16-1 CHAPTER 16 Cost Analysis for Decision Making McGraw-Hill/Irwin © 2008 The McGraw-Hill...

16-1

CHAPTER 16

Cost Analysis for Decision Making

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

16-2

Decision Making

Strategic, Operational,and Financial (Planning)

Planning and Control Cycle

Executing operational

activities (Managing)

Data collection and Performance Feedback

Performance analysis: Plans vs.

actual results (Controlling)

L O 1

Implement Plans

Rev

isit

Plan

s

16-3

A relevant costrelevant cost is a future cost that differs between alternatives.

1 2

Relevant Cost InformationL O 1

16-4

Relevant Cost Information

Relevant IrrelevantDifferential Cost -- will differ Allocated Cost -- a common cost thataccording to alternative activities has been arbitrarily assigned to abeing considered. product or activity.

Opportunity Cost -- income foregone Sunk Cost -- has already been incurredby choosing one alternative over and will not change.another.

L O 1

16-5

Example: If you were notattending college, you couldbe earning $20,000 per year. Your opportunity cost ofattending college for oneyear is $20,000.

Opportunity costs are not recorded in the accounting records, but are relevant to

decisions because they are a real sacrifice.

Opportunity CostL O 1

16-6

Will you drive or fly to Colorado for a spring break ski trip? You have gathered the following information to help you with

the decision. Motel cost is $90 per night. Meal cost is $25 per day. Your car insurance is $75 per month. Kennel cost for your dog is $7 per day. Round-trip cost of gasoline for your car is $200. Round-trip airfare and rental car for a week is $700.

Driving requires two days, with an overnight stay, cutting your time in Colorado by two days.


16-7

Colorado Spring BreakDrive/Fly Analysis

Cost Drive FlyMotel 720$ 720$ Meals 200 200 Kennel cost 56 56 Car insurance 75 75 Gasoline 200 - Airfare/rental car - 700

8 days @ $90

8 days @ $25

8 days @ $7


16-8

Costs do not differ,so they are not

relevant to decision.

Also, car insuranceis not relevant tothe decision as itis a sunk cost.


16-9

Transportationcosts differ betweenthe two alternatives,so they are relevant

to your decision.

Are the two extradays in Coloradoworth the $500

extra cost to fly?

Colorado Spring BreakDrive/Fly Analysis

Cost Drive FlyMotel 720$ 720$ Meals 200 200 Kennel cost 56 56 Car insurance 75 75 Gasoline 200 - Airfare/rental car - 700


16-10

The decision to accept additional business should be based on incremental

costs and incremental revenues. Incremental amounts are those amounts

that occur if the company decides to accept the new business.

The Special Pricing DecisionL O 3

16-11

MicroTech currently sells 4,400 laptopcomputers. The company has revenue

and expenses as shown below: Per Unit Total

Sales 2,400$ 10,560,000$ Direct materials 800$ 3,520,000$ Direct labor 450 1,980,000 Variable overhead 250 1,100,000 Fixed overhead 500 2,500,000 Total manufacturing costs 2,000$ 9,100,000$ Sales commission 120 528,000 Total expenses 2,120$ 9,628,000$ Operating income 280$ 932,000$

The Special Pricing Decision

Based on capacity of 5,000 units:$2,500,000 ÷ 5,000 units = $500 per unit.

L O 3

16-12

MicroTech receives an offer to purchase500 of its laptop computers for $1,800 each.

If MicroTech accepts the offer, total fixed overhead will not increase and a selling

commission will not be paid on the computers in the special order.

Should MicroTech accept the offer?


16-13

First let’s look at incorrect reasoningthat leads to an incorrect decision.

Our manufacturing costis $2,000 per unit. Ican’t sell for $1,800

per unit.


16-14

Current Business

Special Order

Combined

Sales 10,560$ 900$ 11,460$ Direct materials 3,520$ 400$ 3,920$ Direct labor 1,980 225 2,205 Variable overhead 1,100 125 1,225 Fixed overhead 2,500 0 2,500 Total manufacturing costs 9,100$ 750$ 9,850$ Sales commission 528 0 528 Total expenses 9,628$ 750$ 10,378$ Operating income 932$ 150$ 1,082$

This analysis leads to the correct decision.


000’s omitted from all numbers.

