Chapter 8 : Relevant Costs and Short-Term Decision-Making

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Rules of thumb to be aware of when making business decisions:

1. Identify and focus on relevant information

• Item differs between alternatives AND pertains to the future

• ‘Sunk Costs’ aren’t relevant to decision making because they are costs that have occured in the past

2. Consider qualitative factors

• These factors can’t be quantified. Examples include Employee Morale, Company reputation, etc.

3. Analyze Variable Costs and Fixed Costs separately using a Contribution Margin

• Be careful about using unit cost data UNLESS it is purely a variable cost per unit

If given total Variable costs, we need to convert to

the ‘constant’

FOR VARIABLE COSTS, THE CONSTANT IS PER UNIT!!!!

• Variable Cost Per Unit = Total Variable Cost / Units

If given Fixed Costs per unit, we need to convert to

the “constant”

FOR FIXED COSTS THE CONSTANT IS TOTAL!!!

• Total Fixed Costs = Fixed Costs Per Unit x Units

Five Types of Short-Term Decisions

1. Special Order Decisions

2. Make or Buy Decisions (Outsourcing)

3. Dropping Unprofitable Segments

4. Sell or Process Further

5. Product Mix with Constrained Resource

What is a special order?

A customer may approach us and ask to purchase a certain number of units. Often, the customer will agree to purchase a large quantity for a reduced price.

What are some key points to consider when deciding whether to accept a special order?

• Excess capacity is the difference between full capacity and the current operating level.

• If excess capacity is greater than the units requested in the special order, then sales won’t be affected in the short run if we accept the order.

• If excess capacity is less than the units for the special order, then the company will have to “give up” regular unit sales in the short run if the special order is accepted

• Will the reduced sales price be high enough to cover the incremental costs of filling the order?

• Incremental costs are the variable costs of filling the order and any additional fixed costs.

• (Special SP – Special Unit VC) X Units in Order – Additional FC = Additional Operating Income

• Will the special order affect regular sales in the long run?

• Consider the effect on current customer base or potential customer

base

Accept the special order only if

The revenue from the special order exceeds the incremental costs of filling the order

With Make or Buy decisions, the company evaluates two alternatives. What are they?

1. Make a product internally

2. Buying that part or product from an external supplier

For Make or Buy Decisions, the company needs to consider :

• What are the variable costs of making the part/product, compared to the price the supplier would charge?

• Can any of the fixed costs be avoided by going with the outside supplier?

• What will the company do with the idle facilities if the company chooses outsourcing?

• What impact will outsourcing have on product quality, delivery times, and staffing

The point of indifference is

the maximum outsourcing price they should be willing to pay.

If the offer price is less than the indifference price, the company would

prefer to buy the good

If the offer price is greater than the indifference price the company would

prefer to make the good

Indifference Point Calculation

Cost to Make = Cost to Buy

• (VC/Unit x Units) + FC = (Purch Price x Units) + FC - Additional operating Income

  • Fixed costs may be lower when buying if some FC are avoidable

  • Additional Operating income represents any returns from using freed-up capacity to generate income (if any)

When calculating the indifference point, we can also take an incremental approach :

(VC/ Units x Units) = (Purch Price x Units) + Additional FC - Additional Operating Income

• Both the total Cost Approach and the Incremental Cost Approach will result in the same indifference price

MAKE OR BUY DECISIONS : SHOULD WE OUTSOURCE?

• If the incremental costs of making EXCEED the incremental costs of the outsourcing

then we outsource

MAKE OR BUY DECISIONS : SHOULD WE OUTSOURCE?

• If the incremental costs of making ARE LESS THAN the incremental costs of the outsourcing

DONT OUTSOURCE!!! MAKE

What is a segment?

A segment can be defined as any part of a company, such as a product line, store, or department.

For this type of decision, the question is : Should we keep all segments, or is there a segment we should drop?

Key considerations to make when dropping a segment :

• What contribution margin would be lost?

