Short-Term Business Decisions

How mangers make decisions?

1. Define business goals.
2. Identify alternative courses of action.
3. Gather and analyze relevant information: compare alternatives (role of
management accountants).
4. Choose the best alternative.

When managers make decisions, they focus on costs and revenues that are
relevant to the decisions.
Relevant information: is the expected future (cost and revenue) data that differs
among alternatives. This information is relevant because they can affect the decision
taken, such as relevant costs, relevant revenue.
Example: if a manger want to make decision about buying a truck, the cost of truck,
sales tax, insurance premium are relevant costs.
Irrelevant information: are those that do not affect the decision, such as sunk costs.
Example: if there are two models of trucks, both have similar fuel efficiency and
maintenance rate, in this case because costs do not differ, they do not affect the
manger decision, therefore they are irrelevant to the decision maker.
Sunk Costs: are costs that were incurred in the past and cannot be changed regardless
of which future action is taken.
Example: the price the company already paid for a truck is a sunk cost, all what we
can do is to keep the truck, trade in it, or sell it for the best price the company can get,
even if it is less than the actual price initially paid.

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Incremental Analysis Approach (Relevant Information Approach)
Instead of looking at the company’s entire income statement under each decision
alternative, we will just look at how operating income would change or differ under
each alternative. Using this approach, we will leave out irrelevant information – the
costs and revenuers that will not differ between alternatives.

Two keys to making short-term special decisions:

1. Focus on relevant revenue, costs, and profits. Irrelevant information creates
information overloads.
2. Use a contribution margin approach that separates variable costs from fixed costs,
because fixed costs and variable costs behave differently, they must be analyzed
separately. Traditional (absorption costing) income statement, which blend fixed
costs and variable costs together, can mislead mangers. Contribution margin
income statement, which isolate costs by behavior (variable or fixed).

1. Special Sales Order Decisions

A special order occurs when a customer requests a one-time order at a reduced sale
price.
Before agreeing to the special deal, a management must consider:
1. Does the company have excess capacity available to fill this order?
If the company is already making as many units as possible (full capacity) with its
existing manufacturing capacity and selling them all at its regular sales price, it
would not make sense to fill a special order at a reduced sales price.
2. Will the reduced sales price be high enough to cover the incremental costs of
filling the order (the variable costs and any additional fixed costs)?
The special price must exceed the variable costs of filling the order or the
company will lose money on the deal. The special order must provide a positive

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contribution margin. Also in some cases, management may have to incur some other
fixed cost to fill the special order. If so they will need to consider whether the special
sales price is high enough to generate a positive contribution margin and cover the
additional fixed costs.
3. Will the special order affect regular sales in the long run?
Will regular customers find out about the special order and demand a lower price or
take their business elsewhere? Will the special order customer come back again and
again, asking for the same reduced price? Will the special order price start a price war
with competitors? Managers must decide whether any profit from the special sales
order is worth these risks or not.
Decision Rule: Accept Special Order?
Accept the special order Reject the special order
If expected increase in If expected increase in
revenues exceeds expected revenues is less than
increase in variable and fixed expected increase in variable
costs. and fixed costs.

Example on special sales order

Suppose that ABC Company made and sold 100,000 units at a selling price $ 12
per unit, manufacturing cost per unit is $ 7 per unit ($ 6.5 variable cost), and fixed
marketing and administrative expenses $ 110,000.
Assume a customer has offered ABC Company $ 67,500 for 10,000 units ($ 6.75 per
unit).
This special sale:
 Will use manufacturing capacity that would otherwise be idle (excess capacity).
 Will not change fixed costs.

