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Confirming Pages Chapter Find more at www.downloadslide.com 7 Differential Analysis: The Key to Decision Making Massaging the Numbers LEARNING OBJECTIVES After studying Chapter 7, you should be able to: Identify relevant and irrelevant costs and benefits in a decision. LO 7–2 Prepare an analysis showing whether a product line or other business segment should be added or dropped. LO 7–3 Prepare a make or buy analysis. LO 7–4 Prepare an analysis showing whether a special order should be accepted. LO 7–5 Determine the most profitable use of a constrained resource. LO 7–6 Determine the value of obtaining more of the constrained resource. LO 7–7 Prepare an analysis showing whether joint products should be sold at the split-off point or processed further. Building and expanding convention centers appears to be an obsession with politicians. Indeed, billions of dollars are being spent to build or expand convention centers in numerous cities across the United States. Given that trade show attendance across the country has been steadily declining, how do politicians justify these enormous investments? Politicians frequently rely on consultants who produce studies that purport to show a favorable economic impact on the area of a new convention center. These economic impact studies are bogus in two respects. First, a large portion of the so-called favorable economic impact would be realized by a city even if it did not invest in a new or expanded convention center. For example, Portland, Oregon, voters overwhelmingly opposed spending $82 million to expand their city’s convention center. Nonetheless, local politicians proceeded with the project. After completing the expansion, more than 70% of the people spending money at trade shows in Portland were from the Portland area. How much of the money spent by these locals would have been spent in Portland anyway if the convention center had not been expanded? We don’t know, but in all likelihood much of this money would have been spent at the zoo, the art museum, the theater, local restaurants, and so on. This portion of the “favorable” economic impact cited by consultants and used by politicians to justify expanding convention centers should be ignored. Second, because the supply of convention centers throughout the United States substantially exceeds demand, convention centers must offer substantial economic incentives, such as waiving rental fees, to attract trade shows. The cost of these concessions, although often excluded from consultants’ projections, further erodes the genuine economic viability of building or expanding a convention center. ■ BUSINESS FOCUS LO 7–1 Source: Victoria Murphy, “The Answer Is Always Yes,” Forbes, February 28, 2005, pp. 82–84. 258 nor25427_ch07_258-308.indd 258 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com Differential Analysis: The Key to Decision Making M 259 anagers must decide what products to sell, whether to make or buy component parts, what prices to charge, what channels of distribution to use, whether to accept special orders at special prices, and so forth. Making such decisions is often a difficult task that is complicated by numerous alternatives and massive amounts of data, only some of which may be relevant. Every decision involves choosing from among at least two alternatives. In making a decision, the costs and benefits of one alternative must be compared to the costs and benefits of other alternatives. The key to making such comparisons is differential analysis— focusing on the costs and benefits that differ between the alternatives. Costs that differ between alternatives are called relevant costs. Benefits that differ between alternatives are called relevant benefits. Distinguishing between relevant and irrelevant costs and benefits is critical for two reasons. First, irrelevant data can be ignored—saving decision makers tremendous amounts of time and effort. Second, bad decisions can easily result from erroneously including irrelevant costs and benefits when analyzing alternatives. To be successful in decision making, managers must be able to tell the difference between relevant and irrelevant data and must be able to correctly use the relevant data in analyzing alternatives. The purpose of this chapter is to develop these skills by illustrating their use in a wide range of decision-making situations. These decision-making skills are as important in your personal life as they are to managers. After completing your study of this chapter, you should be able to think more clearly about decisions in many facets of your life. Cost Concepts for Decision Making Identifying Relevant Costs and Benefits Only those costs and benefits that differ in total between alternatives are relevant in a decision. If the total amount of a cost will be the same regardless of the alternative selected, then the decision has no effect on the cost, so the cost can be ignored. For example, if you are trying to decide whether to go to a movie or rent a DVD for the evening, the rent on your apartment is irrelevant. Whether you go to a movie or rent a DVD, the rent on your apartment will be exactly the same and is therefore irrelevant to the decision. On the other hand, the cost of the movie ticket and the cost of renting the DVD would be relevant in the decision because they are avoidable costs. An avoidable cost is a cost that can be eliminated by choosing one alternative over another. By choosing the alternative of going to the movie, the cost of renting the DVD can be avoided. By choosing the alternative of renting the DVD, the cost of the movie ticket can be avoided. Therefore, the cost of the movie ticket and the cost of renting the DVD are both avoidable costs. On the other hand, the rent on your apartment is not an avoidable cost of either alternative. You would continue to rent your apartment under either alternative. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. To refine the notion of relevant costs a little further, two broad categories of costs are never relevant in decisions—sunk costs and future costs that do not differ between the alternatives. As we learned in Chapter 2, a sunk cost is a cost that has already been incurred and cannot be avoided regardless of what a manager decides to do. For example, suppose a used car dealer purchased a five-year-old Toyota Camry for $12,000. The amount paid for the Camry is a sunk cost because it has already been incurred and the transaction cannot be undone. Even though it is perhaps counterintuitive, the amount the dealership paid for the Camry is irrelevant in making decisions such as how much to sell the car for. Sunk costs are always the same no matter what alternatives are being considered; therefore, they are irrelevant and should be ignored when making decisions. Future costs that do not differ between alternatives should also be ignored. Continuing with the example discussed earlier, suppose you plan to order a pizza after you go to the movie theater or you rent a DVD. If you are going to buy the same pizza regardless of nor25427_ch07_258-308.indd 259 LEARNING OBJECTIVE 7–1 Identify relevant and irrelevant costs and benefits in a decision. 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com 260 Chapter 7 your choice of entertainment, the cost of the pizza is irrelevant to the choice of whether you go to the movie theater or rent a DVD. Notice, the cost of the pizza is not a sunk cost because it has not yet been incurred. Nonetheless, the cost of the pizza is irrelevant to the entertainment decision because it is a future cost that does not differ between the alternatives. To summarize, only those costs and benefits that differ between alternatives are relevant in a decision. Relevant costs are often called avoidable costs. The key to successful decision making is to focus on just these relevant costs and benefits and to ignore everything else—including the sunk costs and future costs and benefits that do not differ between the alternatives. IN BUSINESS THE RELEVANT COST OF EXECUTIVE PERKS The Securities and Exchange Commission is concerned about CEOs who use company-owned airplanes for personal travel. For example, consider a CEO who uses his employer’s Gulfstream V luxury airplane to transport his family on a 2,000 mile roundtrip vacation from New York City to Orlando, Florida. The standard practice among companies with personal travel reimbursement policies would be to charge their CEO $1,500 for this flight based on a per-mile reimbursement rate established by the Internal Revenue Service (the IRS rates are meant to approximate the per-mile cost of a first-class ticket on a commercial airline). However, critics argue that using IRS reimbursement rates grossly understates the flight costs that are borne by shareholders. Some of these critics claim that the $11,000 incremental cost of the flight, including fuel, landing fees, and crew hotel charges, should be reimbursed by the CEO. Still others argue that even basing reimbursements on incremental costs understates the true cost of a flight because fixed costs such as the cost of the airplane, crew salaries, and insurance should be included. These costs are relevant because the excessive amount of personal travel by corporate executives essentially requires their companies to purchase, insure, and staff additional airplanes. This latter group of critics argues that the relevant cost of the trip from New York City to Orlando is $43,000—the market price that would have to be paid to charter a comparable size airplane for this flight. What is the relevant cost of this flight? Should shareholders expect their CEO to reimburse $0 (as is the practice at some companies), $1,500, $11,000, or $43,000? Or, should all companies disallow personal use of corporate assets? Source: Mark Maremont, “Amid Crackdown, the Jet Perk Suddenly Looks a Lot Pricier,” The Wall Street Journal, May 25, 2005, pp. A1 and A8. Different Costs for Different Purposes We need to recognize a fundamental concept from the outset of our discussion—costs that are relevant in one decision situation are not necessarily relevant in another. This means that managers need different costs for different purposes. For one purpose, a particular group of costs may be relevant; for another purpose, an entirely different group of costs may be