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

2. Copyright © by Houghton Mifflin Company. All rights reserved.2 Chapter 27 Analysis for Decision Making

3. Copyright © by Houghton Mifflin Company. All rights reserved.3 LEARNING OBJECTIVES 1.Explain how managers make short- run decisions during the management cycle, and identify the steps in the management decision cycle. 2.Define and explain incremental analysis and its related concepts. 3.Prepare evaluations of alternatives for make-or-buy decisions, and sell or process-further decisions.

4. Copyright © by Houghton Mifflin Company. All rights reserved.4 LEARNING OBJECTIVES 4.Identify the types of projected costs and revenues used to evaluate alternatives for capital investment. 5.Apply the concept of time value of money. 6.Analyze capital investment proposals using the net present value method. 7.Analyze capital investment proposals using the accounting rate-of-return method and the payback period method.

5. Copyright © by 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 © by Houghton Mifflin Company. All rights reserved.6 Information for Short-Run Decisions u In the execution stage of the management cycle, managers make short-run decisions using cost and revenue information gathered in the planning stage. u Information should be: 4 Relevant 4 Timely 4 In an easy-to-use format u Information should help answer: “What will happen if we choose one alternative over another?”

7. Copyright © by Houghton Mifflin Company. All rights reserved.7 Cost Information for Short-Run Decisions in the Management Cycle

8. Copyright © by Houghton Mifflin Company. All rights reserved.8 Short-Run Decisions u The following are common types of short-run decisions: 4 Whether to buy parts externally or make them internally. 4 Which special orders to accept. 4 Which products, services, or divisions are unprofitable and whether to discontinue them.

9. Copyright © by Houghton Mifflin Company. All rights reserved.9 Short-Run Decisions (continued…) 4 Which products are most profitable and whether their markets can be expanded. 4 Whether a product should be sold “as is” or processed further. 4 What mix of products to make given resource constraints.

10. Copyright © by Houghton Mifflin Company. All rights reserved.10 Qualitative Factors u Qualitative factors must be weighed in the decision. 4 Competition 4 Economic conditions 4 Social issues 4 Product or service quality 4 Timeliness 4 Compatibility with the long-term strategic plan

11. Copyright © by Houghton Mifflin Company. All rights reserved.11 The Management Cycle u Decision making is an integral part of the management cycle: 4 During the planning phase, managers must identify the type of decisions they will need to make and the kinds of information they need to support those decisions. 4 During the executing phase, information is gathered and analyzed and a decision is made.

12. Copyright © by Houghton Mifflin Company. All rights reserved.12 The Management Cycle (continued…) 4 During the reviewing phase, the decision is evaluated to determine if the forecasted results were obtained and if corrective action is necessary. 4 Reporting occurs continuously throughout the decision-making process.

13. Copyright © by Houghton Mifflin Company. All rights reserved.13 Management Decision Cycle u The management decision cycle consists of five steps: 1. Discovering the problem or need. 2. Identifying alternative courses of action. 3. Analyzing the effects of each alternative. 4. Selecting the best course of action. 5. Appraising the results of the decision.

14. Copyright © by Houghton Mifflin Company. All rights reserved.14 The Management Decision Cycle

15. Copyright © by Houghton Mifflin Company. All rights reserved.15 A. A. Buy or make. Which special orders to accept. Which products, services, divisions to discontinue. Sell or process further.Discussion Q. Q.What type of short-run decisions do managers commonly make?

16. Copyright © by Houghton Mifflin Company. All rights reserved.16 Incremental Analysis OBJECTIVE 2 Define and explain incremental analysis and its related concepts.

17. Copyright © by Houghton Mifflin Company. All rights reserved.17 Incremental Analysis u Incremental analysis compares cost and revenue data that differ among alternatives. u The best alternative is the one that results in the highest increase in net income or cost savings (quality issues should also be considered). u The format in which the accountant presents information should facilitate the decision-making process.

18. Copyright © by Houghton Mifflin Company. All rights reserved.18 Incremental Analysis u Revenues and costs are irrelevant if they will not differ between alternatives. u A sunk cost (a cost already incurred which cannot be recovered) is irrelevant.

