Managerial Accounting 08

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ost major airlin e s ,in c lu d in gDe lt a , o u t s o u rc ewo rk . I n 20 02, Delta announcedplan s t o s a v e o v e r $ 1 5 millio n a y e a r b y outsourcingits reservationwork to call centersin the Philippinesand costs347"ayear lndia.ln 2005,Deltarevealedplansto cut maintenance b y outsourcing much of its a irp la n e ma in t e n a n c et o Mia mi- a n d firms. But why would Delta outsourceso much of its Canadian-based work? Primarilyto cut costs.Most of the majorairlinesare experiencing fin ancialdifficultiesdue to ri s in gf u e l c o s t sa n d t ig h t c o mp e t it io n ,s o they need to find ways to cut costs.One way is through outsourcing. Companiescan save 20o/oor more by outsourcingcall center work to English-speaking workersin developingcountries. Outsourcingalsoenablescompaniesto concentrateon their core competencies-theoperatingactivitiesin whichthey are experts.When

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companiesfocus on just their core competencies,they often outsource the activitiesthat do not give them a competitive advantage.For example,heavy maintenanceof aircraft,which can take two to three weeks per plane, requires specializedexpertise. This expertise is providedby membersof the outsideairlinemaintenance industry,which performsover half of all airlinemaintenance.Delta'sstrategyis to focus on its core competency-flying passengers-and outsource other operatingactivities,such as reservations and airplanemaintenance, to companieswho excel at those activities.ffi

Learning Objectives fl

Oescribeand identifyinformationrelevantto short-termbusinessdecisions

fl

V"t" specialorderdecisions

ffi

Vrt" pricing decisions

or territorydecisions ffil V.t" droppinga product,department,

ffi

V"t" productmixdecisions

ffi

(make-or-buy) V"t" outsourcing decisions

ffi

Vf.t" sellasis or process furtherdecisions

[n th. last chapter, we saw how managers use cost behavior to determine the company's breakevenpoint and to estimate the sales volume needed to achieve target profits. In this chapter,we'll seehow managersuse their knowledge of cost behavior to make six specialbusinessdecisions,such as whether to outsourceoperating activities.The decisionswe'll discussin this chapter pertain to short periods of time, so managersdo not needto worry about the time value of money.In other words, they do not need to compute the present value of the revenuesand expensesrelating to the decision.In Chapter 9, we will discusslonger-termdecisions(suchas buying equipment and undertaking plant expansions)in which the time value of money becomesimportant. Before we look at the six businessdecisionsin detail, Iet's consider a manager's decision-makingprocessand the information managersneedto evaluatetheir options.

How ManagersMake Decisions Exhibit 8-1 illustrates how managers decide among alternative courses of action. Management accountants help gather and analyze releuant information to compare alternatives. Management accountants also help with the follow-up: comparing the actual results of a decision to those originally anticipated. This feedback helps management as it faces similar types of decisionsin the future. It also helps management adjust current operations if actual results of its decision are markedly different from those anticioated.

Short-TermBusinessDecisions

415

HowManagersMakeDecisions

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managersmake decisions,they focus on costs and revenuesthat are relevant to the decisions.Exhibit B-2 shows that relevant information: 1,. Is expectedfuture data. 2. Differs among alternatives.

RelevantInformation

S alesF o re c a s t Ac c epts pec i aol r d e r

R e j e cstp e c i aol r d e r

Salesr ev en u$e1 0 0M

Salesrevenue $75M

Recall our discussionof relevant costs in Chapter 2. In deciding whether to purchase a Toyota Corolla or Nissan Sentra, the cost of the car, the salestax, and the insurancepremium are relevant becausethesecosts: . Are incurred in the future (after you decide to buy the car). . Differ between abernatiues (each car has a different invoice price, salestax, and insurancepremium).

Describeand identify i nformati on relevant to short-term busi ness decisions

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These costs are releuant because they affect your decision of which car to purchase. Irreleuant costs are costs that do not affect your decision. For example, becausethe Corolla and Sentra both have similar fuel efficiency and maintenance ratings, we do not expect the car operating costs to differ between alternatives. Because these costs do not differ, they do not affect your decision. In other words, they are irreleuant to the decision. Similarly, the cost of a campus parking sticker is also irrelevant because the sticker costs the same whether vou buv the Sentra or the Corolla. Sunk costs are also irrelevant to your decision. Sunk costs are costs that were incurred in the past and cannot be changed regardless of which future action is taken. Perhaps you want to trade in your current truck when you buy your new car. The amount you paid for the truck-which you bought for $15,000 ayear ago-is a sunk cost. In fact,it doesn't matter whether you paid $15,000 or $50,000-it's still a sunk cost. No decision made now can alter the past. You akeady bought the truck, so the price you paid for it is a sunk cost. AII you can do now is keep the truck, trade it in, or sell it for the best price you can get, even if that price is substantially less than what you originally paid for the truck. \7hat rs relevant is what you can get for your truck in the future. Supposethe Nissan dealership offers you $8,000 for your truck. The Toyota dealership offers you $10,000. Becausethe amounts differ and the transaction will take place in the future, the trade-in value is relevant to your decision. The sameprinciple applies to all situations-only releuant data affect decisions. Let's consider another application of this general principle. Suppose Pendleton tffoolen Mills is deciding whether to use pure wool or a wool blend in a new line of sweaters.Assume that Pendleton'Woolen Mills oredicts the following costs under the two alternatives:

The cost of direct materials is relevant becausethis cost differs between alternatives (the wool costs $4 more than the wool blend). The labor cost is irrelevant becausethat cost is the same for both kinds of wool.

Youareconsidering your PentiumlV computerwith the latestmodel.ls replacing the $1,200you spent (in 2005)on the Pentiumrelevantto your decisionabout buyingthe newmodel? Artfiu'+.*r'; The $'l,2OO cost of your Pentiumis irrelevant. The $1,200is a sunkcost that you incurredin the past, so it is the same whether or not you buy the new comouter.

Short-TermBusinessDecisions

Relevant Nonfinancial Information Nonfinancial, or qualitative factors, also play a role in managers' decisions. For example, closing manufacturing plants and laying off employeescan seriously hurt employee morale. Outsourcing can reduce control over delivery time and product quality. Offering discounted prices to select customers can upset regular customers and tempt them to take their businesselsewhere.Managers must think through the likely quantitative and qualitative effects of their decisions. Managers who ignore qualitative factors can make serious mistakes. For example, the City of Nottingham, England, spent $t.6 million on 215 solarpowered parking meters after seeing how well the parking meters worked in countries along the Mediterranean Sea. However, the city did not consider that British skies are typically overcast. The result? The meters didn't always work because of the lack of sunlight. The city /osf money because people ended up parking for free! Relevant qualitative information has the same characteristics as relevant financial information: The qualitative factor occurs in the future, and it differs between alternatives. The amount of futwre sunshine required differed between alternatives: The mechanical meters didn't require any sunshine, but the solar-powered meters needed a great deal of sunshine. Likewise, in deciding between the Corolla and Sentra, you will likely consider qualitative factors that differ between the cars (legroom, trunk capacity, dashboard design, and so forth) before making your final decision. Since you must live with these factors in the future, they become relevant to your decision.

Keysto Nlaking$hort-TerrnSpecialDecisions Our approachto makingshort-termspecialdecisions is calledthereleuantinformation approachor the incrementalanalysisapproach.Instead of looking at the company's entire income statementunder each decisionalternative,we'll just look at how operatingincomewould changeor differ undereachalternative.Usingthis approach, we'II leaveout irrelevantinformation-the costsand revenuesthat won't differ betweenalternatives. 'We'll considersix kinds of decisionsin this chapter: 1. Specialsalesorders 2. Pricing 3. Droppingproducts,departments, and territories 4. Productmix 5. Outsourcing(makeor buy) 6. Sellingasis or processingfurther As you study thesedecisions,keep in mind the two keys in analyzingshort-term specialbusinessdecisionsshownin Exhibit 8-3: 1. Focus on relevant revenues,costs,and profits. Irrelevant information only cloudsthe picture and createsinformation overload.That's why we'll usethe incrementalanalysisapproach.

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2. Use a contribution margin approachthat separates variablecostsfrom fixed costs.Because fixed costsand variablecostsbehavedifferently,theymustbe analyzedseparately. which blend Traditional(absorptioncosting)incomestatements, fixed and variablecosts,can misleadmanagers. Contributionmarginincome statements, which isolatecostsby behavior(variableor fixed), help managers gatherthe cost-behavior informationthey need.Keepin mind that unit manufacturing costsare mixed costs,too, so they can alsomisleadmanagers. If you use the cost'sfixed unit manufacturing makesureyou separate costsin your analysis, and variablecomoonents first.

%

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\7e'll use these two keys in each decision.

Two Keysto MakingShort-Term SpecialDecisions

SpecialSalesOrder and Regular PricingDecisions 'We'll

start our discussionon the six businessdecisionsby looking at specialsales order decisionsand regularpricing decisions.In the past,managersdid not consider pricing to be a short-termdecision.However,product life cyclesare shrinking in most industries.Companiesoften sell productsfor only a few months before replacingthem with an updatedmodel.The clothingand technologyindustrieshave alwayshad short life cycles.Evenauto and housingstyleschangefrequently.Pricing hasbecomea shorter-termdecisionthan it was in the past. Let'sexaminea specialsalesorder in detail;then we will discussregularpricing decisions.

SpecialSalesOrder Decisions Makespecial o r derdec is ions

A specialorder occurswhen a customerrequestsa one time order at a reducedsales pri-e. Often, thesespecialorders are for large quantities.Before agreeingto the must considerthe questionsshownin Exhibit 8-4. specialdeal,management

SpecialOrderConsiderations . Do we have excesscapacity available to fill this order?

:

.'Will the reduced salesprice be high enough to cover the incremental costs of filling the order (the variable costs and any additional fixed costs)?

,,,

. Will the special order affect regular salesin the long run?

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BusinessDecisions Short-Term

First, managers must consider available capacity. If the company is already making as many units as possible and selling them all at its regular sales price, it 'Why sell for less wouldn't make senseto fill a special order at a reduced salesprice. than the current sales price? Therefore, available excess capacity is a necessityfor accepting a special order. This is true for service firms (law firms, caterers, and so forth) as well as manufacturers. Second, managers need to consider whether the special reduced salesprice is high enough to cover the incremental costs of filling the order. The special price must exceed the variable costs of filling the order, or the company will lose money on the deal. In other words, the special order must provide a positive contribution margin. Next, the company must consider fixed costs. If the company has excess capacity, fixed costs probably won't be affected by producing more units (or delivering more service). However, in some cases, management may need to hire a consultant or incur some other fixed cost to fill the special order. If so, management will need to consider whether the special sales price is high enough to generate a positive contribution margin and cover the additional fixed costs. Finally, managersneed to consider whether the special order will affect regular 'Will salesin the long run. regular customersfind out about the special order and demand a lower price or take their businesselsewhere?Vill the specialorder customer 'Sfill the specialorder come back again and again, askingfor the samereduced price? price start a price war with competitors?Managers must gamble that the answersto thesequestionsare no or consider how customerswill respond.Managers may decide that any profit from the specialsalesorder is not worth theserisks. Let's consider a special sales order example. Suppose ACDelco sells oil filters for $3.20 each. Assume that a mail-order company has offered ACDelco $35,000 for 20,000 oil filters, or $1.75 per filter ($3S,OOO+ 20,000 = $1.75). This sale will: o Use manufacturing capacity that would otherwise be idle. o Not change fixed costs. o Not require any variable nonmanufactwring expenses (because no extra marketing costs are incurred with this special order). r Not af.fectregular sales. 'We

have addressed every consideration except one: Is the special sales price high enough to cover the variable manufacturing costs associatedwith the order? Let's take a look at the wrong way and then the right way to figure out the answer to that question. Suppose ACDelco made and sold 250,000 oil filters before considering the special order. Using the traditional (absorption costing) income statement on the left-hand side of Exhibit 8-5, the manufacturing cost per unit is $2 ($500,000 + 250,000). A manager who does not examine these numbers carefully may believe that ACDelco should not accept the special order at a sale price of $1.75 because each oil filter costs $2.00 to manufacture. But appearances can be deceiving! Remember that the unit manufacturing cost of a product ($2) is a mixed cost containing both fixed and variable cost components. To correctly answer our question, we need to find only the variable portion of the manufacturing unit cost.

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Traditional(AbsorptionCosting)Formatand ContributionMargin FormatIncomeStatements - --,

Traditional

Contribution M $800,000 Salesrevenue (500,000) Less variable expenses: Manufacturing 300,000 (200,000) Marketing and administrative

Format

Sales revenue Less cost of goods sold Gross profit Less marketing and administrative expenses

Contribution margin

$800,000 $(300,000) (7s,000) (37s,000 ) 425,000

Less fixed expenses: Manufacturing Marketing and Operating income

$1o0,oo0

Operating income

$(200,000) administrative (125,000) (325,000) $100,000

The right-handsideof Exhibit 8-5 showsthe contributionmarginincomestarement that separates variableexpenses from fixed expenses. The coniributionmargin incomestatementshowsthat the uariablemanufacturingcostper unit is only $1.20 ($300,000+ 250,000).The specialsalespriceof $1.75is higherthan the variable manufacturingcost of $1.20.Therefore,the specialorder will providea positive contributionmarginof $0.55per unit ($1.2S- $1.20).Sincethe specialorderis for 20,000 units, ACDelco'stotal contributionmargin should increaseby $tt,000 (20,000unitsx $0.55per unit) if it accepts thisorder. Rememberthat in this example,ACDelco'svariablemarketing expensesare irrelevant becausethe company will not incur the usual variable marketing expenseson this specialorder.However,this won't always be the case.Many times,companieswill also incur variableoperatingexpenses(suchas freight-out) on specialorders. Using an incrementalanalysisapproach,ACDelco comparesthe additional revenuesfrom the specialorder with the incrementalexpensesto seeif the special order will contributeto profits. Exhibit 8-6 showsthat the specialsalesorder will increaserevenueby $gs,o00 (20,000x $1.75),but it will alsoincreasevariable manufacturingcost by $24,000 (20,000 x $1.20). As a result,ACDelco's contributionmargin will increaseby $11,000,as previouslyanticipated.

