1. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Relevant Costs for Short-Term Decisions Chapter 8 1

2. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 1 Describe and identify information relevant to short-term business decisions 2

3. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. How Managers Make Decisions Define business goals Identify alternative courses of action Gather and analyze relevant information Choose best alternative Implement decision Follow-up: Compare actual with anticipated results 3

4. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Relevant and Irrelevant Information Relevant – Expected future (cost and revenue) data – Differs among alternative courses of action – Is both quantitative and qualitative Irrelevant – Costs that do not differ between alternatives – Sunk costs – incurred in past and cannot be changed 4

5. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Relevant Nonfinancial Information Nonfinancial, or qualitative factors, also play a role in managers’ decisions. – laying off employees – outsourcing, reduced control over delivery time and product quality – discounted prices to select customers Managers who ignore qualitative factors can make serious mistakes. 5

6. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Six Short-Term Special Decisions Special sales orders Pricing Discontinuing products, departments, and stores Product mix Outsourcing (make or buy) Selling as is or processing further 6

7. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Keys to Making Short-Term Special Decisions Decisions approach – Relevant information approach or incremental analysis approach Two keys in analyzing short-term special business decisions – Focus on relevant revenues, costs, and profits – Use contribution margin approach that separates variable costs from fixed costs 7

8. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Sustainability and Short-term Business Decisions View every decision as having an impact on – People – Planet – Profitability Timberland, “doing well and doing good” – Example: Employees given PTO to volunteer Costly 8

9. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 2 Decide whether to accept a special order 9

10. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. DECISION RULE: Do we have excess capacity available to fill this order? Yes Consider further No Reject the special order A customer requests a one-time order at a reduced sale price, often for a large quantity: Special Order Considerations 10

11. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Special Sales Order DECISION RULE: Is the special reduced sales price high enough to cover the incremental costs of filling the order? If revenues are greater than expected cost increase Accept the special order If revenues are less than expected cost increase Reject the special order 11

12. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Special Sales Order DECISION RULE: Will the special order affect regular sales in the long run? If no to these questions Accept the special order If yes to these questions Reject the special order 12

13. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Incremental Analysis of Special Sales Order, Exhibit 8-6 Expected increase in revenues—sale of 20,000 oil filters x $1.75 each $ 35,000 Expected increase in expenses—variable manufacturing costs: 20,000 oil filters $1.20 each (24,000) Expected increase in operating income $ 11,000 13

14. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to E8-16A 14

15. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-16A 1.Prepare an incremental analysis to determine whether Collectible Cards should accept the special sales order assuming fixed costs would not be affected by the special order. Would accept the special order because the cost per part to make it is only $0.30 per part versus the $0.40 per part selling price being offered by the buyer. Variable costs: Direct Materials Direct Labor Variable Overhead $0.13 0.06 0.11 Total Cost $0.30 15

16. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-16A (cont.) 2.Now assume that the Hall of Fame wants special hologram baseball cards. Collectible Cards must spend $5,000 to develop this hologram, which will be useless after the special order is completed. Should Collectible Cards accept the special order under these circumstances? Show your analysis. Expected increase in revenues—sale of 57,000 cards x $0.40 each $ 22,800 Expected increase in expenses—variable manufacturing costs: 57,000 cards x $0.30 each Special hologram cost (17,100) (5,000) Expected increase in operating income $ 700 16

17. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 3 Describe and apply different approaches to pricing 17

18. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Regular Pricing Considerations What is our target profit? How much will customers pay? Are we a price-taker or a price-setter for this product? 18

19. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Price-Taker vs Price-Setter Price-TakersPrice-Setters Product lacks uniquenessProduct is more unique Heavy competitionLess competition Pricing approach emphasizes target costing Pricing approach emphasizes cost-plus pricing 19

20. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Target Costing – Exhibit 8-9 Market price minus desired profit = target cost Target Cost includes: – Development cost– Marketing cost – Design cost– Delivery cost – Production cost– Service cost 20 CalculationsTotal Revenue at market price250,000 units x $3.00 price = $ 750,000 Less: Desired profit10% x $1,000,000 of assets (100,000) Target total cost$650,000

21. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Two potential outcomes when using target costing 1.Actual cost less than target total cost 2.Actual cost greater than target total cost 21

22. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Other Strategies Increase sales – Use CVP analysis to compute target sales to achieve its target profit. Change or add to its product mix – Offer levels of the same product – Offer new items to the product mix with high CM – Remove items with the lowest CM Differentiate its products – (make it unique) – Branding – Quality – Service packs 22

23. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Cost-Plus Pricing The opposite of the target-pricing approach – Starts with the company’s full costs – Adds the desired profit to determine a cost-plus price Total cost Plus: Desired profit Cost –plus price 23

24. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Calculating Cost-Plus Price, Exhibit 8-12 If the current price is $3.00, can the company charge $3.20? Total Current variable costs250,000 units x $1.50 per unit =$ 375,000 Plus: Current fixed costs+ 325,000 Current total costs$700,000 Plus: Desired profit10% x $1,000,000 of assets+ 100,000 Target revenue$800,000 Divided by number of units ÷ 250,000 Cost-plus price per unit$ 3.20 24

25. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Pricing Decisions DECISION RULE: How to Approach Pricing? If company is a price-taker for the product: Emphasize target costing approach If the company is a price- setter for the product: Emphasize cost-plus pricing approach 25

26. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to E8-19A 26

27. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-19A 1.Which approach to pricing should Smith Builders emphasize? Why? – Target costing – Firm is a price taker, product lacks uniqueness and there is heavy competition 27

28. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-19A (cont.) 2.Will Smith Builders be able to achieve its target profit levels? Show your computations. The answer is no, the target cost is less than variable cost. CalculationsTotal Revenue at market price$ 206,000 Less: Desired Profit14% of the variable cost $190,000 (26,600) Target cost$ 179,400 28

29. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-19A (cont.) 3.If Smith Builders upgrades, what will the new cost-plus price per home be? Should the company differentiate its product in this manner? Show your analysis. Yes, they should customize – they will achieve their target profit levels with the cost-plus price. Total Current total costs($190,000 + $18,000)$208,000 Plus: Desired profit (14% x variable cost of $208,000) + 29,120 Cost-plus price$237,120 29

30. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 4 Decide whether to discontinue a product, department, or store 30

31. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Other Short-term Business Decisions Managers Face When to discontinue a product, department, or store How to factor constrained resources into product mix decisions When to make a product or outsource it When to sell as is or process further 31

32. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Considerations for Discontinuing Products, Departments or Stores, Exhibit 8-14 Does product provide positive contribution margin? 32

33. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Considerations for Discontinuing Products, Departments or Stores Will the total fixed costs continue to exist even if the product line is discontinued? Can any direct fixed costs of the product be avoided if the product line is discontinued? Use incremental analysis for discontinuing a product 33

34. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Discontinuing Products, Departments or Stores DECISION RULE: Discontinue a product, department, or store? If lost revenues from discontinuing a product, department, or store exceed the cost savings from discontinuing: Do not discontinue If total cost savings exceed the lost revenues from discontinuing a product, department, or store: Discontinue 34

35. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to E8-20A 35

36. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-20A 1.Prepare an incremental analysis to show whether Entertainment Plus should discontinue the DVD product line. Will discontinuing DVDs add $18,000 to operating income? Explain. Expected decrease in revenues: Sale of DVDs$136,000 Expected decrease in expenses: Variable manufacturing expenses86,000 Expected decrease in operating income$50,000 36

37. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-20A (cont.) 2.Assume that Entertainment Plus can avoid $20,000 of fixed expenses by discontinuing the DVD product line (these costs are direct fixed costs of the DVD product line). Prepare an incremental analysis to show whether Entertainment Plus should stop selling DVDs. 37 Expected decrease in revenues: Sale of DVDs$136,000 Expected decrease in expenses: Variable manufacturing expenses$86,000 Direct fixed expenses$20,000 Expected decrease in total expenses106,000 Expected decrease in operating income$30,000

38. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-20A (cont.) 3.Now, assume that all $68,000 of fixed costs assigned to DVDs are direct fixed costs and can be avoided if the company stops selling DVDs. However, marketing has concluded that Blu-ray disc sales would be adversely affected by discontinuing the DVD line. Blu-ray disc production and sales would decline 10%. What should the company do? 38 Expected decrease in revenues: Sale of DVDs$136,000 Sale of Blu-rays14,300$150,300 Expected decrease in expenses: Variable manufacturing expenses$86,000 Direct fixed expenses$68,000 Expected decrease in total expenses154,000 Expected increase in operating income$3,700

39. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 5 Factor resource constraints into product mix decisions 39

40. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Product Mix Considerations – Example from pages 477 - 479 DataPer Unit ShirtsJeans Sale price Less: Variable expenses Contribution margin Contribution margin ratio: Product A — Product B — 40 $30$60 (12)(48) $18$12 60% 20% $18 ÷ $30 $12 ÷ $60

41. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Product Mix Considerations – Exhibit 8-18 ShirtsJeans (1) Units that can be produced each machine hour 1020 (2) Contribution margin per unitx $18x $12 Contribution margin per machine hour (1) x (2) $ 180$ 240 Available capacity—number of machine hoursx 2,000 Total contribution margin at full capacity$360,000$480,000 41

42. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Product Mix DECISION RULE: Which product to emphasize? Emphasize the product with the highest contribution margin per unit of constraint 42

43. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Product Mix When Demand Is Limited or Fixed Costs Change What if demand is limited, due to competition or other factors? [In this example, company has demand for only 30,000 jeans, which consume in total 1,500 hours (30,000 jeans/20 jeans per hour)] What if fixed costs are different when a different product mix is emphasized? ExampleShirtsJeans Contribution margin per machine hour$ 180$ 240 Machine hours devoted to productx 500x 1,500 Total contribution margin at full capacity$90,000$360,000 43

44. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to E8-22A 44

45. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-22A What product mix will maximize operating income? Get Fit Product Mix Analysis DeluxeRegular Sale price per unit Variable costs per unit Contribution margin per unit Units produced with equivalent number of machine hours Contribution margin for equivalent number of machine hours 45

46. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-22A What product mix will maximize operating income? Get Fit Product Mix Analysis DeluxeRegular Sale price per unit$1,010$560 Variable costs per unit 781 a 427 b Contribution margin per unit 229133 Units produced with equivalent number of machine hours × 1× 3 Contribution margin for equivalent number of machine hours$ 229$399 a ($310 + $ 88 + $264 + $119) b ($90 + $184 + $ 88 + $ 65) Get Fit should produce only the Regular model. 46

47. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 6 Analyze outsourcing (make-or-buy) decisions 47

48. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Outsourcing (Make or Buy) Considerations To buy a product or service or produce it in-house The heart of the decisions : how best to use available resources – How do our variable costs compare to the outsourcing cost? – Are any fixed costs avoidable if we outsource? – What could we do with the freed capacity? 48

49. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Outsourcing DECISION RULE: Should the company outsource? If the incremental costs of making exceed the incremental costs of outsourcing: Outsource If the incremental costs of making are less than the incremental costs of outsourcing: Do not outsource 49

50. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to E8-25A 50

51. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-25A 1.Given the same cost structure, should OptiSystems make or buy the switch? OptiSystems Incremental Analysis for Outsourcing Decision Make UnitBuy Unit Cost to Make Minus Cost to Buy Variable cost per unit: Direct materials Direct labor Variable overhead Purchase price from outsider Variable cost per unit 51

52. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-25A 1.Given the same cost structure, should OptiSystems make or buy the switch? OptiSystems Incremental Analysis for Outsourcing Decision Make UnitBuy Unit Cost to Make Minus Cost to Buy Variable cost per unit: Direct materials$ 10.00 a $ — $ 10.00 Direct labor 2.50 b —2.50 Variable overhead 3.00 c —3.00 Purchase price from outsider — 17.00 (17.00) Variable cost per unit$15.50$17.00$ (1.50) a $720,000 / 72,000 = $10.00/unit b $180,000 / 72,000 = $2.50/unit c $216,000 / 72,000 = $3.00/unit 52

53. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-25A (cont.) 2.Now, assume that OptiSystems can avoid $100,000 of fixed costs a year by outsourcing production. In addition, because sales are increasing, OptiSystems needs 77,000 switches a year rather than 72,000. What should OptiSystems do now? Make switchesBuy switches Variable cost per unit (from part 1) × Units needed Total variable costs Fixed costs Total relevant costs 53

54. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-25A (cont.) 2.Now, assume that OptiSystems can avoid $100,000 of fixed costs a year by outsourcing production. In addition, because sales are increasing, OptiSystems needs 77,000 switches a year rather than 72,000. What should OptiSystems do now? Make switchesBuy switches Variable cost per unit (from part 1)$ 15.50$ 17.00 × Units needed 77,000 Total variable costs$ 1,193,500 1,309,000 Fixed costs 468,000 368,000* Total relevant costs$1,661,500$1,677,000 *($468,000 − $100,000 avoidable) 54

55. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-25A (cont.) 3.Given the last scenario, what is the most OptiSystems would be willing to pay to outsource the switches? Cost if making switches=Cost of outsourcing switches * Where x = outsourcing cost per switch 55 ($15.50 × 77,000) + $468,000=(x)* (77,000) + $368,000 Variable costs + fixed costs= $1,193,500 + $468,000=77,000x + $368,000 $1,293,500=77,000x $16.80(rounded)=x

56. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Objective 7 Make sell as-is or process further decisions 56

57. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Sell As-Is or Process Further Considerations How much revenue is generated if we sell the product as is? How much revenue is generated if we sell the product after processing it further? How much will it cost to process the product further? 57

58. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Analysis for Sell As Is or Process Further Decision – Exhibit 8-25 Sell As-Is Process Further Additional Revenue/(Cos ts) from Processing Further Expected revenue from selling 50,000 quarts of regular olive oil at $5.00 per quart $250,000 Expected revenue from selling 50,000 quarts of gourmet dipping oil at $7.00 per quart $350,000$100,000 Additional costs of $0.75 per quart to convert 50,000 quarts of plain olive oil into gourmet dipping oil (37,500) Total net benefit $250,000$312,500$62,500 58

59. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Sell As-Is or Process Further DECISION RULE: Sell as-is or process further? If extra revenue (from processing further) exceeds extra cost of processing further: Process further If extra revenue (from processing further) is less than extra cost of processing further: Sell as is 59

60. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Now turn to E8-28A 60

61. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. E8-28A Sell as is (gallons) Process further Sales revenue per unit$ 6.00$ 0.50 Additional process costs per unit - packaging(0.10) (0.05) Additional process costs per unit - fruit (0.00)(0.15) Net benefit per unit $ 5.90 $ 0.30 Number of units produced per batch × 600× 12,800 Net benefit per batch$3,540$ 3,840 61

62. Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. End of Chapter 8 62