Decision Making with Relevant Costs and Strategic Analysis: A Few Insights When you complete your study

of material in this section, you should be able to: . Explain and illustrate the following terms: - book value - differential cost - incremental cost - opportunity cost - outlay costs (out-of-pocket costs) - relevant costs (or relevant revenues) - sunk costs Consider the strategic issues that are part of the decision context. Analyze the relevant costs in a special order decision. Analyze the relevant costs in a make, lease or buy decision. Sell before or after additional processing. Keep or Drop a product line. Determine the most profitable product (products) to produce given scarce resources. Explain why costs that are not relevant in the short run may be important in the longer term.

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Decision Making Process First, what are the strategic issues surrounding the decision? Is the short-term impact aligned with our long-term strategy? Second, what criteria have been specified by management to guide the decision process? Third, have a relevant and strategic cost analysis been conducted? Fourth, have we selected and implemented the BEST course of action?

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Fifth, do we have an evaluation plan in place? Relevance, Costs, and the Decision Process Firms are trying to allocate limited resources. Money is not the only limited resource Management time and talent are often problem areas. This may be the most critical resource in many situations.

Accounting information helps us understand the consequences of various allocation decisions. It helps us answer questions such as: Am I going to make more or less than before? Which costs are likely to change if I do this?

Financial accounting data does not, by itself, provide enough information to make the decision. Information related to a decision is relevant. Other information does not matter for a particular decision. What information is relevant depends on the decision. A decision to buy a new machine requires different information than a decision to outsource production of the product. A decision to attend a public school like North Texas versus a private school like Wesleyan is influenced by not only tuition and fees but also convenience and faculty accessibility (class size).

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A decision to take financial or managerial accounting is not influenced by the fees. They are the same. It is influenced by the subject matter, the prerequisites, your interests, and requirements.

Relevant Costs for Management Decisions

Almost all problems in this area will contain some irrelevant information. But this is not unusual because in real life managers are bombarded with a large amount of irrelevant information. You must act as a "data filter," sifting through the information to determine what should be included and what can be excluded. The first step is to identify the relevant costs: Relevant costs include: 1. future, differential cash outflows and inflows 2. opportunity costs: Irrelevant costs include: 1. future, nondifferential cash outflows and inflows 2. sunk costs 3. allocated common or indirect costs. Differential costs change based on a course of action. Incremental costs or revenues are measures of the amount of change. If I drive 200 miles my gasoline cost changes. My insurance premium doesn't change. However, if I convert my truck into a commercial vehicle and haul freight my insurance premium does change and becomes relevant for that decision.

A major problem is to measure all of the potential costs that might exist. Making a modification in a basic product may involve more

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than just a change in materials or direct labor. + There are design costs, different equipment requirements, and a variety of other activities.

You need to understand the activities that must take place in the new environment.

Typically for special purpose decisions we focus on variable or fixed costs. This may not identify effects on activities that cause costs if don't do analysis well.

Opportunity costs are difficult to measure and quantify. You must develop an understanding of the concept of opportunity cost.

Importance to decision maker More precise information gets the most weight in most decision models. Should we give this information more weight? Often we overanalyze easy decisions because numbers are more readily available.

Data is relevant only if it affects the future.

Special Orders -- This situation usually involves a potential sale to a customer at a price lower than normal. Most special order problems are set up as a "one-time" deal.

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Basic decision criterion: 1) Determine if you have the "capacity" to accept the special order. 2) If the special order has to be produced, then all variable manufacturing costs will be relevant. (If the units have already been produced, the production costs are sunk costs, therefore irrelevant.) 3) Determine if all or part of the normal selling costs might be avoided on the special order. If so, then the avoidable selling costs are irrelevant to your decision to accept the special order. Other considerations: 1) If the special order is "ongoing" then fixed costs may need to be considered. There are also strategic implications. What might they be? 2) If you expand capacity to accept the special order, additional fixed production costs will have to be added to the total production costs. 3) Are your regular customers affected by accepting the special order? If you are unable to service your regular customers because of accepting the special order, then the lost revenue from regular customers becomes an opportunity cost. This opportunity cost must be added in to the costs of producing the special order. Example 1: Direct materials Direct labor Variable manufacturing support Fixed manufacturing support Total manufacturing costs Markup (50%) Targeted selling price $33 15 24 52 124 62 $186

Axle and Wheel Manufacturing has excess capacity.

