Chapter 12 Accounting

Advantages of vertical integration

1. less dependent on suppliers 2. ensure a smoother flow of parts and materials for production than a nonintegrated company 3. quality control 4. company may realize profits from the parts and materials that it is making rather than buying as well as profits from its regular operations

why is isolating relevant costs desirable?

1. only rarely will enough information be available to prepare a detailed income statement for both alternatives 2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention from the information that is critical.

Why do you have to look out for allocated fixed costs?

they can distort the keep or drop decision

In volume trade off situations companies must either

trade off or sacrifice production of some products in favor of others in order to maximize profits

vertically integrated

when a company is involved in more than one activity in the entire value chain

Opportunity cost consideration in make or buy decisions

if the space now being used to produce the shifters would otherwise be useless then the company should continue making its own product if the space being use to make a prduct could be used for some other purpose then the opportunity cost would be equal to the segment margin that could be derived from the best alternative use of the space

In a constraint situation management can also increase profits by

increasing the capacity of bottleneck operation

Avoidable cost

is a cost that can be eliminated by choosing one alternative over another

Companies are forced to make ______ when they do not have enough capacity to produce all of the products and sales volumes demanded by their customers

volume trade off decisions

When analyzing a special order only the ________ are relevant

incremental costs and benefits Since the existing fixed manufacturing overhead costs would not be affected by the order they are not relevant

Sell or process further decision

the decision as to whether a joint product should be sold or processed further and sold for a higher price

Advantages of using external suppliers

By pooling demand from a number of companies a supplier may be able to enjoy economies of scale these economies of scale can result in higher quality and lower costs than would be possible if the company were to attempt to make the parts or provide the service on its own

Constraint

is anything that prevents you from getting more of what you want

Opportunity cost

is the potential benefit that is given up when one alternative is selected ver another are not usually found in accounting records

Comparative Income approach for adding or dropping a segment

preparing comparative income statements showing results with and without the digital watch segment

Joint products

two or more products that are produced from a single raw material output.

Unavoidable common fixed costs makes the product line appear to be ________ when in fact dropping the product line would _______ the company's overall net operating income.

unprofitable, decrease

Relaxing (or elevating) the constraint

when a manager increases the capacity of the bottleneck example: eight hour shift to overtime

How will relating product contribution margins to the amount of the constrained resource they consume help a company maximize its profits?

Assuming fixed costs are not affected, profits are maximized when the total contribution margin is maximized. A company can maximize its contribution margin by focusing on the products will the greatest amount of contribution margin by focusing on the products with the greatest amount of contribution margin per unit of the constrained resource.

Variable costs and differential costs mean the same thing." Do you agree? Explain.

No. A variable cost is a cost that varies in total amount in direct proportion to changes in the level of activity. A differential cost is the difference in cost between two alternatives. If the level of activity is the same for the two alternatives, a variable cost will not be affected and it will be irrelevant.

"Sunk costs are easy to spot - they're the fixed costs associated with a decision." Do you agree? Explain.

No. Not all fixed costs are sunk—only those for which the cost has already been irrevocably incurred. A variable cost can be a sunk cost if it has already been incurred.

"All future costs are relevant in decision making." Do you agree? Why?

No. Only those future costs that differ between the alternatives are relevant.

Are variable costs always relevant costs? Explain.

No. Variable costs are relevant costs only if they differ in total between the alternatives under consideration.

Differential approach

focuses solely on the relevant costs and benefits

total cost approach

includes all o the costs and benefits relevant or not

Sunk cost

is a cost that has already been incurred and that cannot be changed by any decision made now or in the future

Special order

is a one-time order that is not considered a part of the company's normal ongoing business. If the order is accepted companies have to determine the price that should be charged

Incremental cost

is an increase in cost between two alternatives

Managers may choose to retain an unprofitable product line if

it helps sell other products or serves as a magnet to attract customers

split-off point

the point in a manufacturing process where joint products can be recognized as separate products

real or economic depreciation

the reduction in resale value of an asset through use or over time.

6 Steps in the decision making process

1. Define alternatives being considered 2. Identify criteria for choosing among them 3. Conduct Differential analysis 4. Sunk costs are always irrelevant 5. Future costs and benefits that do not differ between alternatives are irrelevant to the decision making process 6. Opportunity costs need to be considered when making decisions

Process in the sell or process further decision (3)

1. Ignore all joint costs or all costs incurred up to the split off point 2. determine the incremental revenue earned after further processing (revenue earned after further processing the joint product - the revenue that could be earned by selling the joint product at the split off point 3. incremental revenue - incremental costs associated with processing the joint product beyond the split off point

Differential cost

A future cost that differs between any two alternatives.

