Management

Accounting: The
Cornerstone for
Business Decisions
Short-Run Decision
Making; Relevant Costing
and Inventory Management
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
 Learning Objectives
1. Describe the short-run decision-making
model and explain how cost behavior
affects the information used to make
decisions.
2. Apply relevant costing and decision-
making concepts in a variety of
business situations.
3. Choose the optimal product mix when
faced with one constrained resource.
 Learning Objectives
4. Explain the impact of cost on pricing
decisions.
5. Discuss inventory management under
the economic order quantity and JIT
models.
Illustrate Make or Buy
Decision
 What are the steps of the
decision model?
1. Recognize and define the problem.
2. Identify alternatives as possible solutions to the
problem; eliminate alternatives that are clearly not
feasible.
3. Identify the costs and benefits associated with each
feasible alternative. Classify costs and benefits as
relevant or irrelevant and eliminate irrelevant ones
from consideration.
4. Total the relevant cost and benefits for each
alternative.
5. Assess the qualitative factors.
6. Select the alternative with greatest overall benefit.
 How to structure a make or
12-1 buy problem.
Buttons Manufacturing needed to determine if it would be
cheaper to make 12,000 units of a component in house or
purchase them from an outside supplier for $4.80 each.
Absorption-costing information for internal production
includes the following :
Total Cost Unit Cost
Direct materials $12,000 $1.00
Direct labor 24,000 2.00
Variable overhead 10,200 0.85
Fixed overhead 52,800 4.40
Total $89,000 $8.25
Fixed overhead will continue whether the component is
produced internally or externally. No additional cost of
purchasing will be incurred beyond the purchase price.
 How to structure a make or
12-1 buy problem.
REQUIRED:
1. What are the alternatives for Buttons Manufacturing?
2. List the relevant cost(s) of the internal production and
external purchase.
3. Which alternative is more cost effective and by how
much?
4. Now assume that the fixed overhead includes $12,000 of
cost that can be avoided if the component is purchased
externally. Which alternative is more cost effective, and
by how much?
Calculation:
1. There are two alternatives: make the component in hours
or purchase it externally.
 How to structure a make or
12-1 buy problem.
2. Relevant costs of making the component in-house include
direct materials, direct labor, and variable overhead.
Relevant cost of purchasing the component externally
include the purchase price.
Alternatives Differential
Make Buy Cost to Make
Direct materials $12,000 0 $12,000
Direct labor $24,000 0 24,000
Variable overhead 10,200 0 10,200
Purchase price 0 $57,000 (57,000)
Total relevant costs $46,200 $57,000 $(10,800)
3. It is cheaper to make the component in house. This
alternative is better by $10,200.
 How to structure a make or
12-1 buy problem
4. Relevant costs of making the component in-house include
direct materials, direct labor, and variable overhead.
Relevant cost of purchasing the component externally
include the purchase price.
Alternatives Differential
Make Buy Cost to Make
Direct materials $12,000 0 $12,000
Direct labor $24,000 0 24,000
Variable overhead 10,200 0 10,200
Avoidable fixed cost 12,000 0 12,000
Purchase price 0 $57,000 (57,000)
Total relevant costs $58,200 $57,000 $(1,200)
Now, it is cheaper to purchase the component. This
alternative is better by $1,200.
Illustrate Accept a Special
Order Decision
 How to structure a special-
12-2 order problem.
Leibnitz Company has an offer by a new customer to
purchase 22,000 units of model BL7 for $8 each. The
new customer is geographically separated from the
company’s other customers, and existing sales would
not be affected. Leibnitz normally produces 100,000
units of BL7 per year but only plans to produce and
sell 75,000 in the coming year. The normal sales price is
$14 per unit. Unit cost information is as follows:
Direct material $2.50
Direct labor 2.30
Variable overhead 1.50
Fixed overhead 2.00
Total $8.30
 How to structure a special-
12-2 order problem.
Fixed overhead will not be affected whether or not the
special order is accepted.
REQUIRED:
1. What are the relevant costs and benefits of the two
alternatives (accept or reject the special order)?
2. By how much will operating income increase or
decrease if the order is accepted?
Calculations:
1. Relevant costs and benefits of accepting the special
order include the sales price of $8, direct materials,
direct labor, and variable overhead. No relevant costs
or benefits are attached to rejecting the order.
 How to structure a special-
12-2 order problem.
2. If the problem is done on the unit basis:
Differential
Benefit to
Accept Reject Accept
Price $8.00 $ 0 $8.00
Direct materials (2.50) 0 (2.50)
Direct labor (2.30) 0 (2.30)
Variable overhead (1.50) 0 (1.50)
Increase in
operating income $1.70 0 $1.70
Operating income will increase $37,400 ($1.70 x
22,000 units) if the special order is accepted.
 How to structure a keep-or-
12-3 drop product line problem.
The roofing tile line has a contribution margin of $15,000
(sales of $160,000 less variable expense of $145,000). All
variable costs are relevant. Relevant fixed costs
associated with this line include $15,000 in advertising
and $35,000 in supervision.
