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McGraw-Hill/Irwin
25-1
© The McGraw-Hill Companies, Inc., 2005
Capital Budgeting and Managerial Decisions
Chapter
2525
McGraw-Hill/Irwin
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© The McGraw-Hill Companies, Inc., 2005
1. Capital Budgeting Method Not using Time Value of Money
Method using Time Value of Money
2. Managerial Decision Decision and Information
Managerial Decision Scenarios
3. Decision Analysis Break-Even Time
Learning objectivesLearning objectives Exh. 25-5,6
McGraw-Hill/Irwin
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© The McGraw-Hill Companies, Inc., 2005
Capital budgeting:Analyzing alternative long-
term investments and deciding which assets to acquire or sell.
Outcomeis uncertain.
Large amounts ofmoney are usually
involved.
Investment involves along-term commitment.
Decision may bedifficult or impossible
to reverse.
1. Capital Budgeting- Risks of Capital Budgeting
1. Capital Budgeting- Risks of Capital Budgeting
McGraw-Hill/Irwin
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Paybackperiod
= Cost of Investment Annual Net Cash Flow
Method Not using Time Value of Money- Payback PeriodMethod Not using Time Value of Money- Payback Period
The payback period of an investmentis the time expected to recoverthe initial investment amount.
The payback period of an investmentis the time expected to recoverthe initial investment amount.
Managers prefer investing in projects with shorter payback periods.
Exh. 25-2
McGraw-Hill/Irwin
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FasTrac is considering buying a new machine that will be used in its manufacturing operations. The machine costs $16,000 and is expected to produce annual net cash flows
of $4,100. The machine is expected to have an 8-year useful life with no salvage value.
Calculate the payback period.
Paybackperiod
= Cost of Investment Annual Net Cash Flow
Paybackperiod
= $16,000
$4,100= 3.9 years
Payback Period with Even Cash FlowsPayback Period with Even Cash Flows
McGraw-Hill/Irwin
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In the previous example, we assumed that the increase in cash flows would be the same each year. Now, let’s look at an
example where the cash flows vary each year.
$4,100
$5,000
Payback Period with Uneven Cash FlowsPayback Period with Uneven Cash Flows
McGraw-Hill/Irwin
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FasTrac wants to install a machine
that costs $16,000 and has an 8-year
useful life with zero salvage
value. Annual net cash flows are:
YearAnnual Net Cash Flows
Cumulative Net Cash
Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 4,000 6 3,000 7,000 7 2,000 9,000 8 2,000 11,000
Payback Period with Uneven Cash FlowsPayback Period with Uneven Cash FlowsExh. 25-3
McGraw-Hill/Irwin
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YearAnnual Net Cash Flows
Cumulative Net Cash
Flows0 (16,000)$ (16,000)$ 1 3,000 (13,000) 2 4,000 (9,000) 3 4,000 (5,000) 4 4,000 (1,000) 5 5,000 4,000 6 3,000 7,000 7 2,000 9,000 8 2,000 11,000
4.2
We recover the $16,000purchase price between
years 4 and 5, about4.2 years for the payback period.
Payback Period with Uneven Cash FlowsPayback Period with Uneven Cash FlowsExh. 25-3
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Ignores the time valueof money.
Ignores cashflows after the payback
period.
Unacceptable forprojects with longlives where time
value ofmoney effects
are major.
Using the Payback PeriodUsing the Payback Period
McGraw-Hill/Irwin
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Consider two projects, each with a five-year lifeand each costing $6,000.
Project One Project TwoNet Cash Net Cash
Year Inflows Inflows
1 2,000$ 1,000$ 2 2,000 1,000 3 2,000 1,000 4 2,000 1,000 5 2,000 1,000,000
Would you invest in Project One just because it has a shorter payback period?
Using the Payback PeriodUsing the Payback Period
McGraw-Hill/Irwin
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The accounting rate of return focuses onannual income instead of cash flows.
