# Marginal costing applications

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Published on August 9, 2008

Author: divinvarghese

Source: slideshare.net

## Description

Marginal costing applications

Chapter 26 Special Business Decisions and Capital Budgeting

Identify the relevant information for a special business decision. Objective 1

Identify the relevant information

Relevant Information for Decision Making Relevant information has two distinguishing characteristics. It is expected future data that differs among alternatives. Only relevant data affect decisions.

Relevant information has two distinguishing characteristics.

Make five types of short-term special business decisions. Objective 2

Make five types of short-term

Special Sales Order A. B. Fast is a manufacturer of automobile parts located in Texas. Ordinarily A. B. Fast sells oil filters for \$3.22 each. R. Pino and Co., from Puerto Rico, has offered \$35,400 for 20,000 oil filters, or \$1.77 per filter.

A. B. Fast is a manufacturer of automobile parts located in Texas.

Ordinarily A. B. Fast sells oil filters for \$3.22 each.

R. Pino and Co., from Puerto Rico, has offered \$35,400 for 20,000 oil filters, or \$1.77 per filter.

Special Sales Order A. B. Fast’s manufacturing product cost is \$2 per oil filter which includes variable manufacturing costs of \$1.20 and fixed manufacturing overhead of \$0.80. Suppose that A. B. Fast made and sold 250,000 oil filters before considering the special order. Should A. B. Fast accept the special order?

A. B. Fast’s manufacturing product cost is \$2 per oil filter which includes variable manufacturing costs of \$1.20 and fixed manufacturing overhead of \$0.80.

Suppose that A. B. Fast made and sold 250,000 oil filters before considering the special order.

Should A. B. Fast accept the special order?

Special Sales Order The \$1.77 offered price will not cover the \$2 manufacturing cost. However, the \$1.77 price exceeds variable manufacturing costs by \$.57 per unit. Accepting the order will increase A. B. Fast’s contribution margin. 20,000 units × \$.57 contribution margin per unit = \$11,400

The \$1.77 offered price will not cover the \$2 manufacturing cost.

However, the \$1.77 price exceeds variable manufacturing costs by \$.57 per unit.

Accepting the order will increase A. B. Fast’s contribution margin.

20,000 units × \$.57 contribution margin per unit = \$11,400

Dropping Products, Departments, Territories Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil filters and 20,000 air cleaners). Suppose that the company is considering dropping the air cleaner product line. Revenues for the air cleaner product line are \$41,000. Should A. B. Fast drop the air cleaner line?

Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil filters and 20,000 air cleaners).

Suppose that the company is considering dropping the air cleaner product line.

Revenues for the air cleaner product line are \$41,000.

Should A. B. Fast drop the air cleaner line?

Dropping Products, Departments, Territories Variable selling and administrative expenses are \$0.30 per unit. Variable manufacturing expenses are \$1.20 per unit. Total fixed expenses are \$335,000. Total fixed expenses will continue even if the product line is dropped.

Variable selling and administrative expenses are \$0.30 per unit.

Variable manufacturing expenses are \$1.20 per unit.

Total fixed expenses are \$335,000.

Total fixed expenses will continue even if the product line is dropped.

Dropping Products, Departments, Territories Product Line Oil Filters Air Cleaners Total Units 250,000 20,000 270,000 Sales \$805,000 \$ 41,000 \$846,000 Variable expenses 375,000 30,000 405,000 Contribution margin \$430,000 \$ 11,000 \$441,000 Fixed expenses 310,185 24,815 335,000 Operating income/(loss) \$119,815 (\$13,815) \$106,000

Dropping Products, Departments, Territories To measure product-line operating income, A. B. Fast allocates fixed expenses in proportion to the number of units sold. Total fixed expenses are \$335,000 ÷ 270,000 units, or \$1.24 fixed unit cost. Fixed expenses allocated to the air cleaner product line are 20,000 units × \$1.24 per unit, or \$24,815.

To measure product-line operating income, A. B. Fast allocates fixed expenses in proportion to the number of units sold.

Total fixed expenses are \$335,000 ÷ 270,000 units, or \$1.24 fixed unit cost.

