ShortRun Decision Analysis

1
Short-Run Decision Analysis
Chapter 24

• Multimedia Slides by Gail A. Mestas, MAcc, New
  Mexico State University

2
Learning Objectives

• Explain how managers make short-run decisions
  during the management cycle.
  
• Define incremental analysis and describe how it
  applies to short-run decision analysis.
  
• Perform incremental analysis for outsourcing
  decisions.

3
Learning Objectives (contd)

• Perform incremental analysis for special order
  decisions.
  
• Perform incremental analysis for segment
  profitability decisions.
  
• Perform incremental analysis for sales mix
  decisions involving constrained resources.
  
• Perform incremental analysis for sell or
  process-further decisions.

4
Short-Run Decision Analysis and the Management
Cycle

• Objective 1
• Explain how managers make short-run decisions
  during the management cycle

5
Short-Run Decision Analysis and the Management
Cycle

• Readers of financial reports are interested in
  knowing what happened to produce those particular
  results
  
• Answer this question using the historical
  information in these reports
  
• Provides financial and nonfinancial quantitative
  information
  
• Should be relevant, timely, and presented in a
  format that is easy to use in decision making

6
Short-Run Decision Analysis and the Management
Cycle (contd)

• Short-run decision analysis
• The systematic examination of any decision whose
  effects will be felt over the course of the next
  year
  
• Managers frequently take five predictable actions
  when deciding what to do
  
• First four actions
• During the planning stage
• Last action
• During the reviewing stage

7
Planning

• Managers take the following four actions during
  the planning stage when performing short-run
  decision analysis
  
• Discover a problem or need
• Identify all reasonable courses of action
• Prepare a thorough analysis of each possible
  solution
  
• Identify total costs, savings, and other
  financial effects
  
• Select the best course of action

8
Planning (contd)

• The following qualitative factors will influence
  a bank managers decision to keep or eliminate a
  branch location
  
• Competition
• Do competitors have a branch office located
  here?
  
• Economic conditions
• Does this branch location benefit the community
  we serve?
  
• Product or service quality
• Can we attract more business because of the
  service quality of this branch?
  
• Timeliness
• Does the branch promote customer service?

9
Executing

• Stage in which managers
• Must adapt to changing environments
• Take advantage of opportunities that will improve
  the organizations profitability and liquidity in
  the short-run
  
• During this stage a bank manager may choose to
• Eliminate a branch office
• Because costs exceed revenues
• Keep a branch office
• Because the community expects the organization to
  provide this service

10
Reviewing

• Managers evaluate each decision to determine
  whether it produced the forecasted results
  
• This is the fifth predictable action when
  performing short-run decision analysis
  
• If results fell short, managers identify and
  prescribe corrective action
  
• If the solution is not satisfactory or the
  problem remains, the management cycle begins again

11
Reporting

• Managers prepare reports related to short-run
  decisions throughout the management cycle
  
• Develop budgets that show estimated costs and
  revenues related to alternative courses of
  action
  
• Compile analyses of data that support their
  decisions

12
Discussion

• What are the five predictable actions frequently
  taken by managers during short-run decision
  analysis?
  
• Discover a problem or need
• Identify all reasonable courses of action
• Prepare a thorough analysis of each possible
  solution
  
• Identify total costs, savings, and other
  financial effects
  
• Select the best course of action
• Evaluate each decision to determine whether it
  produced the forecasted results

13
Incremental Analysis for Short-Run Decisions

• Objective 2
• Define incremental analysis and describe how it
  applies to short-run decision analysis

14
Incremental Analysis

• is a method of comparing alternatives by
  focusing on the differences in their projected
  revenues and costs
  
• Also called differential analysis if it ignores
  revenues or costs that stay the same or do not
  differ among alternatives

15
Irrelevant Costs and Revenues

• Differential cost
• A cost that changes between alternatives
• Also referred to as an incremental cost
• Irrelevant revenue
• Revenues that will not differ between
  alternatives
  