Method Not using Time Value of Money- Accounting Rate of ReturnMethod Not using Time Value of Money- Accounting Rate of Return
Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Beginning book value + Ending book value2
Exh. 25-5,6
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Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Beginning book value + Ending book value2
Accounting Rate of ReturnAccounting Rate of Return Exh. 25-5,6
McGraw-Hill/Irwin
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Accounting Annual after-tax net incomerate of return Annual average investment
Accounting Annual after-tax net incomerate of return Annual average investment
=
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Accounting Rate of ReturnAccounting Rate of Return
Beginning book value + Ending book value2
Exh. 25-5,6
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Accounting $2,100rate of return $8,000
Accounting $2,100rate of return $8,000
= = 26.25%
$16,000 + $02
Accounting Rate of ReturnAccounting Rate of Return
Reconsider the $16,000 investment being considered by FasTrac. The annual after-tax net income is $2,100. Compute the
accounting rate of return.
Exh. 25-5,6
McGraw-Hill/Irwin
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Depreciation may be calculated several ways.
Income may vary from year to year.
Time value ofmoney is ignored.
So why would I ever want to use this method
anyway?
Using Accounting Rate of ReturnUsing Accounting Rate of Return
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Future value of $100 today compounded for 5 years at 10 percent.
TodayToday 11 22 33 44 FutureFuture
FV FV = $161= $161
$100$100
Compound at 10%
$110$110 $121$121 $133$133 $146$146
× 1.1
× 1.1
× 1.1
× 1.1
× 1.1
Method using Time Value of Money - Time Value of MoneyMethod using Time Value of Money - Time Value of Money
McGraw-Hill/Irwin
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Present value of $100 paid in 5 years discounted at 10 percent.
TodayToday 11 22 33 44 FutureFuture
PV = PV = $62.1$62.1
$100$100
Discount at 10%
90.990.982.682.675.175.168.368.3
÷1.1÷1.1÷1.1÷1.1÷1.1
Method using Time Value of Money - Present ValueMethod using Time Value of Money - Present Value
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Method using Time Value of Money - Present Value TableMethod using Time Value of Money - Present Value Table
Periods 6% 8% 10% 12% 25 0.2330 0.1460 0.0923 0.0588 30 0.1741 0.0994 0.0573 0.0334 35 0.1301 0.0676 0.0356 0.0189
PV = $1,000 X 0.0994 = $99.4
The government will pay you $1,000 30 years later. There is no annual interest payment. If the market interest rate is 8%, how much is the price for the
bond? (using Table I)
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Now let’s look at a capital budgeting modelthat considers the time value of cash flows.
Method using Time Value of Money - Net Present ValueMethod using Time Value of Money - Net Present Value
McGraw-Hill/Irwin
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Discount the future net cash flows from the investment at the required rate of return.
Subtract the initial amount invested from sum of the discounted cash flows.
FasTrac is considering the purchase of a conveyor costing $16,000 with an 8-year useful life with zero salvage value that promises annual net cash flows of $4,100. FasTrac requires a 12 percent compounded annual return on its
investments.
Net Present ValueNet Present Value
McGraw-Hill/Irwin
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YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
Net Present Value with Even Cash FlowsNet Present Value with Even Cash FlowsExh. 26-7
McGraw-Hill/Irwin
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YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
Present value factorsfor 12 percent
Net Present Value with Even Cash FlowsNet Present Value with Even Cash FlowsExh. 26-7
McGraw-Hill/Irwin
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YearAnnual Net Cash Flows
Present Value of $1
Factor
Present Value of
Cash Flows1 4,100$ 0.8929 3,661$ 2 4,100 0.7972 3,269 3 4,100 0.7118 2,918 4 4,100 0.6355 2,606 5 4,100 0.5674 2,326 6 4,100 0.5066 2,077 7 4,100 0.4523 1,854 8 4,100 0.4039 1,656
Total 32,800$ 20,367$
Amount to be invested (16,000) Net present value of investment 4,367$
A positive net present value indicates that thisproject earns more than 12 percent on the investment.
