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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIA

Cnthia J. !oone, Ph.D., CPAMcGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies Inc! "ll rights reser#e$!

Di""erential Analsis: #he

$e to De%ision Makin&Cha'ter ()

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*earnin& +be%ti-e (

Identify relevant andirrelevant costs and

benefits in a decision.

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!ele-ant Costs and Bene"its

A relevant costis a %ost that di""ersbetween alternati-es.

1 2

A relevant benefitis a bene"it thatdi""ers between alternati-es.

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Identi"in& !ele-ant Costs

An avoidable cost is a cost that can beeliminated, in whole or in part, by choosing

one alternative over another. Avoidable costs

are relevant costs. Unavoidable costs areirrelevant costs.

Two broad categories of costs are never relevant in

any decision. They include:un! costs.

A future cost that does not differ between thealternatives.

An avoidable cost is a cost that can beeliminated, in whole or in part, by choosing

one alternative over another. Avoidable costs

are relevant costs. Unavoidable costs areirrelevant costs.

Two broad categories of costs are never relevant in

any decision. They include:un! costs.

A future cost that does not differ between thealternatives.

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$es to Su%%ess"ul De%ision

Makin&(. /o%us onl on rele-ant %osts 0also %alled a-oidable%osts, di""erential %osts, or in%remental %osts1 andrele-ant bene"its 0also %alled di""erential bene"its or

in%remental bene"its1.2. I&nore e-erthin& else in%ludin& sunk %osts and"uture %osts and bene"its that do not di""er betweenthe alternati-es.

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Di""erent Costs "or Di""erent

Pur'oses "osts that arerelevant in one

decision situation

may not be relevantin another conte#t.

Thus, in eachdecision situation,the manager must

e#amine the data athand and isolate the

relevant costs.

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Identi"in& !ele-ant CostsCnthia, a Boston student, is %onsiderin& -isitin& her "riend in 3ew 4ork.Cnthia, a Boston student, is %onsiderin& -isitin& her "riend in 3ew 4ork.

She %an dri-e or take the train. B %ar, it is 25) miles to her "riend6sShe %an dri-e or take the train. B %ar, it is 25) miles to her "riend6sa'artment. She is trin& to de%ide whi%h alternati-e is less e7'ensi-ea'artment. She is trin& to de%ide whi%h alternati-e is less e7'ensi-e

and has &athered the "ollowin& in"ormation:and has &athered the "ollowin& in"ormation:

89 'er month89 'er month ; < months; < months $2.%& per gallon ' 2% ()*

829,))) %ost829,))) %ost= 8(),))) sal-a&e -alue > ears= 8(),))) sal-a&e -alue > ears

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% +eduction in resale value of car per mile of wear &.&2,$

- +oundtip train fare 1&/$0 enefits of rela#ing on train trip

1& "ost of putting dog in !ennel while gone /&$

11 enefit of having car in 3ew 4or!

12 5assle of par!ing car in 3ew 4or!

16 )er day cost of par!ing car in 3ew 4or! 27$

ome Additional Information

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8hich costs and benefits are relevant in "ynthia9s8hich costs and benefits are relevant in "ynthia9s

decisiondecision

The cost of thecar is a sun! cost

and is notrelevantto the

current decision.

5owever, the cost of gasoline is clearly relevant if shedecides to drive. If she ta!es the train, the cost would

not be incurred, so it varies depending on the decision.

The annual cost ofinsurance is not

relevant. It will remainthe same if she drives

or ta!es the train.

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8hich costs and benefits are relevant in "ynthia9sdecision

The cost ofmaintenance and

repairs is relevant. Inthe longrun these

costs depend uponmiles driven.

The monthly schoolpar!ing fee is not

relevantbecause itmust be paid if "ynthia

drives or ta!es thetrain.

At this point, we can see that some of the average cost

of $&.10 per mile are relevant and others are not.

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The decline in resalevalue due to additional

miles is a relevantcost.

The roundtrip trainfare is clearly relevant.If she drives the cost

can be avoided.

+ela#ing on the train isrelevanteven though itis difficult to assign a

dollar value to the

benefit.

The !ennel cost is notrelevantbecause

"ynthia will incur thecost if she drives or

ta!es the train.