L O 3

16-15

Current Business

Special Order

Combined



500 new units × $800 = $400,000

500 new units × $1,800 selling price = $900,000

L O 3

16-16

Current Business

Special Order

Combined


500 new units × $450 = $225,000


500 new units × $250 = $125,000

L O 3

16-17

Current Business

Special Order

Combined


Even though the $1,800 selling price is less than thenormal $2,400 selling price, MicroTech should accept the

offer because net income will increase by $150,000.


16-18

If MicroTech accepts the offer, netincome will increase by $150,000.

Increase in revenue (500 × $1,800) $900,000Increase in variable costs (500 × $1,500) (750,000)Increase in operating income $150,000

We can reach the same results more quickly like this:

Special order contribution margin = $1,800 – $1,500 = $300 Change in income = $300 × 500 units = $150,000.


16-19

Should Icontinue to make

the part, or shouldI buy it?

What will I do with my

idle facilities ifI buy the part?

The Make or Buy DecisionL O 3

16-20

The Make or Buy Decision

The relevant cost of making a component is the cost that can be avoided by buying the component from an outside supplier.

Decision rule: Costs avoided must be greater than outside supplier’s price to consider buying the component.

L O 3

16-21

MicroTech currently makes the motherboardsused in its laptop computers. Unit costs for

manufacturing the motherboards are:

Unit CostsDirect Material 120$ Direct Labor 80 Variable Overhead 50 Fixed Overhead 100 Total 350$


16-22

An outside supplier has offered to provide the motherboards at a cost of $300 each plus a $5

shipping charge per motherboard. Twenty percent of the fixed overhead will be avoided if the

motherboards are purchased. MicroTech has no alternative use for the facilities.

Should MicroTech accept the offer?


16-23

Unit CostDirect Material 120$ Direct Labor 80 Variable Overhead 50 Fixed Overhead (20% of $100) 20 Total 270$

Differential costs of making (costs avoided if bought from outside supplier):

The Make or Buy Decision

MicroTech should not pay $305 per unit to an outside supplier to avoid the $270 per unit differential cost of

making the part ($35 disadvantage).

L O 3

16-24

If MicroTech buys the motherboards from the outside supplier, the idle facilities

could be used to expand production of flat screen monitors that have a contribution margin of $50 each.

Does this information change MicroTech’s decision?


16-25

The real question to answer is: “What is the best use of MicroTech’s facilities?”

Disadvantage of buying ( $305 - $270 ) 35$ Opportunity cost of facilities: Monitor contribution margin 50 Advantage of buying part 15$

The opportunity cost of facilities changes the decision.


16-26

Continue or Discontinue a Segment

Total Company

Sailboat Division

Motorboat Division

Repair Parts

DivisionSales 2,240,000$ 1,280,000$ 640,000$ 320,000$ Variable expenses 960,000 512,000 288,000 160,000 Contribution Margin 1,280,000 768,000 352,000 160,000 Fixed expenses 1,128,000 656,000 288,000 184,000 Operating income 152,000$ 112,000$ 64,000$ (24,000)$

CRUISERS, INC.CRUISERS, INC.Segmented Income StatementSegmented Income Statement

For the Year Ended December 31stFor the Year Ended December 31stDiscontinue the Discontinue the

Repair Parts Repair Parts Division and Division and

increase increase operating income operating income

by $24,000by $24,000

L O 3

16-27

Continue or Discontinue a SegmentL O 3

What about What about fixed fixed

expenses?expenses?Total

CompanySailboat Division

Motorboat Division

Repair Parts

DivisionDirect fixed Expenses 680,000$ 400,000$ 160,000$ 120,000$ Common fixed expensesallocated in proportionto sales 448,000 256,000 128,000 64,000 Total fixed expenses 1,128,000$ 656,000$ 288,000$ 184,000$

Analysis of Fixed Expenses

16-28

Continue or Discontinue a Segment

We must eliminate more in fixed expenses than theWe must eliminate more in fixed expenses than the amount of contribution margin we are losing. amount of contribution margin we are losing.

