accounting chapter 25

Short-Term Business Decisions

Chapter 25

Learning Objectives

1. Identify information that is relevant for making short-term decisions

2. Make regular and special pricing decisions

Learning Objectives

3. Make decisions about dropping a product, product mix, and sales mix

4. Make outsourcing and processing further decisions

Learning Objective 1

Identify information that Identify information that is relevant for making is relevant for making short-term decisionsshort-term decisions

How Managers Make Decisions

Relevant versus Irrelevant Information

Relevant•Expected future data•Differs among alternatives

Irrelevant•Does not affect the decision•Sunk costs

– Incurred in the past– Cannot be changed regardless of which

future action is taken

Relevant Information

• Financial (quantitative)

• Nonfinancial (qualitative)

Types of Short-TermSpecial Decisions

• Regular and special pricing

• Dropping unprofitable products and segments, product mix, and sales mix

• Outsourcing and further processing

Keys in Analyzing Short-termSpecial Business Decisions

1. Focus on relevant revenues, costs, and profits

2. Use a contribution margin approach that separates variable costs from fixed costs

Doherty Company is considering replacing the individual printers each employee in the corporate office currently uses with a network printer located in a central area. The network printer is more efficient and would, therefore, cost less to operate than the individual printers. However, most of the office staff thinks having to use a centralized printer would be inconvenient. They prefer to have individual printers located at each desk. Identify the following information as financial or nonfinancial and relevant or irrelevant. The first item has been completed as an example.

Financial Nonfinancial Relevant Irrelevant

1. Amount paid forcurrent printers

✓ ✓

2. Resale value of current printers

3. Cost of new printer

4. Operating costs of current printers

5. Operating costs ofnew printers

6. Employee morale

✓ ✓

3. Cost of new printer

6. Employee morale

✓ ✓

3. Cost of new printer ✓ ✓

6. Employee morale

✓ ✓

6. Employee morale

✓ ✓

6. Employee morale

✓ ✓

6. Employee morale ✓ ✓

Make regular and Make regular and special pricing special pricing

decisionsdecisions

Three Basic Questions to Ask When Setting Regular Prices

• What is the company’s target profit?

• How much will customers pay?

• Is the company a price-taker or a price-setter for this product or service?

Price-Takers versus Price-Setters

Exhibit 25-2 Price-Takers versus Price-SettersExhibit 25-2 Price-Takers versus Price-Setters

Target Pricing Formula

Basic Profit Calculation:

Revenues

Less: Costs

Profits

Basic Profit Calculation: Rewritten as:

Revenues Revenues

Less: Costs Less: Profits

Profits Costs

Basic Profit Calculation: Rewritten as: Target pricing formula:

Revenues Revenues Revenue at market price

Less: Costs Less: Profits Less: Desired profit

Profits Costs Target full product cost

Smart Touch Learning’sBudgeted Income Statement

Target Full Product Cost

What Options DoesSmart Touch Learning Have?

1. Accept the lower operating income of $236,000, which is a 9.44% return ($236,000 operating income/$2,500,000 average assets), not the 10% target return required by stock-holders.

2.Reduce fixed costs by $14,000 or more.

3.Reduce variable costs by $14,000 or more.

4.Attempt to increase sales volume. If the company has excess manufacturing capacity, making and selling more units would only affect variable costs; however, it would mean that current fixed costs are spread over more units.

5.Change or add to its product mix (covered later in this chapter).

6.Attempt to differentiate its tablet computer from the competition to gain more control over sales prices (become a price-setter).

7. A combination of the above strategies that would increase revenues and/or decrease costs by $14,000.

Cost-Plus Pricing

Full product cost

Plus: Desired profit

Cost-plus price

Decision Rule for Pricing

DECISION RULE: How to approach pricing?

If the company is a price-takerfor the product:

If the company is a price-setterfor the product:

Emphasize a target pricingapproach

Emphasize a cost-plus pricingapproach

Special Pricing—Questions to Consider

• Does the company have the excess capacity available to fill the order?

