Describe and explain the tactical decision- making model.

1
Learning Objectives

• Describe and explain the tactical decision-
  making model.
• Explain how the activity resource usage model is
  used in assessing relevancy.
• Apply the tactical decision-making concepts in a
  variety of business situations.
• Choose the optimal product mix when faced with
  one constrained resource.

2
Learning Objectives (continued)

• Explain the impact of cost on pricing decisions.
• Explain why decisions makers sometimes appear to
  use sunk costs in making decisions
• Use linear programming to find the optimal
  solution to a problem of multiple constrained
  resources. (Appendix)

3
Decision-Making Process

• Recognize and define the problem.
• Identify alternatives as possible solutions to
  the problem eliminate alternatives that are
  clearly not feasible.
• Identify the costs and benefits associated with
  each feasible alternative. Classify costs and
  benefits as relevant or irrelevant and eliminate
  irrelevant ones from consideration.

4
Decision-Making Process (continued)

• Total the relevant costs and benefits for each
  alternative.
• Assess qualitative factors.
• Select the alternative with the greatest overall
  benefit.

5
Relevant Costs Defined

• Costs that differ across alternatives
• Costs that deal with future courses of action

6
Some Types of Decisions Illustrated

• Make or Buy
• Keep or Drop
• Special Order
• Sell or Process Further
• Product Mix

Important Short-term Perspective
7
Activity Resource Usage Model and Assessing
Relevancy
Flexible Resources Resources Acquired as Needed
a. Demand Changes b. Demand Constant
Relevant
Not Relevant
8
Activity Resource Usage Model and Assessing
Relevancy (continued)
Committed Resources Acquired in Advance (Short
Term)
a. Demand Increase lt Unused Capacity b. Demand
Increase gt Unused Capacity c. Demand Decrease
(Permanent) 1. Activity Capacity Reduced 2.
Activity Capacity Unchanged
Not Relevant
Relevant
Relevant
Not Relevant
9
Activity Resource Usage Model and Assessing
Relevancy (continued)
Committed Resources Resources Acquired in Advance
(Multiperiod Capacity)
a. Demand Increase lt Unused Capacity b. Demand
Decrease (Permanent) c. Demand Increase gt Unused
Capacity
Not Relevant
Not Relevant
Capital Decision
10
Solution to Exercise 10-8Make-or-Buy Decision

• 1. Make Buy
• Direct materials 1,000,000 0
• Direct labour 720,000 0
• Variable overhead 840,000 0
• Fixed overhead 0 0
• Purchase cost 0 2,800,000
• Total relevant costs 2,560,000 2,800,000
• Pomona Company should continue manufacturing the
  part.
• 2. 2,560,000 400,000 - 2,800,000 160,000
  increase

11
Solution to Exercise 10-9Keep-or-Drop A Segment
Decision

• 1. Segmented income statement
• Product A Product B Total
• Sales 100,000 250,000 350,000
• Less Variable exp. 50,000 145,000
  195,000
• Contribution margin 50,000 105,000 155,00
  0
• Less Direct fixed exp. 60,000
  60,000 120,000
• Segment margin (10,000) 45,000 35,000
• Less Common fixed exp. 70,000
• Operating income (loss) (35,000 )
• Product A 100,000/350,000 x 70,000 20,000
• 80,000 - 20,000 60,000
• Product B 250,000/350,000 x 70,000 50,000
• 110,000 - 50,000 60,000

12
Solution to Exercise 10-9Keep-or-Drop A Segment
Decision (continued)

• 2. Alternatives Keep Drop Drop A Drop B
• Both Both Keep B Keep A
• Sales 350,000 0 275,000 150,000
• Less Variable exp. 195,000 0
  159,500 75,000
• Contribution margin 155,000
  0 115,500 75,000
• Less Direct fixed exp. 120,000
  0 60,000 60,000
• Segment margin 35,000 0
  55,500 15,000
• Less Common fixed exp. 70,000 70,000
  70,000 70,000
• Operating income (loss) (35,000 ) (70,000 )
  (14,500 ) (55,000 )
• Willem should drop product A unless the common
  fixed costs can be avoided if both products are
  dropped

13
Solution to Exercise 10-10Special Order Decision

• 1. The company should not accept the offer
  because the additional revenue is less than the
  additional costs (assuming fixed overhead is
  allocated and will not increase with the special
  order)
• Incremental revenue per box 4.20
• Incremental cost per box 4.25
• Loss per box 0.05
• Total loss 0.05 x 5,000 250

14
Solution to Exercise 10-10Special Order Decision
(continued)

• 2. Costs associated with the layoff
• Increase state UI premiums (0.01 x
  1,460,000) 14,600
• Notification costs (25 x 20) 500
• Rehiring and retraining costs (150 x 20)
  3,000
• Total 18,100
• The order should be accepted. The loss of 250
  on the order is more than offset by the 18,100
  savings by not laying off employees.

