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