Management Accounting: A Road of Discovery

Management Accounting : A Road of Discovery James T. Mackey Michael F. Thomas Presentations by: Roderick S. Barclay Texas A&M University - Commerce James T. Mackey California State University - Sacramento © 2000 South-Western College Publishing

Chapter 7 But, what if we do….? Incremental CVP analysis for unplanned events

Key Learning Objectives Calculate the relevant cashflows from transferring intermediate products. Use incremental CVP analysis to determine special sales prices. Compute the relevant cashflows for a make-or-buy decision. Determine whether an intermediate product should be sold or processed further. Explain the need for a markup policy with budgeted sales.

Different Costs for Different Purposes Cost-plus markups and Management by the Numbers. We determine our prices based on the cost of production. A Price Taker tends to use prices sent by the marketplace. A Price Setter tends to set prices based on its own costs.

Bid Sheet for Mountie Huts $20,000Actual bid price per hut $20,038Projected bid price per hut 3,34020% of total costs=Profit $16,698Total costs 3,38828% of mfg. costs=Allocated administrative costs 1,21010% of mfg. costs=Allocated marketing costs $12,100Total manufacturing costs 1,000$5/hr x 200 hrs=Fixed overhead 600$3/hr x 200 hrs=Variable overhead 2,000$10/hr x 200 hrs=Direct labor 8,400Direct materials $ 100$2,000$25/hr x 80 hrs=Direct design & architecture Per hutPer jobCosts:

Decision — Special Sales Price This is a short-term decision that will not influence long-term value. It must be based on specific considerations that follow as we expand the discussion.

Definitions and Decision Related Terms Relevant costs versus sunk cashflows. Decisions must be ‘mutually exclusive’. Cashflows that change as a result of the decision are ‘relevant’. Cash flows that do not change are ‘sunk’. ‘Opportunity costs’ are the foregone cashflows resulting form our decision.

Full-Cost View vs. Incremental Cost View Cost plus view — Recover full GAAP costs plus a normal profit percentage. Incremental cost view — Cover only incremental costs to improve value and profit. Surplus capacity costs that do not change are not relevant. Incremental increases in fixed costs are relevant. Opportunity cost (net cash flow forfeited because of the decision) are relevant. Externalities are relevant because they influence value, but they cannot always be measured.

Incremental Cashflow Analysis for Mountie Huts $18,000Shipping & setup costs $12,000Average total cost per hut $1,000 Average fixed cost per hut ¸ 20Allocate fixed costs per hut $11,000$20,000Total costs 28% of mfg. costs=Allocated administrative costs 10% of mfg. costs=Allocated marketing costs $11,000$2,000Total manufacturing costs n/a$5/hr x 200 hrs=Fixed overhead 600$3/hr x 200 hrs=Variable overhead 2,000$10/hr x 200 hrs=Direct labor 8,400Direct materials $2,000$25/hr x 80 hrs=Direct design & architecture VariableFixedCosts:

Surplus Capacity and Opportunity Costs Surplus capacity costs that do not change are not relevant. However, if we must give up current capacity (and sales) there are opportunity costs. Usually, these are the lost contribution margin from the production given up.

An Example — Special Order Decision We receive a bid for 5,000 special order bicycles at $70 each. Normally we sell the bicycles for $90. Variable costs are $50 dollars for all sales. We must invest $40,000 in new fixtures if we accept the order. We have surplus capacity to produce 4,000 bicycles. We will have to give up 1,000 normal bicycle sales in order to fill the order. There is potential for further orders in the future from this customer.

Relevant Cashflows If We Accept Order $ 20,000 Increase (decrease) in profits = $330,00040,000 Opportunity costs 1,000 x ($90 - $50) $250,000 40,000 $290,000 Incremental costs Variable (5,000 x $50) Fixed = $350,000(5,000 x $70)Incremental revenue

A Problem Suppose we have sufficient capacity to make 10,000 more units. What is the break-even bid for each bicycle?

Decision Two: Sell Now or Process Further The decision here is to sell a product ‘as is’, or to process it further. Review Exhibit 7-7, p. 241, it is an excellent example of the sell now or process further concepts.

An Example — Sell Grapes or Make Wine Contribution margin per barrel for grape juice is $90. Incremental processing costs of converting grape juice into wine is $20 per barrel. Incremental fixed costs are $30,000 for additional equipment to process the grapes. Wine sells for $130 a barrel. How many barrels do we need to sell to breakeven on making wine from the grape juice?

Relevant Cashflows Incremental Revenue from further processing ($130 - $90) $40 Less incremental costs per barrel 20 Net incremental cashflow per barrel $20 Incremental fixed costs to make wine$30,000 Breakeven number of barrels of wine to cover fixed costs: $30,000 + $20 = 1,500 barrels What is the opportunity cost of selling grape juice?

Decision 3 — Transfer Pricing Independent operating divisions or plants of the same company can buy and sell among themselves. The sales price between these related divisions is called a ‘transfer price’. A transfer price can be negotiated, dictated, or market driven depending on the company’s management structure and style.

