Accounting for decision making ACC 557: MANAGEMENT ACCOUNTING Lecture 3 Relevant cost for decision making (Break-even analysis) by Kwame Oduro Amoako (Ph.D.) Learning Objectives • Distinguish between relevant and irrelevant costs and revenues in (alternative-choice) decisions. • Prepare analyses showing – whether to add or drop a segment – whether to make or buy a component – whether to accept or reject a special order – the most profitable use of a scarce resource – whether to sell or further process a product Cost Concepts for Decision Making A relevant cost is a cost that differs between alternatives. Identifying Relevant Costs An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. Two broad categories of costs are never relevant in any decision. They include: Sunk costs. Future costs that do not differ between the alternatives. Decision Making – Six Key Concepts Sunk costs are always irrelevant when choosing among alternatives. • A sunk cost is a cost that has already been incurred and cannot be changed regardless of what a manager decides to do. Future costs and revenues that do not differ between alternatives are irrelevant to the decision-making process. Decision Making – Future cost and revenues The key to effective decision making is differential analysis – focusing on the future costs and revenues that differ between the alternatives. Everything else is irrelevant and should be ignored. • A future cost that differs between any two alternatives is known as a differential cost. • A future revenue that differs between any two alternatives is known as a differential revenue. • An incremental cost is an increase in cost between two alternatives. • An avoidable cost is a cost that can be eliminated by choosing one alternative over another. • Opportunity costs also need to be considered when making decisions. An opportunity cost is the potential benefit that is given up when one alternative is selected over another. Relevant Cost Analysis: A Two-Step Process Step 1 Eliminate costs and benefits that do not differ between alternatives. Step 2 Use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable costs. Types of Alternative-Choice Decisions • • • • • • Adding or dropping a product or other segments. Making or buying a component (outsourcing). Accepting or rejecting a special order. Rationing of a scarce resource. Sale versus further processing. Note: These decisions normally have a relatively short time horizon. – Time value of money and taxes are ignored. General Steps in the Analysis • Define the problem/opportunity • Determine possible alternative actions/solutions – the obviously unattractive ones are eliminated • For each alternative, measure the differential (incremental) revenues, costs, or profit • Evaluate the alternatives • Reach a decision Note: Qualitative information is sometimes more important than differential revenues and expenses. Adding/Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment. Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess this impact, it is necessary to carefully analyze the costs. Adding or Dropping a Segment • An add or drop decision should be based only on the differential (incremental) revenues and costs. Revenue and cost items unaffected by the decision should be disregarded. • Differential revenues and costs are segment contribution margin and some traceable fixed costs. Note: Qualitative considerations are important. Adding or Dropping a Segment: Example • Rolex Company is considering dropping its digital watch segment. • The CM of the segment is GH¢300,000. • Dropping the segment will yield the following fixed cost savings: Salary of the division manager GH¢90,000 Direct advertising GH¢100,000 Rent for factory space GH¢70,000 Adding/Dropping Segments Segment Income Statement Digital Watches Sales Less: variable expenses Variable manufacturing costs Variable shipping costs Commissions Contribution margin Less: fixed expenses General factory overhead Salary of line manager Depreciation of equipment Advertising - direct Rent - factory space General admin. expenses Net operating loss GH¢500,000 GH¢120,000 5,000 75,000 GH¢60,000 90,000 50,000 100,000 70,000 30,000 GH¢200,000 GH¢300,000 400,000 (GH¢100,000) Adding/Dropping Segments Due to the declining popularity of digital watches, Rolex Company’s digital watch line has not reported a profit for several years. Rolex is