SHORT-TERM DECISION MAKING

PREPARED BY: OLEA SHINEHA A. TUAZON

Short-term decisions

Operational, tactical in nature, meeting short-term goals, or reacting to a crisis, i.e. making the
best of resources in the short term.

Each decision involves relatively small amounts of monetary value

Relatively easy to change decision, withdraw from activity if the business environment changes

A. Make-or-Buy Decision
What is a 'Make-or-Buy Decision’

A make-or-buy decision is the act of choosing between manufacturing a product in-house or

purchasing it from an external supplier. In a make-or-buy decision, the most important factors to
consider are part of quantitative analysis, such as the associated costs of production and whether
the business can produce at required levels.

Outsourcing or sometimes called Make/Buy, decisions are rooted in the best way to use
available resources.

Three considerations:

1. How do variable costs compare to the outsourced cost?

2. Are any fixed costs avoidable if outsourced?

3. How could freed up capacity be used?

Example: A company produces 10,000 headphones and has the following costs:

Per Unit Total

Direct Materials $ 10 $100,000
Direct Labor $ 5 $50,000
Variable MFG Overhead $ 7 $70,000
Fixed MFG Overhead ---- $50,000
Total MFG Costs $ 270,000
Produce 10,000 units / 10,000
Average cost per unit $ 27.00

Outside vendor will produce the headphones for $24 per unit

Assume the following costs a company incurs to produce 10,000 headphones. Based on the data
Provided, the average cost is $27 per headphone set. What if an outside vendor could produce the
headphones for $24 per set? Should we do it?

Initially we might think that’s great because it saves us $3 per set. But remember there are three
things that we can consider when performing this kind of analysis.
Analysis: How do variable costs compare to the outsourced cost?

Make Buy
Direct Materials $100,000 -
Direct Labor 50,000 -
Variable MFG Overhead 70,000 -
Purchase Price - $240,000
Total Variable Costs $220,000 $240,000

The company is $20,000 worse off by purchasing the headphones than making them.
Start comparing the variable cost and the manufacturing headphones to the purchase price of
buying them. In this case, the variable cost and to manufacturing is $20,000 then less the
purchase them. We would require the purchase price of $2 per set less based on this information.

Analysis: Are any fixed costs avoidable if outsourced?

Make Buy
Direct Materials $100,000 -
Direct Labor 50,000 -
Variable MFG Overhead 70,000 -
Fixed MFG Overhead 50,000 $ 40,000
Total MFG Costs $270,000 $ 40,000
Purchase Price - $240,000
Total Costs $270,000 $280,000

If $10,000 of fixed costs are avoidable, then that would make the gap closer.

What if buying headphones rather than making them meant we can reduce plant supervision and
avoid a $10,000 of a fixed cost? Although that improves the decision to buy the headphones
we’d still be $10,000 better off by making them ourselves.

Analysis: How could freed capacity be used?

Make Buy
Total MFG Costs $270,000 $ 40,000
Purchase Price - $240,000
Total Costs $270,000 $280,000

Sell 10,000 more Earbuds @ $5 CM $ 50,000

If additional space and capacity meant we could produce and sell more earbuds? We would need
to consider the additional margin of the earbuds.
In this example in the additional $50,000 a contribution from the year but it’s more than offsets
the additional $10,000 costs of buying 10,000 costs of buying the headphones, so we would be
$40,000 better off by buying the headphones and producing more earbuds with the additional
space.

If additional space and capacity could be used to produce 10,000 more earbuds at a contribution
margin of $5, then the $10,000 of additional cost would be offset by $50,000 of additional
contribution margin.
Each example you see is a little bit but remember to focus on the incremental changes and the
following considerations:

Are outsourced cost less than variable costs?

Are any fixed costs avoidable if outsource?

Could freed capacity generate additional contribution margin?

Each example you see is a little bit but remember to focus the incremental changes and the
following considerations

B. Accept or Reject Special Orders

A customer requests a one time order at a reduced sale price, often for a large quantity.

QUALITATIVE ISSUES:
1. Does the plant have capacity to handle the increased volume?
2. Will the one-time sale impact future, regular sales? Change in f
3.
QUANTITATIVE ISSUES:
1. Does incremental revenue exceed incremental costs?

Sometimes customers request large, one-time orders at a reduced price and management must
decide whether or not to accept it. There are both qualitative issues, like if a plant has capacity to
accept order and if accepted does hurt regular sales, and quantitative issues, like If the
incremental revenue is greater than the incremental costs. Let’s look at an example.

7-11 wants to purchase 50,000 football card packs for a special promotional campaign and offers
$0.50 per pack, a total of $25,000. Cards-R-Us total production cost is $0.80 per pack, as
follows:
Variable Costs:
Direct Materials ………………………………………………... $ 0.15
Direct Labor………………………………………………………0.05
Variable Overhead……………………………..............................0.10
Fixed Overhead……………………………………………………0.50
Total cost…………………………………………………………$ 0.80
Cards-R-Us has enough excess capacity to handle the special order.

To answer the question we need to perform incremental analysis and identify the relevant data.
So the special price of $0.50 per pack is relevant to the decision. So is the direct material cost of
15c per pack. So was the direct labor cost of 5c per pack. As is the variable overhead cost of 10c
per pack.

