1. Chapter Thirteen Short-Run Decision Making: Relevant Costing COPYRIGHT © 2012 Nelson Education Ltd.

2. Learning Objectives 1.Describe the short-run decision-making model, and explain how cost behaviour affects the information used to make decisions 2.Apply relevant costing and decision-making concepts in a variety of business situations 3.Choose the optimal product mix when faced with one constrained resource 4.Explain the impact of cost on pricing decisions 13-2

3. OBJECTIVE  1 1 Describe the short-run decision-making model, and explain how cost behaviour affects the information used to make decisions

4. COPYRIGHT © 2012 Nelson Education Ltd. Short-Run Decisions Small-scale actions that serve a larger purpose Decisions are made using a decision model –Used to structure the thinking process –Organizes information Consists of choosing among alternatives with an immediate or limited end in view 13-4

5. COPYRIGHT © 2012 Nelson Education Ltd. Decision-Making Model 1.Recognize and define the problem 2.Identify the alternatives 3.Identify the costs and benefits associated with each feasible alternative 4.Estimate the relevant costs and benefits for each alternative 5.Assess the qualitative factors 6.Select alternative with the greatest net benefit 13-5

6. COPYRIGHT © 2012 Nelson Education Ltd. Relevant Costs Can consist of both variable and fixed costs Changes in supply and demand for resources must be considered Also known as differential or incremental costs Practical interpretation 13-6

7. OBJECTIVE  2 2 Apply relevant costing decision-making concepts in a variety of business situations

8. COPYRIGHT © 2012 Nelson Education Ltd. Make-or-Buy Decisions Decisions involving a choice between internal and external production Decision process: –Identify feasible alternatives –Identify which costs are relevant –Compare total relevant costs of manufacturing with cost of buying –Make a choice 13-8

9. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 13-1 Information: Direct materials Direct labour Variable overhead Fixed overhead Unit CostTotal Cost $10,000$1.00 20,0002.00 8,0000.80 44,0004.40 Total$82,000$8.20 Determine if it would be cheaper to make 10,000 units of a component in-house or to purchase them from an outside supplier for $4.75 each HOW TO Structure a Make-or-Buy Problem 13-9

10. COPYRIGHT © 2012 Nelson Education Ltd. Example Information continued: Fixed overhead will continue whether the component is produced internally or externally. No additional costs of purchasing will be incurred beyond the purchase price 1.What are the alternatives? 2.List the relevant cost(s) of internal production and of external purchase 3.Which alternative is more cost effective and by how much? 4.Now assume that the fixed overhead includes $10,000 of avoidable cost (if the component is purchased externally) Which alternative is more cost effective and by how much? Required: 13-10

11. COPYRIGHT © 2012 Nelson Education Ltd. Example 1.Alternatives: Make the component in-house, or Purchase the component from an outside supplier 2.Relevant costs: Producing in-house ‒ Direct Materials ‒ Direct Labour ‒ Variable Overhead Purchasing the component externally ‒ Purchase Price 13-11

12. COPYRIGHT © 2012 Nelson Education Ltd. Example Differential Cost to Make Direct materials Direct labour Variable overhead Purchase cost BuyMake $10,000 20,000 8,000 Alternatives ---- 20,000 8,000 Fixed overhead is not included in the analysis. It will remain the same under either alternative 13-12

13. COPYRIGHT © 2012 Nelson Education Ltd. Example Differential Cost to Make Direct materials Direct labour Variable overhead Purchase cost BuyMake $10,000 20,000 8,000 Alternatives ---- 20,000 8,000 The only cost under the “buy” alternative is the purchase cost $47,500 ---- 13-13

14. COPYRIGHT © 2012 Nelson Education Ltd. Example Differential Cost to Make Direct materials Direct labour Variable overhead Purchase cost BuyMake $10,000 20,000 8,000 Alternatives ---- 20,000 8,000 If they buy the component, they will incur $47,500 in additional costs $47,500 ---- (47,500) 13-14

15. COPYRIGHT © 2012 Nelson Education Ltd. Example Differential Cost to Make Direct materials Direct labour Variable overhead Purchase cost BuyMake $10,000 20,000 8,000 Alternatives ---- 20,000 8,000 $47,500 ---- (47,500) Total$47,500$38,000$(9,500) It is cheaper to make the component in-house This alternative is better by $9,500 13-15

16. COPYRIGHT © 2012 Nelson Education Ltd. Example Differential Cost to Make Direct materials Direct labour Variable overhead Avoidable fixed overhead BuyMake $10,000 20,000 8,000 Alternatives ---- 20,000 8,000 Part 4: $10,000 of avoidable fixed overhead If they make the component, fixed costs will increase by $10,000. If they buy it, the $10,000 in fixed costs will be avoided. ----10,000 13-16