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  Will not require any variable non-manufacturing expenses as there is no extra
marketing costs are incurred with this special order.
 Will not affect regular sales.
Required
1. Prepare the income statement before considering special order.
2. Express your opinion in accepting or rejecting this special order.
Solution
Required 1
Traditional (Absorption Costing) Contribution margin (Variable costing)
ABC Company ABC Company
Income statement Income statement
Month ended December 31, 2008 Month ended December 31, 2008

Sales Revenue $ 1,200,000 Sales Revenue $ 1,200,000

- Cost of goods sold (700,000) - Variable expense
Manufacturing cost (650,000)

Gross profit $ 500,000 Contribution margin 550,000

- Marketing and administrative expense (110,000) - Fixed expense
Manufacturing (50,000)
Marketing and administrative (110,000)
Operating income $ 390,000 Operating income $ 390,000

Required 2
According to the traditional (absorption costing) income statement, manager will
reject the special order because cost per unit ($ 7) is higher than selling price ($ 6.75).
Although this cost per unit ($ 7) is a mixed cost containing both fixed and variable
cost components.
On the other hand and according to the contribution margin income statement
which separate fixed and variable cost, variable cost is only $ 6.5 per unit which is
less than selling price ($ 6.75), which means the company is making positive
contribution margin $ 0.25 per.

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 Therefore the manger will accept the special order as using the incremental
approach.

Expected increase in revenue (10,000 units X $ 6.75) $ 67,500

- Expected increase in variable manufacturing costs (10,000 units X $ 6.5) (65,000)
Expected increase in operating income $ 2,500

2. Drop or Delete Products Decisions

Mangers make decisions to decide whether to drop/delete products, departments
those are not as profitable as desired.
Before agreeing to the Delete Products, a management must consider:
 Does the product provide a positive contribution margin?
 Will fixed costs continue to exist, even if the company drops the product?
 Are there any direct fixed costs that can be avoided if the company drops the
product?
 Will dropping the product affect sales of the company’s other products?
 What could the company do with the freed capacity?

Decision Rule: Should we drop a product?

Do not drop Drop
If lost revenue from dropping a If total cost savings exceed the
product or department exceed the lost revenues from dropping a
cost savings from dropping. product or department.

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Example 1
Description A B C
Sales $ 40,000 $ 20,000 $ 30,000
- Variable costs:
Direct Material 5,000 2,500 5,000
Direct Labor 2,000 2,500 8,000
Overhead 5,000 2,500 10,000
- Fixed Costs 10,000 5,000 10,000
Total Costs (Variable & Fixed) $ 22,000 $ 12,500 $ 33,000

Required
The cost accountant’s opinion is to close division C!!!? Do you agree? Why?
Note: fixed cost is not allocated, means that dropping C will not reduce F.C
(unavoidable).
Solution
A B C Total
Sales 40,000 20,000 30,000 90,000
Less V.C (12,000) (7,500) (23,000) (42,500)
C.M 28,000 12,500 7,000 47,500
Less F.C (10,000) (5,000) (10,000) (25,000)
NI 18,000 7,500 (3,000) 22,500

Total Drop C Result

Sales 90000 30000 60000
- VC 42500 23000 19500
CM 47500 7000 40500
- FC (25000) ---- (25000)
NI 22500 7000 15500

Net income will decrease by 7,000 as 25000 will not be allocated.

The optimal opinion is not to drop division C as it achieves positive C.M.

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Example 2
Sharp Company has three product lines, A, B and C. The following information
is available:

A B C
Sales $ 95,000 $ 60,000 $ 34,000
- Variable Costs 58,000 30,000 24,000
CM 37,000 30,000 10,000
- Fixed costs:
Avoidable 14,000 15,000 4,000
Unavoidable 9,000 17,000 2,000
Operating Income $ 5,000 ($ 2,000) $ 2,000

Sharp Company is thinking of dropping product line B because it is reporting a loss.

Required:
1. Make the required analysis assuming Sharp drops line B and does not replace it.
2. Make the required analysis assuming Sharp drops line B and triples the production
and sales of product A without increasing fixed costs.
Solution:
Required 1
Total Drop B Result
Sales 189,000 60,000 129,000
Less V.C 112,000 30,000 82,000
CM 77,000 30,000 47,000
Fixed costs:
Avoidable 33,000 15,000 18,000
Unavoidable 28,000 ----- 28,000
Operating Income 16,000 15,000 1,000

B achieves a positive C.M.

Do not drop B as dropping it will decrease net income by 15,000.

