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Managerial Accounting & Decision Making

Note Set # 2:

Economics of Decision Making

July 2016

Professor Swaminathan Sridharan (Sri)


6252 Jacobs Center
847-491-3427
s-sridharan@kellogg.northwestern.edu

Overall Theme for this Module


How to create value through:
1.
2.
3.
4.
5.

Proper resource management;


Optimal resource allocation to acquire new business;
Determining appropriate metrics of profitability depending on the decision context;
Identifying profitable customer segments correctly;
Taking corrective actions to improve yield management based on appropriate
activities;
6. Management of Customer Retention and Minimizing Customer Attrition Rates;
7. Making short and long-term resource allocation decisions through cost-benefit
analysis; and
8. Strategic Management of Value Drivers

Practical Approaches for Value Creation


Managing Income statement value drivers
Revenue drivers
Cost drivers
Creating strategies to increase revenues and decrease costs
Managing Balance sheet value drivers
Manage capital employed effectively

Examples of problems involving relevant costs

Make or buy
Add or drop a product
Sell now or process further
Shut down a business unit or keep it running
Special order pricing
Excess capacity pricing
Short term pricing vs. long term pricing
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Relevant Costs
Several topics have an underlying common idea: incremental
costs vs. incremental benefits (CVP, Relevant Costs, ShortTerm Pricing, Transfer Pricing)

Relevant costs are costs that are material to any decision


Relevant costs are costs that differ across different
alternatives
Relevant costs include all avoidable costs (fixed or variable)

Short Case # 1

Add a new product line?

Island Novelties, Inc., of Palau makes two products, Hawaiian Fantasy (HF)
and Tahitian Joy (TJ). Present revenue, cost, and sales data on the two
products follow:
HF
TJ
Selling price per unit
$15
$100
Variable expenses per unit
$ 9
$ 20
Number of units sold annually 20,000
5,000
Fixed expenses total $475,800 per year. The Republic of Palau uses the
U.S. dollar as its currency.

Short case # 1
Implications of adding a new product line

REQUIRED
Assuming the sales mix given above, do the following:

Prepare a contribution income statement for the company as a whole.

Compute the break-even point in dollars for the company as a whole and the margin of
safety in both dollars and percent.

Another product, Samoan Delight, has just come onto the market. Assume that the company
could sell 10,000 units at $45 each. The variable expenses would be $36 each. The
company's fixed expenses would not change.

Compute the companys new break-even point in dollars and the new margin of safety in
both dollars and percent.

The CEO of the company examines your figures and says, Theres something strange here.
Our fixed costs havent changed and you show greater total contribution margin if we add
the new product, but you also show our break-even point going up. With greater
contribution margin, the break-even point should go down, not up. Youve made a mistake
somewhere. Explain to the CEO what has happened.
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Short case # 1

Hawaiian Fantasy
Current product mix

Amount

%age

Tahitian Joy
Amount

%age

Total
Amount

%age

Sales

Less: Variable costs

Contribution margin

Less: Fixed costs

Net income
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Short case # 1
Implications of adding a new product line
New Product Mix

Hawaiian Fantasy

Amount

%age

Tahitian Joy

Amount

%age

Sales

$300,000 100.00% $500,000 100.00%

Less: Variable costs

$180,000

60.00% $100,000

20.00%

Contribution margin

$120,000

40.00% $400,000

80.00%

Samoan Delight

Amount

%age

Total

Amount

%age

Less: Fixed costs

Net income

Short case # 1
Implications of adding a new product line

New product mix

Fixed costs

Weighted CM ratio

BEP in $ Sales
Margin of safety = current sales BE
sales
Margin of safety in percentage = Margin
of safety/actual sales

Current product mix

$475,800

0.65
=$475,800/0.65
= $732,000
= $800,000-732,000
= $68,000
= $68,000/800,000
=8.5%

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Addition of a new product (Short case # 1) Take-aways

1. Difficulties involved in interpreting BEP levels in absolute


terms, particularly in a multi-product setting
2. BEP versus Margin of Safety: a higher break-even level is not
necessarily bad if accompanied by a much greater significant
margin of safety
3. Likelihood of breaking even can actually increase with the
addition of a third product line
4. Margin of safety in percentage terms can provide another
useful comfort level

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Activity-based costing (ABC): Cost Hierarchies


(from Cooper and Kaplan)

Costs driven by
volume, e.g. energy,
DM, DL, etc.