• Can any fixed costs be avoided?

• Will discontinuing affect sales of other products?

• What can be done with freed capacity?

Definition of a Segment Margin

The overall impact of the segment that is separate from any common fixed costs

If a segment is removed, the segment margin will _

no longer exist in the company’s operating income

If a segment is added, the segment margin will

be added to the company’s operating income

The use of a segment margin allows us to analyze our segments through

a Segmented Income Statement

Traceable Costs :

• Costs that relate directly to the operations of a given segment.

• These costs will not be incurred if the segment is dropped.

• Variable costs are always traceable to a segment.

• Fixed costs can be traceable to a segment

Common Costs:

• Costs incurred that DO NOT directly relate to the operations of a given segment.

• Common costs are often allocated arbitrarily to segments within a company.

• Common costs REMAIN if the segment is dropped and are allocated to another segment.

• Common costs should not be used to decide if a segment should be dropped.

• Fixed costs can be common costs

DECISION RULE : SHOULD WE DISCONTINUE A SEGMENT?

If the segment margin lost from discontinuing the segment is positive

DO NOT DISCONTINUE

DECISION RULE : SHOULD WE DISCONTINUE A SEGMENT?

If the segment margin lost from discontinuing the segment is negative

DISCONTINUE!!!

Sell or Process Further decisions consider

Should we sell the product now, as it currently stands, OR

Should we continue processing it (incur more costs) and sell later at a higher price

Key Considerations of Sell or Process Further decisions :

• How much revenue will the company receive if it sells the product now?

• How much revenue will the company receive if it processes the product further?

• How much will it cost to process further?

Costs previously incurred (sunk costs) should not be considered when making this decision

DECISION RULE : SELL AS IS OR PROCESS FURTHER?

If incremental revenue from processing further EXCEEDS extra cost of processing further :

PROCESS FURTHER

DECISION RULE : SELL AS IS OR PROCESS FURTHER?

If incremental revenue from processing further IS LESS THAN extra cost of processing further :

DO NOT PROCESS FURTHER

Should the manager allocate all the scare resource to the product with the highest contribution margin per unit of the resource to maximize operating income?

YES if demand is such that the company can sell every unit it makes

• If demand for the product is limited, produce enough to meet that demand, and use the remaining machine hours to produce other products.

DECISION RULE : WHICH PRODUCTS SHOULD WE EMPHASIZE?

There is NO CONSTRAINT :

Emphasize the product with the highest contribution margin per unit

DECISION RULE : WHICH PRODUCTS SHOULD WE EMPHASIZE?

There is A CONSTRAINT :

Emphasize the product with the highest contribution margin per unit of the constraint.

Which of the following is considered when deciding whether to accept a special​ order?

a. Are fixed costs ​affected?

b. Will regular sales be affected in the long ​run?

c. Is there sufficient excess​ capacity?

d. Is the special unit contribution margin ​positive?

e. All of the above are considered.

e. All of the above are considered

Which of the following costs would be considered sunk costs?

A. CEO salary, not based on performance

B. Direct Labor wages

C. Yearly depreciation on factory equipment

D. Utilities expense

E. None of the above

C. Yearly depreciation on factory equipment

T/F : The only criteria necessary to make information relevant to the decision-making process is that it differs between alternatives.

FALSE

Which of the following factors would lead a company to buy a component rather than make it?

A. Greater control over production quality

B. Employee concerns about outsourcing

C. Excess productive capacity

D. An unpredictable supplier of the component

E. None of the above

E. None of the above

Which of the following products could not usually be processed further?

A. Wheat

B. Flour

C. Wristwatch

D. Cloth

E. All of the above

C. Wristwatch

Which of the following statements is true with regard to​ short-term decision-making?

a. Fixed costs should be considered on a per unit basis.

b. Variable costs should be considered in total.

c. Qualitative and quantitative information should be considered.

c. Qualitative and quantitative information should be considered