Note 4 - Notes PDF

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DIFFERENTIAL A NAL YSISMaking decisions is an important management function. Management’s decision- making process does not always follow a set pattern because decisions vary significantly in their scope, urgency and importance. The steps in management’s decision-making process are: Identify the pro...

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DIFFERENTIAL ANAL ANALYSIS YSIS Making decisions is an important management function. Management’s decisionmaking process does not always follow a set pattern because decisions vary significantly in their scope, urgency and importance. The steps in management’s decision-making process are: 1. Identify the problem and assign responsibility. 2. Determine and evaluate possible courses of action. 3. Make a decision. 4. Review results of the decision. Accounting’s contribution to the decision-making process occurs primarily in Steps 2 and 4. In Step 2, for each possible course of action, relevant revenue and cost data are provided. These show the expected overall effect on net income. In Step 4, internal reports are prepared that review the actual impact of the decision, which reports usually contain financial data of actual revenue and cost (through performance reports, for example). Decisions are made in all phases of organizational activities. Decisions may be strategic, tactical, or operational. Strategic decisions have long-term effects, its focus is growth and stability, it uses capital budgeting as management accounting tool or technique and it is concerned of meeting the needs of investors. Tactical decisions are made regularly, with medium-term effects in the organizational activities and outcome, its focus is profitability and liquidity, it uses the management accounting tools or techniques of standard costing, responsibility accounting, budgeting, CVP analysis and incremental or differential analysis, and it is concerned with customer’s satisfaction. Operational decisions are made on a daily basis where the judgment call of a supervisor is at its greatest use. In making business decisions, management ordinarily considers both financial and nonfinancial information. Financial information is related to revenues and costs and their effect on the company’s overall profitability. Nonfinancial information relates to such factors as the effect of the decision on employees’ turnover, the environment, or the overall image of the company in the community. Nonfinancial information can be as important as the financial information in making decisions. Decisions involve a choice among alternative courses of action. Differential analysis uses relevant revenues and costs to make decisions. It is the result of defining a decision rule and quantifying and formatting relevant information. Differential analysis contrasts choices by comparing incremental contribution margins. Two commonly used approaches are applicable to all decision types---the incremental analysis approach and the total analysis approach. The incremental analysis approach includes only incremental revenues and costs of each choice, while total analysis approach shows the results for the total entity, including the alternative and then, excluding the alternative. The process used to identify the financial data that change under alternative

courses of action is called incremental analysis. When using incremental analysis, in some cases, both revenues and costs will vary, while in other cases, only revenues or costs will vary. Incremental profit is the difference between the relevant/incremental revenues and the relevant/incremental costs of each choice. Re Relevant levant revenues and

costs are defined as the current and future values that differ among the choices considered. In most cases, the term “incremental” is used as a substitute for “relevant”. In choosing among choices, all past and committed costs (often referred to as sunk costs costs) and all costs that remain the same across all choices are irrelevant and are ignored. Relevant revenues are often assumed to be cash inflows, and relevant costs are cash outflows. OutOut-of of of-pocket -pocket costs refer to costs that are cash outflows. Another relevant factor in making decision is the opportunity cost of using capacity (if there is any).

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Key cost concepts used in incremental analysis: Relevant cost - are those costs that differ across alternatives. Relevant costs have two features --- diff differential erential and future-oriented future-oriented. If a cost differs from one option to another, that cost is differential which may be incremental (if cost is increasing) or decremental (if cost is decreasing) in nature. Future costs are referred to as planned costs, budgeted costs, projected costs, or estimated costs. Future costs are yet to be incurred in upcoming or future activities. Opportunity cost - The lost benefit or the opportunity given up to benefit from some other course of action. Sunk cost - costs that have already been incurred and will not be changed or avoided by any future decision. Sunk costs are not relevant costs.

