Tactical Decision Making

*Class Meeting 9TACTICAL DECISION MAKINGRiwayadi

*TACTICAL DECISION MAKING: DefinitionConsists of choosing among alternatives with an immediate or limited end in view.LO 1

*STRATEGIC DECISION MAKING: DefinitionIs selecting among alternative strategies so that long term competitive advantage is established.LO 1

*TACTICAL DECISION MODELA general approach to tactical decision making includes:Recognize, define the problemIdentify alternatives, eliminating those that are unfeasibleIdentify costs & benefitsTotal relevant costs, benefits of each alternativeAssess qualitative factorsSelect alternative with greatest overall benefitLO 1Assess qualitative factors

*TIDWELL PRODUCTS: BackgroundTidwell Products Inc. is facing expanded production that is straining the capacity in facilities with 5 years remaining on their lease. Two feasible alternatives under consideration are a) to rent an additional building for warehousing and b) outsource production. The CFO will prepare a report of detailed costs for these alternatives.LO 1

*APPLYING TACTICAL MODELLO 1Continued

Step 1: Define the problemIncrease capacity for warehousing & productionStep 2: Identify alternativesBuild new facilityLease larger facility; sublease current facilityLease additional facilityLease warehouse spaceBuy shafts & bushings; free up space

*APPLYING TACTICAL MODELLO 1

Step 3: Identify costs, benefitsAlt 4: + BenefitsAlt 5: + BenefitsStep 4: Total relevant costs & benefitsAlt 4: cost $ 1.000 rent dan makeAlt 5: Cost $ 800 (buy from supplier Differential cost $ 200 (alt 5 is chosen)Step 5: Assess qualitative factorsProduct QualityReliability of external supplierPrice stabilityLabor relations & community imageStep 6: Make decisionContinue producing & lease warehouse (alternative 4 is chosen if assuming qualitative factors are not met))

*RELEVANT COSTS: DefinitionAre future costs that differ across alternatives.LO 1differ across alternatives.Relevant cost is the cost that affects the decision

*Cost concepts associated with decision makingOpportunity costBenefit (revenue) that is sacrificed because of choosing alternativeOpportunity cost because you choose to study in international program: salary from working for the companyOpportunity cost is relevan costAvoidable and unavoidable costAvoidable cost is the cost that will vanish by choosing the alternatives. For examples are variable production costs and avoidable fixed factory overhead cost.Avoidable cost is relevant costUnavoidable cost is the cost that will still occur whatever alternatives are chosen. Unavoidable cost is irrelevant costSunk cost Cost that occurred because of previous decision, for example depreciation expenseSunk cost is irrelevant cost

*Differential costs (incremental cost or decremental cost) are the costs that differ among the alternatives. Differential cost is a relevant cost.For example, raw material A Rp 1.000 per kg, raw material B Rp 800. If raw material B is chosen, differential cost (decremental cost) is Rp 200. It means that the company has cost saving of Rp 200 per kg.

*RELEVANT VS. IRRELEVANT COSTSLO 1Direct labor is the relevant cost because it differs between alternatives.

Cost to MakeCost Not to MakeDifferen tial Cost Direct labor$ 150,000---$ 150,000 Depreciation125,000$ 125,000--- Allocated lease 12,00012,000---$ 287,000$ 137,000$150,000

*Objective to understand the relevant costTo simplify the calculation because only relevant cost is accounted for

*APPLICATION OF RELEVANT COSTSMake or buy decisionKeep or drop decisionSpecial order decisionSell at split off point or process further decision

*MAKE OR BUY DECISIONWhen is this decision made? When there is a supplier offering the same component at lower price. Example, manufacturing cost for component A per unit Rp 1.000, and supplier offers for Rp 800 per unit, do we accept or reject?What are relevant costs and irrelevant costs in this decisionRelevant costs are avoidable costs. Examples are variable production cost, avoidable fixed factory overhead cost, and opportunity cost.Irrelevant costs are unavoidable fixed factory overhead cost. Examples are depreciation expense of factory building, and production manager salary

