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Chapter 12 - Lecture Notes
12-10
ii. In the Essex Company example that we
just completed, if Essex had an alternative
use for the capacity that it used to make
part 4A, there would have been an
opportunity cost to factor into the analysis.
1. The opportunity cost would have been equal
to the segment margin that could have
been derived from the best alternative use
of the space.
IV. Special orders
Learning objective 4: Prepare an analysis showing
whether a special order should be accepted.
A. Key terms and concepts
i. A special order is a one-time order that is
not considered part of the company’s
normal ongoing business.
ii. When analyzing a special order, only the
incremental costs and benefits are
relevant. Since the existing fixed
manufacturing overhead costs would not
be affected by the order, they are not
relevant.
Helpful Hint: Emphasize the incremental concept in the
decision-making process. If a company accepts a
special order to produce an item without carefully
determining existing capacity, it might have to cut into
regular production. The effects of lost sales from
ongoing products might be devastating.
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B. Jet Inc. – an example
i. Assume the following information with
respect to a special order opportunity for
Jet Inc. Should Jet accept the offer?
ii. A contribution format income statement
for Jet Inc.’s normal sales of 5,000 units is
as shown.
iii. If Jet accepts the special order, the
incremental revenue of $30,000 will
exceed the incremental costs of $24,000 by
$6,000. This suggests that Jet should
accept the order. Notice:
1. This answer assumes that the fixed costs are
unavoidable and that variable marketing
costs must be incurred on the special order.
Quick Check – special order decision making
V. Utilization of a constrained resource
Learning Objective 5: Determine the most profitable
use of a constrained resource.
A. Key terms and concepts
i. When a limited resource of some type
restricts the company’s ability to satisfy
demand, the company is said to have a
constraint. The machine or process that is
limiting overall output is called the
bottleneck—it is the constraint.
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Helpful Hint: A production process can be thought of
as a chain; each link in the chain represents a step in
the process. A chain is only as strong as its weakest
link. Likewise, the capacity of a production process is
determined by its weakest link, which is the constraint.
To increase the strength of a chain, its weakest link
must be strengthened. To increase the output of the
entire process, the output of the constraint must be
increased. Strengthening the stronger links has no
effect on the strength of the entire chain. The moral is
to identify the constraint and concentrate management
attention on effectively increasing its capacity.
ii. Fixed costs are usually unaffected in these
situations, so the product mix that
maximizes the company’s total
contribution margin should ordinarily be
selected.
iii. A company should not necessarily promote
those products that have the highest unit
contribution margins. Rather, total
contribution margin will be maximized by
promoting those products or accepting
those orders that provide the highest
contribution margin in relation to the
constraining resource.
B. Ensign Company – an example
i. Assume that Ensign Company produces
two products and selected data are as
shown. In addition assume that:
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1. Machine A1 is the constraint.
2. There is excess capacity on all other
machines.
3. Machine A1 has a capacity of 2,400
minutes per week.
4. Ensign is trying to decide if it should focus
its efforts on product 1 or 2.
Quick Check – constrained resource calculations
ii. As suggested by the answer to the Quick
Check question, Ensign should emphasize
product 2 because it generates a
contribution margin of $30 per minute
of the constrained resource relative to
$24 per minute for product 1.
iii. Ensign can maximize its contribution
margin by first producing product 2 to
meet customer demand and then using any
remaining capacity to produce product
1. The calculations would be performed as
follows:
1. Satisfying the weekly demand of 2,200
units for product 2 would consume 1,100
minutes of available capacity on machine
A1.
2. This implies that 1,300 constraint minutes
would still be available to satisfy demand
for product 1.
3. Since each unit of product 1 requires one
minute of A1 machine time, Ensign could
produce 1,300 units of product 1 with its
remaining capacity.
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4. This mix of production (e.g., 2,200 units of
product 2 and 1,300 units of product 1)
would yield a total contribution margin of
$64,200.
Learning Objective 6: Determine the value of obtaining
more of the constrained resource.
iv. How much should Ensign be willing to pay
for an additional minute of A1 machine
time?
1. Because the additional machine time would
be used to make more units of Product 1,
Ensign should be willing to pay up to $24
per minute. This amount equals the
contribution margin per minute of machine
time that would be earned producing more
units of Product 1.
Quick Check – constrained resource calculations
C. Managing constraints
i. It is often possible for a manager to
increase the capacity of a bottleneck,
which is called relaxing (or elevating) the
constraint, in numerous ways such as:
1. Working overtime on the bottleneck.
2. Subcontracting some of the processing that
would be done at the bottleneck.
3. Investing in additional machines at the
bottleneck.
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4. Shifting workers from non-bottleneck
processes to the bottleneck.
5. Focusing business process improvement
efforts on the bottleneck.
6. Reducing defective units processed through
the bottleneck.
ii. If a company has more than one potential
constraint, the proper “mix” of products
can be found using a quantitative method
known as linear programming, which is
covered in quantitative methods and
operations management courses.
VI. Joint product costs and the contribution approach
Learning Objective 7: Prepare an analysis showing
whether joint products should be sold at the split-off
point or processed further.
A. Key terms/concepts
i. In some industries, a number of end
products are produced from a single raw
material input. When two or more products
are produced from a common input these
products are known as joint products. The
split-off point is the point in the
manufacturing process at which the joint
products can be recognized as separate
products.
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1. For example, in the petroleum refining
industry a large number of products are
extracted from crude oil, including gasoline,
jet fuel, home heating oil, lubricants,
asphalt, and various organic chemicals.
ii. The term joint cost is used to describe
costs incurred up to the split-off point.
Joint costs are common costs incurred to
simultaneously produce a variety of end
products.
1. Joint costs are traditionally allocated among
different products at the split-off point. A
typical approach is to allocate joint costs
according to the relative sales value of the
end products.
2. Although allocation is needed for some
purposes such as balance sheet inventory
valuation, allocations of this kind are very
dangerous for decision making.
B. Sell or process further decisions
i. Joint costs are irrelevant in decisions
regarding what to do with a product from
the split-off point forward. Therefore, these
costs should not be allocated to end
products for decision-making purposes.
ii. With respect to sell or process further
decisions, it is profitable to continue
processing a joint product after the split-off
point so long as the incremental revenue
from such processing exceeds the
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incremental processing costs incurred
after the split-off point.
C. Sell or process further decisions – an example
i. Assume the facts as shown with respect to
Sawmill, Inc.
1. Sawmill has two joint products – lumber
and sawdust. Selected financial information
is shown for each joint product.
2. The incremental revenue from further
processing of the lumber and sawdust is
$130 and $10, respectively.
3. The profit (loss) from further processing is
$80 for the lumber and ($10) for the
sawdust.
4. The lumber should be processed further
and the sawdust should be sold at the split-
off point.
D. Activity-based costing and relevant costs
1. Activity-based costing can be used to help
identify potentially relevant costs for
decision-making purposes. However,
managers should exercise caution against
reading more into this “traceability” than
really exists. People often assume that if a
cost is traceable to a segment, then the cost
is automatically avoidable, which is untrue.
Before making a decision, managers must
decide which of the potentially relevant
costs are actually avoidable.
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