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* USING ACCOUNTING INFORMATION IN DECISION MAKING * RELEVANT COSTS AND BENEFITS DECISION MAKING - the function of selecting courses of action for the future - The process of examining your possibilities, options, comparing them, and choosing a course of action. DECISION MODEL - A formal method used by managers for making a choice. It often involves both quantitative and qualitative analyses. BASIC STEPS IN A DECISION MODEL IDENTIFY THE PROBLEM. The typical short-term decision-making case may involve questions on: 1. Accept or reject 5. Best product mix 2. Make or buy 6. Profit factors to change 3. Sell or process further 7. Pricing decisions 4. Continue or close business B. OBTAIN INFORMATION AND MAKE PREDICTIONS 1. QUALITATIVE AND QUANTITATIVE INFORMATION a. Qualitative factors - cannot be easily and accurately measured in numerical terms b. Quantitative factors – can be more easily expressed in numerical terms 2. RELEVANT INFORMATION – relevant and related to the decision – making case a. Relevant Costs and Revenues – differ among alternative courses of action The following are relevant: 1. Differential costs - present in one alternative in a decision-making case, but are absent in whole in part in another alternative 2. Avoidable costs - can be eliminated when one alternative is chosen over another 3. Opportunity costs- income is lost when one action is taken over the next best alternative course of action The following are irrelevant: 1. Sunk costs - cost that has been incurred and cannot be avoided 2. Future costs - do not differ between or among the alternatives C. IDENTIFY AND EVALUATE THE ALTERNATIVE COURSES OF ACTION, THEN CHOOSE THE BEST ALTERNATIVE ^ Only relevant factors should be considered in evaluating alternatives ^ As a general rule, the best alternative is the one will give the organization the highest income (or lowest loss) D. IMPLEMENT THE DECISION E. EVALUATE THE PERFORMANCE OF THE DECISION IMPLEMENTED TO PROVIDE FEEDBACK ^ making better decisions in the future Accept or Reject a Special Order Special orders or one-time orders usually involve a larger volume and a discounted or lower sales price. Orders like this should be evaluated considering the costs relevant to the situation, availability of productive capacity and the goals of the company. TOTAL APPROACH Under this type of analysis, the total revenues and costs are determined for each alternative and the results are compared to serve as bases for making decisions. DIFFERENTIAL ANALYSIS The total approach is quite long, requiring the analysis of all the data involved in the case. A short-cut method to analyze problem can be applied. Under this method of analysis, only the differences or changes (increases and decreases or increments and decrements) in revenues and costs are considered. _____________________________________________________________________________________ Dao-oil Company, which sells a chemical product called Fallurin, received a special order for 1,000 litres of Fallurin from a valued customer. Because of the large volume of this order, the customer is asking for discount of 40% off the regular selling price of P25 per litre. Pertinent data about product Fallurin are as follows: Normal plant capacity 5, 000 litres Present sales volume-regular customers 3, 500 litres Production costs: Materials 3.00 per litre: Labor 2.00 per litre; Factory overhead: Variable 3.00 per litre Fixed 7,500 per month Selling and administrative: Variable 2.00 per litre; Fixed 11,250 per month It was ascertained that the special order will not require additional selling and administrative costs and that the same will not affect regular sales. Dao-oil Company wants to make a decision on whether to accept or reject the special order. ____________________________________________________________________________________ Assume that Benedicto Company presently produces and sells 20, 000 units of Product X which represent only 80% of its normal capacity of P25, 000 units. Its regular selling price is P50 per unit and its manufacturing, selling and administrative costs are as follows: Materials P10 Labor 12 Variable Overhead 8 Fixed overhead (P60, 000/20,000) 3 Variable selling and administrative costs 7 Fixed selling and administrative costs (P40, 000/20,000) 2 Total Unit Cost 42 Benedicto Company received an order from a provincial distributor for 3,000 units. The customer asks for a special discount of 30%. It is expected that the company will incur no additional selling and administrative costs. Will the company accept or reject the special order? ____________________________________________________________________________________ SEATWORK: Daimler company’s normal capacity is 60, 000 units, half of this are utilized. For last month, the result of its operations is summarized in the ff, statement: Sales (30, 000 units) p 1, 500, 000 Less variable costs 600, 000 Contribution Margin 900, 000 Less fixed costs 500, 000 Profit 400, 000 Of the variable and fixed costs shown on the statements, ¾ are manufacturing costs; the balance is selling and administrative costs: This month, a customer submitted a proposal to buy 35, 000 units of the product at P25 per unit. The only selling cost to be incurred for this order is P4 per unit representing freight charges that will be shouldered by Daimler. If this special order proves to be acceptable, Daimler is willing to reduce sales to regular customers so as not to exceed it normal capacity. 