Make Buy Special Order Lecture Notes PDF

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this helps you to do buy and sell and much more. by Mrs. Sterling...

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UNIVERSITY OF TECHNOLOGY SCHOOL OF BUSINESS ADMINISTRATION MAKE OR BUY/SPECIAL ORDER LECTURE Learning Objectives Students should be able to: 1. 2. 3. 4. 5.

distinguish between relevant and irrelevant information using appropriate criteria. explain the use of incremental and opportunity costs in decision-making apply relevant costing principles to make or buy sourcing decisions. apply relevant costing principles to special order decisions. specify the qualitative factors which are relevant to make or buy and special order decisions.

Relevant Costs in Nonroutine Decisions TYPES OF NONROUTINE DECISIONS When performing the manufacturing and selling functions, management is constantly faced with the problem of choosing between alternative courses of action. Typical questions to be answered include: What to make? How to make it? Where to sell the product? and What price should be charged? In the short run, management is typically faced with the following non- routine, nonrecurring types of decisions: 1

Acceptance or rejection of a special order

2.

Pricing standard products

3.

Make or buy

4.

Sell or process further

5.

Add or drop a certain product line

6.

Utilization of scarce resources(limiting factor)

RELEVANT COSTS DEFINED In each of the above situations, the ultimate management decision rests on cost data analysis. Cost data are important in many decisions, since they are the basis for profit calculations. Cost data are classified by function, behavior patterns, and other criteria. However, not all costs are of equal importance in decision making, and managers must identify the costs that are relevant to a decision. Such costs are called relevant costs. The relevant costs are the expected future costs (and also revenues) which differ between the decision alternatives. Therefore, the sunk costs (past and historical costs) are not considered relevant in the decision at hand. What is relevant are the incremental or differential costs. Under the concept of relevant costs, which may be appropriately titled the incremental, differential, or relevant cost approach, the decision involves the following steps: 1.

Gather all costs associated with each alternative.

2.

Drop the sunk costs.

3.

Drop those costs which do not differ between alternatives.

4.

Select the best alternative based on the remaining cost data.

EXAMPLE 1. To illustrate the irrelevance of sunk costs and the relevance of incremental costs, let us consider a replacement decision problem. A company owns a milling machine that was purchased three years ago for $25,000. Its present book value is $17,500. The company is contemplating replacing this machine with a new one which will cost $50,000 and have a five-year useful life. The new machine will generate the same amount of revenue as the old one but will substantially cut down on variable operating costs. Annual sales and operating costs of the present machine and the proposed replacement are based on normal sales volume of 20,000 units and are estimated as follows:

Sales

Present Machine

New Machine

$60,000

$60,000

Variable costs Fixed costs: Depreciation (straight-line) Insurance, taxes, etc. Net income

35,000

20,000

2,500 4,000 $18,500

10,000 4,000 $26,000

2

At first glance, it appears that the new machine provides an increase in net income of $7,500 per year. The book value of the present machine, however, is a sunk cost and is irrelevant in this decision. Furthermore, sales and fixed costs such as insurance, taxes, etc., also are irrelevant since they do not differ between the two alternatives being considered. Eliminating all the irrelevant costs leaves us with only the incremental costs, as follows: Savings in variable costs Less: Increase in fixed costs Net annual cash savings arising from the new machine

$15,000 $10,000 (exclusive of $2,500 sunk costs) $ 5,000

OTHER DECISION-MAKING APPROACHES-TOTAL PROJECT AND OPPORTUNITY COST APPROACHES The same decision can be obtained by using the total project approach (or comparative statement approach), which looks at all the items of revenue and cost data (whether they are relevant or not) under the two alternatives and compares the net income results. Under this approach, however, comparatively income statements are prepared in a contribution format. EXAMPLE 2 The total project approach to Example 1 would be shown as follows:

Sales Less: Variable costs Contribution margin Less: Fixed costs Depreciation Other Net income

Present Machine $60,000 35,000 $25,000 4,000 $21,000

New Machine $60,000 20,000 $40,000 $10,000 4,000 $26,000

Increment (or Difference) $(15,000) $ 15,000 $ 10,000 $ 5,000

The total project approach's schedule shows an increase in net income of $5,000 with the purchase of the new milling machine. [This example is discussed only to show the irrelevance of certain items in a replacement decision problem. The real decision to be made is whether this increase in net income (or savings) is enough to justify an additional investment of $50,000 in new machinery. This question should be answered using the concepts of return on investment and time value of the money.] Besides the incremental approach and the total project approach, the concept of opportunity costs can be applied to solve a short-term, non-routine decision problem. The approach is hereafter called the opportunity cost approach. An opportunity cost is the net revenue lost by rejecting some alternative course of action. Its significance in decision making is that the best decision is always sought since it considers the cost of the best available alternative not taken. The opportunity cost does not appear on formal accounting statements. EXAMPLE 3

In Example 1, using the opportunity cost approach, the new machine alternative can be analyzed as follows: New Machine Net income expected $26,000 Less: Opportunity cost of not keeping the old machine 21,000 ($60,000 - $35,000 - $4,000) Difference in favor of buying the new machine $ 5,000

The opportunity cost in this example is the $2 1,000 net income from the old machine given up. The opportunity cost approach is most effective when there are excessive alternatives available that are too numerous to consider on the total project approach's schedule. PRICING SPECIAL ORDERS A company often receives a short-term, special order for its products at lower prices than usual. In normal times, the company may refuse such an order since it will not yield a satisfactory profit. If times are bad, however, such an order should be accepted if the incremental revenue obtained from it exceeds the incremental costs involved. The company is better off to receive some revenue, above its incremental costs, than to receive nothing at all. Such a price, one lower than the regular price, is called a contribution price. This approach to pricing is often called the contribution approach to pricing or the variable pricing model. This approach is most appropriate under the following conditions: 1.

When operating in a distress situation

2.

When there is idle capacity

3.

When faced with sharp competition or in a competitive bidding situation...