Transcript CHAPTER 22
CHAPTER 22
S
HORT
T
ERM
D
ECISION
M
AKING
DIFFERENTIAL ANALYSIS
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Traditional Income Statement
Sales Revenue Less: Cost of goods sold Gross margin Less: Selling & administrative expenses Net income $ 100,000 70,000 $ 30,000 20,000 $ 10,000 22-2 Emphasis is on functional classification of costs, not cost behavior.
Contribution Margin Income Statement
Sales Revenue Less: Variable costs Contribution margin Less: Fixed costs Net income Total $ 100,000 60,000 $ 40,000 30,000 $ 10,000 Unit $ 50 30 $ 20 22-3 The emphasis is on cost behavior and contribution margin
Contribution Margin Income Statement
Sales Revenue Less: Variable costs Contribution margin Less: Fixed costs Net income Total $ 100,000 60,000 $ 40,000 30,000 $ 10,000 Unit $ 50 30 $ 20 22-4 Contribution margin is the amount by which revenue exceeds variable costs.
Traditional vs. Contribution Approach
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Comparison of the Traditional Income Statement with the Contribution Income Statement Traditional Approach (costs organized by function) Contribution Approach (costs organized by behavior) Sales Less cost of goods sold Gross margin Less operating expenses Net income $ 100,000 70,000 $ 30,000 20,000 $ 10,000 Sales Less variable expenses Contribution margin Less fixed expenses Net income $ 100,000 60,000 $ 40,000 30,000 $ 10,000 22-5 Do you see the difference between gross margin and contribution margin ?
Differential Analysis
22-6 Def.
- Analyzing the different costs and revenues for different alternatives.
Relevant Costs and Revenues
Future costs and revenues that differ among alternatives. Example : You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. 22-7 What is the difference in revenue between the two alternatives?
Relevant Costs and Revenues
Future costs and revenues that differ among alternatives. Example : You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. 22-8 What is the difference in revenue between the two alternatives?
$2,000 – $1,500 = $500
Relevant Costs and Revenues
Future costs and revenues that differ among alternatives. Example : You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. 22-9 What is the difference in cost between the two alternatives?
Relevant Costs and Revenues
Future costs and revenues that differ among alternatives. Example : You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is $300 per month. 22-10 What is the difference in cost between the two alternatives?
$300
Relevant Costs and Revenues
Future costs and revenues that differ among alternatives. Example : You have a job paying $1,500 per month in your hometown. You have a job offer in a neighboring city that pays $2,000 per month. The commuting cost to the city is .
$300 per month. 22-11 Net monetary advantage of city job is $500 – $300 = $200.
Would you commute to the city for $200?
Sunk Costs
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Past costs that cannot be changed by a current decision.
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Irrelevant for decision making.
Example: You bought an automobile that cost $10,000 two years ago. The $10,000 cost is sunk because whether you drive it, park it, trade it, or sell it, you cannot change the $10,000 cost.
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Sunk Costs
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Cost = $10,000 .
two years ago Trade ?
Cost = $25,000 today The dealer will trade for $20,000 plus your car.
What amount is relevant to your decision, the $10,000 cost of your car or the amount of cash differential that you will pay?
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Two Types of Fixed Costs
Committed Long-term and cannot be reduced in the short term.
Discretionary May be altered in the short-term by current managerial decisions.
Examples Depreciation on Buildings and Equipment Examples Advertising and Research and Development 22-14
Opportunity Costs
Benefits foregone by rejecting the next best alternative course of action
Example: If you were not attending college, you could be earning $20,000 per year. Your opportunity cost of attending college for one year includes the $20,000.
Opportunity costs are not recorded in the accounting records, but are relevant to decisions because they are a real sacrifice.
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Differential Analysis
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Processing or selling joint products Pricing decisions processing or selling joints in rejecting special orders 22-16 Adding or eliminating products, segments or customers Deciding whether to make or buy products
Pricing Decisions
Objective: select a price for a product that maximizes income.
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Fixed costs are irrelevant because they usually are not affected by short-run pricing decisions.
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Since fixed costs are the same regardless of decision, maximizing income really means maximizing contribution margin.
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Pricing Decisions Example
Clay Co. is planning to introduce a new stuffed animal product. Marketing analysis indicates the following annual demand for the product:
10,000 units at $10.00 per unit
13,000 units at $9.00 per unit
16,000 units at $8.00 per unit
20,000 units at $7.00 per unit If the unit variable cost is $4.00 and there are no new fixed costs associated with the new product, what price should Clay charge? 22-18
Pricing Decisions Example
Unit Price $ 10.00
8.00
7.00
Unit Variable Cost Unit Contribution Margin Demand in Units Total Contribution Margin $ 4.00
4.00
4.00
4.00
10,000 13,000 16,000 20,000 22-19 What is the unit contribution margin for each unit price?
Pricing Decisions Example
Unit Price $ 10.00
8.00
7.00
Unit Variable Cost Unit Contribution Margin Demand in Units Total Contribution Margin $ 4.00
4.00
4.00
4.00
$ 6.00
5.00
4.00
3.00
10,000 13,000 16,000 20,000 22-20 What is the total contribution margin for each unit price?
Pricing Decisions Example
Unit Price $ 10.00
8.00
7.00
Unit Variable Cost Unit Contribution Margin Demand in Units Total Contribution Margin $ 4.00
4.00
4.00
4.00
$ 6.00
5.00
4.00
3.00
10,000 13,000 16,000 20,000 $ 60,000 65,000 64,000 60,000 22-21 Therefore, a price of $9.00 per unit maximizes total contribution margin given this relationship between sales price and demand.
