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Chapter 10:
Short-term decision
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What you will learn?

 Relevant costs

 Make or buy decision

 Outsourcing decision

 Shut down decision

 Further processing
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Short-term decision
The importance of relevant cost

Select among
different
options

Short-term Solved by using

decisions relevant cost

Whether to
do or not to
do something
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Short-term decision
Definition

Relevant costs and revenues are

In the INCREMENTAL
CASH only AVOIDABLE
FUTURE only

Sunk cost Depreciation Common costs Cost that will

is and notional that are not happen
irrelevant cost are resulted in the regardless of
irrelevant decision are decisions are
irrelevant irrelevant

Other potential relevant costs include opportunity costs

Opportunity cost is the value of a benefit sacrificed when one course of
action is chosen, in preference to an alternative.
The opportunity cost is represented by the forgone potential benefit from
the best rejected course of action.
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Short-term decision
Relevant cost of labour

Relevant cost of
labour

Labour is fully
Work can be done in Labour is fully employed and no
idle time required further labour is
available

Relevant cost is the Relevant cost = direct

Relevant cost is 0 additional payments labour cost +
required contribution forgone

To hire additional
Overtime payment
labour
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Short-term decision
Relevant cost of labour - Example

A company has a new project which requires the following three

types of labour:
Hours req. Additional information
Paid at $8 per hour and existing staff are fully utilised.
Unskilled 12,000 The company will hire new staff to meet this additional
demand.

Paid at $12 per hour. These employees are difficult to

recruit and the company retains a number of
Semi-
2,000 permanently employed staff, even if there is no work to
skilled
do. There is currently 800 hours of idle time available
and any additional hours would be fulfilled by
temporary staff that would be paid at $14/hour.

Paid at $15 per hour. There is a severe shortage of

employees with these skills and the only way that this
Skilled 8,000 labour can be provided for the new project would be
for the company to move employees away from making
Product X. A unit of Product X takes 4 hours to make
and makes a contribution of $24/unit.

Require: What is the relevant cost of the labour hours required for
manufacture of the new product?
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Short-term decision
Relevant cost of labour - Example

Taking each type of labour in turn:

Unskilled – 12,000 hours are required for the project and the
company is prepared to hire more staff to meet this need. The
incremental cash outflow of this decision is (12,000 hours x $8) =
$96,000.

Semi-skilled - Of the 2,000 hours needed, 800 are already available

and already being paid. There is no incremental cost of using these
spare hours on the new project. However, the remaining 1,200
hours are still required and will need to be fulfilled by hiring
temporary workers. Therefore, there is an extra wage cost of (1,200
hours x $14) = $16,800.

Skilled: Determining the relevant cost of labour if it is diverted from

existing activities is tricky and is often done incorrectly. If this is the
case, then the relevant cost is the variable cost of the labour plus
the contribution foregone from not being able to use the labour for
its existing purpose.
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Short-term decision
Relevant cost of labour - Example
The temptation is to see that the same number of skilled
employees are paid before and after being moved to the new
project and therefore the opportunity cost of contribution foregone
from diverting hours away from the existing production of Product
X is the only relevant cost ($24/4 hours = $6 per hour). This is
incorrect.

Say, for example, that 4 hours of labour were simply removed by

‘sacking’ an employee for four hours, one less unit of Product X
could be made. Using the contribution foregone figure of $24 is the
net effect of losing the revenue from that unit and also saving the
material, labour and the variable costs. In this situation however,
the labour is simply being redeployed so $24 understates the effect
of this, as the labour costs are not saved.

Therefore, the relevant cost of skilled labour is:

8,000 hours x $15 (current labour cost per hour) $120,000
8,000 hours x $6 (lost contribution per hour diverted
$48,000
from making Product X)
$168,000
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Short-term decision
Relevant cost of material

In warehouse?

No Yes

Yes
Replacement cost Use regularly?

No

Higher of value in
Scrap/ disposal other use or scrap
value value (If there are
(If no other use) other uses)
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Short-term decision
Relevant cost of material - Example

A company is considering making a new product which requires

several types of raw material:
Units Units
Additional information
in inventory required

Material A Nil 40 Current purchase price is $7/unit.

Current purchase price is $14/unit. The

material has no use in the company
100 purchased
Material B 150 other than for the project under
for $10/unit
consideration. Units in inventory can be
sold for $12/unit.

Current purchase price is $22/unit. The

50 purchased
Material C 120 material is regularly used in current
for $20/unit
manufacturing operations.

Require: What is the relevant cost of the materials required for

manufacture of the new product?
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Short-term decision
Relevant cost of material - Example

Material A – As there is no inventory, all 40 units required will have

to be bought in at $7 per unit. This is a clear cash outflow caused by
the decision to make the new product. Therefore, the relevant cost
of Material A for the new product is (40 units x $7) = $280.

