24/11/2010

Week Eight

Tactical Decision Making

Tactical Decision Making

 Is the study of two or more alternatives to decide which is
the best one given certain conditions.
 e.g. make or buy decision; accepting a special offer,
utilising idle capacity

• Some tactical decision tend to be short-run in nature but it

may serve a larger purpose

• Therefore, the overall objective is to established a long-term

competitive advantage.

1
 24/11/2010

 Before taking final decision, need to consider qualitative as

well as quantitative factors.

 Qualitative factors include:

 The quality of the project, reliability of supply sources,
ability to retain skill labour force, seasonal fluctuations,
trade secrets, expected stability of the prices

 Managers can evaluate qualitative factors after analysing the

financial alternatives, or they can identify relevant qualitative
factors and then attempted to quantify them.

Relevant Information
 Focusing on relevant information is important because:
 It shortens the data gathering process

 Does not waste peoples’ time

 Reduces the likelihood of information overload

 Remember – information’s relevancy is dependent on the

situation or decision being made.

2
 24/11/2010

Relevant Cost
 Are future costs that differ across alternative courses of
action. e.g.
 If DM costs for one alternative is $30,000 and for the
other is $ 17,000, then the cost of the DM is relevant.

 These are normally referred to avoidable costs.

 An avoidable cost can be eliminated (in whole or in part) by

choosing one alternative over another. So Avoidable
costs are relevant costs.

Irrelevant costs
 Are costs that have been incurred in the past and future
costs that do not differ across alternatives.

 Unavoidable costs are irrelevant costs.

 Two broad categories of costs are never relevant in any

decision and include:
 Sunk costs.

 Future costs that do not differ between the

alternatives.

3
 24/11/2010

Identifying Relevant Costs

John, a Massey University student in Wellington, is considering visiting

his friend in Auckland. He can drive or take the train. By car it is 600
miles to his friend’s apartment. He is trying to decide which alternative is
less expensive and has gathered the following information:
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at Massey 360 0.036
6 Total average cost $ 0.569

$45 per month × 8 months $1.60 per gallon ÷ 32 MPG

$18,000 cost – $4,000 salvage value ÷ 5 years

Automobile Costs (based on 10,000 miles driven per year)

Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.050
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.569

Some Additional Information

7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 200
9 Benefits of relaxing on train trip ????
11 Benefit of having car in Auckland ????
12 Hassle of parking car in Auckland ????
13 Per day cost of parking car in Auckland $ 25

Q. - Which costs and benefits are relevant in John’s

decision?

4
 24/11/2010

Which costs and benefits are relevant in John’s

decision?

The cost of the The annual cost of

car is a sunk cost insurance is not relevant.
and is not It will remain the same if
relevant to the he drives or takes the
current decision. train.

However, the cost of gasoline is clearly relevant if

he decides to drive. If he takes the drive the cost
would now be incurred, so it varies depending on
the decision.

Which costs and benefits are relevant in John’s

decision?
The monthly
The cost of Massey parking
maintenance and fee is not relevant
repairs is relevant. In because it must
the long-run these costs be paid if John
depend upon miles drives or takes
driven. the train.

At this point, we can see that some of the average cost

of $0.569 per mile are relevant and others are not.

5
 24/11/2010

Which costs and benefits are relevant in John’s

decision?

The decline in resale The round-trip train fare

value due to additional is clearly relevant. If he
miles is a relevant cost. drives the cost can be
avoided.

Relaxing on the train is

relevant even though it
is difficult to assign a
dollar value to the
benefit.

Which costs and benefits are relevant in John’s

decision?

The cost of parking is

relevant because it can
be avoided if he takes
the train.

The benefits of having a car in Auckland and

the problems of finding a parking space are
both relevant but are difficult to assign a dollar
amount.

6
 24/11/2010

From a financial standpoint, John would be better off

taking train to visit his friend. Some of the non-
financial factor may influence his final decision.

