Special Business Decisions and Capital Budgeting

Special Business
Decisions
and Capital Budgeting
Chapter
26
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

Objective 1
Identify the relevant information

for a special business decision.

Relevant Information
for Decision Making
 Relevant information has two distinguishing
characteristics.
ItIt isis expected
expected future
future data
data that
that
differs
differs among
among alternatives.
alternatives.
Only
Only relevant
relevant data
data affect
affect decisions.
decisions.

Objective 2
Make five types of short-term

special business decisions.

Special Sales Order
 A. B. Fast is a manufacturer of automobile

parts located in Texas.
 Ordinarily A. B. Fast sells oil filters for
$3.22 each.
 R. Pino and Co., from Puerto Rico, has
offered $35,400 for 20,000 oil filters, or
$1.77 per filter.

Special Sales Order
 A. B. Fast’s manufacturing product cost is $2

per oil filter which includes variable
manufacturing costs of $1.20 and fixed
manufacturing overhead of $0.80.
 Suppose that A. B. Fast made and sold
250,000 oil filters before considering the
special order.
 Should A. B. Fast accept the special order?
Special Sales Order
 The $1.77 offered price will not cover the $2

manufacturing cost.
 However, the $1.77 price exceeds variable
manufacturing costs by $.57 per unit.
 Accepting the order will increase A. B. Fast’s
contribution margin.
 20,000 units × $.57 contribution margin per
unit = $11,400

Dropping Products,
Departments, Territories
 Assume that A. B. Fast already is operating at
the 270,000 unit level (250,000 oil filters and
20,000 air cleaners).
 Suppose that the company is considering
dropping the air cleaner product line.
 Revenues for the air cleaner product line are
$41,000.
 Should A. B. Fast drop the air cleaner line?

Dropping Products,
 Variable selling and administrative expenses
are $0.30 per unit.
 Variable manufacturing expenses are $1.20
per unit.
 Total fixed expenses are $335,000.
 Total fixed expenses will continue even if
the product line is dropped.

Dropping Products,
Product Line
Oil Filters Air Cleaners Total
Units 250,000 20,000 270,000
Sales $805,000 $ 41,000 $846,000
Variable expenses 375,000 30,000 405,000
Contribution margin $430,000 $ 11,000 $441,000
Fixed expenses 310,185 24,815 335,000
Operating income/(loss) $119,815 ($13,815) $106,000
©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1

Dropping Products,
 To measure product-line operating income,
A. B. Fast allocates fixed expenses in
proportion to the number of units sold.
 Total fixed expenses are $335,000 ÷ 270,000
units, or $1.24 fixed unit cost.
 Fixed expenses allocated to the air cleaner
product line are 20,000 units × $1.24 per unit,
or $24,815.
Dropping Products,
Oil Filters Alone

Units 250,000
Sales $805,000
Variable expenses 375,000
Contribution margin 430,000
Fixed expenses 335,000
Operating income $ 95,000

Dropping Products,
 Suppose that the company employs a supervisor
for $25,000.
 This cost can be avoided if the company stops
producing air cleaners.
 Should the company stop producing air
cleaners?
 Yes!
 $11,000 – $25,000 = ($14,000)

Product Mix
 Companies must decide which products to

emphasize if certain constraints prevent
unlimited production or sales.
 Assume that A. B. Fast produces oil filters
and windshield wipers.
 The company has 2,000 machine hours
available to produce these products.

Product Mix
A. B. Fast can produce 5 oil filters in one hour

or 8 windshield wipers.
Product
Oil Windshield
Per Unit Filters Wipers
Sales price $3.22 $13.50
Variable expenses 1.50 12.00
Contribution margin $1.72 $ 1.50
Contribution margin ratio 53% 11%
Product Mix
Which product should A. B. Fast emphasize?

Oil filters:
$1.72 contribution margin per unit × 5 units per hour
= $8.60 per machine hour
Windshield wipers:
$1.50 contribution margin per unit × 8 units per hour
= $12.00 per machine hour

Outsourcing (Make or Buy)
 A. B. Fast is considering the production of

a part it needs, or using a model produced
by C. D. Enterprise.
 C. D. Enterprise offers to sell the part for
$0.37.
 Should A. B. Fast manufacture the part or
buy it?

A. B. Fast has the following costs for

250,000 units of Part no. 4:
Part no. 4 costs: Total
Direct materials $ 40,000
Direct labor 20,000
Variable overhead 15,000
Fixed overhead 50,000
Total $125,000
$125,000 ÷ 250,000 units = $0.50/unit
 Assume that by purchasing the part, A. B.

Fast can avoid all variable manufacturing
costs and reduce fixed costs by $15,000
(fixed costs will decrease to $35,000).
 A. B. Fast should continue to manufacture
the part.
 Why?

