"creating" business exercises

USING ACCOUNTING INFORMATION TO MAKE MANAGERIAL DECISIONS

Dr. Asish Satpathy UCR / SoBA Lecture – 8

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Decision making is not always easy

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TYPES OF DECISIONS

1. Accept a special order 2. Make or buy; outsourcing 3. Keep or drop a product line or business

segment (operation) 4. Replace or retain equipment 5. Sell “as-is” or process further 6. Allocating constrained resources

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Need Information (what kind?)

Accurate information Timely Information – can’t wait forever Relevant Information – allows us to identify what is relevant information in terms of revenue and product cost

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IDENTIFYING RELEVANT INFORMATION

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WHAT IS RELEVANT INFORMATION?

Information that is directly related to the decision being made Information about something that will happen in the future Information that differs between alternatives

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Relevant Information

Making decisionStarting Project

 Irrelevant cost  Sunk cost  We can’t change them  Not influencing decision

 Reflects what differs across decision alternatives

 Relevant cost  Opportunity cost

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Sunk Cost

Definition ◦Costs that have been incurred or committed to and cannot be avoided in the feasible decision alternatives ◦Usually irrelevant to a decision

Examples ◦Rent ◦Contracted salary

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Example: Are these decisions same?

You have spent $10,000 mining an area for minerals. You’re 90% sure it’s not a rich site. You can spend another $10,000 to find out for sure vs. You have spent $1,000,000 mining an area for minerals. You’re 90% sure it’s not a rich site. You can spend another $10,000 to find out for sure. 3/1/2016 9

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Opportunity Costs

Definition ◦Value of “next best alternative” ◦Usually relevant to a decision

Example Option 1 Option 2 Keep Working + Salary - education

Going Bus School - Salary + education

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Opportunity Cost

Complex issue ◦Difficult to identify ◦Difficult to quantify

Ambiguous Not always salient to decision ◦Often overlooked

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LET’S IDENTIFY RELEVANT INFORMATION

Accord Mazda 6 Relevant?

MSRP $25,405 $23,370

MPG, City 27 21

MPG, highway 36 30

Warranty 36,000 miles,

36 months 36,000 miles,

36 months

Leg room (front) 42.5” 42.5”

Trunk capacity 15.8 ft3 16.6 ft3

✖

✖

✔

✔

✔

✔

Buy Accord or Mazda 6?

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SO WHEN IS A COST RELEVANT?

(1) NOT Sunk cost (2) Differential (diff. between alternatives)

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IMPORTANT TERMS TO KNOW

Avoidable cost ◦ Cost associated with a particular alternative

that will be eliminated if alternative is eliminated

Unavoidable cost ◦ Cost that will continue regardless of the

alternative selected

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LET’S PRACTICE

The temptation is to make this comparison… Cost to Drive Cost to Fly

500 miles @ $0.15/mile = $75 $65

You are getting ready to take a 500-mile trip and are trying to decide whether to drive or fly. You know that it costs you $1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just gotten of a special $65 round trip airfare.

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LET’S PRACTICE

Is it cheaper to drive or to fly?

You are getting ready to take a 500-mile trip and are trying to decide whether to drive or fly. You know that it costs you $1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just gotten wind of a special $65 round trip airfare.

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LET’S PRACTICE

Cost to Drive Cost to Fly

500 miles @ $0.10/mile = $50 $65

You are getting ready to take a 500-mile trip and are trying to decide whether to drive or fly. You know that it costs you $1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just gotten wind of a special $65 round trip airfare.

But, that comparison includes irrelevant costs…

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WATCH OUT FOR SUNK COSTS

Sunk costs are NEVER relevant to a decision These costs have been incurred in the past and nothing you can do today can change them

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A RELEVANT COST DECISION MODEL

Identify the decision Identify the alternatives

Identify the relevant revenues and costs Identify the qualitative issues to consider Identify the alternative with the greatest benefit or least cost

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EXAMPLE

You are considering to replace your old car with a new, more efficient, hybrid car. Here is some information related the decision. You are planning to use either car for six years.

