Incremental Analysis for Short-Term Decision Making Chapter 7 Chapter 7: Incremental Analysis for Short-Term Decision Making. Incremental Analysis for Short-Term Decision Making PowerPoint Authors: Jon A. Booker, Ph.D., CPA, CIA Charles W. Caldwell, D.B.A., CMA Susan Coomer Galbreath, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Steps in the Decision-Making Process 7-2 Steps in the Decision-Making Process Step 1 Identify the decision problem Step 2 Determine the decision alternatives Step 3 Evaluate the costs and benefits of the alternatives The managerial decision-making process has five basic steps: Identify the decision problem. We begin the decision process by identifying the decision problem presented to us. Determine the decision alternatives. This is a critical step because the remainder of the decision process hinges on the decision alternatives identified here. Evaluate the costs and benefits of the alternatives. We must evaluate the costs and benefits of each alternative. We may use a differential analysis by analyzing the differences in costs and benefits among the alternatives. Make the decision. In addition to the numerical analysis performed, managers should incorporate a variety of other factors, such as strategic issues, quality considerations, legal and ethical issues, and the like before making the final decision. Review the results of the decision-making process. We need to evaluate the results of the decision made as time goes by. As a result of the evaluation, we may wish to change the decision originally made. Step 5 Review the results of the decision-making process Step 4 Make the decision Improve future decisions

Relevant versus Irrelevant Costs and Benefits 7-3 Relevant versus Irrelevant Costs and Benefits Relevant costs are costs that will change depending on the alternative selected. Part I. Relevant costs differ depending on the alternative a manager selects. Part II. Relevant costs are often referred to as differential costs, incremental costs, or avoidable costs. Avoidable costs can be eliminated in whole or in part by choosing one alternative over another. Relevant costs are also called differential costs, incremental costs, or avoidable costs.

Relevant versus Irrelevant Costs and Benefits 7-4 Relevant versus Irrelevant Costs and Benefits Irrelevant costs are costs that do not differ between alternatives. Costs that have been incurred in the past. (sunk costs) Costs that are the same regardless of the alternative chosen. Part I. Irrelevant costs do not differ between alternatives. Part II. There are two broad categories of costs are never relevant in any decision: Sunk costs have already been incurred and cannot be avoided regardless of the decision. Costs that do not differ between alternatives are never relevant to a decision.

Opportunity Costs and Capacity Considerations 7-5 Opportunity Costs and Capacity Considerations An opportunity cost is a benefit that is given up when one alternative is selected over another. At capacity, adding additional work requires giving up a portion of the existing work. The benefit of the existing work given up is an opportunity cost. With idle capacity, additional work may be added without sacrificing existing work. There is no opportunity cost to the additional work. Part I. An opportunity cost is a benefit that is given up when one alternative is selected over another. Part II. Capacity is a measure of the limit placed on specific resources. It could be the number of people that can fit into an airplane, the number of employees that are available to serve clients, or the amount of machine time that is available to make a product. When operating at capacity, adding additional work requires giving up a portion of the existing work. The benefit of the existing work given up is an opportunity cost. Part III. When idle capacity exists, additional work may be added without sacrificing existing work. With idle capacity, there is no opportunity cost to the additional work.

Special-Order Decisions 7-6 Special-Order Decisions 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. 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. Some costs may not change if we accept additional business. Those costs are not relevant as they do not differ between the alternative to accept or reject the additional business.

Special-Order Decisions A major university has asked Mattel to make a special University Barbie, dressed in a sporty outfit with the school’s logo and colors. The university bookstore has offered to buy 25,000 of these dolls at a price of $7.00 each. Mattel has the capacity to fill the order without affecting production of other Barbie products, which are normally sold to toy stores and discount chains for $9.00 each. A major university has approached Mattel to see if the company would produce a special University Barbie, dressed in a sporty outfit with the school’s logo and colors. The university bookstore has offered to buy 25,000 of these dolls at a price of $7.00 each. Mattel has the capacity to fill the order without affecting production of other Barbie products, which are normally sold to toy stores and discount chains for $9.00 each. More Information

Special-Order Decisions 7-8 Special-Order Decisions Mattel estimates that its unit cost to produce the University Barbie will be: Mattel estimates that its unit cost to produce the University Barbie is $7.50 based on the following cost components: $3.50 for direct materials (silicone rubber, clothing, accessories) $1.00 for direct labor $0.50 for variable manufacturing overhead (indirect materials, power, etc.) $2.50 for fixed manufacturing overhead (factory rent, insurance, etc.) Should Mattel accept the special order? The answer will depend upon whether Mattel has idle capacity or is operating at full capacity. Should Mattel accept the special order?

Incremental Analysis (with Excess Capacity) 7-9 Incremental Analysis (with Excess Capacity) Incremental analysis reveals that special order will result in a profit of $2.00 per doll and a total profit of $50,000. Note that fixed overhead costs are irrelevant to the decision because they will be incurred regardless of whether Mattel accepts or rejects the special order. Fixed manufacturing overhead costs are items like rent, insurance, and supervision that will be incurred regardless of whether Mattel accepts the special order. Since Mattel has excess capacity, the special order should be accepted. The special order will result in a profit of $2.00 per doll and a total profit of $50,000. Note that fixed costs are excluded because they are irrelevant to the decision.

