Lecture 18 Incremental Analysis Mc Graw-Hill Irwin The

Lecture 18 Incremental Analysis Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Make or Buy Decisions Should I continue to make the part, or should I buy it? I suppose I should compare the outside purchase price with the additional costs to manufacture the part. Mc. Graw-Hill/Irwin What will I do with my idle facilities if I buy the part? © The Mc. Graw-Hill Companies, Inc. , 2002

Make or Buy Decisions l Incremental costs also are important in the decision to make a product or buy it from a supplier. l The cost to produce an item must include (1) direct materials, (2) direct labor and (3) incremental overhead. l We should not use the predetermined overhead rate to determine product cost. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Make or Buy Decisions Exitel makes computer chips used in one of its products. Unit costs, based on production of 20, 000 chips per year, are: Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Make or Buy Decisions An outside supplier has offered to provide the 20, 000 chips at a cost of $25 per chip. Fixed overhead costs will not be avoided if the chips are purchased. Exitel has no alternative use for the facilities. Should Exitel accept the offer? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Make or Buy Decisions Differential costs of making (costs avoided if bought from outside supplier) Exitel should not pay $25 per unit to an outside supplier to avoid the $15 per unit differential cost of making the part. Fixed costs are irrelevant to decision. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Make or Buy Decisions If Exitel buys the chips from the outside supplier, the idle facilities could be leased to another company for $250, 000 per year. Should Exitel buy the chips and lease the facilities? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Make or Buy Decisions The opportunity cost of facilities changes the decision. The real question to answer is, “What is the best use of Exitel’s facilities? ” Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Sell, Scrap, or Rebuild Decisions Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered. As long as rebuild costs are recovered through sale of the product, and rebuilding does not interfere with normal production, we should rebuild. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Sell, Scrap, or Rebuild Decisions Oser. Co has 10, 000 defective units that cost $1. 00 each to make. The units can be scrapped now for $. 40 each or rebuilt at an additional cost of $. 80 per unit. If rebuilt, the units can be sold for the normal selling price of $1. 50 each. Rebuilding the 10, 000 defective units will prevent the production of 10, 000 new units that would also sell for $1. 50. Should Oser. Co scrap or rebuild? Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Sell, Scrap, or Rebuild Decisions 10, 000 units × $0. 40 per unit 10, 000 units × $1. 50 per unit Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Sell, Scrap, or Rebuild Decisions 10, 000 units × $0. 80 per unit 10, 000 units × ($1. 50 - $1. 00) per unit Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Sell, Scrap, or Rebuild Decisions Oser. Co should scrap the units now. If Oser. Co fails to include the opportunity cost, the rework option would show a return of $7, 000, mistakenly making rebuild appear more favorable. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Joint Product Decisions Two or more products produced from a common input are called joint products. Product 1 Joint Costs Product 2 Joint costs are the costs of processing prior to the split-off point. Product 3 The split-off point is the point in a process where joint products can be recognized as separate products. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Joint Product Decisions Businesses are often faced with the decision to sell partially completed products at the split-off point or to process them to completion. General rule: process further only if incremental revenues > incremental costs. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Joint Product Decisions Ames Co. produces two products, A and B, from this process. Should the products be sold at split-off or processed further? Joint Cost $100, 000 Common Production Process Revenue $70, 000 Mc. Graw-Hill/Irwin Final Sale $120, 000 Additional Processing $20, 000 Final Sale $65, 000 A Revenue $50, 000 Split-Off Point Additional Processing $40, 000 B © The Mc. Graw-Hill Companies, Inc. , 2002

Joint Product Decisions Product A incremental revenue = $120, 000 - $70, 000 Product B incremental revenue = $65, 000 - $50, 000 Decision: Process product A, but sell product B at the split-off point. Note that the $100, 000 joint cost is irrelevant to the processing decision. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Joint Product Decisions Joint costs are really common costs incurred to simultaneously produce a variety of end products. Joint costs are commonly allocated to end products on the basis of the relative sales value of each product or on some other basis. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Joint Product Decisions Joint costs are not relevant in decisions regarding what to do with a product after the split-off point. As a general rule. . . It is always profitable to continue processing a joint product after the split-off point so long as the incremental revenue exceeds the incremental processing costs. Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002

Source: Adopted from Mc. Graw-Hill/Irvin Hey dude, it’s party time! Mc. Graw-Hill/Irwin © The Mc. Graw-Hill Companies, Inc. , 2002