Chapter 4: Relevant Costs and Benefits for Decision- Making - PDF document

Chapter 4: Relevant Costs and Benefits for Decision- Making Agenda � Sunk/Opportunity Costs � Decision Relevance � Differential Analysis 2 1

It’s all relevant … Sunk Costs – outlays of resources or effort from past � periods. These costs should be ignored. Opportunity Costs – revenues (or profits) foregone � by choosing an alternate course of action. For example, the opportunity cost of you being here is the salary you could be making if you remained in the workforce. Remember that we use managerial accounting for two � major purposes: Decision-making � Control and evaluation � 3 With respect to decision relevance: Fixed Cost Classification Depreciation on equipment already Sunk and irrelevant purchased (not incremental) President’s salary which will not change Not sunk (but still when deciding between two options irrelevant), (not incremental) Salary of supervisor who will be retained Not sunk and not if one action is taken and fired if the irrelevant other action is taken (incremental) 4 2

Return to our copy center example: � The copy center hours are currently from 6am to 8pm. The student union is trying to determine whether they should extend the closing time from 8pm to 12 midnight. � The manager estimates that revenue will increase by $800 per day if he extends hours. But he will have to pay a part-time worker for 4 additional hours at $20/hour. Additional paper, toner, and other miscellaneous costs of $500 will be incurred. Finally, utility costs will be increased by $10. � Should the manager extend the hours? 5 Should the manager extend the hours? Incremental revenue per day $800 Incremental costs per day: Salary $ 80 Paper, toner, etc. 500 Utilities 10 590 Incremental profit $210 6 3

Well, heck … should we stay open even later? ( How about until 2am ?) � Additional revenue in the last two hours is $70. � Paper, toner, etc. is $27 for the last two hours and utility costs are $5. � Should the manager stay open until 2am? 7 Should the manager stay open until 2 a.m.? Incremental revenue per day $70 Incremental costs per day: Salary $ 40 Paper, toner, etc. 27 Utilities 5 72 Incremental profit ($ 2) 8 4

Differential Analysis: Differential analysis is a tool that determines the effect on � profitability of possible courses of action to be taken in the future. Differential analysis allows the decision- maker to rank-order � decision alternatives based on incremental effect of profitability. Pricing changes � Production changes � Vendor comparisons � Cost consumption analyses (i.e., discretionary costs such as marketing, � R&D, etc.) Customer selection � Product line selection � Special orders � 9 Differential Analysis Cont.: Differential analysis allows the decision- maker � to rank-order decision alternatives based on incremental effect of profitability. Acquisitions, mergers, and divestitures � Joint ventures � Outsourcing decisions � Make or buy decisions � Bonus/compensation plans � Sell or process further � 10 5

Caution Immediate profit effects should be considered in light � of effects on pricing, production capacity constraints, duration of contract (product demand and cost structures may change over time), etc. It’s usually not relevant to consider fixed costs in � differential analysis unless the decision involves exceeding current capacity levels (then there is a marginal increase in fixed costs that would be relevant). Likewise, long-term contracts should consider all � costs since a firm has to cover its total costs to stay in business in the long-run. 11 Additional Processing Decision: PowerComp has decided to discontinue its Model 250 � computer. It currently has 5,000 partially completed units on hand. � To date, the company has spent $800 per unit, or $4,000,000 � to bring these computers to their current stage of completion. What kind of cost is the $4,000,000? � SUNK � Should it be considered for decision-making at this point in � time? NO � 12 6

Additional Processing Decision: � The company estimates that an additional $400 per unit will be incurred to complete production. � Because the company has announced the product will be discontinued, prices have fallen. � If the units are completed, they can be sold for only $1,000. How does this price compare to total cost per unit? � $1,000 price < ($800 + $400) total cost � Should the company complete production? Or should they sell them to an assembly company as they are for $500/unit? 13 Additional Processing Decision: Sell in current state $ 500 Sell in completed state $1,000 Additional costs to complete (400) Profit $ 600 What should we do? 14 7

