Com 317 - Chapter 12 (Relevant costs for Decision Making)

Strategic Aspects of the Make or Buy Decision - Vertical Integration?

Advantages: - Smoother flow of parts and materials - Better quality control - Realize profits Disadvantages - Companies may fail to take advantage of suppliers who can create economies of scale advantage by pooling demand from numerous companies

Joint product costs?

Costs that are incurred up to the split-off point in producing joint products.

Why Isolate Relevant Costs?

In the preceding example, we used two different approaches to analyze the alternatives. First, we considered only the relevant costs. Second, we considered all costs, both those that were relevant and those that were not. We obtained the same answer under both approaches. It would be natural to ask, "Why bother isolating relevant costs when total costs will do the job just as well?" Using the differential approach is desirable for two reasons: 1) Only rarely will enough information be available to prepare detailed income statements for both alternatives. Assume, for example, that you are called on to make a decision relating to a single product of a multi-departmental, multi-product firm. Under these circumstances, it would be virtually impossible to prepare an income statement of any type. 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. 2) Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.

Split-off point?

That point in the manufacturing process where some or all of the joint products can be recognized as individual products.

Joint products?

Two or more items that are produced from a common input.

Special orders example?

look at notes

Another reason why a manager could keep an unprofitable product line?

- Additionally, we should note that managers may choose to retain an unprofitable product line if the line is necessary to the sale of other products or if it serves as a "magnet" to attract customers. - Bread, for example, is not an especially profitable line in food stores, but customers expect it to be available, and many would undoubtedly shift their buying elsewhere if a particular store decided to stop carrying bread. - Accordingly, to the extent that dropping a product line or segment results in decreases (or increases) to sales of other products or segments, the related impact on contribution margin should be included in the keep versus drop analysis.

Final Comparison with the affect on the contribution margin?

In this case, the fixed costs that can be avoided by dropping the product line are less than the contribution margin that will be lost. Therefore, based on the data given, the digital camera line should not be discontinued unless a more profitable use can be found for the floor and counter space that it is occupying.

Relaxing (or elevating) the constraint?

Increasing the capacity of a bottleneck.

Going back to the AFM Electronics - digital watch, why keep something that has a negative profit?

"The answer lies in the way we allocate common fixed costs to our products. Our allocations can make a segment look less profitable than it really is." - The explanation for this apparent inconsistency lies at least in part with the common fixed costs that are being allocated to the product lines. Beware of allocated fixed costs. - As we observed in Chapter 11, one of the great dangers in allocating common fixed costs is that such allocations can make a product line (or other segment of a business) look less profitable than it really is. - By allocating the common fixed costs among all product lines, the digital camera line has been made to look as if it were unprofitable, whereas, in fact, dropping the line would result in a decrease in overall company operating income. - This point can be seen clearly if we recast the data in Exhibit 12-2 by eliminating the allocation of the common fixed costs. - As shown in Exhibit 12-4, the digital camera line is covering all of its own traceable fixed costs and is generating a $2,400 segment margin toward covering the common fixed costs of the company.

Sell or Process Further?

- A decision as to whether a joint product should be sold at the split-off point or processed further and sold at a later time in a different form. - Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward, because by the time the split-off point is reached, the joint product costs have already been incurred and therefore are sunk costs. - It will always be profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs incurred after the split-off point.

Constraint?

- A limitation under which a company must operate (such as limited machine time available or limited raw materials available) that restricts the company's ability to satisfy demand for its products or services.

Relevant cost?

- A relevant cost is a cost that differs between alternatives and that will be incurred in the future (i.e., the cost has not already been incurred)

Special orders?

- A special order is a one-time order that is not considered part of the company's normal ongoing business. - When analyzing a special order, only the incremental costs and benefits are relevant. - incremental cost: additional cost, happens in increments. - The objective in setting a price for special orders is to achieve positive incremental operating income.

An avoidable cost?

- An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. - Avoidable costs are relevant costs. - Unavoidable costs are irrelevant costs. Ex. By choosing the alternative of going to the movie, the cost of downloading a movie can be avoided. By choosing the alternative of downloading a movie, the cost of the movie ticket can be avoided. Therefore, the cost of the movie ticket and the cost of downloading a movie are both avoidable costs Ex2) On the other hand, the lease payments on the car are not an avoidable cost because you would continue to lease your car under either alternative.

Opportunity cost?

