Short-Term Decisions and Accounting Information
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Short-Term Decisions and Accounting Information. 5. Prepared by Douglas Cloud Pepperdine University. Objectives. Explain why decision making requires information not included in regular accounting reports. Determine what costs and revenues are relevant to decisions.

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Short term decisions and accounting information

Short-Term Decisions and Accounting Information

5

Prepared by

Douglas Cloud Pepperdine University


Short term decisions and accounting information

Objectives

  • Explain why decision making requires information not included in regular accounting reports.

  • Determine what costs and revenues are relevant to decisions.

  • Analyze the quantitative factors relevant to typical decisions.

  • Explain the importance of complementary effects to decisions of a segment of a larger entity.

After reading this chapter, you should be able to:

Continued


Short term decisions and accounting information

Objectives

  • Identify nonquantitative or long-term considerations that influence short-term decisions.

  • Describe some of the legal constraints on managers’ decisions.


The criterion for short term decisions

The Criterion for Short-term Decisions

Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss).

Two Subrules

1.The only revenues and costs that are relevant in making decisions are the expected future revenues and costs that will differ among the available choices.

2.Revenues and costs that have already been earned or incurred are irrelevant in making decisions.


Definitions

Definitions

Differential revenuesand costs are the expected future revenues and costs that will differ among the choices that are available.

Incremental revenues and costs

are those differential revenues and costs that actually increase.


Definitions1

Definitions

Sunk costs are costs that have already been incurred and therefore will be the same no matter which alternative a manager selects.

Examples:

  • Book value of equipment

  • Original purchase price of building


Definitions2

Definitions

An opportunity cost is the benefit lost by taking one action as opposed to another.

Example:Rental income lost if facility is used for production.


Typical short term decisions

Typical Short-Term Decisions

  • Drop a Segment

  • Make-or-Buy

  • Joint Product

  • Special Order

  • Factors of Limited Supply

Important: Short-term Perspective


Short term decisions and accounting information

Basic Example

Gloucester Visuals recently manufactured 100 specialized workstation monitors for a customer that has since gone bankrupt. A rival company has offered to buy the monitors for $12,000. The cost to manufacture the monitors was $17,000.

Should the company accept the offer?


Short term decisions and accounting information

Basic Example

Differential revenues$12,000

Differential costs 0

Differential profit$12,000

Accept the offer!


Short term decisions and accounting information

Basic Example

Third Alternative

A competitor offers to pay $20,000 for the monitors provided that Gloucester disguises the original logo and makes a few other modifications. The production manager estimated the incremental cost of the modifications at $6,000.

Should the company accept the offer?


Short term decisions and accounting information

Basic Example

Third Alternative

Differential revenues ($20,000 – $12,000) $8,000

Differential costs ($6,000 – $0) 6,000

Differential profit$2,000

Decision: Make modifications!


Short term decisions and accounting information

Basic Example

Comparison of the three methods

Throw Out Monitors

Sell Monitors As Is

Rework and Sell

Incremental revenue$0$12,000$20,000

Incremental costs 0 0 (6,000)

Incremental profit (loss)$0$12,000$14,000


Short term decisions and accounting information

Activity-Based Estimates

Using ABC helps managers focus on what activities change as a result of a decision.


Dropping a segment decision

ClothingShoesJewelryTotal

Sales $45,000$40,000$15,000$100,000

Variable costs 25,000 18,000 11,000 54,000

Contribution margin$20,000$22,000$ 4,000$ 46,000

Fixed costs:

Direct–all avoidable(4,000)(3,400)(1,500)(8,900)

Indirect (common),

allocated on sales (9,450) (8,400) (3,150) (21,000)

Income (loss)$ 6,550$10,200$ (650)$ 16,100

Dropping a Segment Decision

Should Jewelry be eliminated?


Dropping a segment decision1

Differential revenues:

Lost sales from jewelry$15,000

New rent revenue 400

Net revenue lost$14,600

Differential costs:

Variable costs saved on jewelry$11,000

Direct fixed costs saved1,500

Indirect fixed costs saved 1,000

Total cost saving 13,500

Differential loss from dropping jewelry$ 1,100

Dropping a Segment Decision

Genco’s analysis shows that dropping jewelry would reduce common costs by $1,000. If jewelry is dropped, the available space can be rented for $400 per month.

Keep jewelry!


Short term decisions and accounting information

Complementary Effects

Decision: Substitute Music for Jewelry

Differential contribution margin—increase ($12,000 – $4,000)$8,000

Differential costs—increase in directfixed costs ($2,700 – $1,500) 1,200

Differential profit favoring substitution$6,800


Complementary effects

Complementary Effects

Complementary effects happen when a change in the sale of one product might be accompanied by a change in the sale of another.

Genco’s managers believe that some people coming to shop for music are also likely to buy clothing. After reviewing the results of market studies, the managers estimate that clothing sales will increase 7 percent if music is substituted for jewelry.


Short term decisions and accounting information

Complementary Effects

Decision: Substitute Music for Jewelry

Differential contribution margin:Increase due to selling music vs. jewelry$8,000

Increase due to higher clothing sales

(7% x $20,000 contribution margin on current sales)1,400

Net Increase in contribution margin$9,400

Differential costs—increase in directfixed costs ($2,700 – $1,500) 1,200

Differential profit favoring substitution$8,200


Short term decisions and accounting information

Loss Leader

  • A loss leader is a special case of complementary effects where a product or line shows a negative profit in the sense that its contribution margin does not cover its avoidable fixed costs.

