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Chapter 26

Special Business Decisions

and Capital Budgeting

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Identify the relevant information

for a special business decision.

Objective 1

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It is expected future data thatdiffers among alternatives.

It is expected future data thatdiffers among alternatives.

Only relevant data affect decisions.Only relevant data affect decisions.

Relevant Informationfor Decision Making

Relevant information has two distinguishing characteristics.

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Make five types of short-term

special business decisions.

Objective 2

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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.

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Special Sales Order

A. B. Fast’s 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?

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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. Fast’s contribution margin.

20,000 units × Rs..57 contribution margin per unit = Rs.11,400

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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?

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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.

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Product LineOil Filters Air Cleaners Total

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

Dropping Products,Departments, Territories

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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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Oil Filters AloneUnits 250,000Sales Rs. 805,000Variable expenses 375,000Contribution margin 430,000Fixed expenses 335,000Operating income Rs. 95,000

Dropping Products,Departments, Territories

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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 WipersSales price Rs. 3.22 Rs. 13.50Variable expenses 1.50 12.00Contribution margin Rs. 1.72 Rs. 1.50Contribution 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 for250,000 units of Part no. 4:

Part no. 4 costs: TotalDirect materials Rs. 40,000Direct labor 20,000Variable overhead 15,000Fixed overhead 50,000Total 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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Purchase cost (250,000 × Rs.0.37) Rs. 92,500Fixed costs that will continue 35,000Total Rs.127,500

The unit cost is then Rs.0.51(Rs.127,500 ÷ 250,000).

127,500 – 125,000 = Rs.2,500, which is thedifference in favor of manufacturing the part.

Outsourcing (Make or Buy)

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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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Expected cost of obtaining 250,000 parts:

Make part Rs.125,000Buy part and leave facilities idle Rs.127,500Buy part and use facilities for gas filters Rs.110,500*

*Cost of buying part: Rs.127,500 lessRs.17,000 contribution from gasoline filters.

Best Use of Facilities

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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: Rs.500,000

Sell these parts for Rs.3.22 each: 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. 75,000Less processing cost 25,000Net gain by processing further Rs. 50,000

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Explain the difference between

correct analysis and incorrectanalysis of a particular

business decision.

Objective 3

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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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Use opportunity costs

in decision making.

Objective 4

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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. Fast’s 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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Use four capital budgetingmodels to make longer-

terminvestment decisions.

Objective 5

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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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4 5 6 7 8 9 10

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18 19 20 21 22 23 24

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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.

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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 Present Value0 (Rs.450,000) 1.000 (Rs.450,000)1 225,000 0.862 193,9502 230,000 0.743 170,8903 210,000 0.641 134,610

Total PV of net cash inflows Rs. 499,450Net present value of project 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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Compare and contrast popular

capital budgeting methods.

Objective 6

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Comparison of CapitalBudgeting 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 CapitalBudgeting 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.