ACCT Chapter 12

Contribution Margin per Unit of the Constrained Resource

Because a company cannot fully satisfy demand, managers must decide which products or services should be cut back Fixed costs are usually unaffected by such choices, so the course of action that will maximize the company's total contribution margin should ordinarily be selected Correct solution is to favor the products that provide the highest contribution margin per unit of the constrained resource

What is constraint?

Constraint/bottleneck: anything that prevents you from getting more of what you want Determined by the step that limited total output because it has the smallest capacity To be effective, improvement efforts must be focused on the constraint Identify the weakest link, which is the constraint. Do not place a greater strain on the system than the weakest link can handle - if you do, the chain will break. Concentrate improvement efforts on strengthening the weakest link. If the improvement efforts are successful, eventually the weakest link will improve to the point where it is no longer the weakest link

Adding and Dropping Product Lines and Other Segments

Decisions relating to whether product lines or other segments of a company should be dropped and new ones added are among the most difficult that a manager has to make. Any final decision to drop a business segment or to add a new one hinges primarily on the impact the decision will have on net operating income

Managing Constraints

Key to increased profits Relaxing/elevating the Constraint: when a manager increases the capacity of the bottleneck/constraint Benefits: enormous and can be easily quantified Calculations indicate that managers should pay great attention to the bottleneck operation. If a bottleneck machine breaks down or is ineffectively utilized, the losses to the company can be quite large

External Suppliers Disadvantages

Must be cautious to retain control over activities that are essential to maintain its competitive position

Why Isolate Relevant Costs?

Only rarely will enough information be available to prepare a detailed income statement for both alternatives. You would have to rely on your ability to recognize which costs are relevant and which are not in order to assemble the data necessary to make a decision Mingling irrelevant costs with relevant costs may cause confusion and distract attention from the information that is really critical

Identifying Relevant Costs and Benefits

Only those costs and benefits that differ in total between alternatives are relevant in a decision If the total amount of a cost will be the same regardless of the alternative selected, then the decision has no effect on the cost, so the cost can be ignored

Problem of Multiple Constraints

Proper combination/mix of products can be found by use of a quantitative method known as linear programming, which is covered in quantitative methods and operations management courses

Costs NOT relevant in decision making

Sunk Cost: cost that has already been incurred and cannot be avoided regardless of what a manager decides to do Future Cost: If they do not differ between alternatives, then future costs should be ignored

External Suppliers Advantages

Supplier may be able to enjoy economies of sales Can result in higher quality and lower costs

Avoidable Cost

cost that can be eliminated by choosing one alternative over another. Relevant costs

Make or Buy Decision

decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier Also involve decisions concerning whether to outsource development tasks, after-sales service, or other activities

Differential Cost

difference in cost between any two alternatives Relevant costs, relevant to decision making

Split-off Point

point in the manufacturing process at which the join products can be recognized as separate products

Joint Cost

the costs incurred up to the split-off point

Opportunity Cost

the potential benefit that is given up when one alternative is selected over another Not usually found in accounting record, but they are costs that must be explicitly considered in every decision a manager makes

Vertically Integrated

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

Reconciling the Total and Differential Approaches

A positive number in the differential costs and benefits column indicates that the difference between the alternatives favors the new; a negative number indicates that the differences favors the current situation A zero in that column means that the total amount for the item is exactly the same for both alternatives Because the difference in the net operating income equals the sum of the differences for the individual items, any cost or benefit that is the same for both alternatives will have no impact on which alternative is preferred. This is the reason that costs and benefits that do not differ between alternatives are irrelevant and can be ignored

Activity-Based Costing and Relevant Costs

Activity-based costing can be used to help identify potentially relevant costs for decision-making purposes. Activity-based costing improves the traceability of costs by focusing on activities caused by a product or other segment Costs provided by a well-designed activity-based costing system are only potentially relevant Before making a decision, managers must still decide which of the potentially relevant costs are actually avoidable. Only those costs that are avoidable are relevant and the others should be ignored

The Pitfalls of Allocation

Joint costs are common costs that are incurred to simultaneously produce a variety of end products. They are often allocated among different products at the split-off point - Typical approach is to allocate the joint costs according to the relative sales value of the end products Although allocation of joint product costs is needed for some purposes, such as balance sheet inventory valuation, allocations of this kind are extremely misleading for decision making

Sell or Process Further Decisions

Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward. One the split-off point is reached, the joint costs have already been incurred and nothing can be done to avoid them Even if the product were disposed of in a landfill without any further processing, all of the joint costs must be incurred to obtain the other products that come out of the joint process None of the joint costs are avoidable by disposing of any one of the products that emerge from the split-off point. None of the joint costs are economically attributable to any one of the intermediate or end products Joint costs are a common cost of all the intermediate and end products and should not be allocated to them for purposes of making decisions about individual products 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 cost incurred after the split-off point - Joint costs that have already been incurred up to the split-off point are always irrelevant in decisions concerning what to do from the split-off point forward

Vertical integration Advantages

Less dependent on its suppliers May be able to ensure a smoother flow of parts and materials for production than a nonintegrated company Can control quality better by producing their own parts and materials, rather than by relying on the quality control standards of outside suppliers Integrated company realizes profits from the parts and materials that is "making" rather than "buying," as well as profits from its regular operations

Different Costs for Different Purposes

Managers need different costs for different purposes Each decision situation must be carefully analyzed to isolate the relevant costs. Otherwise, irrelevant data may cloud the situation and lead to a bad decision

Beware of Allocated Fixed Costs

One of the greatest dangers in allocating common fixed costs is that such allocations can make a product line look less profitable than it really is Managers may choose to retain an unprofitable profit line if the line helps sell other products, or if it serves as a magnet to attract customers

Special Orders

One-time order that is not considered part of the company's normal ongoing business

Capacity of a bottleneck can be effectively increased in a number of ways, including

Working overtime on the bottleneck Subcontracting some of the processing that would 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 - Essentially free and may even yield additional cost savings. Focusing business process improvement efforts on the bottleneck - Essentially free and may even yield additional cost savings. 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. - Essentially free and may even yield additional cost savings.

Differential Revenue

difference in revenue between any two alternatives Relevant benefits, relevant to decision making

Joint Products

two or more products that are produced from a common input