What is the full cost of the product per unit?

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What is the contribution margin per unit?

Which costs are relevant for making the decision regarding this one-time-only special order? Why?

For Axle and Wheel Manufacturing, what is the minimum acceptable price of this one-time-only special order?

When, if ever, might Axle and Wheel consider selling below the minimum acceptable price?

For this one-time-only special order, should Axle and Wheel Manufacturing consider a price of $100 per unit? Why or why not?

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Example 2 Cochran Corporation has a plant capacity of 100,000 units per month. Unit costs at capacity are: Direct materials $4.00 Direct labor 6.00 Variable overhead 3.00 Fixed overhead 1.00 Marketing - fixed 7.00 Marketing/distribution - variable3.60 Current monthly sales are 95,000 units at $30.00 each. Suzie, Inc., has contacted Cochran Corporation about purchasing 2,000 units at $24.00 each. Current sales would not be affected by the onetime-only special order. What is Cochrans change in operating profits if the one-time-only special order is accepted?

What if Suzie, Inc., wishes to buy 7,000 units from Cochran for $24.00 each?

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Sunk Cost A sunk cost is a cost incurred in past. You can't change these costs. You spend $2,000 on a new motor for your car. You then ruin the engine and must decide whether to sell the car or buy a new motor. The fact that you spend $2,000 last week for a motor should not affect your decision about what to do now.

.Make or Buy decisions The auto industry is trying to make more use of outside suppliers. They can produce the product cheaper and often make better products. Peterbilt makes the gas tanks and the fifth wheels at their assembly facility in Denton, Texas. They buy everything else that goes into the trucks. They make these two items because of the desire to have absolute control of the quality. If one of these items fails on the road, Peterbilt has a major legal problem.

. .

The relevant cost of the buy alternative is the purchase price of the item(s). The relevant costs of the make alternative are: 1) the variable production costs, 2) any avoidable fixed production costs, (Since this decision has long-run effects, some of the fixed manufacturing costs are typically relevant because they can be avoided if the company does not manufacture the product.) and

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3)

any opportunity costs. (The opportunity cost of making the product is the value of the best alternative use for the resources committed.) Opportunity costs are often found in make or buy problems. If a company does not manufacture a part or product, that productive space usually has one or more alternative uses.

There are also qualitative factors that may impact the make or buy decision. For example, the continuing availability and/or dependence on a supplier should be considered. The quality of a suppliers goods/services must equal to or be better than what a company produces. Remember the customer equates the name on the product with the quality of the product. If something inside a product doesnt work, the customer usually doesnt investigate to determine if that part of the product was outsourced. What happens to employees/the community if we outsource? What about the long-term contract price of the part if we outsource?

Example 1: Quiett Truck manufactures part WB23 used in several of its truck models. 10,000 units are produced each year with production costs as follows: Direct materials Direct manufacturing labor Variable support costs Fixed support costs Total costs $ 45,000 15,000 35,000 25,000 $120,000

Quiett Truck has the option of purchasing part WB23 from an outside supplier at $11.20 per unit. If WB23 is outsourced, 40% of the fixed costs cannot be immediately converted to other uses.

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a. Describe avoidable costs. What amount of the WB23 production costs is avoidable?

b. Should Quiett Truck outsource WB23? Why or why not?

c. What other items should Quiett Truck consider before outsourcing any of the parts it currently manufactures?