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The cost of par!ing in3ew 4or! is relevant

because it can beavoided if she ta!es

the train.

The benefits of having a car in 3ew 4or! andthe problems of finding a par!ing space are

both relevantbut are difficult to assign adollar amount.


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rom a financial standpoint, "ynthia would be betteroff ta!ing the train to visit her friend. ome of the

nonfinancial factors may influence her final decision.

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#otal and Di""erential Cost A''roa%hes

The management of a company is considering a new laborsavingmachine that rents for $6,&&& per year. ;ata about the company9sannual sales and costs with and without the new machine are:

"urrent

ituation

ituation

8ith 3ew

(achine

;ifferential

"osts and

enefits

ales 2&&,&&&$ 2&&,&&&$ ?ess variable e#penses:

;irect materials %&,&&& %&,&&&

;irect labor /&,&&& 27,&&& 17,&&&

@ariable overhead 1&,&&& 1&,&&&

Total variable e#penses 12&,&&& 1&7,&&&

"ontribution margin -&,&&& 07,&&& 17,&&&?ess fi#ed e#pense:

ther 2,&&& 2,&&&

+ent on new machine 6,&&&

Total fi#ed e#penses 2,&&& 7,&&&

3et operating income 1-,&&&$ 6&,&&&$ 12,&&&

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As you can see, the only costs that differ between thealternatives are the direct labor costs savings and theincrease in fi#ed rental costs.

"urrent

ituation

ituation

8ith 3ew

(achine

;ifferential

"osts and

enefitsales 2&&,&&&$ 2&&,&&&$

?ess variable e#penses:

;irect materials %&,&&& %&,&&&

;irect labor /&,&&& 27,&&& 17,&&&

@ariable overhead 1&,&&& 1&,&&&

Total variable e#penses 12&,&&& 1&7,&&&

"ontribution margin -&,&&& 07,&&& 17,&&&

?ess fi#ed e#pense:

ther 2,&&& 2,&&&

+ent on new machine 6,&&&

Total fi#ed e#penses 2,&&& 7,&&&

3et operating income 1-,&&&$ 6&,&&&$ 12,&&&

8e can efficiently analyBe the decision byloo!ing at the different costs and revenues

and arrive at the same solution.

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Using the differential cost approach isdesirable for two reasons:

1. nly rarely will enough information beavailable to prepare detailed incomestatements for both alternatives.

2. (ingling irrelevant costs with relevant costs

may cause confusion and distract attentionaway from the information that is reallycritical.

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*earnin& +be%ti-e 2

)repare an analysisshowing whether a

product line or otherbusiness segment should

be added or dropped.

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Addin&?Dro''in& Se&ments

ne of the most importantdecisions managers ma!eis whether to add or drop a

business segment.Ultimately, a decision to

drop an old segment or adda new one is going to hinge

primarily on the impact thedecision will have on net

operating income.

ne of the most importantdecisions managers ma!eis whether to add or drop a

business segment.Ultimately, a decision to

drop an old segment or adda new one is going to hinge

primarily on the impact thedecision will have on net

operating income.

To assess thisimpact, it isnecessary to

carefully analyBethe costs.

To assess thisimpact, it is

necessary tocarefully analyBe

the costs.

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;ue to the declining popularity of digital

watches, ?ovell "ompany9s digitalwatch line has not reported a profit for

several years. ?ovell is considering

discontinuing this product line.

;ue to the declining popularity of digital

watches, ?ovell "ompany9s digitalwatch line has not reported a profit for

several years. ?ovell is considering

discontinuing this product line.

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A Contribution Mar&in A''roa%h

;C"II3 +U?C

?ovell should drop the digital watchsegment only if its profit would

increase.

?ovell will compare the contributionmargin that would be lost to the coststhat would be avoided if the line was to

be dropped.

;C"II3 +U?C

?ovell should drop the digital watchsegment only if its profit would

increase.

?ovell will compare the contributionmargin that would be lost to the coststhat would be avoided if the line was to

be dropped.

