Managerial Accounting

Professor Gary Hetch

Welcome and Course Overview ................................................................................... 2

Module 1 ........................................................................................................................... 4

Lesson 1.1: Fundamental Concepts ............................................................................. 4

Lesson 1.1:Sunk Costs ................................................................................................. 8

Lesson 1.1: Opportunity Costs ................................................................................... 11

Lesson 1.1: Common Mistakes .................................................................................. 14

Lesson 1.1: What We’ve Learned in Lesson 1.1 ........................................................ 16

Lesson 1.2: Learning Objectives and Overview ......................................................... 17

Lesson 1.2: Keep or Drop a Product Line ................................................................... 18

Lesson 1.2: Make or Buy ............................................................................................ 22

Lesson 1.2: Replace or Retain Equipment ................................................................. 28

Lesson 1.2:Additional Considerations ........................................................................ 33

Lesson 1.2: What We've Learned in Lesson 1.2 ........................................................ 35

Lesson 1.3: Learning Objectives and Overview ......................................................... 36

Lesson 1.3: Sell "As-Is" or Process Further ................................................................ 36

Lesson 1.3: Accepting a Special Order ...................................................................... 39

Lesson 1.3: What We've Learned in Lesson 1.3 ........................................................ 44

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 Managerial Accounting
Professor Gary Hetch

Welcome and Course Overview

Managerial accounting information is the lifeblood of the organization. It helps managers

plan the effective and efficient allocation of resources, guides managers, and
employees to work on behalf of the organization and facilitates all types of business
decisions. In this course, we explore all of these aspects of managerial accounting.
We'll begin with common business settings and understand managerial accounting's
role in these settings. We'll address common pitfalls that can trip up manager and
employees and discuss on how focusing on relevant managerial accounting information
helps avoid these problems. We'll then turn to the role and process of budgeting in the
organization.

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Professor Gary Hetch

This is the key tool that managers use to plan the allocation of resources and we'll
explore a variety of components of budgets and the budgeting process. Then we'll see
how the targets and goals at the heart of these budgets are used to evaluate and
monitor managers and employees. We'll focus on variance analysis, which provides a
view of operations and activities and how they compare to owners and upper
management's expectations.

We'll conclude with an overall of organization's performance measurement, evaluation,

and compensation system. In particular, we'll discuss financial and non-financial
measures, strategic performance measurement systems, and subjective performance
evaluation. In this course we will use video lectures to discuss these topics. We will also
have practice quizzes following each lesson that you can use as a self-check of your
knowledge. Then at the end of each module, we will have quizzes and assignments that
will help you apply this knowledge.

I look forward to you joining me in the course. We'll be discussing just about everyone in
the organization, from the operational employees, trying to meet budgeted targets to the
product line managers, looking to improve processes, all the way up to the corporate
executives implementing strategy. And ultimately, how important and crucial managerial
accounting is for these individuals as they pursue organizational goals.

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Professor Gary Hetch

Module 1
Lesson 1.1: Fundamental Concepts

In this first lesson, we'll have the following objectives. We will understand the concept of
relevance in decision-making. We'll focus on why it's important in decisions and we'll
talk about the common business decisions in which relevance plays a big role. Let's first
talk about important information characteristics. Arguably, the following characteristics
are most important for information when it comes to making decisions.

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Professor Gary Hetch

First off, you want accurate information. Sometimes you have to trade off accuracy in
order to get timely information. We can't wait forever to make a decision. In business,
it's often too late if we wait for the perfect information set. But you also want relevant
information, information that's important to the decision and the decision setting. Why is
relevance so important? Well, in general, we're talking about a concept that allows us to
identify what is relevant and distinguish it from information that is not relevant.

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Professor Gary Hetch

This is especially important in a rich information or data filled environment. Specifically,

our application is going to be on revenues and costs that are relevant to the decision in
a business setting. So let's talk about what relevant information is. Relevant information
reflects what differs across decision alternatives or alternatively, it reflects what
potentially differs. The focus is on what makes a difference in the decision being made.
If a piece of information is the same across decision alternatives, it's irrelevant.

