mcgraw-hill/irwin1 25-1 © the mcgraw-hill companies, inc., 2006 capital budgeting and managerial...
TRANSCRIPT
McGraw-Hill/Irwin1
25-1
© The McGraw-Hill Companies, Inc., 2006
Capital Budgeting and Managerial Decisions
Chapter
2525
McGraw-Hill/Irwin2
25-2
© The McGraw-Hill Companies, Inc., 2006
Capital budgeting:Analyzing alternative long-
term investments and deciding which assets to acquire or sell.
Outcomeis uncertain.
Large amounts ofmoney are usually
involved.
Investment involves along-term commitment.
Decision may bedifficult or impossible
to reverse.
Capital BudgetingCapital Budgeting
McGraw-Hill/Irwin3
25-3
© The McGraw-Hill Companies, Inc., 2006
Paybackperiod
= Cost of Investment Annual Net Cash Flow
Payback PeriodPayback Period
The payback period of an investmentis the time expected to recoverthe initial investment amount.
The payback period of an investmentis the time expected to recoverthe initial investment amount.
Managers prefer investing in projects with shorter payback periods.
Exh. 25-2
McGraw-Hill/Irwin4
25-4
© The McGraw-Hill Companies, Inc., 2006
FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produce annual net cash flows
of $4,100. The machine is expected to have an 8-year useful life with no salvage value.
Calculate the payback period.
Paybackperiod
= Cost of Investment Annual Net Cash Flow
Paybackperiod
= $16,000
$4,100= 3.9 years
Payback Period with Even Cash FlowsPayback Period with Even Cash Flows
McGraw-Hill/Irwin5
25-5
© The McGraw-Hill Companies, Inc., 2006
In the previous example, we assumed that the increase in cash flows would be the same each year. Now, let’s look at an
example where the cash flows vary each year.
$4,100
$5,000
Payback Period withUneven Cash FlowsPayback Period withUneven Cash Flows
McGraw-Hill/Irwin6
25-6
© The McGraw-Hill Companies, Inc., 2006
FasTrac wants to install a machine
that costs $16,000 and has an 8-year
useful life with zero salvage
value. Annual net cash flows are:
YearAnnual Net Cash Flows
Cumulative Net Cash
Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 4,000 6 3,000 7,000 7 2,000 9,000 8 2,000 11,000
Payback Period withUneven Cash FlowsPayback Period withUneven Cash Flows Exh.
25-3
McGraw-Hill/Irwin7
25-7
© The McGraw-Hill Companies, Inc., 2006
YearAnnual Net Cash Flows
Cumulative Net Cash
Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 4,000 6 3,000 7,000 7 2,000 9,000 8 2,000 11,000
4.2
We recover the $16,000purchase price between
years 4 and 5, about4.2 years for the payback period.
Payback Period withUneven Cash FlowsPayback Period withUneven Cash Flows Exh.
25-3
McGraw-Hill/Irwin8
25-8
© The McGraw-Hill Companies, Inc., 2006
Ignores the time valueof money.
Ignores cashflows after the payback
period.
Unacceptable forprojects with longlives where time
value ofmoney effects
are major.
Using the Payback PeriodUsing the Payback Period
McGraw-Hill/Irwin9
25-9
© The McGraw-Hill Companies, Inc., 2006
Consider two projects, each with a five-year lifeand each costing $6,000.
Project One Project TwoNet Cash Net Cash
Year Inflows Inflows
1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000
Would you invest in Project One just because it has a shorter payback period?
Using the Payback PeriodUsing the Payback Period
McGraw-Hill/Irwin10
25-10
© The McGraw-Hill Companies, Inc., 2006
The accounting rate of return focuses onannual income instead of cash flows.
Accounting Rate of ReturnAccounting Rate of Return
Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Beginning book value + Ending book value2
Exh. 25-5,6
McGraw-Hill/Irwin11
25-11
© The McGraw-Hill Companies, Inc., 2006
Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Beginning book value + Ending book value2
Accounting Rate of ReturnAccounting Rate of Return Exh. 25-5,6
McGraw-Hill/Irwin12
25-12
© The McGraw-Hill Companies, Inc., 2006
Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Accounting Rate of ReturnAccounting Rate of Return
Beginning book value + Ending book value2
Exh. 25-5,6
McGraw-Hill/Irwin13
25-13
© The McGraw-Hill Companies, Inc., 2006
Accounting $2,100rate of return $8,000
Accounting $2,100rate of return $8,000
= = 26.25%
$16,000 + $02
Accounting Rate of ReturnAccounting Rate of Return
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Exh. 25-5,6
McGraw-Hill/Irwin14
25-14
© The McGraw-Hill Companies, Inc., 2006
Depreciation may be calculated several ways.
