Differential Analysis and Decision Making Upon
Description: Differential Analysis and Decision Making Upon completion of this online module and in-class session, participants will be able to: Classify costs as relevant or irrelevant to a decision Understand the concept of sunk and opportunity costs
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slide1. Differential Analysis
and
Decision Making<br>
slide2. Upon completion of this online module and in-class session, participants will be able to:
Classify costs as relevant or irrelevant to a decision
Understand the concept of sunk and opportunity costs
Conduct differential analysis of relevant costs and revenue
Analyze impact on profits of
Special orders (with and without idle capacity)
Outsourcing (make versus buy) decisions
Sell or process further decisions
Assigning limited resources to multiple products under single or multiple constraints<br>
slide3. Decision-Making Process Stage 4
Planning & Implementation Stage 5
Obtaining Feedback 1 2 3 4 5<br>
slide4. Stage 1: Setting Goals & Objectives Organizations must set objectives to provide clear guidance. Tangible objectives provide benchmarks against which to measure performance. Intangible objectives: tend to be abstract
may provide guidance
are difficult to measure<br>
slide5. Target Profit and Target Cost Determine target selling price.
Determine target cost.
Determine target profit
Deduct target return on sales
Result is target cost
Compare target cost to currently feasible total cost.
The difference is the Cost-Reduction Target
Redesign products and processes to achieve the cost-reduction target.<br>
slide6. Stage 2: Gathering Information Relevance Timeliness Objectivity vs. Subjectivity Accuracy Information Quality and Decision Usefulness Cost vs. Quality<br>
slide7. Identification of Relevant Costs and Benefits Relevant costs are costs to be incurred at some future time and that differ for each option available to the decision maker.<br>
slide8. Decision: Trading an old car for a new car. Identification of Relevant Costs and Benefits<br>
slide9. Stage 3: Evaluating Alternatives 3. Measure the benefits and costs of each set of outcomes. 1. List decision alternatives in the order the decisions must be made. 2. Trace the path of each decision to its ultimate outcome. Consider qualitative as well as quantitative factors.<br>
slide10. Stage 3: Evaluating Alternatives Anticipating future outcomes of each action Consider the past
Although past costs are sunk and therefore irrelevant, they can be used to help estimate future costs that are relevant. Completely new products
Use prototype products to estimate costs.
Consider consultants who have knowledge of similar products.<br>
slide11. Outsourcing or Make-or-Buy Decision When the company needs goods or services, should they be “made” internally or “bought” externally? When goods or services are acquired externally, it is called “outsourcing”.<br>
slide12. Outsourcing or Make-or-Buy Decision Is it cheaper to make or buy? How dependable is the supplier? What are the relevant costs?<br>
slide13. Outsourcing or Make-or-Buy Decision Identify the fixed costs that we could avoid if we outsource. Identify the variable costs that would disappear if we outsource. Identify the new variable costs that we would incur if we outsource.<br>
slide14. Outsourcing or Make-or-Buy Decision Let’s look at a make-or-buy decision faced by the management of Thor Company.<br>
slide15. Outsourcing or Make-or-Buy Decision Thor Co. manufactures 20,000 of part X457 that is currently used in one of its products. The costs to make this part are:<br>
slide16. Outsourcing or Make-or-Buy Decision Thor Co. manufactures 20,000 of part 457 that is currently used in one of its products. The costs to make this part are: Fixed manufacturing overhead is the cost of leasing and operating the equipment necessary to produce part 457.<br>
slide17. Outsourcing or Make-or-Buy Decision Common costs are allocated on the basis of direct labor hours.
Total unit cost of $29 is based on 20,000 parts produced each year.
An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part.
