Presentation on theme: "5 Short-Term Decisions and Accounting Information"— Presentation transcript:
1 5 Short-Term Decisions and Accounting Information Prepared byDouglas Cloud Pepperdine University
2 After reading this chapter, you should be able to: ObjectivesExplain why decision making requires information not included in regular accounting reports.Determine what costs and revenues are relevant to decisions.Analyze the quantitative factors relevant to typical decisions.Explain the importance of complementary effects to decisions of a segment of a larger entity.After reading this chapter, you should be able to:Continued
3 ObjectivesIdentify nonquantitative or long-term considerations that influence short-term decisions.Describe some of the legal constraints on managers’ decisions.
4 The Criterion for Short-term Decisions Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss).Two Subrules1. The only revenues and costs that are relevant in making decisions are the expected future revenues and costs that will differ among the available choices.2. Revenues and costs that have already been earned or incurred are irrelevant in making decisions.114
5 DefinitionsDifferential revenues and costs are the expected future revenues and costs that will differ among the choices that are available.Incremental revenues and costsare those differential revenues and costs that actually increase.125
6 DefinitionsSunk costs are costs that have already been incurred and therefore will be the same no matter which alternative a manager selects.Examples:Book value of equipmentOriginal purchase price of building136
7 DefinitionsAn opportunity cost is the benefit lost by taking one action as opposed to another.Example: Rental income lost if facility is used for production.147
8 Typical Short-Term Decisions Drop a SegmentMake-or-BuyJoint ProductSpecial OrderFactors of Limited SupplyImportant: Short-term Perspective9916
9 Should the company accept the offer? Basic ExampleGloucester Visuals recently manufactured 100 specialized workstation monitors for a customer that has since gone bankrupt. A rival company has offered to buy the monitors for $12,000. The cost to manufacture the monitors was $17,000.Should the company accept the offer?
10 Basic Example Differential revenues $12,000 Differential costs 0 Differential profit $12,000Accept the offer!
11 Should the company accept the offer? Basic ExampleThird AlternativeA competitor offers to pay $20,000 for the monitors provided that Gloucester disguises the original logo and makes a few other modifications. The production manager estimated the incremental cost of the modifications at $6,000.Should the company accept the offer?
13 Comparison of the three methods Basic ExampleComparison of the three methodsThrow Out MonitorsSell Monitors As IsRework and SellIncremental revenue $0 $12,000 $20,000Incremental costs (6,000 )Incremental profit (loss) $0 $12,000 $14,000
14 Activity-Based Estimates Using ABC helps managers focus on what activities change as a result of a decision.
16 Dropping a Segment Decision Genco’s analysis shows that dropping jewelry would reduce common costs by $1,000. If jewelry is dropped, the available space can be rented for $400 per month.Differential revenues:Lost sales from jewelry $15,000New rent revenueNet revenue lost $14,600Differential costs:Variable costs saved on jewelry $11,000Direct fixed costs saved 1,500Indirect fixed costs saved 1,000Total cost saving 13,500Differential loss from dropping jewelry $ 1,100Keep jewelry!111811
17 Complementary Effects Decision: Substitute Music for JewelryDifferential contribution margin— increase ($12,000 – $4,000) $8,000Differential costs—increase in direct fixed costs ($2,700 – $1,500) 1,200Differential profit favoring substitution $6,800
18 Complementary Effects Complementary effects happen when a change in the sale of one product might be accompanied by a change in the sale of another.Genco’s managers believe that some people coming to shop for music are also likely to buy clothing. After reviewing the results of market studies, the managers estimate that clothing sales will increase 7 percent if music is substituted for jewelry.1912
19 Complementary Effects Decision: Substitute Music for JewelryDifferential contribution margin: Increase due to selling music vs. jewelry $8,000Increase due to higher clothing sales(7% x $20,000 contribution margin on current sales) 1,400Net Increase in contribution margin $9,400Differential costs—increase in direct fixed costs ($2,700 – $1,500) 1,200Differential profit favoring substitution $8,200
20 Loss LeaderA loss leader is a special case of complementary effects where a product or line shows a negative profit in the sense that its contribution margin does not cover its avoidable fixed costs.The manager of a local pizzeria prepares the income statement shown on Slide 5-20, based on a normal week, for the 11 a.m. to 2 p.m. period. All costs are incremental.
