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I'm Larry Walther.
This is principlesofaccounting.com, Chapter 24.
And in this module, we are going to look at a general frame of reference for
making rational business decision, followed by some specific examples.
First of all, the general decision making approach is to identify your
decision alternatives, log the relevant cost and benefits of each choice,
evaluate all of the qualitative issues, selecting the most desirable option
based on a judgmental balancing of quantitative and qualitative aspects.
The process begins and ends with judgment.
One should clearly look at both quantitative and
qualitative factors in trying to make business decisions.
Let's next turn our attention to some specific examples,
starting of outsourcing.
Outsourcing is where we hire someone outside of the business to provide goods
and services that we have customarily or historically provided internally.
This can involve tech support, data processing,
payroll services, even actual manufacturing of goods and services.
These are sometimes called make or buy decisions,
we have to decide whether to make a product ourselves or
continue to provide the service, or hire someone externally to do that.
All relevant cost and benefits need to be considered.
Recognize that if we outsource, some costs may not be able to be avoided,
such as rent of a facility when under a long-term contract.
Importantly, unavoidable costs do not vary and can be disregarded in the analysis.
So by example, better shown by example, Pilot produces software for
handheld global positioning systems.
And they maintain a tech support department that's
available around the clock.
Here's the budget.
It totals $635,360 consisting of labor, utilities, rent, the leasing of phones and
computers, and annual depreciation, total cost of the department.
The labor is made up of three people per shift,
working three shifts a day at $12 an hour.
Utilities and maintenance is fixed,
but would be avoided if the unit were shut down.
The building is leased under a long-term contract, it's unavoidable.
The phone and computer equipment is leased, but
we can cancel that lease without penalty.
And the annual depreciation is going to continue on the furniture and
fixtures since it's something we own and hold.
The tech support services, look we're just gonna charge you $12 per tech call.
You're running about 50,000 tech calls a year, so
the total cost of outsourcing is $600,000.
At first glance, you might say, well,
600 is less than the 635,000, but that would be the wrong analysis.
We need to drill down in our data and
recognize that the building rent is going to continue in any event.
The furniture and fixture depreciation is going to continue in any event.
We'll avoid the labor.
We'll avoid the computer leasing, a few other things.
But what we're going to find is the relevant items are 415,360 as
shown by this slide.
And we can avoid 415,000, but no more.
Why would we spend 600,000 to avoid that?
So we're better off continuing to provide our own tech support.
Let's look at how we can look at capacity constraints.
Outsourcing can free up some capacity that would allow us to produce other goods and
services or expand our overall production, in which case,
we wanna look at the contribution margin associated with the additional production.
There is a term called opportunity cost, the cost of a foregone alternative.
Let's see how this comes into play for Mueller Building Systems.
In an effort to free up capacity,
they've outsourced production of their roof trusses, and that
outsourcing frees up 10% capacity and the factory to produce even more buildings.
We've got direct labor to produce the trusses,
currently producing at 3.8 million.
Direct materials, current production, 4 million, variable factory overhead,
2 million, and avoidable factory, 1 million.
So the relevant cost to produce the trust is as $10.8 million.
But by freeing up capacity, I'm assuming they're able to produce an additional 10%
which increases our overall margin of $3 million.
So we can spend up to $13.8 million on outsourcing,
given the cost that we're able to avoid and the additional contribution
that we're able to generate by having additional capacity freed up.
However, we also wanna consider the cost of placing and tracking orders,
freight, customs fees, commissions, and so on.
And also, we wanna think if the decision results in employee layoffs,
there could be increases in employment taxes and so on.
We also wanna think about qualitative issues, outsourcing places,
quality control, production scheduling, and so on, in the hands of a third party.
When we're involving international outsourcing,
delays can be associated with logistical issues.
There may be risks associated with relying on suppliers in potentially unstable,
politically unstable regions.
There's language barriers.
And then also some customers may view the outsourced decision unfavorably.
