Chapter 12 Managerial Accounting

Contribution Margin per Unit of the Constrained Resource

Managers routinely face the probelm of deciding how constrained resources are going to be used Managers must decide which products or services make the best use of the constrained resource - 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 If some products must be cut back because of a constraint, the key to maximizing the total contribution margin may seem obvious (favor the products with the highest contribution margins) -unfortunately, that is not quite correct -rather, the correct solution is to favor the prodcuts that provide the highest contribution margin per unit of the constrained resource Managers should focus on the contriibution margin per unit of the constrained resource -this figure is computed by dividing a product's contribution margin per unit by the amount of the constrained resouce required to make a unit of that product The contribution margin must be viewed in relation to the amount of the constrained resouce each product requires

What is a Constraint?

A constraint is anythign that prevents you from getting more of what you want Every individual and every organization faces at least one constraint, so it is not difficult to find examples of contraints The constraint, or bottleneck, in the system is determined by the step that limits total output because it has the smallest capcity - A business process is like a chain -clearly, focusing your effort on the weakest link will bring the biggest benefit The procedure to strengthen the chain - First, identify the weakest link, which is the constraint - Second, do not place a greater starin on the system than the weakest link can handle, if you do, the chain will break -Third, concentrate improvement efforts on stregthening the weakest link

Special Orders

A special oder is a one-time order that is not considered part of the company's normal ongoing business Only the incremental costs and benefits are relevant. Because the existing fixed manfuacturing overhead costs would not be affected by the order, they are not relevant. In general, a special order is profitable if the incremental revenue from this special order exceeds the incremental costs of the order -however, it is importnat to make sure that there is indeed idle capacity and that the special order does not cut into normal unit sales or undercut prices on normal sales

Opportunity Cost

Idle space that has no alternative use has an opportunity cost of zero Opportunity costs are not recorded in the organization's general ledger because they do not represent actual dollar outlays -rather, they represent economic beenfits that are foregone as a result of pursuing some course of action

Joint Product Costs and the Contribution Approach

In some industries, a number of end products are produced from a single raw material input Two or more products that are produced from a common input are known as joint products The split-off point is the point in the manufacturing process at which the joint produces can be recognized as separate producsts Join cost- costs incurred up to the split-off point Intermediate product- not finished

Different Costs for Different Purposes

Costs that are relevant in one decision situation are not necessarily relevant in another Managers need 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, each decision situation must be carefully analyzed to isolate the relvant costs. Otherwise, irrelevant data may cloud the situation and lead to a bad decision `

Why Isolate Relevant Costs?

In the preceding example, we used two different approaches to analyze the alternatives First, we considered all costs, both those that were releant and those that were not; and second, we considered only the relevant costs -we obtained the same answer under both approaches Isolating relevant costs is desirable for at least two reason First, only rarely will enough info be available to prepare a detailed income statement for both alternatives Second, mingling irrelevant costs with relevant costs may cause confusion and distract attention from the information that is really critical -furthermore, the danger always exists that an irrelvant piece of data may be used improperly, resulting in an incorrect decision -the best approach is to ignore irrelevant data and base the decision entirely on relevant data Relevant cost analysis, combined with the contribution approach to the income statment, provides a powerful tool for making decisions

The Pitfalls of Allocation

Joint costs are common costs that are inccured to simultaneously produce a variety of end products These joint costs are often allocated among the different products at the split-off point A typical approach is to allocate the joing 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

The Make or Buy Decision

Providing a product or service to a customer involves many steps All of these activities, from development, to production, to after-sales service are called a value chain Separate companies may carry out each of the activities in teh value chain or a single company may carry out several When a company is involved in more than one activity in the entire value chain, it is vertically integrated Some companies control all of the activities in the value chain from producing basic raw materials right up to the final distribution of finished goods and provision of after-sales service Other companies are content to integrate on a smaller scale by purchasing many of the parts and mateirals that go into their finished products A decision to carry out one of the activities in the valuee chain internally, rather than to buy externally from a supplier, is called a make or buy decision -quite often these decisions involve whether to buy a particular part or to make it interanally Make or buy decisions also involve decisions concerning whether to outsource development tasks, after-sales services, or other activities

The Problem of Multiple Constraints

The proper combination or "mix" of products can be found by use of a quantitatvie method known as linear programming, which is covered in quantitative methods and operation management courses

A Comparative format

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

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 In such decisions, many qualitative and quantitative factors must be considered Ultimately, however, 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 - to assess this impact, costs must be carefully analyzed

An Example of Make or Buy

Depreciation of special equipment is listed as one of the costs of producing the shifters internally -because the equipment has already been purchased, this depreciation is a sunk cost and is therefore irrelveant If the equipment could be sold, its salvage value would be relevant -or if the machine could be used to make other products, this could be relevant as well

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 the activities caused by a product or other segment -however, managers should exercise caution against reading more into this "traceability" than really exists People have a tendency to assume that if a cost is traceable to a segment, then the cost is automatically an avoidable cost -that is not ture because the costs provided by a well-designed activity-based costing system are only potentailly relveant -before making a decision, maangers 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 method used to assign a cost to a prodcut or other segment does not change the basic nature of the cost A sunk cost such as depreciation of old equipment is still a sunk cost regardless of whteher it is straced directly to a particular segment on an activity basis, allocated to all segments on the basis of labor-hours, or treated in some other way in the costing process -regardless of the method used to assign costs to products or other segments, the principels discused in this chapter must be applied to determine the costs that are avoidable in each situation

