Special Business Decisions and Capital Budgeting Chapter 26
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Objective 1
Identify the relevant information for a special business decision.
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Relevant Information for Decision Making
?
Relevant information has two distinguishing characteristics.
It is expected future data that differs among alternatives. Only relevant data affect decisions.
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Objective 2
Make five types of short-term special business decisions.
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Special Sales Order
A. B. Fast is a manufacturer of automobile parts located in Texas. ? Ordinarily A. B. Fast sells oil filters for $3.22 each. ? R. Pino and Co., from Puerto Rico, has offered $35,400 for 20,000 oil filters, or $1.77 per filter.
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Special Sales Order
A. B. Fast’s manufacturing product cost is $2 per oil filter which includes variable manufacturing costs of $1.20 and fixed manufacturing overhead of $0.80. ? Suppose that A. B. Fast made and sold 250,000 oil filters before considering the special order. ? Should A. B. Fast accept the special order?
?
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Special Sales Order
The $1.77 offered price will not cover the $2 manufacturing cost. ? However, the $1.77 price exceeds variable manufacturing costs by $.57 per unit. ? Accepting the order will increase A. B. Fast’s contribution margin. ? 20,000 units × $.57 contribution margin per unit = $11,400
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Dropping Products, Departments, Territories
Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil filters and 20,000 air cleaners). ? Suppose that the company is considering dropping the air cleaner product line. ? Revenues for the air cleaner product line are $41,000. ? Should A. B. Fast drop the air cleaner line?
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Dropping Products, Departments, Territories
Variable selling and administrative expenses are $0.30 per unit. ? Variable manufacturing expenses are $1.20 per unit. ? Total fixed expenses are $335,000. ? Total fixed expenses will continue even if the product line is dropped.
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Dropping Products, Departments, Territories
Product Line Oil Filters Air Cleaners Total Units 250,000 20,000 270,000 Sales $805,000 $ 41,000 $846,000 Variable expenses 375,000 30,000 405,000 Contribution margin $430,000 $ 11,000 $441,000 Fixed expenses 310,185 24,815 335,000 Operating income/(loss) $119,815 ($13,815) $106,000
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Dropping Products, Departments, Territories
To measure product-line operating income, A. B. Fast allocates fixed expenses in proportion to the number of units sold. ? Total fixed expenses are $335,000 ÷ 270,000 units, or $1.24 fixed unit cost. ? Fixed expenses allocated to the air cleaner product line are 20,000 units × $1.24 per unit, or $24,815.
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Dropping Products, Departments, Territories
Oil Filters Alone
Units Sales Variable expenses Contribution margin Fixed expenses Operating income
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250,000 $805,000 375,000 430,000 335,000 $ 95,000
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Dropping Products, Departments, Territories
Suppose that the company employs a supervisor for $25,000. ? This cost can be avoided if the company stops producing air cleaners. ? Should the company stop producing air cleaners? ? Yes! ? $11,000 – $25,000 = ($14,000)
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Product Mix
Companies must decide which products to emphasize if certain constraints prevent unlimited production or sales. ? Assume that A. B. Fast produces oil filters and windshield wipers. ? The company has 2,000 machine hours available to produce these products.
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Product Mix
A. B. Fast can produce 5 oil filters in one hour or 8 windshield wipers. Product Oil Windshield Per Unit Filters Wipers Sales price $3.22 $13.50 Variable expenses 1.50 12.00 Contribution margin $1.72 $ 1.50 Contribution margin ratio 53% 11%
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Product Mix
Which product should A. B. Fast emphasize? Oil filters: $1.72 contribution margin per unit × 5 units per hour = $8.60 per machine hour Windshield wipers: $1.50 contribution margin per unit × 8 units per hour = $12.00 per machine hour
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Outsourcing (Make or Buy)
A. B. Fast is considering the production of a part it needs, or using a model produced by C. D. Enterprise. ? C. D. Enterprise offers to sell the part for $0.37. ? Should A. B. Fast manufacture the part or buy it?