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Addin&?Dro''in& Se&mentsegment Income tatement;igital 8atches

ales 7&&,&&&$

?ess: variable e#penses

@ariable manufacturing costs 12&,&&&$

@ariable shipping costs 7,&&&"ommissions %7,&&& 2&&,&&&

"ontribution margin 6&&,&&&$

?ess: fi#ed e#penses

*eneral factory overhead &,&&&$

alary of line manager 0&,&&&;epreciation of eDuipment 7&,&&&

Advertising direct 1&&,&&&

+ent factory space %&,&&&

*eneral admin. e#penses 6&,&&& /&&,&&&e opera ng oss $

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egment Income tatement;igital 8atches

ales 7&&,&&&$










*eneral admin. e#penses 6&,&&& /&&,&&&e opera ng oss

$


An in-esti&ation has re-ealed thatAn in-esti&ation has re-ealed that the "i7edthe "i7ed

&eneral "a%tor o-erhead&eneral "a%tor o-erheadandand "i7ed &eneral"i7ed &eneral

administrati-e e7'ensesadministrati-e e7'enseswill not be a""e%ted bwill not be a""e%ted bdro''in& the di&ital wat%h line. #he "i7ed &eneraldro''in& the di&ital wat%h line. #he "i7ed &eneral

"a%tor o-erhead and &eneral administrati-e"a%tor o-erhead and &eneral administrati-e

e7'enses assi&ned to this 'rodu%t would bee7'enses assi&ned to this 'rodu%t would be

reallo%ated to other 'rodu%t lines.reallo%ated to other 'rodu%t lines.

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egment Income tatement;igital 8atches

ales 7&&,&&&$










*eneral admin. e#penses 6&,&&& /&&,&&&e opera ng oss

$


#he [email protected]'ment used to manu"a%ture#he [email protected]'ment used to manu"a%ture

di&ital wat%hes has no resaledi&ital wat%hes has no resale-alue or alternati-e use.-alue or alternati-e use.

hould ?ovell retain or dropthe digital watch segment

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A Contribution Mar&in A''roa%h"ontribution (argin

olution

"ontribution margin lost if digital

watches are dropped $

?ess fi#ed costs that can be avoided

alary of the line manager 0&,&&&$Advertising direct 1&&,&&&

+ent factory space %&,&&& 2&,&&&

3et disadvantage $

+etain

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Com'arati-e In%ome A''roa%h

The ?ovell solution can also be obtained bypreparing comparative income statements

showing results with and without thedigital watch segment.

?et9s loo! at this second approach.

The ?ovell solution can also be obtained bypreparing comparative income statements

showing results with and without thedigital watch segment.

?et9s loo! at this second approach.

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"omparative Income Approach

olution

Eeep

;igital8atches

;rop

;igital8atches ;ifference

ales 7&&,&&&$ $ $


(anufacturing e#penses 12&,&&& 12&,&&&

hipping 7,&&& 7,&&&

"ommissions %7,&&& %7,&&&Total variable e#penses 2&&,&&& 2&&,&&&

"ontribution margin 6&&,&&&

?ess fi#ed e#penses:

*eneral factory overhead &,&&&

alary of line manager 0&,&&&

;epreciation 7&,&&&Advertising direct 1&&,&&&


*eneral admin. e#penses 6&,&&&

Total fi#ed e#penses /&&,&&&3et operating loss $

If the digital watchline is dropped, the

company loses$6&&,&&& in

contribution margin.

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olution

Eeep

;igital8atches

;rop


ales 7&&,&&&$ $ $



hipping 7,&&& 7,&&&




*eneral factory overhead &,&&& &,&&&

alary of line manager 0&,&&&





n the other hand, the generalfactory overhead would be thesame under both alternatives,

so it is irrelevant.

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olution

Eeep

;igital8atches

;rop


ales 7&&,&&&$ $ $



hipping 7,&&& 7,&&&





alary of line manager 0&,&&& 0&,&&&





The salary of the product linemanager would disappear, so

it is relevant to the decision.

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olution

Eeep

;igital8atches

;rop


ales 7&&,&&&$ $ $



hipping 7,&&& 7,&&&






;epreciation 7&,&&& 7&,&&& Advertising direct 1&&,&&&




The depreciation is a sun! cost. Also, remember thatthe eDuipment has no resale value or alternative use,

so the eDuipment and the depreciation e#penseassociated with it are irrelevant to the decision.

