Special Business Decisions and Capital Budgeting Chapter 26

Objective 1

Identify the relevant information for a special business decision.

Relevant Information for Decision Making

Relevant information has two distinguishing characteristics.

It is expected future data that differs among alternatives. Only relevant data affect decisions.

Objective 2

Make five types of short-term special business decisions.

Special Sales Order

A. B. Fast is a manufacturer of automobile parts located in Texas. Ordinarily A. B. Fast sells oil filters for Rs.3.22 each. R. Pino and Co., from Puerto Rico, has offered Rs.35,400 for 20,000 oil filters, or Rs.1.77 per filter.

Special Sales Order

A. B. Fasts manufacturing product cost is Rs.2 per oil filter which includes variable manufacturing costs of Rs.1.20 and fixed manufacturing overhead of Rs.0.80. Suppose that A. B. Fast made and sold 250,000 oil filters before considering the special order. Should A. B. Fast accept the special order?

Special Sales Order

The Rs.1.77 offered price will not cover the Rs.2 manufacturing cost. However, the Rs.1.77 price exceeds variable manufacturing costs by Rs..57 per unit. Accepting the order will increase A. B. Fasts contribution margin. 20,000 units Rs..57 contribution margin per unit = Rs.11,400

Dropping Products, Departments, Territories

Assume that A. B. Fast already is operating at the 270,000 unit level (250,000 oil filters and 20,000 air cleaners). Suppose that the company is considering dropping the air cleaner product line. Revenues for the air cleaner product line are Rs.41,000. Should A. B. Fast drop the air cleaner line?

Dropping Products, Departments, Territories

Variable selling and administrative expenses are Rs.0.30 per unit. Variable manufacturing expenses are Rs.1.20 per unit. Total fixed expenses are Rs.335,000. Total fixed expenses will continue even if the product line is dropped.

Dropping Products, Departments, Territories

Product Line Oil Filters Air Cleaners Units 250,000 20,000 Sales Rs. 805,000 41,000 Variable expenses 375,000 30,000 Contribution margin Rs. 430,000 11,000 Fixed expenses 310,185 24,815 Operating income Rs. 119,815 (13,815) Total 270,000 846,000 405,000 441,000 335,000 106,000

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Dropping Products, Departments, Territories

To measure product-line operating income, A. B. Fast allocates fixed expenses in proportion to the number of units sold. Total fixed expenses are Rs.335,000 270,000 units, or Rs.1.24 fixed unit cost. Fixed expenses allocated to the air cleaner product line are 20,000 units Rs.1.24 per unit, or Rs.24,815.

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Dropping Products, Departments, Territories

Oil Filters Alone
Units Sales Variable expenses Contribution margin Fixed expenses Operating income 250,000 Rs. 805,000 375,000 430,000 335,000 Rs. 95,000
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Dropping Products, Departments, Territories

Suppose that the company employs a supervisor for Rs.25,000. This cost can be avoided if the company stops producing air cleaners. Should the company stop producing air cleaners? Yes! Rs.11,000 Rs.25,000 = (Rs.14,000)

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Product Mix
Companies must decide which products to emphasize if certain constraints prevent unlimited production or sales. Assume that A. B. Fast produces oil filters and windshield wipers. The company has 2,000 machine hours available to produce these products.

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Product Mix
A. B. Fast can produce 5 oil filters in one hour or 8 windshield wipers. Product Oil Windshield Per Unit Filters Wipers Sales price Rs. 3.22 Rs. 13.50 Variable expenses 1.50 12.00 Contribution margin Rs. 1.72 Rs. 1.50 Contribution margin ratio 53% 11%
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Product Mix
Which product should A. B. Fast emphasize? Oil filters: Rs.1.72 contribution margin p.u. 5 units per hour = Rs.8.60 per machine hour Windshield wipers: Rs.1.50 contribution margin p.u. 8 units per hour = Rs.12.00 per machine hour
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Outsourcing (Make or Buy)

A. B. Fast is considering the production of a part it needs, or using a model produced by C. D. Enterprise. C. D. Enterprise offers to sell the part for Rs.0.37. Should A. B. Fast manufacture the part or buy it?

