Transcript 1B ch020_inst

Chapter 20
1
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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
2
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1
Describe and identify information relevant to
business decisions
3
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Repeat existing patterns without question
Why did the accountant cross the road?
Triage management
Deal with most urgent problems as they come up
Trial and error
Shooting from the hip, seat of the pants
Information based decision making
Base decisions on mission aligned options
supported with relevant information
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How do we
utilize
excess
capacity?
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Should we
accept this
special order?
Relevant costs,
market effects
Accept the
offer if it
helps us meet
our business
goals.
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Relevant costs affect decisions
Differ among the alternatives
Haven’t happened yet
Any costs that fit those above two categories
Irrelevant costs do not affect decisions
Costs that do not differ between options
Sunk costs
Occurred in the past
Are never relevant to any decision
The trouble is we are human and we hate to lose.
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Impact on employee morale
Outsourcing
Layoffs
Impact on quality
Product recall, higher warranty costs
Brand equity, lost sales
Customer relations
Reactions to your decisions
Opportunity cost
What you forego to get something else
Use same guidelines as relevant costs
Occurs in the future
Differs between alternatives
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If a cost doesn’t change between two
decision options, ignore it.
Average costs as reported by financial
accounting reports are frequently NOT
purely relevant costs.
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Relevant information approach
Also called the incremental analysis approach
Only display relevant numbers
Focuses attention on just what matters
Fast, clear, concise
Total cost approach
Follow the same principles
Show all the numbers
Shows the whole picture, nothing hiding
Builds trust, removes doubt & mystery
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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.
b.
c.
d.
e.
The price of the new printer
The price you paid for the old printer
The trade-in value of the old printer
Paper costs
The difference between ink cartridges’ costs
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Relevant
Irrelevant
Relevant
Irrelevant
Relevant
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2
Make special order and pricing decisions
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These are NOT regular, everyday pricing
decisions.
Special orders are considerations
in addition to your regular business
Extra sales opportunities
Using this pricing methodology for everyday
transactions will bankrupt you.
Want to know why?
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To add profits, special orders need only cover
incremental costs, leaving the rest of nondifferential cost coverage for someone else…
Requirements
Can’t effect regular customers
Must use excess capacity
Why is this?
Other considerations
Grey market?
Brand equity?
Future negotiations?
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The key is find which costs and revenues are effected
by the special order, and only use those relevant costs
in the quantitative aspects of your decision.
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Your small photography firm specializes in life
capturing photography. Your everyday pricing is built
on the following cost structure:
Should you accept a
special order offer of
Amount
$100 considering the
Everyday selling price per portrait
$ 300
Travel cost per photo site
60
following situation?
Set up cost per setting
Direct materials
Direct labor per portait
Variable overhead per portrait
Fixed overhead allocated per portrait
Total average cost per portrait
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$
15
20
20
15
20
150
It is 11:00am, you are
done with your only shoot
of the day at Lover’s
Point. An Andorran tourist
offers you $100 for a
portrait using your current
setting.
Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.
Your small photography firm specializes in life
capturing photography. Your everyday pricing is built
on the following cost structure:
Should you accept a
special order offer of
Amount
$100 considering the
Everyday selling price per portrait
$ 300
Travel cost per photo site
60
following situation?
Set up cost per setting
Direct materials
Direct labor per portait
Variable overhead per portrait
Fixed overhead allocated per portrait
Total average cost per portrait
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$
15
20
20
15
20
150
You said “Yes”. Now
that same tourist gets a
call. The caller asks if
you can come back
tomorrow at the same
time for the same deal.
Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.
Your small photography firm specializes in life
capturing photography. Your everyday pricing is built
on the following cost structure:
Everyday selling price per portrait
Travel cost per photo site
Set up cost per setting
Direct materials
Direct labor per portait
Variable overhead per portrait
Fixed overhead allocated per portrait
Total average cost per portrait
Amount
$ 300
60
15
20
20
15
20
$ 150
What is horribly wrong with the
technically right answer?
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A real estate agent
wants to purchase
portraits for staging a
home. You have
several whose
customers have
abandoned them. Each
required separate travel
and other costs to
complete. What is the
minimum price you
should accept?
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Considering again the original $100 acceptable deal
It is 11:00am, you are done with your only shoot of the day at Lover’s Point. An
Andorran tourist offers you $100 for a portrait using your current setting.
The tourist wants a portrait. We are the only ones there set up to
a professional quality job.
Amount Sell at discount Sell at regular price
Everyday selling price per portrait
$ 300
100
300
Travel cost per photo site
60
Set up cost per setting
15
Direct materials
20
20
20
Direct labor per portait
20
20
20
Variable overhead per portrait
15
15
15
Fixed overhead allocated per portrait
20
Total cost per portrait
$ 150
55
55
Incremental contribution margin per sale
45
245
Probability of closing a sale
100%
0%
Expected value of outcome
45
0
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Why are USA companies are able to sell their
medicines cheaper in other countries?
Why are “international version” text books so
much cheaper?
What is “price discrimination” and how does it
explain these business issues?
Coupons
Internet only pricing (not available in store)
Intentionally carrying closeout items after the season
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What is our
target profit?
How much
will customers
pay?
Are we a
price-taker or
a price-setter?
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Owners expect a certain rate of return
Risk factors
Historical performance
Options available
If owners have $1,000,000 in equity and expect
a 10% return, they expect the company to earn
$100,000 in profits for them.
