Section 3.) Special Order Pricing Decision
Another decision that managers need to make on occasion is the decision as to whether to accept a special order. For our purposes, these “special orders” are orders that are outside of the standard customer base, and they are usually proposals for a short term deeply discounted price. For example, a customer from out of town may propose to buy 1,000 units of the company’s product at a rate of $18, even though the current market rate is much higher (e.g., $30.) In most cases, the price difference is severe enough to cause a student to question right off the bat whether the order makes any sense at all. Of course, the main determining factor as to whether to accept the special offer is simply whether doing so will increase profit or not.
This type of decision focuses heavily on relevant costs. We must review all the costs that are given in the problem to determine which ones are relevant. For example, differential costs will be relevant because they will differ if we accept the special order or not. Some good examples of these are direct materials, direct labor, and any variable overhead, since they are all based directly on whether our activity level changes. If we produce more units (due to this special order) then we will have increased costs. On the other hand, certain costs, such as fixed costs, may not change at all even though we are increasing our activity level. However, I stress the words “may not.” It all depends on whether we have sufficient excess capacity to handle the additional production. For example, if we are currently operating at 15,000 units, but have the capacity to operate at 25,000 units, then we could accept a special order of 7,500 units but would not be able to accept a special order of 12,500 units (at least not without using a different calculation.)
If we have sufficient capacity to handle the special order, then we do not need to include fixed costs in our determination of an allowable price. Instead, we only need to include the direct materials, direct labor, and variable overhead. If the special-order proposed price is higher than that variable cost, then we can accept the order and we will still be more profitable than before.
Current Price $30
Current Costs
Direct Materials $10
Direct Labor $8
Variable Overhead $6
Using the above data, the variable cost is $24 (10+8+6). As such, if the special-order price is above that, it should be a good deal to accept it.
If we do not have sufficient capacity to handle the special order, then we must either consider expanding our capacity and including the total of the new fixed costs in our special-order calculation OR we must get rid of some existing customers to make room for the special order. Generally speaking, the second option would be the only one that would stand a chance of possibly being acceptable. In that situation, not only would we have to include the direct materials, direct labor, and variable overhead, we would also have to include the “opportunity cost” of the lost customers. This opportunity cost would be that we had to give up any contribution margin that the old customers were providing.
Remember that the contribution margin is sales minus variable costs. It represents the amount leftover from the revenues that we can use to “contribute” to covering the fixed costs and leaving some amount leftover as profit. If the special-order proposed price is higher than that variable cost + opportunity cost, then we can accept the order and we will still be more profitable than before. Let’s use the same data set as before and see how the results may differ.
Current Price $30
Current Costs
Direct Materials $10
Direct Labor $8
Variable Overhead $6
In this case, the first thing to remember is that we have to calculate the contribution margin from the existing sales. $30 minus all of the variable costs $24 = $6 contribution margin.
The allowable price would be the variable costs plus the opportunity cost of the forgone contribution margin. Of course, this puts the acceptable price back up to $30, which was the original price anyways. So, what would cause us to accept a lower special-order price? Some sort of cost savings from the special order. This often occurs with variable selling and administrative costs that decrease, such as not having to pay sales commissions on the special-order sales.
Qualitative Characteristics to Consider
Although the profit determination is important, there are other issues that need to be considered as well. One is whether the special order will impact our existing customer base. If other existing customers get word of the special price we gave the new customer, they may be upset and may demand that new price themselves. Of course, if we charge everyone that lower price, we will never be able to recover our full fixed costs. Another thing to consider is whether we have any potential plans for expansion. If we do, that may change our special-order decision soon, since we may no longer have sufficient capacity to absorb the new order.
The below video goes through the concept of special-order decisions.
Section 4.) Make or Buy Outsourcing Decision
In these types of decisions managers are faced with the option of continuing to make a part as they have in the past or outsourcing the production of that part to some other entity. In many cases the price that is offered will be less than your current total price of production. However, as with many of these decisions it is important to first look at what costs we will avoid by getting rid of this production.
