Short Term Decisions.pptx FDSFWSAFASFASF

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1. Short-term decisions Relevant costs Decision-making scenarios Make or buy decisions Further processing and shutdown Joint costs and products Qualitative factors

2. Syllabus learning outcomes (1) Explain the concept of relevant costing. Identify and calculate relevant costs for a specific decision situation from given data. Explain and apply the concept of opportunity costs. Explain the issues surrounding make vs. buy and outsourcing decisions. Calculate and compare 'make' costs with 'buy-in' costs. Compare in-house costs and outsource costs of completing tasks and consider other issues surrounding this decision.

3. Syllabus learning outcomes (2) Apply relevant costing principles in situations involving shut down, one-off contracts and the further processing of joint products.

4. Chapter overview In this chapter, we look in depth at relevant costs and at how they should be applied in decision-making situations. We look at a variety of common short-run business decisions and consider how they can be dealt with using relevant costs as appropriate.

5. Chapter summary diagram Short-term decisions Relevant costs Future Cash flow Specific to decision Opportunity costs Decisions Accept or reject Make or buy Outsourcing Shut down Minimum price Further processing

6. Tackling the exam Relevant costing calculations can be examined in a variety of contexts. Eg further processing and whether to extend opening hours have been examined Issues around outsourcing decisions are a potential discussion requirement. Two basic types of decisions where relevant costs are used: Whether to do something or whether not to do it Selecting between two or more different options about what to do

7. Relevant costs (1) Relevant costs should be used when making business decisions.

8. Relevant costs (2) Relevant costs are future costs, incremental costs and cash flows. Avoidable costs are costs which would not be incurred if the activity to which they relate did not exist. A differential cost is the difference in total costs between alternatives. An opportunity cost is the benefit which would have been earned, but has been given up, by choosing one option instead of another.

9. Relevant costs (3) Relevant costs are: Incremental Cash Future They may also be: Opportunity costs

10. Relevant costs (4) Relevant costs are not: Apportioned Committed Sunk

11. Relevant costs (5) Other costs that are not relevant: General overheads Joint costs

12. Relevant costs (6) A controllable cost is one which can be directly influenced by a given manager within a given time span. Relevant cost of materials Not owned – current replacement cost Owned – will be replaced – current replacement cost Owned – will not be replaced; higher of current resale value and value if put to an alternative use

13. Not in inventories held In inventories held In continual use No other use Scarce Have to buy it If use will be replaced If use won't be replaced If use can't replace Relevant cost is... Current replacement cost Current replacement cost Current resale value Opportunity cost Relevant costs (7)

14. Relevant costs (8) Relevant cost of labour Direct labour cost plus contribution lost by diverting labour to make another product Non-relevant costs Sunk cost – a past (historical) cost which is not directly relevant in decision making Fixed costs – unless indication to the contrary, assume fixed costs are irrelevant and variable costs are relevant

15. Spare capacity Additional work can be undertaken Hire more staff Cannot hire more staff Relevant cost is... Nil Current rate of pay Variable cost and lost contribution Additional work cannot be undertaken Relevant costs (9) Full capacity

16. Question: Relevant cost A contract requires 400kg of X and 200kg of Y. The following data is available: X is no longer used by the company; Y is regularly used for other products/purposes within the business. Required What is the relevant cost of X and Y to be included in the contract cost? In inventory Historic cost Current purchase price Scrap value X 300 kg $2/kg $3/kg $2.20/kg Y 300 kg 50c/kg $2/kg $1.50/kg

17. Answer: Relevant cost (cont'd) Material Y – 200kg needed Inventory is regularly used Relevant cost = current purchase price 200  $2.00 $ 400

18. Answer: Relevant cost (cont'd) Material Y – 200kg needed Inventory is regularly used Relevant cost = current purchase price 200  $2.00 $ 400

19. Question: Labour cost A plc is deciding whether to undertake a new contract. 15 hours of labour are required for the contract. Labour is currently at full capacity producing X. Required What is the cost of using 15 hours of labour for the contract? Cost card for X $/unit Direct materials (10 kg @ $2) 20 Direct labour (5 hrs @ $6) 30 50 Selling price 75 Contribution 25

