Chapter 6 Relevant Information and Decision-Making PDF

Chapter 6 Relevant Information and Decision- Making with a Focus on Operational Decisions  Objective 1 Define Opportunity Cost and Use it to Analyze the Income Effects of a Given Alternative  Opportunity, Outlays and Differential Costs Opportunity cost...

Chapter 6 Relevant Information and Decision- Making with a Focus on Operational Decisions  Objective 1 Define Opportunity Cost and Use it to Analyze the Income Effects of a Given Alternative  Opportunity, Outlays and Differential Costs Opportunity cost is the maximum available contribution to profit forgone (or passed up ) by using limited resources for a particular purpose. This definition indicates that opportunity cost is not the usual outlay cost recorded in accounting. Opportunity cost is the contribution of the best alternative that is excluded.  Outlay cost A cost that requires a cash disbursement. Outlay cost is the typical cost recorded by account. Differential cost Or incremental cost is the difference in total cost between two alternatives.  Opportunity Cost The contribution to profit of best of the rejected alternatives. ( contribution of the best alternative is excluded from consideration.) An example The salary forgone by a person who quits a job to start a business.  Alternatives under Consideration Remain Open as a new Difference employee business Revenues 60,000 200,000 140,000 Outlay costs - 120,000 120,000 Income effect per year 60,000 80,000 20,000 The opportunity cost of the new business is 60,000 the forgone annual salary. Alternative chosen: New business Revenues 200,000 Expenses: Outlay costs 120,000 Opportunity cost of employee salary 60,000 180,000 Income effect per year 20,000  The first solution (tabulation) does not mention opportunity cost because the economic impacts are individually measured for each of the alternatives. Neither alternative has been excluded from consideration The second mention opportunity cost (60.000 salary, impact of the best excluded alternative) as a cost of the chosen alternative The failure to recognize opportunity cost in the second tabulation wile misstate the difference between alternatives.  If the first alternatives is chosen Alternative chosen: Remain as employee Revenues 60,000 Expenses: Outlay costs - Opportunity cost of independent practice 80,000 80,000 Income effect per year (20,000)  Objective 2 Analyze Given Data to Support a Decision to Make or Buy Certain Parts or Products  Make or Buy and Idle Facilities Companies often must decide whether to produce its own parts and subassemblies or buy them from an outside supplier. Sometimes quantitative factors dominate qualitative assessments of costs. Some manufactures always make parts because they want to control quality, others because they possess special know-how, usually skilled labor or rare raw materials needed for production. Alternatively, some companies always purchase parts to protect mutually advantageous long-run relationships with their suppliers. What quantitative factors are relevant to the decision to make or buy ? A key Factor is whether there are idle facilities. The key to make-or-buy decisions is identifying the additional costs for making ( or the costs avoided by buying ) a part or subcomponent. The relevant costs to this decision include the additional variable costs, and the fixed costs that will be eliminated if the parts are bought instead of made  Make Buy Total Per Total Per unit unit Purchase cost : 200,000 10 Direct material 20,000 1 Direct labor 80,000 4 Variable factory overhead 40,000 2 Fixed factory overhead that can be avoided by not making (supervisor’s salary) 20,000 1 Total relevant costs 160,000 8 200,000 10 Difference in favor of making 40,000 2  Make or Buy : Use of Facilities The choice in make- or- buy decisions is not only whether to make or buy, it is how best to use available facilities. Suppose the released facilities can be used in some other manufacturing activity ( to produce a contribution to profits of, say, L.E. 55.000) or can be rented out (say, for L.E. 35.000).  The alternatives are: 1. Make the parts. 2. Buy the part and leave facilities idle. 3. Buy and rent out facilities. 