Chapter 4: Fundamentals of Cost Analysis for Decision Making

Fundamentals of Cost Analysisfor Decision MakingChapter 4Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinDifferential AnalysisL.O. 1 Use differential analysis to analyze decisions.Differential analysis:The process of estimating revenues and costsof alternative actions available to decision makersand of comparing these estimates to the status quoShort run:The period of time over which capacity will beunchanged, usually one year4 - *Differential CostsWith two or more alternatives, costs that differamong or between alternativesCosts that change in response to an alternativecourse of actionDifferential costs differ between actions.Alternative AAlternative BLO14 - *Sunk CostsCosts incurred in the past that cannot bechanged by present or future decisionsA sunk cost is NOT relevant for making decisions.LO14 - *Differential Analysisand Pricing DecisionsL.O. 2 Understand how to apply differential analysis to pricing decisions.Variable costs mustalways be covered.Fixed costs must becovered in the long run.4 - *Short-Run Pricing Decisions:Special Orders An order that will not affect other sales and is usually a one-time occurrenceValue ofoption 1Value ofoption 2Acceptspecialorder?Isoption 1> option 2?Option 1Option 2Status quo: Reject special orderAlternative: Accept special orderLO24 - *Long-Run Pricing DecisionsL.O. 3 Understand several approaches for establishing prices based on costs for long-run pricing decisions. Full cost is the total cost to produce and sell a unit. Full costs are relevant for the long-term pricing decisions.4 - *Life-Cycle ProductCosting and Pricing Product life-cycle is concerned with covering costs in all categories of the life cycle.R & DDesignManufacturingMarketing anddistributionCustomerserviceTake back(disposal)LO34 - *Target Costing fromTarget Pricing Target price: The price based on customers’ perceived value for the product and the price that competitors charge What would a customer pay? How much profit do I need? Can I make it at this cost?Target price – Desired profit = Target costLO34 - *Use of Differential Analysisfor Production DecisionL.O. 4 Understand how to apply differential analysis to production decisions.Make or buyDecision to make goods or services internally or purchase them externallyAdd or dropa segmentDecision to add or drop a productline or close a business unitProductchoiceDecision on what products or services to offer (product mix)4 - *Add or Drop DecisionsSales revenueCost of sales (all variable)Contribution marginLess fixed costs: Rent Salaries Marketing and administrativeOperating profit (loss)$80,000 53,000$27,000 4,000 5,000 3,000$15,000$10,000 8,000$ 2,000 1,000 1,000 500$ (500)$50,000 30,000$20,000 2,000 2,500 1,500$14,000Total$20,000 15,000$ 5,000 1,000 1,500 1,000$ 1,500PrintsCamerasFramesU-DevelopFourth Quarter Product Line Income StatementLO44 - *Add or Drop DecisionsSales revenueCost of sales (all variable)Contribution marginLess fixed costs: Rent Salaries Marketing and administrativeOperating profit (loss)$80,000 53,000$27,000 4,000 5,000 3,000$15,000$70,000 45,000$25,000 4,000 4,000 2,750$14,250$10,000 decrease 8,000 decrease$ 2,000 decrease -0- 1,000 decrease 250 decrease$ 750 decreaseStatus quo:Keep printsAlternative:Drop printsDifferenceU-DevelopDifferential Analysis Profits decrease $750, so keep prints.LO44 - *Product Choice DecisionsU-DevelopRevenue and Cost Information$50 8 8 4$30PriceLess: Variable costs per unit Material Labor OverheadContribution margin per unitFixed costs Manufacturing Marketing and administrative$80 22 24 4$30MetalframesTotal$3,000 1,500$4,500WoodframesLO44 - *Product Choice DecisionsU-DevelopRevenue and Cost Information$ 30÷ 0.5$ 60Per unit:Contribution marginMachine hours requiredContribution margin per machine hour$ 30÷ 1.0$ 30MetalframesWoodframes Metal Frames have a higher contribution margin per machine hour.LO44 - *Product Choice Decisions Suppose U-Develop has 200 machine hours per month available. 400 × $30$12,000 3,000 1,500$ 7,500CapacityContribution margin per unitTotal contribution marginLess: Fixed manufacturing costsLess: Fixed marketing and admin. costsOperating profit 200 × $30$6,000 3,000 1,500$1,500MetalframesWoodframes Selling metal frames will result in higher profits than selling wooden frames.LO44 - *The Theory of ConstraintsL.O. 5 Understand the theory of constraints. Theory of constraints: Focuses on revenue and cost management when faced with bottlenecks Bottleneck: Operation where the work required limits production The bottleneck is the constraining resource. Throughput contribution: Sales dollars minus direct materials costs and variables such as energy and piecework labor4 - *End of Chapter 4Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin