Chapter 8 ShortRun Decision Making Relevant Costing MowenHansenHeitger

Chapter 8 Short-Run Decision Making: Relevant Costing Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Learning Objectives 1. Describe the short-run decision-making model, and explain how cost behavior affects the information used to make decisions 2. Apply relevant costing and decision-making concepts in a variety of business situations 3. Choose the optimal product mix when faced with one constrained resource 4. Explain the impact of cost on pricing decisions Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Short-Run Decision Making • Short-run decision making consists of choosing among alternatives with an immediate or limited end in view • Also referred to as tactical decisions because they involve choosing between alternatives with an immediate or limited time frame in mind • Example: Accepting a special order for less than the normal selling price to utilize idle capacity and to increase this year’s profits • Some decisions tend to be short run in nature • Short-run decisions often have long-run consequences Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

The Decision-Making Model (1 of 2) • A decision model, a specific set of procedures that produces a decision, can be used to structure the decision maker’s thinking and to organize the information to make a good decision • The following is an outline of one decision-making model: o Step 1. Recognize and define the problem o Step 2. Identify alternatives as possible solutions to the problem. Eliminate alternatives that clearly are not feasible Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

The Decision-Making Model (2 of 2) o Step 3. Identify the costs and benefits associated with each feasible alternative. Classify costs and benefits as relevant or irrelevant, and eliminate irrelevant ones from consideration o Step 4. Estimate the relevant costs and benefits for each feasible alternative o Step 5. Assess qualitative factors o Step 6. Make the decision by selecting the alternative with the greatest overall net benefit Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: IN YOUR COLLEGE TOWN (1 of 3) As an inquisitive undergraduate business major, Jack wondered if the relevant decisions mentioned in his managerial accounting class could actually be observed in his college town. He quickly identified a number of exciting relevant decisions at work in the uptown businesses he frequented near campus. For instance, Jack noticed numerous product-line additions (i. e. , keep -or-drop decisions), including the unveiling of two additional Starbucks cafes, Chipotle’s initial entry into town, and even the arrival of an Apple Store! He also noticed that the Target pharmacy where he used to fill all of his prescriptions Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: IN YOUR COLLEGE TOWN (2 of 3) had been converted into a CVS Pharmacy even though it was still located within the Target store! Examples of relevant decisions also cropped up on campus. When Jack’s senior pre-med roommate, Daniel, registered for his capstone course, he was told that it had been outsourced (i. e. , make-or-buy decisions) to an online university that specialized in certain senior-level medical courses. The dean informed Daniel that it was much cheaper for the university to allow its few pre-med students to take the course from another university rather than hire the specialized instructors necessary to teach the course Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: IN YOUR COLLEGE TOWN (3 of 3) in-house. Finally, Jack was disappointed when his intramural basketball tournament was moved away from the university arena to make way for the local high school graduation. After some investigation, he learned that the university often rented out its high-end capacity assets (e. g. , auditorium, sports arenas, business school atrium) to outside organizations (i. e. , special sales decisions). To Jack’s surprise, relevant decisions were quite common in his college town, which excited him to study this useful topic! Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Step 1: Recognize and Define the Problem • The first step is to recognize and define a specific problem. o For example, if the members of a management team recognized the need for additional productive capacity as well as increased space for raw materials and finished goods inventories, they would consider: • • The number of workers and the amount of space needed The reasons for the need How the additional space would be used However, the central question is how to acquire the additional capacity Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Step 2: Identify the Alternatives as Possible Solutions • The second step is to list and consider possible solutions • Some alternatives are dismissed either because they involve too much risk, or they are not proven, or they are outside of cost constraints • One of the best strategies is to link the short-run decision (like an increase in productive capacity) to the company’s overall growth strategy by rejecting alternatives that involved too much risk at a particular stage of a company’s development Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Step 3: Identify the Costs and Benefits Associated with Each Feasible Alternative • In the third step, the costs and benefits associated with each feasible alternative are identified • At this point, clearly irrelevant costs can be eliminated from consideration • It is fine to include irrelevant costs and benefits in the analysis as long as they are included for all alternatives. We usually do not include them because focusing only on the relevant costs and benefits reduces the amount of data to be collected Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Step 4: Estimate the Relevant Costs and Benefits for Each Feasible Alternative • The differential cost is the difference between the summed costs of two alternatives in a decision Compares the sum of each alternative’s relevant costs only o Emphasis on differential cost allows decision makers to occasionally include irrelevant costs in the alternatives if they choose to do so o • The inclusion of irrelevant costs is acceptable only if all irrelevant costs are included for each alternative Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Step 5: Assess Qualitative Factors (1 of 2) • Qualitative factors can significantly affect the manager’s decision Political Pressure: Some managers worry that such political pressure from customers can have long-term negative effects on sales that more than offset the labor cost savings that spurred the decision to offshore o Product Safety: Product safety represents another key qualitative factor for outsourcing organizations o Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Step 5: Assess Qualitative Factors (2 of 2) • Qualitative factors, such as the impact of late orders on customer relations, must be taken into consideration in the final step of the decision-making model—the selection of the alternative with the greatest overall benefit Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Step 6: Make the Decision (1 of 2) • Once all relevant costs and benefits for each alternative have been assessed and the qualitative factors weighed, a decision can be made • Ethical concerns revolve around the way in which decisions are implemented and the possible sacrifice of long-run objectives for short-run gain • Relevant costs are used in making short-run decisions Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Step 6: Make the Decision (2 of 2) • Decision makers should always maintain an ethical framework • Whenever relevant costing is used, it is important to include all costs that are relevant—including those involving ethical ramifications Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Relevant Costs Defined • The decision-making approach just described emphasized the importance of identifying and using relevant financial items • Relevant costs (and revenues) possess two characteristics: they are future items AND o they differ across alternatives o • All pending decisions relate to the future • Accordingly, only future costs and future revenues can be relevant to decisions Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Opportunity Costs • Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over another • An opportunity cost is relevant because it is both a future cost and one that differs across alternatives • An opportunity cost is never an accounting cost, because accountants do not record the cost of what might happen in the future (i. e. , they do not appear in financial statements) Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: IN YOUR LIFE (1 of 4) Finding ways to generate extra cash appeals to almost everyone, especially college students. At the end of each semester, Allyson has to make an important decision regarding what to do with her textbooks—either keep them or sell them back to the university bookstore. After taking her last exam, she ran to the bookstore and learned that each of her five textbooks could be sold for $25 per book. She quickly calculated that the opportunity cost of her keeping the books (i. e. , not selling them back to the bookstore) was $125, which would go a long way for some end-of-the-semester beverages Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: IN YOUR LIFE (2 of 4) or Christmas presents for friends and family. However, as she placed her books upon the buyback counter, she quickly wondered if there was an opportunity cost of selling (i. e. , not keeping) them that she should estimate before collecting her cash. And if there was an opportunity cost of selling the books, how would she estimate this cost? Allyson will need to determine the likelihood that she will want to access any of the information in the books during her remaining courses or upcoming professional internship. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: IN YOUR LIFE (3 of 4) If so, she also will need to estimate the amount of time she would need to spend finding such information when she no longer has access to her old textbooks, plus the monetary value she places on her time spent searching for this needed information. For example, Allyson believes that her roommate asked to borrow one of her textbooks while on an Apple internship this semester to help prepare geographically segmented income statements. Suddenly, Allyson wasn’t so sure that the opportunity cost of selling back her textbooks was $0. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: IN YOUR LIFE (4 of 4) Increasingly, she wondered whether she might even be better off financially by keeping her textbooks this semester because the opportunity cost of selling them back to the bookstore could actually be higher than the opportunity cost of keeping them! Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Sunk Costs (1 of 2) • A sunk cost is a cost that cannot be affected by any future action • It is important to note the psychology behind managers’ treatment of sunk costs • Although managers should ignore sunk costs for relevant decisions, it unfortunately is human nature to allow sunk costs to affect these decisions Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Sunk Costs (2 of 2) • For example, depreciation, a sunk cost, is sometimes allocated to future periods though the original cost is unavoidable • In choosing between the two alternatives, the original cost of an asset and its associated depreciation are not relevant factors Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Cost Behavior and Relevant Costs (1 of 2) • Most short-run decisions require extensive consideration of cost behavior • It is easy to fall into the trap of believing that variable costs are relevant and fixed costs are not • But this assumption is not true • The key point is that changes in supply and demand for resources must be considered when assessing relevance Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Cost Behavior and Relevant Costs (2 of 2) • If changes in demand supply for resources across alternatives bring about changes in spending, then the changes in resource spending are the relevant costs that should be used in assessing the relative desirability of the two alternatives Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Some Common Relevant Cost Applications • Relevant costing is of value in solving many different types of problems. Traditionally, these applications include decisions: to make or buy a component o to keep or drop a segment or product or service line o to accept a special order at less than the usual price o to further process joint products or sell them at the split-off point o • Though by no means an exhaustive list, many of the same decision-making principles apply to a variety of problems Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Make-or-Buy Decisions • Managers face the decision of whether to make a particular product (or provide a service) or to purchase it from an outside supplier • Make-or-buy decisions are those decisions involving a choice between internal and external production Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: AT NAVISTER, INC (1 of 3) Let’s return briefly to Navistar, Inc. ’s use of relevant analysis in making the make-or-buy decision for its additional axle needs. In question was whether it should manufacture (i. e. , “make”) the additional axles it needed or purchase (i. e. , “buy”) them from an external vendor. After a careful discussion with a cross-functional team representing personnel from Human Resources, Accounting, Purchasing, and Finance, managers decided that the key costs on the “make” side included one-time capital and start-up expenditures on machines and ongoing expenditures for labor, repairs and maintenance, Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: AT NAVISTER, INC (2 of 3) utilities, depreciation, and insurance. Key costs on the “buy” side included onetime vendor tooling expenditures and ongoing expenditures for freight, logistics, inventory storage and movement, and training. In addition, managers considered important qualitative characteristics such as ensuring high quality, which was particularly relevant for the training costs because Navistar wanted to be sure that any purchased axles were of a high quality and delivered to the right place at the appropriate time. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: AT NAVISTER, INC (3 of 3) After these relevant costs were identified, quantified, and analyzed, Navistar confidently elected to outsource its additional axle production. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 1: How to Structure a Make-or-Buy Problem (1 of 5) Swasey Manufacturing needed to determine if it would be cheaper to make 10, 000 units of a component in-house or to purchase them from an outside supplier for $4. 75 each. Cost information on internal production includes the following: Total Cost Direct materials Direct labor Variable overhead Fixed overhead Total Unit Cost $10, 000 $1. 00 20, 000 2. 00 8, 000 0. 80 44, 000 4. 40 $82, 000 $8. 20 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 1: How to Structure a Make-or-Buy Problem (2 of 5) Fixed overhead will continue whether the component is produced internally or externally. No additional costs of purchasing will be incurred beyond the purchase price. Required: 1. What are the alternatives for Swasey Manufacturing? 2. List the relevant cost(s) of internal production and of external purchase. 3. Which alternative is more cost effective and by how much? Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 1: How to Structure a Make-or-Buy Problem (3 of 5) 4. Now assume that fixed overload includes $10, 000 of cost that can be avoided if the component is purchased externally. Which alternative is more cost effective and by how much? Solution: 1. There are two alternatives: make the component in-house or purchase it externally. 2. Relevant cost of making the component in-house include direct materials, direct labor, and variable overhead. Relevant costs of purchasing the component externally include the purchase price. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 1: How to Structure a Make-or-Buy Problem (4 of 5) Direct materials Direct labor Variable overhead Purchase cost Total relevant cost Alternatives for Make Alternatives for Buy Differential Cost to Make $10 000 — $ 10, 000 20, 000 — 20, 000 8, 000 — $47, 500 (47, 500) $38, 000 $47, 500 $ (9, 500) 3. It is cheaper (by $9, 500) to make the component in-house. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 1: How to Structure a Make-or-Buy Problem (5 of 5) 4. Direct materials Direct labor Variable overhead Avoidable fixed overhead Purchase cost Total relevant cost Alternatives for Make Alternatives for Buy Differential Cost to Make $10 000 — $ 10, 000 20, 000 — 20, 000 8, 000 — 8, 000 10, 000 — $47, 500 (47, 500) $48, 000 $47, 500 $ 500 Now it is cheaper (by $500) to purchase the component. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: SUSTAINABILITY AT HEWLETT-PACKARD (1 of 2) One type of relevant cost that is becoming increasingly large due to globalization and the green environmental movement concerns the disposal costs associated with electronic waste (or e-waste). Increasingly, government agencies are assessing manufacturers of computers, televisions, digital music devices, etc. , a costly fee at production to cover product disposal costs that public landfills eventually incur once the products reach the end of their life cycle, become obsolete, and are thrown out to pollute the environment. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: SUSTAINABILITY AT HEWLETT-PACKARD (2 of 2) Hewlett-Packard Co. has taken a strategic leadership position by recycling approximately 10%of its sales as a more cost-effective means than incurring the aforementioned governmental fees at production. Some experts estimate annual global e-waste at approximately 50 million tonnes. Not all companies are as business savvy or environmentally responsible as Hewlett-Packard, as evidenced by the $19 billion estimated value of illegally traded and dumped ewaste. The failure to properly forecast e-waste levels and consider their relevant life cycle costs can cause the make side of the make-or-buy analysis to appear more attractive (i. e. , less costly) than it is in reality. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Special Order Decisions • A company may consider offering a product or service at a price different from the usual price • Firms have the opportunity to consider special orders from potential customers in markets not ordinarily served Special-order decisions focus on whether a specially priced order should be accepted or rejected o These orders often can be attractive, especially when the firm is operating below its maximum productive capacity o Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 2: How to Structure a Special-Order Problem (1 of 3) Leibnitz Company has been approached by a new customer with an offer to purchase 20, 000 units of model TR 8 at a price of $89 each. The new customer is geographically separated from the company's other customers, and existing sales would not be affected. Leibnitz normally produces 100, 000 units of T R 8 per year but only plans to produce and sell 75, 000 in the coming year. The normal sales price is $14 pet unit. Unit cost information for the normal level of activities is as follows: Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 2: How to Structure a Special-Order Problem (2 of 3) Direct materials $3. 00 Direct labor 2. 80 Variable overhead 1. 50 Fixed overhead 2. 00 Total $9. 30 Fixed overhead will not be affected by whether or not the special order is accepted. Required: 1. What are the relevant costs and benefits of the two alternatives (accept or reject the special order)? 2. By how much will operating income increase or decrease if the order is accepted? Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 2: How to Structure a Special-Order Problem (3 of 3) 1. Relevant costs and benefits of accepting the special order include the sales price of $89, direct materials, direct labor, and variable overhead. No Relevant costs or benefits are attached to rejecting the order. 2. If the problem is analyzed on a unit basis: Accept Reject Differential Benefit to Accept Price $ 9. 00 $— $ 9. 00 Direct materials (3. 00) — (3. 00) Direct labor (2. 80) — (2. 80) Variable overhead (1. 50) — (1. 50) $ 1. 70 Increase in operating income Operating income will increase by $34, 000 ($1. 70 × 20, 000 units) if the special order is accepted. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Keep-or-Drop Decisions (1 of 2) • A manager needs to determine whether a segment, such as a particular product or service line or a geographic sales region, should be kept or dropped • Making effective keep-or-drop decisions requires that managers identify and consider only the relevant information of the business segment in question • A segment is a subunit of a company of sufficient importance to warrant the production of performance reports Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Keep-or-Drop Decisions (2 of 2) • Segmented reports prepared on a variable-costing basis are important because they provide managers with this valuable information • Both the contribution margin and the segment margin shown on a segmented income statement are useful in evaluating the performance of segments and, in particular, identifying the relevant information necessary for making effective keep-or-drop decisions Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Segmented Income Statements Using Variable Costing • Variable costing is useful in preparing segmented income statements because it gives useful information on variable and fixed expenses • In segmented income statements, fixed expenses are broken down into two categories: direct