Managerial Accounting Chapter 12: Relevant Costs for Decision Making PDF

CHAPTER 12: Relevant Costs for Decision Making Prepared by Ruth Ann Strickland, CPA Western University © 2024 McGraw Hill Limited  Learning Objectives 1 1. Distinguish...

CHAPTER 12: Relevant Costs for Decision Making Prepared by Ruth Ann Strickland, CPA Western University © 2024 McGraw Hill Limited  Learning Objectives 1 1. Distinguish between relevant and irrelevant costs in decision making. 2. Prepare analyses for various decision situations. 3. Determine the most profitable use of a constrained resource and the value of obtaining more of the constrained resource. © 2024 McGraw Hill Limited 12-2  Learning Objectives 2 4. (Appendix 12A) Compute selling prices based on costs using the absorption and variable costing approaches. 5. (Appendix 12A) Understand how customers’ sensitivity to changes in pricing should influence pricing decisions. 6. (Appendix 12A) Analyze pricing decisions using value-based pricing. 7. (Appendix 12A) Compute target costs based on selling prices. © 2024 McGraw Hill Limited 12-3 Identifying Relevant Costs and Benefits A relevant cost is a cost that differs between alternatives. An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs; Unavoidable costs are irrelevant costs. Two broad categories of costs that are never relevant in any decision are: Sunk costs. Future costs that do not differ between the alternatives. © 2024 McGraw Hill Limited 12-4 Relevant Cost Analysis: A Two-Step Process To identify the costs and benefits that are relevant in a particular decision situation, these steps should be followed: 1. Eliminate costs and benefits that do not differ between alternatives. 2. Use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable, costs. © 2024 McGraw Hill Limited 12-5 Different Costs for Different Purposes Costs that are relevant in one decision situation may not be relevant in another context. © 2024 McGraw Hill Limited 12-6 Identifying Relevant Costs 1 Cynthia, an MBA student in Halifax, is considering visiting her friend in Moncton over the weekend. She needs to decide whether to drive or to take the train. By car, it is 280 kilometers to her friend’s apartment. Which alternative is least expensive? Automobile Costs (based on 16,000 kilometers driven per year) Annual Cost per Fixed Costs Kilometer 1 Annual straight-line depreciation on car $ 2,800 $ 0.175 2 Cost of gasoline 0.180 3 Annual cost of auto insurance and license 2,000 0.125 4 Maintenance and repairs 0.050 5 Parking fees at school 360 0.023 6 Tires ($600 to replace all 4 tires every 50,000 km) 0.012 Total average cost per kilometer $ 0.565 $1.80 litre ÷ 10 km per litre $24,000 cost – $10,000 salvage value ÷ 5 years $45 per month x 8 months © 2024 McGraw Hill Limited 12-7 Identifying Relevant Costs 2 Automobile Costs (based on 16,000 kilometers driven per year) Annual Cost per Cost of Kilometer 1 Annual straight-line depreciation on car $ 2,800 $ 0.175 2 Cost of gasoline 0.180 3 Annual cost of auto insurance and license 2,000 0.125 4 Maintenance and repairs 0.050 5 Parking fees at school ($45 per month x 8 months) 360 0.023 6 Tires ($600 for 4 tires every 50,000 km) 0.012 Total average cost $ 0.565 Additional Information 7 Round-tip train fare $ 140 8 Benefits of relaxing on train trip ???? 9 Cost of putting dog in kennel while gone $ 80 10 Benefit of having car in Moncton ???? 11 Hassle of parking car in Moncton ???? 12 Cost per day for parking car in Moncton $ 35 13 Environmental impact of driving vs. taking the train ???? © 2024 McGraw Hill Limited 12-8 Identifying Relevant Costs 3 are relevant in Which costs and benefits Cynthia’s decision? The cost of the car is a sunk cost and is not relevant to the current decision. The annual cost of insurance is not relevant. It will remain the same whether she drives or takes the train. However, the cost of gasoline is relevant if she decides to drive. If she takes the train, the cost would not be incurred, so it varies depending on the decision. © 2024 McGraw Hill Limited 12-9 Identifying Relevant Costs 4are relevant to Which costs and benefits Cynthia’s decision (continued)? The cost of car maintenance and repairs is relevant. These costs depend upon the number of kilometers driven. The monthly school parking fee is not relevant because it must be paid whether Cynthia drives or takes the train. © 2024 McGraw Hill Limited 12-10 Identifying Relevant Costs 5 are relevant to Which costs and benefits Cynthia’s decision (continued)? The round-trip train fare is relevant. If she drives the cost can be avoided. Relaxing on the train is relevant even though it is impossible to assign a dollar value to the benefit. The kennel cost for the dog is not relevant because Cynthia will incur the cost whether she drives or takes the train. © 2024 McGraw Hill Limited 12-11 Identifying Relevant Costs 6 are relevant to Which costs and benefits Cynthia’s decision (continued)? The cost of parking is relevant because it can be avoided if she takes the train. The benefits of having a car in Moncton and the problems of finding a parking space are both relevant but are impossible to assign a dollar amount. © 2024 McGraw Hill Limited 12-12 Identifying Relevant Costs 7 Cynthia would be From a financial standpoint, better off taking the train to visit her friend. Some of the non-financial factors may influence her