Financial & Managerial Accounting 2002e

Financial & Managerial Accounting 2002e Belverd E. Needles, Jr. Marian Powers Susan Crosson - - - - - - - - - - - Multimedia Slides by: Harry Hooper Santa Fe Community College Copyright © Houghton Mifflin Company. All rights reserved.

LEARNING OBJECTIVES • Explain how managers make short-run decisions during the management cycle. • Define and explain incremental analysis and its related concepts. • Apply incremental analysis to outsourcing decisions. • Apply incremental analysis to special order decisions. • Apply incremental analysis to segment profitability decisions. Copyright © Houghton Mifflin Company. All rights reserved.

LEARNING OBJECTIVES • Apply incremental analysis to product mix decisions involving constrained resources. • Apply incremental analysis to sell or process-further decisions. • Apply incremental analysis to service organizations. Copyright © Houghton Mifflin Company. All rights reserved.

Information forShort-Run Decisions OBJECTIVE 1 Explain how managers make short-run decisions during the management cycle, and identify the steps in the management decision cycle. Copyright © Houghton Mifflin Company. All rights reserved.

Short-Run Decisions • Short-run decision analysis is an important component of the management cycle. • In the planning stage, managers estimate costs and revenues for use in making short-run decision. Copyright © Houghton Mifflin Company. All rights reserved.

The Management Cycle • In the executing stage, managers make and implement short-run decisions to improve the organization’s profitability and liquidity in the short run. • Managers use financial and nonfinancial information to decide to: • Accept a special order. • Keep or drop a segment. • Select the appropriate product mix. • Contract with outside suppliers. • Sell a product as is or process further. Copyright © Houghton Mifflin Company. All rights reserved.

The Management Cycle • In the reviewing stage, each decision is evaluated to determine if it produced the forecasted results. • The reporting stage takes place throughout the management cycle. Copyright © Houghton Mifflin Company. All rights reserved.

Short-Run Decisions • Both quantitative and qualitative factors influence short-run decisions. • Managers must assess the importance of qualitative information such as: • Product (or service) quality. • Timeliness. • Social issues. Copyright © Houghton Mifflin Company. All rights reserved.

Discussion • What are some examples of ways that managers use financial and nonfinancial information? • 1. Accept a special order. 2. Keep or drop a segment. 3. Select the appropriate product mix. 4. Contract with outside suppliers. 5. Sell a product as is or process further. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis for Management Decisions • The management decision cycle: • Begins with the determination of a problem or need. • Then alternative courses of action are identified. • The effects of each alternative are evaluated. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis • Also called differential analysis. • Ignores revenues or costs that stay the same or that do not differ among alternatives. (Irrelevant revenue and costs.) • Ignores sunk costs, already incurred and not recoverable. Copyright © Houghton Mifflin Company. All rights reserved.

Relevant Decision Information • Any data related to future costs, revenues, or uses of resources that will differ among alternative courses of action are considered relevant decision information. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis • Step 1: Eliminate irrelevant revenues and costs. • Step 2: Prepare the analysis using only projected revenues and expenses that will differ. • Step 3: Consider other relevant issues, such as quality, reputation, etc. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis Lennox Company Incremental Analysis Difference in favor of Grinder C Grinder W Grinder W Increase in revenues $ 16,200 $ 19,800 $ 3,600 Increase in operating costs Direct labor $ 2,200 $ 4,100 ($ 1,900) Variable manufacturing overhead 2,100 3,050 (950) Total relevant operating costs $ 4,300 $ 7,150 ($ 2,850) Resulting change in net income $ 11,900 $ 12,650 $ 750 Copyright © Houghton Mifflin Company. All rights reserved.

Decision Costs • Opportunity costs are the benefits forgone when one alternative is selected over another. • Incremental analysis helps managers compare alternatives by focusing on the differences in their projected revenues and costs. • Such a report helps identify which alternative contributes the most to profits or incurs the lowest cost. Copyright © Houghton Mifflin Company. All rights reserved.

Traditional Versus Special Decision Reports • Frequently contribution format incremental analyses are used to support special decisions. • If qualitative factors are very important, special formats must be used to support quantitative analysis with qualitative information. Copyright © Houghton Mifflin Company. All rights reserved.

Discussion • What data should be omitted from the analyses and reports accountants present to management? • 1. Past data. 2. Data that are identical under all alternatives. Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing • Outsourcing is the use of suppliers outside the organization to perform services or produce goods that could be performed or produced internally. • Outsourcing includes make-or-buy decisions, which are decisions about whether to make a part internally or buy it from an external supplier. Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing • Many organizations outsource functions that do not represent core competencies such as: • Payroll processing. • Selling and marketing. • Fleet management. • Training. • Custodial services. • Information management. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Outsourcing Decision Kriegel Electronics Company Outsourcing Decision Incremental Analysis Difference Make Buy in favor of Make Direct materials ¸ ´ $ 16,800 -------- ($ 16,800) (20,000 100 $84) Direct labor 8,000 -------- (8,000) ¸ ´ (20,000 20 $8) Variable manufacturing overhead 4,000 -------- (4,000) ¸ ´ (20,000 20 $4) To purchase completed castings --------- $ 30,000 30,000 ´ (20,000 $1.50) Totals $ 28,800 $ 30,000 $ 1,200 Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing Benefits • Loss of control. • Loss of expertise within the organization. • Growing dependence on suppliers. • Potential loss of critical information to competitors. Copyright © Houghton Mifflin Company. All rights reserved.

