Marginal costing applications

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Marginal costing applications

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Marginal costing applications

  1. 1. Chapter 26 Special Business Decisions and Capital Budgeting
  2. 2. <ul><li>Identify the relevant information </li></ul><ul><li>for a special business decision. </li></ul>Objective 1
  3. 3. Relevant Information for Decision Making <ul><li>Relevant information has two distinguishing characteristics. </li></ul>It is expected future data that differs among alternatives. Only relevant data affect decisions.
  4. 4. <ul><li>Make five types of short-term </li></ul><ul><li>special business decisions. </li></ul>Objective 2
  5. 5. Special Sales Order <ul><li>A. B. Fast is a manufacturer of automobile parts located in Texas. </li></ul><ul><li>Ordinarily A. B. Fast sells oil filters for $3.22 each. </li></ul><ul><li>R. Pino and Co., from Puerto Rico, has offered $35,400 for 20,000 oil filters, or $1.77 per filter. </li></ul>
  6. 6. Special Sales Order <ul><li>A. B. Fast’s manufacturing product cost is $2 per oil filter which includes variable manufacturing costs of $1.20 and fixed manufacturing overhead of $0.80. </li></ul><ul><li>Suppose that A. B. Fast made and sold 250,000 oil filters before considering the special order. </li></ul><ul><li>Should A. B. Fast accept the special order? </li></ul>
  7. 7. Special Sales Order <ul><li>The $1.77 offered price will not cover the $2 manufacturing cost. </li></ul><ul><li>However, the $1.77 price exceeds variable manufacturing costs by $.57 per unit. </li></ul><ul><li>Accepting the order will increase A. B. Fast’s contribution margin. </li></ul><ul><li>20,000 units × $.57 contribution margin per unit = $11,400 </li></ul>
  8. 8. Dropping Products, Departments, Territories <ul><li>Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil filters and 20,000 air cleaners). </li></ul><ul><li>Suppose that the company is considering dropping the air cleaner product line. </li></ul><ul><li>Revenues for the air cleaner product line are $41,000. </li></ul><ul><li>Should A. B. Fast drop the air cleaner line? </li></ul>
  9. 9. Dropping Products, Departments, Territories <ul><li>Variable selling and administrative expenses are $0.30 per unit. </li></ul><ul><li>Variable manufacturing expenses are $1.20 per unit. </li></ul><ul><li>Total fixed expenses are $335,000. </li></ul><ul><li>Total fixed expenses will continue even if the product line is dropped. </li></ul>
  10. 10. Dropping Products, Departments, Territories Product Line Oil Filters Air Cleaners Total Units 250,000 20,000 270,000 Sales $805,000 $ 41,000 $846,000 Variable expenses 375,000 30,000 405,000 Contribution margin $430,000 $ 11,000 $441,000 Fixed expenses 310,185 24,815 335,000 Operating income/(loss) $119,815 ($13,815) $106,000
  11. 11. Dropping Products, Departments, Territories <ul><li>To measure product-line operating income, A. B. Fast allocates fixed expenses in proportion to the number of units sold. </li></ul><ul><li>Total fixed expenses are $335,000 ÷ 270,000 units, or $1.24 fixed unit cost. </li></ul><ul><li>Fixed expenses allocated to the air cleaner product line are 20,000 units × $1.24 per unit, or $24,815. </li></ul>
  12. 12. <ul><li>Oil Filters Alone </li></ul><ul><li>Units 250,000 </li></ul><ul><li>Sales $805,000 </li></ul><ul><li>Variable expenses 375,000 </li></ul><ul><li>Contribution margin 430,000 </li></ul><ul><li>Fixed expenses 335,000 </li></ul><ul><li>Operating income $ 95,000 </li></ul>Dropping Products, Departments, Territories
  13. 13. Dropping Products, Departments, Territories <ul><li>Suppose that the company employs a supervisor for $25,000. </li></ul><ul><li>This cost can be avoided if the company stops producing air cleaners. </li></ul><ul><li>Should the company stop producing air cleaners? </li></ul><ul><li>Yes! </li></ul><ul><li>$11,000 – $25,000 = ($14,000) </li></ul>
