Introduction to Management Accounting 2008 Prentice Hall Business
Introduction to Management Accounting © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 1
Introduction to Management Accounting Chapter 6 Relevant Information for Decision Making with a Focus on Operational Decisions © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 2
Learning Objective 1 Opportunity, Outlay, and Differential Costs Differential cost is the difference in total cost between two alternatives. Differential revenue is the difference in total revenue between two alternatives. Incremental cost are additional costs or reduced benefits generated by the proposed alternative. Incremental benefits are the additional revenues or reduced costs generated by the proposed alternative. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 3
Opportunity, Outlay, and Differential Costs An incremental analysis is an analysis of the additional costs and benefits of a proposed alternative. An opportunity cost is the maximum available contribution to profit forgone (or passed up) by using limited resources for a particular purpose. An outlay cost requires a cash disbursement. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 4
Opportunity, Outlay, and Differential Costs Nantucket Nectars has a machine for which it paid $100, 000 and it is sitting idle. Nantucket Nectars has three alternatives: 1. Increase production of Peach juice 2. Sell the machine 3. Produce a new drink Papaya Mango © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 5
Opportunity Cost Peach Juice Contribution margin is $60, 000. Sell machine for $50, 000. Produce Papaya Mango juice with projected sales of $500, 000 Revenue Costs: Outlay Costs Financial benefit before opportunity costs Opportunity cost of machine Net financial benefit $500, 000 400, 000 $100, 000 60, 000 $ 40, 000 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 6
Learning Objective 2 Make-or-Buy Decisions Managers often must decide whether to produce a product or service within the firm or purchase it from an outside supplier. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 7
Make or Buy Decisions Nantucket Nectars Company’s Cost of Making 12 -ounce Bottles Direct material $ 60, 000 Direct labor 20, 000 Variable factory overhead 40, 000 Fixed factory overhead 80, 000 Total costs $200, 000 $. 06. 02. 04. 08 $. 20 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 8
Make-or-Buy Example Another manufacturer offers to sell Nantucket the bottles for $. 18. If the company buys the bottles, $50, 000 of fixed overhead would be eliminated. Should Nantucket make or buy the bottles? © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 9
Relevant Cost Comparison Buy Make Total Purchase cost Direct material Direct labor Variable overhead Fixed OH avoided by not making Total relevant costs Difference in favor of making $ 60, 000 20, 000 40, 000 Per Bottle Total Per Bottle $180, 000 $. 18 $. 06. 02. 04 50, 000 $170, 000 . 05 $. 17 $ 10, 000 $. 01 0 $180, 000 0 $. 18 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 10
Make or Buy and the Use of Facilities Suppose Nantucket can use the released facilities in other manufacturing activities to produce a contribution to profits of $55, 000, or can rent them out for $25, 000. What are the alternatives? © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 11
Make or Buy and the Use of Facilities (000) Rent revenue Contribution from other products Variable cost of bottles Net relevant costs Make $ — — (170) $(170) Buy and leave facilities idle Buy and use Buy and facilities for other rent out facilities products $ — — (180) $ 25 — (180) $(155) $ 55 (180) $(125) © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 12
Learning Objective 3 Avoidable and Unavoidable Costs Avoidable costs are costs that will not continue if an ongoing operation is changed or deleted. Unavoidable costs are costs that continue even if an operation is halted. Common costs are costs of facilities and services that are shared by users. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 13
Department Store Example Consider a discount department store that has three major departments: Groceries General merchandise Drugs © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 14
Department Store Example Departments Groceries General Mdse. Drugs Sales $1, 900 $1, 000 Variable expenses 1, 420 800 Contribution margin $ 480 (25%) $ 200 (20%) Fixed expenses: Avoidable $ 265 $ 150 Unavoidable 180 60 Total fixed expenses $ 445 $ 210 Operating income $ 35$ (10) Total $800 $100 560 60 $240 (30%) $ 40 (40%) $100 $200 $ 40 $ 15 20 $ 35 $ 5 ($000) © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 15
Department Store Example Assume that the only alternatives to be considered are dropping or continuing the grocery department, which has consistently shown an operating loss. Assume further that the total assets invested would be unaffected by the decision. The vacated space would be idle and the unavoidable costs would continue. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 16
Department Store Example Store as a Whole ($000) Sales Variable expenses Contribution margin Avoidable fixed expenses Profit contribution to common space and other unavoidable costs Unavoidable expenses Operating income Total Before Change Effect of Dropping Groceries $1, 900 1, 420 $ 480 265 $1, 000 800 $ 200 150 $900 620 $280 115 $ 215 180 $ 35 $ $165 180 $ (15) $ 50 0 50 Total After Change © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 17
Department Store Example Assume that the store could use the space made available by the dropping of groceries to expand the general merchandise department. This will increase sales by $50, 000, generate a 30% contribution-margin, and have avoidable fixed costs of $70, 000. $80, 000 – $50, 000 = $30, 000 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 18