L O 3

Decrease in Contribution Margin (160,000) Direct fixed expenses (Repair Parts Division) 120,000Net decrease in contribution margin (40,000)$

Relevant Cost Analysisof Discontinuing the Repair Parts Division

Closing the Repair Parts Division will eliminate:Closing the Repair Parts Division will eliminate:

SalesSales $320,000$320,000Variable ExpensesVariable Expenses 160,000160,000Contribution MarginContribution Margin 160,000 160,000

16-29

Continue or Discontinue a SegmentL O 3

Total Company

Sailboat Division

Motorboat Division

Repair Parts

DivisionSales 2,240,000$ 1,280,000$ 640,000$ 320,000$ Variable expenses 960,000 512,000 288,000 160,000 Contribution Margin 1,280,000 768,000 352,000 160,000 Fixed expenses 1,128,000 656,000 288,000 184,000 Operating income 152,000$ 112,000$ 64,000$ (24,000)$

Sales 1,920,000$ 1,280,000$ 640,000$ Variable expenses 800,000$ 512,000 288,000 Contribution Margin 1,120,000$ 768,000 352,000 Fixed expenses 1,008,000$ 698,667 309,333 Operating income 112,000$ 69,333$ 42,667$

Operating IncomeOperating IncomeDecreases by Decreases by $40,000 if we$40,000 if we

discontinue thediscontinue theRepair PartsRepair Parts

Division.Division.

Operating Income with Repair Parts DivisionOperating Income with Repair Parts Division $152, 000$152, 000Operating Income without Repair Parts DivisionOperating Income without Repair Parts Division (112,000)(112,000)Decrease in Operating IncomeDecrease in Operating Income $ 40,000$ 40,000

16-30

Managers often face the problem of deciding how scarce resources are going to be utilized.

Usually, fixed costs are not affected by this particular decision, so management can focus

on maximizing total contribution margin.

Short-Term Allocationof Scarce Resources

L O 3

16-31

Integrated Technologies produces two productsand selected data are shown below:

Products 1 2

Selling price per unit $ 300 $ 200 Less: variable expenses per unit 150 100 Contribution margin per unit 150$ 100$

Processing time required (hours) 2 1


If 120 hours of processing time are available,which product should be produced?

L O 3

16-32

Let’s calculate the contribution marginper hour of processing time.

Products1 2

Contribution margin per unit $ 150 $ 100 Time required to produce one unit ÷ 2 hours ÷ 1 hourContribution margin per hour 75$ 100$


L O 3

16-33


Products1 2



Product 2 should be emphasized. It is the more valuable use of processing time, yielding a contribution margin of $100 per hour as opposed to $75 per hour

for Product 1.

L O 3

16-34


Products1 2



If there are no other considerations, the best plan would be to produce enough products to meet current demand

for Product 2 and then use of any remaining time to make Product 1.

L O 3

16-35

Let’s change topics.

Long-Run Investment DecisionsL O 4

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Capital Budgeting

Managers must plan significant outlays for projects that have long-term implications such as the purchase of new equipment

and introduction of new products.

L O 4

16-37

Capital budgeting:Analyzing alternative long-

term investments and deciding which assets to acquire or sell.

Outcomeis uncertain.

Large amounts ofmoney are usually

involved.

Investment involves along-term commitment.

Decision may bedifficult or impossible

to reverse.

Capital BudgetingL O 4

16-38

?

?

?

LimitedInvestment

Funds

PlantExpansion

NewEquipment

OfficeRenovation

I will choose theproject with the mostprofitable return on

available funds.

Investment Decision Special Considerations

L O 4

16-39

• Business investments extend over long periods of time, so we must recognize the time value of money.

• Investments that promise returns earlier in time are preferable to those that promise returns later in time.

Investment Decision Special Considerations

L O 5

16-40

• The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate used to calculate the present value of the investment proposal being analyzed.

• The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.

Cost of CapitalL O 6

16-41

Capital Budgeting Techniques

Methods that use present value analysis:• Net present value (NPV).• Internal rate of return (IRR).

Methods that do not use present value analysis:• Payback.• Accounting rate of return.

L O 6

16-42

A comparison of the present value of cash inflows with the present value of

cash outflows

Net Present Value (NPV)L O 7

16-43

Chose a discount rate – the minimum required rate of return.

Calculate the presentvalue of cash inflows.

Calculate the presentvalue of cash outflows.

NPV = –


16-44

General decision rule . . .

If the Net Present Value is . . . Then the Project is . . .

Positive . . . Acceptable, since it promises a return greater than the cost of

capital.

Zero . . . Acceptable, since it promises a

return equal to the cost of capital.

Negative . . . Not acceptable, since it

promises a return less than the cost of capital.


16-45

BoxMover, Inc. is considering the purchase of a conveyor costing $16,000 with a 7-year useful life and a $5,000 salvage value.