20. Answer: Labour cost Full capacity Relevant cost is variable cost and lost contribution. Lost contribution: 15 hours are needed so cannot make 3 units of X Variable cost Labour (15 hours @ $6) $ 75 90 165

21. Decision making scenarios (1) (a) Accept or reject (b) Make or buy (c) Outsource (d) Shutdown (e) Minimum price of an order/job/contract (f) Further processing decisions

22. Decision making scenarios (2) Accept projects with positive return. Reject those which are negative. However, negative projects may be accepted in order to: Undercut a competitor Gain market share Attract a new customer

23. Make or buy decisions (1) A make or buy problem is a decision about whether a company should make a product/carry out an activity with its own internal resources or Whether it should pay another organisation to make the product/carry out the activity. If no scarce resource: The relevant costs of the decision are the differential costs between making and buying.

24. Make or buy decisions (2) Buy in if cost effective. Other key considerations: Quality of bought in product Reliability of supplier Possibility of becoming dependent on supplier Likelihood of future price increases How to use spare capacity Confidentiality issues

25. Make or buy decisions (3) With scarce resources If an organisation has to subcontract because of insufficient in-house resources to produce everything that it needs, then the decision is not whether to make or buy. Instead, it is which items to make. Total costs are minimised if: The units bought have the lowest extra variable cost of buying (compared with making) per unit of scarce resource saved by buying.

26. Make or buy decisions (4) Example – limited labour hours A B Variable cost of making $16 $14 Variable cost of buying $20 $19 Extra variable cost of buying $4 $5 Labour hours saved by buying 2 2 Extra variable cost of buying per hour saved $2 $2.50 Priority for making in-house 2nd 1st

27. Make or buy decisions (5) Outsourcing The use of external suppliers for finished products, components or services Advantages of outsourcing Superior quality and efficiency Capital is freed up Greater capacity and flexibility to cope with changes in demand Useful if not enough work to keep internal staff fully occupied

28. Make or buy decisions (6) Disadvantages of outsourcing Reliability of supplier Loss of control and flexibility Effect on existing workforce Note that decisions about outsourcing are a form of 'make or buy' decision and basic principles are the same.

29. Question: Decision making Mars Co makes units Pluto & Jupiter, for which costs in the forthcoming year are expected to be as follows: Directly attributable fixed costs per annum and committed fixed costs: A sub-contractor has offered to supply units of P for $12 and J for $21. Should Mars make or buy the components? What other factors should be considered before making a decision? P J Production (units) 1,000 1,500 $ $ Direct materials 6 5 Direct labour 3 9 Variable production overheads 2 3 11 17 $ Incurred as a direct consequence of making P 1,500 Incurred as a direct consequence of making J 3,000 Other fixed costs (committed) 10,000 14,500

30. Answer: Decision making P J    $  $  Variable cost of making 11 17  Variable cost of buying 12 21 Extra cost of buying / unit 1   4

31. Answer: Decision making (cont'd) P J  Production (units) 1,000 1,500    $   $  Extra variable cost of buying (pa)  1,000  6,000  Fixed costs saved by buying  (1,500)  (3,000)  Extra total cost of buying  (500)  3,000 P should be bought. J should be made in house,

32. Further processing and shutdown (1) Further processing decisions Decision is whether to sell joint product at split-off or processed further before selling. A joint product should be processed further past the split-off point if additional sales revenue exceeds the relevant further processing costs. The apportionment of joint processing costs is irrelevant to the decision. Any short-term decision must consider qualitative factors related to the impact on employees, customers, competitors and suppliers.

33. Further processing and shutdown (2) Shut down problems involve decisions about whether to close down a product line, department or other activity, perhaps because it is making losses or running costs are too expensive. If the decision is to shut down, decide whether the closure should be permanent or temporary .

34. Further processing and shutdown (3) Calculate what is earned by the process at present (perhaps in comparison with others). Calculate what will be the financial consequences of closing down (selling machines, redundancy costs etc). Compare the results and act accordingly. Some fixed costs may no longer be incurred if the decision is to shutdown and they are therefore relevant to the decision.

