1. Short-Term Business Decisions Chapter 8
Professor Garvin, JD; CPA – ACG2071

2. 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

3. Relevant and Irrelevant Information
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)

4. 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

5. Six Short-Term Special Decisions
Special sales orders
Pricing of Products
Dropping products, departments, or territories
Optimum product mix
Outsourcing (make or buy)
Selling as is or processing further

6. 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

7. Relevant or Irrelevant Factors
You are trying to decide whether to trade in your ink-jet printer for a more recent model. Your usage pattern will remain unchanged, but the old & new printers use different ink cartridges. Are the following relevant or irrelevant to decision?
The price of the new printer
The price you paid for the old printer
The trade-in value of the old printer
Paper costs
The difference between the cost of ink cartridges

8. “What does this product cost?”
Why do you want to know?
No single cost number is relevant for all decisions
Must find incremental information that is applicable to the decision
Co. president trying to decide whether to accept a one-time special order.
Co. president trying to decide whether to drop a specific product

9. Special Order Considerations9
A customer requests a one-time order at a reduced sale price, often for a large quantity:
DECISION RULE: Do we have excess capacity available to fill this order?
Yes
Consider further No
Reject the special order

10. Special Sales Order Accept the special order Reject the special order10
DECISION RULE: Is the special reduced sales price high enough to cover the incremental costs of filling the order?
If revenues greater than expected costs increase
Accept the special order
If revenues are less than expected costs increase
Reject the special order

11. Special Sales Order 11
Decision Tree: Will the special order affect regular sales in the long run?
If NO to these questions
Accept the special order
If YES to these questions
Reject the special order

12. Special Sales Order Accept the special order Reject the special order12
DECISION RULE: Is the special sales price high enough to cover the variable manufacturing costs?
If revenues greater than variable cost
Accept the special order
If revenues less than variable cost
Reject the special order

13. Incremental Analysis of Special Sales Order13
ACDelco makes oil filters, normally they sell for $3.20 each. Co. receives request from mailorder Customer for a one-time large special order of 20,000 filters for $35,000, or $1.75 each. Mgt has analyzed & Co. can handle special order w/o disrupting normal production. Variable cost/unit is $1.20, and fixed costs are not expected to change with the special order. Should ACDelco accept this special order?
Expected increase in revenues—sale of 20,000 oil filters x $1.75 each
$ 35,000
Expected increase in expenses—variable manufacturing costs:
20,000 oil filters $1.20 each
(24,000)
Expected increase in operating income
$ 11,000

14. Baseball Hall of Fame in Cooperstown, NY, has approached Sports-Cardz w/a special order. Hall of Fame wants to purchase 50,000 baseball card packs for a special promotional campaign & offers $0.40 per pack, a total of $20,000. Sports-Cardz’s total production cost is $0.60 per pack, as follows: Variable costs per unit:
Direct materials $ 0.14
Direct labor
Variable overhead
Fixed overhead
Total cost $ 0.60
Sports-Cardz has excess capacity to handle special order. Prepare an incremental analysis to determine whether Sports-Cardz should accept the special sales order assuming fixed costs would not be affected by the special order. 14
Expected increase in revenues—sale of 50,000 bb cards x $0.40 each
$ 20,000
Expected increase in expenses—variable manufacturing costs:
50,000 bb cards $0.35 each
(17,500)
Expected increase in operating income
$ 2,500

15. 15
Now assume that Hall of Fame wants special hologram baseball cards. Sports-Cardz must spend $5,000 to develop this hologram, which will be useless after special order completed. Should Sports-Cardz accept the special order under these circumstances? Show your analysis.
Expected increase in revenues—sale of 50,000 bb cards x $0.40 each
$ 20,000
Expected increase in expenses—variable manufacturing costs:
50,000 bb cards $0.35 each
special hologram cost
(17,500) (5,000)
Expected decrease in operating income
$ (2,500)

16. Regular Pricing Considerations
Major influences on Pricing Decisions
Customer demand
Actions of Competitors
Costs
Political, Legal and Image-Related issues
Specific Company Considerations
What is our target profit?
How much will customers pay for our product?
Are we a price-taker or a price-setter for this product?

17. Price-Taker vs. Price-Setter17
Price-Takers
Price-Setters
Product lacks uniqueness
Product is more unique
Heavy competition
Less competition
Pricing approach emphasizes target costing
Pricing approach emphasizes cost-plus pricing

18. Target Costing $200 30%, so $200 x 30%=$60 profit/unit1.
30%, so $200 x 30%=$60 profit/unit 2. 3.
$200-$60=$140 Target Cost 4.

