HOW DO MANAGERS MAKE OUTSOURCING AND PROCESSING FURTHER DECISIONS?
4. How do managers make outsourcing and processing further decisions?
■
■ Some of the questions managers must consider when deciding whether to outsource include the following:
• How do the company’s variable costs compare with the outsourcing costs?
• Are any fixed costs avoidable if the company outsources?
• What could the company do with the freed manufacturing capacity?
■
■ Remember the outsourcing decision rule:
• If the differential costs of making the product exceed the differential costs of outsourcing, outsource.
• If the differential costs of making the product are less than the differential costs of outsourcing, do not outsource.
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■
■ Some questions managers consider when deciding whether to sell as is or process further include:
• How much revenue will the company receive if it sells the product as is?
• How much revenue will the company receive if it sells the product after processing it further?
• How much will it cost to process the product further?
■
■ Joint costs, the cost of production that yields multiple products, are sunk costs and, therefore, are not relevant to the decision of processing further.
■
■ Remember the sell or process further decision rule:
• If the additional revenue from processing further exceeds the additional cost of processing further, process further.
• If the additional revenue from processing further is less than the additional cost of processing further, sell—do not process further.
> Check Your Understanding 25-1
Check your understanding of the chapter by completing this problem and then looking at the solution. Use this practice to help identify which sections of the chapter you need to study more.
MC Alexander Industries makes tennis balls. Its only plant can produce as many as 2,500,000 cans of tennis balls per year. Current production is 2,000,000 cans. Annual manufacturing, selling, and administrative fixed costs total $700,000. The variable cost of making and selling each can of tennis balls is $1.00. Stockholders expect a 12%
annual return on the company’s $3,000,000 of assets.
Requirements
1. What is MC Alexander’s current full product cost of making and selling 2,000,000 cans of tennis balls? What is the current full unit product cost of each can of tennis balls?
(See Learning Objective 2)
2. Assume MC Alexander is a price-taker, and the current market price is $1.45 per can of tennis balls (the price at which manufacturers sell to retailers). What is the target full product cost of producing and selling 2,000,000 cans of tennis balls? Given MC Alexander’s current costs, will the company reach the stockholders’ profit goals? (See Learning Objective 2)
3. If MC Alexander cannot change its fixed costs, what is the target variable cost per can of tennis balls? (See Learning Objective 2)
4. Suppose MC Alexander 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 advertising costs, what cost-plus price will MC Alexander want to charge for a can of tennis balls? (See Learning Objective 2)
5. Nelson, Inc. has just asked MC Alexander to supply the company with 400,000 cans of tennis balls at a special order price of $1.20 per can. Nelson wants MC Alexander
CHAPTER 25
Requirement 1
The full product cost per unit is as follows:
Fixed costs $ 700,000
Plus: Total variable costs (2,000,000 cans * $1.00 per can) 2,000,000
Total full product costs $ 2,700,000
Divided by the number of cans , 2,000,000
Full product cost per can $ 1.35
Requirement 2
The target full product cost is as follows:
Revenue at market price (2,000,000 cans * $1.45 per can) $ 2,900,000 Less: Desired profit (12% * $3,000,000 of assets) 360,000
Target full product cost $ 2,540,000
MC Alexander’s current total full product costs ($2,700,000 from Requirement 1) are
$160,000 higher than the target full product cost ($2,540,000). If MC Alexander can- not reduce product costs, it will not be able to meet stockholders’ profit expectations.
Requirement 3
Assuming MC Alexander cannot reduce its fixed costs, the target variable cost per can is as follows:
Target full product cost (from Requirement 2) $ 2,540,000
Less: Fixed costs 700,000
Target total variable costs $ 1,840,000 Divided by the number of cans , 2,000,000 Target variable cost per can $ 0.92
Because MC Alexander cannot reduce its fixed costs, it needs to reduce variable costs by $0.08 per can ($1.00 - $0.92) to meet its profit goals. This would require an 8%
cost reduction, which may not be possible.