• Irrelevant cost
• A cost that does not differ between alternatives
• Includes sunk costs
• Costs that were incurred because of a previous
  decision and cannot be recovered through the
  current decision

16
Irrelevant Costs and Revenues (contd)
Home State Bank managers must decide to buy one
of two ATM machinesC or W. The machines have
the same purchase price but different revenues
and cost characteristics. The company currently
owns ATM B, which it bought 3 years ago for
15,000 and which has accumulated depreciation of
9,000. It is now obsolete and cannot be sold or
traded in
The accountant has collected the following annual
revenue and operating cost estimates for the two
new machines
17
Irrelevant Costs and Revenues (contd)
Home State Bank managers must decide to buy one
of two ATM machinesC or W. The machines have
the same purchase price but different revenues
and cost characteristics. The company currently
owns ATM B, which it bought 3 years ago for
15,000 and which has accumulated depreciation of
9,000. It is now obsolete and cannot be sold or
traded in

• The first step in incremental analysis is to
  eliminate any irrelevant revenues and costs
  
• Sunk costs
• The book value of ATM B
• Represents money that was spent in the past and
  does not affect the decision about whether to
  replace the old ATM with a new one

ATM B would be of interest only if it could be
sold or traded in
18
Irrelevant Costs and Revenues (contd)

• Recall the annual revenue and operating cost
  estimates for the two new machines
  
• The costs of direct materials and fixed overhead
  are the same under both alternatives
  
• These are irrelevant costs and can also be
  eliminated from the analysis

19
Irrelevant Costs and Revenues (contd)

• The incremental analysis is prepared using only
  the differential revenues and costs that will
  change between the alternative ATMs

20
Incremental Analysis
21
Opportunity Costs

• are the benefits that are forfeited or lost
  when one alternative is chosen over another
  

22
Opportunity Costs (contd)

• When deciding between alternatives, managers
• Use incremental analysis
• Simplifies managements evaluation of a decision
• Reduces time needed to choose the best course of
  action
  
• Determine opportunity costs
• Must consider other issues, such as quality and
  reputation

23
Opportunity Costs (contd)
A plant nursery has been in operation for many
years at the intersection of two highways. A
bank has offered the owner a high price for the
land

• The interest that could be earned from the
  proceeds of the sale is an opportunity cost for
  the nursery owner
  
• It is revenue the owner has chosen to forego to
  continue operating the nursery in that location

24
Opportunity Costs (contd)
A bank teller is deciding whether to go back to
school full time to earn a degree in finance

• The salary the teller would lose by returning to
  school is an opportunity cost
  
• The total cost of school includes not only
  tuition, books, supplies, and living expenses,
  but also the amount of salary foregone while the
  teller is a full-time student

25
Opportunity Costs (contd)

• Opportunity costs often come into play when a
  company is operating at or near full capacity and
  must choose what products or services to offer

26
Discussion

• What is an opportunity cost?
• A benefit that is given up because one course of
  action is taken instead of another

27
Incremental Analysis for Outsourcing Decisions

• Objective 3
• Perform incremental analysis for outsourcing
  decisions

28
Incremental Analysis for Outsourcing Decisions

• Outsourcing
• The use of suppliers outside the organization to
  perform services or produce goods that could be
  performed or produced internally
  
• Make-or-buy decisions
• Decisions about whether to make a part internally
  or buy it from an external supplier
  
• May lead to outsourcing

29
Incremental Analysis for Outsourcing Decisions
(contd)

• Core competencies
• The activities an organization performs best
• Many companies focus their resources on their
  core competencies to
  
• Improve operating income
• Compete effectively in global markets

30
Incremental Analysis for Outsourcing Decisions
(contd)

• Organizations may outsource expensive,
  nonvalue-adding activities
  
• Payroll processing
• Training
• Managing fleets of vehicles
• Sales and marketing
• Custodial services
• Information management