Should we accept the supplier’s offer?<br>
slide18. Outsourcing or Make-or-Buy Decision 20,000 × $5 per unit 20,000 × $9 per unit 20,000 × $1 per unit<br>
slide19. Outsourcing or Make-or-Buy Decision 20,000 × $29 per unit<br>
slide20. Outsourcing or Make-or-Buy Decision The common costs remain unchanged. 20,000 × $25 purchase price<br>
slide21. Outsourcing or Make-or-Buy Decision Should we make or buy
part X457?<br>
slide22. Outsourcing or Make-or-Buy Decision What is the relevant unit cost of making part X457? Advantage of making
20,000 units × ($25.00 – $24.00) = $20,000<br>
slide23. Outsourcing or Make-or-Buy Decision If Thor could use the space currently being used to make Part X457 for another purpose, resulting in a cost savings of $45,000, would you change your decision? Yes. The cost savings (opportunity cost) of $45,000 overcomes the $20,000 disadvantage of buying. Now there is a $25,000 advantage to buying. The real issue is the most profitable use of the space.<br>
slide24. Pitfalls of Outsourcing Loss of sensitive information to supplier. Freed-up resources are not used as planned. Supplier quality is not as high as anticipated. Customers may object. Customer contact may be reduced. Supplier technology and knowledge base may not be as anticipated.<br>
slide25. Decision to Add or Drop a Product, Service, or Business Unit If we shut down our U.S. Digital Watch line, we might anger our American customers. . . . Not to mention the bad press! That is why we have to consider the relevant benefits and the relevant costs BEFORE making a final decision.<br>
slide26. Decision to Add or Drop a Product, Service, or Business Unit That is why we have to consider the relevant benefits and the relevant costs BEFORE making a final decision. Let’s get started. The digital line
has become less profitable and it is difficult to compete
in the market. . . . Not to mention the bad press!<br>
slide27. Decision to Add or Drop a Product, Service, or Business Unit<br>
slide28. Decision to Add or Drop a Product, Service, or Business Unit If the digital watch line is dropped, the
fixed general factory overhead and general
administrative expenses will be allocated
to other product lines.<br>
slide29. Decision to Add or Drop a Product, Service, or Business Unit The equipment used to manufacture
digital watches has no resale
value or alternative use.<br>
slide30. Decision to Add or Drop a Product, Service, or Business Unit Should Market retain or drop
the digital watch line?<br>
slide31. Decision to Add or Drop a Product, Service, or Business Unit DECISION RULE
Market should drop the digital watch segment only if its fixed cost savings exceed lost contribution margin.
Let’s look at this solution.<br>
slide32. Decision to Add or Drop a Product, Service, or Business Unit Should we drop the digital
watch segment?<br>
slide33. Decision to Add or Drop a Product, Service, or Business Unit The same result can also be obtained by preparing a differential analysis showing operating results with and without the digital watch segment.
Let’s look at this approach.<br>
slide34. Decision to Add or Drop a Product, Service, or Business Unit<br>
slide35. Decision to Add or Drop a Product, Service, or Business Unit Keeping the Digital Watch product line may have an opportunity cost that we have not yet considered. Example: If the idled facilities can be used to make a product generating $350,000 per year in contribution margin, with no other change in fixed costs, might this change your decision? The opportunity cost of retaining the digital watch line is measured by the differential profits given up if the next best use of the production facilities is rejected.<br>
slide36. Decision to Add or Drop a Product, Service, or Business Unit Measuring cost savings and lost revenues from closing a business unit is only part of the story.
The closing will impact . . .
Employees’ personal lives,
Morale of retained employees,
The community at large. 13-36<br>
slide37. Relevant Costs of Replacing Equipment Old machine cost $5,400 when purchased.
Old machine has a book value of $1,500.
Purchase price of a new machine is $10,000.
New machine will reduce labor from $12.00 to $11.00 per unit.
New machine is expected to last two years.
Repairs to old machine would be $4,600 and would allow two more years of productivity.
Power for either machine is expected to be $2.50 per unit.
Expected level of output: 1,000 units per year. Which costs are relevant to the decision to replace an old machine with a new machine?<br>
slide38. Relevant Costs of Replacing Equipment Old machine cost $5,400 when purchased.
Old machine has a book value of $1,500.
Purchase price of a new machine is $10,000.
New machine will reduce labor from $12.00 to $11.00 per unit.
New machine is expected to last two years.
Repairs to old machine would be $4,600 and would allow two more years of productivity.
Power for either machine is expected to be $2.50 per unit.