35. Question: Shutdown Lewis Co manufactures three products, the Keir , the Lucy and the Gareth. Forecasted statements of profit or loss for next year are as follows: The directors are considering the closure of the Keir product line, due to the losses incurred. You obtain the following information. (1) Fixed production overheads consist of an apportionment of general factory overheads, based on 80% of direct materials cost. The remaining overheads are specific to the product concerned. (2) Selling costs are based on commission paid to sales staff. Required (a) Determine if the Keir product line should be closed down. (b) Suggest other factors that should be considered prior to a final decision. K L G Total $'000 $'000 $'000 $'000 Sales 600 300 200 1,100 Cost of production Materials 200 60 30 290 Labour 95 20 10 125 Variable overhead 75 10 5 90 Fixed overhead 200 50 80 330 Gross margin 30 160 75 265 Selling costs 40 20 15 75 Net margin (10) 140 60 190

36. Answer: Shutdown $'000 Lost revenue 600 Saved: Materials 200 Labour 95 Variable overheads 75 Fixed overheads (20%) 40 Selling costs 40 450 150 Keir should not be closed.

37. Answer: Shutdown (cont'd) $'000 Loss forecast (10) Fixed overheads (80%) 160 Net relevant contribution from Keir 150 Keir should not be closed.

38. Answer: Shutdown (cont'd) Other factors Product interdependencies Over 54% revenue lost – impact on customers and costs Capital costs such as asset write offs Redundancy costs Opportunity costs – are other decisions feasible such as altering commissions or purchases from suppliers Timing of decision

39. Question: Further processing Joint processing costs are $20,000. Required Which products should be processed further? Product Output Selling price at separation Selling price after separation Post separation costs X 2,500 3 5 10,000 Y 1,500 5 10 8,000 Z 2,000 8 15 12,000

40. Answer: Further processing Incremental revenue/unit Inc revenue Further costs Inc benefit/ (cost) Process further? X 2 5,000 10,000 (5,000) No

41. Answer: Further processing (cont'd) Incremental revenue/unit Inc revenue Further costs Inc benefit/ (cost) Process further? X 2 5,000 10,000 (5,000) No Y 5 7,500 8,000 (500) No

42. Answer: Further processing (cont'd) Incremental revenue/unit Inc revenue Further costs Inc benefit/ (cost) Process further? X 2 5,000 10,000 (5,000) No Y 5 7,500 8,000 (500) No Z 7 14,000 12,000 2,000 Yes

43. Joint costs and products Joint costs are sunk. They are not relevant when considering whether to process further. Joint costs can be apportioned based on: Quantities Sales value Net realisable value

44. Qualitative factors Don’t forget to consider the qualitative factors when making your decision.

45. Question: Relevant costing A company has received a special order for which it is considering the use of Material B which it has held in its inventory for some time. This inventory of 945kg was bought at $4.50 per kg. The special order requires 1,500kg of Material B. If the inventory is not used for this order, it would be sold for $2.75 per kg. The current price of Material B is $4.25 per kg. What is the total relevant cost of Material B for the special order? A $4,957.50 B $6,375 C $4,125 D $6,611.25

46. Answer: Relevant costing A. $4,957.50 Incremental purchases = (1,500 – 945)kg × $4.25 per kg = $2,358.75 Opportunity cost of materials already purchased = 945 kg × $2.75 = $2,598.75 Total relevant cost = $2,358.75 + $2,358.75 = $4,957.50

47. Belton Park (Q163 Mar/Jun 2019) Belton Park Resort is a new theme park resort located in the country of Beeland . The resort is made up of a theme park, a hotel and an indoor water park. The resort opened two months ago and is already very popular. As all theme parks in Beeland are required by law to shut down in the colder month of January because of the risk of accidents, Belton Park Resort must decide whether to shut down the whole resort or just the theme park. It could choose to keep open the hotel and/or the water park. Since Belton Park Resort has not been open for long, there is limited historical data available about costs and revenues.