final decision. Relevant Financial Cost of Driving Gasoline (280 km x 2 x $0.18 per km) $ 100.80 Maintenance (280 km x 2 x $0.050 per km) 28.00 Tires (280 km x 2 x $0.012 per km) 6.72 Parking in Moncton (2 days @ $35 per day) 70.00 Total $ 205.52 Relevant Financial Cost of Taking the Train Round-trip ticket $ 140.00 © 2024 McGraw Hill Limited 12-13 Total and Differential Cost Approaches 1 The management of a company is considering renting a new labour-saving machine for $3,000 per year. Data about the company’s annual sales and costs with and without the new machine are: Situation Differential Current With New Costs and Situation Machine Benefits Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 - Less variable expenses: Direct materials (5,000 units @ $14 per unit) 70,000 70,000 - Direct labour (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000 Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 - Total variable expenses 120,000 105,000 - Contribution margin 80,000 95,000 15,000 Less fixed expense: Other 62,000 62,000 - Rent on new machine - 3,000 (3,000) Total fixed expenses 62,000 65,000 (3,000) Operating income $ 18,000 $ 30,000 12,000 © 2024 McGraw Hill Limited 12-14 Total and Differential Cost Approaches 2 The only costs that differ between the alternatives are the direct labour costs savings and the increase in fixed rental costs. Situation Differential Current With New Costs and Situation Machine Benefits Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 - Less variable expenses: Direct materials (5,000 units @ $14 per unit) 70,000 70,000 - Direct labour (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000 Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 - Total variable expenses 120,000 105,000 - The decision can be efficiently analyzed Contribution margin 80,000 95,000 15,000 Less fixed expense: by considering only the differential costs Other 62,000 62,000 - to arrive at the same conclusion. Rent on new machine Total fixed expenses - 62,000 3,000 65,000 (3,000) (3,000) Operating income Net Advantage to Renting the New Machine $ 18,000 $ 30,000 12,000 Decrease in direct labour cost (5,000 units @ $3 per unit) $ 15,000 Increase in fixed rental expenses (3,000) Net annual cost saving from renting the new machine $ 12,000 © 2024 McGraw Hill Limited 12-15 Total and Differential Cost Approaches 3 Using the differential approach is desirable for two reasons: 1.Only rarely will enough information be available to prepare detailed income statements for both alternatives. 2.Blending irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical. © 2024 McGraw Hill Limited 12-16 Adding/Dropping Segments 1 One of the most important decisions managers make is whether to add or drop a business segment, such as a product or a store. Differential revenues and costs should be used in this type of decision. © 2024 McGraw Hill Limited 12-17 Adding/Dropping Segments 2 Due to the declining popularity of digital watches, Lovell Company’s digital watch line has not reported a profit for several years. Lovell is considering discontinuing this product line. © 2024 McGraw Hill Limited 12-18  A Contribution Margin Approach - Decision Rule Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin. © 2024 McGraw Hill Limited 12-19 Adding/Dropping Segments 3 Statement Segment Income Digital Watches Sales $ 500,000 Less: variable expenses Variable manufacturing costs $ 120,000 Variable shipping costs 5,000 Commissions 75,000 200,000 Contribution margin $ 300,000 Less: fixed expenses General factory overhead $ 60,000 Salary of line manager 90,000 Depreciation of equipment 50,000 Advertising – direct 100,000 Rent – factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss $ (100,000) © 2024 McGraw Hill Limited 12-20 Adding/Dropping Segments 4 Segment Income Statement Digital Watches Sales $ 500,000 Less: variable expenses Total fixed Variable general manufacturing factory costs overhead and $ 120,000 general Variable administrative shipping costs expenses 5,000 would not be Commissions affected if the digital watch75,000 200,000 line is dropped. Contribution margin $ 300,000 The fixed general Less: fixed expenses factory overhead and general administrative General factory overhead expenses $ 60,000 assigned to this product Salary would be reallocated of line manager 90,000 to other Depreciation of equipment product lines. 50,000 Advertising – direct 100,000 Rent – factory space 70,000 General admin. expenses 30,000 400,000 Net operating loss $ (100,000) © 2024 McGraw Hill Limited 12-21 Adding/Dropping Segments Digital5 Segment Income Statement Watches Sales $ 500,000 Less: variable expenses Variable manufacturing costs $ 120,000 The Variable equipment used to manufacture shipping costs 5,000 digital Commissionswatches has no resale 75,000 200,000 valuemargin Contribution or alternative use. $ 300,000 Less: fixed expenses General factory overhead $ 60,000 Salary of line manager 90,000 Depreciation of equipment 50,000 Advertising – direct Should Lovell retain or drop 100,000 Rent – factory spacethe digital watch 70,000 segment? General admin. expenses 30,000 400,000 Net operating loss $ (100,000) © 2024 McGraw Hill Limited 12-22  A Contribution Margin Approach Contribution Margin Solution Contribution margin lost if digital watches are dropped $ (300,000) Less fixed costs that can be avoided Salary of the line