1. Accept or Reject? 2. Contribution Margin per unit – Regular sales? 3. Contribution Margin per unit – Special order? 4. Contribution Margin (Pesos) to be lost by reducing sales to regular customers? 5. Profit or loss from special order? 1. ACCEPT 2. 30 3. 6 4. 150, 000 5. 60, 000 _____________________________________________________________________________________ Continue or Discontinue Operating a Business Segment Heiko Enterprises sell three products, A, B, and C. Heiko, the owner, is concerned about the losses incurred by C, and is considering to discontinue its production and sales. Sales and costs data about Heiko’s three products are as follows: A B C TOTAL Sales price per unit P 5 P 7 P 9 P 21 Variable cost per unit 2 3 7 12 Contribution margin per unit 3 4 2 9 Fixed cost per unit 1 2 3 6 Profit (Loss) Per unit P 2 P 2 P (1) P 3 Fixed costs are allocated among the three products based on the floor are they occupy. Heiko is thinking that if he would eliminate C, its loss of P1 per unit from P3 (P2 + P2 – P1) to P4 (P2 + P2). Is Heiko’s analysis correct? _____________________________________________________________________________________ Ace operates a chain of bookstores with branches in Manila, Quezon City and Makati. A summary of operating results of the three branches during a typical month is shown below: MANILA MAKATI QUEZON TOTAL Sales P 300, 000 P 400,000 P 500,000 P 1,200,000 Costs and expenses: Variable 120,000 160,000 200,000 480,000 Direct fixed costs 50,000 140,000 70,000 260,000 Allocated home office costs P 90,000 P 120,000 P 140,000 P 350,000 Total costs and expenses 260,000 420,000 410,000 1,090,000 Operating Profit (Loss) 40,000 (20,000) 90,000 110,000 Like in the previous months, Ace observed that the Makati Branch operated at a loss. Due to this, Ace is considering to close the Makati Branch, hoping that the loss would be eliminated. She disclosed her plan to her accountant who in turn informed her that if she would push through with her plan, Makati’s sales, variable costs and direct fixed costs would all be eliminated. However, total home office costs would not change; the amount allocated to Makati would just be absorbed by the other branches. Should Ace continue operating the Makati Branch despite its operating loss? __________________________________________________________________________________________________ Temporary Shut Down This may involve discontinuance of operations of not merely a business segment but the business itself as a whole This problem arises when some internal or external factors adversely affect the operations of the business on a temporary basis, which may warrant temporary closure of the business. Such factors include labor unrest in the company or customers’ businesses, political and economic instability, building or road construction within or near the company’s premises, or shortage in materials and other supplies. As soon as situations go back to normal, operations may be resumed. When a business temporarily shut down its operations, it will stop generating revenue and avoid incurring variable and some fixed costs. There are costs, however, that the company will continue to incur even when there is no operation. These are called shut down costs which may include security and maintenance of the facilities and other unavoidable costs. Example: Mr. Juan Cruz operates a snack counter selling sandwiches and soft drinks to students of the school across his store, as well as to his neighbors and passers-by. Each unit sale is composed of a sandwich and a cup of soft drinks which is sold at a lot price of P15. Variable cost amounts to P8 per unit. Under normal conditions, Mr. Cruz sells an average of 3, 000 units per month, during which he incurs the following fixed costs: A joint strike of teachers and students which started the other day dramatically reduced the sales of Mr. Cruz’ snack counter composed only 800 units because customers would now be composed only his neighbours and passers-by. Mr. Cruz is considering shutting down operations for one month to avoid incurring losses due to the reduced sales volume. He notes that if he shuts down his operations, his share in the allocated cost of utilities would be reduced to P500, and he could asked to take a forced leave without pay the sales clerk while the business is closed. All the other fixed costs would be incurred despite the discontinuance of operations Should the snack counter be shut down for one month? Rent P 3,000 Allocated cost of utilities 2,000 Salary of Sales Clerk 1,500 Janitor's Salary 1,000 Security agency's billing 2,500 Total 10,000 Shut Down Point This is also called indifference point, which may be expressed in terms of units or pesos. This refers to the number of units that must be sold or the amount of sales in pesos that must be generated such that the resulting loss would be equal to the loss to be incurred if operations were discontinued. The formulas for shutdown point are: Fixed costs under continued operations - Shutdown costs Shutdown point in pesos = Contribution Margin Ratio Seatwork: Tennis Company plans to discontinue a department that has a contribution margin of P24, 000, 4.00, in pesos and per unit, respectively, sales of P60, 000, and P48, 000 in fixed costs. Of the fixed costs, P21, 000 cannot be eliminated. 