(22) Short-Term Business Decisions (Chapter 10): Study Notes for Financial-Accounting Students

Short-Term Business Decisions

Introduction

This chapter focuses on the process and considerations involved in making short-term business decisions. These decisions are crucial for managers seeking to optimize profitability and operational efficiency in the short run. The main topics include identifying relevant information, pricing strategies, product and sales mix decisions, outsourcing, and processing further decisions.

Relevant Information for Short-Term Decisions

Definition and Importance

• Relevant Information: Expected future data that differs among alternatives and impacts the decision-making process.

• Relevant Costs: Costs that will change depending on the decision made.

• Relevant Revenues: Revenues that will differ among alternatives.

• Irrelevant Costs and Revenues: Costs and revenues that do not affect the decision, either because they are sunk (incurred in the past) or do not differ among alternatives.

• Sunk Costs: Past costs that cannot be changed by any future action (e.g., depreciation, original purchase price).

Nonfinancial (Qualitative) Factors

• Qualitative factors can be relevant, such as employee morale, customer relationships, and product quality.

• Examples: Outsourcing may reduce control over quality; closing plants may affect morale; special pricing may upset regular customers.

Differential Analysis

• A method for making short-term decisions by focusing on differences in revenues and costs between alternatives.

• Key steps: Identify relevant revenues, costs, and profits; use a contribution margin approach (separating variable from fixed costs).

Regular and Special Pricing Decisions

Setting Regular Prices

• Managers consider: target profit, customer willingness to pay, and whether the company is a price-taker or price-setter.

• Price-Taker: Little control over price; uses target pricing.

• Price-Setter: More control over price; uses cost-plus pricing.

Target Pricing

• Used by price-takers. Starts with market price, subtracts desired profit to find maximum allowed cost.

• All costs (product and period, fixed and variable) must be covered.

• Options if target profit is not met: reduce costs, increase sales volume, change product mix, differentiate product, or combine strategies.

Cost-Plus Pricing

• Used by price-setters. Starts with total product cost, adds desired profit to set price.

• Formula: $\text{Cost-Plus Price} = \text{Total Cost per Unit} + \text{Desired Profit per Unit}$

Special Pricing Decisions

• Occur when a customer requests a one-time order at a reduced price.

• Considerations: excess capacity, whether price covers differential costs, and impact on regular sales.

• Decision rule: Accept if incremental revenue exceeds incremental costs and there are no negative long-term effects.

Dropping a Product, Product Mix, and Sales Mix Decisions

Dropping Unprofitable Products or Segments

• Key questions: Does the product provide a positive contribution margin? Will fixed costs continue? Are direct fixed costs avoidable? Will dropping affect other sales? What to do with freed capacity?

• Allocated fixed costs are generally irrelevant unless they can be avoided.

• Decision rule: Drop if total relevant costs saved exceed lost contribution margin.

Product Mix Decisions

• Constraints (e.g., machine hours, materials) limit production.

• Managers should prioritize products with the highest contribution margin per unit of the constraint.

• Formula: $\text{Contribution Margin per Constraint Unit} = \frac{\text{Contribution Margin per Unit}}{\text{Constraint Used per Unit}}$

• Maximize total contribution margin within constraint and market limits.

Sales Mix Decisions

• Merchandising companies face constraints like display space.

• Choose products that maximize contribution margin per unit of constraint (e.g., per foot of shelf space).

Outsourcing and Processing Further Decisions

Outsourcing (Make-or-Buy Decisions)

• Managers decide whether to produce components in-house or buy from external suppliers.

• Consider variable costs, avoidable fixed costs, and opportunity costs (benefits forgone by not using resources for another purpose).

• Decision rule: Outsource if the cost to buy plus any opportunity cost is less than the cost to make.

Sell or Process Further Decisions

• Decide whether to sell a product as is or process it further for additional revenue.

• Key considerations: additional revenue from further processing, additional costs, and joint costs (irrelevant as they are sunk for this decision).

• Decision rule: Process further if incremental revenue exceeds incremental processing costs.

Key Formulas and Decision Rules

• Contribution Margin: $\text{Contribution Margin} = \text{Sales Revenue} - \text{Variable Costs}$

• Contribution Margin Ratio: $\text{Contribution Margin Ratio} = \frac{\text{Contribution Margin}}{\text{Sales Revenue}}$

• Target Full Product Cost: $\text{Target Full Product Cost} = \text{Market Price} - \text{Desired Profit}$

• Cost-Plus Price: $\text{Cost-Plus Price} = \text{Total Cost per Unit} + \text{Desired Profit per Unit}$

• Contribution Margin per Constraint Unit: $\text{Contribution Margin per Constraint Unit} = \frac{\text{Contribution Margin per Unit}}{\text{Constraint Used per Unit}}$

Summary Table: Short-Term Decision Types and Key Considerations

Decision Type	Main Considerations	Key Rule
Regular Pricing	Target profit, market price, cost structure	Cover all costs and desired profit
Special Pricing	Excess capacity, incremental costs, long-term effects	Accept if incremental revenue > incremental cost
Dropping Product/Segment	Contribution margin, avoidable fixed costs, effect on other sales	Drop if costs saved > lost contribution margin
Product Mix	Constraints, contribution margin per constraint unit	Emphasize highest contribution margin per constraint
Sales Mix	Display space, contribution margin per space unit	Maximize profit per constraint unit
Outsourcing	Variable and avoidable fixed costs, opportunity cost	Outsource if buy cost + opportunity cost < make cost
Sell or Process Further	Incremental revenue and cost, joint costs (irrelevant)	Process further if incremental revenue > incremental cost

Additional info:

• All formulas and decision rules are standard in managerial accounting and are inferred from the context of the provided slides and textbook structure.