Requirement 4
If MC Alexander can differentiate its tennis balls, it will gain more control over pric- ing. The company’s new cost-plus price would be as follows:
Current total costs (from Requirement 1) $ 2,700,000 Plus: Additional cost of advertising 100,000 Plus: Desired profit (from Requirement 2) 360,000
Target revenue $ 3,160,000
Divided by the number of cans 2,000,000
Cost-plus price per can $ 1.58
> Solution
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MC Alexander must study the market to determine whether retailers would pay $1.58
per can of tennis balls.
Requirement 5
Nelson’s special order price ($1.20) is less than the current full product cost of each can of tennis balls ($1.35 from Requirement 1). However, this should not influence management’s decision. MC Alexander could fill Nelson’s special order using existing excess capacity. MC Alexander takes a differential analysis approach to its decision, comparing the extra revenue with the differential costs of accepting the order. Vari- able costs will increase if MC Alexander accepts the order, so the variable costs are relevant. Only the additional fixed costs of changing the packaging machine ($10,000) are relevant because all other fixed costs will remain unchanged.
Revenue from special order (400,000 cans * $1.20 per can) $ 480,000 Less: Variable costs of special order (400,000 cans * $1.00 per can) 400,000
Contribution margin from special order 80,000
Less: Additional fixed costs of special order 10,000
Operating income provided by special order $ 70,000
MC Alexander should accept the special order because it will increase operating income by $70,000. However, MC Alexander also needs to consider whether its regular customers will find out about the special order price and demand lower prices, too.
> Check Your Understanding 25-2
Check your understanding of the chapter by completing this problem and then looking at the solution. Use this practice to help identify which sections of the chapter you need to study more.
Shelly’s Shades produces standard and deluxe sunglasses:
Standard Deluxe
Sales price per pair $ 20 $ 30
Variable expenses per pair 16 21
The company has 15,000 machine hours available. In one machine hour, Shelly’s can produce 70 pairs of the standard model or 30 pairs of the deluxe model.
Requirements
1. Which model should Shelly’s emphasize? (See Learning Objective 3)
2. Shelly’s also produces a third product: sport sunglasses. Shelly’s incurs the following costs for 20,000 pairs of its sport sunglasses:
Direct materials $ 20,000
Direct labor 80,000
CHAPTER 25
Another manufacturer has offered to sell similar sunglasses to Shelly’s for $10 per unit, a total purchase cost of $200,000. If Shelly’s outsources and leaves its plant idle, it can save $50,000 of fixed overhead costs. Or it can use the freed manufacturing facilities to make other products that will contribute $70,000 to profits. In this case, the company will not be able to avoid any fixed costs. Identify and analyze the alter- natives. What is the best course of action? (See Learning Objective 4)
> Solution
Requirement 1
Standard Deluxe
Sales price per pair $ 20 $ 30
Less: Variable expenses per pair 16 21
Contribution margin per pair $ 4 $ 9
Units produced each machine hour * 70 * 30
Contribution margin per machine hour $ 280 $ 270 Capacity—number of machine hours * 15,000 * 15,000 Total contribution margin at full capacity $ 4,200,000 $ 4,050,000
Decision: Emphasize the standard model because it has the higher contribution mar- gin per unit of the constraint—machine hours.
Requirement 2
Buy Sunglasses Make
Sunglasses Facilities
Idle Make Other Products Relevant Costs:
Direct materials $ 20,000
Direct labor 80,000
Variable overhead 40,000
Fixed overhead 50,000 $ 50,000
Purchase cost (20,000 pairs * $10 per pair) $ 200,000 200,000 Total cost of obtaining sunglasses 190,000 200,000 250,000
Profit from other products (70,000)
Net cost of obtaining sunglasses $ 190,000 $ 200,000 $ 180,000
Decision: Shelly’s should buy the sunglasses from the outside supplier and use the freed manufacturing facilities to make other products.
