hhofma3e ch20 inst

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 20

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.2

Describe and identify information relevant to business decisions

Make special order and pricing decisions

Make dropping a product and product-mix decisions

Make outsourcing and sell as is or processfurther decisions


Describe and identify information relevant to business decisions

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1. Expected future data2. Differs among alternatives

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Relevant costsAffect decisionsOccur in the futureDiffer among the alternatives

Irrelevant costsDo not affect decisionsSunk costs

Occurred in the past Always irrelevant to the decisionCannot be changed

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Considering qualitative factors in decision-making

Impact on employee moraleOutsourcingLayoffs

Impact on qualityProduct recall, higher warranty costsUpset customers

Customer relationsDiscounted prices to select customers

Use same guidelines as relevant costsOccurs in the futureDiffers between alternatives

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Relevant information approachAlso called the incremental analysis approach

How operating income differs under alternativesIrrelevant information is ignoredOnly relevant data affect decisions

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You are trying to decide whether to trade in your inkjet printer for a more recent model. Your usage pattern will remain unchanged, but the old and new printers use different ink cartridges.1.Indicate if the following items are relevant or irrelevant to your decision:a.The price of the new printerb.The price you paid for the old printerc.The trade-in value of the old printerd.Paper costse.The difference between ink cartridges’ costs

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Relevant

Irrelevant

Relevant

Irrelevant

Relevant


Make special order and pricing decisions

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Special orderWhen a customer requests a one-time order at a reduced sale price

Considerations:Does the company have excess capacity available to fill this order?Will the reduced sales price be high enough to cover the incremental costs of filling the order (the variable costs and any additional fixed costs)?Will the special order affect regular sales in the long run?

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1. Focus on relevant data (revenues and costs that will change if it accepts the special order)

2. Use of a contribution margin approach that separates variable costs from fixed costs

3. The special sales order will increase operating income by $2,500. Fixed costs remain the same.

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Examples: Food commoditiesNatural resources Generic consumer products and services

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Examples: Original art, jewelrySpecially manufactured machineryPatented perfume scentsLatest tech gadget


Starts with the market price of the product The price customers are willing to pay

Subtracts the company’s desired profit Determine the product’s target full cost

Full cost to develop, produce, and deliver the product or service


Accept the lower operating income, not the target return required by stockholdersReduce fixed costs Reduce variable costs Use other strategies

Increase capacity to spread the fixed costs are spread over more unitsChange or add to product mixDifferentiate its product (become a price setter)

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Emphasizes a cost-plus approachOpposite of the target-pricing approachStarts with the full costs and adds desired profit to determine a cost-plus priceUnique product = more control over pricing

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Full cost

Plus: Desired profit

Equals Cost-plus price


Unique products Consider what customers are willing to payHow well has the company been able to differentiate its product?

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Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardz’s total production cost is $0.61 per pack, as follows:

Hobby-Cardz has enough excess capacity to handle the special order.1. Prepare an incremental analysis to determine whether Hobby-Cardz should accept the special sales order.


Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardz’s total production cost is $0.61 per pack, as follows:

Hobby-Cardz has enough excess capacity to handle the special order.1. Prepare an incremental analysis to determine whether Hobby-Cardz should accept the special sales order.

Accept the

special order


2. Now assume that the Hall of Fame wants special hologram baseball cards. Hobby-Cardz will spend $5,900 to develop this hologram, which will be useless after the special order is completed. Should Hobby-Cardz accept the special order under these circumstances?

Reject the

special order


Green Thumb operates a commercial plant nursery where it propagates plants for garden centers throughout the region. Green Thumb has $4,800,000 in assets. Its yearly fixed costs are $600,000, and the variable costs for the potting soil, container, label, seedling, and labor for each gallon-size plant total $1.35. Green Thumb’s volume is currently 470,000 units. Competitors offer the same plants, at the same quality, to garden centers for $3.60 each. Garden centers then mark them up to sell to the public for $9 to $12, depending on the type of plant.

