Cost Management ACCOUNTING AND CONTROL

1. Cost ManagementACCOUNTING AND CONTROL HANSEN & MOWEN

2. 18 CHAPTER Activity Resource Usage Model And Tactical Decision Making

3. 1 Tactical Decision Making OBJECTIVE 1. Recognize and define the problem. 2. Identify alternatives as possible solutions to the problem, and eliminate alternatives that are not feasible. 3. Identify the predicted costs and benefits associated with each feasible alternative. Eliminate the costs and benefits that are not relevant to the decision. The Tactical Decision-Making Process Continued

4. 1 Tactical Decision Making OBJECTIVE The Tactical Decision-Making Process 4. Compare the relevantcosts and benefits for each alternative, and then relate each alternative to the overall strategic goals of the firm and other important qualitative factors. 5. Select the alternative with the greatest benefit which also supports the organization’s strategic objectives.

5. 1 Tactical Decision Making OBJECTIVE Step 1: Define the Problem Each year 25 percent of the harvest by an apple processor is small and odd-shaped. These apples cannot be sold in the normal distribution channels and have simply been dumped in the orchards for fertilizer. What should the firm do with these apples?

6. 1 Tactical Decision Making OBJECTIVE Step 2: Identify Feasible Alternatives 1. Sell the apples to pig farmers. 2. Bag the apples in five-pound bags and sell them to local supermarkets as seconds. 3. Rent a local canning facility and convert the apples to applesauce. 4. Rent a local canning facility and convert the apples to pie filling. 5. Continue with the current dumping practice.

7. 1 Tactical Decision Making OBJECTIVE Step 3: Predicting Costs and Benefits and Eliminating Irrelevant Costs Labor and materials (bags and ties) for the bagging option would cost $0.05 per pound. A five-pound bag of apple could be sold for $1.30 to local supermarkets. Making applesauce would cost $0.40 per pound for rent, labor, apples, cans, and other materials. It takes six pounds of apples to produce five, 16-ounce cans of applesauce. Each can sells for $0.78.

8. 1 Tactical Decision Making OBJECTIVE Step 4: Comparing Relevant Costs and Relating to Strategic Goals. The bagging alternative costs $0.25 to produce a five-pound bag ($0.05 x 5 pounds). The revenue is $1.30 per bag, or $0.26 per pound. The net benefit is $0.21 per pound ($0.26 – $0.05). The net benefit of converting the apples into applesauce is $0.25 per pound ($0.65 – $0.40).

9. 1 Tactical Decision Making OBJECTIVE Step 5: Select Best Alternative. Since the apple producer is reluctant to follow a forward integration strategy, the bagging alternative should be chosen.

10. 1 Tactical Decision Making OBJECTIVE Example What to do with small, ill-shaped apples. Step 1 1. Sell to pig farmers. 2. Sell bagged apples (feasible). 3. Make applesauce (feasible). 4. Make pie filling. 5. Continue dumping. Step 2 Decision Model: Tactical Decision-Making Process Continued

11. 1 Tactical Decision Making OBJECTIVE Step 4 Bagged Applesauce Revenue $0.26 $0.65 Cost 0.05 0.40 Net benefit $0.21 $0.25 Bagged: Differentiation Applesauce: Forward integration Bagged alternative: a. Revenue $1.30 per bag ($0.26 per pound) b. Cost $0.05 per pound Applesauce alternative: a. Revenue: $0.78 per can ($0.65 per pound) b. Cost: $0.40 per pound Step 3 Continued

12. 1 Tactical Decision Making OBJECTIVE Step 5 Select bagging alternative because it is profitable and is more consistent with strategic positioning desired by producer.

13. 2 Relevant Costs and Revenues OBJECTIVE Relevant costs are future costs that differ across alternatives. A cost must not only be a future cost but must also differ between alternatives.

14. 2 Relevant Costs and Revenues OBJECTIVE Sunk costs are past costs. Example: The original cost of a building is a sunk cost when you are trying to decide whether or not to sell the business five years later.

15. 3 Relevancy, Cost Behavior, and the Activity Resource Usage Model OBJECTIVE Flexible resources can be easily purchased in the amount needed and at the time of use… like electricity.

