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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Short-Term Business Decisions

Chapter 20

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Learning Objectives

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Describe and identify information relevant to business decisionsMake special order and pricing decisionsMake dropping a product and product-mix decisionsMake outsourcing and sell as is or processfurther decisions


Describe and identify information relevant to business decisions

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How Managers Make Decisions

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Repeat existing patterns without questionWhy did the accountant cross the road?

Triage managementDeal with most urgent problems as they come up

Trial and errorShooting from the hip, seat of the pants

Information based decision makingBase decisions on mission aligned options supported with relevant information


How Good Managers Make Decisions

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How do we utilize excess

capacity?

Should we accept this

special order?

Relevant costs, market effects

Accept the offer if it helps us meet our business

goals.


Relevant and Irrelevant CostsRelevant costs affect decisions

Differ among the alternativesHaven’t happened yetAny costs that fit those above two categories

Irrelevant costs do not affect decisionsCosts that do not differ between optionsSunk costs

Occurred in the past Are never relevant to any decisionThe trouble is we are human and we hate to lose.

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http://www.leisnetwork.com/2009/08/sunk-cost/


Other relevant costs to considerImpact on employee morale

OutsourcingLayoffs

Impact on qualityProduct recall, higher warranty costsBrand equity, lost sales

Customer relationsReactions to your decisions

Opportunity costWhat you forego to get something else

Use same guidelines as relevant costsOccurs in the futureDiffers between alternatives

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Relevant Costs Bottom Line

If a cost doesn’t change between two decision options, ignore it.Average costs as reported by financial accounting reports are frequently NOT purely relevant costs.


Two approaches to the analysisRelevant information approach

Also called the incremental analysis approachOnly display relevant numbersFocuses attention on just what mattersFast, clear, concise

Total cost approachFollow the same principlesShow all the numbersShows the whole picture, nothing hidingBuilds trust, removes doubt & mystery

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S20-1: DESCRIBING AND IDENTIFYING INFORMATION RELEVANT TO BUSINESS DECISIONS

You are trying to decide whether to trade in your inkjet printer for a more recent model. Your usage pattern will remain unchanged, but the old and new printers use different ink cartridges.1. Indicate if the following items are relevant or

irrelevant to your decision:a. The price of the new printerb. The price you paid for the old printerc. The trade-in value of the old printerd. Paper costse. The difference between ink cartridges’ costs

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RelevantIrrelevantRelevantIrrelevantRelevant


Make special order and pricing decisions

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These are NOT regular, everyday pricing decisions.Special orders are considerations in addition to your regular business

Extra sales opportunitiesUsing this pricing methodology for everyday transactions will bankrupt you. Want to know why?

Special Orders


To add profits, special orders need only cover incremental costs, leaving the rest of non-differential cost coverage for someone else…Requirements

Can’t effect regular customersMust use excess capacity

Why is this?

Other considerationsGrey market?Brand equity?Future negotiations?

Special Orders

http://www.bloomberg.com/news/2010-12-13/u-s-supreme-court-divides-evenly-in-costco-gray-market-case.html


Decision Rule

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The key is find which costs and revenues are effected by the special order, and only use those relevant costs in the quantitative aspects of your decision.


Special order exampleYour small photography firm specializes in life capturing photography. Your everyday pricing is built on the following cost structure:

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AmountEveryday selling price per portrait 300$ Travel cost per photo site 60Set up cost per setting 15Direct materials 20Direct labor per portait 20Variable overhead per portrait 15Fixed overhead allocated per portrait 20Total average cost per portrait 150$

Should you accept a special order offer of $100 considering the following situation?

It is 11:00am, you are done with your only shoot of the day at Lover’s Point. An

Andorran tourist offers you $100 for a portrait

using your current setting.



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Should you accept a special order offer of $100 considering the following situation?

You said “Yes”. Now that same tourist

gets a call. The caller asks if you can come back tomorrow at the

same time for the same deal.



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A real estate agent wants to purchase

portraits for staging a home. You have

several whose customers have

abandoned them. Each required

separate travel and other costs to

complete. What is the minimum price you should accept?

What is horribly wrong with the technically right

answer?


Probability of conversion Considering again the original $100 acceptable deal

The tourist wants a portrait. We are the only ones there set up to a professional quality job.

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Amount Sell at discount Sell at regular priceEveryday selling price per portrait 300$ 100 300Travel cost per photo site 60Set up cost per setting 15Direct materials 20 20 20Direct labor per portait 20 20 20Variable overhead per portrait 15 15 15Fixed overhead allocated per portrait 20Total cost per portrait 150$ 55 55Incremental contribution margin per sale 45 245Probability of closing a sale 100% 0%Expected value of outcome 45 0

It is 11:00am, you are done with your only shoot of the day at Lover’s Point. An Andorran tourist offers you $100 for a portrait using your

current setting.


Topics related to special order pricing

Why are USA companies are able to sell their medicines cheaper in other countries?Why are “international version” text books so much cheaper?What is “price discrimination” and how does it explain these business issues?