Many areas that are outsourced involve either
relatively low skill areas or highly specialized
knowledge that can be better acquired from
experts outside the company
31
Incremental Analysis for Outsourcing Decisions
(contd)

• Outsourcing production or operating activities
  can reduce a companys
  
• Investment in physical assets and human
  resources
  
• Improves cash flow
• Operating costs
• Improves operating income

32
Incremental Analysis for Outsourcing Decisions
(contd)

• A common decision facing managers is whether to
  make or buy a part
  
• Goal
• Select the most profitable alternative
• Must identify the costs of each alternative and
  their effects on revenues and existing costs

33
Incremental Analysis for Outsourcing Decisions
(contd)

• Managers need the following information for
  analysis

34
Incremental Analysis for Outsourcing Decisions
(contd)
For the past five years, Box Company has
purchased packing cartons from an outside
supplier at a cost of 1.25 per carton. The
supplier has just informed Box Company that it
will be raising the price to 1.50 per carton,
effective immediately
Should Box Company continue to outsource the
cartons?

• Box Company has idle machinery that could be
  adjusted and used to produce packing cartons

35
Incremental Analysis for Outsourcing Decisions
(contd)
For the past five years, Box Company has
purchased packing cartons from an outside
supplier at a cost of 1.25 per carton. The
supplier has just informed Box Company that it
will be raising the price to 1.50 per carton,
effective immediately

• Annual production and usage would be 20,000
  cartons
  
• Estimated cost of direct materials is .84 per
  carton
  
• Workers earn 8.00 per hour and can produce 20
  cartons per hour (.40 per carton)

36
Incremental Analysis for Outsourcing Decisions
(contd)
For the past five years, Box Company has
purchased packing cartons from an outside
supplier at a cost of 1.25 per carton. The
supplier has just informed Box Company that it
will be raising the price to 1.50 per carton,
effective immediately

• Cost of variable manufacturing OH will be 4 per
  direct labor hour and 1,000 direct labor hours
  will be required
  
• Fixed overhead per year includes 4,000 of
  depreciation and 6,000 of other fixed costs
  
• There is space to produce the cartons and the
  machines will remain idle if the part is purchased

37
Incremental Analysis for Outsourcing Decisions
(contd)
For the past five years, Box Company has
purchased packing cartons from an outside
supplier at a cost of 1.25 per carton. The
supplier has just informed Box Company that it
will be raising the price to 1.50 per carton,
effective immediately

• Irrelevant costs
• Depreciation costs and other fixed manufacturing
  OH costs
  
• Machinery and factory space have no other use
• Costs are the same for both alternatives
• Relevant costs and revenues
• Compared for each alternative in an incremental
  analysis

38
Incremental Analysis Outsourcing Decision
The company should make the cartons because it
will save 1,200
39
Discussion

• What are core competencies?
• Core competencies are the activities an
  organization performs best. In other words, the
  company is highly competent at performing these
  activities.
• Many companies focus their resources on their
  core competencies to improve operating income and
  compete effectively in global markets. Other
  activities may be outsourced

40
Incremental Analysis for Special Order Decisions

• Objective 4
• Perform incremental analysis for special order
  decisions

41
Incremental Analysis for Special Order Decisions

• Special order decisions
• Decisions about whether to accept or reject
  special orders at prices below normal market
  prices
  
• Usually involve large numbers of similar items
  that are sold in bulk
  
• Are not expected and so are not included in
  annual cost or sales estimates
  
• Are one-time events and should not be included in
  revenue or cost estimates for subsequent years

42
Incremental Analysis for Special Order Decisions
(contd)

• Before accepting a special product order
• Ensure that the products involved are
  sufficiently different from the regular product
  line to avoid
  
• Violating federal price discrimination laws
• Reducing unit sales from the full-priced regular
  product line

43
Incremental Analysis for Special Order Decisions
(contd)

• A special product order should be accepted only
  if it maximizes operating income
  