  14. 14. Product Mix <ul><li>Companies must decide which products to emphasize if certain constraints prevent unlimited production or sales. </li></ul><ul><li>Assume that A. B. Fast produces oil filters and windshield wipers. </li></ul><ul><li>The company has 2,000 machine hours available to produce these products. </li></ul>
  15. 15. Product Mix A. B. Fast can produce 5 oil filters in one hour or 8 windshield wipers. Product Oil Windshield Per Unit Filters Wipers Sales price $3.22 $13.50 Variable expenses 1.50 12.00 Contribution margin $1.72 $ 1.50 Contribution margin ratio 53% 11%
  16. 16. Product Mix Which product should A. B. Fast emphasize? Oil filters: $1.72 contribution margin per unit × 5 units per hour = $8.60 per machine hour Windshield wipers: $1.50 contribution margin per unit × 8 units per hour = $12.00 per machine hour
  17. 17. Outsourcing (Make or Buy) <ul><li>A. B. Fast is considering the production of a part it needs, or using a model produced by C. D. Enterprise. </li></ul><ul><li>C. D. Enterprise offers to sell the part for $0.37. </li></ul><ul><li>Should A. B. Fast manufacture the part or buy it? </li></ul>
  18. 18. Outsourcing (Make or Buy) A. B. Fast has the following costs for 250,000 units of Part no. 4: Part no. 4 costs: Total Direct materials $ 40,000 Direct labor 20,000 Variable overhead 15,000 Fixed overhead 50,000 Total $125,000 $125,000 ÷ 250,000 units = $0.50/unit
  19. 19. Outsourcing (Make or Buy) <ul><li>Assume that by purchasing the part, A. B. Fast can avoid all variable manufacturing costs and reduce fixed costs by $15,000 (fixed costs will decrease to $35,000). </li></ul><ul><li>A. B. Fast should continue to manufacture the part. </li></ul><ul><li>Why? </li></ul>
  20. 20. Outsourcing (Make or Buy) Purchase cost (250,000 × $0.37) $ 92,500 Fixed costs that will continue 35,000 Total $127,500 The unit cost is then $0.51 ($127,500 ÷ 250,000). $127,500 – $125,000 = $2,500, which is the difference in favor of manufacturing the part.
  21. 21. Best Use of Facilities <ul><li>Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the facilities previously used to manufacture Part no. 4 to produce gasoline filters. </li></ul><ul><li>The expected annual profit contribution of the gasoline filters is $17,000. </li></ul><ul><li>What should A. B. Fast do? </li></ul>
  22. 22. Best Use of Facilities Expected cost of obtaining 250,000 parts: Make part $125,000 Buy part and leave facilities idle $127,500 Buy part and use facilities for gas filters $110,500* *Cost of buying part: $127,500 less $17,000 contribution from gasoline filters.
  23. 23. Sell As-Is Or Process Further <ul><li>The sell as-is or process further is a decision whether to incur additional manufacturing costs and sell the inventory at a higher price, </li></ul><ul><li>or sell the inventory as-is at a lower price. </li></ul><ul><li>Suppose that A. B. Fast spends $500,000 to produce 250,000 oil filters. </li></ul><ul><li>A. B. Fast can sell these filters for $3.22 per filter, for a total of $805,000. </li></ul>
  24. 24. Sell As-Is Or Process Further <ul><li>Alternatively, A. B. Fast can further process these filters into super filters at an additional cost of $25,000, which is $0.10 per unit ($25,000 ÷ 250,000 = $0.10). </li></ul><ul><li>Super filters will sell for $3.52 per filter for a total of $880,000. </li></ul><ul><li>Should A. B. Fast process the filters into super filters? </li></ul>
  25. 25. Sell As-Is Or Process Further <ul><li>A. B. Fast should process further, because the $75,000 extra revenue ($880,000 – $805,000) outweighs the $25,000 cost of extra processing. </li></ul><ul><li>Extra sales revenue is $0.30 per filter. </li></ul><ul><li>Extra cost of additional processing is $0.10 per filter. </li></ul>
  26. 26. Sell As-Is Or Process Further Cost to produce 250,000 parts: $500,000 Sell these parts for $3.22 each: $805,000 Cost to process original parts further: $ 25,000 Sell these parts for $3.52 each: $880,000 Sales increase ($880,000 – $805,000) $ 75,000 Less processing cost 25,000 Net gain by processing further $ 50,000
  27. 27. <ul><li>Explain the difference between </li></ul><ul><li>correct analysis and incorrect </li></ul><ul><li>analysis of a particular </li></ul><ul><li>business decision. </li></ul>Objective 3