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olution

Eeep

;igital8atches

;rop


ales 7&&,&&&$ $ $



hipping 7,&&& 7,&&&






;epreciation 7&,&&& 7&,&&& Advertising direct 1&&,&&& 1&&,&&&

+ent factory space %&,&&& %&,&&&

*eneral admin. e#penses 6&,&&& 6&,&&&

Total fi#ed e#penses /&&,&&& 1/&,&&& 2&,&&&3et operating loss $ $ $

The complete comparative

income statements reveal that?ovell would earn $/&,&&& of

additional profit by retaining thedigital watch line.

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Beware o" Allo%ated /i7ed Costs

8hy should we !eep the8hy should we !eep the

digital watch segmentdigital watch segment

when it9s showing awhen it9s showing a

$1&&,&&&$1&&,&&&lossloss

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The answer lies in theway we allocate

common fi#ed costs

to our products.

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ur allocations canma!e a segment

loo! less profitablethan it really is.

Including unavoidablecommon fi#ed costs

ma!es the product lineappear to be unprofitable.

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*earnin& +be%ti-e 5

)repare a ma!e or buyanalysis.

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#he Make or Bu Analsis

8hen a company is involved in more than oneactivity in the entire value chain, it is

vertically integrated. A decision to carry out

one of the activities in the value chaininternally, rather than to buy e#ternally from asupplier is called a Fma!e or buyG decision.

8hen a company is involved in more than oneactivity in the entire value chain, it is

vertically integrated. A decision to carry outone of the activities in the value chain

internally, rather than to buy e#ternally from asupplier is called a Fma!e or buyG decision.

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#he Make or Bu De%ision: An

7am'lesse7 Com'an manu"a%tures 'art 9A that is used in oneo" its 'rodu%ts. #he unit 'rodu%t %ost o" this 'art is:

;irect materials $ 0

;irect labor 7

@ariable overhead 1

;epreciation of special eDuip. 6upervisorHs salary 2

*eneral factory overhead 1&Unit product cost 6&$

;irect materials $ 0

;irect labor 7

@ariable overhead 1

;epreciation of special eDuip. 6upervisorHs salary 2

*eneral factory overhead 1&Unit product cost 6&$

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#he Make or Bu De%ision

#he s'e%ial [email protected]'ment used to manu"a%ture 'art 9A hasno resale -alue.

#he total amount o" &eneral "a%tor o-erhead, whi%h isallo%ated on the basis o" dire%t laborhours, would be

una""e%ted b this de%ision. #he 85) unit 'rodu%t %ost is based on 2),))) 'arts

'rodu%ed ea%h ear.

An outside su''lier has o""ered to 'ro-ide the 2),)))

'arts at a %ost o" 82 'er 'art.

Should we a%%e't the su''lier6s o""erShould we a%%e't the su''lier6s o""er

#he s'e%ial [email protected]'ment used to manu"a%ture 'art 9A hasno resale -alue.

#he total amount o" &eneral "a%tor o-erhead, whi%h isallo%ated on the basis o" dire%t laborhours, would be

una""e%ted b this de%ision. #he 85) unit 'rodu%t %ost is based on 2),))) 'arts

'rodu%ed ea%h ear.

An outside su''lier has o""ered to 'ro-ide the 2),)))

'arts at a %ost o" 82 'er 'art.

Should we a%%e't the su''lier6s o""erShould we a%%e't the su''lier6s o""er

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The avoidable costsassociated with ma!ing part /A include directmaterials, direct labor, variable overhead, and the supervisor9s salary.

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The depreciation of the special eDuipment represents a sun!cost. The eDuipment has no resale value, thus its cost and

associated depreciation are irrelevant to the decision.

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3ot avoidable irrelevant. If the product isdropped, it will be reallocated to other products.

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hould we ma!e or buy part /A*iven that the total avoidable costs are less than the cost of

buying the part, Csse# should continue to ma!e the part.

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+''ortunit Cost

An opportunity cost is the benefit that isforegone as a result of pursuing some course

of action.

pportunity costs are not actual cash outlaysand are not recorded in the formal accounts of

an organiBation.

