thème 9: decision making and relevant information

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Contrôle Interne Avancé-HEC Contrôle Interne Avancé-HEC Lausanne-2007/2008 Lausanne-2007/2008 1 Thème 9: Decision Thème 9: Decision Making Making and and Relevant Information Relevant Information

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Thème 9: Decision Making and Relevant Information. Define differential costs and sunk costs. Before making a decision, the associated costs and revenues related to each decision must be identified. The costs and revenues that are different for alternatives are relevant to each alternative. - PowerPoint PPT Presentation

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Contrôle Interne Avancé-HEC LausanneContrôle Interne Avancé-HEC Lausanne-2007/2008-2007/2008

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Thème 9: Decision MakingThème 9: Decision Makingandand

Relevant InformationRelevant Information

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Define differential costs and sunk Define differential costs and sunk costscosts

Before making a decision, the associated costs Before making a decision, the associated costs and revenues related to each decision must be and revenues related to each decision must be identified.identified.The costs and revenues that are different for The costs and revenues that are different for alternatives are relevant to each alternative.alternatives are relevant to each alternative.

Differential costsDifferential costs: : future costs that change as a future costs that change as a result of a decision.result of a decision.

Sunk costsSunk costs:: past costs that cannot be changed past costs that cannot be changed by current and future decisions; disregarded by current and future decisions; disregarded when determining the differential costs of a when determining the differential costs of a project. project.

Before making a decision, the associated costs Before making a decision, the associated costs and revenues related to each decision must be and revenues related to each decision must be identified.identified.The costs and revenues that are different for The costs and revenues that are different for alternatives are relevant to each alternative.alternatives are relevant to each alternative.

Differential costsDifferential costs: : future costs that change as a future costs that change as a result of a decision.result of a decision.

Sunk costsSunk costs:: past costs that cannot be changed past costs that cannot be changed by current and future decisions; disregarded by current and future decisions; disregarded when determining the differential costs of a when determining the differential costs of a project. project.

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Three different approaches to Three different approaches to decision makingdecision making

Differential Costs: Only the costs unique to each alternative are identified.

Total Cost: All costs are identified with each alternative.

Qualitative Considerations: Factors that affect a decision but are not subject to measurement in dollar terms.

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Example 1: Differential CostsExample 1: Differential Costs

The following costs relate to a customer’s order of 100 printed shirts. Identify the differential costs.

Variable costs:Shirts. . . . . . . . . . . . . . . . . . . . . $400Printing labor. . . . . . . . . . . . . . . 75

Fixed costs:Print screen. . . . . . . . . . . . . . . . $ 95Machine depreciation . . . . . . . . 50Manager’s salary. . . . . . . . . . . . 90

Total. . . . . . . . . . . . . . . . . . . $710

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Variable costs:

Fixed costs:

Example 1: Differential CostsExample 1: Differential Costs

• The print screen is a differential cost since a screen must be created for this order.

• The printing labor for the shirts is a differential cost since it is a future expense due to the order.

• The cost of the shirts is a differential cost since it would not be an expense if the job were not taken.

Shirts. . . . . . . . . . . . . . . . . . . . . $400

Printing labor. . . . . . . . . . . . . . . 75

Print screen. . . . . . . . . . . . . . . . 95

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Variable costs:Shirts. . . . . . . . . . . . . . . . . . . . . $400Printing labor. . . . . . . . . . . . . . . 75

Fixed costs:Print screen. . . . . . . . . . . . . . . . 95

Total differential costs . . . . . $570

Example 1: Differential CostsExample 1: Differential Costs

• Depreciation is the allocation of a past cost and therefore is not a differential cost.

• A salary is not a differential cost because the salary will be paid regardless of the specific order.

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Example 2: Differential CostsExample 2: Differential CostsMike bought a machine two years ago for $2,000. If he buys a new machine for $3,000, he can sell the old machine for $500. The electricity cost for both machines is $0.30 per hour. The old machine requires maintenance costs of $500 a year, while the new machine will only incur costs of $200 per year. What are the differential costs?