manager $ 90,000 Advertising – direct 100,000 Rent – factory space 70,000 260,000 Net disadvantage $ (40,000) © 2024 McGraw Hill Limited 12-23 A Comparative Format The Lovell solution can also be obtained by preparing comparative income statements showing results with and without the digital watch segment. © 2024 McGraw Hill Limited 12-24  Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales $ 500,000 $ - $ (500,000) Less variable expenses: - Manufacturing expenses 120,000 - 120,000 Shipping 5,000 - 5,000 Commissions 75,000 - 75,000 Total variable expenses 200,000 - 200,000 Contribution margin 300,000 - (300,000) Less fixed expenses: General factory overhead 60,000 Salary of line manager 90,000 Depreciation 50,000 If the digital Advertising – direct 100,000 watch line is Rent – factory space 70,000 General admin. expenses 30,000 dropped, the Total fixed expenses 400,000 company gives Net operating loss $ (100,000) up its contribution © 2024 McGraw Hill Limited margin. 12-25  Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales $ 500,000 $ - $ (500,000) Less variable expenses: - Manufacturing expenses 120,000 - 120,000 Shipping 5,000 - 5,000 Commissions 75,000 - 75,000 Total variable expenses 200,000 - 200,000 Contribution margin 300,000 - (300,000) Less fixed expenses: General factory overhead 60,000 60,000 - Salary of line manager 90,000 Depreciation 50,000 Advertising – direct 100,000 Rent – factory space The 70,000general factory General admin. expenses overhead 30,000 would be the Total fixed expenses same, 400,000so this cost is not Net operating loss $ (100,000) relevant. © 2024 McGraw Hill Limited 12-26  Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales $ 500,000 $ - $ (500,000) Less variable expenses: - The Manufacturing expenses product line 120,000 manager - 120,000 Shipping would no 5,000 longer be - 5,000 Commissions 75,000 - 75,000 Total variable expenses needed. 200,000 - 200,000 Contribution margin 300,000 - (300,000) Less fixed expenses: General factory overhead 60,000 60,000 - Salary of line manager 90,000 - 90,000 Depreciation 50,000 Advertising – direct 100,000 Rent – factory space 70,000 General admin. expenses 30,000 Total fixed expenses 400,000 Net operating loss $ (100,000) © 2024 McGraw Hill Limited 12-27  Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales $ 500,000 $ - $ (500,000) If the digital watch line is dropped, the net Less variable expenses: - Manufacturing expenses 120,000 120,000 - book value of the equipment would be written Shipping 5,000 5,000 - off. The depreciation that would have been Commissions 75,000 75,000 - Total variable expenses 200,000 200,000 - taken will flow through the income statement Contribution margin 300,000 (300,000) - as a loss instead. Less fixed expenses: General factory overhead 60,000 - 60,000 Salary of line manager 90,000 - 90,000 Depreciation 50,000 50,000 - Advertising – direct 100,000 Rent – factory space 70,000 General admin. expenses 30,000 Total fixed expenses 400,000 Net operating loss $ (100,000) © 2024 McGraw Hill Limited 12-28  Comparative Income Approach Solution Keep Drop Digital Digital Watches Watches Difference Sales $ 500,000 $ - $ (500,000) Less variable expenses: - Manufacturing expenses 120,000 - 120,000 Shipping 5,000 - 5,000 Commissions 75,000 - 75,000 Total variable expenses 200,000 - 200,000 Contribution margin 300,000 - (300,000) Less fixed expenses: General factory overhead 60,000 60,000 - Salary of line manager 90,000 - 90,000 Depreciation 50,000 50,000 - Advertising – direct 100,000 - 100,000 Rent – factory space 70,000 - 70,000 General admin. expenses 30,000 30,000 - Total fixed expenses 400,000 140,000 260,000 Net operating loss $ (100,000) $ (140,000) $ (40,000) © 2024 McGraw Hill Limited 12-29 Beware of Allocated Fixed Why should theCosts digital watch segment be kept when it’s showing a $100,000 loss? The answer lies in the way common fixed costs are allocated to products. Allocations can make a segment look less profitable than it really is. If the segment is dropped, those common fixed costs will need to be transferred to other segments. The company loses all the contribution margin but does not save all the costs. © 2024 McGraw Hill Limited 12-30 The Make or Buy Decision When a company is involved in more than one activity in the entire value chain, it is vertically integrated. A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier is called a ‘make or buy’ decision. © 2024 McGraw Hill Limited 12-31 Strategic Aspects of the Make or Buy Decision Advantages of making Smoother flow of parts and materials Better quality control Realize higher profits Disadvantage of making Companies may fail to take advantage of suppliers who can create economies of scale by pooling demand from numerous © 2024 McGraw Hill Limited 12-32 An Example of Make or Buy Essex Company manufactures Part 4A that is used in one of its products. The unit product cost to make this part is: Direct materials $ 9 Direct labour 5 Variable overhead 1 Depreciation of special equip. 