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Professor Gary Hetch

So we don't care about revenues or costs that do not differ across decision alternatives.
They don't help us and in some situations having that information actually hurts us. We'll
focus on a variety of types of decisions in this module. We'll talk about make or buy
decisions, otherwise known as outsourcing decisions.

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Professor Gary Hetch

We'll talk about keeping or dropping a product line or business segment or department.
We'll focus on decisions related to replacing or retaining equipment. We'll look at a
decision referred to as accepting a special order. And we'll consider whether or not we
should sell our product as is or process it further.

Lesson 1.1:Sunk Costs

Let's talk about some key concepts. Those key concepts are sunk costs and opportunity
costs. Let's begin with sunk costs. The definition of a sunk cost is a cost that has been
incurred or committed to and cannot be avoided in the feasible decision alternatives.
Sunk costs are usually irrelevant to a decision.

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Examples are rent for a factory or facility or a contracted salary. If you've agreed to pay
these costs regardless of outcome over, to say, the next year, then they're sunk. They
have occurred in the past and they cannot be recovered. Again, these types of costs will
be irrelevant in many decision settings. Now are all fixed costs sunk?

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We can't necessarily think about sunk costs as perfectly related to costs behavior. In
truth, we have to think about whether a cost is avoidable. Just because a cost doesn't
change with some level of activity, doesn't mean that we can't get out of it in some way.
Suppose you have rented an apartment or a home for the next two years and over the
first year you've signed a lease and you intend to live in that home for two years and
intend to sign the lease going forward.

That cost is fixed no matter how many nights you stay there, the cost is the same over
the next two years. But if you can get out of that second year of your lease, then the
cost is avoidable. So just because the cost is fixed doesn't necessarily mean it's
automatically sunk. Now one aspect of sunk costs is it's very difficult to not consider
them. There's a sunk cost fallacy that a lot of people fall subject to and the following
example exemplifies part of that. Let's make the following comparison. Let's suppose
you have a decision in front of you.

You have spent $10,000 mining an area for minerals. You're 90% sure that it's not a rich
mineral site. You can spend another $10,000 to find out for sure. Now consider a
second version of this scenario. Suppose you have spent $1,000,000 mining an area for
minerals. You're 90% sure it's not a rich site. You can spend another $10,000 to find out
for sure. Now regardless of what your decision is, let's compare these two scenarios.
They seem quite different but in fact they are the same decision, whether or not you
spend another $10,000 to find out for sure. The fact that they feel quite different is
because of the initial investment that has already been made. In the first scenario, you
spent $10,000 in the past. In the second scenario, you spent the million dollars. But in
both of these scenarios, the $10,000 upfront investment and the million dollar upfront

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investment are sunk costs. They cannot be recovered. So in fact they're irrelevant to the
decision. Those costs that have been incurred should not influence whether or not you
spend another ten thousands of dollars to find out for sure. The fact that these two
situations feel so different exemplifies how much trouble people have ignoring sunk
costs.

Lesson 1.1: Opportunity Costs

Let's continue our discussion of our two key concepts, sunk costs and opportunity costs.
And now let's focus on the notion of opportunity costs. The definition of an opportunity
cost is that it's the value of the next best alternative. This next best alternative and its
value is usually relevant to a decision.

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Professor Gary Hetch

It represents what you're given up in order to go down one path. Let's consider an
example. Take my wife, Sadie, and in her past she had multiple boyfriends. One was
named Gary. One was named Luke. And one was named Han. Now, I've changed the
names to protect the innocent. My wife's name is actually Gina. But she had multiple
decisions to make in terms of who she would date, Gary, Luke or Han. And Gary just
has a lot of benefits about him. He's an all-around wonderful person. Luke is a rock star
and he could promise traveling around the world to different shows. And Han is an
excellent tennis player.

And Gina or Sadie likes tennis and likes a competitive match with her boyfriend. So she
has a decision to make. And let's suppose the traveling rock star life is not to her liking.
So Luke is off the table. So it's between Gary and Han. And let's suppose she's thinking
about dating Gary. Well the opportunity costs that Gina feels has to do with the loss of
the competitive tennis match, which Gary is not able to give her. So ultimately, the next
best alternative, the competitive tennis with Han is the opportunity costs that Gina feels
as she makes the choice to date Gary. So opportunity costs are actually quite a
complex issue.