fixed expenses and o common fixed expenses o Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Direct Fixed Expenses • Direct fixed expenses are fixed expenses that are directly traceable to a segment • These are sometimes referred to as avoidable fixed expenses or traceable fixed expenses because they vanish if the segment is eliminated o For example, if the segments were sales regions, a direct fixed expense for each region would be the rent for the sales office Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Common Fixed Expenses • Common fixed expenses are jointly caused by two or more segments • These expenses persist even if one of the segments to which they are common is eliminated o For example, depreciation on the corporate headquarters building or the salary of the CEO would be a common fixed expense for most large companies Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 3: How to Prepare a Segmented Income Statement (1 of 4) • Audiomatronics Inc. produces MP 3 players and smartphones in a single factory. The following information was provided for the coming year: MP 3 Players Smartphones Sales $400, 000 $290, 000 Variable cost of goods sold 200, 000 150, 000 Direct fixed overhead 30, 000 20, 000 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 3: How to Prepare a Segmented Income Statement (2 of 4) A 5% sales commission is paid for each of the product lines. Direct fixed selling and administrative expense was estimated to be $10, 000 for the MP 3 line and $15, 000 for the smartphone line. Common fixed overhead for the factory was estimated to be $100, 000; common selling and administrative expense was estimated to be $20, 000. Required: Prepare a segmented income statement for Audiomatronics Inc. for the coming year, using variable costing. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 3: How to Prepare a Segmented Income Statement (3 of 4) Solution: Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: AT FOLSOM MANUFACTURING (1 of 3) You are the Financial Vice President for Folsom Company, which sells three products, Alpha, Beta, and Gamma. You have just received the income statement shown in Panel A of the information provided in slide 53. Clearly, Gamma is unprofitable. In fact, the company is losing $13, 740 a year on Gamma. Should you drop Gamma? Will income go up if you do? Take a closer look at the income statement. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: AT FOLSOM MANUFACTURING (2 of 3) Observe that both the direct fixed costs and the allocated common fixed costs are subtracted from each segment’s contribution margin. This observation is misleading; it seems that dropping any segment would result in losing the operating income associated with the segment. However, if one segment is dropped, the allocated common fixed costs will remain. A more useful income statement—one that is segmented—is presented in Panel B in slide 53. Here, the segment margin for all three products is positive, as is overall income. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: AT FOLSOM MANUFACTURING (3 of 3) While Gamma is not as profitable as Alpha and Beta, it is profitable. Dropping Gamma will result in a decrease in operating income of $12, 000, the amount of the segment margin. Separating the direct fixed costs from the common fixed costs, and focusing on the segment margin, will give a truer picture of a segment’s profitability. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Comparison of Segmented Income Statement With and Without Allocated Common Fixed Expense Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 4: How to Structure a Keep-or-Drop Product-Line Problem (1 of 4) • Shown below is a segmented income statement for Norton Materials Inc. ’s three product lines: Blocks Bricks Tile Total $500, 000 $800, 000 $150, 000 $1, 450, 000 Less: Variable expenses 250, 000 480, 000 140, 000 870, 000 Contribution margin $250, 000 $320, 000 $ 10, 000 $ 580, 000 Advertising (10, 000) (30, 000) Supervision salaries (37, 000) (40, 000) (35, 000) (112, 000) Depreciation (53, 000) (40, 000) (103, 000) $150, 000 $230, 000 $(45, 000) $ 335, 000 Sales revenue Less direct fixed expenses: Segment margin Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 4: How to Structure a Keep-or-Drop Product-Line Problem (2 of 4) The roofing tile line has a contribution margin of $10, 000 (sales of $150, 000 minus total variable costs of $140, 000). All variable costs are relevant. Relevant fixed costs associated with this line include $10, 000 in advertising and $35, 000 in supervision salaries. Required: 1. List the alternatives being considered with respect to the roofing tile line. 2. List the relevant benefits and costs for each alternative. 3. Which alternative is more cost effective and by how much? Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 4: How to Structure a Keep-or-Drop Product-Line Problem (3 of 4) Solution: 1. The two alternatives are to keep the roofing tile line or to drop it. 2. The relevant benefits and costs of keeping the roofing tile line include sales of $150, 000, variable costs of $140, 000, advertising cost of $10, 000, and supervision cost of $35, 000. None of the relevant benefits and costs of keeping the roofing tile line would occur under the drop alternative. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 4: How to Structure a Keep-or-Drop Product-Line Problem (4 of 4) 3. Keep Sales Drop Differential Amount to Keep $150, 000 $— $150, 000 Less: Variable expenses 140, 000 — 140, 000 Contribution margin $ 10, 000 $— $ 10, 000 (10, 000) — (10, 000) (35, 000) — (35, 000) $0 $ (35, 000) Less: Advertising Cost of supervision Total relevant benefit (loss) The difference is $35, 000 in favor of dropping the roofing tile line. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Keep or Drop with Complementary Effects • A potential complication of a keep-or-drop analysis is the implication such a decision might have on other aspects of the business • Such implications must be included in the analysis before making a final decision • Sometimes dropping one line would lower sales of another line, as many customers buy both lines at the same time • This information can affect the keep-or-drop decision Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 5: How to Structure a Keep-or-Drop-Product Line Problem with Complementary Effects (1 of 4) Refer to Norton Materials’ segmented income statement in Example 8. 4 (p. 412). Assume that dropping the product line reduces sales of blocks by 10% and sales of bricks by 8%. All other information remains the same. Required: 1. If the roofing tile line is dropped, what is the contribution margin for the block line? For the brick line? 2. Which alternative (keep or drop the roofing tile line) is now more cost effective and by how much? Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 5: How to Structure a Keep-or-Drop-Product Line Problem with Complementary Effects (2 of 4) Solution: 1. Previous contribution margin of blocks was $250, 000. A 10% decrease in sales implies a 10% decrease in total variable costs, so the contribution margin decreases by 10%. New Contribution Margin for Blocks = $250, 000 − 0. 10($250, 000) = $225, 000 The reasoning is the same for the brick line, but the decrease is 8%. New Contribution Margin for Bricks = $320, 000 − 0. 08($320, 000) = $294, 400 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 5: How to Structure a Keep-or-Drop-Product Line Problem with Complementary Effects (3 of 4) Therefore, if the roofing tile product line were dropped, the resulting total contribution margin for Norton Materials would equal $519, 400 ($225, 000 + $294, 400). 2. Contribution margin Less: Advertising Cost of supervision Total Differential Amount to Keep Drop $ 580, 000 $519, 400 $ 60, 600 (30, 000) (20, 000) (112, 000) (77, 000) (35, 000) $ 438, 000 $422, 400 $ 15, 600 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 5: How to Structure a Keep-or-Drop-Product Line Problem with Complementary Effects (4 of 4) Notice that the contribution margin for the drop alternative equals the new contribution margins of the block and brick lines ($225, 000 + $294, 400). Also, advertising and supervision remain relevant across these alternatives. Now the analysis favors keeping the roofing tile line. In fact, company income will be $15, 600 higher if all three lines are kept as opposed to dropping the roofing tile line. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: DATA ANALYTICS AND YANKEE STADIUM (1 of 7) You are an elected official in a major city that is considering whether or not to move forward with a proposed plan to demolish the city’s existing professional sports stadium and build an elaborate new stadium. One of the most difficult aspects of this decision is estimating the new stadium’s incremental revenues and costs that would result if it were built. What specific types of relevant revenues and relevant costs would you consider in making this important decision? Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: DATA ANALYTICS AND YANKEE STADIUM (2 of 7) • There are many stadium events for which the associated relevant revenues and relevant costs must be estimated accurately if the correct decision is to be made. These stadium events (and their relevant revenues and costs) include: Main attraction sporting events (e. g. , ticket revenues from baseball, basketball, and/or football games for which the stadium would be built; additional staffing, cleanup, and insurance costs) o Concessions and other sales (e. g. , contribution margins or fees earned from product and service sales—most new stadiums o Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: DATA ANALYTICS AND YANKEE STADIUM (3 of 7) boast as many high-end shopping opportunities as an upscale mall!) o Television contract terms (e. g. , the amount and percentage of revenue brought in by additional games being televised in the new stadium, perhaps in primetime slots) o Offseason events (e. g. , the ticket revenue from boxing matches, music concerts, etc. ) • For this relevant stadium decision, estimating the relevant revenues might be even more difficult than estimating the relevant costs. For instance, projecting how many more people Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: DATA ANALYTICS AND YANKEE STADIUM (4 of 7) will want to attend games in a new stadium can be unclear, as well as how much money they would be willing to spend for various seats located around the stadium. Increasingly, all parties involved in these high-priced stadium deals rely on data analytics to estimate the relevant revenues and costs as accurately as possible. Several New York City area stadiums experienced difficulty in accurately estimating these relevant financial items. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: DATA ANALYTICS AND YANKEE STADIUM (5 of 7) In other words, decision makers struggled to estimate the amount of incremental revenue that would result from some of the more important seats in a new Yankee stadium. Undaunted by such challenging relevant analyses, however, the New York area also built a $1. 