1. Green Thumb’s owners want to earn a 10% return on the company’s assets. What is Green Thumb’s target full cost?

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Revenue at current market price (470,000 units × $3.60 per unit) $1,692,000

Less: Desired profit ($4.8 million × 10%) 480,000Target full cost $1,212,000


2. Given Green Thumb’s current costs, will its owners be able to achieve their target profit?

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Green Thumb’s actual total full costs of $1,234,500 are higher than its target full cost, therefore Green Thumb will not meet the stockholders’ profit expectations. Current variable cost (500,000 × 1.70) $ 634,500Current fixed costs 600,000Total full cost $1,234,500


3. Assume Green Thumb has identified ways to cut its variable costs to $1.20 per unit. What is its new target fixed cost? Will this decrease in variable costs allow the company to achieve its target profit?

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The new target fixed cost is $648,000. Target full cost (from requirement 1) $1,212,000Less: Reduced level of variable costs

(470,000 × $1.20) (564,000)New target fixed costs $ 648,000 Since the company’s actual fixed costs are less than or equal to the new target fixed cost amount, Green Thumb will be able to achieve its target profit without having to take any other cost-cutting measures.


4. Green Thumb started an aggressive advertising campaign strategy to differentiate its plants from those grown by other nurseries. Monrovia Plants made this strategy work, so Green Thumb has decided to try it, too. Green Thumb does not expect volume to be affected, but it hopes to gain more control over pricing. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not?

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4. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not?

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Green Thumb’s cost-plus price is $3.74 Current fixed costs $ 600,000Plus: Additional fixed costs of advertising 115,000Plus: Total variable costs (470,000 × $1.20) 564,000Total full costs $1,279,000Plus: Desired profit ($4.8 million × 10%). 480,000Desired revenue $1,759,000Divided by: Number of units ÷ 470,000Cost-plus price per unit $ 3.74 Retailers will be more willing to pay the cost-plus price if the marketing campaign is effective. Other wise, Green Thumb may be considered a generic nursery.


Make dropping a product and product-mix decisions

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Does the product, department, or territory provide a positive contribution margin?Will fixed costs continue to exist, even if the company drops the product?Are there any direct fixed costs that can be avoided if the company drops the product, department, or territory?Will dropping the product, department, or territory affect sales of the company’s other products?What could the company do with the freed manufacturing capacity?


Focus on a decrease in volume

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If product has a negative contribution margin, then drop Unavoidable fixed costs

Fixed costs that continue to exist even after a product is dropped—irrelevant

Avoidable, direct fixed costs—relevantIf costs decrease more than the decrease in revenues, product should be dropped

Would dropping the product line, department, or territory hurt other sales?

Consider lost contribution margins from other productsWill more profitable products be produced with freed capacity?

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ConstraintsSomething that restricts production or sale of productManufacturers

Limitations on labor or machine hours or available materials

MerchandisersAmount of display space

Stiff competition may limit demand

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What constraint(s) stop(s) the company from making (or displaying) all the units the company can sell?Which products offer the highest contribution margin per unit of the constraint?Would emphasizing one product over another affect fixed costs?Decision rule:

Decision Rule - Which product to

emphasize?

Decision Rule - Which product to

emphasize?

Emphasize the product with the highest contribution margin per unit of the constraint.

Emphasize the product with the highest contribution margin per unit of the constraint.


Deela Fashions operates three departments: Men’s, Women’s, and Accessories. Departmental operating income data for the third quarter of 2012 are as follows:

Assume that the fixed expenses assigned to each department include only direct fixed costs of the department:● Salary of the department’s manager● Cost of advertising directly related to that departmentIf Deela Fashions drops a department, it will not incur these fixed expenses.39


1. Under these circumstances, should Deela Fashions drop any of the departments? Give your reasoning.

Deela Fashions should drop the Accessories Department because relevant expenses are greater than the revenues which will result in an increase in operating income if the department is dropped.

