Introduction to Management Accounting PDF

Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-1 Introduction to Management Accounting Chapter 6 Relevant Information for Decision Making with a Focus on Operational Decisions Copyright © 2011 Pearson Education, In...

Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-1 Introduction to Management Accounting Chapter 6 Relevant Information for Decision Making with a Focus on Operational Decisions Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-2  Chapter 6 Learning Objectives When you have finished studying this chapter, you should be able to: 1. Use a differential analysis to examine income effects across alternatives and show that an opportunity-cost analysis yields identical results. 2. Decide whether to make or to buy certain parts or products. 3. Choose whether to add or delete a product line using relevant information. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-3  Chapter 6 Learning Objectives 4. Compute the optimal product mix when production is constrained by a scarce resource. 5. Decide whether to process a joint product beyond the split-off point. 6. Decide whether to keep or replace equipment. 7. Identify irrelevant and misspecified costs. 8. Discuss how performance measures can affect decision making. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-4  Learning Opportunity, Outlay, and Objective 1 Differential Costs Differential cost is the difference in total cost between two alternatives. Differential revenue is the difference in total revenue between two alternatives. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-5  Learning Opportunity, Outlay, and Objective 1 Differential Costs Incremental costs are additional costs or reduced benefits generated by the proposed alternative. Incremental benefits are the additional revenues or reduced costs generated by the proposed alternative. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-6 Opportunity, Outlay, and Differential Costs An incremental analysis is an analysis of the additional costs and benefits of a proposed alternative. An opportunity cost is the maximum available contribution to profit forgone (or passed up) by using limited resources for a particular purpose. An outlay cost requires a cash disbursement. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-7  Opportunity, Outlay, and Differential Costs Nantucket Nectars has a machine for which it paid $100,000 and it is sitting idle. Nantucket Nectars has three alternatives: 1. Increase production of Peach juice 2. Sell the machine 3. Produce a new drink Papaya Mango Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-8  Opportunity Costs Introducing Papaya Mango entails two types of costs, outlay costs and opportunity costs. Outlay costs include costs for items such as materials and labor. Opportunity cost is the maximum available benefit forgone (or passed up) by using such a resource for a particular purpose instead of the best alternative use. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6-9  Opportunity Cost Peach Juice Contribution margin is $60,000. Sell machine for $50,000. Produce Papaya Mango juice with projected sales of $500,000. Suppose Nantucket Nectars will have total sales over the life cycle of Papaya Mango 100% Juice of $500,000. The production and marketing costs (outlay costs), excluding the cost of the machine, are $400,000. What is the net financial benefit from producing the Papaya Mango? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 10  Opportunity Cost Revenues $500,000 Costs: Outlay costs 400,000 Financial benefit before opportunity costs $100,000 Opportunity cost of machine 60,000 Net financial benefit $ 40,000 Nantucket Nectars will gain $40,000 more financial benefit using the machine to make Papaya Mango than it would make using it for the next most profitable alternative. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 11  Learning Objective 2 Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 12  Make-or-Buy Decisions Nantucket Nectars Company’s Cost of Making 12-ounce Bottles Direct material $ 60,000 $.06 Direct labor 20,000.02 Variable factory overhead 40,000.04 Fixed factory overhead 80,000.08 Total costs $200,000 $.20 Another manufacturer offers to sell Nantucket Nectars the bottles for $.18. Should Nantucket Nectars make or buy the bottles? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 13  Make-or-Buy Example Perhaps Nantucket Nectars will eliminate $50,000 of fixed costs if the company buys the bottles instead of making them. For example, the company may be able to release a supervisor with a $50,000 salary. If the company buys the bottles, $50,000 of fixed overhead would be eliminated. Should Nantucket make or buy the bottles? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 14  Relevant Cost Comparison *Note that unavoidable fixed costs of $80,000 – $50,000 = $30,000 are irrelevant. Thus, the irrelevant costs per unit are $.08 – $.05 = $.03. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 15 Make or Buy and the Use of Facilities Suppose Nantucket can use the released facilities in other manufacturing activities to produce a contribution to profits of $55,000, or can rent them out for $25,000. What are the alternatives? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 16  Make or Buy and the Use of Facilities Buy and Buy and use leave Buy and facilities facilities rent out for other (000) Make idle facilities products Rent revenue $ — $ — $ 25 $ — Contribution from other products — — — 55 Variable cost of bottles (170) (180) (180) (180) Net relevant costs $(170) $(180) $(155) $(125) Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 17  Learning Deletion or Addition of Products, Objective 3 Services, or Departments Often, existing businesses will want to expand or contract their operations to improve profitability. Decisions about whether to add or to drop products or whether to add or to drop departments will use the same analysis: examining all the relevant costs and revenues. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 18 Avoidable and Unavoidable Costs Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Unavoidable costs are costs that continue even if an operation is halted. Common costs are costs of facilities and services that are shared by users. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 19  Department Store Example Consider a discount department store that has three major departments: Groceries General merchandise Drugs Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 20  Department Store Example Departments Generral ($000) Total Groceries Mdse. Drugs Sales $1,900 $1,000 $800 $100 Variable exp. 1,420 800 560 60 Contribution margin $ 480 (25%) $ 200 (20%) $240 (30%) $ 40 (40%) Fixed expenses: Avoidable $ 265 $ 150 $100 $ 15 Unavoidable 180 60 100 20 Total fixed exp. $ 445 $ 210 $200 $ 35 Operating income$ 35 $ (10) $ 40 $ 5 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 21  Department Store Example Assume that the only alternatives to be considered are dropping or continuing the grocery department, which has consistently shown an operating loss. Assume further that the total assets invested would be unaffected by the decision. The vacated space would be idle and the unavoidable costs would continue. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 22  Department Store Example Total Effect of Total Before Dropping After Store as a Whole ($000) Change Groceries Change 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 Unavoidable expenses 180 0 180 Operating income $ 35 $ 50 $ (15) Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 23  Department Store Example Assume that the store could use the space made available by the dropping of groceries to expand the general merchandise department. This will increase sales by $500,000, generate a 30% contribution-margin, and have avoidable fixed costs of $70,000. $80,000 – $50,000 = $30,000 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 24  Department Store Example Total Expand Total Before Drop General After Store as a Whole ($000) Change Groceries Merchandise Change 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 Profit contribution to common space and other unavoidable costs$ 215 $ 50 $80 $245 Unavoidable expenses 180 0 0 180 Operating income $ 35 $ 50 $80 $ 65 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 25  Learning Objective 4 Optimal Use of Limited Resources A limiting factor or scarce resource restricts or constrains 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. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 26  Optimal Use of Limited Resources Nike produces the Air Court tennis shoe and the Air Max running shoe. Assume that one factory is the only facility that produces the shoes, and Nike managers must decide how many shoes of each type to produce. Machine time is the measure of capacity in this factory, and there is a maximum of 10,000 hours of machine time. The factory can produce 10 pairs of Air Court shoes or 5 pairs of Air Max shoes in 1 hour of machine time. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 27 Optimal Use of Limited Resources Which is more profitable? If the limiting factor is demand, that is, pairs of shoes, the more profitable product is Air Max. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 28  Optimal Use of Limited Resources Air Max is the product with the higher contribution per unit. The sale of a pair of Air Court shoes adds $20 to profit. The sale of a pair of Air Max shoes adds $36 to profit. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 29 Optimal Use of Limited Resources Suppose that demand for either shoe would fill the plant’s capacity. Now, capacity is the limiting factor. Which is more profitable? If the limiting factor is capacity, the more profitable product is Air Court. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 30 Optimal Use of Limited Resources Air Court Contribution margin per pair × 10,000 hours = $2,000,000 contribution Air Max: Contribution margin per pair × 10,000 hours = $1,800,000 contribution Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 31  Optimal Use of Limited Resources In retail stores, the limiting factor is often floor space. The focus is on products taking up less space or on using the space for shorter periods of time. Retail stores seek faster inventory turnover (the number of times the average inventory is sold per year). Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 32  Optimal Use of Limited Resources Faster inventory turnover makes the same product a more profitable use of space in a discount store. Regular Discount Department Department Store Store Retail Price $4.00 $3.50 Costs of Merchandise and other variable costs 3.00 3.00 Contribution to profit per unit $1.00 (25%) $.50 (14%) Units sold per year 10,000 22,000 Total contribution to profit, assuming the same space allotment in both stores $10,000 11,000 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 33  Learning Objective 5 Joint Product Costs Joint products have relatively significant sales values. They are not separately identifiable as individual products until their split-off point. The split-off point is that juncture of manufacturing where the joint products become individually identifiable. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 34  Joint Product Costs Separable costs are any costs beyond the split-off point. Joint costs are the costs of manufacturing joint products before the split-off point. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 35  Joint Product Costs Suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process. The joint processing cost is $100,000. Both products are sold to the petroleum industry to be used as ingredients of gasoline. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 36  Joint Product Costs 1 million liters of X at a selling price of $.09 = $90,000 500,000 liters of Y at a selling price of $.06 = $30,000 Total sales value at split-off is $120,000 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 37 Illustration of Sell or Process Further Suppose the 500,000 liters of Y can be processed further and sold to the plastics industry as product YA. The additional processing cost would be $.08 per liter for manufacturing and distribution, a total of $40,000. The net sales price of YA would be $.16 per liter, a total of $80,000. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 38  Illustration of Sell or Process Further Sell at Process Split-off Further and as Y Sell as YA Difference Revenues $30,000 $80,000 $50,000 Separable costs beyond split-off @ $.08 – 40,000 40,000 Income effects $30,000 $40,000 $10,000 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 39  Learning Objective 6 Equipment Replacement The book value of equipment is not a relevant consideration in deciding whether to replace the equipment. Because it is a past, not a future cost. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 40  Book Value of Old Equipment Depreciation is the periodic allocation of the cost of equipment. The equipment’s book value (or net book value) is the original cost less accumulated depreciation. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 41  Book Value of Old Equipment Suppose a $10,000 machine with a 10-year life span has depreciation of $1,000 per year. What is the book value at the end of 6 years? Original cost $10,000 Accumulated depreciation (6 × $1,000) 6,000 Book value $ 4,000 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 42 Keep or Replace the Old Machine? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 43  Relevance of Equipment Data A sunk cost is a cost already incurred and is irrelevant to the decision-making process. Book value of old equipment Disposal value of old equipment Gain or loss on disposal Cost of new equipment Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 44  Relevance of Equipment Data The book value of old equipment is irrelevant because it is a past (historical) cost. Therefore, depreciation on old equipment is irrelevant. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 45 Disposal Value of Old Equipment The disposal value of old equipment is relevant because it is an expected future inflow that usually differs among alternatives. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 46  Gain or Loss on Disposal This is the difference between book value and disposal value. It is a meaningless combination of irrelevant (book value) and relevant items (disposal value). It is best to think of each separately. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 47  Cost of New Equipment The cost of new equipment is relevant because it is an expected future outflow that will differ among alternatives. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 48  Cost Comparison Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 49  Learning Objective 7 Irrelevant or Misspecified Costs The ability to recognize irrelevant costs is important to decision makers. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 50  Irrelevant or Misspecified Costs Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. The original manufacturing cost of these parts was $100,000. General Dynamics can remachine the parts for $30,000 and then sell them for $50,000, or scrap them for $5,000. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 51  Irrelevant or Misspecified Costs Remachine Scrap Difference Expected future revenue $ 50,000 $ 5,000 $45,000 Expected future costs 30,000 0 30,000 Relevant excess of revenue over costs $ 20,000 $ 5,000 $15,000 Accumulated historical inventory cost* 100,000 100,000 0 Net loss on project $(80,000) $ (95,000) $15,000 * Irrelevant because it is unaffected by the decision. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 52 Irrelevant or Misspecified Costs There are two major ways to go wrong when using unit costs in decision making: 1. including irrelevant costs 2. comparing unit costs not computed on the same volume basis Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 53  Irrelevant or Misspecified Costs Assume that a new $100,000 machine with a five-year life can produce 100,000 units a year at a variable cost of $1 per unit, as opposed to a variable cost per unit of $1.50 with an old machine. Is the new machine a worthwhile acquisition? Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 54  Irrelevant or Misspecified Costs Old Machine New Machine Units 100,000 100,000 Variable cost $150,000 $100,000 Straight-line depreciation 0 20,000 Total relevant costs $ 45,000 $120,000 Unit relevant costs $ 1.50 $ 1.20 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 55  Irrelevant or Misspecified Costs It appears that the new machine will reduce costs by $.30 per unit. However, if the expected volume is only 30,000 units per year, the unit costs change in favor of the old machine. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 56  Irrelevant or Misspecified Costs Old Machine New Machine Units 30,000 30,000 Variable costs $45,000 $30,000 Straight-line depreciation 0 20,000 Total relevant costs $45,000 $50,000 Unit relevant costs $1.50 $1.6667 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 57  Learning Decision Making and Performance Objective 8 Evaluation To motivate managers to make the right choice, the method used to evaluate performance should be consistent with the decision model. Consider the replacement decision where replacing a machine has a $2,500 advantage over keeping it. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 58  Decision Making and Performance Evaluation Year 1 Years 2, 3, and 4 Keep Replace Keep Replace Cash operating costs $5,000 $3,000 $5,000 $3,000 Depreciation 1,000 2,000 1,000 2,000 Loss on disposal ($4,000 – $2,500) 0 $1,500 0 0 Total charges against revenue $6,000 $6,500 $6,000 $5,000 Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 59 Decision Making and Performance Evaluation Performance is often measured by accounting income, consider the accounting income in the first year after replacement compared with that in years 2, 3, and 4. If the machine is kept rather than replaced, first-year costs will be $500 lower ($6,500 – $6,000), and first-year income will be $500 higher. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 60 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America. Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 6 - 61