considering discontinuing this product line. Should Rolex dispose of its digital watch segment? A Contribution Margin Approach DECISION RULE Rolex should drop the digital watch segment only if its profit would increase. Rolex will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped. Let’s look at this solution. Adding or Dropping a Segment Fixed costs reduction Contribution margin lost if digital watch segment is dropped Net disadvantage GH¢260000 (GH¢300,000) (GH¢40,000) Rolex should not drop its digital watch segment because its fixed cost savings does not exceed lost contribution margin. • This same answer can be reached by preparing income statements with and without the segment. Beware of Allocated Fixed Costs Why should we keep the digital watch segment when it’s showing a GH¢100,000 loss? Beware of Allocated Fixed Costs The answer lies in the way we allocate common fixed costs to our products. Beware of Allocated Fixed Costs Including unavoidable common fixed costs makes the product line appear to be unprofitable. Our allocations can make a segment look less profitable than it really is. Illustration 2 A company has three products: Product A, Product B and Product C. Income statements of the three product lines for the latest month are given below. Should product B be dropped since it is incurring a net loss of GH¢3,000. Product Line A B C GH¢467,000 GH¢314,000 GH¢598,000 Variable Costs 241,000 169,000 321,000 Contribution Margin 226,000 145,000 277,000 Direct Fixed Costs 91,000 86,000 112,000 Allocated Fixed Costs 93,000 62,000 120,000 Net Income 42,000 − 3,000 45,000 Sales Solution Contribution margin lost Direct Fixed Costs avoided GH¢ 145,000 (86,000) Decrease in Net Income of the Company 59,000 Making or Buying a Component • Should we outsource a component that we are currently making? Should we make a component that we are currently outsourcing? – Dependability, quality consideration, and focus are important qualitative considerations. • A make or buy decision should be based only on the differential (incremental) costs. Cost items unaffected by the decision should be disregarded. • The cost of the buy alternative is usually easy to estimate. The more difficult problem is to find the differential costs of the make alternative. Illustration 1: The estimated costs of producing 6,000 units of a component are: Per Unit Total GH¢10 GH¢60,000 Direct Labor 8 48,000 Applied Variable Factory Overhead 9 54,000 12 72,000 GH¢39 GH¢234,000 Direct Material Applied Fixed Factory Overhead GH¢1.5 per direct labor dollar • The same component can be purchased from market at a price of GH¢ 29 per unit. If the component is purchased from market, 25% of the fixed factory overhead will be saved. • Should the component be purchased from the market? Solution Per unit Make (GH¢) Buy (GH¢) Purchase Price Direct Material Total Make (GH¢) GH¢174,000 29 10 60,000 Direct Labor 8 48,000 Variable Overhead 9 54,000 Relevant Fixed Overhead 3 18,000 Total Relevant Costs 30 Difference in Favor of Buying 29 1 Buy (GH¢) 180,000 174,000 6,000 Making or Buying: Illustration 2 • Kantanka Motors incurs the following cost for part No. 300: Total (10,000) Per unit Direct materials GH¢80,000 GH¢8 Direct labor 10,000 1 Variable overhead (OH) 40,000 4 Fixed OH (traceable) 20,000 2 Fixed OH (Common) 30,000 3 • Another company offers to sell Kantanka Motors the same part for GH¢16 per unit. There are no alternative uses of the capacity that becomes available. • Should Kantanka Motors continue to make or buy the part? Making or Buying: Solution • Items of differential costs are as follows: If part No. 300 is manufactured Direct material GH¢8 Direct labor 1 Variable OH 4 Fixed OH (part 300) 2 Total GH¢15 • Based on financial consideration alone, Kantanka Motors should continue to make the part. • What if the released facility can be used for ...? The Make or Buy Decision: An Example 3 • Aspect A Company manufactures part 4A that is used in one of its products. • The unit product cost of this part is: Direct materials Direct labor Variable overhead Depreciation of special equip. Supervisor's salary(traceable) General factory overhead Unit product cost GH¢9 5 1 3 2 10 GH¢30 The Make or Buy Decision • The special equipment used to manufacture part 4A has no resale value. • The total amount of general factory overhead, which is allocated on the basis of direct labor