REQUIRED:
1. List the alternatives being considered.
2. List the relevant benefits and costs for each alternative.
3. Which alternative is more cost efficient and by how
much?
Calculation:
1. The two alternatives are to keep the roofing tile line or
drop it.
 How to structure a keep-or-
12-3 drop product line problem.
2. The relevant benefits and costs of keeping the roofing tile line
include sales of $160,000, variable costs of $145,000, advertising
costs of $15,000 and supervision cost of $35,000.
None of the relevant cost of keeping the roofing tile line would
occur under the drop alternative
3. Differential
Keep Drop Amount to Keep
Sales $160,000 $0 $160,000
Less: Variable expenses 145,000 0 145,000
Contribution margin $15,000 $0 $15,000
Less: Advertising (15,000) 0 (15,000)
Cost of supervision (35,000) 0 (35,000)
Total relevant benefits (loss) $(35,000) $0 $(35,000)
The difference is $35,000 in favor of dropping the roofing tile line.
 How to structure a keep-or-drop
product line problem with
12-4 complementary effects.
Dropping the product line reduces sales of blocks
by 8% and sales of bricks by 10%. All other
information remains the same.
REQUIRED:
1. If the roofing tile line is dropped, what is the
contribution margin for the block line? For the
brick line?
2. Now which alternative (keep or drop the
roofing tile line) is more cost effective, by how
much?
 How to structure a keep-or-drop
product line problem with
12-4 complementary effects.
Calculation:
Previous contribution margin of blocks was
$250,000. A 8% decrease in sales implies a 8%
decrease in variable costs, so contribution
margin decreases by 8%.
New contribution margin for blocks = $250,000
– ($250,000 x .08) = $250,000 - $20,000 = $230,000
The reasoning is the same for brick line, but the
decrease is 10%.
New contribution margin for bricks = $320,000 –
($320,000 x .10) = $320,000 - $32,000 = $288,000
 How to structure a keep-or-drop
product line problem with
12-4 complementary effects.
2. Differential
Keep Drop Amount
to Keep
Contribution margin $585,000 $518,000 $62,000
Less: Advertising (30,000) (20,000) (15,000)
Cost of supervision (112,000) (77,000) (35,000)
Total $443,000 $ 421,000 $12,000
Notice that the contribution margin for the drop alternative equals
the new margins of the block and brick lines ($230,000 +
$288,000). Also, the advertising and supervision remains relevant
under all three alternatives.
Now the analysis favors keeping the roofing tile line. In fact,
company income will be $ 12,000 higher if all three lines are kept
as opposed to dropping the roofing tile line.
 How to structure the sell-or-
12-5 process further decision.
Appletime must decide to whether to sell Grade B pears at
the split-off or process further for pear sauce. The
company normally sells Grade B pears in units of 120 5lb
bags at a net price of $1.20 per bag. If the pears are
processed further the result would be 500 cans of sauce
with an additional cost of $0.19 per can. The buyer will
pay $0.85 per can.
REQUIRED:
1. What is the contribution margin from selling the Grade B
pears in the 5lb bag?
2. What is the contribution to income from processing the
the Grade B pears in to pear sauce?
3. Should they sell the pears in bags or process them further?
 How to structure the sell-or-
12-5 process further decision.
Calculation:
1. Revenue from selling pears in bags = ($1.20 x
120) = $144
2. Revenue from further processing = $0.85 x
500 = $425
Further processing cost = $0.24 x 500 = $120
Income from further process = $425 - $120 =
$305
3. Appletime should process the Grade B pears
into pear sauce. It will make $305 versus the
$144 it would make by selling them in bags.
Illustrate Further Processing
Decision
 How to determine the optimal
product mix with one constrained
12-6 resource.
Jorgeson Company produces two types of gearboxes, X2 and
Y3 with unit contribution margins of $50 and $20,
respectively. Each gearbox must stamped by a special
machine. The company owns four machines that provide
20,000 hours of machine time per year. Gearbox X2
requires 1 hour of machine time, while gearbox Y3
requires 0.25 hour of machine time. There are no other
constraints.
REQUIRED:
1. What is the contribution margin per hour of machine
time per gearbox?
2. What is the optimal mix of gearboxes?
3. What is the total contribution margin for the optimal
mix?
 How to determine the optimal
product mix with one constrained
12-6 resource.
Calculation:
1. Gearbox X2 Gearbox Y3
Contribution margin per unit $25 $10
Divide Hours of machine time 1 0.25
Contribution margin $25 $40
per hour of machine time
2. Since gearbox Y3 yields $40 of contribution margin per
hour of machine time, all machine time should be
devoted to the production of gearbox Y3.
Units Gearbox Y3 = 20,000 hours / 0.25 hours = 80,000
units. The optimal mix is 80,000 units of Y3 and 0 units
of X2.
3. Total contribution margin of optimal mix = (80,000 units
Gearbox Y3) x $10 = $800,000
 How to determine the optimal
product mix with one constrained
12-7 resource and a sales constraint.
Everything is exactly the same as Cornerstone 12-6 with the
addition that only a maximum of 50,000 units of either
gearbox can be sold.
