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CHAPTER 24
Short-Run Decision Analysis

PLANNING MATRIX
Enhancing Your
Building Your Basic Knowledge Knowledge, Skills, and
Learning Objective and Skills Critical Thinking
1. Describe how managers make SE 1, 2 E 1, 2 C1
short-run decisions using C2
incremental analysis.
2. Perform incremental analysis for SE 3, 4 E 3, 4 P 1, 6 C3
outsourcing decisions.
3. Perform incremental analysis for SE 5, 6 E 5, 6, 7 P 2, 7 C4
special order decisions. C6
4. Perform incremental analysis for SE 7 E 8, 9 P 3, 8 C5
segment profitability decisions. C6
5. Perform incremental analysis for SE 8 E 10, 11, 12 P 4, 9
sales mix decisions involving
constrained resources.
6. Perform incremental analysis for SE 9, 10 E 13, 14 P 5, 10 C6
sell or process-further decisions

MEMORANDA:
SE: Short Exercises
E: Exercises
P: Problems
All questions are in the text with related Learning Objectives (Stop, Think, and Apply).

SUGGESTED INSTRUCTIONAL STRATEGY

Output Skills Developed:
Technical, Communication

Related Learning Objective:

2

Instructional Strategy
Learning activity: Role-playing
Learning environment: Active, in-class

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300 Chapter 24: Short-Run Decision Analysis

Learning tool: Textbook assignment Case 1

Steps to Implement
1. Assign Case 3 at least a week before introducing this learning activity in class. Working on Case 3
individually, students are to write a brief paper outlining the recommendation the consultant will
make to management about whether to close the restaurant in Prague and specifying the
information used in making the recommendation.
2. Choose two students to perform the role-play, one acting as the consultant and the other as a
member of Gourmet Burgers’ management team. The students may present their own views,
though to dramatize the interaction, you may want to give them some help in preparing a
dialogue.
3. The students in the audience are to perform the following tasks:
a. List the similarities between the responses they gave in their homework assignments and
those presented in the role-playing.
b. List the ways their responses differ from those in the role-playing and justify why they
believe their responses are correct.
4. Distribute the in-class assignment before the role-playing begins. Remind students that taking
notes during the role-playing will be helpful in completing the assignment. Allow students 10 to
15 minutes after the role-playing to finish the assignment.
5. In a general discussion, ask students to share the ways in which their responses differed and how
they justified their position. Emphasize that good decisions require careful weighing of both
quantitative and qualitative information. Allow about 10 minutes for the discussion.

Assessment
Technical skills: Grade the homework and in-class assignments. Give a brief quiz at the end of the
period to test recall and comprehension. Ask a related question on the next examination.
Communication skills: Grade the written assignments for content, organization, clarity, succinctness,
grammar, and spelling.

RESOURCE MATERIALS AND OUTLINES

OBJECTIVE 1: Descibe how managers make short-run decisions using incremental
analysis.
Summary Statement
Short-run decision analysis is the systematic examination of any decision whose effects will be felt
over the course of the next year. Both quantitative and qualitative information are important in this type
of analysis. Such information should be relevant, timely, and presented in a format that is easy to use in
decision making.
When performing short-run decision analysis during the planning stage of the management process,
managers identify a problem or need, determine all reasonable courses of action that may solve the
problem or meet the need, perform a complete analysis of the effects of each solution, and decide on the
best course of action. During the year, managers make many decisions that affect their organization’s
profitability and liquidity in the short run, including whether to outsource a product or service, whether

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
 Chapter 24: Short-Run Decision Analysis 301

to accept or reject a special order, whether to keep or drop a segment, whether to allocate a limited
resource among products, and whether to sell a product as is or process it further.
Incremental analysis helps managers compare alternative solutions to a problem by focusing on the
differences in the revenues and costs projected for each solution. Managers are thus able to choose the
alternative that contributes the most to profits or incurs the lowest cost.
The first step in incremental analysis is to eliminate any revenues and costs that will not differ among
the alternative courses of action. Information about these revenues and costs is irrelevant to the decision
process. A sunk cost is a past cost that cannot be recovered; it, too, is irrelevant to the decision process.
A cost that will change among alternatives is called a differential cost.
Once irrelevant revenues and costs have been eliminated, the incremental analysis can be performed
using only projected revenues and expenses that differ among the alternatives.
Because incremental analysis focuses on only the quantitative differences among alternatives, it
simplifies the decision process and reduces the time needed to choose the best course of action.
However, incremental analysis is only one input to the final decision. Managers must also consider the
effects of opportunity costs, which are the revenues forfeited or lost when one alternative is chosen over
another.