17. COPYRIGHT © 2012 Nelson Education Ltd. Example Differential Cost to Make Direct materials Direct labour Variable overhead Avoidable fixed overhead BuyMake $10,000 20,000 8,000 Alternatives ---- 20,000 8,000 Part 4: $10,000 of avoidable fixed overhead ----10,000 $48,000Total$47,500 (47,500) $ 500 Now it is cheaper to purchase the component. This alternative is better by $500 Purchase cost ---- 13-17

18. COPYRIGHT © 2012 Nelson Education Ltd. Special Order Decisions Focus on whether a specially priced order should be accepted or rejected Orders can be attractive –Especially when firm is operating below maximum productive capacity 13-18

19. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 13-2 A new customer has offered to purchase 20,000 units of model TR8 @ $9 each New customer is geographically separated from company’s other customers Existing sales not affected Normal production is 100,000 units per year –Company plans to produce and sell 75,000 in the coming year Normal sales price is $14 per unit Information: HOW TO Structure a Special-Order Problem 13-19

20. COPYRIGHT © 2012 Nelson Education Ltd. Example Information continued: Direct materials Direct labour Variable overhead Fixed overhead Unit Cost $3.00 2.80 1.50 2.00 Total$9.30 1.What are the relevant costs and benefits of the two alternatives (accept or reject the special order)? 2.By how much will operating income increase or decrease if the order is accepted? Required: 13-20

21. COPYRIGHT © 2012 Nelson Education Ltd. Example 1.Relevant cost and benefits: Accept the order Sales price of $9 (Benefit) Direct materials (Cost) Direct labour (Cost) Variable overhead (Cost) Reject the order: There are no relevant costs or benefits 13-21

22. COPYRIGHT © 2012 Nelson Education Ltd. Example AcceptReject Differential Benefit to Accept Price Direct Materials Direct Labour Variable Overhead $9.00$ ---$9.00 (3.00) --- (3.00) (2.80) --- (2.80) (1.50) --- Increase in operating income $1.70 $ 0 $1.70 Operating income will increase by $34,000 ($1.70 × 20,000 units) if the special order is accepted. Per Unit: 13-22

23. COPYRIGHT © 2012 Nelson Education Ltd. Keep-or-Drop Decisions Decision to keep or drop a segment such as a product line Variable costing segment financial reports provide information –Contribution margin –Segment margin Relevant costing provides structure to decision making 13-23

24. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 13-3 Roofing tile line has a contribution margin of $10,000 (sales of $150,000 less total variable costs of $140,000) All variable costs are relevant Relevant fixed costs associated with this line include: –Advertising $10,000 –Supervision $35,000 Information: HOW TO Structure a Keep-or-Drop Product Line Problem 1.List the alternatives being considered 2.List the relevant benefits and costs for each alternative 3.Which alternative is more cost effective? By how much? Required: 13-24

25. COPYRIGHT © 2012 Nelson Education Ltd. Example 1.Alternatives: Keep roofing tile line OR Drop roofing tile line 2.Relevant costs and benefits: Keep the order Sales of $150,000 (Benefit) Variable costs of $140,000 (Cost) Advertising $10,000 (Cost) Supervision $35,000 (Cost) Reject the order: None of the relevant costs or benefits will occur if line is dropped 13-25

26. COPYRIGHT © 2012 Nelson Education Ltd. Example KeepDrop Differential Amount to Keep Sales Less: Variable Expenses Contribution Margin Less: Advertising $150,000$ ---$150,000 140,000 --- 140,000 $ 10,000 --- $ 10,000 (10,000) --- Cost of supervision $ 0$(35,000) The difference is $35,000 in favour of dropping the roofing tile line (35,000) --- (35,000) Total relevant benefit (loss) $(35,000) 13-26

27. COPYRIGHT © 2012 Nelson Education Ltd. HOW TO Structure a Keep-or-Drop Line Problem with Complementary Effects Example: Cornerstone 13-4 Information: BlocksBricks Sales Less: Variable Expenses Contribution Margin Less direct fixed expenses: $500$800 250480 $250$320 (10) Advertising (40) (37)(40) Segment margin$150 (53) Salaries Depreciation $230 13-27

28. COPYRIGHT © 2012 Nelson Education Ltd. Example Dropping the roofing tile product line reduces: –Sales of blocks by 10% –Sales of bricks by 8% All other information remains the same Information continued: 1.If the roofing tile line is dropped, what is the contribution margin: For the block line? For the brick line? 2.Which alternative (keep or drop the roofing tile line) is now more cost effective and by how much? Required: 13-28

