Chapter 21-102808 - GOOD READ PDF

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CHAPTER 21 INCREMENTAL ANALYSIS OVERVIEW OF BRIEF EXERCISES, EXERCISES, PROBLEMS, AND CRITICAL THINKING CASES Brief Exercises B. Ex. 21.1 B. Ex. 21.2 B. Ex. 21.3 B. Ex. 21.4 B. Ex. 21.5 B. Ex. 21.6 B. Ex. 21.7 B. Ex. 21.8 B. Ex. 21.9 B. Ex. 21.10

Exercises 21.1 21.2

Topic Using average unit costs Make or buy Joint cost allocation Outsource a product Opportunity costs Identifying costs Allocating productive capacity Match decision and relevant costs/revenues Sell at split-off or process further Scrap or rebuild

21.4 21.5

Topic Accounting terminology Real World: Home Depot Incremental, sunk, and opportunity costs Incremental analysis: Accepting a special order Scarce resources Special order decisions and opportunity costs

21.6 21.7 21.8 21.9 21.10

21.11 21.12 21.13 21.14 21.15

21.3

Learning Objectives 1, 3 2–4 1, 2, 4 2, 4, 5 2 2 4 1, 3, 4 2–4 2–4

Skills Analysis Analysis, judgment Analysis, judgment Analysis, judgment Analysis Analysis, judgment Analysis Analysis Analysis Analysis

Learning Objectives Skills 1–5 Analysis 1, 2 Analysis, communication, judgment 1–3 Analysis 1–4 1–4

Analysis Analysis

Incremental analysis: Make or buy decision Make or buy decision Sunk costs: Scrap or rework decision Scarce resources Joint products

1–4 1–4 1–4 1–4 1–4

Analysis Analysis Analysis Analysis Analysis, communication, judgment

Joint processes: Sell or process further Pricing a special order Evaluating a special order Scarce resources Real World: Home Depot’s charitable contributions

1–4 1–3 1–3 1–5 1–3

Analysis Analysis, judgment Analysis Analysis, judgment Analysis, communication, research

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Problems Sets A, B 21.1 A,B 21.2 A,B 21.3 A,B 21.4 A,B

Topic Evaluating a special order

21.5 A,B 21.6 A,B

Make or buy decision Make or buy decision Determining the most profitable product Given scarce resources Sell or rebuild deficient units Sell or rebuild

21.7 A,B 21.8 A

Joint products Pay off or pay up?

21.8 B

Scarce resources

Critical Thinking Cases 21.1 Factors that limit capacity 21.2

Relevant information and opportunity costs

21.3

Health care costs (Business Week) Real World: Dow Chemical Co. (Internet)

21.4

21. 5

SEC enforcement fines (Ethics, fraud and corporate governance)

Learning Objectives Skills 1–3, 5 Analysis, communication, judgment 1–4 Analysis 1–4 Analysis 1–4 Analysis, communication 1–5 1–5 1–4 1–3, 5 1–5

4 1–3, 5 1–3 3–5

1–3

© The McGraw-Hill Companies, Inc., 2010 CH21-Overview (p.2)

Analysis, communication Analysis, communication, judgment Analysis Analysis, communication, judgment Analysis, communication, judgment

Analysis, communication, judgment Analysis, communication, judgment Analysis, communication, judgment Analysis, communication, judgment, research, technology Analysis, communication, judgment

DESCRIPTIONS OF PROBLEMS AND CRITICAL THINKING CASES Below are brief descriptions of each problem, case, and the first Internet assignment. These descriptions are accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time estimates assume use of the partially filled-in working papers. Problems 21.1 A,B D. Lawrance/F. Scott Use of incremental analysis to determine whether it would be advantageous to accept a large special order at a sales price below average unit cost. Student is also asked to identify other considerations in this type of decision.

25 Easy

21.2 A,B

Crafty Tools/Matchless Corp. Use incremental analysis in a make or buy decision. Includes an assumption that facilities can be put to an alternative productive use.

30 Medium

21.3 A,B

Parsons Plumbing & Heating/James Lighting Use incremental analysis in a make or buy decision. Includes an assumption that facilities can be put to an alternative productive use.

