Special Business Decisions
and Capital Budgeting
Chapter 26
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Objective 1
Identify the relevant information
for a special business decision.
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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.
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Objective 2
Make five types of short-term
special business decisions.
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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.

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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?

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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

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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?

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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.

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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
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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.

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Dropping Products,
Departments, Territories
Oil Filters Alone
Units
Sales
Variable expenses
Contribution margin
Fixed expenses
Operating income
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250,000
$805,000
375,000
430,000
335,000
$ 95,000
Horngren/Harrison/Bamber 26 - 12
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)

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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.

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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%
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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
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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?

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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
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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?

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Outsourcing (Make or Buy)
Purchase cost (250,000 × $0.37)
Fixed costs that will continue
Total
$ 92,500
35,000
$127,500
$127,500 – $125,000 = $2,500, which is the
difference in favor of manufacturing the part.
The unit cost is then $0.51
($127,500 ÷ 250,000).
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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?

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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.
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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.

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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?

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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.

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Sell As-Is Or Process Further
Cost to produce 250,000 parts:
Sell these parts for $3.22 each:
$500,000
$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
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Objective 3
Explain the difference between
correct analysis and incorrect
analysis of a particular
business decision.
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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.

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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.

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Objective 4
Use opportunity costs
in decision making.
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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.
–
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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

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Objective 5
Use four capital budgeting
models to make longer-term
investment decisions.
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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.
–
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Capital Budgeting

–
–
–
–
Capital budget models using net cash inflow
from operations are:
payback
accounting rate of return
net present value
internal rate of return
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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.
–
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Horngren/Harrison/Bamber 26 - 36
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.

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Payback Example
How long would it take to recover the
investment?
 $200,000 ÷ $40,000 = 5 years
 5 years is the payback period.

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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.

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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

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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.
–
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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.

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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%

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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.

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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.

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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?

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Net Present Value Example
Periods Amount
PV Factor
0
($450,000)
1.000
1
225,000
0.862
2
230,000
0.743
3
210,000
0.641
Total PV of net cash inflows
Net present value of project
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Present Value
($450,000)
193,950
170,890
134,610
$499,450
$ 49,450
Horngren/Harrison/Bamber 26 - 47
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.
–
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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

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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)

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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.

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Objective 6
Compare and contrast popular
capital budgeting methods.
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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.

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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.

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End of Chapter 26
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