1. Total units produced? 5. Profit or loss under 8. Net peso advantage? continued operation? 2. Variable cost ratio? 9. Shutdown point in units? 6. Profit or loss under 3. Break-even in units? discontinued operation? 4. Break-even in pesos? 7. Continue or discontinue? 10. Shutdown point in pesos? ANSWERS: 3. 12, too units 1. 6, 000 units 4. P120, 000 2. 60% 5. P24, 000 loss 6. P21, 000 loss 9. 6,750 units 7. Discontinue 10. P67, 500 8. P3, 000 Make or Buy It involves choosing between producing an item and buying it from outside suppliers. In most cases, such item involves a tangible product such as a part, subassembly or materials needed in manufacturing the company’s major product line. Make or buy decision cases are not limited tangible products. At times, they involve service activities Make or buy decision analysis usually involves comparing the net relevant manufacturing costs with the cost of buying the item. COST TO MAKE COST TO BUY PURCHASE PRICE X DIRECT MATERIALS X MATERIALS HANDLING COSTS X X DIRECT LABOR X VARIABLE OVERHEAD X AVOIDABLE FIXED OVERHEAD X SAVINGS IF THE PART IS BOUGHT (X) RENTAL INCOME FROM RELEASED FACILITIES (X) CONTRIBUTION MARGIN FROM NEW PRODUCT BEING PRODUCED USING THE RELEASED FACILITIES (X) RENTAL EXPENSE IF THE PART IS BOUGHT X TOTAL RELEVANT COST X X MATERIALS HANDLING COSTS apply to materials and other purchases and are normally allocated based on a purchase cost. Inasmuch as the cost of purchase changes, consequently, the allocated costs change as well, and therefore are relevant costs in the short-term decision making. Seat Company, a manufacturer of furniture sets, is considering to purchase the seat pillows needed for its chairs. The expected purchase price of these seat pillows is P50 per unit. Seat has been making its own seat pillows since it started operating. If it would continue to produce these pillows, the company expects to incur the following costs: Raw material P 13 Direct labor 15 Variable overhead 5 Fixed overhead(based on the average production 20 requirement of P10, 000 units) Total production cost per unit P 53 Make or Buy? Seat Company, a manufacturer of furniture sets, is considering to purchase the seat pillows needed for its chairs. The expected purchase price of these seat pillows is P50 per unit. Seat has been making its own seat pillows since it started operating. If it would continue to produce these pillows, the company expects to incur the following costs: Raw material P 13 Direct labor 15 Variable overhead 5 Fixed overhead(based on the average production 20 requirement of 10, 000 units) Total production cost per unit P 53 ---- Assume that the 40% of the fixed overhead could be eliminated if the company would discontinue the manufacture of seat pillows? Make or Buy? Purchase price of these seat pillows is P50 per unit. Costs: Raw material P 13 Direct labor 15 Variable overhead 5 Fixed overhead(based on the average production 20 requirement of P10, 000 units) Total production cost per unit P 53 --- Assume that materials and labor costs are expected to increase by 20% next period. Factory overhead costs will remain the same, except 40% of the fixed overhead will be eliminated in case the company decides to buy the seat cushions from the other suppliers. Moreover, the facilities presently being used in the manufacture of seat pillows can be utilized to manufacture another part of the main product in case such facilities become vacant when the company decides to stop producing the seat pillows. This alternative use of resources would result into cost savings of P100, 000 for Seat Company. Assume further that the company’s requirement for seat pillows is expected to increase by 4, 000 units next period. 1. Total fixed cost after increasing the units? 2. Total unit variable cost? 3. Relevant Manufacturing costs? 4. Make or Buy? 5. Net advantage of making or buying the pillows? 1. P200, 000 4. Buy 2. P38.60 5. P20, 400 3. P620, 400 Sell or Process Further Some firms manufacture products which have a ready market once a certain stage of completion is reached; or the firm may decide to process the product further to give the product a higher sales value though this may require additional processing costs. Should the firm process the product or sell it as is? In solving this type of decision making problem, the decision maker should compare the differential revenue with differential costs if the product is processed further. ______________________________________________________________________________________________ Pnoy, Inc. produces a product called Balut. The company buys duck eggs, the materials needed to make balut, from different suppliers in Pateros at P1.50 each. To convert the eggs into balut, the same process by boiling for about 30 minutes. Processing costs composed of labor and factory overhead average at P0.50 per unit. Pnoy sells the product at P3.00 per unit. Pnoy’s product may