30 Medium

21.4 A,B

Optical Instruments/Superior Instruments Decision regarding which product should be produced when machine hours create a production constraint.

30 Medium

21.5 A,B

BestView/Bold Face Decision of whether older models should be discontinued or upgraded. Involves sunk costs, opportunity costs, and capacity considerations.

25 Medium

21.6 A,B

Silent Sentry/Fire Code Decision of whether gas leak detectors/smoke detectors should be repaired, sold at a discount, or shipped overseas. Also requires students to consider ethical and legal implications of decision.

25 Medium

21.7 A,B

Kelp Company/Green Leaf Company Decision of whether to sell products at the split-off point or to process them further.

25 Medium

© The McGraw-Hill Companies, Inc., 2010 Description of Problems

21.8 A

McKay Chemical Company A chemical company that for years has been engaged in illegal dumping and now is threatened with public exposure. Supurb ethics problem.

35 Strong

21.8 B

Home Run Corporation Direct Labor hours constrain production and there are complementary products.

20 Medium

© The McGraw-Hill Companies, Inc., 2010 Desc. of Problems (p.2)

Critical Thinking Cases 21.1 I Knew That A limiting resource problem that relates this accounting concept to students’ everyday experiences. Students are to develop strategies for maximizing contribution margin in familiar business settings. (We always assign this one.)

35 Medium

21.2

McFriendly Software A short, single-concept problem focusing upon the importance, and also the subjectivity, of opportunity costs.

15 Medium

21.3

Incremental Analysis: Health Savings Accounts Business Week Students identify sunk costs, opportunity costs and incremental costs associated with opening a health savings account. Student also consider ethical issues.

30 Medium

21.4

The Dow Corporation Internet This assignment focuses on the types of incremental decisions that might be made at this firm. In addition, the student is asked to think of qualitative factors that might be considered in the decision-making process.

20 Easy

21.5

SEC Enforcement Fines Ethics, Fraud & Corporate Governance Students consider how the SEC fines policy creates relevant costs that managers may (or may not) consider when thinking about undertaking fraudulent reporting.

20 Medium

© The McGraw-Hill Companies, Inc., 2010 Desc. of Cases

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS 1. The basic characteristic of “relevant” information is that it varies among the alternative courses of action being considered. Information that remains the same under any alternative course of action is not relevant to the decision at hand. 2. Short-run decisions are made with a fixed set of resources and must meet the demands of the current marketplace. There is no time to create demand or acquire a significantly different set of resources. For long-run decisions, plans are created to acquire the resources necessary to create the additional demand and then meet that demand. 3. Incremental costs, defined as the difference in costs between alternative courses of action and incremental revenues, defined as the difference in revenues between alternative courses of action, are compared to each other to determine the incremental profits between alternative actions. If the incremental revenue less the incremental cost of action one is higher than the incremental revenue less the incremental cost of action two, then action one is preferred to action two (all else equal). 4. Opportunity costs are an important factor in decision making; they are costs of taking some action in terms of the value foregone (given up) because that particular action was taken. Because opportunity costs are not recorded in the accounting records and are often difficult to quantify, they are often ignored in making decisions. Failure to consider the potential benefits of alternative actions that cannot be taken because another course of action is selected represents a common error in cost analyses and decision making. 5. A sunk cost is an outlay that has been irrevocably incurred at some time in the past; sunk costs cannot be changed no matter what course of action is taken and are irrelevant for purposes of decisions involving the future. An expenditure of current funds (cash or other liquid resources) is known as an out-of-pocket cost. 6. Nonfinancial questions regarding a special order decision may include (1) Is there excess capacity, or will regular customers have to be turned away? (2) If regular customers are turned away, will they return? (3) Will the special order customer eventually become a regular customer if we fill the order? (4) Will the quality of the special order be of the same quality as our regular products or services? 7. Costs incurred up to the split-off point are sunk costs. These costs will be incurred regardless of the products chosen in the decision-making process. Thus, they should not influence future decisions. 8. These are complementary products. That is, the sale of razors supports the demand for the more profitable razor blades.

