2 Management’s Decision-Making Process Decision-making is an important management function that does not always follow a set pattern.Steps in management’s decision-making process:Accounting helps management in making decisions by evaluating possible courses of action (step 2) and reviewing results (step 4).Illustration 7-1SO 1: Identify the steps in management’s decision-making process.
3 Management’s Decision-making Process Both financial and nonfinancial information are considered in decision-making.Decisions vary in scope, urgency and importance.Financial information includes revenues and costs as well as their effect on profitability.Nonfinancial information relates to factors such as: the effect of the decision on employee turnover, the environment, or company image.SO 1: Identify the steps in management’s decision-making process.
4 Incremental Analysis Approach Decisions involve a choice among alternative courses of action.Financial data relevant to a decision are the data that vary in the future among alternatives.Both costs and revenues may vary,orOnly revenues may vary,Only costs may vary.SO 2: Describe the concept of incremental analysis.
5 Incremental AnalysisProcess used to identify the financial data that change under alternative courses of action.Identifies the probable effects of decisions on future earnings.Involves estimates and uncertainty.Incremental analysis is also called differential analysis because it focuses on differences.SO 2: Describe the concept of incremental analysis.
6 Incremental Analysis GATHERING DATA MAY INVOLVE: MARKET ANALYSTS ENGINEERSACCOUNTANTSNEED TO PRODUCE THE MOST RELIABLE INFORMATION AVAILABLE AT THE TIME THE DECISION MUST BE MADE.
7 How Incremental Analysis Works BE 7-2Marlowe Company is considering two alternatives.Revenues Costs Net IncomeAlternative A $150,000 $100,000. $50,000Alternative B $185,000 $125,000. $60,000$35,000 ($25,000) $10,000Compare Alternative A to Alternative B showing incremental revenues, cost and net income.Illustration 7-2Comparing alternative B to A, the net income differences between the two are $35,000 with less net income under alternative A. A $25,000 incremental cost saving will be realized with alternative A. However, alternative B will produce $10,000 more net income than A...SO 2: Describe the concept of incremental analysis.
8 How Incremental Analysis Works Uses Three Important Cost Concepts:Relevant Cost:Opportunity Cost:Sunk Cost:Illustration 7-3SO 2: Describe the concept of incremental analysis.
9 Types of Incremental Analysis Accept an order at a special price.Make or buy components or finished products.Sell products or process further.Retain or replace equipment.Eliminate an unprofitable business segment.Allocate limited resources.SO 2: Describe the concept of incremental analysis.
10 Accept an Order at a Special Price Obtain additional business by making price concessions to a specific customer.Assumes sales of the product in other markets would not be affected by this special order.Assumes company is not operating at full capacity.SO 3: Identify the relevant costs in accepting an order at a special price.
11 Accept an Order at a Special Price E7-3 Shandling Company manufactures toasters. For the first 8 months of 2011, the company reported the following operating results while operating a 75% of plant capacityPrepare an incremental analysis for the special orderShould Shandling Company accept the special order? Why or why not?Sales (350,000 units) $4,375,000 Cost of goods sold 2,500,000 Gross Profit 1,875,000 Operating Expenses 875,000 Net Income 1,000,000Cost of goods sold was 70% variable and 30% fixed; operating expenses were also 70% variable and 30% fixedIn September, Shandling Company received a special order for 15,000 toasters at $7.50 each from Bierko Company of Mexico City. Acceptance of the order would result in an additional $3,000 of shipping costs but no increase in fixed operating expenses.
12 Accept an Order at a Special Price E 7-3 a) Reject Order Accept Order Net Income Revenues (15,000 X $7.50) $0 $112,500 $112,500 Cost of goods sold 0 75,000* (75,000) Operating Expenses 0 29,250** (29,250) Net Income 0 $ 8,250 $ 8,250Cost of Goods Sold:Variable cost: 2,500,000 X .70 = 1,750,000 ($5/unit)$5. X 15,000 = $75,000*Operating Expenses:Variable cost: 875,000 X .7 = 612,500612,500 / 350,000 = $1.75$1.75 X 15,000 = 26,250+$3,000(shipping)=29,250**b) Shandling should accept the special order.