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Professor Gary Hetch

First of all, it's difficult to identify the opportunity costs and where they're coming from.
And because it's a decision alternative that you may not have actually implemented, it's
difficult to quantify the relevant revenues and costs and the value of that next best
alternative. It's also ambiguous.

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Professor Gary Hetch

You may not always know what your next best alternative is or that one exists.
And finally it's not always salient to the decision process. It's often overlooked by
individuals. In fact, if we return back to our business setting, the information that's
included on a financial statement does not include opportunity costs. As a matter of fact,
sunk costs are represented on those financial statements. So it's somewhat ironic that
irrelevant information is included in common accounting information and relevant
information such as opportunity costs is often excluded.

Lesson 1.1: Common Mistakes

Let's talk about some common mistakes that managers and employees might fall victim
to. The first has to do with sunk costs. There is a tendency to overweight that which has
occurred in the past and or that which cannot be changed. And in this case, not only is
the sunk cost irrelevant to the decision but considering it might lead to a poor decision.
Another example relates to fixed costs. And there are two aspects to these common
mistakes. The first is sometimes how accounting information is presented to managers
and employees.

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Professor Gary Hetch

In certain reports, fixed costs are provided on a per unit basis. Under some approaches,
they're divided by sum activity measure and assigned to the units of product. In
essence, they appear variable and are deemed more important than they really are.
Another way in which fixed costs can lead to common mistakes is that in the concept of
allocated fixed costs. A possible result is that a product or department may actually
appear unprofitable as a function of the allocation method chosen.

This means that the fixed cost that the firm incurs as a whole is shared across all the
business units. And it can make some business units look less profitable than they
really are. If they were to eliminate that business unit, the fixed costs would not be
saved; they would just be put back into the pool and allocated to the remaining business
units. And finally, another common mistake has to do with opportunity costs.

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People tend to overlook opportunity costs or treat them as less important than the more
salient out of pocket costs. So in the coming examples, we'll talk about how managers
and employees might fall victim to these common mistakes and use relevant information
to overcome these common obstacles.

Lesson 1.1: What We’ve Learned in Lesson 1.1

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What have we learned in Lesson 1? First of all, we talked about the concept of
relevance. Then we talked about different decisions in which relevance and relevant
information is important. And then we talked about some fundamental concepts and
these included sunk costs, opportunity costs, and some common mistakes that
managers and employees make when making decisions.

Lesson 1.2: Learning Objectives and Overview

Now we turn to lesson two and the following objectives. Specifically, we'll talk about the
decision to keep or drop a product line. We'll talk about the decision to make or buy or
outsource and we'll talk about the decision to replace or retain equipment. Now a few
notes about the coming slides. First off, I'm keeping it relatively simple here. That
means that I'm not bombarding you will a lot of information, just so that we can make
sure that we get the fundamental concepts from each example.

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Professor Gary Hetch

Of course, in the real world, situations are much more complex, but we don't need all
that complexity to make the key points. And second, I'll be adopting a more quantitative
or financial focus. Of course, with every decision, there are strategic and other
qualitative considerations that are just as important if not more important than the
financial perspective. So we'll eventually talk about those, but for a while, we'll keep
things focused on the financial perspective.

Lesson 1.2: Keep or Drop a Product Line

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Professor Gary Hetch

So let's explore our first example, keeping or dropping a product line. And of course, this
example extends itself to thinking about keeping or dropping a department or an entire
business unit. In this example, we're talking about Scout Corporation. Scout Corporation
has three divisions with the following financial results. Division A has sales revenue of
800,000, variable expenses of 520,000, ultimately resulting in a contribution margin of
280,000. Division B has a slightly smaller contribution margin of 90,000.

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Professor Gary Hetch

And C trails with a $10,000 contribution margin. The fixed expenses for each of the
divisions are allocated 80,000, 50,000, and 30,000 for A, B, and C respectively. So the
resulting net income after subtracting all expenses from the revenue is 200,000 for
division A and 40,000 for division B. Division C is the outcast here. It appears as though
they are losing money for the corporation as a whole with a $20,000 negative net
income or loss. Now let's analyze this situation.