*Fixed CostsDirect Fixed CostsIndirect Fixed Cost (Common Fixed Cost)Avoidable fixed cost - Supervisors salaryfor particular productUnavoidable fixed cost:- Depr. Exp. Of machine that is only used for particular product (direct fixed cost)Property tax (indirect fixed cost) Depr. Exp. Of factory building

*When is buy decision made?When avoidable manufacturing costs is greater than cost of purchase or cost of purchase minus opportunity cost

*ILLUSTRATIONProduction costs of componen X at capacity of 1.000 units are as follows:Unit cost TotalRaw materialRp 500Rp 500.000Direct labor 400 400.000FOH variable 150 150.000FOH - fixed 450 450.000TotalRp 1.500 Rp1.500.000

*Of total fixed factory overhead cost, included property tax Rp 50.000, and depreciation expense of factory building Rp 200.000. External supplier offers the same component for Rp 1.350 per unit.Required:a. Should we accept the suppliers offering? Assuming that capacity is idle if the components are purchased from supplierb. If idle capacity can be rented to other party for Rp 150.000, what is your recommendation?c. What qualitative factors should be considered if we buy from supplier?

*Solutiona. Total production cost Rp 1.500.000Unavoidable fixed cost(property tax & depr.) (250.000)Avoidable production cost Rp 1.250.000Cost of purchase: 1.000 x Rp 1.350 1.350.000Cost saving if made internally Rp 100.000Decision: it is better to make internally

*Prove:Total production cost: 1.000 x Rp 1.500 Rp 1.500.000Cost of purchase:1.000 x Rp 1.350Rp 1.350.000Unavoidable fixed cost 250.000Total cost if buy 1.600.000Cost saving if made internally Rp 100.000

*b. Avodiable production costs Rp 1.250.000Cost of purchase Rp 1.350.000Rent income 150.000Net cost of purchase 1.200.000Cost saving if buy Rp 50.000

Decision: its better to buy

*alternativeAvoidable manufacturing cost Rp 1.250.000Opportunity cost (rent income sacrificed ) 150.000Manufacturing cost 1.400.000Cost of purchase 1.350.000Cost saving if buy50.000

*c. Qualitative factors should be considered if we buy:Quality of productsSupplier reliability (timely and availability as needed)Labor relationship (corporate social responsibility)Product innovation

*Class Meeting 10TACTICAL DECISION MAKINGRiwayadi

*KEEP OR DROP DECISIONKeep or drop decision is the decision about whether or not a segment, such as a product line, division, or branch should be kept or dropped. When is this decision made? When the segment is getting a loss.Segmented report prepared on a variable costing basis provides valuable information for keep or drop decision.

*What are relevant costs and irrelevant costs for this decision?Relevant costs are avoidable costs (variable costs and avoidable fixed costs) and opportunity costIrrelevant costs are unavoidable fixed costsWhen is drop decision made?When revenues of dropped segment is lower than their avoidable costs or when segment has a loss.

IllustrationPT Coca Cola produces three kinds of products: Coca Cola, Fanta, and Sprite. The accounting manager has prepared the following estimated income statement for 200X (in thousands of rupiahs)

* Coca Cola Fanta Sprite TotalSales 500 800 150 1.450Variable expenses (250) (480) (120) (850)Contribution margin 250 320 30 600Direct fixed expenses: Advertising (10) (10) (10) (30) Salaries (17) (20) (15) (52) Depreciation (73) (60) (30) (163) Total (100) (90) (55) (245)Segment margin 150 230 (25) 355Common fixed expenses (40)(40) (40) (120)Operating income (loss) 110 190 (65) 235

*Because the projected performance of sprite product line shows a negative segment margin, management of PT Coca Cola is trying to decide to drop the sprite product line. By dropping the sprite product line, company can save Rp 65.000 (sprite loss), and total operating income will increase from Rp 235.000 to Rp 300.000.Salaries is paid for lines supervisor. Supervisor will be dismissed and advertising will be eliminated when product line is dropped. Depreciation expense and common fixed expenses will still occur even though the product line is dropped.