Make-or-Buy Decisions 7-10 Make-or-Buy Decisions A decision to make a part or provide a service internally rather than to buy externally from a supplier is called a “make-or-buy” decision. Part I. A decision to make a part or provide a service internally rather than to buy externally from a supplier is called a make-or-buy decision. Part II. Make-or-buy decisions are also called insourcing versus outsourcing decisions. Make-or-buy decisions are also called insourcing versus outsourcing decisions.

Make-or-Buy Decisions 7-11 Make-or-Buy Decisions Mattel is trying to decide whether to continue packaging the American Girl doll “in-house” or outsource the packaging process to an external supplier. Mattel’s packaging costs for the dolls are: Mattel’s internal cost data show $700,000 or $3.50 per unit to package 200,000 dolls annually. The packaging costs are: $300,000 ($1.50 per unit) for packaging materials (cardboard, plastic, etc.). $90,000 ($0.45 per unit) for packaging direct labor. $60,000 ($0.30 per unit) for indirect materials (e.g., glue). $50,000 ($0.25 per unit) for packaging supervision. $200,000 ($1.00 per unit) for other fixed manufacturing overhead. The outside supplier bid $3.00 per doll for the packaging work. Should Mattel outsource the packaging? The outside supplier bid $3.00 per doll for the packaging work. Should Mattel outsource the packaging?

Make-or-Buy Decisions 7-12 Make-or-Buy Decisions The agreement with the outside supplier includes a 3-year contract for a minimum of 200,000 units per year. All costs directly related to the packaging activities, including all direct and indirect materials, labor, and supervision, would be avoided if the packaging is outsourced. Other total fixed manufacturing overhead costs would remain unchanged. The factory space that is now used for packaging could be used to expand production of a popular product line. The expansion would generate an additional $150,000 in profit per year. Mattel gathers the following information to support its make-or-buy decision: The agreement with the outside supplier includes a 3-year contract for a minimum of 200,000 units per year. All costs directly related to the packaging activities, including all direct and indirect materials, labor, and supervision, would be avoided if the packaging is outsourced. Other total fixed manufacturing overhead costs would remain unchanged. The factory space that is now used for packaging could be used to expand production of a popular product line. The expansion would generate an additional $150,000 in profit per year. Should Mattel continue to do their own packaging, or outsource it to the supplier? To answer this question, Mattel should first consider whether all of the costs associated with the packaging process are relevant. Another way to think about it is to consider which costs are avoidable, or that can be eliminated by outsourcing.

7-13 Incremental Analysis Outsourcing is $50,000 cheaper, primarily because of the $150,000 opportunity cost of the factory space. Note that other fixed overhead costs are irrelevant to the decision because they will be incurred regardless of whether Mattel packages internally or outsources the packaging. Mattel should outsource the packaging. Outsourcing is $50,000 less. Note that fixed costs are excluded because they are irrelevant to the decision. Mattel should outsource the packaging.

Decisions to Eliminate Unprofitable Segments 7-14 Decisions to Eliminate Unprofitable Segments One of the most important decisions managers make is whether to continue or eliminate a business segment, such as a product or a store. A segment is a candidate for elimination if its revenues are less than its relevant (avoidable) expenses. Managers should consider eliminating poorly performing segments. A segment may be a division, territory, store, or product line. You have no doubt seen a segment eliminated. It might have been a large segment such a an automobile or it may have been a much smaller segment such as a store or restaurant closing. How should we make segment elimination decisions? Ultimately, a decision to eliminate an old segment is going to hinge primarily on the impact the decision will have on profit margins. To assess this impact, it is necessary to carefully analyze the costs.

Sell-or-Process Further Decisions 7-15 Sell-or-Process Further Decisions Businesses are often faced with the decision to sell partially completed products or to process them to completion and hopefully sell them at a higher price. As a general rule, we process further only if incremental revenues exceed incremental costs. Costs of manufacturing the product up to the sell-or- process decision point are sunk and therefore irrelevant. Many products can be sold in an unfinished state, or processed further into a finished product that will sell for a higher price. The decision to sell or process should be based on incremental revenues and incremental costs. The costs of manufacturing the product up to the sell-or-process decision point are sunk and therefore irrelevant.

Prioritizing Products with Limited Resources 7-16 Prioritizing Products with Limited Resources When a limited resource restricts a company’s ability to satisfy demand, the company is said to have a constrained resource that is referred to as a bottleneck. To maximize profits in the short run, a company with a bottleneck must prioritize its products or services so as to maximize contribution margin per unit of the constrained resource. Part I. When a limited resource of some type restricts a company’s ability to satisfy demand, the company is said to have a constrained resource that is referred to as a bottleneck. Part II. To maximize profits in the short run, a company with a bottleneck must prioritize its products or services so as to maximize contribution margin per unit of the constrained resource. Part III. The focus is on contribution margin instead of segment margin because fixed costs will not change in the short run, and are not relevant. The focus is on contribution margin instead of segment margin because fixed costs will not change in the short run, and are not relevant.

End of Chapter 7 End of chapter 7. McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.