managerial accounting, chapter 10 by crosson, needles

Chapter 10

Short-RunDecision Analysis

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Short-Run Decision Analysis

• Objective 1Describe how managers make short-run decisions.


Short-Run Decision Analysis

• Managers frequently take five predictable actions when making short-run decisions.– First four actions happen during the planning stage.– Last action happens during the evaluating stage.

The systematic examination of any decision whose effects will be felt over

the course of the next year


Planning

Managers take the following four actions during the planning stage when performing short-run decision analysis: 1. Discover a problem or need.2. Identify all reasonable courses of action that can

solve the problem or meet the need.3. Prepare a thorough analysis of each possible solution, identifying its total costs, savings, other financial effects, and other qualitative factors.4. Select the best course of action.


Performing

Take advantage of opportunities that will improve profitability and liquidity in the short run.• Accept a special order.• Examine the profitability of a segment. • Contract with outside suppliers of goods and services. • Sell products as they are, or process further.

Managers must adapt to changing environments.


Evaluating

• Managers evaluate each decision to determine whether it produced the forecasted results.

• If results fall short, managers identify and prescribe corrective action.

If the solution is not satisfactory or the

problem remains, the management process

begins again.


Communicating

• Develop budgets that show estimated costs and revenues related to alternative courses of action

• Compile analyses of data that support their decisions

Managers prepare reports related to short-run decisions throughout the management process.


Stop & Review

Q. What are the five predictable actions frequently taken by managers during short-run decision analysis?

1. Discover a problem or need.2. Identify all reasonable courses of action that can

solve the problem or meet the need.3. Prepare a thorough analysis of each possible solution,

identifying its total costs, savings, other financial effects, and other qualitative factors.

4. Select the best course of action.5. Evaluate each decision to determine whether it

produced the forecasted results.

A.


Incremental Analysisfor Short-Run Decisions

• Objective 2Define incremental analysis, and explain how it applies to short-run decision making.


Also called differential analysis if it ignores revenues or costs that stay the

same or do not differ among alternatives

Incremental Analysis

A method of comparing alternatives by focusing on the differences in their

projected revenues and costs


Irrelevant Costs and Revenues

Irrelevant Cost• A cost that does

not differ between alternatives

• Includes sunk costs

Differential Cost• A cost that

changes between alternatives

• Also referred to as an incremental cost

Irrelevant Revenue• Revenue that will

not differ between alternatives


Irrelevant Costs andRevenues Illustrated

Home State Bank managers must decide to buy one of two ATM machines—C or W. The machines have the same purchase price but different revenue and cost characteristics. The company currently owns ATM B, which it bought 3 years ago for $15,000 and which has accumulated depreciation of $9,000. It is now obsolete and cannot be sold or traded in.

The accountant has collected the following annual revenue and operating cost estimates for the two new machines:


• Sunk costs– The book value of ATM B

• Represents money that was spent in the past and does not affect the decision about whether to replace the old ATM with a new one

Irrelevant Costs andRevenues Illustrated (cont’d)

ATM B would be of interest only if it could be sold or traded in.

Step 1 in incremental analysis: Eliminate any irrelevant revenues and costs.



• Recall the annual revenue and operating cost estimates for the two new machines:

The costs of direct materials and fixed overhead are the same under both alternatives.

–These are irrelevant costs and can be eliminated from the analysis.



• The incremental analysis is prepared using only the differential revenues and costs that will change between the alternative ATMs.


Incremental Analysis


Opportunity Costs

The benefits that are forfeited or lost when one alternative is chosen over another

• Using incremental analysis simplifies management’s evaluation of a decision and reduces the time needed to choose the best action.

• Determine opportunity costs.– Must consider other issues, such as quality and reputation


Opportunity Costs Illustrated

• The interest that could be earned from theproceeds of the sale is an opportunity cost forthe nursery owner.

• It is revenue the owner has chosen to foregoto continue operating the nursery in that location.

A plant nursery has been in operation for many years at the intersection of two highways. A bank has offered the owner a high price for the land.


Opportunity Costs Illustrated

• The salary the teller would lose by returning to school is an opportunity cost.

• The total cost of school includes not only tuition, books, supplies, and living expenses, but also the amount of salary foregone while the teller is a full-time student.

A bank teller is deciding whether to go back to school full time to earn a degree in finance.


