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Chapter 7. Incremental Analysis for Short-Term Decision Making. Learning Objective 7-1. Describe the five steps in the decision-making process. Steps in the Decision-Making Process. Learning Objective 7-2. Define and identify relevant costs and benefits.
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Chapter 7 Incremental Analysis for Short-Term Decision Making
Learning Objective 7-1 Describe the five steps in the decision-making process.
Learning Objective 7-2 Define and identify relevant costs and benefits.
Relevant versus Irrelevant Costsand Benefits Relevant Costs have the potential to influence a decision. Two Criteria for a Relevant Cost Occurs in the future Differs between decision alternatives Relevant costs are also called differential costs, incremental costs, or avoidable costs.
Relevant versus Irrelevant Costsand Benefits Irrelevant costsarethose that will not influence a decision. Costs that have been incurred in the past. (sunk costs) Costs that are the same regardless of the alternative chosen.
Opportunity Costs and Capacity Considerations An opportunity cost is the benefit that is given up when one alternative is selected over another. At full capacity, adding additional work requires giving up a portion of the existing work. The benefit of the existing work given up is an opportunity cost. With idle capacity, additional work may be added without sacrificing existing work. There is no opportunity cost to the additional work.
Learning Objective 7-3 Analyze a special-order decision.
Special-Order Decisions A special order is a one-time order that is outside the scope of normal sales. When analyzing a special order, only the incremental costs and benefits are relevant.
Special-Order Decisions A major university has asked Mattel to make a special University Barbie, dressed in a sporty outfit with the school’s logo and colors. The university bookstore has offered to buy 25,000 of these dolls at a price of $7.00 each. Mattel has the capacity to fill the order without affecting production of other Barbie products, which are normally sold to toy stores and discount chains for $9.00 each. More Information
Special-Order Decisions Mattel estimates that its unit cost to produce the University Barbie will be: Should Mattel accept the special order?
Incremental Analysis (with Excess Capacity) The special order will result in a profit of $2.00 per doll and a total profit of $50,000. Note that fixed costs are excluded because they are irrelevant to the decision.
Qualitative Analysis Two Important Cautions Mattel should only use this analysis for one-time or special orders. In the long-term, all costs, including fixed costs, must be covered. The managers should also consider the impact that the special order price might have on customers who pay through regular channels. The results of this analysis are valid only if the company has excess, or idle, capacity.
Incremental Analysis (without Excess Capacity) Now assume that Mattel is operating at full production capacity and cannot fill the special order for 25,000 University Barbie dolls without giving up production and sale of Barbie dolls sold through normal channels. The dolls are normally sold to stores and discount chains for $9 each. Should Mattel’s managers accept a special-order price of $7?
Incremental Analysis (without Excess Capacity) Variable Cost = $5.00 The opportunity costis the contributionmargin lost onregular sales.
Incremental Analysis (without Excess Capacity) Without excess capacity, the special order will result in a loss when the opportunity costof regular sales is considered.
Learning Objective 7-4 Analyze a make-or-buy decision.
A decision to perform a particular activity or function in-house or purchase from an outside supplier has traditionally been called a make-or-buy decision, but could also be called an insourcing versus outsourcing decision. Make-or-Buy Decisions Key Questions What costs will change? Are there opportunity costs associated with either alternative? Are there other qualitative factors to consider?
Make-or-Buy Decisions Mattel is trying to decide whether to continue packaging the American Girl doll “in-house” or outsource the packaging process to an external supplier. Mattel’s packaging costs for the dolls are: An outside supplier bid $3.00 per doll for the packaging work.Should Mattel outsource the packaging?
Incremental Analysis Note that fixed costs are excluded because they are irrelevantto the decision. Mattel should outsource the packaging.
Qualitative Analysis Other Qualitative Factors • Will the quality of the packaging be as good, or even better, than Mattel can provide internally? • Will the supplier be reliable in delivering the packaging? • What will happen if demand for the product rises above 200,000 units? Does the supplier have the capacity to meet the increased demand? • What will happen in three years? Will the supplier increase the price significantly? • What if the expected profit from expanding the other product line has been substantially over- or underestimated? • Does outsourcing the packaging create any additional risks?