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Professor Gary Hetch

Pretend we're a manager and we see these financial results. And often times a
manager might say perhaps we should get rid of the product line or department C. The
reason is they are losing us some money. And if we didn't have them, we would
perhaps make more money as a corporation. So the status quo currently, right now,
with all three divisions is that we are earning a total net income of $220,000. That's the
total net income for division A, B, and C combined. I'm going to label that, as I said, the
status quo because that is what is existing currently. Now if we were to drop product line
C or department C, we would lose the revenue that department C is earning us. So we
would have an adjustment to this $220,000 status quo amount.

The lost revenue, which is revenue that was being added to create the $220,000 of net
income, would be gone. So to eliminate its effect we would subtract it and that amount
was $100,000. However, if we drop product line C, we save the variable costs
associated with that division. So that number was being subtracted from company-wide
revenues in order to earn the total net income. So to remove its effect we would add
that back.

The saved variable cost, if we were to eliminate product line C, is $90,000. So taking
into account just these items, the status quo has changed. It's $220,000 is what we
were earning with product line C. If we were to eliminate it, we would lose the revenue
of 100,000 but save 90,000 in variable costs. So that's a net impact of $210,000. The
manager would say this is not complete. They would say what about the fixed costs that
we would save?

Well then the question becomes what happens to those fixed costs if we were to
eliminate product line C? If those fixed costs were completely unavoidable then the

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Professor Gary Hetch

fixed costs would not be saved. The fixed costs that would be allocated to product line C
would then be just divvied up between product line A and B if C were no longer there.
So the end result would be the $210,000 that we've just calculated. We wouldn't save
additional fixed costs. So again, if we can't avoid the fixed costs then this is a bad
decision to eliminate product line C.

The reason is we've changed the status quo to a smaller net income number. If the fixed
costs were avoidable, we would have a different story. The fixed costs then become
relevant to our decision. The reason is because if we keep product line C, we incurred
those fixed costs and if we eliminate it, we avoid them. Because the fixed costs are
being treated differently across the different decisions, they become relevant to our
decision.

So if they are completely avoidable, we would also have saved fixed costs and that
would be $30,000. Adding back to the status quo, which we subtracted to get to it,
would mean that our new net income would now be $240,000. And this means that the
decision is, from a financial perspective, favorable. As you can see, it all comes down to
the extent to which fixed costs are avoidable versus unavoidable.

And we need to understand and know more about how those fixed costs are calculated
and/or allocated to product line C before we can make this decision. Now again, we've
just adopted a very simple example. And we haven't talked a bit about the strategic
considerations or other qualitative considerations surrounding the decision to keep or
drop product line C. We'll save that for future examples.

Lesson 1.2: Make or Buy

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Professor Gary Hetch

Now let's talk about a make or buy decision. In this example, we'll be talking about
Thrasher Company, which has purchased 10,000 pumps annually from Nordique,
Incorporated. Because the price keeps increasing and reached $68 per unit last year,
Thrasher's management has asked for an estimate of the cost of manufacturing the
pump in its own facilities, as opposed to buying it from Nordique. The engineering,
manufacturing, and accounting departments have prepared a report for management
that includes the estimate for an assembly run of 10,000 pumps to replace those that
we currently purchase.

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Professor Gary Hetch

Additional production employees would be hired to manufacture the pumps, but no

additional equipment, space, or supervision would be needed. So according to the
report, the total cost for 10,000 units is estimated to be $957,000 or $95.70 per unit for
each of those 10,000 units. The current purchase price is $68 a unit. So ultimately the
report recommends continued purchase of the product.

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Professor Gary Hetch

The information at the heart of the report contain the following. The components
amounted to $120,000 worth of costs. The assembly labor amounted to $300,000, and
per the available information, assembly labor consists of hourly production workers. The
third line reports manufacturing overhead. That amount is $450,000. Now,
manufacturing overhead is applied or estimated for products on a direct labor dollar
basis.

That means for every direct labor dollar spent for a product, a certain amount of variable
overhead is tacked on. The variable overhead add-on is 50 percent of each direct labor
dollar. So if we spend a dollar of direct labor on a product, we incur 50 cents worth of
variable overhead. And fixed overhead is added to the product at a rate of 100 percent,
that is, dollar for dollar. For each direct labor dollar spent, we incur a dollar of fixed
overhead. The general and administrative overhead is basically calculated as ten
percent of other costs.