Incremental Analysisof Special SalesOrder Expected increasein revenues-sale of 20,000 oil filters x $1.75 each Expected increasein expenses-variable manufacturing costs: 20,000 oil filters X $1.20 each

The other costs shown in Exhibit 8-5 are irrelevant. Variable marketing and administrative expenseswill be the same whether or not ACDelco accepts the special order because ACDelco made no marketing efforts to get this sale. Fixed manufacturing expenseswon't change becauseACDelco has enough idle capacity to produce 20,000 extra oil filters without requiring additional facilities. Fixed marketing and administrative expenseswon't be affected by this special order either.

Short-TermBusinessDecisions

Becausethere are no additional fixed costs,the total increasein contribution margin flows directly to operating income. As a result, the special salesorder will increase operating income by $11,000. Notice that the analysis follows the two keys to making short-term special businessdecisions discussedearlier: (1) focus on relevant data (revenuesand costs that will change if ACDelco accepts the special order) and (2) use a contribution margin approach that separatesvariable costs from fixed costs. To summarize, for special salesorders, the decision rule is:

The absorptioncostingincomestatementon the left-handside of ExhibitB-5 What is the filtersis $500,000. 250,000 showsthat the total costof manufacturing flawin reasoning that ACDelcoshouldacceptspecialordersonly if the saleprice exceeds$2 each? Ammvrru*m arisesfrom treatinga mixedcostas thoughit The flaw in this analysis werevariable.Manufacturing one extraoil filterwill costonly$1.20-the variable manufacturing cost. Fixedexpensesare irrelevantbecauseACDelcowill incur whetheror not the company overheadexpenses of fixedmanufacturing $200,000 tota/ acceptsthe specialorder.Producing20,000moreoil filterswill not increase at the rateof $1.20per unit,not fixedexpenses, costsincrease so manufacturing 6^

^^ )z.uu oer unt r .

Regular Pricing Decisions In the specialorder decision,ACDelcodecidedto sella limited quantityof oil filters for $1.75 eacheventhough the normal price was $3.20 per unit. But how did ACDelco decideto set its regularprice at $3.20 per filter? Exhibit 8-7 showsthat managersstart with three basicquestionswhen settingregular pricesfor their Droductsor services.

RegularPricing Considerations . What is our target profit? . How much rMill customers pay? r Are we a price-taker or a price-setterfor this product?

Makepri ci ng deci si ons

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The answers to these questions are often complex and ever-changing. Stockholders expect the company to achieve certain profits. Economic conditions, historical company earnings, industry risk, competition, and new business developments all affect the level of profit that stockholders expect. Stockholders usually tie their profit expectations to the amount of assets invested in the company. For example, stockholders may expect a 1,0%"annual return on their investment. A company's stock price tends to decline if the company does not meet target profits, so managers must keep costs low while generating enough revenue to meet target profits. This leads to the second question: How much will customers pay? Managers cannot set prices above what customers are willing to pay, or sales will decline. The amount customers will pay depends on the competition, the product's uniqueness, the effectivenessof marketing campaigns, general economic conditions, and so forth. To addressthe third pricing question, imagine a continuum with price-takers at one end and price-settersat the other end. A company's products and servicesfall somewhere along this continuum, shown in Exhibit 8-8. Companies are price-takers when they have little or no control over the prices of their products or services.This occurs when their products and servicesare not unique or when competition is heavy. Examples include food commodities (milk and corn), natural resources (oil and lumber), and generic consumer products and services (paper towels, dry cleaning,and banking).

Price-Takers VersusPrice-Setters Price-takers

Price-setters

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lil

Companies are price-setterswhen they have more control over pricing-in other words, they can "set" the price to some extent. Companies are price-setters when their products are unique, which results in less competition. Unique products such as original art and jewelrS specially manufactured machinery, patented perfume scents,and custom-made furniture can command higher prices. Obviously, managers would rather be price-setters than price-takers. To gain more control over pricing, companies try to differentiate their products. They want to make their products unique in terms of features, service, or quality-or at least make you think their product is unique or somehow better even if it isn't. How do they do this? Primarily through advertising. Consider Nike's tennis shoes,Starbucks' coffee, Hallmark's wrapping paper, Nexus' shampoo, Tylenol's acetaminophen, General Mills' cereal, Capital One's credit cards, Shell'sgas,Abercrombie and Fitch's jeans-the list goes on and on. Are theseproducts really better or significantly different from their lower-priced competitors? Possibly.If these companies can make you think so, they've gained more control over their pricing becauseyou are willing to pay more for their products or services.The downside? These companies must charge higher prices or sell more just to cover their advertising costs.

Short-TermBusinessDecisions

A company's approach to pricing depends on whether its product or service is on the price-taking or price-setting side of the spectrum. Price-takers emphasize a target-pricing approach. Price-settersemphasizea cost-plus pricing approach. Keep in mind that many products fall somewhere along the continuum. Therefore, managers tend to use both approaches to some extent. 'We'll now discuss each approach in turn.

Target Pricing \flhen a company is a price-taker, it emphasizesa target pricing approach to pricing. Target pricing starts with the market price of the product (the price customers are willing to pay) and subtracts the company's desiredprofit to determine the product's target full cost-the full cost to develop, design, produce, market, deliver, and service the product. In other words, the full cost includes every cost incurred throughout the value chain. Revenueat market price Less:Desiredprofit

Iarggtls!-sqq-In this relationship, the market price is "taken." If the product's current cost is higher than the target cost, the company must find ways to reduce costs; otherwise it will not meet its profit goals. Managers often use ABC costing along with value engineering (as discussedin Chapter 5) to find ways to cut costs. Let's look at an example of target pricing. Let's assumethat oil filters are a commodity and that the current market price i s $3. 00 per f ilt er (n o t th e $ 3 .2 0 s a l e s p ri c e assumed i n the earl i er A C D el co example). Becausethe oil filters are a commodity, ACDelco will emphasize a target-pricing approach. Let's assumethat ACDelco's stockholdersexpect a 1,0Yo annual return on the company'sassets.If the company has $1,000,000 of assets,the desiredprofit is $100,000 ($1,000,000x 10%). Exhibit 8-9 calculatesthe target full cost at the current salesvolume (250,000 units). Once we know the target full cost, we can analyzethe fixed and variable cost components separately.

TargetFullCost Calculating Total Revenue at market price Less: Desired profit

full cost

250,000unitsX $3.00price= 10% x $1,000,000 of assets

$750,000 I

000

Can ACDelco make and sell 250,000 oil filters at a fsII cost of $650,000?We know from ACDelco's contribution margin income statement (Exhibit 8-5) that the co m pany ' s v ar iab l e c o s ts a re $ 1 .5 0 p e r u n i t ($375,000 + 250,000 uni ts). Thi s variable cost per unit includes both manufacturing costs ($t.ZO per unit) and marketing and administrative costs ($0.30 per unit). We also know that the company incurs $325,000 in fixed costs in its current relevant range. Again, some fixed cost stems from manufacturing and some from marketing and administrative activities. In setting regwlar sales prices, companies must couer all of their costswhether inuentoriable or period, fixed or uariable.

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Making and selling 250,000 filters currently costs the company $700,000 [(250,000 units x $1.50 variable cost per unit) + $325,000 of fixed costs],which is more than the target full cost ($650,000). So, what are ACDelco's options? 1. Accept a lower profit (an operating income of $50,000, which is a 5"/o return, not the 10"/" target return) 2. Cut fixed costs 3. Cut variable costs 4. Use other strategies. For example, ACDelco could attempt to increase salesvolume. Recall that the company has excesscapacity, so making and selling more units would affect only variable costs. The company could also consider changing or adding to its product mix. Finally, it could attempt to differentiate its oil filters (or strengthen its name brand) to gain more control over salesprices. Let's look at some of these options. ACDelco may first try to cut fixed costs. As shown in Exhibit 8-10, the company would have to reduce fixed costs to $275,000 to meet its target profit level.

CalculatingTargetFixedCost Total 375

$27s

The companywould start by consideringwhetherany discretionaryfixed costs could be eliminatedwithout harmingthe company.Sincecommittedfixed costsare nearlyimpossibleto changein the short run, ACDelcowill probablynot be ableto reducethis type of fixed cost. If the companycan'treduceits fixedcostsby $50,000($325,000currentfixed costs- $275,000target fixed costs),it would haveto lower its variablecost ro $1.30per unit, asshownin Exhibit 8-11.

CalculatingTargetUnitVariableCost Total Target full cost Less: Current fixed costs Target total variable costs Divided by number of units i:-

,

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25 $325,000 +2

1.30

Perhapsthe company could renegotiateraw materials costs with its suppliers or find a less costly way of packaging or shipping the air filters.

Short-TermBusinessDecisions

However, if ACDelco can't reduce variable costs to $1.30 per unit, could it meet its target profit through a combination of lowering both fixed costs and variable costs?

ffi', lf it wants SupposeACDelcocanreduceitscurrentfixedcostsbut onlyby $25,000. to meet its targetprofit,by how muchwill it haveto reducethe variablecost of units. eachunit?Assumethat salesvolumeremainsat 250,000 1" Companiestypicallytry to cut both fixed and variablecosts Because 'ilir";'', ACDelcocancut itsfixedcostsonlyby $25,000, to meet itstargetprofit,it would haveto cut itsvariablecostsaswell: Targetfull cost...... Less:Reduced fixedcosts($325,000 - $25,000).............. Targettotal variablecosts

$ 650,000 (300,000)

Dividedby numberof units.......

$ 350,000 + 250,000

Targetvariablecostper unit.............

$

1.40

In additionto cutting its fixed costsby $25,000, the companymust reduceits variablecostsby $0.'10per unit ($1.50- $1.40)to meet its target profit at the existingvolumeof sales.

Another strategy would be to increasesales.ACDelco's managers can use CVP analysis,as you learned in Chapter 7, to figure out how many oil filters the company would have to sell to achieve its target profit. How could the company increase demand for the oil filters? Perhaps it could reach new markets or advertise. How much would advertising cost-and how many extra oil filters would the company have to sell to cover the cost of advertising? These are only some of the questions managersmust ask. As you can see,managers don't have an easytask when the current cost exceedsthe target full cost. Sometimes,companies just can't compete given the current market price. If that's the case, they may have no other choice than to exit the market for that product.

Cost-PlusPricing S7hen a company is a price-setter, it emphasizes a cost-plus approach to pricing. This pricing approach is essentiallythe opposite of the target-pricing approach. Cost-plus pricing starts with the product's full costs (as a given) and adds its desired profit to determine a cost-plus price. Full cost Plus:Desiredprofit Cost-plusprice

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When the product is unique, the company has more control over pricing. However, the company still needsto make sure that the cost-plus price is not higher than what customers are willing to pay. Let's go back to our original ACDelco example. This time, let's assumethat the oil filters benefit from brand recognition, so the company has some control over the price it charges for its filters. Exhibit 8-12 takes a cost-plus pricing approach assumingthe current level of sales:

CalculatingCost-Plus Price

Current variable costs

Calculations 250,000unitsx $1.50perunit =

Total

$375,000 325,000 $700,000 + 100,000 $800,000 250.000 $ 3.20

Plus: Current fixed costs

+

Full product cost Plus: Desired profit

,t:

10% x $1,000,000 ofassets

Ta.rget revenue Divided by number of units Cost-plus orice per unit r'l'

If the current market price for generic oil filters is $3.00, as we assumed earlier, can ACDelco sell its brand-name filters for $3.20 apiece? The answer depends on how well the company has been able to differentiate its product or brand name. The company may use focus groups or marketing surveys to find out how customers would respond to its cost-plus price. The company may find out that its cost-plus price is too high, or it may find that it could set the price even higher without jeopardizingsales.

W Wh i c h c o s ti n g s y s tem (j ob costi ng or process costi ng) do you thi nk pri ce-s et t er s a n d p ri c e -ta k e rstypi cal l yuse? h,,t'tyt,,tr,il,r.:tu, Companies tend to be price-setters when their products are unique. U n i q u e p ro d u c tsa re produced as si ngl e i tems or i n smal l batches.Therefore,t hese c o mp a n i e s u s e j o b costi ng to determi ne the product' scost. H ow ever,companies a re p ri c e -ta k e rs when thei r products are hi gh-vol ume commodi ti es. P rocess costing better suits this type of product.

Notice how pricing decisions used our two keys to decision making: (1) focus on relevant information and (2) use a contribution margin approach that separates variable costs from fixed costs. In pricing decisions,all cost information is relevant becausethe company must cover all costs along the value chain before it can generatea profit. However, we still neededto consider variable costs and fixed costs separatelybecausethey behave differently at different volumes.