Expected level of output: 1,000 units per year 13-38 Relevant because of labor savings over the 2-year life. Which costs are relevant to the decision to replace an old machine with a new machine?<br>
slide39. 1,000 units @ $12.00 for 2 years 1,000 units @ $11.00 for 2 years Conclusion: keep old machine. Relevant Costs of Replacing Equipment<br>
slide40. Pricing Decisions Customers Competitors Political
Issues Product
Life Cycle Product
Costs<br>
slide41. Pricing Decisions Prices are determined by the market, subject to costs that must be covered in the long run. Prices are based on costs, subject to reactions of customers and competitors.<br>
slide42. Pricing Law in the United States Price
Discrimination Predatory
Pricing Price
Fixing<br>
slide43. Special-Order Price Decisions We just received
a special order. Do
you think we should
accept it?<br>
slide44. Special-Order Price Decisions A travel agency offers Worldwide Airways $150,000 for a round-trip flight from Japan to Hawaii on a jumbo jet.
Worldwide usually gets $250,000 in passenger ticket revenue from this flight.
The airlines is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency.
The next screen shows cost data developed by managerial accountants at Worldwide.<br>
slide45. Special-Order Price Decisions Worldwide will save about $5,000 in reservation
and ticketing costs if the charter is accepted.<br>
slide46. Special-Order Price Decisions Since the charter will contribute to fixed costs and Worldwide has idle capacity, the company should accept the flight.<br>
slide47. Special-Order Price Decisions What if Worldwide had no excess capacity? If Worldwide adds the charter, it will have to cut its least profitable route that currently contributes $80,000 to fixed costs and profits. Should Worldwide still accept the charter?<br>
slide48. Special-Order Price Decisions Worldwide has no excess capacity, so it should reject the special charter, or try to renegotiate a higher price.<br>
slide49. Special-Order Price Decisions With excess capacity . . .
Relevant costs usually will be the variable costs associated with the special order.
Without excess capacity . . .
Same as above but opportunity cost of using the firm’s facilities for the special order are also relevant.<br>
slide50. Special-Order Price Decisions Additional considerations
Impact on regular customers and markets
Will the special order lead to future regular business?<br>
and
Decision Making<br>
slide2. Upon completion of this online module and in-class session, participants will be able to:
Classify costs as relevant or irrelevant to a decision
Understand the concept of sunk and opportunity costs
Conduct differential analysis of relevant costs and revenue
Analyze impact on profits of
Special orders (with and without idle capacity)
Outsourcing (make versus buy) decisions
Sell or process further decisions
Assigning limited resources to multiple products under single or multiple constraints<br>
slide3. Decision-Making Process Stage 4
Planning & Implementation Stage 5
Obtaining Feedback 1 2 3 4 5<br>
slide4. Stage 1: Setting Goals & Objectives Organizations must set objectives to provide clear guidance. Tangible objectives provide benchmarks against which to measure performance. Intangible objectives: tend to be abstract
may provide guidance
are difficult to measure<br>
slide5. Target Profit and Target Cost Determine target selling price.
Determine target cost.
Determine target profit
Deduct target return on sales
Result is target cost
Compare target cost to currently feasible total cost.
The difference is the Cost-Reduction Target
Redesign products and processes to achieve the cost-reduction target.<br>
slide6. Stage 2: Gathering Information Relevance Timeliness Objectivity vs. Subjectivity Accuracy Information Quality and Decision Usefulness Cost vs. Quality<br>
slide7. Identification of Relevant Costs and Benefits Relevant costs are costs to be incurred at some future time and that differ for each option available to the decision maker.<br>
slide8. Decision: Trading an old car for a new car. Identification of Relevant Costs and Benefits<br>
slide9. Stage 3: Evaluating Alternatives 3. Measure the benefits and costs of each set of outcomes. 1. List decision alternatives in the order the decisions must be made. 2. Trace the path of each decision to its ultimate outcome. Consider qualitative as well as quantitative factors.<br>
slide10. Stage 3: Evaluating Alternatives Anticipating future outcomes of each action Consider the past
Although past costs are sunk and therefore irrelevant, they can be used to help estimate future costs that are relevant. Completely new products
Use prototype products to estimate costs.