Fixed expenses allocated to the air cleaner product line are 20,000 units × \$1.24 per unit, or \$24,815.

Oil Filters Alone Units 250,000 Sales \$805,000 Variable expenses 375,000 Contribution margin 430,000 Fixed expenses 335,000 Operating income \$ 95,000 Dropping Products, Departments, Territories

Oil Filters Alone

Units 250,000

Sales \$805,000

Variable expenses 375,000

Contribution margin 430,000

Fixed expenses 335,000

Operating income \$ 95,000

Dropping Products, Departments, Territories Suppose that the company employs a supervisor for \$25,000. This cost can be avoided if the company stops producing air cleaners. Should the company stop producing air cleaners? Yes! \$11,000 – \$25,000 = (\$14,000)

Suppose that the company employs a supervisor for \$25,000.

This cost can be avoided if the company stops producing air cleaners.

Should the company stop producing air cleaners?

Yes!

\$11,000 – \$25,000 = (\$14,000)

Product Mix Companies must decide which products to emphasize if certain constraints prevent unlimited production or sales. Assume that A. B. Fast produces oil filters and windshield wipers. The company has 2,000 machine hours available to produce these products.

Companies must decide which products to emphasize if certain constraints prevent unlimited production or sales.

Assume that A. B. Fast produces oil filters and windshield wipers.

The company has 2,000 machine hours available to produce these products.

Product Mix A. B. Fast can produce 5 oil filters in one hour or 8 windshield wipers. Product Oil Windshield Per Unit Filters Wipers Sales price \$3.22 \$13.50 Variable expenses 1.50 12.00 Contribution margin \$1.72 \$ 1.50 Contribution margin ratio 53% 11%

Product Mix Which product should A. B. Fast emphasize? Oil filters: \$1.72 contribution margin per unit × 5 units per hour = \$8.60 per machine hour Windshield wipers: \$1.50 contribution margin per unit × 8 units per hour = \$12.00 per machine hour

Outsourcing (Make or Buy) A. B. Fast is considering the production of a part it needs, or using a model produced by C. D. Enterprise. C. D. Enterprise offers to sell the part for \$0.37. Should A. B. Fast manufacture the part or buy it?

A. B. Fast is considering the production of a part it needs, or using a model produced by C. D. Enterprise.

C. D. Enterprise offers to sell the part for \$0.37.

Should A. B. Fast manufacture the part or buy it?

Outsourcing (Make or Buy) A. B. Fast has the following costs for 250,000 units of Part no. 4: Part no. 4 costs: Total Direct materials \$ 40,000 Direct labor 20,000 Variable overhead 15,000 Fixed overhead 50,000 Total \$125,000 \$125,000 ÷ 250,000 units = \$0.50/unit

Outsourcing (Make or Buy) Assume that by purchasing the part, A. B. Fast can avoid all variable manufacturing costs and reduce fixed costs by \$15,000 (fixed costs will decrease to \$35,000). A. B. Fast should continue to manufacture the part. Why?

Assume that by purchasing the part, A. B. Fast can avoid all variable manufacturing costs and reduce fixed costs by \$15,000 (fixed costs will decrease to \$35,000).

A. B. Fast should continue to manufacture the part.

Why?

Outsourcing (Make or Buy) Purchase cost (250,000 × \$0.37) \$ 92,500 Fixed costs that will continue 35,000 Total \$127,500 The unit cost is then \$0.51 (\$127,500 ÷ 250,000). \$127,500 – \$125,000 = \$2,500, which is the difference in favor of manufacturing the part.

Best Use of Facilities Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the facilities previously used to manufacture Part no. 4 to produce gasoline filters. The expected annual profit contribution of the gasoline filters is \$17,000. What should A. B. Fast do?

Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the facilities previously used to manufacture Part no. 4 to produce gasoline filters.

The expected annual profit contribution of the gasoline filters is \$17,000.

What should A. B. Fast do?

Best Use of Facilities Expected cost of obtaining 250,000 parts: Make part \$125,000 Buy part and leave facilities idle \$127,500 Buy part and use facilities for gas filters \$110,500* *Cost of buying part: \$127,500 less \$17,000 contribution from gasoline filters.