CouponsInternet only pricing (not available in store)Intentionally carrying closeout items after the season


Regular Pricing Considerations

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What is our target profit?

How much will customers

pay?

Are we a price-taker or a price-setter?


Targeting profits

Owners expect a certain rate of returnRisk factorsHistorical performanceOptions available

If owners have $1,000,000 in equity and expect a 10% return, they expect the company to earn $100,000 in profits for them.

If they don’t get it, the value of the firm will dropSomehow or another the company needs to try and hit that target.

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Price-taker or Price-setter?

Examples: Food commoditiesNatural resources Generic consumer products and services

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Examples: Original art, brandsSpecialty machineryPatented perfume scentsLatest technology


Target Pricing

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Starts with the market price of the product The price customers are willing to pay

Subtracts the company’s desired profit Determine the product’s target full cost

Full cost to develop, produce, and deliver the product or service

Revenue at market priceLess:Desired profitTarget full cost structure


Cost-Plus PricingStarts at cost, then adds desired profitsOpposite of the target-pricing approachRequires market control over pricingCommon practice with standard industry pricing models

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Full cost

Plus: Desired profit

Equals Cost-plus price


What if you can't price high enough to earn target profits?

Accept the lower operating income, not the target return required by stockholdersReduce fixed costs Reduce variable costs Use other strategies

Increase capacity to spread the fixed costs are spread over more unitsChange or add to product mixDifferentiate its product (become a price setter)Reduce ownershipGo out of business

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Make dropping a product and product-mix decisions

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Dropping segment or product guidelinesDrop segments with negative contribution marginUnavoidable fixed costs are irrelevant

Fixed costs that continue to exist even after a segment is dropped

Avoidable, direct fixed costs are relevantIf you drop and you save, it counts!

Would dropping the product line, department, or territory hurt or help other sales?

Dropping can help focus, or hurt cross promotionCan freed capacity be put to use?Bottom line:

Drop if fixed cost savings exceed lost contribution margin.

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Example: Problem 20-23AShould Safe Zone drop the unprofitable Industrial System segment? Prepare an incremental analysis.They will eliminate $84,000 in fixed manufacturing costs, and reduce fixed marketing & administration by $14,000.

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Your turn

Work problem E20-13

Really? Should they drop VCR tapes?

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Our previous Contribution Margin analysis stressed CM per sales dollar.

We maximized profits by selling the item with the highest contribution per sales dollar.

This is valid if plentiful resources exist to fulfill our maximum sales volume. That is, if sales volume is our constraining resource.

Product Mix: Which Product to Emphasize?


What constraint limits capacity?Constraints

Something that restricts production or sale of productManufacturer example

Limitations on labor or machine hours or available materials

Merchandiser exampleAmount of display space

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Product Mix Considerations

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What constraint stops a company from processing everything demanded?Which products offer the highest contribution margin per unit of the constraint?Decision rule:

Decision Rule - Which product to

emphasize?

Emphasize the product with the highest contribution margin per unit of the constraint.


Which product to emphasize?

Where should this business focus their sales efforts? They have too many customers and too little time.

Selling Price 100$ 500$ Variable Costs 50 300Contribution Margin 50$ 200$

Hours per sale 0.25 1.25

CM per hour 200$ 160$


Product mix emphasis A mass merchant retailer has one aisle of space available to display automotive merchandise. They are considering offering large high-profit items like car top carriers, and/or small items like spray oils. There are so many items they could carry, that the limited space is their biggest concern. Given the two example products below, which one maximizes their monthly contribution margin per square foot, the Large items (car top carriers), or the small items (automotive chemicals)? Car top carriers Automotive chemicals Sales price per unit $300 $3.00 Variable costs per unit $200 $2.00 Per unit CM $100 $1.00 Sales Units Per month 10 100 Shelf space required 25 sq ft 1 sq ft

Your turn: Shelf Space Utilization


Make outsourcing and sell as is or process further decisions

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Deciding whether to make an item internally or buy it from an outside supplier

This is an excellent application of the relevant cost principles we are learning.

The Outsourcing Decision

http://www.alibaba.com/


The Outsourcing Decision

DECISION RULE, Accounting portionIn deciding whether to switch to an outside

supplier, we isolate the relevant costs of making the part by eliminating:

The sunk costs.The future costs that will not differ between making or buying the parts.Recognizing the opportunity costs of any freed up capacity.


Opportunity Cost

The benefits that are foregone as a result of pursuing some course of action.

Opportunity costs are not actual dollar outlays and are not recorded in the formal accounts

of an organization.


Outsourcing Decision Rule

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Should the company outsource?

If the incremental costs of making exceed incremental

costs to outsource

Outsource

If the incremental cost of making are less than the

incremental costs to outsource

Do not outsource


Work opportunity: P20-25AOutdoor Life gets the call from LancasterThe costs are compared

Outsourced goods in hand: $13.00 eachShould they outsource?

