Activity Resource Usage Model and Tactical Decision Making

Activity Resource Usage Model and Tactical Decision Making Prepared by Douglas Cloud Pepperdine University 21 -1

Objectives 1. Describe the. After tactical decision-making model. studying this chapter, ofyou shouldcosts and 2. Define the concept relevant be able to: revenues. 3. Explain how the activity resource usage model is used in assessing relevancy. 4. Apply the tactical decision-making concepts in a variety of business situations. 21 -2

The Tactical Decision. Making Process Tactical decision making consists of choosing among alternatives with an immediate or limited end in view. 21 -3

The Tactical Decision. Making Process 1. Recognize and define the problem. 2. Identify alternatives as possible solutions to the problem, and eliminate alternatives that are not feasible. 3. Identify the predicted costs and benefits associated with each feasible alternative. Eliminate the costs and benefits that are not relevant to the decision. Continued 21 -4

The Tactical Decision. Making Process 4. Compare the relevant costs and benefits for each alternative, and then relate each alternative to the overall strategic goals of the firm and other important qualitative factors. 5. Select the alternative with the greatest benefit which also supports the organization’s strategic objectives. 21 -5

The Tactical Decision. Making Process—Example Step 1: Define the Problem Each year 25 percent of the harvest by an apple processor is small and odd-shaped. These apples cannot be sold in the normal distribution channels and have simply been dumped in the orchards for fertilizer. What should the firm do with these apples? 21 -6

The Tactical Decision. Making Process—Example Step 2: Identify Feasible Alternatives 1. Sell the applies to pig farmers. 2. Bag the applies in five-pound bags and sell them to local supermarkets as seconds. 3. Rent a local canning facility and convert the apples to applesauce. 4. Rent a local canning facility and convert the applies to pie filling. 5. Continue with the current dumping practice. 21 -7

The Tactical Decision. Making Process—Example Step 3: Predicting Costs and Benefits and Eliminating Irrelevant Costs Labor and materials (bags and ties) for the bagging option would cost $0. 05 per pound. A five-pound bag of apple could be sold for $1. 30 to local supermarkets. Making applesauce would cost $0. 40 per pound for rent, labor, apples, cans, and other materials. It takes six pounds of apples to produce five, 16 -ounce cans of applesauce. Each can sells for $0. 78. 21 -8

The Tactical Decision. Making Process—Example Step 4: Comparing Relevant Costs and Relating to Strategic Goals. The bagging alternative costs $0. 25 to produce a five-pound bag ($0. 05 x 5 pounds). The revenue is $1. 30 per bag, or $0. 26 per pound. The net benefit is $0. 21 per pound ($0. 26 – $0. 05). The net benefit of converting the apples into applesauce is $0. 25 per pound ($0. 65 – $0. 40). 21 -9

The Tactical Decision. Making Process—Example Step 5: Select Best Alternative. Since the apple producer is reluctant to follow a forward integration strategy, the bagging alternative should be chosen. 21 -10

The Tactical Decision. Making Process—Review Step 1 Step 2 Continued Define Problem Identify Alternatives What to do with small, ill-shaped apples. 1. Sell to pig farmers. 2. Sell bagged apples (feasible). 3. Make applesauce (feasible). 4. Make pie filling. 5. Continue dumping. 21 -11

Step 3 Step 4 Continued Predict Costs Compare Costs Bagged alternative: a. Revenue $1. 30 per bag ($0. 26 per pound) b. Cost $0. 05 per pound Applesauce alternative: a. Revenue: $0. 78 per can ($0. 65 per pound) b. Cost: $0. 40 per pound Bagged Applesauce Revenue $0. 26 Cost 0. 05 Net benefit $0. 21 $0. 65 0. 40 $0. 25 Bagged: Differentiation Applesauce: Forward integration 21 -12

Step 5 Select Alternatives Select bagging alternative because it is profitable and is more consistent with strategic positioning desired by producer. 21 -13

Relevant Costs Defined Relevant costs are future costs that differ across alternatives. A cost must not only be a future cost but must also differ between alternatives. 21 -14

Irrelevant Cost Illustrated Sunk costs are past costs. Example: The original cost of a building is a sunk cost when you are trying to decide whether or not to sell the business five years later. 21 -15

Flexible Resources Flexible resources can be easily purchased in the amount needed and at the time of use… like electricity. 21 -16

Flexible Resources a. Demand Changes Relevant b. Demand Constant Not Relevant 21 -17

Committed Resources Committed resources are purchased before they are used, such as salaried employees. 21 -18

Committed Resources Supply – Demand = Unused Capacity a. Demand Increase < Unused Capacity Not relevant b. Demand Increase > Unused Capacity Relevant c. Demand Decease (Permanent) 1. Activity Capacity Reduced 2. Activity Capacity Unchanged Relevant Not Relevant 21 -19