48. Belton Park ( cont ) However, based on the last two months, the following average monthly data is available: Hotel   Number of rooms 120 Average room rate per night $100 Average occupancy rate per month 90% Average nightly spend on 'extras' per room $20 Contribution margin for 'extras'* 60% Water park   Number of visitors per month 12,000 Admission price per visitor $21 Average spend on 'extras' per visitor $12 Contribution margin for 'extras'* 60%

49. Belton Park ( cont ) *'Extras' includes anything purchased by the customer not included in the room rate or admission price. Management estimates that, for January, the average room rate per night would need to decrease by 30% and the admission price for the water park by 20%. With such reductions, it is estimated that an occupancy rate of 50% would be achieved for the hotel and that the number of visitors to the water park would be 52% lower than current levels. The average nightly spend on 'extras' per room of $20 at the hotel and $12 per customer at the water park is expected to remain unchanged.

50. Belton Park ( cont ) The running costs for the hotel and water park for each of the last two months are as follows:   Notes Hotel Water park     $ $ Staff costs 1 120,000 75,600 Maintenance costs 2 14,600 6,000 Power costs 3 20,000 18,000 Security costs 4 13,600 8,000 Water costs 5 12,900 12,100

51. Belton Park ( cont ) Notes (1) Staff costs Permanent staff Included in the staff costs for the hotel is the salary of $30,000 per annum for the hotel manager and $24,000 per annum for the head chef. These are both permanent members of staff who are paid for the full year regardless of their working hours. The water park employs one permanent member of staff, the manager, on a salary of $24,000 who is also paid for the full year regardless of his working hours.

52. Belton Park ( cont ) Temporary staff The remaining staff costs relate to temporary staff who are only paid for the hours they work. If the hotel stays open in January, half of these staff members will continue to work their current hours because their jobs are largely unaffected by guest occupancy rates. However, the other half of the staff will work proportionately less hours to reflect the 50% occupancy rate in January as opposed to the 90% occupancy rate of the last two months. At the water park, the temporary staff's working hours will fall according to the number of visitors, hence a fall of 52% would be expected for January.

53. Belton Park ( cont ) (2) Maintenance costs Maintenance is undertaken by a local company, ' Techworks ', which bills Belton Park Resort for all work carried out each month. If the hotel and water park are closed, Techworks will instead be paid a flat fee for the month of $4,000 for the hotel and $2,000 for the water park.

54. Belton Park ( cont ) (3) Power costs Electricity Belton Park Resort pays a fixed monthly charge for electricity of $8,000 for the hotel and $7,000 for the water park, all year round. Gas The gas charges relate to heating and include a fixed charge of $2,200 per month for the hotel and $1,500 per month for the water park. The remainder of the gas charges is based solely on usage and would be expected to increase by 50% in January because of the colder weather.

55. Belton Park ( cont ) (4) Security costs If the hotel and water park close, no changes will be made to the current arrangements for security whilst the premises are empty. (5) Water costs It is estimated that water costs for the hotel would fall to $6,450 for the month if it remains open in January. However, the water costs for the water park would be expected to remain at their current level. If the hotel and water park were closed, all water would be turned off and no charges would arise.

56. Belton Park ( cont ) Required Calculate the incremental cash flows, for the month of January (31 days), if Belton Park Resort decides to keep open: ( i ) The hotel (ii) The water park In each case, state whether it should remain open or should close. (15 marks) Discuss any other factors which Belton Park Resort should consider when making the decision in part (a). (5 marks) (Total = 20 marks)

57. Belton Park ( cont ) Hotel incremental revenue      $ Room revenue     Number of rooms  120   Number of nights  31   Total room nights  3,720   Occupancy rate  50%   Total nights occupied  1,860   Rate per night  $70   Total room revenue    130,200 Extras' contribution     Total nights occupied  1,860   Contribution per night  $12.00   Total 'extras' contribution     22,320 Total cash inflows    152,520

58. Belton Park ( cont ) Incremental running costs     Staff costs  $120,000   Less: manager's salary  ($2,500)   Less: chef's salary  ($2,000 )      $115,500   50% normal hours    57,750 50% at reduced hours  50/90    32,083 Maintenance costs:     If open  $14,600   If closed  $4,000   Incremental cost    10,600 Power costs:     Electric  $0   Gas – fixed charge  $0   Gas – variable ($20,000 – $10,200)  1·5    14,700 Security    0 Water     6,450 Total cash outflows    121,583 Total incremental cash flows     30,937

