Accounting Principles 8th Edition

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Preview of Chapter 21
Financial and Managerial Accounting Weygandt
Kimmel Kieso
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Management Functions
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Management Hierarchy
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Decisions are broadly taken at 3 levels

• Strategic decisions big choices of identity /
  direction.
• WHO / WHAT / WHERE Who are we? Where are
  we heading?
• Complex and multi-dimensional. Often large
  dollars, a long-term impact
• made by senior management.
• Tactical decisions manage resources to achieve
  strategy.
• HOW What is needed? Time-frame?
  Distinctive, within clearer
• boundaries. May involve significant
  resources, made by senior or middle
• managers.
• Operational decisions routine and follow known
  rules.
• DO IT How many? To what specification?
  These decisions involve
• more limited resources, shorter-term
  application, made by middle or first
• line managers.

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Types of Decision Making

• Programmed Decisions routine, automatic
  process.
• There are rules or guidelines to follow.
• Ex Deciding to reorder office supplies.
• Non-programmed Decisions unusual situations
  that
• have not been often addressed.
• No rules to follow since the decision is new.
• These decisions are made based on data, info, and
  
• mangers intuition, and judgment.
• Ex Should the firm invest in a new technology?

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The Proces of Making (rational) Decisions
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Incremental Analysis Approach

• Decisions involve a choice among alternative
  actions.
• Process used to identify the financial data that
  change under alternative courses of action.
• Both costs and revenues may vary or
• Only revenues may vary or
• Only costs may vary

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Important concepts - incremental analysis

• Relevant cost
• Revenues or Costs that DIFFER between options
• Option 1 Buy a Honda Civic with a GPS
  20,500
• Option 2 Buy Honda Civic without GPS
  21,000
• Relevant cost is the 500 for a GPS

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Important concepts - incremental analysis

• Opportunity cost.
• Potential benefit lost when you choose one thing
  over another the next best choice.
• Opportunity costs of going away to college
  full-time - include
• wages that could have been earned,
  the value of any
  activities missed to study,
  value of items that you could have
  bought with tuition money.

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Important concepts - incremental analysis

• Sunk Costs.
• Cost that cannot be changed or avoided by any
  present or future choice.
• Money spent on a non-refundable deposit.
• Concert tickets already bought for this weekend.

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Types of Incremental Analysis

1. Accept an order at a special price.

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Accept an Order at a Special Price

• Obtain additional business by making a major
  price concession to a specific customer.
• Assumes that sales of products in other markets
  are not affected by special order.
• Assumes company is not operating at full capacity.

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Accept an Order at a Special Price

• Ex Company makes 100,000 a blenders per month
  (80 cap.)
• Variable manufacturing costs 8 per unit.
• Fixed mfg costs are 400,000, 4 per unit.
• Blenders normally sell to retailers 20 each.
• New customer wants an additional 2,000 blenders
  at 11 each. (Acceptance will not affect other
  sales of product).
• What should you do? What data is relevant?

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Accept an Order at a Special Price

• Fixed costs do not change since within existing
  capacity thus fixed costs are not relevant.
• Variable manufacturing costs and expected
  revenues change thus both are relevant to the
  decision.

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• You make a product that sells for 42.
• Your costs are 28 per unit (18 variable
  10 fixed)
• Foreign company offers to buy 5,000 units at 25
  ea.
• You will incur additional shipping costs of 1
  per unit.
• Assuming you have excess operating capacity.
  Should you accept or reject this special order?

Accept or Reject?
Accept or Reject?
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Types of Incremental Analysis

1. Accept an order at a special price.
2. Make or buy parts or finished products.

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Make or Buy (Outsource or not)

• Ex Your annual costs to make 25,000 switches
  are

Should you outsource (buy) the switches at 8
ea. What should you do?
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Make or Buy

• Total cost to make switch is 1 higher per unit
  than buy price.
• Must absorb at least 50,000 of fixed costs under
  either option.

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Make or Buy Opportunity Cost
Ex If you buy the switches, you can use the
released capacity to generate additional income
of 38,000 by making a different product. So
what ? This lost income is an additional
cost of making switches.
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Review Question

• In a make-or-buy decision, relevant costs are

a. Manufacturing costs that will be saved. b.
The purchase price of the units. c.
Opportunity costs. d. All of the above.
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• Should you make or buy plug-in cords for
  appliances you make.
• Your costs of making 166,000 the cords are as
  follows.
• Direct materials 90,000 Variable overhead
  32,000
• Direct labor 20,000 Fixed overhead .
  24,000
• Make cords cost per unit 1.00 ea.
  (166,000 166,000)
• Buy cords cost per unit 0.90 ea.
• Buying cords, eliminates all variable costs and
  1/4 of the fixed costs.
• Prepare an analysis of whether company should
  make or buy the cords.
• What if the released capacity will generate
  additional income of 5,000?