Annual net cash flows are shown in the following table. BoxMover’s cost of capital is 12 percent. Ignoring taxes, compute the NPV for this investment.

Net Present ValueL O 7

16-46

YearAnnual Net Cash Flows

Present Value of $1

Factor

Present Value of

Cash Flows1 $4,000 0.8929 $3,5712 $4,200 0.7972 $3,3483 $4,200 0.7118 $2,9894 $4,400 0.6355 $2,7965 $4,800 0.5674 $2,7246 $4,000 0.5066 $2,0277 $3,800 0.4523 $1,719

Salvage $5,000 0.4523 $2,262Total $34,400 $21,436Amount to be invested ($16,000)Net present value of investment $5,436


16-47


Present Value of $1

Factor

Present Value of

Cash Flows1 4,000$ 0.8929 $3,5712 4,200$ 0.7972 $3,3483 4,200$ 0.7118 $2,9894 4,400$ 0.6355 $2,7965 4,800$ 0.5674 $2,7246 4,000$ 0.5066 $2,0277 3,800$ 0.4523 $1,719

salvage 5,000$ 0.4523 $2,262Total 34,400$ $21,436Amount to be invested -$16,000Net present value of investment $5,436

Present value factorsfor 12 percent


16-48


Present Value of $1

Factor

Present Value of

Cash Flows1 4,000$ 0.8929 3,571$ 2 4,200 0.7972 3,348 3 4,200 0.7118 2,989 4 4,400 0.6355 2,796 5 4,800 0.5674 2,724 6 4,000 0.5066 2,027 7 3,800 0.4523 1,719

salvage 5,000 0.4523 2,262 Total 34,400$ 21,436$ Amount to be invested (16,000) Net present value of investment 5,436$

A positive net present value indicates that thisproject earns more than 12 percent, so the

investment should be made.


16-49

Brown Company can buy a new machine for $96,000 that will save $20,000 cash per year in

operating costs. If the machine has a useful life of 10 years and Brown’s cost of capital return is 12

percent, what is the NPV? Ignore taxes.

a. $ 4,300b. $12,700c. $11,000d. $17,004


16-50

Brown Company can buy a new machine for $96,000 that will save $20,000 cash per year in

operating costs. If the machine has a useful life of 10 years and Brown’s cost of capital return is 12

percent, what is the NPV? Ignore taxes.

a. $ 4,300b. $12,700c. $11,000d. $17,004

Using the present value of an annuity

PV of inflows = $20,000 × 5.6502 = $113,004

NPV = $113,004 - $96,000 = $17,004


16-51

Calculate the NPV if Brown Company’s cost of capital is 14 percent instead of 12 percent.

Note that the NPV is smallerusing the larger interest rate.

Using the present value of an annuity

PV of inflows = $20,000 × 5.2161 = $104,322

NPV = $104,322 - $96,000 = $8,322


16-52

Ranking Investment Projects

Profitability Present value of cash inflows index Investment required=

A BPresent value of cash inflows $81,000 $6,000Investment required 80,000 5,000Profitability index 1.01 1.20

Investment

The higher the profitability index, themore desirable the project.

L O 7

16-53

The actual rate of return that will be earned by a proposed investment.

The interest rate that equates the present value of inflows and outflows from an investment project – the discount rate at which NPV = 0.

Internal Rate of Return (IRR)L O 7

16-54

Decker Company can purchase a new machine at a cost of $104,322 that will save $20,000 per year in cash operating costs.

The machine has a 10-year life.


16-55

Future cash flows are the same every year in this example, so we can

calculate the internal rate of return as follows:

Investment required Net annual cash flows

PV factor for theinternal rate of return =

$104, 322 $20,000 = 5.2161


16-56

Find the 10-period row, move across until you find the factor 5.2161. Look at the top of the column and you find a rate of 14%14%.

Periods 10% 12% 14%1 0.9091 0.8929 0.87722 1.7355 1.6901 1.6467

. . . . . . . . . . . .9 5.7590 5.3282 4.946410 6.1446 5.6502 5.2161

Using the present value of an annuity of $1 table . . .


16-57

Decker Company can purchase a new machine at a cost of $104,322 that will save $20,000 per year in cash operating costs.

The machine has a 10-year life.

Internal Rate of Return (IRR)

The internal rate of return internal rate of return on this project is 14%.

If the internal rate of return is equal to or greater than the company’s required rate of return, the project is acceptable.

