Chapter 4

Short-term
Decision Making

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Short-Term Decisions
• Model cost/revenue behavior to make short-
term operating decisions
• Assume that capacity is fixed
 Cannot increase or decrease the physical
facility, workers or relocate
• Impact the future long-term decisions
• Cannot be planned during the normal planning
process
 Arise due to change in the business
environment and must be addressed in a
timely manner
 Must be analyzed as a unique opportunity
Cost-Volume-Profit Analysis (CVP)

• Study of how costs, revenues, and profits change

in response to changes in the volume of goods or
services provided to the customer
 What is the CVP Model?
• Cost-volume-profit model (short-term)
 Use to explore relationships among costs,
volumes, and profits
• Assumptions (linearity)
 Selling price is constant per unit
 Variable cost is constant per unit
 Fixed cost is constant in total
 Number of units produced = number of units
sold

4-4
 CVP Graph

Total Revenue

Profit area
Total Cost

$
Breakeven point

Loss area

Units produced and sold

4-5
How are the CVP
Components Defined
Mathematically?
• Total revenue
 SP * Q
• Total cost
 VC * Q + FC
• Breakeven
 (SP * Q – VC * Q) – FC = 0
• Where, Q = quantity produced and sold
4-6
 CVP Continued
• Contribution margin
 SP – VC
 Breakeven = CM * Q – FC = 0
• Target profit before taxes
 CM * Q – FC = P
• Target profit after taxes
 CM * Q – FC = P/(1 – tax rate)

4-7
Contribution Margin Approach is a
quicker way to calculate it?
• FC + P/CM = Q

Contribution margin approach to determine target

profit after taxes
• FC + (BTP/[1-tax rate])/CM = ATP
 Sensitivity Analysis
Process of changing the key variables (but not the
assumptions) in CVP analysis to determine how sensitive
the CVP relationships are to change.
• Change in selling price • Change in fixed cost
 Increase—decreases  Increase—increases
breakeven breakeven
 Decrease—increases  Decrease—decreases
breakeven breakeven
• Change in variable cost • Change in tax rate
 Increase—increases  No impact on
breakeven breakeven
 Decrease—decreases
4-9
breakeven
 What are Product and Nonproduct
Costs?
• Product costs
 Incurred in connection with buying or making
the product.
 Associated with producing the product
• Nonproduct costs
 Incurred in connection with selling the product
and administering (running) the company
 Associated with selling the product and
administering the company

4-10
 What are the 3 Types of
Product Costs?
• Direct materials
 Traceable
 Worth the cost of tracing
• Direct labor
 Cost of employees making the product
• Manufacturing overhead
 All manufacturing costs not classified as direct
materials or labor
 Indirect costs of production (indirect materials,
indirect labor, and other manufacturing costs)
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 What are the Activity Levels
Associated with Costs?
• Unit-related
 Vary with units produced or sold
• Batch-related
 Vary with batches (groups) regardless of the
number of units in the batch
• Product-sustaining
 Vary with the number of product lines
• Facility-sustaining
 Fixed or capacity costs

4-12
 Types and Activity Levels

Product Nonproduct

Unit-related Materials Commissions

Batch-related Set ups Ordering

Product- Research & Advertising

sustaining development
Facility- Rental of CEO salary
sustaining equipment

4-13
 What are the 2 Characteristics of a
Relevant Variable?
• Future
 The variable must occur in the future

• Different
 The variable must differ between the
alternatives considered

4-14
 Relevant Variables Continued
• Sunk costs
 Past, irrelevant for decision making
• Opportunity costs
 Benefits foregone, relevant for decision
making
• Incremental costs/revenues
 Additional cost/revenue, relevant if different
between alternatives
• Helps determine what is relevant to a
particular decision situation
4-15
 What are the Types of Short-
Term Decisions Considered?
• Accept-or-reject decisions
 Special order
 Base decision on incremental profit from the order
• Make-or-buy decisions
 Outsourcing
 Base decision on cost comparison between make and buy

4-16
Lecture Example #1
1. A certain company sells its only product for $12 per unit. The variable costs to
produce the product are $7 per unit and it costs approximately $1 per unit for selling and
administrative costs. The fixed costs of production are $400,000 per period and the
fixed selling and administrative costs are $200,000 per year. The company is subject to
a 30 percent tax rate. Answer the following questions.

