CHAPTER 16

1. CHAPTER 16 Cost Analysis for Decision Making

2. Revisit plans Implement plans Data collection andperformance feedback Decision Making Strategic, Operational,and Financial Planning Planning and control cycle Performance analysis: Plans vs. actual results (Controlling) Executing operational activities (Managing)

3. 1 2 Relevant Cost Information A relevant costis a future cost that differs between alternatives.

4. Will you drive or fly to Colorado for an eight-day springbreak 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. Relevant Cost Information

5. Relevant Cost Information 8 days @ $90 8 days @ $25 8 days @ $7

6. Relevant Cost Information Costs do not differ,so they are notrelevant to decision. Also, car insuranceis not relevant tothe decision as itis a past cost.

7. Relevant Cost Information Are the two extradays in Coloradoworth the $500extra cost to fly? Transportationcosts differ betweenthe two alternatives,so they are relevantto your decision

8. Relevant Cost Information

9. 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 Cost

10. The Special Pricing Decision The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those that occur if the company decides to acceptthe new business.

11. The Special Pricing Decision MicroTech currently sells 4,400 laptopcomputers. The company has revenueand expenses as shown below: Based on capacity of 5,000 units: $2,500,000 ÷ 5,000 units = $500 per unit.

12. The Special Pricing Decision 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?

13. The Special Pricing Decision First let’s look at incorrect reasoningthat leads to an incorrect decision. Our manufacturing costis $2,000 per unit. Ican’t sell for $1,800per unit.

14. The Special Pricing Decision This analysis leads to the correct decision. 000’s omitted from all numbers.

15. The Special Pricing Decision 500 new units × $1,800 selling price = $900,000 500 new units × $800 = $400,000

16. The Special Pricing Decision 500 new units × $450 = $225,000 500 new units × $250 = $125,000

17. The Special Pricing Decision Even though the $1,800 selling price is less than the normal $2,400 selling price, MicroTech should accept theoffer because net income will increase by $150,000.

18. The Special Pricing Decision If MicroTech accepts the offer, netincome will increase by $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.

19. Should Icontinue to makethe part, or shouldI buy it? What will I do with myidle facilities ifI buy the part? The Make or Buy Decision

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.

21. The Make or Buy Decision MicroTech currently makes the motherboardsused in its laptop computers. Unit cost for manufacturing the motherboards are:

22. The Make or Buy Decision 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?

23. The Make or Buy Decision Differential costs of making (costs avoided if bought from outside supplier): 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).

24. The Make or Buy Decision 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?

25. The Make or Buy Decision The opportunity cost of facilities changes the decision. The real question to answer is,“What is the best use of MicroTech’s facilities?”

26. Short-Term Allocationof Scarce Resources 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.

27. Short-Term Allocationof Scarce Resources Integrated Technologies produces two productsand selected data is shown below: If 120 hours of processing time are available,which product should be produced?

28. Short-Term Allocationof Scarce Resources Let’s calculate the contribution marginper hour of processing time.

29. Short-Term Allocationof Scarce Resources Let’s calculate the contribution marginper hour of processing time. 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.

30. Short-Term Allocationof Scarce Resources Let’s calculate the contribution marginper hour of processing time. If there are no other considerations, the best plan would be to produce to meet current demand for Product 2 and then use any time that remains to make Product 1.

31. Long-Run Investment Decisions Let’s change topics.

32. Capital Budgeting How managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.

33. Capital Budgeting • Outcomeis uncertain. • Large amounts ofmoney are usuallyinvolved. Capital budgeting:Analyzing alternative long-term investments and deciding which assets to acquire or sell. • Decision may bedifficult or impossibleto reverse. • Investment involves along-term commitment.

34. I will choose theproject with the mostprofitable return onavailable funds. Investment Decision Special Considerations PlantExpansion ? LimitedInvestmentFunds NewEquipment ? ? OfficeRenovation

35. Investment Decision Special Considerations • 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.

36. Cost of Capital • The firm’scost of capitalis usually regarded as the most appropriate choicefor the discount rate to determinethe present value of the investment proposalbeing 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.

37. 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.

38. Net Present Value (NPV) A comparison of the present value of cash inflows with the present value of cash outflows

39. Net Present Value (NPV) • Chose a discount rate – the minimum required rate of return. • Calculate the presentvalue of cash inflows. • Calculate the presentvalue of cash outflows. NPV =  – 

40. Net Present Value (NPV) General decision rule . . .

41. Net Present Value BoxMover, Inc. is considering the purchase of a conveyor costing $16,000 with a 7-year useful life and a $5,000 salvage value that promises annual net cash flows as shown in the following table. BoxMover’s cost of capital is 12 percent. Ignoring taxes, compute the NPV for this investment.

42. Net Present Value

43. Net Present Value Present value factorsfor 12 percent

44. Net Present Value A positive net present value indicates that thisproject earns more than 12 percent, so theinvestment should be made.

45. Net Present Value (NPV) 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. $ 4,300 b. $12,700 c. $11,000 d. $17,000

46. Net Present Value (NPV) 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. $ 4,300 b. $12,700 c. $11,000 d. $17,000 Using the present value of an annuity PV of inflows = $20,000 × 5.650 = $113,000 NPV = $113,000 - $96,000 = $17,000

47. Net Present Value (NPV) Calculate the NPV if Brown Company’s cost of capital is 15 percent instead of 12 percent. Using the present value of an annuity PV of inflows = $20,000 × 5.019 = $100,380 NPV = $100,380 - $96,000 = $4,380 Note that the NPV is smallerusing the larger interest rate.

48. Profitability Present value of cash inflows index Investment required = Ranking Investment Projects The higher the profitability index, the more desirable the project.

49. Internal Rate of Return (IRR) • 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.

50. Internal Rate of Return (IRR) • Decker Company can purchase a new machine at a cost of $104,320 that will save $20,000 per year in cash operating costs. • The machine has a 10-year life.