Give at lease four examples of possible constraints.

Any resource that is required to make products and get them into the hands of customers could be a constraint. Some examples are machine time, direct labor time, floor space, raw material, investment capital, supervisory time, and storage space. While not covered in often take the form of a formal or informal policy that prevents the organization from furthering its goals.

What guideline should be used in determining whether a joint product should be sold at the split-off point or processed further?

As long as the incremental revenue from further processing exceeds the incremental costs of further processing, the product should be processed further.

Differential analysis

Focusing on future costs and benefits that differ between the alternatives. Similarities should be ignored.

How does opportunity cost enter into a make or buy decision?

If a company decides to make a part internally rather than to buy it from an outside supplier, then a portion of the company's facilities have to be used to make the part. The company's opportunity cost is measured by the benefits that could be derived from the best alternative use of the facilities.

From a decision-making point of view, should joint costs be allocated among joint products?

Joint costs should not be allocated among the join products that emerge from the process. If joint costs are allocated among the joint products, then managers may think they are avoidable costs of the end products. However, the join costs will continue to be incurred as long as the process is run regardless of what is done with one of the end products. Thus, when making decision about the end products, the join costs are not avoidable and are irrelevant.

"If a product is generating a loss, then it should be discontinued." Do you agree? Explain.

Not necessarily. An apparent loss may be the result of allocated common costs or of sunk costs that cannot be avoided if the product is dropped. A product should be discontinued only if the contribution margin that will be lost as a result of dropping the product is less than the fixed costs that would be avoided. Even in that situation the product may be retained if it promotes the sale of other products.

Prentice Company is considering dropping one of its product lines. What costs of the product line would be relevant to this decision? What costs would be irrelevant?

Only those costs that would be avoided as a result of dropping the product line are relevant in the decision. Costs that will not be affected by the decision are irrelevant.

What is the danger in allocating common fixed costs among products or other segments of an organization?

The danger is that such allocations can make a product line or other segment of organization appear to be unprofitable, whereas in fact the line may be profitable.

One of the most important decisions managers make is whether to

add or drop a business segment

Value Chain

all activities from development, to production, to after-sales service.

accounting depreciation

attempts to match the sunk cost of an asset with the periods that benefit from that cost.

Contribution margin approach in deciding whether to add or drop a segment

compare the contribution margin that would be lost if the segment was dropped to the fixed expenses that would be avoided if the line was discontinued

In all of the decision making contexts a financial advantage exists if pursuing an alternative passes the _______

cost/benefit test

The key for choosing among alternatives is distinguishing between ____________________

relevant and irrelevant costs and benefits

Make or buy decisions

a decision whether to carry out one of the activities in the value chain rather than to buy externally from a supplier

Bottleneck

a machine or some other part of a process that limits the total output of the entire system the step that limits the total output because it has the smallest capacity

Differential revenue

future revenue that differs between any two alternatives

When a constraint exists in order to maximize profits companies must favor the products that provide the

highest contribution margin per unit of constrained resource

Ways that the capacity of a bottleneck can be effectively increased (6)

working overtime on the bottleneck Subcontracting some of the processing that would normally be done at the bottleneck Investing in additional machines at the bottleneck Shifting workers from processes that are not bottlenecks to the process that is the bottleneck Focusing business process improvement efforts on the bottleneck Reducing defective units. Each defective unit that is processed through the bottleneck and subsequently scrapped takes the place of a good unit that could have been sold

Airlines sometimes offer reduced rates during certain times of the week to members of a businessperson's family if they accompany him or her on trips. How does the concept of relevant costs enter into the decision by the airline to offer reduced rates of this type?

Most costs of a flight are either sunk costs, or costs that don't depend on the number of passengers on the flight. Depreciation of the aircraft, salaries of personnel on the ground and in the air, and fuel costs, for example, are the same whether the flight is full or almost empty. Therefore, adding more passengers at reduced fares at certain time of week when seats would otherwise be empty does little to increase that total costs of making the flight, but can do much to increase the total contribution and total profit.