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MGT 4143/8180 – MANAGERIAL ACCOUNTING

Overview

Last LM, we saw briefly how CVP analysis can help us make some basic decisions in business.  The key is identifying the costs and benefits of a given proposal.  In general, if benefits exceed costs, then we lean towards a “go” decision.  In this chapter, we tackle some much more difficult decisions…

Around the planet, business managers make thousands of decisions each day.  Decisions like:

• Should we hire more employees to meet increased production targets?
• Should we outsource the company’s HR training function to reduce training costs?
• Should we approve a new advertising campaign to increase sales?
• Should we launch a new product line to take advantage of unused factory capacity?
• Should we agree to supply a one-time special order for a customer, at a price lower than normal for other customers?

And then, there’s some really, really tough decisions like whether to shut down a struggling division or product line.  Such decisions can impact all of the company’s stakeholders, including the local community.  There can be mental health costs as well as financial costs to these decisions.  The city of Detroit, for example, is suffering broadly from numerous plant shutdowns over the last decade and the resulting economic dislocation.

In this module, we’ll try to bring some structure and logic to these difficult decisions.  That’s how management accountants can help.  The decision still might be very difficult, but at least we can bring some data and order to the discussion.

The decision rule – meaning, what we use to ultimately make the call – is quite simple:  IF BENEFITS EXCEED COSTS, THEN GO WITH IT.   Or, in a business context, if incrementalrevenues exceed incrementalexpenses, then thumbs up!  More profit is good.  That’s a key for this chapter… the notion of incremental, which drives the notion of relevance.

INCREMENTAL REVENUES VERSUS INCREMENTAL EXPENSES

We’ll work on that key shortly.  But, beware!  As you’ve seen before, there’s always more to the story in managerial accounting than the numbers.  Getting the correct numerical answer to a homework exercise or exam problem gives us a warm feeling.  But, that’s just the start of the analysis.  We must look at our underlying assumptions, estimates, and qualitative factors imbedded in the decision as well.  Let’s get started on the material.

First, let’s set up a framework for approaching a decision.  A decision means choosing between two or more mutually exclusive options.  An example is the choice you made a few years ago to attend Wake.  At that point, you could have chosen Wake or that other school… but NOT both.  That’s what “mutually exclusive” means.  Choosing one option means we forgo the other option.

In our context, the key is to identify exactly what the choice is that management is facing.  That may seem obvious – like, we launch a new product line, or we don’t – but students often stumble with this important first step: identifying exactly what the options are in a decision.

The reason that this step is so important is that it guides our search for relevant data to analyze and support the decision.  If you find that you’re struggling to identlfy and organize the data in a HW problem, it might be because you haven’t clearly articulated what the decision is about.

To help you approach this task, I’ve developed a three-step checklist:

Practice those steps in the homework until it becomes habit.

Relevant costs and benefits

Next let’s set up some vocabulary.  In our world, the term “incremental” means the amount by which things change if we choose Option A versus Option B.  By “things,” I mean revenues and expenses.  The notion of incremental change leads us to the term “relevance.”  Relevance is about whether it matters to our decision, or not.  Here’s an easy way to grasp the notion of relevance…

That’s what management really cares about… what’s going to change?  The quickest way to get to a decision is to identify what’s relevant to Option A or B, meaning what changes if we choose A or B.  Ignore everything else.  Like in CVP analysis, getting to the answer in the shortest shortcut possible is important for making the analysis easier (and for time management on exams!).

DANGER:  Fixed costs ahead!

When making a call on relevance, watch out for fixed expenses!  If they are truly fixed, then by definition they don’t change within a given decision analysis.  However, more caution… when we get into more sophisticated and longer-term decisions, some of our typical fixed expenses can start to behave more like variable expenses.  Such as, given enough time, we can sell off our factory building… and shed the associated depreciation expense.  But, asset sales and other restructurings take A LONG TIME.

What’s my point?  When making decisions, approach fixed costs very carefully.  They are often – but not always – irrelevant in our analysis.  (Damn those fixed costs!)  Eventually, we’ll introduce the notion of “avoidable” or “un-avoidable” as a new wrinkle in our approach to fixed expenses in decision analysis.

Decisions, decisions…

Here’s our list of decision types:

1. Shut down or keep going
2. Make or buy
3. Accept/reject special order
4. Sell as is or process further

DECISION 1: Shut down?

Let’s start with that first one: a decision to discontinue a product line, a division, or a segment that seems to be under-performing.  I use the word “seems” because first appearances are not always accurate in this kind of analysis.

The keys are (1) watching out for fixed costs and (2) keeping an eye on contribution margin for the product line or division.  I mention these keys because it is very easy to make a wrong decision in these situations… a wrong, and potentially very expensive decision.

Here’s a simple example:  Rock Corporation has two divisions – Canyon and Mountain.  Results for 2018 for each division are shown in the table below.  Study the results for each division.

Rock’s management is concerned about persistently weak performance in the Canyon Division.  As you can see, Canyon reported a net operating loss for the most recent year (36,800), while Mountain has been steadily profitable.

The CEO is thinking of shutting down Canyon.  What do you think?  What would you recommend?

Here’s what typically happens in these types of problems.  Our eye naturally goes to the bottom line… net operating income… or, in Canyon’s case, net operating loss.  Seems like an easy call.  It’s a dog, and we should shut it down.  Right?

