1. Copyright © Houghton Mifflin Company. All rights reserved.1 Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College

2. Copyright © Houghton Mifflin Company. All rights reserved.2 Chapter 24 Short-Run Decision Analysis

3. Copyright © Houghton Mifflin Company. All rights reserved.3 1.Explain how managers make short-run decisions during the management cycle. 2.Define and explain incremental analysis and its related concepts. 3.Apply incremental analysis to outsourcing decisions. 4.Apply incremental analysis to special order decisions. 5.Apply incremental analysis to segment profitability decisions. LEARNING OBJECTIVES

4. Copyright © Houghton Mifflin Company. All rights reserved.4 6.Apply incremental analysis to product mix decisions involving constrained resources. 7.Apply incremental analysis to sell or process-further decisions. 8.Apply incremental analysis to service organizations. LEARNING OBJECTIVES

5. Copyright © Houghton Mifflin Company. All rights reserved.5 Information for Short-Run Decisions OBJECTIVE 1 Explain how managers make short-run decisions during the management cycle, and identify the steps in the management decision cycle.

6. Copyright © Houghton Mifflin Company. All rights reserved.6 Short-Run Decisions Short-run decision analysis is an important component of the management cycle.Short-run decision analysis is an important component of the management cycle. In the planning stage, managers estimate costs and revenues for use in making short-run decision.In the planning stage, managers estimate costs and revenues for use in making short-run decision.

7. Copyright © Houghton Mifflin Company. All rights reserved.7 The Management Cycle In the executing stage, managers make and implement short-run decisions to improve the organization’s profitability and liquidity in the short run.In the executing stage, managers make and implement short-run decisions to improve the organization’s profitability and liquidity in the short run. Managers use financial and nonfinancial information to decide to: – –Accept a special order. – –Keep or drop a segment. – –Select the appropriate product mix. – –Contract with outside suppliers. –. –Sell a product as is or process further.

8. Copyright © Houghton Mifflin Company. All rights reserved.8 The Management Cycle In the reviewing stage, each decision is evaluated to determine if it produced the forecasted results. The reporting stage takes place throughout the management cycle.

9. Copyright © Houghton Mifflin Company. All rights reserved.9 Short-Run Decisions Both quantitative and qualitative factors influence short-run decisions. Managers must assess the importance of qualitative information such as: Product (or service) quality. Timeliness. Social issues.

10. Copyright © Houghton Mifflin Company. All rights reserved.10 The Management Cycle

11. Copyright © Houghton Mifflin Company. All rights reserved.11 The Management Decision Cycle

12. Copyright © Houghton Mifflin Company. All rights reserved.12 Discussion Q QWhat are some examples of ways that managers use financial and nonfinancial information? A A1.Accept a special order. 2.Keep or drop a segment. 3.Select the appropriate product mix. 4.Contract with outside suppliers. 5.Sell a product as is or process further.

13. Copyright © Houghton Mifflin Company. All rights reserved.13 The Decision-Making Process OBJECTIVE 2 Define and explain incremental analysis and its related concepts.

14. Copyright © Houghton Mifflin Company. All rights reserved.14 Incremental Analysis for Management Decisions The management decision cycle: 1. 1.Begins with the determination of a problem or need. 2. 2.Then alternative courses of action are identified. 3. 3.The effects of each alternative are evaluated.

15. Copyright © Houghton Mifflin Company. All rights reserved.15 Incremental Analysis 1. 1.Also called differential analysis. 2. 2.Ignores revenues or costs that stay the same or that do not differ among alternatives. (Irrelevant revenue and costs.) 3. 3.Ignores sunk costs, already incurred and not recoverable.

16. Copyright © Houghton Mifflin Company. All rights reserved.16 Relevant Decision Information Any data related to future costs, revenues, or uses of resources that will differ among alternative courses of action are considered relevant decision information.