21 Loss Leader Pizza Soft Drinks Total Sales (200 $1.80) $360 $100 $460Variable costsContribution margin $240 $ 60 $300Wages of part-time employeesIncome $220
22 Loss Leader Pizza Soft Drinks Total Sales $ 720 $ 0 $720 Variable costs 240a 100b 340Contribution margin $480a $(100) $380Wages of part-time employees ($80 + $40)Income $260a Variable costs computed at the same rate as before, one-third or 33 1/3% of selling price.b Variable costs computed as two and one-half times the previous costs.
23 Make-or-Buy Decision Total Cost Unit Cost Assume the following cost data relate to the decision to produce12,000 units of a product or buy from external source:Rental of equipment $15,000 $1.25Equip. depreciation ,Direct materials ,Direct labor ,Variable overhead ,Fixed overhead ,Total $99,000 $8.25Total Cost Unit CostThe purchase price from an outside vendor is $5.50 per unit.131320
24 Decision: Manufacture parts in-house Make-or-Buy DecisionDifferentialMake Buy Cost to MakeRental of equip. $15, $15,000Direct materials , ,000Direct labor , ,000Variable overhead 9, ,000Purchase cost $66,000 $(66,000 )Relevant costs $60,000 $66,000 $(6,000 )Decision: Manufacture parts in-houseThe cost to make is $5.00 per unit.The price to buy is $5.50 per unit.141421
26 Joint ProductsWhen a single manufacturing process invariably produces two or more separate products, the products are called joint products.QBT, a chemical company, operates a joint process that results in two products. Each 1,000 pounds of material yields 600 pounds of Alpha and 400 pounds of Omega.2516
27 Joint Products Alpha Omega Selling price at split-off $1,200 $1,600 Selling price after additional processing $3,600 $2,000Costs of additional processing, all variable $900 $500171726
28 Joint Products Alpha Omega Differential revenues $2,400 $ 400 Differential costsDifferential profits $1,500 $(100 )Decisions: Process Alpha further and sell Omega at the split-off point172718
29 Special Order Example Per Unit Total Sales (60,000 units) $15 $900,000 Manufacturing costs:Materials $4 $240,000Direct labor ,000Overhead (1/3 variable) ,000Total $ ,000Gross margin $120,000Selling and admin. expenses ,000Operating income $ 40,000Per Unit TotalShould the company sell a special on-time order for 20,000 at $10 per unit to a company in a new market?19
30 Decision: Accept special order Special Order ExamplePer Unit TotalDifferential revenues (20,000 units) $10 $200,000Differential costs:Materials $4 $80,000Direct labor ,000Variable overhead ,000Total $ ,000Incremental profit favoring acceptance $ 20,000Decision: Accept special order20
31 Special Order Example Differential revenues: : New revenues (20,000 units) $200,000Lost revenues (5,000 units x $15) (75,000 )Total differential revenues $125,000Differential costs:Costs of special order $180,000Costs from not making regular sales:Variable manufacturing cost5,000 x $9 ($4 + $3 + $2) (45,000 )Commissions (5,000 x $0.30) (1,500 )Total differential costs ,500Differential loss, favoring rejecting order $ (8,500 )21
32 Resource Constraint Selling price $10 $6 Variable cost 6 4 Drive Chip Modem ChipSelling price $ $6Variable costContribution margin $ $2Number of units that can be made per MHWhich product should be processed assuming only 100 machine hours are available?22
33 Resource Constraint Number of units that can be made per MH 60 150 Contribution margin per unit x $ x $2Contribution margin permachine hour $ $300Drive Chip Modem ChipDecision: Produce modem chips23
34 Decision Making Under Environmental Constraints Antitrust laws forbid actions that might substantially reduce competition.Anti-dumping laws address aspects of unfair competition in international trade.3324
35 Decision Making Under Environmental Constraints The Sherman Act, Clayton Act, Robinson-Patman Act, and the statutes of many states prohibit predatory pricing.Predatory pricing is pricing below cost in the short term to drive competitors out of business and eventually to raise prices.3425
36 Decision Making Under Environmental Constraints The Robinson-Patman Act forbids charging different prices to different customers unless there are intrinsic cost differences in serving the different customers; in other words, this act forbids discriminatory pricing.The Federal Trade Commission (FTC) is the regulatory agency responsible for enforcing the act.3526
37 Decision Making Under Environmental Constraints Anti-dumping laws prevent unfair competitive practices in international trade by prohibiting a company in one country from selling its products in another country at less than fair value.The International Trade Administration, part of the Commerce Department, deals with charges of dumping in the United States.3627