Net Present Value with Even Cash FlowsNet Present Value with Even Cash FlowsExh. 26-7
McGraw-Hill/Irwin
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General decision rule . . .If the Net Present
Value is . . . Then the Project is . . .
Positive . . . Acceptable, since it promises areturn greater than the required
rate of return.
Zero . . . Acceptable, since it promises areturn equal to the required rate
of return.
Negative . . . Not acceptable, since it
promises a return less than therequired rate of return.
Using Net Present ValueUsing Net Present Value
McGraw-Hill/Irwin
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PresentVa lue of
Net Cash Flow s $1 Factor PV of Net Cash Flow sYear A B C at 10% A B C
1 5,000$ 8,000$ 1,000$ 0.9091 4,546$ 7,273$ 909$ 2 5,000 5,000 5,000 0.8264 4,132 4,132 4,132 3 5,000 2,000 9,000 0.7513 3,757 1,503 6,762
Tota l 15,000$ 15,000$ 15,000$ 12,435$ 12,908$ 11,803$
Amount invested (12,000) (12,000) (12,000) Net Present Va lue 435$ 908$ (197)$
Although all projects require the same investment and havethe same total net cash flows, project B has a higher net present
value because of a larger net cash flow in year 1.
Net Present Value with Uneven Cash FlowsNet Present Value with Uneven Cash Flows
Exh. 26-8
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Method using Time Value of Money - Internal Rate of Return (IRR)Method using Time Value of Money - Internal Rate of Return (IRR)
The interest rate that makes . . .
Presentvalue of
cash inflows
Presentvalue of
cash outflows=
The net present value equal zero.
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Projects with even annual cash flows
Project life = 3 yearsInitial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.
1. Compute present value factor.
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
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1. Compute present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Projects with even annual cash flows
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
Project life = 3 yearsInitial cost = $12,000
Annual net cash inflows = $5,000
Determine the IRR for this project.
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
Locate the rowwhose number
equals the periods in theproject’s life.
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
In that row,locate the
interest factorclosest in
amount to thepresent value
factor.
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
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Periods 10% 12% 14%1 0.90909 0.89286 0.87719 2 1.73554 1.69005 1.64666 3 2.48685 2.40183 2.32163 4 3.16987 3.03735 2.91371 5 3.79079 3.60478 3.43308
1. Determine the present value factor. $12,000 ÷ $5,000 per year = 2.4000
2. Using present value of annuity table . . .
IRR is theinterest rate
of the columnin which the
present valuefactor is found.
IRR isapproximately
12%.
Internal Rate of Return (IRR)Internal Rate of Return (IRR) Exh. 26-9
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If cash inflows are unequal, trial and error solution will result if present value tables
are used.
Sophisticated business calculators and electronic spreadsheets can be used to
easily solve these problems.
Internal Rate of Return – Uneven Cash FlowsInternal Rate of Return – Uneven Cash Flows
McGraw-Hill/Irwin
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Internal Rate of Return Compare the internal rate
of return on a project to a predetermined hurdle rate (cost of capital).
To be acceptable, a project’s rate of return cannot be less than thecost of capital.
Using Internal Rate of ReturnUsing Internal Rate of Return
McGraw-Hill/Irwin
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Exh. 25-10
Payback Accounting Net present Internal rateperiod rate of return value of return
Basis of Cash Accrual Cash flows Cash flowsmeasurement flows income Profitability Profitability
Measure Number Percent Dollar Percentexpressed as of years Amount
Easy to Easy to Considers time Considers timeUnderstand Understand value of money value of money
Strengths Allows Allows Accommodates Allowscomparison comparison different risk comparisons
across projects across projects levels over of dissimilara project's life projects
Doesn't Doesn't Difficult to Doesn't reflectconsider time consider time compare varying risk
value of money value of money dissimilar levels over theLimitations projects project's life
Doesn't Doesn't giveconsider cash annual rates
flows after over the lifepayback period of a project
Comparing Methods
McGraw-Hill/Irwin
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Let’s change topics.
2. Managerial Decisions2. Managerial Decisions
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Decision making involves five steps: Define the problem. Identify alternatives. Collect relevant information on
alternatives. Select the preferred alternative. Analyze decisions made.