Stop & Review

Q. What are opportunity costs?

A. Benefits that are given up because one course of action is taken instead of another


Incremental Analysisfor Outsourcing Decisions

• Objective 3

Perform incremental analysis for outsourcing decisions.


Make-or-Buy Decisions• Decisions about whether

to make a part internallyor buy it from an external supplier– May lead to outsourcing

Incremental Analysisfor Outsourcing Decisions

Outsourcing• The use of suppliers

outside the organization to perform services or produce goods that could be performed or produced internally


Incremental Analysisfor Outsourcing Decisions (cont’d)

Many companies focus their resources on their core competencies to• Improve operating income• Compete effectively

in global markets

Core competencies

Activities an organization performs best


Incremental Analysis for Outsourcing Decisions (cont’d)

• Organizations may outsource expensive, nonvalue-adding activities:– Payroll processing– Training– Managing fleets of vehicles– Sales and marketing– Custodial services– Information management

Many areas that are outsourced involve either relatively low skill areas or highly specialized knowledge that can be better acquired

from experts outside the company.


Incremental Analysis for Outsourcing Decisions (cont’d)

Outsourcing production or operating activities can reduce a company’s investment in physical assets and human resources and operating costs.

Improves cash flow

Improves operating income


Make-or-Buy Decisions

• Select the most profitable alternative.• Identify the costs of each alternative and their

effects on revenues and existing costs.

A common decision facing managers is whether to make or buy a part.

Goal


Make-or-Buy Decisions (cont’d)

Managers need the following information for analysis:


Make-or-BuyDecision Illustrated

For the past five years, Box Company has purchased packing cartons from an outside supplier at a cost of $1.25 per carton. The supplier has just informed Box Company that it will be raising the price to $1.50 per carton, effective immediately.

• Box Company has idle machinery that could be adjusted and used to produce packing cartons.– Annual production and usage would be 20,000 cartons.– Estimated cost of direct materials is $.84 per carton.– Workers earn $8.00 per hour and can process 20 cartons

per hour ($.40 per carton).

Should Box Company continue to outsource the cartons?


Make-or-BuyDecision Illustrated (cont’d)

– Cost of variable overhead will be $4 per direct labor hour and 1,000 direct labor hours will be required.

– Fixed overhead per year includes $4,000 of depreciation and $6,000 of other fixed costs.

– There is space to produce the cartons and the machines will remain idle if the part is purchased.



Make-or-BuyDecision Illustrated (cont’d)

• Irrelevant costs– Depreciation costs and other fixed overhead costs

• Machinery and factory space have no other use.– Costs are the same for both alternatives.

• Relevant costs and revenues– Compared for each alternative in an incremental analysis



Incremental Analysis:Outsourcing Decision

The company should make the cartons because it will save $1,200.


Stop & Review

Q. What are core competencies?

A. Core competencies are the activities an organization performs best. In other words, the company is highly competent at performing these activities. Many companies focus their resources on their core competencies to improve operating income and compete effectively in global markets. Other activities may be outsourced.


Incremental Analysisfor Special Order Decisions

• Objective 4

Perform incremental analysis for special order decisions.


Incremental Analysis for Special Order Decisions

• Decisions about whether to accept or reject special orders at prices below normal market prices– Usually involve large numbers of similar items that are sold

in bulk– Are not expected and so are not included in annual cost or

sales estimates• Are one-time events and should not be included in revenue or

cost estimates for subsequent years

• A special product order should be accepted only if it maximizes operating income.

Special Order Decisions


Approaches forSpecial Order Decisions

• Compare special order price to relevant costs to produce, package, and ship the order.– Relevant costs include:

• Variable costs• Variable selling costs, if any• Other costs directly associated with the special order

(e.g., freight, insurance, packaging, and labeling the product)

• Prepare a special order bid price.– Calculate a minimum selling price:

• Equals relevant costs plus an estimated profit


Costs to Exclude fromSpecial Order Decision Analysis

Fixed costs of existing facility• Do not change if the

company accepts the special order

Sales commission expenses• Customer may have

contacted the company directly


Costs Relevant toSpecial Order Decisions

Fixed costs that must be incurred to fill the special order:• Purchase of additional machinery• Increase in supervisory help• Increase in insurance premiums


Incremental Analysis forSpecial Order Decision Illustrated

Home State Bank has been approved to provide and service four ATMs at a special event. The event sponsors want the fee per ATM transaction reduced to $.50. Past ATM usage at special events has averaged 2,000 transactions per machine. The bank has located four idle ATMs for the event.