What that means is, whatever costs the product are incurring, ten percent of that
amount is added on as a general and administrative overhead estimation. So that
120,000 for components, 300,000 for labor, and $450,000 for manufacturing overhead
amounts to $870,000. Ten percent of that is tacked on in the form of general and
administrative overhead. Combine these four line items amount to $957,000 and divvied
up over the 10,000 units that is generated by these costs comes out to be the $95.70
per unit. Now, let's take a look at the decision to continue to buy these products for $68
as opposed to making them ourselves for what is projected to be $95.70 each.

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Professor Gary Hetch

Now, a lot of accounting is going on in the available information. So the true question
would be, what are the actual costs that would be incurred in order to make this product
ourselves? Now, the line items started with components. Components would be the
materials at the heart of these pumps. And so in the sense that each pump requires
certain components, this information is relevant to this decision. The reason is, is if we
don't make the pumps we don't incur the components' cost. If we do, we do incur these
costs.

The costs are different between the different alternatives, so therefore, it's relevant. That
the $120,000 in components' costs would be relevant. The labor we were told amounts
to $300,000. That $300,000 is relevant because we were told that if we were to make
the pumps ourselves, we would have to hire additional production employees. If we
don't make them, we don't incur this costs. So again, this $300,000 is relevant to our
decision. Now how about overhead? How much is relevant for our decision going
forward? Well, we were told that we wouldn't require additional supervision or any

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Professor Gary Hetch

additional facilities.

So we're perhaps going to treat variable overhead and fixed overhead differently. Let's
look at how this $450,000 in overhead was calculated. Fifty-percent of the amount of
money spent on direct labor represents the variable overhead because we applied
overhead of the variable type at a 50 percent rate of direct labor dollars. And then, 100
percent is applied for fixed overhead. So that's an additional 300,000 based on a dollar-
for-dollar match of the direct labor dollars spent. Now the fixed overhead is likely
irrelevant.

Reason is, we didn't receive information about having to expand facilities. In fact, we
received information suggesting that we don't need to. So I would argue that the
$300,000 in fixed overhead is irrelevant. And it's questionable whether or not the
variable overhead is relevant. I'll give it the benefit of the doubt and include it. In terms
of the general and administrative overhead that's a pure cost allocation amount. There's
no consideration of actual costs in that number at all. It's just an additional 10 percent
overhead charge, likely coming from corporate headquarters.

And because we don't have information that suggests that we need more corporate
employees that $87,000 tack on is probably just an allocation of an existing pool. It's not
a true actual cost that would be incurred if we were to make the pumps ourselves. So
I'm not going to have any representation of that general and administrative overhead in
this example. So combining what I believe to be the relevant information in this
example, the components, the labor, and with some question, the variable overhead
portion, the total actual cost incurred is $570,000. If I divide that by the 10,000 units that

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Professor Gary Hetch

we produce with these costs. I get $57 per unit of actual incremental cost that we would
incur to make this product ourselves.

Compare that to what we're paying, and you can see from a financial perspective that
the recommendation of the report to continue to buy is actually costing us money. Now,
as you can see, a lot of times you need to make certain assumptions about information
that's provided to you for you to ultimately make a decision. And in the real world, you
can collect additional information that will help facilitate the decision, but you're always
lacking something. And the key here is to focus on that which is relevant to the ultimate
decision.

Lesson 1.2: Replace or Retain Equipment

Now we're going to talk about the decision to replace or keep or retain a piece of
equipment. In our example, Scout Corporation uses an older machine in its main
production line. Given its age, the machine creates some inefficiencies. For example, it
requires frequent maintenance. It has a significant amount of down time and perhaps,
there's higher labor costs associated with using this machine. Managers are deciding
whether to replace the machine with a new one. [ Background sounds ] So the
information that we have in this example is that the original purchase cost of the old
machine was $110,000.