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Outsourcing (Make or Buy)

A. B. Fast has the following costs for 250,000 units of Part no. 4: Part no. 4 costs: Total Direct materials Rs. 40,000 Direct labor 20,000 Variable overhead 15,000 Fixed overhead 50,000 Total Rs. 125,000 Rs.125,000 250,000 units = Rs.0.50/unit
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Outsourcing (Make or Buy)

Assume that by purchasing the part, A. B. Fast can avoid all variable manufacturing costs and reduce fixed costs by Rs.15,000 (fixed costs will decrease to Rs.35,000). A. B. Fast should continue to manufacture the part. Why?

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Outsourcing (Make or Buy)

Purchase cost (250,000 Rs.0.37) Rs. 92,500 Fixed costs that will continue 35,000 Total Rs.127,500
127,500 125,000 = Rs.2,500, which is the difference in favor of manufacturing the part. The unit cost is then Rs.0.51 (Rs.127,500 250,000).
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Best Use of Facilities

Assume that if A. B. Fast buys the part from C. D. Enterprise, it can use the facilities previously used to manufacture Part no. 4 to produce gasoline filters. The expected annual profit contribution of the gasoline filters is Rs.17,000. What should A. B. Fast do?

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Best Use of Facilities

Expected cost of obtaining 250,000 parts: Make part Rs.125,000 Buy part and leave facilities idle Rs.127,500 Buy part and use facilities for gas filters Rs.110,500* *Cost of buying part: Rs.127,500 less Rs.17,000 contribution from gasoline filters.

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Sell As-Is Or Process Further

The sell as-is or process further is a decision whether to incur additional manufacturing costs and sell the inventory at a higher price, or sell the inventory as-is at a lower price. Suppose that A. B. Fast spends Rs.500,000 to produce 250,000 oil filters. A. B. Fast can sell these filters for Rs.3.22 per filter, for a total of Rs.805,000.

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Sell As-Is Or Process Further

Alternatively, A. B. Fast can further process these filters into super filters at an additional cost of Rs.25,000, which is Rs.0.10 per unit (Rs.25,000 250,000 = Rs.0.10). Super filters will sell for Rs.3.52 per filter for a total of Rs.880,000. Should A. B. Fast process the filters into super filters?

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Sell As-Is Or Process Further

A. B. Fast should process further, because the Rs.75,000 extra revenue (Rs.880,000 Rs.805,000) outweighs the Rs.25,000 cost of extra processing. Extra sales revenue is Rs.0.30 per filter. Extra cost of additional processing is Rs.0.10 per filter.

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Sell As-Is Or Process Further

Cost to produce 250,000 parts: Sell these parts for Rs.3.22 each: Rs.500,000 Rs.805,000

Cost to process original parts further: Rs. 25,000 Sell these parts for Rs.3.52 each: Rs.880,000

Sales increase (880,000 805,000) Rs. 75,000 Less processing cost 25,000 Net gain by processing further Rs. 50,000
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Objective 3
Explain the difference between correct analysis and incorrect analysis of a particular business decision.

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Correct Analysis
A correct analysis of a business decision focuses on differences in revenues and expenses. The contribution margin approach, which is based on variable costing, often is more useful for decision analysis. It highlights how expenses and income are affected by sales volume.

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Incorrect Analysis
The conventional approach to decision making, which is based on absorption costing, may mislead managers into treating a fixed cost as a variable cost. Absorption costing treats fixed manufacturing overhead as part of the unit cost.

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Objective 4

Use opportunity costs in decision making.

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Opportunity Cost...
is the benefit that can be obtained from the next best course of action. Opportunity cost is not an outlay cost, so it is not recorded in the accounting records. Suppose that A. B. Fast is approached by a customer that needs 250,000 regular oil filters.

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Opportunity Cost
The customer is willing to pay more than Rs.3.22 per filter. A. B. Fasts managers can use the Rs.855,000 (Rs.880,000 Rs.25,000) opportunity cost of not further processing the oil filters to determine the sales price that will provide an equivalent income. Rs.855,000 250,000 units = Rs.3.42

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Objective 5
Use four capital budgeting models to make longer-term investment decisions.

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Capital Budgeting...
is a formal means of analyzing long-range capital investment decisions. The term describes budgeting for the acquisition of capital assets. Capital assets are assets used for a long period of time.