Income may vary from year to year.
Time value ofmoney is ignored.
So why would I ever want to use this method
anyway?
Using Accounting Rate of ReturnUsing Accounting Rate of Return
McGraw-Hill/Irwin15
25-15
© The McGraw-Hill Companies, Inc., 2006
Now let’s look at a capital budgeting modelthat considers the time value of cash flows.
Net Present ValueNet Present Value
McGraw-Hill/Irwin16
25-16
© The McGraw-Hill Companies, Inc., 2006
Discount the future net cash flows from the investment at the required rate of return.
Subtract the initial amount invested from sum of the discounted cash flows.
FasTrac is considering the purchase of a conveyor costing $16,000 with an 8-year useful life with zero salvage value that promises annual net cash flows of $4,100. FasTrac requires a 12 percent compounded annual return on its
investments.
Net Present ValueNet Present Value
McGraw-Hill/Irwin17
25-17
© The McGraw-Hill Companies, Inc., 2006
YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
Net Present Valuewith Even Cash FlowsNet Present Valuewith Even Cash Flows Exh.
26-7
McGraw-Hill/Irwin18
25-18
© The McGraw-Hill Companies, Inc., 2006
YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
Present value factorsfor 12 percent
Net Present Valuewith Even Cash FlowsNet Present Valuewith Even Cash Flows Exh.
26-7
McGraw-Hill/Irwin19
25-19
© The McGraw-Hill Companies, Inc., 2006
YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
A positive net present value indicates that thisproject earns more than 12 percent on the investment.
Net Present Valuewith Even Cash FlowsNet Present Valuewith Even Cash Flows Exh.
26-7
McGraw-Hill/Irwin20
25-20
© The McGraw-Hill Companies, Inc., 2006
General decision rule . . .If the Net Present
Value is . . . Then the Project is . . .
Positive . . . Acceptable, since it promises a return greater than the required
rate of return.
Zero . . . Acceptable, since it promises a return equal to the required rate
of return.
Negative . . . Not acceptable, since it
promises a return less than the required rate of return.
Using Net Present ValueUsing Net Present Value
McGraw-Hill/Irwin21
25-21
© The McGraw-Hill Companies, Inc., 2006
PresentVa lue of
Net Cash Flow s $1 Factor PV of Net Cash Flow sYear A B C at 10% A B C
1 5,000$ 8,000$ 1,000$ 0.9091 4,546$ 7,273$ 909$ 2 5,000 5,000 5,000 0.8264 4,132 4,132 4,132 3 5,000 2,000 9,000 0.7513 3,757 1,503 6,762
Tota l 15,000$ 15,000$ 15,000$ 12,435$ 12,908$ 11,803$
Amount invested (12,000) (12,000) (12,000) Net Present Va lue 435$ 908$ (197)$
Although all projects require the same investment and havethe same total net cash flows, project B has a higher net present
value because of a larger net cash flow in year 1.
Net Present Valuewith Uneven Cash FlowsNet Present Valuewith Uneven Cash Flows Exh.
26-8
McGraw-Hill/Irwin22
25-22
© The McGraw-Hill Companies, Inc., 2006
Internal Rate of Return (IRR)Internal Rate of Return (IRR)
The interest rate that makes . . .
Presentvalue of
cash inflows
Presentvalue of
cash outflows=
The net present value equal zero.
McGraw-Hill/Irwin23
25-23
© The McGraw-Hill Companies, Inc., 2006
Projects with even annual cash flows
Project life = 3 yearsInitial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.
1. Compute present value factor.
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
McGraw-Hill/Irwin24
25-24
© The McGraw-Hill Companies, Inc., 2006
1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Projects with even annual cash flows
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
Project life = 3 yearsInitial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.
McGraw-Hill/Irwin25
25-25
© The McGraw-Hill Companies, Inc., 2006
Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
Locate the rowwhose number
equals the periods in theproject’s life.
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
McGraw-Hill/Irwin26
25-26
© The McGraw-Hill Companies, Inc., 2006
Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
In that row,locate the
interest factorclosest in
amount to thepresent value
factor.
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
McGraw-Hill/Irwin27
25-27
© The McGraw-Hill Companies, Inc., 2006
Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
IRR is theinterest rate
of the columnin which the
present valuefactor is found.
