Fundamentals of Cost Analysis for Decision Making

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Fundamentals of Cost Analysis for Decision Making
Chapter 4 Fundamentals of Cost Analysis for Decision Making Now that you are comfortable with CVP analysis and the impact of fixed versus variable costs, we can extend the concepts and apply the theories to a multitude of business conditions. Acc 355 4 - 1

Learning Objectives L.O. 1 Use differential analysis to analyze decisions. L.O. 2 Understand how to apply differential analysis to pricing decisions. L.O. 3 Understand several approaches for establishing prices based on costs for Full cost pricing decisions. L.O. 4 Understand how to apply differential analysis to production decisions. L.O. 5 Understand the theory of constraints. After you finish this chapter you should be able to understand and use differential analysis. Understand several approaches for establishing prices and the theory of constraints. This chapter begins by discussing differential analysis and then presents conditions that are conducive to the model. Most of us use differential analysis on a daily basis without even knowing we are implementing a management tool! 4 - 2

Differential Analysis
L.O. 1 Use differential analysis to analyze decisions. Differential analysis: The process of estimating revenues and costs of alternative actions available to decision makers and of comparing these estimates to the status quo Now that you see the value of CVP analysis for decision-making, let’s move on to other decisions. In Chapter 1 we discussed differential costs and differential revenues. Today, every decision that a manager makes requires comparing one or more proposed alternatives with the status quo. Differential analysis is the process of estimating revenues and costs of alternative actions and comparing these estimates to the status quo. Differential analysis is used for both Special Order decisions and Full cost decisions. Short run is defined as the period over which capacity will be unchanged. Short run: The period of time over which capacity will be unchanged, usually one year 4 - 3

Differential Costs With two or more alternatives, costs that differ
LO1 Differential Costs With two or more alternatives, costs that differ among or between alternatives Costs that change in response to an alternative course of action Differential costs differ between actions. Remember from Chapter 1, differential costs differ between actions. In Chapter 1, Carmen was trying to decide whether she should expand her cookie operations or not. In Chapter 1, you looked at Carmen’s differential revenues and differential costs to determine if it was beneficial for Carmen to expand. If a cost is differential, or differs between alternatives, it is relevant to the decision-making analysis. Differential costs are sometimes called relevant costs. If the cost does not differ between alternatives it is not relevant to the decision making analysis. Alternative A Alternative B 4 - 4

Sunk Costs Costs incurred in the past that cannot be
LO1 Sunk Costs Costs incurred in the past that cannot be changed by present or future decisions A sunk cost is NOT relevant for making decisions. An important category of cost to identify when making decisions includes costs that were incurred in the past and cannot be changed regardless of the decision made. These costs are called sunk costs and are not relevant for a decision. 4 - 5

Differential Costs versus Total Costs
LO1 Differential Costs versus Total Costs Information presented to management can show the detailed costs that are included for making a decision, or it can show just the differences between alternatives, as follows. Sales revenue Variable costs Contribution margin Fixed costs Operating profit \$750 (250) \$500 (350) \$150 \$900 (300) \$600 \$250 (50) \$100 -0- Status Quo Difference Alternative Information presented to management can show the differences between alternatives. 4 - 6

Differential Analysis and Pricing Decisions
L.O. 2 Understand how to apply differential analysis to pricing decisions. Variable costs must always be covered. Differential analysis is useful for many decisions that managers make about pricing because it provides information about the likely impact of these decisions on profit. Variable costs must always be covered and fixed costs must be covered in the long run. Fixed costs must be covered in the long run. 4 - 7

Special Order versus Full cost Pricing Decisions
Year 1 Special Order pricing decision: No additional fixed cost Pricing a one-time special order. Full cost pricing decision: Additional Fixed Costs Pricing a new product. For example, if a manager is pricing a one-time special order he asks: How much material is required for the order? But if the manager is pricing a new product he asks: Do I need a new plant? 4 - 8

Status quo: Reject special order Alternative: Accept special order
Special Orders An order that will not affect other sales and is usually a one-time occurrence Value of option 1 option 2 Accept special order? Is > option 2? Option 1 Option 2 Status quo: Reject special order Alternative: Accept special order A special order is an order that will not affect other sales and is usually a one-time occurrence. The manager has two alternatives. One alternative is to reject the special order and maintain the status quo. Another alternative is to accept the special order. 4 - 9