5ow would this concept potentially relate tothe Csse# "ompany

An opportunity cost is the benefit that isforegone as a result of pursuing some course

of action.

pportunity costs are not actual cash outlaysand are not recorded in the formal accounts of

an organiBation.

5ow would this concept potentially relate tothe Csse# "ompany

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*earnin& +be%ti-e 9

)repare an analysis

showing whether aspecial order should beaccepted.

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$e #erms and Con%e'ts

A special order is a onetimeorder that is not considered

part of the company9s normalongoing business.

8hen analyBing a specialorder, only the incremental

costs and benefits arerelevant.

ince the e#isting fi#edmanufacturing overhead costswould not be affected by theorder, they are not relevant.

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S'e%ial +rders

Jet, Inc., ma!es a single product whose normal sellingprice is $2& per unit.

A foreign distributor offers to purchase 6,&&& units for$1& per unit.

This is a onetime order that would not affect thecompany9s regular business.

Annual capacity is 1&,&&& units, but Jet, Inc., is currentlyproducing and selling only 7,&&& units.

Jet, Inc., ma!es a single product whose normal sellingprice is $2& per unit.

A foreign distributor offers to purchase 6,&&& units for$1& per unit.

This is a onetime order that would not affect thecompany9s regular business.

Annual capacity is 1&,&&& units, but Jet, Inc., is currentlyproducing and selling only 7,&&& units.

hould Jet accept the offerhould Jet accept the offer

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S'e%ial +rders

8< -ariable %ost8< -ariable %ost

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S'e%ial +rders

I" Jet a%%e'ts the s'e%ial order, the in%remental re-enuewill e7%eed the in%remental %osts. In other words, net

o'eratin& in%ome will in%rease b 8,))). #his su&&eststhat Jet should a%%e't the order.

Increase in revenue 6&,&&&$

Increase in costs 2/,&&&

Increase in net income ,&&&$

Increase in revenue 6&,&&&$

Increase in costs 2/,&&&

Increase in net income ,&&&$

3ote: This answer assumes that the fi#ed costs areunavoidableand that variable mar!eting costs must be

incurred on the special order.

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Eui%k Che%k

3orthern +'ti%al ordinaril sells the Flens "or 8). #he-ariable 'rodu%tion %ost is 8(), the "i7ed 'rodu%tion %ostis 8(< 'er unit, and the -ariable sellin& %ost is 8(. A%ustomer has [email protected] a s'e%ial order "or (),))) units

o" the Flens to be im'rinted with the %ustomer6s lo&o.#his s'e%ial order would not in-ol-e an sellin& %osts, but3orthern +'ti%al would ha-e to 'ur%hase an im'rintin&ma%hine "or 8),))).

0see the ne7t 'a&e1

3orthern +'ti%al ordinaril sells the Flens "or 8). #he-ariable 'rodu%tion %ost is 8(), the "i7ed 'rodu%tion %ostis 8(< 'er unit, and the -ariable sellin& %ost is 8(. A%ustomer has [email protected] a s'e%ial order "or (),))) units

o" the Flens to be im'rinted with the %ustomer6s lo&o.#his s'e%ial order would not in-ol-e an sellin& %osts, but3orthern +'ti%al would ha-e to 'ur%hase an im'rintin&ma%hine "or 8),))).

0see the ne7t 'a&e1

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Eui%k Che%k

What is the ro%k bottom minimum 'ri%e below whi%h3orthern +'ti%al should not &o in its ne&otiations with the%ustomer In other words, below what 'ri%e would3orthern +'ti%al a%tuall be losin& mone on the sale

#here is am'le idle %a'a%it to "ul"ill the order and theim'rintin& ma%hine has no "urther use a"ter this order.

a. 8)

b. 8()

%. 8(

d. 82

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Eui%k Che%k

What is the ro%k bottom minimum 'ri%e below whi%h3orthern +'ti%al should not &o in its ne&otiations with the%ustomer In other words, below what 'ri%e would3orthern +'ti%al a%tuall be losin& mone on the sale

#here is am'le idle %a'a%it to "ul"ill the order and theim'rintin& ma%hine has no "urther use a"ter this order.

a. 8)

b. 8()

%. 8(

d. 82

@ariable production cost $1&&,&&&

Additional fi#ed cost L 7&,&&&Total relevant cost $17&,&&&3umber of units 1&,&&&Average cost per unitM $17

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*earnin& +be%ti-e

;etermine the most

profitable use of aconstrained resource.

