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Relevant Costs for Short-Term Decisions

Chapter 8

Objective 1

Describe and identify information relevant to short-term business decisions

How Managers Make Decisions

Define business goals

Identify alternative courses of action

Gather and analyze relevant information

Choose best alternative

Implement decision

Follow-up: Compare actual with anticipated results

Relevant and Irrelevant Information

Relevant

Expected future (cost and revenue) data

Differs among alternative courses of action

Is both quantitative and qualitative

Irrelevant

Costs that do not differ between alternatives

Sunk costs – incurred in past and cannot be changed

Relevant Nonfinancial Information

Nonfinancial, or qualitative factors, also play a role in managers’ decisions.

laying off employees

outsourcing, reduced control over delivery time and product quality

discounted prices to select customers

Managers who ignore qualitative factors can make serious mistakes.

Six Short-Term Special Decisions

Special sales orders

Pricing

Discontinuing products, departments, and stores

Product mix

Outsourcing (make or buy)

Selling as is or processing further

Keys to Making Short-Term Special Decisions

Decisions approach

Relevant information approach or incremental analysis approach

Two keys in analyzing short-term special business decisions

Focus on relevant revenues, costs, and profits

Use contribution margin approach that separates variable costs from fixed costs

Sustainability and Short-term Business Decisions

View every decision as having an impact on

People

Planet

Profitability

Timberland, “doing well and doing good”

Example: Employees given PTO to volunteer

Costly

Objective 2

Decide whether to accept a special order

A customer requests a one-time order at a reduced sale price, often for a large quantity:

Special Order Considerations

DECISION RULE:

Do we have excess capacity available to fill this order?

Yes

Consider further

Reject the special order

Special Sales Order

DECISION RULE:

Is the special reduced sales price high enough to cover the incremental costs of filling the order?

If revenues are greater than expected cost increase

Accept the special order

If revenues are less than expected cost increase

Reject the special order

Special Sales Order

DECISION RULE:

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

If no to these questions

Accept the special order

If yes to these questions

Reject the special order

Incremental Analysis of Special Sales Order, Exhibit 8-6


Expected increase in revenues—sale of 20,000 oil filters x $1.75 each	$ 35,000
Expected increase in expenses—variable manufacturing costs: 20,000 oil filters $1.20 each	(24,000)
Expected increase in operating income	$ 11,000

Now turn to E8-16A

E8-16A

Prepare an incremental analysis to determine whether Collectible Cards should accept the special sales order assuming fixed costs would not be affected by the special order.

Would accept the special order because the cost per part to make it is only $0.30 per part versus the $0.40 per part selling price being offered by the buyer.


Variable costs: Direct Materials Direct Labor Variable Overhead	$0.13 0.06 0.11
Total Cost	$0.30

E8-16A (cont.)

Now assume that the Hall of Fame wants special hologram baseball cards. Collectible Cards must spend $5,000 to develop this hologram, which will be useless after the special order is completed. Should Collectible Cards accept the special order under these circumstances? Show your analysis.


Expected increase in revenues—sale of 57,000 cards x $0.40 each	$ 22,800
Expected increase in expenses—variable manufacturing costs: 57,000 cards x $0.30 each Special hologram cost	(17,100) (5,000)

Expected increase in operating income	$ 700

Objective 3

Describe and apply different approaches to pricing

Regular Pricing Considerations

What is our target profit?

How much will customers pay?

Are we a price-taker or a price-setter for this product?

Price-Taker vs Price-Setter

Price-Takers	Price-Setters
Product lacks uniqueness	Product is more unique
Heavy competition	Less competition
Pricing approach emphasizes target costing	Pricing approach emphasizes cost-plus pricing

Target Costing – Exhibit 8-9

Market price minus desired profit = target cost

Target Cost includes:

Development cost – Marketing cost

Design cost – Delivery cost

Production cost – Service cost

	Calculations	Total
Revenue at market price	250,000 units x $3.00 price =	$ 750,000
Less: Desired profit	10% x $1,000,000 of assets	(100,000)
Target total cost		$650,000

Two potential outcomes when using target costing

Actual cost less than target total cost

Actual cost greater than target total cost

Other Strategies

Increase sales

Use CVP analysis to compute target sales to achieve its target profit.

Change or add to its product mix

Offer levels of the same product

Offer new items to the product mix with high CM

Remove items with the lowest CM

Differentiate its products – (make it unique)

Branding

Quality

Service packs

Cost-Plus Pricing

The opposite of the target-pricing approach

Starts with the company’s full costs

Adds the desired profit to determine a cost-plus price

Total cost

Plus: Desired profit

Cost –plus price

Calculating Cost-Plus Price, Exhibit 8-12

If the current price is $3.00, can the company charge $3.20?

		Total
Current variable costs	250,000 units x $1.50 per unit =	$ 375,000
Plus: Current fixed costs		+ 325,000
Current total costs		$700,000
Plus: Desired profit	10% x $1,000,000 of assets	+ 100,000
Target revenue		$800,000
Divided by number of units		÷ 250,000
Cost-plus price per unit		$ 3.20

Pricing Decisions

DECISION RULE:

How to Approach Pricing?

