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5-1
Short-Term Short-Term Decisions and Decisions and Accounting Accounting InformationInformation
Prepared by Douglas Cloud
Pepperdine University
Prepared by Douglas Cloud
Pepperdine University
55
5-2
Explain why decision making requires information not included in regular accounting reports.
Determine what costs and revenues are relevant to decisions.
Analyze the quantitative factors relevant to typical decisions.
Explain the importance of complementary effects to decisions of a segment of a larger entity.
ObjectivesObjectivesObjectivesObjectives
After reading this After reading this chapter, you should chapter, you should
be able to:be able to:
After reading this After reading this chapter, you should chapter, you should
be able to:be able to:
ContinuedContinuedContinuedContinued
5-3
Identify nonquantitative or long-term considerations that influence short-term decisions.
Describe some of the legal constraints on managers’ decisions.
ObjectivesObjectivesObjectivesObjectives
5-4
The Criterion for Short-The Criterion for Short-term Decisionsterm Decisions
The Criterion for Short-The Criterion for Short-term Decisionsterm Decisions
Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss).
Two SubrulesTwo Subrules
1. The only revenues and costs that are relevant in making decisions are the expected future revenues and costs that will differ among the available choices.
2. Revenues and costs that have already been earned or incurred are irrelevant in making decisions.
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DefinitionsDefinitionsDefinitionsDefinitions
Differential revenues and costs are the expected future
revenues and costs that will differ among
the choices that are available.
Differential revenues and costs are the expected future
revenues and costs that will differ among
the choices that are available.
Incremental revenues and
costsare those
differential revenues and
costs that actually increase.
Incremental revenues and
costsare those
differential revenues and
costs that actually increase.
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Sunk costs are costs that have already been incurred and therefore will be the same no matter which alternative a manager selects.
Examples:– Book value of equipment – Original purchase price of building
DefinitionsDefinitionsDefinitionsDefinitions
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Example: Rental income lost if facility is used for production.
An opportunity cost is the benefit lost by taking one action as opposed to another.
DefinitionsDefinitionsDefinitionsDefinitions
5-8
Important: Short-term Perspective
Typical Short-Term DecisionsTypical Short-Term DecisionsTypical Short-Term DecisionsTypical Short-Term Decisions
Drop a Segment
Make-or-Buy
Joint Product
Special Order
Factors of Limited Supply
5-9
Basic ExampleBasic ExampleBasic ExampleBasic Example
Gloucester Visuals recently manufactured 100 specialized workstation monitors for a customer that has since gone bankrupt. A rival company
has offered to buy the monitors for $12,000. The cost to manufacture the monitors was $17,000.
Should the company accept the offer?
Should the company accept the offer?
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Basic ExampleBasic ExampleBasic ExampleBasic Example
Differential revenues $12,000
Differential costs 0
Differential profit $12,000
Accept the offer!Accept the offer!Accept the offer!Accept the offer!
5-11
Basic ExampleBasic ExampleBasic ExampleBasic Example
A competitor offers to pay $20,000 for the monitors provided that Gloucester disguises the original logo
and makes a few other modifications. The production manager estimated the incremental cost
of the modifications at $6,000.
Third AlternativeThird Alternative
Should the company accept the offer?
Should the company accept the offer?
5-12
Basic ExampleBasic ExampleBasic ExampleBasic Example
Third AlternativeThird Alternative
Differential revenues ($20,000 – $12,000) $8,000
Differential costs ($6,000 – $0) 6,000
Differential profit $2,000
Decision: Make Decision: Make modifications!modifications!
Decision: Make Decision: Make modifications!modifications!
5-13
Basic ExampleBasic ExampleBasic ExampleBasic Example
Comparison of the three methodsComparison of the three methods
Throw Out Monitors
Sell Monitors As Is
Rework and Sell
Incremental revenue $0 $12,000 $20,000
Incremental costs 0 0 (6,000 )
Incremental profit (loss) $0 $12,000 $14,000
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Activity-Based EstimatesActivity-Based Estimates
Using ABC helps managers focus on what
activities change as a result of a decision.
Using ABC helps managers focus on what
activities change as a result of a decision.
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Dropping a Segment Decision
Should Jewelry be eliminated?Should Jewelry be eliminated?
