1. Copyright © 2008 Prentice Hall All rights reserved 8-1 Short-Term Business Decisions Chapter 8

2. Copyright © 2008 Prentice Hall All rights reserved 8-2 Objective 1 Describe and identify information relevant to short term business decisions

3. Copyright © 2008 Prentice Hall All rights reserved 8-3 How Managers Make Decisions Define business goals Identify alternative courses of action Gather and analyze relevant information Compare alternatives Choose best alternative Implement decision Follow-up: Compare actual results with results anticipated

4. Copyright © 2008 Prentice Hall All rights reserved 8-4 Relevant Information Expected future (cost and revenue) data Differs among alternative courses of action Is both quantitative and qualitative

5. Copyright © 2008 Prentice Hall All rights reserved 8-5 Irrelevant Costs Costs that do not differ between alternatives Sunk costs – incurred in past and cannot be changed

6. Copyright © 2008 Prentice Hall All rights reserved 8-6 Relevant Information 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. Copyright © 2008 Prentice Hall All rights reserved 8-7 Objective 2 Make special order decisions

8. Copyright © 2008 Prentice Hall All rights reserved 8-8 Special Sales Order Do we have excess capacity available to fill this order? Yes Consider further No Reject the special order A customer requests a one-time order at a reduced sale price, often for a large quantity:

9. Copyright © 2008 Prentice Hall All rights reserved 8-9 Special Sales Order DECISION RULE: Accept Special Order? If expected increase in revenues exceeds expected increase in variable and fixed costs Accept the special order If expected increase in revenues is less than expected increase in variable and fixed costs Reject the special order

10. Copyright © 2008 Prentice Hall All rights reserved 8-10 Qualitative Factors Will special order affect regular sales in the long run? Risk factors: Other customers hear of special order and demand lower price Special order customer returns, asking for the same reduced price Special order price starts a price war with competitors

11. Copyright © 2008 Prentice Hall All rights reserved 8-11 E8-16 1. Special Order Decision: Scenario 1 Sports-Cardz Incremental Analysis of Special Sales Order Expected increase in revenues (50,000 packs  $0.40)$ 20,000 Expected increase in expenses: Variable manufacturing cost: Expected increase in operating income$ 2,500 Hint: What are the factors needed to compute the variable costs for producing the additional cards?

12. Copyright © 2008 Prentice Hall All rights reserved 8-12 E8-16 2. Special Order Decision: Scenario 2 Sports-Cardz Incremental Analysis of Special Sales Order Expected increase in revenues (50,000 packs  $0.40)$ 20,000 Expected increase in expenses: Variable manufacturing cost: (50,000  $0.35)$(17,500) Fixed manufacturing costs(5,000)(22,500) Expected decrease in operating income$(2,500)

13. Copyright © 2008 Prentice Hall All rights reserved 8-13 Objective 3 Make pricing decisions

14. Copyright © 2008 Prentice Hall All rights reserved 8-14 Regular Pricing Considerations What is our target profit? How much will customers pay? Are we a price-taker or a price-setter for this product?

15. Copyright © 2008 Prentice Hall All rights reserved 8-15 Price Taker vs Price-Setter Price TakersPrice-Setters Product lacks uniqueness Product is more unique Heavy competitionLess competition Pricing approach emphasizes target pricing Pricing approach emphasizes cost-plus pricing

16. Copyright © 2008 Prentice Hall All rights reserved 8-16 Target Pricing: When a Company is a Price-Taker Starts with the market price of the product and then subtracts the company’s desired profit to determine the product’s target full cost, which covers:  Development  Design  Production  Marketing  Delivery  Service Revenue at market price Less: Desired profit Target full cost

17. Copyright © 2008 Prentice Hall All rights reserved 8-17 Cost-Plus Pricing: When a Company is a Price Setter The opposite of the target-pricing approach  Starts with the company’s full costs  Adds the desired profit to determine a cost-plus price Full cost Plus: Desired profit Cost-plus price

18. Copyright © 2008 Prentice Hall All rights reserved 8-18 Pricing Decisions DECISION RULE: How to Approach Pricing? If company is a price-taker for the product: Emphasize target pricing approach If the company is a price-setter for the product: Emphasize cost- plus pricing approach

19. Copyright © 2008 Prentice Hall All rights reserved 8-19 E8-18 2. Pricing Decisions Req 2: Revenue at market price$200,000 - Desired profit ($? x ?%)(?) Target full cost $172,700 Actual current variable cost182,000 Shortfall$9,300 Hint: How is the desired profit calculated? Start with the Total Cost of Production.