• Will the reduced sales price be high enough to cover the differential costs of filling the order?

• Will the special order affect regular sales in the long run?

Special Pricing Example

Smart Touch Learning normally sells its tablet computers for $500 each. Assume that a company has offered Smart Touch Learning $68,750 for 250 tablets, or $275 per tablet. The special pricing requested is substantially less that the regular sales price. Additional information about this sale includes:

•Production will use manufacturing capacity that would otherwise be idle (excess capacity).

•No change in fixed costs.

•No additional variable nonmanufacturing expenses (because no extra selling or administrative costs are incurred with this special order).

•No effect on regular sales.

Smart Touch Learning’s Budgeted Income Statement—Traditional and Contribution

Margin Formats

Cost per Tablet—Traditional Format versus Contribution Format Income Statement

Per traditional format income statement

= $698,000 COGS / 2,400 tablets

= $290.83 per tablet, rounded

Per contribution format income statement

Cost per Tablet—Traditional Format versus Contribution Format Income Statement

Per traditional format income statement

= $698,000 COGS / 2,400 tablets

= $290.83 per tablet (rounded)

Per contribution format income statement

= $588,000 variable costs / 2,400 tablets

= $245 per tablet

Effect on Contribution Margin

Effect on contribution margin per tablet

= $275 – $245

= $30 per tablet

Effect on total contribution margin

Effect on Contribution Margin

Effect on contribution margin per tablet

= $275 – $245

= $30 per tablet

Effect on total contribution margin

= 250 tablets × $30 per tablet

= $7,500

Differential Analysis

Decision Rule for Special Pricing

DECISION RULE: Accept special pricing order?

If the expected increase inrevenues exceeds the expected

increase in variable and fixed costs:

If the expected increase inrevenues is less than the expectedincrease in variable and fixed costs:

Accept the special pricing order Reject the special pricing order

Thomas Company makes a product that regularly sells for $12.50. The product has variable manufacturing costs of $8.50 per unit and fixed manufacturing costs of $2.00 per unit (based on $200,000 total fixed costs at current production of 100,000 units). Therefore, total production cost is $10.50. Thomas Company receives an offer from Wesley Company to purchase 5,000 units for $9.00 each. Selling and administrative costs and future sales will not be affected by the sale and Thomas does not expect any additional fixed costs.

8. Does your answer change if Thomas Company is operating at capacity? Why or why not?

Thomas should not accept the offer if operating at capacity. To sell these 5,000 units at the reduced price of $9.00 means the company cannot sell them at the regular price of $12.50. Operating income would decrease if the order is accepted by the difference in revenues:

($12.50 – $9.00) × 5,000 units = $17,500

Make decisions about Make decisions about dropping a product, dropping a product, product mix, and product mix, and

sales mixsales mix

Dropping Products and Segments—Questions to Consider

• Does the product or segment provide a positive contribution margin?

• Will fixed costs continue to exist, even if the company drops the product or segment?

• Are there any direct fixed costs that can be avoided if the company drops the product or segment?

• Will dropping the product or segment affect sales of the company’s other products?

• What would the company do with the freed manufacturing capacity or store space?

Budgeted Income Statementby Product

Effects of Fixed Costs

• Will the fixed costs continue to exist even if the product is dropped?

• Are there any direct fixed costs of the Premium Tablets that can be avoided if the product is dropped?

Differential Analysis of Dropping a Product—Fixed Costs Will Not Change

Notice the decrease inoperating income is equalto the contribution marginfor the Premium Tablets.

Differential Analysis of Dropping a Product—Fixed Costs Will Change

Other Considerations

• Would dropping the product or segment hurt other product sales?

• What could be done with the freed manufacturing capacity?

Decision Rule forDropping a Product or Segment

DECISION RULE: Drop product or segment?

If the lost revenues exceed thetotal cost savings:

If the lost revenues are less thanthe total cost savings:

Do not drop Drop

Constraints—Questions to Consider

• What constraint(s) stop(s) the company from making (or displaying) all the units the company can sell?