Special Orders U-Develop has received a one-time offer for 500 prints
at a special price of 40¢ per print (\$200). The regular price is 50¢ and they have enough idle capacity in the week to take the offer. Sales for the week (5,000 prints at 50¢) \$2,500 Variable costs, including paper, maintenance, and usage payment to machine owner (5,000 copies at 20¢) ,000 Total contribution margin \$1,500 Fixed costs (supplies, plus allocated costs of the print shop) ,200 Operating profit for the week \$ 300 Back to U-Develop. The art teacher at the local high school asks U-Develop to allow students in the photography club to print 500 images for a special price of \$0.40 a print. U-Develop has idle capacity. This means that U-Develop has no additional long run costs associated with the special order. The special order is a Special Order pricing decision based on differential cost. The differential cost associated with the special order is the variable costs of the prints. Variable costs of the prints are \$0.20 per unit. 4 - 10

Special Orders Analysis of Special Order: U-Develop
Comparison of Totals Sales revenue Variable costs Total contribution Fixed costs Operating profit Alternative Presentation: Differential Analysis Differential sales, 500 at 40¢ Less: Differential costs, 500 at 20¢ Differential operating profit (before taxes) \$2,500 (1,000) \$1,500 (1,200) \$ 300 \$2,700 (1,100) \$1,600 \$ 400 \$ 200 100 \$ 100 \$200 (100) \$100 -0- Status Quo: Reject Special Offer Alternative: Accept Difference A sales price of \$0.40 per unit minus variable costs of \$0.20 per unit results in an increase in operating profit before taxes of \$0.20 per unit, or \$100 for 500 units. Notice the fixed costs of \$1,200 to not change between alternatives. 4 - 11

Full Cost Pricing Decisions
L.O. 3 Understand several approaches for establishing prices based on costs for Full cost pricing decisions. Full cost is the total cost to produce and sell a unit. Full costs are relevant for the long-term pricing decisions. Most firms rely on full cost information reports when setting prices. 4 - 12

Cost Analysis for Pricing
LO3 Cost Analysis for Pricing In the long run an organization must cover all variable and fixed costs – both manufacturing and selling. In the long run all costs must be covered. We will look at life-cycle and target costing. 4 - 13

Life-Cycle Product Costing and Pricing
LO3 Life-Cycle Product Costing and Pricing Product life-cycle is concerned with covering costs in all categories of the life cycle. R & D Design Manufacturing Product life-cycle is the time from initial research and development of the product to the time that support to the customer ends and the product is disposed of. Life-cycle costing is concerned with covering costs in all categories of the life-cycle. To be profitable, companies must generate enough revenue to cover costs incurred in all categories of the value chain. Marketing and distribution Customer service Take back (disposal) 4 - 14

Target Costing from Target Pricing
LO3 Target Costing from Target Pricing Target price: The price based on customers’ perceived value for the product and the price that competitors charge What would a customer pay? How much profit do I need? Can I make it at this cost? Target costing is the concept of “price-based costing” instead of “cost-based pricing.” A target price is the estimated price for a product or service that potential customers will be willing to pay. A target cost is the estimated Full cost cost of a product or service whose sale enables the company to achieve a targeted profit. Target price – Desired profit = Target cost 4 - 15

Use of Differential Analysis for Production Decision
L.O. 4 Understand how to apply differential analysis to production decisions. Make or buy Decision to make goods or services internally or purchase them externally Add or drop a segment Decision to add or drop a product line or close a business unit We now apply our cost analysis concepts to production and operating decisions. Typical production and operating questions that managers often ask are: Should we make the product internally or buy it from an outside source? Should we add to or drop parts of our operations? Which products should we continue to produce and which should we drop? To make these decisions, the manager asks what costs and revenues will differ as a result of the choices made and which course of action would be the most profitable for the company? Product choice Decision on what products or services to offer (product mix) 4 - 16

LO4 Make-or-Buy Decisions U-Develop’s current costs of developing prints: Costs directly traceable: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Common costs allocated to this product line Total costs \$0.05 0.12 .03 \$ 5,000 12,000 3,000 4,000 10,000 \$34,000 Per unit 100,000 prints A make-or-by decision is any decision by a company to acquire goods or services internally or externally. The make-or-by decision is often part of the Company’s Full cost strategy. Whether to rely on outsiders for a substantial amount of materials depends on both differential cost comparisons and other factors that are not easily quantified, such as suppliers’ dependability and quality control. Let’s look at U-Develop’s cost to develop prints from film (nondigital) cameras. The current cost of developing 100,000 prints is \$34,000. Costs directly traceable to the prints include direct materials, direct labor, variable manufacturing overhead, and \$4,000 of fixed manufacturing overhead. Costs not directly traceable, common costs, of \$10,000, are allocated to the cost of the prints. The full cost of processing prints is \$0.34 per unit (\$34,000 ÷ 100,000 units). This year’s expected volume is 100,000 prints, so the full cost of processing a print is \$34,000 ÷ 100,000 = \$0.34 4 - 17