relevant. Thus, each decision situation must be carefully analyzed to isolate the relevant costs. Otherwise, irrelevant data may cloud the situation and lead to a bad decision. The concept of “different costs for different purposes” is basic to managerial accounting; we shall frequently see its application in the pages that follow. An Example of Identifying Relevant Costs and Benefits Cynthia is currently a student in an MBA program in Boston and would like to visit a friend in New York City over the weekend. She is trying to decide whether to drive or take the train. Because she is on a tight budget, she wants to carefully consider the costs nor25427_ch07_258-308.indd 260 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com Differential Analysis: The Key to Decision Making 261 of the two alternatives. If one alternative is far less expensive than the other, that may be decisive in her choice. By car, the distance between her apartment in Boston and her friend’s apartment in New York City is 230 miles. Cynthia has compiled the following list of items to consider: Automobile Costs Item (a) Annual straight-line depreciation on car [($24,000 original cost 2 $10,000 estimated resale value in 5 years)/5 years] . . . . . . . . . . . . . . (b) Cost of gasoline ($2.70 per gallon 4 27 miles per gallon) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (c) Annual cost of auto insurance and license . . . . . . . (d) Maintenance and repairs . . . . . . . . . . . . . . . . . . . . (e) Parking fees at school ($45 per month 3 8 months) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (f) Total average cost per mile . . . . . . . . . . . . . . . . . . . Annual Cost of Fixed Items Cost per Mile (based on 10,000 miles per year) $2,800 $0.280 $1,380 0.100 0.138 0.065 $360 0.036 $0.619 Additional Data Item (g) Reduction in the resale value of car due solely to wear and tear . . . . . . . . . . . . . . . . . . . . . . (h) Cost of round-trip train ticket from Boston to New York City . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (i) Benefit of relaxing and being able to study during the train ride rather than having to drive . . . . . . . . (j) Cost of putting the dog in a kennel while gone . . . . (k) Benefit of having a car available in New York City . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (l) Hassle of parking the car in New York City . . . . . . . (m) Cost of parking the car in New York City . . . . . . . . . $0.026 per mile $104 ? $40 ? ? $25 per day Which costs and benefits are relevant in this decision? Remember, only those costs and benefits that differ between alternatives are relevant. Everything else is irrelevant and can be ignored. Start at the top of the list with item (a): the original cost of the car is a sunk cost. This cost has already been incurred and therefore can never differ between alternatives. Consequently, it is irrelevant and should be ignored. The same is true of the accounting depreciation of $2,800 per year, which simply spreads the sunk cost across five years. Item (b), the cost of gasoline consumed by driving to New York City, is a relevant cost. If Cynthia takes the train, this cost would not be incurred. Hence, the cost differs between alternatives and is therefore relevant. Item (c), the annual cost of auto insurance and license, is not relevant. Whether Cynthia takes the train or drives on this particular trip, her annual auto insurance premium and her auto license fee will remain the same.1 1 If Cynthia has an accident while driving to New York City or back, this might affect her insurance premium when the policy is renewed. The increase in the insurance premium would be a relevant cost of this particular trip, but the normal amount of the insurance premium is not relevant in any case. nor25427_ch07_258-308.indd 261 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com 262 Chapter 7 Item (d), the cost of maintenance and repairs, is relevant. While maintenance and repair costs have a large random component, over the long run they should be more or less proportional to the number of miles the car is driven. Thus, the average cost of $0.065 per mile is a reasonable estimate to use. Item (e), the monthly fee that Cynthia pays to park at her school during the academic year is not relevant. Regardless of which alternative she selects—driving or taking the train—she will still need to pay for parking at school. Item (f) is the total average cost of $0.619 per mile. As discussed above, some elements of this total are relevant, but some are not relevant. Because it contains some irrelevant costs, it would be incorrect to estimate the cost of driving to New York City and back by simply multiplying the $0.619 by 460 miles (230 miles each way 3 2). This erroneous approach would yield a cost of driving of $284.74. Unfortunately, such mistakes are often made in both personal life and in business. Because the total cost is stated on a per-mile basis, people are easily misled. Often people think that if the cost is stated as $0.619 per mile, the cost of driving 100 miles is $61.90. But it is not. Many of the costs included in the $0.619 cost per mile are sunk and/or fixed and will not increase if