29. COPYRIGHT © 2012 Nelson Education Ltd. Example Sales $500,000 Before dropping line After dropping line $450,000 Blocks Less: Variable expenses250,000225,000 Contribution Margin$250,000$225,000 10% reduction in Block sales = $500,000 – 10% ($500,000) = $450,000 Variable expenses are also reduced by 10%, resulting in a 10% decrease in Contribution Margin 13-29

30. COPYRIGHT © 2012 Nelson Education Ltd. Example Sales$500,000 Before dropping line After dropping line $450,000 Blocks Less: Variable expenses250,000225,000 Contribution Margin$250,000$225,000 Sales$800,000$736,000 Bricks Less: Variable expenses480,000441,600 Contribution Margin$320,000$294,400 13-30

31. COPYRIGHT © 2012 Nelson Education Ltd. Example KeepDrop Differential Amount to Keep Contribution Margin$580,000$519,400 Blocks $225,000 + Bricks $294,400 Blocks $250,000 + Bricks $320,000 + Tile $10,000 13-31

32. COPYRIGHT © 2012 Nelson Education Ltd. Example KeepDrop Differential Amount to Keep Contribution Margin Less: Advertising Cost of supervision $580,000$519,400$60,600 (30,000) (20,000)(10,000) (112,000) (77,000) (35,000) $15,600 Now the difference is $15,600 in favour of keeping tile line Total $438,000 $422,400 13-32

33. COPYRIGHT © 2012 Nelson Education Ltd. Further Processing of Joint Products Joint products –Include both common processes and costs up to split-off point Split-off point –The point at which separate products become distinguishable Common costs are not relevant to the decision making 13-33

34. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 13-5 Appletime must decide between –Selling the Grade B apples at split-off 120 two-kilogram bags Selling price is $1.25 per bag –If processed into apple pie filling Generates 500 cans of filling $0.24 additional cost to process Selling price will be $0.90 per can Information: HOW TO Structure the Sell-or-Process-Further Decision 13-34

35. COPYRIGHT © 2012 Nelson Education Ltd. Example 1.What is the contribution to income from selling the Grade B apples in two-kilogram bags? 2.What is the contribution to income from processing the Grade B applies into pie filling? 3.Should Appletime continue to sell the Grade B apples in bags or process them further into pie filling? Required: 13-35

36. COPYRIGHT © 2012 Nelson Education Ltd. Example 1.Contribution to income from selling apples in bags 120 bags x $1.25 selling price $150 revenue from selling apples in bags There are no additional costs, so all the additional revenue is additional profit 13-36

37. COPYRIGHT © 2012 Nelson Education Ltd. Example 2.Contribution to income from processing into pie filling… Sales of the pie filling will bring in additional revenue 500 cans x $0.90 selling price = $450 revenue But processing the apples, will add additional costs: $0.24 per can x 500 cans = $120 $450 - $120 = $330 Income 13-37

38. COPYRIGHT © 2012 Nelson Education Ltd. Example Selling the apples in two-kilogram bags would bring in an additional $150 in revenue with no additional costs Processing the apples into pie filling would contribute $330 in additional income Appletime should process the apples into pie filling because it generates the most income 13-38

39. OBJECTIVE  3 3 Choose the optimal product mix when faced with one constrained resource 13-39

40. COPYRIGHT © 2012 Nelson Education Ltd. Product Mix Decisions Organizations have wide flexibility in choosing their product mix –Mix has significant impact on profitability Maximizing total profit is the goal –Fixed cost will not change with mix, therefore not relevant Focus should be on maximizing total contribution margin Limitations on resources are called “constraints” 13-40

41. COPYRIGHT © 2012 Nelson Education Ltd. HOW TO Determine the Optimal Product Mix with One Constrained Resource Example: Cornerstone 13-6 Jorgenson Company produces two types of gears: X: Unit contribution margin of $25 Requires 2 hours of machine time Y: Unit contribution margin of $10 Requires 0.5 hours of machine time Eight machines provide 40,000 machine hours per year Information: 13-41

42. COPYRIGHT © 2012 Nelson Education Ltd. Example 1.What is the contribution per hour of machine time for each gear? 2.What is the optimal mix of gears? 3.What is the total contribution margin earned for the optimal mix? Required: 13-42

43. COPYRIGHT © 2012 Nelson Education Ltd. Example Gear XGear Y Contribution margin per unit Machine hours required per gear Contribution margin per machine hour $ 25$ 10 ÷ 2 $12.50$20 ÷ 0.5 13-43

