IE 335

Illustrative Examples- Cost Analysis to Obtain Relevant Information for Management Decision Making

Marketing Related

a.                    Pricing – Goal is to:

1.      Set price that will maximize total profits

2.      Set price that will win competitive bid

·        Types of pricing

Cost plus + mark up

Target cost + % profit

Fixed price- set by competitive market or is the bid price

Example I-    To determine what markup % to use in order to achieve an annual budgeted profit.

Proforma Annual Budget –

Bases Sales Forecast

% Markup to apply if total costs are used

Profit                 =             500,000 =       20%    

Total costs        =      2,500,000 =   

So if an order is figured to have a total cost of $30,000 the customer would be charged

                        30,000 X 1.2  =   $36,000

                                                       =      6,000 profit

% if direct material and direct labor only is used to price

Total sales   =                                         3,000,000 = 250%

 Direct material and direct labor          1,200,000

Say DM + DL cost=  .48 (30,000)  = 14,400

14,400 X 250% - 36,000

Example II      Whether to take special orders

Economic Rule – Take if marginal revenue is greater than marginal cost of the special order.

Intangibles need also to be considered (ie best use of resources, systems effects)

For Example

The Costco Company has approached the Campbell Soup Company to place an order for 10 million cans of soup that costs Campbell 23¢ a can to produce and which it sells for 25¢.  Costco is willing to pay 18¢.   Campbell has the idle capacity so it is considering whether to do this.   Its cost per can is 5¢ for the ingredients, 3¢ for direct labor, 5¢ for variable overhead and has a fixed overhead of $5,000,000 which it incurs to be able to produce 50 million cans a year.  What would be your advice?

                                    Special Order

Normal price 25¢    Marginal Revenue -  18¢ X 10,000,000

Variable Cost/Can              Variable Cost/Can

DM 5¢                                                  DM  5¢

DL. 3¢                                                  DL   3¢

VOH 5¢                                               VOH 5¢

            .13                                                  .13

            .12                                                 (.05)

Contribution Profit

Fixed Cost/ Can                                           Fixed Cost/Can

5,000,000 =.10                                                          = .10

50,000,000                                         

Total Cost .23                           Total Cost -.23

Profit/Can = .02                    Loss per can -= .05               (based on total cost)

Correct analysis

Marginal Revenue = .18                          Total profit from order

- Marginal cost                                     10000000 (.05) = $500,000

  (all variable cost =  13                     

- fixed cost                   0                                   take the order

profit per can             .05

Example III              Drop or Add line                  

SONY INC

1.      Should stereo III be dropped?

2.      If it is dropped an additional $1000 of Stereo I could be produced or an additional $1000 of Stereo II.   What would be your recommendation?

Stereo III is dropped                       New profit would be

Sales               4400 –1200 = 3200

Variable cost   2500-  700 =  1800

Contribution Profit                   1400

Avoidable expense  510- 350 = 350

Unavoidable fixed expense        600

Net Income                                          640

Choice Stereo I would be produced instead    Choice: Stereo II would be produced instead

Sales    3200 + 1000 = 4200                             3200+ 1000 = 4200

V.C                   1800 +   555   = 2355                  1800 + 571 = 2371

CP                                            1445                                         1829

Avoidable  160 +111 = 271                               160+ 115       285

Fixed Exp.                      600                                                   600

Net income.                   574                                                 1144

Recommendation:

a.       Do not drop if nothing else can be produced instead

b.      Drop and produce Stereo II

Example IV             Most Productive use of Fixed Asset

The Prentice Hall Publishing Co. has a printing facility that can be used to produce a cookbook or Horngreen’s accounting text.  The following cost data was compiled.

There are 400 production hours available. Suppose it is estimated that 500 cookbooks and 1000 Horngreen texts can be sold, how should the production facility be utilized?  How much profit would be made?

Sell 1600 Horngreens

            1600 (360) = 576,000

will use  1600 = 89 hours

                18

400 – 89 = 311 hours for cookbook

311(10) = 3110 cookbooks can be produced

CP profit

            Horngreen = 1600 (360)  = 576,000

            Cookbook     3110 (300) =  933,000

                                                       1,509,000

Fixed Cost                                      1,000,000

            Net Income                  $      509,000

Example V     Profit Maximization

An NJIT graduate thinks there is an opportunity to open a copy center near NJIT/Rutgers.  He figures that 5¢ per copy is a reasonable charge that students will pay and that fixed cost for a store will be $10,000 a year with variable costs dependent on the sales    volume Q

The total cost function for this facility is estimated to be:

TC = 10,000 + .01Q + 00000001Q²

MC= 01+ .00000002Q

At what sales level will profits be maximized?