Costs related to set-ups,


orders, material handling,
inspections, etc.
Output
Unit-level
costs

Batch-level costs
Costs that cannot be
traced to individual
products or services but
relate to the entire
operation, e.g., plant
administration costs

Product-sustaining costs

Facility-sustaining Costs

Costs related to
individual product or
service lines, e.g., design
costs, product managers
costs, etc.

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Short case # 2:
Strategic Outsourcing Decision
Short case # 2 integrates the ABC Hierarchy with
relevant cost analysis.
Remember that ABC does not consider only
incremental costs.
The activity cost pools have sunk costs
(depreciation) along with other fixed and variable
costs.
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Short case # 2:
Strategic Outsourcing Decision

Ace Company produces bicycles. This years expected production is 10,000 units.
Currently, Ace makes the chains for its bicycles. Aces accountant reports the following costs for making the
10,000 bicycle chains:

Unit
cost
Direct materials

Cost for
10,000 units

$4.00

$ 40,000

Direct manufacturing labor

2.00

20,000

Variable manufacturing overhead


(power and utilities)

1.50

15,000

Inspection, setup, materials handling

2,000

Machine rent

3,000

Allocated fixed costs of plant administration,


taxes, and insurance
TOTAL COST

30,000

110,000
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Short case # 2:
Strategic Outsourcing Decision
Ace has received an offer from an outside vendor to supply any number
of chains Ace requires at $8.20 per chain.
Following additional information is provided:
Inspection, set-up and materials handling costs vary with the number of
batches in which the chains are produced. Ace produces chains in batch sizes
of 1000 units. Ace estimates that it will produce the 10,000 units in 10
batches.
Ace rents the machines used to make the chains. If Ace buys all its chains
from the outside vendor, it does not need to pay rent on this machine.

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Short case # 2:
Strategic Outsourcing Decision

REQUIRED:
1.

Assume that if Ace purchases the chains from the outside supplier, the facility where the chains
are currently made will remain idle.
a.

2.

Should Ace accept the outside suppliers offer at the anticipated production (and sales) volume of 10,000 units? Show your
calculations.

For this question assume that if the chains are purchased outside, the facilities where the chains
are currently made will be used to upgrade the bicycles by adding mud flaps and reflectors.
a.

Following the upgrade, the selling price of the bicycles is expected to increase by $20 each.

b.

The variable costs per unit of the upgrade would be $18, and additional tooling costs of $16,000 would be incurred.

c.

Should Ace make or buy the chains, assuming that 10,000 units are produced (and sold)? Show your calculations.

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Short case # 2:
Strategic Outsourcing Decision
3.

The sales manager at Ace is concerned that the estimate of 10,000 units
may be high and believes that only 6,200 units will be sold.
a) Production will be cut back, freeing up work space.
b) This space can be used to add the mud flaps and reflectors whether Ace goes
outside for the chains or makes them in-house.
c) At this lower output, Ace will produce the chains in eight batches of 775 units
each.
d) Should Ace purchase the chains from the outside vendor? Show your calculations.

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Short case # 2:
Strategic Outsourcing Decision
Part 1
Relevant costs under buy alternative:
Purchase 10,000 units @ $8.20/unit
Relevant costs under make alternative:
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Inspection, setup, materials handling
Machine rent

Total relevant costs under make alternative

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Short case # 2:
Strategic Outsourcing Decision
Part 2
A. Relevant costs under buy alternative:
Purchase 10,000 units @ $8.20/unit
Additional fixed costs
Additional contribution margin from using the space where the
chains were made to upgrade the bicycles by adding mud flaps
and reflector bars, 10,000 x ($20 $18)
Total relevant costs under the buy alternative
B. Relevant costs under make alternative:

Direct materials
Direct manufacturing labor
Variable manufacturing overhead

Inspection, setup, materials handling


Machine rent
Total relevant costs under make alternative
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Short case # 2:
Strategic Outsourcing Decision
Part 3
A. Relevant costs under buy alternative:
Purchase 6,200 units @ $8.20/unit

