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Principles of Accounting, Volume 2: Managerial Accounting

10.5 Evaluate and Determine Whether to Sell or Process Further

Principles of Accounting, Volume 2: Managerial Accounting10.5 Evaluate and Determine Whether to Sell or Process Further
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  1. Preface
  2. 1 Accounting as a Tool for Managers
    1. Why It Matters
    2. 1.1 Define Managerial Accounting and Identify the Three Primary Responsibilities of Management
    3. 1.2 Distinguish between Financial and Managerial Accounting
    4. 1.3 Explain the Primary Roles and Skills Required of Managerial Accountants
    5. 1.4 Describe the Role of the Institute of Management Accountants and the Use of Ethical Standards
    6. 1.5 Describe Trends in Today’s Business Environment and Analyze Their Impact on Accounting
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Thought Provokers
  3. 2 Building Blocks of Managerial Accounting
    1. Why It Matters
    2. 2.1 Distinguish between Merchandising, Manufacturing, and Service Organizations
    3. 2.2 Identify and Apply Basic Cost Behavior Patterns
    4. 2.3 Estimate a Variable and Fixed Cost Equation and Predict Future Costs
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Cost-Volume-Profit Analysis
    1. Why It Matters
    2. 3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin
    3. 3.2 Calculate a Break-Even Point in Units and Dollars
    4. 3.3 Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations
    5. 3.4 Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations
    6. 3.5 Calculate and Interpret a Company’s Margin of Safety and Operating Leverage
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  5. 4 Job Order Costing
    1. Why It Matters
    2. 4.1 Distinguish between Job Order Costing and Process Costing
    3. 4.2 Describe and Identify the Three Major Components of Product Costs under Job Order Costing
    4. 4.3 Use the Job Order Costing Method to Trace the Flow of Product Costs through the Inventory Accounts
    5. 4.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production
    6. 4.5 Compute the Cost of a Job Using Job Order Costing
    7. 4.6 Determine and Dispose of Underapplied or Overapplied Overhead
    8. 4.7 Prepare Journal Entries for a Job Order Cost System
    9. 4.8 Explain How a Job Order Cost System Applies to a Nonmanufacturing Environment
    10. Key Terms
    11. Summary
    12. Multiple Choice
    13. Questions
    14. Exercise Set A
    15. Exercise Set B
    16. Problem Set A
    17. Problem Set B
    18. Thought Provokers
  6. 5 Process Costing
    1. Why It Matters
    2. 5.1 Compare and Contrast Job Order Costing and Process Costing
    3. 5.2 Explain and Identify Conversion Costs
    4. 5.3 Explain and Compute Equivalent Units and Total Cost of Production in an Initial Processing Stage
    5. 5.4 Explain and Compute Equivalent Units and Total Cost of Production in a Subsequent Processing Stage
    6. 5.5 Prepare Journal Entries for a Process Costing System
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  7. 6 Activity-Based, Variable, and Absorption Costing
    1. Why It Matters
    2. 6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method
    3. 6.2 Describe and Identify Cost Drivers
    4. 6.3 Calculate Activity-Based Product Costs
    5. 6.4 Compare and Contrast Traditional and Activity-Based Costing Systems
    6. 6.5 Compare and Contrast Variable and Absorption Costing
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  8. 7 Budgeting
    1. Why It Matters
    2. 7.1 Describe How and Why Managers Use Budgets
    3. 7.2 Prepare Operating Budgets
    4. 7.3 Prepare Financial Budgets
    5. 7.4 Prepare Flexible Budgets
    6. 7.5 Explain How Budgets Are Used to Evaluate Goals
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Standard Costs and Variances
    1. Why It Matters
    2. 8.1 Explain How and Why a Standard Cost Is Developed
    3. 8.2 Compute and Evaluate Materials Variances
    4. 8.3 Compute and Evaluate Labor Variances
    5. 8.4 Compute and Evaluate Overhead Variances
    6. 8.5 Describe How Companies Use Variance Analysis
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  10. 9 Responsibility Accounting and Decentralization
    1. Why It Matters
    2. 9.1 Differentiate between Centralized and Decentralized Management
    3. 9.2 Describe How Decision-Making Differs between Centralized and Decentralized Environments
    4. 9.3 Describe the Types of Responsibility Centers
    5. 9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  11. 10 Short-Term Decision Making
    1. Why It Matters
    2. 10.1 Identify Relevant Information for Decision-Making
    3. 10.2 Evaluate and Determine Whether to Accept or Reject a Special Order
    4. 10.3 Evaluate and Determine Whether to Make or Buy a Component
    5. 10.4 Evaluate and Determine Whether to Keep or Discontinue a Segment or Product
    6. 10.5 Evaluate and Determine Whether to Sell or Process Further
    7. 10.6 Evaluate and Determine How to Make Decisions When Resources Are Constrained
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  12. 11 Capital Budgeting Decisions
    1. Why It Matters
    2. 11.1 Describe Capital Investment Decisions and How They Are Applied
    3. 11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions
    4. 11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities
    5. 11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions
    6. 11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Balanced Scorecard and Other Performance Measures
    1. Why It Matters
    2. 12.1 Explain the Importance of Performance Measurement
    3. 12.2 Identify the Characteristics of an Effective Performance Measure
    4. 12.3 Evaluate an Operating Segment or a Project Using Return on Investment, Residual Income, and Economic Value Added
    5. 12.4 Describe the Balanced Scorecard and Explain How It Is Used
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  14. 13 Sustainability Reporting
    1. Why It Matters
    2. 13.1 Describe Sustainability and the Way It Creates Business Value
    3. 13.2 Identify User Needs for Information
    4. 13.3 Discuss Examples of Major Sustainability Initiatives
    5. 13.4 Future Issues in Sustainability
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Thought Provokers
  15. Financial Statement Analysis
  16. Time Value of Money
  17. Suggested Resources
  18. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
  19. Index

