Session 07 - Decision Making_in class

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Session 7 Accounting 102
2 Collect Relevant Data (Part 2) Identify Relevant Information (Part 1) Forecast Costs and Select Actions (Part 3) Evaluate Performance (Part 4) The Strategic Cost Management Decision-Making Process Determine the Strategic Issues
3 A Quick Review The following financial data apply to the production of a single unit of your company’s product: Manufacturing Cost per Unit Direct Materials $1.50 Direct Manufacturing Labor 0.80 Variable Manufacturing Overhead 0.70 Fixed Manufacturing Overhead 1.00 Total Manufacturing Costs $4.00 Variable manufacturing overhead varies with respect to units produced. Fixed overhead is general plant administration and building costs. Fixed overhead of $1 per unit is based on production of 150,000 units per month. Each unit currently sells for $5. A salesperson has asked the vice-president of marketing for permission to sell 10,000 units at $3.80 per unit to a customer who is not in its normal marketing channels.
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A Summary of Cost Concepts for Decision Making • relevant are only costs that will differ across alternatives in the future: • Will my costs change if I make this decision? • If so, by how much? • relevant costs are in terms of cash flow, not accounting costs • How much money will go into or out of my pocket if I make this decision? • just because a cost is classified as “fixed” does not mean it can’t change (e.g., getting rid of a building) • just because a cost is classified as “variable” does not mean it will change (e.g., a part costs $10 per unit, but you already signed a contract to buy 100 units; even if you no longer need the parts, you are contractually required to pay the $1,000 for them) • many costs that companies define as “variable” are really a series of steps; you need to identify where these steps are for decision making
What Do These Movies Have in Common? • The Lord of the Rings trilogy which made over $2.9 billion at the box office. • Return of the Jedi which made $475 million on a budget of $32 million. • Harry Potter and the Order of the Phoenix which made $939 at the box office worldwide. • Batman (1989) which made $411 million in revenues worldwide. • My Big Fat Greek Wedding which cost $6 million and made over $350 million at the box office. • The Exorcism of Emily Rose which made over $150 on a budget of $19 million. 6
What Do These Movies Have in Common? • The Lord of the Rings trilogy showed “horrendous losses”. • Return of the Jedi has never shown a profit. • Harry Potter and the Order of the Phoenix ended up with a loss of $167 million • Batman (1989) showed a $36 million deficit. • My Big Fat Greek Wedding lost $20 million. • The Exorcism of Emily Rose no profit. 7 and they were all subject to a law suit of some kind
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Let’s Take a Closer Look at Forrest Gump
Winston Groom ● Wrote the book Forrest Gump ● Shopped it around to a lot of studios ● Paramount offers “Standard Industry Contract” ● A little upfront cash plus percentage of movie’s “net profits” ● Net profits calculated according to industry standards
Paramount’s role • Investor • financing costs • profit/loss participation • Subcontractor • production cost (direct and indirect) • Distributor • promotion and distribution cost (direct and indirect)
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Statement of Profit and Loss for Net Profit Participants on the Motion Picture Forrest Gump through December 31, 1994 Box office gross revenues $ 382 Amount retained by movie theaters (approx. 50%) 191 Paramount's gross revenues $ 191 Negative costs: Direct costs: Production costs $ 66.8 Gross profit participation by directors, actors, etc. (16% of studio gross revenues) 30.6 Total direct costs $ 97.4 Studio overhead (allocated - 15% of direct costs) 14.6 Total negative costs $ 112.0 Promotion and distribution costs $ 67.2 Advertising overhead (allocated - 10% of promotion and distribution costs) 6.7 Distribution fee (32% of studio gross revenues) 61.1 135.0 Financing costs calculated at 3% above prime, on unrecovered costs - the 'loss' below) 6.0 Total costs 253 Profit (loss) through December 31, 1994 ($ 62)
How much revenue must Forrest Gump earn so that the Net Profit Participants will begin to receive a payout?
• Another way to ask this question is: What is the break-even gross revenue for Forrest Gump’s Net Profit Participants? • To answer this question, we need to be able to identify the relevant variable and fixed costs. • And, to do that, we need to determine what the relevant cost driver is. What do you think it is?