Short-Term Business Decisions 427

Our pricing decision rule is:

lf company is a ., ;r : fortheproduct:

. 'r . : l f c o m p a ni ys a fortheproduct:

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DecisionGuidelines Relevarur lruronumoNFoRBusrruess Decrsrorrrs Nike makesspecialorder and regular pricing decisions.Even though it sellsmass-produced tennis shoesand sportsclothing, Nike has differentiatedits productswith advertising.Nike's managersconsiderboth quantitative and qualitative factors as they make pricing decisions.Here are key guidelinesthat Nike's managersfollow in makins their decisions.

Decision

Guideline

\fhat information is relevant to a short-term soecial businessdecision?

Relevantinformation:

\fhat are two key guidelines in making short-term specialbusinessdecisions?

J,. Focus on releuant data. 2. Use a contribution margin approach that separates variable costs from fixed costs.

Should Nike accept a lower salesprice than the regular price for a large order from a customer in S5o Paulo, Brazil?

If the revenue from the order exceedsthe extra variable and fixed costs incurred to fill the order, then accepting the order will increaseoperatrng rncome.

\7hat shouldNike considerin settingits regular productprices?

Nike considers: 'S7hat 1. profit stockholders expect 2. \7hat price customerswill pay 'lThether 3. it is a price-setteror a price-taker

\7hat approachshouldNike take to pricing?

Nike has differentiatedits products through advertisingits brand name.Thus, Nike tendsto be a price-setter.Nike's managerscan emphasizea cost-plusapproachto pricing.

\7hat approach should discount shoe stores such as PaylessShoeSourcetake to pricing?

PaylessShoeSourcesellsgeneric shoes (no-name brands) at low prices. Paylessis a price-taker, so managers use a target-pricing approach to pncrng.

1. Pertainsto thefwtwre 2. Differs betweenalternatives

ffiwffiffiffiffi3r ffimwfuffiwmre -ffi SzigetyIndustriesmakestennis balls. Szigety'sonly plant can produce up to 2.5 million cans of balls per year. Current production is 2 million cans. Annual manufacturing, selling,and administrativefixed coststotal $700,000. The variable cost of making and selling each can of balls is $1. Stockholdersexpect a 12'h annual return on the company's$3 million of assets. Requirernearts 1. \fhat is Szigety'scurrent full cost of making and selling 2 million cans of tennis balls? \ifhat is the current hlll wnit cost of each can of tennis balls? 2. Assumethat SzigetyIndustriesis a price-takerand the current market price is $1.45 per can of balls (this is the price at which manufacturerssell to retailers).\7hat is the target full cost of producing and selling 2 million cans of balls? Given Szigety Industries'currentcosts,will the companyreachstockholders'profitgoals? 3. If Szigety Industries cannot change its fixed costs, what is the target variable cost per can of balls? 4. SupposeSzigetyIndustries could spend an extra $100,000 on advertising to differentiate its product so that it could be a price-setter.Assuming the original volume and costs plus the $100,000 of new advertisingcosts,what cost-plus price will SzigetyIndustries want to charge for a can of balls? 5. Nike has just askedSzigetyIndustriesto supply400,000 cansof balls at a special order price of $1.20 per can. Nike wants SzigetyIndustriesto packagethe balls under the Nike label (Szigetywill imprint the Nike logo on each ball and can). SzigetyIndustrieswill have to spend $10,000 to changethe packagingmachinery. Assuming the original volume and costs,should SzigetyIndustriesaccept this specialorder? (Unlike the chapter problem, assumethat Szigetywill incur variable sellingcostsas well as variable manufacturing costsrelated to this order.)

ffi,wtnlwnhilmnl* Heq nniremrrenrlit .'11 The full unit cost is:

Fixedcosts

$ 70o,ooo Plus:Total variablecosts(2 million cansx $1 per unit) ......... + 2,000,000 Totalfull costs........... $2,700,000 * 2,000,000 Dividedby numberof cans........ Fullcostpercan....... 1.3s $ ffiequnrememtP The targetfull costis: Revenueat marketprice(2,000,000units x $1.45price)..........$2,900,000 Less:Desiredprofit (12"/.X $3,000,000of assets) (3 6 0 , 0 0 0 ) Targetfwll cost......

$2,540,000

Industries' Szigety currenttotal full costs($2,700,000 from Requirement 1) are If SzigetyIndustries can'tcur $160,000higherthanthe targetfull cost($2,540,000). costs,it won't be ableto meetstockholders'profit expectatrons.

Chapter8

r.Beqrunneennonnit .B Assumingthat SzigetyIndustriescannot reduceits fixed costs,the target variable cost pef can ls:

Target fwll cost (from Requirement2)...............

$ 2,540,000 (700.000)

L es s :F ix ed c os ts ........... Target total variable costs

$ 1,840,000

D iv ided by num b e r o f u n i ts .......

+ 2,000,000

T ar get v ar iablec o s t p e r u n i t.............

$

O.gZ

Since SzigetyIndustries cannot reduce its fixed costs,it needsto reduce variable co s t sby $0. 08 per c a n ($ 1 .0 0 - $ 0 .9 2 )to me e t i ts profi t goal s.Thi s w oul d requi re an 8"/" cost reduction in variable costs,which may not be possible. filetqLurntrernerat 4 If Szigety Industries can differentiate its tennis balls, it will gain more control over pricing. The company's new cost-plus price would be: C ur r ent t ot al c o s ts(fro m R e q u i re m e n t1 )..... ...........

$2,70o,ooo + 100,000 + 360,000 $3,160,000 + 2,000,000 1.58 $

PI us :A ddit iona l c o s t o f a d v e rti s i n g................. Plus :Des ir edpro fi t (fro m R e q u i re me tn 2 ).... .......... Target revenue D iv ided by num b e r o f u n i ts ....... C os t - pluspr ic e p e r u n i t.............

SzigetyIndustries must study the market to determine whether retailers would p a y $1. 58 per c an o f b a l l s . Rt+ie1.U il 5 I L'enrlr+Lll Nike's specialorder price ($1.201is iessthan the current full cost of eachcan of balls ($ 1. : S f r om Requ i re me n t 1 ). H o w e v e r, th i s s h oul d not i nfl uence management' s decision. Szigety Industries could fill Nike's special order using existing excess capacity.SzigetyIndustriestakes an incremental analysisapproach to its decision: comparing the extra revenue with the incremental costs of accepting the order. Variable costs will increaseif SzigetyIndustries acceptsthe order, so the variable costs are relevant. Only the additional fixed costs of changing the packaging machine ($10,000) are relevantsinceall other fixed costswill remain unchanged. Revenuefrom specialorder (400,000 x $1.20 per unit) Less:Variable cost of specialorder (400,000 x $1.00)

$480,000 (400,000)

Contribution margin from specialorder...........

$ 80,000 (10,000)

Less:Additional fixed costsof specialorder.......... O per at inginc o m ep ro v i d e d b y s p e c i a lo rd e r. .........

..

$ 70,000

SzigetyIndustriesshould acceptthe specialorder becauseit will increaseoperating income by $70,000. However, SzigetyIndustriesalso needsto considerwhether its regular customerswill find out about the specialprice and demand lower prices,too.

Short-TermBusinessDecisions

43(J

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Other Short-TermSpecial BusinessDecisions In the second part of the chapter, we'll look at other short-term businessdecisions that managers face, including:

.

'$7hen to drop a product, department, or territory. 'Sfhich products to emphasizein product mix decisions. '$fhen to outsource.

.

When to sell as is or orocessfurther.

. .

Decisionsto Drop Products, Departments, or Territories M ak edr oppinga product,department, or territorydecisions

Managers often must decide whether to drop products, departments, or territories that are not as profitable as desired. Newell Rubbermaid-maker of Sharpie markers, Graco strollers, and Rubbermaid plastics-recently dropped some of its European products lines. Home Depot closed some of its Expo stores. Kroger food stores replaced some in-store movie rental departments with health food departments. How do managersmake these decisions?Exhibit 8-13 shows some questions managersmust consider when deciding whether to drop a product line, department, or terrltory.

Considerationsfor DroppingProducts, Departments,or Territories . Does the product provide a positive contribution margin? . \7ill fixed costs continue to exist even if we drop the product? . Are there any direct fixed costs that can be avoided if we drop the product? . Will dropping the product affect salesof the company's other products? . What could we do with the freed caoacitv?

Once again, we follow the two key guidelines for special business decisions: (1) focus on relevant data and (2) use a contribution margin approach. The relevant financial data are still the changesin revenuesand expenses,but now we are considering a decreasein volume rather than an increase, as we did in the special sales order decision. In the following example, we will consider how managers decide to drop a product. Managers use the same process in deciding whether to drop a department or territory. Earlier, we assumedthat ACDelco offered only one product-oil filters. Now, let's assumethat it makes and sells air cleaners,too. Exhibit 8-14 shows the company's contribution margin income statement by product line. Becausethe air cleaner product line has an operating loss of $19,074, management is considering dropping it. The first question management should ask is, does the product provide a positive contribution margin? If the product line has a negative contribution margin, the product is not even covering its variable costs. Therefore, the company should drop the product line. However, if the product line has a positive contribution margin, it is

Short-TermBusinessDecisions

ContributionMarginIncomeStatements by ProductLine Product Line Total

$ 8 3 5 ,0 0 0

$800,000 (375,000)

C o n t r i b u t i o n m ar g in ............

Air Cleaners

QZ-QS_0.* t.rut)__". PJ9,glgu ni1s)=- (?Q,QQQqnrts)

....................... (405,000)

S a l e sr e v e n u e . . . ........... L e s s :V a r i a b l e . " o."r J

Oil Filters

430,000

i.i|,{l{liri

425,000

Less: Fixed expenses: Manufacturing Marketing and adrninistratiye..... Total fixed expenses Operatir-rgincome (loss)

(200,000) (12s,000) (325,000) $105,000

(18s,18s ). (11.s,741)I (300,926)

50.74074= $14,875 x $0 462963= $9.2s9

helping to cover at least some of the company's fixed costs.In ACDelco's case,the air cleanersprovide a $5,000 positive contribution margin. ACDelco's managersnow need to consider fixed costs. SupposeACDelco allocatesfixed expensesbetween product lines in proportion to the number of units sold. Dividing the fixed manufacturing expenseof $200,000 b y 270, 000 t ot al u n i ts (o i l fi l te rs , 2 5 0 ,0 0 0 ; a ir cl eaners,20,000) yi el ds a fi xed manufacturing cost of $0.74074 per unit. Allocating this unit cost to the 250,000 oil filters assignsfixed manufacturing cost of $185,185 to this product, as shown in Exh ibit 8- 14. T he s a me p ro c e d u re a l l o c a te s$ 1 4,815 to the 20,000 ai r cl eaners. Fixed marketing and administrative expensesare allocated in the same manner. It is important to note that this allocation method is arbitrary. ACDelco could allocate fixed costs in many different ways, and each way would have allocated a different amount of fixed costs to each product line. Sincethe amount of fixed costs allocated to each product line will differ depending on the allocation method used, we need to look at fixed costs in a different light. What matters is this: 1. \fill the total fixed costs continue to exist euen if the product line is dropped? 2. Can any direct fixed costs of the air cleaners be avoided if the product line is dropped?

Fixed Costs Continue to Exist (UnavoidableFixed Costs) Fixed costs that will continue to exist even after a product is dropped are often called unavoidable fixed costs.Unavoidable fixed costs are irrelevant to the decision becausethey will not differ between alternatives - they will be incurred regardless of whether the product line is dropped. Let's assumethat all of ACDelco's fixed costs ($325,000) will continue to exist even if the company drops the air cleaners. Perhaps ACDelco makes the air cleanersin the same manufacturing facilities as the oil filters and uses the same administrative overhead. If that is the case, only the contribution margin the air cleaners provide is relevant. If ACDelco drops the air cleaners,it will lose the $5,000 contribution margin that they provide. The incremental analysis shown in Exhibit 8-15 verifies the loss. If ACDelco drops the air cleaners,revenue will decreaseby $35,000; but variable expenseswill decreaseby only $30,000, resulting in a net $5,000 decreasein operating income. Becausethe company's total fixed costs are unaffected, they aren't included in the analysis.This analysis suggeststhat management should not drop the air cleaners.

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Analysisfor Droppinga Product Incremental WhenFixedCostsContinueto Exist Expected decrease in revenues: Sal eof ai r cl eaners(20,000 x $1.75)

$3s,000

Expected decrease in expenses: Variable manufacturing expenses(20,000 x $1.50)

Pxp,""ls!,4cqry!:9A

lncome

'We could also verify that our analysisis correctby looking at what would remainif the air cleanerswere dropped: Contributionmarginfrom oil filters.......... $ +2S,OOO (all unavoidable)...................... (325,000) Less:Company'sfixed expenses Remainingoperatingincome........ $ 100p00 The company'soperatingincomeafter droppingthe air cleaners($100,000) would be $5,000lessthan before($105,000).This verifiesour earlierconclusion: Keepin by $5,000if it droppedthe air cleaners. ACDelco'sincomewould decrease mind that most companieshave many product lines. Therefore,analyzingthe more easilyby performing decisionto drop a particularproductline is accomplished an incrementalanalysis(aswe did in Exhibit 8-15) rather than addingup all of the 'We revenuesand expensesthat would remain after dropping one product line. simplyshow this secondanalysisas a meansof proving our original result.

