Managerial Accounting: An Introduction To Concepts, Methods, And Uses Chapter 8 Differential Cost Analysis for Production Decisions Maher, Stickney and Weil

Learning Objectives (Slide 1 of 2) Explain why businesses apply differential analysis to product choice decisions. Explain the theory of constraints. Identify the factors underlying make-or-buy decisions. Explain how to identify the costs of producing joint products and the relevant costs for decisions to sell or process further.

Learning Objectives (Slide 2 of 2) Explain the use of differential analysis to determine when to add or drop parts of operations. Identify the factors of inventory management decisions. Explain how linear programming optimizes the use of scarce resources. Identify the use of the economic order quantity model.

Product Choice Decisions (Slide 1 of 2) Due to capacity limitations, firms must often choose which goods to make and services to provide When the firm has a scarce resource used in production (e.g., machine time, skilled labor) Firm should produce product that gives the largest contribution margin per unit of constrained resource If more than one scarce resource is involved, choice is more difficult May use linear programming to determine best product mix

Product Choice Decisions (Slide 2 of 2) Incorrect use of accounting information In making short-run product choice decisions, one should not rely on product cost information that includes cost allocations Full-absorption product costing allocates fixed manufacturing costs to units produced May result in incorrect decisions

Theory of Constraints (Slide 1 of 3) Focuses on increasing the excess of differential revenue over differential costs when firms face bottlenecks Bottleneck-an operation in which the work performed equals or exceeds the available capacity Results in inventory waiting until the bottleneck is free

Theory of Constraints (Slide 2 of 3) Encourages managers to find ways to increase profits by relaxing constraints and increasing throughput Focuses on the following factors: Throughput contribution - Sales dollars minus variable costs Investments - Assets required for production and sales Other operating costs - Other than short-run variable costs

Theory of Constraints (Slide 3 of 3) Objective is to maximize throughput contribution while minimizing investments and operating costs Key steps involved: Recognize that bottlenecks determine throughput contribution for the plant as a whole Find the bottleneck resource Subordinate all nonbottleneck resources to the bottleneck resource Increase bottleneck efficiency and capacity

Make-or-Buy Decisions Involve the decision of whether to meet needs internally or to acquire goods and services from external sources (often called outsourcing) Decision depends on cost factors as well as nonquantitative factors Differential cost analysis is useful in making these decisions

Example-Make or Buy Decision (Slide 1 of 2) Ben & Jerry Cookie Co. can buy part of its product or produce it internally. Relevant info is as follows: Buy Make Unit Selling Price $ 30 $ 30 Sales Volume 800/mth. 800/mth. Unit Variable Costs $ 11 $ 22 Purchased Ingredients $ 12 $ 0 Total Fixed Costs $3,840 $4,800

Example-Make or Buy Decision (Slide 2 of 2) __Buy Make Difference Revenue $24,000 $24,000 -0- Less: Variable Costs -Produce & Sell 8,800 17,600 $(8,800) -Costs of Goods Bought 9,600 -0- 9,600 Contribution Margin $ 5,600 $ 6,400 $( 800) Less Fixed Costs 3,840 4,800 (960) Operating Profit $ 1,760 $ 1,600 $ 160

Joint Products: Sell or Process Further As part of a single production process, multiple products are produced The point in the production process at which identifiable products emerge is called the splitoff point Costs incurred up to this point are called joint costs Costs incurred after the splitoff point are called additional processing costs

Joint Production Process Additional Processing Costs Incurred Joint Costs: Direct Materials Direct Labor Overhead Sale of Product A Sale of Product B Splitoff Point

Adding or Dropping Parts of Operations General Rule: If differential revenue from sale of a product > differential costs of providing the product, then the product generates profits and firm should continue production Even though product may show a loss on financial statements due to overhead allocation to the product This rule applies to short-run decisions If more profitable uses of the facilities can be found, it may outweigh the contribution margin lost by dropping a product

Inventory Management Decisions Inventory management affects profitability Having correct amount and type of inventory can: Prevent production shutdowns Avoid lost sales Inventory is costly to maintain Costs include storage, insurance, losses from damage and theft, property taxes, etc.

Differential Costs for Inventory Management Two opposing costs to consider Setup or order costs - costs of setting up machinery for a production run or costs to process a purchase order Carrying Costs - e.g., cost of maintaining warehouse facilities Management would like to find the optimal trade-off point between these two costs Called the economic order quantity (EOQ)

Estimating Costs of Maintaining Inventory Differential Costs to consider include: Order costs - costs of salaries, lost time for production setups, receiving and inspecting orders, processing invoices, and freight costs Carrying costs - insurance, inventory taxes, opportunity cost of funds invested in inventory, additional warehouse space

Just-in-Time (Slide 1 of 2) JIT is a method of managing purchasing, production, and sales where the firm attempts to: Produce items only as needed for the next step in the production process, or Time purchases so items arrive just in time for production or sale Can substantially reduce inventory levels

Just-in-Time (Slide 2 of 2) Requires lay out of production process so there is a continuous flow once production starts Requires reliable processing systems

Linear Programming Managers may face short-run constraints in production resources such as factory capacity, personnel time, floor space, etc Linear programming is used to address production decisions involving limited resources Referred to as a constrained optimization technique

Economic Order Quantity Can be determined through trial and error or use the following formula: N=D/Q Where: Q = N = optimal number of orders Q = economic order quantity D = period demand K0= order or setup cost Kc= cost of carrying one unit in inventory

Dr. Donald R. Trippeer, CPA Colorado State University-Pueblo If you have any comments or suggestions concerning this PowerPoint Presentation for Managerial Accounting, An Introduction To Concepts, Methods, And Uses, please contact: Dr. Donald R. Trippeer, CPA donald.trippeer@colostate-pueblo.edu Colorado State University-Pueblo