Chapter 23: Managerial Decision Scenarios (Read pages 912-920, 923-924; NTK Comp. pg 926)

Outsourcing

manager decision to buy a product or service from another entity; part of a make or buy decision; also called make or buy.

In short term decisions, managers focus on Relevant benefits and relevant costs: (2)Incremental revenues

Additional revenue generated by selecting a certain course of action over another, are the key rewards from that action.

Additional Factors

An analysis o the incremental costs pertaining to the additional volume is always relevant for this type of decision. We must be careful when the additional volume approaches or exceeds factory's existing available capacity. If additional volume requires the company to expand its capacity by obtaining more equipment, more space, or more personnel, the incremental costs could quickly exceed incremental revenue. Another cautionary note is the effect on existing sales. All new units of the extra business will be sold outside FasTrac's normal domestic sales channels. If accepting additional business would cause existing sales to decline, this information must be included in our analysis. The contribution margin lost from a decline in sales is an opportunity cost. The company must also consider whether this customer is really a one-time customer. If not, can the company continue to offer this low price in Long run?

Scrap or Rework EX: Assume that FasTrac has 10,000 defective unit of a product that have already cost $1 per unit to manufacture. These units can be sold as is (As scrap) for $0.40 each, or they can be reworked for $0.80 per unit and then sold for their full price of $1.50 each. Should FasTrac sell units as scrap or rework them?

$1 per unit manufacturing cost already incurred is a sunk cost and is relevant. The $0.40 selling price as scrap is opportunity cost of reworking. Our analysis is reflected in Example. FasTrac should rework the units and obtain higher incremental income

Bell Brewery paid $1,000,000 for land three years ago. Bell estimates it can sell the land for $1,200,000, net of selling costs. If the land is not sold, Bell plans to develop the land at a cost of $1,500,000. Bell estimates net cash flow from the development in the first year of operations would be $500,000. What is Bell's opportunity cost of the development?

$1,200,000 Recall that an opportunity cost is the potential benefit that is given up when one alternative is selected over another. In this situation, the opportunity cost is $1,200,000, which is the amount that the land can be sold for net of selling costs. This amount will be given up if the land is not sold.

Special Offers EX: FasTrac produces and sells approximately 100,000 units of product annually. Its per unit and annual total sales and costs are shown in the Selected Operating Income Data. Its normal selling price is $10.00 per unit, and each unit sold generates $1.00 per unit of operating income

A current customer wants to buy more units and exports them to another country. This buyer offers to buy 10,000 units of product at $8.50 per unit. The offer price is below the normal price of $10.00 per unit, but this sale would be several times larger than any single previous sale and it would use idle capacity. Because the units will be exported, this new business will not affect current domestic sales. Management needs to know whether accepting the offer will increase income. If management relies incorrectly on per unit historical costs, it would mistakenly reject the sale because selling price ($8.50) per unit is less than total historical costs per unit ($9.00).

Three types of relevant costs: (1)Sunk Costs

Arises from past decision and cannot be avoided or changed; it is relevant to future decisions. An example is the cost of computer equipment previously purchased by a company. This cost is not relevant to the decision of whether to replace the computer equipment. Likewise, depreciation of the original cost of plant (and intangible) assets is a sunk cost. Most of the company's allocated costs, including fixed overhead items such as depreciation and administrative expenses, are sunk costs.

A division of a large company reports the information shown below for a recent year. Variable costs and direct fixed costs are avoidable, and 50% of the indirect fixed costs are avoidable. Based on this information, should the division be eliminated?

Avoidable Expense: $143,000 + $34,000 + $55,000(50%) = $204,500. The division should not be eliminated because its sales of $270,000 are greater than its avoidable expenses of $204,500.

Keen or Replace Equipment

Businesses periodically must decide whether to keep using equipment or replace it. Advances in technology typically means newer equipment can operate more efficiently and at lower cost than older equipment. If the reduction in variable manufacturing costs with new equipment is greater than its net purchase price, the equipment should be replaced. In this setting, the net purchase price of equipment is its total cost - Any trade-in allowance or cash receipts for the old equipment.

