1. Short-Term-Business-Decisions
Chapter 20
Short-Term-Business-Decisions

2. How Managers Make Decisions
Increasing profits or Market share
Special order Special price Product mix Outsource Process further
Product costs Fixed costs Variable costs Capacity
Using relevant information choose best alternative

3. Relevant Information
1. Expected future data 2. Differs among alternatives

4. Relevant and Irrelevant Costs
Affect decisions
Occur in the future
Differ among the alternatives
Irrelevant costs
Do not affect decisions
Sunk costs
Occurred in the past
Always irrelevant to the decision
Cannot be changed

5. Relevant Non-Financial Information
Considering qualitative factors in decision-making
Impact on employee morale
Outsourcing
Layoffs
Impact on quality
Product recall, higher warranty costs
Upset customers
Customer relations
Discounted prices to select customers
Use same guidelines as relevant costs
Occurs in the future
Differs between alternatives

6. Keys to Making Short-Term Special Decisions
Relevant information approach
Also called the incremental analysis approach
How operating income differs under alternatives
Irrelevant information is ignored
Only relevant data affect decisions

7. 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.
Indicate if the following items are relevant or irrelevant to your 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 ink cartridges’ costs
Relevant
Irrelevant
Relevant
Irrelevant
Relevant

8. When to Accept a Special Sales Order
Special order
When a customer requests a one-time order at a reduced sale price
Considerations:
Does the company have excess capacity available to fill this order?
Will the reduced sales price be high enough to cover the incremental costs of filling the order (the variable costs and any additional fixed costs)?
Will the special order affect regular sales in the long run?

9. Special Sales Order Is there excess capacity? Yes Consider further No
Reject the special order

10. Special Sales Order Does reduced price cover variable cost? Yes
Consider fixed costs No
Reject the special order

11. Special Sales Order
Will the special order affect regular sales in the long run?
Will regular customers find out and demand a lower price?
Will special order start a price war with competitors?
Will special order customer demand lower price on a regular basis?

12. Incremental Analysis
Focus on relevant data (revenues and costs that will change if it accepts the special order)
Use of a contribution margin approach that separates variable costs from fixed costs
The special sales order will increase operating income by $2,500. Fixed costs remain the same.

13. Decision Rule

14. Regular Pricing Considerations
What is our target profit?
How much will customers pay?
Are we a price-taker or a price-setter?

15. Price-taker or Price-setter?
Examples:
Food commodities
Natural resources
Generic consumer products and services
Examples:
Original art, jewelry
Specially manufactured machinery
Patented perfume scents
Latest tech gadget

16. Target Pricing 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

17. Options
Accept the lower operating income, not the target return required by stockholders
Reduce fixed costs
Reduce variable costs
Use other strategies
Increase capacity to spread the fixed costs are spread over more units
Change or add to product mix
Differentiate its product (become a price setter)

18. Cost-Plus Pricing Full cost Plus: Desired profit
Emphasizes a cost-plus approach
Opposite of the target-pricing approach
Starts with the full costs and adds desired profit to determine a cost-plus price
Unique product = more control over pricing
Full cost
Plus: Desired profit
Equals Cost-plus price

19. Calculating Cost-Plus Pricing
Unique products
Consider what customers are willing to pay
How well has the company been able to differentiate its product?

20. Pricing Decision Rule How to Approach Pricing?
Is company a price-taker for the product?
Emphasize target pricing approach
Is company a price-setter for the product?
Emphasize cost-plus pricing approach

21. E20-10: Making special order and pricing decisions
Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardz’s total production cost is $0.61 per pack, as follows: Hobby-Cardz has enough excess capacity to handle the special order. 1. Prepare an incremental analysis to determine whether Hobby-Cardz should accept the special sales order.

22. E20-10: Making special order and pricing decisions
Suppose the Baseball Hall of Fame in Cooperstown, New York, has approached Hobby-Cardz with a special order. The Hall of Fame wishes to purchase 57,000 baseball card packs for a special promotional campaign and offers $0.41 per pack, a total of $23,370. Hobby-Cardz’s total production cost is $0.61 per pack, as follows: Hobby-Cardz has enough excess capacity to handle the special order. 1. Prepare an incremental analysis to determine whether Hobby-Cardz should accept the special sales order.
Accept the special order

23. E20-10: Making special order and pricing decisions
2. Now assume that the Hall of Fame wants special hologram baseball cards. Hobby-Cardz will spend $5,900 to develop this hologram, which will be useless after the special order is completed. Should Hobby-Cardz accept the special order under these circumstances?
Reject the special order

24. P20-22A: Making special order and pricing decisions
Green Thumb operates a commercial plant nursery where it propagates plants for garden centers throughout the region. Green Thumb has $4,800,000 in assets. Its yearly fixed costs are $600,000, and the variable costs for the potting soil, container, label, seedling, and labor for each gallon-size plant total $1.35. Green Thumb’s volume is currently 470,000 units. Competitors offer the same plants, at the same quality, to garden centers for $3.60 each. Garden centers then mark them up to sell to the public for $9 to $12, depending on the type of plant. 1. Green Thumb’s owners want to earn a 10% return on the company’s assets. What is Green Thumb’s target full cost?
Revenue at current market price (470,000 units × $3.60 per unit) $1,692,000
Less: Desired profit ($4.8 million × 10%) ,000
Target full cost $1,212,000

25. P20-22A: Making special order and pricing decisions
2. Given Green Thumb’s current costs, will its owners be able to achieve their target profit?
Green Thumb’s actual total full costs of $1,234,500 are higher than its target full cost, therefore Green Thumb will not meet the stockholders’ profit expectations.
Current variable cost (500,000 × 1.70) $ 634,500
Current fixed costs ,000
Total full cost $1,234,500

26. P20-22A: Making special order and pricing decisions
3. Assume Green Thumb has identified ways to cut its variable costs to $1.20 per unit. What is its new target fixed cost? Will this decrease in variable costs allow the company to achieve its target profit?
The new target fixed cost is $648,000.
Target full cost (from requirement 1) $1,212,000
Less: Reduced level of variable costs
(470,000 × $1.20) (564,000)
New target fixed costs $ 648,000
Since the company’s actual fixed costs are less than or equal to the new target fixed cost amount, Green Thumb will be able to achieve its target profit without having to take any other cost-cutting measures.