Direct Fixed Costs That Can Be Avoided Even though ACDelco allocatesits fixed costsbetweenproduct lines, some of the fixed costs might belong strictly to the air cleanerproduct line. Thesewould be direct fixed costsof the air cleaners.lFor example,supposeACDelco employsa part-time supervisor to overseejwst the air cleanerproduct line. The supervisor's$13,000 salary is a direct fixed cost that ACDelco can auoid if it stops producing air cleaners.Avoidable fixed costs, such as the supervisor'ssalary, are releuant to the decision becausethey differ betweenalternatives(they will be incurred if the company keepsthe product line; they will not be incurred if the company drops the product line). Exhibit 8-16 shows that in this situation, operating income wlll increaseby $8,000 if ACDelco drops air cleaners. \il/hy? Becauserevenues will decline by $35,000 but expenseswill decline even more-by $+.l,OOO.The result is a net increaseto operating income of $8,000. This analysis suggeststhat management should drop the air cleaners.

Other Considerations Management must also consider whether dropping the product line, department, or territory would hurt other sales.In the examples given so far, we assumedthat dropping the air cleaners would not affect oil filter sales.However, think about a

1To aid in decision making, companies should separatedirect fixed costs from indirect fixed costs on their contribution margin income statements. Companies shot:,ldtrace direct fixed costs to the appropriate product line and allocate only indirect fixed costs among product lines. As in the ACDelco example, companies do not always make this distinction on the income statement.

Short-Term Business Decisions 433

Incremental Analysisfor Droppinga Product WhenDirectFixedCosts Can Be Avoided

T

grocery store. Even if the produce department is not profitable, would managers drop it? Probably not, because if they did, they would lose customers who want one-stop shopping. In such situations, managers must also include the loss of contribution margin from other departments affected by the change when performing the financial analysis shown previously. Management should also consider what they could do with freed capacity. In the ACDelco example, we assumedthat the company produces oil filters and air cleanersusing the same manufacturing facilities. If ACDelco drops the air cleaners, could it make and sell another product using the freed capacity? Managers should consider whether using the facilities to produce a different product would be more profitable than using the facilities to produce air cleaners.

Assumethat all of ACDelco's fixedcostsareunavoidable. lf the companydropsair cleaners,they could make sparkplugs with the freed capacity.The company expectssparkplugs would provide$50,000of sales,incur$30,000of variable costs,and incur$'10,000 of new directfixed costs.ShouldACDelcodrop the air cleaners and usethe freedcapacityto makesparkplugs? , 'r r lf all fixedcostsare unavoidable, ACDelcowould lose$5,000of contribution marginif it droppedair cleaners. ACDelcoshouldcomparethis losswith the expectedgain from producingand sellingsparkplugswith the freed capacity: Salesof sparkplugs Less:Variablecostsof sparkplugs.......... Less:Directfixedcostsof sparkp1ugs.......... Operatingincomegainedfrom sparkplugs..........

$ 50,000 (30,000) (10,000) $ 10,000

The gainfrom producingsparkplugs($10,000) outweighsthe lossfrom dropping air cleaners($5,000)Thissuggeststhat managementshouldreplaceair cleaner productionwithsparkplug production.

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Special decisions should take into account all costs affected by the choice of action. Managers must ask what total costs-variable and fixed-will change. As Exhibits 8-15 and 8-16 show, the key to deciding whether to drop products, departments, or territories is to compare the lost revenueagainst the coststhat can be saved and to consider what would be done with the freed capacity.The decision rule is:

Product Mix Decisions Makeproduct m ix dec is ions

Companiesdo not haveunlimitedresources. Constraintsthat restrictproductionor saleof a productvary from companyto company.For a manufacturersuchas Dell, the production constraintis often (becauseit's not alwaysthe case)labor hours, machinehours, or availablematerials.For a merchandisersuch as Wal-Mart, the primary constraintis cubic feet of displayspace.Other companiesare constrained by salesdemand.Competitionmay be stiff, so the companymay be ableto sellonly a limited numberof units. In suchcases,the companyproducesonly as much as it can sell.However,if a companycan sellall of the units it produces,which products should it emphasize,or make more of? Companiesfacingconstraintsconsiderthe questionsin Exhibit 8-17.

ProductMix Considerations . S7hat constraint(s) stops us from making (or displaying) all of the units we can sell? . $7hich products offer the highest contribution margin per unit of the constraint? . Would emphasizing one product over another affect fixed costs?

Consider Chazz, a manufacturer of shirts and jeans. The company can sell all of the shirts and jeans it produces, but it has only 2,000 machine hours of capacity. The company usesthe same machines to produce both jeans and shirts. In this case, machine hours is the constraint. Note that this is a short-term decision, becausein the long run, Chazz could expand its production facilities to meet salesdemand if it

Short-TermBusinessDecisions

made financial senseto do so. The following data suggestthat shirts are more profitable than jeans:

However,an important pieceof information is missing-the time it takesto makeeachproduct.Let'sassumethat Chazzcan produceeither20 pairs of ieansor 10 shirts per machinehour. The com.panywill incur the sarnefixed costseither way, so fixed costsare irreleuant.\7hich product shouldit emphasize? To maximizeprofits when fixed costsare irrelevant,follow the decisionrule:

Because machinehoursis the constraint,Chazzneedsto figureout which product has the highestcontributionmargin per machinehour.Exhibit 8-18 showsthe contributionmarginper machinehour for eachproduct.

ProductMix-Which Productto Emphasize

Jeanshave a highercontribution margin per machinehour ($240) than shirts ($tSO1.ThereforeChazzwill earn more profit by producingjeans.Why? Because eventhough jeanshave a lower contributionmargin per wnit, Chazzcan make

435

436

Chapter8

rwice as many jeansas shirtsin the availablemachinehours. Exhibit 8-18 also provesthat Chazzearnsmofe total profit by making jeans.Multiplying the contritution margin per machinehour by the availablenumber of machinehours shows that Chazz.u.r .urn $480,000of contributionmargin by producingjeansbut only $360,000by producingshirts. To maximizeprofit, Chazzshouldmake40,000ieans(2,000machinehoursX 20 for everymachinehour spent jeansper hour) andzeroshirts.\7hy zeroshirts?Because makingshirts,Chazzwould giuewp $60 of contributionmargin ($240per hour for jeansversus$180per hour for shirts).

ChangingAssumptions:Product Mix When Demand ls Limited 'We

made two assumptions about Chazz; (1,)Chazz's salesof other products, if any, won't be hurt by this decision and (2) Chazz can sell as many ieans and shirts as it can produce. Let's challenge these assumptions.First, how could making only jeans other production land not shirts) hurt salesof the company's other products? Using with their coordinate that knit sweaters ties and equipment, Chazz also makes shirts. coordinating longer offers no fallif Chazz shirtr. Ti. and sweater salesmight the decreased has new competitor A assumption. Let's challengeour second Chazz pairs of 30,000 sell only can company ieans. demand for Chazz'sjeans.Now, the should make only as many jeans as it can sell and use the remaining machine hours to oroduce shirts. Let's seehow this constraint in salesdemand changesprofitability. Recall from Exhibit 8-18 that Chazz will earn $480,000 of contribution margin from using all 2,000 machine hours to produce jeans. Howevet, if Chazz makes only 30,000 jeans,it will use only 1,500 machine hours (30,000 jeans + 20 ieans per'machine hour). That leaves 500 machine hours available for making shirts. Chazz'snew contribution margin will be:

Shirts Contribution margin per machine h o u r (fro m E x hi bi t 8-18).' .........." .

s

Machine hours devotedto product "...'

X

Total contribution margin at full capacity

u!J99

180 500

Jeans

240 $ x 1,500 $360,000

Total

2,000 $450,000

Becauseof the change in product mix, Chazz'stotal contribution margin will fall from $480,000 to $4s0,000, a $30,000 decline. chazz had to give up $60 of contribution margin per machine hour ($240 - $180) on the 500 hours it spent producing shirts rather than ieans. However, Chazz had no choice-the company would hi,e incurred an actwal /oss from producing jeans that it could not sell. If Chazz had produced 40,000 ieans but sold only 30,000, the company would have spent $480,000 to make the unsold jeans (10,000 jeans x $48 variable cost per pair of jeans) yet would have received no salesrevenue from them. \(hat about fixed costs?In most cases,changing the product mix emphasis in the short run will not affect fixed costs, so fixed costs are irrelevant. However, fixed costs could differ when a different product mix is emphasized.'$7hatif Chazz had a month-to-month lease on a zipper machine used only for making jeans? If Chazzmade only shirts, it could auoid the leasecost. However, if Chazz makes any jeans, it needs the machine. In this case, the fixed costs become relevant because ihey differ between alternative product mixes (shirts only uersus jeans only or ieans and shirts).

Short-Term Business Decisions 437

Wo uld Chaz z ' spr o d u c t m i x d e c i s i o nc h a n g e i f i t had a $20,000cancel abl el easeon a zi pper m ac hine n e e d e d o n l y fo r j e a n p ro d u c ti on?A ssume that C hazzcan sel l as ma n y unit s as it m a k e s . ,i!,r"r:,.:"rr'ri*c"r We would compare the profitability as follows:

Evenconsidering the zippermachinelease,producingjeansis more profitable than producingshirts.Chazzwould prefer producingjeans over shirtsunless demandfor jeansdropsso lowthatthe net benefitfromjeansis lessthan$360,000 (thebenefitgainedfrom solelyproducingshirts). Notice that the analysis again follows the two guidelines for special business decisions: (1) focus on relevant data (only those revenuesand costs that differ) and (2) use a contribution margin approach, which separates variable from fixed costs.

SutsCIurailmg ffiecfisfi mms(fuTmke-mn'-ffiuy) Recall from the chapter's opening story that Delta outsources much of its reservation work and airplane maintenance. Outsourcing decisions are sometimes called make-or-buy decisions becausemanagers must decide whether to buy a component product or service or produce it in-house. The heart of these decisions is bow best to wseauailable resources. Let's seehow managers make outsourcing decisions.Deflone, a manufacturer of music CDs, is deciding whether to make paper liners for CD jewel boxes (the plastic casesin which CDs are sold) in-house or whether to outsource them to MDz-Art, a company that specializesin producing paper liners. DefTone's cost to produce 250,000 liners rs:

Makeoutsourcing (make-or-buy) deci si ons

438

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Muz-Art offers to sell DefTone the liners for $0.37 each. Should DefTone make the liners or buy them from Muz-Art? DefTone's $0.50 cost per unit to make the Iiner is $0.13 higher than the cost of buying it from Muz-Art. It first appears that DefTone should outsource the liners. But the correct answer is not so simple. Why? Becausemanufacturing unit costs contain both fixed and variable components. In deciding whether to outsource, managersmust consider fixed and variable costs separately.Exhibit 8-19 shows some of the questions management must consider when deciding whether to outsource.

Outsourcing Considerations . How do our variable costs compare to the outsourcing cost? . Are any fixed costs avoidable if we outsource? . What could we do with the freed caoacitv?

Let's seehow these considerations apply to DefTone. By purchasing the liners, DefTone can avoid all variable manufacturing costs-$40,000 of direct materials, $20,000 of direct labor, and $15,000 of variable manufacturing overhead.In total, the company will save $75,000 in variable manufacturing costs, or $0.30 per liner ($75,000 + 250,000 liners). However, DefTone will have to pay the variable outsourcing cost of $0.37 per unit, or $92,500 for the 250,000 liners. Basedonly on variable costs, the lower cost alternative is to manufacture the liners in-house. However, managers must still consider fixed costs. Assume that DefTone cannot avoid any of the fixed costs by outsourcing.In this case,the company's fixed costs are irrelevant to the decision becauseDefTone would continue to incur $50,000 of fixed costsregardlessof whether the company outsources the liners. The fixed costs are irrelevant becausethey do not differ between alternatives. DefTone should continue to make its own liners becausethe variable cost of outsourcing the liners ($92,500) exceedsthe variable cost of making the liners ($75,000). However, what if DefTone can avoid some fixed costs by outsourcing the liners?Let's assumethat managementcan reducefixed overheadcost by $10,000 by outsourcing the liners. DefTone will still incur $40,000 of fixed overhead ($50,000 - $10,000)evenif they outsourcethe liners.In this case,fixed costsbecome relevant to the decision becausethey differ between alternatives.Exhibit 8-20 shows the differencesin costs betweenthe make and buv alternativesunder this scenario.

Incremental Analysisfor OutsourcingDecision

Variable costs: Direct materials Direct labor Variable overhead

$ 40,000 20,000 15,000

,i'.1'

Purchasecost from Muz-Art

(250,000 x $0,37)

$ 92,500

Fixed overhead Total cost of liners

Exhibit 8-20 showsthat it would still costDefTonelessto makethe linersthan to buy them from MDz-Art,evenwith the $10,000reductionin fixed costs.The net savingsfrom making250,000linersis $7,500.