6 billion new Meadowlands Stadium to be shared by the New York Jets and New York Giants. In addition to the previously mentioned relevant items, some citizens raise objections to such large amounts of money being spent on replacing existing fully functional sporting facilities Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: DATA ANALYTICS AND YANKEE STADIUM (6 of 7) with gargantuan sports palaces. They argue that $1 billion could be better spent on different causes. Such sentiments, whether you agree or disagree with them, represent potentially important qualitative factors that effective managerial accountants should take into account when performing relevant analyses for proposed new stadiums, especially when these citizens represent taxpayers or potential fans the stadium builders count on for purchasing expensive tickets in the future. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Here’s How It’s Used: DATA ANALYTICS AND YANKEE STADIUM (7 of 7) Data analytics are very helpful in estimating the relevant costs and revenues for such stadiums, including offseason events, as well as additional qualitative factors like citizen sentiment toward the team and the local community. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Further Processing of Joint Products • Joint products have common processes and costs of production up to a split-off point. At that point, they become distinguishable as separately identifiable products • The point of separation is called the split-off point • Sometimes it is more profitable to process a joint product further, beyond the split-off point, prior to selling it (sell or-process-further decision) Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 6: How to Structure the Sell-or-Process. Further Decision (1 of 3) • Appletime grows apples and then sorts them into one of three grades, A, B, or C, based on their condition. Appletime must decide whether to sell the Grade B apples at split-off or to process them into apple pie filling. The company normally sells the Grade B apples in 120 five-pound bags at a per-unit price of $1. 25. If the apples are processed into pie filling, the result will be 500 cans of filling with additional costs of $0. 24 per can. The buyer will pay $0. 90 per can. Required: 1. What is the contribution to income from selling the Grade B apples in fivepound bags? Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 6: How to Structure the Sell-or-Process. Further Decision (2 of 3) 2. What is the contribution to income from processing the Grade B apples into pie filling? 3. Should Appletime continue to sell the Grade B apples in bags or process them further into pie filling? Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 6: How to Structure the Sell-or-Process. Further Decision (3 of 3) Solution: 1. Revenue from Apples in Bags = $1. 25 × 120 = $150 2. Revenue from Further Processing = $0. 90 × 500 = $450 Further Processing Cost = $0. 24 × 500 = $120 Income from Further Processing = $450 − $120 = $330 3. Appletime should process the Grade B apples into pie filling because the company will make $330 versus the $150 it would make by selling the apples in bags. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Product Mix Decisions (1 of 2) • Organizations have wide flexibility in choosing their product mix • Product mix refers to the relative amount of each product manufactured (or service provided) by a company • Decisions about product mix can have a significant impact on an organization’s profitability Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Product Mix Decisions (2 of 2) • Every firm faces limited resources and limited demand for each product. These limitations are called constraints • A manager must choose the optimal mix given the constraints found within the firm Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 7: How to Determine the Optimal Product Mix with One Constrained Resource (1 of 3) Jorgenson Company produces two types of gears, X and Y, with unit contribution margins of $25 and $10, respectively. Each gear must be notched by a special machine. The firm ownseight machines that together provide 40, 000 hours of machine time per year. Gear X requires 2 hours of machine time, and Gear Y requires 0. 5 hour of machine time. There are no other constraints. Required: 1. What is the contribution margin per hour of machine time for each gear? 2. What is the optimal mix of gears? Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 7: How to Determine the Optimal Product Mix with One Constrained Resource (2 of 3) 3. What is the total contribution margin earned for the optimal mix? Solution: 1. Gear X Gear Y Contribution margin per unit Required machine time per unit Contribution margin per hour of machine time $25. 00 $10. 00 ÷ 2 ÷ 0. 5 $12. 50 $20. 00 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 7: How to Determine the Optimal Product Mix with One Constrained Resource (3 of 3) 2. Since Gear Y yields $20 of contribution margin per hour of machine time, all machine time should be devoted to the production of Gear Y. The optimal mix is Gear Y = 80, 000 units and Gear X = 0 units. 3. Total Contribution Margin of Optimal Mix = (80, 000 units Gear Y) $10 = $800, 000 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 8: How to Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint (1 of 4) Jorgenson Company produces two types of gears, X and Y, with unit contribution margins EXAMPLE 8. 