Chapter 11

Excess Capacity

In situations where excess capacity exists, the general rule is that the special order price must simply be higher than the additional variable costs incurred in accepting the special order, if excess capacity exists

relaxing or elevating the constraint

Manager should focus their attention on managing the bottleneck manager should emphasize products that make the most profit from the use of constrained resource also make sure that the products are processed smoothly through the bottleneck with minimal loss time due to breakdowns and setups find ways to increase the capacity at the bottleneck

allocated fixed costs

The great danger in allocating common fixed cost is allocations can make a product line look less profitable than it really is

opportunity cost

The potential benefit that is given up when one Alternatives is selected over the other usually not found an accounting records but are a type of differential cost that must be considered

make or buy decision

When a company is involved in more than one activity in the entire value chain, it is vertically integrated A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier is called a "make or buy decision"

decision analysis: Differential approach

focuses solely on the relevant cost and benefits

increasing the capacity of constrained resource should lead to

increased production and sales

why isolate relevant costs

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

Contribution Margin Income Statement

the income statement that groups cost by behavior - variable or fixed - and highlights the contribution margin sales less variable costs = contribution margin less fixed costs = NOI

pitfalls of allocation

Joint costs are traditionally allocated among different products at the split off point A typical approach is to allocate joint costs according to the relative sales value of the end products Although allocation is needed for some purposes such as balance sheet inventory valuation, allocations of this kind are very dangerous for decision making

avoidable cost

that can be eliminated by choosing one alternative for another example: the cost of a ticket to get into the movie theater is an avoidable cost when deciding to watch a movie at home or in the theater

the capacity of the bottleneck can be effectively increased in a number of ways including

working overtime on the bottleneck subcontracting some of the processing that would ordinarily be done at the bottleneck investing an additional machines at the bottom neck shifting workers from processes that are not bottlenecks to processes that is a bottleneck focusing business process improvements efforts on the bottleneck reducing defective units, each defective unit is processed through the bottleneck and subsequently scrapped takes place of a good unit that has been sold

steps to help determine most profitable use of constrained resource

1) calculate each products contribution margin per unit 2) identify the constraining resource and the quantity of that resource that is consumed to make one unit of each product 3) calculate each products contribution margin per unit of the constraining resource 4) rank products from highest CM per unit of constraining resource to lowest

three steps to quantify financial advantage (disadvantage) of discontinuing a business segment

1) calculate the contribution margin that would disappear if the segment is dropped. Put this number in parentheses to denote it as a cash outflow 2) calculate fixed costs that would be avoidable if segment is dropped. Do not put this in parentheses (denoting it as a cash inflow) 3) add amounts from step 1 and step 2. If result is negative then do not drop segment. if positive, drop the segment

three steps for financial advantage /disadvantage of make/buy decision

1) calculate total amount that would be paid to the supplier if the buy option is chosen 2) calculate total differential manufacturing costs. (variable manufacturing costs and traceable fixed costs incurred if chosen to make but avoided if buy) 3) calculate difference between steps 1 and 2. If amount from step 1 exceeds step 2, choose make option. If step 1 is less, choose buy option

three steps for the financial advantage/disadvantage of accepting special order

1) calculate total revenue generated by special order 2) calculate total incremental costs that will be incurred to produce special order 3) take amount in step 1 and subtract it from amount in step 2. If positive, accept order. If negative, reject.

bottleneck

A machine or some other part of a process that limits the total output of the entire system.

activity based costing and relevant costs

Activity base costing can be used to help identify a potential relevant cost for decision making purposes activity based costing improves the traceability of cost by focusing on activities caused by product or other segment people have tendency to assume that if a cost is traceable, then cost is automatically avoidable must decide which of the potentially relevant costs are actually avoidable

volume trade-off decisions

Companies are forced to make volume trade-off decisions when they do not have enough capacity to produce all the products and sales volume demanded by customers companies must trade off or sacrifice production of some products in favor of others in an effort to maximize profits

vertical integration disadvantages

Companies may fail to take advantages of suppliers who can create economics of scale advantages by pooling demand from numerous companies While economics of scale factor can be appealing, a company must be careful to retain control over activities that are essential to maintaining its competitive position

Special Order Decision

Deciding whether to accept a special order is a short-run decision. Management must decide one-time order that is not considered part of the company's normal ongoing business What sales price is appropriate for one time customers? Does the company have excess capacity Can it produce additional units with its existing resources

managing constraints

Effectively managing an organization's constraints is key to increasing profits managers can increase profits by producing products with highest contribution margin per unit of the constrained resource it can also increase profit by increasing capacity of bottleneck operation

utilization of constrained resource

Fixed costs are usually unaffected in these situations so the product mix that maximizes the company's total contribution margin should ordinarily be selected Company should not necessarily promote those products that have the highest unit CM Rather, total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest contribution margin in relation to the constraining resources

three steps for sell or process further decision

Ignore all joint costs (all costs incurred up to the split off point) should be ignored because they remain the same under both alternatives determine the incremental Revenue that is earned by further processing The Joint product performed by taking the revenue earned after further processing The Joint product and subtracting the revenue that could have been earned by selling the joint product at split off take incremental revenue from Step 2 and subtract the incremental cost associated with processing the joint product beyond split off point >>> if the resulting answer is positive, joint product should be processed further and sold for higher price >>> if negative, joint product should be sold at split off point without further processing

