© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 21-1 INCREMENTAL ANALYSIS Chapter 21

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 21-2 Special order decisions Product mix decisions Make or buy decisions Joint product decisions Product markets can change quickly due to competitor price cuts, changing customer preferences, and introduction of new products by competitors. Managers must make short-run decisions, with a fixed set of resources, to react to the changing market place. The Challenge of Changing Markets

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 21-3  Will you drive or fly to Florida for spring break?  You have gathered the following information to help you with the decision. Motel cost is $80 per night. Meal cost is $20 per day. Your car insurance is $100 per month. Kennel cost for your dog is $5 per day. Round-trip cost of gasoline for your car is $200. Round-trip airfare and rental car for a week is $500.  Driving requires two days, with an overnight stay, cutting your time in Florida by two days.  Will you drive or fly to Florida for spring break?  You have gathered the following information to help you with the decision. Motel cost is $80 per night. Meal cost is $20 per day. Your car insurance is $100 per month. Kennel cost for your dog is $5 per day. Round-trip cost of gasoline for your car is $200. Round-trip airfare and rental car for a week is $500.  Driving requires two days, with an overnight stay, cutting your time in Florida by two days. The Concept of Relevant Cost Information

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin $80 8 $20 8 $5 The Concept of Relevant Cost Information

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 21-5 Costs do not differ, so they are not relevant to decision. Also, car insurance is not relevant to the decision as it is a past cost. The Concept of Relevant Cost Information

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 21-6 Transportation costs differ between the two alternatives, so they are relevant to your decision Are the extra two days in Florida worth the $300 extra cost to fly? The Concept of Relevant Cost Information

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 21-7 Decision making involves five steps:  Define the problem.  Identify the alternatives.  Collect information on alternatives.  Eliminate irrelevant information.  Make a decision with the remaining relevant information. Decision Making

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 21-8 Information that varies among the possible courses of action being considered. — Incremental costs and revenues — Important cost concepts for business decisions. Opportunity costs. Sunk costs. Out-of-pocket costs. 1 2 Relevant Information in Business Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin 21-9 The benefit that could have been attained by pursuing an alternative course of action. Opportunity Cost Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year includes the $20,000. Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are a real sacrifice.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions. Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost. All costs incurred in the past that cannot be changed by any decision made now or in the future. Sunk costs should not be considered in decisions. Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost. Sunk Costs Versus Out-of-Pocket Costs

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Cost = $10,000 two years ago Cost = $25,000 today The dealer will trade for $20,000 plus your car. What amount is relevant to your decision, the $10,000 sunk cost of your car or the $20,000 out-of-pocket cash differential? Trade ? Sunk Costs Versus Out-of-Pocket Costs