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Outsourcing (Make or Buy)
A. B. Fast has the following costs for 250,000 units of Part no. 4: Part no. 4 costs: Total Direct materials $ 40,000 Direct labor 20,000 Variable overhead 15,000 Fixed overhead 50,000 Total $125,000 $125,000 ÷ 250,000 units = $0.50/unit
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Outsourcing (Make or Buy)
Assume that by purchasing the part, A. B. Fast can avoid all variable manufacturing costs and reduce fixed costs by $15,000 (fixed costs will decrease to $35,000). ? A. B. Fast should continue to manufacture the part. ? Why?
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Outsourcing (Make or Buy)
Purchase cost (250,000 × $0.37) Fixed costs that will continue Total $ 92,500 35,000 $127,500
$127,500 – $125,000 = $2,500, which is the difference in favor of manufacturing the part. The unit cost is then $0.51 ($127,500 ÷ 250,000).
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Best Use of Facilities
Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the facilities previously used to manufacture Part no. 4 to produce gasoline filters. ? The expected annual profit contribution of the gasoline filters is $17,000. ? What should A. B. Fast do?
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Best Use of Facilities
Expected cost of obtaining 250,000 parts: Make part $125,000 Buy part and leave facilities idle $127,500 Buy part and use facilities for gas filters $110,500* *Cost of buying part: $127,500 less $17,000 contribution from gasoline filters.
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Sell As-Is Or Process Further
The sell as-is or process further is a decision whether to incur additional manufacturing costs and sell the inventory at a higher price, – or sell the inventory as-is at a lower price. ? Suppose that A. B. Fast spends $500,000 to produce 250,000 oil filters. ? A. B. Fast can sell these filters for $3.22 per filter, for a total of $805,000.
?
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Sell As-Is Or Process Further
Alternatively, A. B. Fast can further process these filters into super filters at an additional cost of $25,000, which is $0.10 per unit ($25,000 ÷ 250,000 = $0.10). ? Super filters will sell for $3.52 per filter for a total of $880,000. ? Should A. B. Fast process the filters into super filters?
?
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Sell As-Is Or Process Further
A. B. Fast should process further, because the $75,000 extra revenue ($880,000 – $805,000) outweighs the $25,000 cost of extra processing. ? Extra sales revenue is $0.30 per filter. ? Extra cost of additional processing is $0.10 per filter.
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Sell As-Is Or Process Further
Cost to produce 250,000 parts: Sell these parts for $3.22 each: $500,000 $805,000
Cost to process original parts further: $ 25,000 Sell these parts for $3.52 each: $880,000
Sales increase ($880,000 – $805,000) $ 75,000 Less processing cost 25,000 Net gain by processing further $ 50,000
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Objective 3
Explain the difference between correct analysis and incorrect analysis of a particular business decision.
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Correct Analysis
A correct analysis of a business decision focuses on differences in revenues and expenses. ? The contribution margin approach, which is based on variable costing, often is more useful for decision analysis. ? It highlights how expenses and income are affected by sales volume.
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Incorrect Analysis
The conventional approach to decision making, which is based on absorption costing, may mislead managers into treating a fixed cost as a variable cost. ? Absorption costing treats fixed manufacturing overhead as part of the unit cost.
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Objective 4
Use opportunity costs in decision making.
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Opportunity Cost...
is the benefit that can be obtained from the next best course of action. ? Opportunity cost is not an outlay cost, so it is not recorded in the accounting records. ? Suppose that A. B. Fast is approached by a customer that needs 250,000 regular oil filters.
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Opportunity Cost
The customer is willing to pay more than $3.22 per filter. ? A. B. Fast’s managers can use the $855,000 ($880,000 – $25,000) opportunity cost of not further processing the oil filters to determine the sales price that will provide an equivalent income. ? $855,000 ÷ 250,000 units = $3.42
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Objective 5
Use four capital budgeting models to make longer-term investment decisions.
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Capital Budgeting...
is a formal means of analyzing long-range capital investment decisions. ? The term describes budgeting for the acquisition of capital assets. ? Capital assets are assets used for a long period of time.
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Capital Budgeting
? –
–
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Capital budget models using net cash inflow from operations are: payback accounting rate of return net present value internal rate of return
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Payback...
is the length of time it takes to recover, in net cash inflows from operations, the dollars of capital outlays. ? An increase in cash could result from an increase in revenues, a decrease in expenses, or a combination of the two.
