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Chapter Outline
I. Managerial Decision Scenariosconsider 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 AnalysisBreak-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
