Decision-Making Incremental Analysis Relevant Costs Special Order Make

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Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Managerial Accounting Second Edition Weygandt / Kieso / Kimmel Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide Next Slide S EL End Show 9 -1

Illustration 9 -1 Management’s Decision-making Process Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 -3 Next Slide Consider both financial and nonfinancial information. Nonfinancial information relates to: • Effect of decision on employee turnover • The environment • Overall image of company in community.

Illustration 9 -2 Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Incremental Analysis The process of identifying the financial data that change under alternative courses of action. Retain/Replace Equipment Eliminate segment? Revenues Costs Net income Sales Mix Previous Slide End Show 9 -5 Next Slide Alternative A $125, 000 100, 000 $ 25, 000 Alternative B $110, 000 80, 000 $ 30, 000 Net Income Increase (Decrease) $(15, 000) 20, 000 $ 5, 000

Illustration 9 -3

Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 -7 Next Slide Types of Incremental Analysis • Accept an order at a special price. • Make or buy component parts or finished products. • Sell products or process further. • Retain or replace equipment. • Eliminate an unprofitable business segment.

Illustration 9 -4 Accept An Order At A Special Price Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Assume sales of the products in other markets would not be affected by special order. Assume company is not operating at full capacity. Eliminate segment? Sales Mix Previous Slide End Show 9 -8 Next Slide Revenues Costs Net income Reject Order $ -0 -0$ -0 - Accept Order $22, 000 16, 000 $ 6, 000 Net Income Increase (Decrease) $ 22, 000 (16, 000) $ 6, 000

Illustration 9 -5 Make or Buy Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 -9 Next Slide Assume sales of the products in other markets would not be affected by special order. Assume company is not operating at full capacity.

Illustration 9 -5 Make or Buy Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Sales Mix End Show 9 - 10 Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Total manufacturing costs Total cost per unit ($225, 000 25, 000) $ 50, 000 75, 000 40, 000 60, 000 $225, 000 $9. 00 Alternatively, Baron may purchase the ignition switches from Ignition, Inc. , at a price of $8 per unit. Eliminate segment? Previous Slide COST TO MAKE Next Slide Question: Should Baron make or buy the ignition switches?

Illustration 9 -6 Make or Buy Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Decision: Barton Company will incur $25, 000 of additional costs by buying the switches. Therefore, Barton should continue to make the switches. Sales Mix Previous Slide End Show 9 - 11 Direct materials Direct labor Variable manufacturing costs Fixed manufacturing costs Purchase price Total annual cost Make Buy $ 50, 000 $ - 0 75, 000 -040, 000 -060, 000 50, 000 -0200, 000 $225, 000 $250, 000 Net Income Increase (Decrease) $ 50, 000 75, 000 40, 000 10, 000 (200, 000) $ (25, 000) Next Slide

Opportunity cost Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 12 Next Slide The potential benefit that may be obtained from following an alternative course of action.

Illustration 9 -7 Make or Buy - Opportunity Cost Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Assume the company can use the released capacity to generate $ 28, 000 additional income. Sell or Process Further Retain/Replace Equipment Eliminate segment? Total annual cost Opportunity cost Total cost Make Buy $225, 000 $250, 000 28, 000 -0$253, 000 $250, 000 Net Income Increase (Decrease) $(25, 000) 28, 000 $ 3, 000 Sales Mix Previous Slide End Show 9 - 13 Next Slide Decision: It is now advantageous to buy the switches. Barton will save $3, 000 worth of costs with this alternative.

Sell or Process Further? Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 14 Next Slide Illustration 9 -8 A, Inc. makes tables. The cost to manufacture an unfinished table is $35. Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Total manufacturing costs $ 15 10 6 4 $35 Unfinished units sell for $50. Finished tables sell for $60 each. For a finished table direct materials and direct labor costs will increase $2 and $4, respectively. Variable overhead will increase by $2. 40 (60% of direct labor). There will be no increase in fixed overhead. Question: Should A, INC. sell the unfinished tables or process them further?

Sell or Process Further? Sales per unit Cost per unit Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Total Net income per unit Illustration 9 -9 Sell $50. 00 Process Further $60. 00 Net Income Increase (Decrease) $10. 00 15. 00 10. 00 6. 00 4. 00 $35. 00 17. 00 14. 00 8. 40 4. 00 $43. 40 (2. 00) (4. 00) (2. 40) -0$(8. 40) $15. 00 $16. 60 $ 1. 60 Process further as long as the incremental revenue from such processing exceeds the incremental processing costs.

Joint costs Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 16 Next Slide For joint products, all costs incurred prior to the point at which two products are separately identifiable.

Illustration 9 -10 Sell/Process Further-Multiple Products Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 17 Next Slide Use Incremental Analysis to Decide.

Sunk cost Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 18 Next Slide The book value of the old machine is a sunk cost which is a cost that cannot be changed by any present or future decision. Sunk costs are not relevant in incremental analysis.

Retain or Replace Equipment Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Jeffcoat Company has a factory machine with a book value of $40, 000 and a remaining useful life of four years. A new machine is available for $120, 000 and is expected to have zero salvage value at the end of its 4 -year useful life. If the new machine is acquired, variable manufacturing costs are expected to decrease from $160, 000 to $125, 000 annually and the old unit will be scrapped. Sales Mix Previous Slide End Show 9 - 19 Next Slide Question: Should Jeffcoat Company retain or replace the machine?