13 Let’s ReviewIt costs a company $14 of variable costs and $6 of fixed costs to produce product Z200 that sells for $30. A foreign buyer offers to purchase 3,000 units at $18 each. If the special offer is accepted and produced with unused capacity, net income will:a. decrease $6,000.b. increase $6,000.c. increase $12,000.d. increase $9,000.$18 - $14= $4$4 × 3,000 units = $12,000SO 3: Identify the relevant costs in accepting an order at a special price.
14 Make or Buy Management must decide whether to make or buy components. SO 4: Identify the relevant costs in a make-or-buy decision.
15 Make or Buy – Continued BE 7-4 The decision should be to make the part.Make or Buy – Continued BE 7-4Lafleur Manufacturing incurs unit costs of $7.50 ($4.50 variable cost and $3 fixed cost) in making a sub-assembly part for its finished product. A supplier offers to make 10,000 of the assembly part at $5 per unit. If the offer is accepted, Lafleur will save all variable costs but no fixed costs. Prepare an analysis showing the total cost saving, if any, Lafleur will realize by buying parts.MakeBuyNet IncomeIncrease(Decrease)Variable manufacturing costsFixed manufacturing costsPurchase priceTotal annual cost$45,00030,000 –0– $75,000$ –0– 50,000$80,000$ 45,000 0(50,000)($ (5,000)
16 Make or Buy Opportunity Costs Definition: The potential benefits that may be obtained from following an alternative course of action.Suppose that LaFluer had the opportunity to generate an additional $20,000 in income by purchasing the assembly parts and using their machinery to assemble a completely different product.If Lafleur continues making this product the income is lost.SO 4: Identify the relevant costs in a make-or-buy decision.
17 Make or Buy – Opportunity Cost Example This Opportunity cost, this lost income, is added to the “Make” column as an additional “cost” for comparative purposes.It is now more advantageous to purchase the assembly parts for Lafleur.LaFleur would be better off by $15,000 to purchase in this scenario.Make Buy Net IncomeIncrease (Decrease)Total Annual Cost 75, ,000 (5,000)Opportunity Cost 20, ,000Total Cost 95, , ,000SO 4: Identify the relevant costs in a make-or-buy decision.
18 Sell or Process Further Many manufacturers have the option of selling a product now or continuing to process hoping to sell at a higher price.Decision Rule:Process further as long asthe incremental revenue fromsuch processing exceeds theincremental processing costs.SO 5: Identify the relevant costs in determining whetherto sell or process materials further.
19 Sell or Process further? BE 7-5 EXAMPLE Bolus Inc, makes unfinished bookcases that it sells for $60. Production costs are $35 variable and $10 fixed. Because it has unused capacity, Bolus is considering finishing the book cases and selling them for $70. Variable finishing costs are expected to be $8 per unit with no increase in fixed costs.Instructions:Prepare an analysis on a per unit basis showing whether Bolus should sell unfinished or finished bookcases.
20 Sell or Process further? BE 7-5 EXAMPLE Net IncomeIncrease(Decrease)Sales priceper unitCost perunitVariableFixedTotalNet income$60.0035.00 10.00 45.00$15.00$70.0043.00 53.00$17.00$10.00( (8.00) 0( (8.00)$ 2.00The bookcases should be processed further because the incremental revenues exceed incremental costs by $2.00 per unit.
21 Sell or Process Further - Example Single-Product CaseCost to manufacture one unfinished table:Selling price of unfinished unit is $50; unused capacity can be used to finish the tables to sell for $60.Relevant unit costs of finishing tables:Direct materials increase $2; Direct labor increases $4.Variable manufacturing overhead costs increase by $ (60 percent of direct labor increase).Fixed manufacturing costs will not increase.Illustration 7-8SO 5: Identify the relevant costs in determining whetherto sell or process materials further.
22 Sell or Process Further Illustration 7-9Incremental revenues ($10) exceed incremental costs ($8.40); Income increases $1.60 per unit.Process further.SO 5: Identify the relevant costs in determining whetherto sell or process materials further .
23 Sell or Process Further Multiple-Product CaseIn many industries, a number of end-products are produced from a single raw material and a common production process.Multiple end-products are commonly called joint products:Petroleum – gasoline, lubricating oil, kerosene.Meat Packing – meat, hides, bones.SO 5: Identify the relevant costs in determining whetherto sell or process materials further.
