Chapter 20

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Describe and identify information relevant to business decisions Make special order and pricing decisions Make dropping a product and product-mix decisions Make outsourcing and sell as is or process further decisions

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Describe and identify information relevant to business decisions

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1. Expected future data 2. Differs among alternatives

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Relevant costs
Affect decisions Occur in the future Differ among the alternatives

Irrelevant costs
Do not affect decisions Sunk costs
Occurred in the past Always irrelevant to the decision Cannot be changed

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Considering qualitative factors in decisionmaking

Impact on employee morale
Outsourcing Layoffs

Impact on quality
Product recall, higher warranty costs Upset customers

Customer relations
Discounted prices to select customers

Use same guidelines as relevant costs

Occurs in the future Differs between alternatives
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Relevant information approach

Also called the incremental analysis approach

How operating income differs under alternatives

Irrelevant information is ignored Only relevant data affect decisions

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You are trying to decide whether to trade in your inkjet printer for a more recent model. Your usage pattern will remain unchanged, but the old and new printers use different ink cartridges. 1.Indicate if the following items are relevant or irrelevant to your decision:
a.The price of the new printer b.The price you paid for the old printer c.The trade-in value of the old printer d.Paper costs e.The difference between ink cartridges costs
Relevant Irrelevant Relevant Irrelevant Relevant

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Make special order and pricing decisions

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Special order
When a customer requests a one-time order at a reduced sale price

Considerations:
Does the company have excess capacity available to fill this order? Will the reduced sales price be high enough to cover the incremental costs of filling the order (the variable costs and any additional fixed costs)? Will the special order affect regular sales in the long run?

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1. Focus on relevant data (revenues and costs that will change if it accepts the special order) 2. Use of a contribution margin approach that separates variable costs from fixed costs

3. The special sales order will increase operating income by $2,500. Fixed costs remain the same.
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Examples:
Food commodities Natural resources Generic consumer products and services
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Examples:
Original art, jewelry Specially manufactured machinery Patented perfume scents Latest tech gadget
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Starts with the market price of the product

The price customers are willing to pay

Subtracts the companys desired profit Determine the products target full cost
Full cost to develop, produce, and deliver the product or service

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Accept the lower operating income, not the target return required by stockholders Reduce fixed costs Reduce variable costs Use other strategies
Increase capacity to spread the fixed costs are spread over more units Change or add to product mix Differentiate its product (become a price setter)

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Emphasizes a cost-plus approach Opposite of the target-pricing approach Starts with the full costs and adds desired profit to determine a cost-plus price Unique product = more control over pricing

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Full cost Plus: Desired profit Equals Cost-plus price

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Unique products
Consider what customers are willing to pay How well has the company been able to differentiate its product?

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Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardzs total production cost is $0.61 per pack, as follows:

Hobby-Cardz has enough excess capacity to handle the special order. 1. Prepare an incremental analysis to determine whether HobbyCardz should accept the special sales order.
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Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardzs total production cost is $0.61 per pack, as follows: Hobby-Cardz has enough excess capacity to handle the special order. 1. Prepare an incremental analysis to determine whether HobbyCardz should accept the special sales order.

e h t t p r e e c d c A al or i c e sp
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2. Now assume that the Hall of Fame wants special hologram baseball cards. Hobby-Cardz will spend $5,900 to develop this hologram, which will be useless after the special order is completed. Should Hobby-Cardz accept the special order under these circumstances?

e h t t c r e e j d e R al or i c e sp

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Green Thumb operates a commercial plant nursery where it propagates plants for garden centers throughout the region. Green Thumb has $4,800,000 in assets. Its yearly fixed costs are $600,000, and the variable costs for the potting soil, container, label, seedling, and labor for each gallon-size plant total $1.35. Green Thumbs volume is currently 470,000 units. Competitors offer the same plants, at the same quality, to garden centers for $3.60 each. Garden centers then mark them up to sell to the public for $9 to $12, depending on the type of plant. 1. Green Thumbs owners want to earn a 10% return on the companys assets. What is Green Thumbs target full cost? Revenue at current market price (470,000 units $3.60 per unit) Less: Desired profit ($4.8 million 10%) Target full cost
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$1,692,000 480,000 $1,212,000