IRR isapproximately
12%.
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
McGraw-Hill/Irwin28
25-28
© The McGraw-Hill Companies, Inc., 2006
If cash inflows are unequal, trial and error solution will result if present value tables
are used.
Sophisticated business calculators and electronic spreadsheets can be used to
easily solve these problems.
Internal Rate of Return –Uneven Cash FlowsInternal Rate of Return –Uneven Cash Flows
McGraw-Hill/Irwin29
25-29
© The McGraw-Hill Companies, Inc., 2006
Internal Rate of Return Compare the internal rate
of return on a project to a predetermined hurdle rate (cost of capital).
To be acceptable, a project’s rate of return cannot be less than thecost of capital.
Using Internal Rate of ReturnUsing Internal Rate of Return
McGraw-Hill/Irwin30
25-30
© The McGraw-Hill Companies, Inc., 2006
Exh. 25-10
Payback Accounting Net present Internal rateperiod rate of return value of return
Basis of Cash Accrual Cash flows Cash flowsmeasurement flows income Profitability Profitability
Measure Number Percent Dollar Percentexpressed as of years Amount
Easy to Easy to Considers time Considers timeUnderstand Understand value of money value of money
Strengths Allows Allows Accommodates Allowscomparison comparison different risk comparisons
across projects across projects levels over of dissimilara project's life projects
Doesn't Doesn't Difficult to Doesn't reflectconsider time consider time compare varying risk
value of money value of money dissimilar levels over theLimitations projects project's life
Doesn't Doesn't giveconsider cash annual rates
flows after over the lifepayback period of a project
Comparing Methods
McGraw-Hill/Irwin31
25-31
© The McGraw-Hill Companies, Inc., 2006
Let’s change topics.
Managerial DecisionsManagerial Decisions
McGraw-Hill/Irwin32
25-32
© The McGraw-Hill Companies, Inc., 2006
Decision making involves five steps: Define the problem. Identify alternatives. Collect relevant information on
alternatives. Select the preferred alternative. Analyze decisions made.
Decision MakingDecision Making Exh. 25-11
McGraw-Hill/Irwin33
25-33
© The McGraw-Hill Companies, Inc., 2006
Costs that are applicableto a particular decision.
Costs that should have a bearing on which alternative a manager selects.
Costs that are avoidable.Future costs that differ
between alternatives.
1
2
Relevant CostsRelevant Costs
McGraw-Hill/Irwin34
25-34
© The McGraw-Hill Companies, Inc., 2006
All costs incurred in the past that cannot be changed by any decision made now or in the future.
Sunk costs should not be considered in decisions.
All costs incurred in the past that cannot be changed by any decision made now or in the future.
Sunk costs should not be considered in decisions.
Classification by Relevance:Sunk CostsClassification by Relevance:Sunk Costs
Example: You bought an automobile that cost$10,000 two years ago. The $10,000 cost is sunkbecause whether you drive it, park it, trade it, or sellit, you cannot change the $10,000 cost.
McGraw-Hill/Irwin35
25-35
© The McGraw-Hill Companies, Inc., 2006
Future outlays of cash associatedwith a particular decision.
Future outlays of cash associatedwith a particular decision.
Example: Considering the decision to take a vacation or stay at home, you will have travel costs (out-of-pocket costs) only if you choose a vacation.
Classification by Relevance:Out-of-Pocket CostsClassification by Relevance:Out-of-Pocket Costs
McGraw-Hill/Irwin36
25-36
© The McGraw-Hill Companies, Inc., 2006
The potential benefit that is given up when one alternative is selected over another.Example: If you were
not attending college,you could be earning$20,000 per year. Your opportunity costof attending college for one year is $20,000.
Classification by Relevance: Opportunity CostsClassification by Relevance: Opportunity Costs
McGraw-Hill/Irwin37
25-37
© The McGraw-Hill Companies, Inc., 2006
We will now examine several
different types of managerial
decisions.
Managerial Decision TasksManagerial Decision Tasks
McGraw-Hill/Irwin38
25-38
© The McGraw-Hill Companies, Inc., 2006
The decision to accept additional business should be based on incremental
costs and incremental revenues.
Incremental amounts are those that occur if the company decides to accept the new
business.