Differential costs:

• $3,000 – cost of new machine• $500 – salvage value of old machine • $300 – difference in maintenance costs

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Example 3: Total CostsExample 3: Total CostsA machine, used in production, has been owned and used for seven years. The machine only has two more years before the company disposes of it and its useful life ends. It runs okay, yet the company could use a newer, more productive machine. Should the machine be used for two more years, or should the company purchase a new machine?

Note: When using the total-cost approach, we must look at all costs.

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Example 3: Total CostsExample 3: Total Costs

Variable costs:$1.10 x 10,000 hours $11,000$1.00 x 8,500 hours $ 8,500

Fixed costs:Depreciation expense 3,000 4,500Book value of old machine 3,000Resale value of old machine (500)

Total cost $14,000 $15,500

Old Machine New Machine

$1,500Difference

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Special ordersSpecial orders

Should we make orbuy the componentor service we need?

BUYER SELLER

Should we acceptthe special orderfor our products

or services?

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Make or buy a componentMake or buy a componentThe Tree Company must decide whether to make or buy a chainsaw motor. A vendor will sell them the necessary motors for $14,000. The total cost figures to build the motors are as follows. Assuming excess capacity, what should The Tree Company do?

Direct materials. . . . . . . . . . . . .

$ 2,000Direct labor . . . . . . . . . . . . . . . .

6,000Variable overhead. . . . . . . . . . .

3,000Fixed overhead:

Direct . . . . . . . . . . . . . . . . . . .

$ 1,500Indirect . . . . . . . . . . . . . . . . .

3,000 Total cost. . . . . . . . . . . . . . .

$15,500

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Make or buy a componentMake or buy a componentBuy Make

Purchase cost. . . . . . . . . . . . $ 14,000Direct materials. . . . . . . . . . . $ 2,000Direct labor . . . . . . . . . . . . . . 6,000Variable overhead. . . . . . . . . 3,000

Fixed overhead: Direct . . . . . . . . . . . . . . . . 1,500 Indirect . . . . . . . . . . . . . . . Total cost. . . . . . . . . . . . . . . . $14,000 $12,500

Differential. . . . . . . . . . . . . . . $1,500

The Tree Company should make the motors.

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Purchase services or provide Purchase services or provide them internallythem internally

Consider the differential costs of each Consider the differential costs of each alternative, as well as qualitative factors, such alternative, as well as qualitative factors, such as:as: The quality of the service.The quality of the service. Whether space exists to house the service.Whether space exists to house the service. Whether services can be delivered on time.Whether services can be delivered on time. Management’s interest in keeping workers on the Management’s interest in keeping workers on the

payroll.payroll.

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Purchase services or provide Purchase services or provide them internallythem internally

Atlas Co. is considering outsourcing its payroll department to a payroll company. Listed below are the costs of both outsourcing and maintaining its current payroll department.

Cost of outsourcing:Payroll company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$50,000 Rent saved by eliminating payroll department. . . . . . . . . . (20,000) Net cost of outsourcing. . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000

Should Atlas Co. outsource its payroll department?

Cost of maintaining payroll department:Total cost of payroll department. . . . . . . . . . . . . . . . . . . . . $35,000 Less non-differential costs: Utilities & depreciation expense for payroll department. . . . . (6,000)Differential costs of payroll department . . . . . . . . . . . . . . . . $29,000

Excess costs incurred by outsourcing . . . . . . . . . . . . . . $ 1,000

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Purchase services or provide Purchase services or provide them internallythem internally

Atlas Co. is considering outsourcing its payroll department to a payroll company. Listed below are the costs of both outsourcing and maintaining its current payroll department.

Cost of outsourcing:Payroll company. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,000 Rent saved by eliminating payroll department. . . . . . . . . . . (20,000) Net cost of outsourcing. . . . . . . . . . . . . . . . . . . . . . . . . . . . $30,000

Cost of maintaining payroll department:Total cost of payroll department. . . . . . . . . . . . . . . . . . . . . $35,000 Less non-differential costs: Utilities & depreciation expense for payroll department. . . . . (6,000)Differential costs of payroll department . . . . . . . . . . . . . . . . $29,000

Excess costs incurred by outsourcing . . . . . . . . . . . . . . $ 1,000

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Add or drop a product matchingAdd or drop a product matching

DROP: Replace a product or a productline with another that contributes more to indirect fixed costs.

