1. Needles Powers Crosson Principles of Accounting 12e Short-Run Decision Analysis and Capital Budgeting 25 C H A P T E R ©human/iStockphoto

2. Concepts Underlying Decision Analysis  The concept of cost-benefit holds that the benefits to be gained from a course of action or alternative should be greater than the costs of implementing it. –Managers frequently take the following actions when applying the cost-benefit concept:  Step 1: Discover a problem or need.  Step 2: Identify all reasonable courses of action than can solve the problem or meet the need.  Step 3: Prepare a thorough analysis of each possible solution, identifying its total costs, savings, benefits, other financial effects, and any qualitative factors.  Step 4: Select the best course of action. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

3. Concepts Underlying Decision Analysis  Short-run decision analysis is the systematic examination of any decision whose effects will be felt over the course of the next year or less. –In making such decisions, managers analyze not only the quantitative cost and benefit factors relating to profitability and liquidity; but they also analyze qualitative factors.  Capital investment analysis (capital budgeting) involves the evaluation of alternative proposals for large capital investments, including considerations for financing the projects. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

4. Concepts Underlying Incremental Analysis  Comparing alternatives by focusing on the differences in their projected revenues and costs is called incremental analysis. –Incremental analysis can be used for capital investment or short-run decisions. –If incremental analysis excludes revenues or costs that stay the same or that do not change between the alternatives, it is called differential analysis. –A cost that changes between alternatives is known as a differential cost (or incremental cost). ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

5. Incremental Analysis  The first step in the incremental analysis is to eliminate any irrelevant revenues and costs. –Irrelevant revenues are those that will not differ between the alternatives. –Irrelevant costs include costs that will not differ between the alternatives and sunk costs.  A sunk cost is a cost that was incurred because of a previous decision and cannot be recovered through the current decision.  Once the irrelevant revenues and costs have been identified, the incremental analysis can be prepared using only the differential revenues and costs that will change between the alternatives. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

6. Opportunity Costs  Opportunity costs are the benefits that are forfeited or lost when one alternative is chosen over another and when the choice eliminates the possibility of another course of action. –Opportunity costs often come into play when a company is operating at or near capacity and must choose which products or services to offer. –The income that might have been received from the alternative that was not chosen is the opportunity cost of the chosen alternative. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

7. Incremental Analysis for Outsourcing Decisions  Outsourcing is the use of suppliers outside the company to perform services or produce goods that could be performed or produced internally. - Outsourcing can reduce a company’s investment in physical assets and human resources, as well as operating costs. –Make-or-buy decisions, which are decisions about whether to make a part internally or buy it from an external supplier, may lead to outsourcing. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

8. Incremental Analysis for Special Order Decisions  Managers are often faced with special order decisions, which are decisions about whether to accept or reject special orders at prices below the normal market prices. –Before a company accepts a special product order, it must be sure that excess capacity exists to complete the order and that the order will not reduce unit sales from its full-priced regular product line. –In addition, a special order should be accepted only if it maximizes operating income. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

9. Special Order Analysis: Minimum Bid Price for Special Order  Another approach to this kind of decision is to prepare a special order bid price by calculating a minimum selling price for the special order. –The bid price must cover the relevant costs and an estimated profit. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

10. Incremental Analysis for Segment Profitability Decisions  Another type of operating decision that management must make is whether to keep or drop unprofitable segments. –A segment margin is a segment’s sales revenue minus its direct costs.  Such costs are assumed to be avoidable costs, which are costs that could be eliminated if management were to drop the segment. –An analysis of segment profitability includes the preparation of a segmented income statement using variable costing to identify variable and fixed costs.  The fixed costs that are traceable to the segments are called direct fixed costs.  The remaining fixed costs are common costs and are not assigned to segments. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

11. Incremental Analysis for Sales Mix Decisions  Limits on resources like machine time or available labor may restrict the types or quantities of products or services that a company can provide.  To satisfy customers’ demands and maximize operating income, management must make a sales mix decision to offer the most profitable combination of products and services. –To decide on the optimal sales mix, managers calculate the contribution margin per constrained resource (such as labor or machine hours) for each product or service. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

12. Sales Mix Analysis  The objective of a sales mix decision is to select the alternative that maximizes the contribution margin per constrained resource. –The decision analysis consists of two steps:  Step 1: Calculate the contribution margin per unit for each product or service affected by the constrained resource as follows:  Step 2: Calculate the contribution margin per unit of the constrained resource as follows: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

