978-0077862275 Chapter 25 Lecture Note Part 2

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Chapter Outline

I. Managerial Decision Scenariosconsider each decision task

discussed below independent from the others.

A. Additional Business

1. Effect on net income must be considered when deciding

whether to accept or reject an order; reject if loss results.

2. Historical costs are not relevant to this decision.

3. Incremental or additional costs (also called differential costs)

are additional costs incurred if company pursues certain

course of action; relevant to this decision.

4. Minimum acceptable price per unit can be determined by

dividing incremental cost by the number of units in the order.

5. Incremental costs of additional volume are relevant.

6. If additional volume approaches or exceeds existing available

capacity of factory, incremental costs required to expand

capacity may quickly exceed incremental revenue.

7. Accepting order may cause existing sales to decline; the

contribution margin lost from the decline in sales is an

opportunity cost and is relevant (if future cash flows over

several time periods are affected, net present value should be

computed).

8. Note – Allocated overhead costs, which are historical costs,

should not automatically be considered; only incremental costs

to be incurred are relevant.

9. Key point: management must not blindly use historical costs,

especially allocated to overhead costs. Instead the accounting

system needs to provide incremental cost information if the

additional business is accepted.

B. Make or Buy

1. When determining whether to make or buy a component of a

product, only incremental costs are relevant.

2. Only incremental (additional) overhead costs are relevant; an

incremental overhead rate should be determined.

3. If the incremental costs of making the component exceed the

purchase price paid to buy the component, decision rule would

be to buy; however, several other factors should be considered.

a. Product quality.

b. Timeliness of delivery (especially in JIT settings).

c. Reactions of customers and suppliers.

d. Other intangibles (employee morale and workload).

e. Must also consider if making the part will require

incremental fixed costs to expand plant capacity.

1 Make or buy decision for component parts can also be used for

decisions about the outsourcing of services.

Notes

Chapter Outline

C. Scrap or Rework

1. Costs already incurred in manufacturing units of product not

meeting quality are sunk costs and are irrelevant in any

decision on whether to sell to substandard units as scrap or

rework to meet quality standards.

2. Incremental revenues, incremental costs of reworking defects,

and opportunity costs (the contribution margin lost if sales of

other units are given up) are all relevant.

D. Sell or Process Further

1. Partially completed products can be sold as is or they can be

processed further and then sold as other products.

2. Compute incremental revenue from further processing

(amount of revenue after further processing less revenue from

selling the products as partially completed)

3. Compute incremental cost from further processing.

4. Process further and sell if incremental revenue from further

processing exceeds related incremental costs.

E. Sales Mix Selection

1. When more that one product is sold, some are likely to be

more profitable than others; management should concentrate

sales efforts on more profitable products.

2. If production facilities or other factors are limited, an increase

in production and sale of one product usually requires

reduction in production and sale of others.

3. The most profitable combination, or sales mix, of products

should be determined. To identify the best sales mix,

management focuses on the contribution margin per unit of

scarce resource. The scarce resource could be the machines

used to make the products.

4. Determine the contribution margin of each product, the

facilities required to produce these products and any

constraints on facilities and markets for the products.

5. If demand is unlimited and the products use the same inputs

then the product with the highest contribution margin should

be produced.

6. If demand is unlimited but the products use different inputs

then determine contribution margin per unit of the constraint

(the factor that limits capacity, such as machine time

required); produce the product with the highest contribution

margin per unit of the constraint.

1 If demand is limited then the company should first produce the

most profitable product, up to the point of the total demand.

The remaining capacity should be used to produce the next

most profitable product.

Notes

Chapter Outline

F. Segment Elimination

1. If segment, division, or store is performing poorly,

management must consider eliminating it.

2. It is not sufficient to base the decision on net income (loss) or

its contribution to overhead.

3. Need to consider avoidable and unavoidable expenses:

a. Avoidable (or escapable) expenses are costs or expenses

that would not be incurred if the segment is eliminated.

b. Unavoidable (or inescapable) expenses are costs or

expenses that would continue even if the segment is

eliminated.

4. Decision rule – Segment is candidate for elimination if its

revenues are less than its avoidable expenses.

5. Should also assess impact of elimination on other segments.

a. An unprofitable segment might contribute to another

segment’s revenue and expenses

b. A profitable segment might be eliminated if its space,

assets and staff can be more profitably used by another

segment or new segment.

G. Keep or Replace Equipment

1. Must decide whether the reduction in variable manufacturing

costs over its life is greater than the net purchase price of the

new equipment.

a. Net purchase price is the cost of the new equipment less

any trade in allowance given or cash receipt for the old

equipment.

b. Book value of the old equipment is not used. It is a sunk

cost.

II. Decision AnalysisBreak-Even Time (BET) A variation of the

payback period method – overcomes the limitation of not using the

time value of money

A. The future cash flows are restated in terms of their present values;

B. The payback period is computed using these present values

C. Break-even time (BET) is useful measure; managers know when

to expect cash flows to yield net positive returns.

D. If BET is less than estimated life of investment, positive net

present value can be expected from investment.

E. To compare and rank alternative investment projects, choose the

project with the lowest break-even time.

Notes

Alternate Demo Problem Twenty-Five

A company is planning to buy a new machine at a cost of $200,000. The

machine is expected to last for 10 years and have no salvage value at the

end of its useful life. Straight-line depreciation will be used. The company

expects to save 10,000 hours of direct labor each year because of the new

machine, as well as $4,000 each year in other operating costs.

Management’s best estimate is that on average the hourly rate for the labor

saved will be $5.50. With the exception of the initial purchase, assume all

cash flows take place at the end of the year, and a tax rate of 40%.

Required:

1. Calculate the payback period on the investment in new machinery.

2. Calculate the rate of return on the average investment.

3. Calculate the net present value of the investment and profitability index:

(a) Ignoring income taxes, using a discount rate of 10%.

(b)Including the effect of taxes, using a 10% discount rate.

Solution: Alternate Demo Problem Twenty-Five

1. First, calculate annual net cash flow:

Determine increase in after-tax net income:

Labor savings: 10,000 hours @ $5.50 per hour $55,000

Other operating savings 4,000

Annual cash savings before tax 59,000

Less: annual depreciation expense 20,000

Increase in net income before tax 39,000

Less: Increase in annual income tax @ 40% 15,600

Increase in net income after tax $23,400

Then, add back depreciation expense (noncash):

Increase in net income after tax $23,400

Plus annual depreciation expense 20,000

Annual net cash flow $43,400

Payback period equals cost of new machine divided by annual net cash flow or

$200,000 / $43,400 = 4.6 years.

2. The rate of return on average investment equals the increase in net income after

tax divided by the amount of the average investment.

The average investment would be $200,000 / 2, or $100,000.

Rate of return on average investment = $23,400 / $100,000 = 23.4%

3(a) There is a cash savings of $59,000 each year for 10 years if income taxes are

ignored. The present value factor for a 10-year annuity at 10% is 6.1446.

Present value of cash savings ($59,000 x 6.1446) $362,531

Present value of investment 200,000

Net present value (positive) $162,531

Profitability Index = Net Present Value = $ 162,531 = .813

Cost of Investment $ 200,000

3(b) There is a cash savings of only $43,400 each year for 10 years if income taxes are

considered.

Present value of cash savings ($43,400 x 6.1446) $266,676

Present value of investment 200,000

Net present value (positive) $ 66,676

Profitability Index = Net Present Value = $ 66,676 = .333

Cost of Investment $ 200,000