If they don’t get it, the value of the firm will drop
Somehow or another the company needs to try
and hit that target.
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Examples:
Food commodities
Natural resources
Generic consumer
products and services
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Examples:
Original art, brands
Specialty machinery
Patented perfume scents
Latest technology
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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
Revenue at market price
Less:Desired profit
Target full cost structure
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Starts at cost, then adds desired profits
Opposite of the target-pricing approach
Requires market control over pricing
Common practice with standard industry pricing
models
Full cost
Plus: Desired profit
Equals Cost-plus price
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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)
Reduce ownership
Go out of business
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3
Make dropping a product and product-mix
decisions
37
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Drop segments with negative contribution margin
Unavoidable fixed costs are irrelevant
Fixed costs that continue to exist even after a segment is
dropped
Avoidable, direct fixed costs are relevant
If you drop and you save, it counts!
Would dropping the product line, department, or territory
hurt or help other sales?
Dropping can help focus, or hurt cross promotion
Can freed capacity be put to use?
Bottom line:
Drop if fixed cost savings exceed lost contribution margin.
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Should Safe Zone drop the unprofitable Industrial System
segment? Prepare an incremental analysis.
They will eliminate $84,000 in fixed manufacturing costs, and
reduce fixed marketing & administration by $14,000.
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Work problem E20-13
Really? Should they drop VCR tapes?
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Our previous Contribution Margin analysis
stressed CM per sales dollar.
We maximized profits by selling the item with
the highest contribution per sales dollar.
This is valid if plentiful resources exist to fulfill
our maximum sales volume. That is, if sales
volume is our constraining resource.
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Constraints
Something that restricts production or sale of
product
Manufacturer example
Limitations on labor or machine hours or available
materials
Merchandiser example
Amount of display space
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What constraint stops a company from
processing everything demanded?
Which products offer the highest contribution
margin per unit of the constraint?
Decision rule:
Decision Rule Which product to
emphasize?
Emphasize the product with the
highest contribution margin per
unit of the constraint.
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Where should this business focus their
sales efforts? They have too many
customers and too little time.
Selling Price
Variable Costs
Contribution Margin
$
$
Hours per sale
CM per hour
$
100 $
50
50 $
500
300
200
0.25
1.25
200
$
160
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Product mix emphasis
A mass merchant retailer has one aisle of space available to display automotive
merchandise. They are considering offering large high-profit items like car top
carriers, and/or small items like spray oils. There are so many items they could
carry, that the limited space is their biggest concern.
Given the two example products below, which one maximizes their monthly
contribution margin per square foot, the Large items (car top carriers), or the
small items (automotive chemicals)?
Sales price per unit
Variable costs per unit
Per unit CM
Sales Units Per month
Shelf space required
Car top carriers
$300
$200
$100
10
25 sq ft
Automotive chemicals
$3.00
$2.00
$1.00
100
1 sq ft
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Make outsourcing and sell as is or process
further decisions
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Deciding whether to make an item internally
or buy it from an outside supplier
This is an excellent application of the relevant
cost principles we are learning.
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DECISION RULE, Accounting portion
In deciding whether to switch to an outside
supplier, we isolate the relevant costs of
making the part by eliminating:
The sunk costs.
The future costs that will not differ between
making or buying the parts.
Recognizing the opportunity costs of any freed
up capacity.
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The benefits that are foregone as a result of
pursuing some course of action.
Opportunity costs are not actual dollar outlays
and are not recorded in the formal accounts
of an organization.
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Should the company outsource?
If the incremental costs of
making exceed incremental
costs to outsource
If the incremental cost of
making are less than the
incremental costs to
outsource
Outsource
Do not
outsource
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Outdoor Life gets the call from Lancaster
The costs are compared
Outsourced goods in hand: $13.00 each
Should they outsource?
Direct materials
Direct labor
Variable overhead
Fixed* overhead
Total manufacturing cost for 2,000 bindings
Relevant
per unit
costs
Total costs
$ 17,550
3,400
2,040
6,300
$ 29,290
* $2,100 are avoidable traceable costs, the
rest are allocated common costs which
cannot be avoided.
What next?
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Benefit given up by not choosing an alternative
course of action
If Outdoor Life could use the freed up capacity
to produce another component, how profitable
Relevant
would it have to be?
per unit
Direct materials
Direct labor
Variable overhead
Fixed* overhead
Total manufacturing cost for 2,000 bindings
Total costs
$ 17,550
3,400
2,040
6,300
$ 29,290
costs
* $2,100 are avoidable traceable costs, the
rest are allocated common costs which
cannot be avoided.
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Outsourcing Special Notes
Alignment of incentives with decisions
What else happens when you outsource
production?
Tough to reverse course once everyone is fired.
Outsourced cost inflation?
Reliance on business partners
Logistics
Who cares more about YOUR quality?
YOUR production equipment doesn’t get
obsolete.
Focus on newest releases and core competencies
Technology simplifies
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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
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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?
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Decision rule:
Sell as-is or process further?
If extra revenue from
processing further
exceeds extra cost
If extra revenue from
processing further is less
than extra cost
Process further
Sell as is
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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?
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1. What is the unit cost of making the bread in-house (use
absorption costing)?
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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?
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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.
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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.
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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.
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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.
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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.
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