Managerial Accounting 2002e

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

Chapter 10 Short-Run Decision Analysis
Copyright © Houghton Mifflin Company. All rights reserved.

Copyright © Houghton Mifflin Company. All rights reserved.
LEARNING OBJECTIVES Explain how managers make short-run decisions during the management cycle. Define and explain incremental analysis and its related concepts. Apply incremental analysis to outsourcing decisions. Apply incremental analysis to special order decisions. Apply incremental analysis to segment profitability decisions. Copyright © Houghton Mifflin Company. All rights reserved.

LEARNING OBJECTIVES Apply incremental analysis to product mix decisions involving constrained resources. Apply incremental analysis to sell or process-further decisions. Apply incremental analysis to service organizations. Copyright © Houghton Mifflin Company. All rights reserved.

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. Copyright © Houghton Mifflin Company. All rights reserved.

Short-Run Decisions Short-run decision analysis is an important component of the management cycle. In the planning stage, managers estimate costs and revenues for use in making short-run decision. Copyright © Houghton Mifflin Company. All rights reserved.

The Management Cycle In the executing stage, managers make and implement short-run decisions to improve the organization’s profitability and liquidity in the short run. Managers use financial and nonfinancial information to decide to: Accept a special order. Keep or drop a segment. Select the appropriate product mix. Contract with outside suppliers. Sell a product as is or process further. Copyright © Houghton Mifflin Company. All rights reserved.

The Management Cycle In the reviewing stage, each decision is evaluated to determine if it produced the forecasted results. The reporting stage takes place throughout the management cycle. Copyright © Houghton Mifflin Company. All rights reserved.

Short-Run Decisions Both quantitative and qualitative factors influence short-run decisions. Managers must assess the importance of qualitative information such as: Product (or service) quality. Timeliness. Social issues. Copyright © Houghton Mifflin Company. All rights reserved.

The Management Decision Cycle

Discussion What are some examples of ways that managers use financial and nonfinancial information? 1. Accept a special order. 2. Keep or drop a segment. 3. Select the appropriate product mix. 4. Contract with outside suppliers. 5. Sell a product as is or process further. Copyright © Houghton Mifflin Company. All rights reserved.

The Decision-Making Process
OBJECTIVE 2 Define and explain incremental analysis and its related concepts. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis for Management Decisions
The management decision cycle: Begins with the determination of a problem or need. Then alternative courses of action are identified. The effects of each alternative are evaluated. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis Also called differential analysis. Ignores revenues or costs that stay the same or that do not differ among alternatives. (Irrelevant revenue and costs.) Ignores sunk costs, already incurred and not recoverable. Copyright © Houghton Mifflin Company. All rights reserved.

Relevant Decision Information
Any data related to future costs, revenues, or uses of resources that will differ among alternative courses of action are considered relevant decision information. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis Step 1: Eliminate irrelevant revenues and costs. Step 2: Prepare the analysis using only projected revenues and expenses that will differ. Step 3: Consider other relevant issues, such as quality, reputation, etc. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis Lennox Company Incremental Analysis Difference in favor of Grinder C Grinder W Grinder W Increase in revenues $ 16,200 $ 19,800 $ 3,600 Increase in operating costs Direct labor $ 2,200 $ 4,100 ($ 1,900) Variable manufacturing overhead 2,100 3,050 (950) Total relevant operating costs $ 4,300 $ 7,150 ($ 2,850) Resulting change in net income $ 11,900 $ 12,650 $ Copyright © Houghton Mifflin Company. All rights reserved.

Special Considerations in Short-Run Decision Analysis
The effects of opportunity costs The need to prepare special decision reports Copyright © Houghton Mifflin Company. All rights reserved.

Decision Costs Opportunity costs are the benefits forgone when one alternative is selected over another. Incremental analysis helps managers compare alternatives by focusing on the differences in their projected revenues and costs. Such a report helps identify which alternative contributes the most to profits or incurs the lowest cost. Copyright © Houghton Mifflin Company. All rights reserved.