Consider consultants who have knowledge of similar products.<br>
slide11. Outsourcing or Make-or-Buy Decision When the company needs goods or services, should they be “made” internally or “bought” externally? When goods or services are acquired externally, it is called “outsourcing”.<br>
slide12. Outsourcing or Make-or-Buy Decision Is it cheaper to make or buy? How dependable is the supplier? What are the relevant costs?<br>
slide13. Outsourcing or Make-or-Buy Decision Identify the fixed costs that we could avoid if we outsource. Identify the variable costs that would disappear if we outsource. Identify the new variable costs that we would incur if we outsource.<br>
slide14. Outsourcing or Make-or-Buy Decision Let’s look at a make-or-buy decision faced by the management of Thor Company.<br>
slide15. Outsourcing or Make-or-Buy Decision Thor Co. manufactures 20,000 of part X457 that is currently used in one of its products. The costs to make this part are:<br>
slide16. Outsourcing or Make-or-Buy Decision Thor Co. manufactures 20,000 of part 457 that is currently used in one of its products. The costs to make this part are: Fixed manufacturing overhead is the cost of leasing and operating the equipment necessary to produce part 457.<br>
slide17. Outsourcing or Make-or-Buy Decision Common costs are allocated on the basis of direct labor hours.
Total unit cost of $29 is based on 20,000 parts produced each year.
An outside supplier has offered to provide the 20,000 parts at a cost of $25 per part.
Should we accept the supplier’s offer?<br>
slide18. Outsourcing or Make-or-Buy Decision 20,000 × $5 per unit 20,000 × $9 per unit 20,000 × $1 per unit<br>
slide19. Outsourcing or Make-or-Buy Decision 20,000 × $29 per unit<br>
slide20. Outsourcing or Make-or-Buy Decision The common costs remain unchanged. 20,000 × $25 purchase price<br>
slide21. Outsourcing or Make-or-Buy Decision Should we make or buy
part X457?<br>
slide22. Outsourcing or Make-or-Buy Decision What is the relevant unit cost of making part X457? Advantage of making
20,000 units × ($25.00 – $24.00) = $20,000<br>
slide23. Outsourcing or Make-or-Buy Decision If Thor could use the space currently being used to make Part X457 for another purpose, resulting in a cost savings of $45,000, would you change your decision? Yes. The cost savings (opportunity cost) of $45,000 overcomes the $20,000 disadvantage of buying. Now there is a $25,000 advantage to buying. The real issue is the most profitable use of the space.<br>
slide24. Pitfalls of Outsourcing Loss of sensitive information to supplier. Freed-up resources are not used as planned. Supplier quality is not as high as anticipated. Customers may object. Customer contact may be reduced. Supplier technology and knowledge base may not be as anticipated.<br>
slide25. Decision to Add or Drop a Product, Service, or Business Unit If we shut down our U.S. Digital Watch line, we might anger our American customers. . . . Not to mention the bad press! That is why we have to consider the relevant benefits and the relevant costs BEFORE making a final decision.<br>
slide26. Decision to Add or Drop a Product, Service, or Business Unit That is why we have to consider the relevant benefits and the relevant costs BEFORE making a final decision. Let’s get started. The digital line
has become less profitable and it is difficult to compete
in the market. . . . Not to mention the bad press!<br>
slide27. Decision to Add or Drop a Product, Service, or Business Unit<br>
slide28. Decision to Add or Drop a Product, Service, or Business Unit If the digital watch line is dropped, the
fixed general factory overhead and general
administrative expenses will be allocated
to other product lines.<br>
slide29. Decision to Add or Drop a Product, Service, or Business Unit The equipment used to manufacture
digital watches has no resale
value or alternative use.<br>
slide30. Decision to Add or Drop a Product, Service, or Business Unit Should Market retain or drop
the digital watch line?<br>
slide31. Decision to Add or Drop a Product, Service, or Business Unit DECISION RULE
Market should drop the digital watch segment only if its fixed cost savings exceed lost contribution margin.