8 of $25 and $10, respectively. Each gear must be notched by a special machine. The firm owns eight machines that together provide 40, 000 hours of machine time per year. Gear X requires 2 hours of machine time, and Gear Y requires 0. 5 hour of machine time. A maximum of 60, 000 units of each gear can be sold. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 8: How to Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint (2 of 4) Required: 1. What is the contribution margin per hour of machine time for each gear? 2. What is the optimal mix of gears? 3. What is the total contribution margin earned for the optimal mix? Solution: 1. Gear X Contribution margin per unit Required machine time per unit Contribution margin per hour of machine time Gear Y $25. 00 $10. 00 ÷ 2 ÷ 0. 5 $12. 50 $20. 00 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 8: How to Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint (3 of 4) 2. Since Gear Y yields $20 of contribution margin per hour of machine time, the first priority is to produce all of Gear Y that the market will take (i. e. , demands). Machine Time Required for Maximum Amount of Gear Y = 60, 000 units × 0. 5 machine hour required for each Gear Y unit = 30, 000 hours needed to manufacture 60, 000 Gear Y units Remaining Machine Time for Gear X = 40, 000 − 30, 000 hours = 10, 000 hours Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 8: How to Determine the Optimal Product Mix with One Constrained Resource and a Sales Constraint (4 of 4) Units of Gear X to Be Produced in Remaining 10, 000 Hours = 10, 000 hours/2 hour per Gear X unit = 5, 000 Gear X units Now the optimal mix is 60, 000 units of Gear Y and 5, 000 units of Gear X. This mix will precisely exhaust the machine time available. 3. Total Contribution Margin of Optimal Mix = (60, 000 units Gear Y × $10) + (5, 000 units Gear X × $25) =$725, 000 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Multiple Constrained Resources (1 of 2) • The presence of only one constrained resource might not be realistic • Organizations often face multiple constraints, including: limitations of raw materials o limitations of skilled labor o limited demand for each product o Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Multiple Constrained Resources (2 of 2) • The solution of the product mix problem in the presence of multiple constraints is more complicated and requires the use of a specialized mathematical technique known as linear programming, which is reserved for advanced cost management courses Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Cost-Based Pricing (1 of 2) • Demand is one side of the pricing equation; supply is the other side • Since revenue must cover all costs for the firm to make a profit, many companies start with cost to determine price • That is, they calculate product (or service) cost and add the desired profit • The mechanics of this approach involve a cost base and a markup Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Cost-Based Pricing (2 of 2) • The markup is a percentage applied to the base cost • It includes desired profit and any costs not included in the base cost • Companies that bid for jobs routinely base bid price on cost Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 9: How to Calculate Price by Applying a Markup Percentage to Cost (1 of 2) Elvin Company assembles and installs computers to customer specifications. Elvin has decided to price its jobs at the cost of direct materials and direct labor plus 20%. The job for a local vocational-technical school included the following costs: Direct materials $65, 000 Direct labor (assembly and installation) 4, 000 Required: Calculate the price charged by Elvin Company to the vocational-technical school. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 9: How to Calculate Price by Applying a Markup Percentage to Cost (2 of 2) Solution: Price = Cost + (Markup Percentage × Cost) = $69, 000 + 0. 20($69, 000) = $69, 000 + $13, 800 = $82, 800 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Target Costing and Pricing • Many firms set the price of a new product as the sum of the costs and the desired profit • The company must earn sufficient revenues to cover all costs and yield a profit • Target costing is a method of determining the cost of a product or service based on the price (target price) that customers are willing to pay • The marketing department determines what characteristics and price for a product are most demanded by consumers Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 10: How to Calculate a Target Cost (1 of 2) Digitime manufactures wristwatches and is designing a new watch model that incorporates a PDA, which Digitime hopes consumers will view as a fun and valuable design feature. As such, the new PDA watch has a target price of $200. Management requires a 15% profit on new product revenues. Required: 1. Calculate the amount of desired profit. 2. Calculate the target cost. Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part

Example 8. 10: How to Calculate a Target Cost (2 of 2) Solution: 1. Desired Profit = 0. 15 × Target Price = 0. 15 × $200 = $30 2. Target Cost = Target Price – Desired Profit = $200 − $30 = $170 Mowen/Hansen/Heitger, Managerial Accounting: The Cornerstone of Business Decision Making, 7 th Edition. © 2018 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part