17. Copyright © Houghton Mifflin Company. All rights reserved.17 Incremental Analysis Step 1: Eliminate irrelevant revenues and costs. Step 2: Prepare the analysis using only projected revenues and expenses that will differ. Step 3: Consider other relevant issues, such as quality, reputation, etc.

18. Copyright © Houghton Mifflin Company. All rights reserved.18 Incremental Analysis Lennox Company Incremental Analysis Grinder CGrinder W Difference in favor of Grinder W Increase in revenues Increase in operating costs Direct labor Variable manufacturing overhead Total relevant operating costs $ 16,200 $ 2,200 2,100 $ 4,300 $ 19,800 $ 4,100 3,050 $ 7,150 $ 3,600 ($ 1,900) (950) ($ 2,850) Resulting change in net income$ 11,900$ 12,650$ 750

19. Copyright © Houghton Mifflin Company. All rights reserved.19 Special Considerations in Short-Run Decision Analysis The effects of opportunity costs The need to prepare special decision reports

20. Copyright © Houghton Mifflin Company. All rights reserved.20 Decision Costs Opportunity costs are the benefits forgone when one alternative is selected over another. Incremental analysis helps managers compare alternatives by focusing on the differences in their projected revenues and costs. Such a report helps identify which alternative contributes the most to profits or incurs the lowest cost.

21. Copyright © Houghton Mifflin Company. All rights reserved.21 Traditional Versus Special Decision Reports Frequently contribution format incremental analyses are used to support special decisions. If qualitative factors are very important, special formats must be used to support quantitative analysis with qualitative information.

22. Copyright © Houghton Mifflin Company. All rights reserved.22 Discussion Q. Q.What data should be omitted from the analyses and reports accountants present to management? A. A.1. Past data. 2. Data that are identical under all alternatives.

23. Copyright © Houghton Mifflin Company. All rights reserved.23 Outsourcing Decisions OBJECTIVE 3 Apply incremental analysis to outsourcing decisions.

24. Copyright © Houghton Mifflin Company. All rights reserved.24Outsourcing Outsourcing is the use of suppliers outside the organization to perform services or produce goods that could be performed or produced internally. Outsourcing includes make-or-buy decisions, which are decisions about whether to make a part internally or buy it from an external supplier.

25. Copyright © Houghton Mifflin Company. All rights reserved.25 Outsourcing Many organizations outsource functions that do not represent core competencies such as: Payroll processing. Selling and marketing. Fleet management. Training. Custodial services. Information management.

26. Copyright © Houghton Mifflin Company. All rights reserved.26 Incremental Analysis: Outsourcing Decision Kriegel Electronics Company Outsourcing Decision Incremental Analysis MakeBuy Difference in favor of Make Direct materials (20,000  100  $84) Direct labor (20,000  20  $8) Variable manufacturing overhead (20,000  20  $4) To purchase completed castings (20,000  $1.50) $ 16,800 8,000 4,000 --------- -------- $ 30,000 ($ 16,800) (8,000) (4,000) 30,000 Totals$ 28,800$ 30,000$ 1,200

27. Copyright © Houghton Mifflin Company. All rights reserved.27 Outsourcing Benefits   Loss of control.   Loss of expertise within the organization.   Growing dependence on suppliers.   Potential loss of critical information to competitors.

28. Copyright © Houghton Mifflin Company. All rights reserved.28 Outsourcing Problems Some of the problems associated with outsourcing include: Loss of control. Loss of expertise within the organization. Growing dependence on suppliers. Potential loss of critical information to competitors.