Not so fast.  Do this: compute what company-wide NOI would have been last year (2018) if Canyon had been shut down as of Jan 1 2018.  Caution: if Canyon’s fixed expenses are truly fixed, then what happens to those costs if we shut down Canyon?

Answer: nothing!  Those fixed costs are still in our world… whether the division is open or closed… at least in the short-run.

Canyon decision: Relevant revenues and expenses

If we trust the notion of relevance, then this decision actually becomes quite easy.  If we were to shut down Canyon, then what changes?  Two things: sales go away, and variable expenses go away.  That’s it.  The fixed expenses stay.

So, the key to these kinds of decisions is to focus on our good buddy “contribution margin.”  Compute Canyon’s CM last year. Let’s see… total CM = total Sales – total VC, or… $15,300… positive!  As bad as things are at Canyon, it still has a positive CM.  If we shut down Canyon, we lose that positive CM… and, that’s bad.  Our company-wide NOI would actually drop by $15,300.

Time out!

1. Cleary we have issues in the Canyon Division. But, at least in the short run, shutting it down makes us worse off.  We need to examine the long-run, structural problems at Canyon before making this call.  Eventually, we might conclude that shut-down is the right call… in the long-run.

But, recognize that what we lose in the short run is $15,300 in contribution margin towards the company’s bottom line.  Clearly, Rock Company is between a rock and a hard place on this problem.  However, shutting down Canyon is not the quick fix that the CEO thinks it is.

THE KEY TO SHUT-DOWN DECISIONS: CONTRIBUTION MARGIN (TOTAL)

Let’s see what the text says about these shut-down types of decisions…

Reading

• 287-291

Practice

• Ex 7-2

DECISION 2: Make or buy?

This is a choice that nearly every manufacturer faces – possibly for every single part or ingredient that goes into our production process.  Think about BMW … there are hundreds of components that go into the assembly of a vehicle.  Maybe thousands.  For each component, management has a choice of (a) making it within BMW or (2) buying it in finished form from a supplier.

Want to watch the BMW factory in action, down in Spartanburg SC?

Let’s talk about the tires, for example.  Does BMW make those tires?  No.  They buy them from Goodyear, Michelin, or other suppliers.  Why?  Why not make an in-house, BMW-brand tire?  The short answer is that it must be cheaper for BMW to let someone else make those tires.

But, how does BMW know that?  Because they’ve done a make-or-buy decision about those tires… and every other component that goes into their vehicles.  In fact, most of the components at BMW are made by suppliers, NOT by BMW.  The BMW factory is more about assembling those components than it is about making those components in-house.  BMW uses lots of local suppliers for its components.  Again, why?  Because they’ve figured out it’s cheaper in the long run.

In these make-or-buy decisions, it’s critical to identify the relevant data – and IGNORE the irrelevant data.  Students tend to do very complete and lengthy analyses of make-or-buy data, much of which is not relevant to the decision.  When you do a make-or-buy analysis, try to focus – again – ONLY ON WHAT CHANGES in the decision.

THE KEY TO MAKE-OR-BUY DECISIONS: WHAT DOES IT COST US TO BUY FROM A SUPPLIER vs WHAT DOES IT COST US TO MAKE – RELEVANT COSTS ONLY!

Let’s return to the text…

Reading

• 291-94

Practice

• Ex 7-3

DECISION 3: Special orders

Next up… accept or reject a special order – at a lower than usual price – from a customer.

This one is loaded with subtleties and potential pitfalls.  Here’s when considering the qualitative impacts of a decision becomes critical.  Why?  Here’s an example: If you agree to produce a special order for one customer – probably at a lower selling price – how will your other customers react when they find out about this deal?  And, they will eventually find out!  Not good.

So, in practice be very careful with the broader implications of accepting a special order.  Is it worth making one customer happy if it annoys the rest of your customer base?

The good news is that we can use the same approach to evaluate special orders… incremental revenues versus incremental expenses.

THE KEY TO SPECIAL ORDER DECISIONS: WHAT DOES IT COST US TO MAKE ONE MORE UNIT OF OUR PRODUCT?  IS THAT LESS THAN THE SPECIAL ORDER SELLING PRICE?

Let’s see how the authors illustrate it.

Reading

• 294-5

Practice

• Ex 7-4

DECISION 4: Sell as is or process further?

Last one.  And, this one’s my favorite, because it usually involves food or wine.  Example: every dairy farmer faces the dilemma of selling raw milk (sell as is) or processing it into, for example, cheese (process further).

I think you know what the key is to these decisions… identify the incremental revenues and expenses from each option and choose the profit-maximizing option.

Speaking of wine, here’s a problem I put on a recent final exam.  See if you can do it.  But, to keep yourself from going crazy, focus on this: the timing in this problem matters.  We cannot change what has happened in the past.  We can only change what happens going forward.

Want to know the right choice?   It’s Option 3.  Can you prove it?

If you struggle with this problem, try it with your teammates.  There’s a lot of data to manage.  I’ll walk through the solution in class.

THE KEY TO SELL AS IS OR PROCESS FURTHER DECISIONS: WE CANNOT CHANGE THE PAST (PAST COSTS ARE IRRELVANT).  WE CAN ONLY CHANGE WHAT HAPPENS GOING FORWARD.

Reading

• 302-3

Practice

• Ex 7-7

That’s it for LMs!  Done!

Remember to take the online quiz by 5:45pm before your class this week.

END OF LM5