Old car Hybrid car

Original cost new $25000 $30000

Accumulated depreciation $5000 -

Salvage value $10000 -

Annual Operating cost $20000 $15000

What would you do?

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To replace or not to replace

Keep Old Car Replace with Hybrid

Operating cost $120,000 $90,000

New car cost - $30,000

Salvage of old car - ($10,000)

Total relevant cost $120,000 $110,000

Replace with a Hybrid car

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PRACTICE TIME

Exercise 8-3

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E 8-3 SOLUTION Stat-Max Buy Tracker

Purchase price $912,000 $500,000 Programmer hours 80 hours 125 hours Annual License fee $0 $10,000 Technical support 24-hour 8 a.m. – 5 p.m. CST

not relevant: disk storage space and hours of user training

b. Ease of report customization, customer satisfaction/testimonies, frequency of upgrades, other potential future costs

c. The out-of-pocket cost will be more than the relevant cost due to the cost of the disk storage space.

a.

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SPECIAL ORDER PRICING

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SPECIAL ORDER PRICING DECISIONS

Sometimes a company may get an order from a customer asking for a “special price” that is less than the stated selling price Could be a grocery chain approaching Kleenex maker Kimberly-Clark to produce a “private label” facial tissue Sometimes the price requested appears to be less than the full product cost

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WHY ACCEPT SPECIAL ORDER PRICING?

For product made to customer specs For unusual order (quantity, packaging, means of delivery, etc.) For one-time job To utilize idle production facilities

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EXAMPLE

Baron Company produces 100,000 coffee grinders per month. The monthly capacity is 125,000. Per-unit data for the past month is as follows:

Selling price $20 Variable costs $8 Fixed costs $4

A special order has been received from North-Star, Inc. They offered to purchase 2,000 grinders at $11 per unit.

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What costs are relevant? Should Coopersmith accept

the special order? Fixed costs will not change with the special order. Accepting the special order will result in an extra $80,000 in contribution magin ($8/barrel x 10,000 barrels), so ACCEPT IT!

DM $5 ✔ DL 2 ✔ VOH 3 ✔ FOH 9 ✖

$19 $10

ANOTHER EXAMPLE… Coopersmith produces premium wooden barrels. A one liter barrel sells for $25, but a fancy Swiss ski resort has offered to buy 10,000 barrels for $18 each for its St. Bernard patrol. The barrel has the following product costs, based on annual production of 30,000 barrels:

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Assume that the ski lodge requires special packaging that will cost Coopersmith $2 per barrel. Should Coopersmith accept the special order?

DM $ 5 ✔ DL 2 ✔ VOH 3 ✔ FOH 9 ✖

$ 19 $ 10 VS&A 2 ✔

$ 12

AN EXAMPLE… Coopersmith produces premium wooden barrels. A one liter barrel sells for $25, but a fancy Swiss ski resort has offered to buy 10,000 barrels for $18 each for its St. Bernard patrol. The barrel has the following product costs, based on annual production of 30,000 barrels:

Additional variable costs of $2/barrel will be incurred, thus the relevant cost per barrel is $12. The special order will result in an extra $60,000 in contribution margin: ($6/barrel x 10,000 barrels)

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QUALITATIVE ISSUES TO CONSIDER

What precedent does this special order set for future jobs? How will regular customers react? Is there enough capacity to produce the order without reducing normal production?

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RECAP OF SPECIAL ORDER PRICING

Decision: Should we accept an order at a price less than normal selling price? Factors: differential income for the order Qualitative issues: affect on regular sales, expectation of continued special treatment Watch out: unavoidable fixed costs Decision Rule: as long as the special order covers differential costs and provides profit, accept the order

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A SPECIAL TIME

Exercise 8-6

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E 8-6 SOLUTION

Sales price $35 Variable costs per unit: Direct materials 6 Direct labor 4 Variable overhead ($15 × .4) 6 Total variable costs 16 Contribution margin $19 × 15,000 pairs = $285,000

Lybrand’s income will increase by $285,000

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OUTSOURCING

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WHAT IS OUTSOURCING?