19. Target Costing Market price minus desired profit = target cost
Target cost includes:
Development cost
Marketing cost
Design cost
Delivery cost
Production cost
Service cost
Calculations
Total
Revenue at market price
250,000 units $3.00 price =
$ 750,000
Less: Desired profit
10% x $1,000,000 of assets
(100,000)
Target cost
$650,000

20. Target Costing Access Production, Engineering & Cost Accounting Dept
Can we produce product for $2.60/unit?
If actual cost less than target total cost
Okay, proceed with product price & production of new units

21. Target Costing If actual cost greater than target total cost
Accept a lower profit
Cut fixed costs
Cut variable costs
Use other strategies
Increase sales volume
Differentiate our products so can increase sales price

22. Cut Fixed Costs: Discretionary/Committed
Calculate target fixed cost
Calculations
Total
Target cost
$ 650,000
Less: Current variable costs
250,000 units $1.50
(375,000)
Target fixed cost
$275,000
Calculate target variable cost
Total
Target cost
$ 650,000
Less: Current fixed costs
($50,000 more than target fixed cost)
(325,000)
Target total variable costs
$325,000
Divided by number of units
÷ 250,000
Target variable cost per unit $

23. Other Strategies Increase sales
Use CVP analysis to compute target sales to achieve its target profit
Change or adding 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

24. 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
Total cost
Plus: Desired profit
Cost –plus price

25. Calculating Cost-Plus Price
If the current price is $3.00, can the company charge $3.20?
Total
Current variable costs
250,000 units x $1.50 per unit =
$ 375,000
Plus: Current fixed costs
+ 325,000
Current total costs
$700,000
Plus: Desired profit
10% x $1,000,000 of assets
+ 100,000
Target revenue
$800,000
Divided by number of units
÷ 250,000
Cost-plus price per unit $

26. Pricing Decisions Decision Tree: How to Approach Pricing?26
Decision Tree: How to Approach Pricing?
If company is a price-taker for the product:
Emphasize target costing approach
If the company is a price-setter for the product:
Emphasize cost-plus pricing approach

27. Which approach to pricing should Bennett Builders emphasize?
Bennet Builders builds 1,500 sq. foot starter tract homes in fast-growing suburbs of Atlanta. Land & labor are cheap, & competition among developers is fierce. The homes are cookie-cutter, w/any upgrades added by buyer after the sale. Costs per developed sublot are as follows:
Land $ 50,000
Construction $125,000
Landscaping $ 5,000
Variable marketing costs $ 2, $182,000
BB would like to earn profit of 15% of variable cost of each home. Similar homes offered by competing builders sell for $200,000 each. 27
Which approach to pricing should Bennett Builders emphasize?
Will Bennett Builders be able to achieve its target profit levels?
Target costing: Firm is price taker, Product lacks uniqueness, heavy competition
Calculations
Total
Revenue at market price
$ 200,000
Less: Desired profit
15% of the variable cost
$182,000
(27,300)
Target cost
$172,700

28. We see that bathrooms & kitchens are typically the most important selling features of a home. BB could differentiate their homes by upgrading bathrooms & kitchens. The upgrades would cost $20,000/home but would enable BB to increase the selling prices by $35,000/home (in general, kitchen & bathroom upgrades typically add at least 150% of their cost to the value of any home). If Bennett Builders upgrades, what will the new cost-plus price per home be? Should the company differentiate its product in this manner? Show your analysis. 28
Total
Total Variable Costs
$182, ,000
$202,000
Plus: Desired profit
15% x of the variable cost $202,000
+ 30,300
Cost-plus price
$232,300
Expected market price of upgraded home is $200, ,000 = $235,000.
If BB can sell upgraded homes for $235,000, BB will earn more than target profit and should upgrade so BB can achieve target profit of $30,300 on each home.

