit divided by the total costs from step #1. Step 4: The final step is to determine the actual selling price per unit. The Selling price per unit is equal to Total cost per unit + Markup per unit from step #3 Let’ look at one example… Step 3: Determine the dollar markup per unit: Markup per unit = Total costs per unit x Markup percentage Markup % = Desired profit Total costs Step 4: Determine selling price per unit: Atef Abuelaish Selling price per unit = Total costs per unit + Markup per unit

Setting Product Price A 2 A company that produces MP3 players desires a 20% return on its assets of $1,000,000 and expects to produce and sell 10,000 players. Cost information follows Variable costs (per unit) Production costs $44 Nonproduction costs 6 Fixed costs (in dollars) Overhead $140,000 Nonproduction 60,000 We apply our four-step process to determine price. Step 1: Determine total costs Total costs = [($44 x 10,000 units) + $140,000] + [($6 x 10,000 units) + $60,000] = $700,000 To illustrate, consider a company that produces MP3 players. The company desires a 20% return on its assets of $1,000,000, and it expects to produce and sell 10,000 players. The variable and fixed costs for the company are shown in the table. To determine the product price, we will apply our four-step process as shown on the screen. The selling price will be $90 which includes the total cost per unit of $70 plus a $20 markup. Companies use cost-plus pricing as a starting point for determining selling prices. Many factors determine price, including consumer preferences and competition. Step 2: Determine total cost per unit = $700,000/ 10,000 units= $70/per unit Step 3: Determine the dollar markup per unit: $70 x [(20% x $1,000,000)/$700,000] = $20/per unit Step 4: Determine selling price per unit: Atef Abuelaish Selling price per unit = $70 + $20 = $90

Simplified Income Statement
Setting Product Price A 2 A company that produces MP3 players desires a 20% return on its assets of $1,000,000 and expects to produce and sell 10,000 players. Cost information follows Variable costs (per unit) Production costs $44 Nonproduction costs 6 Fixed costs (in dollars) Overhead $140,000 Nonproduction 60,000 Let’s verify the price yielded the desired profit of $200,000 (20% x $1,000,000.) = $70 + $20 = $90 In Step 4 we Determined the selling price need to be: To verify that our price yields the $200,000 desired profit (20% x $1,000,000), we compute the following simplified income statement using the cost information for the company. Based on a estimated selling price of $90 per unit, the company estimates that it will earn a $200,000 profit. This is a 20% return on its assets of $1,000,000. Simplified Income Statement Sales ($90 x 10,000) $900,000 Expenses: Variable ($50 x 10,000) 500,000 Fixed ($140,000 + $60,000) 200,000 Income $200,000 A simplified income statement using the above information and our estimated selling price of $90, yields a $200,000 profit which is a 20% return on our $1,000,000 of assets. Atef Abuelaish

Happiness is having all homework up to date
Homework assignment Using Connect – 8 Questions for 60 Points; Chapter 10. Last day of the Homework for Chapters 6, 7, 8, 9, 10. and 11 is 12/06 at 11:59 PM. Prepare chapter 11 “Capital Budgeting and Investment Analysis.” Happiness is having all homework up to date Atef Abuelaish

Thank you, and see you, On Wednesday at the Same Time
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