Based on the following cost data, should Home State Bank accept the special event offer?

Performing a special order incremental analysis will assist in the decision process.


Incremental Analysis forSpecial Order Decision Illustrated (cont’d)

Irrelevant costs:• Fixed costs

– The only costs affected by the order are direct materials, direct labor, and variable overhead.


Incremental Analysis forSpecial Order Decision Illustrated (cont’d)

Accepting the special offer will increase contribution margin, and therefore operating income, by $1,200.


Stop & Review

Q. Is the decision to accept or reject a special order based solely on the order’s effects on contribution margin?

A. No. Qualitative factors must be taken into consideration in the decision-making process, such as the impact of the special order on regular customers, the potential of the special order to lead to new sales, and the customer’s ability to maintain an ongoing relationship regarding good ordering and paying practices.


Incremental Analysis forSegment Profitability Decisions

• Objective 5

Perform incremental analysis for segment profitability decisions.



Managers must decide whether to keep or drop unprofitable segments:• Product lines• Services• Sales territories• Divisions• Departments• Stores• Outlets


Incremental Analysis forSegment Profitability Decisions (cont’d)

Objective of This AnalysisIdentify the segments that have a negative

segment margin.

• Management must select the alternative that maximizes operating income based on– The organization’s strategic plan and objectives– Relevant revenues and costs– Qualitative factors


Segment Margin

A segment’s sales revenue minus its direct costs (direct variable costs and direct fixed

costs traceable to the segment)

Such costs are assumed to be avoidable costs(they can be eliminated if the segment were dropped).


Segment Margin (cont’d)

• Drop the segment. • The remaining segments

must be able to cover the unavoidable costs (common costs that will be incurred regardless of the decision).

Positive Segment Margin Negative Segment Margin• Keep the segment.

• The segment is able to cover its own direct costs.

• The segment can contribute a portion of its revenue to cover common costs and add to operating income.



• Direct fixed costs– The fixed costs that are traceable to the segments

• Common costs– The remaining fixed costs

• Are not assigned to segments

To analyze segment profitability:• Prepare a segmented income statement (use variable

costing to identify variable and fixed costs).


Incremental analysis shows that operating income will increase by $9,000 if the Safe Deposit Division is dropped.

Once the segmented income statement has been completed, an incremental analysis can be prepared.




Incremental analysis now shows that operating income will decrease by $7,500 if the Safe Deposit Division is dropped.

Assume that Bank Operation’s sales will decrease 20 percent if management eliminates the Safe Deposit Division.


Stop & Review

Q. What is the object of incremental analysis for segment profitability decisions?

A. The object of this analysis is to identify the segments of a business that have a negative segment margin. Segment margin is equal to the segment’s sales revenue minus its direct costs. A positive segment margin means the segment is able to cover its own direct costs and contribute a portion of its revenue to cover common costs and add to operating income.


Incremental Analysisfor Sales Mix Decisions

• Objective 6

Perform incremental analysis for sales mix decisions involving constrained resources.



Resource constraints (machine time, available labor, other activities) may cause companies to

consider which products are best to offer.

Identify by calculating the contribution margin per constrained resource for each product or service.


Sales Mix Decision

• Select the alternative that maximizes the contribution margin per constrained resource based on the organization’s– Strategic plan and objectives– Relevant revenues and costs– Qualitative factors

• Use incremental analysis.



Two Steps:1. Calculate contribution margin per unit for

each product or service affected by the constrained resource:

– Equals selling price per unit less variable costs per unit

2. Calculate contribution margin per unit of the constrained resource:

– Equals contribution margin per unit divided by the quantity of the constrained resource required per unit


Incremental Analysis forSales Mix Decisions Illustrated

Home State Bank offers three types of loans: commercial loans, auto loans, and home loans. Current loan application capacity is 100,000 processing hours.

The product line data are as follows:

Question 1Which product line should be advertised and promoted initially because it is the most profitable for the bank? Which should be second? Which should be last?


Incremental Analysis forSales Mix Decisions Illustrated (cont’d)



• The analysis indicates that the loans should be sold in the following order:1. Auto loans2. Home loans3. Commercial loans

Loans that provide the highest contribution margin per processing hour should be sold first.



Home State Bank offers three types of loans: commercial loans, auto loans, and home loans. Current loan application capacity is 100,000 processing hours.