Purchase cost (250,000 × $0.37) $ 92,500

Fixed costs that will continue 35,000
Total $127,500
$127,500 – $125,000 = $2,500, which is the
difference in favor of manufacturing the part.
The unit cost is then $0.51

($127,500 ÷ 250,000).
Best Use of Facilities
 Assume that if A. B. Fast buys the part from

C. D. Enterprise, it can use the facilities
previously used to manufacture Part no. 4 to
produce gasoline filters.
 The expected annual profit contribution of
the gasoline filters is $17,000.
 What should A. B. Fast do?

Best Use of Facilities
Expected cost of obtaining 250,000 parts:

Make part $125,000
Buy part and leave facilities idle $127,500
Buy part and use facilities for gas filters $110,500*
*Cost of buying part: $127,500 less
$17,000 contribution from gasoline filters.

Sell As-Is Or Process Further
 The sell as-is or process further is a decision

whether to incur additional manufacturing
costs and sell the inventory at a higher price,
– or sell the inventory as-is at a lower price.
 Suppose that A. B. Fast spends $500,000 to
produce 250,000 oil filters.
 A. B. Fast can sell these filters for $3.22 per
filter, for a total of $805,000.

 Alternatively, A. B. Fast can further process

these filters into super filters at an additional
cost of $25,000, which is $0.10 per unit
($25,000 ÷ 250,000 = $0.10).
 Super filters will sell for $3.52 per filter for a
total of $880,000.
 Should A. B. Fast process the filters into
super filters?
 A. B. Fast should process further, because

the $75,000 extra revenue ($880,000 –
$805,000) outweighs the $25,000 cost of
extra processing.
 Extra sales revenue is $0.30 per filter.
 Extra cost of additional processing is $0.10
per filter.

Cost to produce 250,000 parts: $500,000

Sell these parts for $3.22 each: $805,000
Cost to process original parts further: $ 25,000

Sell these parts for $3.52 each: $880,000
Sales increase ($880,000 – $805,000) $ 75,000

Less processing cost 25,000
Net gain by processing further $ 50,000
Objective 3
Explain the difference between

correct analysis and incorrect
analysis of a particular
business decision.

Correct Analysis
 A correct analysis of a business decision

focuses on differences in revenues and
expenses.
 The contribution margin approach, which is
based on variable costing, often is more
useful for decision analysis.
 It highlights how expenses and income are
affected by sales volume.
Incorrect Analysis
 The conventional approach to decision

making, which is based on absorption
costing, may mislead managers into treating
a fixed cost as a variable cost.
 Absorption costing treats fixed
manufacturing overhead as part of the unit
cost.

Objective 4
Use opportunity costs

in decision making.

Opportunity Cost...
– is the benefit that can be obtained from the

next best course of action.
 Opportunity cost is not an outlay cost, so it
is not recorded in the accounting records.
 Suppose that A. B. Fast is approached by a
customer that needs 250,000 regular oil
filters.

Opportunity Cost
 The customer is willing to pay more than

$3.22 per filter.
 A. B. Fast’s managers can use the $855,000
($880,000 – $25,000) opportunity cost of not
further processing the oil filters to determine
the sales price that will provide an equivalent
income.
 $855,000 ÷ 250,000 units = $3.42
Objective 5
Use four capital budgeting

models to make longer-term
investment decisions.

Capital Budgeting...
– is a formal means of analyzing long-range

capital investment decisions.
 The term describes budgeting for the
acquisition of capital assets.
 Capital assets are assets used for a long
period of time.

Capital Budgeting
 Capital budget models using net cash inflow

from operations are:
– payback
– accounting rate of return
– net present value
– internal rate of return

Payback...
– is the length of time it takes to recover, in

net cash inflows from operations, the dollars
of capital outlays.
 An increase in cash could result from an
increase in revenues, a decrease in expenses,
or a combination of the two.
1 2 3
4 5 6 7 8 9 10
11 12 13 14 15 16 17
18 19 20 21 22 23 24
25 26 27 28 29 30 31

Payback Example
 Assume that A. B. Fast is considering the

purchase of a machine for $200,000, with
an estimated useful life of 8 years, and zero
predicted residual value.
 Managers expect use of the machine to
generate $40,000 of net cash inflows from
operations per year.

Payback Example
 How long would it take to recover the

investment?
 $200,000 ÷ $40,000 = 5 years
 5 years is the payback period.

Payback Example
 When cash flows are uneven, calculations

must take a cumulative form.
 Cash inflows must be accumulated until the
amount invested is recovered.
 Suppose that the machine will produce net
cash inflows of $90,000 in Year 1, $70,000
in Year 2, and $30,000 in Years 3 through 8.

Payback Example
 What is the payback period?

 Years 1, 2, and 3 together bring in $190,000.
 Recovery of the amount invested occurs
during Year 4.
 Recovery is 3 years + $10,000.
 3 years + ($10,000 ÷ $30,000) = 3 years and
4 months

Accounting Rate of Return...
– measures profitability.
 It measures the average return over the life
of the asset.
 It is computed by dividing average annual
operating income by the average amount of
investment in the asset.