Decision and Information- Decision MakingDecision and Information- Decision Making Exh.
25-11
McGraw-Hill/Irwin
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Costs that are applicableto a particular decision.
Costs that should have a bearing on which alternative a manager selects.
Costs that are avoidable.Future costs that differ
between alternatives.
1
2
Decision and Information- Relevant CostsDecision and Information- Relevant Costs
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All costs incurred in the past that cannot be changed by any decision made now or in the future.
Sunk costs should not be considered in decisions.
All costs incurred in the past that cannot be changed by any decision made now or in the future.
Sunk costs should not be considered in decisions.
Classification by Relevance:Sunk CostsClassification by Relevance:Sunk Costs
Example: You bought an automobile that cost$10,000 two years ago. The $10,000 cost is sunkbecause whether you drive it, park it, trade it, or sellit, you cannot change the $10,000 cost.
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Future outlays of cash associatedwith a particular decision.
Future outlays of cash associatedwith a particular decision.
Example: Considering the decision to take a vacation or stay at home, you will have travel costs (out-of-pocket costs) only if you choose a vacation.
Classification by Relevance:Out-of-Pocket CostsClassification by Relevance:Out-of-Pocket Costs
McGraw-Hill/Irwin
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The potential benefit that is given up when one alternative is selected over another.Example: If you were
not attending college,you could be earning$20,000 per year. Your opportunity costof attending college for one year is $20,000.
Classification by Relevance: Opportunity CostsClassification by Relevance: Opportunity Costs
McGraw-Hill/Irwin
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We will now examine several
different types of managerial
decisions.
2. Managerial Decisions - Managerial Decision Tasks2. Managerial Decisions - Managerial Decision Tasks
McGraw-Hill/Irwin
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The decision to accept additional business should be based on incremental
costs and incremental revenues.
Incremental amounts are those that occur if the company decides to accept the new
business.
Managerial Decision Tasks - Accepting Additional BusinessManagerial Decision Tasks - Accepting Additional Business
McGraw-Hill/Irwin
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FasTrac currently sells 100,000 units of its product. The company has revenue and costs as shown below:
Per Unit Total Sales 10.00$ 1,000,000$ Direct materials 3.50 350,000 Direct labor 2.20 220,000 Factory overhead 1.10 110,000 Selling expenses 1.40 140,000 Administrative expenses 0.80 80,000 Total expenses 9.00$ 900,000$ Operating income 1.00$ 100,000$
Accepting Additional BusinessAccepting Additional Business Exh. 25-12
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FasTrac is approached by an overseascompany that offers to purchase10,000 units at $8.50 per unit.
If FasTrac accepts the offer, total factory overhead will increase by $5,000; total selling
expenses will increase by $2,000; and total administrative expenses will increase
by $1,000.
Should FasTrac accept the offer?
Accepting Additional BusinessAccepting Additional Business
McGraw-Hill/Irwin
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First let’s look at incorrect reasoningthat leads to an incorrect decision.
First let’s look at incorrect reasoningthat leads to an incorrect decision.
Our cost is $9.00per unit. I can’t sell for $8.50 per unit.
Accepting Additional BusinessAccepting Additional Business
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Current Business
Additional Business Combined
Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses 900,000$ 65,000$ 965,000$ Operating income 100,000$ 20,000$ 120,000$
10,000 new units × $8.50 selling price = $85,000
10,000 new units × $3.50 = $35,000
10,000 new units × $2.20 = $22,000
This analysis leads to the correct decision.
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Current Business
Additional Business Combined
Sales 1,000,000$ 85,000$ 1,085,000$ Direct materials 350,000$ 35,000$ 385,000$ Direct labor 220,000 22,000 242,000 Factory overhead 110,000 5,000 115,000 Selling expenses 140,000 2,000 142,000 Admin. expenses 80,000 1,000 81,000 Total expenses 900,000$ 65,000$ 965,000$ Operating income 100,000$ 20,000$ 120,000$
Even though the $8.50 selling price is less than thenormal $10 selling price, FasTrac should accept theoffer because net income will increase by $20,000.