Sell As-Is Or Process Further The sell as-is or process further is a decision whether to incur additional manufacturing costs and sell the inventory at a higher price, or sell the inventory as-is at a lower price. Suppose that A. B. Fast spends \$500,000 to produce 250,000 oil filters. A. B. Fast can sell these filters for \$3.22 per filter, for a total of \$805,000.

The sell as-is or process further is a decision whether to incur additional manufacturing costs and sell the inventory at a higher price,

or sell the inventory as-is at a lower price.

Suppose that A. B. Fast spends \$500,000 to produce 250,000 oil filters.

A. B. Fast can sell these filters for \$3.22 per filter, for a total of \$805,000.

Sell As-Is Or Process Further Alternatively, A. B. Fast can further process these filters into super filters at an additional cost of \$25,000, which is \$0.10 per unit (\$25,000 ÷ 250,000 = \$0.10). Super filters will sell for \$3.52 per filter for a total of \$880,000. Should A. B. Fast process the filters into super filters?

Alternatively, A. B. Fast can further process these filters into super filters at an additional cost of \$25,000, which is \$0.10 per unit (\$25,000 ÷ 250,000 = \$0.10).

Super filters will sell for \$3.52 per filter for a total of \$880,000.

Should A. B. Fast process the filters into super filters?

Sell As-Is Or Process Further A. B. Fast should process further, because the \$75,000 extra revenue (\$880,000 – \$805,000) outweighs the \$25,000 cost of extra processing. Extra sales revenue is \$0.30 per filter. Extra cost of additional processing is \$0.10 per filter.

A. B. Fast should process further, because the \$75,000 extra revenue (\$880,000 – \$805,000) outweighs the \$25,000 cost of extra processing.

Extra sales revenue is \$0.30 per filter.

Extra cost of additional processing is \$0.10 per filter.

Sell As-Is Or Process Further Cost to produce 250,000 parts: \$500,000 Sell these parts for \$3.22 each: \$805,000 Cost to process original parts further: \$ 25,000 Sell these parts for \$3.52 each: \$880,000 Sales increase (\$880,000 – \$805,000) \$ 75,000 Less processing cost 25,000 Net gain by processing further \$ 50,000

Explain the difference between correct analysis and incorrect analysis of a particular business decision. Objective 3

Explain the difference between

correct analysis and incorrect

analysis of a particular

Correct Analysis A correct analysis of a business decision focuses on differences in revenues and expenses. The contribution margin approach, which is based on variable costing, often is more useful for decision analysis. It highlights how expenses and income are affected by sales volume.

A correct analysis of a business decision focuses on differences in revenues and expenses.

The contribution margin approach, which is based on variable costing, often is more useful for decision analysis.

It highlights how expenses and income are affected by sales volume.

Incorrect Analysis The conventional approach to decision making, which is based on absorption costing, may mislead managers into treating a fixed cost as a variable cost. Absorption costing treats fixed manufacturing overhead as part of the unit cost.

The conventional approach to decision making, which is based on absorption costing, may mislead managers into treating a fixed cost as a variable cost.

Absorption costing treats fixed manufacturing overhead as part of the unit cost.

Use opportunity costs in decision making. Objective 4

Use opportunity costs

in decision making.

Opportunity Cost... is the benefit that can be obtained from the next best course of action. Opportunity cost is not an outlay cost, so it is not recorded in the accounting records. Suppose that A. B. Fast is approached by a customer that needs 250,000 regular oil filters.

is the benefit that can be obtained from the next best course of action.

Opportunity cost is not an outlay cost, so it is not recorded in the accounting records.

Suppose that A. B. Fast is approached by a customer that needs 250,000 regular oil filters.

Opportunity Cost The customer is willing to pay more than \$3.22 per filter. A. B. Fast’s managers can use the \$855,000 (\$880,000 – \$25,000) opportunity cost of not further processing the oil filters to determine the sales price that will provide an equivalent income. \$855,000 ÷ 250,000 units = \$3.42

The customer is willing to pay more than \$3.22 per filter.

A. B. Fast’s managers can use the \$855,000 (\$880,000 – \$25,000) opportunity cost of not further processing the oil filters to determine the sales price that will provide an equivalent income.