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$e #erms and Con%e'ts

8hen a limited resource ofsome type restricts the

company9s ability to satisfydemand, the company issaid to have a constraint.

The machine orprocess that is

limiting overall outputis called the

bottlenec!N it is theconstraint.

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Htiliation o" a Constrained

!esour%e i#ed costs are usually unaffected in these situations,so the product mi# that ma#imiBes the company9stotal contribution margin should ordinarily beselected.

A company should not necessarily promote thoseproducts that have the highest unit contributionmargins.

+ather, total contribution margin will be ma#imiBed by

promoting those products or accepting those ordersthat provide the highest contribution margin inrelation to the constraining resource.

i#ed costs are usually unaffected in these situations,so the product mi# that ma#imiBes the company9stotal contribution margin should ordinarily beselected.

A company should not necessarily promote thoseproducts that have the highest unit contributionmargins.

+ather, total contribution margin will be ma#imiBed by

promoting those products or accepting those ordersthat provide the highest contribution margin inrelation to the constraining resource.

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Htiliation o" a Constrained !esour%e:An 7am'lensi&n Com'an 'rodu%es two 'rodu%ts and sele%ted data

are shown below:

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Htiliation o" a Constrained !esour%e:An 7am'le

(achine A1 is the constrained resource and is beingused at 1&&O of its capacity.

There is e#cess capacity on all other machines.

(achine A1 has a capacity of 2,/&& minutes per wee!.

Should nsi&n "o%us its e""orts onShould nsi&n "o%us its e""orts on

Produ%t ( or Produ%t 2Produ%t ( or Produ%t 2

(achine A1 is the constrained resource and is beingused at 1&&O of its capacity.

There is e#cess capacity on all other machines.

(achine A1 has a capacity of 2,/&& minutes per wee!.

Should nsi&n "o%us its e""orts onShould nsi&n "o%us its e""orts on

Produ%t ( or Produ%t 2Produ%t ( or Produ%t 2

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10-56

Eui%k Che%k

5ow many units of each product can beprocessed through (achine A1 in one minute

)roduct 1 )roduct 2a. 1 unit &.7 unit

b. 1 unit 2.& units

c. 2 units 1.& unit

d. 2 units &.7 unit

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10-57

5ow many units of each product can beprocessed through (achine A1 in one minute

)roduct 1 )roduct 2a. 1 unit &.7 unit

b. 1 unit 2.& units

c. 2 units 1.& unit

d. 2 units &.7 unit

Eui%k Che%k

Just chec!ing to ma!e sure you are with us.Just chec!ing to ma!e sure you are with us.

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Eui%k Che%k

What &enerates more 'ro"it "or the %om'an, usin& oneminute o" ma%hine A( to 'ro%ess Produ%t ( or usin& oneminute o" ma%hine A( to 'ro%ess Produ%t 2

a. Produ%t (

b. Produ%t 2

%. #he both would &enerate the same 'ro"it.

d. Cannot be determined.

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10-59

Eui%k Che%k


a. Produ%t (

b. Produ%t 2


d. Cannot be determined.


a. Produ%t (

b. Produ%t 2


d. Cannot be determined.8ith one minute of machine A1, Cnsign could

ma!e 1 unit of )roduct 1, with a contributionmargin of $2/, or 2 units of )roduct 2, each with a

contribution margin of $17 per unit.

2 K $17 M $6& P $2/

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!esour%e#he ke is the %ontribution mar&in 'er unit o" the%onstrained resour%e.

Cnsign should emphasiBeCnsign should emphasiBe )roduct 2)roduct 2because itbecause itgenerates a contribution margin of $6& per minutegenerates a contribution margin of $6& per minute

of the constrained resource relative to $2/ perof the constrained resource relative to $2/ per

minute for )roduct 1.minute for )roduct 1.

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!esour%e#he ke is the %ontribution mar&in 'er unit o" the%onstrained resour%e.