Moving production outside the organization Offshoring is moving production to a foreign country (It may or may not be outsourcing)

Outsourcing is a big trend in business today Sometimes referred to as a “make-or-buy” decisions (Do I make a component myself, or do I but it already fabricated from someone else?)

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WHAT COSTS ARE RELEVANT?

Price we have to pay to buy the component All avoidable costs we would incur to make the component Watch out for fixed overhead per unit; it may or may not be avoidable

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EXAMPLE – Make or Buy

Thrasher Company has purchased 10,000 pumps annually from Nordique, Inc. Because the price keeps increasing and reached $68 per unit last year, Thrasher’s management has asked for an estimate of the cost of manufacturing the pump in its own facilities. The engineering, manufacturing, and accounting departments have prepared a report for management that includes the estimate for an assembly run of 10,000 pumps. Additional production employees would be hired to manufacture the pumps, but no additional equipment, space, or supervision would be needed.

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EXAMPLE (contd.)

According to the report, the total cost for 10,000 units is estimated to be $957,000 or $95.70 per unit. The current purchase price is $68 a unit, so the report recommends continued purchase of the product.

Components $120,000 Assembly labor* 300,000 Manufacturing overhead** 450,000 General & administrative overhead*** 87,000 Total costs $957,000 * Assembly labor consists of hourly production workers ** Mfg O/H is applied to products on a DL$ basis. Variable O/H is 50%. Fixed O/H is 100%. *** General and administrative O/H is 10% of other costs.

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MAKE of BUY – Relevant info.

Components $120,000

Labor $300,000

Overhead (variable OH only) $150,000

General & Admin OH -

Total $570,000

Unit cost to make in-house: 570000/10,000 = $57.00

Should we continue to buy at $68.00/unit from outside?

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8 DM $ 3 DL 4 VOH 1 FOH 6

$ 14

Which costs are relevant?

AN EXAMPLE…

Thomas Company makes bicycles. It has always made its own tires but has recently received a bid from Tiny Tires, Inc. to supply the tires for $12 each. Thomas’s tire costs are shown below. Of the fixed overhead, 40% is related to plant occupancy costs that will continue even if tires are purchased from Tiny. Should Thomas make or buy the 5,000 tires it needs?

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8 Which costs are

relevant?

DM $ 3 ✔ DL 4 ✔ VOH 1 ✔ FOH 6 ✔ But only $3.60

$ 14

DM $ 3 DL 4 VOH 1 FOH 6

$ 14

AN EXAMPLE…

Thomas Company makes bicycles. It has always made its own tires but has recently received a bid from Tiny Tires, Inc. to supply the tires for $12 each. Thomas’s tire costs are shown below. Of the fixed overhead, 40% is related to plant occupancy costs that will continue even if tires are purchased from Tiny. Should Thomas make or buy the 5,000 tires it needs?

So, the relevant cost to make a tire is only $11.60

$ 11.60

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WHAT ABOUT OPPORTUNITY COSTS?

Opportunity costs of using our facilities may be relevant What alternative uses of the capacity exist?

Can we generate additional income by using the freed up facilities in some way?

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WHAT IF…

Suppose that if Thomas Company buys tires from Tiny, it could use the freed up manufacturing capacity to produce a new line of tricycles. The new tricycles are expected to generate $6,000 in net income.

Should Thomas make or buy the 5,000 tires it needs?

Make Buy $11.60 × 5,000 = $58,000

$58,000

$12 x 5,000 = $60,000 Less new income ($6,000)

$54,000

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QUALITATIVE FACTORS TO CONSIDER…

Relative net advantage given uncertainty of estimates (costs, risks, etc.) Reliability and number of sources of supply

Ability to assure quality Future bargaining position with suppliers Perceptions regarding possible future price changes

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RECAP OF OUTSOURCING DECISION

Decision: Do you make a component in house or buy it from an outsider? Factors: avoidable costs to make, purchase price, alternative uses of facility

Qualitative issues: supplier reliability and quality, theft of intellectual property, transfer or technological risk Watch out: non-differential fixed costs Decision Rule: If purchase price is less than avoidable costs, buy from outside

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PRACTICE TIME

Exercise 8-8

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a. Direct Materials $ 2 Direct Labor 3 Variable Overhead 4 Relevant cost to make $9

Outland should continue to make as the relevant cost to make ($9) is less than the cost to buy ($12).

b.