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(a) Prepare an incremental analysis showing
whether the company should make or buy the
electrical cords.
You will incur 1,400 of added costs buying vs
making cords.
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(b) Is your answer be different if the released
capacity will generate additional income of
5,000?
Yes, net income is increased by 3,600 buying vs
making cords.
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Types of Incremental Analysis

1. Accept an order at a special price.
2. Make or buy component parts or finished products.
3. Sell or process further.

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Sell or Process Further

• You have option to sell product at a given point
  in production or to process further and sell at a
  higher price.
• Decision Rule
  Process further as long as
  the incremental revenue from processing exceeds
  the incremental processing costs.

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Sell or Process Further Single Product

• Ex You make tables. Your cost to make an
  unfinished table is 35. The selling price
  per unfinished unit is 50.
• You have unused capacity that can be used to
  finish the tables and sell them at 60 per unit.
  Process further
• Direct materials will increase 2
• Direct labor costs will increase 4.
• Variable overhead will increase ?? 2.40
  (60 of direct labor).
• No increase is anticipated in fixed overhead.

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Sell or Process Further Single Product
The incremental analysis on a per unit basis is
as follows.
Should Woodmasters sell or process further.
Should you sell or process further?
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Sell or Process Further Multiple Products
Joint product situation for DairyCo. Cream and
skim milk result from the processing of raw milk.
Joint product costs are sunk costs and thus not
relevant to the sell-or-process further decision.
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Sell or Process Further Multiple Products
Cost and revenue data per day for cream.
Determine whether DairyCo should just sell the
cream or process it further into cottage cheese.
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Sell or Process Further - Multiple Products
Analysis of whether to sell cream or process into
cottage cheese.
Marais should or should not process the cream
further?
DairyCo should or should not process the
cream further?
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Sell or Process Further Multiple Products
Cost and revenue data per day for skim milk.
Determine whether DairyCo should sell the skim
milk or process it further into condensed milk.
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Sell or Process Further Multiple Products
Analysis of whether to sell skim milk or process
into condensed milk.
Marais should or should not process the milk
further?
Marais should or should not process the milk
further?
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Review Question

• The decision rule is a sell-or-process-further
  decision
• Process further as long as the incremental
  revenue from processing exceeds

a. Incremental processing costs. b. Variable
processing costs. c. Fixed processing costs. d.
No correct answer is given.
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Types of Incremental Analysis

1. Accept an order at a special price.
2. Make or buy component parts or finished products.
3. Sell or process further them further
4. Repair, retain, or replace equipment.

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Repair, Retain, or Replace Equipment

• Decision Replace old machine with new. Old
  machine originally cost 110,000. Book value is
  40,000. It has a remaining useful life of four
  years (_at_ depreciation rate of 70,000 per year).
• New machine costs 120,000.
• Expected salvage value after 4-year useful life
  is zero.
• New machine will decrease variable mfg costs from
  640,000 to 500,000
• The old machine can be sold for 5,000.

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Repair, Retain, or Replace Equipment

• Additional Considerations
• Book value of old machine does not affect
  decision. (Book Value calculation Asset Cost
  - Accumulated Depreciation)
• Book value is a sunk cost.
• Costs which cannot be changed by future decisions
  (sunk cost) are not relevant in incremental
  analysis.
• However, any trade-in allowance or cash disposal
  value of the existing asset is relevant.

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Repair, Retain, or Replace Equipment
Prepare the incremental analysis for the
four-year period.
REPLACE Machine
KEEP Machine
Retain or Replace?
Retain or Replace?
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Types of Incremental Analysis

1. Accept an order at a special price.
2. Make or buy component parts or finished products.
3. Sell or process further them further
4. Repair, retain, or replace equipment.
5. Eliminate unprofitable business segment or
   product(s).

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Eliminate an Unprofitable Segment

• Key Focus on Relevant Costs.
• Consider effect on related product lines.
• Fixed costs allocated to the unprofitable segment
  must be absorbed by the other segments.
• Net income may decrease when an unprofitable
  segment is eliminated.
• Decision Rule Retain the segment unless fixed
  costs eliminated exceed contribution margin lost.

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Eliminate an Unprofitable Segment

• Illustration Company makes 3 models of tennis
  rackets
• Profitable lines Pro and Master
• Unprofitable line Champ

Should Champ be eliminated?
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Eliminate an Unprofitable Segment

• Prepare income data after eliminating Champ
  product line. Assume fixed costs are allocated
  2/3 to Pro and 1/3 to Master.

Total income is changed by 10,000.
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Eliminate an Unprofitable Segment

• Incremental analysis of Champ provided the same
  results
• Do Not Eliminate Champ

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Review Question

• If an unprofitable segment is eliminated

a. Net income will always increase. b. Variable
expenses of the eliminated segment will have to
be absorbed by other segments. c. Fixed
expenses allocated to the eliminated segment will
have to be absorbed by other segments. d. Net
income will always decrease.
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Company makes accessories including hats and
scarves. Sales of hats scarves
400,000,
Variable expenses 310,000,

Fixed expenses 120,000,

for a net loss 30,000. If company
eliminates hats and scarves, 20,000 of fixed
costs will remain. Should company eliminate
hats and scarves.
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Other Considerations in Decision-Making
Qualitative (vs Quantitative) Factors

• Potential effects of decision on existing
  employees and the community.
• Cost of lost morale that might result.
• Cost of (potentially) lost sales.