6 for Self-Study
Problem 7.6 for Self-Study
I NVENTORY D ECISIONS . Compute the minimum total costs for JIT-not Incorporated, given the following facts:
Differential Costs per Order ......................................................................................................
Total Units Purchased per Year ...............................................................................................
40,000 Units
Differential Carrying Costs per Unit of Inventory ..............................................................
$5.35 per Unit
Prepare a table like Exhibit 7.14, and find the minimum total costs of ordering and holding inventory. (Hint: Start with 50 annual orders.)
The solution to this self-study problem is at the end of the chapter on page 243.
S ummar y
The following items correspond to the learning objectives presented at the beginning of the chapter.
1. Explain the differential principle and know how to identify costs for differential analysis. Differential analysis is an extension of financial modeling. The relevant costs for
240 Chapter 7 Differential Cost Analysis for Operating Decisions
differential analysis are the differential costs. The model focuses on cash flows because cash is the medium of exchange and because cash serves as a common, objective measure of the benefits and costs of alternatives.
2. Explain the relation between costs and prices. The three major influences on pricing decisions are customers, competitors, and costs. The differential approach to pricing presumes that the price must at least equal the differential cost of producing and selling the product. In the short run, this practice will result in a positive contribution to covering fixed costs and generating profit. In the long run, this practice will cover all costs because both fixed and variable costs are differential in the long run.
Short-run decisions include pricing for a special order with no long-term implications. Typically the time horizon is six months or less. Long-run decisions include pricing a main product in a major market.
Companies typically use full costs for pricing decisions in three circumstances: (1) when
a firm enters into a long-term contractual relationship to supply a product; (2) for development and production of customized products and contracts with the government; and (3) when managers initially set prices to cover full costs plus a profit and then adjust to reflect market conditions.
3. Explain how to base target costs on target prices. Target pricing is based on customers’ perceived value for the product and the prices competitors charge. Target costs equal target prices minus target profits.
4. Describe how to use differential analysis to measure customer profitability. Customer profitability is determined using differential analysis with the customer as the cost object. Customer costs generally fall under four categories: cost to acquire the customer, cost to provide goods and services, cost to maintain customers, and cost to retain customers.
5. Explain how businesses apply differential analysis to product choice decisions. Most firms can supply a number of goods and services, but manufacturing or distribution
constraints limit what firms can produce. In the short run, capacity limitations require choices among alternatives.
6. Explain the theory of constraints. The theory of constraints focuses on revenue and cost management when dealing with bottlenecks. The objective is to increase throughput contribution (i.e., sales dollars minus direct materials costs), minimize investments, and manage production by letting the bottleneck set the pace for the rest of operations.
7. Identify the factors underlying make-or-buy decisions. Whether to make or buy depends on cost factors and on nonquantitative factors, such as dependability of suppliers and the quality of purchased materials.
8. Explain how to identify the costs of producing joint products and the relevant costs for decisions to sell or process further. The point at which the identifiable products emerge is the splitoff point. Costs incurred up to the splitoff point are the joint costs. Additional processing costs—costs incurred after the splitoff point—are the relevant costs for decisions to sell or process further.
9. Explain the use of differential analysis to determine when to add or drop parts of operations. In the short run, capacity does not change. If the differential revenue from the sale of a product exceeds the differential costs required to provide the product for sale, then the product generates profits, and the firm should continue its production.
10. Identify the factors of inventory management decisions. The optimal number of units to order or produce is the economic order quantity, which is the optimal trade-off between setup
(or order) costs and carrying costs. In estimating order costs and carrying costs, only differential costs matter. Just-in-time inventory is a method of managing purchasing, production, and sales, by which (a) the firm attempts to produce each item only as needed for the next step in the production process, or (b) the firm attempts to time purchases so that items arrive just in time for sale or production. The use of total quality management and flexible manufacturing practices to reduce setup costs enhances companies’ abilities to use just-in- time inventory.