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9. When faced with scarce resources, it is often a good strategy to produce those products with the highest contribution margin per unit of scarce resource. Thus, if machine-hours represent a scarce resource, profit can be maximized by producing the products with the highest contribution margins per machine-hour. However, due to the demand for certain products, this strategy isn’t always possible. 10. When thinking about outsourcing the production of a part, Harley-Davidson Motorcycle Company should consider additional factors such as the quality of the part, the reliability and financial stability of the potential outsource companies. In addition, any legal, ethical, or environmental issues that might arise because of the outsourcing should be investigated. 11. When opportunity costs are ignored in a make or buy decision, the resulting decision might be wrong. For example, choosing a supplier with a poor reputation among customers may cause the market share of the product to decline and result in very large opportunity costs. 12. If the Wolvo Company decides to sell the products, it must consider any legal or ethical issues associated with selling a defective product. Scrapping the defective products avoids any legal customer-related complaints, but might create environmental issues that should be considered. If disposing of the product creates hazardous waste, the cost of cleaning the waste will be important. A decision to rebuild the defective products would need to identify the incremental costs and revenues from such an approach in order to compare with the costs associated with either selling the product as is or scrapping the product. 13. Relative sales value is the proportion of the total sales value of all joint products that comes from a single joint product. The relative sales value is used to apportion the total joint costs among the joint products. This method of allocating joint costs splits the cost among the joint products on their ability to bear those costs. That is, those products with higher sales values receive a higher proportion of the joint costs. 14. Opportunity costs are the benefits foregone by not choosing a particular action. They are the costs of choosing to pass up the opportunity to do something different than what was chosen. For example, if a person chooses to attend higher education, then that person foregoes the benefits of

any earnings that could have been obtained by working during the hours they are attending class, doing homework, etc. 15. Sunk costs represent cash flows that have already occurred. No cash flow effects are associated with opportunity costs. These are cash flows that have been given up to choose another course of action. Out-of-pocket costs are planned cash outflows. 16. The contribution margin is important in incremental decision making because the contribution margin is typically the incremental profit that is earned on sales. The contribution margin is important for special order, make or buy, and production constraint decisions.

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17.

Harry Haney is correct in his assessment about how the purchase of new equipment would affect his performance evaluation. Many companies use return on investment (ROI) type measures to evaluate divisional performance. These types of measures encourage managers to keep old equipment with a lower investment base and, as a result, frequently discourage investment in new more efficient equipment. So this is not about sunk costs, this is about how those costs are used to evaluate a manager.

18.

While it is true that traditional accounting systems do not identify opportunity costs, this does not mean they are not important. It is the decision-maker’s job to carefully consider any opportunity costs that are associated with each alternative, quantify those costs if possible, and take those costs into account when doing incremental analysis.

19.

Agree: a company can run the risk of filling up capacity with products and special orders that cover their variable costs, but do not provide enough contribution to cover the total fixed costs. When this happens, the firm is moving out of short-run decision category and needs to consider long-run implications of using those fixed resources in a more productive fashion or selling those fixed resources.

20.

Complementary products are two or more products for which sales of one product contributes to the sales of the other(s). When making decisions about individual products, it is important to understand the impact on all products that are complementary with that product. Thus, if Gillette chose to stop selling its razor blades, it needs to be aware that sales of its razors may also decline.

© The McGraw-Hill Companies, Inc., 2010 Q17-20

SOLUTIONS TO BRIEF EXERCISES B. Ex. 21.1

The first consideration is whether there is idle capacity. Thus, if some regular sales of washing machines at the $180 price are displaced because there is not enough capacity to make 20,000, then the opportunity cost associated with the displaced sales must be included in the incremental analysis. The second consideration is whether $175 covers all the incremental costs associated with accepting the special order. Those incremental costs include all variable costs to make the washing machines plus the opportunity cost of displaced sales and any other costs associated with the special order (e.g. special shipping, etc.). The company will accept the special order if the incremental revenue ($175) is greater than the incremental cost and all other non financial considerations have been taken into account. Notice that the regular selling price of $250 and the average selling price of $180 are not relevant.