59. Belton Park ( cont )      $ Visitor revenue     Number of visitors  5,760   Admission cost  $16.80   Admission revenue    96,768 Extras' contribution     Number of visitors  5,760   Contribution per visitor  $7.20   Total contribution     41,472 Total cash inflows    138,240 Water park

60. Belton Park ( cont ) Incremental running costs     Staff costs:     Manager  $0   Other staff ($75,600 – $2,000)  48%    35,328 Maintenance costs:     If open  $6,000   If closed  ($2,000 )   Incremental cost    4,000 Power costs:     Electric  $0   Gas – fixed charge  $0   Gas – variable ($18,000 – $8,500)  1.5    14,250 Security    0 Water     12,100 Total cash outflows    65,678 Total incremental cash flows    72,562

61. Belton Park ( cont ) Conclusion Based on these figures, both of them should stay open because the incremental cash flows are both positive.

62. Belton Park ( cont ) (b). As regards the estimates calculated, these have been based on very limited data and should be approached with caution. The calculations are based on the first two months' of opening only and, consequently, it is difficult to say how accurate they are likely to be. In addition, the basis of estimating the revised occupancy rates for the hotel, for example, has not been given. If these estimates are too optimistic, the actual results could be far worse. The figures suggest that both the water park and the hotel should stay open. Given that this is a new business and therefore it is still building up its customer base, this would seem like a wise decision anyway, even if the calculations had shown that the estimated incremental cash flows were not as positive as this.

63. Belton Park ( cont ) Similarly, if Belton Park were to close either the hotel or the water park, they would invariably lose some valuable staff who might seek out other jobs after the closure. These staff might not be available again when the hotel and water park reopened in February. The interdependency of the two sets of projections has not been taken into account in the calculations either. Since the incremental cash flows suggest that both the hotel and the water park should stay open, it is not a big problem. However, if they had shown, for example, that the water park alone should close, the effect that this could have on the number of hotel visitors would also need to be taken into account. Many visitors may be attracted to the hotel because it has a water park.

64. Chapter summary (1) Relevant costs Decisions should be made on the basis of relevant costs. Relevant costs must be future, cash flows and specific to the decision. They may also be opportunity costs. Decision making scenarios Accept projects with positive return. Reject those which are negative. Negative projects, however, may be accepted in order to: Undercut a competitor Gain market share Attract a new customer

65. Chapter summary (2) Make or buy decisions A make or buy problem is a decision about whether a company should make a product/carry out an activity with its own internal resources; or Whether it should pay another organisation to make the product/carry out the activity. Further processing and shutdown A joint product should be processed further past the split-off point if the additional sales revenue exceeds the relevant further processing costs. Shut down problems involve decisions about whether to close down a product line, department or other activity, perhaps because it is making losses or running costs are too expensive.

66. Chapter summary (3) Joint costs and products Joint costs are sunk. They are not relevant when considering whether to process further. Qualitative factors Non-financial considerations should also be taken into account before making a final decision.

67. Recent exam questions Nature of question Exam details Explain the concept of relevant costing. Identify and calculate relevant costs for a specific decision situations from given data. Section B Mock exam 2 Q26-30 Specimen exam (10 marks) Section C Q163 Belton Park (Mar/Jun 19) (20 marks) Section C Q168 The Alka Hotel Mar/Jun 2018 (12 marks) Explain and apply the concept of opportunity costs. Explain the issues surrounding make vs buy and outsourcing decisions .

68. Recent exam questions Nature of question Exam details Calculate and compare ‘make’ costs with ‘buy-in’ costs . Compare in-house costs and outsource costs of completing tasks and consider other issues surrounding this decision . Apply relevant costing principles in situations involving shut down, one off contracts and the further processing of joint products . Section A Mock exam 3 Q6 Dec 2016 (2 marks) Section C Mock exam 1 Q32(a) Sep 2016 (6 marks)