• Based on
• The organizations strategic plan and objectives
• Relevant costs of the special order
• Qualitative factors

44
Incremental Analysis for Special Order Decisions
(contd)

• Approaches to determining whether a special order
  should be accepted
  
• Compare special order price to relevant costs to
  produce, package, and ship the order
  
• Relevant costs include
• Variable costs
• Variable selling costs, if any
• Other costs directly associated with the special
  order (e.g., freight, insurance, packaging, and
  labeling the product)
  
• Prepare a special order bid price
• Calculate a minimum selling price
• Equals relevant costs plus an estimated profit

45
Incremental Analysis for Special Order Decisions
(contd)

• Costs that may be excluded from a special order
  decision analysis
  
• Sales commission expenses
• Customer may have contacted the company directly
• Fixed costs of existing facility
• Do not change if the company accepts the special
  order

46
Incremental Analysis for Special Order Decisions
(contd)

• Costs relevant to the decision
• Fixed costs that must be incurred to fill the
  special order
  
• Purchase of additional machinery
• Increase in supervisory help
• Increase in insurance premiums

47
Incremental Analysis for Special Order Decisions
(contd)
Home State Bank has been approved to provide and
service four ATMs at a special event. The event
sponsors want the fee per ATM transaction to be
.50. Past ATM usage at special events has
averaged 2,000 transactions per machine. The
bank has located four idle ATMs for the event
Based on the following cost data, should Home
State Bank accept the special event offer?
Performing a special order incremental analysis
will assist in the decision process
48
Incremental Analysis for Special Order Decisions
(contd)

• Irrelevant costs
• Fixed costs
• The only costs affected by the order are
• Direct materials
• Direct labor
• Variable overhead

49
Incremental Analysis Special Order Decision
Accepting the special offer will increase
contribution margin, and therefore operating
income, by 1,200
50
Discussion

• Is the decision to accept or reject a special
  order based solely on the orders effects on
  contribution margin?
  
• No. Qualitative factors must be taken into
  consideration in the decision-making process,
  such as the impact of the special order on
  regular customers, the potential of the special
  order to lead into new sales, and the customers
  ability to maintain an ongoing relationship
  regarding good ordering and paying practices

51
Incremental Analysis for Segment Profitability
Decisions

• Objective 5
• Perform incremental analysis for segment
  profitability decisions

52
Incremental Analysis for Segment Profitability
Decisions

• Managers must decide whether to keep or drop
  unprofitable segments
  
• Product lines
• Services
• Sales territories
• Divisions
• Departments
• Stores
• Outlets

53
Incremental Analysis for Segment Profitability
Decisions (contd)

• Management must select the alternative that
  maximizes operating income based on
  
• The organizations strategic plan and objectives
• Relevant revenues and costs
• Qualitative factors
• Objective of this analysis
• Identify the segments that have a negative
  segment margin

54
Incremental Analysis for Segment Profitability
Decisions (contd)

• Segment margin
• A segments sales revenue minus its direct costs
  (direct variable costs and direct fixed costs
  traceable to the segment)
  
• Such costs are assumed to be avoidable costs
• Can be eliminated if the segment were dropped

55
Incremental Analysis for Segment Profitability
Decisions (contd)

• If a segment has a positive segment margin, it
  should be kept
  
• It is able to cover its own direct costs
• Can contribute a portion of its revenue to cover
  common costs and add to operating income
  
• If a segment has a negative segment margin, it
  should be eliminated
  
• However, the remaining segments must be able to
  cover the unavoidable costs
  
• Common cost that will be incurred regardless of
  the decision

56
Incremental Analysis for Segment Profitability
Decisions (contd)

• To analyze segment profitability
• Prepare a segmented income statement
• Use variable costing to identify variable and
  fixed costs
  
• Direct fixed costs
• The fixed costs that are traceable to the
  segments
  
• Common costs
• The remaining fixed costs
• Are not assigned to segments

57
Incremental Analysis for Segment Profitability
Decisions (contd)
Once the segmented income statement has been
completed, an incremental analysis can be prepared
Incremental analysis shows that operating income
will increase by 9,000 if the Safe Deposit
Division is dropped
58
Incremental Analysis for Segment Profitability
Decisions (contd)
Assume that Bank Operations sales will decrease
20 percent if management eliminates the Safe
Deposit Division
Incremental analysis now shows that operating
income will decrease by 7,500 if the Safe
Deposit Division is dropped
59
Discussion

• What is the object of incremental analysis for
  segment profitability decisions?
  