ADD: Add a product or a product line that contributes (significantly) to indirect fixed costs.

REPLACE: Drop a product or a product line that does not contribute to indirect fixed costs.

DROP: Replace a product or a productline with another that contributes more to indirect fixed costs.

ADD: Add a product or a product line that contributes (significantly) to indirect fixed costs.

REPLACE: Drop a product or a product line that does not contribute to indirect fixed costs.

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Add or drop a productAdd or drop a product

Product A B C

Sales revenue. . . . . . . . . $15,000 $10,000 $12,000 Variable costs. . . . . . . . . . 8,000 6,000 8,000 Contribution margin . . . . $ 7,000 $ 4,000 $ 4,000 Direct fixed costs . . . . . . . 5,000 3,000 5,000 Contribution to indirect fixed costs. . . . .$ 2,000 $ 1,000 $(1,000)

Identify which of the following products should be retained.

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Add or drop a productAdd or drop a product Product A B C

Sales revenue. . . . . . . . . . $15,000 $10,000 $12,000 Variable costs. . . . . . . . . . 8,000 6,000 8,000 Contribution margin . . . . . $ 7,000 $ 4,000 $ 4,000 Direct fixed costs . . . . . . . 5,000 3,000 5,000 Contribution to indirect fixed costs. . . . . $ 2,000 $ 1,000 $(1,000)

Products A and B are contributing to indirect fixed costs and should be retained unless a more profitable product is available.

Product C should be dropped because it does not cover its own costs.

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Best utilization of a critical Best utilization of a critical resourceresource

Critical Resource Factor:

In a manufacturing process, it is the resource that limits operating capacity by its availability.

In deciding which product to manufacture, management should choose the item that provides the greatest contribution margin per unit of the most critical resource.

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Best utilization of a critical Best utilization of a critical resourceresource

Handy Designs has identified its critical resource as 10,000 machine hours. Using the following data, select the products that should be produced with the limited machine hours.

Product A B C

Selling price . . . . . . . . . . . $20 $16$10

Variable costs. . . . . . . . . . 11 10 5

Contribution margin . . . . . $ 9 $ 6$ 5

Machine hours requiredper unit. . . . . . . . . . . . . 3 2

1 Contribution per

machine hour. . . . . . . . $ 3 $ 3$ 5

Product C should be the first product produced.

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Set selling pricesSet selling prices

Handset Software uses the following cost information to set the normal price on a new program. Computer Outlet has offered to buy the new program for $45 to sell as a store brand. Should Handset accept the offer?

Direct materials. . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15Manufacturing overhead. . . . . . . . . . . . . . . . . . . . 20

Total manufacturing cost . . . . . . . . . . . . . . . . . . $40Markup (50% of cost) . . . . . . . . . . . . . . . . . . . . . . 20

Estimated selling price . . . . . . . . . . . . . . . . . . . . $60

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How to set selling prices?How to set selling prices?

Special order pricing takes into account the differential costs:Sales price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $45

Direct materials. . . . . . . . . . . . . . . . . . . . . . . . . $ 5Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . .15Variable overhead . . . . . . . . . . . . . . . . . . . . . . 8Differential fixed costs. . . . . . . . . . . . . . . . . . . . 10

Total variable and fixed costs. . . . . . . . . . . . . 38Expected contribution per unit . . . . . . . . . . . . . . . $ 7

Direct materials. . . . . . . . . . . . . . . . . . . $ 5Direct labor . . . . . . . . . . . . . . . . . . . . . 15Manufacturing overhead. . . . . . . . . . . 20 Total manufacturing cost . . . . . . . . . $40Markup (50% of cost) . . . . . . . . . . . . . . 20 Estimated selling price . . . . . . . . . . . $60