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Thème 9: Decision Making and Relevant Information Contrôle Interne Avancé-HEC Lausanne -2007/2008 1

Define differential costs and sunk costs Before making a decision, the associated costs and revenues related to each decision must be identified. The costs and revenues that are different for alternatives are relevant to each alternative. Ø Differential costs: future costs that change as a result of a decision. Ø Sunk costs: past costs that cannot be changed by current and future decisions; disregarded when determining the differential costs of a project. Contrôle Interne Avancé-HEC Lausanne -2007/2008 2

Three different approaches to decision making Differential Costs: Only the costs unique to each alternative are identified. Total Cost: All costs are identified with each alternative. Qualitative Considerations: Factors that affect a decision but are not subject to measurement in dollar terms. Contrôle Interne Avancé-HEC Lausanne -2007/2008 3

Example 1: Differential Costs The following costs relate to a customer’s order of 100 printed shirts. Identify the differential costs. Variable costs: Shirts. . . . . \$400 Printing labor. . . . 75 Fixed costs: Print screen. . . . \$ 95 Machine depreciation. . . . 50 Manager’s salary. . . 90 Total. . . . . \$710 Contrôle Interne Avancé-HEC Lausanne -2007/2008 4

Example 1: Differential Costs Variable costs: Shirts. . . . . \$400 Printing labor. . . . 75 Fixed costs: Print screen. . . . • • • 95 The cost of the shirts is a differential cost since it would not be an expense if the job were not taken. The printing labor for the shirts is a differential cost since it is a future expense due to the order. The print screen is a differential cost since a screen must be created for this order. Contrôle Interne Avancé-HEC Lausanne -2007/2008 5

Example 1: Differential Costs Variable costs: Shirts. . . . . \$400 Printing labor. . . . 75 Fixed costs: Print screen. . . . 95 Total differential costs. . . \$570 • Depreciation is the allocation of a past cost and therefore is not a differential cost. • A salary is not a differential cost because the salary will be paid regardless of the specific order. Contrôle Interne Avancé-HEC Lausanne -2007/2008 6

Example 2: Differential Costs Mike bought a machine two years ago for \$2, 000. If he buys a new machine for \$3, 000, he can sell the old machine for \$500. The electricity cost for both machines is \$0. 30 per hour. The old machine requires maintenance costs of \$500 a year, while the new machine will only incur costs of \$200 per year. What are the differential costs? Differential costs: • \$3, 000 – cost of new machine • \$500 – salvage value of old machine • \$300 – difference in maintenance costs Contrôle Interne Avancé-HEC Lausanne -2007/2008 7

Example 3: Total Costs A machine, used in production, has been owned and used for seven years. The machine only has two more years before the company disposes of it and its useful life ends. It runs okay, yet the company could use a newer, more productive machine. Should the machine be used for two more years, or should the company purchase a new machine? Note: When using the total-cost approach, we must look at all costs. Contrôle Interne Avancé-HEC Lausanne -2007/2008 8

Example 3: Total Costs Old Machine Variable costs: \$1. 10 x 10, 000 hours \$1. 00 x 8, 500 hours Fixed costs: Depreciation expense Book value of old machine Resale value of old machine Total cost New Machine \$11, 000 \$ 8, 500 3, 000 4, 500 3, 000 (500) \$15, 500 \$14, 000 Difference \$1, 500 Contrôle Interne Avancé-HEC Lausanne -2007/2008 9

Special orders BUYER Should we make or buy the component or service we need? Contrôle Interne Avancé-HEC Lausanne -2007/2008 SELLER Should we accept the special order for our products or services? 10

Make or buy a component The Tree Company must decide whether to make or buy a chainsaw motor. A vendor will sell them the necessary motors for \$14, 000. The total cost figures to build the motors are as follows. Assuming excess capacity, what should The Tree Company do? Direct materials. . . \$ 2, 000 Direct labor. . . . 6, 000 Variable overhead. . . 3, 000 Fixed overhead: Direct. . . . . \$ 1, 500 Indirect. . . . 3, 000 Total cost. . . . \$15, 500 Contrôle Interne Avancé-HEC Lausanne -2007/2008 11

Make or buy a component Buy Purchase cost. . . \$ Direct materials. . . Direct labor. . . Variable overhead. . 14, 000 Fixed overhead: Direct. . . . Indirect. . . . Total cost. . . . \$14, 000 Differential. . . . Make \$ 2, 000 6, 000 3, 000 1, 500 \$12, 500 \$1, 500 The Tree Company should make the motors. Contrôle Interne Avancé-HEC Lausanne -2007/2008 12

Purchase services or provide them internally Consider the differential costs of each alternative, as well as qualitative factors, such as: Ø Ø The quality of the service. Whether space exists to house the service. Whether services can be delivered on time. Management’s interest in keeping workers on the payroll. Contrôle Interne Avancé-HEC Lausanne -2007/2008 13