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Professor Gary Hetch

The point at which we've accumulated depreciation is 70,000 of that original amount.
The estimated useful life from here on out is 4 remaining years. The new machine, its
cost will be $120,000. Since we haven't purchased or put it into use it, it has no
accumulated depreciation. And its estimated life is 4 years as well. Additional piece of
information is that the new machine will provide an annual cost savings of $35,000.
Also, the old machine can be sold for $5,000 right now. If used for their entire lives, the
machines will have 0 value.

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So the $5,000 is only recoverable right now for the old machine and if we use the new
machine for all 4 years, it won't have any value at all. So now let's explore the relevant
information in this example and ignore all the information that would be irrelevant.
Currently, our status quo is to keep the current -- the old machine. And so our change or
our decision is to replace it.

So let's think about what incrementally would occur if we were to replace the machine.
First of all, we would have cost savings. The reduction of the down time, the decreased
labor costs, and the other inefficiencies that the old machine is costing us money would
be saved by using the new machine. That amount was $35,000 and that savings would
occur annually for the next 4 years in which we would have the new machine. That total
is $140,000.

What else is relevant to this decision? Well, we're either going to keep the old machine
or purchase a new one. And so the purchase price of the new machine is something
that's different between the decision alternatives. It's an incremental cost if we were to
replace the machine. So the cost of the new machine is something we definitely want to
include in our analysis. For the given information, that cost was $120,000 and that's a
negative amount given that's something that we have to incur. And then we have the
sale of the old machine.

That amount would occur if we were to replace it with the new machine right now. We
would sell that machine for $5,000. and that would be a plus to our consideration. So
net $140,000 in cost savings plus the sale of the old machine resources of $5,000 but

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subtracting the $120,000 cost of the new machine, leaves us with a $25,000 net effect
and that is to the plus side.

So ultimately the net impact of replacing the current machine with a new one is $25,000
to the good. So let's consider some additional information in our example. Suppose that
managers have identified an investment opportunity not related to machinery and
equipment. An investment can be made only if the new machine is not purchased. That

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is the investment is made with the cash used to purchase the new machine.

So it amounts to $120,000. The question would be what percentage return does this
alternative investment need to lead the manager to retain the old equipment? Well, very
simply we can think about what happens when we replace the old machine with the new
one. Like we said, it's a net incremental impact of $25,000. If we earn approximately
that same amount via this alternative investment, we wouldn't necessarily need to
replace the old machine.

We could keep it and invest our $120,000 in this alternative investment. So the rate of
return that would be required for this alternative investment would be equivalent to
$25,000 in cash. Twenty-five thousand as a percentage of the $120,000 investment is
equal to 20.83%. If the alternative investment earns 21% or so or higher, then it makes
it more worthwhile to keep the old machine. Not replace it.

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And invest the $120,000 elsewhere. In this example, this additional information signaled
the potential for there to be an opportunity cost. A next best alternative associated with
the $120,000 and depending on how much it returned, it actually might be our best
alternative.

Lesson 1.2:Additional Considerations

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So, let's talk about a few additional considerations. First off, the common mistakes that
managers can make are everywhere. They're in every decision. As you saw allocative
fixed cost, the notion of an opportunity cost, and a cost, can be in any of these
examples. Also, there are qualitative concerns that we have ignored for the time being.

These qualitative concerns exist in every decision as well. For example, in the keep or
drop a product line decision, a qualitative decision might be: If we were to drop product
line C, does that influence our sales of product line A or B? As a matter of fact, maybe
some customers might buy some of each of our product, and if they couldn't get product
line C from us, given that we dropped, perhaps our sales for A and B decrease.

We haven't thought those strategic concerns, and of course, we'd need additional
information to consider them. In the make or buy decision, often times it comes down to
quality. Sometimes when we make products ourselves, the quality that we have in that
product might be different than that which we can get elsewhere on the marketplace.
And we've ignored that consideration just for simplicity sake. And of course, the replace
or retain equipment decision has its share of qualitative issues.

There are often times hidden costs with a new purchase, and there was uncertainty
associated with exactly how much cost savings there might be as a result of buying that
new machine. Obviously, these qualitative concerns are important, and you would need
additional information to consider them in the decisions as a whole. Inside firms in the
real world, there is a strive for great balance between the quantitative and qualitative
issues and the consideration of those in making decisions. Often times, accountants

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adopt a financial perspective, and that financial perspective is combined with other
strategic perspectives as well. Of course, how these things balance out depends on the
decision and the setting.