Special Orders
Special orders involve the opportunity to sell a product in a new market on a one-time basis.
Fixed costs are usually unchanged by special orders, so any special order price in excess of variable cost will increase profit. 22-22
Special Order Example
Jones Co. makes Barry Bears under its own label for exclusive children’s stores. Jones has adequate capacity to consider a special order from a major retailer for 100,000 bears. The retailer has offered an average price of $18 per bear. Use the following unit cost information to advise Jones whether or not to accept the order.
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Special Order Example
Direct Material Direct Labor Variable Overhead Fixed Overhead Total Unit Cost $ 8.00
6.00
2.00
4.00
$ 20.00
Fixed overhead totals $2,000,000 for a capacity of 500,000 bears. Jones normally sells its bears wholesale for an average price of $30 per bear.
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Special Order Example
Direct Material Direct Labor Variable Overhead Fixed Overhead Total Unit Cost $ 8.00
6.00
2.00
4.00
$ 20.00
Total unit variable cost is $16.00
Total fixed overhead will not change if the special order is accepted and is irrelevant to the decision.
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Special Order Example
Direct Material Direct Labor Variable Overhead Fixed Overhead Total Unit Cost $ 8.00
6.00
2.00
4.00
$ 20.00
Total unit variable cost is $16.00
Unit contribution on special order = $18 - $16 = $2 Total contribution on order = 100,000 units × $2 = $200,000 Accept the order. Income will increase by $200,000.
Adding or Eliminating Products or Segments
Distinguish between avoidable and unavoidable costs.
Unavoidable costs continue when a product is eliminated.
Avoidable costs stop when a product is eliminated.
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Eliminate a product only if avoidable costs are greater than lost revenues.
Adding or Eliminating Products or Segments
Avoidable costs disappear over time if the segment itself disappears.
22-28 No typewriter division means . . .
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Adding or Eliminating Products or Segments
Unavoidable costs arise because of overall operation of the company and are not due to the existence of a particular segment. No typewriter division but . . .
We still have a company president.
Eliminating a Product Line Example
Ray’s Department Store is considering eliminating the hardware department. Revenue from hardware is $200,000 annually, with cost of goods sold of $160,000. Salaries of $20,000 would be eliminated. However, hardware’s allocated portion of store overhead is $45,000 and would continue regardless of the decision. Should the hardware department be discontinued? 22-30
Eliminating a Product Line Example
Hardware Department Keep Close Difference Revenue Less: Variable costs Contribution margin Less: Fixed costs Income $ $ 200,000 160,000 $ 40,000 65,000 (25,000) $ $ 45,000 $ (45,000) $ 200,000 160,000 $ $ 40,000 20,000 (20,000) 22-31 (The facts imply that $20,000 of salaries are “discretionary” fixed costs and could be eliminated.)
Eliminating a Product Line Example
Hardware Department Keep Close Difference Revenue Less: Variable costs Contribution margin Less: Fixed costs Income $ $ 200,000 160,000 $ 40,000 65,000 (25,000) $ $ 45,000 $ (45,000) $ 200,000 160,000 $ $ 40,000 20,000 (20,000) 22-32 (The facts imply that $20,000 of salaries are “discretionary” fixed costs and could be eliminated.) Closing the hardware department will result in a $20,000 decrease in income to a new loss of $45,000. The hardware department should be kept open unless a new product line is found with a higher contribution margin.
Make or Buy Decisions
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Pssssst...
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Make or Buy Decisions
The outside purchase price is compared with the avoidable costs of manufacturing the part.
If facilities have an alternative use, then the Should I continue to make the part, or should I buy it?
opportunity cost of the facilities must also be considered in the decision.
Make or Buy Example
Exitel makes computer chips used in one of its products. Unit costs, based on production of 20,000 chips per year, are: 22-35 Direct Material Direct Labor Variable Overhead Fixed Overhead Total Unit Costs $ 9.00
5.00
1.00
13.00
$ 28.00
Make or Buy Example
An outside supplier has offered to provide the 20,000 chips at a cost of $25 per chip. Fixed overhead costs will continue if the chips are purchased. Exitel has no alternative use for the facilities. Should Exitel accept the offer?
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Make or Buy Example
Differential costs of making (costs avoided if bought from outside supplier) Direct Material Direct Labor Variable Overhead Total avoidable cost Unit Cost $ 9.00
5.00
1.00
$ 15.00
Exitel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the part. Fixed costs are irrelevant to decision.
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Make or Buy Example
However, suppose the idle facilities could be leased to another company for $250,000 per year if Exitel buys the chips from the outside supplier.
Should Exitel buy the chips and lease the facilities?
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Make or Buy Example
Disadvantage of buying 20,000 units × ($25 - $15) Opportunity cost of facilities: The lease revenue Advantage of buying the part and leasing out facilities $ 200,000 250,000 $ 50,000 The opportunity cost of facilities changes the decision. 22-39 The real question to answer is “what is the best use of Exitel’s facilities?”
Applying Differential Analysis to Quality
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Applying Differential Analysis to Quality
22-41 Costs
Applying Differential Analysis to Quality
Differential costs undertaken to improve quality are usually less than the benefits gained from producing high quality products.
22-42 Examples of costs: Higher quality raw materials Better trained workers Costs Benefit s Examples of benefits: Decreased scrap and rework Increased sales and income
The End
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