19. Copyright © by Houghton Mifflin Company. All rights reserved.19 Incremental Analysis – Lennox Company Grinder CGrinder W Difference in favor of Grinder W Increase in revenues Increase in operating costs Direct labor Variable manufacturing overhead Total increase in 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 income$ 11,900$ 12,650$ 750

20. Copyright © by Houghton Mifflin Company. All rights reserved.20 Special Considerations u Opportunity Costs – the revenues forfeited when one alternative is chosen over another. 4 Managers must include opportunity costs when analyzing short-run decisions. u Special Decision Reports – a contribution margin format is often used for income statements developed to support short- run decision-making.

21. Copyright © by Houghton Mifflin Company. All rights reserved.21 A. A.The best alternative is the one that results in the highest increase in net income or cost savings.Discussion Q. Q.What determines the best alternative?

22. Copyright © by Houghton Mifflin Company. All rights reserved.22 Types of Short-Run Decisions OBJECTIVE 3 Prepare evaluations of alternatives for make-or-buy decisions, special order decisions, product mix decisions and sell or process-further decisions.

23. Copyright © by Houghton Mifflin Company. All rights reserved.23 Make-or-Buy Decisions u Incremental analysis is probably the best decision-making method to employ. 4 The alternative that results in the lowest incremental cost should be adopted. 4 The relevant costs of each alternative should be compared.

24. Copyright © by Houghton Mifflin Company. All rights reserved.24 Incremental Analysis: Make-or-Buy Decision

25. Copyright © by Houghton Mifflin Company. All rights reserved.25 Special Order Decisions u Special order analysis is designed to help management decide whether to accept or reject a special order. 4 Incremental analysis for special order decisions ignores fixed costs if unused capacity exists. 4 Contribution margin analysis highlights the effect of changes in variable costs. 4 Special pricing for special orders should consider federal price discrimination laws. 4 If additional fixed costs would be incurred, they would be relevant.

26. Copyright © by Houghton Mifflin Company. All rights reserved.26 Contribution Margin Analysis: Special Order Decision Goodman Sporting Goods, Inc. Special Order Decision Contribution Margin Analysis Without Deck Order (410,000 products) With Deck Order (440,000 products) Sales Less variable costs Direct materials Direct labor Variable manufacturing overhead Packaging costs Total variable costs Contribution margin Less fixed costs Manufacturing overhead Advertising Selling and administrative Total fixed costs $1,640,000 $ 369,000 246,000 205,000 123,000 $ 943,000 $ 697,000 $ 100,000 60,000 120,000 $ 280,000 $1,713,500 $ 396,000 264,000 220,000 125,500 $ 1,005,500 $ 708,000 $ 100,000 60,000 120,000 $ 280,000 Net income$ 417,000 $ 428,000

27. Copyright © by Houghton Mifflin Company. All rights reserved.27 Product Mix Decisions u Sales mix analysis is used to find the most profitable combination of product sales, given scarce resources. 4 For each product, calculate the contribution margin per unit. 4 For each product, calculate the ratio of contribution margin to the amount of scarce resource. 4 Shift production to the more profitable product, per unit of scarce resource.

28. Copyright © by Houghton Mifflin Company. All rights reserved.28 Contribution Margin Analysis: Product Mix Decision Bradley Enterprises Product Mix Decision Contribution Margin Analysis Product C S F Unit sales price Variable costs Manufacturing Selling Total variable costs Contribution margin per unit (A) Machine hours required 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

29. Copyright © by Houghton Mifflin Company. All rights reserved.29 Sell or Process-Further Decisions u Two or more products or services that are created simultaneously from a common input are called joint products. u At the split-off point joint products become separate and identifiable. u Products may be sold at the split-off point or processed further.

30. Copyright © by Houghton Mifflin Company. All rights reserved.30 Sell or Process-Further Decisions u Sell or process-further analysis helps decision makers by comparing incremental costs and revenues. u Under an incremental analysis, joint costs incurred before the split-off are irrelevant because they are past costs and are incurred regardless of the point at which the products are sold.

31. Copyright © by Houghton Mifflin Company. All rights reserved.31 Sell or Process Further u If costs of additional processing exceed additional revenues, do not process further. u If additional revenues exceed additional processing costs, process further.

32. Copyright © by Houghton Mifflin Company. All rights reserved.32 A. A. 1. Make-or-Buy. 2. Special Order. 3. Sales Mix. 4. Sell or Process-Further.Discussion Q. Q. What are four common operating decisions made by managers?