29. Copyright © Houghton Mifflin Company. All rights reserved.29 Hidden Costs of Outsourcing the Production of Parts for Assembly Operations When manufacturers purchase parts from suppliers, they expect quality parts to be delivered quickly for a reasonable price. The hidden costs of maintaining an outsourcing relationship with a supplier can include the following: Costs of Quality for Parts Purchased from Suppliers  Cost of inspecting parts delivered to the company  Cost of labor and shipping to return defective parts to suppliers  Cost of training suppliers to follow quality methods Costs of Late Deliveries from Suppliers  Cost of lost customer sales due to late parts deliveries from suppliers  Cost of carrying extra direct materials and finished goods inventory to compensate for late parts deliveries from suppliers  Cost of back orders due to partial shipments

30. Copyright © Houghton Mifflin Company. All rights reserved.30 Hidden Costs Hidden costs of maintaining an outsourcing relationship with a supplier can include: Costs of quality. Costs of late deliveries. To manage the hidden costs, companies may add clauses to their contracts with suppliers to specify penalties for poor quality or late deliveries.

31. Copyright © Houghton Mifflin Company. All rights reserved.31 Make-or-Buy Decisions To decide whether to make a product or to buy from an outside supplier, the following information is needed: Make Need for additional equipment Variable costs of making the item Incremental fixed costs Buy Purchase price of the item Rent or net cash flow from facilities freed up Salvage value of unused equipment

32. Copyright © Houghton Mifflin Company. All rights reserved.32 Special Order Decisions OBJECTIVE 4 Apply incremental analysis to special order decisions.

33. Copyright © Houghton Mifflin Company. All rights reserved.33 Special Order Decisions Special order decisions are decisions about whether to accept or reject special product orders at prices below the normal market prices. A special order is a one-time, nonrecurring order. Before accepting a special order, compliance with federal price discrimination laws should be checked.

34. Copyright © Houghton Mifflin Company. All rights reserved.34 Special Order Decisions Two different approaches to special order decisions include: Compare the special order price to the relevant costs to produce, package, and ship the order. Prepare a special order bid price by calculating a minimum selling price for the special order.

35. Copyright © Houghton Mifflin Company. All rights reserved.35 Incremental Analysis: Special Order Decision Incremental Analysis: Special Order Decision Jens Sporting Goods, Inc. Without Leiden Order (410,000 baseballs) With Leiden Order (440,000 baseballs) Difference in Favor of Accepting Leiden Order Sales$ 1,640,000$ 1,713,500$ 73,500 Less variable costs Direct materials$ 369,000$ 396,000($ 27,000) Direct labor246,000264,000(18,000) Variable manufacturing overhead 205,000220,000(15,000) Packaging costs123,000125,500(2,500) Total variable costs$ 943,000$ 1,005,500($62,500) Contribution margin$ 697,000$ 708,000$ 11,000 * Assuming available existing production capacity, so no additional fixed costs are incurred.

36. Copyright © Houghton Mifflin Company. All rights reserved.36 Special Orders: Qualitative Factors These may include: Impact on sales to regular customers Potential of special order to lead into new sales areas Customer’s ability to maintain an ongoing relationship

37. Copyright © Houghton Mifflin Company. All rights reserved.37 Fixed Costs Examples of relevant fixed costs include: Purchase of additional machinery. Increase in supervisory help. Increase in insurance premiums.

38. Copyright © Houghton Mifflin Company. All rights reserved.38 Segment Profitability Decisions OBJECTIVE 5 Apply incremental analysis to segment profitability decisions.

39. Copyright © Houghton Mifflin Company. All rights reserved.39 Segment Profitability Decisions Segment profitability decisions involve the review of segments of an organization, such as: Product lines. Services. Sales territories. Divisions. Departments.

40. Copyright © Houghton Mifflin Company. All rights reserved.40 Segment’s sales revenue Segment’s sales revenue Segment Margin - fixed costs that will be avoided if that segment avoided if that segment is dropped is dropped A segment margin is: - direct variable costs - direct variable costs

41. Copyright © Houghton Mifflin Company. All rights reserved.41 Segment Profitability Decisions Often managers must decide whether to add or drop a segment. If a segment has a negative segment margin, the segment may be dropped. Common costs that will be incurred regardless of the decision are unavoidable costs.