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Capital Budgeting

Capital budget models using net cash inflow from operations are: payback accounting rate of return net present value internal rate of return

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Payback...
is the length of time it takes to recover, in net cash inflows from operations, the dollars of capital outlays. An increase in cash could result from an increase in revenues, a decrease in expenses, or a combination of the two.

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31

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Payback Example
Assume that A. B. Fast is considering the purchase of a machine for Rs.200,000, with an estimated useful life of 8 years, and zero predicted residual value. Managers expect use of the machine to generate Rs.40,000 of net cash inflows from operations per year.

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Payback Example
How long would it take to recover the investment? Rs.200,000 Rs.40,000 = 5 years 5 years is the payback period.

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Payback Example
When cash flows are uneven, calculations must take a cumulative form. Cash inflows must be accumulated until the amount invested is recovered. Suppose that the machine will produce net cash inflows of Rs.90,000 in Year 1, Rs.70,000 in Year 2, and Rs.30,000 in Years 3 through 8.

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Payback Example
What is the payback period? Years 1, 2, and 3 together bring in Rs.190,000. Recovery of the amount invested occurs during Year 4. Recovery is 3 years + Rs.10,000. 3 years + (Rs.10,000 Rs.30,000) = 3 years and 4 months

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Accounting Rate of Return...

measures profitability. It measures the average return over the life of the asset. It is computed by dividing average annual operating income by the average amount of investment in the asset.

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Accounting Rate of Return Example

Assume that a machine costs Rs.200,000, has no residual value, and has a useful life of 8 years. How much is the straight-line depreciation per year? Rs.25,000 Management expects the machine to generate annual net cash inflows of Rs.40,000.

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Accounting Rate of Return Example

How much is the average operating income? Rs.40,000 Rs.25,000 = Rs.15,000 How much is the average investment? Rs.200,000 2 = Rs.100,000 What is the accounting rate of return? Rs.15,000 Rs.100,000 = 15%

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Discounted Cash-Flow Models

Discounted cash-flow models take into account the time value of money. The time value of money means that a dollar invested today can earn income and become greater in the future. These methods take those future values and discount them (deduct interest) back to the present.

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Net Present Value

The (NPV) method computes the expected net monetary gain or loss from a project by discounting all expected cash flows to the present. The amount of interest deducted is determined by the desired rate of return. This rate of return is called the discount rate, hurdle rate, required rate of return, or cost of capital.

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Net Present Value Example

A. B. Fast is considering an investment of Rs.450,000. This proposed investment will yield periodic net cash inflows of Rs.225,000, Rs.230,000, and Rs.210,000 over its life. A. B. Fast expects a return of 16%. Should the investment be made?

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Net Present Value Example

Periods Amount PV Factor 0 (Rs.450,000) 1.000 1 225,000 0.862 2 230,000 0.743 3 210,000 0.641 Total PV of net cash inflows Net present value of project Present Value (Rs.450,000) 193,950 170,890 134,610 Rs. 499,450 Rs. 49,450

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Internal Rate of Return...

is another model using discounted cash flows. The internal rate of return (IRR) is the rate of return that a company can expect to earn by investing in a project. The higher the IRR, the more desirable the investment.

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Internal Rate of Return

The IRR is the rate of return at which the net present value equals zero. Investment = Expected annual net cash inflow PV annuity factor Investment Expected annual net cash inflow = PV annuity factor

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Internal Rate of Return Example

Assume that A. B. Fast is considering investing Rs.500,000 in a project that will yield net cash inflows of Rs.152,725 per year over its 5-year life. What is the IRR of this project? Rs.500,000 Rs.152,725 = 3.274 (PV annuity factor)

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Internal Rate of Return Example

The annuity table shows that 3.274 is in the 16% column for a 5-period row in this example. Therefore, 16% is the internal rate of return of this project. If the minimum desired rate of return is 16% or less, A.B. Fast should undertake this project.

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Objective 6

Compare and contrast popular capital budgeting methods.

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Comparison of Capital Budgeting Models

The discounted cash-flow models, net present value, and internal rate of return are conceptually superior to the payback and accounting rate of return models. Strengths of the payback include: It is easy to calculate, highlights risks, and is based on cash flows.

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Comparison of Capital Budgeting Models

Its weaknesses are that it ignores cash flows beyond the payback, the time value of money, and profitability. The strength of the accounting rate of return is that it is based on profitability. Its weakness is that it ignores the time value of money.

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