Relevant Financial Cost of Driving

Gasoline (1200 @ $0.050 per mile) $ 60.00
Maintenance (1200 @ $0.065 per mile) 78.00
Reduction in resale (1200 @ $0.026 per mile) 31.20
Parking in Auckland (2 days @ $25 per day) 50.00
Total $ 219.20

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 200.00

Differential (Incremental) Cost

Analysis

 A differential (incremental) cost is the difference in total

cost between two alternatives.
 The relevant costs are more likely to be variable and
semi-variable costs, but can include fixed costs when a
change in capacity or production volume is anticipated.

 It can be performed on a per unit cost basis, or a total

relevant cost basis.

7
 24/11/2010

Example:
Say, a company is considering to rent a new machine instead of
using its existing old machine. Following information are available
for decision making.
Situation
Current With New
Situation Machine
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000
Total variable expenses 120,000 105,000
Contribution margin 80,000 95,000
Less fixed expense:
Other 62,000 62,000
Rent on new machine - 3,000
Total fixed expenses 62,000 65,000
Net operating income $ 18,000 $ 30,000

As you see, the only costs that differ between the alternatives are the
direct labor costs savings and the increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
We can efficiently analyze the decision by62,000
Other 62,000 -
Rent on new machine
- 3,000 (3,000)
looking at the different costs and revenues and
Total fixed expenses
62,000 65,000 (3,000)
Net operating income
$ 18,000 $ 30,000 12,000
arrive at the same solution.
Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Increase in fixed rental expenses (3,000)
Net annual cost saving from renting the new machine $ 12,000

8
 24/11/2010

 There are three types of differential analysis normally

performed:
 Make-or-buy decision

 Keep-or-drop decision

 Accept-or-decline special order decision

 Make-or-buy decision
 This is where organisation has to decide whether to
make or buy a product, component or assembly that is
used in the manufacturing process.
 This is commonly referred to as outsourcing

Make-or-Buy decision

 Note:
 It is difficult to make a clear cut rules as what costs and
benefits are relevant because they are situation specific
 When deciding whether to make or buy a manager
needs to consider whether they have the available
capacity, and there alternative uses for plant,
equipment and labour. Opportunity cost can also be
important
 The decision to make or buy can be influence by
qualitatives factors as well.
 Production may require special knowledge or technical
capabilities, or may require the ability to control the
quality and/or reliability of the supply

9
 24/11/2010

Example - Make or Buy Decision:

 Essex Company manufactures part 4A that is used in one

of its products.
 The unit product cost of this part is:

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30

Other information available:

 The special equipment used to manufacture part 4A has
no resale value.
 The total amount of general factory overhead, which is
allocated on the basis of direct labour hours, would be
unaffected by this decision.
 The $30 unit product cost is based on 20,000 parts
produced each year.
 An outside supplier has offered to provide the 20,000
parts at a cost of $25 per part.

Should the supplier’s offer be accepted?

10
 24/11/2010

Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

20,000 × $9 per unit = $180,000

Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The special equipment has no resale value

and is a sunk cost.

11
 24/11/2010

Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Not avoidable; irrelevant. If the product is dropped,

it will be reallocated to other products.

Cost
Per Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Should the company make or buy part 4A?

12
 24/11/2010

 Keep-or-drop decision
 Where a firm reviews the product they are
manufacturing, the departments (segment) they have or
the services they provide to determine whether
unprofitable areas should be kept or dropped.
 The focus is on the impact the decision will have on net
operating income.

 Two types of cost involved in a keep or drop decision:

 Escapable costs

 Non-escapable costs

 Escapable costs:
 The cost avoided by discontinuing an activity

 Non-escapable costs:
 The cost not eliminated by discontinuing an activity. These
cost must be reassigned to the remaining activities.
 Note: when deciding to discontinue an activity, need to
consider:
 The value of activity to the organisation

 Any effect on sales of other product lines, parts of the

business, customer and employees that the decision may
have.
 Any alternative use for the production space, machinery,
employee etc.