16. 3 Relevancy, Cost Behavior, and the Activity Resource Usage Model OBJECTIVE a. Demand Changes Relevant b. Demand Constant Not Relevant Flexible Resources

17. 3 Relevancy, Cost Behavior, and the Activity Resource Usage Model OBJECTIVE Committed resources are purchased before they are used, such as salaried employees.

18. 3 Relevancy, Cost Behavior, and the Activity Resource Usage Model OBJECTIVE a. Demand Increase < Unused Capacity Not relevant b. Demand Increase > Unused Capacity Relevant • Activity Capacity Reduced Relevant • Activity Capacity Unchanged Not Relevant Committed Resources Supply – Demand = Unused Capacity c. Demand Decease (Permanent)

19. 3 Relevancy, Cost Behavior, and the Activity Resource Usage Model OBJECTIVE A company has five manufacturing engineers who supply a capacity of 10,000 engineering hours (2,000 hours each). The cost of this activity capacity is $250,000, or $25 per hour. The firm expects to use 9,000 hours. If the firm decides to reject a special order requiring 500 hours, the cost of engineering would be irrelevant.

20. 3 Relevancy, Cost Behavior, and the Activity Resource Usage Model OBJECTIVE The firm can purchase a component that will drop the demand from engineering hours from 9,000 to 7,000. Since engineering activity capacity is acquired in chunks of 2,000, the company can lay off one engineer or reassign the engineer to another plant.

21. 3 Relevancy, Cost Behavior, and the Activity Resource Usage Model OBJECTIVE Resource demand and Supply

22. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE Assumptions of C-V-P Analysis 1. The analysis assumes a linear revenue function and a linear cost function. 2. The analysis assumes that price, total fixed costs, and unit variable costs can be accurately identified and remain constant over the relevant range. 3. The analysis assumes that what is produced is sold. 4. For multiple-product analysis, the sales mix is assumed to be known. 5. The selling price and costs are assumed to be known with certainty.

23. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE • Make or Buy • Keep or Drop • Special Order • Sell or Process Further Important: Short-term Perspective

24. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE Make-or-Buy Decisions Talmage Company produces a mechanical part used in one of its engines. (Talmage produces engines for snowblowers.) An outside supplier has offered to sell a part (Part 34B) for $4.75. The company normally produces 100,000 units of the part each year.

25. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE ABC Make-or-Buy Analysis: Talmage Company Buy the part!

26. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE Functional-Based Make-or-Buy Analysis: Talmage Company Make the part!

27. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE ABC Segmented Income Statement DROP?

28. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE ABC Keep-or-Drop Analysis Dropping the product saves $45,000!

29. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE Special-Order Cost Polarcreme, Inc., an ice-cream company, is operating at 80 percent of its 20 million half-gallon capacity. A distributor from another geographically area offered to buy 2 million units of premium ice cream at $1.75 per unit. They have agreed to provide their own label and pay transportation costs. This sale would avoid a sales commission.

30. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE Special-Order Cost Variable costs: Dairy ingredients $0.70 Sugar 0.10 Flavoring 0.15 Direct labor 0.25 Packaging 0.20 Commissions 0.02 Distribution 0.03 Other 0.05 Total unit-level costs $1.50 Which costs are irrelevant? $1.45

31. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE Special-Order Cost The nonunit-level variable costs will also be incurred, producing a total increment cost of $304,000 or $0.152 per unit (for an order of 2 million units). Revenue per unit of $1.75, less the unit-level variable cost ($1.45) plus the nonunit-level variable cost ($0.152) provides a net benefit of $0.148 per unit. Thus Polarcreme’s profit would increase by $296,000 ($0.148 x 2,000,000).

32. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE Sell or Process Further Joint productshave common processes and costs of production up to a split-off point. The point of separation is called thesplit-off point. Assume that Delrio can sell hot sauce for $1.50 per bottle. Also, assume that additional processing costs amount to $1,000. The total revenue at split-off for Grade A tomatoes are $400 ($0.40 x 1,000 pounds). If the Grade A tomatoes are processed into hot sauce, the total revenues are $1,500 ($1.50 per bottle).

33. Illustrative Examples of Tactical Decision Making 4 OBJECTIVE Sell or Process Further Differential Amount Sell Process Further to Process Further Revenues $400 $1,500 $1,100 Processing costs ---- 1,000 1,000 Total $400 $ 500 $ 100 Decision: Further Process

34. End of Chapter 18