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Chapter 4 Short-term Decision Making Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Chapter 4 Short-term Decision Making Mc. Graw-Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

What is the CVP Model? • Cost-volume-profit model (short-term) § Use to explore relationships What is the CVP Model? • Cost-volume-profit model (short-term) § Use to explore relationships among costs, volumes, and profits • Assumptions (linearity) § § 4 -2 Selling price is constant per unit Variable cost is constant per unit Fixed cost is constant in total Number of units produced = number of units sold

CVP Graph Total Revenue Profit area Total Cost $ Breakeven point Loss area Units CVP Graph Total Revenue Profit area Total Cost $ Breakeven point Loss area Units produced and sold 4 -3

How are the CVP Components Defined Mathematically? • Total revenue § SP * Q How are the CVP Components Defined Mathematically? • Total revenue § SP * Q • Total cost § VC * Q + FC • Breakeven § (SP * Q – VC * Q) – FC = 0 • Where, Q = quantity produced and sold 4 -4

CVP Continued • Contribution margin § SP – VC § Breakeven = CM * CVP Continued • Contribution margin § SP – VC § Breakeven = CM * Q – FC = 0 • Target profit before taxes § CM * Q – FC = P • Target profit after taxes § CM * Q – FC = P/(1 – tax rate) 4 -5

Contribution Margin Approach is a quicker way to calculate it? • FC + P/CM Contribution Margin Approach is a quicker way to calculate it? • FC + P/CM = Q Contribution margin approach to determine target profit after taxes • FC + (BTP/[1 -tax rate])/CM = ATP

CVP Continued • Change in selling price § Increase—decreases breakeven § Decrease—increases breakeven • CVP Continued • Change in selling price § Increase—decreases breakeven § Decrease—increases breakeven • Change in variable cost § Increase—increases breakeven § Decrease—decreases breakeven • Change in fixed cost § Increase—increases breakeven § Decrease—decreases breakeven • Change in tax rate § No impact on breakeven 4 -7

What are Product and Nonproduct Costs? • Product costs § Incurred in connection with What are Product and Nonproduct Costs? • Product costs § Incurred in connection with buying or making the product • Nonproduct costs § Incurred in connection with selling the product and administering (running) the company 4 -8

What are the 3 Types of Product Costs? • Direct materials § Traceable § What are the 3 Types of Product Costs? • Direct materials § Traceable § Worth the cost of tracing • Direct labor § Cost of employees making the product • Manufacturing overhead § Indirect costs of production (indirect materials, indirect labor, and other manufacturing costs) 4 -9

What are the Activity Levels Associated with Costs? • Unit-related § Vary with units What are the Activity Levels Associated with Costs? • Unit-related § Vary with units produced or sold • Batch-related § Vary with batches (groups) regardless of the number of units in the batch • Product-sustaining § Vary with the number of product lines • Facility-sustaining § Fixed or capacity costs 4 -10

Types and Activity Levels Product Nonproduct Unit-related Commissions Batchrelated Set ups Ordering Productsustaining Facilitysustaining Types and Activity Levels Product Nonproduct Unit-related Commissions Batchrelated Set ups Ordering Productsustaining Facilitysustaining 4 -11 Materials Research & Advertising development Rental of CEO salary equipment

What are the 2 Characteristics of a Relevant Variable? • Future § The variable What are the 2 Characteristics of a Relevant Variable? • Future § The variable must occur in the future • Different § The variable must differ between the alternatives considered 4 -12

Relevant Variables Continued • Sunk costs § Past, never relevant for decision making • Relevant Variables Continued • Sunk costs § Past, never relevant for decision making • Opportunity costs § Benefits foregone, always relevant for shortterm decision making • Incremental costs/revenues § Additional cost/revenue, relevant if different between alternatives 4 -13

What are the Types of Short-Term Decisions Considered? • Accept-or-reject decisions § Special order What are the Types of Short-Term Decisions Considered? • Accept-or-reject decisions § Special order § Base decision on incremental profit from the order • Make-or-buy decisions § Outsourcing § Base decision on cost comparison between make and buy • Keep-or-drop decisions § Product mix § Base decision on revenues lost versus costs saved 4 -14

Lecture Example #1 1. A certain company sells its only product for $12 per Lecture Example #1 1. A certain company sells its only product for $12 per unit. The variable costs to produce the product are $7 per unit and it costs approximately $1 per unit for selling and administrative costs. The fixed costs of production are $400, 000 period and the fixed selling and administrative costs are $200, 000 per year. The company is subject to a 30 percent tax rate. Answer the following questions. a. What is the breakeven point in units? b. What is the breakeven point in dollars? c. How many units must be sold to earn a profit of $70, 000 before tax? d. How many units must be sold to earn a profit of $70, 000 after tax? e. If the variable costs increase 10 percent, what increase is necessary in selling price to maintain the same breakeven point in units? f. If the fixed costs increase, what is the effect on breakeven? On contribution margin per unit? g. If the tax rate increases, what is the effect on breakeven? On contribution margin per unit?