- An opportunity cost is the benefit that is foregone as a result of pursuing some course of action. - Opportunity costs are not actual dollar outlays and are not recorded in the formal accounts of an organization. - If the space now being used to produce the shifters would otherwise be idle, then OSN Cycles should continue to produce its own shifters and the supplier's offer should be rejected, as stated above. - Idle space that has no alternative use has an opportunity cost of zero. - But what if the space now being used to produce shifters could be used for some other purpose? - In that case, the space has an opportunity cost that must be considered in assessing the desirability of the supplier's offer. - What is this opportunity cost? It is the segment margin that could be derived from the best alternative use of the space. To illustrate, assume that the space now being used to produce shifters could be used to produce disc brakes that would generate a segment margin of $60,000 per year. Under these conditions, OSN Cycles would be better off to accept the supplier's offer and to use the available space to produce the new product line

Different Costs for Different Purposes?

- Costs that are relevant in one decision situation may not be relevant in another context. - Simply put, this means that the manager needs different costs for different purposes - For one purpose, a particular group of costs may be relevant; for another purpose, an entirely different group of costs may be relevant. - Thus, in each decision situation the manager must examine the data at hand and isolate the relevant costs. - Otherwise, the manager runs the risk of being misled by irrelevant data.

In summary?

- Go through the costs and classify which ones are avoidable and which ones are not avoidable, make a separate statement for this. -Then compare the cost you would save (avoidable cost) with the loss of CM with dropping the line. -If the avoidable costs are smaller than the loss for CM its not worth it to drop the line - But if the avoidable costs are bigger than the loss in CM, it is recommended to drop the line.

Joint costs?

- In some industries, a number of end products are produced from a single raw material input. - Two or more products produced from a common input are called joint products. - For example, in the petroleum-refining industry, a large number of products are extracted from crude oil, including gasoline, jet fuel, home heating oil, lubricants, asphalt, and various organic chemicals. - The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point.

What is the relevant cost in this situation?

- Indeed, the only costs that do differ between the alternatives are direct labour costs and the fixed rental cost of the new machine. - Hence, these are the only relevant costs. - The two alternatives can be compared based on just these relevant costs: - The only costs and benefits that matter in the final comparison of the operating incomes are those that differ between the two alternatives and therefore are not zero in the last column of Exhibit 12-1.

The Pitfalls of Allocation?

- Joint costs are often allocated to end products on the basis of the relative sales value of each product or on some other basis. - Although allocation is needed for some purposes such as balance sheet inventory valuation, allocations of this kind are very dangerous for decision making. - because allocated joint product costs are sunk costs, they should never be used when making decisions about what to do with the joint products beyond the split-off point (i.e., sell immediately or process further).

The Make or Buy Decision?

- Many steps may be involved in getting a finished product into the hands of a consumer. - First, raw materials may have to be obtained through mining, drilling, growing crops, raising animals, and so forth. - Second, these raw materials may have to be processed to remove impurities and to extract the desirable and usable materials. - Third, the usable materials may have to undergo some preliminary conversion so as to be usable in final products. - For example, cotton must be made into thread and textiles before being made into clothing. - Fourth, the actual manufacturing of the finished product must take place. - And, finally, the finished product must be distributed to the ultimate consumer. Each of these steps is part of the value chain - Separate companies may carry out each step in the value chain, or a single company may carry out several of the steps. - When a single company is involved in more than one of these steps in the value chain, it is following a policy of vertical integration. Vertical integration: The involvement by a single company in more than one of the steps of the value chain, from production of basic raw materials to the manufacture and distribution of a finished. - 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. A decision to produce internally, rather than to buy externally from a supplier, is called a make or buy decision.

Total and Differential Cost Approaches?

- OfficeMate Company is considering a new labour-saving machine that rents for $3,000 per year. - The machine will be used in the production of the company's best-selling heavy-duty stapler. - Data concerning the company's annual sales and costs of producing these staplers with and without the new machine are shown in the following table: - Note that the operating income is higher by $12,000 with the new machine, so it is the better alternative. - Note also that the $12,000 advantage for the new machine can be obtained in two different ways. - It is the difference between the $30,000 operating income with the new machine and the $18,000 operating income for the current situation. - It is also the sum of the differential costs and benefits as shown in the last column of Exhibit 12-1. - A positive number in the Differential Costs and Benefits column indicates that the difference between the alternatives favours the new machine; a negative number indicates that the difference favours the current situation. - A zero in that column simply means that the total amount for the item is exactly the same for both alternatives. - So, since the difference in the operating incomes 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 why we stated earlier that costs and benefits that do not differ between alternatives are irrelevant and can be ignored. - If we properly account for them, they will cancel out when we compare the alternatives.

Adding/Dropping Segments

- One of the most important decisions managers make is whether to add or drop a business segment, such as a product or a store. - Ultimately, however, any final decision to drop an old segment or to add a new one will hinge primarily on the impact the decision will have on operating income

Are opportunity costs recorded in the accounts of an organization?