4. Buy and use facilities for other products. Make Buy & Buy &rent Buy &use leave out facilities for facilities facilities other idle product Rent revenue - - 35 - Contribution from other - - - 55 products Obtaining of parts (160) (200) (200) (200) Net relevant costs (160) (200) (165) (145)  Example Electrical Plastic Industrial and Housing Drills Mechanical Components Revenue100,000 unit,@ L.E. 100 10,000,000 Variable costs : Direct material 4,400,000 500,000 4,900,000 Direct labor 400,000 300,000 700,000 Variable factory overhead 100,000 200,000 300,000 Other variable costs 100,000 - 100,000 Sales commissions @ 10% of sales 1,000,000 - 1,000,000 Total variable costs 6,000,000 1,000,000 7,000,000 Contribution margin 3,000,000 Reparable fixed costs 1,900,000 400,000 2,300,000 Common fixed costs 320,000 80,000 400,000 Total fixed costs 2,220,000 480,000 2,700,000 Operating income 300,000  Required 1 During the year a prospective customer in an unrelated market offered L.E. 82.000 for 1,000 drills. The latter would be in addition to the 100,000 units sold. The regular sales commission rate would have been paid. The president rejected the order because " it was below cur costs of L.E. 97 per unit " What would operating income have been if the order had been accepted? 2 A supplier offered to manufacture the year's supply of 100,000 plastic housings for L.E. 13.50 each. What would be the effect on operating income if the Block Company purchased rather than made the housings? Assume that L.E.350,000 of the separable fixed costs assigned to housings would have been avoided if the housings were purchased. 3 The company could have purchased the housings for L.E. 13.50 each and used the vacated space for the manufacture of a deluxe version of its drill. Assume that 20,000 deluxe units could have been made ( and sell them for LE 130 in addition to the 100,000 regular units) at a unit variable cost of L.E.90, exclusive of housings and exclusive of the 10% sales commission. The 20,000 extra plastic housings could also be purchased for L.E. 13.50 each. All the fixed costs pertaining to plastic housing would have continued, because these costs related primarily to the manufacturing facilities used. What would operating income have been if Block had bought the housings and made and sold the deluxe units?  Solution 1 The costs of filling the special order follow: Direct material 49,000 Direct labor 7,000 Variable factory overhead 3,000 Other variable costs 1,000 Sales commissions @ 10% of sales × 82,000 8,200 Total variable costs 68,200 Selling price 82,000 Contribution margin 13,800 Operating income would have been L.E.300.000 + L.E. 13.800 or L.E. 313.800, if the order had been accepted. In a sense, the decision to reject the offer implies that the Block Company is willing to invest L.E. 13.800 in immediate gains forgone (an opportunity cost ) in order to preserve the long – run selling- price structure. 2 Assuming that L.E. 350.000 of the fixed costs could have been avoided by not making the housings and that the other fixed costs would have been continued, the alternatives can be summarized as follows: Make Buy Purchase cost 1,350,000 Variable costs 1,000,000 Avoidable fixed costs 350,000 Total relevant costs 1,350,000 1,350,000 If the facilities used for plastic housings became idle, the Block Company would be indifferent as to whether to make or buy. Operating income would be unaffected.  3 The effect of purchasing the plastic housings and using the vacated facilities for manufacture of a deluxe version of its drill is: Sales would increase by 20,000 units,@ L.E. 130 2,600,000 Variable costs exclusive of parts would increase by 1,800,000 20,000 units,@ L.E. 90 Plus: sales commission, 10% of L.E. 2, 600,000 260,000 2.060,000 Contribution margin on 20,000 units 540,000 Housing: 120,000 rather than 100,000 would be Needed Buy 120,000@ L.E. 13.50 1,620,000 Make 100,000 @ L.E. 10 (only the variable costs 1,000,000 Are relevant) Excess cost of outside purchase 620,000 Fixed costs, unchanged - Disadvantage of making deluxe units 80,000 Operating income would decline to L.E. 220,000 (L.E.300,000 - L.E. 80,000). The deluxe un bring in a contribution margin of L.E. 540,000, but the additional costs of buying rather than making housings is L.E. 620,000, leading to a net disadvantage of L.E. 80,000.  Objective 3 Analyze Data by the Relevant- Information Approach to Support a Decision for Adding or Deleting a Product Line.  Objective Objective63 Analyze AnalyzeData Databy bythe theRelevant- Relevant- Information InformationApproach ApproachtotoSupport Support aaDecision Decisionfor forAdding AddingororDeleting Deleting aaProduct ProductLine. Line. Avoidable costs include department salaries and other costs that could be eliminated by not operating the specific department. Unavoidable Costs Costs that continue even if an operation is halted- are not relevant because they are not affected by a decision to delete the department. Unavoidable costs include many common costs, which are defined as those costs of facilities and services that are shared by users. Examples are store depreciation, heating, air conditioning, and general management expenses. Segment Margin (or Product Line Margin): Represents the excess of revenues over direct variable expenses and avoidable fixed expenses. It is the amount remaining to cover unavoidable fixed expenses and, then, to provide profits. The segment margin figure Is the appropriate one on which to base continuation, elimination decisions, since it provides a measure of the segment's contribution to the coverage of unavoidable costs.  