The product line data are as follows:

Commercial Loans

Auto Loans

Home Loans

Current loan application demand 20,000 30,000 18,000 Processing hours per loan application 2 1 2.5 Loan origination fee $24.00 $18.00 $32.00 Variable processing costs $12.50 $10.00 $18.75 Variable selling costs $6.50 $5.00 $6.25

Question 2How many of each type of loan should be sold to maximize the bank’s contribution margin based on current loan activity of 100,000 processing hours? What is the total contribution margin for that combination?



• Compare current loan application activity to the required loan activity to meet the current loan demand.

The current demand exceeds the current capacity by 15,000 processing hours.



• Management must determine the sales mix that maximizes the company’s contribution margin.– Will also maximize its operating income


Stop & Review

Q. Why are sales mix decisions important?

A. Sales mix decisions are important because of limited resources. Incremental analysis for sales mix decisions helps managers determine which products or services contribute the most to company profitability in relation to the amount of capital assets or other constrained resources needed to offer those items.


Incremental Analysis for Sell or Process-Further Decisions

• Objective 7

Perform incremental analysis for sell or process-further decisions.


Incremental Analysis forSell or Process-Further Decisions

Meatpacking Company• Can sell sides of beef

and pounds of bones to other companies for further processing

• Can decide to cut and package meat, process bone into fertilizer, and tan hides into leather

Some companies offer products or services that can either be sold in a basic form or be processed further and sold as a more refined product or service to a different market.


Incremental Analysis for Sell or Process-Further Decisions (cont’d)

• Sell or process-further decision– A decision about whether to sell a joint product at the split-

off point or sell it after further processing

• Joint products– Two or more products, made from a common material or

process, that cannot be identified as separate products or services during some or all of the processing

• Split-off point– A specific point where joint products or services become

separate and identifiable– Point at which a company may choose to sell or process

further



Select the alternative that maximizes operating income based on: • Organization’s strategic plan and objectives• Relevant revenues and costs• Qualitative factors

Objective of incremental analysis for sell or process-further decisions



Steps in incremental analysis process• Calculate incremental revenue.

– Difference between total revenue if sold at split-off point and total revenue if sold after processing further

• Compare incremental revenue to incremental costs of processing further.

– Choose to process further if incremental revenue exceeds incremental costs.

– If incremental costs exceed incremental revenue, choose to sell at the split-off point.



• Joint costs, or common costs, are ignored in the analysis.– They are incurred before the split-off point and

do not change if further processing occurs.

Even though joint costs are assigned to products or services when valuing inventories and calculating cost of goods sold,

they are not relevant to a sell or process-further decision.


Incremental Analysis for Sell or Process-Further Decisions Illustrated

• Basic Checking– Online checking account, debit card, and online bill payment with

a required minimum average balance (RMAB) of $500

• Premier Checking– Paper and online checking account, debit card, a credit card, and a

small life insurance policy equal to the maximum credit limit on the credit card. RMAB $1,000

• Personal Banker– All the features of Premier Checking plus a safe deposit box,

$5,000 personal line of credit at prime, financial investment advice, and a toaster on opening the account. RMAB $5,000

Home State Bank’s management is looking for new markets for banking services. It is considering adding two levels of service beyond the Basic Checking account services, Premier Checking and Personal Banker.


• The bank can earn sales revenue of 5 percent on its checking account balances.

• The total cost of Basic Checking is currently $50,000.• The bank’s accountant provided the following data per

account:

Incremental Analysis for Sell or Process-Further Decisions Illustrated (cont’d)



• The analysis indicates that the bank should offer personal banking services in addition to Basic Checking accounts.

Notice that the $50,000 joint costs of Basic Checking were ignored because they are sunk costs that will not

influence the decision.


Stop & Review

Q. What is the objective of a sell or process-further decision?

A. The objective is to select the alternative that maximizes operating income, based on the organization’s strategic plan and objectives, the relevant revenues and costs, and qualitative factors.


Chapter Review

1. Describe how managers make short-run decisions. 2. Define incremental analysis, and explain how it

applies to short-run decision making. 3. Perform incremental analysis for outsourcing

decisions. 4. Perform incremental analysis for special order

decisions. 5. Perform incremental analysis for segment

profitability decisions. 6. Perform incremental analysis for sales mix decisions

involving constrained resources.


Chapter Review (cont’d)

7. Perform incremental analysis for sell or process-further decisions.

managerial accounting, chapter 10 by crosson, needles

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