Short-TermBusinessDecisions

Exhibit 8-20 also shows that outsourcingdecisionsfollow our two key guidelines for specialbusinessdecisions:(1) focus on relevantdata (differencesin costsin this case) and (2) usea contribution margin approachthat separatesvariablecostsfrom fixed costs. Note how the unit cost-which does not separate costs according to behavior-can be deceiving. If DefTone's managers made their decision by comparing the total manufacturing cost per liner ($0.50) to the outsourcing unit cost per liner ($0.37), they would have incorrectly decidedto outsource. Recall that the manufacturing unit cost ($0.S01contains both fixed and variable components whereas the outsourcing cost ($0.:21 is strictly variable. To make the correct decision, DefTone had to separatethe two cost components and analyzethem separately. Our decision rule for outsourcing is:

lftheincremental costsof makingelt,ilerril the incremental costsof outsourcing

costsof making lf theincremental i i ti r ti i ,i j i L

the i nc r gm ental

costs ofoutsourcing

t

i 0ilrjtsr,l;Lirf f;

$top tv Think., Assuming in fixedcostsby outsourcing, whatisthe that DefTonecouldsave$10,000 mostthe companywould be willingto pay per linerto outsourceproductionof 250,000 liners? ,lit,i't'tl\uitt,i:' To answerthat question,we must find the outsourcingprice at which DefTonewould 6e indifferent the liners. about makingthe linersor outsourcing DefTonewould be indifferentif the total costswerethe sameeitherway: Costsif making liners = Costsif outsourcingliners Variablemanufacturingcosts+ Fixed costs= Variable outsourcingcosts+ Fixed costs (250,000units x $0.30per unit) + $50,000= (250,000X outsourcingcostper unit) + $40,000 $75,000+ $50,000- $40,000= (250,000X outsourcingcostper unit) $85,000 = (250,000 X outsourcingcost per unit) = outsourcingcostper unit + 250,000 $85,000 $0.34= outsourcingcostper unit Def To ne wou ld be indif f er ent about m ak ing or o u t s o u r c i n g t h e l i n e r s i f t h e o u t -

sourcingcostpricewas$0.34per unit.At that price,DefTonewouldincurthe samecostto manufacture or outsource the liners.DefTonewouldsavemoney onlyif the outsourcing pricewaslessthan$0.34per unit.Therefore, the most DefTonewouldpayto outsourceis $0.33per liner.As shown[gle'n,a+(n ?? ^6r liner,DefTonewouldsave$2,500from outsourcing: Liner Costs

Make Liners

unitsx $0.30perunit) $ 75,000(250,000 Plus: Fixed costs 50,000 Total costs $125,000 Variablecosts

Buy Liners

Difference

x $0.33perunit) ($7,500) $ 82,500(250,000 40,000 10,000 $122,500 @

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\Jfe haven't consideredwhat DefTone could do with the freed capacity it would have if it decided to outsource the liners. The analysis in Exhibit 8-20 assumesno other use for the production facilities if DefTone buys the liners from MDz-Art. But suppose DefTone has an opportunity to use its freed capacity to make more CDs for an additional profit of $18,000. Now, DefTone must consider its opportunity cost-the benefit forgone by not choosing an alternative course of action. In this case, DefTone's opportunity cost of making the liners is the $18,000 profit it forgoes if it does not free its production facilities to make the additional CDs. Let's seehow DefTone's managers decide among three alternatives: 1. Use the facilities to make the liners 2. Buy the liners and leave facilities idle (continue to assume$10,000 of avoidable fixed costs from outsourcing liners) 3. Buy the liners and use facilities to make more CDs (continue to assume$10,000 of avoidable fixed costs from outsourcing liners) The alternative with the lowest net cost is the best use of DefTone's facilities. Exhibit 8-21 compares the three alternatives.

BestUseof FacilitiesGivenOpportunityCosts

Make Liners

Liners Facilities Make il Idle Addi[onal CPs 11

Expectedcostof 250,000liners (from Exhibit 8-20) Expectedprofit fuomadditional CDs

$125,000

$132,500

Expectednet costof obtaining250,000liners

$12s,000

$132,500

1;I r4,.500

DefToneshould buy the liners from M[z-Art and usethe vacatedfacilitiesto make more CDs. If DefTonemakesthe linersor buysthe linersfrom Muz-Art but leavesits productionfacilitiesidle,it will forgothe opportunityto earn$18,000.

,*ffiryo< Think,r How will the $18,000opportunitycost changethe maxirnumamountDefToneis willingto payto outsource eachliner? fir,v,11'1,t,;11.;ii1'n'1, DefTonewill now be willingto pay more Io outsourceits liners.In essence, the companyis willingto payfor the opportunity to makemoreCDs

DefTone's managers should consider qualitative factors as well as revenue and cost differences in making their final decision. For example, DefTone managers may believe they can better control quality or delivery schedules by making the liners themselves. This argues for making the liners. Outsourcing decisions are increasingly important in today's globally wired economy. In the past, make-or-buy decisionsoften ended up as "make" because coordination, information exchange, and paperwork problems made buying from suppliers too inconvenient. Now, companies can use the Internet to tap into information systems of suppliers and customers located around the world.

Short-TermBusinessDecisions

Paperwork vanishes, and information required to satisfy the strictest JIT delivery scheduleis available in real time. As a result, companies are focusing on their core competenciesand outsourcing more functions.

Sel!As ls or ProcessFurthenDecisions At what point in processingshould a companysell its product?Many companies, especiallyin the food processingand natural resourceindustries,face this businessdecision.Companiesin theseindustriesprocessa raw material (milk, corn, livestock,crude oil, lumber, and so forth) to a point before it is saleable. For example, Kraft pasteurizesraw milk before it is saleable.Kraft must then decidewhether it should sell the pasteurizedmilk as is or processit further into other dairy products (reduced-fatmilk, butter, sour cream, cottage cheese, yogurt, blocks of cheese,shreddedcheese,and so forth). Managersconsider the questionsshown in Exhibit 8-22 when deciding whether to sell as is or processfurther.

SellAs ls or ProcessFurther Considerations . How muchrevenuewill we receiveif we sellthe productasis? . How much revenuewill we receiveif we sell the product after processingit further? . How muchwill it costto processthe productfurther?

Let's look at one of Chevron'ssell or processfurther decisions.Suppose Chevron spent $125,000 to processcrude oil into 50,000 gallons of regular gasoline,as shownin Exhibit 8-23.After processingcrudeoil into regulargasoline, should Chevron sell the regular gas as is or should it spendmore to processthe gasolineinto premiumgrade?In makingthe decision,Chevron'smanagersconsider the following relevantinformation:

SellAs ls or ProcessFurtherDecision

Makesel las i s or processfurther deci si ons

441

442

Chapter8

.

Chevron could sell regular gasoline for $3 per gallon, for a total of

x $3.00). (5o,oo0 $150,000 o

Chevron could sell premium gasoline for $3.20 per gallon, for a total of

.

$160,000(50,000x $3.20). Chevronwould haveto spend$0.11per gallon,or $5,500(50,000gallons x $0.11),to further processregulargasolineinto premium-gradegas.

Notice that Chevron'smanagersdo not considerthe $125,000spenton processingcrudeoil into regulargasoline.Why? It is a sunkcost.Recallfrom our previous discussionthat a sunk cost is a past cost that cannot be changedregardlessof which future action the companytakes.Chevronhas incurred$125,000regardless it further into premium of whether it sellsthe regular gasolineas is or processes gasoline.Therefore,the cost is not rclevantto the decision. IncrementalAnalysis for Sell As ls or Process Further Decision

SellAs Is

Process Further

Difference

$150,000

$160,ooo (s,500 ) $150.000

$ 154,500

seethat theycan By analyzingonlythe relevantcostsin Exhibit 8-24, managers gasoline. premium gasoline into regular convert the if they increaseprofit by $+,S00 incremental ($160,000 the outweighs $150,000) The $10,000extra revenue $5,500costof the extraprocessing. Thus,the decisionrule is:

Recall that our keys to decisionmaking include (1) focusing on relevant information and (2) using a contribution margin approach that separatesvariable costs from fixed costs.The analysisin Exhibit 8-24 includes only those future costsand revenues 'We assumedthat Chevron already has the equipment that differ between alternatives. gasolineinto premium-gtadegasoline.Because regular to convert labor necessary and they were irrelevant. However, if alternatives, between not differ would fixed costs

Short-TermBusinessDecisions

443

chevron has to acquire equipment or hire employees to convert the gasoline into premium-gradegasoline,the extra fixed costs would be relevant. once again, we see that fixed costs are relevant only if they differ between alternatives.

supposeone of chevron'scustomers wantsto buy the 50,000gallons,but in the form of regulargasoline,not premiumgasoline.The customeiis wiliingto pay more than $3 a gallon for the regulargasoline.what is the minimumprice Chevronshouldcharge? Affisuqdwr; Exhibit8-24showsthat if Chevrondoes not processthe gasolineinto premiumgrade,it willgiveup $154,500 of net revenue($160,000 revenues givenup - $5,500furtherprocessing costnot incurred). To obtainat leastthe sameincome fromsellingthe gasoline asregulargrade,Chevronmustsellthe requlargasoline for at least$3.09per gallon($154,500 + 50,000 gallonsof regulargasofne). At $3.09per gallon,Chevronwouldbe indifferent aboutthe two alternatiues. lf the customeroffers to paymorethan$3.09per gallon,Chevron willbe betteroff sellingregulargasoline to this customer. lf the customerofferslessthan$3.09,Chevronwill be bJtteroff furtherprocessing the gasoline intopremium-grade gasoline.

DecisionGuidelines Sxonr-Tenu SpeclalBusrruess Decrslols Amazon'com has confronted most of the special businessdecisions we've covered. Here are the key guidelines Amazon.com's managers follow in making their decisions.

Decision ShouldAmazon.comdro@

Guideline If the costsavingsexceedthe lost revenues from dropping the electronics productline,thendroppingwill increase operatingincome.

Givenlimited warehousespace,which productsshould Amazon.comfocuson selline?

Amazon.comshouldfocuson sellingthe productswith the highestcontributionmarginper unit of the constraint. which is cubicfeetof warehouse space.

Should Amazon.com outsource its warehousing operations?

If the incremental costs of operating its own warehouses exceedthe costs of outsourcing, then outsourcing will increaseoperating income.

How should a company decide whether to sell a product as is or processfurther?

Processfurther only if the extra salesrevenue (from processingfurther) exceedsthe extra costs of additional processing.

ffi ffimwfuffiwrc ffiwffiffiffiffi&fl Reqttrfrremen-nts 1. Aziz producesstandardand deluxesunglasses: Per Pair Standard

Deluxe

$20 16

$30 21,

Saleprice Variable expenses

The company has 15,000 machine hours available.In one machine hour, Aziz can produce 70 pairs of the standard model or 30 pairs of the deluxe model. Assuming machine hours is a constraint, which model should Aziz emphasize? 2. Just Do It! incurs the following costs for 20,000 pairs of its high-tech hikine socks:

Fixed nanufacturing overhead

$ 20,000 80,000 40,000 8 0 , 0 00

T o ta l ma n u fa c tu ri ugcost............

$220,000

C o s t p e r p a i r ($ 2 20,000:20,000) . .....' ........'

$

D i re c t ma te ri a l s..... D i re c t Ia b o r........... overhead Varia ble mar.rufacturing

rr

Another manufacturer has offered to sell Just Do It! similar socks for $10 a pan, a total purchasecost of $200,000. If Just Do It! outsourcesand leavesits plant i d l e . i t c a n s a v e $50,000 of fi xed overhead cost. Or the company can use t he releasedfacilitiesto make other products that will contribute $70,000 to profits. In rhis case,the company will not be able to avoid any fixed costs. Identify and analyze the alternatives.What is the best courseof action?

Y:n ffi il4,/'Y"[^H,W #ttflt ll{er'4[,rireffimeini!

Styleof Sunglasses Standard S a l ep ri c e p e r p ai r.......

$zo$:o (16)

Va ri a b l e e x p e n seper pai r...... Contribution margin per Pair Units produced each machine hour ..............

Total contribution margin at full capacity....

444

Chapter8

(21)

$+$s x70x30

C o n tri b u ti o n m argi n per machi nehour........ $280$ Capacity-number of machine hours ...........

Deluxe

x 15,000

270 x 15,000

$4,200,000 $4,050,000

Decision: Emphasizethe standard model becauseit has the higher contribution margin per unit of the constraint-machine hours-resulting in a higher contribution margin for the company.

Requirement 2 Bwy Socks Make Socks

Facilities ldle

Make Other Products

Relevantcosts: Dir ec t m at er i a l s ..... Dir ec t labor ........... Variable overhead F ix ed ov er he a d ...............

$ 20,000 90,000 40,000 80,000 $ i0,000

$ 80,000

Purchasecost from outsider

( 20 ,00x0 $10)

200,000

Total costof obtainingsocks...... 220,000

230,000

Profitfrom otherproducts......... Net costof obtaining20,000 pairsof socks..........

$220,000 $Z30,OOO

200,000 280,000 (70,000) $210,000

Decision:JustDo It! shouldbuy the socksfrom the outsidesupplierand usethe releasedfacilitiesto makeother oroducts.

Short-TermBusinessDecisions

RgVigW

Short-TermBusinessDecisions

wAccounting Vocabulary Gonstraint. (p. 434) A factor that restricts production or sale of a product.

Relevant Information. (p. 415) Exoected future datathal differs among alternatives.

Cost-Plus Pricing. $. a25l An approachto pricingthat beginswith the oroduct'sfull costs and adds a desiredprofitto determinea cost-plusPrice.

Sunk Gost. (p. 4t6) A past cost that cannot be changedregardless of which futureaction is taken.

Opportunity Gost. (p. 440) The benefitforgoneby not choosingan alternativecourseof action.

Target Full Cost. (p. 423) The total cost to develop,design,produce, market,deliver,and servicea product.