  28. 28. Correct Analysis <ul><li>A correct analysis of a business decision focuses on differences in revenues and expenses. </li></ul><ul><li>The contribution margin approach, which is based on variable costing, often is more useful for decision analysis. </li></ul><ul><li>It highlights how expenses and income are affected by sales volume. </li></ul>
  29. 29. Incorrect Analysis <ul><li>The conventional approach to decision making, which is based on absorption costing, may mislead managers into treating a fixed cost as a variable cost. </li></ul><ul><li>Absorption costing treats fixed manufacturing overhead as part of the unit cost. </li></ul>
  30. 30. <ul><li>Use opportunity costs </li></ul><ul><li>in decision making. </li></ul>Objective 4
  31. 31. Opportunity Cost... <ul><li>is the benefit that can be obtained from the next best course of action. </li></ul><ul><li>Opportunity cost is not an outlay cost, so it is not recorded in the accounting records. </li></ul><ul><li>Suppose that A. B. Fast is approached by a customer that needs 250,000 regular oil filters. </li></ul>
  32. 32. Opportunity Cost <ul><li>The customer is willing to pay more than $3.22 per filter. </li></ul><ul><li>A. B. Fast’s managers can use the $855,000 ($880,000 – $25,000) opportunity cost of not further processing the oil filters to determine the sales price that will provide an equivalent income. </li></ul><ul><li>$855,000 ÷ 250,000 units = $3.42 </li></ul>
  33. 33. <ul><li>Use four capital budgeting </li></ul><ul><li>models to make longer-term </li></ul><ul><li>investment decisions. </li></ul>Objective 5
  34. 34. Capital Budgeting... <ul><li>is a formal means of analyzing long-range capital investment decisions. </li></ul><ul><li>The term describes budgeting for the acquisition of capital assets. </li></ul><ul><li>Capital assets are assets used for a long period of time. </li></ul>
  35. 35. Capital Budgeting <ul><li>Capital budget models using net cash inflow from operations are: </li></ul><ul><li>payback </li></ul><ul><li>accounting rate of return </li></ul><ul><li>net present value </li></ul><ul><li>internal rate of return </li></ul>
  36. 36. Payback... <ul><li>is the length of time it takes to recover, in net cash inflows from operations, the dollars of capital outlays. </li></ul><ul><li>An increase in cash could result from an increase in revenues, a decrease in expenses, or a combination of the two. </li></ul>
  37. 37. Payback Example <ul><li>Assume that A. B. Fast is considering the purchase of a machine for $200,000, with an estimated useful life of 8 years, and zero predicted residual value. </li></ul><ul><li>Managers expect use of the machine to generate $40,000 of net cash inflows from operations per year. </li></ul>
  38. 38. Payback Example <ul><li>How long would it take to recover the investment? </li></ul><ul><li>$200,000 ÷ $40,000 = 5 years </li></ul><ul><li>5 years is the payback period. </li></ul>
  39. 39. Payback Example <ul><li>When cash flows are uneven, calculations must take a cumulative form. </li></ul><ul><li>Cash inflows must be accumulated until the amount invested is recovered. </li></ul><ul><li>Suppose that the machine will produce net cash inflows of $90,000 in Year 1, $70,000 in Year 2, and $30,000 in Years 3 through 8. </li></ul>
  40. 40. Payback Example <ul><li>What is the payback period? </li></ul><ul><li>Years 1, 2, and 3 together bring in $190,000. </li></ul><ul><li>Recovery of the amount invested occurs during Year 4. </li></ul><ul><li>Recovery is 3 years + $10,000. </li></ul><ul><li>3 years + ($10,000 ÷ $30,000) = 3 years and 4 months </li></ul>
  41. 41. Accounting Rate of Return... <ul><li>measures profitability. </li></ul><ul><li>It measures the average return over the life of the asset. </li></ul><ul><li>It is computed by dividing average annual operating income by the average amount of investment in the asset. </li></ul>