• Which products offer the highest contribution margin per unit of the constraint?

• Would emphasizing one product over another affect fixed costs?

Smart Touch Learning’sContribution Margin per Product

Decision Rule for a Constraint

DECISION RULE: Which product to emphasize?

Emphasize the product with thehighest contribution margin per unit of the constraint.

Smart Touch Learning’s Contribution Margin per Machine Hour

Total Contribution Margin with Machine Hour Constraint

Production to Maximize Profit

Production of Standard Tablets:= 19,500 machine hours available / 7.5 machine hours required

= 2,600 Standard Tablets

Production of Premium Tablets:= 0

Total Contribution Margin—Machine Hour Constraint and Limited Market

Constraints for a Merchandiser

Total Contribution Margin withDisplay Space Constraint

9.If fixed costs cannot be avoided, should McCollum drop Product B? Why or why not?

10. If 50% of the fixed costs are avoidable, should McCollum drop Product B? Why or why not?

Make outsourcing and Make outsourcing and processing further processing further

decisionsdecisions

Smart Touch Learning’s Costto Produce 2,400 Casings

Outsourcing—Questions to Consider

• How do the company’s variable costs compare to the outsourcing costs?

• Are any fixed costs avoidable if the company outsources?

• What could the company do with the freed manufacturing capacity?

Differential Analysis for Outsourcing Decision—Fixed Costs Will Not Change

Differential Analysis for Outsourcing Decision—Fixed Costs Will Change

Decision Rule for Outsourcing

DECISION RULE: Outsource?

If the differential costs of makingthe product exceed the differential

costs of outsourcing:

If the differential costs of makingthe product are less than the

differential costs of outsourcing:

Outsource Do not outsource

Three Alternatives forSmart Touch Learning

1. Use the facilities to make the casings.

2. Buy the casings and leave facilities idle (continue to assume $12,000 of avoidable fixed costs from outsourcing casings).

3. Buy the casings and use facilities to make the new product (continue to assume $12,000 of avoidable fixed costs from outsourcing casings).

Differential Analysis for Outsourcing Decision—Fixed Costs Will Change and Opportunity Cost Exists

Sell or Process Further—Questions to Consider

• How much revenue will the company receive if it sells the product as is?

• How much revenue will the company receive if it sells the product after processing it further?

• How much will it cost to process the product further?

Sell or Process Further—Smart Touch Learning Example

• Sell as is for $500

• Process further

– Add front accessible USB ports to the tablets at a cost of $5 per tablet

– Sell for $520

Differential Analysis for Sell or Process Further Decision

Joint Costs

Joint costsof producing2,400 tablets$(964,000)

Cost ofprocessing

further$(12,000)

Revenues fromprocessing

further$1,248,000

Revenues fromselling as is$1,200,000

Exhibit 25-18 Joint CostsExhibit 25-18 Joint Costs

Decision Rule forSell or Process Further

DECISION RULE: Sell or process further?

If the additional revenue fromprocessing further exceeds the

additional cost of processing further:

If the additional revenue fromprocessing further is less than the

additional cost of processing further:

Process further Sell; do not process further

Grimm Company makes wedding cakes. The company is considering buying the cakes rather than baking them, which will allow it to concentrate on decorating. The company averages 100 wedding cakes per year and incurs the following costs from baking wedding cakes:

Fixed costs are primarily the depreciation on kitchen equipment such as ovens and mixers. Grimm expects to retain the equipment. Grimm can buy the cakes for $25.

Grimm should continue to make the cakes. Outsourcing will decrease profits by $800.

11. Should Grimm make the cakes or buy them? Why?

12. If Grimm decides to buy the cakes, what are some qualitative factors that Grimm should also consider?

Qualitative factors include quality and on-time delivery. Will the purchased cakes taste as good and be as fresh? Is the vendor reliable or will there be delivery issues?

End of Chapter 25

accounting chapter 25

pearson education

prentice hall

decisions copyright

individual printers

processing copyright

fixed costs copyright

makingis relevant

relevant revenues

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