44. COPYRIGHT © 2012 Nelson Education Ltd. Example Since Gear Y yields $20 of contribution margin per machine hour….. ALL the machine time should be devoted to the production of Gear Y 40,000 machine hours / 0.5 hours per Gear Y = 80,000 units Optimal mix Gear Y = 80,000 units and Gear X = 0 units Contribution Margin of Optimal Mix 80,000 units × $10 = $800,000 13-44

45. COPYRIGHT © 2012 Nelson Education Ltd. HOW TO Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint Example: Cornerstone 13-7 Jorgenson Company produces two types of gears: –X provides unit contribution margin $25, requires two hours of machine time –Y provides unit contribution margin of $25, requires 0.5 hours of machine time Eight machines provide 40,000 machine hours per year Maximum sales of 60,000 units of each gear can be sold Information: 13-45

46. COPYRIGHT © 2012 Nelson Education Ltd. Example 1.What is the contribution per hour of machine time for each gear? 2.What is the optimal mix of gears? 3.What is the total contribution margin earned for the optimal mix? Required: 13-46

47. COPYRIGHT © 2012 Nelson Education Ltd. Example Gear XGear Y Contribution margin per unit Machine hours required per gear Contribution margin per machine hour $ 25$ 10 ÷ 2 $12.50$20 ÷ 0.5 13-47

48. COPYRIGHT © 2012 Nelson Education Ltd. Example Since Gear Y yields $20 of contribution margin per machine hour….. First priority is to produce ALL of Gear Y that the market will take 60,000 units × 0.5 hours = 30,000 hours 60,000 is the maximum sales for any gear. 60,000 units use 30,000 machine hours. This leaves 10,000 hours of production time. 13-48

49. COPYRIGHT © 2012 Nelson Education Ltd. Example Since Gear Y yields $20 of contribution margin per machine hour….. First priority is to produce ALL of Gear Y that the market will take 60,000 units x 0.5 hours = 30,000 hours 10,000 hours will produce 5,000 units of Gear X 10,000 hours ÷ 2 hours per Gear X = 5,000 units 13-49

50. COPYRIGHT © 2012 Nelson Education Ltd. Example Since Gear Y yields $20 of contribution margin per machine hour….. First priority is to produce ALL of Gear Y that the market will take 60,000 units × 0.5 hours = 30,000 hours 10,000 hours ÷ 2 hours per Gear X = 5,000 units Optimal mix: Gear Y = 60,000 units Gear X = 5,000 units 13-50

51. COPYRIGHT © 2012 Nelson Education Ltd. Example Optimal mix Gear Y = 60,000 units and Gear X = 5,000 units Contribution Margin of Optimal Mix 60,000 units Gear Y × $10 = $600,000 5,000 units Gear X × $25 = $125,000 Contribution Margin$725,000 13-51

52. OBJECTIVE  4 4 Explain the impact of cost on pricing decisions 13-52

53. COPYRIGHT © 2012 Nelson Education Ltd. Cost-Based Pricing Most companies start with cost to determine price Formula: Price = Product cost + Markup Markup is percentage of base cost Includes costs not in base cost & desired profit Advantage – Ease of use 13-53

54. COPYRIGHT © 2012 Nelson Education Ltd. HOW TO Calculate Price by Applying a Markup Percentage to Cost Example: Cornerstone 13-8 Elvin Company assembles and installs computers to customer specifications Jobs are priced at the cost of direct materials and direct labour plus 20% Job for a local vocational-technical school includes: –direct materials $65,000 –direct labour $4,000 Information: Calculate the price charged by Elvin Company to the school Required: 13-54

55. COPYRIGHT © 2012 Nelson Education Ltd. Example Price = Cost + 20% (Cost) Cost = Direct Materials + Direct Labour Cost = $65,000 + $4,000 Cost = $69,000 Price = $69,000 + 20% ($69,000) Price = $82,800 Price = $69,000 +$13,800 13-55

56. COPYRIGHT © 2012 Nelson Education Ltd. Target Costing and Pricing Determining price based on what customers are willing to pay Company then must design and develop product –Cost must be low enough to allow for desired profit 13-56

57. COPYRIGHT © 2012 Nelson Education Ltd. Example: Cornerstone 13-9 Digitime’s new wristwatch plus PDA has a target price of $200 Management requires a 15% profit on new products Information: Required: 1.Calculate the amount of desired profit 2.Calculate the target cost HOW TO Calculate a Target Cost 13-57

58. COPYRIGHT © 2012 Nelson Education Ltd. Example Desired Profit 0.15 × Target Price 0.15 × $200 $30 Target Cost Target Price – Desired Profit $200 – $30 $170 13-58