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Short-Term Business Decisions

Chapter 8


Making Decisions

• Define goals• Identify alternative courses of action• Gather and analyze relevant information• Compare alternatives• Choose best alternative


Objective 1

Describe and identify information relevant to business decisions


Relevant Information

• Affects the future and• Differs among alternative courses of action• Quantitative and qualitative


Relevant Information Approach

• Incremental analysis - how operating income differs under each alternative

• Two keys– Focus on relevant revenues, costs, and profits– Use contribution margin approach


Irrelevant Costs

• Costs that do not differ between alternatives

• Sunk costs – incurred in past and cannot be changed


Objective 2

Make special order and pricing decisions


Special Sales Order

Is there excess capacity?

Yes

Consider further

No

Reject the special order


Special Sales Order

DECISION RULE: Accept special order?

Increase in revenues > increase in variable & fixed

costs?

Accept the special order

Increase in revenues < increase in variable & fixed

costs?

Reject the special order


Qualitative Factors

Will special order affect regular sales in the long run?


E8-16 (1)Sports-Cardz

Incremental Analysis of Special Sales OrderExpected increase in revenues

(50,000 packs $0.40) $ 20,000Expected increase in expenses:

Variable manufacturing cost:(50,000 $0.35) (17,500)

Expected increase in operating income $ 2,500


E8-16 (2)Sports-Cardz

Incremental Analysis of Special Sales OrderExpected increase in revenues

(50,000 packs $0.40) $ 20,000Expected increase in expenses:

Variable manufacturing cost:(50,000 $0.35) $(17,500)Fixed manufacturing costs (5,000)(22,500)

Expected decrease in operating income $(2,500)


Setting Regular Prices

• What is our target profit?• How much will customers pay?• Are we a price-taker or a price-setter for

this product?


Price Taker

• Product lacks uniqueness• Heavy competition• Pricing approach emphasizes target

pricing


Target Pricing

Revenue at market price- Desired profit Target full cost


Price Setters

• Product is more unique• Less competition• Pricing approach emphasizes cost-plus

pricing


Cost-Plus Pricing

Full cost+ Desired profit Cost-plus price


Pricing Decisions

DECISION RULE: How to Approach Pricing?

Is company a price-taker for the product?

Emphasize target pricing approach

Is company a price-setter for the product?

Emphasize cost-plus pricing approach


E8-18

Req 2 Revenue at market price $200,000- Desired profit ($182,000 x 15%) (27,300) Target full cost $172,700 Actual current variable cost 182,000 Shortfall $9,300


E8-18

Req 3 Full cost $202,000+ Desired profit ($202,000 X 15%) 30,300 Cost-plus price $232,300


Objective 3

Make dropping a product and product-mix decisions


Dropping Products, Departments or Territories

• Does product provide positive contribution margin?

• Will dropping the product affect sales of the company’s other products?

• What can be done with the freed capacity?



• Are there unavoidable fixed costs?– Unavoidable fixed costs continue even if the

product line is dropped• Are there avoidable fixed costs?


DECISION RULE: Drop a product,

department, or territory?

Are lost revenues > its relevant costs?

Do not drop

Are lost revenues < its relevant costs?

Drop



E8-19Video Avenue

Analysis of Dropping VCR-Tape LineExpected decrease in revenues $ (120,000)Expected decrease in expenses:

Variable costs 80,000Expected decrease in operating

income $(40,000)


E8-20Video Avenue

Analysis of Dropping VCR-Tape LineExpected decrease in revenues $ (120,000)Expected decrease in expenses:

Variable costs 80,000Fixed costs 30,000

Expected decrease in operating income $(10,000)


Product Mix

• What constraint(s) stops us from making (or displaying) all the units we can sell?

• Which products offer the highest contribution margin per unit of the constraint?

• Would emphasizing one product over another affect fixed costs?


Product Mix

DECISION RULE: Which product to

emphasize?

The product with the highest contribution margin per unit of

constraint


E8-22 Designer Moderate

Contribution margin per unit $115.00 $60.00Units displayed per sq ft.

300/10,000 x .030650/10,000 x.065

Contribution margin per sq ftof display space $3.45 $3.90

Capacity – sq ft of display space x10,000 x10,000 Total contribution margin at

capacity $34,500 $39,000


Objective 4

Make outsourcing and “sell as is or process further” decisions


Outsourcing (Make or Buy)

• 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?


OutsourcingDECISION RULE:

Should the company outsource?

Are relevant costs to make > relevant costs to buy?

Outsource

Are relevant costs to make < relevant costs to buy?

Do not outsource


E8-24 Make Buy DifferenceIncremental cost per unit:

Direct materials $9.00 $0$9.00Direct labor 1.50 01.50Variable overhead 2.00 02.00Purchase price $14 (14.00)

Incremental cost per unit $12.50 $14$(1.50)


E8-25MakeIncremental cost per unit: $12.50Number of switches x 80,000Total incremental costs $1,000,000

Buy and leave facilities idleIncremental cost per unit: $14.00Number of switches 80,000Total incremental costs $1,120,000


E8-22

Buy and use facilities for other productIncremental cost per unit: $14Number of switches 80,000Total incremental costs to buy $1,120,000Expected profit contribution from

other product (220,000)

Expected net cost$900,000


Sell As-Is or Process Further

• 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?


Sell As-Is or Process Further

DECISION RULE: Sell as is or process further?

Are extra revenues from processing further > extra cost

to process further?

Process further

Are extra revenues from processing further < extra cost

to process further?

Sell as is


8-27Process

Sell As Is FurtherExpected revenue/unit $6.00 $0.50Extra packaging costs/unit (0.10) (0.08)Extra cost for fruit (0.10)Expected net revenue/unit $5.90 $0.32Number of units per batch x 500 x 10,667Net benefit per batch $2,950 $3,413


End of Chapter 8