13. Incremental Analysis for Sell-or-Process- Further Decisions  Some companies offer products that can either be sold in a basic form or be processed further and sold as a more refined product. –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 products during some or all of the processing.  Only at a specific point, called the split-off point, do joint products become separate and identifiable. At that point, a company may choose to sell the product or process it further. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

14. Sell-or-Process-Further Analysis  The objective of a sell-or-process-further decision is to select the alternative that maximizes operating income. –The decision analysis entails calculating the incremental revenue as follows: –The common costs shared by two or more products before they are split off are called joint costs (or common costs).  Joint costs are not relevant to a sell-or-process-further decision because they are incurred before the split-off point. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

15. Analyzing Capital Investments  Ca pital investment decisions are decisions about when and how much to spend on capital facilities and other long-term projects. –Capital investment analysis (or capital budgeting) is the process of identifying the need for a capital investment, analyzing courses of action to meet that need, choosing the best alternative, and allocating funds among competing needs. It follows six key steps:  Step 1: Identify capital investment needs.  Step 2: Prepare formal requests for capital investments.  Step 3: Conduct a preliminary screening.  Step 4: Establish the acceptance-rejection standard.  Step 5: Evaluate proposals.  Step 6: Make capital investment decisions. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

16. The Minimum Rate of Return on Investment  Most companies set a minimum rate of return to guard their profitability, and any capital expenditure proposal that fails to produce that rate of return is automatically refused. –The minimum rate of return is often called a hurdle rate because it is the rate that must be exceeded, or hurdled. –If the return from a capital investment falls below the minimum rate of return, the funds can be used more profitably in another part of the organization. –If there are too many proposals to fund adequately, managers must rank the proposals according to their rates of return and begin a second selection process. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

17. Net Present Value Method  The net present value method evaluates a capital investment by discounting its future cash flows to their present values and subtracting the amount of the initial investment from their sum. –Future cash inflows and outflows are discounted by the company’s minimum rate of return to determine their present values. The minimum rate of return should at least equal the company’s average cost of capital. –Projects with the highest net present value—the amount that exceeds the initial investment—are selected. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

18. The Payback Period Method  If two investment alternatives are being studied, management should choose the investment that pays back its initial cost in the shorter time. –That period of time is known as the payback period, and the method of evaluation is called the payback period method.  The payback period method is simple to use, but it does not consider the time value of money.  The payback period is computed as follows: (The annual net cash inflows are the annual cash revenues minus the cash expenses.) ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

19. Unequal Annual Net Cash Inflows  If a proposed capital investment has unequal annual net cash inflows, the payback period is determined as follows: –When a zero balance is reached, the payback period has been determined.  The portion of the final year is computed by dividing the amount needed to reach zero (the unrecovered portion of the investment) by the entire year’s estimated cash inflow. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

20. Advantages and Disadvantages of the Payback Period Method  The payback period method is especially useful in areas in which technology changes rapidly and when risk is high. –However, this approach has several disadvantages:  The payback period method does not measure profitability.  It ignores differences in the present values of cash flows from different periods; thus, it does not adjust cash flows for the time value of money.  It emphasizes the time it takes to recover the investment rather than the long-term return on the investment.  It ignores all future cash flows after the payback period is reached. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

21. The Accounting Rate-of-Return Method  The accounting rate-of-return method is an imprecise but easy way to measure the estimated performance of a capital investment, since it uses financial statement information. –It does not use an investment’s cash flows but considers the financial reporting effects of the investment instead. –It measures expected performance using two variables: the estimated annual net income from the project and average investment cost.  The average investment cost is computed as follows: ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

22. Advantages and Disadvantages of the Accounting Rate-of-Return Method  The accounting rate-of-return method is easy to understand and apply. –However, it has several disadvantages:  Because net income is averaged over the life of the investment, it is not a reliable figure, as actual net income may vary considerably from the estimates.  It ignores cash flows.  It does not consider the time value of money; thus, future and present dollars are treated as equal. ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

23. Variance Analysis and the Management Process ©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.  Manager responsibilities for standard costing and variance analysis within the management process of planning, performing, evaluating, and reporting on cost center operations are:  Plan  Perform  Evaluate  Communicate