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1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31
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Payback Example
Assume that A. B. Fast is considering the purchase of a machine for $200,000, with an estimated useful life of 8 years, and zero predicted residual value. ? Managers expect use of the machine to generate $40,000 of net cash inflows from operations per year.
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Payback Example
How long would it take to recover the investment? ? $200,000 ÷ $40,000 = 5 years ? 5 years is the payback period.
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Payback Example
When cash flows are uneven, calculations must take a cumulative form. ? Cash inflows must be accumulated until the amount invested is recovered. ? Suppose that the machine will produce net cash inflows of $90,000 in Year 1, $70,000 in Year 2, and $30,000 in Years 3 through 8.
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Payback Example
What is the payback period? ? Years 1, 2, and 3 together bring in $190,000. ? Recovery of the amount invested occurs during Year 4. ? Recovery is 3 years + $10,000. ? 3 years + ($10,000 ÷ $30,000) = 3 years and 4 months
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Accounting Rate of Return...
measures profitability. ? It measures the average return over the life of the asset. ? It is computed by dividing average annual operating income by the average amount of investment in the asset.
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Accounting Rate of Return Example
Assume that a machine costs $200,000, has no residual value, and has a useful life of 8 years. ? How much is the straight-line depreciation per year? ? $25,000 ? Management expects the machine to generate annual net cash inflows of $40,000.
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Accounting Rate of Return Example
How much is the average operating income? ? $40,000 – $25,000 = $15,000 ? How much is the average investment? ? $200,000 ÷ 2 = $100,000 ? What is the accounting rate of return? ? $15,000 ÷ $100,000 = 15%
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Discounted Cash-Flow Models
Discounted cash-flow models take into account the time value of money. ? The time value of money means that a dollar invested today can earn income and become greater in the future. ? These methods take those future values and discount them (deduct interest) back to the present.
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Net Present Value
The (NPV) method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present. ? The amount of interest deducted is determined by the desired rate of return. ? This rate of return is called the discount rate, hurdle rate, required rate of return, or cost of capital.
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Net Present Value Example
A. B. Fast is considering an investment of $450,000. ? This proposed investment will yield periodic net cash inflows of $225,000, $230,000, and $210,000 over its life. ? A. B. Fast expects a return of 16%. ? Should the investment be made?
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Net Present Value Example
Periods Amount PV Factor 0 ($450,000) 1.000 1 225,000 0.862 2 230,000 0.743 3 210,000 0.641 Total PV of net cash inflows Net present value of project Present Value ($450,000) 193,950 170,890 134,610 $499,450 $ 49,450
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Internal Rate of Return...
is another model using discounted cash flows. ? The internal rate of return (IRR) is the rate of return that a company can expect to earn by investing in a project. ? The higher the IRR, the more desirable the investment.
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Internal Rate of Return
The IRR is the rate of return at which the net present value equals zero. ? Investment = Expected annual net cash inflow × PV annuity factor ? Investment ÷ Expected annual net cash inflow = PV annuity factor
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Internal Rate of Return Example
Assume that A. B. Fast is considering investing $500,000 in a project that will yield net cash inflows of $152,725 per year over its 5-year life. ? What is the IRR of this project? ? $500,000 ÷ $152,725 = 3.274 (PV annuity factor)
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Internal Rate of Return Example
The annuity table shows that 3.274 is in the 16% column for a 5-period row in this example. ? Therefore, 16% is the internal rate of return of this project. ? If the minimum desired rate of return is 16% or less, A.B. Fast should undertake this project.
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Objective 6
Compare and contrast popular capital budgeting methods.
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Comparison of Capital Budgeting Models
The discounted cash-flow models, net present value, and internal rate of return are conceptually superior to the payback and accounting rate of return models. ? Strengths of the payback include: ? It is easy to calculate, highlights risks, and is based on cash flows.
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Comparison of Capital Budgeting Models
Its weaknesses are that it ignores cash flows beyond the payback, the time value of money, and profitability. ? The strength of the accounting rate of return is that it is based on profitability. ? Its weakness is that it ignores the time value of money.
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End of Chapter 26
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doc_721117983.ppt
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1
Objective 1
Identify the relevant information for a special business decision.
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Relevant Information for Decision Making
?
Relevant information has two distinguishing characteristics.
It is expected future data that differs among alternatives. Only relevant data affect decisions.
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26 - 3
Objective 2
Make five types of short-term special business decisions.
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Special Sales Order
A. B. Fast is a manufacturer of automobile parts located in Texas. ? Ordinarily A. B. Fast sells oil filters for $3.22 each. ? R. Pino and Co., from Puerto Rico, has offered $35,400 for 20,000 oil filters, or $1.77 per filter.
?
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 5
Special Sales Order
A. B. Fast’s manufacturing product cost is $2 per oil filter which includes variable manufacturing costs of $1.20 and fixed manufacturing overhead of $0.80. ? Suppose that A. B. Fast made and sold 250,000 oil filters before considering the special order. ? Should A. B. Fast accept the special order?
?
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Special Sales Order
The $1.77 offered price will not cover the $2 manufacturing cost. ? However, the $1.77 price exceeds variable manufacturing costs by $.57 per unit. ? Accepting the order will increase A. B. Fast’s contribution margin. ? 20,000 units × $.57 contribution margin per unit = $11,400
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Dropping Products, Departments, Territories
Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil filters and 20,000 air cleaners). ? Suppose that the company is considering dropping the air cleaner product line. ? Revenues for the air cleaner product line are $41,000. ? Should A. B. Fast drop the air cleaner line?
?
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Dropping Products, Departments, Territories
Variable selling and administrative expenses are $0.30 per unit. ? Variable manufacturing expenses are $1.20 per unit. ? Total fixed expenses are $335,000. ? Total fixed expenses will continue even if the product line is dropped.
?
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Dropping Products, Departments, Territories
Product Line Oil Filters Air Cleaners Total Units 250,000 20,000 270,000 Sales $805,000 $ 41,000 $846,000 Variable expenses 375,000 30,000 405,000 Contribution margin $430,000 $ 11,000 $441,000 Fixed expenses 310,185 24,815 335,000 Operating income/(loss) $119,815 ($13,815) $106,000
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Dropping Products, Departments, Territories
To measure product-line operating income, A. B. Fast allocates fixed expenses in proportion to the number of units sold. ? Total fixed expenses are $335,000 ÷ 270,000 units, or $1.24 fixed unit cost. ? Fixed expenses allocated to the air cleaner product line are 20,000 units × $1.24 per unit, or $24,815.
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Dropping Products, Departments, Territories
Oil Filters Alone
Units Sales Variable expenses Contribution margin Fixed expenses Operating income
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250,000 $805,000 375,000 430,000 335,000 $ 95,000
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Dropping Products, Departments, Territories
Suppose that the company employs a supervisor for $25,000. ? This cost can be avoided if the company stops producing air cleaners. ? Should the company stop producing air cleaners? ? Yes! ? $11,000 – $25,000 = ($14,000)
?
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Product Mix
Companies must decide which products to emphasize if certain constraints prevent unlimited production or sales. ? Assume that A. B. Fast produces oil filters and windshield wipers. ? The company has 2,000 machine hours available to produce these products.
?
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Product Mix
A. B. Fast can produce 5 oil filters in one hour or 8 windshield wipers. Product Oil Windshield Per Unit Filters Wipers Sales price $3.22 $13.50 Variable expenses 1.50 12.00 Contribution margin $1.72 $ 1.50 Contribution margin ratio 53% 11%
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Product Mix
Which product should A. B. Fast emphasize? Oil filters: $1.72 contribution margin per unit × 5 units per hour = $8.60 per machine hour Windshield wipers: $1.50 contribution margin per unit × 8 units per hour = $12.00 per machine hour
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Outsourcing (Make or Buy)
A. B. Fast is considering the production of a part it needs, or using a model produced by C. D. Enterprise. ? C. D. Enterprise offers to sell the part for $0.37. ? Should A. B. Fast manufacture the part or buy it?
?