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Make outsourcing and sell as is or process further decisions

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Managers decide whether to buy a component product or service or produce it in-houseCheaper is not always the deciding factorConsiderations:

How do the company’s variable costs compare to the outsourcing cost?Are any fixed costs avoidable if the company outsources?What could the company do with the freed manufacturing capacity?

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If fixed costs stay the same—irrelevantIf fixed costs change—relevant

Differs between alternatives

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Company can avoid $10,000 in fixed cost if outsourced.However, total costs are more, so do not outsource.


Benefit given up by not choosing an alternative course of actionExample:

If the company chooses not to outsource, it will lose any revenue from freed capacityIf company outsources, freed capacity can be used to produce other products, maybe earning more

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Qualitative factorsControl over quality

Outsourcing considerationsCoordination, information exchange, and paperwork problems

GlobalizationUse Internet to find information systems of suppliers and customers located around the worldCompanies can now focus on their core competencies—quality and delivery

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Considerations:How much revenue will the company receive if the company sells the product as is?How much revenue will the company receive if the company sells the product after processing it further?How much will it cost to process the product further?

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Decision rule:

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Suppose a Roasted Olive restaurant is considering whether to (1) bake bread for its restaurant in-house or (2) buy the bread from a local bakery. The chef estimates that variable costs of making each loaf include $0.52 of ingredients, $0.24 of variable overhead (electricity to run the oven), and $0.70 of direct labor for kneading and forming the loaves. Allocating fixed overhead (depreciation on the kitchen equipment and building) based on direct labor assigns $0.96 of fixed overhead per loaf. None of the fixed costs are avoidable. The local bakery would charge $1.75 per loaf.

1. What is the unit cost of making the bread in-house (use absorption costing)?2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why?3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision?50


1. What is the unit cost of making the bread in-house (use absorption costing)?

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2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why?

Decision: Roasted Olive should bake the bread in-house since the variable cost of making each loaf is less than the cost of outsourcing each loaf.

3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision?Roasted Olive should consider the following qualitative factors before making a final decision:Will the local bakery meet their delivery time requirements?How does the quality and freshness of the local bakery bread compare to Roasted Olive bread?

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Relevant information is expected future data that differs among alternatives. Relevant costs are costs that may affect which decision you make. Irrelevant costs are costs that won’t change the decision you make. Sunk costs are costs that were incurred in the past and cannot be changed regardless of which future action is taken. The two keys to making short-term decisions are to focus on relevant revenues, costs, and profits, and to use a contribution margin approach to separate variable and fixed costs.

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Managers must consider three things when considering a special order:

1) Does the company have excess manufacturing capacity?

2) Does the special sales price cover the incremental costs of filling the special order?

3) Will fixed costs change because of the special order?

If the expected increase in revenues exceeds the expected increase in costs, the company should accept the special order. When setting prices, the company must consider its target profit goal, how much customers will pay for the product, and whether the company is a price-taker or a price-setter. Price setters use a cost-plus pricing approach to pricing, whereas price-takers use a target pricing approach.

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The first product mix question is “Does the product provide a positive contribution margin?” What is relevant is whether the fixed costs continue to exist if the product is dropped and whether there are any avoidable direct fixed costs if the product is dropped. Unavoidable fixed costs and are irrelevant to the decision. If direct fixed costs will change, those costs are relevant to the decision of whether a product should be dropped. When there is a constraint on production, such as total machine hours, this constraint must be considered when determining which product should be emphasized. If the company can sell whatever product it makes, the company should emphasize producing the product with the highest contribution margin per unit of the constraint.

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When a company is considering outsourcing, if the incremental costs of making the product exceed the incremental costs of outsourcing, then the company should outsource the product. When a company is considering selling a product as is or processing it further, if the extra revenue from processing the product further exceeds the extra costs to process the product further, then the company should process the product further.

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Copyright

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