3 Supervisor's salary 2 General factory overhead 10 Unit product cost $ 30 © 2024 McGraw Hill Limited 12-33 The Make or Buy Decision 1 The special equipment used to manufacture Part 4A has no resale value. The total amount of general factory overhead, which is allocated on the basis of direct labour hours, would be unaffected by this decision. The $30 unit product cost is based on 20,000 parts produced each year. An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part. Should the supplier’s offer be accepted? © 2024 McGraw Hill Limited 12-34 The Make or Buy Decision 2 Cost Per Unit Cost for 20,000 Units Make Buy Outside purchase price $ 25 $ 500,000 Direct materials $ 9 180,000 Direct labour 5 100,000 Variable overhead 1 20,000 Depreciation of equip. 3 - Supervisor's salary 2 40,000 General factory overhead 10 - Total cost $ 30 $ 340,000 $ 500,000 20,000 × $9 per unit = $180,000 © 2024 McGraw Hill Limited 12-35 The Make or Buy Decision 3 Cost Per Unit Cost for 20,000 Units Make Buy Outside purchase price $ 25 $ 500,000 Direct materials $ 9 180,000 Direct labour 5 100,000 Variable overhead 1 20,000 Depreciation of equip. 3 - Supervisor's salary 2 40,000 General factory overhead 10 - Total cost $ 30 $ 340,000 $ 500,000 The special equipment has no resale value. It is a sunk cost. © 2024 McGraw Hill Limited 12-36 The Make or Buy Decision 4 Cost Per Unit Cost for 20,000 Units Make Buy Outside purchase price $ 25 $ 500,000 Direct materials $ 9 180,000 Direct labour 5 100,000 Variable overhead 1 20,000 Depreciation of equip. 3 - Supervisor's salary 2 40,000 General factory overhead 10 - Total cost $ 30 $ 340,000 $ 500,000 General factory overhead is not avoidable, so it is irrelevant. If the product is purchased, general factory overhead will be reallocated to other 12-37 products. © 2024 McGraw Hill Limited The Make or Buy Decision 5 Cost Per Unit Cost of 20,000 Units Make Buy Outside purchase price $ 25 $ 500,000 Direct materials $ 9 180,000 Direct labour 5 100,000 Variable overhead 1 20,000 Depreciation of equip. 3 - Supervisor's salary 2 40,000 General factory overhead 10 - Total cost $ 30 $ 340,000 $ 500,000 hould the company make or buy Part 4A © 2024 McGraw Hill Limited 12-38  Opportunity Cost An opportunity cost is the benefit that is given up as a result of pursuing some course of action. Opportunity costs are not actual dollar outlays and are not recorded in the formal accounts of an organization. What opportunity costs should Essex Company consider? © 2024 McGraw Hill Limited 12-39  Special Orders 1 A special order is a one-time order that is not considered part of the company’s normal ongoing business. When analyzing a special order, only the incremental costs and benefits are relevant. © 2024 McGraw Hill Limited 12-40  Special Orders 2 Jet, Inc. makes a single product with a normal selling price of $20 per unit. A foreign distributor has offered to purchase 3,000 units for $10 per unit. This is a one-time order that would not affect the company’s regular business. Annual capacity is 10,000 units, but Jet, Inc. is currently producing and selling only 5,000 units. Should Jet accept the offer? © 2024 McGraw Hill Limited 12-41  Special Orders 3 J et, Inc. Contribution Income Statement Revenue (5,000 × $20) $ 100,000 Variable costs: Direct materials $ 20,000 Direct labour 5,000 Manufacturing overhead 10,000 Marketing costs 5,000 Total variable costs 40,000 Contribution margin $8 per unit variable cost 60,000 Fixed costs: Manufacturing overhead $ 28,000 Marketing costs 20,000 Total fixed costs 48,000 Net operating income $ 12,000 © 2024 McGraw Hill Limited 12-42  Special Orders 4 If Jet accepts the special order, the incremental revenue will exceed the incremental costs and operating income will increase by $6,000. This suggests that Jet should accept the order. Increase in revenue (3,000 × $10) $30,000 Increase in costs (3,000 × $8 variable cost) 24,000 Increase in operating income $ 6,000 This answer assumes that the fixed costs are unavoidable and that variable marketing costs must be incurred on the special order. © 2024 McGraw Hill Limited 12-43  Quick Check  Northern Optical currently makes and sells 15,000 units of its X-lens per year for $50 per unit. The company has an annual capacity to make up to 30,000 units. The variable production cost is $10 per unit and the normal variable selling cost is $1 per unit. Annual fixed production costs are $270,000 in the relevant range of 0 to 30,000 units. The company has received a special order for 10,000 units of the X-lens to be imprinted with the customer’s logo. This special order would not involve any selling costs, but Northern Optical would have to purchase an imprinting machine for $50,000. © 2024 McGraw Hill Limited 12-44  Quick Check  What is the lowest price Northern Optical should accept from the customer to ensure that it is not losing money on the sale? Assume that the imprinting machine has no further use after this order. a. $50 b. $10 c. $15 d. $29 © 2024 McGraw Hill Limited 12-45  Quick Check  What is the lowest price Northern Optical should accept from the customer to ensure that it is not losing money on the sale? Assume that the imprinting machine has no further use after this order. Answer: c. $15 Variable production cost $100,000 Additional fixed cost + 50,000 Total relevant cost $150,000 © 2024 McGraw Hill Limited 12-46  Joint Product Costs In some industries, multiple end products are produced from a single raw material input. Two or more products produced from a common input are called joint products. The point in the manufacturing process where multiple products can be produced is called the split-off point. © 2024 McGraw Hill Limited 12-47  Joint Products 1 Joint Costs