33. Copyright © by Houghton Mifflin Company. All rights reserved.33 Capital Investment Decisions OBJECTIVE 4 Identify the types of projected costs and revenues used to evaluate alternatives for capital investment.

34. Copyright © by Houghton Mifflin Company. All rights reserved.34 Capital Investment Analysis u Three techniques are commonly used to evaluate proposed capital investments (long-term decision- making for purchases of plant and equipment). 1. Accounting rate-of-return method. 2. Payback period method. 3. Net present value method.

35. Copyright © by Houghton Mifflin Company. All rights reserved.35 Capital Expenditures u Evaluating capital expenditure proposals requires dealing with large amounts of information, most of which are projected data. u Decisions are based on: 4 Target cost of capital or desired rate of return. 4 Cash availability. 4 Sales trends and estimated new product demand. 4 Facility needs.

36. Copyright © by Houghton Mifflin Company. All rights reserved.36 Relevant Information u The types of information relevant to capital investment analysis include: 4 Net income and net cash inflows (or cost savings). 4 Equal versus unequal cash flows. 4 Carrying value of assets. 4 Depreciation expense and income taxes. 4 Disposal or residual values.

37. Copyright © by Houghton Mifflin Company. All rights reserved.37 A. A. 1. Net income and net cash inflows. 2. Equal versus unequal cash flows. 3. Carrying value of assets. 4. Depreciation expense and income taxes. 5. Disposal or salvage values. 6. Disposal or residual values.Discussion Q. Q. What are the types of information relevant to capital expenditure decisions?

38. Copyright © by Houghton Mifflin Company. All rights reserved.38 Time Value of Money OBJECTIVE 5 Apply the concept of time value of money.

39. Copyright © by Houghton Mifflin Company. All rights reserved.39 The Time Value of Money u The concept that cash flows in the future have different present values because of the effects of compound interest. u The notions of interest, present value and future value are all relevant to the time value of money.

40. Copyright © by Houghton Mifflin Company. All rights reserved.40 u Interest is the cost associated with the use of money for a specific period. u There are two types of interest. 4 Simple interest. 4 Compound interest.Interest

41. Copyright © by Houghton Mifflin Company. All rights reserved.41 Simple Interest u The interest cost for one or more periods assuming the amount on which the interest is computed remains constant from period to period. u Simple Interest = Principal x Rate x Time

42. Copyright © by Houghton Mifflin Company. All rights reserved.42 Compound Interest u The interest that assumes that after each period the interest of that period is added to the amount on which interest is computed in future periods. Interest for Period 1 = Principal Period 1 x Rate Interest for Period 2 = (Principal Period 1 + Interest Period 1) x Rate

43. Copyright © by Houghton Mifflin Company. All rights reserved.43 Future Value u Future value u Future value is the amount that an investment will be worth at a future date if invested at compound interest. u An ordinary annuity u An ordinary annuity is a series of equal payments made at the end of equal intervals of time, with compound interest on the payments. Future Value in year n = Present Value x (1.0 x Interest Rate)n

44. Copyright © by Houghton Mifflin Company. All rights reserved.44 Present Value u Present value is the amount that must be invested now at a given rate of compound interest to produce a given future value. u The present value of an ordinary annuity is the present value of a series of payments or receipts.

45. Copyright © by Houghton Mifflin Company. All rights reserved.45 Applying Present Value to Simple Accounting Situations u Present value may be used to: 4 Compute interest on non-interest-bearing notes. 4 Value a bond or other asset. 4 Compute the present value of deferred payments. 4 Determine a bargaining range in negotiating the sale of a business. 4 Determine the future value of an investment of idle cash or the accumulation of a fund. 4 Record lease obligations.

46. Copyright © by Houghton Mifflin Company. All rights reserved.46Discussion Q. Q. What is the difference between simple interest and compound interest? A. A. Simple interest is the interest cost for one or more periods assuming the amount on which the interest is computed remains constant from period to period. Compound interest assumes that after each period the interest of that period is added to the amount on which interest is computed in future periods.