Time and Materials Pricing

Companies set a price for labor and price for materials, and each includes a charge for overhead costs and a desired profit margin. Auto mechanics, construction companies, electricians, and accounting and law firms commonly use time and materials pricing (Step 1) compute the rate (In $) per hour of direct labor. This rate includes a charge for other (Non-materials related) overhead costs plus a desired profit margin. (Step 2) Compute Materials markup (%) which includes the overhead costs related to buying, storing, and handling materials, plus a desired profit margin on the materials' cost. (Step 3) Estimate the number of direct labors (DLH) and the total Direct materials cost for the service.

Keen or Replace Equipment Ex: FasTrac has a piece of manufacturing equipment with a book value (cost minus accumulated depreciation) of $20,000 and a remaining useful life of four years. At the end of four years, the equipment will have a salvage value of zero. The market value of equipment is currently $25,000.

FasTrac can purchase a new machine for $100,000 and receive $25,000 in return for trading in its old machine. The new machine will reduce FasTrac's variable manufacturing costs by $18,000 per year over the four year life of the new machine. Exhibit shows that FasTrac should not replace old equipment with this newer version as it will decrease income by $3,000. The book value of the old equipment ($20,000) is not relevant to this analysis. Book value is a sunk cost, and it cannot be changed regardless of whether FasTrac keeps or replaces this equipment. Decision Rule: If the reduction in variable manufacturing cost is greater than the net cost to buy the new machine, the machine should be replaced. The analysis above ignores the time value of money.

Classification of segment operating expenses for analysis: to illustrate, FasTrac is considering eliminating its Treadmill division, which reported a $500 operating loss for the recent year. The next step is to classify the division's cost as either avoidable or unavoidable. Variable costs, such as cost of goods sold and wages expense, are avoidable.

For example, If treadmill division were eliminated, FastTrac could reduce its overall advertising expense by $00 and its overall insurance expense by $300. In addition, FastTrac could avoid office department expenses of $2,200 and purchasing expenses of $1,000 if the treadmill division were eliminated. These avoidable expenses would not be allocated to other divisions of the company; rather, these expenses would be eliminated. Unavoidable expenses, however, would be reallocated to other divisions if Treadmill were eliminated. FasTrac can avoid a total of $41,800 if it eliminates the Treadmill division. However, because this division's sales are $47,800, eliminating division would reduce FasTrac's income by $6,000 = ($47,800 -$41,800). Based on this analysis, FasTrac should not eliminate its Treadmill division. Decision Rule: A segment is a candidate for elimination if its revenues are less than its avoidable expenses.

NTK: (2) Green Company uses Part JR3 in Manufacturing its products. It has always purchased this part from a supplier fro $40 each. It recently upgraded its own manufacturing capabilities and has enough excess capacity (including trained workers) to begin manufacturing Part JR3 instead of buying it. The company prepares the following costs projects of making the part, assuming that overhead is allocated to the part at the normal predetermined rate of 200% of direct labor cost. The required volume of output to produce the part will nor require any incremental fixed overhead. Incremental variable cost will be $17 per unit. Should the company make or buy this part?

For this make or buy decision, the analysis must include only incremental overhead per unit ($30 - $17). When only the $17 incremental overhead is included, the relevant unit cost of manufacturing the part is shown in the following table. It would be better to continue buying the part for $40 instead of making it for $43.

Contribution margin from Sales mix with Resource Constraint

If demand for Product A is limited-Say, to 80,000 units-FasTrac will begin by producing those 80,000 units. This production level would leave 20,000 machine hours to devote to production of Product B. FasTrac would use these remaining machine hours to produce 10,000 units (20,000 machine hours/2 machine hours per unit) of Product B. This sales mix would yield the Contribution margin shown in exhibit. With limited demand for Product A, the optimal sales mix yields a contribution margin of $140,000, the best the company can do subject to its resource constraint and market demand. Decision Rule: If demand for products is limited, produce the most profitable product (Per unit of scarce resource) up to the point of total demand (or capacity constraint). Use Remaining Capacity to produce the next most profitable product.

Make or Buy decision: FastTract currently buys part 417, a component of the main product it sells, for $1.20 per unit. With excess productive capacity, management is considering making 417 instead of buying it, Making Part 417 would incur variable costs of $0.45 for direct materials and $0.50 for direct labor. FastTrac's normally predetermined overhead rate is 100% of direct labor cost.