Oil Common Joint Production Gasoline Input Process Chemicals Split-Off Point © 2024 McGraw Hill Limited 12-48  Joint Products 2 Joint Costs Oil Separate Final Processing Sale Common Joint Final Production Gasoline Input Sale Process Separate Final Chemicals Processing Sale Split-Off Separate Point Product Costs © 2024 McGraw Hill Limited 12-49  Joint Products 3 Exhibit 12-6 Joint Input © 2024 McGraw Hill Limited 12-50 The Pitfalls of Allocation Joint costs are often allocated to end products on the basis of the relative sales value of each product or on some other basis. Although allocation is needed for balance sheet inventory valuation, allocations of this kind should be avoided for decision making. © 2024 McGraw Hill Limited 12-51  Sell or Process Further Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward. It will always be profitable to continue processing a joint product after the split-off point if the incremental revenue exceeds the incremental processing costs incurred after the split-off point. © 2024 McGraw Hill Limited 12-52 Sell or Process Further: An Example Sawmill, Inc. cuts logs from which unfinished lumber and sawdust are the immediate joint products. Unfinished lumber can be sold ‘as is’ or processed further into finished lumber. Sawdust can also be sold ‘as is’ to gardening wholesalers or processed further into ‘presto-logs.’ © 2024 McGraw Hill Limited 12-53 Sell or Process Further 1 Data about Sawmill’s joint products: Per Unit Lumber Sawdust Sales value at the split-off point $ 140 $ 40 Sales value after further processing 270 50 Allocated joint product costs 176 24 Cost of further processing 50 20 © 2024 McGraw Hill Limited 12-54  Sell or Process Further 2 Analysis of Sell or Process Further Per Unit Lumber Sawdust Sales value after further processing $ 270 $ 50 Sales value at the split-off point 140 40 Incremental revenue 130 10 © 2024 McGraw Hill Limited 12-55 Sell or Process Further 3 Analysis of Sell or Process Further Per Unit Lumber Sawdust Sales value after further processing $ 270 $ 50 Sales value at the split-off point 140 40 Incremental revenue 130 10 Cost of further processing 50 20 Profit (loss) from further processing $ 80 $ (10) © 2024 McGraw Hill Limited 12-56 Sell or Process Further 4 Analysis of Sell or Process Further Per Log Lumber Sawdust Sales value after further processing $ 270 $ 50 Sales value at the split-off point 140 40 Incremental revenue 130 10 Cost of further processing 50 20 Profit (loss) from further processing $ 80 $ (10) Which product should be processed further? © 2024 McGraw Hill Limited 12-57 Utilization of a Constrained Resource When a limited resource of some type restricts the company’s ability to satisfy demand, the company is said to have a constraint. The theory of constraints (TOC) maintains that effectively managing a constraint is important to the financial success of an organization. The challenge is deciding how to best utilize the constrained resource to maximize the company’s profits. © 2024 McGraw Hill Limited 12-58  Contribution Margin in Relation to a aConstrained When constraint exists, a Resource company should select a product mix that maximizes the total contribution margin earned, since fixed costs usually remain unchanged. A company should not necessarily promote those products that have the highest unit contribution margin. Rather, it should promote those products that earn the highest contribution margin in relation to the constrained resource. © 2024 McGraw Hill Limited 12-59 Example: Contribution Margin in Relation to a Constrained Resource 1 Ensign Company produces two products. Selected data are shown below: Product 1 2 Selling price per unit $ 60 $ 50 Less variable expenses per unit 36 35 Contribution margin per unit $ 24 $ 15 Current demand per week (units) 2,000 2,200 Contribution margin ratio 40% 30% Processing time required on Machine A1 per unit 1.00 min. 0.50 min. © 2024 McGraw Hill Limited 12-60 Example: Contribution Margin in Relation to a Constrained Resource 2 Machine A1 is the constrained resource. It is currently being used at 100% of its capacity of 2,400 minutes per week. There is excess capacity on all other machines. Should Ensign focus its efforts on Product 1 or Product 2? © 2024 McGraw Hill Limited 12-61  Quick Check  How many units of each product can be processed through Machine A1 in one minute? Product 1 Product 2 a. 1 unit 0.5 unit b. 1 unit 2.0 units c. 2 units 1.0 unit d. 2 units 0.5 unit © 2024 McGraw Hill Limited 12-62  Quick Check  How many units of each product can be processed through Machine A1 in one minute? Answer: Product 1 Product 2 b. 1 unit 2.0 units Product 1 takes 1 minute per unit. Product 2 takes 0.5 minute per unit. © 2024 McGraw Hill Limited 12-63  Quick Check  What generates more profit for the company; using one minute of Machine A1 to process Product 1 or using one minute of Machine A1 to process Product 2? a. Product 1 b. Product 2 c. They both would generate the same profit. d. Cannot be determined. © 2024 McGraw Hill Limited 12-64  Quick Check  What generates more profit for the company, using one minute of Machine A1 to process Product 1 or using one minute of Machine A1 to process Product 2? Answer: b. Product 2 One minute of machine A1, can make 1 unit of Product 1, with a contribution margin of $24, or 2 units of Product 2, each with a contribution margin of $15. 