- Opportunity costs are not recorded in the accounts of an organization because they do not represent actual dollar outlays. - Rather, they represent economic benefits that are forgone as a result of pursuing a particular course of action. - Because of this, opportunity costs are often erroneously ignored by managers when making decisions. - The opportunity costs of OSN Cycles are sufficiently large in this case to make continued production of the shifters very costly from an economic point of view.

Managing Constraints

- Profits can be increased by effectively managing constraint. One aspect of managing constraints is to decide how best to utilize them - Managers should focus their attention on managing bottlenecks and find ways to increase the capacity at the bottlenecks, which can be accomplished in a number of ways: 1) Improve the process 2) Add overtime or another shift 3) Hire new workers or acquire more machines 4) Subcontract production 5) Reduce amount of defective units produced 6) Add workers transferred from non-bottleneck departments

What process should managers go through to determine if a line should be dropped or not?

- Ultimately, however, any final decision to drop an old segment or to add a new one will hinge primarily on the impact the decision will have on operating income. - To assess this impact, it is necessary to prepare a careful analysis of the costs involved. - Consider the three major product lines of AFM Electronics—plasma TVs, E-readers, and digital cameras. - One product line—digital cameras—shows an operating loss for the month. Perhaps dropping this line would cause profits in the company as a whole to improve. - If the digital camera line is dropped, then the company will lose $16,000 per month in contribution margin. - By dropping the line, however, it may be possible to avoid some fixed costs by, for example, laying off certain employees or reducing advertising costs. - If by dropping the digital camera line the company is able to avoid more in fixed costs than it loses in contribution margin, then it will be better off if the line is eliminated, because overall operating income should improve. - On the other hand, if the company is not able to avoid as much in fixed costs as it loses in contribution margin, then the digital camera line should be retained. - In short, the manager should ask, "What costs can I avoid if I drop this product line?"

Contribution Margin in Relation to a Constrained Resource?

- When a constraint exists, a company should select a product mix that maximizes the total contribution margin earned since fixed costs usually remain unchanged. - A company should not necessarily promote those products that have the highest unit contribution margin. - Rather, it should promote those products that earn the highest contribution margin in relation to the constraining resource.

Utilization of a Constrained Resource?

- When a limited resource 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 limiting overall output is called the bottleneck - it is the constraint.

An Example of Make or Buy?

- let's consider OSN Cycles. The company is now producing the heavy-duty gear shifters used in its most popular line of mountain bikes. The company's Accounting Department reports the following costs of producing the shifter internally (pic) - An outside supplier has offered to sell OSN Cycles 8,000 shifters per year at a price of only $19 each. - Should the company stop producing the shifters internally and start purchasing them from the outside supplier? - To approach the decision from a financial point of view, the manager should again focus on the differential costs. - As we have seen, the differential costs can be obtained by eliminating those costs that are not avoidable—that is, by eliminating (1) the sunk costs and (2) the future costs that will continue regardless of whether the shifters are produced internally or purchased outside. - The costs that remain after making these eliminations are the costs that are avoidable to the company by purchasing outside. - If these avoidable costs are less than the outside purchase price, then the company should continue to manufacture its own shifters and reject the outside supplier's offer. - That is, the company should purchase outside only if the outside purchase price is less than the costs that can be avoided internally as a result of stopping production of the shifters. Depreciation of special equipment is assumed to be a sunk cost, therefore irrelevant. Assume that the equipment has no salvage value and that it has no other use except in making the heavy-duty gear shifters. Also note that the company is allocating a portion of its general overhead costs to the shifters. Any portion of this general overhead cost that would actually be eliminated if the gear shifters were purchased rather than made is relevant in the analysis. However, it is likely that the general overhead costs allocated to the gear shifters are in fact common to all items produced in the factory and would continue unchanged even if the shifters were purchased from outside. Such allocated common costs are not differential costs (because they do not differ between the make and buy alternatives) and should be eliminated from the analysis along with the sunk costs. The variable costs of producing the shifters (materials, labour, and variable overhead) are differential costs, because they can be avoided by buying the shifters from the outside supplier. If the supervisor can be laid off and her salary avoided by buying the shifters, then her salary will be a differential cost and relevant to the decision. Assuming that both the variable costs and the supervisor's salary can be avoided by buying from the outside supplier, the analysis takes the form shown in Exhibit 12-5. (shown in next cue card).

Two broad categories of costs that are never relevant in any decision are?

1) Sunk costs: (e.g., a previously owned computer used to download the movie), a cost that has already been incurred and that cannot be avoided, regardless of what a manager decides to do. Sunk costs do not change, regardless of the alternatives being considered, and they are therefore always irrelevant and should be ignored 2) Future costs that do not differ between the alternatives. e.g., car lease payments when making a "go to a movie" versus "download a movie" decision).

How could we have come to the same solution by ignoring the irrelevant costs and benefits?

