1. ACCT 2302 Fundamentals of Accounting II Spring 2011 Lecture 17 Professor Jeff Yu

2. Chapter 13: Relevant Costs Relevant costs are those costs that differ between two (or more) decision 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. Relevant Cost = Avoidable Cost = Differential Cost

3. Relevant Cost Analysis A Two-Step Process:  Step 1: Eliminate costs and benefits that DO NOT differ between alternatives. Examples: (1) Sunk costs; (2) Future costs that do not differ between alternatives  Step 2: Use the remaining costs and benefits that DO differ between alternatives (Differential Costs and Benefits) in making the decision.

4. Practice Problem: Equipment Replacement A manager at White Co. wants to replace an old machine with a new machine. The old machine’s original cost was $72,000. Currently, it has a 5-year remaining life, a net book value of $60,000 and a disposal value of $15,000. The new machine’s list price is $90,000, with a 5-year expected life. White’s sales are $200,000 per year. Annual variable expenses are $80,000 using the new machine and $100,000 using the old machine. Fixed expenses, other than depreciation, are $70,000 per year. We are thinking about replacing old equipment with more efficient new equipment. Do you think we should? Q: What are the relevant costs in this equipment replacement decision? Should the old machine be replaced with the new machine?

5. Decision to Add or Drop Segments In making a decision to add or drop a segment, many qualitative and quantitative factors must be considered. Our focus is on the impact such a decision has on NOI. Differential Benefit to add or retain a segment: Segment Contribution Margin Differential Costs to add or retain a segment : Traceable fixed costs. Recall: Common fixed costs are unavoidable, hence irrelevant in the decision.

6. Boyle Co. has two departments, Bath and Kitchen. The projected operating results for next month is as follows: Bath Kitchen Sales $ 1,000 $ 4,000 Variable Expenses 300 1,600 Fixed Expenses 900 1,800 If the Bath department is dropped, $370 of the allocated fixed expenses (e.g. general factory overhead and general admin. expenses) cannot be eliminated, and the sales of the Kitchen department will decrease by 10%. Q: How will the company’s overall NOI for next month change if the Bath department is dropped? Practice Problem

7. Transfer Pricing Decision A transfer price is the price charged when one segment provides goods or services to another segment of the company. The objective in setting transfer prices is to motivate managers to act in the best interests of the overall company. The transfer price affects the profit measure for both the selling segment and the buying segment.

8. Negotiated Transfer Prices Transfer price results from negotiations between the selling and buying divisions. Advantages: 1.They preserve the autonomy of the divisions. 2.The managers negotiating the transfer price are likely to have much better information than others. Upper limit is set by the buying division. Lower limit is set by the selling division. Range of Acceptable Transfer Prices

9. Negotiated Transfer Prices Buyer’s perspective: Transfer Price <= best price from outside suppliers Or, if an outside supplier does not exist: Transfer Price <= NOI per unit (not considering the transfer price in the calculation of NOI) Seller’s perspective: Transfer Price >= VC per unit + Opportunity cost per unit Opportunity cost per unit = Total CM on lost sales / # of units transferred Note: if some of the units transferred could have been sold to external customers for a profit, then the opportunity cost of internal transfer is the total contribution margin given up on lost sales.

10. Negotiated Transfer Prices Minimum transfer price = VC per unit + Opportunity cost per unit Opportunity cost depends on the idle capacity. Idle capacity is the difference between the segment’s production capacity and its budgeted production (meeting both external sales & inventory needs), and by definition the idle capacity has no alternative use. (1)If idle capacity = 0, then opportunity cost per unit = CM per unit, minimum transfer price = Market price (2) If idle capacity >= units transferred, then opportunity cost per unit = 0, minimum transfer price = VC per unit (3) If 0< idle capacity <= units transferred, then min. transfer price = w*VC per unit + (1-w)*Market price where the weight: w = idle capacity ÷ units transferred.

11. The Battery Division makes a standard 12-volt battery. Production capacity 300,000 units Selling price per battery $40 (to outsiders) Variable costs per battery $18 Fixed costs per battery $ 7 (at 300,000 units) The Auto Division would like to use 100,000 units of these batteries in its X-7 model. They can buy a similar battery from an outside vendor for $35 per unit, but only if they buy all 100,000 units. Q: (1) If Battery division has no idle capacity, what is the lowest acceptable transfer price? (2) If Battery division has an idle capacity of 150,000 units, what is the lowest acceptable transfer price? (3) If Battery division only has an idle capacity of 60,000 units, what is the lowest acceptable transfer price? (4) Identify the range of acceptable transfer prices, if any, for the above three cases. Practice Problem

12. Evaluation: Negotiated Transfer Prices If a transfer within a company would result in higher overall profits for the company, there is always a range of transfer prices within which both the selling and buying divisions would have higher profits if they agree to the transfer. However, if managers are evaluated against each other rather than a reasonable benchmark, a non-cooperative atmosphere is almost guaranteed.