Deletion or Addition of products or Departments The same principles of relevance applied to special orders apply- albeit in slightly different ways_ to decisions about adding or deleting products or departments Avoidable and Unavoidable Costs: Fixed costs are divided into two categories, avoidable and unavoidable. Avoidable Costs Costs that will not continue if an ongoing operation is changed or deleted- are relevant. Segment Margin (or Product Line Margin): Represents the excess of revenues over direct variable expenses and avoidable fixed expenses. It is the amount remaining to cover unavoidable fixed expenses and, then, to provide profits. The segment margin figure Is the appropriate one on which to base continuation, elimination decisions, since it provides a measure of the segment's contribution to the coverage of unavoidable costs.  Departments General Groceries Merchandise Drugs Total L.E. L.E. L.E. L.E. Sales 1,000 800 100 1,900 Variable Costs of 800 560 60 1,420 Goods Sold & Exp. 20% 30% 40% 25% Contribution Margin 200 240 40 480 Fixed Expenses (salaries, Depreciation, insurance, Property taxes, etc.): Avoidable 150 100 15 265 Unavoidable 60 100 20 180 Total Fixed Expenses 210 200 35 448 Operating income (10) 40 5 35  Segment Margin Income Statement ( In thousands) Departments General Groceries Merchandise Drugs Total L.E. L.E. L.E. L.E. Sales 1,000 800 100 1,900 Less: Variable costs 800 560 60 1,420 Contribution Margin 200 240 40 480 20% 30% 40% 25% Avoidable fixed expenses 150 100 15 265 Segment margin 50 140 25 215 Unavoidable Fixed costs 180 Operating income 35  Store as a Whole Total Before Effect of Total After Change dropping Changes (a) Groceries (a)–(b) (b) L.E. L.E. Sales 1,900 1,000 900 Variable expenses 1,420 800 620 Contribution margin 480 200 280 Avoidable fixed expenses 265 150 115 Profit contribution to common space And other unavoidable costs 215 50 165 Common space and other unavoidable costs 180 - 180 Operating income 35 50 (15)  Store as a Whole Total Before Effect of Total After Change dropping Changes (a) Groceries (a)–(b) (b) L.E. L.E. Sales 1,900 1,000 900 Variable expenses 1,420 800 620 Contribution margin 480 200 280 Avoidable fixed expenses 265 150 115 Profit contribution to common space And other unavoidable costs 215 50 165 Common space and other unavoidable costs 180 - 180 Operating income 35 50 (15)  The preceding analysis shows that groceries bring in contribution margin of L.E. 200,000, which is L.E.50,000 more than the L.E. 150,000 fixed expenses that would be saved by closing the grocery department. So the matters would be worse, rather than better, if groceries were. dropped and vacated facilities left idle. Assumptions 1. The only alternatives to be considered are dropping or continuing the grocery department. 2. The total assets invested would be unaffected by the decision. The vacated space would be idle, and the unavoidable costs would continue. Assume that the space made available by the dropping of groceries could be used to expand the general merchandise department, and this would increase sales by L.E. 500.000, and have avoidable fixed costs of L.E. 70.000.  Effects of Changes Total Before Drop Expand General Total After Change Groceries Merchandise (c) Changes (a) (b) (a)–(b)+(c) L.E. L.E. L.E. Sales 1,900 1,000 500 1,400 Variable expenses 1,420 800 350 970 Contribution margin 480 200 150 430 Avoidable fixed expenses 265 150 70 185 Contribution to common space And other unavoidable costs 215 50 80 245 Common space and other unavoidable costs 180 - - 180 Operating income 35 50 80 65  Profit Contribution of Given Space Expansion of General Groceries Merchandise Difference L.E. L.E. Sales 1,000 500 500 Variable expenses 800 350 450 Contribution margin 200 150 50 Avoidable fixed expenses 150 70 80 contribution to common space and other unavoidable costs 50 80 30 Example: Deleting a Segment National Ltd is a wholesaler who sells its products to a wide range of retailers. Marketing is done through three geographical areas: the south, The Midlands and the North. The estimates of the costs and revenues for each sales territory for the next accounting period are as follows:  ( In thousands) South Midlands North Total Sales L.E. L.E. L.E. L.E. L.E. L.E. L.E. 800 900 900 2,600 Cost of goods Sold (variable) 400 450 500 1,350 Gross profit 400 450 400 1,250 Selling costs: Sales men's Salaries 80 100 120 Sales office & management 40 60 80 Expenses Advertising 50 50 50 Salesmen‘s expenses 50 60 80 220 270 330 Head quarters Administration Expenses 80 90 90 Warehousing Costs 30 36 36 Total costs 330 396 456 1182 Net profit (or loss) 70 54 (56) 68  The products are packed and dispatched from a central warehouse and it is estimated that 50% of the warehousing costs are variable and the remainder are fixed. All of the selling costs are fixed with the exception of salesmen's expenses, which are variable with sales revenue. All of the administration expenses of the head – quarters are common and unavoidable to all alternatives and have been apportioned to sales territories on the basis of sales value. In view of the loss, should the North area be closed?  