Traditional Versus Special Decision Reports
Frequently contribution format incremental analyses are used to support special decisions. If qualitative factors are very important, special formats must be used to support quantitative analysis with qualitative information. Copyright © Houghton Mifflin Company. All rights reserved.

Discussion What data should be omitted from the analyses and reports accountants present to management? 1. Past data. 2. Data that are identical under all alternatives. Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing Decisions
OBJECTIVE 3 Apply incremental analysis to outsourcing decisions. Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing Outsourcing is the use of suppliers outside the organization to perform services or produce goods that could be performed or produced internally. Outsourcing includes make-or-buy decisions, which are decisions about whether to make a part internally or buy it from an external supplier. Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing Many organizations outsource functions that do not represent core competencies such as: Payroll processing. Selling and marketing. Fleet management. Training. Custodial services. Information management. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Outsourcing Decision
Kriegel Electronics Company Outsourcing Decision Incremental Analysis Difference Make Buy in favor of Make Direct materials (20,000 100 $84) $ 16,800 ($ 16,800) Direct labor (20,000 20 $8) 8,000 (8,000) Variable manufacturing overhead (20,000 20 $4) 4,000 (4,000) To purchase completed castings (20,000 $ 30,000 30,000 $1.50) Totals $ 28,800 $ 30,000 $ 1,200 Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing Benefits Loss of control. Loss of expertise within the organization. Growing dependence on suppliers. Potential loss of critical information to competitors. Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing Problems Some of the problems associated with outsourcing include: Loss of control. Loss of expertise within the organization. Growing dependence on suppliers. Potential loss of critical information to competitors. Copyright © Houghton Mifflin Company. All rights reserved.

Hidden Costs of Outsourcing the Production of Parts for Assembly Operations When manufacturers purchase parts from suppliers, they expect quality parts to be delivered quickly for a reasonable price. The hidden costs of maintaining an outsourcing relationship with a supplier can include the following: Costs of Quality for Parts Purchased from Suppliers Cost of inspecting parts delivered to the company Cost of labor and shipping to return defective parts to suppliers Cost of training suppliers to follow quality methods Costs of Late Deliveries from Suppliers Cost of lost customer sales due to late parts deliveries from suppliers Cost of carrying extra direct materials and finished goods inventory to compensate for late parts deliveries from suppliers Cost of back orders due to partial shipments Copyright © Houghton Mifflin Company. All rights reserved.

Hidden Costs Hidden costs of maintaining an outsourcing relationship with a supplier can include: Costs of quality. Costs of late deliveries. To manage the hidden costs, companies may add clauses to their contracts with suppliers to specify penalties for poor quality or late deliveries. Copyright © Houghton Mifflin Company. All rights reserved.

Make-or-Buy Decisions
To decide whether to make a product or to buy from an outside supplier, the following information is needed: Make Need for additional equipment Variable costs of making the item Incremental fixed costs Buy Purchase price of the item Rent or net cash flow from facilities freed up Salvage value of unused equipment Copyright © Houghton Mifflin Company. All rights reserved.

Special Order Decisions
OBJECTIVE 4 Apply incremental analysis to special order decisions. Copyright © Houghton Mifflin Company. All rights reserved.

Special order decisions are decisions about whether to accept or reject special product orders at prices below the normal market prices. A special order is a one-time, nonrecurring order. Before accepting a special order, compliance with federal price discrimination laws should be checked. Copyright © Houghton Mifflin Company. All rights reserved.

Two different approaches to special order decisions include: Compare the special order price to the relevant costs to produce, package, and ship the order. Prepare a special order bid price by calculating a minimum selling price for the special order. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Special Order Decision Jens Sporting Goods, Inc.
Without Leiden Order (410,000 baseballs) With Leiden Order (440,000 baseballs) Difference in Favor of Accepting Leiden Order Sales $ 1,640,000 $ 1,713,500 $ 73,500 Less variable costs Direct materials $ 369,000 $ 396,000 ($ 27,000) Direct labor 246,000 264,000 (18,000) Variable manufacturing overhead 205,000 220,000 (15,000) Packaging costs 123,000 125,500 (2,500) Total variable costs $ 943,000 $ 1,005,500 ($62,500) Contribution margin $ 697,000 $ 708,000 $ 11,000 * Assuming available existing production capacity, so no additional fixed costs are incurred. Copyright © Houghton Mifflin Company. All rights reserved.