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2. Given Green Thumbs current costs, will its owners be able to achieve their target profit?
Green Thumbs actual total full costs of $1,234,500 are higher than its target full cost, therefore Green Thumb will not meet the stockholders profit expectations. Current variable cost (500,000 1.70) Current fixed costs Total full cost $ 634,500 600,000 $1,234,500

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3. Assume Green Thumb has identified ways to cut its variable costs to $1.20 per unit. What is its new target fixed cost? Will this decrease in variable costs allow the company to achieve its target profit?
The new target fixed cost is $648,000. Target full cost (from requirement 1) Less: Reduced level of variable costs (470,000 $1.20) New target fixed costs $1,212,000 (564,000) $ 648,000

Since the companys actual fixed costs are less than or equal to the new target fixed cost amount, Green Thumb will be able to achieve its target profit without having to take any other cost-cutting measures. 29

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4. Green Thumb started an aggressive advertising campaign strategy to differentiate its plants from those grown by other nurseries. Monrovia Plants made this strategy work, so Green Thumb has decided to try it, too. Green Thumb does not expect volume to be affected, but it hopes to gain more control over pricing. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not?

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4. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not?
Green Thumbs cost-plus price is $3.74 Current fixed costs Plus: Additional fixed costs of advertising Plus: Total variable costs (470,000 $1.20) Total full costs Plus: Desired profit ($4.8 million 10%). Desired revenue Divided by: Number of units Cost-plus price per unit $ 600,000 115,000 564,000 $1,279,000 480,000 $1,759,000 470,000 $ 3.74

Retailers will be more willing to pay the cost-plus price if the marketing campaign is effective. Other wise, Green Thumb may be considered a generic nursery.
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3
Make dropping a product and product-mix decisions

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Does the product, department, or territory provide a positive contribution margin? Will fixed costs continue to exist, even if the company drops the product? Are there any direct fixed costs that can be avoided if the company drops the product, department, or territory? Will dropping the product, department, or territory affect sales of the companys other products? What could the company do with the freed manufacturing capacity?
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Focus on a decrease in volume

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If product has a negative contribution margin, then drop Unavoidable fixed costs Fixed costs that continue to exist even after a product is droppedirrelevant Avoidable, direct fixed costsrelevant If costs decrease more than the decrease in revenues, product should be dropped Would dropping the product line, department, or territory hurt other sales? Consider lost contribution margins from other products Will more profitable products be produced with freed capacity?

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Constraints
Something that restricts production or sale of product Manufacturers
Limitations on labor or machine hours or available materials

Merchandisers
Amount of display space

Stiff competition may limit demand

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What constraint(s) stop(s) the company from making (or displaying) all the units the company can sell? Which products offer the highest contribution margin per unit of the constraint? Would emphasizing one product over another affect fixed costs? Decision rule:
Decision Decision Rule Rule -Which Which product product to to emphasize? emphasize?
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Emphasize Emphasize the the product product with with the the highest highest contribution contribution margin margin per per unit unit of of the the constraint. constraint.
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Deela Fashions operates three departments: Mens, Womens, and Accessories. Departmental operating income data for the third quarter of 2012 are as follows:

Assume that the fixed expenses assigned to each department include only direct fixed costs of the department: Salary of the departments manager Cost of advertising directly related to that department If Deela 39 Fashions drops a department, it will not incur these fixed expenses.
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1. Under these circumstances, should Deela Fashions drop any of the departments? Give your reasoning.