Now it makes financial sense to buy the parts and use the facilities to earn an additional $5,000 in contribution margin.

E 8-8 SOLUTION

Make Buy Total relevant cost to make $9 × 1,000 = $9,000 Total cost to buy $12 × 1,000 = $12,000 Contribution margin from released facilities (5,000)

Net cost to buy $7,000

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KEEPING OR ELIMINATING OPERATIONS

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MAKING THE OPERATIONS DECISION

How do we know when to add or drop a portion of operations? Decision should be based on relevant costs of those operations

A lot of costs that a company incurs support the entire company, not a specific segment; these common costs are often allocated to segments and are the ones that cause the problems

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WHAT IS RELEVANT TO THE DECISION?

All direct costs associated with the segment • Variable costs • Direct avoidable fixed costs

Calculate the segment margin • Revenues – Variable Costs – Avoidable Fixed Costs

Watch out for allocated common fixed costs

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TOTALS Dept. A Dept. B Dept. C

Sales $ 65,000 $20,000 $15,000 $30,000

COGS

Variable 29,000 4,000 10,000 15,000

Direct Fixed 9,000 2,000 1,000 6,000

S, G, & A

Variable 9,000 2,000 4,000 3,000

Direct Fixed 4,000 1,000 2,000 1,000

Common FC 13,000 4,000 3,000 6,000

Net Income $ 1,000 $ 7,000 $ (5,000) $ (1,000)

AN EXAMPLE…

If we eliminate departments B and C, what revenues and costs will disappear?

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AN EXAMPLE… TOTALS Dept. A Dept. B Dept. C

Sales $ 65,000 $20,000 $15,000 $30,000

Variable

COGS 29,000 4,000 10,000 15,000

S, G, & A 9,000 2,000 4,000 3,000

Product CM 27,000 14,000 1,000 12,000

Avoidable FC

COGS 9,000 2,000 1,000 6,000

S, G, & A 4,000 1,000 2,000 1,000

Segment Margin $ 14,000 $ 11,000 $ (2,000) $ 5,000

Department C is contributing $5,000 in segment margin to cover common fixed costs. Do not drop this department.

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RECAP OF PRODUCT LINE DECISION

Decision: Should we keep an existing segment that appears to have a net loss? Factors: contribution margin, segment margin, direct fixed costs

Qualitative issues: customer relations, preferences Watch out: allocated common fixed costs Decision Rule: If segment margin is positive, keep the segment

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LET’S PRACTICE

Exercise 8-17

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E 8-17 SOLUTION

Segment margin of Round: Sales $6,600 Variable costs 3,000 Contribution margin 3,600 Avoidable fixed costs 1,680 ($4,200 × 40%) Segment margin $1,920

Since the Round Game’s segment margin is positive, dropping the Round Game before the last quarter would have resulted in a lower operating income:

Operating income with Round $3,250 Lost segment margin without Round (1,920) Operating income without Round $1,330

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REPLACE OR RETAIN EQUIPMENT

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EXAMPLE

Scout Corporation uses an older machine in its main production line. Given its age, the machine creates some inefficiencies (e.g., requires frequent maintenance, significant amount of downtime, higher labor costs, etc.). Managers are deciding whether to replace the machine with a new one.

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Replace or Retain Equipment

Further, the new machine will provide annual cost savings of $35,000. The old machine can be sold for $5,000. Further, the new machine will provide annual cost savings of $35,000. The old machine can be sold for $5,000.

If used for their entire lives, the machines will have zero value.

