chapter 4

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 4Chapter 4

Short-term Decision Making

4-2

CVP ContinuedCVP Continued

• Change in selling price Increase—decreases breakeven Decrease—increases breakeven

• Change in variable cost Increase—increases breakeven Decrease—decreases breakeven

• Change in fixed cost Increase—increases breakeven Decrease—decreases breakeven

• Change in tax rate No impact on breakeven

4-3

What are Product and Nonproduct Costs?What are Product and Nonproduct Costs?

• Product costs Incurred in connection with buying or making

the product• Nonproduct costs

Incurred in connection with selling the product and administering (running) the company

4-4

What are the 3 Types of Product Costs?What are the 3 Types of Product Costs?

• Direct materials Traceable Worth the cost of tracing

• Direct labor Cost of employees making the product

• Manufacturing overhead Indirect costs of production (indirect materials,

indirect labor, and other manufacturing costs)

4-5

What are the Activity Levels Associated with Costs?What are the Activity Levels Associated with Costs?

• Unit-related Vary with units produced or sold

• Batch-related Vary with batches (groups) regardless of the

number of units in the batch• Product-sustaining

Vary with the number of product lines• Facility-sustaining

Fixed or capacity costs

4-6

Types and Activity LevelsTypes and Activity Levels

Product Nonproduct

Unit-related Materials Commissions

Batch-related

Set ups Ordering

Product-sustaining

Research & development

Advertising

Facility-sustaining

Rental of equipment

CEO salary

4-7

What are the 2 Characteristics of a Relevant Variable?What are the 2 Characteristics of a Relevant Variable?

• Future The variable must occur in the future

• Different The variable must differ between the

alternatives considered

4-8

Relevant Variables ContinuedRelevant Variables Continued

• Sunk costs Past, never relevant for decision making—Sunk costs

arise from past decisions and represent items that have already been purchased. (for example, make a bad decision and attempt to fix it by putting more money into the project)

• Opportunity costs Benefits foregone, always relevant for short-term

decision making---Since accepting one alternative means rejecting other alternatives, the opportunity cost is the benefit provided by the next best alternatives. (grocer accepts the soda offer and gives up the space for potato chips.)

Relevant Variables ContinuedRelevant Variables Continued

• Incremental costs/revenues Additional cost/revenue, relevant if different

between alternatives—

There are three steps in a relevant variable analysis• Identify the possible alternative actions• Determine the relevant revenues, costs, and/or

profits of each alternative• Choose the best alternative

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What are the Types of Short-Term Decisions Considered?What are the Types of Short-Term Decisions Considered?

• Accept-or-reject decisions Special order Base decision on incremental profit from the order

• Make-or-buy decisions Outsourcing Base decision on cost comparison between make and

buy

• Keep-or-drop decisions Product mix Base decision on revenues lost versus costs saved

Lecture Example #1Lecture Example #1

1. A certain company sells its only product for $12 per unit. The variable costs to produce the product are $7 per unit and it costs approximately $1 per unit for selling and administrative costs. The fixed costs of production are $400,000 per period and the fixed selling and administrative costs are $200,000 per year. The company is subject to a 30 percent tax rate. Answer the following questions.

a. What is the breakeven point in units?b. What is the breakeven point in dollars?c. How many units must be sold to earn a profit of $70,000 before tax?d. How many units must be sold to earn a profit of $70,000 after tax?e. If the variable costs increase 10 percent, what increase is necessary in selling price to maintain the same breakeven point in units?f. If the fixed costs increase, what is the effect on breakeven? On contribution margin per unit?g. If the tax rate increases, what is the effect on breakeven? On contribution margin per unit?

Lecture Example #1 Cont.Lecture Example #1 Cont.

• Answer:• a. SP = $12; VC = $8; CM = $4; FC = $600,000• $600,000/4 = 150,000• b. CM = $4; SP = $12; CM % = 33.3333%• $600,000/33.3333% = $1,800,000• c. ($600,000 + $70,000)/4 = 167,500• d. $70,000/(1 - .3) = $100,000• ($600,000 + $100,000)/4 = 175,000• e. To maintain the same breakeven point, CM must remain the same.• VC = $8.80; CM = $4; therefore SP = $12.80• f. If fixed costs increase, breakeven increases. Fixed costs do not affect

contribution margin per unit.• g. Tax rate increases do not affect breakeven or contribution margin per

unit.