> Key Terms
Constraint (p. 1388) Cost-Plus Pricing (p. 1380) Differential Analysis (p. 1375) Irrelevant Cost (p. 1375) Joint Cost (p. 1397)
Opportunity Cost (p. 1395) Price-Setter (p. 1377) Price-Taker (p. 1377) Relevant Cost (p. 1374)
Relevant Information (p. 1374)
Sunk Cost (p. 1375) Target Full Product Cost
(p. 1378)
Target Pricing (p. 1378)
CHAPTER 25
1. In making short-term business decisions, what should you do?
a. Use a traditional costing approach.
b. Focus on total costs.
c. Separate variable from fixed costs.
d. Focus only on quantitative factors.
2. Which of the following is relevant to Kitchenware.com’s decision to accept a special order at a lower sales price from a large customer in China?
a. The cost of shipping the order to the customer
b. The cost of Kitchenware.com’s warehouses in the United States c. Founder Eric Crowley’s salary
d. Kitchenware.com’s investment in its Web site
3. Which of the following costs are irrelevant to business decisions?
a. Avoidable costs
b. Costs that differ between alternatives
c. Sunk costs d. Variable costs 4. When making decisions, managers should consider
a. revenues that differ between alternatives.
b. costs that do not differ between alternatives.
c. only variable costs.
d. sunk costs in their decisions.
5. When pricing a product or service, managers must consider which of the following?
a. Only period costs
b. Only manufacturing costs
c. Only variable costs d. All costs
6. When companies are price-setters, their products and services a. are priced by managers using a target-pricing emphasis.
b. tend to have a lot of competitors.
c. tend to be commodities.
d. tend to be unique.
7. In deciding whether to drop its electronics product line, Smith Company should consider a. how dropping the electronics product line would affect sales of its other products.
b. the costs it could save by dropping the product line.
c. the revenues it would lose from dropping the product line.
d. All of the above.
Learning Objective 1
Learning Objective 1
Learning Objective 1
Learning Objective 1
Learning Objective 2
Learning Objective 2
Learning Objective 3
> Quick Check
CHAPTER 25
9. When making outsourcing decisions, which of the following is true?
a. Expected use of the freed capacity is irrelevant.
b. The variable cost of producing the product in-house is relevant.
c. The total manufacturing unit cost of making the product in-house is relevant.
d. Avoidable fixed costs are irrelevant.
10. When deciding whether to sell as is or process a product further, managers should ignore which of the following?
a. The costs of processing the product thus far b. The cost of processing further
c. The revenue if the product is sold as is
d. The revenue if the product is processed further Check your answers at the end of the chapter.
Learning Objective 4
Learning Objective 4
ASSESS YOUR PROGRESS
> Review Questions
1. List the four steps in short-term decision making. At which step are managerial accountants most involved?
2. What makes information relevant to decision making?
3. What makes information irrelevant to decision making?
4. What are sunk costs? Give an example.
5. When is nonfinancial information relevant?
6. What is differential analysis?
7. What are the two keys in short-term decision making?
8. What questions should managers answer when setting regular prices?
9. Explain the difference between price-takers and price-setters.
10. What is target pricing? Who uses it?
11. What does the target full product cost include?
12. What is cost-plus pricing? Who uses it?
13. What questions should managers answer when considering special pricing orders?
14. When completing a differential analysis, when are the differences shown as positive amounts? As negative amounts?
15. When should special pricing orders be accepted?
16. What questions should managers answer when considering dropping a product or segment?
17. Explain why a segment with an operating loss can cause the company to have a decrease in total operating income if the segment is dropped.