If management incorrectly relies on this historical overhead rate, it would mistakenly believe that the cost to make the component is $1.45 ($0.45+$0.50 +$0.50) and concludes the company is better off buying part at $1.20 per unit. This analysis is flawed, however, because it uses the historical predetermined overhead rate. Only incremental overhead costs are relevant to this decision. Incremental overhead costs of making the part might include, for example, additional power for operating machines, extra supplies, added cleanup costs, materials handling, and quality control. The exhibit shows that the relevant costs to make Part 417 is $1.15. it is cheaper to make the part than to buy it. If incremental overhead costs are less than $0.25 per unit, the total costs to make the part will be less than the purchase price of $1.20 per unit. Decision Rule: If the incremental cost to make it less than the cost to buy, make the product.

A guitar manufacturer is considering eliminating its electric guitar division because its $86,050 expenses are higher than its $79,020 sales. The company reports the following expenses for this division. Should the division be eliminated? (Any loss amount should be indicated with minus sign.)

Kept expenses: Avoidable + unavoidable = Overall Expense --Direct Expense of $12,100 = $9,350 + $2,750 Sales - Total Expenses = Net income(Loss).

Marshall Grocery Delivery Service reports the following information: Rate per hour of direct labor is: The materials markup for a job that will use 100 labor hours and $2,000 of materials is:

Labor (100 hours @ $25.80 per labor hour) = $2,580 Materials costs = $2,000 Material Markup= Labor - Material costs. Material Markup = $460

Decision Making

Manager decisions making involve five steps (1) Define the decision task (2) Identify alternative course of action (3) Collect relevant information and evaluate each alternative (4) Select preferred course of action (5) analyze and assess decision made Both managerial and financial accounting information play important roles in management decisions. The accounting system provides primarily financial information such as performance reports and budget analysis for decision making. Non financial information is important and includes environment effects, political sensitivities, and social responsibility.

Three types of relevant costs: (3) Opportunity costs

Potential benefit lost by taking a specific action when two or more alternative choices are available. An example is a student giving up wages from a job to attend summer school. The forgone wages should be considered as part of the total cost of attending summer school. Companies continually choose between alternative courses of action. For instance, a company making standardized products might be approached by a customer to supply a special (nonstandard) product). A decision to accept or reject the special order must consider not only the profit to be made from the special order but also the profit given up by devoting time and resources to this order instead of pursuing an alternative project. The profit given up is an opportunity cost. Consideration of opportunity cost is important. Although opportunity costs are not entered in accounting records, they are relevant to many managerial decisions.

Sell or Process Further: Suppose FastTrac has 40,000 units of partially finished Product Q. It has already spent $30,000 to manufacture these 40,000 units. FastTrac Can sell the 40,000 units to another manufacturer as raw materials for $50,000. Alternatively, it can process them further and produce finished products X, Y, and Z.

Processing the units further will cost an additional $80,000 and will yield total revenues of $150,000. FastTrac must decide whether the added revenues from selling finished products X,Y, and Z exceeds the cost of finishing them. The incremental income from processing further ($70,000) is greater than the incremental income ($50,000) from selling Product Q as is. Therefore, FastTrac should process further and earn an additional $20,000 of income ($70,000 - $50,000). The $30,000 of previously incurred manufacturing costs are excluded from analysis. These costs are sunk, and they are not relevant to the decision. The incremental revenue from selling Product Q as is ($50,000) is properly included. It is the opportunity cost associated with processing further. The incremental income from processing further is $20,000. Decision Rule: Select the alternative with higher incremental income.

Additional Factors on Make or Buy decision Example

Product quality, timeliness of delivery (especially in just-in-time setting) reactions of customers and suppliers, and other intangibles like employee morale and workload. It must consider whether making the part requires incremental fixed costs to expand plant capacity. When these additional factors are considered, small unit cost differences might not matter.