Solution:

 Profit is maximum where MR = MC

MR = .05

05= .01+ .00000002Q

Q= 2,000,000 copies

Example VI    Competitive Cost Estimation

A competitor sells a printer for $ 600.  If the average profit is 20% of the sales price, what do you estimate to be their average variable cost per printer?

Solution

            AVC = Price – Profit Contribution

            P-.2P

            = .8P

            .8 (600) = $ 480

Production Decisions

Example I             Outsourcing (make or buy)

The decision what to do is based on economic (cost) and non-economic                       (reliability, quality, innovation, etc) factors. Here we only do an economic comparison.

Ford Motor is producing a part that its accountants have figured costs $20 per a unit.

A supplier has offered to sell Ford this part for $17.00.  If the capacity is used to produce the part would become and stay idle.  However, it will be possible to reduce the fixed overhead by $120,000

a.)              What should be done?

Solution

Keep producing unless something else can be done with this capacity

Example II             Joint Costing

Involves a situation where you have one raw material that is processed and consequently utilized in a number of products.  For instance petroleum is refined and then utilized to produce gasoline jet fuel, lubricants etc.   Question is how much of the raw material cost to allocate to the individual end products?  Basically can be on the basis of quantity or $ value.

Example

Two types of paint at B are produced from 50,000 gallons of raw material costing $150,000. 20,000 gallons are used to make paint at which is sold for $8.00 a gallon and 30,000 is used to produce paint B, which is sold for $6.00 a gallon.   Allocate the joint costs to the end product on the basis of:

1. Sales Price

Paint A =  8 ( 150,000) = 85714

                     8+6

      Paint B     6 (150,000) –64285

                    8+6

Quantity

Paint A  =  20,000 (150,000)  = 60,000

                  50,000

                   30,000 (150,000) = 90,000

Paint B   =  50,000

Example III                Sell or Process Further

The rule is if total profit increases as a result of further processing, everything else equal, it should be done.   Other items should be sold at split off.

A furniture company produces 2 categories of chairs that can be sold as is or further worked on which will increase their sales price.   Based on the data noted below what would be your recommendation?   Would the firm’s profitability increase?   If so by how much? 

Illustrative Example:

Joint Production Cost   $900,000

Answer :

    If not processed further

Sales

15000 (60) = 900,000

25000 (40) =1,000,000

                     1,900,000

Total cost        900,000

Net Profit     1,000,000

Recommendation – Sell chair #1 at split off.  Process chair# 2 further profitability will increase by $50,000

Example IV--   Replacement of Capital Equipment

Often companies are approached by a vendor who proposes that if the company buys one of their machines it can reduce its present manufacturing costs.   Usually a cost study is done by the vendor to support his position to help make the sale. 

For example:

A company is using a machine that cost it $200,000 5 years ago and which is being depreciated at the rate of $20,000 a year.  It has a zero salvage value because it has been superseded by more modern equipment.  The vendor wants the company to buy a new machine costing $400,000 that can produce a product for $ 40 a unit, compared to $60 a unit it is costing now.  Assuming a 5-year need of 50,000 units a year for the product should the company make the switch?  (Cost of capital should also be included)

Example V                  Irrelevance of Past Cost

Past costs should not affect future decisions. 

For Example:

Suppose you bought a 100 share of Hilton Hotels for $25 a share 3 years ago.  Today its price is $10 a share.  Somebody recommended you sell the Hilton shares and with the proceeds buy 50 shares of Lockheed Martin for $20.  Is it a good idea to take the $1500 loss?  What would you recommend?

Example VI      Opportunity Cost

The cost of a forgone opportunity.  For instance by going to school one gives up the opportunity to have employment income.  More broadly opportunity cost is the difference in the return obtained from a resource compared to the largest possible one at the time the decision is made.  They are calculated for decision-making and not recorded on a company’s books.   Only the actual decision’s numbers are.

For example:  Student going to college fulltime instead of working  - 1 year period

Total opportunity cost = $35,000

The increased earning power that this education will provide should be estimated and deducted.

Example VII               Target Cost

A method developed by the Japanese to maintain profitability.   The assumption that in most instances the sales price of a product or service is determined by the competitive market place and is not under control of the manufacturer.  What is under control is the cost.

Target Cost-  What the product should cost

Sales price-desired profit =  Target cost       This is the maximum cost it should be produced to make the specified profit.   If this cost cannot be met thru redesign, production efficiency, etc., serious consideration should be given to dropping the product

A company is producing a pump that it figures could be sold for $50.   The engineers estimated it would cost to produce

It would like to have a 20% profit margin over cost.  How much must the manufacturing cost of $54.00 be reduced?

50 = C + 20C

     1.2 C = 50

           C= 41.67

Needed cost reduction

54.00 = 41.67 = 12.33

How could this be done?