15
Solution to Exercise 10-11Sell or Process Further

• 1. Sales 223,000
• Costs 158,000
• Operating profit 65,000
• Process Sell Further Difference
• 2. Revenues 100,000 120,000 20,000
• Process cost 0 23,900 (23,900)
• Operating profit 100,000 96,100 (3,900)
• The company should not process Alpha further as
  gross profit would increase by 3,900. (Note
  Joint costs are irrelevant to this decision, as
  the company will incur them whether or not Alpha
  is processed further.)

16
One Constrained Resource

• Thurman Company produces two types of disk
  players economy and deluxe. The deluxe model
  has a contribution margin of 40 per unit and the
  economy model has a unit contribution margin of
  25. The components of each model must be
  assembled manually. Assembly labour available
  per year is limited to 20,000 hours. The company
  can sell all that it produces of either model.
  The assembly time required for the economy model
  is two hours per unit. Because of the number and
  complexity of the parts for the deluxe model, the
  assembly time required is four hours per model.

How many of each model should be produced?
17
One Constrained Resource (continued)

• Answer
• To maximize total contribution margin, select the
  product that yields the highest contribution
  margin per unit of scarce resource
• Deluxe 40/4 10 per hour
• Economy 25/2 12.50 per hour
• The economy model yields the highest CM per unit
  of scarce resource. Thus, 20,000/2 10,000
  units of the economy model should be produced and
  none of the deluxe.

18
Two Approaches to Pricing

• 1. Cost-Based Pricing
• 2. Target Costing and Pricing

19
A Product Pricing Example

• Revenues 856,500
• Cost of goods sold
• Direct materials 489,750
• Direct labour 140,000
• Overhead 84,000 713,750
• Gross profit 142,750
• Selling and administrative expenses 25,000
• Operating income 117,750

20
Determining Markup Percentages
Markup on COGS (S A expenses Operating
income) / COGS (25,000 117,750) /
713,750 0.20 Markup on direct materials
(DL OH S A expenses Oper. income) /
Direct mater. (48,750 80,000 25,000
117,750) / 585,000 0.464
21
Target Costing and Pricing

• Target costing is a method of determining the
  cost of a product or service based on the price
  (target price) that customers are willing to pay.
• This is referred to as price-driven costing.

22
The Sunk Cost Fallacy

• Dilemma
• Sunk costs are not relevant in decision making
  and thus should not affect decisions, but
• There is anecdotal and empirical evidence that
  managers pay attention to sunk costs
• Therefore, some explanation is necessary why
  managers pay attention to sunk costs when they
  shouldnt

23
Why Do Managers Pay Attention to Sunk Costs?

• There are two primary reasons
• Performance evaluation, and
• Self justification (next slide)
• Performance evaluation
• Managers are not only influenced by the
  prospective nature of decision making but also by
  the retrospective nature of performance
  evaluation.
• Performance evaluation systems tend to focus on
  short-term profitability. While sunk costs do
  not affect future cash flows, they affect short
  term profit measures.
• External evaluation of corporate performance is
  based on GAAP-based financial reports. GAAP uses
  the historical cost principle. Historical cost
  is, by definition, a sunk cost. Managers may pay
  attention to how decisions will affect their
  companys GAAP income.

24
Self Justification

• When confronted with a failing course of action,
  managers may attempt to delay the admission of
  bad judgment by escalating their commitment to
  that action. This benefits them in three ways
• They may obtain the upward movement they seek.
• With more time, good luck may mask or reverse the
  expected bad outcome.
• The eventual bad outcome is delayed until after
  the responsible manager has moved upward or is no
  longer responsible for it.
• Note This may invoke the issue of managerial
  ethical conduct. However, it is important to
  keep in mind that the motivation to justify ones
  past actions is subtle and often the person doing
  so is not aware of an ethical dilemma.

25
Multiple Constrained Resource

• To the Thurman Company example for a one
  constrained resource, add the following
  additional constraint the market limits sales
  of the economy disk player to 3,000 units.
  Formulate the linear programming problem and
  solve using the graphical method
• Let X1 deluxe models, and
• X2 economy models
• Formulation Max CM 40X1 25X2
• Subject to 4X 2X2 lt 20,000
• X2 lt 3,000

26
Multiple Constrained Resource (continued)
X
2
10,000
4X 2X lt 20,000
1
2
D
C
X lt 3,000
3,000
2
B
X
A
5,000
1
27
Multiple Constrained Resource (continued)

• Corner Point X1 X2 CM 40X1 25X2
• A 0 0 0
• B 5,000 0 200,000
• C 3,500 3,000 215,000
• D 0 3,000 75,000
• Point C is optimal
• The X1 value of point C is found by substituting
  the second equation into the first one like so
• X1 2 (3,000) 20,000
• 4X1 6,000 20,000
• 4X1 14,000
• X1 3,500