Special Orders: Qualitative Factors
These may include: Impact on sales to regular customers Potential of special order to lead into new sales areas Customer’s ability to maintain an ongoing relationship Copyright © Houghton Mifflin Company. All rights reserved.

Fixed Costs Examples of relevant fixed costs include: Purchase of additional machinery. Increase in supervisory help. Increase in insurance premiums. Copyright © Houghton Mifflin Company. All rights reserved.

Segment Profitability Decisions
OBJECTIVE 5 Apply incremental analysis to segment profitability decisions. Copyright © Houghton Mifflin Company. All rights reserved.

Segment profitability decisions involve the review of segments of an organization, such as: Product lines. Services. Sales territories. Divisions. Departments. Copyright © Houghton Mifflin Company. All rights reserved.

Segment Margin A segment margin is: Segment’s sales revenue - direct variable costs - fixed costs that will be avoided if that segment is dropped Copyright © Houghton Mifflin Company. All rights reserved.

Often managers must decide whether to add or drop a segment. If a segment has a negative segment margin, the segment may be dropped. Common costs that will be incurred regardless of the decision are unavoidable costs. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Segment Profitability Decision
Lebo Corporation Segment Profitability Decision Incremental Analysis Difference in Favor of Keep Drop Dropping Division Y Division Y Division Y Sales $ 150,000 $ 135,000 ($ 15,000) Less variable costs 60,000 52,500 7,500 Contribution margin $ 90,000 $ 82,500 ($ 7,500) Less direct fixed costs 72,000 55,500 16,500 Segment margin $ 18,000 $ 27,000 $ 9,000 Less common fixed costs 12,000 12,000 Net income $ 6,000 $ 15,000 $ 9,000 Copyright © Houghton Mifflin Company. All rights reserved.

Product Mix Decisions Product mix decisions require the selection of the most profitable combination of product sales when a company makes more than one product using a common constrained resource. Copyright © Houghton Mifflin Company. All rights reserved.

Constrained Resources
The constrained or limited resource may be: Labor time. Machine time. Quantity of a raw material. Copyright © Houghton Mifflin Company. All rights reserved.

Decision Analysis The steps in the decision analysis include: Calculation of the contribution margin per unit for each product line affected by the constrained resource. Divide the contribution margin per unit by the quantity of the constrained resource required per unit. Copyright © Houghton Mifflin Company. All rights reserved.

Decision Analysis Profit will be maximized in the short run by devoting limited resources to the product(s) with the highest contribution margin per unit of the constrained resource. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Product Mix Decision Involving Constrained Resources Grady Enterprises Product Mix Decision: Ranking the Order of Production Incremental Analysis Rising Star Ghost Master Road Warrior Selling price per unit $24.00 $18.00 $32.00 Less: Variable costs Manufacturing $12.50 $10.00 $18.75 Selling 6.50 5.00 6.25 Total unit variable costs $19.00 $15.00 $25.00 Contribution margin per unit (A) $ 5.00 $ 3.00 $ 7.00 Machine hours per unit (B) 2 1 2.5 Contribution margin per $ 2.50 $ 3.00 $ 2.80 machine hour (A ÷ B) Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Product Mix Decision
Constraints: Maximum production capacity: 100,000 machine hours Current maximum sales demand: Rising star: ,000 units Ghost master: 30,000 units Road Warrior: 18,000 units Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Product Mix Decision
Grady Enterprises Number of Units to Make Total Machine Hours Available Maximize contribution from Ghost Master (30,000 units x 1 machine hour per unit). Balance of Machine Hours Available 2) Maximize contribution from Road Warrior (18,000 units x 2.5 machine hours per unit). 3) Use remaining hours to make Rising Star (12,500 units x 2 machine hours per unit). Machine Hours 100,000 30,000 70,000 45,000 25,000 Copyright © Houghton Mifflin Company. All rights reserved.

