Short Term Decisions

Things You Must Know

Medium Practice Test

When making a short-term decision, you should do the following:

1) Identify irrelevant costs and ignore them

2) Identify relevant costs and use them in the analysis
Relevant costs are avoidable or incremental in (total for the company)

A cost that is relevant to one decision may be irrelevant to another decision

Irrelevant Costs
Will not change regardless of the decision.
Are the same for all alternatives, ignore these

Sunk Cost – Always Irrelevant
Cost that have already been incurred and are irrevocable; cannot be recovered with a future decision

Relevant Costs
Total costs that will be different if a decision is made and implemented

Important: A variable cost is relevant when the cost per unit stays the same and the total cost changes because the quantity changes.

Avoidable
Can be eliminated in whole or part by choosing one alternative over the other

Incremental
Additional cost the company will incur because you chose this alternative

Opportunity costs
An amount that is not gained or forfeited if you chose a different alternative

Incremental Analysis
Uses only the costs that are relevant

Types of costs always relevant to a decision:

Fixed costs that must be added
Fixed costs that can be saved

Variable product costs – DM, DL, Variable O/H that are incurred every time you make another unit, (also saved every time you do not make a unit)

Opportunity costs – what you do not gain if you chose a different alternative

Types of costs always irrelevant to a decision:

Depreciation – the cost was incurred when the fixed asset was bought and cannot be recovered; also. the cost or book value of fixed assets

Day to day costs of operations that are not specific to a product or customer and have to be incurred because the company is in business

Common short-term decisions made at a company:

A good decision should add to the company’s operating income

1) Dropping a Product Line:

Compare the contribution margin that will be lost to the fixed costs that can be avoided if the line is dropped

Sales $ per unit
– All variable cost per unit related to product line
= Contribution Margin lost if discontinued
– Fixed costs avoided if discontinued
= Change to operating income – keep if this is positive

2) Adding a Product Line:

Compare the contribution margin that will be gained to the additional fixed costs that will be incurred if the line is added

Sales $ per unit
– All variable cost per unit related to product line
= Contribution Margin gained if added
– Fixed costs added if add the product line
= Change to operating income

Get contribution per unit and then:
CM per unit x units sold to get total contribution

3) Special Orders:

A one-time order that is not considered part of normal business, usually at a reduced sale price

Special orders have no effect on unavoidable fixed overhead costs.
Special orders reduce other sales if the plant is already at capacity

Added Revenues – Added costs = impact to profits

Common format:

Sales $ per unit
– All variable cost per unit related to the order
= CM per unit
x Total units of the special order
= Total contribution margin from the order
– Additional total fixed costs
= Impact on profits from the special order

When the company is already at capacity, and will have to give up other sales in order to sell the special order you must also consider the lost contribution margin from the sales to other customers you will not be able to sell

Use the above common format for and compute contribution margin on lost sales using the normal sales price (leave out fixed costs).

Net the lost contribution margin from the lost sales with the impact on profits from the special order

4) Make or Buy Decision:

Compare the cost of the company doing the work or contracting the work to another company.

Common Format:

Make (Do it Yourself)

Variable costs
x Quantity of Units
= Total Variable Costs
+ Fixed Costs Saved
=Total net cost to make

Important: Include only costs that will not be paid in “Make” costs.

Buy (Use Another Company)

Purchase price to buy the product
x Quantity of Units
= Total Variable Costs
+ Opportunity Costs
= Total net cost to buy

Chose the one that gives the lowest net cost in most situations.

5) Sell at Split-off or Process Further:

Joint Products
Two or more products that are produced from a common process and common resources input into production

Split-off Point
The point in the manufacturing process that products can be distinguished as separate products

Joint Costs
Costs incurred up to the split-off point
Joint costs will be allocated to the different products

Management must decide if it is more profitable to process the products after spit off
point in order to turn them into a different product using resources specific to the
new product. This decision is normally stated in terms of sell or process further?

Joint costs are irrelevant in the decision of what to do with the product from
the split-off point forward (sunk costs)

Common format:

Final Sales $ after further processing
– Sales $ at the split-off point
= Incremental Revenue from further processing
– Cost of further processing
= Profit or Loss from further processing

Process further if you will make more profits if you process further

6) Constrained Resources:

A limited resource that limits the company’s ability to satisfy demand

The limited resource can be direct labor hours, a type of direct material square feet in a facility, machine hours, etc.

Total contribution margin will be maximized by selling the products that provide the highest unit contribution margin for each unit of the limited resource.

Common format:

Contribution margin per unit
Amount required of the resource for one unit

= Contribution margin per unit of resource

Then:

Contribution margin per unit of resource
x Quantity of Units to Produce
= Maximum contribution margin

Important:
When sales are changing – always use the contribution margin format
(Add a product, Drop a product, Special Order)