Financial & Managerial
Accounting 2002e
Belverd E. Needles, Jr.
Marian Powers
Susan Crosson
----------Multimedia Slides by:
Harry Hooper
Santa Fe Community College
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1
Chapter 24
Short-Run Decision
Analysis
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2
LEARNING OBJECTIVES
1. Explain how managers make short-run decisions
during the management cycle.
2. Define and explain incremental analysis and its
related concepts.
3. Apply incremental analysis to outsourcing
decisions.
4. Apply incremental analysis to special order
decisions.
5. Apply incremental analysis to segment
profitability decisions.
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3
LEARNING OBJECTIVES
6. Apply incremental analysis to product
mix decisions involving constrained
resources.
7. Apply incremental analysis to sell or
process-further decisions.
8. Apply incremental analysis to service
organizations.
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4
Information for
Short-Run Decisions
OBJECTIVE 1
Explain how managers make short-run
decisions during the management cycle,
and identify the steps in the management
decision cycle.
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5
Short-Run Decisions
• Short-run decision analysis is an
important component of the
management cycle.
• In the planning stage, managers
estimate costs and revenues for
use in making short-run decision.
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The Management Cycle
• In the executing stage, managers make and
implement short-run decisions to improve the
organization’s profitability and liquidity in the short
run.
• Managers use financial and nonfinancial
information to decide to:
– Accept a special order.
– Keep or drop a segment.
– Select the appropriate product mix.
– Contract with outside suppliers.
– Sell a product as is or process further.
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The Management Cycle
• In the reviewing stage, each decision
is evaluated to determine if it
produced the forecasted results.
• The reporting stage takes place
throughout the management cycle.
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Short-Run Decisions
• Both quantitative and qualitative factors
influence short-run decisions.
• Managers must assess the importance
of qualitative information such as:
• Product (or service) quality.
• Timeliness.
• Social issues.
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The Management Cycle
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10
The Management Decision Cycle
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Discussion
Q
What are some examples of ways that
managers use financial and nonfinancial
information?
A
1.
2.
3.
4.
5.
Accept a special order.
Keep or drop a segment.
Select the appropriate product mix.
Contract with outside suppliers.
Sell a product as is or process further.
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12
The Decision-Making Process
OBJECTIVE 2
Define and explain incremental analysis
and its related concepts.
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13
Incremental Analysis for Management
Decisions
• The management decision cycle:
1. Begins with the determination of a
problem or need.
2. Then alternative courses of action are
identified.
3. The effects of each alternative are
evaluated.
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Incremental Analysis
1. Also called differential analysis.
2. Ignores revenues or costs that stay
the same or that do not differ among
alternatives. (Irrelevant revenue and
costs.)
3. Ignores sunk costs, already incurred
and not recoverable.
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Relevant Decision Information
• Any data related to future costs,
revenues, or uses of resources that
will differ among alternative courses
of action are considered relevant
decision information.
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Incremental Analysis
• Step 1: Eliminate irrelevant revenues
and costs.
• Step 2: Prepare the analysis using only
projected revenues and expenses that
will differ.
• Step 3: Consider other relevant issues,
such as quality, reputation, etc.
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17
Incremental Analysis
Lennox Company
Incremental Analysis
Grinder C
Grinder W
Difference
in favor of
Grinder W
Increase in revenues
Increase in operating costs
Direct labor
Variable manufacturing overhead
Total relevant operating costs
$ 16,200
$ 19,800
$ 3,600
$
$
Resulting change in net income
$ 11,900
$
2,200
2,100
4,300
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$
4,100
3,050
7,150
$ 12,650
($ 1,900)
(950)
($ 2,850)
$
750
18
Special Considerations in Short-Run
Decision Analysis
• The effects of opportunity costs
• The need to prepare special
decision reports
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Decision Costs
•Opportunity costs are the benefits
forgone when one alternative is selected
over another.
•Incremental analysis helps managers
compare alternatives by focusing on the
differences in their projected revenues
and costs.
• Such a report helps identify which
alternative contributes the most to profits
or incurs the lowest cost.
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Traditional Versus Special
Decision Reports
• Frequently contribution format
incremental analyses are used
to support special decisions.
• If qualitative factors are very
important, special formats must
be used to support quantitative
analysis with qualitative
information.
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21
Discussion
Q.What data should be omitted from
the analyses and reports accountants
present to management?