*Required:Do you agree with management decision to drop the sprite product line? Assuming the sprite capacity is idle.What is your recommendation if sprite capacity can be used for expansion of Fanta product line that can increase Fantas sales of 20%.What is your recommendation if sprite capacity can be rented to other party for Rp 50.000.What qualitative factors should be considered?

*Solutiona.Dropping sprite and the capacity is idle:Sales revenuesRp 150.000Avoidable costs:Variable expensesRp 120.000Avoidable Fixed cost: Advertising 10.000 Salaries 15.000Total avoidable cost 145.000Segment marginRp 5.000

*Decision:It is better to keep sprite product line because it still contributes segment margin for Rp 5.000. This contribution can be used to cover unavoidable fixed cost. If sprite is dropped, total operating income will decrease by Rp 5.000 or decrease from Rp 235.000 to Rp 230.000.

* Before dropped Sprite After DroppedSales 1.450 150 1.300Variable expenses (850) (120) (730)Contribution margin 600 30 570Direct fixed expenses: Advertising (30) (10) (20) Salaries ( 52) (15) ( 37) Depreciation (163) (163) Total (245) (25) (220)Segmen margin 355 5 350Common fixed expenses (120) (120)Operating income 235 5 230Prove:

*b. Dropping Sprite and expand FantaAdditional sales of Fanta: 20% x Rp 800Rp 160 Additional variable expenses: 20% x Rp 480 (96)Additional contribution margin Rp 64 Opportunity cost (sprite margin that is forgone) 5Additional incomeRp 59

*Decision:It is better to drop Sprite and the idle capacity is used for expansion of Fanta because it will increase the operating income from Rp 235 to Rp 294 (Rp 235 + 59)

*c. Sprite is dropped and the idle capacity is rented to other party for Rp 50.000

Rent incomeRp 50.000Opportunity cost (spritemargin forgone) 5.000Additional incomeRp 45.000Decision: Its better to drop Sprite and rent the idle capacity to other party because it will increase the total operating income from Rp 235.000 to Rp 280.000 (Rp 235.000 + Rp 45.000)

*Comparison of Three AlternativesTotal Operating IncomeSprite is dropped and capacity is idleRp 230Sprite is dropped and capacity is used for expansion of FantaRp 294Sprite is dropped and capacity is rented to other partyRp 280Among of the alternatives, alternative 2 is chosen because it generates the highest total operating income.

*d. Qualitative factors that should be considered:1. The workers who work for Sprite (should be lay off or can be transferred to other segment?)2. The possibility of redesigning Sprite (flavor, packaging, etc.)3. Impact on the two other product lines4. New competitor

*SPECIAL ORDER DECISIONThis decision is related to accept or reject the special order from a particular customerWhen is this decision made?When customer wants to buy the product at highly lower price. For example, regular price is Rp 1.000, and cost of product is Rp 800, and customer wants to buy at Rp 600, should we accept?Special order is the order from potential customers in markets not ordinarily served or non regular customers. Fixed costs will not be assigned to special order because they have been fully assigned to regular sales (orders)

*IllustrationTargeted participants of one-day seminar is 100 persons. Capacity of seminar room is 120 persons. In this case, 100 participants are regular customers, while the remaining capacity can be used for special orders.

Seminar fee Rp 100.000 per participantVariable cost Rp 50.000 per participantFixed costRp 20.000 per participant or Rp 2.000.000 in total. Will you accept if someone wants to joint the one-day seminar and pay Rp 65.000 using special order?

*What are relevant costs and irrelevant costs for this decision?Relevant costs are variable costs and additional costs related to special order, for example, putting a particular label in the productIrrelevant costs are fixed costWhen will special order be accepted?When the price of special order is greater than variable costs and additional costs related to special order.