2 × $15 = $30 > $24 © 2024 McGraw Hill Limited 12-65  CM in Relation to a Constrained Resource – Example Part 1 The key is the contribution margin per unit of the constrained resource. Product 1 2 Contribution margin per unit $ 24 $ 15 Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min. Contribution margin per minute $ 24 $ 30 Product 2 should be emphasized. It provides more valuable use of the constrained resource, Machine A1, because it provides a contribution margin of $30 per minute as opposed to $24 per minute for Product 1. © 2024 McGraw Hill Limited 12-66  CM in Relation to a Constrained Resource – Example Part 2 The key is the contribution margin per unit of the constrained resource. Product 1 2 Contribution margin per unit $ 24 $ 15 Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min. Contribution margin per minute $ 24 $ 30 If there are no other considerations, the best plan is to produce enough Product 2 to meet current demand and then use any remaining capacity of Machine A1 to produce Product 1. © 2024 McGraw Hill Limited 12-67  CM in Relation to a Constrained Resource – DetermineExample Part how many units 3 be made. should Allocation Allocationof ofConstrained ConstrainedResource Resource(Machine (MachineA1) A1) Weekly Weeklydemand demandforforProduct Product22 2,200 2,200 units units Time Timerequired requiredper perunit unit × × 0.50 0.50 min. min. Total Totaltime timerequired requiredto tomake make Product Product22 1,100 1,100 min. min. © 2024 McGraw Hill Limited 12-68  CM in Relation to a Constrained Resource – Determine Example Part how many units 4be made. should Allocation Allocation of of Constrained Constrained Resource Resource (Machine (Machine A1) A1) Weekly Weekly demand demand forfor Product Product 22 2,200 2,200 units units Time Time required required per per unit unit ×× 0.50 0.50 min. min. Total Total time time required required to to make make Product Product 22 1,100 1,100 min. min. Total Total time time available available 2,400 2,400 min. min. Time Time used used to to make make Product Product 22 1,100 1,100 min. min. Time Time available available for for Product Product 11 1,300 1,300 min. min. © 2024 McGraw Hill Limited 12-69  CM in Relation to a Constrained Resource – DetermineExample Part how many units 5 be made. should Allocation Allocationof ofConstrained ConstrainedResource Resource(Machine (MachineA1) A1) Weekly Weeklydemand demandforforProduct Product22 2,200 2,200 units units Time Timerequired requiredper perunit unit ×× 0.50 0.50 min. min. Total Totaltime timerequired requiredto tomake make Product Product22 1,100 1,100 min. min. Total Totaltime timeavailable available 2,400 2,400 min. min. Time Timeused usedtotomake makeProduct Product22 1,100 1,100 min. min. Time Timeavailable availablefor forProduct Product11 1,300 1,300 min. min. Time Timerequired requiredper perunit unit ÷÷ 1.00 1.00 min. min. Production Productionof ofProduct Product11 1,300 1,300 units units © 2024 McGraw Hill Limited 12-70  CM in Relation to a Constrained Resource – Example Part 6 For maximum contribution margin, 1,300 units of Product 1 and 2,200 units of Product 2 and should be produced. Product 1 Product 2 Production and sales (units) 1,300 2,200 Contribution margin per unit $ 24 $ 15 Total contribution margin $ 31,200 $ 33,000 Ensign’s total contribution margin is $64,200. © 2024 McGraw Hill Limited 12-71  Quick Check  Colonial Heritage makes reproduction colonial furniture from select hardwoods. Chairs Tables Selling price per unit $80 $400 Variable costs per $30 $200 unit Board feet per unit 2 10 Monthly demand 600 100 The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand? a. Yes b. No © 2024 McGraw Hill Limited 12-72  Quick Check  Colonial Heritage makes reproduction colonial furniture from select hardwoods. Chairs Tables Selling price per unit $80 $400 Variable costs per unit $30 $200 Board feet per unit 2 10 Monthly demand 600 100 The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. Is this enough hardwood to satisfy demand? b. No (2 x 600) + (10 x 100) = 2,200 > 2,000 © 2024 McGraw Hill Limited 12-73  Quick Check  Chairs Tables Selling price per unit $80 $400 Variable costs per unit $30 $200 Board feet per unit 2 10 Monthly demand 600 100 The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What mix would maximize profits? a. 500 chairs and 100 tables b. 600 chairs and 80 tables c. 500 chairs and 80 tables d. 600 chairs and 100 tables © 2024 McGraw Hill Limited 12-74  Quick Check  Chairs Tables Chairs SellingTable price $ 80 $ 400 s Variable cost 30 200 Selling price per unit $80 $400 Variable costs per $30 $200margin Contribution $ 50 $ 200 unit Board feet 2 10 Board feet per unit 2 board CM per 10 foot $ 25 $ 20 Monthly demand 600 100 The company’s supplier ofofhardwood Production chairs will 600 only be able to supply 2,000 Board board feet 1,200 feet required this month. What mix would Board maximize profits? feet remaining 800 Board feet per table 10 Production of tables 80 Answer b. 600 chairs and 80 tables © 2024 McGraw Hill Limited 12-75  Quick Check  As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the proposed plan. What is the maximum amount Colonial Heritage should be willing to pay above the usual price to obtain more hardwood from another supplier? a. $40 per board foot b. $25 per board foot c. $20 per board foot d. Zero © 