Ch. 8 Relevant Costs for Short-Term Decisions

Outsourcing Considerations

- 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? - What volume do we need?

Price-Setters

-Product is more unique -Product is branded -Less competition -Pricing approach emphasizes cost-plus pricing

Price-Takers

-Product lacks uniqueness -Not a brand name -Heavy competition -Pricing approach emphasizes target costing

Regular Pricing Considerations

-What is our target profit? -How much are customers willing pay? -Are we a price-taker or a price-setter for this product?

Decision Pitfalls to Avoid

1. Avoid including sunk costs in your analysis 2. Avoid using unit costs unless they are purely variable in nature.

Differences between a product line income statement and a segment margin income statement

1. Only direct fixed costs that can be traced to specific product lines are deducted from the product line's contribution margin. The resulting income or loss for each individual product line is known as a segment margin. 2. All common fixed costs are shown under the company "total" column but are not allocated among product lines.

Six Kind of Decisions

1. Pricing 2. Special Orders 3. Discontinuing products, departments, or stores 4. Product mix when resources are constrained 5. Outsourcing(make or buy) 6. Selling as is or processing further

Cost-Plus Pricing

An approach to pricing used by price-setters; cost-plus pricing begins with the product's total costs and adds the company's desired profit to determine a cost-plus price.

Target Costing

An approach to pricing used by price-takers; target costing begins with the revenue at market price and subtracts the company's desired profit to arrive at the target total cost.

Why are price-setters and price-takers important?

Both branding and product differentiation give managers more control over pricing. Without such features, a company must often settle for selling its product at the same price as the competition.

Irrelevant Costs

Do NOT affect a decision

Decision Rule: Should we discontinue a product, department, or store?

Do Not Discontinue: If the contribution margin lost form discontinuing a product, department, or store exceeds the fixed cost savings from discontinuing. Discontinue: If the fixed cost savings exceed the contribution margin lost form discontinuing a product, department, or store.

If the product line is discontinued, will avoidable fixed cost still be relevant?

If the product line is discontinued, these costs will go away.

When do you accept a special order?

If the revenue from the special order exceeds the incremental costs of filling the order

When do you deny a special order?

If the revenue from the special order is less than the incremental costs of filling the order.

Decision Rule: Which products should we emphasize?

If there is NO constraint: Emphasize the product with the highest contribution margin per unit. If there IS a constraint: Emphasize the product with the highest contribution margin per unit of the constraint.

What is the approach used to make short-term special decisions?

Incremental Analysis Approach

Are unavoidable fixed costs relevant to the decision?

No, unavoidable costs are irrelevant to the decision because they are kept regardless of whether a product line is kept or discontinued.

Decision Rule: Should we outsource?

Outsource: If the incremental costs of making exceed the incremental costs of outsourcing. Do not outsource: If the incremental costs of making are less than the incremental costs of outsourcing.

Outsorcing

Refers to the contracting an outside company to produce a product or perform a service

Target Costing Equation

Revenue at market price - Desired Profit = Target Total Cost

Product Line Income Statement

an income statement that shows the operating income of each product line, as well as the company as a whole

Avoidable Fixed Costs

any fixed costs that can be eliminated as a result of discontinuing the product

Outsourcing Decisions

are sometimes called "make-or-buy" decisions because managers must decide whether to make a product or service in-house or buy it form another ocmpany.

Unavoidable fixed costs

fixed costs that will continue to be incurred even if a particular course of action is taken

Negative Contribution Margin

means management would either need to raise the price of the product or reduce variable costs

Positive Contribution Margin

means the product line is generating enough revenue to cover its own variable costs

Offshoring

refers to having work performed overseas. (1)operating their own manufacturing plants and call centers overseas (2) outsourcing the overseas work to another company

Special Order Considerations

- Do we have excess capacity available to fill this order? - Will the reduced sales price be high enough to cover the incremental costs to filling the order (the variable costs of filling the order and any additional fixed costs)? - Will the special order affect regular sales in the long run?

Considerations for Discontinuing Products, Departments, or Stores

- Does the product provide a positive contribution margin? - Are there any fixed costs that can be avoided if we discontinue the product? - Will discontinuing the product affect sales of the company's other products? - What could we do with the freed capacity?

Sell As-Is or Process Further Considerations

- How much revenue is generated if we sell the product as is? - How much revenue is generated if we sell the product after processing it further? - How much will it cost to process the product further?

Pitfall to Avoid on Outsourcing Decisions

- One of the most common mistakes managers make when analyzing whether or not to outsource is to compare the absorption cost per unit. - Absorption costing includes fixed manufacturing costs.

Product Mix Considerations

- What constraint(s) stops us from making or displaying all of the units we can sell? - Which products offer the highest contribution margin per unit of the constraint? - Would emphasizing one product over another affect fixed costs?

How do managers make decisions?

1. Define Business Goals 2. Identify Alternative Courses of Action 3. Gather and Analyze Relevant Information: Compare Alternatives 4. Choose the Best Alternative 5. Implement Decision 6. Follow-Up: Compare Actual Results with the Results Anticipated

Two Keys to Analyzing Business Decisions

1. Focus on relevant revenues, costs, and profits. 2. Use a contribution margin approach that separates variable costs from fixed costs.

Segment Margin Income Statement

A product line income statement that contains no allocation of common fixed costs. Only direct fixed costs that can be traced to specific product lines are subtracted from the product line's contribution margin. All common fixed costs remain unallocated, and are shown only under the company total.

Special Order Decisions

A special order occurs when a customer requests a one-time order at a reduced sales price. (often large quantities)

Are avoidable fixed costs relevant to the decision?

Avoidable fixed costs are relevant to the decision because they will be incurred only if the product line is retained.

Why are sunk costs irrelevant?

Because the costs cannot be recovered or changed regardless of a future action taken

Relevant Information for Short-Term Decision Making

Expected future benefits vs. costs Difference between alternatives The information must have impact on the decision being made Relevant information can be quantitative or qualitative

Incremental Analysis Approach

Looks at how operating income will change under each alternative, relating to the immediate future.

Would management keep a product line with a negative contribution margin?

Management would rarely keep a product line with a negative contribution margin unless the product had a companion product whose sales would decline as a result.

Contract Manufacturers

Manufacturers that make products for other companies, not for themselves

Pitfalls to Avoid on Discontinuation Decisions

One of the most common mistakes managers make when analyzing whether or not to discontinue a product is to base the decision on a product line income statement that contains an allocation of common fixed expenses.

Decision Rule: Sell as is or process further?

Process further: If the incremental revenue from processing further exceeds extra cost of processing further. Do not process further: If incremental revenue from processing further is less than extra cost of processing further.

Opportunity Cost

The benefit forgone by choosing a particular course of action

Segment Margin

The income resulting from subtracting only the direct fixed costs of a product line from its contribution margin. The segment margin contains no allocation of common fixed costs.

Cost-Plus Price Equation

Total cost + Desired Profit = Cost-Plus Price

What decision making approach should real life managers take that will also consider the impact on the people and the environment?

Triple-Bottom Line Approach

Constraint

a factor that restricts the production or sale of a product

Sunk Costs

a past cost that cannot be changed regardless of which future action is taken.

Common Fixed Expenses

expenses that can not be traced to a particular product line