*IllustrationIce-cream company is operating at 80% of its productive capacity. The company has a capacity of 20.000 kg. Total costs and unit cost associated with producing and selling 16.000 kg are as follows:

* Total Cost Unit CostVariable Costs:Dairy Ingredients Rp 11.200.000 Rp 700Sugar 1.600.000 100Flavoring 2.400.000 150Direct labor 4.000.000 250Packaging 3.200.000 200Commission 320.000 20Distribution 480.000 30Other 800.000 50Total variable cost Rp 24.000.000 Rp 1.500

* Total Cost Unit CostFixed Costs:SalariesRp 960.000 Rp 60Depreciation 320.000 20Utilities 80.000 5Taxes 32.000 2 Other 160.000 10Total fixed costs Rp 1.552.000 Rp 97Total costs Rp 25.552.000 Rp 1.597Wholesale sellingRp 32.000.000 Rp 2.000

*An Ice-Cream Distributor from Bukittinggi not normally served by company has offered to buy 2.000 kg at Rp 1.500 per kg. The distributor has agreed to pay the transportation costs. Since the distributor approached the company directly, there is no sales commission.Required:You are as a management accountant, what recommendation may give to the manager of the Ice-Cream Company?What qualitative factors should be considered?

*SolutionThe price of special orderRp 1.500Total unit variable cost Rp 1.500Commission (20)Distribution (30) 1.450Contribution margin per unitRp 50Decision:It is better to accept the special order because it will increase the profit for Rp 50 per kg or Rp 100.000 (2.000 kg x Rp 50) in total.

*Prove:Regular Order Special Order Total(16.000 kg) (2.000 kg) (18.000 kg)Sales 32.000.000 3.000.000 35.000.000VC(24.000.000) (2.900.000) (26.900.000)CM 8.000.000 100.000 8.100.000FC (1.552.000) - (1.552.000Net income 6.448.000 100.0006.548.000======== ====== ========

*Qualitative Factors that should be considered are:Capacity (any idle capacity or not)Regular customer (will ask the same price as special order or not)The prospect of special order customer to be regular customers.

*SELL AT SPLIT OFF POINT OR PROCESS FURTHER DECISIONJoint products are two or more products that are produced through a common processJoint products can be identified at a split off point (the point that products are distinguishable). For example, premium, diesel fuel, and kerosene are produced from crude oil.Joint costs are the costs to produce the joint products

*Separable costs are the costs incurred after products are identifiable or costs to process furtherSometimes, it is more profitable to process a joint product further, beyond the split off point.What are relevant costs and irrelevant costs for this decision:Relevant costs are separable costs and opportunity cost (revenues of split off product foregone because of processing further) as well as the price after products are processed further Irrelevant costs are joint costs

*When is process the product further decision made?When additional revenue is greater than separable cost or when sales revenue after products are processed further is greater than separable costs and opportunity costs.IlluatrationSelling price of Crude Palm Oil (CPO) Rp 1.000 per kgCost of CPO Rp 400 per kgSelling price of fried oil Rp 4.000 per kgUnits produced 5.000 kgSeparable cost (cost to process further) Rp 10 millionShould be processed CPO further? What qualitative factors should be considered?

*Solution yes, because it will increase total income by Rp 5 million as calculated below:Additional revenue: (4.000 1.000) 5.000 Rp 15.000.000Separable cost 10.000.000Additional incomeRp 5.000.000

*Another alternative:Total revenues from fried oil:5.000 x Rp 4.00020.000.000Separable costRp 10.000.000Opportunity cost:5.000 x Rp 1.000 5.000.000 Total cost15.000.000Additional income 5.000.000

*CPOFRIED OILSALES5.000.000 20.000.000COST: 2.000.000 Cost of CPO 2.000.000Separable cost 10.000.000Total cost 2.000.000 12.000.000Net income 3.000.000 8.000.000

Additional income if processed further will be Rp 5.000.000

Qualitative factors that should be considered*