Make or Buy Decision: � Suppose we manufacture refrigerators and compressors are one of our numerous components. Cooper Compressors offers to sell us their compressors at $310 per unit. We currently make our own compressors (50,000 units) and our costs are as follows: 15 Costs: Variable Costs Direct materials ($100 per unit) $ 5,000,000 Direct labor ($120 per unit) 6,000,000 Variable overhead ($80 per unit) 4,000,000 Total Variable Costs $15,000,000 Fixed Costs Depreciation of Building $ 600,000 Depreciation of Equipment 800,000 Supervisory Salaries 500,000 Other 350,000 Total Fixed Costs $ 2,250,000 Total Cost $17,250,000 Cost per unit $345 16 8

Make or Buy Decision: � The market value of the machine that makes the compressors is zero. � Five production supervisors will be fired if we buy the compressors from Cooper – however, one supervisor has an employment contract that requires that he will be paid $110,000 annually until retirement (although his services will no longer be required). What should the company do? Make or Buy? 17 Make or Buy Decision: Cost of manufacturing 50,000 compressors: $17,250,000 total costs Cost of buying 50,000 compressors: $15,500,000 (50,000 x $310) Should we make or buy? (Or is this an incomplete analysis?) 18 9

Incremental cost analysis: Cost of buying 50,000 compressors $15,500,000 Less Cost savings from buying (avoidable costs): Variable costs $15,000,000 Supervisor salaries $ 390,000 (15,390,000) Incremental cost of buying compressors $ 110,000 19 Incremental cost analysis: Side-by-Side Comparison Make Buy Purchase Price 15,500,000 Variable Costs 15,000,000 Fixed Costs: Deprec. - Bldg. 600,000 600,000 Deprec. - Eqmt. 800,000 800,000 Supervisor Salaries 500,000 110,000 Other 350,000 350,000 Total Cost 17,250,000 17,360,000 20 10

Make or Buy Decision: � Now what if another company offered to lease the space that we have been using for compressor manufacture for $500,000 if we decide to buy the compressors instead? � Then we should buy , because our incremental cost savings is $390,000 ($500,000 less $110,000 previous incremental cost). 21 Product Line Analysis: � Magnolia Hardware sells three product lines: tools, hardware supplies, and garden supplies. 22 11

Here is a Product Line Income Statement for Magnolia Hardware: Tools Hardware Garden Total Supplies Supplies Sales $120,000 $200,000 $80,000 $400,000 Cost of goods sold 81,000 90,000 60,000 231,000 Gross margin 39,000 110,000 20,000 169,000 Other variable 2,000 4,000 1,000 7,000 costs Contribution 37,000 106,000 19,000 162,000 margin Direct fixed costs 8,000 5,000 3,500 16,500 Allocated fixed 24,000 40,000 16,000 80,000 costs Total fixed costs 32,000 45,000 19,500 96,500 Net income (loss) $5,000 $61,000 ($500) $65,500 23 Product Line Analysis: � Direct fixed costs are directly associated with a product line. � Allocated fixed costs are overhead in nature and are allocated to the product lines based on their relative sales value. � For example, hardware supplies comprises one-half ($200,000/$400,000) of the total sales revenue, so they receive one-half ($40,000/$80,000) of the total allocated fixed costs. � Would you recommend dropping the garden supplies product line? 24 12

Product Line Analysis: Lost sales $80,000 Cost Savings: Cost of goods sold $60,000 Other variable costs 1,000 Direct fixed costs 3,500 (depends on if this is avoidable)** Total Cost Savings (64,500) Net loss from dropping product line $15,500 ** A salaried employee without an employment contract would be an avoidable cost. Rent would generally not be avoidable. The results would be even more dramatic if the direct fixed costs were not avoidable. 25 Product Line Analysis: � What happens to the profitability of the other product lines if we drop garden supplies? � The allocated fixed costs that were allocated to garden supplies now must be re-allocated to tools and hardware supplies (thus lowering their profitability). � A company could enter into a cost allocation death spiral by eliminating products. 26 13

Pricing Special Orders � Suppose that we make camera lenses and Thomas Corporation asks us to produce 20,000 lenses for their compact 35-millimeter camera. The lens is identical to Model A that we already produce and sell for $85. However, they have offered to buy the lenses for $73 per unit. We sold 280,000 units last year and are operating at only 75% of capacity. 27 Costs per unit are as follows: Direct material $30.00 Direct labor 15.00 Variable overhead 10.00 Fixed overhead 20.00 Total cost $75.00 28 14