Marginal costing-applications

26 - 1©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber

Chapter 26

Special Business Decisions

and Capital Budgeting


Identify the relevant information

for a special business decision.

Objective 1


It is expected future data thatdiffers among alternatives.

It is expected future data thatdiffers among alternatives.

Only relevant data affect decisions.Only relevant data affect decisions.

Relevant Informationfor Decision Making

Relevant information has two distinguishing characteristics.


Make five types of short-term

special business decisions.

Objective 2


Special Sales Order

A. B. Fast is a manufacturer of automobile parts located in Texas.

Ordinarily A. B. Fast sells oil filters for $3.22 each.

R. Pino and Co., from Puerto Rico, has offered $35,400 for 20,000 oil filters, or $1.77 per filter.


Special Sales Order

A. B. Fast’s manufacturing product cost is $2 per oil filter which includes variable manufacturing costs of $1.20 and fixed manufacturing overhead of $0.80.

Suppose that A. B. Fast made and sold 250,000 oil filters before considering the special order.

Should A. B. Fast accept the special order?


Special Sales Order

The $1.77 offered price will not cover the $2 manufacturing cost.

However, the $1.77 price exceeds variable manufacturing costs by $.57 per unit.

Accepting the order will increase A. B. Fast’s contribution margin.

20,000 units × $.57 contribution margin per unit = $11,400


Dropping Products,Departments, Territories

Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil filters and 20,000 air cleaners).

Suppose that the company is considering dropping the air cleaner product line.

Revenues for the air cleaner product line are $41,000.

Should A. B. Fast drop the air cleaner line?



Variable selling and administrative expenses are $0.30 per unit.

Variable manufacturing expenses are $1.20 per unit.

Total fixed expenses are $335,000. Total fixed expenses will continue even if

the product line is dropped.


Product LineOil Filters Air Cleaners Total

Units 250,000 20,000 270,000Sales $805,000 $ 41,000 $846,000Variable expenses 375,000 30,000 405,000Contribution margin $430,000 $ 11,000 $441,000Fixed expenses 310,185 24,815 335,000Operating income/(loss) $119,815 ($13,815) $106,000




To measure product-line operating income, A. B. Fast allocates fixed expenses in proportion to the number of units sold.

Total fixed expenses are $335,000 ÷ 270,000 units, or $1.24 fixed unit cost.

Fixed expenses allocated to the air cleaner product line are 20,000 units × $1.24 per unit, or $24,815.


Oil Filters AloneUnits 250,000Sales $805,000Variable expenses 375,000Contribution margin 430,000Fixed expenses 335,000Operating income $ 95,000




Suppose that the company employs a supervisor for $25,000.

This cost can be avoided if the company stops producing air cleaners.

Should the company stop producing air cleaners?

Yes! $11,000 – $25,000 = ($14,000)


Product Mix

Companies must decide which products to emphasize if certain constraints prevent unlimited production or sales.

Assume that A. B. Fast produces oil filters and windshield wipers.

The company has 2,000 machine hours available to produce these products.


Product Mix

A. B. Fast can produce 5 oil filters in one hour or 8 windshield wipers.

Product Oil Windshield

Per Unit Filters WipersSales price $3.22 $13.50Variable expenses 1.50 12.00Contribution margin $1.72 $ 1.50Contribution margin ratio 53% 11%


Product Mix

Which product should A. B. Fast emphasize?

Oil filters:$1.72 contribution margin per unit × 5 units per hour

= $8.60 per machine hour

Windshield wipers:$1.50 contribution margin per unit × 8 units per hour

= $12.00 per machine hour


Outsourcing (Make or Buy)

A. B. Fast is considering the production of a part it needs, or using a model produced by C. D. Enterprise.

C. D. Enterprise offers to sell the part for $0.37.

Should A. B. Fast manufacture the part or buy it?



