Cost Management Measuring, Monitoring, and Motivating Performance

Cost Management Measuring, Monitoring, and Motivating Performance Chapter 1 The Role of Accounting Information in Management Decision Making © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Chapter 1: The Role of Accounting Information in Management Decision Making Learning objectives Q1 – What is the process of strategic management and decision making? Q2 – What types of control systems do managers use? Q3 – What is the role of accounting information in strategic management? Q4 – What information is relevant for decision making? Q5 – How does business risk affect management decision making? Q6 – How do biases affect management decision making? Q7 – How can managers make higher-quality decisions? Q8 – What is ethical decision making, and why is it important? © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 2 Q1: Organizational Vision and Core Competencies • The organizational vision is the core purpose and ideology of the organization. • Determining the organizational vision precedes all other management decision making. • Management must also isolate the organization’s core competencies – its strengths relative to competitors. © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q1: Organizational Vision and Core Competencies Organizational Vision The organizational vision and the core competencies are closely related. The organization’s strengths should help shape the vision. Core Competencies The vision should help locate the organization’s strengths. If you were starting an accounting practice, what would be your organizational vision? What do you think would be your core competencies? © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q1: Organizational Strategies Organizational Vision & Core Competencies Organizational strategies are the tactics that managers use to work toward the organizational vision while taking advantage of the core competencies. These strategies are long-term in nature. Organizational Strategies Examples include organization structure, financial structure, and long-term resource allocation strategies. If you were starting an accounting practice, what would be some of your organizational strategies? How do these work toward your organizational vision? How do they take advantage of your core competencies? © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 5 Q1: Operating Plans Organizational Strategies Operating Plans Operating plans are the short-term implementations of the organizational strategies. Operating plans usually include budgeted goals for revenues and expenses. Examples include schedules for employees and procedures for daily relationship management decisions with suppliers. If you were starting an accounting practice, what would be some of your operating plans? How do these relate to your organizational strategies? © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 6 Q1: Actual Operations Actual operations are the actions taken and the results achieved. Operating Plans Actual Operations The organization’s information system measures the results of actual operations. Examples include number of units sold, advertising expense, and the wage expense for the period. If you had an accounting practice, what would information would you want to collect about the results of your actual operations? © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 7 Q1: Monitoring and Motivating Performance Actual Operations Organizational Vision & Core Competencies Managers use the results of actual operations to monitor performance and ensure that it is in line with the organizational vision. Managers may find that the results of actual operations make them re-think the organizational vision or their view of the organization’s core competencies. If you had an accounting practice, can you think of an example of a measure of actual operations and how you would use it to motivate performance? Can you think of an example of a measure of actual operations that might make you redefine your organizational vision or your view of your core competencies? © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 8 Q2: Management Control Systems • Belief Systems – Vision, Mission, Core Values Statements • Boundary Systems – Code of Conduct, Procedure Manuals, Compliance Actions • Diagnostic Control Systems – Measure, monitor, and motivate employees against preset goals • Interactive Control Systems – Recurring information and reports to evaluate performance and direct actions © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 9 Q3: Financial, Managerial, and Cost Accounting Financial accounting prepares reports most frequently used by decision makers external to the organization. Managerial accounting prepares reports most frequently used by decision makers internal to the organization. Cost accounting includes both financial and nonfinancial information and is used for both financial and managerial accounting. © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 10 Q3: Strategic Cost Management and the Balanced Scorecard • Strategic cost management is an approach to reducing costs while strengthening the organization’s strategic position. • The balanced scorecard can be used to formalize strategic cost management efforts by detailing financial and nonfinancial benchmarks for all segments of the organization. • Examples of such benchmarks include: • Personnel can reduce costs by completing all hiring within 20 days of initial interview. • Production can reduce costs and improve quality if Engineering can reduce the number of processes in the production process. © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 11 Q4: What Information is Relevant for Decision Making? • Information is relevant if: • Differs across the alternatives, and • Is about the future. • Relevant information can be quantitative or qualitative • Information is irrelevant if: • Does not vary with the option chosen or action taken Irrelevant information is NOT useful in decision making! © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 12 Q4: Relevant Cash Flows • Relevant cash flows are future cash flows that differ across the alternatives. • also called incremental cash flows • also called avoidable cash flows • Irrelevant cash flows are: • non-incremental and unavoidable cash flows • do not vary among alternatives • Must look at the cash flow relevance to the decision being made • Electricity costs are relevant to the decision to open a business or not • Electricity costs are not relevant in the decision to lease or buy a building for your business © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 13 Q4: What Information is Relevant for Decision Making? You have a small computer repair company and are deciding whether to replace your old copy machine or repair it. In the list of information below, identify which data are relevant to this decision and which are irrelevant. • The purchase price of the copy machine was $1200. • The repair costs are $320. • The copy machine can make 20 copies per minute. • If you repair it, the machine will use less toner than it does now. • You make approximately 1000 copies per month. • The repair won’t fix the broken stapler. • The repair carries a one-year warranty. • The copy machine was a gift from your spouse. © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 14 Q4: Relevance of Income Statement Information • Income Statements include: – Period costs – Product costs (recorded as cost of goods sold) • Many business decisions require the incremental cost to produce a unit • Cost per unit on the income statement includes both fixed and variable costs • Including fixed costs does not represent the true incremental cost of a unit © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 15 Q5: Impact of Business Risk on Decision Making • Business Risk is the possibility an event will occur and interfere with the organization’s strategic goals Economic & Financial People, Legal & Health Political and Social Reputation Weather Criminal and Terrorist Informational & Operational Environment & Man Made • The existence of business risk can cloud management’s decision making process © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 16 Q6: Uncertainties, Biases, and Decision Quality • Uncertainties are issues and information about which there is doubt. • Biases are preconceived notions adopted without careful thought. • Decision quality refers to the characteristics of a decision that affect the likelihood of achieving a positive outcome. • Both uncertainty and bias reduce decision quality. © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 17 Q6: Uncertainties and Biases in Information • Uncertainties come from many sources and can be exogenous or endogenous. • The future is always uncertain. • Managers may be uncertain that the right information was captured in a report. • Biases can come from many sources. • The decision maker may be biased towards or against a particular alternative (predisposition bias) • The methods used to collect information could have introduced bias (information bias) • The decision maker may exercise an error in judgment or processing information (cognitive bias) © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 18 Q6: Motorola’s Iridium Project • How did uncertainties and bias effect Motorola’s decision making process? © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 19 Q6: Uncertainties, Biases, and Decision Quality Lori loves to sew and has always made her own clothes. People often tell her that she is the best-dressed person they’ve ever met. She can design and sew a lovely outfit in under 2 days. She is considering opening a store that could sell her home-made fashions. Then she could combine her work with her hobby. Can you identify some of the uncertainties Lori faces? Can you think of any way she can reduce some of these uncertainties? Can you identify any possible personal biases that Lori may have? How could these affect her decision making process? © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 20 Q7: Characteristics of Higher-Quality Decisions Higher quality decisions come from a higher quality decision making process. Such a process is thorough, unbiased, focused, strategic, creative, and visionary. This process requires reports that are relevant, understandable, and available. These reports must contain information that is more certain, complete, relevant, timely and valuable. © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 21 Q8: Components of Ethical Decision Making Identify ethical problems as they arise © John Wiley & Sons, 2011 Consider the well