Chapter 4Chapter 4

Short-Term Short-Term Decision MakingDecision Making

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Day OneDay One

• Short Term Decisions – pg. 101

• Cost-Volume-Profit Analysis & Breakeven point – pgs. 102-106

• Learning Objective 2 – Explain the purpose of, and perform, cost-volume-profit (CVP) analysis

Short-Term DecisionsShort-Term Decisions• Assume that capacity is fixed

A company cannot increase its physical capacity to operate by building new facilities, adding a shift of workers, or relocating

• Short-term operating decisions are ad-hoc They cannot be planned during the normal

planning process

• Short-term operating decisions are unique Each decision must be analyzed as a distinct

opportunity

• A model is a representation of reality They help organize and sort information –decision

making tools

4-4

What is the CVP Model?What is the CVP Model?

• Cost-volume-profit model (short-term) Use to explore relationships among costs,

volumes, and profits Valuable planning tool because management

must assess whether the company can sell a given product in sufficient volume to cover the costs

Simplifies reality to make predictions without considering every factor

What is the CVP Model? (cont.)What is the CVP Model? (cont.)

• Assumptions (linear relationships) Selling price is constant per unit sold Variable cost is constant per unit purchased or

made Fixed cost is constant in total Number of units produced = number of units

sold Sales mix is constant

• The activity driver is the number of units produced and sold

4-6

CVP GraphCVP Graph

Breakeven point

Loss area

Profit area

Units produced and sold

$

Total Revenue

Total Cost

4-7

How are the CVP Components Defined Mathematically?How are the CVP Components Defined Mathematically?

• Total revenue – selling price * units sold SP * Q

• Total cost – variable cost * units produced (purchased) + fixed costs VC * Q + FC

• Breakeven – total revenue = total costs, profit=0 (SP * Q – VC * Q) – FC = 0

• Where, Q = quantity produced and sold

4-8

CVP ContinuedCVP 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)

4-9

Sensitivity AnalysisSensitivity AnalysisThe process of changing the key variables (but not

the assumptions) in CVP analysis • Change in selling price

Increase—decreases breakeven Decrease—increases breakeven

• Change in variable cost Increase—increases breakeven Decrease—decreases breakeven

• Change in fixed cost Increase—increases breakeven Decrease—decreases breakeven

• Change in tax rate No impact on breakeven

ExampleExample

A certain company sells its only product for $10 per unit. The variable costs to produce the product are $3 per unit and it costs approximately $1 per unit for selling and administrative costs. The fixed costs of production re $400,000 per period while the fixed selling and administrative costs are $200,000 per period. The company is subject to a 20 percent tax rate.

4-10

Example cont.Example cont.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 $72,000 before tax?

d) How many units must be sold to earn a profit of $72,000 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?

4-11

ReviewReview

Review –pages 119-124

E 4.1, E 4.2, E 4.3, E 4.4, E 4.5, E 4.6, E 4.7, E 4.8,

P 4.8

4-12

What are Product and Nonproduct Costs?What are Product and Nonproduct Costs?• Nonproduct costs

Incurred in connection with selling the revenue and expenditure process

• Associated with selling the product and administering (running) the company

Selling (marketing) costs – salaries/commissions paid to salespeople, maintaining delivery vehicles, advertising costs, etc.

Administrating costs – salaries paid to execs, rent on office space, income taxes paid on profits, etc.

4-14

What are Product and Nonproduct Costs?What are Product and Nonproduct Costs?• Product costs

Incurred in connection with the conversion process

• Associated with obtaining or producing the product

Merchandising firm – costs incurred to purchase and receive the product

• Cost of product + cost of freight + cost of insurance

Manufacturing firm – cost incurred to make the product

• Direct materials, direct labor, manufacturing overhead

4-15

What are the 3 Types of Product Costs?What are the 3 Types of Product Costs?• Direct materials