11. Explain how linear programming optimizes the use of scarce resources (Appendix 7.1). Linear programming (a) finds the product mix that will maximize profits given the
Solutions to Self-Study Problems 241
constraints, (b) provides opportunity costs of constraints, and (c) allows for sensitivity analysis.
12. Identify the use of the economic order quantity model (Appendix 7.2). The economic order quantity model derives the optimal number of orders or production runs.
Key Terms and Concepts
Additional processing costs
Order costs
Bottleneck
Other operating costs
Carrying costs
Predatory pricing
Cash flow
Product life cycle
Differential analysis
Relevant cost analysis
Differential cost
Setup costs
Dumping
Shadow price*
Economic order quantity (EOQ)
Splitoff point
Economic order quantity (EOQ) model**
Status quo
Investments
Target cost
Joint costs
Target price
Just-in-time (JIT)
Theory of constraints (TOC)
Linear programming*
Throughput contribution
Make-or-buy decision
Value engineering
Objective function*
*Term appears in Appendix 7.1. **Term appears in Appendix 7.2.
S olutions to S elf-Study Problems
Volume .................................................................................. 4,500 units
5,000 units
Revenue a ..............................................................................
$200,000 lower
Unit-Level Costs b ...............................................................
250,000 lower
Customer-Level Costs c .......................................................
75,000 lower
Facility-Level Costs d ..........................................................
7,500 lower
Operating Profit .................................................................
$132,500 higher
b Number of units c Number of units d Number of customers Given in the problem.
Domer Technologies should raise its price to $1,900 per unit because profits are projected to increase to $3,757,500, an increase of $132,500.
242 Chapter 7 Differential Cost Analysis for Operating Decisions
SUGGESTEDSOLUTIONTOPROBLEM7.2FORSELF-STUDY
Alternative: Drop
Status Quo:
Jamoca Joe’s
Total Difference
Revenue (fees charged) ..............................................................
$1,160 $460 lower
Customer-Level Costs
Costs of Services .......................................................................
$1,035 $425 lower
Facility-Level Costs
Salaries, Rent, and General Administration (fixed) .........
Total Operating Costs ..............................................................
$1,135 $425 lower
Operating Profit ............................................................................
$ 25 $ 35 lower
McKlintoff should not drop Jamoca Joe’s in the short run, as profits would drop by $35,000.
SUGGESTEDSOLUTIONTOPROBLEM7.3FORSELF-STUDY
Buy
Make ¼ Difference
Less: Variable Costs to Produce and Sell ................................
47,500 ¼ 3,500 lower
Variable Costs of Goods Bought .....................................
0 ¼ 4,000 higher
Total Contribution Margin ...........................................
$122,500 ¼ $ 500 lower
Less Fixed Costs .................................................................
5,500 ¼ 800 lower
Operating Profit .................................................................
$117,000 ¼ $ 300 higher
Operating profit for the Franklin Company increases by $300 if it purchases the handles rather than makes them.
SUGGESTEDSOLUTIONTOPROBLEM7.4FORSELF-STUDY Sell
Less Additional Processing Variable Costs ...................
0¼ 25,000 higher
Total Contribution Margin before Considering
Costs Prior to Splitoff Point ..................................
Less Additional Fixed Costs .............................................
0¼ 25,000 higher
Operating Profit .................................................................
Operating profit for the Demi Company will be the same whether it processes the scrap lumber into plywood or sells scrap lumber at splitoff.
SUGGESTEDSOLUTIONTOPROBLEM7.5FORSELF-STUDY Baltimore should not drop Product B in the short run. It continues to have a positive contribution
margin even if the revenue and variable costs drop by 50 percent.
Appendix 7.1: Linear Programming 243
S U G G E S T E D S O L U T I O N T O P R O B L E M 7 . 6 F O R S E L F - S T U DY
a Average Number
Inventory
Order Size
of Units in
Annual Orders in Units
Inventory
Costs b Costs c Costs
b 40,000 units/number of orders. c Average units in inventory Number of orders
Minimum total costs are $4,188 at 51 orders per year.