Sell or Process Further

Sell or Process Further LEARNING OBJECTIVE 4 Identify the relevant costs in deciding whether to sell or process materials further. Many manufacturers have the option of selling products at a particular point in the production cycle or continuing to process the products in order to sell them later at a higher price. For example, a bicycle manufacturer such as Rocky Mountain could sell its bicycles to retailers either unassembled or assembled. A furniture manufacturer such as Durham Furniture could sell its dining room sets to furniture stores either unfinished or finished. A company should make the sell-or-process-further decision on the basis of incremental analysis. The basic decision rule is as follows: Process further as long as the incremental revenue from the processing is more than the incremental processing costs. Single-Product Case Assume, for example, that Woodmasters Inc. makes tables. The cost to manufacture an unfinished table is $35, as calculated in Illustration 7.10. ILLUSTRATION 7.10Per-unit cost of unfinished table Direct materials $15 Direct labour 10 Variable manufacturing overhead 6 Fixed manufacturing overhead 4 Manufacturing cost per unit $35 The selling price per unfinished unit is $50. Woodmasters currently has unused productive capacity that is expected to continue indefinitely. What are the relevant costs? Management concludes that it can use some of this capacity to finish the tables and sell them at $60 per unit. For a finished table, direct materials will increase by $2 and direct labour costs will increase by $4. Variable manufacturing overhead costs will increase by $2.40 (60% of direct labour). Management doesn't anticipate any increase in fixed manufacturing overhead. Should the company sell the unfinished tables or should it process them further (see Helpful Hint)? Illustration 7.11 shows the incremental analysis on a per-unit basis. HELPFUL HINT Current net income is known. Net income from processing further is an estimate. In making its decision, management could add a “risk” factor for the estimate. ILLUSTRATION 7.11Incremental analysis—sell or process further A B C 1 2 Sales per unit D Net Income Sell Process Further Increase (Decrease) $50.00 $60.00 $10.00 3 Cost per unit 4 Direct materials 15.00 5 Direct labour 10.00 6 Variable manufacturing overhead 6.00 17.00 14.00 8.40 (2.00) (4.00) (2.40) A 7 Fixed manufacturing overhead 8 Total 9 Net income per unit 10 B 4.00 35.00 $15.00 C D 4.00 43.40 $16.60 0.00 (8.40) $ 1.60 It would be advantageous for Woodmasters to process the tables further. The incremental revenue of $10.00 from the additional processing is $1.60 higher than the incremental processing costs of $8.40. Multiple-Product Case Sell-or-process-further decisions are especially relevant to production processes that produce multiple products simultaneously. In many industries, several end products are produced from a single raw material and a common production process. These multiple end products are commonly called joint products. For example, in the meatpacking industry, a single sheep produces meat, internal organs, hides, wool, bones, and fat. In the petroleum industry, crude oil is refined to produce gasoline, lubricating oil, kerosene, paraffin, and ethylene. Illustration 7.12 presents a joint product situation for Marais Creamery, which must decide whether to sell or process further cream and skim milk. Both of these products result from the processing of raw milk. ILLUSTRATION 7.12Joint production process—Marais Creamery Marais Creamery incurs many costs before it manufactures cream and skim milk. All costs that are incurred before the point at which the two products are separately identifiable (the split-off point) are called joint costs. To determine the cost of each product, joint product costs must be allocated to the individual products. This is frequently done based on the relative sales value of the joint products. Although this allocation is important for determining the product cost, it is irrelevant in sell-or-process-further decisions. This is because these joint product costs are sunk costs. That is, the company has already incurred them and cannot change or avoid them with any later decision. Illustration 7.13 shows the daily cost and revenue data for Marais Creamery. ILLUSTRATION 7.13Cost and revenue data per day Costs (per day) Joint cost allocated to cream $ 9,000 Joint cost allocated to skim milk 5,000 Processing cream into cottage cheese 10,000 Processing skim milk into condensed milk 8,000 Expected Revenues from Products (per day) Cream $19,000 Skim milk 11,000 Cottage cheese 27,000 Condensed milk 26,000 From this information, we can determine whether the company should simply sell the cream and skim milk, or process them further into cottage cheese and condensed milk. Illustration 7.14 shows the analysis the company needs to do to decide whether to sell the cream or process it further into cottage cheese. ILLUSTRATION 7.14Analysis of whether to sell cream or make cottage cheese A B C D Net Income 1 Sell Process Further Increase (Decrease) 2Sales per day $19,000 $27,000 $ 8,000 3Cost per day 4 Processing cream into cottage cheese 0 10,000 (10,000) 5 6 $19,000 $17,000 $ (2,000) From this analysis, we can see that Marais Creamery should not process the cream further because it will sustain an incremental loss of $2,000. Illustration 7.15, however, shows that Marais Creamery should process the skim milk into condensed milk, as it will increase net income by $7,000. ILLUSTRATION 7.15Analysis of whether to sell skim milk or process into condensed milk A B C D 1 Net Income Increase (Decrease) $26,000 $15,000 Sell Process Further 2Sales per day $11,000 3Cost per day 4 Processing skim milk into condensed milk 0 5 $11,000 6 8,000 $18,000 (8,000) $ 7,000 Note that the amount of joint costs allocated to each product ($9,000 to the cream and $5,000 to the skim milk) is irrelevant in deciding whether to sell or process further. Why? The joint costs remain the same whether or not there is further processing. It is important to understand that these decisions need to be re-evaluated as market conditions change. For example, if the price of skim milk increases relative to the price of condensed milk, it may become more profitable to sell the skim milk rather than process it into condensed milk. Consider also oil refineries. As market conditions change, they must constantly reassess which products to produce from the oil they receive at their plants. DO IT! 4 Sell or Process Further Easy Does It manufactures unpainted furniture for the do-it-yourself market. It currently sells a child's rocking chair for $25. Production costs are $12 variable and $8 fixed. Easy Does It is considering painting the rocking chair and selling it for $35. Variable costs to paint each chair are expected to be $9, and fixed costs are expected to be $2. Prepare an analysis showing whether Easy Does It should sell unpainted or painted chairs. ACTION PLAN •Identify the revenues that will change as a result of painting the rocking chair. •Identify all costs that will change as a result of painting the rocking chair, and net the amount against the revenues. Solution Net Income Increase (Decrease) Revenues $25 $35 $10 Variable costs 12 21 (9) Fixed costs 8 10 (2) Net income $ 5 $ 4 $(1) The analysis indicates that the rocking chair should be sold unpainted because net income per chair will be $1 greater. SellProcess Further