1. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 20 1

2. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Describe and identify information relevant to business decisions Make special order and pricing decisions Make dropping a product and product-mix decisions Make outsourcing and sell as is or process further decisions

3. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Describe and identify information relevant to business decisions 1 1 3

4. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 4 Increasing profits or Market share Special order Special price Product mix Outsource Process further Product costs Fixed costs Variable costs Capacity Using relevant information choose best alternative

5. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1. Expected future data 2. Differs among alternatives 5

6. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Relevant costs Affect decisions Occur in the future Differ among the alternatives Irrelevant costs Do not affect decisions Sunk costs Occurred in the past Always irrelevant to the decision Cannot be changed 6

7. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Considering qualitative factors in decision- making Impact on employee morale Outsourcing Layoffs Impact on quality Product recall, higher warranty costs Upset customers Customer relations Discounted prices to select customers Use same guidelines as relevant costs Occurs in the future Differs between alternatives 7

8. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Relevant information approach Also called the incremental analysis approach How operating income differs under alternatives Irrelevant information is ignored Only relevant data affect decisions 8

9. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. You are trying to decide whether to trade in your inkjet printer for a more recent model. Your usage pattern will remain unchanged, but the old and new printers use different ink cartridges. 1.Indicate if the following items are relevant or irrelevant to your decision: a.The price of the new printer b.The price you paid for the old printer c.The trade-in value of the old printer d.Paper costs e.The difference between ink cartridges’ costs 9 Relevant Irrelevant Relevant Irrelevant Relevant

10. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Make special order and pricing decisions 2 2 10

11. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Special order When a customer requests a one-time order at a reduced sale price Considerations: Does the company have excess capacity available to fill this order? Will the reduced sales price be high enough to cover the incremental costs of filling the order (the variable costs and any additional fixed costs)? Will the special order affect regular sales in the long run? 11

12. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 12 Is there excess capacity? Yes Consider further No Reject the special order

13. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 13 Does reduced price cover variable cost? Yes Consider fixed costs No Reject the special order

14. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 14 Will the special order affect regular sales in the long run? Will regular customers find out and demand a lower price? Will special order start a price war with competitors? Will special order customer demand lower price on a regular basis?

15. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1.Focus on relevant data (revenues and costs that will change if it accepts the special order) 2.Use of a contribution margin approach that separates variable costs from fixed costs 3.The special sales order will increase operating income by $2,500. Fixed costs remain the same. 15

16. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 16

17. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 17 What is our target profit? How much will customers pay? Are we a price-taker or a price-setter?

18. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Examples: Food commodities Natural resources Generic consumer products and services 18 Examples: Original art, jewelry Specially manufactured machinery Patented perfume scents Latest tech gadget

19. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 19 Starts with the market price of the product The price customers are willing to pay Subtracts the company’s desired profit Determine the product’s target full cost Full cost to develop, produce, and deliver the product or service

20. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Accept the lower operating income, not the target return required by stockholders Reduce fixed costs Reduce variable costs Use other strategies Increase capacity to spread the fixed costs are spread over more units Change or add to product mix Differentiate its product (become a price setter) 20

21. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Emphasizes a cost-plus approach Opposite of the target-pricing approach Starts with the full costs and adds desired profit to determine a cost-plus price Unique product = more control over pricing 21 Full cost Plus: Desired profit Equals Cost-plus price

22. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Unique products Consider what customers are willing to pay How well has the company been able to differentiate its product? 22

23. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 23 How to Approach Pricing? Is company a price-taker for the product? Emphasize target pricing approach Is company a price-setter for the product? Emphasize cost- plus pricing approach

24. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 24 Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardz’s total production cost is $0.61 per pack, as follows: Hobby-Cardz has enough excess capacity to handle the special order. 1. Prepare an incremental analysis to determine whether Hobby- Cardz should accept the special sales order.

25. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 25 Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardz’s total production cost is $0.61 per pack, as follows: Hobby-Cardz has enough excess capacity to handle the special order. 1. Prepare an incremental analysis to determine whether Hobby- Cardz should accept the special sales order. Accept the special order

26. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 26 2. Now assume that the Hall of Fame wants special hologram baseball cards. Hobby-Cardz will spend $5,900 to develop this hologram, which will be useless after the special order is completed. Should Hobby-Cardz accept the special order under these circumstances? R e j e c t t h e s p e c i a l o r d e r

27. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Green Thumb operates a commercial plant nursery where it propagates plants for garden centers throughout the region. Green Thumb has $4,800,000 in assets. Its yearly fixed costs are $600,000, and the variable costs for the potting soil, container, label, seedling, and labor for each gallon-size plant total $1.35. Green Thumb’s volume is currently 470,000 units. Competitors offer the same plants, at the same quality, to garden centers for $3.60 each. Garden centers then mark them up to sell to the public for $9 to $12, depending on the type of plant. 1. Green Thumb’s owners want to earn a 10% return on the company’s assets. What is Green Thumb’s target full cost? 27 Revenue at current market price (470,000 units × $3.60 per unit) $1,692,000 Less:Desired profit ($4.8 million × 10%) 480,000 Target full cost$1,212,000

28. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2. Given Green Thumb’s current costs, will its owners be able to achieve their target profit? 28 Green Thumb’s actual total full costs of $1,234,500 are higher than its target full cost, therefore Green Thumb will not meet the stockholders’ profit expectations. Current variable cost (500,000 × 1.70) $ 634,500 Current fixed costs 600,000 Total full cost $1,234,500

29. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 3. Assume Green Thumb has identified ways to cut its variable costs to $1.20 per unit. What is its new target fixed cost? Will this decrease in variable costs allow the company to achieve its target profit? 29 The new target fixed cost is $648,000. Target full cost (from requirement 1) $1,212,000 Less: Reduced level of variable costs (470,000 × $1.20) (564,000) New target fixed costs$ 648,000 Since the company’s actual fixed costs are less than or equal to the new target fixed cost amount, Green Thumb will be able to achieve its target profit without having to take any other cost-cutting measures.

30. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 4. Green Thumb started an aggressive advertising campaign strategy to differentiate its plants from those grown by other nurseries. Monrovia Plants made this strategy work, so Green Thumb has decided to try it, too. Green Thumb does not expect volume to be affected, but it hopes to gain more control over pricing. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not? 30

31. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 4. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not? 31 Green Thumb’s cost-plus price is $3.74 Current fixed costs$ 600,000 Plus:Additional fixed costs of advertising 115,000 Plus: Total variable costs (470,000 × $1.20) 564,000 Total full costs$1,279,000 Plus: Desired profit ($4.8 million × 10%). 480,000 Desired revenue$1,759,000 Divided by:Number of units ÷ 470,000 Cost-plus price per unit $ 3.74 Retailers will be more willing to pay the cost-plus price if the marketing campaign is effective. Other wise, Green Thumb may be considered a generic nursery.

32. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Make dropping a product and product-mix decisions 3 3 32

33. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 33 Does the product, department, or territory provide a positive contribution margin? Will fixed costs continue to exist, even if the company drops the product? Are there any direct fixed costs that can be avoided if the company drops the product, department, or territory? Will dropping the product, department, or territory affect sales of the company’s other products? What could the company do with the freed manufacturing capacity?

34. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Focus on a decrease in volume 34

35. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If product has a negative contribution margin, then drop Unavoidable fixed costs Fixed costs that continue to exist even after a product is dropped—irrelevant Avoidable, direct fixed costs—relevant If costs decrease more than the decrease in revenues, product should be dropped Would dropping the product line, department, or territory hurt other sales? Consider lost contribution margins from other products Will more profitable products be produced with freed capacity? 35

36. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 36 Drop a product, department, or territory? Are lost revenues > cost savings? Do not drop Are lost revenues < cost savings? Drop

37. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Constraints Something that restricts production or sale of product Manufacturers Limitations on labor or machine hours or available materials Merchandisers Amount of display space Stiff competition may limit demand 37

38. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 38 What constraint(s) stop(s) the company from making (or displaying) all the units the company can sell? Which products offer the highest contribution margin per unit of the constraint? Would emphasizing one product over another affect fixed costs? Decision rule: Decision Rule - Which product to emphasize? Emphasize the product with the highest contribution margin per unit of the constraint.

39. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Deela Fashions operates three departments: Men’s, Women’s, and Accessories. Departmental operating income data for the third quarter of 2012 are as follows: Assume that the fixed expenses assigned to each department include only direct fixed costs of the department: ● Salary of the department’s manager ● Cost of advertising directly related to that department If Deela Fashions drops a department, it will not incur these fixed expenses. 39

40. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1.Under these circumstances, should Deela Fashions drop any of the departments? Give your reasoning. Deela Fashions should drop the Accessories Department because relevant expenses are greater than the revenues which will result in an increase in operating income if the department is dropped. 40

41. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Make outsourcing and sell as is or process further decisions 4 4 41

42. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Managers decide whether to buy a component product or service or produce it in-house Cheaper is not always the deciding factor Considerations: How do the company’s variable costs compare to the outsourcing cost? Are any fixed costs avoidable if the company outsources? What could the company do with the freed manufacturing capacity? 42

43. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If fixed costs stay the same—irrelevant If fixed costs change—relevant Differs between alternatives 43 Company can avoid $10,000 in fixed cost if outsourced. However, total costs are more, so do not outsource.

44. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 44 Should the company outsource? If the incremental costs of making exceed incremental costs to outsource Outsource If the incremental cost of making are less than the incremental costs to outsource Do not outsource

45. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Benefit given up by not choosing an alternative course of action Example: If the company chooses not to outsource, it will lose any revenue from freed capacity If company outsources, freed capacity can be used to produce other products, maybe earning more 45

46. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Qualitative factors Control over quality Outsourcing considerations Coordination, information exchange, and paperwork problems Globalization Use Internet to find information systems of suppliers and customers located around the world Companies can now focus on their core competencies—quality and delivery 46

47. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Considerations: How much revenue will the company receive if the company sells the product as is? How much revenue will the company receive if the company sells the product after processing it further? How much will it cost to process the product further? 47

48. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 48

49. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Decision rule: 49 Sell as-is or process further? If extra revenue from processing further exceeds extra cost Process further If extra revenue from processing further is less than extra cost Sell as is

50. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Suppose a Roasted Olive restaurant is considering whether to (1) bake bread for its restaurant in-house or (2) buy the bread from a local bakery. The chef estimates that variable costs of making each loaf include $0.52 of ingredients, $0.24 of variable overhead (electricity to run the oven), and $0.70 of direct labor for kneading and forming the loaves. Allocating fixed overhead (depreciation on the kitchen equipment and building) based on direct labor assigns $0.96 of fixed overhead per loaf. None of the fixed costs are avoidable. The local bakery would charge $1.75 per loaf. 1. What is the unit cost of making the bread in-house (use absorption costing)? 2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why? 3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision? 50

51. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1. What is the unit cost of making the bread in-house (use absorption costing)? 51

52. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why? Decision: Roasted Olive should bake the bread in-house since the variable cost of making each loaf is less than the cost of outsourcing each loaf. 3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision? Roasted Olive should consider the following qualitative factors before making a final decision: Will the local bakery meet their delivery time requirements? How does the quality and freshness of the local bakery bread compare to Roasted Olive bread? 52

53. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Relevant information is expected future data that differs among alternatives. Relevant costs are costs that may affect which decision you make. Irrelevant costs are costs that won’t change the decision you make. Sunk costs are costs that were incurred in the past and cannot be changed regardless of which future action is taken. The two keys to making short-term decisions are to focus on relevant revenues, costs, and profits, and to use a contribution margin approach to separate variable and fixed costs. 53

54. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Managers must consider three things when considering a special order: 1) Does the company have excess manufacturing capacity? 2) Does the special sales price cover the incremental costs of filling the special order? 3) Will fixed costs change because of the special order? If the expected increase in revenues exceeds the expected increase in costs, the company should accept the special order. When setting prices, the company must consider its target profit goal, how much customers will pay for the product, and whether the company is a price-taker or a price-setter. Price setters use a cost-plus pricing approach to pricing, whereas price-takers use a target pricing approach. 54

55. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The first product mix question is “Does the product provide a positive contribution margin?” What is relevant is whether the fixed costs continue to exist if the product is dropped and whether there are any avoidable direct fixed costs if the product is dropped. Unavoidable fixed costs and are irrelevant to the decision. If direct fixed costs will change, those costs are relevant to the decision of whether a product should be dropped. When there is a constraint on production, such as total machine hours, this constraint must be considered when determining which product should be emphasized. If the company can sell whatever product it makes, the company should emphasize producing the product with the highest contribution margin per unit of the constraint. 55

56. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. When a company is considering outsourcing, if the incremental costs of making the product exceed the incremental costs of outsourcing, then the company should outsource the product. When a company is considering selling a product as is or processing it further, if the extra revenue from processing the product further exceeds the extra costs to process the product further, then the company should process the product further. 56

57. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 57

58. Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 58 Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.