• The object of this analysis is to identify the
  segments of a business that have a negative
  segment margin
  
• Segment margin is equal to the segments sales
  revenue minus its direct costs. A positive
  segment margin means the segment is able to cover
  its own direct costs and contribute a portion of
  its revenue to cover common costs and add to
  operating income

60
Incremental Analysis for Sales Mix Decisions

• Objective 6
• Perform incremental analysis for sales mix
  decisions involving constrained resources

61
Incremental Analysis for Sales Mix Decisions

• Resource constraints
• Limits on resources may restrict types or
  quantities of products or services a company can
  provide
  
• Machine time
• Available labor
• Other activities
• Inspection
• Equipment setup

62
Incremental Analysis for Sales Mix Decisions
(contd)

• Organizations must decide which products or
  services contribute the most to company
  profitability in relation to the amount of
  capital assets or other constrained resources
  needed to offer these items
• Identify by calculating the contribution margin
  per constrained resource for each product or
  service

63
Incremental Analysis for Sales Mix Decisions
(contd)

• Sales mix decision
• To select the alternative that maximizes the
  contribution margin per constrained resource
  
• Based on the organizations
• Strategic plan and objectives
• Relevant revenues and costs
• Qualitative factors
• Use incremental analysis

64
Incremental Analysis for Sales Mix Decisions
(contd)

• Decision analysis uses two steps
• Calculate contribution margin per unit for each
  product or service affected by the constrained
  resource
  
• Equals selling price per unit less variable costs
  per unit
  
• Calculate contribution margin per unit of the
  constrained resource
  
• Equals contribution margin per unit divided by
  the quantity of the constrained resource required
  per unit

65
Incremental Analysis for Sales Mix Decisions
(contd)
Home State Bank offers three types of loans
commercial loans, auto loans, and home loans.
Current loan application capacity is 100,000
processing hours
The product line data are as follows
Question 1 Which product line should be advertise
d and promoted initially because it is the most
profitable for the bank? Which should be second?
Which should be last?
66
Incremental Analysis Sales Mix Decision
Involving Constrained Resources
67
Incremental Analysis for Sales Mix Decisions
(contd)

• Loans that provide the highest contribution
  margin per processing hour should be sold first
  
• The analysis indicates that the loans should be
  sold in the following order
  
• Auto loans
• Home loans
• Commercial loans

68
Incremental Analysis for Sales Mix Decisions
(contd)
Home State Bank offers three types of loans
commercial loans, auto loans, and home loans.
Current loan application capacity is 100,000
processing hours
The product line data are as follows
Question 2 How many of each type of loan should b
e sold to maximize the banks contribution margin
based on current loan activity of 100,000
processing hours? What is the total contribution
margin for that combination?
69
Incremental Analysis for Sales Mix Decisions
(contd)

• Compare current loan application activity to the
  required loan activity to meet the current loan
  demand

The current demand exceeds the current capacity
by 15,000 processing hours
70
Incremental Analysis for Sales Mix Decisions
(contd)

• Management must determine the sales mix that
  maximizes the companys contribution margin
  
• Will also maximize its operating income

71
Incremental Analysis Sales Mix Decision
Involving Constrained Resources
72
Incremental Analysis for Sales Mix Decisions
(contd)
73
Discussion

