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lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Direct materials, direct labor, and shipping are excluded because Baxter Baery’s exisng cost system can direct. At Baxter Baery, the following distribuon of resource consumpon across acvity cost pools...
lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Direct materials, direct labor, and shipping are excluded because Baxter Baery’s exisng cost system can direct. At Baxter Baery, the following distribuon of resource consumpon across acvity cost pools is determined. Indirect factory wages Percent consumed by costumer orders $ 6.000.000,00 30% $ 1.800.000,00 Factory equipment $ depreciaon 3.500.000,00 Percent consumed by costumer orders 20% $ 700.000,00 Learning Objecve 3: Compute acvity rates for cost pools CALCULATE ACTIVITY RATES 30 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi The ABC team determines that Baxter Baery will have these total acvies for each acvity cost pool: – 10,000 customer orders – 4,000 design changes – 800,000 machine-hours – 2,000 customers served Now the team can compute the individual acvity rates by dividing the total cost for each acvity by the total acvity levels. These are organizaon-sustaining costs and will not be assigned to products or customers. Learning Objecve 4: Assign costs to a cost object using a second-stage allocaon ASSIGNING OVERHEAD TO PRODUCTS SureStart LongLife 1. Requires no new design resources 2. 800,000 baeries ordered with 4,000 separate orders 1. Requires new design resources 2. 400,000 baeries ordered with 6,000 separate orders 3. Each SureStart requires 36 minutes of machine me for a total of 480,000 machine-hours 3. 4,000 custom designs prepared 4. Each LongLife requires 48 minutes of machine me for a total of 320,000 machine-hours DIFFERENTIAL ANALYSIS: THE KEY TO DECISION MAKING 31 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Learning Objecve 1 – Idenfy relevant and irrelevant costs and benets in a decision DECISION MAKING – SIX KEY CONCEPTS Key Concept 1: Every decision involves choosing from among at least two alternaves. Therefore, the rst step in decision-making is to dene the alternaves being considered Key Concept 2: Once you have dened the alternaves, you need to idenfy the criteria for choosing among them Relevant costs and relevant benets should be considered when making decisions Irrelevant costs and irrelevant benets should be ignored when making decisions Key Concepts 3: The key to eecve decision making is dierenal analysis— focusing on the future costs and benets that dier between the alternaves. Everything else is irrelevant and should be ignored A future cost that diers between any two alternaves is known as a dierenal cost Future revenue that diers between any two alternaves is known as dierenal revenue An incremental cost is an increase in cost between two alternaves An avoidable cost is a cost that can be eliminated by choosing one alternave over another Key Concept 4: Sunk costs are always irrelevant when choosing among alternaves A sunk cost is a cost that has already been incurred and cannot be changed regardless of what a manager decides to do Key Concept 5: Future costs and benets that do not dier between alternaves are irrelevant to the decisionmaking process Key Concept 6: Opportunity costs also need to be considered when making decisions An opportunity cost is the potenal benet that is given up when one alternave is selected over another IDENTIFYING RELEVANT COSTS – AN EXAMPLE Cynthia, a Boston student, is considering vising her friend in New York. She can drive or take the train. By car, it is 230 miles to her friend’s apartment. She is trying to decide which alternave is less expensive and has gathered the following informaon. IDENTIFYING RELEVANT COSTS Which costs and benets are relevant in 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 if she drives or takes the train However, the cost of gasoline is clearly relevant if she decides to drive. If she takes the train, she will avoid the cost of the gasoline, so the cost diers between the alternave The cost of maintenance and repairs is relevant. In the long run, these costs depend upon miles driven The monthly school parking fee is not relevant because it must be paid if Cynthia drives or takes the train The decline in resale value due to addional miles is a relevant cost The round-trip train fare is clearly relevant. If she drives the cost can be avoided 32 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Relaxing on the train is relevant even though it is dicult to assign a dollar value to the benet The kennel cost is not relevant because Cynthia will incur the cost if she drives or takes the train The cost of parking in New York is relevant because it can be avoided if she takes the train The benets of having a car in New York and the problems of nding a parking space are both relevant but are dicult to assign a dollar amount From a nancial standpoint, Cynthia would be beer o taking the train to visit her friend. Some of the non-nancial factors may inuence her nal decision. TOTAL AND DIFFERENTIAL COST APPROACHES TOTAL COST APPROACH The management of a company is considering a new labor saving machine that rents for $3,000 per year. Data about the company’s annual sales and costs with and without the new machine are: DIFFERENTIAL COST APPROACH As you can see, the only costs that dier between the alternaves are the direct labor costs savings and the increase in xed rental costs. Using the dierenal approach is desirable for two reasons: 1. Only rarely will enough informaon be available to prepare detailed income statements for both alternaves. 