being of others and society Clarify and apply ethical values Continuously improve your personal ethics Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 22 Q8: The IMA’s Code of Ethics • The Institute of Management Accountants (IMA) has a Code of Ethics that states that IMA members have a responsibility to: • maintain an appropriate level of professional competence and perform their professional duties in accordance with laws, regulations, and standards; • refrain from disclosing confidential information (unless legally obligated), or using (or even appearing to use) confidential information to illegal advantage; • avoid actual and apparent conflicts of interest; and • communicate information fairly and objectively, and disclose all relevant information to decision makers. © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 23 Q8: Ethical Decision Making Suppose you work for the Lee K. Fawcett Plumbing Company as Mr. Fawcett’s administrative assistant. Recently Mr. Fawcett asked you to type some financial statements from his hand-written notes so that he can take them to the bank as part of a loan application. This exercise seems odd to you because the company’s CPA recently delivered the monthly financial statements that she prepares. While typing the financial statements you notice that the building the company rents is listed as an asset. Also, you write checks each month for the monthly payments on two car loans, and these are not listed as liabilities. Do you have an ethical dilemma? Discuss your approach to handling this situation. © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 24 Appendix: Steps for Better Thinking Steps for Better Thinking is a process to help address openended questions. Open-ended questions have no single correct solution; managers must seek the best solution. © John Wiley & Sons, 2011 (c) 2002.Information C. L. Lynch, in S. Management K. Wolcott, andDecision G. E. Huber, “Steps for Better Thinking: A Chapter 1: The RoleSource: of Accounting Making Developmental Problem-Solving Process” (August 5, 2002). Eldenburg & Wolcott’s Cost Management, 1e Slide # 25 Appendix: Steps for Better Thinking – Foundation (Knowing) • Foundation level skills include a knowledge of the terminology and basic concepts that are relevant to the decision at hand. • An individual with Foundation level skills can: • perform calculations to arrive at correct answer • define terms in his/her own words • describe a concept • list the elements contained in a concept or process © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 26 Appendix: Steps for Better Thinking – Identifying • Step 1 skills include the ability to identify relevant information and uncertainties. • An individual with Step 1 skills can: • create a list of issues related to the decision • sort information that is relevant • identify the reasons for the underlying uncertainties • perform research to obtain input into the decision © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 27 Appendix: Steps for Better Thinking – Exploring • Step 2 skills include the ability to explore interpretations of the information and connections between alternative solutions approaches. • An individual with Step 2 skills can: • recognize and control for his/her own biases • articulate assumptions and reasoning associated with alternative points of view • organize information in meaningful ways to encompass problem complexities • compare and contrast different approaches to a problem’s solutions © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 28 Appendix: Steps for Better Thinking – Prioritizing • Step 3 skills include the ability to prioritize alternatives, come to a decision, and implement the decision. • An individual with Step 3 skills can: • develop guidelines for prioritizing alternatives • prioritize alternatives after objective analysis • communicate findings in a manner appropriate to the audience • describe how the solution or decision might change if priorities change © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 29 Appendix: Steps for Better Thinking – Envisioning • Step 4 skills include the ability to monitor the decision and innovate new strategies to modify the decision when circumstances change. • An individual with Step 4 skills can: • explain the limitations of the decision made • establish a plan for monitoring the performance of the decision • explain how conditions may change in the future and how this may change the decision © John Wiley & Sons, 2011 Chapter 1: The Role of Accounting Information in Management Decision Making Eldenburg & Wolcott’s Cost Management, 2e Slide # 30 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 2 The Cost Function © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Chapter 2: The Cost Function Learning objectives • Q1: What are the different ways to describe cost behavior? • Q2: What process is used to estimate future costs? • Q3: How are engineered estimates, account analysis, and two-point methods used to estimate cost functions? • Q4: How does a scatter plot assist with categorizing a cost? • Q5: How is regression analysis used to estimate a cost function? • Q6: How are cost estimates used in decision making? © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 2 Q1: Different Ways to Describe Costs • Costs can be defined by how they relate to a cost object, which is defined as any thing or activity for which we measure costs. • Costs can also be categorized as to how they are used in decision making. • Costs can also be distinguished by the way they change as activity or volume levels change. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q1: Assigning Costs to a Cost Object Cost Assignment Determining the costs that should attach to a cost object is called cost assignment. cost tracing Direct Costs Cost Object Indirect Costs Direct costs are easily traced to the cost object. Indirect costs are not easily traced to the cost object, and must be allocated. cost allocation © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q1: Direct and Indirect Costs • In manufacturing: • all materials costs that are easily traced to the product are called direct material costs • all labor costs that are easily traced to the product are called direct labor costs • all other production costs are called overhead costs • Whether or not a cost is a direct cost depends upon: • the definition of the cost object • the precision of the bookkeeping system that tracks costs • the technology available to capture cost information • whether the benefits of tracking the cost as direct exceed the resources expended to track the cost • the nature of the operations that produce the product or service © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 5 Q1: Linear Cost Behavior Terminology • Total fixed costs are costs that do not change (in total) as activity levels change. • Total variable costs are costs that increase (in total) in proportion to the increase in activity levels. • Total costs equal total fixed costs plus total variable costs. • The relevant range is the span of activity levels for which the cost behavior patterns hold. • A cost driver is a measure of activity or volume level; increases in a cost driver cause total costs to increase. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 6 Q1: Behavior of Total (Linear) Costs $ Total Costs If costs are linear, then total costs graphically look like this. Cost Driver $ Total Fixed Costs Total fixed costs do not change as the cost driver increases. Higher total fixed costs are higher above the x axis. Cost Driver © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 7 Q1: Behavior of Total (Linear) Costs $ Total Costs If costs are linear, then total costs graphically look like this. Cost Driver $ Total Variable Costs Total variable costs increase as the cost driver increases. A steeper slope represents higher variable costs per unit of the cost driver. Cost Driver © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 8 Q1: Total Versus Per-unit (Average) Cost Behavior $ Total Variable Costs If total variable costs look like this . . . slope = $m/unit Cost Driver $/unit Per-Unit Variable Costs . . . then variable costs per unit look like this. m Cost Driver © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 9 Q1: Total Versus Per-Unit (Average) Cost Behavior $ Total Fixed Costs If total fixed costs look like this . . . Cost Driver $/unit Per-Unit Fixed Costs . . . then fixed costs per unit look like this. Cost Driver © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 10 Q1: Total Versus Per-Unit (Average) Cost Behavior Lari’s Leather produces customized motorcycle jackets. The leather for one jacket costs $50, and Lari rents a shop for $450/month. Compute the total costs per month and the average cost per jacket if she made only one jacket per month. What if she made 10 jackets per month? Average variable costs are constant 1 Jacket Total variable costs go up 10 Jackets Total Average Costs/ Cost/ Month Jacket Total Average Costs/ Cost/ Month Jacket Leather $50 $50 Leather $500 $50 Rent $450 $450 Rent $450 $45 Total $500 $500 Total $950 $95 Total fixed costs are constant © John Wiley & Sons, 2011 Average fixed costs go down Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 11 Q1: The Cost Function When costs are linear, the cost function is: TC = F + V x Q, where F = total fixed cost, V = variable cost per unit of the cost driver, and Q = the quantity of the cost driver. $ Total Costs The intercept is the total fixed cost. The slope is the variable cost per unit of the cost driver. slope = $V/unit of cost driver F Cost Driver © John Wiley & Sons, 2011 A cost that includes a fixed cost element and a variable cost element is known as a mixed cost. Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 12 Q1: Nonlinear Cost Behavior Sometimes nonlinear costs exhibit linear cost behavior over a range of the cost driver. This is the relevant range of activity. intercept = total fixed costs Total Costs slope = variable cost per unit of cost driver Cost Driver Relevant Range © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 13 Q1: Stepwise Linear Cost Behavior Some costs are fixed at one level for one range of activity and fixed at another level for another range of activity. These are known as stepwise linear costs. Total Supervisor Salaries Cost in $1000s Example: A production supervisor makes $40,000 per year and the factory can produce 100,000 units annually for each 8-hour shift it operates. 