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Example 2: Southwestern Company needs 1,000 motors in its manufacture of automobiles. It can buy the motors from Jinx Motors for $1,250 each. Southwesterns plant can manufacture the motors for the following costs per unit: Direct materials Direct manufacturing labor Variable manufacturing overhead Fixed manufacturing overhead Total $ 500 250 200 350 $1,300

If Southwestern buys the motors from Jinx, 70% of the fixed manufacturing overhead applied will not be avoided.

Should the company make or buy the motors?

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What additional factors should Southwestern consider in deciding whether or not to make or buy the motors?

Sell at Split-off Point or Process Further If incremental revenue is greater than incremental cost, then process further; otherwise, sell at the split-off point. Leonard Manufacturing Company produces products A, B, C and D through a joint process. The joint costs amount to $100,000. Units Produced 1,500 2,500 2,000 3,000 Sales Value at Split-off __ $10,000 30,000 20,000 40,000 If processed further Additional Sales Costs Value $2,500 $3,000 $4,000 $6,000 $15,000 $35,000 $25,000 $45,000

Product A B C D

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Product Mix: Best use of limited resources -- Two or more limited resources requires the use of linear programming to determine the optimal production mix. However, for our purposes we are considering the case in which there is only one limiting resource. The main question is how best to allocate the limited resource among the different products in order to maximize profit. The main decision criterion for best use of limited resource is to determine which product has the highest contribution per unit of scarce resource used to make it. Example 1: Nortons Mufflers manufactures three different product lines, Model X, Model Y, and Model Z. Considerable market demand exists for all models. The following per unit data apply: Model X Model Y Model Z Selling price $80 $90 $100 Direct materials 30 30 30 Direct labor ($10 per hour) 15 15 20 Variable support costs ($5/mh) 5 10 10 Fixed support costs 20 20 20 For each model, compute the contribution margin per unit.

For each model, compute the contribution margin per machinehour.

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If there is excess capacity, which model is the most profitable to produce? Why?

If there is a machine breakdown or a constraint on the number of machine hours available, which model is the most profitable to produce? Why?

How can Norton encourage her sales people to promote the more profitable model?

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Dropping or Adding a Product Basic rule of thumb: Compare the contribution margin that will be lost against the costs that can be avoided if the line is dropped (REMEMBER: ALLOCATED FIXED COSTS CANNOT BE AVOIDED, UNLESS THE FIXED ASSET GIVING RISE TO THE ALLOCATION IS SOLD OR DISPOSED OF.) If the fixed costs that can be avoided are less than the contribution lost, then do not drop the product line. Look at this in reverse for the decision to add a product line. Example 1: Hackerott Camera is considering eliminating Model AE1 from its camera line because of losses over the past quarter. The past three months of information for model AE1 is summarized below. Sales (1,000 units) Manufacturing costs: Direct materials Direct labor ($15 per hour) Support Operating loss $250,000 140,000 30,000 100,000 ($20,000)

Support costs are 70% variable and the remaining 30% is depreciation of special equipment for model AE1 that has no resale value. Should Hackerott Camera eliminate Model AE1 from its product line? Why or why not?

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The management accountant for the Chocolate Smore Company has prepared the following income statement for the most current year.
Chocolate Sales $40,000 Cost of goods sold 26,000 Contribution margin 14,000 Delivery & ordering costs* 2,000 Rent (per sq. foot used)* 3,000 Allocated corporate costs 5,000 Corporate profit $4,000 * Denotes variable cost Other Candy $25,000 15,000 10,000 3,000 3,000 5,000 $(1,000) Fudge $35,000 19,000 16,000 2,000 2,000 5,000 $7,000 Total $100,000 60,000 40,000 7,000 8,000 15,000 $10,000

Do you recommend discontinuing the Other Candy product line? Why or why not?

If the Chocolate product line had been discontinued, corporate profits for the current year would have decreased by what amount?