Information for Decision making
nguyp035's 2016-05-18 13:38
Measuring relevant costs and revenues for decision making...
Relevant cost is... a cost that differs between alternatives
Avoidable costs are.. costs that can be eliminated by choosing one alternative over another (they are a relevant cost)
Unavoidable costs are.. never RELEVANT as they do not differ (includes Sunk cost and future cost)
Sunk cost.. a cost that has been incurred and cannot be avoided regardless ( not relevant)
By removing all unavoidable costs we are left with... avoidable costs.
We need to make decisions such as... Keep old machine or purchase new machine?
In order to determine this we use methods such as.. Comparative profit approach OR Contribution Margin approach
Comparative profit approach
Step 1 We need to compare the costs and revenues for the firm (3 columns Keep/Buy New/ Difference
Step 2 Arrive at a total expense and total net profit for each (NOTE Depreciation for old = book remaining value and is kept for both OLD and NEW machine)
Depreciation for new equipment only applies to NEW - it is an expense
Salvage value is the value of the old machine when you sell it after it has depreciated. If you purchase the new machine, you will minus this from the total expenses of new machine as you are earning)
NOTE remaining book value of old machine is a sunk cost and is not relevant to decision making
Even if there is a loss, should we purchase new machine?
Step 3 Construct a relevant cost analysis (work out how much you save in Var expense from buying new machine - cost of new machine + any salvage value = NET EFFECT)
Step 4 If net effect is POSITIVE we should keep.
Extra (in terms of segment) - sometimes we may make a loss but we should keep it because... of how we allocate fixed cost which makes segments appear less profitable..
Adding/Dropping segments Is a important decision managers make (drop a business segment e.g. product/store)
Sometimes we may keep a segment even if it makes a loss... due to how we allocate our fixed costs, allocations can make segments appear less profitable
Contribution Margin Approach (drop/keep segment):
Step 1 Draw out a profit statement (Sales - Var) = Contribution - Fixed exp = Net(prof/loss) - MAY BE GIVEN
Step 2 Identify which fixed costs will be kept if segment is dropped & find identify any salvage value
Step 3 Find out the Contribution margin lost if digital watch is dropped on Profit statement
Step 4 Minus fixed cost that can be avoided (if we drop segment)
Step 5 check to see if we are losing out if we go to new segment (net disadvantage?)
NOTE depreciation with no resale value is not relecant to decision since it is a sunk cost + not avoidable.
Make or buy decision should we produce product internally or externally?
STEP 1 3 columns (cost per unit to make 1 / cost per unit to MAKE X amt / cost charged to buy X amt)
NOTE Do not include irrelevant costs that are fixed such as Depreciation (if has no resale value and is sunk cost) or Gen OH as they are not avoidable and IRRELEVANT to decision making) - i.e. sunk costs and future costs which do not differ
STEP 2 It may be a matter of opportunity cost to see if you should buy or make them.
Sometimes Special order questions may come up i.e. should we accept this extra order? - will we benefit from it?
Step 1 Draw up a profit & contribution statement (for what they produce now)
Step 2 Determine the benefits of accepting new order e.g. What is the revenue that will be gained from order , what will be the increase in var cost be?
Step 3 Increase in revenue - Increase in cost = Increase in net profit
Step 4 Did it increase or decrease?
NOTE: Faster method = special order contribution (Price per -var cost per) * units ordered = change in profit
Utilizing constraint resources which product should we maximise - how do we best utilize our constraint resource?
Note Fixed cost are not affected by this decision so the focus is CONTRIBUTION MARGIN
Step 1 Construct a table showing with columns (product 1 and product 2) - find the contribution margin per unit
Step 2 Identify the constrained resource.. e.g. can be used at 100% capacity? maximum 2400mins per week
Step 3 Construct a new table showing column (product 1 and product 2) - identify the contribution margin per unit (i.e. CMPU/time to product 1)
Step 4 The product with the highest contribution PER MINUTE should be PRIORITISED as you get more use out of constraining factor
You should now meet the demand for the product with highest contribution per minute
Step 5 Construct another table to allocate the constrained resource
Identify the total time to make product with highest CM per min (weekly demand of the product x time needed to make)
Now you have total time to make product with highest CM you minus that away from TOTAL TIME AVAILIABLE - the leftover is the remaining time to be allocated to product 1
Divide the remaining time by time to make product 1 per unit = how many of product 1 you can make
Step 6 Work out the total contribution of each product (How many units you make multiplied by contribution per unit)
Step 7 Add both contribition margin of both product together to give total for both companies
Total contribution will be maximized... by promoting products or accepting orders that provides highest UNIT CONTRIBUTION MARGIN in relation to CONSTRAINED RESOURCE e.g. time
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