“MAKE OR BUY A PRODUCT” DATA ANALYSIS FORMAT OF THE ‘MAKE’ OR ‘BUY’ DECISION: ‘MAKE’ Costs/Costs to ‘MAKE’: Materials and direct labor Variable overhead costs Avoidable fixed overhead costs Opportunity costs of additional resources needed TOTAL RELEVANT COSTS TO “MAKE”

xxx xxx xxx _xxx XXXX

‘BUY’ Costs/Costs to ‘BUY’: Purchase cost xxx Handling costs xxx Incremental revenue or earnings from use of released resources (xxx) Savings in buying the part/product (xxx) TOTAL RELEVANT COSTS TO “BUY” XXXX In deciding to make or buy a part or product, the total relevant costs of each option should be taken. Whichever option gives a low relevant cost (resulting to a net advantage or savings compared to the one with a high relevant cost) would be a better alternative, assuming no other quantitative and qualitative factors are to be considered. SAMPLE PROBLEM 1: Sharp Corp. has bids from several suppliers for a control device, a unit used in

several models of its Hibeam Line of lighting features. Sharp made these devices for the past several years and needs 30,000 units for this year’s production requirements. Walker Wiring returned the most attractive bid at $3 per unit delivered. Quality control

inspections of purchased units would cost Sharp $3,000. Sharp’s costs for 25,000 units last year were: Per Unit Total Costs Materials $ 1.25 $ 31,250 Direct labor .60 15,000 Variable overhead .50 12,500 Fixed overhead applied 1.00 25,000 Total $ 3.35 $ 83,750 All costs are direct costs, except fixed factory overhead. The only direct and avoidable fixed factory overhead is $6,000, the cost of leasing specialized equipment required to make the control device. If the device is purchased, Sharp could return the specialized equipment, void the lease, and use the space for storage. Renting storage space would cost $4,000 next year. Will Sharp make or buy the unit? Why?

SAMPLE PROBLEM 2: Toblerone Corp. manufactures Part X-24 for use in its production cycle. The cost per unit for 10,000 units of Part X-24 are as follows: Direct materials P 6.00 Materials handling costs (20%) 1.20 Direct labor 20.00 Variable overhead 5.00 Fixed overhead 11.00 Total P 43.20 Ferrero Co. has offered to sell Toblerone Corp. 10,000 units of Part X-24 for P40 per unit. If Toblerone accepts Ferrero’s offer, P4 of the fixed overhead per unit could be eliminated. The materials handling costs pertain to the cost of receiving and inspecting incoming materials and other components which are not included in the overhead. If the Part is outsourced from an outside supplier, one-half of the released facilities could be used to produce a new product, Citrus, which is expected to generate a contribution margin of P90,000 per year. Additionally, a saving of P15,000 is expected if the Parts are purchased outside. The other half of the released facilities could be rented out for P60,000 per annum. The outside supplier requires that an equipment be leased to meet the order of the Company. The equipment rental cost of P80,000 shall be charged to the Company. What alternative is better, make or buy the Part, and by how much is its advantage?

SOLUTIONS TO THE SAMPLE PROBLEMS SHARP: Materials ($1.25 x 30,000) Direct labor ($0.60 x 30,000) Variable overhead ($0.50 x 30,000) Equipment lease cost/avoidable fixed overhead Purchase price ($3 x 30,000) Quality control costs Rent on storage space

Costs to MAKE $ 37,500 18,000 15,000 6,000

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Costs to BUY

----$ 90,000 3,000 _(4,000)

TOTAL RELEVANT COSTS NET ADV ADVANT ANT ANTAGE/SA AGE/SA AGE/SAVINGS VINGS TO “MAKE”

$ 76,500 $ 12,500

$ 89,000

TOBLERONE: Direct materials (P6 x 10,000) Direct labor (P20 x 10,000) Variable overhead (P5 x 10,000) Avoidable fixed overhead (P4 x 10,000) Materials handling costs: To make (P60,000 x 20%) P12,000 To buy (P400,000 x 20%) 80,000 Purchase price (P40 x 10,000) Additional savings if the part is bought Rental income from released facilities Contribution margin from a new product, Citrus Rental of equipment if the part is bought TOTAL RELEVANT COSTS NET ADV ADVANT ANT ANTAGE/SA AGE/SA AGE/SAVINGS VINGS TO “MAKE”