42. Copyright © Houghton Mifflin Company. All rights reserved.42 Incremental Analysis: Segment Profitability Decision Lebo Corporation Segment Profitability Decision Incremental Analysis Keep Division Y Drop Division Y Difference in Favor of Dropping Division Y Sales Less variable costs Contribution margin Less direct fixed costs Segment margin Less common fixed costs Net income $ 150,000 60,000 $ 90,000 72,000 $ 18,000 12,000 $ 6,000 $ 135,000 52,500 $ 82,500 55,500 $ 27,000 12,000 $ 15,000 ($ 15,000) 7,500 ($ 7,500) 16,500 $ 9,000 0

43. Copyright © Houghton Mifflin Company. All rights reserved.43 Product Mix Decisions OBJECTIVE 6 Apply incremental analysis to product mix decisions involving constrained resources.

44. Copyright © Houghton Mifflin Company. All rights reserved.44 Product mix decisions require the selection of the most profitable combination of product sales when a company makes more than one product using a common constrained resource. Product Mix Decisions

45. Copyright © Houghton Mifflin Company. All rights reserved.45 Constrained Resources The constrained or limited resource may be: Labor time. Machine time. Quantity of a raw material.

46. Copyright © Houghton Mifflin Company. All rights reserved.46 Decision Analysis The steps in the decision analysis include: Calculation of the contribution margin per unit for each product line affected by the constrained resource. Divide the contribution margin per unit by the quantity of the constrained resource required per unit.

47. Copyright © Houghton Mifflin Company. All rights reserved.47 Decision Analysis Profit will be maximized in the short run by devoting limited resources to the product(s) with the highest contribution margin per unit of the constrained resource.

48. Copyright © Houghton Mifflin Company. All rights reserved.48 Incremental Analysis: Product Mix Decision Involving Constrained Resources Grady Enterprises Product Mix Decision: Ranking the Order of Production Incremental Analysis Rising Star Ghost Master Road Warrior Selling price per unit Less: Variable costs Manufacturing Selling Total unit variable costs Contribution margin per unit (A) Machine hours per unit (B) $24.00 $12.50 6.50 $19.00 $ 5.00 2 $18.00 $10.00 5.00 $15.00 $ 3.00 1 $32.00 $18.75 6.25 $25.00 $ 7.00 2.5 Contribution margin per machine hour (A ÷ B) $ 2.50$ 3.00$ 2.80

49. Copyright © Houghton Mifflin Company. All rights reserved.49 Incremental Analysis: Product Mix Decision Constraints: 1) 1)Maximum production capacity: 100,000 machine hours 2) 2)Current maximum sales demand: Rising star: 20,000 units Ghost master: 30,000 units Road Warrior: 18,000 units

50. Copyright © Houghton Mifflin Company. All rights reserved.50 Incremental Analysis: Product Mix Decision Grady Enterprises Number of Units to Make Total Machine Hours Available Maximize contribution from Ghost Master (30,000 units x 1 machine hour per unit). Balance of Machine Hours Available 2) Maximize contribution from Road Warrior (18,000 units x 2.5 machine hours per unit). Balance of Machine Hours Available 3) Use remaining hours to make Rising Star (12,500 units x 2 machine hours per unit). Machine Hours 100,000 30,000 70,000 45,000 25,000

51. Copyright © Houghton Mifflin Company. All rights reserved.51 Sell or Process-Further Decisions OBJECTIVE 7 Apply incremental analysis to sell or process further decisions.

52. Copyright © Houghton Mifflin Company. All rights reserved.52 Sell or Process-Further Decisions A sell or process-further decision is a decision about whether to sell a joint product at the split-off point or sell it after further processing. Joint products are two or more products made from a common material or process that cannot be identified as separate productions until the split-off point.

53. Copyright © Houghton Mifflin Company. All rights reserved.53 At the split-off point, joint products become separate and identifiable. At that point, a company may choose to sell the product as is or to process it into another form for sale to a different market. Split-Off Points

54. Copyright © Houghton Mifflin Company. All rights reserved.54 Incremental Analysis The objective of the incremental analysis is to determine if the product’s selling price will increase more than the incremental costs of processing further. Only the incremental costs and incremental revenues beyond the split-off are relevant.