Lecture Example #1 Cont. • • • Answer: a. SP = $12; VC = Lecture Example #1 Cont. • • • Answer: a. SP = $12; VC = $8; CM = $4; FC = $600, 000/4 = 150, 000 b. CM = $4; SP = $12; CM % = 33. 3333% $600, 000/33. 3333% = $1, 800, 000 c. ($600, 000 + $70, 000)/4 = 167, 500 d. $70, 000/(1 -. 3) = $100, 000 ($600, 000 + $100, 000)/4 = 175, 000 e. To maintain the same breakeven point, CM must remain the same. VC = $8. 80; CM = $4; therefore SP = $12. 80 f. If fixed costs increase, breakeven increases. Fixed costs do not affect contribution margin per unit. g. Tax rate increases do not affect breakeven or contribution margin per unit.

Lecture Example #2 • • • 2. A company has been approached by a Lecture Example #2 • • • 2. A company has been approached by a supplier with an offer to provide 25, 000 units of a production part for $9 per unit. If the company accepts the offer its direct materials costs are expected to decrease by 60 percent, its direct labor costs are expected to decrease by 30 percent, and its unit-related overhead is expected to decrease by 20 percent. A recent per unit cost report when 25, 000 units were produced is shown below: Direct materials $10 Direct labor 2 Manufacturing overhead 8 Total cost $20 An analysis of manufacturing overhead reveals that overhead consists of unit-related and facility-sustaining overhead. Facility-sustaining overhead consists of depreciation and other fixed items and is approximately $150, 000 period. If the company accepts the supplier’s offer, it will use the released production facilities to produce another product with an expected contribution of $60, 000 period. Should the company accept or reject the supplier’s offer?

Lecture Example #2 Cont. • • • Answer: Total overhead $8 * 25, 000 Lecture Example #2 Cont. • • • Answer: Total overhead $8 * 25, 000 = $200, 000 Less facility-sustaining overhead 150, 000 Unit-related overhead $ 50, 000 Unit-related overhead per unit $50, 000/25, 000 = $2 • • • Relevant variables Direct materials Direct labor Unit-related overhead Purchase price Relevant cost per unit * Number of units Total relevant unit cost Opportunity cost Total relevant cost BUY Make $10. 00 2. 00 -0$14. 00 25, 000 $350, 000 60, 000 $410, 000 Buy $ 4. 00 ($10 *. 4) 1. 40 ($2 *. 7) 1. 60 ($2 *. 8) 9. 00 $16. 00 25, 000 $400, 000 -0$400, 000

Lecture Example #3 3. A company has been approached by a customer with an Lecture Example #3 3. A company has been approached by a customer with an offer to buy 10, 000 units of product but the customer wants a discount of 25 percent off the normal selling price. The company has the capacity to fill the customer’s order. A recent profit report is shown below: Sales (500, 0000 units) Cost of goods sold Gross margin Selling and administrative cost Profit $6, 000 4, 200, 000 $1, 800, 000 1, 000 $ 800, 000 Unit-related cost of goods sold is 40 percent of the current selling price while unit-related selling and administrative costs are 10 percent of the current selling price. To fill the customer’s order, one additional production run will be required at a cost of $6, 000. An additional purchase order will be required at a cost of $500, and shipping costs to the customer will be $800. Should the company accept the customer’s order?

Lecture Example # 3 Cont. • • • • • Answer: Current selling price Lecture Example # 3 Cont. • • • • • Answer: Current selling price = $6, 000/500, 000 = $12 Unit-related cost of goods sold = $12 *. 4 = $4. 80 Unit-related selling and administrative cost = $12 *. 1 = $1. 20 Proposed selling price = $12 *. 75 = $9 Relevant variables Accept Proposed selling price $9. 00 Cost of goods sold 4. 80 Selling and administrative 1. 20 Contribution margin $3. 00 * Number of units requested 10, 000 Total contribution margin $30, 000 Additional batch costs: Production run ( 6, 000) Ordering ( 500) Shipping ( 800) Relevant profit $22, 700 ACCEPT Reject $0. 00 $0. 00 10, 000 $0 -0 -0 -0 - $0

Lecture Example #4 4. A merchandising company currently sells three products—A, B, and C. Lecture Example #4 4. A merchandising company currently sells three products—A, B, and C. Product profit reports for the last period are shown below: Sales Less: cost of goods sold Gross margin Less: selling and administrative costs Profit Product A Product B Product C $100, 000 $200, 000 $150, 000 60, 000 120, 000 90, 000 40, 000 80, 000 60, 000 55, 000 ($10, 000) $20, 000 $5, 000 A cost analysis reveals that cost of goods sold varies proportionately with sales (60%). Selling and administrative costs are $120, 000 plus 10% of sales. The $120, 000 of facility-sustaining selling and administrative cost will continue regardless of how many product lines the company maintains. Should the company keep or drop its existing product lines?

Lecture Example #4 Cont. Answer: If Product A is dropped: Revenues lost Costs saved: Lecture Example #4 Cont. Answer: If Product A is dropped: Revenues lost Costs saved: Cost of goods sold Selling & administrative $100, 000 $60, 000 10, 000 $70, 000 Since the revenues lost exceed the costs saved, the company should keep Product A.