Sell or Process-Further Decisions
A sell or process-further decision is a decision about whether to sell a joint product at the split-off point or sell it after further processing. Joint products are two or more products made from a common material or process that cannot be identified as separate productions until the split-off point. Copyright © Houghton Mifflin Company. All rights reserved.

Split-Off Points At the split-off point, joint products become separate and identifiable. At that point, a company may choose to sell the product as is or to process it into another form for sale to a different market. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis The objective of the incremental analysis is to determine if the product’s selling price will increase more than the incremental costs of processing further. Only the incremental costs and incremental revenues beyond the split-off are relevant. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Sell or Process-Further Decision

Discussion Q. What are five operating decisions facing managers that can be made using incremental analysis? A. Outsourcing decisions. 2. Special order decisions. 3. Segment profitability decisions. 4. Product mix decisions. 5. Sell or process-further decisions. Copyright © Houghton Mifflin Company. All rights reserved.

Short-Run Decisions Typical short-run decisions in service organizations include whether to: Outsource a service. Accept a bid for a special order. Drop an unprofitable service. Provide one service before another because of limited labor hours. Copyright © Houghton Mifflin Company. All rights reserved.

Decision: Complete Basic Web Pages first.
Incremental Analysis: Service Mix Decision Involving Constrained Resources Cyber Web Services Service Mix Decision: Ranking the Order in Which the Services Are Provided Basic Custom Web Pages Web Pages Service revenue per page $200 $ 750 Less variable costs per page 77 600 Contribution margin per page (A) $123 $ 150 Design hours per page (B) 1 12.5 Contribution margin per design hour (A B) $123 $ 12 Decision: Complete Basic Web Pages first. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Outsourcing for a Service Organization
Cyber Web Services Hire a new employee Outsource to outside contractor Difference in favor of outsourcing Cost to outsource $21,600 ($21,600) Cost to do work in-house Direct Labor $19,200 19,200 Service Overhead 1,200 Total Costs $20,400 ($1,200) Opportunity Costs 4,000 Total $24,400 $2,800 Copyright © Houghton Mifflin Company. All rights reserved.

OK, Let’s Review Explain how managers make short-run decisions during the management cycle. Define and explain incremental analysis and its related concepts. Apply incremental analysis to outsourcing decisions. Apply incremental analysis to special order decisions. Apply incremental analysis to segment profitability decisions. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Special Orders for a Service Organization
Cyber Web Services Without THC Order (10 Web Pages) With THC Order (11 Web Pages) Difference in Favor of Rejecting Order Service revenue $7,500 $7,900 $400 Less variable costs Direct Professional Labor 6,000 6,420 (420) Contribution margin $1,500 $1,480 ($ 20) Less fixed costs 1,000 -0- Operating income (loss) $ 500 $ 480 Decision: Reject the Spaced Order Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Segment Profitability for a Service Organization
Cyber Web Services Design Install Maintain Total Service revenue $60,000 $25,000 $65,000 $150,000 Less variable costs 80,000 4,000 36,000 120,000 Contribution margin ($20,000) $21,000 $29,000 $30,000 Less direct fixed costs 6,000 $13,000 13,000 32,000 Segment margin ($ 26,000) $ 8,000 $16,000 ($ 2,000) Decision: Eliminate design segment or improve segment margin. Copyright © Houghton Mifflin Company. All rights reserved.

Discussion Q. What are the typical short-run decisions in service organizations? A. 1. Service outsourcing. 2. Accept a special order bid Drop an unprofitable service What service to provide. Copyright © Houghton Mifflin Company. All rights reserved.

OK, Let’s Review Apply incremental analysis to product mix decisions involving constrained resources. Apply incremental analysis to sell or process-further decisions. Apply incremental analysis to service organizations. Copyright © Houghton Mifflin Company. All rights reserved.

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