April 30, 2014 Differential Analysis: Relevant Costs the Key to Decision Making
Today s Agenda Relevant Costs vs. Irrelevant Costs Differential Approach vs. Total Cost Approach Product Transfer Decision Example Constrained Resources
Relevant Costs Costs that are relevant to decision making are those costs which differ between two or more alternatives Differential costing Costs that are irrelevant to decision making are those that cannot be altered Sunk costs Future costs that cannot be changed By definition, these costs will not be different from each other in differing scenarios These costs are unavoidable Costs that are relevant to one decision may not be relevant to a different decision One can use a total cost approach as opposed to a differential cost approach
Total Cost versus Differential Cost Approach Total Cost Approach Factor in ALL costs More time consuming Provides a complete picture and budget basis Differential Cost Approach Only factor in relevant costs; ie, those that differ between scenarios Quicker Does not provide the full cost picture Either approach should lead to the same business decision conclusion
Total and Differential Cost Approaches Using the differential approach is desirable for two reasons: 1. Only rarely will enough information be available to prepare detailed income statements for both alternatives. 2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.
Relevant Costs and Benefits A relevant cost is a cost that differs between alternatives. A relevant benefit is a benefit that differs between alternatives.
Identifying Relevant Costs An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. Two broad categories of costs are never relevant in any decision. They include: Sunk costs. A future cost that does not differ between the alternatives.
Keys to Successful Decision-Making 1. Focus only on relevant costs (also called avoidable costs, differential costs, or incremental costs) and relevant benefits (also called differential benefits or incremental benefits). 2. Ignore everything else including sunk costs and future costs and benefits that do not differ between the alternatives.
Different Costs for Different Purposes Be mindful and think through each cost for each circumstance What are relevant costs for assessing whether to invest in a university degree? Tuition & books? What is irrelevant? Food? Accommodation? What are relevant benefits? Costs that are relevant in one decision situation may not be relevant in another context. Thus, in each decision situation, the manager must examine the data at hand and isolate the relevant costs.
University Degree Is it worth it? Analyze whether it is worth the investment of your time and money to obtain a university degree What are the benefits? What are the costs? Use the differential approach Which costs and benefits are relevant? What do you conclude?
Production Transfer Decision James Company manufactures Switches It manufactures and sells its products in North America Its best customer has received a price quote from James Co s competitor for $7,000 per unit The customer expects to grow significantly and says that costs are its #1 issue What would happen to the company if it matched the competitor s quote? What should James Co do? North American Production Costs ($thousands except per unit data) Unit Total Volume (units) 50,000 Direct Materials 4,000 200,000 Direct Labour 200 10,000 Shipping 50 2,500 MOH - Variable Power 100 5,000 Other 50 2,500 Total Variable 4,400 220,000 MOH - Fixed Building Lease 200 10,000 Facility Management 600 30,000 Procurement 300 15,000 Corporate Overhead (S&A) 2,000 100,000 Total Fixed 3,100 155,000 Total Costs 7,500 375,000 Price 8,000 400,000 Operating Income 500 25,000
Production Transfer Decision James Co options: Keep prices the same and hope the customer stays Suggest the extra cost is provided in value added service Argue that James Co knows the customer better & can better serve it Argue that James Co quality and timeliness of delivery is superior Match the price, lose money and try to cut costs over time Manufacture in a lower cost location Investigate whether James Co can manufacture the product profitably elsewhere
Production Transfer Decision You are the head of managerial accounting and you learn the following about producing in China: Component parts can be sourced for 70% of current costs Because they are made in China and would not require shipping Labour costs are 20% of what they are in North America Shipping completed product back to North America would cost $250 per unit AND it would add two weeks to the delivery schedule Power is approximately the same cost in both locations If the company transferred production, the customer would conduct a detailed one-time facility inspection at a cost to James Co of $2 million There are other one-time costs Building up extra inventory for the transfer period to ensure continuity of supply Parallel production until China facility is in steady-state It would take a full 12 months to sub-lease the North American facility What information is missing to make a decision whether to transfer production?
Product Transfer Decision North American Production China Production Costs ($thousands except per unit data) Unit Total Assumption Unit Total Volume (units) 50,000 50,000 Direct Materials 4,000 200,000 70% Direct Labour 200 10,000 20% Shipping 50 2,500 250 MOH - Variable Power 100 5,000 100 Other 50 2,500 Total Variable 4,400 220,000 MOH - Fixed Building Lease 200 10,000 Facility Management 600 30,000 20% Procurement 300 15,000 Corporate Overhead (S&A) 2,000 100,000 Total Fixed 3,100 155,000 Total Costs 7,500 375,000 Price 8,000 400,000 350,000 Operating Income 500 25,000
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Product Transfer Decision There has been no consideration for additional inventory required due to increase in delivery time Two weeks additional inventory costs However, there is less inventory ($ value) because it now costs less Also, still need to consider one-time costs China Production One- Time Costs ($'000s) Break Lease 200 Extra Inventory Parallel Production How can these one-time costs be addressed?
Adding/Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment. Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess this impact, it is necessary to carefully analyze the costs.
A Contribution Margin Approach DECISION RULE Chen Co should drop its digital watch segment only if its profit would increase. Chen Co will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped.
The Make or Buy Analysis When a company is involved in more than one activity in the entire value chain, it is vertically integrated. A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier is called a make or buy decision. Should Chen Co, manufacture it s own watch straps? Or, would it be better for them to buy them from a supplier? What are the incremental benefits? Costs? Risks?
Key Terms and Concepts A special order is a one-time order that is not considered part of the company s normal ongoing business. When analyzing a special order, only the incremental costs and benefits are relevant. Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant.
Key Terms and Concepts When a limited resource of some type restricts the company s ability to satisfy demand, the company is said to have a constraint. The machine or process that is limiting overall output is called the bottleneck it is the constraint.
Utilization of a Constrained Resource Fixed costs are usually unaffected in these situations, so the product mix that maximizes the company s total contribution margin should ordinarily be selected. A company should not necessarily promote those products that have the highest unit contribution margins. Rather, total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest contribution margin in relation to the constraining resource. Remember the Balance Sheet ROI remains a factor
Managing Constraints It is often possible for a manager to increase the capacity of a bottleneck, which is called relaxing (or elevating) the constraint, in numerous ways such as: 1. Working overtime on the bottleneck. 2. Subcontracting some of the processing that would be done at the bottleneck. 3. Investing in additional machines at the bottleneck. 4. Shifting workers from non-bottleneck processes to the bottleneck. 5. Focusing business process improvement efforts on the bottleneck. 6. Reducing defective units processed through the bottleneck. These methods and ideas are all consistent with the Theory of Constraints, which was introduced in Chapter 1.
Joint Costs In some industries, a number of end products are produced from a single raw material input. Two or more products produced from a common input are called joint products. The point in the manufacturing process where each joint product can be recognized as a separate product is called the split-off point.
Sell or Process Further Joint costs are irrelevant in decisions regarding what to do with a product from the split-off point forward. Therefore, these costs should not be allocated to end products for decision-making purposes. With respect to sell or process further decisions, it is profitable to continue processing a joint product after the split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs incurred after the split-off point. This is the corollary of the Make or Buy decision, but further down the production line.
Tutorial Assignment Review Build versus Buy Decisions All Case Study models to be functioning