One major decision a company has to make is to determine the point at which to sell their product—in other words, when it is no longer cost effective to continue processing the product before sale. For example, in refining oil, the refined oil can be sold at various stages of the refining process. The point at which some products are removed from production and sold while others receive additional processing is known as the split-off point. As you have learned, the relevant revenues and costs must be evaluated in order to make the best decision for the company.

In making the decision, a company must consider the joint costs, or those costs that have been shared by products up to the split-off point. In some manufacturing processes, several end products are produced from a single raw material input. For example, once milk has been processed it can be sold as milk or it can be processed further into cheese, yogurt, cream, or ice cream. The costs of processing the milk to the stage at which it can be sold or processed further are the joint costs. These costs are allocated among all the products that are sold at the split off point as well as those products that are processed further. Ice cream has the basic costs of the milk plus the costs of processing it further into ice cream.

As another example, suppose a company that makes leather jackets realizes it has a reasonable amount of unused leather from the cutting of the patterns for the jackets. Typically, this scrap leather is sold, but the company is beginning to consider using the scrap to make leather belts. How would the company allocate the costs incurred from processing and preparing the leather before cutting it if they decide to make both the jackets and the belts? Would it be financially beneficial to process the scrap leather further into belts?

Fundamentals of the Decision to Sell or Process Further

When facing the choice of selling or processing further, the company must determine the revenues that would be received if the product is sold at the split-off point versus the net revenues that would be received if the product is processed further. This requires knowing the additional costs of further processing. In general, if the differential revenue from further processing is greater than the differential costs, then it will be profitable to process a joint product after the split-off point. Any costs incurred prior to the split-off point are irrelevant to the decision to process further as those are sunk costs; only future costs are relevant costs.

Even though joint product costs are common costs, they are routinely allocated to the joint products. A potential reason for this treatment is the GAAP (generally accepted accounting principles) requirement that all production costs must be inventoried.

Be aware that some complexities can arise when allocating joint product costs. The first issue is that joint production costs can be allocated based on varying production and sales characteristics or assumptions. For example, a physical measurement method, a relative sales value method at the point of split-off, and a net realizable value method based on additional processing after the split-off point can all be used to allocate joint production costs.

A second complexity is that eliminating the production of one or more joint products will not always enable the company to reduce joint production costs. Because of the mechanics of the common cost allocation process, such an action will only work if reductions are made in all of the joint products collectively. If only some of the joint products are eliminated, the remaining joint product or products would absorb all of the joint product costs.

An example of this last issue might help clarify the point. Assume that you have a lumber production company that cuts trees, prepares board lumber for housing and furniture, and also prepares sawdust and wood scraps that is used in the production of particle board. Assume that in a given year the company experienced $1,100,000 in joint costs. Using one of the three previously mentioned cost allocation methods, the company allocated $1,000,000 in joint costs to the production of board lumber and $100,000 to the production of wood scraps and sawdust.

Assume that in the next year it also experienced $1,100,000 in joint costs. However, in that year, the company lost its buyer of wood scraps and sawdust, so it had to give both of them away, without generating any revenue. In this case, the company would still realize $1,100,000 in joint costs. However, the entire amount would be allocated to the production of the board lumber. The only way to reduce the joint costs is to realize joint costs of less than $1,000,000.