Material B - The 100 units of the material already in inventory has

no other use in the company, so if it is not used on the new
product, then the assumption is that it would be sold for $12/unit.
If the new product is made, this sale won’t happen and the cash
flow is affected. The original purchase price of $10 is a sunk cost
and so is not relevant. In addition, another 50 units are needed for
the new product and these will need to be bought in at a price of
$14/unit.

The total relevant cost for Material B is:

100 units x $12 (lost sale proceeds) $1,200
50 units x $14 (current purchase price) $700
$1,900
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Short-term decision
Relevant cost of material - Example

Material C – This material is regularly used in the company, so if the

50 units in inventory are diverted to the new product then this will
mean that inventory will need to be replenished. In order to do this,
Material C purchases for existing products will be accelerated by 50
units.
The current purchase price of $22 will be used to determine the
relevant cost of Material C as this will be the value of each unit
purchased. The original purchase price of $20 is a sunk cost and so
is not relevant. Therefore the relevant cost of Material C for the
new product is (120 units x $22) = $2,640.
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Short-term decision
Relevant cost of machinery

Cost of machinery

Irrelevant cost Relevant cost

Sunk cost Incremental Opportunity

Non-cash cost
(Cost of cost cost
(Depreciation)
purchase) (Hire charge) (User cost)
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Short-term decision
Relevant cost of machinery - Example
Some years ago, a company bought a piece of machinery for
$300,000. The net book value of the machine is currently $50,000.
The company could spend $100,000 on updating the machine and
the products subsequently made on it could generate a
contribution of $150,000. The machine would be depreciated at
$25,000 per annum. Alternatively, if the machine is not updated,
the company could sell it now for $75,000.

On a relevant cost basis, should the company update and use the
machine or sell it now?
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Short-term decision
Relevant cost of machinery - Example

Immediately we can say that the $300,000 purchase cost is a sunk

cost and the $50,000 book value and $25,000 depreciation charge
are not cash flows and so are not relevant.

If the investment in the machinery is made, then the following cash

flow changes are triggered:

 Machine update cost: $100,000

 Contribution from products: $150,000
 Opportunity cost: $75,000
Therefore, the relevant cost is:
Update cost (negative) = $100,000
Add contribution = $150,000
Less sales proceeds foregone = $75,000
Net cash outflow $25,000

As the relevant cost is a net cash outflow, the machine should be

sold rather than retained, updated and used.
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Short-term decision
Some types of decision making using relevant cost

1 Make or buy decision

2 Outsourcing decision

3 Shut down decision

4 Further processing
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Short-term decision
Make or buy

Or
Make Buy

Buy the components

Manufacture own Or from an
components
outside supplier

Construction company
Or Subcontract the work
should do some work
to another company
with its own employees

Service should be
Or Employ external
carried out by an
organisation
internal department
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Short-term decision
Make or buy

Make or buy

Scare resources?

No Yes

The relevant costs are the The relevant costs are the
differential costs between differential costs between
the two options the two options

Consider Consider
 Quality of bought in
product
 Reliability of supplier
Units bought have the lowest
 Possibility of becoming
extra variable cost of buying per
dependent on supplier
unit of scarce resource saved by
 Likelihood of future price
buying
increases
 How to use spare capacity
 Confidentiality issues
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Short-term decision
Make or buy

If Purchase price < the variable

costs of making

Yes If Purchase price > variable

costs of making

Resource
is scare? Make Buy

if Purchase price >

contribution lost + extra cost
to make
No if Purchase price <
contribution lost + extra cost
to make
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Short-term decision
Outsourcing/Contract manufacturing/Subcontracting.

Operating of internal Or
Use external services
service departments

Advantage
Disadvantages
 Superior quality
and efficiency  Reliability of
 Capital is freed up supplier
 Greater capacity  Loss of control and
and flexibility to flexibility
cope with changes  Effect on existing
in demand workforce
 Useful if not
enough work to
keep internal staff
fully occupied

Exam focus: Consider existing staff will be made redundant or

whether they will be redeployed, and whether there are alternative
uses for the other resources made available by ceasing to perform
the service internally.
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Example
December 2014
A business makes two components which it uses to produce one of
its products. Details are
Component A Component B
Per unit information: $ $
Buy in price 14 17
Material 2 5
Labour 4 6
Variable overheads 6 7
General fixed overheads 4 3
Total absorption cost 16 21
The business wishes to maximise contribution and is considering
whether to continue making the components internally or buy in
from outside.
Which components should the company buy in from outside in
order to maximise its contribution?

A. A only B. B only

C. Both A and B D. Neither A nor B

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Example
December 2014
Which components should the company buy in from outside in
order to maximise its contribution?