Outsourcing. (p. 437) A make-or-buydecision:Managersdecide whetherto buy a componentproductor service or oroduceit in-house.

wQ,uickCheck L. In making short-termspecialdecisions,you should a. focuson total costs b. separatevariablefrom fixed costs c. usea traditional absorptioncostingapproach d. focusonly on quantitativefactors

2. \flhich of the following is relevantto Amazon.com'sdecisionto accepta special order at a lower saleprice from a largecustomerin China? in the United States warehouses a. the costof Amazon.com's \Web in its site b. Amazon.com'sinvestment c. the costof shippingthe order to the customer d. founderJeff Bezos'ssalary wouldconsider productline,Amazon.com 3. In decidingwhetherto dropits electronics a. the costsit could saveby droppingthe product line b. the revenuesit would losefrom droppingthe product line c. how droppingthe electronicsproductline would affectsalesof its other products,suchas CDs d. all of the above 4. In decidingwhich product lines to emphasize,Amazon.comshould focus on the productline that hasthe highest a. contributionmarginper unit of the constrainingfactor b. contributionmarginper unit of product c. contributionmarginratio d. profit per unit of product

446

Chapter8

5. When making outsourcing decisions a.

the manufacturing full unit cost of making the product in-house is relevant

b.

the variable cost of producing the product in-house is relevant

c.

avoidable fixed costs are irrelevant

d.

expected use of the freed capacity is irrelevant 'When 6. companies are price-setters,their products and services a.

are priced by managers using a target-pricing emphasis

b.

tend to be unique

c.

tend to have a great many competitors

d.

tend to be commodities

7. \7hen pricing a product or servrce,managersmust considerwhich of the following? a.

only variable costs

b.

only period costs

c.

only manufacturing costs

d.

all costs

8. \fhich of the following costs are irrelevant to businessdecisions? a.

sunk costs

b.

costs that differ between alternatives

c.

variable costs

d.

avoidable costs

9. When deciding whether to sell as is or process a product further, managers should ignore which of the following?

a, the revenueif the product is processed further b. the costof processing further c. the costsof processing the productthus far d. the revenueif the product is sold as rs 10. When making decisions,managersshould a. considersunk costs b. considercoststhat do not differ betweenalternatives c. consideronly variablecosts d. considerrevenuesthat differ betweenalternatives

Ouick CheckAnswers p'0[ ?'6 p'8 p'l

q ' 9 q ' s p ' f p' t )' 7 q' [

For lnternet Exercises,Excel in Practice, and additional online activities, go to this book's Web site at www.prenhall.com/bamber.

Short-Term Business Decisions 447

AssessYour Progress mLearning Objectives

M Describeand identifyinformationrelevantto short-termbusinessdecisions MTMake specialorder decisions M Make pricingdecisions

wtMake droppinga product,department,or territory decisions &TMake product mix decisions

m

decisions Make outsourcing(make-or-buy)

M

Make sell as is or processfurther decisions

roShort Exercises s8-1

Determine relevance of information (Learning Obiectiue 7) You are trying to decidewhether to trade in your ink-jet printer for a more recent model.Your usagepatternwill remainunchanged,but the old and new printersuse differentink cartridges.Are the following itemsrelevantor irrelevantto your decision? a. The price of the new printer b. The priceyou paid for the old printer c. The trade-invalueof the old printer d. Papercosts e. The differencebetweenthe costof ink cartridges

s8-2

Special order decision given revised data (Leaming Obiectiue2) Suppose Considerthe ACDelco specialsalesorder exampleon pages41.9-421,. ACDelco'svariablemanufacturingcost is $1.35 per oil filter (insteadof $1.20).In addition,ACDelcowould haveto buy a specialstampingmachinethat costs$9,000 to mark the customer'slogo on the special-orderoil filters. The machinewould be scrappedwhen the specialorder is complete. \fould you recommendthat ACDelcoacceptthe specialorder undertheseconditions? Showyour analysis.

s8-3

Determine pricing approach and target price (Leaming Obiectiue3) operatesa Rocky Mountain ski resort.The companyis planningits lift SnowDreams Investorswould like to earna l5o/oreturnon the ticketpricingfor thecomingski season. Thecompanyincursprimarilyfixedcoststo groomthe company's $100million of assets. projectsfixedcoststo be $33,750,000 for the ski runsandoperatethe lifts. SnowDreams Variable eachseason. The resortservesabout750,000skiersand snowboarders season. costsare about $10 per guest.Currently,the resorthas sucha favorablereputation that it hassomecontroloverthe lift ticketprices. amongskiersand snowboarders 'Sfhy? targetpricing or cost-pluspricing. l. \(ould SnowDreamsemphasize 2. If other resortsin the areacharge$70 per day,what price should SnowDreamscharge?

Chapter8

s8-4

Use target pricing to analyze data (Learning Objectiue 3) Consider SnowDreamsfrom S8-3. Assumethat SnowDreams'reputationhas diminished and other resorts in the vicinity are charging only $65 per lift ticket. SnowDreamshas become a price-taker and won't be able to charge more than its competitors.At the market price, SnowDreamsmanagersbelievethey will still serve 750,000 skiers and snowboarderseachseason. 7. If SnowDreamscan't reduce its costs,what profit will it earn? Stateyour answer in dollars and as a percent of assets.Will investors be happy with the profit level? S ho w y o u r a n a l y s i s . 2. Assume that SnowDreams has found ways to cut its fixed costs to $30 million. lVhat is its new target variable cost per skier/snowboarder? Compare this to the current variable cost per skier/snowboarder.Comment.

s8-5

Decide whether to drop a depanment (Learning Objectiue 4) Knight Fashion in New York operates three departments: Men's, \fomen's, and Accessories.Knight Fashion allocates all fixed expenses (unavoidable building depreciationand utilities) basedon each department'ssquare footage. Departmental operating income data for the third quarter of 2007 are as follows: ' Dchartrnpni

Women's

Total

The store will remain in the samebuilding regardlessof whetherany of the departmentsare dropped.ShouldKnight Fashiondrop any of the departments? Give your reason. 58-6

Drop a department: revised information (Learning Objectiue 4) Consider Knight Fashion from S8-5. Assume that the fixed expensesassignedto each department include only direct fixed costs of the department (rather than unavoidable fixed costsas given in S8-5): . Salary of the department's manager o Cost of advertising directly related to thar department If Knight Fashion drops a department,it will not incur thesefixed expenses,Under thesecircumstances, shouldKnight Fashiondrop any of the departments?Give your reason.

S8-7

Replace a department (Learning Objectiue 4) Consider Knight Fashion from S8-5. Assume once again that all fixed costs are unavoidable. If Knight Fashion drops one of the current departments, it plans to replace the dropped department with a shoe department. The company expects the s hoe dep a rtm e n t to p ro d u c e $ 8 0,000 i n sal es and have $50,000 of variable costs. Becausethe shoe business would be new to Knight Fashion, the company would have to incur an additional $7,000 of fixed costs (advertising, new shoe display racks, and so forth) per quarter related to the departmenr. What should Knight Fashion do now?

Short-TermBusinessDecisions

449

s8-8

Product mix decision: unlimited demand (Learning Objegtiue 5) StoreAll produces plastic storage bins for household storage needs. The company makes two sizes of bins: large (50 gallon) and regular (35 gallon). Demand for the product is so high that StoreAll can sell as many of each size as it can produce. The company uses the same machinery to produce both sizes.The machinery can be run for only 3,000 hours per period. StoreAll can produce 10 large bins every hour compared to 15 regular bins in the same amount of time. Fixed expensesamount to $100,000 per period. Salesprices and variable costs are as follows:

\il/hy? 1. Which product shouldStoreAllemphasize? 2. To maximizeprofits,how many of eachsizebin shouldStoreAllproduce? 3. Giventhis productmix, what will the company'soperatingincomebe?

s8-9

Product mix decision: limited demand (LearningObjectiue5) ConsiderStoreAllin S8-8.Assumethat demandfor regularbinsis limitedto 30,000units and demandfor largebinsis limitedto 25,000units. L. How many of eachsizebin shouldStoreAllmakenow? 2. Giventhis productmix, what will be the company'soperatingincome? 3. Explainwhy the operatingincomeis lessthan it was when StoreAllwas producing its optimal productmix.

S8-10

Outsourcing production decision (LearningObiectiues1, 6) Supposean Olive Gardenrestaurantis consideringwhetherto (1) bake breadfor its restaurantin-houseor (2) buy the breadfrom a local bakery.The chef estimatesthat variablecostsof makingeachloaf include$0.50of ingredients,$0.25of variableoverhead(electricityto run the oven),and $0.75 of directlabor for kneadingand forming the loaves.Allocatingfixed overhead(depreciationon the kitchenequipmentand building)basedon directlabor assigns$1.00 of fixed overheadper loaf. None of the fixed costsare avoidable.The local bakerywould chargeOlive Garden$1.75per loaf. 1. \7hat is the unit cost of makingthe breadin-house(useabsorptioncosting)? 2. ShouldOlive Gardenbakethe breadin-houseor buy from the local bakery? \7hy? 3. In addition to the financial analysis,what else should Olive Garden consider when making this decision?

s8-11

450

Chapter8

Relevant information for outsourcing delivery function (Leaming Obiectiues 7,6) U.S. Food in Lexington, KentuckS manufactures and markets snack foods. Betsy Gonzalez manages the company's fleet of 200 delivery trucks. Gonzalez has been charged with "reengineering" the fleet-management function. She has an important decision to make. . Should she continue to manage the fleet in-house with the five employeesreporting to her? To do so, she will have to acquire new fleet-managementsoftware to streamline U.S. Food's fleet-managementprocess.

o Should she outsource the fleet-managementfunction to Fleet Management Services, a company that specializesin managing fleets of trucks for other companies?Fleet Management Serviceswould take over the maintenance,repair, and siheduling of U.S. Food's fleet (but U.S. Food would retain ownership). This alternative would require Gonzalezto lay off her five employees.However, her own job would be secure,as she would be u.S. Food's liaison with Fleet Management Services. Assumethat Gonzalez'srecordsshow the following data concerningU.S. Food'sfleet:

Supposethat FleetManagementServices offersto manageU.S.Food'sfleetfor an annualfeeof $290,000. NThichalternativewill maximizeU.S.Food'sshort-termoperatingincome? s8-12

outsourcing qualitative considerations (Learuingobiectiues1, 6) Referto U.S.Foodin S8-11.\X/hatqualitativefactorsshould Gonzalezconsider before making a final decision?

58-13

Scrap or process further decision (LearningObjectiue7) Auto Componentshasan inventoryof 500 obsoleteremoteentry keys that arecarried in inventoryat a manufacturingcost of $80,000.ProductionSupeivisorTerri Smith must decideto do one of the following: o Processthe inventoryfurther at a costof $20,000,with the expectationof selling it for $28,000 r Scrapthe inventoryfor a saleprice of $6,000 what shouldSmithdo? Presentfiguresto supportyour decision.

s8-14

Determine most profitable final product (Learningobjectiue 7) Chocoliteprocesses cocoabeansinto cocoapowderat a processing cost of $10,000 per batch. Chocolitecan sell the cocoapowder as is, oi it can plocessthe cocoa powder further into chocolatesyrup or boxed assortedchocolates.Once processed. eachbatchof cocoabeanswould resultin the following salesrevenue:

$15,000 $100,000 $200,000 The cost of transforming the cocoa powder into chocolatesyrup would be $20,000. Likewise, the company would incur $180,000 to transfor- ih.-.o.oa powder into boxed assortedchocolates.The company presidenthas decidedto make boxed assorted chocolatesowing to its high salesvalue and to the fact that the $10,000 cosr of process, ing cocoa beans"eats up" most of the cocoa powder profits. Has the presidentmade the right or wrong decision?Explain your answer.Be sure to include the correct financial analysisin your response. Short-TermBusinessDecisions

451

w Exercises EB-1S

Determine relevant and irrelevant information (Learning Obiectiue 7) Fabricut, invested in computer-controlled Joe Roberts, production manager for the machinery from AdvancedDesign at a purchased year. He last production -u.hin.ry DesignrecentlycontactedJoe because Advanced from .ort of $2 million. A representative piece of machinery. The new design more efficient even an the company has designed machinery but cost Fabricut another year-old the of output would double the production to the company president's new equipment this bring to is afraid $3 million. Roberis million in the machinery invest president to $2 the persuaded attention becausehe last year. Requirement Expiain what is relevant and irrelevant to Roberts's dilemma. What should he do?

EB-16

Special order decisions given two scenarios (Learning Obiectiue 2) Supposethe Baseball Hali of Fame in Cooperstown, New York, has approached Splrts-Cardz with a special order. The Hall of Fame wants to purchase 50'000 baseball card packs for a special promotional campaign and offers $0'40 per pack, a total of $ZO,ObO.Sports-Cardz's total production cost is $0.60 per pack, as follows:

sports-cardzhasenoughexcesscapacityto handlethe specialorder. Requirements should 1. Preparean incrementalanalysisto determinewhetherSports-Cardz the specialsalesorder assumingfixed costswould not be affectedby the "..ip, specialorder' 2. Now, assumethat the Hall of Famewants specialhologrambaseballcards' Sporis-Cardzmust spend$5,000to developthis hologram,whichwill be useIessafter the specialorder is completed.ShouldSports-Cardzacceptthe special Showyour analysis' order underthesecircumstances?