New Concepts and Terminology

short-run decision analysis; incremental analysis; differential cost; sunk cost; opportunity costs

Related Text Illustration

Focus on Business Practice: How Much Does It Cost to Process a Check?
Exhibit 1: Incremental Analysis

Lecture Outline
I. Short-run decision analysis is the systematic examination of any decision whose effects will be
felt over the course of the next year
A. Discuss the quantitative information and qualitative information that are important in
making short-run decisions.
II. When performing short-run decision analysis in the planning stage of the management process,
managers
A. Discover a problem or need.
B. Identify alternative ways of solving the problem or meeting the need.
C. Analyze the effects of each solution.
D. Select the best course of action.
III. During the year, managers make many decisions that affect their organization’s profitability and
liquidity in the short run.
IV. Incremental analysis in making short-run decisions
A. Irrelevant costs and revenues
1. Differential cost or incremental cost
B. Incremental analysis
1. Sunk cost
C. Opportunity costs

Teaching Strategy
Use this chapter’s Decision Point to illustrate the kinds of short-run decisions made by managers during
the management process. After discussing the type of information needed to make such decisions, ask
students to distinguish between the qualitative and quantitative information presented in Short Exercise

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302 Chapter 24: Short-Run Decision Analysis

1. Have students work Exercise 1, which requires them to identify relevant data and to prepare an
incremental analysis. Assign Case 1 or 2 to give students more practice in identifying relevant decision
information.

OBJECTIVE 2: Perform incremental analysis for outsourcing decisions.

Summary Statement
Outsourcing is the use of suppliers outside the organization to perform services or produce goods that
could be performed or produced internally. Make-or-buy decisions, which are decisions about whether
to make a part internally or buy it from an external supplier, may lead to outsourcing. An incremental
analysis of the expected costs and revenues of each alternative helps managers identify the best course
of action. An incremental analysis of a decision about outsourcing a product requires information about
making the product (whether it will require additional machinery and the variable costs and incremental
fixed costs that it will involve) and information about buying the product (the purchase price, whether
vacated factory space will generate rent or net cash flows, and the salvage value of unused machinery).

New Concepts and Terminology

outsourcing; make-or-buy decisions

Related Text Illustrations

Exhibit 2: Incremental Analysis: Outsourcing Decision

Lecture Outline
I. Outsourcing decisions.
A. Strong candidates include payroll processing, training, managing vehicle fleets, sales and
marketing, custodial services, and information management.
B. Outsourcing can reduce a company’s investment in physical assets and human resource,
which can improve cash flow.
C. Exhibit 2 provides an example of incremental analysis of an outsourcing decision.

Teaching Strategy
Use Short Exercise 3 to illustrate how incremental analysis facilitates an outsourcing decision.

OBJECTIVE 3: Perform incremental analysis for special order decisions

Special order decisions are decisions about whether to accept or reject special orders at prices below
the normal market prices. One approach to analyzing such a decision is to compare the special order
price with the relevant costs to see if a profit can be generated. Another approach is to prepare a special
order bid price by calculating a minimum selling price for the special order. The bid price equals the
relevant costs plus an estimated profit. Generally, fixed costs are irrelevant to a special order decision
because those costs are covered by regular operations and do not differ among alternatives.
Contribution margin reporting shows whether the special order will increase net income.

New Concepts and Terminology

special order decisions

Related Text Illustrations

Exhibit 3: Incremental Analysis: Special Order Decision

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 Chapter 24: Short-Run Decision Analysis 303

Lecture Outline
I. Decision to accept or reject a special order.
A. Special order analysis
B. Incremental analysis for special order decisions generally ignores fixed costs.
C. Price and relevant cost comparison.
D. Minimum bid price for special order.

