3 Short-Term Decision Making
- Recognize what costs and benefits are relevant to a short-term decision
- Calculate the net of the costs and benefits relevant to a decision scenario
- Given relevant financial information, recommend an appropriate course of action
The Theory
Often, firms need to make short-term, nonrecurring decisions, such as whether to make or buy a product component, whether to accept a special order for their product, or whether to keep or drop a segment of the business. In these situations, firms must perform a relevant cost-benefit analysis by considering which costs and benefits are relevant to the decision at hand. Relevant costs and benefits (1) occur in the future, and (2) differ across alternatives.
To perform a relevant cost-benefit analysis, compare the relevant costs and benefits of each decision alternative and calculate the net benefit of the decision. The net benefit is the effect the decision will have on the company’s profit.
The Method
An organization system can be very helpful when analyzing the relevant costs and benefits of a decision. Numerous systems exist for this purpose, but we will focus on the following method:
First, identify the decision alternatives, and make a column for each.
Next, identify the relevant costs and benefits of each alternative and place them in the appropriate column.
Finally, total each column and find the difference between the columns. This difference is the net benefit of the decision. Determine which decision alternative results in higher profit for the firm.
Illustrative Example
Pellinore Company has received a special order from Maxwell, Inc. Pellinore incurs $150 in variable costs to manufacture each unit and assigns $30 in fixed costs to each unit as well. Maxwell requires product modifications that will require an extra $15 in variable costs per unit. Pellinore ordinarily charges $220 per unit. Maxwell has offered $200,000 for the entire order of 1,000 units. Pellinore has enough production capacity to fill the order in addition to their regular production needs.
Determine whether it would be financially beneficial for Pellinore to accept the order and calculate the net benefit.
First, make a column for each decision alternative.
- Pellinore can accept the special order or reject it (see columns in table below).
Next, place the relevant costs and benefits of each alternative in the columns.
- Pellinore will incur the regular variable cost of $150 per unit for the 1,000 units if the order is accepted, but not if it is rejected. This variable cost is relevant.
- Fixed costs will not change if the order is accepted. The fixed costs are not relevant.
- Pellinore will incur the additional cost of $15 per unit for the 1,000 units if the order is accepted, but not if it is rejected. This additional cost is relevant.
- The regular price of $220 applies only to regular sales, which Pellinore will incur whether the order is accepted or not. This sales price is not relevant.
- Pellinore will receive the $200,000 offer if the order is accepted, but not if it is rejected. This offer price is relevant.
Finally, find the net benefit of the decision and determine which alternative results in higher profit.
- The net benefit of the decision is $35,000 and favors accepting the special order.
|
|
Accept | Reject |
|---|---|---|
|
Variable costs |
(150,000) |
0 |
|
Additional costs |
(15,000) |
0 |
|
Offered price |
200,000 |
0 |
|
Total |
35,000 |
0 |
Sapulpa Company currently manufactures all components of their product. The manager is trying to decide whether the company should continue to manufacture one of the parts or purchase it from an outside supplier, who would charge $15 per part. Fixed costs associated with manufacturing the part are unavoidable. Expected unit sales are 50,000. Sapulpa incurs the following cost per unit to manufacture the part:
|
Unit
|
Cost
|
| Direct materials (DM) | 4.00 |
| Direct labor (DL) | 6.00 |
| Variable overhead (VOh) | 3.00 |
| Fixed overhead | 4.50 |
| Per-unit cost | 17.50 |
Determine whether it is financially beneficial for Sapulpa Company to purchase the part from the outside supplier and calculate the net benefit.
Lecture Example
Toastem manufactures small appliances. The costs of manufacturing these appliances are listed below. Toastem has received a special order for 2,400 toasters from an appliance retailer whose usual supplier cannot supply the toasters because of a labor strike. Toastem would not incur any variable marketing costs on the special order. The retailer has offered Toastem $10 per toaster. Toastem normally charges $13 per toaster. The following costs are based on a production level of 30,000 toasters per year.
| Per unit | Total | |
|---|---|---|
| Direct labor | 3.00 | 90,000 |
| Direct materials | 3.50 | 105,000 |
| Variable overhead | 2.50 | 75,000 |
| Fixed overhead | 1.50 | 45,000 |
| Total | 10.50 | 315,000 |
| Per unit | Total | |
|---|---|---|
| Variable marketing | 1.00 | 30,000 |
| Fixed marketing | 0.75 | 22,500 |
| Total | 1.75 | 52,500 |
Total product costs: $12.25 per unit, $367,500 total
- If Toastem has the capacity to produce 35,000 toasters per year, should they accept the special order?
- If Toastem has the capacity to produce 30,000 toasters per year, should they accept the special order?
An analysis that compares the relevant costs and benefits of two or more alternatives to determine which alternative is most profitable
Describes a cost or benefit that occurs in the future and differs across alternatives
The financial effect of a decision on a company’s profit