120 80 40 100 200 300 Number of units produced, in 1000s © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 14 Q1: Piecewise Linear Cost Behavior Some variable costs per unit are constant at one level for one range of activity and constant at another level for another range of activity. These are known as piecewise linear costs. Total Materials Costs slope= $9/gallon slope= $7.50/gallon slope= $8/gallon 1000 © John Wiley & Sons, 2011 Example: A supplier sells us raw materials at $9/gallon for the first 1000 gallons, $8/gallon for the second 1000 gallons, and at $7.50/gallon for all gallons purchased over 2000 gallons. 2000 Gallons purchased Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 15 Q1: Cost Terms for Decision Making • In Chapter 1 we learned the distinction between relevant and irrelevant cash flows. • Opportunity costs are the benefits of an alternative one gives up when that alternative is not chosen. • Opportunity costs are difficult to measure because they are associated with something that did not occur. • Opportunity costs are always relevant in decision making. • Sunk costs are costs that were incurred in the past. • Sunk costs are never relevant for decision making. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 16 Q1: Cost Terms for Decision Making • Discretionary costs are periodic costs incurred for activities that management may or may not determine are worthwhile. • These costs may be variable or fixed costs. • Discretionary costs are relevant for decision making only if they vary across the alternatives under consideration. • Marginal cost is the incremental cost of producing the next unit. • When costs are linear and the level of activity is within the relevant range, marginal cost is the same as variable cost per unit. • Marginal costs are often relevant in decision making. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 17 Q2: What Process is Used to Estimate Future Costs? Past costs are often used to estimate future, non-discretionary, costs. In these instances, one must also consider: • whether the past costs are relevant to the decision at hand • whether the future cost behavior is likely to mimic the past cost behavior • whether the past fixed and variable cost estimates are likely to hold in the future © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 18 Q3: Engineered Estimates of Cost Functions • Use accountants, engineers, employees, and/or consultants to analyze the resources used in the activities required to complete a product, service, or process. • For example, a company making inflatable rubber kayaks would estimate some of the following: • the amount and cost of the rubber required • the amount and cost of labor required in the cutting department • • • • the amount and cost of labor required in the assembly department overhead costs and the best cost allocation base to use the selling costs, including commissions and advertising the distribution costs © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 19 Q3: Account Analysis Method of Estimating a Cost Function • Review past costs in the general ledger and past activity levels to determine each cost’s past behavior. • For example, a company producing clay wine goblets might review its records and find: • the cost of clay is piecewise linear with respect to the number of pounds of clay purchased • skilled production labor is variable with respect to the number of goblets produced • unskilled production labor is mixed, and the variable portion varies with respect to the number of times the kiln is operated • production supervisors’ salary costs are stepwise linear • distribution costs are mixed, with the variable portion dependent upon the number of retailers ordering goblets © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 20 Q3: Example – Account Analysis Method of Estimating a Cost Function •The table on the right contains the expenditures for Scott Manufacturing during the last year. •100,000 units were produced and sold •$500,000 of sales revenue was recorded Required: 1. Determine the cost function using units produced as the driver 2. Repeat using sales dollars as the driver © John Wiley & Sons, 2011 Expense Amount Direct Materials $500,000 Direct Labor 300,000 Rent 25,000 Insurance 15,000 Commissions 200,000 Property Tax 20,000 Telephone 10,000 Depreciation 85,000 Power & Light 30,000 Admin Salaries 100,000 Total 1,285,000 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Variable Fixed Slide # 21 Q3: Example – Account Analysis Method of Estimating a Cost Function • Steps in estimating a cost function using account analysis – Separate fixed and variable costs – Total the fixed costs – Total the variable costs – Calculate a variable cost per driver – Write out the cost function © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 22 Q3: Solution – Account Analysis Method of Estimating a Cost Function Expense Amount Variable Direct Materials $500,000 500,000 Direct Labor 300,000 300,000 Rent 25,000 25,000 Insurance 15,000 15,000 Commissions 200,000 Property Tax 20,000 Cost Function on Dollars: 20,000 Telephone 10,000 10,000 TC = FC + VC/Sales $ * Sales $ Depreciation 85,000 TC = $285,000 + ($0.20) * Sales $ 85,000 Power & Light 30,000 30,000 Admin Salaries 100,000 100,000 Total 1,285,000 1,000,000 285,000 © John Wiley & Sons, 2011 Fixed Cost Function on Units: TC = FC + VC/Unit * Qty TC = $285,000 + ($10/unit) * Qty 200,000 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 23 Q3: Two-Point Method of Estimating a Cost Function • Use the information contained in two past observations of cost and activity to separate mixed and variable costs. • It is much easier and less costly to use than the account analysis or engineered estimate of cost methods, but: • it estimates only mixed cost functions, • it is not very accurate, and • it can grossly misrepresent costs if the data points come from different relevant ranges of activity © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 24 Q3: Example – Two-Point Method of Estimating a Cost Function In July the Gibson Co. incurred total overhead costs of $58,000 and made 6,200 units. In December it produced 3,200 units and total overhead costs were $40,000. What are the total fixed factory costs per month and average variable factory costs? We first need to determine V, using the equation for the slope of a line. $ rise/run = $58,000 – $40,000 6,200 – 3,200 units = $18,000/3,000 units = $6/unit Then, using TC = F + V x Q, and one of the data points, determine F. $58,000 $58,000 = F + $6/unit x 6,200 units $40,000 $58,000 = F + $37,200 $20,800 $20,800 = F 3,200 © John Wiley & Sons, 2011 6,200 Units Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 25 Q3: High-Low Method of Estimating a Cost Function • The high-low method is a two-point method • the two data points used to estimate costs are observations with the highest and the lowest activity levels • The extreme points for activity levels may not be representative of costs in the relevant range • this method may underestimate total fixed costs and overestimate variable costs per unit, • or vice versa. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 26 Q4: How Does a Scatterplot Assist with Categorizing a Cost? • A scatterplot shows cost observations plotted against levels of a possible cost driver. • A scatterplot can assist in determining: • which cost driver might be the best for analyzing total costs, and • the cost behavior of the cost against the potential cost driver. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 27 Q4: Which Cost Driver Has the Best Cause & Effect Relationship with Total Cost? 8 observations of total selling expenses plotted against 3 potential cost drivers $ $ # units sold $ # customers The number of salespersons appears to be the best cost driver of the 3. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e # salespersons Slide # 28 Q4: What is the Underlying Cost Behavior? $ This cost is probably linear and fixed. # units sold $ This cost is probably linear and variable. # units sold © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 29 Q4: What is the Underlying Cost Behavior? $ This cost is probably linear and mixed. # units sold $ This is likely a stepwise linear cost. # units sold © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 30 Q4: What is the Underlying Cost Behavior? $ This cost may be piecewise linear. # units sold $ This cost appears to have a nonlinear relationship with units sold. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e # units sold Slide # 31 Q5: How is Regression Analysis Used to Estimate a Mixed Cost Function? • Regression analysis estimates the parameters for a linear relationship between a dependent variable and one or more independent (explanatory) variables. • When there is only one independent variable, it is called simple regression. • When there is more than one independent variable, it is called multiple regression. Y=α+βX+ dependent variable independent variable α and β are the parameters;  is the error term (or residual) © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 32 Q5: How is Regression Analysis Used to Estimate a Mixed Cost Function? We can use regression to separate the fixed and variable components of a mixed cost. Yi = α + β Xi + i the predicted total cost for Xi and the actual total cost for observation i Yi is the actual total costs for data point i Xi is the actual quantity of the cost driver for data point i the intercept term is total fixed costs © John Wiley & Sons, 2011 i is the difference between the slope term is the variable cost per unit Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 33 Q5: Regression Output Terminology: Adjusted R-Square • Goodness of fit • How well does the line from the regression output fit the actual data points? • The adjusted R-square statistic shows the percentage of variation in the Y variable that is explained by the regression equation. • The next slide has an illustration of how a regression equation can explain the variation in a Y variable. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 34 Q5: Regression Output Terminology: Adjusted R-Square 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 Values of Y by Observation # Observation # 0 5 10 15 20 25 30 • We have 29 observations of a Y variable, and the average of the Y variables is 56,700. • If we plot them in order of the observation number, there is no discernable pattern. • We have no explanation as to why the observations vary about the average of 56,700. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 35 Q5: Regression Output Terminology: Adjusted R-Square If each Y value had an associated X value, then we could reorder the Y observations along the X axis according to the value of the associated X. 100,000 Values of Y by X Value 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 0 1,000 2,000 3,000 Now we can measure how the Y observations vary from the “line of best fit” instead of from the average of the Y observations. Adjusted RSquare measures the portion of Y’s variation about its mean that is explained by Y’s relationship to X. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 36 Q5: Regression Output Terminology: p-value and t-statistic. • Statistical significance of regression coefficients • When running a regression we are concerned about whether the “true” (unknown) coefficients are non-zero. • Did we get a non-zero intercept (or slope coefficient) in the regression output only because of the particular data set we used? © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 37 Q5: Regression Output Terminology: p-value and t-statistic. • The t-statistic and the p-value both measure our confidence that the true coefficient is non-zero. • In general, if the t-statistic for the intercept (slope) term > 2, we can be about 95% confident (at least) that the true intercept (slope) term is not zero. • The p-value is more precise • it tells us the probability that the true coefficient being estimated is zero • if the p-value is less than 5%, we are more than 95% confident that the true coefficient is non-zero. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 38 Q5: Interpreting Regression Output Suppose we had 16 observations of total costs and activity levels (measured in machine hours) for each total cost. If we regressed the total costs against the machine hours, we would get . . . Regression Statistics Multiple R 0.885 R Square 0.783 Adjusted R Square 0.768 Standard Error 135.3 Observations 16 Std Coefficients Error t Stat P-value Intercept 2937 64.59 45.47 1.31E-16 Machine Hours 5.215 0.734 7.109 5.26E-06 The coefficients give you the parameters of the estimated cost function. Predicted total costs = $2,937 + ($5.215/mach hr) x (# of mach hrs) Total fixed costs are estimated at $2,937. © John Wiley & Sons, 2011 Variable costs per machine hour are estimated at $5.215. Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 39 Q5: Interpreting Regression Output Regression Statistics Multiple R 0.885 R Square 0.783 Adjusted R Square 0.768 Standard Error 135.3 Observations 16 Std Coefficients Error t Stat P-value Intercept 2937 64.59 45.47 1.31E-16 Machine Hours 5.215 0.734 7.109 5.26E-06 The regression line explains 76.8% of the variation in the total cost observations. (5.26E-06 means 5.26 x 10-6, or 0.00000526) © John Wiley & Sons, 2011 The high t-statistics . . . . . . and the low p-values on both of the regression parameters tell us that the intercept and the slope coefficient are “statistically significant”. Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 40 Q5: Regression Interpretation Example Carole’s Coffee asked you to help determine its cost function for its chain of coffee shops. Carole gave you 16 observations of total monthly costs and the number of customers served in the month. The data is presented below, and the a portion of the output from the regression you ran is presented on the next slide. Help Carole interpret this output. Costs Customers $5,100 1,600 $10,800 3,200 $7,300 4,800 $17,050 6,400 $9,900 8,000 $16,800 9,600 $29,400 11,200 $26,900 12,800 $20,000 14,400 $24,700 16,000 $30,800 17,600 $26,300 19,200 $39,600 20,800 $42,000 22,400 $32,000 24,000 $37,500 25,600 © John Wiley & Sons, 2011 $40,000 Carole’s Coffee – Total Monthly Costs $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 Customers Served $0 0 5,000 10,000 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e 15,000 20,000 25,000 Slide # 41 Q5: Regression Interpretation Example Regression Statistics Multiple R 0.91 R Square 0.8281 Std Adjusted R Square 0.8158 Coefficients Error t Stat P-value Standard Error 4985.6 Intercept 4634 2614 1.7723 0.0980879 Observations 16 Customers 1.388 0.169 8.2131 1.007E-06 What is Carole’s estimated cost function? In a store that serves 10,000 customers, what would you predict for the store’s total monthly costs? Predicted total costs = $4,634 + ($1.388/customer) x (# of customers) Predicted total costs at 10,000 customers © John Wiley & Sons, 2011 = $4,634 + ($1.388/customer) x 10,000 customers = $18,514 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 42 Q5: Regression Interpretation Example Regression Statistics Multiple R 0.91 R Square 0.8281 Std Adjusted R Square 0.8158 Coefficients Error t Stat P-value Standard Error 4985.6 Intercept 4634 2614 1.7723 0.0980879 Observations 16 Customers 1.388 0.169 8.2131 1.007E-06 What is the explanatory power of this model? Are the coefficients statistically significant or not? What does this mean about the cost function? The model The slope coefficient is explains 81.58%significantly different from zero. of the variation This means we can be pretty in total costs, sure that the true cost function which is pretty includes nonzero variable costs good. per customer. The intercept is not significantly different from zero. There’s a 9.8% probability that the true fixed costs are zero*. *(Some would say the intercept is significant as long as the p-value is less than 10%, rather than 5%.) © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 43 Q6: Considerations When Using Estimates of Future Costs • The future is always unknown, so there are uncertainties when estimating future costs. • The estimated cost function may have misspecified the cost behavior. • The cost function may be using an incorrect cost driver. • Future cost behavior may not mimic past cost behavior. • Future costs may be different from past costs. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 44 Q6: Considerations When Using Estimates of Future Costs • The data used to estimate past costs may not be of high-quality. • The accounting system may aggregate costs in a way that mis-specifies cost behavior. • Information from outside the accounting system may not be accurate. • The true cost function may not be in agreement with the cost function assumptions. • For example, if variable costs per unit of the cost driver are not constant over any reasonable range of activity, the linearity of total cost assumption is violated. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 45 Appendix 2A: Multiple Regression Example We have 10 observations of total project cost, the number of machine hours used by the projects, and the number of machine set-ups the projects used. $10,000 Total Costs $10,000 $8,000 $8,000 $6,000 $6,000 $4,000 $4,000 $2,000 Total Costs $2,000 Number of Set-ups $0 Number of Machine Hours $0 0 © John Wiley & Sons, 2011 2 4 6 0 10 20 30 40 50 60 70 80 90 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 46 Appendix 2A: Multiple Regression Example Regress total costs on the number of set-ups to get the following output and estimated cost function: Regression Statistics Multiple R 0.788 R Square 0.621 Std Coefficients Error t Stat P-value Adjusted R Square 0.574 2925.6 1284 2.278 0.0523 Standard Error 1804 Intercept Observations 10 # of Set-ups 1225.4 338 3.62 0.0068 Predicted project costs = $2,926 + ($1,225/set-up) x (# set-ups) The explanatory power is 57.4%. The # of set-ups is significant, but the intercept is not significant if we use a 5% limit for the p-value. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 47 Appendix 2A: Multiple Regression Example Regress total costs on the number of machine hours to get the following output and estimated cost function: Regression Statistics Multiple R 0.814 R Square 0.663 Std Adjusted R Square 0.621 Coefficients Error t Stat P-value Standard Error 1701 Intercept -173.8 1909 -0.09 0.9297 Observations 10 # Mach Hrs 112.65 28.4 3.968 0.0041 Predicted project costs = – $173 + ($113/mach hr) x (# mach hrs) The explanatory power is 62.1%. The intercept shows up negative, which is impossible as total fixed costs can not be negative. However, the p-value on the intercept tells us that there is a 93% probability that the true intercept is zero. The # of machine hours is significant. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 48 Appendix 2A: Multiple Regression Example Regress total costs on the # of set ups and the # of machine hours to get the following: Regression Statistics Multiple R 0.959 Std Coefficients Error t Stat P-value R Square 0.919 -1132 1021 -1.11 0.3044 Adjusted R Square 0.896 Intercept 857.4 182.4 4.7 0.0022 Standard Error 891.8 # of Set-ups Observations 10 # of Mach Hrs 82.31 16.23 5.072 0.0014 Predicted project = – $1,132 + ($857/set-up) x (# set-ups) + ($82/mach hr) x (# mach hrs) costs The explanatory power is now 89.6%. The p-values on both slope coefficients show that both are significant. Since the intercept is not significant, project costs can be estimated based on the project’s usage of set-ups and machine hours. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 49 Appendix 2B: What is a Learning Curve? A learning curve is • the rate at which labor hours per unit decrease as the volume of activity increases • the relationship between cumulative average hours per unit and the cumulative number of units produced. A learning curve can be represented mathematically as: Y = α Xr, where Y = cumulative average labor hours, α = time required for the first unit, X = cumulative number of units produced, r = an index for learning = ln(% learning)/ln(2), and ln is the natural logarithmic function. © John Wiley & Sons, 2011 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e Slide # 50 Appendix 2B: Learning Curve Example Deanna’s Designer Desks just designed a new solid wood desk for executives. The first desk took her workforce 55 labor hours to make, but she estimates that each desk will require 75% of the time of the prior desk (i.e. “% learning” = 75%). Compute the cumulative average time to make 7 desks, and draw a learning curve. First compute r: r = ln(75%)/ln(2) = -0.2877/0.693 = -0.4152 Then compute the cumulative average time for 7 desks: 60 x 7(-0.4152) = 25.42 hrs 40 Y = 55 Cumulative Average Hours Per Desk 50 30 In order to draw a learning curve, you must compute the value of Y for all X values from 1 to 7. . . . Hrs per Desk 20 10 Cumulative Number of Desks 0 1 © John Wiley & Sons, 2011 2 Chapter 2: The Cost Function Eldenburg & Wolcott’s Cost Management, 2e 3 4 5 6 7 Slide # 51 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 3 Cost-Volume-Profit Analysis © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Chapter 3: Cost-Volume-Profit Analysis Learning objectives • Q1: What is cost-volume-profit (CVP) analysis, and how is it used for decision making? • Q2: How are CVP calculations performed for a single product? • Q3: How are CVP calculations performed for multiple products? Q4: What assumptions and limitations should managers consider when using CVP analysis? • • Q5: How are the margin of safety and operating leverage used to assess operational risk? © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 2 Q1: CVP Analysis and the Breakeven Point • CVP analysis looks at the relationship between selling prices, sales volumes, costs, and profits. • The breakeven point (BEP) is where total revenue equal total costs. $ Total Revenue (TR) BEP in sales $ Total Costs (TC) units BEP in units © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q2: How is CVP Analysis Used? • CVP analysis can determine, both in units and in sales dollars: • the volume required to break even • the volume required to achieve target profit levels • the effects of discretionary expenditures • the selling price or costs required to achieve target volume levels • CVP analysis helps analyze the sensitivity of profits to changes in selling prices, costs, volume and sales mix. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q2: CVP Calculations for a Single Product Units required to F  Profit achieve target  Q  P -V pretax profit where F = total fixed costs P = selling price per unit V = variable cost per unit P – V = contribution margin per unit To find the breakeven point in units, set Profit = 0. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 5 Q2: CVP Calculations for a Single Product Sales $ required to achieve target  F  Profit CMR pretax profit where F = total fixed costs CMR = contribution margin ratio = (P- V)/P Note that CMR can also be computed as Total Revenue  Total Variable Costs CMR  Total Revenue To find the breakeven point in sales $, set Profit = 0. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 6 Q2: Breakeven Point Calculations Bill’s Briefcases makes high quality cases for laptops that sell for $200. The variable costs per briefcase are $80, and the total fixed costs are $360,000. Find the BEP in units and in sales $ for this company. BEP in units  F 0 $360,000  P  V $200 / unit  $80 / unit $360,000   3,000 units $120 / unit $360,000 F F 0   BEP in sales $  (P  V ) / P ($200  $80) / $200 CMR $360,000   $600,000 60% © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 7 Q2: CVP Graph Draw a CVP graph for Bill’s Briefcases. What is the pretax profit if Bill sells 4100 briefcases? If he sells 2200 briefcases? Recall that P = $200, V = $80, and F = $360,000. Profit at 4100 units = $120 x 4100 – $360,000. TR $132,000 $1000s TC $600 $360 Profit at 2200 units = $120 x 2200 – $360,000. 2200 © John Wiley & Sons, 2011 More easily: 4100 units is 1100 units past BEP, so profit = $120 x 1100 units; 2200 units is 800 units before BEP, so loss = $120 x 800 units. -$96,000 3000 4100 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e units Slide # 8 Q2: CVP Calculations How many briefcases does Bill need to sell to reach a target pretax profit of $240,000? What level of sales revenue is this? Recall that P = $200, V = $80, and F = $360,000. Units needed to F  Profit $360,000  $240,000  reach target  $120 / unit P V pretax profit  5,000 units Sales $ required F  $240,000 F  to reach target  CMR (P  V ) / P pretax profit $600,000   $1,000,000 60% © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Of course, 5,000 units x $200/unit = $1,000,000, too. But sometimes you only know the CMR and not the selling price per unit, so this is still a valuable formula. Slide # 9 Q2: CVP Calculations How many briefcases does Bill need to sell to reach a target after-tax profit of $319,200 if the tax rate is 30%? What level of sales revenue is this? Recall that P = $200, V = $80, and F = $360,000. First convert the target after-tax profit to its target pretax profit: After-tax profit $319,200 Pretax profit    $456,000 (1  Tax rate) (1  0.3) Units needed to $360,000  $456,000   6,800 units reach target $120 / unit pretax profit Sales $ needed to reach target pretax profit © John Wiley & Sons, 2011 $360,000  $456,000   $1,360,000 60% Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 10 Q1,2: Using CVP to Determine Target Cost Levels Suppose that Bill’s marketing department says that he can sell 6,000 briefcases if the selling price is reduced to $170. Bill’s target pretax profit is $210,000. Determine the highest level that his variable costs can so that he can make his target. Recall that F = $360,000. Use the CVP formula for units, but solve for V: Q = 6,000 units  $360,000  $210,000 $170/unit  V $170/unit  V  $360,000  $210,000  $95/unit 6,000 units V  $75/unit If Bill can reduce his variable costs to $75/unit, he can meet his goal. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 11 Q4: Business Risk in Bill’s Decision • After this analysis, Bill needs to consider several issues before deciding to lower his price to $170/unit. • How reliable are his marketing department’s estimates? • Is a $5/unit decrease in variable costs feasible? • Will this decrease in variable costs affect product quality? • If 6,000 briefcases is within his plant’s capacity but lower than his current sales level, will the increased production affect employee morale or productivity? © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 12 Q1: Using CVP to Compare Alternatives • CVP analysis can compare alternative cost structures or selling prices. • high salary/low commission vs. lower salary/higher commission for sales persons • highly automated production process with low variable costs per unit vs. lower technology process with higher variable costs per unit and lower fixed costs. • broad advertising campaign with higher selling prices vs. minimal advertising and lower selling prices • The indifference point between alternatives is the level of sales (in units or sales $) where the profits of the alternatives are equal. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 13 Q1,2: Using CVP to Compare Alternatives Currently Bill’s salespersons have salaries totaling $80,000 (included in F of $360,000) and earn a 5% commission on each unit ($10 per briefcase). He is considering an alternative compensation arrangement where the salaries are decreased to $35,000 and the commission is increased to 20% ($40 per briefcase). Compute the BEP in units under the proposed alternative. Recall that P = $200 and V = $80 currently. First compute F and V under the proposed plan: F = $360,000 – $45,000 decrease in salaries = $315,000 V = $80 + $30 increase in commission = $110 Then compute Q under the proposed plan: Units $315,000 needed to  Q  F  0   3,500 units $200 / unit – $110/unit P V breakeven © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 14 Q1: Determining the Indifference Point Compute the volume of sales, in units, for which Bill is indifferent between the two alternatives. The indifference point in units is the Q for which the profit equations of the two alternatives are equal. Current Plan Proposed Plan Contribution margin per unit $120 $90 Total fixed costs $360,000 $315,000 Profit (current plan) = $120Q – $360,000 Profit (proposed plan) = $90Q – $315,000 $120Q – $360,000 = $90Q – $315,000 $30Q = $45,000 © John Wiley & Sons, 2011 Q = 1,500 units Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 15 Q1,2: CVP Graphs of the Indifference Point Draw a CVP graph for Bill’s that displays the costs under both alternatives. Notice that the total revenue line for both alternatives is the same, but the total cost lines are different. $1000s BEP for the current plan TR TC-proposed plan TC-current plan $600 BEP for the proposed plan $360 $315 indifference point between the plans 1500 © John Wiley & Sons, 2011 3000 3500 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e units Slide # 16 Q1,2: Comparing Alternatives The current plan breaks even before the proposed plan. At 1500 units, the plans have the same total cost. TR $1000s TC-proposed plan TC-current plan $600 Each unit sold provides a larger contribution to profits under the current plan. $360 $315 1500 © John Wiley & Sons, 2011 3000 3500 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e units Slide # 17 Q4: Business Risk in Bill’s Decision • Hopefully Bill is currently selling more than 1500 briefcases, because profits are negative under BOTH plans at this point. • The total costs of the current plan are less than the those of the proposed plan at sales levels past 1500 briefcases. • Therefore, it seems the current plan is preferable to the proposed plan. However, . . . © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 18 Q5: Business Risk in Bill’s Decision . . . this may not be true because the level of future sales is always uncertain. • What if the briefcases were a new product line? • Estimates of sales levels may be highly uncertain. • The lower fixed costs of the proposed plan may be safer. • The plans may create different estimates of the likelihood of various sales levels. • Salespersons may have an incentive to sell more units under the proposed plan. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 19 Q3: CVP Analysis for Multiple Products When a company sells more than one product the CVP calculations must be adjusted for the sales mix. The sales mix should be stated as a proportion • of total units sold when performing CVP calculations for in units. • of total revenues when performing CVP calculations in sales $. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 20 Q3: Sales Mix Computations • The weighted average contribution margin is the weighted sum of the products’ contribution margins: WACM  ni=1  iCM i where λi is product i’s % of total sales in units, CMi is product i’s contribution margin, and n= the number of products. • The weighted average contribution margin ratio is the weighted sum of the products’ contribution margin ratios: where i is product i’s % of total revenues, CMRi is product i’s WACMR  ni=1  iCMR i sales contribution margin ratio, and n= the number of products. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 21 Q3: Multiple Product Breakeven Point Peggy’s Kitchen Wares sells three sizes of frying pans. Next year she hopes to sell a total of 10,000 pans. Peggy’s total fixed costs are $40,800. Each product’s selling price and variable costs is given below. Find the BEP in units for this company. Expected sales in units Small Medium 2,000 5,000 Selling price per unit Variable costs per unit Contribution margin per unit $10.00 $4.00 $6.00 Large Total 3,000 10,000 $15.00 $18.00 $8.00 $11.00 $7.00 $7.00 First note the sales mix in units is 20%:50%:30%, respectively; then compute the weighted average contribution margin: WACM = 20%x$6 + 50%x$7 + 30%x$7 = $6.80 © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 22 Q3: Multiple Product Breakeven Point Next, compute the BEP in terms of total units: Total units F 0 $40,800 needed to  Q    6,000 units P V $6.80/unit breakeven But 6,000 units is not really the BEP in units; the BEP is only 6,000 units if the sales mix remains the same. The BEP should be stated in terms of how many of each unit must be sold: Units required to break even: Small pans 20% 1,200 Medium pans 50% 3,000 Large pans 30% 1,800 6,000 © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 23 Q3: Multiple Product Breakeven Point Find the BEP in sales $ for Peggy’s Kitchen Wares. The total revenue and total variable cost information below is based on the expected sales mix. Small Medium 2,000 5,000 Expected sales in units Total revenue Total variable costs Total contribution margin Contribution margin ratio Large 3,000 Total 10,000 $20,000 $75,000 $54,000 $149,000 $8,000 $40,000 $33,000 $81,000 $12,000 $35,000 $21,000 $68,000 60.0% 46.7% 38.9% 45.6% First compute the weighted average contribution margin ratio: WACMR = (20/149)x60% + (75/149)x46.7% + (54/149)x38.9% = © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 24 Q3: Multiple Product Breakeven Point . . . = 45.6%, of course! Depending on how the given information is structured, it may be easier to compute the CMR as Total contribution margin/Total revenue. Next compute the BEP in sales $: BEP in sales $  F  0 $40,800   $89,474* 0.456 CMR * If you sum the number of units of each size pan required at breakeven times its selling price you get $89,400. The extra $74 in the answer above comes from rounding the contribution margin ratio to three decimals. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 25 Q4: Assumptions in CVP Analysis CVP analysis assumes that costs and revenues are linear within a relevant range of activity. • Linear total revenues means that selling prices per unit are constant and the sales mix does not change. • Offering volume discounts to customers violates this assumption. • Linear total costs means total fixed costs are constant and variable costs per unit are constant. • If volume discounts are received from suppliers, then variable costs per unit are not constant. • If worker productivity changes as activity levels change, then variable costs per unit are not constant. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 26 Q4: Assumptions in CVP Analysis • These assumptions may induce a small relevant range. • Results of CVP calculations must be checked to see if they fall within the relevant range. • Linear CVP analysis may be inappropriate if the linearity assumptions hold only over small ranges of activity. • Nonlinear analysis techniques are available. • For example, regression analysis, along with nonlinear transformations of the data, can be used to estimate nonlinear cost and revenue functions. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 27 Q5: Margin of Safety The margin of safety is a measure of how far past the breakeven point a company is operating, or plans to operate. It can be measured 3 ways. margin of safety in units = actual or estimated units of activity – BEP in units margin of safety in $ = actual or estimated sales $ – BEP in sales $ margin of safety percentage = Margin of safety in units Actual or estimated units Margin of safety in $  Actual or estimated sales $ © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 28 Q5: Margin of Safety Suppose that Bill’s Briefcases has budgeted next year’s sales at 5,000 units. Compute all three measures of the margin of safety for Bill. Recall that P = $200, V = $80, F = $360,000, the BEP in units = 3,000, and the BEP in sales $ = $600,000. margin of safety in units = 5,000 units – 3,000 units = 2,000 units margin of safety in $ = $200 x 5,000 – $600,000 = $400,000 margin of safety percentage = 2,000 units $400,000 = = 40% 5,000 units $200 x 5,000 The margin of safety tells Bill how far sales can decrease before profits go to zero. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 29 Q5: Degree of Operating Leverage • The degree of operating leverage measures the extent to which the cost function is comprised of fixed costs. • A high degree of operating leverage indicates a high proportion of fixed costs. • Businesses operating at a high degree of operating leverage • face higher risk of loss when sales decrease, • but enjoy profits that rise more quickly when sales increase. © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 30 Q5: Degree of Operating Leverage The degree of operating leverage can be computed 3 ways. Contribution margin Profit degree of operating = Fixed costs +1 Profit leverage 1 Margin of safety percentage © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 31 Q5: Degree of Operating Leverage Suppose that Bill’s Briefcases has budgeted next year’s sales at 5,000 units. Compute Bill’s degree of operating leverage. Recall that P = $200, V = $80, F = $360,000, and the margin of safety percentage at 5,000 units is 40%. First, compute contribution margin and profit at 5,000 units: Contribution margin = ($200 – $80) x 5,000 = $600,000 Profit = $600,000 – $360,000 = $240,000 Degree of operating leverage = or, degree of operating leverage = $600,000 = 2.5 $240,000 $360,000 + 1 = 2.5 $240,000 or, degree of operating leverage = © John Wiley & Sons, 2011 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e 1 = 2.5 40% Slide # 32 Q5: Using the Degree of Operating Leverage • The degree of operating leverage shows the sensitivity of profits to changes in sales. • On the prior slide Bill’s degree of operating leverage was 2.5 and profits were $240,000. • If expected sales were to increase to 6,000 units, a 20% increase, then profits would increase by 2.5 x 20%, or 50%, to $360,000.* • If expected sales were to decrease to 4,500 units, a 10% decrease, then profits would decrease by 2.5 x 10%, or 25%, to $180,000.** * $240,000 x 1.5 = $360,000 © John Wiley & Sons, 2011 ** $240,000 x 0.75 = $180,000 Chapter 3: Cost-Volume-Profit Analysis Eldenburg & Wolcott’s Cost Management, 2e Slide # 33 Cost Management Measuring, Monitoring, and Motivating Performance Chapter 4 Relevant Information for Decision Making © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 1 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Learning objectives • • • • • • Q1: What is the process for identifying and using relevant information in decision making? Q2: How is relevant quantitative and qualitative information used in special order decisions? Q3: How is relevant quantitative and qualitative information used in keep or drop decisions? Q4: How is relevant quantitative and qualitative information used in outsourcing (make or buy) decisions? Q5: How is relevant quantitative and qualitative information used in product emphasis and constrained resource decisions? Q6: What factors affect the quality of operating decisions? © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 2 Q1: Nonroutine Operating Decisions • Routine operating decisions are those made on a regular schedule. Examples include: • annual budgets and resource allocation decisions • monthly production planning • weekly work scheduling issues • Nonroutine operating decisions are not made on a regular schedule. Examples include: • accept or reject a customer’s special order • keep or drop business segments • insource or outsource a business activity • constrained (scarce) resource allocation issues © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 3 Q1: Nonroutine Operating Decisions © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 4 Q1: Process for Making Nonroutine Operating Decisions 1. Identify the type of decision to be made. 2. Identify the relevant quantitative analysis technique(s). 3. Identify and analyze the qualitative factors. 4. Perform quantitative and/or qualitative analyses 5. Prioritize issues and arrive at a decision. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 5 Q1: Identify the Type of Decision • • Special order decisions • determine the pricing • accept or reject a customer’s proposal for order quantity and pricing • identify if there is sufficient available capacity Keep or drop business segment decisions • • examples of business segments include product lines, divisions, services, geographic regions, or other distinct segments of the business eliminating segments with operating losses will not always improve profits © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 6 Q1: Identify the Type of Decision • • • Outsourcing decisions • make or buy production components • perform business activities “in-house” or pay another business to perform the activity Constrained resource allocation decisions • determine which products (or business segments) should receive allocations of scarce resources • examples include allocating scarce machine hours or limited supplies of materials to products Other decisions may use similar analyses © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 7 Q1: Identify and Apply the Relevant Quantitative Analysis Technique(s) • • Regression, CVP, and linear programming are examples of quantitative analysis techniques. Analysis techniques require input data. • Data for some input variables will be known and for other input variables estimates will be required. • Many nonroutine decisions have a general decision rule to apply to the data. • The results of the general rule need to be interpreted. • The quality of the information used must be considered when interpreting the results of the general rule. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 8 Q2-Q5 : Identify and Analyze Qualitative Factors • Qualitative information cannot easily be valued in dollars. • • • can be difficult to identify can be every bit as important as the quantitative information Examples of qualitative information that may be relevant in some nonroutine decisions include: • quality of inputs available from a supplier • effects of decision on regular customers • effects of decision on employee morale • effects of production on the environment or the community © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 9 Q1: Consider All Information and Make a Decision • Before making a decision: • Consider all quantitative and qualitative information. • Judgment is required when interpreting the effects of qualitative information. • Consider the quality of the information. • Judgment is also required when user lower-quality information. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 10 Q2: Special Order Decisions • • A new customer (or an existing customer) may sometimes request a special order with a lower selling price per unit. The general rule for special order decisions is: • • accept the order if incremental revenues exceed incremental costs, subject to qualitative considerations. Price >= • Relevant Variable Costs + Relevant Fixed Costs + Opportunity Cost If the special order replaces a portion of normal operations, then the opportunity cost of accepting the order must be included in incremental costs. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 11 Q2: Special Order Decisions RobotBits, Inc. makes sensory input devices for robot manufacturers. The normal selling price is $38.00 per unit. RobotBits was approached by a large robot manufacturer, U.S. Robots, Inc. USR wants to buy 8,000 units at $24, and USR will pay the shipping costs. The per-unit costs traceable to the product (based on normal capacity of 94,000 units) are listed below. Which costs are relevant to this decision? yes$6.20 Relevant? Direct materials yes 8.00 Relevant? Direct labor Variable mfg. overhead yes 5.80 Relevant? no 3.50 Relevant? Fixed mfg. overhead yes Shipping/handling no 2.50 Relevant? Fixed administrative costs no 0.88 Relevant? no 0.36 Relevant? Fixed selling costs $27.24 © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e $20.00 Slide # 12 Q2: Special Order Decisions Suppose that the capacity of RobotBits is 107,000 units and projected sales to regular customers this year total 94,000 units. Does the quantitative analysis suggest that the company should accept the special order? First determine if there is sufficient idle capacity to accept this order without disrupting normal operations: Projected sales to regular customers Special order 94,000 units 8,000 units 102,000 units RobotBits still has 5,000 units of idle capacity if the order is accepted. Compare incremental revenue to incremental cost: Incremental profit if accept special order = ($24 selling price – $20 relevant costs) x 8,000 units = $32,000 © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 13 Q2: Qualitative Factors in Special Order Decisions What qualitative issues, in general, might RobotBits consider before finalizing its decision? • Will USR expect the same selling price per unit on future orders? • Will other regular customers be upset if they discover the lower selling price to one of their competitors? • Will employee productivity change with the increase in production? • Given the increase in production, will the incremental costs remain as predicted for this special order? • Are materials available from its supplier to meet the increase in production? © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 14 Q2: Special Order Decisions and Capacity Issues Suppose instead that the capacity of RobotBits is 100,000 units and projected sales to regular customers this year totals 94,000 units. Should the company accept the special order? Here the company does not have enough idle capacity to accept the order: Projected sales to regular customers Special order 94,000 units 8,000 units 102,000 units If USR will not agree to a reduction of the order to 6,000 units, then the offer can only be accepted by denying sales of 2,000 units to regular customers. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 15 Q2: Special Order Decisions and Capacity Issues Suppose instead that the capacity of RobotBits is 100,000 units and projected sales to regular customers this year total 94,000 units. Does the quantitative analysis suggest that the company should accept the special order? Direct materials Direct labor Variable mfg. overhead Fixed mfg. overhead Shipping/handling Fixed administrative costs Fixed selling costs $6.20 8.00 5.80 3.50 2.50 0.88 0.36 $27.24 Variable cost/unit for regular sales = $22.50. CM/unit on regular sales = $38.00 – $22.50 = $15.50. The opportunity cost of accepting this order is the lost contribution margin on 2,000 units of regular sales. Incremental profit if accept special order = $32,000 incremental profit under idle capacity – opportunity cost = $32,000 – $15.50 x 2,000 = $1,000 © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 16 Q2: Qualitative Factors in Special Order Decisions What additional qualitative issues, in this case of a capacity constraint, might RobotBits consider before finalizing its decision? • What will be the effect on the regular customer(s) that do not receive their order(s) of 2,000 units? • What is the effect on the company’s reputation of leaving orders from regular customers of 2,000 units unfilled? • Will any of the projected costs change if the company operates at 100% capacity? • Are there any methods to increase capacity? What effects do these methods have on employees and on the community? • Notice that the small incremental profit of $1,000 will probably be outweighed by the qualitative considerations. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 17 Q3: Keep or Drop Decisions • Managers must determine whether to keep or eliminate business segments that appear to be unprofitable. • The general rule for keep or drop decisions is: • • keep the business segment if its contribution margin covers its avoidable fixed costs, subject to qualitative considerations. Drop if: Contribution < Relevant Margin Fixed Costs • + Opportunity Cost If the business segment’s elimination will affect continuing operations, the opportunity costs of its discontinuation must be included in the analysis. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 18 Q3: Keep or Drop Decisions Starz, Inc. has 3 divisions. The Gibson and Quaid Divisions have recently been operating at a loss. Management is considering the elimination of these divisions. Divisional income statements (in 1000s of dollars) are given below. According to the quantitative analysis, should Starz eliminate Gibson or Quaid or both? Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166 © John Wiley & Sons, 2011 $96 18 $114 Total $1,660 1,054 606 455 151 81 $70 $139 36 $175 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 19 Q3: Keep or Drop Decisions Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166 $96 18 $114 Total $1,660 1,054 606 455 151 81 $70 $139 36 $175 Contribution margin Avoidable fixed costs Effect on profit if keep Use the general rule to determine if Gibson and/or Quaid should be eliminated. Gibson Quaid $143 $98 154 96 ($11) $2 The general rule shows that we should keep Quaid and drop Gibson. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 20 Q3: Keep or Drop Decisions Revenues Variable costs Contribution margin Traceable fixed costs Division operating income Unallocated fixed costs Operating income Gibson Quaid Russell $390 $433 $837 247 335 472 143 98 365 166 114 175 ($23) ($16) $190 Breakdown of traceable fixed costs: Avoidable $154 Unavoidable 12 $166 $96 18 $114 Total $1,660 1,054 606 455 151 81 $70 $139 36 $175 Using the general rule is easier than recasting the income statements: Gibson Quaid Russell Total Revenues $390 $433 $837 $1,270 Variable costs 247 335 472 807 Contribution margin 143 98 365 $463 Traceable fixed costs 166 114 175 289 Division operating income ($23) ($16) $190 $174 Unallocated fixed costs 81 Gibson’s unavoidable fixed costs 12 Operating income $81 Quaid & Russell only Profits increase by $11 when Gibson is eliminated. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 21 Q3: Keep or Drop Decisions Suppose that the Gibson & Quaid Divisions use the same supplier for a particular production input. If the Gibson Division is dropped, the decrease in purchases from this supplier means that Quaid will no longer receive volume discounts on this input. This will increase the costs of production for Quaid by $14,000 per year. In this scenario, should Starz still eliminate the Gibson Division? Effect on profit if drop Gibson before considering impact on Quaid’s production costs Opportunity cost of eliminating Gibson Revised effect on profit if drop Gibson $11 (14) ($3) Profits decrease by $3 when Gibson is eliminated. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 22 Q3: Qualitative Factors in Keep or Drop Decisions What qualitative issues should Starz consider before finalizing its decision? • What will be the effect on the customers of Gibson if it is eliminated? What is the effect on the company’s reputation? • What will be the effect on the employees of Gibson? Can any of them be reassigned to other divisions? • What will be the effect on the community where Gibson is located if the decision is made to drop Gibson? • What will be the effect on the morale of the employees of the remaining divisions? © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 23 • Q4: Insource or Outsource (Make or Buy) Decisions Managers often must determine whether to • • • make or buy a production input keep a business activity in house or outsource the activity The general rule for make or buy decisions is: • • choose the alternative with the lowest relevant (incremental cost), subject to qualitative considerations If the decision will affect other aspects of operations, these costs (or lost revenues) must be included in the analysis. Outsource if: Cost to Outsource < Cost to Insource Where: © John Wiley & Sons, 2011 Cost to Relevant Relevant Opportunity Insource = FC + VC + Cost Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 24 Q4: Make or Buy Decisions Graham Co. currently of our main product manufactures a part called a gasker used in the manufacture of its main product. Graham makes and uses 60,000 gaskers per year. The production costs are detailed below. An outside supplier has offered to supply Graham 60,000 gaskers per year at $1.55 each. Fixed production costs of $30,000 associated with the gaskers are unavoidable. Should Graham make or buy the gaskers? The production costs per unit for manufacturing a gasker are: yes $0.65 Relevant? Direct materials yes 0.45 Relevant? Direct labor Variable manufacturing overhead yes 0.40 Relevant? no 0.50 Relevant? Fixed manufacturing overhead* $2.00 *$30,000/60,000 units = $0.50/unit $1.50 Advantage of “make” over “buy” = [$1.55 – $1.50] x 60,000 = $3,000 © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 25 Q4: Qualitative Factors in Make or Buy Decisions The quantitative analysis indicates that Graham should continue to make the component. What qualitative issues should Graham consider before finalizing its decision? • Is the quality of the manufactured component superior to the quality of the purchased component? • Will purchasing the component result in more timely availability of the component? • Would a relationship with the potential supplier benefit the company in any way? • Are there any worker productivity issues that affect this decision? © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 26 Q3: Make or Buy Decisions Suppose the potential supplier of the gasker offers Graham a discount for a different sub-unit required to manufacture Graham’s main product if Graham purchases 60,000 gaskers annually. This discount is expected to save Graham $15,000 per year. Should Graham consider purchasing the gaskers? Advantage of “make” over “buy” before considering discount (slide 23) $3,000 Discount Advantage of “buy” over “make” 15,000 $12,000 Profits increase by $12,000 when the gasker is purchased instead of manufactured. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 27 Q5: Constrained Resource (Product Emphasis) Decisions • Managers often face constraints such as • • production capacity constraints such as machine hours or limits on availability of material inputs limits on the quantities of outputs that customers demand • Managers need to determine which products should first be allocated the scarce resources. • The general rule for constrained resource allocation decisions with only one constraint is: • allocate scarce resources to products with the highest contribution margin per unit of the constrained resource, • subject to qualitative considerations. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 28 Q5: Constrained Resource Decisions (Two Products; One Scarce Resource) Urban’s Umbrellas makes two types of patio umbrellas, regular and deluxe. Suppose there is unlimited customer demand for each product. The selling prices and variable costs of each product are listed below. Selling price per unit Variable cost per unit Contribution margin per unit Regular $40 20 $20 Deluxe $110 44 $ 66 Contribution margin ratio 50% 60% Required machine hours/unit 0.4 2.0 Urban has only 160,000 machine hours available per year. Write Urban’s machine hour constraint as an inequality. 0.4R + 2D  160,000 machine hours © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 29 Q5: Constrained Resource Decisions (Two Products; One Scarce Resource) Suppose that Urban decides to make all Regular umbrellas. What is the total contribution margin? Recall that the CM/unit for R is $20. The machine hour constraint is: 0.4R + 2D  160,000 machine hours If D=0, this constraint becomes 0.4R  160,000 machine hours, or R  400,000 units Total contribution margin = $20*400,000 = $8 million Suppose that Urban decides to make all Deluxe umbrellas. What is the total contribution margin? Recall that the CM/unit for D is $66. If R=0, this constraint becomes 2D  160,000 machine hours, or D  80,000 units Total contribution margin = $66*80,000 = $5.28 million © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 30 Q5: Constrained Resource Decisions (Two Products; One Scarce Resource) If the choice is between all Ds or all Rs, then clearly making all Rs is better. But how do we know that some combination of Rs and Ds won’t yield an even higher contribution margin? make all Ds; get $5.28 million make all Rs; get $8 million In a one constraint problem, a combination of Rs and Ds will yield a contribution margin between $5.28 and $8 million. Therefore, Urban will only make one product, and clearly R is the best choice. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 31 Q5: Constrained Resource Decisions (Two Products; One Scarce Resource) The general rule for constrained resource decisions with one scarce resource is to first make only the product with the highest contribution margin per unit of the constrained resource. In Urban’s case, the sole scarce resource was machine hours, so Urban should make only the product with the highest contribution margin per machine hour. R: CM/mach hr = $20/0.4mach hrs = $50/mach hr D: CM/mach hr = $66/2mach hrs = $33/mach hr Notice that the total contribution margin from making all Rs is $50/mach hr x 160,000 machine hours to be used producing Rs = $8 million. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 32 Q5: Constrained Resource Decisions (Multiple Scarce Resources) • Usually managers face more than one constraint. • Multiple constraints are easiest to analyze using a quantitative analysis technique known as linear programming. • A problem formulated as a linear programming problem contains • an algebraic expression of the company’s goal, known as the objective function • • for example “maximize total contribution margin” or “minimize total costs” a list of the constraints written as inequalities © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 33 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) Suppose Urban also need 2 and 6 hours of direct labor per unit of R and D, respectively. There are only 120,000 direct labor hours available per year. Formulate this as a linear programming problem. Max 20R + 66D R,D subject to: 0.4R+2D  160,000 mach hr constraint 2R+6D  120,000 DL hr constraint nonnegativity constraints R0 (can’t make a negative D0 amount of R or D) objective function R, D are the choice variables constraints © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 34 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) Draw a graph showing the possible production plans for Urban. Every R, D ordered pair To determine this, graph the is a production plan. constraints as inequalities. But which ones are feasible, 0.4R+2D  160,000 mach hr constraint given the constraints? When D=0, R=400,000 D When R=0, D=80,000 2R+6D  120,000 DL hr constraint When D=0, R=60,000 When R=0, D=20,000 80,000 20,000 R 60,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 35 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) There are not enough machine hours or enough direct labor hours to produce this production plan. There are enough machine hours, but not enough direct labor hours, to produce this production plan. This production plan is feasible; there are enough machine hours and enough direct labor hours for this plan. D 80,000 The feasible set is the area where all the production constraints are satisfied. 20,000 R 60,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 36 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) The graph helped us realize an important aspect of this problem – we thought there were 2 constrained resources but in fact there is only one. For every feasible production plan, Urban will never run out of machine hours. D The machine hour constraint is non-binding, or slack, but the direct labor hour constraint is binding. 80,000 We are back to a one-scarceresource problem. 20,000 R 60,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 37 Q5: Constrained Resource Decisions (Two Products; One Scarce Resource) Here direct labor hours is the sole scarce resource. We can use the general rule for one-constraint problems. R: CM/DL hr = $20/2DL hrs = $10/DL hr D: CM/DL hr = $66/6DL hrs = $11/DL hr D Urban should make all deluxe umbrellas. 80,000 Optimal plan is R=0, D=20,000. Total contribution margin = $66 x 20,000 = $1,320,000 20,000 R 60,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 38 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) Suppose Urban has been able to train a new workforce and now there are 600,000 direct labor hours available per year. Formulate this as a linear programming problem, graph it, and find the feasible set. Max 20R + 66D R,D subject to: 0.4R+2D  160,000 mach hr constraint 2R+6D  600,000 DL hr constraint R0 D0 The formulation of the problem is the same as before; the only change is that the right hand side (RHS) of the DL hour constraint is larger. © John Wiley & Sons, 2011 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 39 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) The machine hour constraint is the same as before. 0.4R+2D  160,000 mach hr constraint D 100,000 2R+6D  600,000 DL hr constraint When D=0, R=300,000 When R=0, D=100,000 80,000 R 300,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 40 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) There are not enough machine hours or enough direct labor hours for this production plan. There are enough direct labor hours, but not enough machine hours, for this production plan. There are enough machine hours, but not enough direct labor hours, for this production plan. D 100,000 This production plan is feasible; there are enough machine hours and enough direct labor hours for this plan. 80,000 The feasible set is the area where all the production constraints are satisfied. R 300,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 41 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) How do we know which of the feasible plans is optimal? We can’t use the general rule for one-constraint problems. We can graph the total contribution margin line, because its slope will help us determine the optimal production plan. D 100,000 80,000 The objective “maximize total contribution margin” means that we . . . this would be the choose a production plan so that the optimal production plan. contribution margin is a large as possible, without leaving the feasible set. If the slope of the total contribution margin line is lower (in absolute value terms) than the slope of the machine hour constraint, then. . . R 300,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 42 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) What if the slope of the total contribution margin line is higher (in absolute value terms) than the slope of the direct labor hour constraint? If the total CM line had this steep slope, . . D 100,000 . . then this would be the optimal production plan. 80,000 R 300,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 43 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) What if the slope of the total contribution margin line is between the slopes of the two constraints? If the total CM line had this slope, . . D 100,000 . . then this would be the optimal production plan. 80,000 R 300,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 44 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) The last 3 slides showed that the optimal production plan is always at a corner of the feasible set. This gives us an easy way to solve 2 product, 2 or more scarce resource problems. D 100,000 R=0, D=80,000 The total contribution margin here is 0 x $20 + 80,000 x $66 = $5,280,000. R=?, D=? Find the intersection of the 2 constraints. 80,000 R=300,000, D=0 The total contribution margin here is 300,000 x $20 + 0 x $66 = $6,000,000. R 300,000 © John Wiley & Sons, 2011 400,000 Chapter 4: Relevant Costs for Nonroutine Operating Decisions Eldenburg & Wolcott’s Cost Management, 2e Slide # 45 Q5: Constrained Resource Decisions (Two Products; Two Scarce Resources) To find the intersection …

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