Old New

Original purchase cost $110,000 $120,000 Accumulated depreciation $70,000 - Estimated life 4 years 4 years

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RELEVANT INFORMATION

Information Source Price Cost saving $35,000 X 4 $140,000

Cost of new machine

Buying cost ($120,000)

Sale of Old machine

$5000

Net: $25,000

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Additional Information

Managers have identified an investment opportunity not related to machinery and equipment. An investment can be made only if the new machine is not purchased. That is, the investment is made with the cash used to purchase the new machine. Q: What percentage return does the alternative investment need to lead the manager to retain the old equipment?

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Solution

When mangers replace old machine to a new one, the net impact is $25,000. (Derived from the previous slides)

If they earn same amount with this alternative investment, the managers would not lead to replace the old equipment.

So the rate of return required on this alternative investment amounts to $25,000 cash.

IN other words, the managers needs to receive at least (25,000/120,000) = 20.83% return on their $120,000 investment to keep the old machine to maintain $25,000 net impact.

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SELL “AS IS” OR PROCESS FURTHER

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EXAMPLE

Walter, Inc. produces toddler and child-sized furniture. The following information is available for its arts and crafts table. Per-unit data for an unpainted, unassembled version is as follows:

Selling price $25 Variable costs $12 Fixed costs $8

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Further information

Walter managers are considering a completely finished version of its table – painted and assembled. Managers estimate that painting and assembling would incur per-unit variable costs of $9 and per- unit fixed costs of $2. The completely finished version of the table would be sold for $35 per unit.

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DECISIONS

Sell “AS IS” Further Process

Revenue $25 $35 Variable cost $12 $21 Fixed cost $8 $10 Net Income $5 $4

• Note: Fixed cost in evaluating alternatives is not always irrelevant.

• In this example, you incur additional $2 in fixed cost if you decide to go for further processing.

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ALLOCATING CONSTRAINED RESOURCES

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CONSTRAINED RESOURCE ALLOCATION

Most businesses face some constraint in terms of available resources We need a way to decide how to allocate those scarce resources across the business

Focus on the highest contribution margin per unit of scarce resource

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Banners Kites

Sales Price $ 12 $ 15

Variable Costs $ 9 $ 14

CM/unit $ 3 $ 1

Machine hours/unit 1 hour 0.25 hour

CM/machine hour $ 3 $ 4

Banners Kites

Sales Price $ 12 $ 15

Variable Costs $ 9 $ 14

CM/unit $ 3 $ 1

AN EXAMPLE (Exercise 8-14) Wendy’s Windy Things manufactures kites and banners. This month Wendy has orders for 3,000 Valentine banners and Easter 1,000 kites. Wendy only has 1,000 sewing machine hours available.

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WHAT SHOULD WENDY PRODUCE?

1. As many kites as she can sell

1000 kites x .25 hours = 250 hours How many hours are left? 1,000 – 250 = 750 hours

2. Produce as many banners as she can with remaining hours

X banners x 1 hour = 750 hours X = 750 banners

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RECAP OF CONSTRAINED RESOURCE ALLOCATION DECISION

Decision: How should we allocate a scarce resource across all products? Factors: scarce resource, CM per unit of scarce resource, demand for products

Qualitative factors: customer preferences for products, customer service issues Watch out: CM per unit of product Decision Rule: Make the product with the highest contribution margin per unit of scarce resource

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LET’S PRACTICE

Exercise 8-13

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E 8-13 SOLUTION A B C

Sales price per unit $3.00 $5.00 $16.00 Variable costs per unit 1.20 3.40 10.00 Contribution margin per unit 1.80 1.60 6.00 Labor hours per unit ÷ 1.20 ÷ .50 ÷ 5.00 Contribution margin/labor hour $1.50 $3.20 $1.20 Preference #2 #1 #3

Produce Hours per unit Hours used Hours available 1,800

B 600 .50 300 1,500 A 500 1.20 600 900 C 180* 5.00 900 0 * Since only 900 hours remain to make product C, and it takes 5 hours to make one C, only 180 Cs can be made (900 ÷ 5).

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