2. Mingling irrelevant costs with relevant costs may cause confusion and distract aenon away from the informaon that is really crical. Learning Objecve 2: Prepare an analysis showing whether a product line or other business segment should be added or dropped 33 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi ADDING/DROPPING SEGMENTS One of the most important decisions managers make is whether to add or drop a business segment. Ulmately, a decision to drop an old segment or add a new one is going to hinge primarily on its nancial impact. To assess this impact, it is necessary to carefully analyze the costs. Due to the declining popularity of digital watches, Lovell Company’s digital watch line has not reported a prot for several years. Lovell is considering whether to keep this product line or drop it. DECISION RULE Lovell should drop the digital watch segment only if its prot would increase. Lovell will compare the contribuon margin that would be lost if the digital watch line was disconnued to x expenses that would be avoided if the line was disconnued. An invesgaon has revealed that the xed general factory overhead and xed general administrave expenses will not be aected by dropping the digital watch line. The xed general factory overhead and general administrave expenses assigned to this product would be reallocated to other product lines. The equipment used to manufacture digital watched has no resale value or alternave use. Should Lovell retain or drop the digital watch segment. A CONTRIBUTION MARGIN APPROACH SOLUTION COMPARATIVE INCOME APPROACH The Lovell soluon can also be obtained by preparing comparave income statements showing results with and without the digital watch segment. Let’s look at this second approach. The contribuon margin, if we drop a product line or business line, is gone, so we need to make sure that we idened the contribuon margin, not the gross margin since the gross margin include the xed cost that maybe are not avoidable, so we have to use a contribuon margin approach (Chapter 4). Once we have idened the contribuon margin that is loss, one by one we have to look at the xed costs with the intent to separate, one by 34 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi one, the ones that are eliminable and the ones that are not eliminable, and only the ones that are eliminable are relevant. Is it convenient to drop the segment? Absolutely not, because this means that the company will lose $40,000 in terms of operang prot (if the company drops a segment, it loses what the segment is generang). At the beginning the queson was: does the company wants to drop the product line because apparently this product line is losing? Apparently, it is losing from an external accounng like point of view since it shows a loss, but from a managerial point of view this loss is not there because ethe loss is computed considering items that are not eliminable. This is a representaon that considers all the costs incurred by the company; when the manager of the company makes the decision for the future, it only considers the relevant pieces of informaon. So, will this company connue to report losses and sll be kept? Yes, because otherwise its operang prot will even be lower than this. BEWARE OF ALLOCATED FIXED COSTS Be aware that allocated xed costs can distort the keep/drop decision. Lovell’s managers may ask: Why should we keep the digital watch segment when it’s showing a $100,000 loss? The answer lies in the way we allocate common xed costs to our products. Including unavoidable common xed costs makes the product line appear to be unprotable, when in fact dropping the product line would decrease the company’s overall net operang income. Learning Objecve 3: Idenfy the relevant costs and benets associated with sourcing decisions SOURCING DECISIONS Sourcing decision means deciding whether to do something internally or buy it externally, and this decision is related to the type of acvity: if it is not a core acvity it is beer to let somebody else do it. But at some point, the cost of outsourcing could rise such that the company could decide to do that acvity internally, and go insourcing, so it is 35 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi also a maer of volume/size of acvity. When a company is involved in more than one acvity in the enre value chain, it is vercally integrated. A decision to carry out one of the acvies in the value chain internally, rather than to buy externally from a supplier is called a “make or buy” decision. VERTICAL INTEGRATION ADVANTAGES DISADVANTAGES Companies may fail to take advantage of suppliers who can create economies of scale advantage by pooling demand from numerous companies. While the economics of scale factor can be appealing, a company must be careful to retain control over acvies that are essenal to maintaining its compeve posion. SOURCING DECISIONS – AN EXAMPLE Essex Company manufactures part 4A that is used in one of its products. The unit product cost of this part is: Direct materials Direct labor Variable overhead