18. What is a constraint?
19. What questions should managers answer when facing constraints?
CHAPTER 25
20. What is the decision rule concerning products to emphasize when facing a constraint?
21. What is the most common constraint faced by merchandisers?
22. What is outsourcing?
23. What questions should managers answer when considering outsourcing?
24. What questions should managers answer when considering selling a product as is or processing further?
25. What are joint costs? How do they affect the sell or process further decision?
26. What is the decision rule for selling a product as is or processing it further?
> Short Exercises
S25-1 Describing and identifying information relevant to business decisions You are trying to decide whether to trade in your inkjet printer for a more recent model. Your usage pattern will remain unchanged, but the old and new printers use different ink cartridges.
Indicate if the following items are relevant or irrelevant to your decision:
a. The price of the new printer b. The price paid for the old printer c. The trade-in value of the old printer d. Paper cost
e. The difference between ink cartridges’ costs S25-2 Making pricing decisions
Skiable Acres operates a Rocky Mountain ski resort. The company is planning its lift ticket pricing for the coming ski season. Investors would like to earn a 10% return on investment on the company’s $270,000,000 of assets. The company primarily incurs fixed costs to groom the runs and operate the lifts. Skiable Acres projects fixed costs to be $31,000,000 for the ski season. The resort serves about 725,000 skiers and snow- boarders each season. Variable costs are about $8 per guest. Currently, the resort has such a favorable reputation among skiers and snowboarders that it has some control over the lift ticket prices.
Requirements
1. Would Skiable Acres emphasize target pricing or cost-plus pricing? Why?
2. If other resorts in the area charge $85 per day, what price should Skiable Acres charge?
Note: Short Exercise S25-2 must be completed before attempting Short Exercise S25-3.
S25-3 Making pricing decisions
Learning Objective 1
Learning Objective 2
Learning Objective 2
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Requirements
1. If Skiable Acres cannot reduce its costs, what profit will it earn? State your answer in dollars and as a percent of assets. Will investors be happy with the profit level?
2. Assume Skiable Acres has found ways to cut its fixed costs to $30,000,000. What is its new target variable cost per skier/snowboarder?
S25-4 Making dropping a product or segment decisions
Edna Fashions operates three departments: Men’s, Women’s, and Accessories. Depart- mental operating income data for the third quarter of 2018 are as follows:
Learning Objective 3
Operating Income (Loss)
Accessories Total Department
Women’s Men’s
$ (4,000) EDNA FASHIONS
Income Statement
For the Quarter Ended September 30, 2018
$ (18,000)
$ 5,000 Contribution Margin
Net Sales Revenue Variable Costs
Fixed Costs 19,000 29,000 75,000
71,000 11,000
24,000
$ 262,000
$ 102,000
$ 59,000
191,000 91,000
35,000
$ 9,000 27,000 36,000
$ 101,000 65,000
Assume that the fixed costs assigned to each department include only direct fixed costs of the department:
• Salary of the department’s manager
• Cost of advertising directly related to that department
If Edna Fashions drops a department, it will not incur these fixed costs. Under these circumstances, should Edna Fashions drop any of the departments? Give your reasoning.
S25-5 Making product mix decisions
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 products 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 3,300 hours per period. StoreAll can produce 10 large bins every hour, whereas it can produce 17 regular bins in the same amount of time. Fixed costs amount to $115,000 per period. Sales prices and variable costs are as follows:
Regular Large Sales price per unit $ 8.00 $ 10.40 Variable costs per unit 3.50 4.40
Requirements
1. Which product should StoreAll emphasize? Why?
2. To maximize profits, how many of each size bin should StoreAll produce?
3. Given this product mix, what will the company’s operating income be?
Learning Objective 3
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S25-6 Making outsourcing decisions
Suppose Roasted Pepper restaurant is considering whether to (1) bake bread for its restaurant in-house or (2) buy the bread from a local bakery. The chef estimates that variable costs of making each loaf include $0.52 of ingredients, $0.27 of variable overhead (electricity to run the oven), and $0.79 of direct labor for kneading and forming the loaves. Allocating fixed overhead (depreciation on the kitchen equipment and building) based on direct labor, Roasted Pepper assigns $0.96 of fixed overhead per loaf. None of the fixed costs are avoidable. The local bakery would charge $1.78 per loaf.