The manager of a local pizzeria prepares the income statement shown on Slide 5-20, based on a normal week, for the 11 a.m. to 2 p.m. period. All costs are incremental.


Short term decisions and accounting information

Loss Leader

PizzaSoft DrinksTotal

Sales (200 pizzas @ $1.80)$360$100$460

Variable costs 120 40 160

Contribution margin$240$ 60$300

Wages of part-timeemployees 80

Income$220


Short term decisions and accounting information

Loss Leader

PizzaSoft DrinksTotal

Sales $ 720$ 0$720

Variable costs 240a 100b 340

Contribution margin$480a$(100)$380

Wages of part-timeemployees ($80 + $40) 120

Income$260

a Variable costs computed at the same rate as before, one-third or 33 1/3% of selling price.

b Variable costs computed as two and one-half times the previous costs.


Make or buy decision

Make-or-Buy Decision

  • Assume the following cost data relate to the decision to produce

  • 12,000 units of a product or buy from external source:

  • Rental of equipment $15,000$1.25

  • Equip. depreciation 3,000.25

  • Direct materials 12,0001.00

  • Direct labor 24,0002.00

  • Variable overhead 9,000.75

  • Fixed overhead 36,000 3.00

    • Total $99,000$8.25

Total CostUnit Cost

The purchase price from an outside vendor is $5.50 per unit.


Make or buy decision1

Make-or-Buy Decision

Differential

MakeBuyCost to Make

Rental of equip. $15,000----$15,000

Direct materials 12,000----12,000

Direct labor 24,000----24,000

Variable overhead 9,000----9,000

Purchase cost$66,000$(66,000)

Relevant costs $60,000$66,000$(6,000)

Decision: Manufacture parts in-house

The cost to make is $5.00 per unit.

The price to buy is $5.50 per unit.


Make or buy decision2

Make-or-Buy Decision

Qualitative issues:

  • Quality of purchased components

  • Timely delivery

  • Potential price increases


Joint products

Joint Products

When a single manufacturing process invariably produces two or more separate products, the products are called joint products.

QBT, a chemical company, operates a joint process that results in two products. Each 1,000 pounds of material yields 600 pounds of Alpha and 400 pounds of Omega.


Joint products1

AlphaOmega

Selling price at split-off$1,200$1,600

Selling price afteradditional processing$3,600$2,000

Costs of additionalprocessing, all variable $900$500

Joint Products


Joint products2

AlphaOmega

Differential revenues$2,400$ 400

Differential costs 900 500

Differential profits$1,500$(100)

Joint Products

Decisions: Process Alpha further and sell Omega at the split-off point


Special order example

Sales (60,000 units) $15 $900,000

Manufacturing costs:

Materials $4$240,000

Direct labor 3 180,000

Overhead (1/3 variable) 6 360,000

Total $13 780,000

Gross margin $120,000

Selling and admin. expenses 80,000

Operating income $ 40,000

Special Order Example

Per Unit Total

Should the company sell a special on-time order for 20,000 at $10 per unit to a company in a new market?


Special order example1

Differential revenues (20,000 units)$10$200,000

Differential costs:

Materials $4$80,000

Direct labor 3 60,000

Variable overhead 2 40,000

Total $9 180,000

Incremental profit favoringacceptance $ 20,000

Special Order Example

Per Unit Total

Decision:Accept special order


Special order example2

Differential revenues: :

New revenues (20,000 units) $200,000

Lost revenues (5,000 units x $15) (75,000)

Total differential revenues $125,000

Differential costs:

Costs of special order$180,000

Costs from not making regular sales:

Variable manufacturing cost

5,000 x $9 ($4 + $3 + $2) (45,000)

Commissions (5,000 x $0.30) (1,500)

Total differential costs 133,500

Differential loss, favoring rejecting order$ (8,500)

Special Order Example


Resource constraint

Selling price $10 $6

Variable cost 6 4

Contribution margin $ 4 $2

Number of units thatcan be made per MH60150

Resource Constraint

Drive ChipModem Chip

Which product should be processed assuming only 100 machine hours are available?


Resource constraint1

Number of units thatcan be made per MH 60 150

Contribution margin per unit x $4x $2

Contribution margin per

machine hour $240 $300

Resource Constraint

Drive ChipModem Chip

Decision: Produce modem chips


Decision making under environmental constraints

Decision Making Under Environmental Constraints

Antitrust lawsforbid actions that might substantially reduce competition.

Anti-dumping lawsaddress aspects of unfair competition in international trade.


Decision making under environmental constraints1

Decision Making Under Environmental Constraints

The Sherman Act, Clayton Act, Robinson-Patman Act, and the statutes of many states prohibit predatory pricing.

Predatory pricing is pricing below cost in the short term to drive competitors out of business and eventually to raise prices.


Decision making under environmental constraints2

Decision Making Under Environmental Constraints

The Robinson-Patman Actforbids charging different prices to different customers unless there are intrinsic cost differences in serving the different customers; in other words, this act forbids discriminatory pricing.

The Federal Trade Commission (FTC) is the regulatory agency responsible for enforcing the act.


Decision making under environmental constraints3

Decision Making Under Environmental Constraints

Anti-dumping lawsprevent unfair competitive practices in international trade by prohibiting a company in one country from selling its products in another country at less than fair value.

The International Trade Administration, part of the Commerce Department, deals with charges of dumping in the United States.


Short term decisions and accounting information

Chapter 5

The End


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