2024 McGraw Hill Limited 12-76  Quick Check  As before, Colonial Heritage’s supplier of hardwood will only be able to supply 2,000 board feet this month. Assume the company follows the proposed plan. What is the maximum amount Colonial Heritage should be willing to pay above the usual price to obtain more hardwood from another supplier? Answer: c. $20 per board foot The additional wood could be used to make tables. In this case, each additional board foot of wood will allow the company to earn an additional $20 of contribution margin and profit. © 2024 McGraw Hill Limited 12-77  Managing Constraints Profits can be increased by effectively managing constraints. One aspect of managing constraints is to decide how best to utilize them. Managers should focus on managing bottlenecks and finding ways to increase the capacity at the bottlenecks: Improve the process Add overtime or another shift Hire new workers or acquire more machines Subcontract production Reduce the number of defective units produced Add workers transferred from non-bottleneck departments © 2024 McGraw Hill Limited 12-78  The Problem of Multiple Constraints What if a firm has more than one constraint? How would it find the right combination of products to produce? The right combination of products or “mix” of products can be found using a quantitative method called linear programming. © 2024 McGraw Hill Limited 12-79 End of Chapter Summary 1 Relevant costs and benefits are those that will be incurred in the future and that differ among the alternatives under consideration. Sunk costs are irrelevant (incurred in the past). Avoidable, differential, and opportunity costs are all relevant. Decisions often faced by managers include: adding or dropping product lines/segments making versus buying decisions accepting or rejecting special orders selling versus processing joint products further © 2024 McGraw Hill Limited 12-80 End of Chapter Summary 2 When demand exceeds production capacity, calculating a profitability index helps a manager determine the product mix that optimizes the use of the constrained resource. In addition to focusing on relevant costs, managers often need to consider non-financial factors when making decisions. © 2024 McGraw Hill Limited 12-81  Appendix 12A Pricing Products and Services © 2024 McGraw Hill Limited 12-82  Cost-Plus Pricing The usual approach to pricing is to mark up the cost to make a product. A product’s markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost. Selling Price = Cost + (Markup percentage × Cost) Cost-Plus Pricing: A pricing method in which a predetermined markup is applied to a cost base to determine the selling price. © 2024 McGraw Hill Limited 12-83  Setting a Target Selling Price – Absorption Costing 1 Under the absorption approach to cost- plus pricing, the cost base is the absorption costing unit product cost rather than the variable cost. © 2024 McGraw Hill Limited 12-84  Setting a Target Selling Price – Absorption Costing 2 Ritter Company has provided the following information related to a new product. Per Unit Total Direct materials $ 6 Direct labour 4 Variable manufacturing overhead 3 Fixed manufacturing overhead $ 70,000 Variable S & A expenses 2 Fixed S & A expenses 60,000 Assuming Ritter will produce and sell 10,000 units of the new product, and that Ritter typically uses a 50% markup percentage, determine the unit product cost. © 2024 McGraw Hill Limited 12-85  Setting a Target Selling Price – Absorption Costing 3 Per Unit Direct materials $ 6 Direct labour 4 Variable manufacturing overhead 3 Fixed manufacturing overhead 7 Unit product cost $ 20 ($70,000 ÷10,000 units = $7 per unit) Ritter has a policy of marking up unit product costs by 50%. Calculate the target selling price. © 2024 McGraw Hill Limited 12-86  Setting a Target Selling Price – Absorption Costing 4 Ritter would establish a target selling price of $30 per unit to cover selling, general, and administrative expenses and contribute to profit. Per Unit Direct materials $ 6 Direct labour 4 Variable manufacturing overhead 3 Fixed manufacturing overhead 7 Unit product cost $ 20 50% markup 10 Target selling price $ 30 © 2024 McGraw Hill Limited 12-87  Determining the Markup Percentage 1 The markup percentage can be based on an industry norms, company tradition, or it can be explicitly calculated. The equation to calculate the markup percentage is: © 2024 McGraw Hill Limited 12-88 Determining the Markup Percentage 2 Assume that Ritter must make an investment of $100,000, and that the company plans to sell 10,000 units of product each year. The company requires a 20% ROI on all investments. Determine Ritter’s markup percentage on absorption cost. © 2024 McGraw Hill Limited 12-89  Determining the Markup Percentage 3 Markup % (20% × $100,000) + (($2 × 10,000) + $60,000)) on absorption = 10,000 × $20 cost Total fixed SG&A Variable SG&A per unit Markup % ($20,000 + $80,000) on absorption = $200,000 = 50% cost © 2024 McGraw Hill Limited 12-90  Problems with the Absorption Costing Approach 1 The absorption costing approach assumes that customers need the forecasted unit sales and will pay whatever price the company decides to charge. This is flawed logic simply because customers have a choice. © 2024 McGraw Hill Limited 12-91  Problems with the Absorption Costing Approach Assume that 2 units at Ritter sells only 7,000 $30 per unit, instead