13
 24/11/2010

Example - Keep-or-drop decision

Due to the declining popularity of digital watches, Wellington Company’s
digital watch line has not reported a profit (see the following statement) for
several years. Wellington co. is considering dropping this product line.
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)

Analysis of Wellington co.’s current situation revealed

the following addition information:

 Investigation revealed that

 total fixed general factory overhead and general
administrative expenses would not be affected if the
digital watch line is dropped. The fixed general factory
overhead and general administrative expenses assigned
to this product would be reallocated to other product
lines.
 The equipment used to manufacture digital watches has
no resale value or alternative use.

Should Wellington co. retain or drop

the digital watch segment?

14
 24/11/2010

DECISION RULE

Wellington co. should drop the digital watch segment only

if its profit would increase. This would only happen if
the fixed cost savings exceed the lost contribution
margin.

Let’s look at this solution.

Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)

15
 24/11/2010

The Wellington co. solution can also be obtained by

preparing comparative income statements showing
results with and without the digital watch segment.

Let’s look at this second approach.

Comparative Income Approach

Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000
Salary of line manager 90,000
Depreciation 50,000 If the digital watch
Advertising - direct 100,000 line is dropped, the
Rent - factory space 70,000
General admin. expenses 30,000 company gives up its
Total fixed expenses 400,000 contribution margin.
Net operating loss $ (100,000)

16
 24/11/2010

Comparative Income Approach

Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000
Depreciation 50,000
Advertising - direct
On100,000
the other hand, the general
Rent - factory space factory
70,000overhead would be the
General admin. expenses same.
30,000So this cost really isn’t
Total fixed expenses 400,000
Net operating loss $ (100,000)
relevant.

Comparative Income Approach

Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses:
Manufacturing expenses
wouldn’t need a--
But we 120,000 120,000
Shipping manager for5,000
the product line
- 5,000
Commissions anymore.
75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

17
 24/11/2010

Comparative Income Approach

Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
If variable
Less the digital watch line is dropped, the net book
expenses: - value of
the equipment
Manufacturing would be written
expenses off. The depreciation
120,000 - that
120,000
Shipping 5,000 - 5,000
would have been taken will flow
Commissions 75,000
through the -
income75,000
Total variable expensesstatement as a 200,000
loss instead. - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000
Total fixed expenses 400,000
Net operating loss $ (100,000)

Comparative Income Approach

Solution
Keep Drop
Digital Digital
Watches Watches Difference
Sales $ 500,000 $ - $ (500,000)
Less variable expenses: -
Manufacturing expenses 120,000 - 120,000
Shipping 5,000 - 5,000
Commissions 75,000 - 75,000
Total variable expenses 200,000 - 200,000
Contribution margin 300,000 - (300,000)
Less fixed expenses:
General factory overhead 60,000 60,000 -
Salary of line manager 90,000 - 90,000
Depreciation 50,000 50,000 -
Advertising - direct 100,000 - 100,000
Rent - factory space 70,000 - 70,000
General admin. expenses 30,000 30,000 -
Total fixed expenses 400,000 140,000 260,000
Net operating loss $ (100,000) $ (140,000) $ (40,000)

18
 24/11/2010

 Accept-or-decline special order decision

 Where an organisation is asked to manufacture a special
order and must decide whether to accept or reject this
order.
 To decide whether to accept the order a firm compares
the differential costs of the extra units to the differential
income expected, to determine if the order is profitable.

 Note that-
 if there is no excess capacity, then it will have to cut
regular production.
 The revenue lost and cost saved need to taken into
account

Example - Accept-or-decline special

order decision
 Jet, Inc. makes a single product whose normal selling price
is $20 per unit.
 A foreign distributor offers to purchase 3,000 units for $10
per unit.
 This is a one-time order that would not affect the
company’s regular business.
 Annual capacity is 10,000 units, but Jet, Inc. is currently
producing and selling only 5,000 units.
Should Jet accept the offer?

19
 24/11/2010

Income statement for Jet Inc.’s normal sales of 5,000 units reveals
the following information.

Jet, Inc.
Contribution Income Statement
Revenue (5,000 × $20) $ 100,000
Variable costs:
Direct materials $ 20,000
Direct labor 5,000
Manufacturing overhead 10,000 $8 variable cost
Marketing costs 5,000
Total variable costs 40,000
Contribution margin 60,000
Fixed costs:
Manufacturing overhead $ 28,000
Marketing costs 20,000
Total fixed costs 48,000
Net operating income $ 12,000

If Jet accepts the offer, net operating income will

increase by $6,000.