If company is a price-taker for the product:

Emphasize target costing approach

If the company is a price-setter for the product:

Emphasize cost-plus pricing approach

Now turn to E8-19A

E8-19A

Which approach to pricing should Smith Builders emphasize? Why?

Target costing – Firm is a price taker, product lacks uniqueness and there is heavy competition

E8-19A (cont.)

Will Smith Builders be able to achieve its target profit levels? Show your computations.

The answer is no, the target cost is less than variable cost.

	Calculations	Total
Revenue at market price		$ 206,000
Less: Desired Profit	14% of the variable cost $190,000	(26,600)
Target cost		$ 179,400

E8-19A (cont.)

If Smith Builders upgrades, what will the new cost-plus price per home be? Should the company differentiate its product in this manner? Show your analysis.

Yes, they should customize – they will achieve their target profit levels with the cost-plus price.

		Total
Current total costs	($190,000 + $18,000)	$208,000
Plus: Desired profit	(14% x variable cost of $208,000)	+ 29,120
Cost-plus price		$237,120

Objective 4

Decide whether to discontinue a product, department, or store

Other Short-term Business Decisions Managers Face

When to discontinue a product, department, or store

How to factor constrained resources into product mix decisions

When to make a product or outsource it

When to sell as is or process further

Considerations for Discontinuing Products, Departments or Stores, Exhibit 8-14

Does product provide positive contribution margin?

Considerations for Discontinuing Products, Departments or Stores

Will the total fixed costs continue to exist even if the product line is discontinued?

Can any direct fixed costs of the product be avoided if the product line is discontinued?

Use incremental analysis for discontinuing a product

Discontinuing Products, Departments or Stores

DECISION RULE:

Discontinue a product, department, or store?

If lost revenues from discontinuing a product, department, or store exceed the cost savings from discontinuing:

Do not discontinue

If total cost savings exceed the lost revenues from discontinuing a product, department, or store:

Discontinue

Now turn to E8-20A

E8-20A

Prepare an incremental analysis to show whether Entertainment Plus should discontinue the DVD product line. Will discontinuing DVDs add $18,000 to operating income? Explain.


Expected decrease in revenues:
Sale of DVDs	$136,000
Expected decrease in expenses:
Variable manufacturing expenses	86,000
Expected decrease in operating income	$50,000

E8-20A (cont.)

Assume that Entertainment Plus can avoid $20,000 of fixed expenses by discontinuing the DVD product line (these costs are direct fixed costs of the DVD product line). Prepare an incremental analysis to show whether Entertainment Plus should stop selling DVDs.


Expected decrease in revenues:
Sale of DVDs		$136,000
Expected decrease in expenses:
Variable manufacturing expenses	$86,000
Direct fixed expenses	$20,000
Expected decrease in total expenses		106,000
Expected decrease in operating income		$30,000

E8-20A (cont.)

Now, assume that all $68,000 of fixed costs assigned to DVDs are direct fixed costs and can be avoided if the company stops selling DVDs. However, marketing has concluded that Blu-ray disc sales would be adversely affected by discontinuing the DVD line . Blu-ray disc production and sales would decline 10%. What should the company do?

Expected decrease in revenues:
Sale of DVDs	$136,000
Sale of Blu-rays	14,300	$150,300
Expected decrease in expenses:
Variable manufacturing expenses	$86,000
Direct fixed expenses	$68,000
Expected decrease in total expenses		154,000
Expected increase in operating income		$3,700

Objective 5

Factor resource constraints into product mix decisions

Product Mix Considerations – Example from pages 477 - 479

Data	Per Unit
	Shirts	Jeans
Sale price
Less: Variable expenses
Contribution margin
Contribution margin ratio:
Product A —
Product B —

$30

$60

(12)

(48)

$18

$12

60%

20%

$18 ÷ $30

$12 ÷ $60

Product Mix Considerations – Exhibit 8-18

	Shirts	Jeans
(1) Units that can be produced each machine hour	10	20
(2) Contribution margin per unit	x $18	x $12
Contribution margin per machine hour (1) x (2)	$ 180	$ 240
Available capacity—number of machine hours	x 2,000	x 2,000
Total contribution margin at full capacity	$360,000	$480,000

Product Mix

DECISION RULE:

Which product to emphasize?

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

Product Mix When Demand Is Limited or Fixed Costs Change

What if demand is limited, due to competition or other factors? [In this example, company has demand for only 30,000 jeans, which consume in total 1,500 hours (30,000 jeans/20 jeans per hour)]

What if fixed costs are different when a different product mix is emphasized?

Example	Shirts	Jeans
Contribution margin per machine hour	$ 180	$ 240
Machine hours devoted to product	x 500	x 1,500
Total contribution margin at full capacity	$90,000	$360,000

Now turn to E8-22A

E8-22A

What product mix will maximize operating income?