Requirements
1. What is the full product unit cost of making the bread in-house?
2. Should Roasted Pepper bake the bread in-house or buy from the local bakery? Why?
3. In addition to the financial analysis, what else should Roasted Pepper consider when making this decision?
S25-7 Making outsourcing decisions
Priscilla Smiley manages a fleet of 250 delivery trucks for Daniels Corporation. Smiley must decide whether the company should outsource the fleet management function.
If she outsources to Fleet Management Services (FMS), FMS will be responsible for maintenance and scheduling activities. This alternative would require Smiley to lay off her five employees. However, her own job would be secure; she would be Daniels’s liaison with FMS. If she continues to manage the fleet, she will need fleet- management software that costs $9,500 per year to lease. FMS offers to manage this fleet for an annual fee of $300,000. Smiley performed the following analysis:
Retain In-House
Outsource
to FMS Difference Annual leasing fee for software $ 9,500 $ 9,500
Annual maintenance of trucks 147,000 147,000
Total annual salaries of five laid-off employees 185,000 185,000 Fleet Management Service’s annual fee $ 300,000 (300,000) Total differential cost of outsourcing $ 341,500 $ 300,000 $ 41,500
Requirements
1. Which alternative will maximize Daniels’s short-term operating income?
2. What qualitative factors should Daniels consider before making a final decision?
S25-8 Making sell or process further decisions
Heavenly Dessert processes cocoa beans into cocoa powder at a processing cost of
$9,700 per batch. Heavenly Dessert can sell the cocoa powder as is, or it can process the cocoa powder further into either chocolate syrup or boxed assorted chocolates.
Learning Objective 4
Learning Objective 4
Learning Objective 4
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E25-9 Describing and identifying information relevant to business decisions Dan Jacobs, production manager for GreenLife, invested in computer-controlled pro- duction machinery last year. He purchased the machinery from Superior Design at a cost of $3,000,000. A representative from Superior Design has recently contacted Dan because the company has designed an even more efficient piece of machinery. The new design would double the production output of the year-old machinery but would cost GreenLife another $4,500,000. Jacobs is afraid to bring this new equipment to the company president’s attention because he convinced the president to invest $3,000,000 in the machinery last year.
Explain what is relevant and irrelevant to Jacobs’s dilemma. What should he do?
E25-10 Making special pricing decisions
Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Collector-Cardz with a special order. The Hall of Fame wishes to purchase 56,000 baseball card packs for a special promotional campaign and offers $0.38 per pack, a total of $21,280. Collector-Cardz’s total production cost is $0.58 per pack, as follows:
Variable costs:
Direct materials $ 0.11 Direct labor 0.09 Variable overhead 0.08 Fixed overhead 0.30
Total cost $ 0.58
Collector-Cardz has enough excess capacity to handle the special order.
Requirements
1. Prepare a differential analysis to determine whether Collector-Cardz should accept the special sales order.
2. Now assume that the Hall of Fame wants special hologram baseball cards.
Collector-Cardz will spend $5,700 to develop this hologram, which will be useless after the special order is completed. Should Collector-Cardz accept the special order under these circumstances, assuming no change in the special pricing of
$0.38 per pack?
Learning Objective 1
Learning Objective 2 1. $5,600
> Exercises
The cost of transforming the cocoa powder into chocolate syrup would be $72,000.
Likewise, the company would incur a cost of $183,000 to transform the cocoa powder into boxed assorted chocolates. The company president has decided to make boxed assorted chocolates due to their high sales value and to the fact that the cocoa bean processing cost of $9,700 eats up most of the cocoa powder profits.
Has the president made the right or wrong decision? Explain your answer. Be sure to include the correct financial analysis in your response.