Chapter 8: Relevant Costs for Short-Term Decisions – Study Notes

Relevant Costs for Short-Term Decisions

Introduction to Relevant Information

Short-term business decisions require managers to focus on information that is both future-oriented and different among alternatives. This approach ensures that only costs and revenues that will change as a result of the decision are considered, leading to more effective and rational choices.

• Relevant Information: Must (1) pertain to the future and (2) differ among alternatives.

• Sunk Costs: Costs incurred in the past that cannot be changed; these are not relevant to current decisions.

• Incremental Information: Only consider revenues and costs that will change as a result of the decision.

• Contribution Margin Approach: Separate variable revenues and costs (contribution margin) from fixed costs to analyze their distinct effects.

• Fixed Cost Per Unit: Ignore this figure, as fixed costs are incurred in total and often cannot be avoided.

Types of Short-Term Decisions

• Regular Pricing Decisions

• Special Order Decisions

• Discontinue Decisions

• Product Mix with Constraint Decisions

• Outsourcing ("Make or Buy") Decisions

Regular Pricing Decisions

Pricing decisions are fundamental to business profitability. The approach depends on whether the company is a price-setter or a price-taker:

• Price-Setters: Offer unique products, face less competition, and can use Cost-Plus Pricing.

• Price-Takers: Sell commodity products, face more competition, and must use Target Costing to achieve desired profits.

Cost-Plus Pricing

• Calculate total cost: $y = vx + f$ (where $v$ = variable cost per unit, $x$ = number of units, $f$ = total fixed costs)

• Add desired profit: $\text{Desired Profit} = \text{Desired Return \%} \times \text{Assets}$

• Determine total revenue and price per unit:

$\text{Total Cost} + \text{Desired Profit} = \text{Total Revenue}$ $\text{Price per unit} = \frac{\text{Total Revenue}}{\text{Number of Units}}$

Target Costing

• Start with market price and subtract desired profit to find the target cost:

$\text{Revenue at Market} = \text{Market Price} \times \text{Number of Units}$ $\text{Target Cost} = \text{Revenue at Market} - \text{Desired Profit}$

• Compare current costs to target cost and seek cost reductions if necessary.

Special Order Decisions

A special order is a one-time request for a large quantity at a reduced price. The decision is whether to accept or reject the order, based on incremental analysis.

• Assess if there is enough excess capacity to fulfill the order.

• Consider the impact on regular sales and whether the special price covers incremental costs.

Special Order Analysis Steps

1. Contribution Margin (CM) Effect: Calculate additional CM from the order: $(\text{Discounted Sales Price} - \text{Variable Cost per Unit}) \times \text{Number of Units} = \text{Additional CM}$

2. Fixed Costs Effect: Include only additional fixed costs incurred by the special order.

3. Net Effect: Combine the above to determine the overall impact on income. Accept the order if income increases.

Discontinue Decisions

Businesses may consider discontinuing a product, department, or location if it is underperforming. The analysis focuses on the impact on contribution margin, avoidable fixed costs, and potential uses for freed capacity.

• Will discontinuing eliminate a positive contribution margin?

• Are there fixed costs that can be avoided?

• Will discontinuing affect sales of other products?

• Can freed capacity be used for other income-generating activities?

Discontinue Analysis Steps

1. Lost Contribution Margin: Contribution margin lost if discontinued (decreases income).

2. Avoidable Fixed Costs: Fixed costs that can be eliminated (increases income).

3. Other Effects: Impact on other products and income from freed capacity.

4. Net Effect: If discontinuing increases income, proceed; otherwise, do not discontinue.

Product Mix with Constraint Decisions

When production or sales are limited by a constraint (e.g., machine hours, display space), businesses must decide how to allocate resources among products to maximize profit.

• Identify the constraint limiting production or sales.

• Calculate contribution margin per unit of constraint for each product.

• Prioritize products with the highest contribution margin per constraint unit, considering demand.

Product Mix Analysis Example

Product	Sales Price	Variable Cost	CM per Unit	Units per Constraint Unit	CM per Constraint Unit
Product A	$30	$12	$18	10	$180
Product B	$60	$48	$12	20	$240

• Product B yields the highest contribution margin per machine hour ($240), so prioritize its production.

• With 2,000 machine hours and unlimited demand: $2,000 \times 20 = 40,000$ units of Product B can be produced.

Outsourcing ("Make or Buy") Decisions

Outsourcing involves deciding whether to produce a product/component internally or purchase it from an external supplier. The analysis compares the total relevant costs of each alternative.

• Compare variable costs to make versus buy.

• Identify any avoidable fixed costs if outsourcing.

• Consider potential income from freed capacity if outsourcing.

Make or Buy Analysis Table

	Total Cost to Make	Total Cost to Buy
Variable Costs	Variable Mfg. Expense per unit × # units	Purchase Price per unit × # units
Fixed Costs	Blank (most fixed costs are unavoidable)	− Any Avoidable Fixed Costs
Freed Capacity	Blank (no freed capacity if making)	− Any New Income from Freed Capacity
Total Cost	Total	Total

• Choose the option with the lower total cost to maximize operating income.

Additional info: In all analyses, focus on costs and revenues that will change as a result of the decision. Ignore sunk costs and unavoidable fixed costs, as they are not relevant to the decision at hand.