Outsourcing Problems • Some of the problems associated with outsourcing include: • Loss of control. • Loss of expertise within the organization. • Growing dependence on suppliers. • Potential loss of critical information to competitors. Copyright © Houghton Mifflin Company. All rights reserved.

When manufacturers purchase parts from suppliers, they expect quality parts to be delivered quickly for a reasonable price. The hidden costs of maintaining an outsourcing relationship with a supplier can include the following: Costs of Quality for Parts Purchased from Suppliers · Cost of inspecting parts delivered to the company · Cost of labor and shipping to return defective parts to suppliers · Cost of training suppliers to follow quality methods Costs of Late Deliveries from Suppliers · Cost of lost customer sales due to late parts deliveries from suppliers · Cost of carrying extra direct materials and finished goods inventory to compensate for late parts deliveries from suppliers · Cost of back orders due to partial shipments Hidden Costs of Outsourcing the Production of Parts for Assembly Operations Copyright © Houghton Mifflin Company. All rights reserved.

Hidden Costs • Hidden costs of maintaining an outsourcing relationship with a supplier can include: • Costs of quality. • Costs of late deliveries. • To manage the hidden costs, companies may add clauses to their contracts with suppliers to specify penalties for poor quality or late deliveries. Copyright © Houghton Mifflin Company. All rights reserved.

Special Order Decisions • Special order decisions are decisions about whether to accept or reject special product orders at prices below the normal market prices. • A special order is a one-time, nonrecurring order. • Before accepting a special order, compliance with federal price discrimination laws should be checked. Copyright © Houghton Mifflin Company. All rights reserved.

Special Order Decisions • Two different approaches to special order decisions include:Compare the special order price to the relevant costs to produce, package, and ship the order. • Prepare a special order bid price by calculating a minimum selling price for the special order. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Special Order DecisionJens Sporting Goods, Inc. * Assuming available existing production capacity, so no additional fixed costs are incurred. Copyright © Houghton Mifflin Company. All rights reserved.

Special Orders: Qualitative Factors • These may include: • Impact on sales to regular customers • Potential of special order to lead into new sales areas • Customer’s ability to maintain an ongoing relationship Copyright © Houghton Mifflin Company. All rights reserved.

Fixed Costs • Examples of relevant fixed costs include: • Purchase of additional machinery. • Increase in supervisory help. • Increase in insurance premiums. Copyright © Houghton Mifflin Company. All rights reserved.

Segment Profitability Decisions • Segment profitability decisions involve the review of segments of an organization, such as: • Product lines. • Services. • Sales territories. • Divisions. • Departments. Copyright © Houghton Mifflin Company. All rights reserved.

Segment’s sales revenue Segment Margin • A segment margin is: - direct variable costs - fixed costs that will be avoided if that segment is dropped Copyright © Houghton Mifflin Company. All rights reserved.

Segment Profitability Decisions • Often managers must decide whether to add or drop a segment. • If a segment has a negative segment margin, the segment may be dropped. • Common costs that will be incurred regardless of the decision are unavoidable costs. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Segment Profitability Decision Lebo Corporation Segment Profitability Decision Incremental Analysis Difference in Favor of Keep Drop Dropping Division Y Division Y Division Y Sales $ 150,000 $ 135,000 ($ 15,000) Less variable costs 60,000 52,500 7,500 Contribution margin $ 90,000 $ 82,500 ($ 7,500) Less direct fixed costs 72,000 55,500 16,500 Segment margin $ 18,000 $ 27,000 $ 9,000 Less common fixed costs 12,000 12,000 0 Net income $ 6,000 $ 15,000 $ 9,000 Copyright © Houghton Mifflin Company. All rights reserved.

Product Mix Decisions • Product mix decisions require the selection of the most profitable combination of product sales when a company makes more than one product using a common constrained resource. Copyright © Houghton Mifflin Company. All rights reserved.

Decision Analysis • The steps in the decision analysis include: • Calculation of the contribution margin per unit for each product line affected by the constrained resource. • Divide the contribution margin per unit by the quantity of the constrained resource required per unit. Copyright © Houghton Mifflin Company. All rights reserved.

Decision Analysis • Profit will be maximized in the short run by devoting limited resources to the product(s) with the highest contribution margin per unit of the constrained resource. Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Product Mix Decision Involving Constrained Resources Grady Enterprises Product Mix Decision: Ranking the Order of Production Incremental Analysis Rising Star Ghost Master Road Warrior Selling price per unit $24.00 $18.00 $32.00 Less: Variable costs Manufacturing $12.50 $10.00 $18.75 Selling 6.50 5.00 6.25 Total unit variable costs $19.00 $15.00 $25.00 Contribution margin per unit (A) $ 5.00 $ 3.00 $ 7.00 Machine hours per unit (B) 2 1 2.5 Contribution margin per $ 2.50 $ 3.00 $ 2.80 machine hour (A ÷ B) Copyright © Houghton Mifflin Company. All rights reserved.

Incremental Analysis: Product Mix Decision • Constraints: • Maximum production capacity: 100,000 machine hours • Current maximum sales demand: • Rising star: 20,000 units • Ghost master: 30,000 units • Road Warrior: 18,000 units Copyright © Houghton Mifflin Company. All rights reserved.

Financial & Managerial Accounting 2002e