Accepting Additional BusinessAccepting Additional Business
McGraw-Hill/Irwin39
25-39
© The McGraw-Hill Companies, Inc., 2006
FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below:
Per Unit Total Sales 10.00$ 1,000,000$ Direct materials 3.50 350,000 Direct labor 2.20 220,000 Factory overhead 1.10 110,000 Selling expenses 1.40 140,000 Administrative expenses 0.80 80,000 Total expenses 9.00$ 900,000$ Operating income 1.00$ 100,000$
Accepting Additional BusinessAccepting Additional Business Exh. 25-12
McGraw-Hill/Irwin40
25-40
© The McGraw-Hill Companies, Inc., 2006
FasTrac is approached by an overseascompany that offers to purchase10,000 units at $8.50 per unit.
If FasTrac accepts the offer, total factory overhead will increase by $5,000; total selling
expenses will increase by $2,000; and total administrative expenses will increase
by $1,000.
Should FasTrac accept the offer?
Accepting Additional BusinessAccepting Additional Business
McGraw-Hill/Irwin41
25-41
© The McGraw-Hill Companies, Inc., 2006
First let’s look at incorrect reasoningthat leads to an incorrect decision.
First let’s look at incorrect reasoningthat leads to an incorrect decision.
Our cost is $9.00per unit. I can’t sell for $8.50 per unit.
Accepting Additional BusinessAccepting Additional Business
McGraw-Hill/Irwin42
25-42
© The McGraw-Hill Companies, Inc., 2006
Current Business
Additional Business Combined
Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses 900,000$ 65,000$ 965,000$ Operating income 100,000$ 20,000$ 120,000$
This analysis leads to the correct decision.
Accepting Additional BusinessAccepting Additional Business Exh. 25-14
McGraw-Hill/Irwin43
25-43
© The McGraw-Hill Companies, Inc., 2006
Current Business
Additional Business Combined
Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses 900,000$ 65,000$ 965,000$ Operating income 100,000$ 20,000$ 120,000$
10,000 new units × $8.50 selling price = $85,000
Accepting Additional BusinessAccepting Additional Business Exh. 25-14
McGraw-Hill/Irwin44
25-44
© The McGraw-Hill Companies, Inc., 2006
Current Business
Additional Business Combined
Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses 900,000$ 65,000$ 965,000$ Operating income 100,000$ 20,000$ 120,000$
10,000 new units × $3.50 = $35,000
Accepting Additional BusinessAccepting Additional Business Exh. 25-14
McGraw-Hill/Irwin45
25-45
© The McGraw-Hill Companies, Inc., 2006
Current Business
Additional Business Combined
Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses 900,000$ 65,000$ 965,000$ Operating income 100,000$ 20,000$ 120,000$
10,000 new units × $2.20 = $22,000
Accepting Additional BusinessAccepting Additional Business Exh. 25-14
McGraw-Hill/Irwin46
25-46
© The McGraw-Hill Companies, Inc., 2006
Current Business
Additional Business Combined
Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses 900,000$ 65,000$ 965,000$ Operating income 100,000$ 20,000$ 120,000$
Even though the $8.50 selling price is less than thenormal $10 selling price, FasTrac should accept theoffer because net income will increase by $20,000.
Accepting Additional BusinessAccepting Additional Business Exh. 25-14
McGraw-Hill/Irwin47
25-47
© The McGraw-Hill Companies, Inc., 2006
Incremental costs also are important in the decision to make a product or purchase it from a supplier.
The cost to produce an item must include (1) direct materials, (2) direct labor and (3) incremental overhead.
We should not use the predetermined overhead rate to determine product cost.
Make or Buy DecisionsMake or Buy Decisions
McGraw-Hill/Irwin48
25-48
© The McGraw-Hill Companies, Inc., 2006
Cost to Make Part #417
MakeDirect materials 0.45$Direct labor 0.50 Factory overhead 0.50
Total cost to make 1.45$
FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with
the following unit cost:
Make or Buy DecisionsMake or Buy Decisions
McGraw-Hill/Irwin49
25-49
© The McGraw-Hill Companies, Inc., 2006
Make vs. Buy Analysis
Make BuyDirect materia ls 0.45$ ----Direct labor 0.50 ----Factory overhead ? ----Purchase price ---- 1.20$Tota l incremental costs ? 1.20$
FasTrac can buy part #417 from a supplier for $1.20. How much overhead do we have to eliminate before we
can continue to make this part?