Lesson 1.2: What We've Learned in Lesson 1.2

So what have we learned in Lesson 2? Well, we started off talking about common
decisions, keeping or dropping a product line, the make or buy decision and the replace
or retain equipment decision. And then we briefly talked about qualitative considerations
associated with each of these.

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Lesson 1.3: Learning Objectives and Overview

So what have we learned in Lesson 2? Well, we started off talking about common
decisions, keeping or dropping a product line, the make or buy decision and the replace
or retain equipment decision. And then we briefly talked about qualitative considerations
associated with each of theseLet's begin Lesson 3.

In Lesson 3, we'll understand selling as is or processing further type decisions as well

as special orders. Now, one distinction about these types of decisions from the previous
lesson ones is that these are more sales-oriented decisions. Accepting a special order
from a customer and determining what version of our final product we're delivering to
the market are at the center of these two decisions. So, in this lesson, we'll be focusing
on the sales side as opposed to the production side.

Lesson 1.3: Sell "As-Is" or Process Further

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Professor Gary Hetch

Let's first talk about the decision to sell our product as is or process it further. In this
example, we have Whaler, Incorporated. They produce toddler and child-sized furniture.
The following information is available for its arts and crafts table for kids. Per unit data
for an unpainted, unassembled version is as follows. The selling price for this version of
the table is $25. The variable costs incurred to produce the table are $12. And the fixed
costs are $8. All of this information is on a per unit basis. Whaler managers are
considering a completely finished version of its table. In other words, assembled and
painted colors.

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Professor Gary Hetch

Managers estimate that the painting and assembling would incur per unit variable costs
of $9 and per unit fixed cost of $2. The completely finished version of the table could be
sold for $35 per unit. So now let's compare the two versions of the table. We are faced
with two decisions, whether we sell as is, and that is the existing version of the table.

Or we process further, and that is finish the assembled and painted version of the table.
The revenues under each of these different decisions are $25 if we sell the unfinished
version of the table and $35 if we sell the fully processed one, the assembled and
painted version. The variable costs per unit if we were to continue to sell the
unassembled version are 12. We had an additional incremental variable cost of $9 per
unit if we were to paint and assemble it.

So that would make a total of $21 per table in the form of variable costs. And fixed
costs, we were told that is $8 per unit to sell the unfinished version and an incremental
amount of $2 to sell the finished version. So that totals $10 per unit on a fixed cost
basis. The net income on a per unit basis for the original version of the table is $5. And
the net income for the processed version of the table is $4.

So in this case it's not a good decision, from a financial perspective, to process the table
further. We are making more money on a per unit basis for the unassembled, unpainted
version of the table than we would if we were to finish it and assemble it. This assumes
that the revenues and cost information are all accurate. But from a financial perspective,
relying on these estimates, it's a poor decision.

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Professor Gary Hetch

Now, in this example, I wanted to show that fixed costs are not automatically irrelevant.
The additional $2 per unit of fixed costs that would be incurred to assemble and paint
the table are different depending on the decision alternative. That $2 per unit is not
spent if we sell as is and it is if we process it further. So ultimately, the take away here is
just because you see a fixed cost and a fixed cost per unit does not mean you
automatically deem it irrelevant and ignored it for your analysis. Sometimes those costs
are incremental as well.

Lesson 1.3: Accepting a Special Order

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Professor Gary Hetch

So now let's talk about special orders. Special orders occur when a customer comes to
you and asks for a customized product or in this case, they're asking for a customized
price for your product. Let's consider Baron Company. Baron Company produces
100,000 coffee grinders per month.

The monthly capacity that they have in their facility is 125,000 units. So in essence, in
this normal month, they're only using 80% of their available capacity. Per unit data for
the past month, an average one, is as follows. The selling price of each coffee grinder is
$20. The variable costs for each coffee grinder is $8. And it comes out to be $4 per unit
on a fixed cost basis for each coffee grinder. A special order has been received from
North-Star, Inc. They offered to purchase 2,000 grinders at $11 per unit. Let's take a
look at what a manager might do in this situation.

