GOOD NEWS, BAD NEWS FOR C&C

CISD wants 1,000 standard practice jerseys, with a couple of special modifications

Bonadeo Embroidery wants to supply chenille letters at a low cost

There are problems with the jersey fabric order at Bradley Textile Mills

It looks like some sales territories are losing money and might need to be shut down

What’s the real story on these issues?

WHAT IS RELEVANT INFORMATION?

Information that is directly related to the decision being made

Information about something that will happen in the future

Information that differs between alternatives

© Lev Mei/iStockphoto

LET’S IDENTIFY RELEVANT INFORMATION

Accord Mazda 6 Relevant?MSRP $22,565 $22,550

MPG, City 21 24

MPG, highway 31 34

Warranty 36,000 miles, 36 months

36,000 miles, 36 months

Leg room (front) 42.5” 42.5”

Trunk capacity 14.0 ft3 16.6 ft3

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SO WHEN IS A COST RELEVANT?

IMPORTANT TERMS TO KNOW

Avoidable cost• Cost associated with a particular alternative that will

be eliminated if alternative is eliminated

Unavoidable cost• Cost that will continue regardless of the alternative

selected

LET’S PRACTICE

You are getting ready to take a trip and are trying to decide whether to drive or fly. You know that it costs you

$1,000 per year plus $0.10/mile to operate your car. Based on the 20,000 miles you drive each year, you calculate total costs to be $0.15/mile. You have just

gotten wind of a special $65 round trip airfare.

Is it cheaper to drive the 500 miles or fly?

© fotoVoyager/iStockphoto

© kickers/iStockphoto

WATCH OUT FOR SUNK COSTS

Sunk costs are NEVER relevant to a decision

These costs have been incurred in the past and nothing you can do today can change them

A RELEVANT COST DECISION MODEL

Identify the decision

Identify the alternatives

Identify the relevant revenues and costs

Identify the qualitative issues to consider

Identify the alternative with the greatest benefit or least cost

SPECIAL ORDER PRICING DECISIONS

Sometimes a company may get an order from a customer asking for a “special price” that is less than the stated selling price

Could be a grocery chain approaching Kleenex maker Kimberly-Clark to produce a “private label” facial tissue

Sometimes the price requested appears to be less than the full product cost

WHY ACCEPT SPECIAL ORDER PRICING?

For product made to customer specs

For unusual order (quantity, packaging, means of delivery, etc.)

For one-time job

To utilize idle production facilities

QUALITATIVE ISSUES TO CONSIDER

What precedent does this special order set for future jobs?

How will regular customers react?

Is there enough capacity to produce the order without reducing normal production?

AN EXAMPLE…

Coopersmith produces premium wooden barrels. A one liter barrel sells for $25, but a fancy Swiss ski resort has

offered to buy 10,000 barrels for $18 each for its St. Bernard patrol. The barrel has the following product costs, based on annual production of 30,000 barrels:

DM $ 5 ✔

DL 2 ✔

VOH 3 ✔

FOH 9 ✖

$ 19 $ 10

DM $ 5DL 2VOH 3FOH 9

$ 19

What costs are relevant? Should Coopersmith accept

the special order?

Fixed costs will not change with the special order. Accepting the special order will result in an extra $80,000 in contribution margin:

($8/barrel x 10,000 barrels)ACCEPT IT!

AN EXAMPLE…

Coopersmith produces premium wooden barrels. A one liter barrel sells for $25, but a fancy Swiss ski resort has

offered to buy 10,000 barrels for $18 each for its St. Bernard patrol. The barrel has the following product costs, based on annual production of 30,000 barrels:

DM $ 5 ✔

DL 2 ✔

VOH 3 ✔

FOH 9 ✖

$ 19 $ 10VS&A 2 ✔

$ 12

Assume that the ski lodge requires special packaging that will cost Coopersmith $2 per barrel. Should Coopersmith accept the special order?

Additional variable costs of $2/barrel will be incurred, thus the relevant cost per barrel is $12. Accepting the special order will result in an extra $60,000 in contribution margin:

($6/barrel x 10,000 barrels)ACCEPT IT!

DM $ 5DL 2VOH 3FOH 9

$ 19

RECAP OF SPECIAL ORDER PRICING

Decision: Should we accept an order at a price less than normal selling price?

Factors: differential income for the order

Qualitative issues: affect on regular sales, expectation of continued special treatment

Watch out: unavoidable fixed costs

Decision Rule: as long as the special order covers differential costs and provides profit, accept the order

WHAT IS OUTSOURCING?

Moving production outside the organization

Offshoring is moving production to a foreign country (It may or may not be outsourcing)

Outsourcing is a big trend in business today

Sometimes referred to as a “make-or-buy” decisions (Do I make a component myself, or do I but it already fabricated from someone else?)

WHAT COSTS ARE RELEVANT?

Price we have to pay to buy the component

All avoidable costs we would incur to make the component

Watch out for fixed overhead per unit; it may or may not be avoidable

AN EXAMPLE (Exercise 8-9)

Thomas Company makes bicycles. It has always made its own tires but has recently received a bid from Tiny Tires, Inc. to supply the tires for $13 each. Thomas’s tire costs

are shown below. Of the fixed overhead, 40% is related to plant occupancy costs that will continue even if tires are

purchased from Tiny. Should Thomas make or buy the 5,000 tires it needs?

DM $ 3DL 4VOH 1FOH 6

$ 14

WHAT ABOUT OPPORTUNITY COSTS?

Opportunity costs of using our facilities may be relevant

What alternative uses of the capacity exist?

Can we generate additional income by using the freed up facilities in some way?

QUALITATIVE FACTORS TO CONSIDER…

Relative net advantage given uncertainty of estimates (costs, risks, etc.)

Reliability and number of sources of supply

Ability to assure quality

Future bargaining position with suppliers

Perceptions regarding possible future price changes

RECAP OF OUTSOURCING DECISION

Decision: Do you make a component in house or buy it from an outsider?

Factors: avoidable costs to make, purchase price, alternative uses of facility

Qualitative issues: supplier reliability and quality, theft of intellectual property, transfer or technological risk

Watch out: non-differential fixed costs

Decision Rule: If purchase price is less than avoidable costs, buy from outside

CONSTRAINED RESOURCE ALLOCATION

Most businesses face some constraint in terms of available resources

We need a way to decide how to allocate those scarce resources aross the business

Focus on the highest contribution margin per unit of scarce resource

RECAP OF CONSTRAINED RESOURCE ALLOCATION DECISION

Decision: How should we allocate a scarce resource across all products?

Factors: scarce resource, CM per unit of scarce resource, demand for products

Qualitative factors: customer preferences for products, customer service issues

Watch out: CM per unit of product

Decision Rule: Make the product with the highest contribution margin per unit of scarce resource

RECAP OF PRODUCT LINE DECISION

Decision: Should we keep an existing segment that appears to have a net loss?

Factors: contribution margin, segment margin, direct fixed costs

Qualitative issues: customer relations, preferences

Watch out: allocated common fixed costs

Decision Rule: If segment margin is positive, keep the segment