Accepting Additional BusinessAccepting Additional Business Exh. 25-14
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Incremental costs also are important in the decision to make a product or purchase it from a supplier.
The cost to produce an item must include (1) direct materials, (2) direct labor and (3) incremental overhead.
We should not use the predetermined overhead rate to determine product cost.
Managerial Decision Tasks - Make or Buy DecisionsManagerial Decision Tasks - Make or Buy Decisions
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Cost to Make Part #417
MakeDirect materials 0.45$Direct labor 0.50 Factory overhead 0.50
Total cost to make 1.45$
FasTrac currently makes part #417, assigning overhead at 100 percent of direct labor cost, with
the following unit cost:
Make or Buy DecisionsMake or Buy Decisions
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Make vs. Buy Analysis
Make BuyDirect materia ls 0.45$ ----Direct labor 0.50 ----Factory overhead ? ----Purchase price ---- 1.20$Tota l incremental costs ? 1.20$
FasTrac can buy part #417 from a supplier for $1.20. How much overhead do we have to eliminate before we
can continue to make this part?
Make or Buy DecisionsMake or Buy Decisions Exh. 25-15
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Make vs. Buy Analysis
Make BuyDirect materia ls 0.45$ ----Direct labor 0.50 ----Factory overhead 0.25 ----Purchase price ---- 1.20$Tota l incremental costs 1.20 1.20$
FasTrac can buy part #417 from a supplier for $1.20. How much overhead do we have to eliminate before we
can continue to make this part?
We must eliminate $.25 per unit of overhead,leaving a maximum of $0.25 per unit.
Make or Buy DecisionsMake or Buy Decisions Exh. 25-15
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Make or Buy DecisionsMake or Buy Decisions
The company currently makes 1,000 units of part #417. The incremental factory overhead is $100. The overhead per unit is $0.1. (Make)
The company currently makes 1,000 units of part #417. The incremental factory overhead is $500. The overhead per unit is $0.5. (Buy)
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Costs incurred in manufacturing units of product that do not meet quality standards are sunk costs and cannot be recovered.
As long as rework costs are recovered through sale of the product, and rework does not interfere with normal production, we should rework rather than scrap.
Managerial Decision Tasks - Scrap or ReworkManagerial Decision Tasks - Scrap or Rework
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FasTrac has 10,000 defective units thatcost $1.00 each to make. The units can be
scrapped now for $.40 each or reworked at an additional cost of $.80 per unit.
If reworked, the units can be sold for the normal selling price of $1.50 each. Reworking the
defective units will prevent the production of 10,000 new units that would also sell for $1.50.
Should FasTrac scrap or rework?
Scrap or ReworkScrap or Rework
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Scrap Now Rework
Sale of Defects 4,000$ 15,000$ Less rework costs - (8,000) Less opportunity cost - (5,000) Net return 4,000$ 2,000
10,000 units × $0.80 per unit
10,000 units × ($1.50 - $1.00) per unit
Scrap or ReworkScrap or Rework Exh. 25-16
If FasTrac fails to include the opportunity cost,the rework option would show a return of $7,000,
mistakenly making rework appear more favorable.
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Businesses are often faced with the decision to sell partially completed products or to process them to completion.
As a general rule, , we process further only if incremental revenues exceed incremental costs.
Managerial Decision Tasks - Sell or ProcessManagerial Decision Tasks - Sell or Process
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FasTrac has 40,000 units of partially finished product Q. Processing costs to date are $30,000. The 40,000
unfinished units can be sold as is for $50,000 or they can be processed further to produce finished
products X, Y, and Z. The additional processing will cost $80,000 and result in the following revenues:
Continue
Sell or ProcessSell or Process
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Product Price Units Revenue
X 4.00$ 10,000 40,000$ Y 6.00 22,000 132,000 Z 8.00 6,000 48,000
Spoilage - 2,000 - Total 40,000 220,000$
Should FasTrac sell product Q or continueprocessing into products X, Y, and Z?