Another decision management must make on occasion is whether to accept
special orders.
A special order is one that involves terms or pricing,
in particular, outside of the normal pricing schedule for the business.
Management must determine whether the special order sales price
exceeds the variable cost of production,
and any variable selling cost associated with the special order.
By illustration, we have a lure manufacturer.
Lunker Lures produces the Rippin' Rogue lurer.
Their absorption costing structure shows $1.10 to produce each unit,
$0.20 materials, $0.40 labor, and $0.50 for factory overhead.
Of that factory overhead, 30% is variable, and 70% is fixed.
In addition, Lunker Lures pays a dime commission for each unit sold.
And so they've been approached by Walleye Pro Fishing World who wants to order 1
million Walleye Wiggler lures.
The units would not compete with existing sales, and
they're offering to pay $1 per unit.
The sales representatives are paid a 5%, or a $0.05 commission, in this case,
rather than the normal dime.
This offer is priced below the noted cost of production of a dollar and a dime.
However, Lunker Lures should accept the order, nonetheless,
as is shown in the following analysis.
The selling price of a dollar at least covers the variable cost to product
material and variable manufacturing overhead, and
leaves a non-manufacturing margin of $0.25.
>From which we subtract our $0.05 commission, and
we get a contribution margin of $0.20 per unit times the million units.
So we'll actually enhance overall profitability by $200,000 by
accepting this order.
Clearly, what's happened is the fixed costs were going to be there in any event.
What we wanna do is look at the incremental revenue and the incremental or
variable cost associated with the offer, and it computes favorably.
We do need to be careful, however,
in looking at special orders because we can run into capacity constraint issues.
We'll wanna make sure we have capacity to produce these lures
without incurring additional fixed costs, in other words.
Sometimes an error can be made by looking only at the contribution margin.
To demonstrate by example, suppose Fishing World also placed a special order for
a bass fishing lure with a 30% margin on a $1 selling price.
Would you wanna accept the lure that makes 30% margin or 20% margin?
You might say, well, obviously the 30% is better,
but when we throw in capacity constraints, maybe an analysis says we only have room
to make 600,000 of the bass lures or 1 million of the Walleye fishing lures.
And in this case, 1 million units with a $0.20 contribution will
enhance our overall profitability 200,000.
Whereas the higher margin item, we can't produce as many and
will only produce a 180,000 overall increase in profitability.
So in all likelihood, we're going to want to select the Walleye lure as the special
order that we accept, because overall profitability is higher even
though it involves a lower per unit margin.
Another decision has to do with whether to discontinue a product or department.
And the management should not jump to the conclusion that every department that's
losing money should be discontinued or eliminated as fixed costs may continue.
The appropriate analysis is to compare net income with and
without the targeted unit for elimination.
So here's an example, we've got four departments for
this retail sporting goods store, fishing, hunting, camping, and golf.
The golf department's losing money of $30,000.
Should we discontinue golf?
Maybe, it looks like we should.
Maybe we can avoid that loss.
But drilling down,
we learn that 70% of the general administrative cost could be eliminated.
The other 30% would continue.
Rent depreciation would continue to be incurred for the store.
Utilities could be reduced by half for that department.
Selling cost could be eliminated for that department.
And the unavoidable costs are to be shifted equally to the other departments.
And so when we rerun the spreadsheet, just picking one line item here,
you may wanna look in the textbook and look at all the line items.
The rent which totaled a million for
the entire facility was born $250,000 by four departments.
Now it needs to be absorbed 333,334 by each of the three remaining departments.
And note that Camping World now has a loss.
So we can create a downwards spiral by transferring costs to other departments.
Are we going to now discontinue camping?
What would be the effect?
How would that cause a cost shifting?
We ultimately may find we're better off keeping golf in place because,
it's at least covering its variable costs of operations and
contributing toward covering the fixed cost that cannot be avoided.
So a very sensitive analysis in terms of looking at what departments we should
maintain versus those that should
be discontinued.
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