29. Other Short-Term Business Decisions Managers Face
When to drop a product, department, or territory
Which products to emphasize in product mix decisions
When to outsource
When to sell as is or process further

30. Considerations for Dropping Products, Departments or Territories
Does product provide positive contribution margin?
Product Line
Co. makes 2 products: A & B. Last yr segmented CM Income St. shows loss for Product B
Total
(270,000 units)
Product A
(250,000 units)
Product B
(20,000 units)
Sales revenue
$835,000
$800,000
$ 35,000
Less: Variable Manuf. expenses
(305,000)
(300,000)
(5,000)
Variable Selling expenses
(100,000)
(75,000)
(25,000)
Contribution margin
430,000
425,000
5,000
Less: Fixed expenses: (Allocated to Product A & B
in proportion to
Units sold)
Manufacturing fixed costs
(200,000)
(185,185)
(14,815)
Marketing and administrative
(125,000)
(115,741)
(9,259)
Total fixed expenses
(325,000)
(300,926)
(24,074)
Operating income (loss)
$105,000
$124,074
$(19,074)

31. Considerations for Dropping Products, Departments or Territories
Will the total fixed costs continue to exist even if the product line is dropped?
Use incremental analysis for dropping a product when fixed costs continue to exist
If drop Product B:
Expected decrease in revenues:
Sale of product (20,000 $1.75)
($35,000)
Expected decrease in expenses:
Variable manufacturing expenses (20,000 $1.50)
$30,000
Expected decrease in operating income
$(5,000)

32. Considerations for Dropping Products, Departments or Territories
Can any direct fixed costs of the product be avoided if the product line is dropped?
Use incremental analysis for dropping a product when direct fixed costs can be avoided
If drop Product B:
Expected decrease in revenues:
Sale of product B (20,000 x $1.75)
($35,000)
Expected decrease in expenses:
Variable manufacturing expenses (20,000 x $1.50)
$30,000
Avoidable Direct fixed expenses—supervisor’s salary
$13,000
Expected decrease in total expenses
43,000
Expected increase in operating income
$8,000

33. Considerations for Dropping Products, Departments or Territories
Will dropping the product affect sales of the company’s other products?
What can be done with the freed capacity?

34. Dropping Products, Departments or Territories34
DECISION TREE:
Drop a product, department, or territory?
If lost revenues from dropping a product, department or territory exceed the cost savings from dropping:
Do not drop
If total cost savings exceed the lost revenues from dropping a product, department, or territory:
Drop

35. Co. accnts to help them decide whether to drop the DVD product line.
Top Mgrs of Video Avenue are alarmed by operating losses. Below is analysis prepared by
Co. accnts to help them decide whether to drop the DVD product line.
Total Discs DVDs
Sales revenue $420,000 $300, $120,000
Variable expenses , , ,000
Contribution margin , , ,000
Fixed expenses:*
Manufacturing , , ,000
Marketing and administrative , , ,000
Total fixed expenses , , ,000
Operating income (loss) $ (5,000) $ 25, $ (30,000)
*Total fixed costs will not change if Co. stops selling DVDs. 35
Prepare an incremental analysis to show whether Video Avenue should drop the DVD product line. Will dropping DVDs add $30,000 to operating inc.?
Expected decrease in revenues:
Dropping DVDs
($120,000)
Expected decrease in expenses:
Variable manufacturing expenses
80,000
Expected decrease in operating income
($40,000)

36. 2. Assume that Video Avenue can avoid $30,000 of fixed expenses by dropping the DVD product line (these costs are direct fixed costs of the DVD product line). Prepare an incremental analysis to show whether Video Avenue should stop selling DVDs. 36
Expected decrease in revenues:
Dropping DVDs
$120,000
Expected decrease in expenses:
Variable manufacturing expenses
$80,000
Direct fixed expenses
$30,000
Expected decrease in total expenses
110,000
Expected decrease in operating income
$ 10,000
Decision: Do not drop DVDs because the product’s incremental revenues $120,000 exceed its incremental costs of $110,000

37. 3. Now, assume that all $70,000 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? 37
Analysis of Dropping the DVD Product Line
Expected decrease in DVD revenue
$120,000
Expected decrease in DVD expenses:
Variable expenses
$80,000
Direct Fixed expenses
70,000
$150,000
Expected increase in operating income
30,000
Less: Lost contribution margin on Discs (10% x $150,000)
(15,000)*
Net expected increase in operating income
$15,000
Co. should consider dropping DVD line to increase its operating income by $15,000. *Both Disc revenue & variable Disc expenses would decrease by 10%.

