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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 20 1.

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1 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Chapter 20 1

2 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2 Describe and identify information relevant to business decisions Make special order and pricing decisions Make dropping a product and product-mix decisions Make outsourcing and sell as is or process further decisions

3 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Describe and identify information relevant to business decisions 1 1 3

4 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 4 Repeat existing patterns without question Why did the accountant cross the road? Triage management Deal with most urgent problems as they come up Trial and error Shooting from the hip, seat of the pants Information based decision making Base decisions on mission aligned options supported with relevant information

5 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 5 How do we utilize excess capacity? Should we accept this special order? Relevant costs, market effects Accept the offer if it helps us meet our business goals.

6 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Relevant costs affect decisions Differ among the alternatives Haven’t happened yet Any costs that fit those above two categories Irrelevant costs do not affect decisions Costs that do not differ between options Sunk costs Occurred in the past Are never relevant to any decision The trouble is we are human and we hate to lose. 6

7 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Impact on employee morale Outsourcing Layoffs Impact on quality Product recall, higher warranty costs Brand equity, lost sales Customer relations Reactions to your decisions Opportunity cost What you forego to get something else Use same guidelines as relevant costs Occurs in the future Differs between alternatives 7

8 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. If a cost doesn’t change between two decision options, ignore it. Average costs as reported by financial accounting reports are frequently NOT purely relevant costs.

9 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Relevant information approach Also called the incremental analysis approach Only display relevant numbers Focuses attention on just what matters Fast, clear, concise Total cost approach Follow the same principles Show all the numbers Shows the whole picture, nothing hiding Builds trust, removes doubt & mystery 9

10 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. You are trying to decide whether to trade in your inkjet printer for a more recent model. Your usage pattern will remain unchanged, but the old and new printers use different ink cartridges. 1.Indicate if the following items are relevant or irrelevant to your decision: a.The price of the new printer b.The price you paid for the old printer c.The trade-in value of the old printer d.Paper costs e.The difference between ink cartridges’ costs 10 Relevant Irrelevant Relevant Irrelevant Relevant

11 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Make special order and pricing decisions

12 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. These are NOT regular, everyday pricing decisions. Special orders are considerations in addition to your regular business Extra sales opportunities Using this pricing methodology for everyday transactions will bankrupt you. Want to know why?

13 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. To add profits, special orders need only cover incremental costs, leaving the rest of non- differential cost coverage for someone else… Requirements Can’t effect regular customers Must use excess capacity Why is this? Other considerations Grey market? Brand equity? Future negotiations?

14 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1.Focus on relevant data (revenues and costs that will change if it accepts the special order) 2.Use of a contribution margin approach that separates variable costs from fixed costs 3.The special sales order will increase operating income by $2,500. Fixed costs remain the same. 14

15 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 15 The key is find which costs and revenues are effected by the special order, and only use those relevant costs in the quantitative aspects of your decision.

16 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Your small photography firm specializes in life capturing photography. Your everyday pricing is built on the following cost structure: 16 Should you accept a special order offer of $100 considering the following situation? It is 11:00am, you are done with your only shoot of the day at Lover’s Point. An Andorran tourist offers you $100 for a portrait using your current setting.

17 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Your small photography firm specializes in life capturing photography. Your everyday pricing is built on the following cost structure: 17 Should you accept a special order offer of $100 considering the following situation? You said “Yes”. Now that same tourist gets a call. The caller asks if you can come back tomorrow at the same time for the same deal.

18 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Your small photography firm specializes in life capturing photography. Your everyday pricing is built on the following cost structure: 18 A real estate agent wants to purchase portraits for staging a home. You have several whose customers have abandoned them. Each required separate travel and other costs to complete. What is the minimum price you should accept? What is horribly wrong with the technically right answer?

19 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Considering again the original $100 acceptable deal The tourist wants a portrait. We are the only ones there set up to a professional quality job. 19 It is 11:00am, you are done with your only shoot of the day at Lover’s Point. An Andorran tourist offers you $100 for a portrait using your current setting.