\$855,000 ÷ 250,000 units = \$3.42

Use four capital budgeting models to make longer-term investment decisions. Objective 5

Use four capital budgeting

models to make longer-term

investment decisions.

Capital Budgeting... is a formal means of analyzing long-range capital investment decisions. The term describes budgeting for the acquisition of capital assets. Capital assets are assets used for a long period of time.

is a formal means of analyzing long-range capital investment decisions.

The term describes budgeting for the acquisition of capital assets.

Capital assets are assets used for a long period of time.

Capital Budgeting Capital budget models using net cash inflow from operations are: payback accounting rate of return net present value internal rate of return

Capital budget models using net cash inflow from operations are:

payback

accounting rate of return

net present value

internal rate of return

Payback... is the length of time it takes to recover, in net cash inflows from operations, the dollars of capital outlays. An increase in cash could result from an increase in revenues, a decrease in expenses, or a combination of the two.

is the length of time it takes to recover, in net cash inflows from operations, the dollars of capital outlays.

An increase in cash could result from an increase in revenues, a decrease in expenses, or a combination of the two.

Payback Example Assume that A. B. Fast is considering the purchase of a machine for \$200,000, with an estimated useful life of 8 years, and zero predicted residual value. Managers expect use of the machine to generate \$40,000 of net cash inflows from operations per year.

Assume that A. B. Fast is considering the purchase of a machine for \$200,000, with an estimated useful life of 8 years, and zero predicted residual value.

Managers expect use of the machine to generate \$40,000 of net cash inflows from operations per year.

Payback Example How long would it take to recover the investment? \$200,000 ÷ \$40,000 = 5 years 5 years is the payback period.

How long would it take to recover the investment?

\$200,000 ÷ \$40,000 = 5 years

5 years is the payback period.

Payback Example When cash flows are uneven, calculations must take a cumulative form. Cash inflows must be accumulated until the amount invested is recovered. Suppose that the machine will produce net cash inflows of \$90,000 in Year 1, \$70,000 in Year 2, and \$30,000 in Years 3 through 8.

When cash flows are uneven, calculations must take a cumulative form.

Cash inflows must be accumulated until the amount invested is recovered.

Suppose that the machine will produce net cash inflows of \$90,000 in Year 1, \$70,000 in Year 2, and \$30,000 in Years 3 through 8.

Payback Example What is the payback period? Years 1, 2, and 3 together bring in \$190,000. Recovery of the amount invested occurs during Year 4. Recovery is 3 years + \$10,000. 3 years + (\$10,000 ÷ \$30,000) = 3 years and 4 months

What is the payback period?

Years 1, 2, and 3 together bring in \$190,000.

Recovery of the amount invested occurs during Year 4.

Recovery is 3 years + \$10,000.

3 years + (\$10,000 ÷ \$30,000) = 3 years and 4 months

Accounting Rate of Return... measures profitability. It measures the average return over the life of the asset. It is computed by dividing average annual operating income by the average amount of investment in the asset.

measures profitability.

It measures the average return over the life of the asset.

It is computed by dividing average annual operating income by the average amount of investment in the asset.

Accounting Rate of Return Example Assume that a machine costs \$200,000, has no residual value, and has a useful life of 8 years. How much is the straight-line depreciation per year? \$25,000 Management expects the machine to generate annual net cash inflows of \$40,000.

Assume that a machine costs \$200,000, has no residual value, and has a useful life of 8 years.

How much is the straight-line depreciation per year?

\$25,000

Management expects the machine to generate annual net cash inflows of \$40,000.

Accounting Rate of Return Example How much is the average operating income? \$40,000 – \$25,000 = \$15,000 How much is the average investment? \$200,000 ÷ 2 = \$100,000 What is the accounting rate of return? \$15,000 ÷ \$100,000 = 15%

How much is the average operating income?

\$40,000 – \$25,000 = \$15,000

How much is the average investment?

\$200,000 ÷ 2 = \$100,000

What is the accounting rate of return?