A. B. Fast has the following costs for250,000 units of Part no. 4:

Part no. 4 costs: TotalDirect materials $ 40,000Direct labor 20,000Variable overhead 15,000Fixed overhead 50,000Total $125,000

$125,000 ÷ 250,000 units = $0.50/unit



Assume that by purchasing the part, A. B. Fast can avoid all variable manufacturing costs and reduce fixed costs by $15,000 (fixed costs will decrease to $35,000).

A. B. Fast should continue to manufacture the part.

Why?


Purchase cost (250,000 × $0.37) $ 92,500Fixed costs that will continue 35,000Total $127,500

The unit cost is then $0.51($127,500 ÷ 250,000).

$127,500 – $125,000 = $2,500, which is thedifference in favor of manufacturing the part.



Best Use of Facilities

Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the facilities previously used to manufacture Part no. 4 to produce gasoline filters.

The expected annual profit contribution of the gasoline filters is $17,000.

What should A. B. Fast do?


Expected cost of obtaining 250,000 parts:

Make part $125,000Buy part and leave facilities idle $127,500Buy part and use facilities for gas filters $110,500*

*Cost of buying part: $127,500 less$17,000 contribution from gasoline filters.

Best Use of Facilities


Sell As-Is Or Process Further

The sell as-is or process further is a decision whether to incur additional manufacturing costs and sell the inventory at a higher price,

– or sell the inventory as-is at a lower price. Suppose that A. B. Fast spends $500,000 to

produce 250,000 oil filters. A. B. Fast can sell these filters for $3.22 per

filter, for a total of $805,000.



Alternatively, A. B. Fast can further process these filters into super filters at an additional cost of $25,000, which is $0.10 per unit ($25,000 ÷ 250,000 = $0.10).

Super filters will sell for $3.52 per filter for a total of $880,000.

Should A. B. Fast process the filters into super filters?



A. B. Fast should process further, because the $75,000 extra revenue ($880,000 – $805,000) outweighs the $25,000 cost of extra processing.

Extra sales revenue is $0.30 per filter. Extra cost of additional processing is $0.10

per filter.



Cost to produce 250,000 parts: $500,000

Sell these parts for $3.22 each: $805,000

Cost to process original parts further: $ 25,000

Sell these parts for $3.52 each: $880,000

Sales increase ($880,000 – $805,000) $ 75,000Less processing cost 25,000Net gain by processing further $ 50,000


Explain the difference between

correct analysis and incorrectanalysis of a particular

business decision.

Objective 3


Correct Analysis

A correct analysis of a business decision focuses on differences in revenues and expenses.

The contribution margin approach, which is based on variable costing, often is more useful for decision analysis.

It highlights how expenses and income are affected by sales volume.


Incorrect Analysis

The conventional approach to decision making, which is based on absorption costing, may mislead managers into treating a fixed cost as a variable cost.

Absorption costing treats fixed manufacturing overhead as part of the unit cost.


Use opportunity costs

in decision making.

Objective 4


Opportunity Cost...

– is the benefit that can be obtained from the next best course of action.

Opportunity cost is not an outlay cost, so it is not recorded in the accounting records.

Suppose that A. B. Fast is approached by a customer that needs 250,000 regular oil filters.


Opportunity Cost

The customer is willing to pay more than $3.22 per filter.

A. B. Fast’s managers can use the $855,000 ($880,000 – $25,000) opportunity cost of not further processing the oil filters to determine the sales price that will provide an equivalent income.

$855,000 ÷ 250,000 units = $3.42


Use four capital budgetingmodels to make longer-

terminvestment decisions.

Objective 5


Capital Budgeting...

– is a formal means of analyzing long-range capital investment decisions.

The term describes budgeting for the acquisition of capital assets.

Capital assets are assets used for a long period of time.


Capital Budgeting

Capital budget models using net cash inflow from operations are:

– payback– accounting rate of return– net present value– internal rate of return


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Payback...

– is the length of time it takes to recover, in net cash inflows from operations, the dollars of capital outlays.

An increase in cash could result from an increase in revenues, a decrease in expenses, or a combination of the two.


Payback Example

Assume that A. B. Fast is considering the purchase of a machine for $200,000, with an estimated useful life of 8 years, and zero predicted residual value.