B. Relevant costs under make alternative:


Variable costs, ($4 + $2 + $1.50 = $7.50) x 6,200
Batch costs, $200/batch* x 8 batches
Machine rent

Total manufacturing cost for 6,200 chains


*Note: current batch cost $2,000 10 batches

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Short case # 2: Strategic Outsourcing Decision Take-aways


1. Relevant costs in a make-or-buy decision: total costs of
internal production are all not necessarily avoidable
2. Avoidable costs could arise from any part of the ABC cost
hierarchy

3. Often, avoidable out-of-pocket costs from outsourcing are


less than total cost of internal production
4. Opportunity to produce value-added products from current
capacity:
a. Should benefits from these opportunities be allowed to
subsidize the current make-or-buy decision?
5. Sensitivity of outsourcing decision to production volumes
6. How to manage uncertainties?
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Short case # 3:
An introduction to customer/order profitability analysis
Broadway printers operates a printing press with a monthly
capacity of 2,000 machine hours.
Broadway has two main customers, Taylor corporation and
Kelly corporation.
Data on each customer for January follows.

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Short case # 3:
An introduction to customer/order profitability analysis
TAYLOR CORP

KELLY CORP

TOTAL

REVENUES

$120,000

$80,000

$200,000

VARIABLE
EXPENSES

42,000

48,000

90,000

FIXED EXPENSES
ALLOCATED ON
REVENUE

60,000

40,000

100,000

TOTAL
OPERATING
COSTS

102,000

88,000

190,000

OPERATING
INCOME

18,000

(8,000)

10,000

1,500

500

MACHINE HOURS
REQUIRED

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Short case # 3:
An introduction to customer/order profitability analysis
REQUIRED
The following requirements refer only to the preceding data.

Should Broadway drop the Kelly Corporation business, assuming that dropping
Kelly would decrease its total fixed costs by 20 percent? Show all calculations.

Kelly Corporation indicates that it wants Broadway to do an additional $80,000


worth of printing jobs during February.

These jobs are identical to the existing business Broadway did for Kelly in January in terms of
variable costs and machine-hours required.

Broadway anticipates that the business from Taylor Corporation in February would be the same as
that in January.

Broadway can choose to accept as much of the Taylor and Kelly business for February as it wants.

Assume that total fixed costs for February will be the same as the fixed costs in January.

What should Broadway do? What will Broadways operating income be in February?

Show your calculations.


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Short case # 3: An introduction to


customer/order profitability analysis
Expected impact of dropping Kelly Corp., the lossmaking customer
Loss in revenues from dropping Kelly Corp.
Savings in costs:

Variable costs
Fixed costs (20% of $100,000)

Total savings in costs


Effect on operating income

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Short case # 3: An introduction to


customer/order profitability analysis
New customer mix

Taylor
Corporation

Kelly
Corporation

Revenues
Variable costs
Contribution margin
# machine hours
Contribution margin/machine hour

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Short case # 3: An introduction to


customer/order profitability analysis
New customer mix

Taylor
Corporation

Kelly
Corporation

Total

Contribution margin/machine hour

Total available capacity 2,000 machine hours


First allocate as much as the market can
absorb for the higher CM/mhr customer
Allocate the remaining capacity to the less
profitable customer
Contribution margin
Less: Fixed costs
Operating income
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Short case # 3: An introduction to customer/order


profitability analysis Takeaways
1. Who constitutes a more profitable customer?
a. The answer depends on the relative resources consumed in
servicing a given consumer; and
b. How scarce such resources are to the firm?

2. In the context of a single constraining resource:


a.

Use CM per unit of the constraining resource to ensure optimal


usage of a firms internal resources.

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Short Case # 4: Capacity and Pricing Decisions


A game theoretic perspective
As part of a chain, you are evaluating ways to open a new location for
optometry practice and its earnings capacity in Malibu Hills.
Optometrists perform eye exams, prescribe corrective lenses (eyeglasses
and contact lenses), and sell corrective lenses.
One way to expand the practice is to hire an additional optometrist.
The annual cost of the optometrist, including salary, benefits, and payroll
taxes, is $63,000.
You estimate that this individual can conduct two exams per hour at an
average price to the patient of $45 per exam.
The new optometrist will work 40-hour weeks for 48 weeks per year.