the car is driven another 100 miles. The $0.619 is an average cost, not an incremental cost. Beware of such unitized costs (i.e., costs stated in terms of a dollar amount per unit, per mile, per direct labor-hour, per machine-hour, and so on)—they are often misleading. Item (g), the decline in the resale value of the car that occurs as a consequence of driving more miles, is relevant in the decision. Because she uses the car, its resale value declines, which is a real cost of using the car that should be taken into account. Cynthia estimated this cost by accessing the Kelly Blue Book website at www.kbb.com. The reduction in resale value of an asset through use or over time is often called real or economic depreciation. This is different from accounting depreciation, which attempts to match the sunk cost of an asset with the periods that benefit from that cost. Item (h), the $104 cost of a round-trip ticket on the train, is relevant in this decision. If she drives, she would not have to buy the ticket. Item (i) is relevant to the decision, even if it is difficult to put a dollar value on relaxing and being able to study while on the train. It is relevant because it is a benefit that is available under one alternative but not under the other. Item (j), the cost of putting Cynthia’s dog in the kennel while she is gone, is irrelevant in this decision. Whether she takes the train or drives to New York City, she will still need to put her dog in a kennel. Like item (i), items (k) and (l) are relevant to the decision even if it is difficult to measure their dollar impacts. Item (m), the cost of parking in New York City, is relevant to the decision. Bringing together all of the relevant data, Cynthia would estimate the relevant costs of driving and taking the train as follows: Relevant financial cost of driving to New York City: Gasoline (460 miles 3 $0.100 per mile) . . . . . . . . . . . . . . . . . . . . . . . . . . Maintenance and repairs (460 miles 3 $0.065 per mile) . . . . . . . . . . . . . Reduction in the resale value of car due solely to wear and tear (460 miles 3 $0.026 per mile) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of parking the car in New York City (2 days 3 $25 per day) . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.96 50.00 $137.86 Relevant financial cost of taking the train to New York City: Cost of round-trip train ticket from Boston to New York City . . . . . . . . . . . $104.00 $ 46.00 29.90 What should Cynthia do? From a purely financial standpoint, it would be cheaper by $33.86 ($137.86 2 $104.00) to take the train than to drive. Cynthia has to decide if the convenience of having a car in New York City outweighs the additional cost and the disadvantages of being unable to relax and study on the train and the hassle of finding parking in the city. nor25427_ch07_258-308.indd 262 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com Differential Analysis: The Key to Decision Making 263 In this example, we focused on identifying the relevant costs and benefits— everything else was ignored. In the next example, we include all of the costs and benefits—relevant or not. Nonetheless, we’ll still get the correct answer because the irrelevant costs and benefits will cancel out when we compare the alternatives. IN BUSINESS DELL STUMBLES DUE TO POOR CUSTOMER SERVICE Dell Inc. decided to cut customer service costs by shifting most of its call centers overseas and staffing them with temporary workers who were rewarded for minimizing the length of customer calls. The unintended consequences of Dell’s choices were predictable—the number of angry repeat callers skyrocketed and the company’s customer satisfaction and “likely to repurchase” survey scores plummeted. Fearful that unhappy customers would take their business elsewhere, Dell spent $150 million to hire thousands of full-time call center employees in North America. The company also began rewarding these employees based on how well they solved callers’ problems. These changes paid off as Dell began receiving two million fewer customer service calls per quarter. Customer satisfaction and “likely to repurchase” scores rose substantially. Dell’s experience highlights the danger of overemphasizing cost cutting while overlooking the revenues that may be lost due to customer dissatisfaction. Source: David Kirkpatrick, “Dell in the Penalty Box,” Fortune, September 18, 2006, pp. 70–78. Reconciling the Total and Differential Approaches Oak Harbor Woodworks is considering a new labor-saving machine that rents for $3,000 per year. The machine will be used on the company’s butcher block production line. Data concerning the company’s annual sales and costs of butcher blocks with and without the new machine are shown below: Units produced and sold . . . . . . . . . . . . . Selling price per unit . . . . . . . . . . . . . . . . Direct materials cost per unit . . . . . . . . . . Direct labor cost per unit . . . . . . . . . . . . . Variable overhead cost per unit . . . . . . . Fixed costs, other . . . . . . . . . . . . . . . . . . . Fixed costs, rental of new machine . . . . . Current Situation Situation with the New Machine 5,000 $40 $14 $8 $2 $62,000 — 5,000 $40 $14 $5 $2 $62,000 $3,000 Given the data above, the net operating income for the product under the two alternatives can be computed as shown in Exhibit 7–1 on the next page. Note that the net operating income is $12,000 higher with the new machine, so that is the better alternative. Note also that the $12,000 advantage for the new machine can be obtained in two different ways. It is the difference between the $30,000 net operating income with the new machine and the $18,000 net operating income for the current situation. It is also the sum of the differential costs and benefits as shown in the last column of Exhibit 7–1. A positive number in the Differential Costs and Benefits column indicates that the difference between the alternatives favors the new machine; a negative number indicates that the difference favors the current situation. A zero in that column simply means that the total amount for the item is exactly the same for both alternatives. Thus, because the difference in the net operating incomes equals the sum of the differences for the individual items, any cost or benefit that is the same for both alternatives will have no impact on which alternative is preferred. This is the reason that costs and benefits that do not differ between alternatives are irrelevant and can be ignored. If we properly account for them, they will cancel out when we compare the alternatives. nor25427_ch07_258-308.indd 263 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com 264 Chapter 7 E X H I B I T 7–1 Total and Differential Costs Sales (5,000 units 3 $40 per unit) . . . . . . . . Current Situation Situation with New Machine Differential Costs and Benefits $200,000 $200,000 70,000 70,000 0 $ 0 Variable expenses: Direct materials (5,000 units 3 $14 per unit) . . . . . . . . . . . . . . . . . . . . . Direct labor (5,000 units 3 $8 per unit; 5,000 units 3 $5 per unit) . . . . . . . . . . . Variable overhead (5,000 units 3 $2 per unit) . . . . . . . . . . . . . . . . . . . . . . Total variable expenses . . . . . . . . . . . . . . . . Contribution margin . . . . . . . . . . . . . . . . . . . 40,000 25,000 15,000 10,000 120,000 80,000 10,000 105,000 95,000 0 Fixed expenses: Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . Rental of new machine . . . . . . . . . . . . . . . Total fixed expenses . . . . . . . . . . . . . . . . . . . Net operating income . . . . . . . . . . . . . . . . . . 62,000 0 62,000 $ 18,000 62,000 3,000 65,000 $ 30,000 0 (3,000) $12,000 We could have arrived at the same solution much more quickly by completely ignoring the irrelevant costs and benefits. • • • The selling price per unit and the number of units sold do not differ between the alternatives. Therefore, the total sales revenues are exactly the same for the two alternatives as shown in Exhibit 7–1. Because the sales revenues are exactly the same, they have no effect on the difference in net operating income between the two alternatives. That is shown in the last column in Exhibit 7–1, which shows a $0 differential benefit. The direct materials cost per unit, the variable overhead cost per unit, and the number of units produced and sold do not differ between the alternatives. Consequently, the total direct materials cost and the total variable overhead cost are the same for the two alternatives and can be ignored. The “other” fixed expenses do not differ between the alternatives, so they can be ignored as well. Indeed, the only costs that do differ between the alternatives are direct labor costs and the fixed rental cost of the new machine. Hence, the two alternatives can be compared based only on these relevant costs: Net Advantage of Renting the New Machine Decrease in direct labor costs (5,000 units at a cost savings of $3 per unit) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in fixed expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net annual cost savings from renting the new machine . . . . . . . . . . . . . $15,000 (3,000) $12,000 If we focus on just the relevant costs and benefits, we get exactly the same answer as when we listed all of the costs and benefits—including those that do not differ between the alternatives and, hence, are irrelevant. We get the same answer because the only costs and benefits that matter in the final comparison of the net operating incomes are those that differ between the two alternatives and, hence, are not zero in the last column of nor25427_ch07_258-308.indd 264 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com Differential Analysis: The Key to Decision Making 265 Exhibit 7–1. Those two relevant costs are both listed in the above analysis showing the net advantage of renting the new machine. Why Isolate Relevant Costs? In the preceding example, we used two different approaches to analyze the alternatives. First, we considered all costs, both those that were relevant and those that were not; and second, we considered only the relevant costs. We obtained the same answer under both approaches. It would be natural to ask, “Why bother to isolate relevant costs when total costs will do the job just as well?” Isolating relevant costs is desirable for at least two reasons. First, only rarely will