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Required 2
Total Drop B Triple A Result
Sales 189,000 60,000 285,000 414,000
Less V.C 112,000 30,000 174,000 256,000
CM 77,000 30,000 111,000 158,000
Fixed costs:
Avoidable 33,000 15,000 ----- 18,000
Unavoidable 28,000 ----- ------ 28,000
Operating Income 16,000 15,000 111,000 112,000

The optimal decision is to Drop B and triple A, as this will increase net income
by $ 96,000.

Example 3
Pepper industries have three product lines A, B and C. The following
information is available:
A B C
Sales $ 60,000 $ 90,000 $ 24,000
Variable costs (36,000) (48,000) (15,000)
CM 24,000 42,000 9,000
Fixed costs:
Avoidable (9,000) (18,000) (6,000)
Unavoidable (6,000) (9,000) (5,400)
Operating Income $ 9,000 $ 15,000 ($ 2,400)

Assume that product line C is discontinued and replaced with product line B. These
will double the production and sales of product line B without increasing fixed costs.
Required:
Make the required analysis.

Solution:

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 Total Drop C Double B Result
Sales 174,000 24,000 180,000 330,000
Less V.C (99,000) (15,000) (96,000) (180,000)
CM 75,000 9,000 84,000 150,000
Less Fixed costs:
Avoidable (33,000) (6,000) ----- (27,000)
Unavoidable (20,400) ----- ----- (20,400)
Operating Income 21,600 3,000 84,000 102,600

3. Make or Buy (Outsourcing) Decisions

Make or buy decisions are called outsourcing decisions because managers must
decide whether to buy a component product or service, or produce it inside the
company.
Mangers must assess fixed and variable costs separately and know how best to use
available resources.
Managers must consider when deciding whether or not to outsource:
 How do the company’s variable costs compare to the outsourcing cost?
 Are any fixed costs avoidable if the company outsource?
 What could the company do with the freed capacity?
Decision Rule: Should the company outsource?
Outsource Do not Outsource
If the incremental costs of If the incremental costs of
making exceed the incremental making are less than the
costs of outsourcing. incremental costs of outsourcing

Example 1

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 Suppose that company A has records the cost of producing 250,000 units
from product Y as follows:
Total cost
Direct materials $ 40,000
Direct labor 20,000
Variable manufacturing overhead 15,000
Fixed manufacturing overhead 50,000
Total Manufacturing Cost $ 125,000

Assume that Company B offers to sell product Y at $ 0.37 per unit. In case of
outsourcing Company A can avoid $ 10,000 of fixed costs.
Required
Should Company A make or buy product Y?
Solution
Y costs Make Y Buy Y Difference
Variable Costs:
Direct materials $ 40,000 ----- $ 40,000
Direct labor 20,000 ----- 20,000
Variable overhead 15,000 ----- 15,000
Purchase cost (250,000 x $ 0.37) ----- $ 92,500 (92,500)
Fixed overhead 50,000 40,000 (10,000)
Total cost of Y $ 125,000 $ 132,500 $ (7,500)

Note
1. If fixed costs are not differ between alternatives (still $ 50,000) it will become
irrelevant to decision making., but in this case, the fixed cost reduced in case of
outsourcing - differ between outsourcing- so it become relevant to decision
making.
2. Company A will make the product as it is less to make than to buy although $
10,000 reduction of fixed costs. The net savings from making 250,000 units is $
7,500.

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Example 2
Suppose that ABC Company produce X product, the following costs are incurred for
producing 20,000 units:

Direct materials $ 20,000

+ Direct labor 80,000
+ Variable manufacturing overhead 40,000
+ Fixed manufacturing overhead 80,000
Total manufacturing cost $ 220,000
Cost per unit ($ 220,000 / 20,000) $ 11

Another manufacturer has offered to sell product X for $ 10, a total purchase cost
of $ 200,000. If ABC Company outsources and leaves it plant idle, it can save $
50,000 of fixed overhead cost. Or, the company uses the released facilities to make
another product that will contribute $ 70,000 to profits. In this case, the company will
not be able to avoid any fixed costs.
Required
Identify and analyze the alternatives. What is the best course of action?