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what are the fixed costs for “net profit participants”? what are the variable costs for “net profit participants”?
Statement of Profit and Loss for Net Profit Participants on the Motion Picture Forrest Gump through December 31, 1994 Box office gross revenues $ 382 Amount retained by movie theaters (approx. 50%) 191 Paramount's gross revenues $ 191 Negative costs: Direct costs: Production costs $ 66.8 Gross profit participation by directors, actors, etc. (16% of studio gross revenues) 30.6 Total direct costs $ 97.4 Studio overhead (allocated - 15% of direct costs) 14.6 Total negative costs $ 112.0 Promotion and distribution costs $ 67.2 Advertising overhead (allocated - 10% of promotion and distribution costs) 6.7 Distribution fee (32% of studio gross revenues) 61.1 135.0 Financing costs calculated at 3% above prime, on unrecovered costs - the 'loss' below) 6.0 Total costs 253 Profit (loss) through December 31, 1994 ($ 62)
What are the movie’s variable and fixed costs? Variable Cost Fixed Cost Amount retained by movie theaters Production costs Gross profit participation Studio overhead Promotion and distribution costs Advertising overhead Distribution fee Financing costs
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What are the movie’s variable and fixed costs? Variable Cost Fixed Cost Amount retained by movie theaters X Production costs X (Sunk) Gross profit participation X Studio overhead X X Promotion and distribution costs X (Some Sunk) Advertising overhead X Distribution fee X Financing costs X
Now, what are the amounts of those costs? Variable Cost (% of Gross Revenue) Fixed Cost ($ million) Amount retained by movie theaters Production costs Gross profit participation Studio overhead Promotion and distribution costs Advertising overhead Distribution fee Financing costs TOTAL
Now, what are the amounts of those costs? Variable Cost (% of Gross Revenue) Fixed Cost ($ million) Amount retained by movie theaters 50.0% Production costs $66.8 Gross profit participation 16% x (1 – 0.50) 8.0% Studio overhead 15% x 8% 1.2% 15% x 66.8 = 10.0 Promotion and distribution costs 67.2 Advertising overhead 6.7 Distribution fee 32% x (1 – 0.50) 16.0 Financing costs 6.0 TOTAL 75.2% $156.7
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Breakeven Box Office Gross Revenues ($) for “Net Profit Participation” Break Even Box Office Gross Revenue = Fixed Costs Contribution Margin Ratio =
Breakeven Box Office Gross Revenues ($) for “Net Profit Participation” Break Even Box Office Gross Revenue = Fixed Costs Contribution Margin Ratio = 156.7 (1 – 0.752) = $632.0
WAS FORREST GUMP REALLY UNPROFITABLE?
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Let’s take another look at the Income Statement
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Statement of Profit and Loss for Net Profit Participants on the Motion Picture Forrest Gump through December 31, 1994 Box office gross revenues $ 382 Amount retained by movie theaters (approx. 50%) 191 Paramount's gross revenues $ 191 Negative costs: Direct costs: Production costs $ 66.8 Gross profit participation by directors, actors, etc. (16% of studio gross revenues) 30.6 Total direct costs $ 97.4 Studio overhead (allocated - 15% of direct costs) 14.6 Total negative costs $ 112.0 Promotion and distribution costs $ 67.2 Advertising overhead (allocated - 10% of promotion and distribution costs) 6.7 Distribution fee (32% of studio gross revenues) 61.1 135.0 Financing costs calculated at 3% above prime, on unrecovered costs - the 'loss' below) 6.0 Total costs 253 Profit (loss) through December 31, 1994 ($ 62)
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Breakeven Box Office Gross Revenues ($) for Paramount There are several assumptions that we can make for this part. Three are considered below. A. Assume that distribution fees are not relevant costs for Paramount. Variable Costs = 0.752 – 0.16 = 0.592 Contribution margin per $ of ticket sales $1 – 0.592 = 0.408 Breakeven Revenues = $156.7 = $384.1 0.408