enough information be available to prepare a detailed income statement for both alternatives. Assume, for example, that you are called on to make a decision relating to a portion of a single business process in a multidepartmental, multiproduct company. Under these circumstances, it would be virtually impossible to prepare an income statement of any type. You would have to rely on your ability to recognize which costs are relevant and which are not in order to assemble the data necessary to make a decision. Second, mingling irrelevant costs with relevant costs may cause confusion and distract attention from the information that is really critical. Furthermore, the danger always exists that an irrelevant piece of data may be used improperly, resulting in an incorrect decision. The best approach is to ignore irrelevant data and base the decision entirely on relevant data. Relevant cost analysis, combined with the contribution approach to the income statement, provides a powerful tool for making decisions. We will investigate various uses of this tool in the remaining sections of this chapter. Adding and Dropping Product Lines and Other Segments Decisions relating to whether product lines or other segments of a company should be dropped and new ones added are among the most difficult that a manager has to make. In such decisions, many qualitative and quantitative factors must be considered. Ultimately, however, any final decision to drop a business segment or to add a new one hinges primarily on the impact the decision will have on net operating income. To assess this impact, costs must be carefully analyzed. LEARNING OBJECTIVE 7–2 Prepare an analysis showing whether a product line or other business segment should be added or dropped. An Illustration of Cost Analysis Exhibit 7–2 on the next page provides sales and cost information for the preceding month for the Discount Drug Company and its three major product lines—drugs, cosmetics, and housewares. A quick review of this exhibit suggests that dropping the housewares segment would increase the company’s overall net operating income by $8,000. However, this would be a flawed conclusion because the data in Exhibit 7–2 do not distinguish between fixed expenses that can be avoided if a product line is dropped and common fixed expenses that cannot be avoided by dropping any particular product line. In this scenario, the two alternatives under consideration are keeping the housewares product line and dropping the housewares product line. Therefore, only those costs that differ between these two alternatives (i.e., that can be avoided by dropping the housewares product line) are relevant. In deciding whether to drop housewares, it is crucial to identify which costs can be avoided, and hence are relevant to the decision, and which costs cannot be avoided, and hence are irrelevant. The decision should be analyzed as follows. If the housewares line is dropped, then the company will lose $20,000 per month in contribution margin, but by dropping the line it may be possible to avoid some fixed nor25427_ch07_258-308.indd 265 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com 266 Chapter 7 E X H I B I T 7–2 Discount Drug Company Product Lines Product Line Cosmetics Housewares $75,000 25,000 50,000 $50,000 30,000 20,000 29,500 1,000 500 1,000 10,000 2,000 15,000 59,000 12,500 7,500 500 2,000 6,000 500 9,000 38,000 8,000 6,500 1,000 2,000 4,000 500 6,000 28,000 Net operating income (loss) . . . . . . . $ 20,000 $ 16,000 $12,000 $ (8,000) Total Drugs Sales . . . . . . . . . . . . . . . . . . . . . . . . $250,000 $125,000 Variable expenses . . . . . . . . . . . . . . . 105,000 50,000 Contribution margin . . . . . . . . . . . . . . 145,000 75,000 Fixed expenses: Salaries . . . . . . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . Utilities . . . . . . . . . . . . . . . . . . . . . Depreciation—fixtures . . . . . . . . . . Rent . . . . . . . . . . . . . . . . . . . . . . Insurance . . . . . . . . . . . . . . . . . . . . General administrative . . . . . . . . . . Total fixed expenses . . . . . . . . . . . . . 50,000 15,000 2,000 5,000 20,000 3,000 30,000 125,000 costs such as salaries or advertising costs. If dropping the housewares line enables the company to avoid more in fixed costs than it loses in contribution margin, then its overall net operating income will improve by eliminating the product line. On the other hand, if the company is not able to avoid as much in fixed costs as it loses in contribution margin, then the housewares line should be kept. In short, the manager should ask, “What costs can I avoid if I drop this product line?” As we have seen from our earlier discussion, not all costs are avoidable. For example, some of the costs associated with a product line may be sunk costs. Other costs may be allocated fixed costs that will not differ in total regardless of whether the product line is dropped or retained. To show how to proceed in a product-line analysis, suppose that Discount Drug Company has analyzed the fixed costs being charged to the three product lines and determined the following: 1. The salaries expense represents salaries paid to employees working directly on the product. All of the employees working in housewares would be discharged if the product line is dropped. 