be sold as balut, or it may be processed further to come up with another product called pritong balut which actually is fried balut dipped in bread crumbs or corn starch. Pritong balut has proven to be highly salable and commands the price of 3.75 per unit. Materials, labor and overhead costs required converting balut into pritong balut amounts to P0.40 per unit. Pnoy is contemplating to stop selling balut and instead concentrate on selling pritong balut. Should Pnoy push through with his plan? ___________________________________________________________________________________________ Joint Products Sell or process further problems are also encountered by companies engaged in the manufacture of joint products. These products are linked together by some physical relationships which require simultaneous processing. During this joint processing, the manufacturing cost, or the joint cost, is incurred in an individual sum for all the products involved. At the split-off point, where the items emerge as individual products, the total joint costs incurred are allocated to such individual products using various methods and bases of allocation. News Paper Products which produces chipboard, newsprint and kraft paper from pulp which it buys at P5 per kilo. On the average, the company uses 100, 000 kilos of pulp and incurs conversion cost of P500, 000 per month. Monthly production and sales price figures for each product are as follows: PRODUCTION SALES PRICE Chipboard 200, 000 sheets P 2.40 per sheet Newsprint 50, 000 reams 20.00 per ream Kraft paper 30, 000 sheets 1.50 per sheet The total joint cost is allocated based on the weight (in kilos) of the products manufactured during the month. (Assume that the allocation results are: 17%, 80%, and 3% of the total joint cost is allocated to chipboard, newsprint, and Kraft paper, respectively.) One of the joint products, the kraft paper, may be processed further to produce document envelopes which can be sold at P2.00 per unit. Each sheet of Kraft paper may be converted into one document envelope at a cost of sixty centavos. Should the kraft paper be sold at the split off point or converted into document envelope? Seatwork: Agnes Corporation produces three joint products, X, Y, and Z, form one input. The products can be sold at split-off point or processed further. The joint production costs for the month allocated among the products based on the relative physical volume of output are as follows: Materials P 150 000 Labor 30,000 Factory Overhead 20,000 Total joint costs P 200,000 Additional information about the three products is given in the following tabulation: Unit Sales Price Additional processing Production in units cost At Split-off If processed further Product X 5, 000 P80 P100 P15 Product Y 3, 000 45 60 20 Product Z 2, 000 60 75 10 1. Product to sell at split-off, if any? 2. Amount of joint cost allocated to Z? 3. Additional per unit profit (loss) of X if processed further? 4. Additional per unit profit (loss) of Y if processed further? 5. Total Gross Profit if the company took the most profitable action with respect to each of the three products? 1. Money, machine hours, direct labor hours, Product Y 2. P40, 000 3. P5 4. P5 loss 5. P490, 000 Product Combination/Utilization of Scarce Resources supply of materials, technology, and other business resources are subject to scarcity. To optimize scarce resources, sales and production should be allotted to a product that gives the highest profit per scarce resource. If the scarce resource is direct labor hour, then produce the product that gives the highest contribution margin per direct labor hour, computed as follows: CM per hour = UCM / no. of hours per unit CM per hour = UCM X no. of units per hour LABANY SINGKAMY MISTISY Contribution margin per unit P5 P8 P 12 Sales or market limit 10 ,000 UNITS 20, 000 UNITS NONE Machine hours required to produce one unit 1 HR 4 HRS 12 HRS Total fixed cost - P100, 000 Total machine hours available: 120, 000 hours Use all your resources in producing the product that has the highest CM per hour unless such product has market limitation. In such case, after satisfying all the market need of the product having the highest M per hour, produce and sell the product that has the next highest CM per hour, and so on, until all available resources are exhausted. ________________________________________________________________________________________ Tisay Co. produces and sells three product lines – Labany, Singkamy, and Mistisy. Production and sales data about these product lines are given below. What is the best product combination? Gandalf Manufacturing has assembled the data appearing in the next column pertaining to two products. Past experience has shown that the unavoidable fixed factory overhead included in the cost per machine hour averages P10. Gandalf has a policy of filling all sales order, even if it means purchasing units from outside suppliers. BLENDER ELECTRIC DIRECT MATERIALS P6 P11 DIRECT LABOR 4 9 FACTORY OVERHEAD AT P6 per hour 6 12 COST IF PURCHASED FROM AN OUTSIDE SUPPLIER 20 38 ANNUAL DEMAND IN UNITS 20, 000 28, 000 If 50, 000 machine hours are available, and Gandalf Manufacturing desires to follow optimal strategy What is the best product