Committed Resources—Example A company has five manufacturing engineers who supply a capacity of 10, 000 engineering hours (2, 000 hours each). The cost of this activity capacity is $250, 000, or $25 per hour. The firm expects to use 9, 000 hours. If the firm decides to reject a special order requiring 500 hours, the cost of engineering would be irrelevant. 21 -20

Committed Resources—Example The firm can purchase a component that will drop the demand from engineering hours from 9, 000 to 7, 000. Since engineering activity capacity is acquired in chunks of 2, 000, the company can lay off one engineer or reassign the engineer to another plant. 21 -21

Some Types of Decisions Illustrated § Make or Buy § Keep or Drop § Special Order § Sell or Process Further Important: Short-term Perspective 21 -22

Make or Buy Talmage Company produces a mechanical part used in one of its engines. (Talmage produces engines for snowblowers. ) An outside supplier has offered to sell a part (Part 34 B) for $4. 75. The company normally produces 100, 000 units of the part each year. 21 -23

ABC Make-or-Buy Analysis Make Buy Using materials $ 50, 000 $ 0 Using direct labor 200, 000 0 Providing supervision 300, 000 240, 000 Moving materials 394, 000 345, 000 Providing power 90, 000 0 Inspecting products 301, 000 263, 000 Setting up equipment 600, 000 540, 000 Acquiring Part 34 B 0 475, 000 Total $1, 935, 000 $1, 863, 000 Buy the part! Differential Cost $ 50, 000 200, 000 60, 000 49, 000 90, 000 38, 000 60, 000 -475, 000 $ 72, 000 21 -24

Functional Based Make-or-Buy Analysis Make Using materials $ 50, 000 Using direct labor 200, 000 Providing supervision 300, 000 Providing power 90, 000 Acquiring Part 34 B 0 Total $640, 000 Buy $ 0 0 240, 000 0 475, 000 $715, 000 Differential Cost $ 50, 000 200, 000 60, 000 90, 000 -475, 000 $ -75, 000 Make the part! 21 -25

Keep-or-Drop Decisions Seat Covers Floor Mats Sales $950, 000 Less unit-level variable expenses: Direct materials -300, 000 Direct labor -210, 000 Maintenance -90, 000 Power -35, 000 Commission -30, 000 Contribution margin $ 285, 000 Less traceable expenses -405, 000 Product margin $-120, 000 Less common expenses Income before taxes DROP? Total $1, 680, 000 $2, 630, 000 -400, 000 -700, 000 -210, 000 -420, 000 -90, 000 -180, 000 -25, 000 -60, 000 -40, 000 -70, 000 $ 915, 000 $1, 200, 000 -325, 000 -730, 000 $ 590, 000 $ 470, 000 -430, 000 $ 40, 000 21 -26

Keep-or-Drop Decisions Keep Alternative Drop Alternative Contribution margin $285, 000 Advertising, direct fixed -50, 000 Supervision, direct fixed -30, 000 Inspecting products, nonunit variable -20, 000 Inspecting products, traceable fixed -80, 000 Inspecting products, unused capacity -40, 000 Material handling, nonunit variables -10, 000 Material handling, traceable fixed -70, 000 Customer service, traceable fixed -45, 000 Total $ -60, 000 $ 0 0 0 0 -15, 000 $-15, 000 Dropping the product saves $45, 000! 21 -27

Special-Order Cost Polarcreme, Inc. , an ice-cream company, is operating at 80 percent of its 20 million halfgallon capacity. A distributor from another geographically area offered to buy 2 million units of premium ice cream at $1. 75 per unit. They have agreed to provide their own label and pay transportation costs. This sale would avoid a sales commission. 21 -28

Special-Order Cost Which costs are irrelevant? Variable costs: Dairy ingredients Sugar Flavoring Direct labor Packaging Commissions Distribution Other Total unit-level costs $0. 70 0. 15 0. 20 0. 02 0. 03 0. 05 $1. 50 $1. 45 21 -29

Special-Order Cost The nonunit-level variable costs will also be incurred, producing a total increment cost of $304, 000 or $0. 152 per unit (for an order of 2 million units). Revenue per unit of $1. 75, less the unit-level variable cost ($1. 45) plus the nonunit-level variable cost ($0. 152) provides a net benefit of $0. 148 per unit. Thus Polarcreme’s profit would increase by $296, 000 ($0. 148 x 2, 000). 21 -30

Sell or Process Further Joint products have common processes and costs of production up to a split-off point. The point of separation is called the split-off point. Assume that the hot sauce sells for $1. 50 per bottle. Also, assume that the additional processing costs amount to $1, 000. The total revenue at split-off for Grade A tomatoes are $400 ($0. 40 x 1, 000 pounds). If the Grade A tomatoes are processed into hot sauce, the total revenues are $1, 500 ($1. 50 per bottle). 21 -31

Sell or Process Further Sell Revenues Processing costs Total $400 ---$400 Differential Amount Process Further to Process Further $1, 500 1, 000 $ 500 $1, 100 1, 000 $ 100 Decision: Further Process 21 -32

End of Chapter 21 -33

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