24 Sell or Process Further Multiple-Product CaseAll costs incurred prior to the point at which the products are separately identifiable (the split-off point) are called joint costs.Joint costs are (for purposes of determining product cost) allocated to individual products on the basis of relative sales value.Joint costs are not relevant for any sell-or-process-further decisions.Joint product costs are sunk costs.They have already been incurred and cannot be changed.SO 5: Identify the relevant costs in determining whetherto sell or process materials further.
25 Sell or Process Further - Example Multiple-Product CaseMarais Creamery must decide whether to:Sell cream and skim milk now,orProcess each further before selling.Illustration 7-10SO 5: Identify the relevant costs in determining whetherto sell or process materials further.
26 Sell or Process Further – Example Continued The daily cost and revenue data for Marais Creamery are:Illustration 7-11SO 5: Identify the relevant costs in determining whetherto sell or process materials further.
27 Sell or Process Further – Example Continued Sell cream or process further into cottage cheese?Do not process cream further:To do so will incur an incremental loss of $2,000.Illustration 7-12SO 5: Identify the relevant costs in determining whetherto sell or process materials further.
28 Sell or Process Further Sell skim milk or process further into condensed milk?Marais should process the skim milk:To do so will increase net income by $7,000.Illustration 7-13SO 5: Identify the relevant costs in determining whetherto sell or process materials further.
29 Retain or Replace Equipment BE 7-7 Management must decide whether a company should continue to use an asset or replace it.Example: Assessment of replacement of a factory machine:Russel Company has a factory machine with a book value of $90,000 and a remaining useful life of 4 years. A new machine is available at a cost of $250,000. This machine will have a 4 year useful life with no salvage value. The new machine will lower annual variable manufacturing costs from $600,000 to $500,000. Prepare an analysis showing whether the old machine should be retained or replaced.SO 6: Identify the relevant costs to be considered inretaining or replacing equipment.
30 Retain or Replace Equipment – BE7-7 Retain Replace Net 4-yearEquipment Equipment Incr/(Decr) Variable Manufacturingcost for 4 years $2,400,000 $2,000,000 $400,000Ne w Machine Cost 00,000, ,000 (250,000)Total $2,400,000 $2,250,000 $ 150,000The old factory machine should be replaced.Replace the equipment - Lower variable manufacturing costs more than offset cost of new equipment.The book value of the old machine does not affect the decision – it is a sunk cost.However, any trade-in allowance or cash disposal value of the old asset is relevant.SO 6: Identify the relevant costs to be considered inretaining or replacing equipment.
31 Eliminate an Unprofitable Segment Should the company eliminate an unprofitable segment?Key: Focus on relevant costs.Consider effect on related product lines.Fixed costs allocated to the unprofitable segment must be absorbed by the other segments.Net income may decrease when an unprofitable segment is eliminated.Decision Rule:Retain the segment unless fixed costs eliminatedexceed the contribution margin lost.SO 7: Identify the relevant costs in deciding whetherto eliminate an unprofitable segment.
32 Other Considerations in Decision Making Many decisions involving incremental analysis have important qualitative features that must be considered in addition to the quantitative factors.Example – cost of lost morale due to outsourcing or eliminating a plant.Incremental analysis is completely consistent with activity-based costing (ABC).ABC often results in better identification of relevant costs and, thus, better incremental analysis.
33 Chapter Review - Exercise 7-1 Identify each of the following statements as true or false.1. The first step in management’s decision-making process is “Determine and evaluate possible courses of action.”2. The final step in management’s decision-making process is to actually make the decision.3. Accounting’s contribution to management’s decision- making process occurs primarily in evaluating possible courses of action and in reviewing the results.4. In making business decisions, management ordinarily considers only financial information because it is objectively determined.
34 Chapter Review - Exercise 7-1 Continued Identify each of the following statements as true or false.5. Decisions involve a choice among alternative courses of action.6. The process used to identify the financial data that change under alternative courses of action is called incremental analysis.7. Costs that are the same under all alternative courses of action sometimes affect the decision.8. When using incremental analysis, some costs will always change under alternative courses of action, but revenues will not.9. Variable costs will change under alternative courses of action, but fixed costs will not.