REQUIRED:
1. What is the contribution margin per hour of machine
time per gearbox?
2. What is the optimal mix of gearboxes?
3. What is the total contribution margin for the optimal
mix?
Calculation:
1. This is identical to Cornerstone 12-6 and does not need
to be repeated.
The remainder of the calculations are on the next slides.
 How to determine the optimal
product mix with one constrained
12-7 resource and a sales constraint.
2. Since Gearbox Y3 yields $40 of contribution margin per
hour of machine time, the first priority is to produce all
of Gearbox Y3 that the market will take.
Machine time required to for maximum amount of
Gearbox Y3 = 60,000 x 0.25 = 15,000
Remaining machine time for Gearbox X2 = 20,000 –
15,000 = 5,000 hours
Units of Gearbox X2 to be produced in 5,000 hours =
5,000 / 1 = 5,000 units
Now the optimal mix is 60,000 units of Gearbox Y3 and
5,000 of Gearbox X2. This will precisely exhaust the
machine time available.
 How to determine the optimal
product mix with one
12-7 constrained resource and a sales
constraint.
3. Total contribution
margin of optimal mix
= [(60,000 units Gearbox
Y3) x $10 + (5,000 units
Gearbox X2) x $25] =
$725,000
 How to calculate price by applying
12-8 a markup percentage to cost.
Elvin Company assembles and installs computers to
customer specifications. Elvin had decided to price its
jobs at the cost of direct materials and direct labor plus
20%. The job for a local middle school included the
following costs:
Direct materials $150,000
Direct labor 10,000
REQUIRED: Calculate the price charged by Elvin
Company to the middle school.
Calculation: Price = Cost + Markup Percentage x Cost
= $160,000 + ($160,000 x 20%)
= $160,000 + $32,000
= $192,000
 How to calculate a target
12-9 cost.
Digitime’s new pocket watch plus PDA has a target price
$175. Management requires a 20% profit on new
products.
REQUIRED:
1. Calculate the amount of desired profits.
2. Calculate the target cost.
Calculation:
1. Desired profit = 0.20 x Target price
= 0.20 x $175 = $35
2. Target cost = Target price – Desired profit
= $175 - $35 = $140
 Match Definitions
Ordering The costs of having inventory on
Costs hand
The cost of placing and receiving
Carrying an order of inventory
Costs A mathematical model to
determine how much inventory
Stockout should be ordered and when
Costs The costs of not have a product
available when a customer
EOQ demands it
 How to calculate ordering cost,
carrying cost, & total inventory-
12-10
related cost.
Mall-o-Cars, Inc., sells a number of automotive brands and
provides service after the sale of those brands. Part Z9T
is used in the repair of window switches ( the part is
purchased from external suppliers). Each year 5,000 Z9T
are used; they are currently purchased in lots of 500
units. It costs Mall-o-Cars $25 to place the order and the
carrying cost is $2 per part per year.
REQUIRED:
1. How many orders for Part Z9T are placed per year?
2. What is the total ordering cost of Part Z9T per year?
3. What is the total carrying cost of Part Z9T per year?
4. What is the total cost of Mall-o-Car’s inventory for Part
Z9T per year?
 How to calculate ordering cost,
carrying cost, & total inventory-
12-10
related cost.
Calculation:
1. Number of orders = Annual number of units used /
Number of units in an order
= 5,000 / 500 = 10 orders per year
2. Total order cost = Number of orders x Cost per order
= 10 orders x $25 = $250
3. Total carrying cost = Average number of units in inventory
x Cost of carrying one unit in
inventory
= (500 / 2) x $2 = $500
4. Total inventory-related cost = Total ordering cost + Total
carrying cost
= $250 + $500 = $750
 How to calculate the EOQ, ordering
cost, carrying cost, and total inventory-
12-11 related cost.
Mall-o-Cars, Inc., sells a number of automotive brands and
provides service after the sale of those brands. Part Q6B
is used in the repair of window trim. Each year 20,000
Q6B are used; they are currently purchased in lots of
2,000 units. It costs $40 to place the order and the
carrying cost is $2.50 per part per year.
REQUIRED:
1. What is the EOQ for Part Q6B?
2. How many orders for Part Q6B does Mall-o-Cars place
per year?
3. What is the total ordering cost of Part Q6B per year?
4. What is the total carrying cost of Part Q6B per year?
5. What is the total cost of Mall-o-Car’s inventory for Part
Q6B per year?
 How to calculate ordering cost,
carrying cost, & total inventory-
12-11
related cost.
Calculation:
1. EOQ = (2 x 20,000 x $40 / $2.50).5 = 800 units
2. Number of orders = Annual number of units used /
Number of units in an order
= 20,000 / 800 = 25 orders per year
3. Total order cost = Number of orders x Cost per order
= 25 orders x $40 = $1,000
4. Total carrying cost = Average number of units in inventory
x Cost of carrying one unit in
inventory
= (800 / 2) x $2.50 = $1,000
5. Total inventory-related cost = Total ordering cost + Total
carrying cost= $1,000 + $1,000 = $2,000