combination? How many units to buy from outside supplier? __________________________________________________________________________________________________ _ Gandalf Manufacturing has assembled the data appearing in the next column pertaining to two products. Past experience has shown that the unavoidable fixed factory overhead included in the cost per machine hour averages P10. Gandalf has a policy of filling all sales order, even if it means purchasing units from outside suppliers. BLENDER ELECTRIC MIXER DIRECT MATERIALS P6 P11 DIRECT LABOR 4 9 FACTORY OVERHEAD AT P6 per hour 6 12 COST IF PURCHASED FROM AN OUTSIDE SUPPLIER 20 38 ANNUAL DEMAND IN UNITS 20, 000 28, 000 50, 000 machine hours are available, and Gandalf Manufacturing desires to follow optimal strategy. The company is able to reduce the direct materials to P6 per unit. 1. the most profitable product? 2. Contribution margin per hour of the most profitable product? 3. Hours to be allocated to Blender? 4. Hours to be allocated to Mixer? 5. Total no. of units to be purchased from outside supplier? 1. MIXER 4. 50,000 2. P6 5. 23,000 3. ZERO Replace or retain an old asset Old assets need higher budget to maintain than the new one. If the old asset is replaced, there is an immediate outflow of cash. However, there would be savings derived from reduced operating expenses of maintaining the new asset compared with that of the old one. Also, there is a possible inflow from the current residual value of the old asset. If the new cash flow is positive, meaning, the cash inflows are greater than the cash outflow over the life of the asset, then, it is advisable to replace the old asset and generate net benefit over its useful life. All of these are under the assumption that the useful life of the new asset, compared to the old asset, is equal, without considering the time value of money and effects of taxes. _____________________________________________________________________________________________ Efem Company is contemplating to replace one of its existing machines and has gathered the following relative data for analysis: Old New Purchase price P1.0 million P2.0 million Life in years 4 4 Residual value - now P0.25 million n.a. After 4 years none none Annual operating expenses P1.2 million P0.65 million Required:  Without considering the tax effects and the time value of money, determine the net advantage of replacing or retaining the old machine.  What is the net outflow at the date of buying the new machine? SEATWORK:  Ysabelle Industries, Inc. has an opportunity to acquire a new equipment to replace one of its existing equipment. The new equipment would cost P900, 000 and has a five-year useful life, with a zero terminal disposal price. Variable operating cost would be P1 million per year. The present equipment has a book value of P500, 000 and a remaining life of five years. Its disposal price now is P50, 000 but would be zero after five years. Variable operating costs would be P1, 250, 000 per year. Considering the five years in total, but ignoring the time value and income taxes, 1. Ysabelle should retain or replace the old asset? 2. The total savings in operating costs? 3. Net advantage of retaining/replacing the old equipment? Retain Replace Purchase price P900,000 Book value P500,000 Useful life(remaining) 5 years 5 years Salvage value - now 50,000 Variable operating costs 1,250,000 1,000,000 Annual savings in operating cost (P1,250,000 -P1,000,000) P250,000 Therefore: Savings in 5 years (P250,000 x 5 yrs.) P1,250,000 Salvage value of old equipment 50,000 Total cash inflows 1,300,000 Purchase price (900,000) Net advantage of replacing the old equipment P400,000 Scrap or Rework defective units There are products that do not meet the standard production specifications. Some of these products are defective which could be sold as scrap or could be reworked and sold at a higher value. In deciding whether to sell as scrap or rework, the net profit from reworking should be compared with the net profit of selling of scrap without regard to the past costs of producing the product. The past production costs, both variable and fixed, are irrelevant in this situation. They are sunk, historical, and unalterable. Panabo Corporation produces 200,000 units where 10% is considered defective. The companying is studying either to scrap or rework the defective units and has provided the following data for analysis: Cost of production P30 million Sales price of regular good units P200 per unit Sales price as defective units P40 per unit Sales price of defective units after reworking P75 per unit Number of units reworked 120 units Cost of reworking defective units P10 per unit Required:  Net advantage of the better alternative, scrap or rework.  SEATWORK  A company has 7,000 obsolete toys carried in inventory at manufacturing cost of P6 per unit. If the toys are reworked for P2 per unit they could be sold for P3 per unit. If the toys are scrapped, they could be sold for P1.85 per unit.  1. Which alternative is more desirable (rework or scrap)?  2. What is the total peso amount of the advantage of that alternative? Profit from reworking (P7,000 x P1) P7,000 (P3-2) -Profit from scrapping (7,000 X P1.85) (12,950) Net advantage of scrapping P(5,950)