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur only if the company decides to accept the new business. Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin View Co. currently sells 100,000 units of its product. The company has revenue and costs as shown below: Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin View Co. is approached by an overseas company that offers to purchase 10,000 units at $8.50 per unit. If View Co. accepts the offer, total factory overhead will increase by $5,000; total selling expenses will increase by $2,000; and total administrative expenses will increase by $1,000. Should View Co. accept the offer? Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin First let’s look at incorrect reasoning that leads to an incorrect decision. Our cost is $9.00 per unit. I can’t sell for $8.50 per unit. Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin This analysis leads to the correct decision. Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin ,000 new units × $8.50 selling price = $85,000 Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin ,000 new units × $3.50 = $35,000 Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin ,000 new units × $2.20 = $22,000 Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Even though the $8.50 selling price is less than the normal $10 selling price, View Co. should accept the offer because net income will increase by $20,000. Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin We can also look at this decision using contribution margin. Special Order Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. Let’s look at the Kaiser Company example. Production Constraint Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Kaiser Company produces two products and selected data is shown below: Production Constraint Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Machine A1 is the scarce resource because there is excess capacity on other machines. Machine A1 is being used at 100% of its capacity. Machine A1 capacity is 2,400 minutes per week. Should Kaiser focus its efforts on Product 1 or 2? Production Constraint Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Let’s calculate the contribution margin per unit of the scarce resource, machine A1. Production Constraint Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Product 2 should be emphasized. It is the more valuable use of the scarce resource, machine A1, yielding a contribution margin of $30 per minute as opposed to $24 for Product 1. Production Constraint Decisions Let’s calculate the contribution margin per unit of the scarce resource, machine A1.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use any capacity that remains to make Product 1. Production Constraint Decisions Let’s calculate the contribution margin per unit of the scarce resource, machine A1.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Let’s see how this plan would work. Production Constraint Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Production Constraint Decisions Let’s see how this plan would work.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Production Constraint Decisions Let’s see how this plan would work.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin According to the plan, we will produce 2,200 units of Product 2 and 1,300 of Product 1. Our contribution margin looks like this. The total contribution margin for Kaiser is $64,200. Production Constraint Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Should I continue to make the part, or should I buy it? I suppose I should compare the outside purchase price with the additional costs to manufacture the part. What will I do with my idle facilities if I buy the part? Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin  Incremental costs also are important in the decision to make a product or buy it from a supplier.  The cost to produce an item must include (1) direct materials, (2) direct labor and (3) incremental overhead.  We should not use the predetermined overhead rate to determine product cost.  Incremental costs also are important in the decision to make a product or buy it from a supplier.  The cost to produce an item must include (1) direct materials, (2) direct labor and (3) incremental overhead.  We should not use the predetermined overhead rate to determine product cost. Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Excel makes computer chips used in one of its products. Unit costs, based on production of 20,000 chips per year, are: Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin An outside supplier has offered to provide the 20,000 chips at a cost of $25 per chip. Fixed overhead costs will not be avoided if the chips are purchased. Excel has no alternative use for the facilities. Should Excel accept the offer? Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Make or Buy Decisions Differential costs of making (costs avoided if bought from outside supplier) Excel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the part. Fixed costs are irrelevant to decision.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin If Excel buys the chips from the outside supplier, the idle facilities could be leased to another company for $250,000 per year. Should Excel buy the chips and lease the facilities? Make or Buy Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Make or Buy Decisions The real question to answer is, “What is the best use of Excel’s facilities?” The opportunity cost of facilities changes the decision.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered. Sell, Scrap, or Rebuild Decisions As long as rebuild costs are recovered through sale of the product, and rebuilding does not interfere with normal production, we should rebuild.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Servo has 10,000 defective units that cost $1.00 each to make. The units can be scrapped now for $.40 each or rebuilt at an additional cost of $.80 per unit. If rebuilt, the units can be sold for the normal selling price of $1.50 each. Rebuilding the 10,000 defective units will prevent the production of 10,000 new units that would also sell for $1.50. Should Servo scrap or rebuild? Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin ,000 units × $1.50 per unit 10,000 units × $0.40 per unit Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin ,000 units × $0.80 per unit 10,000 units × ($ $1.00) per unit Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Servo should scrap the units now. If Servo fails to include the opportunity cost, the rework option would show a return of $7,000, mistakenly making rebuild appear more favorable. Sell, Scrap, or Rebuild Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Product 2 Joint Costs Product 1 Product 3 Two or more products produced from a common input are called joint products. The split-off point is the point in a process where joint products can be recognized as separate products. Joint costs are the costs of processing prior to the split-off point. Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Businesses are often faced with the decision to sell partially completed products at the split-off point or to process them to completion. Joint Product Decisions General rule: Process further only if incremental revenues > incremental costs.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Ames Co. produces two products, A and B, from this process. Should the products be sold at split-off or processed further? Common Production Process Final Sale $120,000 Split-Off Point Joint Cost $100,000 Revenue $70,000 Additional Processing $40,000 A B Additional Processing $20,000 Final Sale $65,000 Revenue $50,000 Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Decision: Process product A, but sell product B at the split-off point. Note that the $100,000 joint cost is irrelevant to the processing decision. Product A incremental revenue = $120,000 - $70,000 Product B incremental revenue = $65,000 - $50,000 Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Joint costs are really common costs incurred to simultaneously produce a variety of end products. Joint costs are commonly allocated to end products on the basis of the relative sales value of each product or on some other basis. Joint Product Decisions

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin Joint Product Decisions Joint costs are not relevant in decisions regarding what to do with a product after the split-off point. As a general rule... It is always profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs.

© The McGraw-Hill Companies, Inc., 2005 McGraw-Hill/Irwin End of Chapter 21