BMGT 221 - Ch 13 : Differential Analysis
sunk cost
A cost that has already been incurred and that cannot be changed by any decision made now or in the future.
sell or process further decision
A decision as to whether a joint product should be sold at the split-off point or sold after further processing.
differential cost
A future cost that differs between any two alternatives. always relevant can be quantiative or qualitative
constraint
A limitation under which a company must operate, such as limited available machine time or raw materials, that restricts the company's ability to satisfy demand
special orders defined
A special order is a one-time order that is not considered part of the companyʼs normal ongoing business. When analyzing a special order, only the incremental costs and benefits are relevant.
Relaxing (or elevating) the constraint
An action that increases the amount of a constrained resource. Equivalently, an action that increases the capacity of the bottleneck.
contribution margin approach solution
CM margin lost if digital watches dropped - fixed costs that can be avoided = financial disadvantage
volume tradeoff decisions
Companies are forced to make volume trade-off decisionswhen they do not have enough capacity to produce all of the products and sales volumes demanded by their customers. companiesmust trade off or sacrifice production of some products in favor of others in an effort to maximize profits.
key concept #1
Every decision involves choosing from among at least two alternatives. Therefore, the first step in decision-making is to define the alternatives being considered.
Utilization of a Constrained Resource - lets see how this plan would work
allowing our constrained resource (machine a1) we will produce 2,200 units of product 2 and 1,300 of product 1 cm is production & sales * cm per unit = cm product 1 = 1300*24 = 31,200 product 2 = 2,200 *15 = 33,000
incremental cost
an increase in cost between two alternatives ex. choosing between buying standard or deluxe model
opportunity cost
are not actual cash outlay and are not recorded in the formal accounts of an organization is the benefit that is foregone as a result of pursuing some course of action.
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > benefits of having a car in New York & the problems of finding a parking space
both relevant factors --> harder to quantify but must be considered when understanding whether to choose the car or train
vertical itnegration - disadvantages
companies may fail to take advantage of suppliers who can create economies of scale advantage by pooling demand from #s of companies - be careful to retain control over activities that are essential to maintaining its competitive position
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > cost of car
cost of car is a sunk cost --> you already paid for it it is not relevant to the current decision
joint costs
costs that are incurred up to the split-off point in a process that produces joint products
contribution margin approach - lovel example
decision rule - level should drop the digital watch segment only if the profit will increase as a result --> compare the cm which would be lost if the digital watch line was discontinued to the fixed exp that would be avoided if the line was discontinued
differential cost approach -> steps with example
decrease in direct labor costs +increase in fixed rental expense = financial advantage *you get same answer in less steps*
advantages of differential
difficult to include all the costs when using total cost method including the relevant and irrelevant costs can cause confusion
Adding/Dropping Segments - example
due to declining popularity of digital watches , Lovell company's digital watch line has not reported profit.