hours, would be unaffected by this decision. • Supervisors salary is also traceable to the parts produced • The GH¢30 unit product cost is based on 20,000 parts produced each year. • An outside supplier has offered to provide the 20,000 parts at a cost of GH¢25 per part. Should we accept the supplier’s offer? The Make or Buy Decision Cost Per Unit Outside purchase price GH¢25 Direct materials (20,000 Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost GH¢9 5 1 3 2 10 GH¢30 Cost of 20,000 Units Buy Make GH¢500,000 180,000 100,000 20,000 40,000 GH¢340,000 GH¢500,000 The avoidable costs associated with making part 4A include direct materials, direct labor, variable overhead, and the supervisor’s salary. The Make or Buy Decision Cost Per Unit Outside purchase price GH¢25 Direct materials (20,000 Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost GH¢9 5 1 3 2 10 GH¢30 Cost of 20,000 Units Buy Make GH¢500,000 180,000 100,000 20,000 40,000 GH¢340,000 GH¢500,000 Not avoidable; irrelevant. If the product is dropped, it will be reallocated to other products. The Make or Buy Decision Cost Per Unit Outside purchase price GH¢25 Direct materials (20,000 Direct labor Variable overhead Depreciation of equip. Supervisor's salary General factory overhead Total cost GH¢9 5 1 3 2 10 GH¢30 Cost of 20,000 Units Buy Make GH¢500,000 180,000 100,000 20,000 40,000 GH¢340,000 GH¢500,000 Should we make or buy part 4A? Given that the total relevant/avoidable costs of making are less than the cost of buying the part, Aspect A should continue to make the part. Special order A special order is a one-time order that is not considered part of the company’s normal ongoing business. When analyzing a special order, only the incremental costs and benefits are relevant. Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant. Revenue and cost items unaffected by the decision should be disregarded. Accept or reject a special order-With excess capacity • When the company is operating at less than its maximum capacity and the company has enough capacity to produce and fill the special order, the order should be accepted if the additional sales exceed the additional variable costs. A company receives a special order for 200 units that require stamping the buyer’s name on each unit, yielding an additional fixed cost of GH¢400 to its normal costs. Without the order, the company is operating at 75% of capacity and produces 7,500 units of product at the costs below. The company's normal selling price is GH¢22 per unit. The sales price for the special order is GH¢18 per unit. The following is cost estimates of the company. Description Direct materials Direct labour Overhead (30% variable) Selling expenses Costs (7,500 units) Variable costs Fixed costs GH¢37,500 GH¢60,000 GH¢20,000 Per unit GH¢5.00 GH¢8.00 GH¢0.80 GH¢14,000 GH¢25,000 GH¢2.00 GH¢10,000 (60% variable) The special order will not affect normal unit sales and will not increase fixed overhead and selling expenses. variable selling expenses on the special order are reduced to one-half the normal amount. Should the company accept the special order? Solution Special Orders Example 2 • Accra Brewery Limited operates with a monthly capacity of one million barrels of a beer product (Club beer) that has gained significant market share. Current production and sales are 600,000 barrels a month. The selling price is GH¢90 per barrel. The costs are as follows: VC /barrel FC /barrel Direct material (barley, etc.) GH¢ 7 Direct labor 22 Overhead 6 GH¢13 Marketing costs* 5 16 Distribution costs 9 8 * Variable marketing cost is sales commission. Special Orders Example • A Togolese brewery wants to buy 250,000 barrels of Club beer for each of the next four months until its current brewery is renovated. It is willing to pay GH¢45 per barrel. If ABL accepts this order, an additional GH¢300,000 in manufacturing costs will be incurred each month. • No additional costs will be incurred for marketing & distribution. • Should ABL accept the special order? Special Orders Example • Items of differential monthly revenues and costs are: Total revenue GH¢11,250,000 Variable costs GH¢8,750,000 Additional costs 300,000 9,050,000 Differential profit GH¢2,200,000 • Based on profit alone, Accra should accept the offer. Special order-without excess capacity • When the company has no excess capacity, the cost to be considered must include the