20. Copyright © 2008 Prentice Hall All rights reserved 8-20 E8-18 3. Pricing Decisions Req 3: Full cost$202,000 + Desired profit ($202,000 X 15%)30,300 Cost-plus price$232,300

21. Copyright © 2008 Prentice Hall All rights reserved 8-21 Objective 4 Make dropping a product, department or territory decisions

22. Copyright © 2008 Prentice Hall All rights reserved 8-22 Considerations for Dropping Products, Departments or Territories Does product provide positive contribution margin? Will fixed costs continue to exist, even if we drop the product? Are there any direct fixed costs that can be avoided if we drop the product? Will dropping the product affect sales of the company’s other products? What can be done with the freed capacity?

23. Copyright © 2008 Prentice Hall All rights reserved 8-23 Dropping Products, Departments or Territories Are there unavoidable fixed costs?  Unavoidable fixed costs continue even if the product line is dropped ; they are irrelevant because they will not differ between alternatives Are there avoidable fixed costs?  If a cost will not be incurred if a product line is dropped, the cost is relevant to the decision because it causes a difference between alternatives

24. Copyright © 2008 Prentice Hall All rights reserved 8-24 DECISION RULE: 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 Dropping Products, Departments or Territories

25. Copyright © 2008 Prentice Hall All rights reserved 8-25 E8-19 1. Decide Whether to Drop a Product Line Video Avenue Analysis of Dropping VCR-Tape Line Expected decrease in revenues$ (120,000) Expected decrease in expenses: Variable costs80,000 Expected decrease in operating income$(40,000)

26. Copyright © 2008 Prentice Hall All rights reserved 8-26 Objective 5 Make product-mix decisions

27. Copyright © 2008 Prentice Hall All rights reserved 8-27 Product Mix Considerations What constraint(s) stops us from making (or displaying) all 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?

28. Copyright © 2008 Prentice Hall All rights reserved 8-28 Product Mix DECISION RULE: Which product to emphasize? Emphasize the product with the highest contribution margin per unit of constraint

29. Copyright © 2008 Prentice Hall All rights reserved 8-29 E8-22 Determine Product Mix for Retailer Designer Moderate Contribution margin per unit$115.00$60.00 Units displayed per sq ft. 300/10,000 x.030 650/10,000 x.065 Contribution margin per sq ft of display space$3.45$3.90 Capacity – sq ft of display space x10,000 x10,000 Total contribution margin at capacity $34,500 $39,000

30. Copyright © 2008 Prentice Hall All rights reserved 8-30 Objective 6 Make outsourcing (make or buy) decisions

31. Copyright © 2008 Prentice Hall All rights reserved 8-31 Outsourcing (Make or Buy) 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?

32. Copyright © 2008 Prentice Hall All rights reserved 8-32 Outsourcing 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

33. Copyright © 2008 Prentice Hall All rights reserved 8-33 E8-24 Make or Buy Product Component Make Buy Difference Incremental cost per unit: Direct materials$9.00$0$9.00 Direct labor1.5001.50 Variable overhead2.0002.00 Purchase price $14(14.00) Incremental cost per unit$12.50$14$(1.50)

34. Copyright © 2008 Prentice Hall All rights reserved 8-34 E8-25 Make or Buy with Alternative Use of Facilities Make Incremental cost per unit: $12.50 Number of switchesx 80,000 Total incremental costs $1,000,000 Buy and leave facilities idle Incremental cost per unit: $14.00 Number of switches80,000 Total incremental costs $1,120,000

35. Copyright © 2008 Prentice Hall All rights reserved 8-35 E8-25 Make or Buy with Alternative Use of Facilities Buy and use facilities for other product Incremental cost per unit:$14 Number of switches80,000 Total incremental costs to buy $1,120,000 Expected profit contribution from other product (220,000) Expected net cost$900,000

36. Copyright © 2008 Prentice Hall All rights reserved 8-36 Objective 7 Make “sell as is” or “process further” decisions

37. Copyright © 2008 Prentice Hall All rights reserved 8-37 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?

38. Copyright © 2008 Prentice Hall All rights reserved 8-38 Sell As-Is or Process Further 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

39. Copyright © 2008 Prentice Hall All rights reserved 8-39 E8-27 Sell As Is or Process Further Process Sell As IsFurther Expected revenue/unit$6.00$0.50 Extra packaging costs/unit (0.10)(0.08) Extra cost for fruit(0.10) Expected net revenue/unit$5.90$0.32 Number of units per batch x 500 x 10,667 Net benefit per batch $2,950 $3,413

40. Copyright © 2008 Prentice Hall All rights reserved 8-40 End of Chapter 8