of the forecasted 10,000 units. Here is the income statement. RITTER COMPANY Income Statement For the Year Ended December 31 Sales (7,000 units × $30) $ 210,000 Cost of goods sold (7,000 units × $23) 161,000 Gross margin 49,000 SG&A expenses 74,000 Net operating loss $ (25,000) $ (25,000) ROI = = -25% $ 100,000 © 2024 McGraw Hill Limited 12-92  Problems with the Absorption Costing Approach Assume that 3 units at Ritter sells only 7,000 $30 per unit, instead of the forecasted 10,000 The absorption costing units. Here isapproach the incometo statement. pricing is a safe approach only RITTER if PANY COM customers choose Income Statement to buy at least as many units as managers For the Year Ended December 31 forecasted they would$buy. Sales (7,000 units × $30) 210,000 Cost of goods sold (7,000 units × $23) 161,000 Gross margin 49,000 SG&A expenses 74,000 Net operating loss $ (25,000) $ (25,000) ROI = = -25% $ 100,000 © 2024 McGraw Hill Limited 12-93  Setting a Target Selling Price – Variable Costing Some companies use a variable costing approach to determine the target selling price based on either variable manufacturing costs or total variable costs. The key advantages of the variable costing approach are: 1. It is consistent with cost-volume-profit analysis 2. It avoids the need to arbitrarily allocate common fixed costs to specific products © 2024 McGraw Hill Limited 12-94 Setting a Target Selling Price for Service Companies Using Time and Materials Pricing Service companies often use a time and materials pricing model in which two pricing rates are used - one based on direct labour time and the other based on direct material used. © 2024 McGraw Hill Limited 12-95  Pricing and Customer Latitude Customers generally have considerable latitude (choice) in their purchasing decisions. They can purchase a competitor’s product or allocate their spending budget to some other product altogether. This degree of choice should be taken into account when setting prices. © 2024 McGraw Hill Limited 12-96  Value-Based Pricing An alternative to cost-plus pricing is value-based pricing. Companies that use value-based pricing establish selling prices based on the economic value of the benefits that their products and services provide to customers. One approach to value-based pricing relies on a concept known as the economic value to the customer (EVC). © 2024 McGraw Hill Limited 12-97  Economic Value to the Customer A product’s economic value to the customer is the price of the customer’s best available alternative plus the value of what differentiates the product from that alternative. The price of the best available alternative is known as the reference value, whereas the value of what differentiates a product from the best available alternative is known as the differentiation value. © 2024 McGraw Hill Limited 12-98  Differentiation Value A product’s differentiation value can arise in either of two ways. First, a product may differentiate itself by enabling customers to generate more sales and contribution margin than the best available alternative. Second, a product may differentiate itself by enabling customers to realize greater cost savings than the best available alternative. © 2024 McGraw Hill Limited 12-99  EVC In equation form, the EVC is computed as follows: Economic value to customer = Reference value + Differentiation value Once the seller computes the EVC, it seeks to negotiate with the customer a value-based selling price that falls within the following range: Reference value ≤ Value-base price ≤ EVC © 2024 McGraw Hill Limited 12- 100  Target Costing Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be made for that maximum target cost figure. The equation for determining the target price is shown below: Target cost = Anticipated selling price – Desired profit © 2024 McGraw Hill Limited 12-101  Reasons for Using Target Costing 1 The target costing approach was developed in recognition of two important characteristics of markets and costs: 1. Market supply and demand determines the price people are willing to pay. 2. Most of the cost of a product is determined in the design stage. Target costing begins the product development process by recognizing and responding to existing market prices. © 2024 McGraw Hill Limited 12-102 Reasons for Using Target Costing 2 The difference between target costing and other approaches to product development is profound. Instead of designing the product, determining the cost, and setting the price, the target cost is set first and then the product is designed so that the target cost is attained. © 2024 McGraw Hill Limited 12-103  Target Costing 1 Handy Appliance feels there is a niche for a hand mixer with certain features. The Marketing Department believes that a price of $30 would be about right and that about 40,000 mixers could be sold. An investment of $2,000,000 is required to set up for production. The company requires a 15% ROI on invested funds. Determine the target cost. © 2024 McGraw Hill Limited 12-104  Target Costing 2 Projected sales (40,000 units × $30) $ 1,200,000 Desired profit ($2,000,000 × 15%) 300,000 Target cost for 40,000 mixers $ 900,000 Target cost per mixer ($900,000 ÷40,000) $ 22.50 Each functional area within Handy Appliance would be responsible for keeping the actual costs within the target established for its area. © 2024 McGraw Hill Limited 12-105