Your Turn

Luxury Leathers

Luxury Leathers, Inc., produces various leather accessories, such as belts and wallets. In the process of cutting out the leather pieces for each product, 400,000 pounds of scrap leather is produced. Luxury has been selling this leather scrap to Sammy’s Scrap Procurement for $2.25 per pound. Luxury has an employee suggestion box and one of the suggestions was to use most of the scrap to make leather watch bands. The management of Luxury is interested in this idea as the machines necessary to produce the watch bands are the same as the ones used in making belts and would merely need reprogramming for the cutting and stitching processes on the watch bands. The process to attach the buckle would be the same for the watch bands as it was for the belts, thus this would require no additional worker training. Luxury would have additional costs for new packaging and for the supply and insertion of the pins that connect the band to the watch. The total variable cost to produce the watch band would be $2.85. Fixed costs would increase by $85,000 per year for the lease of the packaging equipment, and Luxury estimates it could produce and sell 100,000 watch bands per year. Finished watch bands could be sold for $15.00 each. Should Luxury continue to sell the scrap leather or should Luxury process the scrap into watch bands to sell?

Solution

Sell at Split-Off: Selling price per lb of scrap $2.25 less Variable costs to sell of $0 equals Contribution margin of $2.25 times Units sold of 400,000 pounds for a Total contribution margin and Effect on operating income of $900,000. Process Further: Selling price per watch band $15.00 less Variable costs to sell of $2.85 equals Contribution margin of $12.15 times 100,000 Units sold for a Total contribution margin of $1,215,000 less Additional fixed costs of $85,000 equals Effect on operating income of $1,130,000.

Luxury should process the leather scrap further into watch bands. Not only does the act of processing the scrap further result in an increase in operating income, it offers Luxury another product line that may draw customers to its other products.

Sample Data

Ainsley’s Apples grows organic apples and sells them to national grocery chains, local grocers, and markets. Ainsley purchased a machine for $450,000 that sorts the apples by size. The largest apples are sold as loose apples to the various stores, the medium sized apples are bagged and sold to the grocers in their bagged state, and the smallest apples are sold to deep discounters or to a local manufacturing plant that processes the apples into applesauce. Ainsley is considering keeping the small apples and processing them into apple juice that would be sold under Ainsley’s own label to local grocers. The small apples currently sell to the deep discounters and local manufacturers for $1.10 per dozen. The variable cost to prepare the small apples for sale, including transporting the apples, is $0.30 per dozen. Ainsley can sell each gallon of organic apple juice for $3.50 per gallon. It takes two dozen small apples to make one gallon of apple juice. The cost to produce the organic apple juice will be $0.60 variable cost per gallon plus $200,000 fixed costs for the one-year lease of the equipment needed to make and bottle the juice. Ainsley normally harvests and sells 2,400,000 small apples per year. Should Ainsley continue to sell the small apples to local grocers and the applesauce manufacturer or should Ainsley process the apples further into organic apple juice?

Calculations of Sample Data

In order to decide whether or not to process the small apples or to process them further into applesauce, Ainsley conducts an analysis of the relevant revenues and costs for the two alternatives: sell at split-off or process further into applesauce.

Sell at Split-Off: Selling price per dozen $1.10 less Variable costs to sell $0.30 equals Contribution margin $0.80 times 200,000* Units sold equals Total contribution margin and Effect on operating income of $160,000. Process Further: $3.50 Selling price per gallon less Variable costs to sell $0.60 equals Contribution margin $2.90 times 100,000** Units sold equals Total contribution margin of $290,000 less Additional fixed costs $200,000 equals Effect on operating income of $90,000. *2,400,000 divided by 12 equals 200,000 dozen. **200,000 dozen divided by 2 dozen per gallon equals 100,000 gallons.

Ainsley should continue to sell the apples at split-off rather than process them further, as selling them generates a $160,000 increase in operating income compared to only $90,000 if she processes the apples further.

Final Analysis of the Decision

When making the decision to sell or process further, the company also must consider that processing a product further may create a new successful market or it may undercut sales of already existing products. For example, a furniture manufacturer that sells unfinished furniture may lose sales of the unfinished pieces if it decides to stain some pieces and sell them as finished products.

Think It Through

Disposing of Coffee Grounds

Return to Why It Matters in this chapter. With the knowledge you have gained thus far, answer these questions:

  1. From your perspective, what are the alternatives for the used coffee grounds?
  2. For the alternatives listed in question 1, what information do you need to evaluate between the alternatives?
  3. What type of analysis would you do to choose between alternatives?
  4. What qualitative factors might influence your decision regarding which alternative to select?
  5. Do you think the quantitative and qualitative components both will lead you to the same decision? Why or why not?
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