L O 7

16-58

If annual cash inflows are unequal, trial and error solution will result if present value

tables are used.

Sophisticated business calculators and electronic spreadsheets can be used to

easily solve these problems.


16-59

Some Analytical Considerations Sensitivity analysis and post audits are

helpful in dealing with estimates. Cash flows far into the future are often not

considered because of uncertainty and a small impact on present values.

Cash flows are assumed to occur at the end of the year.

Some projects will require additional investments over time.

L O 8

16-60

Some Analytical Considerations Often, after-tax cash flow can be estimated by

adding back depreciation expense (a noncash item) to net income.

Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered atthe end of the project’s life.

Least cost projects, often requiredby law, will have negative NPV’s.

L O 8

16-61

Jones Company is considering purchasing a machine that costs $55,000 with a 5-year life and $5,000 salvage value.

Cost and revenue informationCost of machine $ 55,000 Revenue 76,000$ Cost of goods sold 50,000 Gross profit 26,000$ Cash operating costs 5,000$ Depreciation 10,000 15,000 Pretax income 11,000$ Income tax 4,400 After-tax income 6,600$

($55,000 - $5,000) ÷ 5 years

Some Analytical ConsiderationsL O 8

16-62

Most capital budgeting techniques use annual net cash flow.

Depreciation is not a cash outflow.

Annual net income 6,600$ Add back annual depreciation 10,000 Annual net cash flow 16,600$

Some Analytical ConsiderationsL O 8

16-63

Payback Period

The payback period of an investmentis the number of years it will take to

recover the amount of the investment.

Managers prefer investing in projects with shorter payback periods.

L O 9

16-64

TexCo wants to install a machine

that costs $17,000 and has an 8-year

useful life with $1,000 salvage

value. Annual net cash flows are:


Cumulative Net Cash

Flows0 (17,000)$ (17,000)$ 1 4,000 (13,000) 2 3,500 (9,500) 3 3,500 (6,000) 4 3,500 (2,500) 5 3,500 1,000 6 3,500 4,500 7 3,000 7,500 8 3,000 10,500

Payback Period

Includes salvage

L O 9

16-65


Cumulative Net Cash

Flows0 (17,000)$ (17,000)$ 1 4,000 (13,000) 2 3,500 (9,500) 3 3,500 (6,000) 4 3,500 (2,500) 5 3,500 1,000 6 3,500 4,500 7 3,000 7,500 8 3,000 10,500

4.7

TexCo recovers the$17,000 purchase price

between years 4and 5, about 4.7

years for the payback period.

Payback PeriodL O 9

2,500/3,500 = .7 years + 4 years2,500/3,500 = .7 years + 4 years

16-66

Ignores the time valueof money.

Ignores cashflows after the payback

period.

Payback PeriodL O 9

16-67

Consider two projects, each with a five-yearlife and each costing $6,000.Project One Project Two

Net Cash Net CashYear Inflows Inflows

1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000

Payback 3 years 4.002 yearsWould you invest in Project One just because

it has a shorter payback period?

Payback PeriodL O 9

Yes...Payback Period

ignores allfuture cashflows after

thepayback period

16-68

The accounting rate of return focuses onaccounting income instead of cash flows.

Accounting Rate of Return

Accounting Operating incomerate of return Average investment=

L O 10

16-69

Reconsider the $17,000 investment being considered by TexCo. The annual operating

income is $2,000. Compute theaccounting rate of return.



L O 10

16-70



Accounting Rate of ReturnCash flow 4,000$ Depreciation 2,000 Operating income 2,000$

Depreciation = ($17,000 -1,000) ÷ 8 years


Beginning book value + Ending book value2

L O 10

16-71


Accounting $ 2,000rate of return $16,000=

$17,000 + $15,0002



= 12.5%

L O 10

16-72

Depreciation may be calculated several ways.

Income may vary from year to year.

Time value ofmoney is ignored.

So why would I ever want to use this method

anyway?

Accounting Rate of ReturnL O 10

16-73

In addition to the consequences of various quantitative models, management’s investment decisions are influenced by such qualitative factors as:1. A business segment requiring special consideration;2. Mandatory regulations and goals;3. Technological developments within the industry; and4. Limited resources and capital rationing.

Investment DecisionsInvestment DecisionsL O 11

1234

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End of Chapter 16

16-1 CHAPTER 16 Cost Analysis for Decision Making McGraw-Hill/Irwin © 2008 The McGraw-Hill...

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