Cost of the primary materials Traceable and worth the cost of tracing

• Direct labor Cost of laborers making the product

• Manufacturing overhead All manufacturing costs that are not classified

as direct materials or direct labor (indirect materials, indirect labor, utilities, rent,

depreciation, etc)

More CostsMore Costs• Depreciation – When a company uses long-

term assets, it must spread the cost out over the period the assets are used

• NOT relevant in short-term decision making

Examples:

• Depreciation on a delivery truck used to get product to customers = selling cost

• Depreciation on production machinery = product cost

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What are the Activity Levels Associated with Costs?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 regardless

of the number of units or batches associated with the product line

• Facility-sustaining Costs incurred to maintain operating capacity,

these costs do not vary in the short-term

4-18

Types and Activity LevelsTypes and Activity Levels

Product Nonproduct

Unit-related Materials Commissions

Batch-related Set ups Ordering

Product-sustaining

Research & development

Advertising

Facility-sustaining

Rental of equipment

CEO salary

4-19

What are the 2 Characteristics of a Relevant Variable?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

4-20

Relevant Variables ContinuedRelevant Variables Continued

• Sunk costs Past cost, never relevant for short-term

decision making• Opportunity costs

Benefits foregone, always relevant for decision making

• Incremental costs/revenues Additional cost/revenue, associated with a

decision, relevant if the amount differs among alternatives

ReviewReview

• Pages 120-121

• E 4.10, E 4.11, E 4.12

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What are the Types of Short-Term Decisions Considered?What are the Types of Short-Term Decisions Considered?• Accept-or-reject decisions

The company must determine whether to sell products to a customer at a reduced price

Base decision on incremental profit associated with the order

Special order

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What are the Types of Short-Term Decisions Considered?What are the Types of Short-Term Decisions Considered?• Make-or-buy decisions

The company must determine whether to outsource a particular activity

Base decision on cost comparison between make and buy

Outsourcing

4-24

What are the Types of Short-Term Decisions Considered?What are the Types of Short-Term Decisions Considered?• Keep-or-drop decisions

The company must determine whether to keep a seemingly unprofitable product

Base decision on revenues lost versus costs saved

Product mix

ExampleExampleA company has been approached by a customer with an offer to buy 10,000 units of product but the customer wants a 25% discount off the normal selling price of $12. Unit-related cost of goods sold is $4.80 while unit-related selling costs are $1.20. To fill the customer’s order, one additional production run at a cost of $6,000 will be needed. In addition, an additional purchase order will be required at a cost of $500 and shipping to the customer will be $800. The company has the capacity to fill the customer’s order without interrupting normal sales. Should the company accept the order?

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AnswerAnswerAccept Reject

Selling price $9 ($12 * 0.75) $0

Cost of goods sold $4.80 $0

Unit selling $1.20 $0

Contribution margin $3.00 $0

Number of units 10,000 0

Total contribution margin $30,000 $0

Less: production run $6,000 $0

Less: purchase order $500 $0

Less: shipping $800 $0

Profit on order $22,7004-26

Another exampleAnother example

Product A Product B Product C

Sales $100,000 $200,000 $150,000

Cost of goods sold

60,000 120,000 90,000

Gross margin 40,000 80,000 60,000

Selling and administrative

50,000 60,000 55,000

Product profit ($10,000) 20,000 5,000

A merchandising company sells 3 products. A recent profit report is shown below.

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Another example continuedAnother example continued

A cost analysis reveals the cost of goods sold varies proportionately with sales (60%). However, selling and administrative costs are both facility-sustaining ($120,000) and unit-related (10% of sales). The facility sustaining costs will remain regardless of what happens to these product lines.

Should the company keep or drop Product A?

4-28

AnswerAnswerRevenues lost if Product A

is dropped: $100,000

Costs saved if Product A

Is dropped:

Cost of goods sold (60%) 60,000

Unit-related selling (10%) 10,000

70,000

Excess revenues lost over

cost saved: $30,000

Keep Product A4-29

ReviewReview

• Page 121

• E 4.13, E 4.14, E 4.16