1. Accept/Reject a Special Order
Special orders are one-time orders from non-regular customers usually at a price below normal selling price. They may be orders for “generic” or no-name products.
The business would normally only consider accepting the special order if the following conditions are met:
· The incremental (relevant) revenue on the order exceeds the incremental (relevant) cost.
· Accepting the order will not disrupt regular markets or customers.
· Also, the business should normally have excess capacity available; otherwise, they would have to give up regular business at normal selling prices in order to accept the special order. (Any margin given up on regular business in order to accept the special order would be considered an opportunity cost.)
The minimum acceptable price for a special order = the total relevant costs of the order per unit plus any opportunity cost (if applicable), divided by the number of units in the order.
2. Make v. Buy a Part or Component
For this type of problem, we usually list the relevant cost of making the part (DM, DL, variable overhead, and any additional fixed costs), and then we list the relevant cost of buying outside (total purchase cost). The business should make the part as long as the relevant cost of making the part is < the cost of buying outside. Qualitative factors affecting the decision include a desire to have better control over the quality of the part and more control over the delivery to the production area when the part is made “in-house”.
Sometimes, if the part is purchased outside, part of the plant facility can be freed-up for other uses. This freed-up space could be sublet to others to earn rental income, or could be used to make another product on which product margin is earned. Such amounts are considered to be “opportunity costs” and can be regarded either as a reduction in the relevant cost of buying outside, or as an additional cost of making in-house.
The maximum price per unit you would be willing to pay to purchase outside = the total relevant cost of making the part plus any opportunity cost (if applicable) divided by the number of units required.
3. Keep vs. Drop a Product Line
This type of decision relates to product lines, divisions, retail outlets, etc. that appear to be losing money. The question is, should the company keep or drop such “marginal” segments. There are two main considerations:
· The CM given up if the segment is dropped (i.e., Sales – TVC) —the “bad news”
· The avoidable fixed costs that would be saved if the segment is dropped —-the “good news”.
These two amounts offset one another. If there is net CM given up, then more is to be gained by keeping the segment going. If there are net avoidable fixed costs saved, then there are greater savings in closing the segment down. It is not a question of profitability but whether the business is better off or worse off to keep the segment going or to shut it down.
Sometimes a segment is retained for qualitative reasons. For example, a “marginal” product line may be maintained because all major competitors have a similar product. Also, sometimes, loss of a given segment may cause sales and hence CM of other segments to increase or decrease. The effect on the CM of other segments should be built into the analysis in these cases (either as a “good news” effect or a “bad news” effect
4. Keep vs. Replace a Piece of Equipment (supplemental, not in text)
When a contemplating the disposal of an older piece of equipment with a newer machine, there are both relevant and irrelevant items, but only the relevant items affect the decision.
In this type of decision, the relevant items are regarded as cash inflows or outflows over the life of the new equipment.
Items to consider:
Purchase cost of new equipment: ——–relevant (outflow of cash)
Salvage value of old equipment ———relevant (inflow of cash)
Book value of old equipment ————this is a combination of purchase cost of old equipment (a sunk cost and therefore irrelevant) and accumulated amortization (also in effect a sunk cost). Therefore, book value is always irrelevant
Gains and losses on disposal—-this is a combination of salvage value (proceeds of disposal) which is relevant, and book value, which is irrelevant; therefore, gains and losses on disposal must be broken down into these two components and be treated separately.
Operating Savings by using the new equipment (over the life of the new equipment) ———relevant (in effect, an inflow of cash)
So only three items are relevant: purchase cost of new equipment (outflow), salvage value or proceeds from selling old equipment (inflow); and annual operating savings over the life of the new machine (inflow). These are the only three items you need to include in the analysis.
It is sometimes difficult to persuade management to buy a new machine based on the above relevant cost analysis because the books may show an accounting loss on disposal. However, as noted above, gains and losses are a mixture of relevant and irrelevant items and should not in themselves affect the decision.
5. Sell as is or Process Further:
Some products are derived from an initial joint process that can be separated in to separate products at a “split off point” . A decision than has to be made as to whether to sell the separate products at the split off point (assuming there is a market for them), or process them further and then sell them. The costs of the joint process up to the split-off point (called “joint costs”) are irrelevant because they are “sunk costs”. The decision as to the best option is based on the following relevant costs and revenues which in this instance are called “incremental (or additional) revenues” and “incremental (or additional) costs”
Incremental revenues = Sales value if processed further minus Sales value if sold at split off
Incremental costs = the additional processing costs
If the incremental revenues are > the incremental costs, then process further
If the incremental revenues are < the incremental costs, then sell at split off without further processing
There is a variation of this type of decision where you have a machine and need to make a decision whether to sell it “as is”and buy a new machine, or rebuild the existing machine. In these instances you compare any cash inflows and outflows of selling “as is” and buying a new machine, vs. cost of rebuilding the old machine.
6. Which products to produce when there is a constraining factor
There is often a “constraining factor that affects how much a company can produce of its products. The most common constraining factors are available labour time or machine time; or raw materials. If the company makes several products, they need to decide which products to produce (assuming the demand is there).
Instead of producing the products with highest CM/unit (the normal situation), they should produce the products with the highest CM per unit of the constraining factor such as CM per direct labour hour.
Steps in this kind of analysis: (assume the constraining factor is hours of labour time)
i) Determine the CM per unit for each product
ii) Determine the time in hrs required to make each type of product
iii) Convert this to the inverse (by dividing into 1) to get the units per hour
iv) Multiply CM per unit x # of units per hour to get the CM per hour
v) Rank the products from highest to lowest CM per hour produce the product with the highest CM per hour.
If demand for the products is limited, determine how many hours are needed to satisfy demand for each product; then start with the highest ranked product and use up the hours to satisfy demand (and calculate the number of units this involves); then move to the second highest ranked product, and the third highest etc., until you have used up all the available hours. The last product usually will have the hours and quantities as a plug amount (so as to not exceed the total amount of the constraint available.
Maximum price that would be paid for the constrained resource = normal price of the constrained resource + CM earned/unit of the constrained resource on the product available to be produced.