1. Short-term Decision Making
Chapter 4
Short-term Decision Making

2. What is the CVP Model? Cost-volume-profit model (short-term)
Use to explore relationships among costs, volumes, and profits
Assumptions (linearity)
Selling price is constant per unit
Variable cost is constant per unit
Fixed cost is constant in total
Number of units produced = number of units sold

3. CVP Graph $ Total Revenue Profit area Total Cost Breakeven point
Loss area
Units produced and sold

4. How are the CVP Components Defined Mathematically?
Total revenue
SP * Q
Total cost
VC * Q + FC
Breakeven
(SP * Q – VC * Q) – FC = 0
Where, Q = quantity produced and sold

5. CVP Continued Contribution margin Target profit before taxes
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)

6. Contribution Margin Approach is a quicker way to calculate it?
FC + P/CM = Q
Contribution margin approach to determine target profit after taxes
FC + (BTP/[1-tax rate])/CM = ATP

7. CVP Continued Change in selling price Change in variable cost
Increase—decreases breakeven
Decrease—increases breakeven
Change in variable cost
Increase—increases breakeven
Decrease—decreases breakeven
Change in fixed cost
Change in tax rate
No impact on breakeven

8. What are Product and Nonproduct Costs?
Incurred in connection with buying or making the product
Nonproduct costs
Incurred in connection with selling the product and administering (running) the company

9. What are the 3 Types of Product Costs?
Direct materials
Traceable
Worth the cost of tracing
Direct labor
Cost of employees making the product
Manufacturing overhead
Indirect costs of production (indirect materials, indirect labor, and other manufacturing costs)

10. 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
Facility-sustaining
Fixed or capacity costs

11. Types 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

12. 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

13. Relevant Variables Continued
Sunk costs
Past, never relevant for decision making
Opportunity costs
Benefits foregone, always relevant for short-term decision making
Incremental costs/revenues
Additional cost/revenue, relevant if different between alternatives

14. What are the Types of Short-Term Decisions Considered?
Accept-or-reject decisions
Special order
Base decision on incremental profit from the order
Make-or-buy decisions
Outsourcing
Base decision on cost comparison between make and buy
Keep-or-drop decisions
Product mix
Base decision on revenues lost versus costs saved

15. Lecture Example #1
1. A certain company sells its only product for $12 per unit. The variable costs to produce the product are $7 per unit and it costs approximately $1 per unit for selling and administrative costs. The fixed costs of production are $400,000 per period and the fixed selling and administrative costs are $200,000 per year. The company is subject to a 30 percent tax rate. Answer the following questions.
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 $70,000 before tax?
d. How many units must be sold to earn a profit of $70,000 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?

16. Lecture Example #1 Cont. Answer:
a. SP = $12; VC = $8; CM = $4; FC = $600,000
$600,000/4 = 150,000
b. CM = $4; SP = $12; CM % = %
$600,000/ % = $1,800,000
c. ($600,000 + $70,000)/4 = 167,500
d. $70,000/(1 - .3) = $100,000
($600,000 + $100,000)/4 = 175,000
e. To maintain the same breakeven point, CM must remain the same.
VC = $8.80; CM = $4; therefore SP = $12.80
f. If fixed costs increase, breakeven increases. Fixed costs do not affect contribution margin per unit.
g. Tax rate increases do not affect breakeven or contribution margin per unit.

17. Lecture Example #2
2. A company has been approached by a supplier with an offer to provide 25,000 units of a production part for $9 per unit. If the company accepts the offer its direct materials costs are expected to decrease by 60 percent, its direct labor costs are expected to decrease by 30 percent, and its unit-related overhead is expected to decrease by 20 percent. A recent per unit cost report when 25,000 units were produced is shown below:
Direct materials $10
Direct labor
Manufacturing overhead 8
Total cost $20
An analysis of manufacturing overhead reveals that overhead consists of unit-related and facility-sustaining overhead. Facility-sustaining overhead consists of depreciation and other fixed items and is approximately $150,000 per period. If the company accepts the supplier’s offer, it will use the released production facilities to produce another product with an expected contribution of $60,000 per period. Should the company accept or reject the supplier’s offer?

18. Lecture Example #2 Cont. Answer: Total overhead $8 * 25,000 = $200,000
Less facility-sustaining overhead 150,000
Unit-related overhead $ 50,000
Unit-related overhead per unit $50,000/25,000 = $2
Relevant variables Make Buy
Direct materials $ $ ($10 * .4)
Direct labor ($2 * .7)
Unit-related overhead ($2 * .8)
Purchase price
Relevant cost per unit $ $16.00
* Number of units 25, ,000
Total relevant unit cost $350,000 $400,000
Opportunity cost ,
Total relevant cost $410,000 $400,000 BUY

19. Lecture Example #3
A company has been approached by a customer with an offer to buy 10,000 units of product but the customer wants a discount of 25 percent off the normal selling price. The company has the capacity to fill the customer’s order. A recent profit report is shown below:
Sales (500,0000 units) $6,000,000
Cost of goods sold ,200,000
Gross margin $1,800,000
Selling and administrative cost 1,000,000
Profit $ 800,000
Unit-related cost of goods sold is 40 percent of the current selling price while unit-related selling and administrative costs are 10 percent of the current selling price. To fill the customer’s order, one additional production run will be required at a cost of $6,000. An additional purchase order will be required at a cost of $500, and shipping costs to the customer will be $800. Should the company accept the customer’s order?

20. Lecture Example # 3 Cont. Answer:
Current selling price = $6,000,000/500,000 = $12
Unit-related cost of goods sold = $12 * .4 = $4.80
Unit-related selling and administrative cost = $12 * .1 = $1.20
Proposed selling price = $12 * .75 = $9
Relevant variables Accept Reject
Proposed selling price $ $0.00
Cost of goods sold
Selling and administrative
Contribution margin $ $0.00
* Number of units requested 10, ,000
Total contribution margin $30,000 $0
Additional batch costs:
Production run ( 6,000)
Ordering ( )
Shipping ( )
Relevant profit $22,700 $0 ACCEPT

21. Lecture Example #4
4. A merchandising company currently sells three products—A, B, and C. Product profit reports for the last period are shown below:
Product A
Product B
Product C
Sales
$100,000
$200,000
$150,000
Less: cost of goods sold
60,000
120,000
90,000
Gross margin
40,000
80,000
Less: selling and administrative costs
50,000
55,000
Profit
($10,000)
$20,000
$5,000
A cost analysis reveals that cost of goods sold varies proportionately with sales (60%). Selling and administrative costs are $120,000 plus 10% of sales. The $120,000 of facility-sustaining selling and administrative cost will continue regardless of how many product lines the company maintains.
Should the company keep or drop its existing product lines?

22. Lecture Example #4 Cont. Answer: If Product A is dropped:
Revenues lost $100,000
Costs saved:
Cost of goods sold $60,000
Selling & administrative 10,000
$70,000
Since the revenues lost exceed the costs saved, the company should keep Product A.