Department Store Example Store as a Whole ($000) Total Expand Total Before Drop General After Change Groceries Merchandise Change Sales $1, 900 Variable expenses 1, 420 Contribution margin $ 480 Avoidable fixed expenses 265 Profit contribution to common space and other unavoidable costs $ 215 Unavoidable expenses 180 Operating income $ 35 $1, 000 800 $ 200 150 $ $ 50 0 50 $500 350 $150 70 $1, 400 970 $ 430 185 $80 0 $80 $245 180 $ 65 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 19
Learning Objective 4 Optimal Use of Limited Resources A limiting factor or scarce resource restricts or constrains the production or sale of a product or service. Assume that the capacity of the facility is determined by machine time, and the maximum capacity is 10, 000 machine hours. The facility can produce 10 pairs of Air Court Shoes or 5 pairs of Air Max shoes per hour. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 20
Optimal Use of Limited Resources Air Court Selling price per pair Variable costs per pair Contribution margin ratio $80 60 $20 25% Air Max $120 84 $ 36 30% © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 21
Optimal Use of Limited Resources Which is more profitable? If the limiting factor is demand, that is, pairs of shoes, the more profitable product is Air Max. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 22
Optimal Use of Limited Resources Air Max is the product with the higher contribution per unit. The sale of a pair of Air Court shoes adds $20 to profit. The sale of a pair of Air Max shoes adds $36 to profit. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 23
Optimal Use of Limited Resources Suppose that demand for either shoe would fill the plant’s capacity. Now, capacity is the limiting factor. Which is more profitable? If the limiting factor is capacity, the more profitable product is Air Court. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 24
Optimal Use of Limited Resources Air Court $20 contribution margin per pair × 10, 000 hours = $2, 000 contribution Air Max: $36 contribution margin per pair × 10, 000 hours = $1, 800, 000 contribution © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 25
Optimal Use of Limited Resources In retails stores, the limiting factor is often floor space. The focus is on products taking up less space or on using the space for shorter periods of time. Retail stores seek faster inventory turnover (the number of times the average inventory is sold per year). © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 26
Optimal Use of Limited Resources Faster inventory turnover makes the same product a more profitable use of space in a discount store. Regular Department Store Discount Department Store Retail Price $4. 00 $3. 50 Costs of Merchandise and other variable costs 3. 00 Contribution to profit per unit $1. 00 (25%) $. 50 (14%) Units sold per year 10, 000 22, 000 Total contribution to profit, assuming the same space allotment in both stores $10, 000 11, 000 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 27
Learning Objective 5 Joint Product Costs Joint products have relatively significant sales values. They are not separately identifiable as individual products until their split-off point. The split-off point is that juncture of manufacturing where the joint products become individually identifiable. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 28
Joint Product Costs Separable costs are any costs beyond the split-off point. Joint costs are the costs of manufacturing joint products before the split-off point. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 29
Joint Product Costs Suppose Dow Chemical Company produces two chemical products, X and Y, as a result of a particular joint process. The joint processing cost is $100, 000. Both products are sold to the petroleum industry to be used as ingredients of gasoline. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 30
Joint Product Costs 1 million liters of X at a selling price of $. 09 = $90, 000 500, 000 liters of Y at a selling price of $. 06 = $30, 000 Total sales value at split-off is $120, 000 Joint-processing cost is $100, 000 Split-off point © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 31
Illustration of Sell or Process Further Suppose the 500, 000 liters of Y can be processed further and sold to the plastics industry as product YA. The additional processing cost would be $. 08 per liter for manufacturing and distribution, a total of $40, 000. The net sales price of YA would be $. 16 per liter, a total of $80, 000. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 32
Illustration of Sell or Process Further Revenues Separable costs beyond split-off @ $. 08 Income effects Sell at Split-off as Y Process Further and Sell as YA Difference $30, 000 $80, 000 $50, 000 – $30, 000 40, 000 $40, 000 $10, 000 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 33
Learning Objective 6 Equipment Replacement The book value of equipment is not a relevant consideration in deciding whether to replace the equipment. Because it is a past, not a future cost. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 34
Book Value of Old Equipment Depreciation is the periodic allocation of the cost of equipment. The equipment’s book value (or net book value) is the original cost less accumulated depreciation. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 35
Book Value of Old Equipment Suppose a $10, 000 machine with a 10 -year life span has depreciation of $1, 000 per year. What is the book value at the end of 6 years? Original cost Accumulated depreciation (6 × $1, 000) Book value $10, 000 6, 000 $ 4, 000 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 36