Deela Fashions should drop the Accessories Department because relevant expenses are greater than the revenues which will result in an increase in operating income if the department is dropped.
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4
Make outsourcing and sell as is or process further decisions

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Managers decide whether to buy a component product or service or produce it in-house Cheaper is not always the deciding factor Considerations:
How do the companys variable costs compare to the outsourcing cost? Are any fixed costs avoidable if the company outsources? What could the company do with the freed manufacturing capacity?

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If fixed costs stay the sameirrelevant If fixed costs changerelevant

Differs between alternatives

Company can avoid $10,000 in fixed cost if outsourced. However, total costs are more, so do not outsource.
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Benefit given up by not choosing an alternative course of action Example:

If the company chooses not to outsource, it will lose any revenue from freed capacity If company outsources, freed capacity can be used to produce other products, maybe earning more

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Qualitative factors
Control over quality

Outsourcing considerations
Coordination, information exchange, and paperwork problems

Globalization
Use Internet to find information systems of suppliers and customers located around the world Companies can now focus on their core competenciesquality and delivery

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Considerations:
How much revenue will the company receive if the company sells the product as is? How much revenue will the company receive if the company sells the product after processing it further? How much will it cost to process the product further?

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Decision rule:

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Suppose a Roasted Olive restaurant is considering whether to (1) bake bread for its restaurant in-house or (2) buy the bread from a local bakery. The chef estimates that variable costs of making each loaf include $0.52 of ingredients, $0.24 of variable overhead (electricity to run the oven), and $0.70 of direct labor for kneading and forming the loaves. Allocating fixed overhead (depreciation on the kitchen equipment and building) based on direct labor assigns $0.96 of fixed overhead per loaf. None of the fixed costs are avoidable. The local bakery would charge $1.75 per loaf. 1. What is the unit cost of making the bread in-house (use absorption costing)? 2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why? 3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision?
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1. What is the unit cost of making the bread in-house (use absorption costing)?

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2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why? Decision: Roasted Olive should bake the bread in-house since the variable cost of making each loaf is less than the cost of outsourcing each loaf. 3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision? Roasted Olive should consider the following qualitative factors before making a final decision: Will the local bakery meet their delivery time requirements? How does the quality and freshness of the local bakery bread compare to Roasted Olive bread?

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Relevant information is expected future data that differs among alternatives. Relevant costs are costs that may affect which decision you make. Irrelevant costs are costs that wont change the decision you make. Sunk costs are costs that were incurred in the past and cannot be changed regardless of which future action is taken. The two keys to making short-term decisions are to focus on relevant revenues, costs, and profits, and to use a contribution margin approach to separate variable and fixed costs.
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Managers must consider three things when considering a special order:

1) Does the company have excess manufacturing capacity? 2) Does the special sales price cover the incremental costs of filling the special order? 3) Will fixed costs change because of the special order?

If the expected increase in revenues exceeds the expected increase in costs, the company should accept the special order. When setting prices, the company must consider its target profit goal, how much customers will pay for the product, and whether the company is a price-taker or a price-setter. Price setters use a cost-plus pricing approach to pricing, whereas price-takers use a target pricing approach.

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The first product mix question is Does the product provide a positive contribution margin? What is relevant is whether the fixed costs continue to exist if the product is dropped and whether there are any avoidable direct fixed costs if the product is dropped. Unavoidable fixed costs and are irrelevant to the decision. If direct fixed costs will change, those costs are relevant to the decision of whether a product should be dropped. When there is a constraint on production, such as total machine hours, this constraint must be considered when determining which product should be emphasized. If the company can sell whatever product it makes, the company should emphasize producing the product with the highest contribution margin per unit of the constraint.
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When a company is considering outsourcing, if the incremental costs of making the product exceed the incremental costs of outsourcing, then the company should outsource the product. When a company is considering selling a product as is or processing it further, if the extra revenue from processing the product further exceeds the extra costs to process the product further, then the company should process the product further.

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Copyright

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.
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