Relevant Costs for Short-Term Decisions

1. Relevant Costs for Short-Term Decisions Chapter 8

2. Objective 1 Describe and identify information relevant to short-term business decisions

3. How Managers Make Decisions • Define business goals • Identify alternative courses of action • Gather and analyze relevant information • Choose best alternative • Implement decision • Follow-up: Compare actual with anticipated results

4. Relevant and Irrelevant Information • Relevant • Expected future (cost and revenue) data • Differs among alternative courses of action • Is both quantitative and qualitative • Irrelevant • Costs that do not differ between alternatives • Sunk costs – incurred in past and cannot be changed

5. Relevant Nonfinancial Information • Nonfinancial, or qualitative factors, also play a role in managers’ decisions. • laying off employees • outsourcing, reduced control over delivery time and product quality • discounted prices to select customers • Managers who ignore qualitative factors can make serious mistakes.

6. Six Short-Term Special Decisions • Special sales orders • Pricing • Discontinuing products, departments, and stores • Product mix • Outsourcing (make or buy) • Selling as is or processing further

7. Keys to Making Short-Term Special Decisions • Decisions approach • Relevant information approach or incremental analysis approach • Two keys in analyzing short-term special business decisions • Focus on relevant revenues, costs, and profits • Use contribution margin approach that separates variable costs from fixed costs

8. Sustainability and Short-term Business Decisions • View every decision as having an impact on • People • Planet • Profitability • Timberland, “doing well and doing good” • Example: Employees given PTO to volunteer • Costly

9. Objective 2 Decide whether to accept a special order

10. Special Order Considerations A customer requests a one-time order at a reduced sale price, often for a large quantity:

11. Special Sales Order

12. Special Sales Order

13. Incremental Analysis of SpecialSales Order, Exhibit 8-6

14. Now turn to E8-16A

15. E8-16A • Prepare an incremental analysis to determine whether Collectible Cards should accept the special sales order assuming fixed costs would not be affected by the special order. Would accept the special order because the cost per part to make it is only $0.30 per part versus the $0.40 per part selling price being offered by the buyer.

16. E8-16A (cont.) • Now assume that the Hall of Fame wants special hologram baseball cards. Collectible Cards must spend $5,000 to develop this hologram, which will be useless after the special order is completed. Should Collectible Cards accept the special order under these circumstances? Show your analysis.

17. Objective 3 Describe and apply different approaches to pricing

18. Regular Pricing Considerations • What is our target profit? • How much will customers pay? • Are we a price-taker or a price-setter for this product?

19. Price-Taker vs Price-Setter

20. Target Costing – Exhibit 8-9 • Market price minus desired profit = target cost • Target Cost includes: • Development cost – Marketing cost • Design cost – Delivery cost • Production cost – Service cost

21. Two potential outcomes when using target costing • Actual cost less than target total cost • Actual cost greater than target total cost

22. Other Strategies • Increase sales • Use CVP analysis to compute target sales to achieve its target profit. • Change or add to its product mix • Offer levels of the same product • Offer new items to the product mix with high CM • Remove items with the lowest CM • Differentiate its products – (make it unique) • Branding • Quality • Service packs

23. Cost-Plus Pricing • The opposite of the target-pricing approach • Starts with the company’s full costs • Adds the desired profit to determine a cost-plus price

24. Calculating Cost-Plus Price, Exhibit 8-12 If the current price is $3.00, can the company charge $3.20?

25. Pricing Decisions

26. Now turn to E8-19A

27. E8-19A • Which approach to pricing should Smith Builders emphasize? Why? • Target costing – Firm is a price taker, product lacks uniqueness and there is heavy competition

28. E8-19A (cont.) • Will Smith Builders be able to achieve its target profit levels? Show your computations. The answer is no, the target cost is less than variable cost.

29. E8-19A (cont.) • If Smith Builders upgrades, what will the new cost-plus price per home be? Should the company differentiate its product in this manner? Show your analysis. Yes, they should customize – they will achieve their target profit levels with the cost-plus price.

30. Objective 4 Decide whether to discontinue a product, department, or store

31. Other Short-term Business Decisions Managers Face • When to discontinue a product, department, or store • How to factor constrained resources into product mix decisions • When to make a product or outsource it • When to sell as is or process further

32. Considerations for Discontinuing Products, Departments or Stores, Exhibit 8-14 • Does product provide positive contribution margin?

33. Considerations for Discontinuing Products, Departments or Stores • Will the total fixed costs continue to exist even if the product line is discontinued? • Can any direct fixed costs of the product be avoided if the product line is discontinued? • Can any direct fixed costs of the product be avoided if the product line is discontinued? • Use incremental analysis for discontinuing a product

34. Discontinuing Products, Departments or Stores

35. Now turn to E8-20A

36. E8-20A • Prepare an incremental analysis to show whether Entertainment Plus should discontinue the DVD product line. Will discontinuing DVDs add $18,000 to operating income? Explain.

37. E8-20A (cont.) • Assume that Entertainment Plus can avoid $20,000 of fixed expenses by discontinuing the DVD product line (these costs are direct fixed costs of the DVD product line). Prepare an incremental analysis to show whether Entertainment Plus should stop selling DVDs.

38. E8-20A (cont.) • Now, assume that all $68,000 of fixed costs assigned to DVDs are direct fixed costs and can be avoided if the company stops selling DVDs. However, marketing has concluded that Blu-ray disc sales would be adversely affected by discontinuing the DVD line . Blu-ray disc production and sales would decline 10%. What should the company do?

39. Objective 5 Factor resource constraints into product mix decisions

40. Product Mix Considerations – Example from pages 477 - 479 $30 $60 (12) (48) $18 $12 $18 ÷ $30 60% $12 ÷ $60 20%

41. Product Mix Considerations – Exhibit 8-18

42. Product Mix

43. Product Mix When Demand Is Limited or Fixed Costs Change • What if demand is limited, due to competition or other factors? [In this example, company has demand for only 30,000 jeans, which consume in total 1,500 hours (30,000 jeans/20 jeans per hour)] • What if fixed costs are different when a different product mix is emphasized?

44. Now turn to E8-22A

45. E8-22A What product mix will maximize operating income?

46. E8-22A What product mix will maximize operating income? a ($310 + $ 88 + $264 + $119) b ($90 + $184 + $ 88 + $ 65) Get Fit should produce only the Regular model.

47. Objective 6 Analyze outsourcing (make-or-buy) decisions

48. Outsourcing (Make or Buy) Considerations • To buy a product or service or produce it in-house • The heart of the decisions : how best to use available resources • How do our variable costs compare to the outsourcing cost? • Are any fixed costs avoidable if we outsource? • What could we do with the freed capacity?

49. Outsourcing

50. Now turn to E8-25A