Teaching Strategy
Identify the circumstances under which fixed costs are relevant to a special order decision. Use Short
Exercise 4 to illustrate the computation of a minimum bid price for a special order.

OBJECTIVE 4: Perform incremental analysis for segment profitability decisions

Managers must often decide whether to keep or drop a business segment, such as a product line,
service, sales territory, division, or department. The incremental approach to analyzing such a decision
isolates the segment and focuses on its segment margin. A segment margin is the segment’s sales
revenue minus its direct costs (variable and fixed costs that are traceable to the segment). If a segment
has a positive segment margin (meaning that its revenue is greater than its direct costs), it should be
retained because it can cover its own direct costs and contribute a portion of its revenue to cover
common costs and add to operating income. If a segment has a negative segment margin (i.e., its
revenue is less than its direct costs), the segment should be dropped. However, certain common costs
will be incurred even if the segment is dropped; these are unavoidable costs. Avoidable costs are costs
traceable to a segment; if the segment is eliminated, the avoidable costs will also be eliminated.

New Concepts and Terminology

segment margin; avoidable costs

Related Text Illustrations

Exhibit 4: Incremental Analysis: Segment Profitability Decision
Focus on Business Practice: Why Banks Prefer Ebanking

Lecture Outline
I. Segment profitability decisions
A. A segment margin is a segment’s sales revenue minus direct cost
1. Positive segment margin: segment’s revenue is greater than its direct costs.
2. Negative segment margin: segment’s revenue is less than its direct costs
B. Includes preparation of segmented income statement using variable costing to identify
variable and fixed costs.
1. Direct fixed costs are traceable to the segment.
2. Common costs are the remaining costs and are not assigned to segments.

Teaching Strategy
Use Exercise 5 and Problem 3 to illustrate the steps taken in deciding to drop an unprofitable business
segment.

OBJECTIVE 5: Perform incremental analysis for sales mix decisions involving constrained
resources.
The objective of a sales mix decision is to find the most profitable combination of products or services
when a company uses a common scarce resource to make more than one product or offer more than one

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304 Chapter 24: Short-Run Decision Analysis

service. The decision analysis, which uses incremental analysis to identify the relevant costs and
revenues, consists of two steps: calculating the contribution margin per unit for each product or service
affected by the scarce resource, and calculating the contribution margin per unit of scarce resource. The
alternative that maximizes the contribution margin per scarce resource is the one that should be
selected.

New Concepts and Terminology

sales mix decision

Related Text Illustrations

Exhibit 5: Incremental Analysis: Sales Mix Decision Involving Constrained Resources

Lecture Outline
I. Sales mix decision.
A. Steps involved in the decision analysis:
1. For each product affected by the scarce resource, calculate the contribution margin per
unit by subtracting the variable costs per unit from the selling price.
2. For each product, calculate the contribution margin per unit of the scarce resource
(such as machine hours) by dividing the contribution margin per unit by the quantity of
the scarce resource required per unit.
B. The alternative that maximizes the contribution margin per scarce resource is the one that
should be selected.

Teaching Strategy
Refer to Exhibit 5 to illustrate the incremental analysis of a sales mix decision. Exercise 11 can also be
used for classroom demonstration.

OBJECTIVE 6: Perform incremental analysis for sell or process-further decisions.

A sell or process-further decision requires managers to choose between selling a joint product at its
split-off point or selling it after further processing. Joint products are two or more products that are
created simultaneously from a common raw material or process. Such products cannot be identified as
separate products during some or all of the production process. Only at a specific point, called the split-
off point, do joint products become separate and identifiable. Managers compare the incremental costs
and revenues of the two alternatives. Joint costs incurred before split-off are irrelevant to the decision
because they are identical for both alternatives. A product should be processed further only if the
incremental revenues generated exceed the incremental costs incurred.