Sales $45,000 $40,000 $15,000$100,000
Variable costs 25,000 18,000 11,000 54,000
Contribution margin $20,000 $22,000 $ 4,000$ 46,000
Fixed costs:
Direct–all avoidable (4,000 ) (3,400 ) (1,500 )(8,900 )
Indirect (common),
allocated on sales (9,450 ) (8,400 ) (3,150 ) (21,000 )
Income (loss) $ 6,550 $10,200 $ (650 )$ 16,100
Clothing Shoes Jewelry Total
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Dropping a Segment DecisionGenco’s analysis shows that dropping jewelry would reduce
common costs by $1,000. If jewelry is dropped, the available space can be rented for $400 per month.
Differential revenues:Lost sales from jewelry $15,000New rent revenue 400Net revenue lost $14,600
Differential costs:Variable costs saved on jewelry $11,000Direct fixed costs saved 1,500Indirect fixed costs saved 1,000Total cost saving 13,500
Differential loss from dropping jewelry $ 1,100
Keep jewelry!Keep jewelry!
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Complementary EffectsComplementary EffectsComplementary EffectsComplementary Effects
Decision: Substitute Music for Jewelry
Differential contribution margin—increase ($12,000 – $4,000) $8,000Differential costs—increase in directfixed costs ($2,700 – $1,500) 1,200Differential profit favoring substitution $6,800
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Complementary EffectsComplementary EffectsComplementary EffectsComplementary Effects
Complementary effects happen when a change in the sale of one product might be accompanied by a change in the sale of another.
Genco’s managers believe that some people coming to shop for music are also likely to buy clothing. After reviewing the results of market studies, the managers estimate that
clothing sales will increase 7 percent if music is substituted for jewelry.
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Complementary EffectsComplementary EffectsComplementary EffectsComplementary Effects
Decision: Substitute Music for Jewelry
Differential contribution margin:Increase due to selling music vs. jewelry $8,000
Increase due to higher clothing sales (7% x $20,000 contribution margin on current sales) 1,400Net Increase in contribution margin $9,400
Differential costs—increase in directfixed costs ($2,700 – $1,500) 1,200Differential profit favoring substitution $8,200
5-20
A loss leader is a special case of complementary effects where a product or line shows a negative profit in the sense that its contribution margin
does not cover its avoidable fixed costs.
Loss LeaderLoss LeaderLoss LeaderLoss Leader
The manager of a local pizzeria prepares the income statement shown on Slide 5-20, based on a normal week, for the 11 a.m. to 2 p.m.
period. All costs are incremental.
5-21
Loss LeaderLoss LeaderLoss LeaderLoss Leader
Pizza Soft Drinks Total
Sales (200 pizzas @ $1.80) $360 $100 $460Variable costs 120 40 160Contribution margin $240 $ 60 $300Wages of part-time
employees 80Income $220
5-22
Loss LeaderLoss LeaderLoss LeaderLoss Leader
Pizza Soft Drinks Total
Sales $ 720 $ 0 $720Variable costs 240a 100b 340Contribution margin $480a $(100) $380Wages of part-time
employees ($80 + $40) 120Income $260
a Variable costs computed at the same rate as before, one-third or 33 1/3% of selling price.b Variable costs computed as two and one-half times the previous costs.
5-23
Assume the following cost data relate to the decision to produce
12,000 units of a product or buy from external source:
Rental of equipment $15,000 $1.25
Equip. depreciation 3,000 .25
Direct materials 12,000 1.00
Direct labor 24,000 2.00
Variable overhead 9,000 .75
Fixed overhead 36,000 3.00
Total $99,000$8.25
The purchase price from an outside vendor is $5.50 per unit.
Make-or-Buy DecisionMake-or-Buy DecisionMake-or-Buy DecisionMake-or-Buy Decision
Total Cost Unit Cost
5-24
Differential
Make BuyCost to Make
Rental of equip. $15,000 ----$15,000
Direct materials 12,000 ----12,000
Direct labor 24,000 ----24,000
Variable overhead 9,000 ----9,000
Purchase cost $66,000$(66,000 )
Relevant costs $60,000 $66,000$(6,000 )
Decision: Manufacture parts in-house
The cost to make is $5.00 per unit.
The price to buy is $5.50 per unit.
