Chapter 8 Notes: Relevant Costs for Short-Term Decisions

Chapter 8: Relevant Costs for Short-Term Decisions

Relevant Information

  • Must pertain to the future.
  • Must differ among alternatives. Clearly define alternatives to check this characteristic.

Keys to Making Short-Term Decisions

  1. Focus on Relevant Information Only
    • Ignore sunk costs: Costs that happened in the past and cannot be changed.
    • Focus on incremental information: Information that changes based on the decision.
    • Ignore information that will not change regardless of the decision, such as unavoidable fixed costs.
  2. Use a Contribution Margin Approach
    • Consider variable revenues and costs (contribution margin) separately from fixed costs.
    • Calculate and separate changes to CM and Fixed Costs from the decision.
    • Ignore any “fixed cost per unit” amounts as misleading.

Five Decisions in Chapter 8

  • Regular Pricing Decisions
  • Special Order Decisions
  • Discontinue Decisions
  • Product Mix with Constraint Decisions
  • Outsourcing (“Make or Buy”) Decisions

Regular Pricing Decisions

  • Pricing affects profits.
  • Determine if the business is a price-setter or price-taker.

Price-Setters

  • More unique product.
  • Less competition.
  • Brand name.
  • Use Cost-Plus Pricing.

Price-Takers

  • Lacks uniqueness.
  • More competition.
  • No brand.
  • Must use Target Costing to get costs down to a level that will allow them to make desired profit.

Cost-Plus Pricing

  • Formula: Total Cost + Desired Profit
  • Equation: y = vx + f + Desired Profit
  • Desired Profit: Desired Return \% × Assets
  • Price per unit: Total Revenue ÷ # Units

Target Costing

  • Revenue @ Market: Market Price × # Units − Desired Profit
  • Desired Profit: Desired Return \% × Assets
  • Target Cost.
  • Must compare current costs to target cost and seek cost savings as needed.

Special Order Decisions

  • Customer requests a one-time special order at a reduced price.
  • Alternatives: accept or reject.
  • Considerations:
    • Excess capacity available?
    • Effect on regular sales in the long run?
    • Will the reduced sales price cover the incremental costs?
      • Variable costs per unit.
      • Additional fixed costs.

Special Order Analysis: Incremental Analysis

  1. CM Effect
    • Additional Contribution Margin brought in by the order.
    • Is the discounted sales price higher than the variable costs per unit?
    • Formula: (Discounted Sales Price – Variable Cost Per Unit) × # Units = Additional CM
    • Increases Income
  2. Fixed Costs Effect
    • Additional Fixed Costs from this particular order.
    • Additional Fixed Costs  Decreases Income
  3. Net Effects
    • If the special order increases income overall, accept it.
    • If the special order decreases income overall, reject it.

Discontinue Decisions

  • Consider discontinuing a product line, department, store location etc.
  • Alternatives: discontinue or do not discontinue.
  • Considerations:
    • Does the product provide a positive contribution margin?
    • Are there any fixed costs that can be avoided if we discontinue?
    • Will discontinuing affect sales of other products?
    • What could be done with the freed capacity?

Discontinue Analysis: Incremental Analysis

  1. CM Effect
    • Amount of Contribution Margin lost if discontinuing.
    • Lost Contribution Margin  Decreases Income
  2. Fixed Costs Effect
    • Avoidable Fixed Costs that would be eliminated if discontinued.
    • Avoidable Fixed Costs  Increases Income
  3. Freed Capacity or Other Product Effects
    • Could discontinuing hurt our income from other products?
    • Could the freed capacity be used to increase income?
    • Decline in CM of another product  Decreases Income
    • Income from freed capacity  Increases Income
  4. Net the Effects
    • If discontinuing would increase income overall, discontinue.
    • If discontinuing would decrease income overall, do not discontinue.

Product Mix with Constraint Decisions

  • Constraint: Restriction on the volume of product that can be made/sold.
    • Examples: production time, display space.
  • Product mix: Number of units of each product that a business chooses to make/sell.
  • Considerations:
    • What constraint limits production/sales?
    • Which product offers the highest contribution margin per unit of the constraint?
    • Would emphasizing one product over another affect fixed costs or sales of other products?

Product Mix with Constraint Analysis

  • Calculate the contribution margin per unit of the constraint for each product.
  • Choose the product with the highest contribution margin per unit of constraint.
  1. Calculate CM per constraint unit for each product
    • Formula: CM per unit / # units that fit in one constraint unit
    • Example:
      Product A:
      Sales Price:30
      Variable Cost: -12
      CM per unit: 18
      Units per machine hour: 10
      CM per machine hour: 180

Product B:
Sales Price: $60
Variable Cost: -48
CM per unit: 12
Units per machine hour: 20
CM per machine hour: $$240

  1. Choose the product with the highest contribution margin per unit of constraint
    • Product B has the highest contribution margin per machine hour
    • We have 2,000 machine hours available and unlimited demand of either product.
    • 2,000 machine hours × 20 units of Product B per machine hour = 40,000 units of Product B
    • (And 0 units of Product A because no machine time left)

Outsourcing / “Make or Buy” Decisions

  • Outsourcing: Purchasing a product from an outside company instead of producing it.
  • Alternatives: make (do not outsource) or buy (outsource).
  • Considerations:
    • How do the variable costs to make compare with the variable costs to buy?
    • Are any fixed costs avoidable if we outsource?
    • What could be done with the freed capacity?

Make or Buy Analysis

  • Compare the total cost to make vs. the total cost to buy.
  • Separate out the effects of variable costs, fixed costs, and freed capacity.
Total Cost to Make
  • Variable Costs
    Variable Mfg. Expense per unit × # units
  • Fixed Costs
    Blank*
  • Freed Capacity
    Blank***
  • Total Cost
    Total
Total Cost to Buy
  • Purchase Price per unit × # units
  • − Any Avoidable Fixed Costs**
  • − Any New Income from Freed Capacity**
  • Total Cost
    Total

Choose the option with the lower total cost.

Notes:
  • Fixed costs are usually unavoidable, so excluding makes analysis more relevant
  • Avoidable fixed costs and income from freed capacity offset the cost of purchasing the product.
  • Freed capacity is only relevant if we decide to buy.