Increase in revenue (3,000 × $10) $ 30,000

Increase in costs (3,000 × $8 variable cost) 24,000
Increase in net income $ 6,000

Note: This answer assumes that fixed costs are

unaffected by the order and that variable marketing
costs must be incurred on the special order.

20
 24/11/2010

 Decision to Sell or Process Further

 Relevant costs for this type of decision are-

 Incremental cost of further processing

 Incremental revenues from processing further.

 Joint costs are irrelevant in decisions regarding what to do

with a product from the split-off point forward.

 It will always be profitable to continue processing a joint

product after the split-off point so long as the incremental
revenue exceeds the incremental processing costs incurred
after the split-off point.

Example - Sell or Process Further

 Sawmill, Inc. cuts logs from which unfinished timber and
sawdust are the immediate joint products.
 Unfinished timber is sold “as is” or processed further into
finished timber.
 Sawdust can also be sold “as is” to gardening wholesalers or
processed further into “presto-logs.”

Per Log
Timber Sawdust
Sales value at the split-off point $ 140 $ 40

Sales value after further processing 270 50

Allocated joint product costs 176 24
Cost of further processing 50 20

21
 24/11/2010

Analysis of Sell or Process Further

Per Log
Timber Sawdust

Sales value after further processing $ 270 $ 50

Sales value at the split-off point 140 40
Incremental revenue 130 10
Cost of further processing 50 20
Profit (loss) from further processing $ 80 $ (10)

Should we process the timber further

and sell the sawdust “as is?”

Utilization of a Constrained
Resource
 When a constraint exists, a company should select a product
mix that maximizes the total contribution margin earned
since fixed costs usually remain unchanged.

 A company should not necessarily promote those products

that have the highest unit contribution margin.

 Rather, it should promote those products that earn the

highest contribution margin in relation to the constraining
resource.

22
 24/11/2010

Utilization of a Constrained
Resource: An Example
Wellington Company produces two products and
selected data is shown below:

Product
1 2
Selling price per unit $ 60 $ 50
Less variable expenses per unit 36 35
Contribution margin per unit $ 24 $ 15
Current demand per week (units) 2,000 2,200
Contribution margin ratio 40% 30%
Processing time required
on machine A1 per unit 1.00 min. 0.50 min.

In addition assume that:

 Machine A1 is the constrained resource and is being used

at 100% of its capacity.
 There is excess capacity on all other machines.
 Machine A1 has a capacity of 2,400 minutes per week.

Should Wellington co. focus its efforts on Product 1 or 2?

23
 24/11/2010

The key is the contribution margin per minute of the constrained

resource.
Product
1 2
Contribution margin per unit $ 24 $ 15
Time required to produce one unit ÷ 1.00 min. ÷ 0.50 min.
Contribution margin per minute $ 24 $ 30

Product 2 should be emphasized. Provides more valuable use of

the constrained resource machine A1, yielding a contribution
margin of $30 per minute as opposed to $24 for Product 1.

If there are no other considerations, the best plan would be to

produce to meet current demand for Product 2 and then use
remaining capacity to make Product 1.

Let’s see how this plan would work.

Let’s Our
Alloting seeConstrained
how this plan would
Resource work.A1)
(Machine

Weekly demand for Product 2 2,200 units

Time required per unit × 0.50 min.
Total time required to make
Product 2 1,100 min.

Total time available 2,400 min.

Time used to make Product 2 1,100 min.
Time available for Product 1 1,300 min.
Time required per unit ÷ 1.00 min.
Production of Product 1 1,300 units

24
 24/11/2010

According to the plan, we will produce 2,200 units

of Product 2 and 1,300 of Product 1. Our
contribution margin looks like this.

Product 1 Product 2
Production and sales (units) 1,300 2,200
Contribution margin per unit $ 24 $ 15
Total contribution margin $ 31,200 $ 33,000

The total contribution margin for Wellington Co. is $64,200.

25