Gelb Company currently manufactures 50,500 units per year of a key component for its manufacturing process. Variable costs are $4.05 per unit, fixed costs related to making this component are $71,000 per year, and allocated fixed costs are $72,500 per year. The allocated fixed costs are unavoidable whether the company makes or buys this component. The company is considering buying this component from a supplier for $3.70 per unit. Calculate the total incremental cost of making 50,500 units and buying 50,500 units. Should it continue to manufacture the component, or should it buy this component from the outside supplier? Cost to Buy

Purchase Price per unit: $3.70 x 50,500 = $186,850

Which of the following are relevant in short-term decision making?

Purchase price, reduction in variable costs, additional revenue and opportunity costs are relevant in short-term decision making. Book value is not relevant in short-term decision making because it is a sunk cost and cannot be changed regardless of the outcome of the decision.

Rory Company has a machine with a book value of $103,000 and a remaining five-year useful life. A new machine is available at a cost of $123,000, and Rory can also receive $76,000 for trading in its old machine. The new machine will reduce variable manufacturing costs by $17,000 per year over its five-year useful life. Calculate the incremental income. (Any losses or outflows should be entered with a minus sign.)

Reduction in variable Manufacturing costs: $17,000(5 years) = $85,000 $123,000 - $85,000 =$38,000 in incremental income(Incremental Cost)

Tyler Industries currently manufactures one of its crucial parts at a cost of $4.50 per unit. This cost is based on a normal production rate of 50,000 units per year. Direct materials and direct labor costs are $2.50 per unit, incremental overhead costs related to making this part are $50,000 per year, and allocated fixed overhead costs are $50,000 per year. Allocated fixed costs are unavoidable whether the company makes or buys the part. Tyler is considering buying the part from a supplier for a quoted price of $3.70 per unit guaranteed for a three-year period. What is the relevant cost of making the 50,000 units?

Relevant Cost of making part = Direct materials and Direct Labor costs of $125,000 (50,000 units x $2.50 per unit) + Incremental Overhead costs of $50,000 = $175,000 Allocated fixed costs of $50,000 are not relevant to this managerial decision because they will continue whether the part is made or bought.

Kando Company incurs a $11.00 per unit cost for Product A, which it currently manufactures and sells for $13.50 per unit. Instead of manufacturing and selling this product, the company can purchase it for $7.00 per unit and sell it for $11.00 per unit. If it does so, unit sales would remain unchanged and $7.00 of the $11.00 per unit costs of Product A would be eliminated. 1. Prepare Incremental cost analysis. Should the company continue to manufacture Product A or purchase it for resale? (Round your answers to 2 decimal places.)

Revenue loss from reduced price ($13.50 − $11.00) = $2.50. Costs eliminated if purchased ($7.00 of $11.00) = $7.00. Kando Co. should continue to manufacture and sell Product A. Purchasing increases costs by $2.50 per unit.

Cobe Company has already manufactured 17,000 units of Product A at a cost of $25 per unit. The 17,000 units can be sold at this stage for $410,000. Alternatively, the units can be further processed at a $220,000 total additional cost and be converted into 6,000 units of Product B and 11,100 units of Product C. Per unit selling price for Product B is $105 and for Product C is $51. 1. Prepare an analysis that shows whether the 17,000 units of Product A should be processed further or not?

Sales in Process further: $105(6000) + $51(11,100) = $1,196,100 Process Further Income (Loss): $1,196,100 - $220,000 = $976,100 Incremental net income(Or loss) if processed further: $976,100 - $410,000 = $566,100

Holmes Company produces a product that can be either sold as is or processed further. Holmes has already spent $86,000 to produce 1,700 units that can be sold now for $93,500 to another manufacturer. Alternatively, Holmes can process the units further at an incremental cost of $270 per unit. If Holmes processes further, the units can be sold for $430 each. Should Holmes sell the product now or process it further?

Sales of Process Further: $430 x 1,700 = $731,000 Addition processing costs and Incremental Costs: ($270 x 1,700) = $459,000. The company should process further. By processing further incremental income will be $178,500= $272,000 − $93,500.

Signal mistakenly produced 1,225 defective cell phones. The phones cost $65 each to produce. A salvage company will buy the defective phones as they are for $40 each. It would cost Signal $88 per phone to rework the phones. If the phones are reworked, Signal could sell them for $134 each. Signal has excess capacity. Should Signal scrap or rework the phones?