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Professor Gary Hetch

So based on the provided information, the manager's first reaction is likely let's not
accept this special offer or special order. The reason is, is that our costs exceed the
actual offered price. If we look at our variable costs per unit, that was $8. Our fixed cost
per unit is $4. So therefore, total costs on a per unit basis are $12. And that is greater
than the $11 price that is being offered by the purchasing company. However, this logic
is potentially faulty.

The reason is that Baron is under capacity for this month. That means that they're not
going to incur any additional fixed costs and they're not going to save any additional
fixed costs if they produce or don't produce these additional 2,000 grinders. The $4 in
this sense is irrelevant. What we should be focused on is just the incremental costs
associated with producing these additional grinders. And that would be the $8 that we
incur for each unit on a variable cost basis.

So a more realistic view of the incremental impact of accepting this order and selling
North-Star these additional 2,000 grinders is $11 in terms of revenue per unit and $8 in
terms of variable cost. The difference being $3 per unit. Again, I've ignored the $4 fixed
cost per unit because it's not like we're giving up capacity -- or have to build capacity in
order to produce these additional 2,000 units.

So each of the additional 2,000 units earns us an incremental amount of $3 which in

total is equal to $6,000 additional contribution I would earn from accepting this offer.
Now let's assume some additional information. Suppose that the current projected sales
for the next month is 124,000 units. That's instead of the 100,000 units normal month.

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Professor Gary Hetch

The monthly capacity is still 125,000 units. The question now, will the manager still
accept this special order? For 1,000 units we have capacity to produce these grinders
and sell it at the offered price. So for 1,000 units we have additional capacity.

We're not using that for any other sales. So we can go ahead and use that 1,000
additional units or that available capacity and produce those for North-Star's offer. But
another 1,000 would actually cannabalize existing sales. Currently we're projecting
124,000 units in sales and we only have capacity for 125,000. One thousand is
irrelevant. We can use -- you can use the available capacity but if we were to complete
the whole 2,000 unit order, we have to take away from existing sales. So for the 1,000
for which we have additional capacity. We would take the $3 contribution margin per
unit because the only incremental cost we would incur to produce those would be the

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Professor Gary Hetch

variable costs per unit of $8.

But for the existing sales, not only do we incur the $8 to make those, we give up the
revenue associated with the existing sale. So we would need to cover costs greater
than just the variable costs to produce. We would have to cover the lost contribution
associated with the existing sales. That is $20 of our normal selling price minus the $8 it
takes to produce.

That means that we would need at least $12 from North-Star to justify selling the 1,000
existing sales to them instead. So, in this case, the manager will likely not accept the
special order given the offered price of $11. It doesn't cover enough of the costs that we
would incur to remove existing sales and sell to them instead. So let's think about some
qualitative concerns in this decision setting.

First off, we need to consider time horizon. Are we adopting more of a short-term focus
or are we thinking along the lines of a longer term relationship? A short-term focus
would be this is a one off deal. This person will probably never purchase from us again
and it's up to us just to consider that in the short-term. But if this is leading to a longer
term relationship, our focus might be different. We might consider whether or not this is
a strategic alliance that we want to incur in and perhaps, giving a little bit in this
transaction leads to gains in the future.

The other implications are for the specific customer. Does it set a precedent? Is this
customer always going to require or demand this special price? And what about if other
customers realize that we've accepted a special order at a lower than normal price?

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Professor Gary Hetch

Does that have implications? Will they demand that lower price as well or deem it
unfair? And that could strain relationships with some important customers. So
ultimately, in this setting, qualitative concerns might offset the financial perspective that
we're adopting. And it ultimately depends on whether we're adopting a short-term or
long-term focus as well as the implications for the current and other customers.

Lesson 1.3: What We've Learned in Lesson 1.3

So what have learned in lesson three? Well, we focused on sales-oriented decisions,

specifically the decision to sell our product as is or process it further into some other
version. We also talked about accepting special orders and we focused on some
strategic considerations inside of that decision.

Lesson 1.3: Module 1 Review

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 Managerial Accounting
Professor Gary Hetch

This concludes Module one. In Module one, we've talked about the fundamentals and
concepts underlying relevant information. We've talked about potential mistakes that
managers can make in making common business decisions and we've explored some
of those decisions and the role of relevant information in them.

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