As you can imagine from prior decisions, fixed cost is one you really want to focus on. In most cases you will not eliminate all of the costs of production by outsourcing the part much of what is left will be overhead that will now need to be shifted to someone else in the organization.
Often you will eliminate the need for variable costs, such as materials, labor, and variable overhead. However, you may still have machinery that you don’t have any use for, a building that now has empty space, and perhaps supervisors that have less work to do since there are fewer laborers around. In addition to the dollar amounts, there are other things that should be considered when making this decision.
These other considerations include issues of quality and whether the new vendor can provide better quality than the company could themselves. The issue of whether the vendor can be reliable comes up. Your company’s overall product is now being determined by how well your vendor produces the product. If you cannot rely on them then your own company’s reputation is at risk as well.
Example:
Let’s assume our current production costs for a certain component of our overall production are as follows:
Direct Materials $35
Direct Labor $12
Variable Overhead $8
Fixed Overhead per unit $14 (based on a total 14,000 of overhead cost divided over expected 1,000 units per month)
Based on this our total product cost at this activity level is $69
Let’s assume another company comes in and offers to sell the component to them for $60. At first, this appears to be a savings of $9 per unit. However, remember that $14 of that was a fixed cost, which may not go away when we buy from the new supplier. Instead, that fixed cost will need to be spread out across the remaining product lines. From a corporate-wide perspective, it is still a cost that will exist. As such, we would look like we are saving $9, but that would be offset by the $14 fixed expense that we still have. As such, we would have a net loss of $5 per unit if we bought from an outside supplier instead of making the part internally.
There are variations of this type of problem, where “some” of the fixed cost may be eliminated, such as the fact that we no longer need one supervisor, since we have fewer employees. In other situations, we may have other uses for the excess capacity that we have created. All of these situations have to be considered when making the final decision of whether to make the part or buy it externally.
The below videos go through the concept of the make or buy outsourcing decision, as well as a practice exercise related to it.
Section 5.) Continue or Discontinue a Segment Decision
With this type of decision, we are looking at a company with multiple divisions or product lines and one of them may appear to be unprofitable. As such, we are considering dropping it. Dropping the product line will definitely result in lost revenues, but also lost costs. The question is whether the reduced costs will truly offset the reduced revenues. There may be some costs that were included in the income statement for this division that really won’t be reduced when we drop the product line/division. Instead, those costs may just be shuffled somewhere else in the company.
Let’s assume the following example:
At first glance, it may appear that we should discontinue division C, since it is operating at a loss. However, the question that comes to mind is whether those fixed costs will truly be eliminated 100% if we discontinue the division. If they can be, then yes, we should eliminate the division. However, let’s assume that the fixed costs can be broken down further as shown below.
In this case, we see that division C is being allocated $64,000 of fixed costs that don’t directly relate to them. These costs will not be eliminated even if the division is eliminated. Instead, the costs will have to be shifted to the other divisions, hurting the overall company. This division is only showing a negative net income of $24,000, which means they must be covering $40,000 of the total $64,000 of allocated fixed costs. If we eliminate that division, they will not be able to cover that $40,000 anymore, and the overall company’s net income would be reduced by that same $40,000. Due to this, we should keep the division, but try to make changes to make it more profitable.
Section 6.) Scarce Resources Decision
Many companies operate multiple product or services lines at any given time. In these situations, management should be able to identify the profitability of each of their product lines. In many cases, this is simply done by determining the contribution margin of each unit of product from each product line.
As a reminder, the contribution margin is simply the sales per unit minus the variable expenses per unit.
Sales
Less Variable Expenses
= Contribution Margin
Recall that the contribution margin from each unit sold contributes to paying off all of the total fixed costs, and once those are paid off, the remaining contribution margin is left as profit.
In a perfect world a company would focus solely on its most profitable product and not even bother with any other product. Of course, there is generally a limited amount of demand for certain products and often times customers want to shop at a store where they can find many of the different products they want. As such, they will continue to produce multiple products even though some are more profitable than others.
In some situations, however, management needs to be aware of issues other than just the limited demand. In some cases, it is the supply of one or more resources that are limited. In some cases, this may be machine time for a specialized machine used to produce both of your products. In other cases, it may be specialized labor or certain materials that are limited. In these cases, we generally won’t be able to produce up to the quantity demanded by the customers for each product. Instead, we must determine which products we will focus on first with our limited resources, and then fulfill that demand before turning to the second product.
In these scarce resource problems, contribution margin per unit of product is no longer the determinant as to which product to focus on. Instead, it is now the contribution margin per unit of scarce resource (hour, pound of material, etc.)
Let’s use the below example to discuss this further. Below, we can see that Product B is the most profitable per unit in terms of contribution margin per unit. However, if we are limited in the number of machine hours we have available to us, then we must instead consider the contribution margin per machine hour.
In this example, Product A then has a contribution margin per machine hour of $70 ($70 divided by 1 machine hour). Product B has a contribution margin per machine hour of $42.50 ($85 divided by machine hours). As such, even though Product B is more profitable per unit of product, we should instead focus our efforts on Product A, since it is more profitable for every machine hour.
In these types of problems, we would want to produce as many of the more profitable product, up to the amount of demand we have for that product. Generally speaking (but not always) this means we fill up the demand for that first product.
In this case, let’s assume we only have 2,000 hours of machine time available to us. That is enough to produce the full demand of 1,000 units of product A, which would require exactly 1,000 hours of machine time.
That leaves us with 1,000 machine hours left to produce Product B. Since each unit of product B takes 2 hours, this means we can only produce 500 units of Product B (1,000 hours divided by 2.) This is less than the 750 units demanded, but it is all we have time to produce.
The below videos go through the concept of the scarce resources decisions as well as a practice exercise on the concepts.
Section 1.) Relevant Cost - Overview
Managers often have to make decisions about which course of action to take in their operations. Many of these decisions boil down to the cost of one alternative or another. Generally speaking, every alternative has a wide range of costs, and some of those costs will be the exact same under one alternative versus another. On the other hand, some of those costs will be different. In order to most efficiently make a decision, managers need to be aware of which of the costs are “relevant” to the decision at hand.
A relevant cost is one that occurs in the future and is different between the alternatives. This is known as “differential” cost. If a cost has already occurred in the past, then obviously it doesn’t matter which choice you make, the cost will still exist. Furthermore, if the cost is the same under either alternative, then it doesn’t matter which decision you make either. As such, we focus on a mixture of costs that will ONLY exist under alternative A and not B, etc. These are the relevant costs.
Management could include all costs into their decision, but that would end up repeating many of those costs in the list between the two alternatives, and basically just clouds up the decision making. Eliminating things that are irrelevant helps them to focus on what really matters. Below is an example decision where the company is trying to decide whether to replace an old machine with a new one or not.
Purchase price of old machine – This is not relevant to the replacement decision, since the cost occurred in the past and cannot be changed by this current decision. It doesn’t matter whether you bought the old machine for $5 or a million. It also doesn’t matter when you last purchased the original machine. These types of irrelevant past costs are referred to as “sunk” costs.
Purchase price of new machine – This is relevant to the decision since the cost will only exist in the alternative where you purchase the new machine.
Trade in or selling value of old machine – This is relevant because we will only get this value if we choose the alternative where we replace the machine.
Utility savings from the newer more energy efficient machine – This is relevant because these benefits will only exist if we buy the new machine and start using it.
Corporate overhead cost that is allocated down to this department – This cost will be the exact same whether we buy the new machine or not, so it is irrelevant to the decision. In fact, these allocated costs are almost always irrelevant to a decision, since the cost will generally still exist somewhere in the company, even if we shift it from one department to another.
When looking at this simple example, the cost benefit analysis becomes:
Cost of buying new machine, less trade in value of old machine vs. utility savings. If you end up saving more money in utilities over the life of the new asset than you had to pay for the new machine then it is worth it and will save you money overall.