Purchase services or provide them internally Atlas Co. is considering outsourcing its payroll department to a payroll company. Listed below are the costs of both outsourcing and maintaining its current payroll department. Cost of outsourcing: Payroll company. . . . \$50, 000 Rent saved by eliminating payroll department. . (20, 000) Net cost of outsourcing. . . . \$30, 000 Cost of maintaining payroll department: Total cost of payroll department. . . . . \$35, 000 Less non-differential costs: Utilities & depreciation expense for payroll department. . . (6, 000) Differential costs of payroll department. . . . \$29, 000 Excess costs incurred by outsourcing. . . \$ 1, 000 Should Atlas Co. outsource its payroll department? Contrôle Interne Avancé-HEC Lausanne -2007/2008 14

Purchase services or provide them internally Atlas Co. is considering outsourcing its payroll department to a payroll company. Listed below are the costs of both outsourcing and maintaining its current payroll department. Cost of outsourcing: Payroll company. . . . \$50, 000 Rent saved by eliminating payroll department. . . (20, 000) Net cost of outsourcing. . . . \$30, 000 Cost of maintaining payroll department: Total cost of payroll department. . . . . \$35, 000 Less non-differential costs: Utilities & depreciation expense for payroll department. . . (6, 000) Differential costs of payroll department. . . . \$29, 000 Excess costs incurred by outsourcing. . . Contrôle Interne Avancé-HEC Lausanne -2007/2008 \$ 1, 000 15

Add or drop a product matching DROP: Replace a product or a product line with another that contributes more to indirect fixed costs. ADD: Add a product or a product line that contributes (significantly) to indirect fixed costs. REPLACE: Drop a product or a product line that does not contribute to indirect fixed costs. Contrôle Interne Avancé-HEC Lausanne -2007/2008 16

Add or drop a product Identify which of the following products should be retained. Product A Sales revenue. . \$15, 000 Variable costs. . 8, 000 Contribution margin. . \$ 7, 000 Direct fixed costs. . . . 5, 000 Contribution to indirect fixed costs. . . \$ 2, 000 B C \$10, 000 6, 000 \$ 4, 000 3, 000 \$12, 000 8, 000 \$ 4, 000 5, 000 \$ 1, 000 \$(1, 000) Contrôle Interne Avancé-HEC Lausanne -2007/2008 17

Add or drop a product Product A Sales revenue. . Variable costs. . Contribution margin. . . Direct fixed costs. . . . Contribution to indirect fixed costs. . . B C \$15, 000 8, 000 \$ 7, 000 5, 000 \$10, 000 6, 000 \$ 4, 000 3, 000 \$12, 000 8, 000 \$ 4, 000 5, 000 \$ 2, 000 \$ 1, 000 \$(1, 000) Products A and B are contributing to indirect fixed costs and should be retained unless a more profitable product is available. Product C should be dropped because it does not cover its own costs. Contrôle Interne Avancé-HEC Lausanne -2007/2008 18

Best utilization of a critical resource Critical Resource Factor: In a manufacturing process, it is the resource that limits operating capacity by its availability. In deciding which product to manufacture, management should choose the item that provides the greatest contribution margin per unit of the most critical resource. Contrôle Interne Avancé-HEC Lausanne -2007/2008 19

Best utilization of a critical resource Handy Designs has identified its critical resource as 10, 000 machine hours. Using the following data, select the products that should be produced with the limited machine hours. Product A Selling price. . . Variable costs. . Contribution margin. . . Machine hours required per unit. . . Contribution per machine hour. . . . B C \$20 11 \$ 9 \$16 10 \$6 \$10 5 \$ 5 3 2 1 \$ 3 \$ 5 Product C should be the first produced. Contrôle Interne Avancé-HEC Lausanne -2007/2008 20

Set selling prices Handset Software uses the following cost information to set the normal price on a new program. Computer Outlet has offered to buy the new program for \$45 to sell as a store brand. Should Handset accept the offer? Direct materials. . . . Direct labor. . . . Manufacturing overhead. . . . . \$ 5 15 20 Total manufacturing cost. . . . Markup (50% of cost). . . . . \$40 20 Estimated selling price. . . . . \$60 Contrôle Interne Avancé-HEC Lausanne -2007/2008 21

How to set selling prices? Direct materials. . . . . \$ 5 Direct labor. . . . . 15 Manufacturing overhead. . . 20 Total manufacturing cost. . \$40 Markup (50% of cost). . . 20 Estimated selling price. . . \$60 Special order pricing takes into account the differential costs: Sales price. . . . \$45 Direct materials. . . \$ 5 Direct labor. . . . 15 Variable overhead. . . . . 8 Differential fixed costs. . . . . 10 Total variable and fixed costs. . . 38 Expected contribution per unit. . . . \$ 7 Contrôle Interne Avancé-HEC Lausanne -2007/2008 22