Sales of Scrap: $40 x 1,225 defective units = $49,000 Sales of Reworked units: $134 x 1,225 units = $164,150 Reworked Costs: $88 x 1,225 units = $107,800 Income from Rework($56,350) - Income from Scrap ($49,000) = $7,350

Radar Company sells bikes for $420 each. The company currently sells 3,950 bikes per year and could make as many as 5,000 bikes per year. The bikes cost $260 each to make: $150 in variable costs per bike and $110 of fixed costs per bike. Radar received an offer from a potential customer who wants to buy 875 bikes for $380 each. Incremental fixed costs to make this order are $48,000. No other costs will change if this order is accepted. Compute Radar's additional income (ignore taxes) if it accepts this order.

Sales: $380 x 875 units = $332,500 Variable Cost: $150 x 875 = $131,250 CM: Sales - VC where $380 - $150 = $230 x 875 = $201,250.

NTK: (1)Packer Company is operating at 80% of its manufacturing capacity of 100,000 product units per year. A chain store has offered to buy an additional 10,000 units at $22 each and sell them to customers so as not to compete with Packer Company. The following data are available. In producing 10,0000 additional units, fixed OH costs would remain at the current level, but incremental variable OH costs of $3 per unit would be incurred. Should the company accept or reject the order?

Since Total unit costs is $27.50, it appears initially as if the offer to sell for $22 should be rejected but $27.50 cost includes FIXED COSTS. When the analysis includes only incremental costs, the per unit cost is as shown in the following table. The offer should be accepted because it will produce $4 of additional profit per unit = (Computed as $22 - $18 Incremental costs) Which yields a total profit of $40,000 for the 10,000 additional units.

Sell or Process Further

Some companies must decide whether to sell partially completed products as is or to process them further for sale as other products. For example, A peanut grower could sell its peanut harvest as is, or it could process peanuts into other products such as peanut butter; trail mix and candy. The decision depends on incremental costs and benefits of further processing.

NTK: (3) Gold Company's Manufacturing process causes a relatively large number of defective parts to be produced. The defective parts can be (a) sold for the scrap, (b) melted to recover the recycled metal for reuse, (c) reworked fro good units. Reworking defective parts reduces the output of other good units because no excess capacity exists. Each reworked unit means that one new unit cannot be produced. The following information reflects 500 defective parts currently available. Should the company melt the parts, sell them as scrap, or rework them?

Th goal of this scrap or rework decision is to identify the alternative that produces the greatest net benefit to the company. To compare the alternatives, we determine the net cost of obtaining 500 marketable units as follows. Analysis shows that the incremental costs of 500 marketable parts is smallest if the defects are reworked. The $5,800 opportunity cost is the lost contribution margin from not being able to produce and sell 500 untis because of reworking, computed as ($40 - ([$14,200/500 units]) x 500 units

Gelb Company currently manufactures 50,500 units per year of a key component for its manufacturing process. Variable costs are $4.05 per unit, fixed costs related to making this component are $71,000 per year, and allocated fixed costs are $72,500 per year. The allocated fixed costs are unavoidable whether the company makes or buys this component. The company is considering buying this component from a supplier for $3.70 per unit. Calculate the total incremental cost of making 50,500 units and buying 50,500 units. Should it continue to manufacture the component, or should it buy this component from the outside supplier? Cost to make

Variable Total Relevant Cost: 50,500 x $4.05 = $204,525 Variable + Fixed Manufacturing costs = total Incremental cost to make

FasTrac must analyze costs of this potential new business different. The $9.00 historical cost per unit is not necessarily the incremental costs, it would cost of this special order. The following information regarding the order is available:

Variable manufacturing costs to produce this order will be the same as for FasTrac's normal business-$3.50 per unit for direct materials, $2.20 Per unit for direct labor, and $0.50 per unit for variable overhead Selling expense for this order will be $0.20 per unit, which is less than the selling expenses of FasTrac's normal business. Fixed overhead expenses will not change regardless of whether this order is accepted. They are not relevant to the decision. This order will incur incremental administrative expenses of $1,000 for clerical work. These are additional fixed costs due to this order.

Scrap or Rework

Variation of the sell or process decision is the scrap or rework decision. Manufacturing processes sometimes yield defective products. Managers must decide whether to scrap or rework these products in process.