38. Product Mix Considerations
What constraint stops us from making (displaying) all the units we can sell?
Which product offers highest contribution margin/unit of the constraint?
Facts: Co. makes 2 types of Jeans. It can sell all the jeans produced, but has only limited machine hours needed to make both types of Jeans. Which Jean should Co. produce until Co. can buy or lease another machine?
Per Unit
Product A
Product B
Sale price
$30
$60
Less: Variable expenses
(12)
(48)
Contribution margin
$18
$12
Contribution margin ratio:
Product A —$18 ÷ $30
60%
Product B —$12 ÷ $60
20%

39. Product Mix Considerations
Consider the time it takes to make each product against the constraint involved.
Product A
Product B
(1) Units that can be produced each machine hour 10 20
(2) Contribution margin per unit
x $18
x $12
Contribution margin per machine hour
(1) x (2)
$ 180
$ 240
Available capacity—number of machine hours
x 2,000
Total contribution margin at full capacity
$360,000
$480,000

40. Which product to emphasize?
Product Mix 40
DECISION TREE:
Which product to emphasize?
Emphasize the product with the highest contribution margin per unit of constraint

41. Product Mix When Demand Limited or Fixed Costs Change
New competitor has decreased demand for Product B. Now, Co. can sell only 30,000 Bs. Before, Co. selling 40,000 (20/hr x 2000 M.Hrs avail). Now what? Co. should not produce more than 30,000 B’s, so devote 1,500 of 2,000 hrs to Product B (30,000 units ÷ 20 per hour = 1500 hrs), and rest to Product A
What if fixed costs different when different product mix is emphasized? What if Co. had a monthly lease of $20,000/month on machine used only for making Product A?
CM at full capacity: $90, $360,000
Less: Avoidable fixed cost (20,000)
Net Benefit $70, $360,000 = $430,000 41
Product A
Product B
Contribution margin per machine hour
$ 180
$ 240
Machine hours devoted to product
x 500
x 1,500
Total contribution margin at full capacity
$90,000
$360,000
(Sales Price A: $30; B:$60)

42. Ex: Lifemaster produces two types of exercise treadmills: Regular and Deluxe. The exercise craze is such that Lifemaster could use all of its available machine hours producing either model. The two models are processed through the same production department Deluxe Regular
Sale price Per Unit $1, $550
Costs:
Direct materials $ $100
Direct labor
Variable manufacturing overhead
Product Contribution Margin
Fixed manufacturing overhead*
Variable operating expenses
Total cost
Operating income $ $ 85
*allocated on basis of M/H 42

43. What Product Mix Will Maximize Operating Income?43
Lifemaster
Product Mix Analysis
Deluxe
Regular
Sale price per unit
$1,000
$550
Variable costs per unit
725a
425b
Contribution margin per unit
275
125
Units produced with equivalent
number of machine hours
× 1
× 3
Contribution margin for equivalent
$ 275
$375
a (Delux) ($290 + $ $240 + $115)=725
b (Regular) ($100 + $180 + $ 80 + $ 65) =425
Lifemaster should produce only the Regular model.

44. What is Units produced with equivalent number of machine hours?
Fixed O/H allocated based on MHrs: $120 FMOH to Deluxe 40 FMOH to Regular so 120/160 = ¾ of total hrs allocated to Deluxe & ¼ to Regular.
Takes longer to produce Deluxe than Regular.
With limited # of MHs, for every 4 products 3 would be Regulars (takes less time to produce) and 1 would be Deluxe.
For every 4 machine hours available, can make 3 regulars & 1 deluxe
Go back to previous slide.

45. Outsourcing (Make or Buy) Considerations
To buy a product or service or produce it in- house
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-up capacity?

46. If Consider Total Costs Only
Co. produces music CDs, should they make liners for CD cases in-house or outsource?
Cost to produce in-house:
Total Cost per (250,000 items)
Direct materials
$ 40,000
Direct labor
20,000
Variable manufacturing overhead
15,000
Fixed manufacturing overhead
50,000
Total manufacturing cost
$ 125,000
Number of items
÷ 250,000
Cost per item $
Co receives an offer to produce the product for only $ Should they take the offer?

47. Incremental Analysis for Outsourcing Decision
Item Costs
Make
Buy
Difference
1. Variable costs:
Liners
Direct materials
$ 40,000
$ 40,000*
Direct labor
20,000
20,000*
Variable overhead
15,000
15,000*
TTL VC of making
*75,000
Purchase cost from outsourcing (250,000 * $0.37)
$ 92,500
($92,500)
Savings by producing In-house
$17,500
2. Co can avoid $10,000 fixed costs
$50,000
$40,000
10,000
Total cost of items
$125,000
$132,500
$ (7,500)

48. DECISION RULE: Should the company outsource?
Outsourcing 48
DECISION RULE: Should the company outsource?
If the incremental costs of making exceed the incremental costs of outsourcing:
Outsource
If the incremental costs of making are less than the incremental costs of outsourcing:
Do not outsource