LO4 Make-or-Buy Decisions U-Develop received an offer from an outside developer to process any number of prints for 25¢ each. Should U-Develop accept this offer? The accounting department prepared cost analyses at volume levels of 50,000 and 100,000 prints per year. U-Develop has received an offer from an outside developer to process prints for 25¢ each. 4 - 18

LO4 Make-or-Buy Decisions Direct costs: Direct materials Labor Variable overhead Fixed overhead Common costs Total costs \$ 5,000 12,000 3,000 4,000 10,000b \$34,000 \$25,000a -0- \$35,000 Process prints 100,000 \$20,000 higher 12,000 lower 3,000 lower 4,000 lower \$ 1,000 higher Outsource processing Difference Differential costs, those costs that will differ between alternatives, the status quo and outsourcing, are materials, labor, and variable overhead. These costs will be saved by outsourcing the processing of the prints. The direct fixed cost is the cost of leasing the machine to process the prints. If U-Develop stops processing the prints they do not have to lease the machine. Because this cost can be eliminated, it is also differential. The common costs, however, remain unchanged. Therefore, these costs could be omitted from the analysis. In addition, a differential cost is the \$25,000 purchase price of the outsourcing. This analysis shows us that differential costs increase by \$1,000 if U-Develop buys the prints. Therefore, the manager would decide to continue processing prints. a 100,000 units purchased at \$0.25 = \$25,000 b These common costs remain unchanged for these volumes. Because they do not change, they could be omitted from the analysis. Differential costs increase by \$1,000, so reject alternative to buy. 4 - 19

LO4 Make-or-Buy Decisions Direct costs: Direct materials Labor Variable overhead Fixed overhead Common costs Total costs \$ 2,500 6,000 1,500 4,000 10,000b \$24,000 \$12,500a -0- \$22,500 Process prints 50,000 \$10,000 higher 6,000 lower 1,500 lower 4,000 lower \$ 1,500 lower Outsource processing Difference Suppose U-Develop processes 50,000 prints a year. Doing the same differential analysis, we see that the differential costs decreased by \$1,500 if U-Develop purchases the prints from the outside supplier. Why is it that at 100,000 prints it is cheaper to make the prints but at 50,000 prints it is cheaper to buy them outside? The common costs still remain unchanged and are still omitted from the analysis. The cost paid to the outside processor and the variable costs were reduced by half because volume was reduced by half. Remember, variable costs vary in total as activity changes. Notice, however, the \$4,000 fixed overhead for renting the machine remains the same whether you develop 50,000 prints or 100,000 prints. a 50,000 units purchased at \$0.25 = \$12,500 b These common costs remain unchanged for these volumes. Because they do not change, they could be omitted from the analysis. Differential costs decrease by \$1,500, so accept alternative to buy. 4 - 20

Opportunity Costs of Making
LO4 Opportunity Costs of Making U-Develop’s expected volume is 100,000 prints. Assume that the facilities used to process prints could be used to offer a new service that would provide a \$2,000 incremental contribution. Should U-Develop accept or reject the alternative? Recall from Chapter 2 that opportunity costs are the foregone benefits from the best alternative course of action. Suppose U-Develop could use the facilities to take passport and visa photos rather than processing prints. 4 - 21

Opportunity Costs of Making
LO4 Opportunity Costs of Making Total cost of 100,000 prints Opportunity cost of using facilities to process prints Total costs, including opportunity costs \$34,000 2,000 \$36,000 \$35,000 -0- Status quo: Process prints \$1,000 highera 2,000 lowera \$1,000 lowera Alternative: Outsource processing Difference a These indicate whether the alternative is higher or lower than the status quo. If that is the case, the total cost of processing 100,000 prints is \$34,000 of outlay costs and \$2,000 opportunity cost. The total cost of processing prints is \$36,000. The cost to buy the prints from an outside developer is \$35,000. In this case, U-Develop would choose to accept the offer from the outside developer. Differential costs decrease by \$1,000, so accept the alternative. 4 - 22