Solution
Item Make X
Buy X

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 Make other
Facilities idle
products
Relevant costs:
Direct Materials $ 20,000 ----- -----
Direct Labor 80,000 ----- -----
Variable Overhead 40,000 ----- -----
Fixed Overhead 80,000 $ 30,000 $ 80,000
Purchase Cost from Outsider (20,000 x $ 10) ----- 200,000 200,000
Total Cost of Obtaining X 220,000 230,000 280,000
Profit from Other Products ----- ----- (70,000)
Net Cost of Obtaining 20,000 Units of X $ 220,000 $ 230,000 $ 210,000

ABC Company buy product X from outside supplier and use the released
facilities to make other products.

4. Sell As Is or Process Further Decisions

Managers consider the following when deciding whether to sell as is or process
further:
 How much revenue will the company receive if it sells the product as is?
 How much revenue will the company receive if the company sells the product after
processing it further?
 How much will it cost to process the product further?
Decision Rule: Sell as is or process further?
Process further Sell as is. Do not Process further
If the extra revenue (from If the extra revenue (from
processing further) exceeds the processing further) is less than the
extra cost of processing further. extra cost of processing further.

Example

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 Suppose that ABC Company spent $ 125,000 to produce 50,000 units from X
product. If you know the following relevant information:
 If X sold as it is without further processing, it will be sold for $ 3.80 per unit.
 If X is processed further, it will cost $ 0.15 per unit to be further processed and it
will be sold for $ 4 per unit.
Required
1. Identify the sunk cost; is the sunk cost relevant to ABC Company’s decision?
2. Should ABC company sell X or process it further? Show the expected net income
difference between the two alternatives?
Solution
1. Mangers do not consider the $ 125,000 spent to produce 50,000 units from X as
they are not relevant to the decision, because they are sunk cost, which is a past
cost that cannot be changed regardless of which future action the company takes
(regardless of whether it sells the product as it is or processes it further).
2. Incremental analysis for sell as it is or process further decision.
Sell As It Is Process Further Difference
Expected revenue from selling 50,000 units of X at $ 3.80 $ 190,000
Expected revenue from selling 50,000 units of X at $ 4 $ 200,000 $10,000
Additional costs of further processing 50,000 units of $ 0.15 (7,500) (7,500)

Net Revenue $ 190,000 $ 192,500 $ 2,500

The optimal decision is to further processing X as this can increase profit by $

2,500.
We assume that ABC Company already has the equipment and labor necessary to
further processing X and the fixed costs will not differ between alternatives.
Therefore they are irrelevant. However, if ABC Company has to acquire equipment,

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or hire employees to further processing, the extra fixed costs will be relevant as they
differ between alternatives.

5. Product Mix: Which Product to Emphasize Decisions?

Companies do not have unlimited resources. Constraints that restrict production or

sale of a product vary from company to company. For example: labor hours, machine
hours, or available materials.
Product mix considerations:
 What constraints stops the company from making all the units the company can
sell?
 Which products offer the higher contribution margin per unit of the constraint?
 Would emphasizing one product over another affect fixed costs?

Decision Rule: Which Product to Emphasize?

Emphasize the product with the highest contribution margin per unit
of the constraint.

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Example
Suppose that ABC Company produces two products X and Y.

Per unit X Y
Sales Price $ 20 $ 30
Variable Expense 16 21

If the company has 15,000 machine hours available, in one hour ABC Company
can produce 70 units of X or 30 units of Y.

Required
Which product ABC Company should produce and emphasize?
Solution

X Y
Sales price per unit $ 20 $ 30
Variable expense per unit (16) (21)
Contribution margin per unit $4 $9
X Units produced each machine hour X 70 X 30
Contribution margin per machine hour $ 280 $ 270
X Capacity – number of machine hours X 15,000 X 15,000
Total contribution margin at full capacity $ 4,200,000 $ 4,050,000

ABC company should emphasize and produce X product, because it has the
higher contribution margin per unit machine hour (the constraint) resulting in a higher
contribution margin of the company.

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