Depreciaon of special equipment Supervisor's salary General factory overhead Unit product cost $ $ $ $ $ $ $ 9,00 5,00 1,00 3,00 2,00 10,00 30,00 This is an absorpon cost: it includes all the variable components + a poron of the xed components, which xed components? Some depreciaon of the special equipment that is specic to this product and some general factory overhead that is not specic to this product (it is always manufacturing but more general manufacturing). So, the responsible of this product line sees the unit product cost, which is $30. – The special equipment used to manufacture part 4A has no resale value (special equipment cannot be resold). – The total amount of general factory overhead, which is allocated on the basis of direct labor hours, would be unaected by this decision. – The $30 unit product cost is based on 20,000 parts produced each year (it is very important that we understand the concept of absorpon cosng, because when we look at the absorpon cost per unit we incorporate a volume assumpon, which is the 20,000 volume assumpon). – An outside supplier has oered to provide the 20,000 parts at a cost of $25 per part. Should the company stop making part 4A and buy it from an outside supplier? 36 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Financial advantage of making part 4A $160,000 We cannot make the decision basing only on the two costs ($25 and $30), but we need to set up a framework. First of all, never use the per unit data since they are misleading, we need to use the total data (volume + per unit data). The avoidable costs associated with making part 4A include direct materials, direct labor, variable overhead, and the supervisor’s salary. The cost incurred to buy the equipment is a sunk cost; the depreciaon simply spreads this sunk cost over the equipment’s useful life. The allocated general factory overhead represents allocated costs common to all items produced in the factory and would connue unchanged. Thus, it is irrelevant to the decision. Should we make or buy part 4A? Given that the total avoidable costs are less than the cost of buying the part, Essex should connue to make the part. OPPORTUNITY COST Opportunity costs are not actual cash outlays and are not recorded in the formal accounts of an organizaon. An opportunity cost is the benet that is foregone as a result of pursuing some course of acon. If the space to make Part 4A had an alternave use, the opportunity cost would have been equal to the segment margin that could have been derived from the best alternave use of the space. Learning Objecve 4: Prepare an analysis showing whether a special order should be accepted SPECIAL ORDERS A special order is a one-me order that is not considered part of the company’s normal ongoing business. When analyzing a special order, only the incremental costs and benets are relevant. Since the exisng xed manufacturing overhead costs would not be aected by the order, they are not relevant. – Jet Inc. makes a single product whose normal selling price is $20 per unit. – A foreign distributor oers to purchase 3,000 units for $10 per unit. – This is a one-me order that would not aect 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 oer? 37 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi If Jet accepts the special order, the incremental revenue will exceed the incremental costs. In other words, net operang income will increase by $6,000. This suggests that Jet should accept the order. Increase in revenue ($3,000 x $10) Increase in costs (3,000 x $8 variable cost) Financial advantage of accepng the order $ $ $ 30.000,00 24.000,00 6.000,00 Note: This answer assumes that the xed costs are unavoidable and that variable markeng costs must be incurred on the special order. Learning Objecve 5: Determine the most protable use of a constrained resource VOLUME TRADE-OFF DECISIONS Companies are forced to make volume trade-o decisions when they do not have enough capacity to produce all of the products and sales volumes demanded by their customers. – In these situaons, companies must trade o, or sacrice producon of some products in favor of others in an eort to maximize prots KEY TERMS AND CONCEPTS When a limited resource of some type restricts the company’s ability to sasfy demand, the company is said to have a constraint. The machine or process that is liming overall output is called the boleneck – it is the constraint. UTILIZATION OF A CONSTRAINED RESOURCE Fixed costs are usually unaected in these situaons, so the product mix that maximizes the company’s total contribuon margin should ordinarily be selected. A company should not necessarily promote those products that have the highest unit contribuon margins. Rather, total contribuon margin will be maximized by promong those products or accepng those orders that provide the highest contribuon margin in relaon to the constraining resource. UTILIZATION OF A CONSTRAINED RESOURCE – AN EXAMPLE Ensign Company produces two products and selected data are shown below: 38 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounng | Marna Marazzi Machine A1 is the constrained resource and is being used at 100% of its capacity. There is excess capacity on all other machines. Machine A1 has a capacity of 2,400 minutes per week. Should Ensign focus its eorts on Product 1 or Product 2? 39 Downloaded by Chiara Davoli ([email protected])