New Concepts and Terminology

sell or process-further decision; joint products; split-off point

Related Text Illustrations

Exhibit 6: Incremental Analysis: Sell or Process-Further Decision

Lecture Outline
I. Incremental analysis of sell or process-further decisions.
A. Managers compare the incremental costs and revenues of selling a joint product at the split-
off point with the incremental costs and revenues of processing it further.
B. Only costs that occur after the split-off point are relevant.

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 Chapter 24: Short-Run Decision Analysis 305

C. A product should be processed further only if the incremental revenues generated exceed the
incremental costs incurred.

Teaching Strategy
Discuss the concept of joint products and the decision that arises at the split-off point. Use Exhibit 6
and Exercise 13 or 14 to illustrate the steps involved in the incremental analysis of sell or process-
further decisions.

REVIEW QUIZ

True-False
1. T F Information used in short-run decision analysis should be relevant, timely, and
presented in a format that is easy to use in decision making.
2. T F Only financial information should be used ins making short-run decisions.
3. T F A decision about whether to outsource a product or service is typical of the short-run
decisions managers make.
4. T F Incremental analysis helps managers evaluate alternatives by reporting revenues and
costs that remain unchanged under all decision alternatives.
5. T F The rule for sales mix decisions is identical regardless of whether a scarce resource
constrains capacity.
6. T F At the split-off point, a company may choose to sell the product or service as is, or to
process it into another form for sale to a different market.
7. T F In special order decisions, the relevant costs include the variable costs, variable selling
costs, and other costs indirectly associated with the special order.

Multiple Choice
8. Short-run decision analysis is the systematic examination of any decision whose effects will be
felt over the course of the next
a. quarter.
b. year.
c. two years
d. month.
e. six months

9. A cost that changes between alternatives is known as a(n)

a. fixed cost.
b. variable cost.
c. differential cost.
d. irrelevant cost.
e. opportunity cost.

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
306 Chapter 24: Short-Run Decision Analysis

10. Outsourcing is useful in areas that involve

a. either relatively low skill levels or highly specialized knowledge.
b. either relatively high skill levels or general knowledge.
c. only relatively low skill levels.
d. only highly specialized knowledge.
e. none of the above.

11. Which of the following is a strong candidate for outsourcing?

a. payroll processing
b. training
c. managing fleets of vehicles
d. sales and marketing
e. all of the above

12. Management should eliminate a segment if

a. its fixed costs are greater than its avoidable costs.
b. the segment is able to cover its own direct costs.
c. the segment has a positive segment margin.
d. the segment has a negative segment margin.
e. the portion of its revenue to cover common costs is too low.

13. In a sales mix decision, the contribution margin per unit for each product or service is the selling
price per using less
a. fixed costs per unit.
b. variable costs per unit.
c. sunk costs per unit.
d. direct labor cost per unit.
e. common costs per unit.

14. The objective of a sell or process-further decision is to select the alternative that
a. minimizes operating income.
b. has the lowest split-off point.
c. have the lowest joint costs.
d. maximizes operating income.
e. has the highest variable costs.

6. Accepting a special order will be profitable when the revenue provided by the special order is
greater than
a. the relevant costs to produce, package, and ship the order.
b. the direct materials and direct labor costs only.
c. the fixed manufacturing overhead costs only.
d. the selling and administrative costs only.
e. all of the above.

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 Chapter 24: Short-Run Decision Analysis 307

7. Which of the following factors would not be considered in an outsourcing decision?

a. Assurance of quality control
b. Special expertise or technology that the supplier possesses
c. Potential loss of critical information to competitors
d. Cost of back orders due to partial shipments
e. All of the above

8. A company manufactures a variety of writing instruments. The space currently devoted to the
production of fountain pens could be used for storage if the manufacture of fountain pens is
outsourced. This would eliminate $40,000 of rental expense currently incurred for storage space.
The $40,000 is a(n)
a. opportunity cost.
b. sunk cost.
c. variable cost.
d. irrelevant cost.
e. none of the above.

ANSWERS TO REVIEW QUIZ

True-False Multiple Choice
1. T 8. b
2. F 9. c
3. T 10. a
4. F 11. e
5. F 12. d
6. T 13. b
7. F 14. d
6. a
7. d
8. a

© 2011 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.