Make or Buy DecisionsMake or Buy Decisions Exh. 25-15
McGraw-Hill/Irwin50
25-50
© The McGraw-Hill Companies, Inc., 2006
Make vs. Buy Analysis
Make BuyDirect materia ls 0.45$ ----Direct labor 0.50 ----Factory overhead 0.25 ----Purchase price ---- 1.20$Tota l incremental costs 1.20 1.20$
FasTrac can buy part #417 from a supplier for $1.20. How much overhead do we have to eliminate before we
can continue to make this part?
We must eliminate $.25 per unit of overhead,leaving a maximum of $0.25 per unit.
Make or Buy DecisionsMake or Buy Decisions Exh. 25-15
McGraw-Hill/Irwin51
25-51
© The McGraw-Hill Companies, Inc., 2006
Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered.
As long as rework costs are recovered through sale of the product, and rework does not interfere with normal production, we should rework rather than scrap.
Scrap or ReworkScrap or Rework
McGraw-Hill/Irwin52
25-52
© The McGraw-Hill Companies, Inc., 2006
FasTrac has 10,000 defective units thatcost $1.00 each to make. The units can be
scrapped now for $.40 each or reworked at an additional cost of $.80 per unit.
If reworked, the units can be sold for the normal selling price of $1.50 each. Reworking the
defective units will prevent the production of 10,000 new units that would also sell for $1.50.
Should FasTrac scrap or rework?
Scrap or ReworkScrap or Rework
McGraw-Hill/Irwin53
25-53
© The McGraw-Hill Companies, Inc., 2006
Scrap Now Rework
Sale of Defects 4,000$ 15,000$ Less rework costs - Less opportunity cost - Net return 4,000$
10,000 units × $1.50 per unit
10,000 units × $0.40 per unit
Scrap or ReworkScrap or Rework Exh. 25-16
McGraw-Hill/Irwin54
25-54
© The McGraw-Hill Companies, Inc., 2006
Scrap Now Rework
Sale of Defects 4,000$ 15,000$ Less rework costs - (8,000) Less opportunity cost - (5,000) Net return 4,000$ 2,000
10,000 units × $0.80 per unit
10,000 units × ($1.50 - $1.00) per unit
Scrap or ReworkScrap or Rework Exh. 25-16
McGraw-Hill/Irwin55
25-55
© The McGraw-Hill Companies, Inc., 2006
Scrap Now Rework
Sale of Defects 4,000$ 15,000$ Less rework costs - (8,000) Less opportunity cost - (5,000) Net return 4,000$ 2,000
FasTrac should scrap the units now.
If FasTrac fails to include the opportunity cost,the rework option would show a return of $7,000,
mistakenly making rework appear more favorable.
Scrap or Rework DefectsScrap or Rework Defects Exh. 25-16
McGraw-Hill/Irwin56
25-56
© The McGraw-Hill Companies, Inc., 2006
Businesses are often faced with the decision to sell partially completed products or to process them to completion.
As a general rule, , we process further only if incremental revenues exceed incremental costs.
Sell or ProcessSell or Process
McGraw-Hill/Irwin57
25-57
© The McGraw-Hill Companies, Inc., 2006
FasTrac has 40,000 units of partially finished product Q. Processing costs to date are $30,000. The 40,000
unfinished units can be sold as is for $50,000 or they can be processed further to produce finished
products X, Y, and Z. The additional processing will cost $80,000 and result in the following revenues:
Continue
Sell or ProcessSell or Process
McGraw-Hill/Irwin58
25-58
© The McGraw-Hill Companies, Inc., 2006
Product Price Units Revenue
X 4.00$ 10,000 40,000$ Y 6.00 22,000 132,000 Z 8.00 6,000 48,000
Spoilage - 2,000 - Total 40,000 220,000$
Should FasTrac sell product Q or continueprocessing into products X, Y, and Z?
Sell or ProcessSell or Process Exh. 25-17
McGraw-Hill/Irwin59
25-59
© The McGraw-Hill Companies, Inc., 2006
Revenue processing 220,000 Revenue unfinished 50,000 Incremental Revenue 170,000 Incremental Cost 80,000 Incremental Net Income 90,000
continue!
FasTrac should continue processing. Note that the earlier $30,000cost for product Q is sunk and therefore irrelevant to the decision.
Sell or ProcessSell or Process
Should FasTrac sell product Q or continueprocessing into products X, Y, and Z?
Exh. 25-17,18
McGraw-Hill/Irwin60
25-60
© The McGraw-Hill Companies, Inc., 2006
When a company sells a variety of products, some are likely to be more profitable than others.
To make an informed decision, management must consider . . .The contribution margin of each product,The facilities required to produce each product
and any constraints on the facilities, andThe demand for each product.