Illustration 9 -14 Retain or Replace Equipment Variable manufacturing costs New machine cost Total Retain $640, 000 a $640, 000 Replace $500, 000 b 120, 000 $620, 000 Net Income Increase (Decrease) $140, 000 (120, 000) $ 20, 000 a(4 years x $160, 000) b(4 years x $125, 000) Decision: It would be to the company’s advantage to replace the equipment. The lower variable manufacturing costs due to replacement more than offset the cost of the new equipment.

Eliminate An Unprofitable Segment Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Often fixed costs allocated to the unprofitable segment must be absorbed by the other segments. Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 21 Next Slide It is possible for net income to decrease when an unprofitable segment is eliminated.

Illustration 9 -15 Eliminate An Unprofitable Segment Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Martina Company manufactures tennis racquets in three models: Pro, Master, and Champ. Pro and Master are profitable lines, whereas Champ operates at a loss. Condensed income statement data are: Retain/Replace Equipment Eliminate segment? Sales Variable expenses Contribution margin Fixed expenses Net income Sales Mix Previous Slide End Show 9 - 22 Next Slide Pro $800, 000 520, 000 280, 000 $200, 000 Master $300, 000 210, 000 90, 000 50, 000 $ 40, 000 Champ $100, 000 90, 000 10, 000 30, 000 $(20, 000) Total $1, 200, 000 820, 000 380, 000 160, 000 $ 220, 000 Question: Should the Champ segment be eliminated?

Illustrations 9 -15&9 -16 Eliminate An Unprofitable Segment Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sales Variable expenses Contribution margin Fixed expenses Net income Pro $800, 000 520, 000 280, 000 $200, 000 Master $300, 000 210, 000 90, 000 50, 000 $ 40, 000 Champ $100, 000 90, 000 10, 000 30, 000 $(20, 000) Total $1, 200, 000 820, 000 380, 000 160, 000 $ 220, 000 Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 23 Next Slide ELIMINATE CHAMP? Sales Variable expenses Contribution margin Fixed expenses Net income Pro $800, 000 520, 000 280, 000 100, 000 $200, 000 Master Total $300, 000 $1, 100, 000 210, 000 730, 000 90, 000 370, 000 60, 000 160, 000 $ 40, 000 $ 210, 000 Total net income decreases $10, 000 ($220, 000 – $210, 000) if the Champ line is discontinued. Decision:

Illustrations 9 -15&9 -16 Eliminate An Unprofitable Segment Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sales Variable expenses Contribution margin Fixed expenses Net income Pro $800, 000 520, 000 280, 000 $200, 000 Master $300, 000 210, 000 90, 000 50, 000 $ 40, 000 Champ $100, 000 90, 000 10, 000 30, 000 $(20, 000) Total $1, 200, 000 820, 000 380, 000 160, 000 $ 220, 000 Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 24 Next Slide ELIMINATE CHAMP? Sales Variable expenses Contribution margin Fixed expenses Net income Pro $800, 000 520, 000 280, 000 100, 000 $200, 000 Master Total $300, 000 $1, 100, 000 210, 000 730, 000 90, 000 370, 000 60, 000 160, 000 $ 40, 000 $ 210, 000 Total net income decreases $10, 000 ($220, 000 – $210, 000) if the Champ line is discontinued. Decision:

Illustrations 9 -17 Eliminate An Unprofitable Segment Decision-Making Incremental Analysis Relevant Costs Special Order Total net income decreases $10, 000 ($220, 000 – $210, 000) if the Champ line is discontinued. Decision: Make or Buy? Sell or Process Further OR Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 25 Next Slide Sales Variable expenses Contribution margin Fixed expenses Net income Continue $100, 000 90, 000 10, 000 30, 000 $(20, 000) Eliminate $ -0 -0 -030, 000 $ 30, 000) Net Income Increase (Decrease $(100, 000) 90, 000 (10, 000) -0$ (10, 000)

Joint products Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 26 Next Slide Multiple end-products produced from a single raw material and a common process.

Sales Mix Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 27 Next Slide The relative combination in which a company’s products are sold.

Illustration 9 -18 Sales Mix Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 28 Next Slide Unit Data Selling price Variable costs Contribution margin Sales mix VCRs $500 300 $200 TVs $800 400 $400 3 1

Limited Resources Illustration 9 -21 Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Collins Co. manufactures deluxe and standard pen and pencil sets. The limited resource is machine capacity, which is 3, 600 hours per month. Relevant data consists of: Contribution margin per unit Machine hours required per unit Deluxe $8. 4 Standard $6. 2 Sales Mix Previous Slide End Show 9 - 29 Next Slide Question: Should Collins Co. shift its sales mix toward deluxe or standard sets?

Illustration 9 -22 Limited Resources Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 30 Next Slide Contribution margin per unit (a) Machine hours required per unit (b) Contribution margin per unit of limited resource (a b) Deluxe $8. 4 $20 Decision: Since the standard set has the higher contribution margin per unit of limited resource, sales mix should shift towards that product. Standard $6. 2 $30

Decision-Making Incremental Analysis Relevant Costs Special Order Make or Buy? Sell or Process Further Retain/Replace Equipment Eliminate segment? Sales Mix Previous Slide End Show 9 - 31 Next Slide