27. P20-22A: Making special order and pricing decisions
4. Green Thumb started an aggressive advertising campaign strategy to differentiate its plants from those grown by other nurseries. Monrovia Plants made this strategy work, so Green Thumb has decided to try it, too. Green Thumb does not expect volume to be affected, but it hopes to gain more control over pricing. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not?

28. P20-22A: Making special order and pricing decisions
4. If Green Thumb has to spend $115,000 this year to advertise, and its variable costs continue to be $1.20 per unit, what will its cost-plus price be? Do you think Green Thumb will be able to sell its plants to garden centers at the cost-plus price? Why or why not?
Green Thumb’s cost-plus price is $3.74
Current fixed costs $ 600,000
Plus: Additional fixed costs of advertising ,000
Plus: Total variable costs (470,000 × $1.20) ,000
Total full costs $1,279,000
Plus: Desired profit ($4.8 million × 10%) ,000
Desired revenue $1,759,000
Divided by: Number of units ÷ 470,000
Cost-plus price per unit $ 3.74
Retailers will be more willing to pay the cost-plus price if the marketing campaign is effective. Other wise, Green Thumb may be considered a generic nursery.

29. Considerations for Dropping Products, Departments, or Territories
Does the product, department, or territory provide a positive contribution margin?
Will fixed costs continue to exist, even if the company drops the product?
Are there any direct fixed costs that can be avoided if the company drops the product, department, or territory?
Will dropping the product, department, or territory affect sales of the company’s other products?
What could the company do with the freed manufacturing capacity?

30. Decision Guidelines Example
Focus on a decrease in volume

31. Dropping Products Under Various Assumptions
If product has a negative contribution margin, then drop
Unavoidable fixed costs
Fixed costs that continue to exist even after a product is dropped—irrelevant
Avoidable, direct fixed costs—relevant
If costs decrease more than the decrease in revenues, product should be dropped
Would dropping the product line, department, or territory hurt other sales?
Consider lost contribution margins from other products
Will more profitable products be produced with freed capacity?

32. Decision Rule for Dropping Products, Departments or Territories
Drop a product, department, or territory?
Are lost revenues >
cost savings?
Do not drop
Are lost revenues <
Drop

33. Product Mix: Which Product to Emphasize?
Constraints
Something that restricts production or sale of product
Manufacturers
Limitations on labor or machine hours or available materials
Merchandisers
Amount of display space
Stiff competition may limit demand

34. Product Mix Considerations
What constraint(s) stop(s) the company from making (or displaying) all the units the company can sell?
Which products offer the highest contribution margin per unit of the constraint?
Would emphasizing one product over another affect fixed costs?
Decision rule:
Decision Rule - Which product to emphasize?
Emphasize the product with the highest contribution margin per unit of the constraint.

35. S20-4: Making dropping a product and product-mix decisions
Deela Fashions operates three departments: Men’s, Women’s, and Accessories. Departmental operating income data for the third quarter of 2012 are as follows: Assume that the fixed expenses assigned to each department include only direct fixed costs of the department: ● Salary of the department’s manager ● Cost of advertising directly related to that department If Deela Fashions drops a department, it will not incur these fixed expenses.

36. S20-4: Making dropping a product and product-mix decisions
Under these circumstances, should Deela Fashions drop any of the departments? Give your reasoning.
Deela Fashions should drop the Accessories Department because relevant expenses are greater than the revenues which will result in an increase in operating income if the department is dropped.

37. Outsourcing
Managers decide whether to buy a component product or service or produce it in-house
Cheaper is not always the deciding factor
Considerations:
How do the company’s variable costs compare to the outsourcing cost?
Are any fixed costs avoidable if the company outsources?
What could the company do with the freed manufacturing capacity?

38. Avoidable Fixed Costs If fixed costs stay the same—irrelevant
If fixed costs change—relevant
Differs between alternatives
Company can avoid $10,000 in fixed cost if outsourced.
However, total costs are more, so do not outsource.

39. Outsourcing Decision Rule
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

40. Opportunity Cost
Benefit given up by not choosing an alternative course of action
Example:
If the company chooses not to outsource, it will lose any revenue from freed capacity
If company outsources, freed capacity can be used to produce other products, maybe earning more

41. Other Factors To Consider
Qualitative factors
Control over quality
Outsourcing considerations
Coordination, information exchange, and paperwork problems
Globalization
Use Internet to find information systems of suppliers and customers located around the world
Companies can now focus on their core competencies—quality and delivery

42. Sell As Is or Process Further
Considerations:
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?

43. Example

44. Sell As Is or Process Further
Decision rule:
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

45. 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?

46. S20-6: Making outsourcing and sell as is or process further decisions
1. What is the unit cost of making the bread in-house (use absorption costing)?

47. S20-6: Making outsourcing and sell as is or process further decisions
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?