Additional Factors when considering elimination of segment,

We must assess its impact on other segments. A segment could be unprofitable on its own, but it might still contribute to other segment's revenues and profits. It is possible then to continue a segment even when its revenues are less than its avoidable expenses. Similarly, a profitable segment might be discontinued if its space, assets, or staff can be more profitability used by expanding existing segments or by creating new ones. Our decision to keep or eliminate a segment requires a more complex analysis than simply looking at a segment's performance report.

Analysis of Special Offer using relevant costs

We use this incremental cost information to determine whether FasTrac should accept this new business. The incremental revenue ($8.50 per unit) exceeds the incremental cost ($6.50 per unit) and the order would yield $20,000 of additional operating income. More generally, FasTrac would increase its income with any price that exceeds $6.50 per unit ($65,000 incremental cost/10,000 additional units). The key points is that management must not blindly use historical costs, especially allocated overhead costs. Instead, management must focus on the incremental costs to be incurred if the additional business is accepted. Point: Ignore allocated Fixed Overhead costs. The analysis uses only incremental fixed overhead costs

Sales Mix selection when resources are constrained

When a company sells a mix of products, some are more profitable than others. Management concentrates sales efforts on more profitable products, If production facilities or other factors are limited, producing more of one product usually requires producing less of others. In this case, management must identify the most profitable combination, or sales mix, of products.

Evaluate Segment elimination decisions

When a segment, division, or store is performing poorly, management must consider eliminating it. As we showed in a previous chapter ,determining a segment's contribution to overhead is an important first step in this analysis. Segments with revenues less than direct costs are candidates for elimination. However, contribution to overhead is not sufficient for this decision. We must further classify segment's expenses as avoidable or unavoidable.

Sales Mix analysis: FastTrac has an existing capacity of 100,000 machine hours per year. In addition, Product A uses 1 machine hour per unit while Product B uses 2 machine hours per unit.

With limited resources, FastTrac should focus its productive capacity on the product that yields the higher contribution margin per machine hour, until market demand for that product is satisfied. Shows that although Product B has a higher contribution margin per unit, Product A has a higher contribution margin per machine hour. In this case, FasTrac should produce as much of product A as possible, up to market demand. For example, if the market will buy all of Product A that FastTrac can produce, FastTrac should produce 100,000 units of Product A and none of Product B. --This sales mix would yield a contribution margin of $150,000 per year, the maximum the company could make subject to its resource constraint. Point: With such high demand, management should consider expanding its productive capacity. Point: A strategy designed to reduce impact of constraints or bottlenecks on production is called theory of constraints.

Cabby Jewelers has two divisions, the ring division and the necklace division. The ring division has shown a net loss of $40,000 for the past year. The necklace division has shown net income of $10,000 for that same period of time. The ring division has avoidable expenses of $30,000 and unavoidable expenses of $20,000. With revenues of $90,000, should the ring division be eliminated?

Yes, revenue exceeds avoidable costs by $60,000. The ring division has revenues of $90,000 and avoidable expenses of $30,000. Since its revenues exceed its avoidable expenses by $60,000 (or $90,000 − $30,000), it should not be eliminated.

Cold Company makes large containers of ice cream at a variable cost of $10 per container. It usually sells the container for $15. Cold Company is operating at less than full capacity. A potential new customer is requesting containers of ice cream at a selling price of $12. Should Cold Company accept the special order?

Yes, there will be a $2 increase in net income for every new container sold. (Selling price of $12 − variable cost of $10) for every container sold to the new customer.

Unavoidable expenses

amounts that would continue even if the segment was eliminated

Avoidable expenses

amounts the company would not incur if it eliminated the segment

In short term decisions, managers focus on Relevant benefits and relevant costs: (1)Incremental costs (Differential costs)

are the relevant costs in making decision. These are the additional costs incurred if a company pursues a certain course of action

Three types of relevant costs: (2) Out of pocket costs

requires outlay of cash and is relevant for current and future decisions. These costs are usually the direct result of management's decisions. For instance, Future purchases of computer equipment involve out of pocket costs. The cost of future computer purchases is relevant to the decision of whether to replace the computer equipment.