Let’s look at this solution.<br>
slide32. Decision to Add or Drop a Product, Service, or Business Unit Should we drop the digital
watch segment?<br>
slide33. Decision to Add or Drop a Product, Service, or Business Unit The same result can also be obtained by preparing a differential analysis showing operating results with and without the digital watch segment.
Let’s look at this approach.<br>
slide34. Decision to Add or Drop a Product, Service, or Business Unit<br>
slide35. Decision to Add or Drop a Product, Service, or Business Unit Keeping the Digital Watch product line may have an opportunity cost that we have not yet considered. Example: If the idled facilities can be used to make a product generating $350,000 per year in contribution margin, with no other change in fixed costs, might this change your decision? The opportunity cost of retaining the digital watch line is measured by the differential profits given up if the next best use of the production facilities is rejected.<br>
slide36. Decision to Add or Drop a Product, Service, or Business Unit Measuring cost savings and lost revenues from closing a business unit is only part of the story.
The closing will impact . . .
Employees’ personal lives,
Morale of retained employees,
The community at large. 13-36<br>
slide37. Relevant Costs of Replacing Equipment Old machine cost $5,400 when purchased.
Old machine has a book value of $1,500.
Purchase price of a new machine is $10,000.
New machine will reduce labor from $12.00 to $11.00 per unit.
New machine is expected to last two years.
Repairs to old machine would be $4,600 and would allow two more years of productivity.
Power for either machine is expected to be $2.50 per unit.
Expected level of output: 1,000 units per year. Which costs are relevant to the decision to replace an old machine with a new machine?<br>
slide38. Relevant Costs of Replacing Equipment Old machine cost $5,400 when purchased.
Old machine has a book value of $1,500.
Purchase price of a new machine is $10,000.
New machine will reduce labor from $12.00 to $11.00 per unit.
New machine is expected to last two years.
Repairs to old machine would be $4,600 and would allow two more years of productivity.
Power for either machine is expected to be $2.50 per unit.
Expected level of output: 1,000 units per year 13-38 Relevant because of labor savings over the 2-year life. Which costs are relevant to the decision to replace an old machine with a new machine?<br>
slide39. 1,000 units @ $12.00 for 2 years 1,000 units @ $11.00 for 2 years Conclusion: keep old machine. Relevant Costs of Replacing Equipment<br>
slide40. Pricing Decisions Customers Competitors Political
Issues Product
Life Cycle Product
Costs<br>
slide41. Pricing Decisions Prices are determined by the market, subject to costs that must be covered in the long run. Prices are based on costs, subject to reactions of customers and competitors.<br>
slide42. Pricing Law in the United States Price
Discrimination Predatory
Pricing Price
Fixing<br>
slide43. Special-Order Price Decisions We just received
a special order. Do
you think we should
accept it?<br>
slide44. Special-Order Price Decisions A travel agency offers Worldwide Airways $150,000 for a round-trip flight from Japan to Hawaii on a jumbo jet.
Worldwide usually gets $250,000 in passenger ticket revenue from this flight.
The airlines is not currently planning to add any new routes and has two planes that are idle and could be used to meet the needs of the agency.
The next screen shows cost data developed by managerial accountants at Worldwide.<br>
slide45. Special-Order Price Decisions Worldwide will save about $5,000 in reservation
and ticketing costs if the charter is accepted.<br>
slide46. Special-Order Price Decisions Since the charter will contribute to fixed costs and Worldwide has idle capacity, the company should accept the flight.<br>
slide47. Special-Order Price Decisions What if Worldwide had no excess capacity? If Worldwide adds the charter, it will have to cut its least profitable route that currently contributes $80,000 to fixed costs and profits. Should Worldwide still accept the charter?<br>
slide48. Special-Order Price Decisions Worldwide has no excess capacity, so it should reject the special charter, or try to renegotiate a higher price.<br>
slide49. Special-Order Price Decisions With excess capacity . . .
Relevant costs usually will be the variable costs associated with the special order.
Without excess capacity . . .
Same as above but opportunity cost of using the firm’s facilities for the special order are also relevant.<br>
slide50. Special-Order Price Decisions Additional considerations
Impact on regular customers and markets
Will the special order lead to future regular business?<br>