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Outsourcing (Make or Buy)
A. B. Fast has the following costs for 250,000 units of Part no. 4: Part no. 4 costs: Total Direct materials $ 40,000 Direct labor 20,000 Variable overhead 15,000 Fixed overhead 50,000 Total $125,000 $125,000 ÷ 250,000 units = $0.50/unit
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Outsourcing (Make or Buy)
Assume that by purchasing the part, A. B. Fast can avoid all variable manufacturing costs and reduce fixed costs by $15,000 (fixed costs will decrease to $35,000). ? A. B. Fast should continue to manufacture the part. ? Why?
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Outsourcing (Make or Buy)
Purchase cost (250,000 × $0.37) Fixed costs that will continue Total $ 92,500 35,000 $127,500
$127,500 – $125,000 = $2,500, which is the difference in favor of manufacturing the part. The unit cost is then $0.51 ($127,500 ÷ 250,000).
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Best Use of Facilities
Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the facilities previously used to manufacture Part no. 4 to produce gasoline filters. ? The expected annual profit contribution of the gasoline filters is $17,000. ? What should A. B. Fast do?
?
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Best Use of Facilities
Expected cost of obtaining 250,000 parts: Make part $125,000 Buy part and leave facilities idle $127,500 Buy part and use facilities for gas filters $110,500* *Cost of buying part: $127,500 less $17,000 contribution from gasoline filters.
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Sell As-Is Or Process Further
The sell as-is or process further is a decision whether to incur additional manufacturing costs and sell the inventory at a higher price, – or sell the inventory as-is at a lower price. ? Suppose that A. B. Fast spends $500,000 to produce 250,000 oil filters. ? A. B. Fast can sell these filters for $3.22 per filter, for a total of $805,000.
?
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Sell As-Is Or Process Further
Alternatively, A. B. Fast can further process these filters into super filters at an additional cost of $25,000, which is $0.10 per unit ($25,000 ÷ 250,000 = $0.10). ? Super filters will sell for $3.52 per filter for a total of $880,000. ? Should A. B. Fast process the filters into super filters?
?
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Sell As-Is Or Process Further
A. B. Fast should process further, because the $75,000 extra revenue ($880,000 – $805,000) outweighs the $25,000 cost of extra processing. ? Extra sales revenue is $0.30 per filter. ? Extra cost of additional processing is $0.10 per filter.
?
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Sell As-Is Or Process Further
Cost to produce 250,000 parts: Sell these parts for $3.22 each: $500,000 $805,000
Cost to process original parts further: $ 25,000 Sell these parts for $3.52 each: $880,000
Sales increase ($880,000 – $805,000) $ 75,000 Less processing cost 25,000 Net gain by processing further $ 50,000
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Objective 3
Explain the difference between correct analysis and incorrect analysis of a particular business decision.
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Correct Analysis
A correct analysis of a business decision focuses on differences in revenues and expenses. ? The contribution margin approach, which is based on variable costing, often is more useful for decision analysis. ? It highlights how expenses and income are affected by sales volume.
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Incorrect Analysis
The conventional approach to decision making, which is based on absorption costing, may mislead managers into treating a fixed cost as a variable cost. ? Absorption costing treats fixed manufacturing overhead as part of the unit cost.
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Objective 4
Use opportunity costs in decision making.
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Opportunity Cost...
is the benefit that can be obtained from the next best course of action. ? Opportunity cost is not an outlay cost, so it is not recorded in the accounting records. ? Suppose that A. B. Fast is approached by a customer that needs 250,000 regular oil filters.
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Opportunity Cost
The customer is willing to pay more than $3.22 per filter. ? A. B. Fast’s managers can use the $855,000 ($880,000 – $25,000) opportunity cost of not further processing the oil filters to determine the sales price that will provide an equivalent income. ? $855,000 ÷ 250,000 units = $3.42
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Objective 5
Use four capital budgeting models to make longer-term investment decisions.
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Capital Budgeting...
is a formal means of analyzing long-range capital investment decisions. ? The term describes budgeting for the acquisition of capital assets. ? Capital assets are assets used for a long period of time.
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Capital Budgeting
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Capital budget models using net cash inflow from operations are: payback accounting rate of return net present value internal rate of return
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Payback...
is the length of time it takes to recover, in net cash inflows from operations, the dollars of capital outlays. ? An increase in cash could result from an increase in revenues, a decrease in expenses, or a combination of the two.