value of a constrained resource - solution
ensign should be willing to pay up to $24 per minute - this amount equals the cm per min of machine time
Utilization of a Constrained Resource - the key is the CM per unit fo constrained resource
ensign should emphasize product 2 because - it generates a CM of $30 per minute of the constrained resrouce relative to $24 per minute for product 1
managers most important responsibility: making decisions
examples of decisions -> deciding what to sell whether to make or buy parts what prices to charge what distribution whether to accept special orders at special prices
sell or process further - an example / additional data
final sales value after processing (lumber / sawdust ) 270. 50 sales value at the split off point (lumber/sawdust) 140. 40 incremental revenue from further processing 130. 10 cost of further processing (lumber/sawdust) -50. - 20 financial advantage (disadvantage) or further processing 80. (10) lumber should be further processed because it is +
beware of allocated fixed costs
fool you why are we keeping the digital watch segment when its showing a $100,000 loss - it depends n the way the common fixed costs are allocated to producst including unavoidable common fixed costs make product line appear to be unprofitable --> when in fact dropping product line would decrease company's overall net operate income
identifying relevant costs : Cynthia
from a financial standpoint, Cynthia would be better off taking the train to visit her friend -> both financial and non financial aspects factor in
differential revenue
future revenue that differs between any two alternatives relevant benefit
differential approach
identifies the relevant costs and benefits of each alternative
special orders - pt.2
if jet accepts the offer - incremental rev exceeds incremental costs incremental rev - incremental csost
total cost approach --> steps with example
in this case you have to do sales - var exp = cm - fixed exp = net operate income
total cost approach
includes all costs and benefits, relevant or not
value of a constrained resource
increasing the capacity of a constrained resource should lead to increased production and sales how much should ensign be willing to pay for an additional minute of machine a1 time
adding/dropping segments - digital watches/statement
investigation revealed that the fixed general factory ahead and fixed general admin costs will not be impacted by dropping the digital watch line the equipment used to manufacture digital watches has no resale value or alternative use --> should Lovell retain or drop the digital watch segment
joint products
joint input -> common production process -> oil -> gasoline -> chemicals
sell vs process further
joint products - produced from a single raw material input
Quick Check 3: the company's suppliers of hardwood will only be able to supply 2000 board feet this month
no (2*600) + (10*100) = 2200 > 2000
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > annual cost of insurance
not relevant because at the end of the day you are going to have to pay for insurance regardless of whether you take a car or train
key concept $6
opportunity costs also need to be considered while making decisions - the potential benefit which is given up when one alternate is selected over another
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > round trip train fare
relevant because if she drives she can avoid the cost of the train
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > parking cost in nyc
relevant because it can be avoided if you take the train
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > cost of gasoline
relevant because you consider it when you decide to drive with the train this cost isn't factored in --> gives you a differing value between alternatives
relevant costs and relevant benefits
should be considered when making decisions
irrelevant costs and irrelevant benefits
should be ignored when making decisions
utilization of a constrained resource - example pt 1
should ensign focus its efforts on product 1 or product 2 machine a1 is the constrained resource and is being used at 100% of its capacity - there is excess capacity on all other machines machine a1 has a capacity of 2400 minutes per week focus on product one or two?
identifying relevant costs and benefits : Cynthia example
should she take her car or use the metro
vertical integration - advantages
smoother flow of parts and materials, better quality control, realize profits
split off point
that point in the manufacturing process where some or all of the joint products can be recognized as individual products
quick check 4a - As before, Colonial Heritage's supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the plan we have proposed. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?
the additional wood would be used to make tables - each board foot of additional wood will allow the company to earn an additional $20 of CM & Profit
opportunity cost
the potential benefit that is given up when one alternative is selected over another
split off point
the process where joint products can be recognized as seperate the point in the manufacturing process where joint products can be recognized as a separate product is called
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > kennel cost
this cost will exist regardless
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > decline on resale value
this factors in when thinking about the additional miles which accumulate as you drive - relevant
identifying relevant costs - which costs and benefits are relevant in Cynthia's decision-- > relaxing on the train
this is relevant although it is difficult to quantify it --> you dont need to stress on the train vs driving
joint products
two or more products that are produced from a common input
quick check 1 Northern Optical ordinarily sells the X-lens for $50. The variable production cost is $10, the fixed production cost is $18 per unit, and the variable selling cost is $1. A customer has requested a special order for 10,000 units of the X-lens to be imprinted with the customer's logo. This special order would not involve any selling costs, but Northern Optical would have to purchase an imprinting machine for $50,000.
what is the rock bottom minimum price below which northern optical should not go in its negotiations variable production + additional fixed cost = total relevant cost/# of units
key terms and concepts
when a limited resources of some type restricts the company's ability to satisfy demand the company is said to have a constraint the machine or process that is limited overall output is called the bottleneck- it is the constraint
quick check 2b - what generates more profit for the company, using one minute of machine AI to process product 1 or using one minute of machine A1 to process product 2?