Managers expect use of the machine to generate $40,000 of net cash inflows from operations per year.


Payback Example

How long would it take to recover the investment?

$200,000 ÷ $40,000 = 5 years 5 years is the payback period.


Payback Example

When cash flows are uneven, calculations must take a cumulative form.

Cash inflows must be accumulated until the amount invested is recovered.

Suppose that the machine will produce net cash inflows of $90,000 in Year 1, $70,000 in Year 2, and $30,000 in Years 3 through 8.


Payback Example

What is the payback period? Years 1, 2, and 3 together bring in $190,000. Recovery of the amount invested occurs

during Year 4. Recovery is 3 years + $10,000. 3 years + ($10,000 ÷ $30,000) = 3 years and

4 months


Accounting Rate of Return...

– measures profitability. It measures the average return over the life

of the asset. It is computed by dividing average annual

operating income by the average amount of investment in the asset.


Accounting Rate of Return Example

Assume that a machine costs $200,000, has no residual value, and has a useful life of 8 years.

How much is the straight-line depreciation per year?

$25,000 Management expects the machine to generate

annual net cash inflows of $40,000.


Accounting Rate of Return Example

How much is the average operating income? $40,000 – $25,000 = $15,000 How much is the average investment? $200,000 ÷ 2 = $100,000 What is the accounting rate of return? $15,000 ÷ $100,000 = 15%


Discounted Cash-Flow Models

Discounted cash-flow models take into account the time value of money.

The time value of money means that a dollar invested today can earn income and become greater in the future.

These methods take those future values and discount them (deduct interest) back to the present.


Net Present Value

The (NPV) method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present.

The amount of interest deducted is determined by the desired rate of return.

This rate of return is called the discount rate, hurdle rate, required rate of return, or cost of capital.


Net Present Value Example

A. B. Fast is considering an investment of $450,000.

This proposed investment will yield periodic net cash inflows of $225,000, $230,000, and $210,000 over its life.

A. B. Fast expects a return of 16%. Should the investment be made?


Net Present Value Example

Periods Amount PV Factor Present Value0 ($450,000) 1.000 ($450,000)1 225,000 0.862 193,9502 230,000 0.743 170,8903 210,000 0.641 134,610

Total PV of net cash inflows $499,450Net present value of project $ 49,450


Internal Rate of Return...

– is another model using discounted cash flows.

The internal rate of return (IRR) is the rate of return that a company can expect to earn by investing in a project.

The higher the IRR, the more desirable the investment.


Internal Rate of Return

The IRR is the rate of return at which the net present value equals zero.

Investment = Expected annual net cash inflow × PV annuity factor

Investment ÷ Expected annual net cash inflow = PV annuity factor


Internal Rate of Return Example

Assume that A. B. Fast is considering investing $500,000 in a project that will yield net cash inflows of $152,725 per year over its 5-year life.

What is the IRR of this project? $500,000 ÷ $152,725 = 3.274 (PV annuity

factor)


Internal Rate of Return Example

The annuity table shows that 3.274 is in the 16% column for a 5-period row in this example.

Therefore, 16% is the internal rate of return of this project.

If the minimum desired rate of return is 16% or less, A.B. Fast should undertake this project.


Compare and contrast popular

capital budgeting methods.

Objective 6


Comparison of CapitalBudgeting Models

The discounted cash-flow models, net present value, and internal rate of return are conceptually superior to the payback and accounting rate of return models.

Strengths of the payback include: It is easy to calculate, highlights risks, and is

based on cash flows.


Comparison of CapitalBudgeting Models

Its weaknesses are that it ignores cash flows beyond the payback, the time value of money, and profitability.

The strength of the accounting rate of return is that it is based on profitability.

Its weakness is that it ignores the time value of money.


End of Chapter 26

Marginal costing-applications

Documents

business publishing

e horngrenharrisonbamber

product mixwhich product

fixed unit cost

fast sells oil filters

air cleaner product

total fixed expenses

contribution margin