Sell or ProcessSell or Process Exh. 25-17
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Product Price Units Revenue
X 4.00$ 10,000 40,000$ Y 6.00 22,000 132,000 Z 8.00 6,000 48,000
Spoilage - 2,000 - Total 40,000 220,000$
FasTrac should continue processing. Note that the earlier $30,000cost for product Q is sunk and therefore irrelevant to the decision.
Sell or ProcessSell or Process
Should FasTrac sell product Q or continueprocessing into products X, Y, and Z?
Exh. 25-17,18
Revenue if processed $220,000 Revenue if sold directly (50,000) Incremental revenue 170,000 Cost if processed (80,000)Incremental net income $ 90,000
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When a company sells a variety of products, some are likely to be more profitable than others.
To make an informed decision, management must consider . . . The contribution margin of each product, The facilities required to produce each product and any
constraints on the facilities, and The demand for each product.
If there is constraints on the facilities, then decision is based on contribution margin of constraint factor
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Consider the following data for two products made and sold by FasTrac.
Per unit amounts Product
A Product
B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$
If each product requires the same time tomake, and the demand is unlimited, FasTrac
should produce only Product B.
Sales Mix SelectionSales Mix Selection Exh. 25-19
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Consider this additional information.
Consider the following data for two products made and sold by FasTrac.
Sales Mix SelectionSales Mix Selection Exh. 25-19
Per unit amounts Product
A Product
B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$ Machine hours required toproduce one unit 1.0 2.0 Contribution per machine hour 1.50$ 1.00$
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Per unit amounts Product
A Product
B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$ Machine hours required toproduce one unit 1.0 2.0 Contribution per machine hour 1.50$ 1.00$
Consider the following data for two products made and sold by FasTrac.Product B has a greater
contribution margin thanProduct A, but it
requires more machine hours per unit to produce.
With unlimited demand for A and B, produce as many units of A as possible since A provides more dollars per hour worked.
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Per unit amounts Product
A Product
B Selling price 5.00$ 7.50$ Variable costs 3.50 5.50 Contribution margin 1.50$ 2.00$ Machine hours required toproduce one unit 1.0 2.0 Contribution per machine hour 1.50$ 1.00$
If demand for A is limited, produce to meet that demand, then use the remaining facilities to produce B.
Consider the following data for two products made and sold by FasTrac.
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FasTrac is considering eliminating its TreadmillDivision because total expenses of $48,300 are
greater than its sales of $47,800.
A segment is a candidate for elimination if its revenues are less than its
avoidable expenses.
Continue
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TotalExpenses
Cost of goods sold 30,200$ Direct expenses: Salaries 7,900 Equipment depreciation 200 Indirect expenses: Rent and utilities 3,150 Advertising 200 Insurance 400 Service department costs: Departmental office 3,060 Purchasing 3,190 Total 48,300$
Let’s identifyavoidable expenses.
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Total Avoidable UnavoidableExpenses Expenses Expenses
Cost of goods sold 30,200$ 30,200$ Direct expenses: Salaries 7,900 7,900 Equipment depreciation 200 200$ Indirect expenses: Rent and utilities 3,150 3,150 Advertising 200 200 Insurance 400 300 100 Service department costs: Departmental office 3,060 2,200 860 Purchasing 3,190 1,000 2,190 Total 48,300$ 41,800$ 6,500$
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Sales 47,800$ Avoidable expenses 41,800 Decrease in incom e 6,000$
Sa les 47,800$ Avoidable expenses 41,800 Decrease in incom e 6,000$
Do not eliminatethe Treadmill Division!
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Qualitative factors are involved in most all managerial decisions. For example:
Quality. Delivery schedule. Supplier reputation. Employee morale. Customer opinions.
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Break-even time incorporates time valueof money into the payback period method
of evaluating capital investments.
Break-even time incorporates time valueof money into the payback period method
of evaluating capital investments.
3. Decision Analysis - Break-Even Time3. Decision Analysis - Break-Even Time