A. 1. Past data.
2. Data that are identical under all
alternatives.
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22
Outsourcing Decisions
OBJECTIVE 3
Apply incremental analysis to
outsourcing decisions.
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Outsourcing
• Outsourcing is the use of suppliers
outside the organization to perform
services or produce goods that could
be performed or produced internally.
• Outsourcing includes make-or-buy
decisions, which are decisions about
whether to make a part internally or buy
it from an external supplier.
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Outsourcing
• Many organizations outsource
functions that do not represent
core competencies such as:
•
•
•
•
•
•
Payroll processing.
Selling and marketing.
Fleet management.
Training.
Custodial services.
Information management.
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25
Incremental Analysis: Outsourcing
Decision
Kriegel Electronics Company
Outsourcing Decision
Incremental Analysis
Buy
Difference
in favor
of Make
$ 16,800
--------
($ 16,800)
8,000
--------
(8,000)
4,000
--------
(4,000)
--------$ 28,800
$ 30,000
$ 30,000
30,000
$ 1,200
Make
Direct materials
(20,000  100  $84)
Direct labor
(20,000  20  $8)
Variable manufacturing overhead
(20,000  20  $4)
To purchase completed castings
(20,000  $1.50)
Totals
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Outsourcing Benefits
 Loss of control.
 Loss of expertise within the
organization.
 Growing dependence on suppliers.
 Potential loss of critical
information to competitors.
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Outsourcing Problems
• Some of the problems associated
with outsourcing include:
• Loss of control.
• Loss of expertise within the
organization.
• Growing dependence on
suppliers.
• Potential loss of critical
information to competitors.
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Hidden Costs of Outsourcing the Production of Parts for
Assembly Operations
When manufacturers purchase parts from suppliers, they expect
quality parts to be delivered quickly for a reasonable price. The
hidden costs of maintaining an outsourcing relationship with a
supplier can include the following:
Costs of Quality for Parts Purchased from Suppliers
 Cost of inspecting parts delivered to the company
 Cost of labor and shipping to return defective parts to suppliers
 Cost of training suppliers to follow quality methods
Costs of Late Deliveries from Suppliers
 Cost of lost customer sales due to late parts deliveries from suppliers
 Cost of carrying extra direct materials and finished goods inventory to
compensate for late parts deliveries from suppliers
 Cost of back orders due to partial shipments
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Hidden Costs
• Hidden costs of maintaining an
outsourcing relationship with a
supplier can include:
• Costs of quality.
• Costs of late deliveries.
• To manage the hidden costs,
companies may add clauses to their
contracts with suppliers to specify
penalties for poor quality or late
deliveries.
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Make-or-Buy Decisions
To decide whether to make a product or
to buy from an outside supplier, the
following information is needed:
Make
Need for additional
equipment
Variable costs of
making the item
Incremental fixed
costs
Buy
Purchase price of the
item
Rent or net cash flow
from facilities freed
up
Salvage value of
unused equipment
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31
Special Order Decisions
OBJECTIVE 4
Apply incremental analysis to
special order decisions.
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Special Order Decisions
• Special order decisions are decisions
about whether to accept or reject
special product orders at prices
below the normal market prices.
• A special order is a one-time,
nonrecurring order.
• Before accepting a special order,
compliance with federal price
discrimination laws should be
checked.
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Special Order Decisions
• Two different approaches to special
order decisions include:
Compare the special order price to
the relevant costs to produce,
package, and ship the order.
• Prepare a special order bid price by
calculating a minimum selling price for
the special order.
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Incremental Analysis: Special Order Decision
Jens Sporting Goods, Inc.
Without
With Leiden
Leiden Order Order (440,000
(410,000
baseballs)
baseballs)
Sales
Difference in Favor
of Accepting
Leiden Order
$ 1,640,000
$ 1,713,500
$ 73,500
$ 369,000
$ 396,000
($ 27,000)
Direct labor
246,000
264,000
(18,000)
Variable manufacturing
overhead
205,000
220,000
(15,000)
Packaging costs
123,000
125,500
(2,500)
$ 943,000
$ 1,005,500
($62,500)
$ 697,000
$ 708,000
$ 11,000
Less variable costs
Direct materials
Total variable costs
Contribution margin
* Assuming available existing production capacity, so no additional fixed costs are incurred.