\$15,000 ÷ \$100,000 = 15%

Discounted Cash-Flow Models Discounted cash-flow models take into account the time value of money. The time value of money means that a dollar invested today can earn income and become greater in the future. These methods take those future values and discount them (deduct interest) back to the present.

Discounted cash-flow models take into account the time value of money.

The time value of money means that a dollar invested today can earn income and become greater in the future.

These methods take those future values and discount them (deduct interest) back to the present.

Net Present Value The (NPV) method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present. The amount of interest deducted is determined by the desired rate of return. This rate of return is called the discount rate, hurdle rate, required rate of return, or cost of capital.

The (NPV) method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present.

The amount of interest deducted is determined by the desired rate of return.

This rate of return is called the discount rate, hurdle rate, required rate of return, or cost of capital.

Net Present Value Example A. B. Fast is considering an investment of \$450,000. This proposed investment will yield periodic net cash inflows of \$225,000, \$230,000, and \$210,000 over its life. A. B. Fast expects a return of 16%. Should the investment be made?

A. B. Fast is considering an investment of \$450,000.

This proposed investment will yield periodic net cash inflows of \$225,000, \$230,000, and \$210,000 over its life.

A. B. Fast expects a return of 16%.

Net Present Value Example Periods Amount PV Factor Present Value 0 (\$450,000) 1.000 (\$450,000) 1 225,000 0.862 193,950 2 230,000 0.743 170,890 3 210,000 0.641 134,610 Total PV of net cash inflows \$499,450 Net present value of project \$ 49,450

Internal Rate of Return... is another model using discounted cash flows. The internal rate of return (IRR) is the rate of return that a company can expect to earn by investing in a project. The higher the IRR, the more desirable the investment.

is another model using discounted cash flows.

The internal rate of return (IRR) is the rate of return that a company can expect to earn by investing in a project.

The higher the IRR, the more desirable the investment.

Internal Rate of Return The IRR is the rate of return at which the net present value equals zero. Investment = Expected annual net cash inflow × PV annuity factor Investment ÷ Expected annual net cash inflow = PV annuity factor

The IRR is the rate of return at which the net present value equals zero.

Investment = Expected annual net cash inflow × PV annuity factor

Investment ÷ Expected annual net cash inflow = PV annuity factor

Internal Rate of Return Example Assume that A. B. Fast is considering investing \$500,000 in a project that will yield net cash inflows of \$152,725 per year over its 5-year life. What is the IRR of this project? \$500,000 ÷ \$152,725 = 3.274 (PV annuity factor)

Assume that A. B. Fast is considering investing \$500,000 in a project that will yield net cash inflows of \$152,725 per year over its 5-year life.

What is the IRR of this project?

\$500,000 ÷ \$152,725 = 3.274 (PV annuity factor)

Internal Rate of Return Example The annuity table shows that 3.274 is in the 16% column for a 5-period row in this example. Therefore, 16% is the internal rate of return of this project. If the minimum desired rate of return is 16% or less, A.B. Fast should undertake this project.

The annuity table shows that 3.274 is in the 16% column for a 5-period row in this example.

Therefore, 16% is the internal rate of return of this project.

If the minimum desired rate of return is 16% or less, A.B. Fast should undertake this project.

Compare and contrast popular capital budgeting methods. Objective 6

Compare and contrast popular

capital budgeting methods.

Comparison of Capital Budgeting Models The discounted cash-flow models, net present value, and internal rate of return are conceptually superior to the payback and accounting rate of return models. Strengths of the payback include: It is easy to calculate, highlights risks, and is based on cash flows.

The discounted cash-flow models, net present value, and internal rate of return are conceptually superior to the payback and accounting rate of return models.

Strengths of the payback include:

It is easy to calculate, highlights risks, and is based on cash flows.

Comparison of Capital Budgeting Models Its weaknesses are that it ignores cash flows beyond the payback, the time value of money, and profitability. The strength of the accounting rate of return is that it is based on profitability. Its weakness is that it ignores the time value of money.

Its weaknesses are that it ignores cash flows beyond the payback, the time value of money, and profitability.

The strength of the accounting rate of return is that it is based on profitability.

Its weakness is that it ignores the time value of money.

End of Chapter 26

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