Cnsign can ma#imiBe its contribution marginCnsign can ma#imiBe its contribution marginby first producingby first producing )roduct 2)roduct 2to meet customerto meet customer

demand and then using any remainingdemand and then using any remaining

capacity to produce )roduct 1. Thecapacity to produce )roduct 1. The

calculations would be performed as follows.calculations would be performed as follows.

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!esour%e*et6s see how this 'lan would work.*et6s see how this 'lan would work.

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10-63



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!esour%eAccording to the plan, we will produce 2,2&& units of)roduct 2 and 1,6&& of )roduct 1. ur contribution

margin loo!s li!e this.

)roduct 1 )roduct 2

)roduction and sales 1,6&& 2,2&&

"ontribution margin per unit 2/$ 17$

Total contribution margin 61,2&&$ 66,&&&$

The total contribution margin for Cnsign is $/,2&&.

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*earnin& +be%ti-e

;etermine the value of

obtaining more of theconstrained resource.

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alue o" a Constrained !esour%e

Increasing the capacityof a constrained

resource should lead to

increased productionand sales.

5ow much shouldCnsign be willing to payfor an additional minute

of A1 machine time

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10-68

The additional machine time would be used toma!e more units of )roduct 1, which had a

contribution margin per minute of $2/.

Cnsign should be willing to pay up to $2/Cnsign should be willing to pay up to $2/

per minute. This amount eDuals theper minute. This amount eDuals the

contribution margin per minute of machinecontribution margin per minute of machinetime that would be earned producing moretime that would be earned producing more

units of )roduct 1.units of )roduct 1.

alue o" a Constrained !esour%e

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10-69

Eui%k Che%k

"olonial 5eritage ma!es reproduction colonialfurniture from select hardwoods.

The company9s supplier of hardwood will only be

able to supply 2,&&& board feet this month. Is thisenough hardwood to satisfy demanda. 4es

b. 3o

Chairs TablesSellin& 'ri%e 'er unit 8

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Eui%k Che%k

"olonial 5eritage ma!es reproduction colonialfurniture from select hardwoods.

The company9s supplier of hardwood will only

be able to supply 2,&&& board feet this month. Isthis enough hardwood to satisfy demand

a. 4es

b. 3o


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Eui%k Che%k

The company9s supplier of hardwood will onlybe able to supply 2,&&& board feet this month.8hat plan would ma#imiBe profits

a. 7&& chairs and 1&& tablesb. && chairs and -& tables

c. 7&& chairs and -& tables

d. && chairs and 1&& tables


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The company9s supplier of hardwood will onlybe able to supply 2,&&& board feet this month.8hat plan would ma#imiBe profits

a. 7&& chairs and 1&& tablesb. && chairs and -& tables

c. 7&& chairs and -& tables

d. && chairs and 1&& tables


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Eui%k Che%k

As before, "olonial 5eritage9s supplier of hardwoodwill only be able to supply 2,&&& board feet thismonth. Assume the company follows the plan wehave proposed. Up to how much should "olonial

5eritage be willing to pay above the usual price toobtain more hardwood

a. $/& per board foot

b. $27 per board foot

c. $2& per board foot

d. Qero





c. $2& per board footd. Qero

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Eui%k Che%k





c. $2& per board foot

d. Qero





c. $2& per board footd. Qero

The additional wood would be used to ma!etables. In this use, each board foot of

additional wood will allow the company to earn

an additional $2& of contribution margin andprofit.

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Mana&in& Constraints

It is often possible for a manager to increase the capacity ofa bottlenec!, which is called rela#ing theconstraint, in numerous ways such as:

1. 8or!ing overtime on the bottlenec!.2. ubcontracting some of the processing that would be done

at the bottlenec!.6. Investing in additional machines at the bottlenec!./. hifting wor!ers from nonbottlenec! processes to the

bottlenec!.7. ocusing business process improvement efforts on the

bottlenec!.. +educing defective units processed through the bottlenec!.

These methods and ideas are all consistent with the Theory

of "onstraints, which was introduced in "hapter 1.

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*earnin& +be%ti-e K

)repare an analysisshowing whether Roint

products should be soldat the splitoff point or

processed further.

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Joint Costs

In some industries, a number o" end'rodu%ts are 'rodu%ed "rom a sin&le rawmaterial in'ut.