20 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Why are USA companies are able to sell their medicines cheaper in other countries? Why are “international version” text books so much cheaper? What is “price discrimination” and how does it explain these business issues? Coupons Internet only pricing (not available in store) Intentionally carrying closeout items after the season

21 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 21 What is our target profit? How much will customers pay? Are we a price-taker or a price-setter?

22 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Owners expect a certain rate of return Risk factors Historical performance Options available If owners have $1,000,000 in equity and expect a 10% return, they expect the company to earn $100,000 in profits for them. If they don’t get it, the value of the firm will drop Somehow or another the company needs to try and hit that target. 22

23 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Examples: Food commodities Natural resources Generic consumer products and services 23 Examples: Original art, brands Specialty machinery Patented perfume scents Latest technology

24 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 24 Starts with the market price of the product The price customers are willing to pay Subtracts the company’s desired profit Determine the product’s target full cost Full cost to develop, produce, and deliver the product or service

25 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Starts at cost, then adds desired profits Opposite of the target-pricing approach Requires market control over pricing Common practice with standard industry pricing models 25 Full cost Plus: Desired profit Equals Cost-plus price

26 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Accept the lower operating income, not the target return required by stockholders Reduce fixed costs Reduce variable costs Use other strategies Increase capacity to spread the fixed costs are spread over more units Change or add to product mix Differentiate its product (become a price setter) Reduce ownership Go out of business 26

27 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Unique products Consider what customers are willing to pay How well has the company been able to differentiate its product? 27

28 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 28 How to Approach Pricing? Is company a price-taker for the product? Emphasize target pricing approach Is company a price-setter for the product? Emphasize cost- plus pricing approach

29 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 29 Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardz’s total production cost is $0.61 per pack, as follows: Hobby-Cardz has enough excess capacity to handle the special order. 1. Prepare an incremental analysis to determine whether Hobby- Cardz should accept the special sales order.

30 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 30 Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardz’s total production cost is $0.61 per pack, as follows: Hobby-Cardz has enough excess capacity to handle the special order. 1. Prepare an incremental analysis to determine whether Hobby- Cardz should accept the special sales order. Accept the special order

31 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall Now assume that the Hall of Fame wants special hologram baseball cards. Hobby-Cardz will spend $5,900 to develop this hologram, which will be useless after the special order is completed. Should Hobby-Cardz accept the special order under these circumstances? R e j e c t t h e s p e c i a l o r d e r

32 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Green Thumb operates a commercial plant nursery where it propagates plants for garden centers throughout the region. Green Thumb has $4,800,000 in assets. Its yearly fixed costs are $600,000, and the variable costs for the potting soil, container, label, seedling, and labor for each gallon-size plant total $1.35. Green Thumb’s volume is currently 470,000 units. Competitors offer the same plants, at the same quality, to garden centers for $3.60 each. Garden centers then mark them up to sell to the public for $9 to $12, depending on the type of plant. 1. Green Thumb’s owners want to earn a 10% return on the company’s assets. What is Green Thumb’s target full cost? 32 Revenue at current market price (470,000 units × $3.60 per unit) $1,692,000 Less:Desired profit ($4.8 million × 10%) 480,000 Target full cost$1,212,000

33 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2. Given Green Thumb’s current costs, will its owners be able to achieve their target profit? 33 Green Thumb’s actual total full costs of $1,234,500 are higher than its target full cost, therefore Green Thumb will not meet the stockholders’ profit expectations. Current variable cost (500,000 × 1.70) $ 634,500 Current fixed costs 600,000 Total full cost $1,234,500

34 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 3. Assume Green Thumb has identified ways to cut its variable costs to $1.20 per unit. What is its new target fixed cost? Will this decrease in variable costs allow the company to achieve its target profit? 34 The new target fixed cost is $648,000. Target full cost (from requirement 1) $1,212,000 Less: Reduced level of variable costs (470,000 × $1.20) (564,000) New target fixed costs$ 648,000 Since the company’s actual fixed costs are less than or equal to the new target fixed cost amount, Green Thumb will be able to achieve its target profit without having to take any other cost-cutting measures.