47. Copyright © by Houghton Mifflin Company. All rights reserved.47 The Present Value of a Single Sum Due in the Future Present Value = Future value  (1 + Interest Rate)n in the year 0 in the year n u The calculation is usually performed using a computer, complete financial calculator, or lump sum present value tables. u Variables used to calculate Present Value are Future Value, Number of Time Periods and Interest Rate.

48. Copyright © by Houghton Mifflin Company. All rights reserved.48 Ordinary Annuity u An ordinary annuity is a series of equal payments made at the end of a number of equal time periods.

49. Copyright © by Houghton Mifflin Company. All rights reserved.49 The Present Value of Ordinary Annuity u The calculation is usually performed using a computer, financial calculator or annuity present value table. u Variables used to calculate the Present Value of an Ordinary Annuity are Future Cash Flow, for each time period, Number of Time Periods and Interest Rate.

50. Copyright © by Houghton Mifflin Company. All rights reserved.50 Net Present Value Method OBJECTIVE 6 Analyze capital investment proposals using the net present value method.

51. Copyright © by Houghton Mifflin Company. All rights reserved.51 Net Present Value u The net present value method evaluates a proposed capital investment by discounting its future cash flows to their present value. u The current cost of the capital investment being evaluated is subtracted from the present value of cash flows, to give its net present value. u The project with the highest (positive) net present values is selected.

52. Copyright © by Houghton Mifflin Company. All rights reserved.52 u The discount rate to determine present values should at least equal the company’s weighted average cost of debt and equity capital. u If NPV is positive, the rate of return on the investment will exceed the company’s minimum rate of return (or hurdle rate).

53. Copyright © by Houghton Mifflin Company. All rights reserved.53 The Net Present Value Method Illustrated $303.50Net present value 17,500.00Less purchase price of Model M $17,803.50Total present value of cash inflows 952.00.4762,000Residual Value 1,904.00.4764,0005 2,484.00.5524,5004 3,205.00.6415,0003 4,086.50.7435,5002 $5,172.00.862$6,0001 Present Value16% FactorNet Cash InflowsYear Model M

54. Copyright © by Houghton Mifflin Company. All rights reserved.54 The Net Present Value Method Illustrated (continued…) ($404.00)Net present value 21,000.00Less purchase price of Model N $20,596.00Total present value of cash inflows 952.00.4762,000Residual value $19,644.003.274$6,0001-5 Present Value16% FactorNet Cash InflowsYear Model N

55. Copyright © by Houghton Mifflin Company. All rights reserved.55 u The accounting rate-of-return formula is as follows: Accounting Rate-of-Return Accounting Rate-of-Return = Project’s Average Annual Net Income Average Investment Cost

56. Copyright © by Houghton Mifflin Company. All rights reserved.56 Accounting Rate-of-Return (continued…) u The accounting rate-of-return (ARR) method is a crude but easy way to measure the estimated performance of a capital investment. u Capital investment proposals must meet the minimum desired rate of return. u If projected ARR is higher than the desired minimum return, invest.

57. Copyright © by Houghton Mifflin Company. All rights reserved.57 u The payback formula is as follows: Payback Period Method Payback Period (in years) = Cost of Investment Annual Net Cash Inflow

58. Copyright © by Houghton Mifflin Company. All rights reserved.58 Payback Period Method (continued…) u The payback period method of evaluating proposed capital investment identifies the project that recoups the original amount of the investment in the shortest time period. u The payback period method ignores the time value of money and long-term profitability.

59. Copyright © by Houghton Mifflin Company. All rights reserved.59 A. A. 1. Accounting Rate-of-Return. 2. Payback Period. 3. Net Present Value.Discussion Q. Q.What three methods are used to analyze proposed capital expenditures?

60. Copyright © by Houghton Mifflin Company. All rights reserved.60 OK, LET’S REVIEW… 1.Explain how managers make short-run decisions during the management cycle, and identify the steps in the management decision cycle. 2.Define and explain incremental analysis and its related concepts. 3.Prepare evaluations of alternatives for make-or-buy decisions, and sell or process- further decisions.

61. Copyright © by Houghton Mifflin Company. All rights reserved.61 AND FINALLY… 4.Identify the types of projected costs and revenues used to evaluate alternatives for capital investment. 5.Apply the concept of time value of money. 6.Analyze capital investment proposals using the net present value method. 7.Analyze capital investment proposals using the accounting rate-of-return method and the payback period method.