13. Evaluation: Transfers at the Cost Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division. Simple to apply, but serious drawbacks: 1.Using full cost as the transfer price can lead to decisions that are not in the best interest of the overall company. 2.Cost-based transfer prices do not provide incentives to control costs.

14. Evaluation: Transfers at Market Price A market price approach works best when the selling division has no idle capacity. The selling segment will not lose anything by making the transfer, while the buying segment will get the correct signal how much it costs the company for the transfer to take place. However, a market price approach does NOT work well when the selling division has idle capacity.

15. Hrubec Inc. operates a Pulp Division with the following data for a ton of pulp: selling price per ton is $70, variable cost per ton is $42, fixed cost per ton based on a capacity of 50,000 tons per year is $18. The newly acquired Carton Division is buying 5,000 tons of pulp per year from a outside supplier at a cost of $70 per ton less a 10% discount. Q: (1) If Pulp Division can sell all of its pulps produced externally at $70 per ton, can an acceptable transfer price be worked out voluntarily? What will be the effects on the profits of the company as a whole if the CEO forces Pulp Division to match the supplier’s price? (2) If Pulp Division could only sell 30,000 tons of pulp each year to external customers at $70 per ton, can an acceptable transfer price be worked out voluntarily? Assume that due to inflexible policies, the Carton Division is required to buy 5,000 tons of pulp each year from Pulp Division at $70 per ton, what will be the effect on profits of the two divisions and the company as a whole? (3) What is the minimum transfer price if idle capacity is only 3,000 tons? Practice Problem

16. Special Order A 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. Since the existing fixed costs would not be affected by the order, they are not relevant. But fixed costs traceable only to the special order (e.g. special equipments required) are relevant.

17. Similar to Transfer pricing: With ample idle capacity... Relevant costs are the variable costs associated with the special order. Without enough idle capacity... Relevant costs: variable costs and the opportunity cost of using the firm’s facilities for the special order. Decision to Accept or Reject a Special Order

18. Your firm has the capacity to produce 10,000 pencils annually. It’s December 15 th. To date your firm has produced 7,000 pencils. You don’t anticipate getting any more regular orders until next January. A special order comes in that offers you $5 per pencil for 2,000 pencils. Your cost and revenue information is as follows: Sales price per pencil$ 10 Variable cost per pencil 3 Total fixed costs 28,000 Q: Should you take this deal? What if the special order is $5 per pencil for 4,000 pencils? Practice Problem

19. Imperial Jewelers is considering a special order for 20 handcrafted gold bracelets at $170 each as wedding party gifts. The normal selling price for the gold bracelet is $190. To produce each gold bracelet, DM cost is $84, DL cost is $45, variable OH cost is $4, and fixed OH cost is $16. The special order further requires special filigree to be applied to the bracelet, which requires additional materials costing $2 per bracelet and buying a special tool costing $250 that have no other use. This order would not affect the company’s regular sales and the company have ample idle capacity to fill this order. Q: How will the company’s NOI change if this special order is accepted? Practice Problem

20. For Next Class  Continue on Chapter 13  Attempt the assigned HW problems.

21. WestTroy Division Sales$600,000$300,000 Variable costs 310,000 200,000 Contribution margin290,000100,000 Traceable fixed costs110,00070,000 Allocated common fixed costs 90,000 45,000 Net operating income (loss)$ 90,000($ 15,000) If Troy Division is dropped, sales of West Division will decrease by 5%. Q: if Troy Division is dropped, how would that affect the overall company’s NOI? Homework Problem 1

22. Valve Division of Collyer Inc. makes a regular valve at variable cost of $16 per unit. The valve can be sold at market price of $30 or transferred internally to Pump Division, which is buying 10,000 valves per year from an overseas supplier at $29 per valve. Q: (1)If Valve Division has ample idle capacity to handle Pump Division’s needs, what is the acceptable range for the transfer price? (2) What if Valve Division has 8,000 units of idle capacity? (3) What If Valve Division has no idle capacity and $3 per unit of variable selling expense can be avoided on internal transfers? (4) If Valve Division receives a special order from Pump Division for 20,000 high-pressure valves, and to make these special valves, Valve Division has to incur $20 variable cost per unit and reduce its production of regular valves from 100,000 units to 70,000 units, what is the lowest acceptable transfer price? Homework Problem 2