452

Chapter8

E8-17

Special order decision and considerations (LearningObjectiue2) Maui JaneSunglasses sellfor about $150 per pair. Suppose the companyincursthe followingaveragecostsper palr:

$2,000,000total fixed manufacturing overhead 100,000pairs of sunglasses

Maui Jane has enough idle capacity to accept a one-time-only special order from LensCrafters for 20,000 pairs of sunglassesat $76 per pair. Maui Jane will not incur any variable marketing expensesfor the order. Requirements 7. How would acceptingthe order affect Maui Jane'soperating income? In addition to the specialorder's effect on profits, what other (longer-termqualitative) factors should Maui Jane'smanagersconsider in deciding whether to acceptthe order? 2. Maui Jane'smarketing manager,Jim Revo, argues against accepting the special order becausethe offer price of $76 is lessthan Maui Jane's$84 cost to make the sunglasses.Revo asks you, as one of Maui Jane'sstaff accountants, to write a memo explaining whether his analysis is correct. E8-18

Pricing decisions given two scenarios (Learning Objectiue 3) Bennett Builders builds 1,500-square-foot starter tract homes in the fast-growing suburbs of Atlanta. Land and labor are cheap, and competition among developersis fierce. The homes are "cookie-cutter," with any upgrades added by the buyer after the sale.BennettBuilders'cost per developedsublot are as follows:

BennettBuilderswould like to eatna profit of 15"/" of the variablecost of each homesale.Similarhomesofferedby competingbuilderssellfor $200,000each. Requirements 1. \X/hichapproachto pricing shouldBennettBuildersemphasize? Why? 2. Nfill BennettBuildersbe ableto achieveits targetprofit levels?Show YOUr COmDUtaflOnS.

continwed .

Short-TermBusinessDecisions

453

3. Bathrooms and kitchens are typically the most important sellingfeaturesof a home. Bennett Builders could differentiate the homes by upgrading bathrooms and kitchens. The upgrades would cost $20,000 per home but would enable Bennett Builders to increasethe selling prices by $35,000 per home (in general,kitchen and bathroom upgrades typically add at least 150% of their cost to the value of any home). If BennettBuildersupgrades,what will the new cost-plusprice per home be? Should the company differentiateits product in this manner? Show your analysis. E8-19

Decide whether to drop a product line (Learning Objectiue 4) Top managersof Video Avenue are alarmed by their operating losses.They are considering dropping the VCR-tape product line. Company accountants have prepared the following analysisto help make this dectston:

Total fixed costswill not changeif the companystopssellingVCR tapes. Requirements 1. Preparean incrementalanalysisto show whetherVideo Avenueshoulddrop the VCR-tapeproduct line. Ifill droppingVCR tapesadd $30,000to operating income?Explain. by dropping 2. Assumethat Video Avenuecan avoid $30,000of fixed expenses (these product fixed VCR product line costs are direct costs of the VCR-tape the Iine).Preparean incrementalanalysisto showwhetherVideo Avenueshould stop sellingVCR tapes. 3. Now, assumethat all $70,000of fixed costsassignedto VCR tapesare direct fixed costsand canbe avoidedif the companystopssellingVCR tapes. However,marketinghasconcludedthat DVD saleswould be adverselyaffected by discontinuingthe VCR line (retailerswant to buy both from the same supplier).DVD productionand saleswould decline1'0'/".What shouldthe companydo?

Chapter8

E8-20

Dropping a product ltne (Learning Objectiue4) SupposeKellogg'sis consideringdroppingits Special-Kproductline. Assumethat during the pastyea! Special-K's productline incomestatementshowedthe following:

Fixedmanufacturing overhead costsaccountfor 40o/oof thecostof goods,whileonly 30% of the operatingexpenses arefixed.Sincethe Special-K line is only oneof Kellogg's breakfast cereals, only $750,000of directfixedcosts(themajorityof whichis advertising) will beeliminatedif theproductlineis discontinued. Theremainderof the fixedcostswill still be incurredby Kellogg's.If the companydecidesto drop the productline,what will happento the company's operatingincome?ShouldKellogg'sdrop theproductline?

E8-21 ldentify constraint, then determine product mix (Leaming Objectiue5) Lifemasterproducestwo typesof exercisetreadmills:Regularand Deluxe.The exercise crazeis suchthat Lifemastercould use all of its availablemachinehours producing eithermodel.The two modelsareprocessed throughthe sameproductiondepartment.

*Allocated on the basis of machine hours.

'!7hat

product mix will maximize operating income? (Hint:Use the allocation of fixed manufacturing overhead to determine the proportion of machine hours used by each product.)

Short-Term Business Decisions

E8-22

Determine product mix for retailer (Learning Objectiue 5) Vivace sells both designer and moderately priced fashion accessories.Top management is deciding which product line to emphasize.Accountants have provided the followine data:

Designer

Priced

'$g+,

Average saleprice........;'.,............;......,;,,.,. $200

The Vivacestore in Reno,Nevada,has 10,000 squarefeet of floor space.If moderatelypriced goods,it can display650 itemsin the store.If Vivaceemphasizes Vivaceemphasizes designerwear,it can displayonly 300 designeritemsto create Thesenumbersare also the averagemonthly more of a boutique-likeatmosphere. salesin units. Preparean analysisto show which productto emphasize.

E8-23 Determineproduct mix for retailer-two stocking scenarios (LearningObiectiue5) Eachmorning,Max Imery stocksthe drink caseat Max's BeachHut in Myrtle Beach, displayspacefor SouthCarolina.Max's BeachHut has 100 linearfeet of rcfuigerated plastic cold drinks.Eachlinearfoot canhold eithersix 12-ouncecansor four 2O-ounce or glassbottles.Max's BeachHut sellsthreetypesof cold drinks: cansfor $1.50per can L Coca-Colain'J.2-oz. 2. A6a\7Root Beerin20-oz.plasticbottlesfor $1.75per bottle 3. MountianDew in 20-oz.glassbottlesfor $2.20per bottle Max's BeachHut paysits suppliers: 1,. $0.25per 12-oz.canof Coca-Cola 2. $0.40per 20-oz.bottleof A&\f Root Beer 3. $0.75per 20-oz.bottleof MountainDew include: Max's BeachHut's monthly fixed expenses Hut rental

..

$ 375 IJ

Max's Beach Hut can sell all drinks stocked in the display caseeach morning. Requirements 'lfhat 'Sfhat 7. is Max's Beach Hut's constraining factor? should Max stock to maximize profits?'What is the maximum contribution margin he could generate from refrigerated drinks each day?

456

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2 . To provide variety to customers, supposeMax refusesto devote more than 60 linear feet and no less than 10 linear feet to any individual product. Under this condition, how many linear feet of each drink should Max stock? How many units of each product will be available for sale each day?

3. Assuming the product mix calculated in Requirement 2, what contribution margin will Max generatefrom refrigerated drinks each day? E8-24

Make-or-buy product component (Learning Objectiue 6) Fiber Systemsmanufactures an optical switch that it uses in its final product. Fiber Systemsincurred the following manufacturing costs when it produced 70,000 units last year:

Fiber Systemsdoesnot yet know how many switchesit will needthis year; however,anothercompanyhas offeredto sell Fiber Systemsthe switch for $14 per unit. If Fiber Systemsbuys the switch from the outsidesupplier,the manufacturing facilitiesthat will be idle cannot be usedfor any other purpose,yet none of the fixed costsare avoidable. Requirements L. Giventhe samecost structure,shouldFiberSystemsmakeor buy the switch? Showyour analysis. 2. Now, assumethat FiberSystemscan avoid $100,000of fixed costsa yearby outsourcingproduction.In addition,becausesalesare increasing,Fiber Systems needs75,000switchesa yearratherthan 70,000.\X/hatshouldFiberSystems do now? would be willing to pay 3. Giventhe last scenario,what is the most Fiber Systems to outsourcethe switches?

E8-25 Make-or-buy with alternative use of facilities (LearningObjectiue6) Referto E8-24.Fiber Systemsneeds80,000optical switchesnext year (assumesame can useits idle facilitiesto manurelevantrange).By outsourcingthem,FiberSystems factureanotherproduct that will contribute$220,000to operatingincome,but none of the fixed costswill be avoidable.ShouldFiber Systemsmake or buy the switches? Showyour analysis.

E8-26 Determine maximum outsourcing price (LearningObiectiue6) linDefTone'ssaleshaveincreased; asa result,the companyneeds400,000jewel-case ersratherthan 250,000.DefTonehasenoughexistingcapacityto makeall of the liners it needs.In addition, due to volume discounts,its variablecostsof making each liner will declineto $0.28 per liner.Assumethat by outsourcing,DefTonecan reduce its current fixed costs($50,000)by $10,000.There is no alternativeuse for the factory spacefreed through outsourcing,so it will just remain idle. What is the maximumDefTonewill pay to outsourceproductionof its CD liners?

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E8-27

Sell as is or process further (Learning Obiectiue 7) Dairymaid processesorganic milk into plain yogurt. Dairymaid sellsplain yogurt to hospitals, nursing homes, and restaurants in bulk, one-gallon containers. Each batch, processedat a cost of $800, yields 500 gallons of plain yogurt. Dairymaid sellsthe onegallon tubs for $6.00 each and spends$0.10 for eachplastic tub. Dairymaid has recently begun to reconsiderits strategy.Dairymaid wonders if it would be more profitable to sell individual-sizeportions of fruited organic yogurt at local food stores.Dairymaid could further processeach batch of plain yogurt into 10,667 individual portions (3/4 cup each) of fruited yogurt. A recent market analysisindicatesthat demand for the product exists. Dairymaid would sell each individual portion for $0.50. Packagingwould cost $0.08 per portion, and fruit would cost $0.10 per portion. Fixed costs would not change.Should Dairymaid continue to sell only the gallon-sizeplain yogurt (sellas is) or convert the plain 'Why? yogurt into individual-sizeportions of fruited yogurt (processfurther)?

w Problems (Probtem setA) 2) P8-28ASpecialorder decisionand considerations(LeamingObiectiue flotationvestsin Tampa,Florida.Buoy'scontributionmargin Buoymanufactures income statement for the most recent month contains the following data:

SupposeOverton'swantsto buy 5,000 vestsfrom Buoy.Acceptanceof the order or any of its will not increaseBuoy'svariablemarketingand administrativeexpenses The Buoy plant has enoughunusedcapacityto manufacturethe fixed expenses. additionalvests.Overton'shas offered $10 per vest,which is below the normal sale priceof $14. Requirements l. Preparean incrementalanalysisto determinewhetherBuoy shouldacceptthis specialsalesorder. 2. Identify long-termfactorsBuoy shouldconsiderin decidingwhetherto accept the soecialsalesorder.

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P8-29A Pricing of nursery plants (Learning Objectiue3) GreenThumboperatesa commercialplant nursery where it propagatesplants for gardencentersthroughoutthe region.GreenThumbhas$5 million in assets. Its yearly fixed costsare $600,000,and the variablecostsfor the potting soil, container,label, seedling,and labor for eachgallon-sizeplant total $1.25. GreenThumb'svolume is currently500,000units. Competitorsoffer the samequality plantsto gardencenters for $3.50 each.Gardencentersthen mark them up to sellto the public for $8 to $10, dependingon the type of plant. Requirements 1. GreenThumb's ownerswant to earna !2"/" returnon the comDany'sassets. \Whatis GreenThumb's targetfull cost? 2. Giventhat GreenThumb's currentcosts,will its ownersbe ableto achievetheir targetprofit? Showyour analysis. 3. Assumethat GreenThumb hasidentifiedwaysto cut its variablecoststo $1.10per 'Iilfill in variablecostsallow unit. \fhat is its new targetfixed cost? this decrease the companyto achieveits targetprofit?Showyour analysis. 4. GreenThumbstartedan aggressiveadvertisingcampaignstrategyto differentiate its plants from thosegrown by other nurseries.Monrovia Plantsmade this strategywork, so GreenThumbhas decidedto try it, too. GreenThumb doesn'texpectvolume to be affected,but it hopesto gain more control over pricing. If GreenThumbhas to spend$100,000this year to advertiseand its variablecostscontinueto be $1.10per unit, what will its cost-plusprice be? Do you think GreenThumbwill be able to sell its plants to gardencentersat the cost-plusprice?'Whyor why not? P8-30A Prepare and use contribution margin statements for dropping a lanedecision (Learning Obiectiue4) Membersof the board of directorsof SecuritySystemshave receivedthe following operatingincomedatafor the yearjust ended:

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Members of the board are surprised that the industrial systemsproduct line is losing money. They commission a study to determine whether the company should drop the line. Company accountants estimate that dropping industrial systems will decreasefixed cost of goods sold by $80,000 and decreasefixed marketins and administrative expensesby $12,000.

Requirements 1'. Prepare an incremental analysis to show whether Security Systemsshould drop the industrial systemsproduct line. 2. Prepare contribution margin income statementsto show Security Systems'total operating income under the two alternatives: (a) with the industrial systemsline and (b) without the line. Compare the difference between the two alternatives' income numbers to your answer to Requirement 1. Ifhat have you learned from this comparison? P8-31A Product mix decision under constraint (Learning Obiectiue S) Brun, located in St. Cloud, Minnesota, produces two lines of electric toothbrushes: deluxe and standard. BecauseBrun can sell all of the toothbrushes it produces, the owners are expanding the plant. They are deciding which product line to emphasize. To make this decision, they assemblethe following data:

After expansion,the factorywill have a production capacityof 4,500 machine hoursper month. The plant can manufactureeither60 standardelectrictoothbrushes or 24 deluxeelectrictoothbrushesper machinehour. Requirements l. Identify the constrainingfactor for Brun. 2, Preparean analysisto show which productline to emphasize.