Keep or Replace the Old Machine? Original cost Useful life in years Current age in years Useful life remaining in years Accumulated depreciation Book value Disposal value (in cash) now Disposal value in 4 years Annual cash operating costs Old Machine Replacement Machine $10, 000 10 6 4 $ 6, 000 $ 4, 000 $ 2, 500 0 $ 5, 000 $8, 000 4 0 N/A 0 $3, 000 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 37
Relevance of Equipment Data A sunk cost is a cost already incurred and is irrelevant to the decision-making process. Ø Book value of old equipment Ø Disposal value of old equipment Ø Gain or loss on disposal Ø Cost of new equipment © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 38
Relevance of Equipment Data The book value of old equipment is irrelevant because it is a past (historical) cost. Therefore, depreciation on old equipment is irrelevant. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 39
Disposal Value of Old Equipment The disposal value of old equipment is relevant because it is an expected future inflow that usually differs among alternatives. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 40
Gain or Loss on Disposal This is the difference between book value and disposal value. It is a meaningless combination of irrelevant (book value) and relevant items (disposal value). It is best to think of each separately. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 41
Cost of New Equipment The cost of new equipment is relevant because it is an expected future outflow that will differ among alternatives. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 42
Cost Comparison Four Years Together Keep Replace Difference Cash operating costs Old equipment (book value): Depreciation, or Lump-sum write-off Disposal value New machine acquisition cost Total costs $20, 000 4, 000 – – – $24, 000 $12, 000 – 4, 000 (2, 500) 8, 000 $21, 500 $8, 000 – – 2, 500 (8, 000) $2, 500 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 43
Learning Objective 7 Irrelevant or Misspecified Costs The ability to recognize irrelevant costs is important to decision makers. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 44
Irrelevant or Misspecified Costs Suppose General Dynamics has 100 obsolete aircraft parts in its inventory. The original manufacturing cost of these parts was $100, 000. General Dynamics can remachine the parts for $30, 000 and then sell them for $50, 000, or scrap them for $5, 000. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 45
Irrelevant or Misspecified Costs Remachine Expected future revenue Expected future costs Relevant excess of revenue over costs Accumulated historical inventory cost* Net loss on project Scrap Difference $ 50, 000 30, 000 $ 5, 000 $ 20, 000 $ 5, 000 100, 000 $(80, 000) 100, 000 $ (95, 000) 0 $45, 000 30, 000 $15, 000 * Irrelevant because it is unaffected by the decision. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 46
Irrelevant or Misspecified Costs There are two major ways to go wrong when using unit costs in decision making: 1) including irrelevant costs 2) comparing unit costs not computed on the same volume basis © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 47
Irrelevant or Misspecified Costs Assume that a new $100, 000 machine with a five-year life can produce 100, 000 units a year at a variable cost of $1 per unit, as opposed to a variable cost per unit of $1. 50 with an old machine. Is the new machine a worthwhile acquisition? © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 48
Irrelevant or Misspecified Costs Old Machine New Machine Units Variable cost Straight-line depreciation Total relevant costs Unit relevant costs 100, 000 $150, 000 100, 000 $100, 000 0 20, 000 $ 45, 000 $120, 000 $ 1. 50 $ 1. 20 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 49
Irrelevant or Misspecified Costs It appears that the new machine will reduce costs by $. 30 per unit. However, if the expected volume is only 30, 000 units per year, the unit costs change in favor of the old machine. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 50
Irrelevant or Misspecified Costs Old Machine Units Variable costs Straight-line depreciation Total relevant costs Unit relevant costs 30, 000 $45, 000 $1. 50 New Machine 30, 000 $30, 000 20, 000 $50, 000 $1. 6667 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 51
Learning Objective 8 Decision Making and Performance Evaluation To motivate managers to make the right choice, the method used to evaluate performance should be consistent with the decision model. Consider the replacement decision where replacing a machine has a $2, 500 advantage over keeping it. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 52
Decision Making and Performance Evaluation Year 1 Keep Replace Cash operating costs Depreciation Loss on disposal ($4, 000 – $2, 500) Total charges against revenue Years 2, 3, and 4 Keep Replace $5, 000 1, 000 $3, 000 2, 000 0 $1, 500 0 0 $6, 000 $6, 500 $6, 000 $5, 000 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 53
Decision Making and Performance Evaluation Performance is often measured by accounting income, consider the accounting income in the first year after replacement compared with that in years 2, 3, and 4. If the machine is kept rather than replaced, first-year costs will be $500 lower ($6, 500 – $6, 000), and first-year income will be $500 higher. © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 54
The End of Chapter 6 © 2008 Prentice Hall Business Publishing, Introduction to Management Accounting 14/e, Horngren/Sundem/Stratton/Schatzberg/Burgstahler 6 - 55
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