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Special Orders: Qualitative Factors
These may include:
•Impact on sales to regular
customers
•Potential of special order to lead
into new sales areas
•Customer’s ability to maintain
an ongoing relationship
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Fixed Costs
• Examples of relevant fixed costs
include:
• Purchase of additional machinery.
• Increase in supervisory help.
• Increase in insurance premiums.
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37
Segment
Profitability Decisions
OBJECTIVE 5
Apply incremental analysis to
segment profitability decisions.
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Segment
Profitability Decisions
• Segment profitability decisions
involve the review of segments of
an organization, such as:
• Product lines.
• Services.
• Sales territories.
• Divisions.
• Departments.
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Segment Margin
• A segment margin is:
Segment’s sales revenue
-
direct variable costs
-
fixed costs that will be
avoided if that segment
is dropped
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Segment Profitability Decisions
• Often managers must decide
whether to add or drop a segment.
• If a segment has a negative
segment margin, the segment may
be dropped.
• Common costs that will be
incurred regardless of the decision
are unavoidable costs.
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Incremental Analysis:
Segment Profitability Decision
Lebo Corporation
Segment Profitability Decision
Incremental Analysis
Keep
Division Y
Sales
Less variable costs
Contribution margin
Less direct fixed costs
Segment margin
Less common fixed costs
Net income
$ 150,000
60,000
$ 90,000
72,000
$ 18,000
12,000
$ 6,000
Drop
Division Y
Difference in
Favor of
Dropping
Division Y
$ 135,000
52,500
$ 82,500
55,500
$ 27,000
12,000
$ 15,000
($ 15,000)
7,500
($ 7,500)
16,500
$ 9,000
0
$ 9,000
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Product Mix Decisions
OBJECTIVE 6
Apply incremental analysis to
product mix decisions involving
constrained resources.
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Product Mix Decisions
• Product mix decisions require the
selection of the most profitable
combination of product sales
when a company makes more
than one product using a common
constrained resource.
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Constrained Resources
• The constrained or limited
resource may be:
• Labor time.
• Machine time.
• Quantity of a raw material.
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Decision Analysis
• The steps in the decision analysis
include:
• Calculation of the contribution margin
per unit for each product line affected by
the constrained resource.
• Divide the contribution margin per unit
by the quantity of the constrained
resource required per unit.
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Decision Analysis
• Profit will be maximized in the
short run by devoting limited
resources to the product(s)
with the highest contribution
margin per unit of the
constrained resource.
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Incremental Analysis: Product Mix Decision Involving
Constrained Resources
Grady Enterprises
Product Mix Decision: Ranking the Order of Production
Incremental Analysis
Selling price per unit
Less: Variable costs
Manufacturing
Selling
Total unit variable costs
Contribution margin per unit (A)
Machine hours per unit (B)
Contribution margin per
machine hour (A ÷ B)
Rising
Star
Ghost
Master
Road
Warrior
$24.00
$18.00
$32.00
$12.50
6.50
$19.00
$ 5.00
$10.00
5.00
$15.00
$ 3.00
$18.75
6.25
$25.00
$ 7.00
2
1
2.5
$ 2.50
$ 3.00
$ 2.80
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Incremental Analysis: Product Mix
Decision
Constraints:
1) Maximum production capacity:
100,000 machine hours
2) Current maximum sales demand:
Rising star:
20,000 units
Ghost master: 30,000 units
Road Warrior: 18,000 units
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Incremental Analysis: Product Mix
Decision
Grady Enterprises
Number of Units to Make
Total Machine Hours Available
Maximize contribution from Ghost Master (30,000 units x 1 machine hour
per unit).
Balance of Machine Hours Available
2) Maximize contribution from Road Warrior (18,000 units x 2.5 machine
hours per unit).
Balance of Machine Hours Available
3) Use remaining hours to make Rising Star (12,500 units x 2 machine
hours per unit).
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Machine
Hours
100,000
30,000
70,000
45,000
25,000
25,000
50
Sell or Process-Further Decisions
OBJECTIVE 7
Apply incremental analysis to sell
or process further decisions.
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Sell or Process-Further Decisions
• A sell or process-further decision is
a decision about whether to sell a
joint product at the split-off point or
sell it after further processing.
• Joint products are two or more
products made from a common
material or process that cannot be
identified as separate productions
until the split-off point.