P8-32A outsourcing decision given alternative use of capacity (Learningobiectiue 6) X-Periencemanufacturessnowboards.Its cost of making 1,800 bindingsis:

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Suppose O'Brien will sell bindings to X-Perience for $14 each. X-Perience will pay $1.00 per unit to transport the bindings to its manufacturing plant, where it will add its own logo at a cost of $0.20 per binding.

Requirements X-Perience's accountantspredictthat purchasingthe bindingsfrom O'Brienwill enablethe companyto avoid $2,200of fixed overhead.Preparean analysisto show whetherX-Perienceshouldmakeor buy the bindings. 2. The facilitiesfreed by purchasingbindingsfrom O'Brien can be usedto manufactureanother product that will contribute $3,100 to profit. Total fixed costswill be the sameas if X-Periencehad producedthe bindings. Show which alternativemakesthe bestuseof X-Perience'sfacilities: (a) make bindings,(b) buy bindingsand leavefacilitiesidle, or (c) buy bindingsand make another product. l.

P8-33A Sell or process further decisions (LearningObjectiue7) Vision Chemicalhasspent$240,000to refine72,000gallonsof acetone,which can be sold for $Zle a gallon.Alternatively,Vision Chemicalcanprocessthe acetonefurther. This processing will yield a total of 60,000gallonsof lacquerthinnerthat can be sold will cost $0.62 per gallonof lacquer for $3.20 a gallon.The additionalprocessing thinner.To sell the lacquerthinner,Vision Chemicalmust pay shippingof $0.22 a gallonand administrative of $0.10a gallonon the thinner. expenses Requirements l. DiagramVision'sdecision,usingExhibit 8-23asa guide. 2. Identifythe sunk cost.Is the sunk costreleyantto Vision'sdecision?rVhy or why not? 3, ShouldVision sellthe acetoneor processit into lacquerthinner?Showthe expectednet revenuedifferencebetweenthe two alternatives.

rHtP1qf,lgfilS

(Probrem set B)

P8-34B Special order decision and considerations (LearningObjectiue2) United Packaging's contributionmargin incomestatementfollows:

Variableexpenses:

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\flallace Farms wants to buy 5,000 produce boxes from United Packaging. Acceptanceof the order will not increaseany of United Packaging'svariable marketing and administrative expensesor any of its fixed expenses.United Packaging'splant has enough unused capacity to manufacture the additional boxes. \Tallace Farms has offered $0.80 per box, which is considerably below the normal sale price of $1.20.

Requirements l.

Preparean incrementalanalysisto determinewhetherUnitedPackagingshould acceptthis specialsalesorder. 2. Identify long-termfactorsthat United Packagingshouldconsiderin deciding whetherto acceptthe specialsalesorder.

P8-35B Pricing of facial tissues (LeamingObjectiue3) Softiesproducesfacial tissues.Softieshas $50 million in assets.Its yearlyfixed costs are$L2 million, and the variablecost of producingand sellingeachbox of tissuesis $0.25.Softiescurrentlysells30 million boxesof tissues.Genericfacialtissuessuchas Softies'productgenerallysell to retailersfor $0.75 per box, while namebrandssuch as Kleenexand Puffssellto retailersfor $1.00 per box. Requirements 1. Softies'stockholdersexpecta 1,0o/" return on the company'sassets. What is Softies'targetfull cost? 2. GivenSofties'currentcosts,will its ownersachievetheir targetprofit? Show your analysis. 3. Softieshasidentifiedwaysto cut its fixed costsby $SOO,OOO. What is its new targetvariablecostper unit? Will Softiesbe ableto reachits targetprofit? 4. Softiesstartedan aggressive advertisingcampaignto transformits product into a namebrand ableto competewith Kleenexand Puffs.Softiesdoesn'tthink volume will be affected,but it hopesto gain more control overpricing.If Softies spends$3 million a yearto advertise,what will its cost-plusprice be?(Continue to assumethat fixed costshavedeclinedby $500,000but that Softieswas unableto reduceits variablecostper unit below $0.25).Do you think Softies will be ableto sellits facialtissuesto retailersat the cost-plusprice?\fhy or why not? P8-36B Prepare and use contribution margin statements for dropping a line decision (Learning Objectiue 4) The following operatingincome data of.AbaloneSeafoodhighlight the lossesof the freshseafoodproductline:

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AbaloneSeafoodis consideringdiscontinuingthe freshseafoodproductline. The company'saccountantsestimatethat dropping the fresh seafoodline will decrease fixed marketingand administrative fixed cost of goodssold by $16,000and decrease expenses by $rO,OOO. Requirements t. Preparean incrementalanalysisto show whetherAbaloneSeafoodshoulddrop the freshseafoodproduct line. to compareAbaloneSeafood's 2, Preparecontributionmargin incomestatements total operatingincome(a) with the freshseafoodproductline and (b) without it. Comparethe differencebetweenthe two alternatives'incomenumbersto your answerto Requirement1. What haveyou learnedfrom this comparison? P8-378 Product mix under constraint (Leaming Objectiue5) in outdoor furniture and spas. EasyLiving of Charlotte,North Carolina,specializes Owner Linda Spring is expandingthe store. Sheis decidingwhich product line to the following data: emphasize. To makethis decision,sheassembles

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Business Decisions 463 Short-Term

After renovation, the store will have 8,000 square feet of floor space.By devoting the new floor spaceto patio sets,Easy Living can display 60 patio sets.Alternativelg Easy Living could display 30 spas.Spring expectsmonthly salesto equal the maximum number of units displayed. Requirements L. Identify the constraining factor for Easy Living. 2. Prepare an analysisto show which product line to emphasize.

P8-388 Outsourcing: alternative use of capacity (Learning Objectiue 6) Morning Grain makes organic cereal. Costs of producing 140,000 boxes of cereal each year follow:

SupposeKellogg'swill sell Morning Grain the cerealfor $4 a box. Morning Grain would alsopay $0.19 a box to transportthe cerealto its warehouse. Requirements 1. Morning Grain'saccountantspredictthat purchasingthe cerealfrom Kellogg's will enablethe companyto avoid $140,000of fixed overhead.Preparean analysisto show whetherMorning Grain shouldmakeor buy the cereal. 2. Assumethat the Morning Grain facilitiesfreed up by purchasingthe cereal from Kellogg'scan be usedto manufacturesnackbars that will contribute $180,000to profit. Total fixed costswill be the sameas if Morning Grain usedthe plant to make cereal.Preparean analysisto show which alternative makesthe bestuseof Morning Grain'sfacilities:(a) makecereal,(b) buy cerealand leavefacilitiesidle, or (c) buy cerealand make snackbars. P8-398 Seff or process further decision (LearningObjectiue7) Acme Petroleumhas spent$200,000to refine 60,000gallonsof petroleumdistillate. SupposeAcme Petroleumcan sell the distillatefor $6 a gallon. Alternatively,it can processthe distillatefurther and produce60,000 gallonsof cleanerfluid. The additional processing will cost another$1.2Sa gallon,and the cleanercan be sold for $8.S0a gallon.To sellcleanerfluid, Acme Petroleummust pay a salescommissionof $0.t0 a gallon and a transportationchargeof $0.15 a gallon. Requirements DiagramAcmePetroleum'salternatives, usingExhibit 8-23 (sellas is or process further) as a guide. 2. Identify the sunk cost.Is the sunk costrelevantto AcmePetroleum'sdecision? 'Why or why not? l.

3. Preparean analysisto indicatewhetherAcmePetroleumshouldsellthe distillate or processit into cleanerfluid. Showthe expectednet revenuedifference betweenthe two alternatives.

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Apply Your Knowledge sm DecisionCase Gase 8-40. Outsourcing e-mail (Learning Obiectiue 6) BKFin.com provides banks access to sophisticated financial information and analysissystemsvia the'Web. The company combines thesetools with benchmarking data access,including e-mail and wirelesscommunications,so that banks can instantly evaluateindividual loan applicationsand entire loan portfolios. BKFin.com's CEO, Jon'Wise, is huppy with the company's growth. To better focus on client service,Wise is considering outsourcing some functions. CFO Jenny Lee suggeststhat the company's e-mail may be the place to start. She recently attended a conferenceand learned that companies such as Continental Airlines, 'Wise asks Lee to DellNet, GTE, and NBC were outsourcing their e-mail function. identify costs related to BKFin.com's in-house Microsoft Exchange mail application, which has 2,300 mailboxes. This information follows:

Requirements 1. Compute the total cost per mailbox per month of BKFin'com's current e-mail function. 2. Suppose Mail.com, a leading provider of Internet messaging outsourcing services, offers to host BKFin.com's e-mail function for $9 per mailbox per month. If BKFin.com outsources its e-mail to Mail.com, BKFin.com will still need the virus protection software; its computer hardware; and one information technology staff member who would be responsible for maintaining virus protection, quarantining suspicious e-mail, and managing content '$7ise accept (e.g., screening e-mail for objectionable content). Should CEO Mail.com's offer?'Why or why not? 3. Supposefor an additional $5 per mailbox per month, Mail.com will also provide virus protection, quarantine, and content-management services' Outsourcing these additional functions would mean that BKFin.com would not need an e-mail information technology staff member or the separatevirus protection license. Should CEO \fise outsource these extra servicesto Mail.com? Whv or whv not?

Business Decisions 465 Short-Term

mEthical lssue fssue 8-41. Outsourcing and ethics (Leaming Objectiue6) Mary Tan is the controllerfor Duck Assocrares, a propertymanagement companyin Portland,Oregon.Eachyear,Tan and payroll clerk Toby Stockmeetwith the external auditorsabout payroll accounting.This year,the auditorssuggestthat Tan consider outsourcingDuck Associates' payroll accountingto a companyspecializing in payroll processingservices.This would allow Tan and her staff to focus on their primary responsibility:accountingfor the propertiesunder management. At present,payroll requires1.5 employeepositions-payroll clerk Toby Stock and a bookkeeperwho spendshalf her time enteringpayrolldatain the system. Tan considersthis suggestion,and she lists the following items relating to outsourcingpayroll accounting: a. The current payroll softwarethat was purchasedfor $4,000 three yearsago would not be neededif payroll processing were outsourced. b. Duck Associates'bookkeeperwould spendhalf her time preparingthe weekly payroll input form that is given ro the payroll processingservice.she is paid $450 a week. c. Duck Associates would no longerneedpayroll clerk Toby stock,whoseannual salaryis $42,000. d. The payroll processingservicewould charge$2,000a monrh. Requircments 1. Would outsourcingthe payroll function increaseor decrease Duck Associates, operatingincome? 2. Tan believesthat oursourcingpayroll would simplify her job, bur shedoesnot like the prospectof havingto lay off stock, who has becomea closepersonal friend. Shedoesnot believethereis anotherposition availablefor Stockat his currentsalary.Can you think of other factorsthat might supportkeepingStock rather rhan outsourcing payroll processing?How should eaih of th. factorsaffectTan'sdecisionif shewantsto do what is bestfor Duck Associates and act ethically?

**Team Project Project8-42. Relevantinformationto outsourcingdecision(LeamingObiectiue 6) JohnMenardis the founderand soleownerof Menards.Analystshaveestimated that his chain of home improvement stores scatteredaround nine midwestern states generateabout $3 billion in annual sales.But how can Menards compete with giant Home Depot? suppose Menard is trying to decide whether to invest $45 million in a state-of-the-art manufacturing plant in Eau Claire, 'sTisconsin. Menard expects the plant would operate for 15 years, after which it would have no residual value. The plant would produce Menards' own line of Formica counrerrops, cabinets, and picnic tables.

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Suppose Menards would incur the following unit costs in producing its own oroduct lines:

l .

'.

'' :].i..

i

€ouitbrtops Dir ec t m at er ials.,... Dir ec t I abor . . . . . ......

variablemanufacturing oveihead

$1s 10 ,.t

: picnic Cabinets", 'Tables

$10 5 ,)

$25 ,15 6

L

Rather than Menard making theseproducts, assumethat he can buy them from outside suppliers. Supplierswould charge Menards $40 per countertop, $25 per cabinet,and $65 per picnic table. N7hether Menard makes or buys these products, assume that he expects the following annual sales: r Countertops-487,200 at $130 each o

Picnic tables-100,000 at $225 each

o

Cabinets-150,000 at $75 each

If "making" is sufficiently more profitable than outsourcing, Menard will build the new plant. John Menard has asked your consulting group for a recommendation. Menard usesthe straight-line depreciation method. Requirements 1. Are the following items relevant or irrelevant in Menard's decision to build a new plant that will manufacture his own products? a.

The unit sale prices of the countertops, cabinets, and picnic tables (the sale prices that Menards chargesits customers)

b.

The prices that outside suppliers would charge Menards for the three products if Menards decidesto outsource the products rather than make them

c.

The $45 million to build the new plant

d.

The direct materials, direct labor, and variable overhead that Menards would incur to manufacture the three oroduct lines

e.

Menard's salary

2. Determine whether Menards should make or outsource the countertops, cabinets, and picnic tables asswmingthat the company bas already buih the plant and, therefore, has the manwfactwring capacity to prodwce these prodwcts. In other words, what is the annual difference in cash flows if Menards decidesto make rather than outsource each of these three products? 3. Write a memo giving your recommendation to Menard. The memo should clearly state your recommendation and briefly summarize the reasonsfor your recommendation.

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