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Payback Example
Assume that A. B. Fast is considering the purchase of a machine for $200,000, with an estimated useful life of 8 years, and zero predicted residual value. ? Managers expect use of the machine to generate $40,000 of net cash inflows from operations per year.
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Payback Example
How long would it take to recover the investment? ? $200,000 ÷ $40,000 = 5 years ? 5 years is the payback period.
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Payback Example
When cash flows are uneven, calculations must take a cumulative form. ? Cash inflows must be accumulated until the amount invested is recovered. ? Suppose that the machine will produce net cash inflows of $90,000 in Year 1, $70,000 in Year 2, and $30,000 in Years 3 through 8.
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Payback Example
What is the payback period? ? Years 1, 2, and 3 together bring in $190,000. ? Recovery of the amount invested occurs during Year 4. ? Recovery is 3 years + $10,000. ? 3 years + ($10,000 ÷ $30,000) = 3 years and 4 months
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Accounting Rate of Return...
measures profitability. ? It measures the average return over the life of the asset. ? It is computed by dividing average annual operating income by the average amount of investment in the asset.
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Accounting Rate of Return Example
Assume that a machine costs $200,000, has no residual value, and has a useful life of 8 years. ? How much is the straight-line depreciation per year? ? $25,000 ? Management expects the machine to generate annual net cash inflows of $40,000.
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Accounting Rate of Return Example
How much is the average operating income? ? $40,000 – $25,000 = $15,000 ? How much is the average investment? ? $200,000 ÷ 2 = $100,000 ? What is the accounting rate of return? ? $15,000 ÷ $100,000 = 15%
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Discounted Cash-Flow Models
Discounted cash-flow models take into account the time value of money. ? The time value of money means that a dollar invested today can earn income and become greater in the future. ? These methods take those future values and discount them (deduct interest) back to the present.
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Net Present Value
The (NPV) method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present. ? The amount of interest deducted is determined by the desired rate of return. ? This rate of return is called the discount rate, hurdle rate, required rate of return, or cost of capital.
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Net Present Value Example
A. B. Fast is considering an investment of $450,000. ? This proposed investment will yield periodic net cash inflows of $225,000, $230,000, and $210,000 over its life. ? A. B. Fast expects a return of 16%. ? Should the investment be made?
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Net Present Value Example
Periods Amount PV Factor 0 ($450,000) 1.000 1 225,000 0.862 2 230,000 0.743 3 210,000 0.641 Total PV of net cash inflows Net present value of project Present Value ($450,000) 193,950 170,890 134,610 $499,450 $ 49,450
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Internal Rate of Return...
is another model using discounted cash flows. ? The internal rate of return (IRR) is the rate of return that a company can expect to earn by investing in a project. ? The higher the IRR, the more desirable the investment.
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Internal Rate of Return
The IRR is the rate of return at which the net present value equals zero. ? Investment = Expected annual net cash inflow × PV annuity factor ? Investment ÷ Expected annual net cash inflow = PV annuity factor
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Internal Rate of Return Example
Assume that A. B. Fast is considering investing $500,000 in a project that will yield net cash inflows of $152,725 per year over its 5-year life. ? What is the IRR of this project? ? $500,000 ÷ $152,725 = 3.274 (PV annuity factor)
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Internal Rate of Return Example
The annuity table shows that 3.274 is in the 16% column for a 5-period row in this example. ? Therefore, 16% is the internal rate of return of this project. ? If the minimum desired rate of return is 16% or less, A.B. Fast should undertake this project.
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Objective 6
Compare and contrast popular capital budgeting methods.
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Comparison of Capital Budgeting Models
The discounted cash-flow models, net present value, and internal rate of return are conceptually superior to the payback and accounting rate of return models. ? Strengths of the payback include: ? It is easy to calculate, highlights risks, and is based on cash flows.
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Comparison of Capital Budgeting Models
Its weaknesses are that it ignores cash flows beyond the payback, the time value of money, and profitability. ? The strength of the accounting rate of return is that it is based on profitability. ? Its weakness is that it ignores the time value of money.
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End of Chapter 26
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