Make-or-Buy DecisionMake-or-Buy DecisionMake-or-Buy DecisionMake-or-Buy Decision
5-25
Qualitative issues:
Quality of purchased components
Timely delivery
Potential price increases
Make-or-Buy DecisionMake-or-Buy DecisionMake-or-Buy DecisionMake-or-Buy Decision
5-26
Joint ProductsJoint Products
When a single manufacturing process invariably produces two or more separate products, the products are called joint products.
QBT, a chemical company, operates a joint process that
results in two products. Each 1,000 pounds of material
yields 600 pounds of Alpha and 400 pounds of Omega.
5-27
Alpha Omega
Selling price at split-off $1,200 $1,600
Selling price afteradditional processing $3,600 $2,000
Costs of additionalprocessing, all variable $900 $500
Joint ProductsJoint Products
5-28
AlphaOmega
Differential revenues $2,400$ 400
Differential costs 900 500
Differential profits $1,500$(100)
Joint ProductsJoint Products
Decisions: Process Alpha further and sell Omega at the split-off point
5-29
Special Order ExampleSpecial Order ExampleSpecial Order ExampleSpecial Order Example
Sales (60,000 units) $15 $900,000
Manufacturing costs:
Materials $4 $240,000
Direct labor 3 180,000
Overhead (1/3 variable) 6 360,000
Total $13 780,000
Gross margin $120,000
Selling and admin. expenses 80,000
Operating income $ 40,000
Should the company sell a special on-time order for 20,000 at $10 per unit to a company in a new market?
Per Unit Total
5-30
Differential revenues (20,000 units) $10 $200,000
Differential costs:
Materials $4 $80,000
Direct labor 3 60,000
Variable overhead 2 40,000
Total $9 180,000
Incremental profit favoringacceptance $ 20,000
Special Order ExampleSpecial Order ExampleSpecial Order ExampleSpecial Order ExamplePer Unit Total
Decision: Accept special order
5-31
Differential revenues: : New revenues (20,000 units) $200,000
Lost revenues (5,000 units x $15) (75,000)Total differential revenues $125,000
Differential costs: Costs of special order $180,000
Costs from not making regular sales:Variable manufacturing cost 5,000 x $9 ($4 + $3 + $2) (45,000)
Commissions (5,000 x $0.30) (1,500)Total differential costs 133,500
Differential loss, favoring rejecting order $ (8,500 )
Special Order ExampleSpecial Order ExampleSpecial Order ExampleSpecial Order Example
5-32
Resource ConstraintResource ConstraintResource ConstraintResource Constraint
Selling price $10 $6Variable cost 6 4Contribution margin $ 4 $2Number of units that
can be made per MH 60 150
Drive Chip Modem Chip
Which product should be processed assuming only 100 machine hours are available?
5-33
Number of units thatcan be made per MH 60 150
Contribution margin per unit x $4 x $2
Contribution margin per
machine hour $240 $300
Resource ConstraintResource ConstraintResource ConstraintResource Constraint
Drive Chip Modem Chip
Decision: Produce modem chips
5-34
Decision Making Under Environmental ConstraintsDecision Making Under
Environmental Constraints
Antitrust laws forbid actions that might substantially reduce competition.
Anti-dumping laws address aspects of unfair competition in international trade.
5-35
The Sherman Act, Clayton Act, Robinson-Patman Act, and the statutes of many states prohibit predatory pricing.
Predatory pricing is pricing below cost in the short term to drive competitors out of business and eventually to raise prices.
Decision Making Under Environmental ConstraintsDecision Making Under
Environmental Constraints
5-36
The Robinson-Patman Act forbids charging different prices to different customers unless there are intrinsic cost differences in serving the different customers; in other words, this act forbids discriminatory pricing.The Federal Trade Commission (FTC) is the regulatory agency responsible for enforcing the act.
Decision Making Under Environmental ConstraintsDecision Making Under
Environmental Constraints
5-37
Anti-dumping laws prevent unfair competitive practices in international trade by prohibiting a company in one country from selling its products in another country at less than fair value.
The International Trade Administration, part of the Commerce Department, deals with charges of dumping in the United States.
Decision Making Under Environmental ConstraintsDecision Making Under
Environmental Constraints
5-38
The EndThe End
Chapter 5Chapter 5
5-39