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Short Case # 4: Capacity and Pricing Decisions A game


theoretic perspective (Contd.)
From past experience, you know that each eye exam drives additional
product sales.
Each eye exam may lead to:
Either an eyeglass sale with a net profit (revenue less cost of sales) of $90;
Or a contact lens sale with net profit of $65 (not including the exam fee).

On average:

60 percent of the exams lead to eyeglass sales;

20 percent lead to contact lens sales; and

20 percent of the exams lead to no further sales.

Besides the salary of the optometrist, additional costs to support the new
optometrist include :
Office occupancy costs
$1,200/year
Leased equipment
$330/year
Office staff
23,000/year
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Short Case # 4: Capacity and Pricing Decisions A game


theoretic perspective (Contd.)
REQUIRED:

1.

In terms of the percentage of available time, what is the minimum level


of examinations the new optometrist in Malibu Hills must perform to
recover all the incremental costs of being hired?

2.

Suppose a rival sets up a similar optometry practice close to your


Malibu Hills practice.
a.
b.
c.
d.

3.

You estimate the rivals total fixed costs of operation (including all salaries, etc.,) are
$76,800.
The rival also is capable of performing two exams in an hour and works 40 hours in a
week and for 48 weeks in a year.
However, the rival does not have any facilities to sell prescription eye glasses or
contact lenses.
What would be the equilibrium market price for eye examination in the short term
assuming the demand for such services in the area is 5,000 examinations per year?

What would you predict to be the long-term market price for eye
exams?
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Short Case # 4: Capacity and Pricing Decisions A game


theoretic perspective (Contd.)

Frequency

Gross
margin

Expected
profits

Eyeglasses
Contact Lenses

Expected gross margin from additional


sales per eye exam
Contribution margin per exam
Exam fee
Expected gross margin from additional sales per eye exam
Total contribution margin per eye exam
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Short Case # 4: Capacity and Pricing Decisions A game


theoretic perspective (Contd.)
Fixed costs per year
Optometrist
Occupancy costs
Equipment
Office staff
Total fixed costs

Break even volume of exams

Total fixed costs___


Contribution margin

Break even volume as a fraction of capacity

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Short Case # 4: Capacity and Pricing Decisions A game


theoretic perspective (Contd.)
Rivals perspective
Total fixed costs for the rival per year

Capacity for the rival (# exams per year)


Minimum price per eye examination to recover all fixed
costs assuming 100% capacity utilization

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Short Case # 4: Capacity and Pricing Decisions A game


theoretic perspective (Contd.)
2. Short-term predictions: However, the ability of the incumbent to cross-sell
prescription eye glasses and contact lenses implies that the incumbent can
charge a bit less than the minimum required by the rival to break-even
(i.e., $76,800/3,840 = $20/eye exam), say, $19 for eye exam and capture
the market for $3,840 eye exams, yielding a total profit of

Incumbents perspective
CM from 3,840 eye exams in a year @ $19
Expected contribution margin from additional sales (3,840*67)
Total CM per year

Fixed costs per year


Expected profits per year
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Short Case # 4: Capacity and Pricing Decisions A game


theoretic perspective (Contd.)

3. Medium-Long term predictions:

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Short Case # 4: Capacity and Pricing Decisions


Major Takeaways
What is the key value driver for the optometrist?
What is the cost structure of the optometrists operation?
Is there a link between the type of industry and cost structure?
What is a good measure of the proportion of fixed costs in the
cost structure?
What are the implications of cost structure for strategy?

Game theoretic perspectives


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Major take-away's from short cases 1-4

1.

Assumption: all costs can be classified into fixed and


variable with respect to volume of production or sales

2.

Severe limitations of this assumption in real life

3.

Yet, the CVP framework is widely used because of its


simplicity and robustness

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Major take-away's from short cases 1-4


4.

Sensitivity analysis: helps a manager to decide on a pricing


point, target revenues, target costs, target inputs and
budgets

5.

Provides significant insights into the appropriateness of a


given strategy at a given point in time for a firm

6.

Design of better pricing strategies

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Major take-away's from short cases 1-4


7.

Helps the manager make complex decisions such as optimal


product mix

8.

Uncertainties regarding prospective demands and


prospective costs exacerbate:
a. The difficulties involved in managerial decision making;
and
b. Agency problems between the firm and the division

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