55. Copyright © Houghton Mifflin Company. All rights reserved.55 Incremental Analysis: Sell or Process-Further Decision

56. Copyright © Houghton Mifflin Company. All rights reserved.56 Discussion Q. Q. What are five operating decisions facing managers that can be made using incremental analysis? A. A. Outsourcing decisions. 2. Special order decisions. 3. Segment profitability decisions. 4. Product mix decisions. 5. Sell or process-further decisions.

57. Copyright © Houghton Mifflin Company. All rights reserved.57 Short-Run Decisions in Service Organizations OBJECTIVE 8 Apply incremental analysis to service organizations.

58. Copyright © Houghton Mifflin Company. All rights reserved.58 Short-Run Decisions Typical short-run decisions in service organizations include whether to: Outsource a service. Accept a bid for a special order. Drop an unprofitable service. Provide one service before another because of limited labor hours.

59. Copyright © Houghton Mifflin Company. All rights reserved.59 Incremental Analysis: Service Mix Decision Involving Constrained Resources Cyber Web Services Service Mix Decision: Ranking the Order in Which the Services Are Provided Basic Web Pages Custom Web Pages Service revenue per page Less variable costs per page Contribution margin per page (A) Design hours per page (B) Contribution margin per design hour (A  B) $200 77 $123 1 $ 750 600 $ 150 12.5 $ 12 Decision: Complete Basic Web Pages first.

60. Copyright © Houghton Mifflin Company. All rights reserved.60 Incremental Analysis: Outsourcing for a Service Organization Cyber Web Services Hire a new employee Outsource to outside contractor Difference in favor of outsourcing Cost to outsource$21,600($21,600) Cost to do work in-house Direct Labor $19,20019,200 Service Overhead 1,200 Total Costs$20,400$21,600($1,200) Opportunity Costs4,000 Total$24,400$21,600$2,800

61. Copyright © Houghton Mifflin Company. All rights reserved.61 OK, Let’s Review 1. 1.Explain how managers make short-run decisions during the management cycle. 2. 2.Define and explain incremental analysis and its related concepts. 3. 3.Apply incremental analysis to outsourcing decisions. 4. 4.Apply incremental analysis to special order decisions. 5. 5.Apply incremental analysis to segment profitability decisions.

62. Copyright © Houghton Mifflin Company. All rights reserved.62 Incremental Analysis: Special Orders for a Service Organization Cyber Web Services Without THC Order (10 Web Pages) With THC Order (11 Web Pages) Difference in Favor of Rejecting Order Service revenue$7,500$7,900$400 Less variable costs Direct Professional Labor 6,0006,420(420) Contribution margin$1,500$1,480($ 20) Less fixed costs 1,000 -0- Operating income (loss)$ 500$ 480($ 20) Decision: Reject the Spaced Order

63. Copyright © Houghton Mifflin Company. All rights reserved.63 Incremental Analysis: Segment Profitability for a Service Organization Cyber Web Services DesignInstallMaintainTotal Service revenue$60,000$25,000$65,000$150,000 Less variable costs80,0004,00036,000120,000 Contribution margin ($20,000)$21,000$29,000$30,000 Less direct fixed costs6,000 $13,00013,00032,000 Segment margin($ 26,000)$ 8,000$16,000($ 2,000) Decision: Eliminate design segment or improve segment margin.

64. Copyright © Houghton Mifflin Company. All rights reserved.64 Discussion Q. What are the typical short-run decisions in service organizations? A. 1. Service outsourcing. 2. Accept a special order bid. 3. Drop an unprofitable service. 4. What service to provide.

65. Copyright © Houghton Mifflin Company. All rights reserved.65 OK, Let’s Review 6. 6.Apply incremental analysis to product mix decisions involving constrained resources. 7. 7.Apply incremental analysis to sell or process-further decisions. 8. 8.Apply incremental analysis to service organizations.