1

CHAPTER 15

SHORT-TERM PLANNING DECISIONS

2

Chapter Overview

How do relevant costs and revenues

contribute to sound decision making?

What type of costs and revenues are

relevant to decision making?

How does a company determine when to

drop a product?

3

What is a make-or-buy decision, and what issues

does a company consider in this decision?

How does a company determine whether to sell

a product or to process it further?

What is a product-mix decision, and what issues

does a company consider in this decision?

Chapter Overview

4

Relevant Costs and Revenues

Relevant costs and revenues are future costs and revenues that will change as a result of a short-term decision opportunity.

Costs and revenues that will not change as a result of a decision are not relevant and should be omitted from the short-term analysis.

The key to identifying potentially relevant costs and revenues is to have a good understanding of the company’s activities that are necessary to carry out the decision.

5

Three-Step Process of Identifying Relevant Costs

Exhibit 15-1

6

Incremental costs and revenues are costs and revenues increases resulting from a higher volume of activity or from the performance of additional activity. They are always relevant items.

Avoidable costs are the costs that a company must incur to perform an activity at a given level, but that it can avoid if the company reduces or discontinues the activity. Avoidable costs are always relevant costs.

Other Cost (and Revenue) Concepts

7

Opportunity costs are the profits that a company foregoes by following a particular course of action.

For example, a decision by Unlimited Decadence to use the refining machine for a short time to produce Pure Decadence bars would cause a decrease in production of the Darkly Decadent bars and foregone profits.

The opportunity cost of choosing to use the refining machine to produce the Pure Decadence bars would be the lost profits from the Darkly Decadent sales.

Other Cost (and Revenue) Concepts

8

In a special order decision, a manager must decide whether to accept a product order for less than the regular selling price.

The key is to identify the incremental revenues and costs related to the special order decision.

The general operating rule would be to accept a special order if the relevant profit (incremental revenues less incremental costs) is positive.

Special Order Decisions

9

Assume Unlimited Decadence receives a special order from a Wyoming customer for 20,000 cases of Darkly Decadent bars for $250,000 ($12.50 per case). Normally, a case of Darkly Decadent bars sells for $16.

Since the company has the excess capacity to produce the 20,000 cases without affecting normal sales, the offer should be considered.

What are the relevant costs and revenues?

Special Order Decisions

10

Cost Data for the Wyoming Sale (revised)

11

Relevant Costs and Revenues for the Wyoming Sale

12

In this short-term decision, a manager must decide whether to continue to produce a product or to drop it.

The key is to identify the lost revenues and avoidable costs relating to the decision.

The general operating rule would be to drop the product line if the lost revenues are less than the relevant costs avoided or saved.

Continue or Drop a Product Line Decisions

13

Assume Unlimited Decadence is evaluating whether to drop its Divinely Decadent Candy Bar line.

The expected profit projection for Divinely Decadent Candy Bars shows a loss of $10,900 while other candy bars collectively show a profit of $5,963,900.

What are the relevant costs and revenues for this decision?

Continue or Drop a Product Line Decisions

14

Expected Profit Computation

15

Analysis for the Decision to Drop a Product

16

Alternative Analysis for the Decision to Drop a Product

17

In a make or buy decision, a manager must decide whether to continue to make a component part of a product or purchase the part externally.

The key is to identify the relevant make and buy costs to the decision.

The general rule would be to continue to make the part internally if the relevant cost of making the item is less than the relevant cost of buying externally.

Make or Buy Decisions

18

Process Control Company manufactures the electronic control panel Unlimited Decadence uses to control some of its production processes.

Process Control currently purchases 1,000 computer chips per month from an outside supplier at a cost of $5.40 per chip. Due to some excess capacity, the company believes it can now make the chips it needs.

What are the relevant costs to this decision?

Make or Buy Decisions

19

Analysis for the Make-or-Buy Decision

20

In a this short-term decision, a manager must decide whether to sell a product “as is” or continued to process it further and sell it as another finished product.

The key is to identify the incremental revenues and costs relating to the decision.

The general rule would be to process a product further if the relevant profit after processing is greater than the relevant profit before further processing.

Sell or Process Further Decisions

21

Suppose Unlimited Decadence can sell all cases produced of the Darkly Decadent candy bars for $16 per case.

If the chocolate bars are further processed, they could be converted into fancy boxed chocolates that sell for $5 per box.

It is estimated that 200,000 boxes of fancy boxed chocolates could be sold.

Sell or Process Further Decisions

22

Additional Revenue and Cost Data for the Sell-or-Process Further Decision

Sales of 31,250 cases of the Darkly Decadent bars at $16 per case would have to be given up to process further ($500,000).

In addition, special equipment would have to be leased at a fixed cost of $14,000.

Lost sales opportunity from other candy bars would be $0.05 per box of fancy chocolate ($10,000).

Variable cost of converting the candy bars into boxed chocolates would be $0.40 per box (80,000).

Lastly, Unlimited Decadence expects delivery cost for the boxed chocolates to be $0.097 per box ($19,400) where the delivery costs for the candy bars was only $0.30 per case ($9,375).

What are the relevant revenues and costs for this decision?

23

Analysis for the Sell-or-Process Further Decision

24

A company can influence the sales volume of its products (or a combination of its products) in many ways, such as by sales activities (advertising), promotional campaigns, and the number of sales personal used for each product.

Many companies operate with limited capacity and cannot produce as much of every product as they can sell.

These decisions involve making choices about where company resources are focused to maximize profits.

Product Mix Decisions

25

This decision involves how to best allocate a fixed pool of advertising dollars to several products that a company may produce.

The operating rule in this case is that the company’s profit increases if the contribution margin resulting from the increased sales is more than the advertising costs incurred.

If the advertising costs between the alternatives does not change, then the operating rule would be to choose the product that produces the largest increase in contribution margin.

Allocating Advertising Dollars

26

To illustrate, assume Unlimited Decadence produces three products: Darkly Decadent, Pure Decadence, and Divinely Decadent bars.

A $200,000 increase in the advertising budget has been obtained and the company plans to spend it on one of the products. Which one?

What are the relevant revenues and costs for this decision?

Allocating Advertising Dollars

27

Analysis for the Advertising Product-Mix Decision

28

This decision involves how to best allocate limited production capacity.

The operating rule in this case is that the company maximizes its profit by allocating the scarce resource to the product that has the highest contribution margin per unit of scarce resource.

Once customer demand has been satisfied, the scarce resource should then be allocated to the product with the second highest contribution margin per unit of scarce resource, and so on.

Allocating Scarce Resources

29

Computation of Contribution Margin per Unit of a Scarce Resource