The Transfer Pricing Decision A key assumption is that divisional managers can buy and sell products as they wish (decentralized management). Thus, they have some control over the transfer price used for intra-divisional sales. The problem — Managers may make decisions that reduce the profit for the company as a whole. Make a decision that adversely impacts profits. Make a decision that influences or undermines internal decisions and performance measurement processes.

The Transfer Pricing Rule Solves This Problem For the selling division, the transfer price must cover the incremental variable and fixed costs plus a lost contribution margin. For the buying division, the choice is between buying from the related division or outside the company. Any price meeting these criteria will improve the company’s profits as a whole and make each division’s profit better.

An Example Multree’s Assembly Division can buy windows from outside suppliers for $85. This is the ceiling price — The maximum they will pay for windows internally. The Window Division has an incremental (variable) cost of $50 and can sell the windows outside the company for $100. However, when they sell inside the company they save $10. Thus, they are indifferent between selling for $100 outside or $90 to sell to the Assembly Division — their profits will be the same

The Transfer Pricing Decision for Profit Center Managers Ceiling – Floor ($5) Ceiling – Floor $35 Relevant cashflow (the the overall firm: Multree) Normal outside sales price less normal costs saved — $90 Incremental window cost of transferring $50 Floor price (Set by the seller: Windows) Outside purchase cost $85 Outside purchase cost $85 Ceiling price (set by buyer: Assembly) Situation 2: Seller has no excess capacity so transferring reduces outside sales Situation 1: Seller has excess capacity, so transferring does not affect outside sales Range of mutually acceptable transfer prices to both managers This is the relevant range of acceptable transfer prices when: (A) Seller has surplus capacity (B) Seller has no surplus capacity.

A Problem What is the range of acceptable transfer prices for both division when: The selling division has surplus capacity? The selling division has no surplus capacity?

Relevant Information for the Transfer Decision (Situation 1) Transfer windows to Assembly or Do not make any more windows Alternatives Relevant Cashflows: Purchase cost from outside supplier - $85 Incremental window making cost if transferred = $50 For buyer (Assembly) For seller (Windows) Window company has sufficient surplus capacity to make the windows desired by Assembly, while continuing to sell to all outside customers. Situation 1

Relevant Information for the Transfer Decision (Situation 2) Transfer windows to Assembly or Sell windows to outside customers Alternatives Relevant Cashflows: Purchase cost from outside supplier - $85 Normal outside sales price = $100 Normal costs saved if transferring (vs. selling) = $10 For buyer (Assembly) For seller (Windows) Window company is selling all of the windows it can make to outside customers at its normal sales price. Situation 2

Decision 4 — The Make or Buy Decision Short-term make or buy. Companies may have short-term production decisions. Companies may have limited orders for custom jobs with few externalities. Strategic outsourcing. Companies making permanent decisions to make components themselves or have them made by another company (outsource) relevant cash flows are the issue in the short term.

Window Make-or-Buy Decision $50.00 / windowIncremental cost per window n/aFixed overhead 5.00 / window1 hour / window$ 5.00 / hourVariable overhead / window1 hour / window$10.00 / hourDirect labor $35.00 /windowDirect materials Standard CostStandard QuantityStandard priceResource Budgeted incremental cost for transfer pricing decision

Window Make-or-Buy Decision $90.00 / windowIncremental cost per window (85.00) /windowLess: window’s purchase cost $ 5.00 / windowNet cashflow if buying window / window4 hours / window$10.00 / hourRework 5.00 / window1 hour / window$ 5.00 / hourVariable overhead / window1 hour / window$10.00 / hourDirect labor $35.00 /windowDirect materials Expected costExpected quantityExpected priceResource Special cost analysis for make-or-buy decision

Long-Run Cashflow Analysis for Outsourcing Windows $10Net saved per window if outsourced $40Average net outsourcing cost per window (45)$45)Average fixed cost saved per window ‘ 1,000Allocate fixed cost over annual window volume $85($45,000)Outsourcing cost 25,000Net annual cashflow from alternate use of capacity $20,000Fixed overhead saved $85Purchase cost Net cost to buy windows: $50Variable manufacturing costs

An Illustration Newsie Inc. makes custom work stations for newspapers. They have the ability to make all their own components or to buy them from outside manufacturers. The Down Under Workstation plant has a limited run of only 30 stations. Engineering has developed the following cost card for a unique component for this order.

Cost Card for Component XYA Two thirds of the manufacturing overhead is fixed. The outside bid for the component is $650. Should Newsie make or buy this component? $850Unit cost 450Manufacturing overhead (15 DL $30) 300Direct labor (15 labor $20) $100Direct materials

Relevant Incremental Costs to Make XYA We should make XYA. We will save ($650 - $550) $100 per component. $550Unit cost 150Variable manufacturing overhead (1/3 x $450) 300Direct labor (15 labor $20) $100Direct materials

Externalities and Outsourcing Externalities are a critical part of outsourcing decisions. Some obvious externalities are: Quality — Will it stay the same or change? Service — Can we rely on the supplier for adequate service levels? Cost — Does the outsourcing agreement really decrease our costs? Labor — What happens to our existing labor force? Management knowledge — Do we eventually lose our expertise in the area? Capacity — What happens to our existing capacity?

Key Concept: Know Your Business Short-term decisions must always be monitored for long-term implications and externalities. The key warning is to know your business!