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Statement of Profit and Loss for Paramount Studio on the Motion Picture Forrest Gump through December 31, 1994 Box office gross revenues $ 382 Amount retained by movie theaters (approx. 50%) 191 Paramount's gross revenues $ 191 Negative costs: Direct costs: Production costs $ 66.8 Gross profit participation by directors, actors, etc. (16% of studio gross revenues) 30.6 Total direct costs $ 97.4 Studio overhead (allocated - 15% of direct costs) 14.6 Total negative costs $ 112.0 Promotion and distribution costs $ 67.2 Advertising overhead (allocated - 10% of promotion and distribution costs) 6.7 Distribution fee (32% of studio gross revenues) 61.1 135.0 Financing costs calculated at 3% above prime, on unrecovered costs - the 'loss' below) 6.0 Total costs 253 Profit (loss) through December 31, 1994 ($ 62) ($0.9) 191.9 73.9
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B. Assume that distribution fees and variable studio overhead are not relevant costs for Paramount. Breakeven Box Office Gross Revenues ($) for Paramount Variable Costs = 0.592 – 0.012 = 0.580 Contribution margin per $ of ticket sales $1 – 0.580 = 0.420 Breakeven Revenues = $156.7 = $373.1 0.420
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Statement of Profit and Loss for Paramount Studio on the Motion Picture Forrest Gump through December 31, 1994 Box office gross revenues $ 382 Amount retained by movie theaters (approx. 50%) 191 Paramount's gross revenues $ 191 Negative costs: Direct costs: Production costs $ 66.8 Gross profit participation by directors, actors, etc. (16% of studio gross revenues) 30.6 Total direct costs $ 97.4 Studio overhead (allocated - 15% of direct costs) 14.6 Total negative costs $ 112.0 Promotion and distribution costs $ 67.2 Advertising overhead (allocated - 10% of promotion and distribution costs) 6.7 Distribution fee (32% of studio gross revenues) 61.1 135.0 Financing costs calculated at 3% above prime, on unrecovered costs - the 'loss' below) 6.0 Total costs 253 Profit (loss) through December 31, 1994 ($ 62) Fixed Studio Overhead 10.0 $ 107.4 ($0.9) 191.9 187.3 $ 3.7 73.9
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C. Assume that distribution fees and ALL studio overhead are not relevant costs for Paramount. Breakeven Box Office Gross Revenues ($) for Paramount Variable Costs = 0.580 Fixed Cost = 156.7 – 10.0 = $146.7 Contribution margin per $ of ticket sales $1 – 0.580 = 0.420 Breakeven Revenues = $146.7 = $349.3 0.420
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Statement of Profit and Loss for Paramount Studio on the Motion Picture Forrest Gump through December 31, 1994 Box office gross revenues $ 382 Amount retained by movie theaters (approx. 50%) 191 Paramount's gross revenues $ 191 Negative costs: Direct costs: Production costs $ 66.8 Gross profit participation by directors, actors, etc. (16% of studio gross revenues) 30.6 Total direct costs $ 97.4 Fixed Studio Overhead 10.0 Total negative costs $ 107.4 Promotion and distribution costs $ 67.2 Advertising overhead (allocated - 10% of promotion and distribution costs) 6.7 73.9 Financing costs calculated at 3% above prime, on unrecovered costs - the 'loss' below) 6.0 Total costs 187.3 Profit (loss) through December 31, 1994 $ 3.7 $13.7 177.7 $ 97.4
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After the settlement, Winston Groom said "I wasn't suing Paramount, I had a question about the royalty statement, which I didn't understand. When I spoke to Paramount I was assured everything was OK. I'm delighted with this agreement."
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What do you think the point of this case is?
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Beware of Your Partner’s Cost Accounting • StudioCanal invested hundreds of millions of dollars in 44 movies produced by Universal Studios. • During most of this period, StudioCanal and Universal were corporate siblings through the common ownership of the French company Vivendi (2000 – 2004). • StudioCanal concluded an audit of the joint venture’s development and overhead expenses, which Universal had managed , and concluded that Universal was violating its fiduciary and contractual obligations to StudioCanal. • Based on the audit reports, StudioCanal alleged that: Universal had double-charged the partnership for production and other fees without StudioCanal’s knowledge or approval; and Universal had deducted millions of dollars in unsubstantiated expenses before reporting the results to its partner, StudioCanal.
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Would you ever enter into such a contract?
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