Solution L.E. Sales revenue 900,000 Variable Costs: Cost of goods Sold 500,000 Salesmen‘s expenses 80,000 Warehousing Costs 18,000 598,000 Contribution Margin 302,000 Avoidable costs (fixed selling expenses) 250,000 Operating income 52,000 Note that the fixed selling expenses are relevant to the decision because they will be eliminated if the North area is closed.  You can see from this calculation that profit will decline by L.E. 52,000 if the North area is closed because the company will lose a contribution of L.E 52,000 toward the unavoidable fixed costs (the administration and warehousing fixed costs). Whenever a segment of a business can provide a contribution toward meeting common and unavoidable (general) fixed costs it should not be closed or dropped, always assuming that facilities have no alternative use which would yield a height contribution, and that the sales in other segments are unaffected by the decision. The projected income statement if the North area is closed is as follows :  South Midlands Total Sales L.E. L.E. L.E. L.E. L.E. 800 900 1,700 Less: Variable Costs Cost of goods Sold 400 450 Salesmen‘s expenses 50 60 Warehousing Costs 15 18 465 528 993 Contribution Margin 335 372 707 Less: Avoidable Fixed Costs Sales men's Salaries 80 100 Sales office & management expenses 40 60 Advertising 50 50 170 210 380 Segment Margin 165 162 327 Less: Unavoidable Fixed Costs Administration Expenses (260) Warehousing Costs (51) Net profit (or loss) 16 Total profit is reduced by L.E. 52,000. Note Note that some fixed costs ( for example, fixed selling expenses) may change when a particular alternative is being considered and can become relevant costs. It can be stated, however, as a general rule that common and unavoidable fixed costs which are allocated to cost objectives on the basis of apportionments are not relevant for decision – making purposes.  Objective 4 Compute a Measure of Product Profitability when Production is Constrained by a Scarce Resource.  Optimal Use of Limited Resources The contribution approach also applies here, because the product to be emphasized or the orders to be accepted is the one that makes the biggest total profit contribution per unit of the Limiting factor. A Limiting Factor or Scarce Resource Is the item that restricts or constraints the production or sale of a product or service.  Limiting factors include labor-hours and machine-hours that limit production and hence sales in manufacturing firms, and square feet of floor space or cubic meters of display space that Limit sales in department stores. The contribution approach must be used wisely, however, Managers sometimes mistakenly favor those products with the biggest contribution margin or gross margin per sales pounds, without regard to scarce resources.  Optimal Use of Limited Resources A B C L.E. L.E. L.E. Sales price 100 50 10 Per unit variable cost 60 25 7 Per unit contribution margin 40 25 3 Ranking 1 2 3 CM% 40% 50% 30% Ranking 2 1 3 Hours needed to produce one unit 8 2 ½ C M per hour 5 12.5 6 Ranking 3 1 2 Demand 5000 20,000 80,000 Hours needed 40,000 40,000 40,000 Total 120,000 Hours available 100,000  Optimal Allocation Hours used Balance Product B (20,000 × 2) 40,000 60,000 Product C (80,000 × ½ ) 40,000 60,000 Product A (20,000 /8)= 20,000 - 2,500 Total Contribution Margin Optimal mix Q Per unit CM Total CM A 2,500 40 100,000 B 20,000 25 500,000 C 80,000 3 240,000 840,000 Wrong allocation based on per unit CM Mix Q Per unit CM Total CM A 5,000 40 200,000 B 20,000 25 500,000 C 40,000 3 120,000 820,000 Wrong allocation based on CM% Mix Q Per unit CM Total CM B 20,000 25 500,000 A 5,000 40 200,000 C 40,000 3 120,000 820,000  Difficulties may arise in applying this procedure when there is more than one scarce resource. It could not be applied if, for example, Labor hours were also scarce and the contribution per labor hour resulted in product Y being ranked first, followed by products X and Z. In this type of situation where more than one resource is scarce it is necessary to resort to linear programming methods in order to determine the optimal production program.