Opportunity Cost

Opportunity costs are not actual cash outlays and are not recorded in the formal accounts of an organization An opportunity cost is the benefit that is foregone as a result of pursing some course of action Idle space that has no alternative use has an opportunity cost of zero

Traditional income statement

Sales Revenue - Cost of Goods Sold = Gross profit - Selling & General and Administrative Expenses = Net Income from Operations

t/f: Future costs and benefits that do not differ between alternatives are irrelevant to the decision-making process

TRUE

t/f: when differential and total cost approaches are done correctly, they provide the same correct answer

TRUE

comparative format

This decision can be approached by comparing comparative income statements by showing the effects of either keeping or dropping product line

sell or process further decision

a decision as to whether a joint product should be sold at the split off point or process further Joint costs are irrelevant in decisions regarding what to do with a product from the split off point forward Therefore, these costs should not be allocated to end products for decision making purposes With respect to sell or process further decisions, it is profitable to continue processing a joint product after the split off point so long as the incremental revenue from such processing exceeds the incremental processing costs incurred after the split-off point

constraint

anything that prevents you from getting more of what you want An example is waiting long periods of time for surgery.

every decision involves

choosing among two alternatives first step and decision-making is to Define alternatives once you have defined alternatives, you need to identify criteria for choosing them key to effective decision making is differential analysis ignore sunk costs future costs and benefits that do not differ between alternatives are irrelevant consider opportunity costs

sunk costs

cost that has already been incurred and cannot be changed regardless of what the manager decides to do example: company purchased a 5-year-old truck. I'm out paid for a truck as a sunk cost because it's already been incurred and cannot be undone

advantages of vertical integration are

counterbalanced by advantages of using external suppliers economies of scale can result in higher quality and lower costs than possible if a company were to attempt to make parts or provide service on its own company must be careful to retain control over activities that are essential to maintaining competitive position

The key to effective decision making is

differential analysis- focusing on the future costs benefits that differ between the alternatives

differential costs/revenue

differential cost >>> future costs that differs between any two alternatives >>> Always relevant differential revenue >>> future revenue that differs between two alternatives >>> example: Relevant benefit

Given that some products must be cut back when constraints exist, the key to maximizing total contribution margin is to...

favor the products that provide the highest contribution margin per unit of the constrained resource computed by dividing the products contribution margin per unit by the amount of the constrained resource

fixed costs consideration when making volume trade-off decisions

fixed costs remain the same regardless of how constrained resources used and should be ignored when making volume trade-off decisions should focus on identifying the mix of products that maximizes total contribution margin

decision analysis: total cost approach

includes all the cost and benefits- relevant or not

incremental cost

increase in cost between two alternatives example: choosing between buying the standard model or Deluxe model. the cost of the upgrades contained in the deluxe model are incremental

Vertical integration advantages

less dependent on its suppliers and able to ensure a smoother flow parts and materials for production Can control quality better by producing their own parts and materials, rather than relying on the quality control of outside suppliers company realizes profits from parts that it's making rather than buying

Managers routinely face the challenge of

managing constrained resources in a manner that maximizes profits a department store has limited amount of four space and therefore cannot stalk every product available when company face constraints their managers must decide which products or Services make most profitable use of limited resources

Managers are likely to focus on

relevant costs Costs that differ among alternatives Costs are avoidable or can be eliminated by choosing one alternative over another

At some point, managers must make

short-term tactical decisions

splitoff point

the point in a manufacturing process where joint products can be recognized as separate products joint products can be sold at the split off point or they can be processed further and sold for a higher price

The constraint or bottleneck is determined by

the step that limits total output because it has the smallest capacity Improvement efforts must be focused on the constraint if you want to increase the strength of a chain, you should focus your effort on the weakest link that will bring the biggest benefit do not place a greater strain on the system than the weakest link can handle- if you do, the chain will break

t/f: Decisions relating to other product lines or other segments of a company should be dropped and new ones added are most difficult

true Ultimately a decision to drop an old segment or add a new one is going to hinge primarily on its financial impact To assess this impact, it is necessary to carefully analyze the costs

joint products

two or more products that are produced from a common input point in the manufacturing process where joint products can be recognized as a separate product is called the split off point A decision as to whether a joint product should be sold at the split off point or processed further is known as sell or process further decision petroleum refining industry a large number of joint products are extracted from crude oil, including gasoline, jet fuel, Home Heating oil, and more