49. Fiber Systems manufactures an optical switch that it uses in its final product. Fiber Systems incurred the following manufacturing costs when it produced 70,000 units last year:
Direct materials $ 630,000
Direct labor ,000
Variable overhead ,000
Fixed overhead ,000
Total manufacturing cost for 70,000 units $1,330,000
Fiber Systems does not yet know how many switches it will need this year; however, another company has offered to sell Fiber Systems the switch for $14 per unit. If Fiber Systems buys the switch from the outside supplier, the manufacturing facilities that will be idle cannot be used for any other purpose, and none of the fixed costs are avoidable. 49

50. 1. Given cost structure, should Fiber Systems make or buy the switch?
Outsourcing Decision
Make Unit
Buy Unit
Cost to Make Minus Cost to Buy
Variable cost per unit:
Direct materials
$ 9.00a
$ —
$ 9.00
Direct labor
1.50b —
1.50
Variable overhead
2.00c
2.00
Purchase price from outsider
14.00
(14.00)
Variable cost per unit
$12.50
$14.00
$ (1.50)
a (DM) $630,000 / 70,000 = $9.00/unit, b (DL) $105,000 / 70,000 = $1.50/unit, c (VOH)$140,000 / 70,000 = $2.00/unit

51. 2. Now, assume Fiber Systems can avoid $100,000 of fixed costs/yr by outsourcing production. In addition, because sales are increasing, Fiber Systems needs 75,000 switches a year rather than 70,000. What should Fiber Systems do now?
Make switches
Buy switches
Variable cost per unit (from part 1) $ $
× Units needed
75,000
Total variable costs
$ 937,500
1,050,000
+ Fixed costs
455,000
355,000*
Total relevant costs
$1,392,500
$1,405,000
*($455,000 − $100,000 avoidable)

52. 3. Given the last scenario (#2), what is the most Fiber Systems would be willing to pay to outsource the switches?
Cost of making switches =
Cost of outsourcing switches
Variable costs + fixed costs
($12.50 × 75,000) + $455,000
(x)* (75,000) + $355,000
$937,500 + $455,000
75,000x + $355,000
$1,037,500
75,000x
$13.83 (rounded) x
* Where x = outsourcing cost per switch

53. 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?

54. Incremental Analysis for Sell As Is or Process Further Decision
Co. spends $100,000 to process olives into olive oil. Should they sell as is, or spend more to process into Garlic Infused Dipping Oils?
Sell As Is
Process Further
Difference
Expected revenue from selling 50,000 quarts of regular olive oil at $5.00 per quart
$250,000
Expected revenue from selling 50,000 quarts of gourmet dipping oil at $7.00 per quart
$350,000
$100,000
Additional costs of $0.75 per quart to convert 50,000 quarts of plain olive oil into gourmet dipping oil
(37,500)
Total net benefit
$312,500
62,500

55. Sell As-Is or Process Further55
DECISION RULE: Sell as is or process further?
If extra revenue (from processing further) exceeds extra cost of processing further:
Process further
If extra revenue (from processing further) is less than extra cost of processing further:
Sell as is

56. Ex: Dairymaid processes organic milk into plain yogurt
Ex: Dairymaid processes organic milk into plain yogurt. Dairymaid sells plain yogurt to hospitals, nursing homes, & restaurants in bulk, one- gallon containers. Each batch, processed at a cost of $800, yields 500 gallons of plain yogurt. Dairymaid sells one-gallon tubs for $6.00 each & spends $0.10 for each plastic tub. Dairymaid has recently begun to reconsider its strategy. Dairymaid wonders if it would be more profitable to sell individual-sized portions of fruited organic yogurt at local food stores. Dairymaid could further process each batch of plain yogurt into 10,667 individual portions (3/4 cup each) of fruited yogurt. A recent market analysis indicates that demand for the product exists. Dairymaid would sell each individual portion for $0.50. Packaging would cost $0.08 per portion, & fruit would cost $0.10 per portion. Fixed costs would not change. Should Dairymaid continue to sell only gallon-sized plain yogurt (sell as is) or convert the plain yogurt into individual-sized portions of fruited yogurt (process further)? Why? 56

57. Sell As Is or Process Further Sell as gallon-size containers
Sell as individual portions
Sales revenue per unit
$ 6.00
$0.50
Additional processing costs per unit-packaging
(0.10)
(0.08)
Additional processing costs per unit- adding fruit
(0.00)
Net benefit per unit
$ 5.90
$0.32
Number of units produced per batch
× 500
× ,667
Net benefit per batch
$2,950
$ 3,413

58. END OF SEGMENT
Professor Garvin, JD; CPA – ACG2071