Chapter 26 Special Business Decisions and Capital Budgeting
Identify the relevant information for a special business decision. Objective 1
Relevant Informationfor Decision Making • Relevant information has two distinguishing characteristics. It is expected future data that differs among alternatives. Only relevant data affect decisions.
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?
Dropping Products,Departments, Territories • 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.
Dropping Products,Departments, Territories Product Line Oil FiltersAir CleanersTotal Units 250,000 20,000 270,000 Sales $805,000 $ 41,000 $846,000 Variable expenses 375,000 30,000 405,000 Contribution margin $430,000 $ 11,000 $441,000 Fixed expenses 310,185 24,815 335,000 Operating income/(loss) $119,815 ($13,815) $106,000
Dropping Products,Departments, Territories • 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 Alone Units 250,000 Sales $805,000 Variable expenses 375,000 Contribution margin 430,000 Fixed expenses 335,000 Operating income $ 95,000 Dropping Products,Departments, Territories
Dropping Products,Departments, Territories • 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 UnitFiltersWipers Sales price $3.22 $13.50 Variable expenses 1.50 12.00 Contribution margin $1.72 $ 1.50 Contribution 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 = $12.00per 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?
Outsourcing (Make or Buy) A. B. Fast has the following costs for 250,000 units of Part no. 4: Part no. 4 costs:Total Direct materials $ 40,000 Direct labor 20,000 Variable overhead 15,000 Fixed overhead 50,000 Total $125,000 $125,000 ÷ 250,000 units = $0.50/unit
Outsourcing (Make or Buy) • 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?
Outsourcing (Make or Buy) Purchase cost (250,000 × $0.37) $ 92,500 Fixed costs that will continue 35,000 Total $127,500 $127,500 – $125,000 = $2,500, which is the difference in favor of manufacturing the part. The unit cost is then $0.51 ($127,500 ÷ 250,000).
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?
Best Use of Facilities Expected cost of obtaining 250,000 parts: Make part $125,000 Buy part and leave facilities idle $127,500 Buy part and use facilities for gas filters $110,500* *Cost of buying part: $127,500 less $17,000 contribution from gasoline filters.
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.
Sell As-Is Or Process Further • 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?
Sell As-Is Or Process Further • 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.
Sell As-Is Or Process Further 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) $ 75,000 Less processing cost 25,000 Net gain by processing further $ 50,000
Explain the difference between correct analysis and incorrect analysis 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 budgeting models to make longer-term investment 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
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 PeriodsAmountPV FactorPresent Value 0 ($450,000) 1.000 ($450,000) 1 225,000 0.862 193,950 2 230,000 0.743 170,890 3 210,000 0.641 134,610 Total PV of net cash inflows $499,450 Net 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)