Sales Mix SelectionSales Mix Selection
McGraw-Hill/Irwin61
25-61
© The McGraw-Hill Companies, Inc., 2006
Consider the following data for two products made and sold by FasTrac.
Per unit amounts Product
A Product
B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$
If each product requires the same time tomake, and the demand is unlimited, FasTrac
should produce only Product B.
Sales Mix SelectionSales Mix Selection Exh. 25-19
McGraw-Hill/Irwin62
25-62
© The McGraw-Hill Companies, Inc., 2006
Consider this additional information.
Consider the following data for two products made and sold by FasTrac.
Sales Mix SelectionSales Mix Selection Exh. 25-19
Per unit amounts Product
A Product
B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$ Machine hours required toproduce one unit 1.0 2.0 Contribution per machine hour 1.50$ 1.00$
McGraw-Hill/Irwin63
25-63
© The McGraw-Hill Companies, Inc., 2006
Per unit amounts Product
A Product
B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$ Machine hours required toproduce one unit 1.0 2.0 Contribution per machine hour 1.50$ 1.00$
Consider the following data for two products made and sold by FasTrac.Product B has a greater
contribution margin thanProduct A, but it
requires more machine hours per unit to produce.
With unlimited demand for A and B, produce as many units of A as possible since A provides more dollars per hour worked.
Sales Mix SelectionSales Mix Selection Exh. 25-19
McGraw-Hill/Irwin64
25-64
© The McGraw-Hill Companies, Inc., 2006
Per unit amounts Product
A Product
B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$ Machine hours required toproduce one unit 1.0 2.0 Contribution per machine hour 1.50$ 1.00$
If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B.
Consider the following data for two products made and sold by FasTrac.
Sales Mix SelectionSales Mix Selection Exh. 25-19
McGraw-Hill/Irwin65
25-65
© The McGraw-Hill Companies, Inc., 2006
FasTrac is considering eliminating its TreadmillDivision because total expenses of $48,300 are
greater than its sales of $47,800.
A segment is a candidate for elimination if its revenues are less than its
avoidable expenses.
Continue
Segment EliminationSegment Elimination
McGraw-Hill/Irwin66
25-66
© The McGraw-Hill Companies, Inc., 2006
TotalExpenses
Cost of goods sold 30,200$ Direct expenses: Salaries 7,900 Equipment depreciation 200 Indirect expenses: Rent and utilities 3,150 Advertising 200 Insurance 400 Service department costs: Departmental office 3,060 Purchasing 3,190 Total 48,300$
Let’s identifyavoidable expenses.
Analysis of DivisionalOperating ExpensesAnalysis of DivisionalOperating Expenses Exh.
25-20
McGraw-Hill/Irwin67
25-67
© The McGraw-Hill Companies, Inc., 2006
Total Avoidable UnavoidableExpenses Expenses Expenses
Cost of goods sold 30,200$ 30,200$ Direct expenses: Salaries 7,900 7,900 Equipment depreciation 200 200$ Indirect expenses: Rent and utilities 3,150 3,150 Advertising 200 200 Insurance 400 300 100 Service department costs: Departmental office 3,060 2,200 860 Purchasing 3,190 1,000 2,190 Total 48,300$ 41,800$ 6,500$
Analysis of DivisionalOperating ExpensesAnalysis of DivisionalOperating Expenses Exh.
25-20
McGraw-Hill/Irwin68
25-68
© The McGraw-Hill Companies, Inc., 2006
Sales 47,800$ Avoidable expenses 41,800 Decrease in incom e 6,000$
Sa les 47,800$ Avoidable expenses 41,800 Decrease in incom e 6,000$
Do not eliminatethe Treadmill Division!
Segment EliminationSegment Elimination
McGraw-Hill/Irwin69
25-69
© The McGraw-Hill Companies, Inc., 2006
Qualitative factors are involved in most all managerial decisions. For example:
Quality. Delivery schedule. Supplier reputation. Employee morale. Customer opinions.
Qualitative Factors in DecisionsQualitative Factors in Decisions
McGraw-Hill/Irwin70
25-70
© The McGraw-Hill Companies, Inc., 2006
Homework for Chapter 25Homework for Chapter 25
Ex 25-2, 5, 7, 8, 9, 10, 11, Problem 1A, 5A,
McGraw-Hill/Irwin71
25-71
© The McGraw-Hill Companies, Inc., 2006
End of Chapter 25End of Chapter 25