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Split-Off Points
• At the split-off point, joint products
become separate and identifiable.
• At that point, a company may
choose to sell the product as is or to
process it into another form for sale
to a different market.
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Incremental Analysis
• The objective of the incremental analysis
is to determine if the product’s selling
price will increase more than the
incremental costs of processing further.
• Only the incremental costs and
incremental revenues beyond the split-off
are relevant.
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Incremental Analysis:
Sell or Process-Further Decision
H & L Beef Products, Inc.
Sell or Process-Further Decision
Incremental Analysis
Incremental revenue if
processed further
Process further
Split-off
Incremental revenue
Less incremental costs
Operating income (loss)
from processing further
Meat
Bones
Hides
$200,000
100,000
$ 100,000
80,000
$ 40,000
20,000
$ 20,000
15,000
$ 55,000
50,000
$ 5,000
10,000
$ 20,000
$
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5,000
($ 5,000)
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Discussion
Q. What are five operating decisions
facing managers that can be made
using incremental analysis?
A. Outsourcing decisions.
2. Special order decisions.
3. Segment profitability decisions.
4. Product mix decisions.
5. Sell or process-further decisions.
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Short-Run Decisions
in Service Organizations
OBJECTIVE 8
Apply incremental analysis to service
organizations.
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57
Short-Run Decisions
• Typical short-run decisions in service
organizations include whether to:
• Outsource a service.
• Accept a bid for a special order.
• Drop an unprofitable service.
• Provide one service before another
because of limited labor hours.
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Incremental Analysis:
Service Mix Decision Involving
Constrained Resources
Cyber Web Services
Service Mix Decision: Ranking the Order in Which the Services Are Provided
Basic
Web Pages
Service revenue per page
Less variable costs per page
Contribution margin per page (A)
Design hours per page (B)
Contribution margin per design
hour (A  B)
Custom
Web Pages
$200
77
$123
1
$ 750
600
$ 150
12.5
$123
$ 12
Decision: Complete Basic Web Pages first.
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59
Incremental Analysis: Outsourcing
for a Service Organization
Cyber Web Services
Hire a new
employee
Cost to outsource
Outsource to
outside contractor
Difference in favor
of outsourcing
$21,600
($21,600)
Cost to do work in-house
Direct Labor
Service Overhead
Total Costs
Opportunity Costs
Total
$19,200
19,200
1,200
1,200
$20,400
$21,600
4,000
$24,400
($1,200)
4,000
$21,600
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$2,800
60
OK, Let’s Review
1. Explain how managers make short-run
decisions during the management cycle.
2. Define and explain incremental analysis and its
related concepts.
3. Apply incremental analysis to outsourcing
decisions.
4. Apply incremental analysis to special order
decisions.
5. Apply incremental analysis to segment
profitability decisions.
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61
Incremental Analysis: Special
Orders for a Service Organization
Cyber Web Services
Without THC
Order (10 Web
Pages)
Service revenue
With THC
Order
(11 Web Pages)
Difference in
Favor of
Rejecting Order
$7,500
$7,900
$400
6,000
6,420
(420)
$1,500
$1,480
($ 20)
1,000
1,000
-0-
$ 500
$ 480
($ 20)
Less variable costs
Direct Professional Labor
Contribution margin
Less fixed costs
Operating income (loss)
Decision: Reject the Spaced Order
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62
Incremental Analysis: Segment
Profitability for a Service Organization
Cyber Web Services
Design
Service revenue
Less variable costs
Contribution margin
Less direct fixed costs
Segment margin
Install
Maintain
Total
$60,000
$25,000
$65,000
$150,000
80,000
4,000
36,000
120,000
($20,000)
$21,000
$29,000
$30,000
6,000
$13,000
13,000
32,000
($ 26,000)
$ 8,000
$16,000
($ 2,000)
Decision: Eliminate design segment or improve segment margin.
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63
Discussion
Q. What are the typical short-run
decisions in service organizations?
A. 1. Service outsourcing.
2. Accept a special order bid.
3. Drop an unprofitable service.
4. What service to provide.
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64
OK, Let’s Review
6. Apply incremental analysis to
product mix decisions involving
constrained resources.
7. Apply incremental analysis to sell
or process-further decisions.
8. Apply incremental analysis to
service organizations.
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65