35 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 4. Green Thumb started an aggressive advertising campaign strategy to differentiate its plants from those grown by other nurseries. Monrovia Plants made this strategy work, so Green Thumb has decided to try it, too. Green Thumb does not expect volume to be affected, but it hopes to gain more control over pricing. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not? 35

36 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 4. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not? 36 Green Thumb’s cost-plus price is $3.74 Current fixed costs$ 600,000 Plus:Additional fixed costs of advertising 115,000 Plus: Total variable costs (470,000 × $1.20) 564,000 Total full costs$1,279,000 Plus: Desired profit ($4.8 million × 10%). 480,000 Desired revenue$1,759,000 Divided by:Number of units ÷ 470,000 Cost-plus price per unit $ 3.74 Retailers will be more willing to pay the cost-plus price if the marketing campaign is effective. Other wise, Green Thumb may be considered a generic nursery.

37 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Make dropping a product and product-mix decisions

38 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Drop segments with negative contribution margin Unavoidable fixed costs are irrelevant Fixed costs that continue to exist even after a segment is dropped Avoidable, direct fixed costs are relevant If you drop and you save, it counts! Would dropping the product line, department, or territory hurt or help other sales? Dropping can help focus, or hurt cross promotion Can freed capacity be put to use? Bottom line: Drop if fixed cost savings exceed lost contribution margin. 38

39 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Should Safe Zone drop the unprofitable Industrial System segment? Prepare an incremental analysis. They will eliminate $84,000 in fixed manufacturing costs, and reduce fixed marketing & administration by $14,

40 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Work problem E20-13 Really? Should they drop VCR tapes? 40

41 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Our previous Contribution Margin analysis stressed CM per sales dollar. We maximized profits by selling the item with the highest contribution per sales dollar. This is valid if plentiful resources exist to fulfill our maximum sales volume. That is, if sales volume is our constraining resource. Our previous Contribution Margin analysis stressed CM per sales dollar. We maximized profits by selling the item with the highest contribution per sales dollar. This is valid if plentiful resources exist to fulfill our maximum sales volume. That is, if sales volume is our constraining resource.

42 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Constraints Something that restricts production or sale of product Manufacturer example Limitations on labor or machine hours or available materials Merchandiser example Amount of display space 42

43 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 43 What constraint stops a company from processing everything demanded? Which products offer the highest contribution margin per unit of the constraint? Decision rule: Decision Rule - Which product to emphasize? Emphasize the product with the highest contribution margin per unit of the constraint.

44 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Where should this business focus their sales efforts? They have too many customers and too little time.

45 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

46 Deela Fashions operates three departments: Men’s, Women’s, and Accessories. Departmental operating income data for the third quarter of 2012 are as follows: Assume that the fixed expenses assigned to each department include only direct fixed costs of the department: ● Salary of the department’s manager ● Cost of advertising directly related to that department If Deela Fashions drops a department, it will not incur these fixed expenses. 46

47 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1.Under these circumstances, should Deela Fashions drop any of the departments? Give your reasoning. Deela Fashions should drop the Accessories Department because relevant expenses are greater than the revenues which will result in an increase in operating income if the department is dropped. 47

48 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Make outsourcing and sell as is or process further decisions

49 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Deciding whether to make an item internally or buy it from an outside supplier This is an excellent application of the relevant cost principles we are learning. Deciding whether to make an item internally or buy it from an outside supplier This is an excellent application of the relevant cost principles we are learning.

50 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. DECISION RULE, Accounting portion eliminating In deciding whether to switch to an outside supplier, we isolate the relevant costs of making the part by eliminating: The sunk costs. The future costs that will not differ between making or buying the parts. Recognizing the opportunity costs of any freed up capacity. DECISION RULE, Accounting portion eliminating In deciding whether to switch to an outside supplier, we isolate the relevant costs of making the part by eliminating: The sunk costs. The future costs that will not differ between making or buying the parts. Recognizing the opportunity costs of any freed up capacity.

51 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The benefits that are 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. The benefits that are 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.