2. The advertising expense represents advertisements that are specific to each product line and are avoidable if the line is dropped. 3. The utilities expense represents utilities costs for the entire company. The amount charged to each product line is an allocation based on space occupied and is not avoidable if the product line is dropped. 4. The depreciation expense represents depreciation on fixtures used to display the various product lines. Although the fixtures are nearly new, they are custom-built and will have no resale value if the housewares line is dropped. 5. The rent expense represents rent on the entire building housing the company; it is allocated to the product lines on the basis of sales dollars. The monthly rent of $20,000 is fixed under a long-term lease agreement. 6. The insurance expense is for insurance carried on inventories within each of the three product lines. If housewares is dropped, the related inventories will be liquidated and the insurance premiums will decrease proportionately. 7. The general administrative expense represents the costs of accounting, purchasing, and general management, which are allocated to the product lines on the basis of sales dollars. These costs will not change if the housewares line is dropped. With this information, management can determine that $15,000 of the fixed expenses associated with the housewares product line are avoidable and $13,000 are not: nor25427_ch07_258-308.indd 266 31/08/12 1:02 PM Confirming Pages Find more at www.downloadslide.com Differential Analysis: The Key to Decision Making Fixed Expenses Salaries . . . . . . . . . . . . . . . . . . . . . Advertising . . . . . . . . . . . . . . . . . . Utilities . . . . . . . . . . . . . . . . . . . . . . Depreciation—fixtures . . . . . . . . . Rent . . . . . . . . . . . . . . . . . . . . . . . . Insurance . . . . . . . . . . . . . . . . . . . General administrative . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . Total Cost Assigned to Housewares $ 8,000 6,500 1,000 2,000 4,000 500 6,000 $28,000 Not Avoidable* 267 Avoidable $ 8,000 6,500 $ 1,000 2,000 4,000 500 6,000 $13,000 $15,000 *These fixed costs represent either sunk costs or future costs that will not change whether the housewares line is retained or discontinued. As stated earlier, if the housewares product line were dropped, the company would lose the product’s contribution margin of $20,000, but would save its associated avoidable fixed expenses. We now know that those avoidable fixed expenses total $15,000. Therefore, dropping the housewares product line would result in a $5,000 reduction in net operating income as shown below: Contribution margin lost if the housewares line is discontinued (see Exhibit 7–2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less fixed costs that can be avoided if the housewares line is discontinued (see above) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Decrease in overall company net operating income . . . . . . . . . . . . . . . . . $(20,000) 15,000 $ (5,000) In this case, the fixed costs that can be avoided by dropping the housewares product line ($15,000) are less than the contribution margin that will be lost ($20,000). Therefore, based on the data given, the housewares line should not be discontinued unless a more profitable use can be found for the floor and counter space that it is occupying. A Comparative Format This decision can also be approached by preparing comparative income statements showing the effects of either keeping or dropping the product line. Exhibit 7–3 on the next page contains such an analysis for the Discount Drug Company. As shown in the last column of the exhibit, if the housewares line is dropped, then overall company net operating income will decrease by $5,000 each period. This is the same answer, of course, as we obtained when we focused just on the lost contribution margin and avoidable fixed costs. Beware of Allocated Fixed Costs Go back to Exhibit 7–2. Does this exhibit suggest that the housewares product line should be kept—as we have just concluded? No, it does not. Exhibit 7–2 suggests that the housewares product line is losing money. Why keep a product line that is showing a loss? The explanation for this apparent inconsistency lies in part with the common fixed costs that are being allocated to the product lines. As we observed in Chapter 5, one of the great dangers in allocating common fixed costs is that such allocations can make a product line (or other business segment) look less profitable than it really is. In this instance, allocating the common fixed costs among all product lines makes the housewares product line appear to be unprofitable. However, as we have shown above, dropping the product line would result in a decrease in the company’s overall net operating income. This point can be seen clearly if we redo Exhibit 7–2 by eliminating the allocation of the common fixed costs. Exhibit 7–4 uses the segmented approach from Chapter 5 to estimate the profitability of the product lines. nor25427_ch07_258-308.indd 267 31/08/12 1:02 PM