Managing Constraints

Effectively managing an organization's constraints is a key to increased profits When a constraint exists in the production process, managers can increase profits by producing the products with the highest contribution margin per unit of the constrained resource -however, they can also increase profits by increasing the capacity of the bottleneck operation When a manager increases the capacity of the bottleneck, it is called relaxing (or elevating) the constraint The benefits from relaxing the constraint are often enormous and can be easily quantified- the key is the contribution margin per unit of the constrained resouce that we have already computed Managers should pay great attention to the bottleneck opeartion -if a bottleneck machine breaks down or is ineffectively utlized, the losses to the company be quite large Managers hsould focus much of their attention on managing the bottleneck -managers should emphasize products that most profitably utilize the constrained resource -they should also make sure that produces are processed smoothly through the bottleneck, with minimal lsot time due to breakdowns and setups -they should try to find ways to increase the capacity at the bottleneck The 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 woerks from processes that are not bottlenecks to the process that is the bottleneck -focusing business process improvement efforts on the bottleneck - reducing defectvie units. Each defective unit that is processed through the bottleneck and subsequently scrapped takes the place ofa good unit that could have been sold The last three methods of increasing the capacity of the bottleneck are particularly attractive because they are essentially free and may even yield additional cost savings

Sell or Process Further Decisions

Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward Once 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 landfil wihtout 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 cost -therefore, none of the joint costs are economically attributale to any one of the intermediate or end prducts The joint costs are a common cost of all the intermediata and end products and should not be allocated to them for purposes of making decisions about the 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 As long as the process is being run to make the other products, no additional joing costs are incurred to make the specific product in question

Differential Analysis: The Key to Decision Making

Managers must decide what products to sell, whether to make or buy component parts, what prices to charge, what channels of distribution to use, whether to accept special orders at special prices, and so forth -making such decisions is often a difficult task that is complicated by numerous alternatives and massive amounts of data, only some of which may be relevant Every decision involves choosing from among at least two alternatives -in making a decision, the costs and benefits of one alternative must be compared to the costs and beenfits of other alternatives -they key to making such comparisons is differential analyis- focusing on the costs and benefits that differ between the alternatives A difference in cost between any two alternatives is known as a differential cost A difference in revenue between any two alternatives is known as differential revenue Differntial costs and revenues are relevant to decision making, whereas costs and revenues that do not differ between alternatvies are irrelevant to decision making Because differential costs and differential revenues are the only inputs that are relevant to decision making, they are also often referred to as relevant costs and relevant benefits Distinguishing between relevant and irrelevant costs and benefits is critical for two reasons -First, irrelevant data can be ignored (saving decision making tremendous amounts of time and effort) - Second, bad decisions can easily result from erroneously including irrelevant costs and benefits when analyzing alternatives To be successful in decision making, maangers must be able to tell the difference between relevant and irrelevant data and must be able to correctly use the relveant data in anaylzing alternatives

Beware of Allocated Fixed Costs

One of the great dangers in allocating common fixed costs is that such allocations can make a product line (or other business segment) look less profitable than it really is - in this instance, allocating the common fixed costs among all product lines make the housewares product line appear to be unprofitable -however, dropping the product line would result in a decrease in the company's overall net operating income Managers may choose to retain an unprofitable product line if the line helps sell other products, or if it serves as a "magnet" to attract customers

Identifying Relevant Costs and Benefits

Only those costs and benefits that differ in total between alternatives are releveant in a decision If the total amount of a cost will be the same regardless of the alternative slected, then the decision has no effect on the cost, so the cost can be ignored An avoidable cost is a cost that can be eliminated by choosing one alternative over another -avoidable costs are relevant costs -unavoidable costs are irrelevant costs Two broad categories of costs are never relevant in decisions- sunk costs and future costs that do not differ between the alternatives sunk cost- a cost that has already been incurred and cannot be avoided regardless of what a manager decides to do -any depreciation expense related is irrelevant in making decisions because depreciation is a noncash expense that simply spreads the cost of the thing over it useful life -sunk costs are always the same no matter what alternatives are being considered; therefore, they are irrelevant and should be ignored when making decisions Future costs that do not differ between alternatives should also be ignored Opportunity costs also need to be considered when making decisions An opportunity cost is the potential benefit that is given up when one alternative is selcted over another Only those costs and benefits that differ between alternatives are relevant in a decision Differentail costs are also referred to as relevant costs or avoidable costs The key to successful decision mkaing is to focus on relevant costs and benefits as well as opportunity costs while ignoring everything else- including sunk costs and future costs and benefits that do not differ between the alternatives `

Strategic Aspects of the Make or Buy Decision

Vertical integration provides certain advantages An integrated company is less dependent on its suppliers and may be able to ensure a smoother flow of parts and materials for production than an onintegrated company Some companies feel that they can control quality better by producing their own parts and matierals, rather than by relying on the quality contorl standards of outside suppliers An integrated company realizes profits from the profits and materials that it is "making" rather than "buying", as well as profits from its regular operations The advantages of vertical integration are counterbalanced by the advantages of using external suppliers -by pooling demand from a number of companies, a supplier may be able to enjoy economies of scale -these economies of scale can result in higher quality and lower costs than would be possible if the company wre to attempt to make the parts or provide the service on its own A company must be careful, however, to retain control over activities that are essential to maintaining its competitive position

Reconciling the Total and Differential Approaches

see pg 537 If we focus on just the relevant costs and benefits, we get exactly the same answer as wehn we listed all of the costs and benefits- including those that do not differ between the alternative and, hence, are irrelevant We get the same answer because the only costs and benefits that matter in the final comparsion of the net operating incomes are those that differ between the two alternatives and, heence, are not zero in the last colum