52 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 52 Should the company outsource? If the incremental costs of making exceed incremental costs to outsource Outsource If the incremental cost of making are less than the incremental costs to outsource Do not outsource

53 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Outdoor Life gets the call from Lancaster The costs are compared Outsourced goods in hand: $13.00 each Should they outsource? What next? 53

54 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Benefit given up by not choosing an alternative course of action If Outdoor Life could use the freed up capacity to produce another component, how profitable would it have to be? 54

55 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Alignment of incentives with decisions What else happens when you outsource production? Tough to reverse course once everyone is fired. Outsourced cost inflation? Reliance on business partners Logistics Who cares more about YOUR quality? YOUR production equipment doesn’t get obsolete. Focus on newest releases and core competencies Technology simplifies Outsourcing Special Notes

56 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Qualitative factors Control over quality Outsourcing considerations Coordination, information exchange, and paperwork problems Globalization Use Internet to find information systems of suppliers and customers located around the world Companies can now focus on their core competencies—quality and delivery 56

57 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Considerations: How much revenue will the company receive if the company sells the product as is? How much revenue will the company receive if the company sells the product after processing it further? How much will it cost to process the product further? 57

58 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 58

59 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Decision rule: 59 Sell as-is or process further? If extra revenue from processing further exceeds extra cost Process further If extra revenue from processing further is less than extra cost Sell as is

60 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Suppose a Roasted Olive restaurant is considering whether to (1) bake bread for its restaurant in-house or (2) buy the bread from a local bakery. The chef estimates that variable costs of making each loaf include $0.52 of ingredients, $0.24 of variable overhead (electricity to run the oven), and $0.70 of direct labor for kneading and forming the loaves. Allocating fixed overhead (depreciation on the kitchen equipment and building) based on direct labor assigns $0.96 of fixed overhead per loaf. None of the fixed costs are avoidable. The local bakery would charge $1.75 per loaf. 1. What is the unit cost of making the bread in-house (use absorption costing)? 2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why? 3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision? 60

61 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 1. What is the unit cost of making the bread in-house (use absorption costing)? 61

62 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why? Decision: Roasted Olive should bake the bread in-house since the variable cost of making each loaf is less than the cost of outsourcing each loaf. 3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision? Roasted Olive should consider the following qualitative factors before making a final decision: Will the local bakery meet their delivery time requirements? How does the quality and freshness of the local bakery bread compare to Roasted Olive bread? 62

63 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Relevant information is expected future data that differs among alternatives. Relevant costs are costs that may affect which decision you make. Irrelevant costs are costs that won’t change the decision you make. Sunk costs are costs that were incurred in the past and cannot be changed regardless of which future action is taken. The two keys to making short-term decisions are to focus on relevant revenues, costs, and profits, and to use a contribution margin approach to separate variable and fixed costs. 63

64 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. Managers must consider three things when considering a special order: 1) Does the company have excess manufacturing capacity? 2) Does the special sales price cover the incremental costs of filling the special order? 3) Will fixed costs change because of the special order? If the expected increase in revenues exceeds the expected increase in costs, the company should accept the special order. When setting prices, the company must consider its target profit goal, how much customers will pay for the product, and whether the company is a price-taker or a price-setter. Price setters use a cost-plus pricing approach to pricing, whereas price-takers use a target pricing approach. 64

65 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. The first product mix question is “Does the product provide a positive contribution margin?” What is relevant is whether the fixed costs continue to exist if the product is dropped and whether there are any avoidable direct fixed costs if the product is dropped. Unavoidable fixed costs and are irrelevant to the decision. If direct fixed costs will change, those costs are relevant to the decision of whether a product should be dropped. When there is a constraint on production, such as total machine hours, this constraint must be considered when determining which product should be emphasized. If the company can sell whatever product it makes, the company should emphasize producing the product with the highest contribution margin per unit of the constraint. 65

66 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. When a company is considering outsourcing, if the incremental costs of making the product exceed the incremental costs of outsourcing, then the company should outsource the product. When a company is considering selling a product as is or processing it further, if the extra revenue from processing the product further exceeds the extra costs to process the product further, then the company should process the product further. 66

67 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 67

68 Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall. 68 Copyright All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.


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