One additional cost term that should be discusses is that of “opportunity costs.” These are not out of pocket costs that you actually have to pay someone. They exist in managerial accounting and economics. It is basically the cost of something you give up choosing one alternative over the other. In other words, if you chose alternative A, then you are giving up any of the benefits that opportunity B may have offered. Since these only exist in one alternative, they are relevant to the decision.
Throughout the rest of this module, we will be looking at examples of special decisions that companies must make, and how relevant costs are analyzed in each of them.
Section 2.) Sell or Process Further Decision
One of the special decisions that managers sometimes need to make is that of whether to sell their products after the first round of processing or invest additional money to process them further and sell them at a higher price. With this type of problem, we are talking about situations where processing starts on some sort of raw materials, and then after a certain level of processing the raw materials are converted into two or more distinct product types. The point at which the raw materials can be identified as two or more distinct products is known as the split off point. Any costs incurred on that initial processing of the raw materials is referred to as joint costs. The two or more products are referred to as joint products if they have approximately equal value. If one is substantially higher in value, that may be referred to as the main product whereas one with much smaller value would be referred to as a byproduct.
Any costs incurred on any of the products after the split off point are referred to as separable costs. Generally speaking, you will be faced with a problem where one batch of raw materials produces two separate products, each with their own selling price. You can either sell one or both products at that point, or you can invest more money in one or both of them to process/refine them further in order to sell at a higher price. The goal is to maximize profit.
The focus of this analysis should be comparing incremental (i.e., additional) costs of further processing with the incremental revenues from selling at the higher price. If the incremental revenues are more than the incremental costs you should process further. Each separate product should be analyzed separately. It is important to note that the joint costs have no relevance to this determination, since they have already been incurred and will not differ based on the alternatives of processing further or not.
To discuss incremental costs and revenues, let’s look at a basic example with a company that builds plain unfinished picnic tables for $20 and sells them at a price of $30. They are now considering whether to start staining the tables, which will increase the cost from $20 to $25 (i.e., $5 extra) and sell at a new price of $40 ($10 higher than the previous $30.) To determine whether this is a good idea, compare the incremental costs $5 to the incremental revenues $10. There is a higher amount of incremental revenues ($5 more than cost), thus it would be considered a good idea to process the tables further. This example was not a join product example but helps to illustrate the concept of incremental analysis.
Let’s take it a step further and identify a product such as cocoa beans that cost $1,000 to produce one ton (2,000 pounds.) The joint processing costs (including labor and overhead) to convert the product into two separate products is $500 per ton, bringing the total cost (materials and labor) to $1,500 per ton. Once processed, we have 1,500 pounds of cocoa butter and 500 pounds of cocoa powder.
In this example, let’s assume we can sell the 1,500 pounds of cocoa butter right away for $1,500. We can also sell the 500 pounds of cocoa powder right away for $900. This gives us a total of $2,400 revenue for the $1,500 joint product costs, which shows a profit of $900.
To take it a step further, let’s assume we can process the cocoa butter for $500 additional costs, which converts it into cocoa butter face cream, which can be sold at a price of $1,800 (compared with the original price of $1,500.) For this particular product, we would be investing $500 additional cost to earn an additional $300. This would not be a profitable move.
However, the other product cocoa powder, which initially sold for $900 sales revenue, can now be processed further for $600 additional cost to get Instant Cocoa Mix, which sells for a total of $1,900. In this case, we would be investing $600 to earn an additional $1,000 in revenue. This would be a profitable move.
If we wanted to determine the actual profit per unit, we would also need to allocate the joint cost. This is similar to the concept of allocating fixed overhead. You can do it based on a number of ways, such as dividing it by the total number of pounds, or the number of units, or the value of the products. These allocation methodologies are discussed in more detail in advanced cost accounting lectures.
The below videos go through the concept as well as a practice exercise on the sell or process further concepts.
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