A. A only B. B only

C. Both A and B D. Neither A nor B

The marginal cost of making A is $12 per unit and of making B is

$18 per unit. It is the marginal cost which is the relevant cost for
the make or buy decision since the fixed costs will be incurred
anyway. Therefore, it is cheaper to make A ($12 marginal cost
CF $14 buy in cost) but it is cheaper to buy in B ($17 buy in cost
CF $18 make cost).
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Short-term decision
Shut down decision

Or
Shutdown Continue

Consider
Permanent Timing Temporary

Financial Non-financial

Close if costs saved Reaction of

Impacts on
exceed revenue lost by competitors,
employees
closing division customers,
remaining
suppliers
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Short-term decision
Shut down decision – Example

A company has two production lines and its management accounts

show the following:
Production Line A Production Line B
$m $m $m $m
Revenue 28 30
Marginal costs 12 20
Fixed costs 10 14
Total cost 22 34
Profit/loss 6 (4)

The total fixed costs of $24m have been apportioned to each

production line on the basis of the floor space occupied by each line
in the factory.

The company is concerned about the loss that is reported by

Production Line B and is considering closing down that line. Closing
down either production line would save 25% of the total fixed costs.

Should the company close down Production Line B?

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Short-term decision
Shut down decision – Example

The incremental cash flows of closing down Production Line B are:

Revenue lost = $30m
Marginal costs saved = $20m
Fixed costs saved ($24m x 25%) = $6m

Therefore, the closure of Production Line B is not a good idea as the

revenue lost is greater than the value of the costs saved.

What about closing down Production Line A?

The incremental cash flows of this decision would be:
Revenue lost = $28m
Marginal costs saved = $12m
Fixed costs saved ($24m x 25%) = $6m

The closure of Production Line A would also result in the revenue

lost being greater than the value of the costs saved, so this isn’t a
good idea either.
Really, the heart of the matter is the misleading effect of the
relatively arbitrary apportionment of the fixed costs.
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Short-term decision
Shut down decision – Example

A more useful presentation of the figures for decision-making

would be:
Production Production
Total
Line A Line B
$m $m $m
Revenue 28 30 58
Marginal costs 12 20 32
Contribution 16 10 26
Fixed costs 24
Profit/loss 2

Note that the $2m total profit is the same as the profit of $6m from
Production Line A and the loss of $4m from Production Line B as
shown in the table at the start of this example.

If either production line were closed down, fixed costs saved are
25% x $24m = $6m, however the contribution lost from the
products (and contribution looks at cash flows caused by
production) would be either $16m or $10m, which exceed the cash
saved on the fixed costs.
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Short-term decision
Further processing decision

Raw
material

Product A

Product B (higher
Sell immediately
price than Product A)

Process further if additional sales revenue exceeds the relevant

post-separation (further processing cost)
Joint (Pre-separation) costs are incurred regardless of the decision
=> Irrelevant to the further processing decision
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Short-term decision
Further processing decision – Example

A company buys a chemical for $12,000, which it breaks down into

two components:
Component Sales value ($) Allocated costs ($)
A 7,000 6,000
B 4,000 6,000
Component A can be converted into Product A if $6,000 is spent
on further processing. Product A would sell for $12,000.

Component B can be converted into Product B if $8,000 is spent on

further processing. Product B would sell for $15,000.

What processing decision should the company make in order to

maximise profits?
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Short-term decision
Further processing decision – Example

As the initial chemical is split into both components, it is not

possible to make one component without the other, therefore if
the company were to make only the components, the costs and
revenues of both components will need to be recognised:

Incremental revenue (sales of both components) = $11,000

Incremental costs (cost of the chemical) = $12,000
Net loss ($1,000)
This is not worthwhile as incremental costs exceed incremental
revenues.
Next we should consider whether the components should be
further processed into the products.
Further processing Component A to Product A incurs incremental
costs of $6,000 and incremental revenues of $5,000 ($12,000 -
$7,000). It is not worthwhile to do this, as the extra costs are
greater than the extra revenue.
Further processing Component B to Product B incurs incremental
costs of $8,000 and incremental revenues of $11,000 ($15,000 –
$4,000). It is worthwhile to do this, as the extra revenue is greater
than the extra costs.
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Short-term decision
Further processing decision – Example

The production plan is therefore:

$ $
Component A revenue 7,000
Component B revenue 15,000
Total revenue 22,000
Chemical cost 12,000
Further processing of Component B 8,000
Total cost 20,000
Contribution 2,000
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Example
December 2016
Jorioz Co makes joint products X and Y. $120,000 joint processing
costs are incurred.
At the split-off point, 10,000 units of X and 9,000 units of Y are
produced, with selling prices of $1.20 for X and $1.50 for Y.

The units of X could be processed further to make 8,000 units of

product Z. The extra costs incurred in this process would be fixed
costs of $1,600 and variable costs of $0.50 per unit of input.
The selling price of Z would be $2.25.

What would be the outcome if product X is further processed?

A. $400 gain B. $600 loss

C. $3,900 gain D. $1,600 loss

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Example
December 2016

What would be the outcome if product X is further processed?

A. $400 gain B. $600 loss

C. $3,900 gain D. $1,600 loss

Before further processing the sales value of X (10,000 units x

$1.20) = $12,000

After further processing:

Sales value of Z (8,000 units x $2.25) = $18,000
Further processing costs ((10,000 units of X x $0.50) + $1,600) =
$6,600
This gives a net return of $11,400 which is $600 less than the
sales value of X.