a. What is the breakeven point in units?

b. What is the breakeven point in dollars?
c. How many units must be sold to earn a profit of $70,000 before tax?
d. How many units must be sold to earn a profit of $70,000 after tax?
e. If the variable costs increase 10 percent, what increase is necessary in selling price to
maintain the same breakeven point in units?
f. If the fixed costs increase, what is the effect on breakeven? On contribution
margin per unit?
g. If the tax rate increases, what is the effect on breakeven? On contribution margin
per unit?
 Lecture Example #1 Cont.
• Answer:
• a. SP = $12; VC = $8; CM = $4; FC = $600,000
• $600,000/4 = 150,000
• b. CM = $4; SP = $12; CM % = 33.3333%
• $600,000/33.3333% = $1,800,000
• c. ($600,000 + $70,000)/4 = 167,500
• d. $70,000/(1 - .3) = $100,000
• ($600,000 + $100,000)/4 = 175,000
• e. To maintain the same breakeven point, CM must remain the same.
• VC = $8.80; CM = $4; therefore SP = $12.80
• f. If fixed costs increase, breakeven increases. Fixed costs do not affect
contribution margin per unit.
• g. Tax rate increases do not affect breakeven or contribution margin per unit.
 Lecture Example #2
• 2. A company has been approached by a supplier with an offer to provide 25,000 units of a
production part for $9 per unit. If the company accepts the offer its direct materials costs are
expected to decrease by 60 percent, its direct labor costs are expected to decrease by 30 percent,
and its unit-related overhead is expected to decrease by 20 percent. A recent per unit cost report
when 25,000 units were produced is shown below:
Direct materials $10
Direct labor 2
Manufacturing overhead 8
Total cost $20
• An analysis of manufacturing overhead reveals that overhead consists of unit-related and
facility-sustaining overhead. Facility-sustaining overhead consists of depreciation and other
fixed items and is approximately $150,000 per period. If the company accepts the supplier’s
offer, it will use the released production facilities to produce another product with an expected
contribution of $60,000 per period. Should the company accept or reject the supplier’s offer?
Lecture Example #2 Cont.
Answer:
Total overhead $8 * 25,000 = $200,000
Less facility-sustaining overhead 150,000
Unit-related overhead $ 50,000
Unit-related overhead per unit $50,000/25,000 = $2

Relevant variables Make Buy

Direct materials $10.00 $ 4.00 ($10 * .4)
Direct labor 2.00 1.40 ($2 * .7)
Unit-related overhead 2.00 1.60 ($2 * .8)
Purchase price -0- 9.00
Relevant cost per unit $14.00 $16.00
* Number of units 25,000 25,000
Total relevant unit cost $350,000 $400,000
Opportunity cost 60,000 -0-
Total relevant cost $410,000 $400,000 BUY
Lecture Example #3
3. A company has been approached by a customer with an offer to buy 10,000 units of product
but the customer wants a discount of 25 percent off the normal selling price. The company
has the capacity to fill the customer’s order. A recent profit report is shown below:

Sales (500,000 units) $6,000,000

Cost of goods sold 4,200,000
Gross margin $1,800,000
Selling and administrative cost 1,000,000
Profit $ 800,000

Unit-related cost of goods sold is 40 percent of the current selling price while unit-related selling
and administrative costs are 10 percent of the current selling price. To fill the customer’s order, one
additional production run will be required at a cost of $6,000. An additional purchase order will be
required at a cost of $500, and shipping costs to the customer will be $800. Should the company
accept the customer’s order?
Lecture Example # 3 Cont.
Answer:
Current selling price = $6,000,000/500,000 = $12
Unit-related cost of goods sold = $12 * .4 = $4.80
Unit-related selling and administrative cost = $12 * .1 = $1.20 Proposed
selling price = $12 * .75 = $9

Relevant variables Accept Reject

Proposed selling price $9.00 $0.00
Cost of goods sold 4.80 0.00
Selling and administrative 1.20 0.00
Contribution margin $3.00 $0.00
* Number of units requested 10,000 10,000
Total contribution margin $30,000 $0
Additional batch costs:
Production run ( 6,000) -0-
Ordering ( 500) -0-
Shipping ( 800) -0-
Relevant profit $22,700 $0
ACCEPT