2 SHORT RUN PRODUCTION DECISIONS Managers have to make short-term production decisions on a continual basis. Some of those production decisions are:Adding or dropping a product line. E.g. should GM add a new line of SUV-Truck hybrids; should it drop its line of Pontiac-Aztek SUVs?Making or buying a component part. E.g. should Daimler-Chrysler make the seats for its cars or should it outsource the seats to a supplier?Accepting or rejecting a special order. E.g. should Ford accept/reject a special order from Hertz for a number of stripped down Ford Escorts?Deciding which product to make when facing an input/capacity constraint. E.g. when there is a shortage of skilled labor, which type of cars should GM primarily manufacture?
3 Identifying Relevant Costs A relevant cost is a cost that differs between alternatives.An avoidable cost can be eliminated (in whole or in part) 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 any decision and include:Sunk costs.Future costs that do not differ between the alternatives.
4 Relevant Cost Analysis: A Two-Step Process Eliminate costs and benefits that do not differ between alternatives.Use the remaining costs and benefits that do differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs.Step 1Step 2
5 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. Let’s see how relevant costs should be used in this type of decision.Due to the declining popularity of digital watches, Lovell Company’s digital watch line has not reported a profit for several years. Lovell is considering dropping this product line.
6 A Contribution Margin Approach DECISION RULELovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin.Let’s look at this solution.
8 Adding/Dropping Segments Investigation has revealed that total fixed general factory overhead and general administrative expenses would not be affected if the digital watch line is dropped. The fixed general factory overhead and general administrative expenses assigned to this product would be reallocated to other product lines.The equipment used to manufacture digital watches has no resale value or alternative use.Should Lovell retain or drop the digital watch segment?
10 Comparative Income Approach The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment.Let’s look at this second approach.
12 The Make or Buy Decision 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.
13 The Make or Buy Decision: An Example Essex Company manufactures part 4A that is used in one of its products.The unit product cost of this part is:
14 The Make or Buy Decision The special equipment used to manufacture part 4A has no resale value.The total amount of general factory overhead, which is allocated on the basis of direct labor hours, would be unaffected by this decision.The $30 unit product cost is based on 20,000 parts produced each year.An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part.Should we accept the supplier’s offer?
15 The Make or Buy Decision Should we make or buy part 4A?
16 Opportunity CostAn 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. How would this concept potentially relate to the Essex Company?
18 Decision To Make/Buy An Input Make part Buy part Revenues: we don’t know anything about the revenues, though we can assume they are the same in both cases. We will focus on the costs. Costs Costs of purchase DM DL VOH FOH Total costs
19 Key Terms and ConceptsA 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.
21 Accept or Reject Special Order Incremental Approach:Status quo: making 150,000 lb. egg noodlesNew project/activity: special order to make 100,000 lb. of additional noodles.Incremental benefits:Incremental costs:Additional DMAdditional DLAdditional VOHTotal:
22 Accept or Reject Special Order If Vince had a maximum capacity of 200,000 lb., should it accept the special order? Assume this is an all or nothing order; Vince either provides all of the 100,000 pounds or none.Note that now we have opportunity costs. The opportunity costs are the benefits forgone from not selling 50,000 lb. to regular customers.Incremental Approach:Status quo: making 150,000 lb. egg noodlesNew project/activity: special order to make 100,000 lb. of additional noodles.Incremental benefits:increase in revenue:Incremental costs:Additional DMAdditional DLAdditional VOHOpportunity costs of 50,000 lb.Total:
23 Utilization of a Constrained Resource Key Terms and Concepts 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.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.
24 Utilization of a Constrained Resource An Example Ensign Company produces two products and selected data are shown below:
25 Utilization of a Constrained Resource An Example Machine A1 is the constrained resource and is being used at 100% of its capacity.There is excess capacity on all other machines.Machine A1 has a capacity of 2,400 minutes per week.Should Ensign focus its efforts on Product 1 or 2?
26 Utilization of a Constrained Resource An Example The key is the contribution margin per unit of the constrained resource.
27 Utilization of a Constrained Resource An Example The key is the contribution margin per unit of the constrained resource.
28 Utilization of a Constrained Resource An Example
29 Joint Products – Sell or Process further The decision is whether to sell the joint products at the split-off point or to process them further and then sell Joint costs – costs of simultaneously producing two or more products, called joint products, that must, by the nature of the process, be produced together. Examples of joint products: Oil and gas, hamburger and steaks Split-off point – the point in the production process at which the joint products become distinct or separate items Note: In joint products problems where a company has to decide whether to process joint products further beyond the split-off point, the costs incurred up to the split-off point are sunk and hence are irrelevant. Any attempt to allocate such costs to joint products and to consequently factor them into the decision process would lead to imprudent production decisions.
30 Joint Products – Sell or Process further Example:Incur $2,000 in costs and sell for $11,000Get it painted and install new stereoBuy a new car for $20,000Current market value is $8,000You can sell as isThis is the split-off pointGet $8,000
31 Joint Products – Sell or Process further Example:Incur $2,000 in costs and sell for $11,000Get it painted and install new stereoBuy a new car for $20,000To answer the question of sell as is or process further, you need to examine the incremental costs and incremental benefitsCurrent market value is $8,000You can sell as isThis is the split-off pointGet $8,000