Accounting Rate of Return
Example
 Assume that a machine costs $200,000, has no
residual value, and has a useful life of 8 years.
 How much is the straight-line depreciation per
year?
 $25,000
 Management expects the machine to generate
annual net cash inflows of $40,000.

Accounting Rate of Return
Example
 How much is the average operating income?
 $40,000 – $25,000 = $15,000
 How much is the average investment?
 $200,000 ÷ 2 = $100,000
 What is the accounting rate of return?
 $15,000 ÷ $100,000 = 15%

Discounted Cash-Flow Models
 Discounted cash-flow models take into

account the time value of money.
 The time value of money means that a dollar
invested today can earn income and become
greater in the future.
 These methods take those future values and
discount them (deduct interest) back to the
present.
Net Present Value
 The (NPV) method computes the expected net

monetary gain or loss from a project by
discounting all expected cash flows to the present.
 The amount of interest deducted is determined by
the desired rate of return.
 This rate of return is called the discount rate,
hurdle rate, required rate of return, or cost of
capital.

Net Present Value Example
 A. B. Fast is considering an investment of

$450,000.
 This proposed investment will yield periodic
net cash inflows of $225,000, $230,000, and
$210,000 over its life.
 A. B. Fast expects a return of 16%.
 Should the investment be made?

Net Present Value Example
Periods Amount PV Factor Present Value

0 ($450,000) 1.000 ($450,000)
1 225,000 0.862 193,950
2 230,000 0.743 170,890
3 210,000 0.641 134,610
Total PV of net cash inflows $499,450
Net present value of project $ 49,450

Internal Rate of Return...
– is another model using discounted cash

flows.
 The internal rate of return (IRR) is the rate
of return that a company can expect to earn
by investing in a project.
 The higher the IRR, the more desirable the
investment.

Internal Rate of Return
 The IRR is the rate of return at which the net

present value equals zero.
 Investment = Expected annual net cash
inflow × PV annuity factor
 Investment ÷ Expected annual net cash
inflow = PV annuity factor

Internal Rate of Return Example
 Assume that A. B. Fast is considering

investing $500,000 in a project that will
yield net cash inflows of $152,725 per year
over its 5-year life.
 What is the IRR of this project?
 $500,000 ÷ $152,725 = 3.274 (PV annuity
factor)

Internal Rate of Return Example
 The annuity table shows that 3.274 is in the

16% column for a 5-period row in this
example.
 Therefore, 16% is the internal rate of return
of this project.
 If the minimum desired rate of return is 16%
or less, A.B. Fast should undertake this
project.
Objective 6
Compare and contrast popular

capital budgeting methods.

Comparison of Capital
Budgeting Models
 The discounted cash-flow models, net
present value, and internal rate of return are
conceptually superior to the payback and
accounting rate of return models.
 Strengths of the payback include:
 It is easy to calculate, highlights risks, and is
based on cash flows.

Comparison of Capital
Budgeting Models
 Its weaknesses are that it ignores cash flows
beyond the payback, the time value of
money, and profitability.
 The strength of the accounting rate of return
is that it is based on profitability.
 Its weakness is that it ignores the time value
of money.

End of Chapter
26

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Special Business

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

Identify the relevant information

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

Make five types of short-term

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

 A. B. Fast is a manufacturer of automobile

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

 A. B. Fast’s manufacturing product cost is $2

 The $1.77 offered price will not cover the $2

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 -

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1

Oil Filters Alone

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1

 Companies must decide which products to

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1

A. B. Fast can produce 5 oil filters in one hour

Which product should A. B. Fast emphasize?

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1

 A. B. Fast is considering the production of

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1

A. B. Fast has the following costs for

 Assume that by purchasing the part, A. B.

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 1

Purchase cost (250,000 × $0.37) $ 92,500

The unit cost is then $0.51

 Assume that if A. B. Fast buys the part from

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 2

Expected cost of obtaining 250,000 parts:

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 2

 The sell as-is or process further is a decision

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 2

 Alternatively, A. B. Fast can further process

 A. B. Fast should process further, because

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 2

Cost to produce 250,000 parts: $500,000

Cost to process original parts further: $ 25,000

Sales increase ($880,000 – $805,000) $ 75,000

Explain the difference between

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 2

 A correct analysis of a business decision

 The conventional approach to decision

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 2

Use opportunity costs

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 3

– is the benefit that can be obtained from the

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 3

 The customer is willing to pay more than

Use four capital budgeting

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 3

– is a formal means of analyzing long-range

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 3

 Capital budget models using net cash inflow

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 3

– is the length of time it takes to recover, in

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 3

 Assume that A. B. Fast is considering the

©2002 Prentice Hall, Inc. Business Publishing Accounting, 5/E Horngren/Harrison/Bamber 26 - 3

 How long would it take to recover the