#wo or more 'rodu%ts 'rodu%ed "rom a%ommon in'ut are %alledoint 'rodu%tsoint 'rodu%ts.

#he 'oint in the manu"a%turin& 'ro%ess

where ea%h oint 'rodu%t %an bere%o&nied as a se'arate 'rodu%t is%alled the s'lito"" 'oints'lito"" 'oint.

In some industries, a number o" end'rodu%ts are 'rodu%ed "rom a sin&le rawmaterial in'ut.

#wo or more 'rodu%ts 'rodu%ed "rom a%ommon in'ut are %alledoint 'rodu%tsoint 'rodu%ts.

#he 'oint in the manu"a%turin& 'ro%ess

where ea%h oint 'rodu%t %an bere%o&nied as a se'arate 'rodu%t is%alled the s'lito"" 'oints'lito"" 'oint.

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Joint Produ%ts

JointIn'ut

CommonProdu%tion

Pro%ess

plitff)oint

+il

Gasoline

Chemi%als

or e#ample,in the petroleumrefining industry,a large numberof products are

e#tracted fromcrude oil,including

gasoline, Ret fuel,

home heating oil,lubricants,asphalt, and

various organicchemicals.

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Joint Produ%ts

Se'aratePro%essin&

Se'arate

Pro%essin&

inalale

inal

ale

/inalSale

eparate)roduct

"osts

JointIn'ut

CommonProdu%tionPro%ess

plitff)oint

+il

Gasoline

Chemi%als

Joint costsare in%urredu' to the

s'lito"" 'oint

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Sell or Pro%ess /urther

Joint costs are irrelevant in decisions regardingwhat to do with a product from the splitoff point

forward. Therefore, these costs should not beallocated to end products for decisionma!ing

purposes.

8ith respect to sell or process further decisions, it isprofitable to continue processing a Roint product

after the splitoff point so long as the incrementalrevenue from such processing e#ceeds the

incremental processing costs incurred after thesplitoff point.

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10-81

Sell or Pro%ess /urther: An

7am'le Sawmill, In%., %uts lo&s "rom whi%h un"inishedSawmill, In%., %uts lo&s "rom whi%h un"inishedlumber and sawdust are the immediate ointlumber and sawdust are the immediate oint

'rodu%ts.'rodu%ts.

Hn"inished lumber is sold Las is or 'ro%essedHn"inished lumber is sold Las is or 'ro%essed"urther into "inished lumber."urther into "inished lumber.

Sawdust %an also be sold Las is to &ardenin&Sawdust %an also be sold Las is to &ardenin&

wholesalers or 'ro%essed "urther into L'restowholesalers or 'ro%essed "urther into L'resto

lo&s.lo&s.

Sawmill, In%., %uts lo&s "rom whi%h un"inishedSawmill, In%., %uts lo&s "rom whi%h un"inished

lumber and sawdust are the immediate ointlumber and sawdust are the immediate oint

'rodu%ts.'rodu%ts.

Hn"inished lumber is sold Las is or 'ro%essedHn"inished lumber is sold Las is or 'ro%essed"urther into "inished lumber."urther into "inished lumber.

Sawdust %an also be sold Las is to &ardenin&Sawdust %an also be sold Las is to &ardenin&

wholesalers or 'ro%essed "urther into L'restowholesalers or 'ro%essed "urther into L'resto

lo&s.lo&s.

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Data about Sawmill6s oint 'rodu%ts in%ludes:

)er ?og

?umber awdust

ales value at the splitoff point 1/&$ /&$

ales value after further processing 2%& 7&

Allocated Roint product costs 1% 2/

"ost of further processing 7& 2&

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Analysis of ell or )rocess :urther

)er ?og

?umber awdust

ales value after further processing 2%&$ 7&$

ales value at the split.off point 1/& /&

Incremental revenue 16& 1&

"ost of further processing 7& 2&)rofit from further processing -&$ $

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#he lumber should be 'ro%essed"urther and the sawdust should be

sold at the s'lito"" 'oint.

Analysis of ell or )rocess :urther

)er ?og

?umber awdust

ales value after further processing 2%&$ 7&$

ales value at the split.off point 1/& /&

Incremental revenue 16& 1&

"ost of further processing 7& 2&)rofit from further processing -&$ $

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