Fourth Quarter Product Line Income Statement
LO4 Add or Drop Decisions U-Develop Fourth Quarter Product Line Income Statement Sales revenue Cost of sales (all variable) Contribution margin Less fixed costs: Rent Salaries Marketing and administrative Operating profit (loss) \$80,000 53,000 \$27,000 4,000 5,000 3,000 \$15,000 \$10,000 8,000 \$ 2,000 1,000 500 \$ (500) \$50,000 30,000 \$20,000 2,000 2,500 1,500 \$14,000 Total 15,000 \$ 5,000 \$ 1,500 Prints Cameras Frames Managers often must decide whether to add or drop a product line or close a business unit. Product lines or business units that were formerly profitable may no longer be profitable. In fact, U-Develop is looking at their product line income statement and sees that prints are no longer profitable. They are considering dropping prints. It appears that operating profit would increase by \$500 if they discontinued the prints. So the accountant was asked to do a differential analysis. 4 - 23

Differential Analysis
LO4 Add or Drop Decisions U-Develop Differential Analysis Sales revenue Cost of sales (all variable) Contribution margin Less fixed costs: Rent Salaries Marketing and administrative Operating profit (loss) \$80,000 53,000 \$27,000 4,000 5,000 3,000 \$15,000 \$70,000 45,000 \$25,000 2,750 \$14,250 \$10,000 decrease 8,000 decrease \$ 2,000 decrease -0- 1,000 decrease 250 decrease \$ decrease Status quo: Keep prints Alternative: Drop prints Difference The differential analysis shows that rent is not relevant for the decision. The rent must be paid whether the prints are dropped or not. Therefore, profits would decrease \$750 if prints are dropped. Profits decrease \$750, so keep prints. 4 - 24

Product Choice Decisions
LO4 Product Choice Decisions Constraints: Activities, resources, or policies that limit the attainment of an objective. Contribution margin per unit of scarce resource: Contribution margin per unit of a particular input with limited availability. Another common managerial decision is determining what products or services to offer. This choice directly affects costs and profits. By now you clearly understand contribution margin. Constraints are activities, resources, or policies that limit the attainment of an objective. With a constrained resource, the important measure of profitability is not the contribution margin per unit of product, but the contribution margin per unit of scarce resource. 4 - 25

Product Choice Decisions
LO4 Product Choice Decisions U-Develop Revenue and Cost Information \$50 8 4 \$30 Price Less: Variable costs per unit Material Labor Overhead Contribution margin per unit Fixed costs Manufacturing Marketing and administrative \$80 22 24 Metal frames Total \$3,000 1,500 \$4,500 Wood Let’s look at the revenue and cost information for U-Develop’s metal and wood frames. Metal frames require a half an hour of machine time and wood frames require an hour. The revenue and cost information indicates that both metal and wood frames have a contribution margin per unit of \$30. Fixed manufacturing costs are \$3,000 per month and fixed marketing and administrative costs are \$1,500 per month. Are metal and wood frames equally profitable? 4 - 26

Product Choice Decisions
LO4 Product Choice Decisions U-Develop Revenue and Cost Information \$ 30 ÷ 0.5 \$ 60 Per unit: Contribution margin Machine hours required Contribution margin per machine hour ÷ 1.0 Metal frames Wood If metal frames require half an hour of machine time, U-Develop can produce two metal frames per hour. This means that even though the contribution margin per unit is \$30, the contribution per machine hour is \$60 for the metal frames. However, U-Develop can only produce one wood frame per hour. So the contribution margin per machine hour is \$30 for wood frames. Metal Frames have a higher contribution margin per machine hour. 4 - 27

Product Choice Decisions
LO4 Product Choice Decisions Suppose U-Develop has 200 machine hours per month available. 400 × \$30 \$12,000 3,000 1,500 \$ 7,500 Capacity Contribution margin per unit Total contribution margin Less: Fixed manufacturing costs Less: Fixed marketing and admin. costs Operating profit 200 \$6,000 \$1,500 Metal frames Wood Machine hours is a constrained resource. Suppose U-Develop has 200 machine hours available per month. U-Develop can produce 400 metal frames for operating profit of \$7,500. Only 200 wood frames can be produced for operating profit of \$1,500. Selling metal frames will result in higher profits than selling wooden frames. 4 - 28

The Theory of Constraints
L.O. 5 Understand the theory of constraints. Theory of constraints: Focuses on revenue and cost management when faced with bottlenecks Bottleneck: Operation where the work required limits production The bottleneck is the constraining resource. The theory of constraints focuses on revenue and cost management when faced with bottlenecks. In essence, bottlenecks are constraints. Throughput contribution: Sales dollars minus direct materials costs and variables such as energy and piecework labor 4 - 29

Using Excel Solver Product Choice Decisions Problem 4-59