Get Fit
Product Mix Analysis
	Deluxe	Regular
Sale price per unit
Variable costs per unit
Contribution margin per unit
Units produced with equivalent
number of machine hours
Contribution margin for equivalent
number of machine hours

E8-22A

What product mix will maximize operating income?

Get Fit
Product Mix Analysis
	Deluxe	Regular
Sale price per unit	$1,010	$560
Variable costs per unit	781a	427b
Contribution margin per unit	229	133
Units produced with equivalent
number of machine hours	× 1	× 3
Contribution margin for equivalent
number of machine hours	$ 229	$399

a ($310 + $ 88 + $264 + $119)

b ($90 + $184 + $ 88 + $ 65)

Get Fit should produce only the Regular model.

Objective 6

Analyze outsourcing (make-or-buy) decisions

Outsourcing (Make or Buy) Considerations

To buy a product or service or produce it in-house

The heart of the decisions : how best to use available resources

How do our variable costs compare to the outsourcing cost?

Are any fixed costs avoidable if we outsource?

What could we do with the freed capacity?

Outsourcing

DECISION RULE:

Should the company outsource?

If the incremental costs of making exceed the incremental costs of outsourcing:

Outsource

If the incremental costs of making are less than the incremental costs of outsourcing:

Do not outsource

Now turn to E8-25A

E8-25A

Given the same cost structure, should OptiSystems make or buy the switch?

OptiSystems
Incremental Analysis for Outsourcing Decision
	Make Unit	Buy Unit	Cost to Make Minus Cost to Buy
Variable cost per unit:
Direct materials
Direct labor
Variable overhead
Purchase price from outsider
Variable cost per unit

E8-25A

Given the same cost structure, should OptiSystems make or buy the switch?

OptiSystems
Incremental Analysis for Outsourcing Decision
	Make Unit	Buy Unit	Cost to Make Minus Cost to Buy
Variable cost per unit:
Direct materials	$ 10.00a	$ —	$ 10.00
Direct labor	2.50b	—	2.50
Variable overhead	3.00c	—	3.00
Purchase price from outsider	—	17.00	(17.00)
Variable cost per unit	$15.50	$17.00	$ (1.50)

a $720,000 / 72,000 = $10.00/unit

b $180,000 / 72,000 = $2.50/unit

c $216,000 / 72,000 = $3.00/unit

E8-25A (cont.)

Now, assume that OptiSystems can avoid $100,000 of fixed costs a year by outsourcing production. In addition, because sales are increasing, OptiSystems needs 77,000 switches a year rather than 72,000. What should OptiSystems do now?

	Make switches	Buy switches
Variable cost per unit (from part 1)
× Units needed
Total variable costs
Fixed costs
Total relevant costs

E8-25A (cont.)

	Make switches	Buy switches
Variable cost per unit (from part 1)	$ 15.50	$ 17.00
× Units needed	77,000	77,000
Total variable costs	$ 1,193,500	1,309,000
Fixed costs	468,000	368,000*
Total relevant costs	$1,661,500	$1,677,000

*($468,000 − $100,000 avoidable)

E8-25A (cont.)

Given the last scenario, what is the most OptiSystems would be willing to pay to outsource the switches?

Cost if making switches

Cost of outsourcing switches

* Where x = outsourcing cost per switch

($15.50 × 77,000) + $468,000

(x)* (77,000) + $368,000

Variable costs + fixed costs

$1,193,500 + $468,000

77,000x + $368,000

$1,293,500

77,000x

$16.80(rounded)

Objective 7

Make sell as-is or process further decisions

Sell As-Is or Process Further Considerations

How much revenue is generated if we sell the product as is?

How much revenue is generated if we sell the product after processing it further?

How much will it cost to process the product further?

Analysis for Sell As Is or Process Further Decision – Exhibit 8-25

	Sell As-Is	Process Further	Additional Revenue/(Costs) from Processing Further
Expected revenue from selling 50,000 quarts of regular olive oil at $5.00 per quart	$250,000
Expected revenue from selling 50,000 quarts of gourmet dipping oil at $7.00 per quart		$350,000	$100,000
Additional costs of $0.75 per quart to convert 50,000 quarts of plain olive oil into gourmet dipping oil		(37,500)	(37,500)
Total net benefit	$250,000	$312,500	$62,500

Sell As-Is or Process Further

DECISION RULE:

Sell as-is or process further?

If extra revenue (from processing further) exceeds extra cost of processing further:

Process further

If extra revenue (from processing further) is less than extra cost of processing further:

Sell as is

Now turn to E8-28A

E8-28A

	Sell as is (gallons)	Process further
Sales revenue per unit	$ 6.00	$ 0.50
Additional process costs per unit - packaging	(0.10)	(0.05)
Additional process costs per unit - fruit	(0.00)	(0.15)
Net benefit per unit	$ 5.90	$ 0.30
Number of units produced per batch	× 600	× 12,800
Net benefit per batch	$3,540	$ 3,840

End of Chapter 8