with one minute ensign could make 1 unit of product 1 - with a CM of 24 or 2 units of product 2 with a CM of $!5 per unit 2*15 = 30 > 24
sell or process further
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
special order - example
ØJet Inc. makes a single product whose normal selling price is $20 per unit. ØA foreign distributor offers to purchase 3,000 units for $10 per unit. ØThis is a one-time order that would not affect the company's regular business. ØAnnual capacity is 10,000 units, but Jet Inc. is currently producing and selling only 5,000 units.
make or buy decision continued
* avoidable costs associated with making part 4A include dm, dl , var ahead and supervisor salary * cost incurred to buy equipment is a sunk cost * The allocated general factory overhead represents allocated costs common to all items produced in the factory and would continue unchanged. Thus, it is irrelevant to the decision. Given that the total avoidable costs are less than the cost of buying the part, Essex should continue to make the part.
make or buy decision example
- special equip used to manufact part 4a has no resale value - total Amt of general factory ahead is unaffected by this decision - the $30 unit product cost is based on 20,000 parts produced each year - outside supplier has offered to provide 20,000 parts at a ocost of $25
comparative income approach
- you an use comparative income statements showing results with and without the segment if the digital watch line is dropped - the company looses $300,000 in CM - the general factory overhead would be the same /irrelevant - salary of product line manager would disappear so it is relevant - depreciation is a sunk cost - comparative statements show that Lovell would earn 40,000 of additional profit by retaining the digital watch line
managing constraints
-It is often possible for a manager to increase the capacity of a bottleneck, which is called relaxing (or elevating) the constraint, in numerous ways such as: 1. Working overtime on the bottleneck. 2. Subcontracting some of the processing that would be done at the bottleneck. 3. Investing in additional machines at the bottleneck. 4. Shifting workers from non-bottleneck processes to the bottleneck. 5. Focusing business process improvement efforts on the bottleneck. 6. Reducing defective units processed through the bottleneck.
the 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.
quick check 2 - how many units of each product can be processed through machine a1 in one minute?
1 minute required per unit for product one 0.5 minute required per unit for product 2 one product for - 1 2 products for - 2
hypothetical questions to ask
1. what is the financial advantage/disadvantage of closing the store? 2. what is the financial ad/disadvantage of buying the component part from a supplier rather than making it (make or buy) 3. what is the financial advantage/dis of accepting the speciall order? 4. what is the financial ad/disadvaantage of further processing the product
quick check 3b - company's supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?
600 chairs and 80 tables you have to think about the board feet required per chair
Utilization of a 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. A company should not necessarily promote those products that have the highest unit contribution margins. 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 resource.
key concept #5
Future costs and benefits that do not differ between alternatives are irrelevant to the decision-making process.
key concept #2
Once you have defined the alternatives, you need to identify the criteria for choosing among them. • Relevant costs and relevant benefits should be considered when making decisions. • Irrelevant costs and irrelevant benefits should be ignored when making decisions.
Adding/Dropping Segments
One of the most important decisions managers make is whether to add or drop a business segment. Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess this impact, it is necessary to carefully analyze the costs.
key concept #4
Sunk costs are always irrelevant when choosing among alternatives
Vertical Integration
The involvement by a company in more than one of the activities in the entire value chain from development through production, distribution, sales, and after-sales service.
key concept #3
The key to effective decision making is differential analysis—focusing on the future costs and benefits that differ between the alternatives. Everything else is irrelevant and should be ignored.
the 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.
relevant benefit
a benefit that should be considered when making decisions
avoidable cost
a cost that can be eliminated by choosing one alternative over another (synonym: differential & relevant cost) going to movie theater or renting movie -> cost of ticket is avoidable
sunk cost
a cost that has already been committed and cannot be recovered have no impact on future cash flows and remain the same no matter what alternatives are considered -> irrelevant
relevant costs
a cost that should be considered when making decisions
make or buy decision
a decision concerning whether an item should be produced internally or purchased from an outside supplier
bottleneck
a machine or some other part of a process that limits the total output of the entire system
special order
a one-time order that is not considered part of the company's normal ongoing business