lost contribution margin from sacrificing regular sales to be able to fill up the special order. Illustration • In a month, ABC Company normally produces and sells 9000 units of its product for GH¢20. • Variable manufacturing cost per unit is GH¢10. • Total fixed manufacturing costs (up to the maximum capacity of 10,000 units) are GH¢38,000. • Variable operating cost is GH¢1 per unit and fixed operating costs total GH¢10,000. • A customer placed a special order for 1,500 units for GH¢15 each. • The customer is willing to shoulder the delivery costs; hence the business will not incur additional variable operating costs. • Should the company accept or reject the special order? Solution Solution w/o Special w/ Special Order Order GH¢180,000 GH¢192,500 90,000 100,000 9,000 8,500 GH¢81,000 GH¢84,000 Fixed manufacturing 38,000 38,000 Fixed operating 10,000 10,000 GH¢33,000 GH¢36,000 Sales Less: Variable costs Var. manufacturing Var. operating Contribution margin Less: Fixed costs Operating Income • The GH¢192,500 sales revenue includes regular sales of 8,500 units (sold at GH¢20 each) and 1,500 specially ordered units (sold at GH¢15). • As mentioned in the problem, the company will incur the variable operating cost only for regular sales. • Fixed costs remain the same. Solution • Since the company has excess capacity of 1,000 units only, it is not enough to fill up the special order of 1,500 units. • Hence, a portion of the regular sales (500 units) must be sacrificed to fill up the entire special order. The lost contribution margin should be considered. • Contribution margin is equal to sales (at GH¢20) minus variable costs (GH¢10 variable manufacturing plus GH¢1 variable operating). • Lost contribution margin = (GH¢20 - GH¢11) x 500 units = GH¢4,500 • The lost contribution margin is allocated over the items sold through the special order. • Lost contribution margin per unit = GH¢4,500 / 1,500 units = GH¢3 • This cost is an additional consideration in the decision. Should the company accept the offer? The answer is still yes since the selling price (GH¢15) is higher than the cost (GH¢13, i.e. variable manufacturing cost per unit of GH¢10 plus lost CM per unit of GH¢3). This will result in additional income of GH¢3,000 (1,500 x GH¢2). Rationing A Scarce Resource • Usually, fixed costs are not affected by this decision. • Therefore, producing products with highest CM per unit of scarce resource maximizes total contribution margin and overall profit. Rationing A Scarce Resource Example • Active Company produces two products and selected data is shown below. A B CM/unit GH¢ 10 GH¢ 12 Std. machine hrs/unit 1 hr. 2 hrs. • If only10,000 machine hours are available, which product should Active focus its efforts on? Rationing A Scarce Resource Example CM/unit Std. requirement/unit CM/hour A GH¢ 10 1 hr. GH¢10 B GH¢ 12 2 hrs. GH¢ 6 • Active should focus its attention on product A, if only 10,000 machine hours are available: Total CM = 10,000 * GH¢10, if only A is produced Total CM = 10,000 * GH¢6, if only B is produced Managing Constraints It is often possible for a manager to increase the capacity of a bottleneck, which is called relaxing (or elevating) the constraint, in numerous ways such as: 1. Working overtime on the bottleneck 2. Subcontracting some of the processing that would be done at the bottleneck 3. Investing in additional machines at the bottleneck 4. Shifting workers from non-bottleneck processes to the bottleneck 5. Focusing business process improvement efforts on the bottleneck 6. Reducing defective units processed through the bottleneck Sale Versus Further Processing • Should we sell our product at some point before the final step in its production? • Costs incurred prior to the point of decision are not relevant in deciding whether to sell or further process a product (joint or otherwise). • As a general rule, a product should be further processed if the incremental revenues from processing it exceed the incremental processing costs. Sensitivity analysis • All decisions involve making assumptions and estimates about the future. It is important to make note of the assumptions and estimates. • After completing the analysis, it is often useful to redo the analysis under different assumptions and estimates to determine the sensitivity of the conclusions. • With computer, the sensitivity (what if) analysis can be performed quickly.