• 2. A company has been approached by a supplier with an offer to provide 25,000 units of a production part for $9 per unit. If the company accepts the offer its direct materials costs are expected to decrease by 60 percent, its direct labor costs are expected to decrease by 30 percent, and its unit-related overhead is expected to decrease by 20 percent. A recent per unit cost report when 25,000 units were produced is shown below:

• Direct materials $10• Direct labor 2• Manufacturing overhead 8• Total cost $20• An analysis of manufacturing overhead reveals that overhead consists of unit-related

and facility-sustaining overhead. Facility-sustaining overhead consists of depreciation and other fixed items and is approximately $150,000 per period. If the company accepts the supplier’s offer, it will use the released production facilities to produce another product with an expected contribution of $60,000 per period. Should the company accept or reject the supplier’s offer?


• Answer:• Total overhead $8 * 25,000 = $200,000• Less facility-sustaining overhead 150,000• Unit-related overhead $ 50,000• Unit-related overhead per unit $50,000/25,000 = $2• • Relevant variables Make Buy• Direct materials $10.00 $ 4.00 ($10 * .4)• Direct labor 2.00 1.40 ($2 * .7)• Unit-related overhead 2.00 1.60 ($2 * .8)• Purchase price -0- 9.00• Relevant cost per unit $14.00 $16.00• * Number of units 25,000 25,000• Total relevant unit cost $350,000 $400,000• Opportunity cost 60,000 -0-• Total relevant cost $410,000 $400,000

BUY


3. A company has been approached by a customer with an offer to buy 10,000 units of product but the customer wants a discount of 25 percent off the normal selling price. The company has the capacity to fill the customer’s order. A recent profit report is shown below:

Sales (500,0000 units) $6,000,000Cost of goods sold 4,200,000Gross margin $1,800,000Selling and administrative cost 1,000,000Profit $ 800,000

Unit-related cost of goods sold is 40 percent of the current selling price while unit-related selling and administrative costs are 10 percent of the current selling price. To fill the customer’s order, one additional production run will be required at a cost of $6,000. An additional purchase order will be required at a cost of $500, and shipping costs to the customer will be $800. Should the company accept the customer’s order?

Lecture Example # 3 Cont.Lecture Example # 3 Cont.

• Answer:• Current selling price = $6,000,000/500,000 = $12• Unit-related cost of goods sold = $12 * .4 = $4.80• Unit-related selling and administrative cost = $12 * .1 = $1.20• Proposed selling price = $12 * .75 = $9• • Relevant variables Accept Reject• Proposed selling price $9.00 $0.00• Cost of goods sold 4.80 0.00• Selling and administrative 1.20 0.00• Contribution margin $3.00 $0.00• * Number of units requested 10,000 10,000• Total contribution margin $30,000 $0• Additional batch costs:• Production run ( 6,000) -0-• Ordering ( 500) -0-• Shipping ( 800) -0-

• Relevant profit $22,700 $0

ACCEPT


Product A Product B Product CSales $100,000 $200,000 $150,000Less: cost of goods sold 60,000 120,000 90,000Gross margin 40,000 80,000 60,000Less: selling and administrative costs

50,000 60,000 55,000

Profit ($10,000) $20,000 $5,000

4. A merchandising company currently sells three products—A, B, and C. Product profit reports for the last period are shown below:

A cost analysis reveals that cost of goods sold varies proportionately with sales (60%). Selling and administrative costs are $120,000 plus 10% of sales. The $120,000 of facility-sustaining selling and administrative cost will continue regardless of how many product lines the company maintains.

Should the company keep or drop its existing product lines?


Answer:If Product A is dropped:

Revenues lost $100,000Costs saved:

Cost of goods sold $60,000Selling & administrative 10,000

$70,000Since the revenues lost exceed the costs saved, the company should

keep Product A.

chapter 4

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