B. Ex. 21.2

The incremental cost of a fishing reel is $7.00  $4.00  $11.00. Thus it is more expensive to buy for $12.50 than to produce for the incremental cost of $11.00. Management should not use total average costs (variable plus fixed) in making this decision unless they are sure that the fixed costs can be eliminated.

B. Ex. 21.3

The total sales value of the joint products is  $360,000  $830,000  $1,190,000. The relative sales value of wood chips is $360,000/$1,190,000  30.3% and for fiber board  $830,000/$1,190,000  69.7%. Joint cost allocated to wood chips  30.3% × $420,000  $127,260. Joint cost allocated to fiber board  69.7% ×$420,000  $292,740.

B. Ex. 21.4

The incremental cost to outsource is: ($2.50 - $2.00) × (200 per month × 12 mos.) = $1,200. This is more than offset by the incremental contribution from the alternative use of the space = $3,500. Thus, the net effect of outsourcing is $3,500 - $1,200 = $2,300. Other factors include the reputation for quality service of the outsourcing company and its financial stability.

B. Ex. 21.5

The opportunity cost to choosing to go to the game instead of sell the ticket is $75. It is not the difference between the cost of the ticket and $75 because the cost of the ticket, $50, is sunk when the decision is made.

B. Ex. 21.6

a. b. c. d. e. f.

Out-of-pocket cost Sunk cost Opportunity cost Opportunity cost Sunk cost Out-of-pocket cost

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B. Ex. 21.7

Contribution margin per hour for the cycle class is $15/2 hours = $7.50 and the contribution margin per hour for the combo class is $12/1.5 hours = $8.00. The gym could make 300 hours × $7.50 + 200 hours × $8.00 = $3,850.

B. Ex. 21.8

a. b. c. d. e.

B. Ex. 21.9

Incremental revenue from processing further  $.32 - $.25  $.07 per pound.

g, j f, j f, g, h g, j i

Incremental cost to process further  $90/1500 pounds  $.06 per pound. Yes, the wings should be processed further because the incremental revenue $.07 is larger than the incremental cost $.06. B. Ex. 21.10

The cost of completion to date, $1,693,000 is a sunk cost. The cost to scrap, $30,000, and to rebuild, $450,000, are out-of-pocket and incremental costs. The potential sales price, $500,000 is incremental revenue. Vickery should rebuild the equipment and earn $500,000 - $450,000  $50,000 of contribution.

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SOLUTIONS TO EXERCISES Ex. 21.1

a. b. c. d. e. f. g.

Incremental analysis Sunk cost Relevant information Opportunity cost Joint products Out-of-pocket cost None (This statement does not describe any accounting term.)

Ex. 21.2

Incremental costs associated with remodeling and refreshing Home Depot stores include the costs of labor, materials and overhead associated with the actual physical remodeling process. In addition, design and planning costs would also be incremental. Other incremental costs include regular store employee costs incurred to rearrange and move merchandise during the remodeling effort. Sunk costs related to remodeling stores are the cost of the current store, including decorations, paint, shelves, displays, carpet, and designs that will be replaced during remodeling. Opportunity costs of the remodeling project would be profits on lost sales if the store is closed during remodeling. Also customer traffic may decline during remodeling because of noise, dirt, or the inconvenience caused by the remodeling. Finally, the store may lose profits on sales because they may not be able to stock the full line of products during the remodeling efforts.

Ex. 21.3

a. Average per-unit manufacturing cost at 110,000 units per month: Variable cost per unit ($45 + $25 + $5) …………………………………… $ Fixed manufacturing cost per unit ($1,430,000 ÷ 110,000 units) ………… Average per-unit manufacturing cost …………………………………$ b. Incremental cost per paper feed drive is the product’s unit variable cost ($45 + $25 + $5) $ c. Unit sales price for a $500,000 pretax profit on 20,000 units: Incremental cost per unit (from part b ) ……………………………………$ Required profit per unit ($500,000 ÷20,000 units) ……………………… Unit sales price ………………………………………………………...