Learning Objective 7-5 Analyze a keep-or-drop decision.
Managers must sometimes decide whether to eliminate a particular division or segment of the business. These decisions are called keep-or-drop decisions or continue-or-discontinue decisions. Decisions to Keep-or-Drop Segments Key Questions How much will total revenue and total costs change? Will other segments or product lines be affected? Are there opportunity costs associated with keeping the segment? Are there other qualitative factors to consider?
Decisions to Keep-or-Drop Segments Should Mattel drop the Barbie Mustang because of the $20,000 loss last year? Mattel should consider the segment margin of $10,000.
Decisions to Keep-or-Drop Segments Impact on Other Segments • Elimination of the Barbie Mustang will eliminate the revenues, variable costs, and direct fixed costs for the Barbie Mustang product. • Elimination of the Barbie Mustang will increase sales of the Dora the Explorer Jeep by 10%, with no effect on the Jeep 4X4. • Total variable costs of the Dora the Explorer Jeep will also increase by 10 % as a result of the increased sales. • Total common fixed costs will not be affected by the elimination of the Barbie Mustang. They will be reallocated to the remaining products based on total sales dollars. Opportunity Costs There are no alternative uses for the resources.
Incremental Analysis Net operating income without the Barbie Mustang is estimated to be $251,000, compared to $240,000 with it. The $11,000 difference is the net effect of eliminating the Barbie Mustang.
Qualitative Analysis • Other Factors to Consider: • What is the impact on customer loyalty and employee moral? • • Will there be any impact on other products and customers? • Regarding substitute goods, customers might choose an alternate good, for example, purchasing the Dora the Explorer Jeep if the Barbie Mustang was unavailable. • However, with complementary goods, eliminating one product could have a negative effect on the related product.
Learning Objective 7-6 Analyze a sell-or-process further decision.
Sell-or-Process Further Decisions Businesses are often faced with the decision to sell a product “as is” or refine it so that it can be sold for a higher price. As a general rule, we process further only if incremental revenues exceed incremental costs. Costs of manufacturing the product up to the sell-or- process decision point are sunk and therefore irrelevant.
Sell-or-Process Further Decisions Mattel has developed a remote control Hummer toy, spending a total of $250,000 on R&D. Demand for the new toy is estimated to be 100,000 units at a price of $15 per unit. If the company spends an additional $100,000 on R&D to enhance the toy, it could be sold for $18 per unit. However, the enhanced toy would have a slightly higher manufacturing cost.
Sell-or-Process Further Decisions Should Mattel sell the product as it is currently designed,or spend more money to create an enhanced design?
Sell-or-Process Further Decisions Mattel will make an additional $25,000in profit by enhancing the product.
Summary of Incremental Analysis • Common Rules for Analyzing Relevant Costs and Benefits: • • Relevant costs and benefits occur in the future and differ between alternatives. • • Variable costs are usually relevant to the decision because they vary with the number of units produced or sold. • • Fixed costs may not be relevant because they do not change with the number of units produced or sold. Fixed costs that are directly related to the decision may be avoidable and thus relevant. • • Opportunity costs are the lost benefit of choosing one alternative over another. These costs are relevant and occur when capacity is reached or resources are constrained. • The quantitative analysis provides a starting point for making decisions, but must be balanced against qualitative factors such as quality considerations, customer loyalty, and other factors.
Learning Objective 7-7 Prioritize products to maximize short-term profit with constrained resources.
Prioritizing Products with Constrained Resources When a limited resource restricts a company’s ability to satisfy demand, the company is said to have a constrained resource that is referred to as a bottleneck. To maximize profits in the short run, a company with a bottleneck must prioritize its products or services so as to maximize contribution margin per unit of the constrained resource. The focus is on contribution margin because fixed costs will not change in the short run, and are not relevant.
Prioritizing Products with Constrained Resources One of Mattel’s factories produces three types of toy cars, Match Box, Hot Wheels, and Remote Control with the following financial and production information. The company needs 360,000 minutes of machine time to meet the full demand for all three products, but only has a total of 330,000 minutes of machine time each month. Machine time is the bottleneck.
Prioritizing Products with Constrained Resources Highest unit contribution margin Highest unit contribution marginper minute of machine time