  42. 42. Accounting Rate of Return Example <ul><li>Assume that a machine costs $200,000, has no residual value, and has a useful life of 8 years. </li></ul><ul><li>How much is the straight-line depreciation per year? </li></ul><ul><li>$25,000 </li></ul><ul><li>Management expects the machine to generate annual net cash inflows of $40,000. </li></ul>
  43. 43. Accounting Rate of Return Example <ul><li>How much is the average operating income? </li></ul><ul><li>$40,000 – $25,000 = $15,000 </li></ul><ul><li>How much is the average investment? </li></ul><ul><li>$200,000 ÷ 2 = $100,000 </li></ul><ul><li>What is the accounting rate of return? </li></ul><ul><li>$15,000 ÷ $100,000 = 15% </li></ul>
  44. 44. Discounted Cash-Flow Models <ul><li>Discounted cash-flow models take into account the time value of money. </li></ul><ul><li>The time value of money means that a dollar invested today can earn income and become greater in the future. </li></ul><ul><li>These methods take those future values and discount them (deduct interest) back to the present. </li></ul>
  45. 45. Net Present Value <ul><li>The (NPV) method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present. </li></ul><ul><li>The amount of interest deducted is determined by the desired rate of return. </li></ul><ul><li>This rate of return is called the discount rate, hurdle rate, required rate of return, or cost of capital. </li></ul>
  46. 46. Net Present Value Example <ul><li>A. B. Fast is considering an investment of $450,000. </li></ul><ul><li>This proposed investment will yield periodic net cash inflows of $225,000, $230,000, and $210,000 over its life. </li></ul><ul><li>A. B. Fast expects a return of 16%. </li></ul><ul><li>Should the investment be made? </li></ul>
  47. 47. Net Present Value Example Periods Amount PV Factor Present Value 0 ($450,000) 1.000 ($450,000) 1 225,000 0.862 193,950 2 230,000 0.743 170,890 3 210,000 0.641 134,610 Total PV of net cash inflows $499,450 Net present value of project $ 49,450
  48. 48. Internal Rate of Return... <ul><li>is another model using discounted cash flows. </li></ul><ul><li>The internal rate of return (IRR) is the rate of return that a company can expect to earn by investing in a project. </li></ul><ul><li>The higher the IRR, the more desirable the investment. </li></ul>
  49. 49. Internal Rate of Return <ul><li>The IRR is the rate of return at which the net present value equals zero. </li></ul><ul><li>Investment = Expected annual net cash inflow × PV annuity factor </li></ul><ul><li>Investment ÷ Expected annual net cash inflow = PV annuity factor </li></ul>
  50. 50. Internal Rate of Return Example <ul><li>Assume that A. B. Fast is considering investing $500,000 in a project that will yield net cash inflows of $152,725 per year over its 5-year life. </li></ul><ul><li>What is the IRR of this project? </li></ul><ul><li>$500,000 ÷ $152,725 = 3.274 (PV annuity factor) </li></ul>
  51. 51. Internal Rate of Return Example <ul><li>The annuity table shows that 3.274 is in the 16% column for a 5-period row in this example. </li></ul><ul><li>Therefore, 16% is the internal rate of return of this project. </li></ul><ul><li>If the minimum desired rate of return is 16% or less, A.B. Fast should undertake this project. </li></ul>
  52. 52. <ul><li>Compare and contrast popular </li></ul><ul><li>capital budgeting methods. </li></ul>Objective 6
  53. 53. Comparison of Capital Budgeting Models <ul><li>The discounted cash-flow models, net present value, and internal rate of return are conceptually superior to the payback and accounting rate of return models. </li></ul><ul><li>Strengths of the payback include: </li></ul><ul><li>It is easy to calculate, highlights risks, and is based on cash flows. </li></ul>
  54. 54. Comparison of Capital Budgeting Models <ul><li>Its weaknesses are that it ignores cash flows beyond the payback, the time value of money, and profitability. </li></ul><ul><li>The strength of the accounting rate of return is that it is based on profitability. </li></ul><ul><li>Its weakness is that it ignores the time value of money. </li></ul>
  55. 55. End of Chapter 26

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