Costs to MAKE P 60,000 200,000 50,000 40,000

Costs to BUY

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________ P 350,000 P33,000

P 68,000 400,000 (15,000) (60,000) (90,000) __80,000 P 383,000

“ACCEPT OR REJEC REJECT T A SPECIAL ORDER ORDER”” DATA ANALYSIS FORMAT OF THE ‘ACCEPT’ OR ‘REJECT’ DECISION: Incremental revenue Incremental costs: Additional variable costs Additional direct fixed costs INCREMENTAL PROFIT/(DECREMENTAL PROFIT)

xxx (xxx) (xxx) XXXX

SAMPLE PROBLEM 1: North Comm’s capacity is 90,000 units of a cellular phone receiver, including 15,000 units made on overtime. North Comm is currently producing and selling 80,000 units per year at $8 per unit. Variable production costs are $3 per unit, and annual fixed factory overhead costs are $200,000. Variable shipping costs are $0.50 per unit. All administrative expenses are $120,000 and fixed. The profit calculation is as follows: Sales (80,000 units x $8) Less: Factory and shipping costs: Variable (80,000 units x $3.50) Fixed overhead Gross profit Less: Administrative expenses Net Income

$ 640,000 $ 280,000 200,000

480,000 160,000 120,000 $ 40,000

A communications company approaches North Comm with an offer to buy 10,000 receivers at $6 each. Sales to that company will not affect North Comm’s regular sales. The special units would require minor modifications and force more overtime, adding $0.80 per unit to variable costs. Additional supervision would cost $3,000. The entire

lot would be packed and shipped for $2,000. Will North Comm accept or reject the special order? Why?

SAMPLE PROBLEM 2: The manufacturing capacity of NorthWind Corporation’s facilities is 50,000 units of product a year. A summary of operating results for the year end December 31 of last year is as follows: Total Per Unit Sales (38,000 units) P 3,800,000 P 100.00 Less: Variable costs and expenses 2,090,000 55.00 Contribution margin P 1,710,000 P 45.00 Less: Fixed costs and expenses 900,000 Operating Income P 810,000 A distributor company has offered to buy 12,000 units at P90 per unit during this year. All of the Corporation’s costs would be at the same levels and rates for this year as that of last year. Should NorthWind Corp. accept or reject the special sales order? Consider the following cases independently: 1. The corporation has no alternative use of the idle capacity. 2. The corporation can rent out the idle capacity for P200,000. 3. The corporation can use the idle capacity to produce a new product that could give a P600,000 contribution margin. 4. If the special order is accepted, 2,000 units of regular sales are expected to be lost. 5. Assuming a distributor has ordered 16,000 units and the corporation has to sacrifice some of its regular customers to accommodate the special order.

SOLUTIONS TO THE SAMPLE PROBLEMS NORTH COMM: Incremental sales revenue ($6 x 10,000 units) Incremental costs: Incremental variable production costs ($3 x 10,000) Additional variable factory costs-overtime ($0.80 x 10,000) Additional supervision costs Packing and shipping costs INCREMENT INCREMENTAL AL PROFIT ON THE SPECIAL ORDER NORTHWIND: 1. Incremental sales revenue (P90 x 12,000 units) Incremental costs-Variable costs & expenses (P55 x 12,000 units) INCREMENT INCREMENTAL AL PROFIT TO ACCEPT SPECIAL ORDER 2. Incremental profit/contribution margin on the special order (P90-P55=P35) x 12,000 units Rent income if the facility is rented out-opportunity cost NET ADV ADVANT ANT ANTAGE AGE OF ACCEPTING the special order

$ 60,000 (30,000) (8,000) (3,000) __(2,000) $ 17 17,000 ,000

P 1,080,000 ___660,000 P 420,000

P 420,000 _(200,000) P 220,000...