What next?53

Total costs

Relevant per unit

costsDirect materials 17,550$ Direct labor 3,400 Variable overhead 2,040 Fixed* overhead 6,300 Total manufacturing cost for 2,000 bindings 29,290$

* $2,100 are avoidable traceable costs, the rest are allocated common costs which cannot be avoided.


Opportunity CostBenefit given up by not choosing an alternative course of actionIf Outdoor Life could use the freed up capacity to produce another component, how profitable would it have to be?

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Total costs

Relevant per unit

costsDirect materials 17,550$ Direct labor 3,400 Variable overhead 2,040 Fixed* overhead 6,300 Total manufacturing cost for 2,000 bindings 29,290$

* $2,100 are avoidable traceable costs, the rest are allocated common costs which cannot be avoided.


Alignment of incentives with decisionsWhat else happens when you outsource production?

Tough to reverse course once everyone is fired. Outsourced cost inflation?Reliance on business partnersLogisticsWho cares more about YOUR quality?YOUR production equipment doesn’t get obsolete.Focus on newest releases and core competenciesTechnology simplifies

Outsourcing Special Notes


Other Factors To ConsiderQualitative factors

Control over qualityOutsourcing considerations

Coordination, information exchange, and paperwork problems

GlobalizationUse Internet to find information systems of suppliers and customers located around the worldCompanies can now focus on their core competencies—quality and delivery

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Sell As Is or Process FurtherConsiderations:

How much revenue will the company receive if the company sells the product as is?How much revenue will the company receive if the company sells the product after processing it further?How much will it cost to process the product further?

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Example

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Sell As Is or Process FurtherDecision rule:

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Sell as-is or process further?

If extra revenue from processing further exceeds extra cost

Process further

If extra revenue from processing further is less

than extra cost

Sell as is


S20-6: MAKING OUTSOURCING AND SELL AS IS OR PROCESS FURTHER DECISIONS

Suppose a Roasted Olive restaurant is considering whether to (1) bake bread for its restaurant in-house or (2) buy the bread from a local bakery. The chef estimates that variable costs of making each loaf include $0.52 of ingredients, $0.24 of variable overhead (electricity to run the oven), and $0.70 of direct labor for kneading and forming the loaves. Allocating fixed overhead (depreciation on the kitchen equipment and building) based on direct labor assigns $0.96 of fixed overhead per loaf. None of the fixed costs are avoidable. The local bakery would charge $1.75 per loaf.

1. What is the unit cost of making the bread in-house (use absorption costing)?

2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why?

3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision?

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1. What is the unit cost of making the bread in-house (use absorption costing)?

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2. Should Roasted Olive bake the bread in-house or buy from the local bakery? Why?

Decision: Roasted Olive should bake the bread in-house since the variable cost of making each loaf is less than the cost of outsourcing each loaf.

3. In addition to the financial analysis, what else should Roasted Olive consider when making this decision?

Roasted Olive should consider the following qualitative factors before making a final decision:Will the local bakery meet their delivery time requirements?How does the quality and freshness of the local bakery bread compare to Roasted Olive bread?

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Chapter 20 SummaryRelevant information is expected future data that differs among alternatives. Relevant costs are costs that may affect which decision you make. Irrelevant costs are costs that won’t change the decision you make. Sunk costs are costs that were incurred in the past and cannot be changed regardless of which future action is taken. The two keys to making short-term decisions are to focus on relevant revenues, costs, and profits, and to use a contribution margin approach to separate variable and fixed costs.

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Chapter 20 SummaryManagers must consider three things when considering a special order:

1) Does the company have excess manufacturing capacity?

2) Does the special sales price cover the incremental costs of filling the special order?

3) Will fixed costs change because of the special order? If the expected increase in revenues exceeds the expected increase in costs, the company should accept the special order. When setting prices, the company must consider its target profit goal, how much customers will pay for the product, and whether the company is a price-taker or a price-setter. Price setters use a cost-plus pricing approach to pricing, whereas price-takers use a target pricing approach.

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Chapter 20 SummaryThe first product mix question is “Does the product provide a positive contribution margin?” What is relevant is whether the fixed costs continue to exist if the product is dropped and whether there are any avoidable direct fixed costs if the product is dropped. Unavoidable fixed costs and are irrelevant to the decision. If direct fixed costs will change, those costs are relevant to the decision of whether a product should be dropped. When there is a constraint on production, such as total machine hours, this constraint must be considered when determining which product should be emphasized. If the company can sell whatever product it makes, the company should emphasize producing the product with the highest contribution margin per unit of the constraint.

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Chapter 20 SummaryWhen a company is considering outsourcing, if the incremental costs of making the product exceed the incremental costs of outsourcing, then the company should outsource the product. When a company is considering selling a product as is or processing it further, if the extra revenue from processing the product further exceeds the extra costs to process the product further, then the company should process the product further.

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.68

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