1) The selling price per unit and the number of units sold do not differ between the alternatives. Therefore, the total sales revenues are exactly the same for the two alternatives, as shown in Exhibit 12-1. Since the sales revenues are exactly the same, they have no effect on the difference in operating income between the two alternatives. That is shown in the last column in Exhibit 12-1, which indicates a $0 differential benefit. 2) The direct materials cost per unit, the variable overhead cost per unit, and the number of units produced and sold do not differ between the alternatives. Consequently, the direct materials cost and the variable overhead cost will be the same for the two alternatives and can be ignored. 3) The "other" fixed expenses do not differ between the alternatives, so they can be ignored as well

Determining relevant costs example: Sarah, a Toronto student, is considering visiting her friend in Windsor. She can drive or take the train. By car, it is 230 kilometers to her friend's apartment. She is trying to decide which alternative is less expensive and has gathered the following information:

1. Annual straight line depreciation: The original cost of the car is a sunk cost. This cost has already been incurred and therefore can never differ between alternatives. Consequently, it is irrelevant and can be ignored. The same is true of the accounting depreciation, which simply spreads the sunk cost across the useful life of the asset. 2. Cost of gasoline: Relevant cost, if the train is take the cost will not be incurred. Hence, the cost differs between alternatives and is therefore relevant. 3. Annual cost of auto insurance and license: The annual cost of auto insurance and licence is not relevant. Whether you take the train or drives on this particular trip, your annual auto insurance premium and your auto licence fee will remain the same. 4. Maintenance and repairs: The cost of maintenance and repairs is relevant. While maintenance and repair costs have a large random component, over the long run they are typically proportional to the amount the car is driven. 5. Parking fees at the school: The monthly fee that you pays to park at the university during the academic year is not relevant in the decision of how to get to Windsor Regardless of which alternative you select—driving or taking the train—you will still need to pay for parking at school. 6. Total average cost: Some elements of the total average cost are relevant, but some are not relevant. 7. Reduction in resale value of car per km of ware: GET this!! 8. Round trip Train fare: The cost of a round-trip ticket on the train is clearly relevant in this decision. If you drive, you will not have to buy the ticket. 9. Benefits of relaxing on the train trip: Although it is difficult to put a dollar value on relaxing and being able to study while on the train, this item is relevant to the decision. It is relevant because it is a benefit that is available only if you takes the train. 10. Cost of putting dog in kennel while gone: The cost of putting your dog in the kennel while she is gone is clearly irrelevant to this decision. Whether you take the train or drives to Windsor you will still need to put your dog in a kennel. 11. Benefits of having car in Windsor: relevant to the decision even if it is difficult to measure their dollar impacts. 12. Hassle of parking car in Windsor: Relevant to the decision even if it is difficult to measure their dollar impacts. 13. Per day cost of parking the car in Windsor: The cost of parking in Windsor is relevant to the decision since it will be incurred only if you takes her car.

What terms are often used interchangeably?

Avoidable cost, differential cost, incremental cost, and relevant cost are often used interchangeably.

Profitability index?

Contribution margin per unit ÷ Quantity of constrained resource required per unit. At OSN Cycles, the bottleneck is a particular stitching machine. The mountain pannier requires four minutes of stitching time, and each unit of the touring pannier requires two minutes of stitching time. Since this stitching machine already has more work than it can handle, production will have to be cut back on one of the models. In this situation, which product is more profitable? To answer this question, the manager should look at the contribution margin per unit of the constrained resource, also known as the profitability index. This figure is computed by dividing the contribution margin by the quantity of the constrained resource required per unit. These calculations are carried out below for the mountain and touring panniers: See pic Using the profitability index, it is easy to decide which product is less profitable and should be de-emphasized. Each minute of processing time on the stitching machine that is devoted to the touring pannier results in an increase of $4 in contribution margin and profits. The comparable figure for the mountain pannier is only $2.50 per minute. Therefore, the touring model should be emphasized.

A comparative format?

Some managers prefer to approach decisions of this type by preparing comparative income statements showing the effects on the company as a whole of either keeping or dropping the product line in question. A comparative analysis of this type for AFM Electronics is shown in Exhibit 12-3. Check if we have to know comparative format vs the other format/

Relevant Cost Analysis: A Two-Step Process?

Step 1: Eliminate costs and benefits that do not differ between alternatives. These irrelevant costs consist of (a) sunk costs and (b) future costs and benefits that do not differ between alternatives. Step 2: Use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.

Verification that the right product is emphasized?

To verify that the touring model is indeed the more profitable product when considering the constrained resource, suppose an hour of additional stitching time is available and that there are unfilled orders for both products. The additional hour on the stitching machine could be used to make either 15 mountain panniers (60 minutes ÷ 4 minutes) or 30 touring panniers (60 minutes ÷ 2 minutes), with the following consequences