• Why are sales mix decisions important?
• Sales mix decisions are important because of
  limited resources. Incremental analysis for
  sales mix decisions helps managers determine
  which products or services contribute the most to
  company profitability in relation to the amount
  of capital assets or other constrained resources
  needed to offer those items

74
Incremental Analysis for Sell or Process-Further
Decisions

• Objective 7
• Perform incremental analysis for sell or
  process-further decisions

75
Incremental Analysis for Sell or Process-Further
Decisions

• Some companies offer products or services that
  can either be sold in a basic form or be
  processed further and sold as a more refined
  product or service to a different market
• Example
• Meatpacking company
• Can sell sides of beef and pounds of bones to
  other companies for further processing
  
• Can decide to cut and package meet, process bone
  into fertilizer, and tan hides into leather

76
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• Sell or process-further decision
• A decision about whether to sell a joint product
  at the split-off point or sell it after further
  processing
  
• Joint products
• Two or more products, made from a common material
  or process, that cannot be identified as separate
  products or services during some or all of the
  processing
• Split-off point
• A specific point where joint products or services
  become separate and identifiable
  
• Point at which a company may choose to sell or
  process further

77
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• Objective of incremental analysis for sell or
  process-further decisions
  
• Select the alternative that maximizes operating
  income
  
• Based on
• Organizations strategic plan and objectives
• Relevant revenues and costs
• Qualitative factors

78
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• Steps in incremental analysis process
• Calculate incremental revenue
• Difference between total revenue if sold at
  split-off point and total revenue if sold after
  processing further
  
• Compare incremental revenue to incremental costs
  of processing further
  
• Choose to process further if incremental revenue
  exceeds incremental costs
  
• If incremental costs exceed incremental revenue,
  choose to sell at the split-off point

79
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• Joint costs, or common costs, are ignored in the
  analysis
  
• They are incurred before the split-off point and
  do not change if further processing occurs

Even though joint costs are assigned to products
or services when valuing inventories and
calculating cost of goods sold, they are not
relevant to a sell or process further decision
80
Incremental Analysis for Sell or Process-Further
Decisions (contd)
Home State Banks management is looking for new
markets for banking services. They are
considering adding two levels of service beyond
the Basic Checking account services, Premier
Checking and Personal Banker

• Basic Checking
• Online checking account, debit card, and online
  bill payment with a required minimum average
  balance (RMAB) of 500
  
• Premier Checking
• Paper and online checking account, debit card, a
  credit card, and a small life insurance policy
  equal to the maximum credit limit on the credit
  card. RMAB 1,000
• Personal Banker
• All the features of Premier Checking plus a safe
  deposit box, 5,000 personal line of credit at
  prime, financial investment advice, and a toaster
  on opening the account. RMAB 5,000

81
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• The bank can earn sales revenue of 5 percent on
  its checking account balances
  
• The total cost of Basic Checking is currently
  50,000
  
• The banks accountant provided the following data
  per account

82
Incremental Analysis Sell or Process-Further
Decision
83
Incremental Analysis for Sell or Process-Further
Decisions (contd)

• The analysis indicates that the bank should offer
  personal banking services in addition to Basic
  Checking accounts
  

Notice that the 50,000 joint costs of Basic
Checking were ignored because they are sunk costs
that will not influence the decision
84
Discussion

• What is the objective of a sell or
  process-further decision?
  
• The objective is to select the alternative that
  maximizes operating income, based on the
  organizations strategic plan and objectives, the
  relevant revenues and costs, and qualitative
  factors

85
Time for Review

• Explain how managers make short-run decisions
  during the management cycle
  
• Define incremental analysis and describe how it
  applies to short-run decision analysis
  
• Perform incremental analysis for outsourcing
  decisions

86
And Finally

• Perform incremental analysis for special order
  decisions
  
• Perform incremental analysis for segment
  profitability decisions
  
• Perform incremental analysis for sales mix
  decisions involving constrained resources
  
• Perform incremental analysis for sell or
  process-further decisions