Here I have created a table for incremental analysis. Incremental revenues total $25,000.
INCREMENTAL ANALYSIS:
Special Order
Incremental Revenues (50,000x $.50) $25,000
Incremental Variable Costs (50,000x $.30) 15,000
Incremental Fixed Costs no charge (irrelevant) -
Increase in Operating Income $ 10,000

Since fixed costs don’t change, the incremental revenue is greater than the incremental costs, so
management should accept this order.

Incremental variable costs total $15,000. This is because the direct materials, direct labor, and
variable overhead total 30c per pack. Finally, there is not an incremental change in fixed costs so
they are irrelevant to the decision. Thus management should accept this order because it
increases operating income $10,000.

INCREMENTAL ANALYSIS: Which items are relevant?

Revenue:
Special Price……………………………………………………….$0.50
Variable costs
Direct materials……………………………………………… $0.25
Direct Labor………………………………………………… 0.05
Variable overhead………………………………………… 0.10

What if the cards need a special hologram and 7-11 logo and Cards-R-Us must buy a machine
that costs $15,000? Now fixed costs do change, increasing $15,000.

INCREMENTAL ANALYSIS:

Special Order
Incremental Revenues (50,000x $.50) $25,000
Incremental Variable Costs (50,000x $.30) 15,000
Incremental Fixed Costs 15,000
Increase in Operating Income $ (5,000)

Since fixed costs now increase greater than incremental contribution margin, the order should be
rejected.
Management should reject the order because the special order would cause a decrease in
operating income.

C. Discontinue Operations

Decisions to discontinue an operating segment, like a store, or a product line, are difficult ones
for organizations to make. There is often employee relations that need to be considered. So here
we have a multi-step income statement for Apu’s Quik-E-Mart for the year ended 2017.
 Apu’s Quik-E-Mart
Income Statement
Year Ended Dec. 31, 2017
Sales Revenue 99,000
Less: COGS 55,000
Gross Margin 44,000
Less: Operating Expenses
Salaries Expense 17, 800
Utilities Expense 1,000
Depreciation Expense 5,000
Other-Fixed Costs 25,000 48,800
Operating Income (4,800)

As you can see, this store lost money and has negative operating income, which we would call an
operating loss. So should this store be closed down? At first glance, the answer might be “yes”
because of the loss, but let’s drive deeper.

Dropping an unprofitable segment

QUALITATIVE ISSUES:
1. Consider only relevant costs
2. Consider effects on related product lines
3.
QUANTITATIVE ISSUES:
1. Discontinue segment if fixed costs eliminated exceed contribution margin lost.

When deciding whether or not to discontinue an operating segment, we need to consider certain
items.

Firstly, we only want to focus on the relevant costs. So cost that have happened in the past aren’t
relevant to the new decisions. Secondly, we want to consider any impact this decision might
have on related stores or product lines. Our decision rule is that we discontinue a segment if the
eliminated fixed costs are greater than the eliminated margin.

Apu’s Quik-E-Mart
Income Statement
Year Ended Dec. 31, 2017

Sales Revenue 99,000

Less: Variable Costs
COGS 55,000
Salaries Expense 17,800
Utilities Expense 1,000 73,800
Contribution Margin 25,200
Less: Fixed Costs
Depreciation Expense 5,000
Other Fixed Costs 25,000 30,000
Operating Income (4,800)

Furthermore, we don’t want to use an external reporting financial statement like the multi-step
income statement to assist in these decisions. We want to use the contribution margin income
statement because the amount of contribution margin is critical to the decision. You can see I’ve
re-arranged the Quik-E-art data into a contribution margin income statement. The store still has
an operating loss of $4,800. Let’s look at a few different scenarios.
Dropping an unprofitable segment

SCENARIO 1:
All fixed costs can be eliminated by closing this store.

With scenario 1, assume that all fixed costs can be eliminated with the closing of the store. So
let’s compare eliminated fixed costs with eliminated contribution margin.

Apu’s Quik-E-Mart
Income Statement
Year Ended Dec. 31, 2017
Sales Revenue 99,000
Less: Variable Costs
COGS 55,000
Salaries Expense 17,800
Utilities Expense 1,000 73,800
Contribution Margin 25,200
Less: Fixed Costs
Depreciation Expense 5,000
Other Fixed Costs 25,000 30,000
Operating Income (4,800)

The contribution margin is $25,200 the fixed costs are $30,000. So the fixed costs savings are
greater than the lost contribution margin. Therefore, the company would be $4,800 better off by
closing the store. However, being able to eliminate all fixed costs is pretty unlikely when closing
a store or product line so lets look at another scenario.

Dropping an unprofitable segment

SCENARIO 1:
All fixed costs can be eliminated by closing this store.
DECISION:
Fixed costs savings ($30,000) are greater than lost contribution margin ($25,200) so the
company would be $4,800 better off closing the segment.

Dropping an unprofitable segment

SCENARIO 2:
No fixed costs can be eliminated by closing this store.

With this scenario, assume that no fixed costs can be eliminated. Let’s compare eliminated fixed
costs with eliminated contribution margin.

Apu’s Quik-E-Mart
Income Statement
Year Ended Dec. 31, 2017
Sales Revenue 99,000
Less: Variable Costs
COGS 55,000
Salaries Expense 17,800
Utilities Expense 1,000 73,800
Contribution Margin 25,200
Less: Fixed Costs
Depreciation Expense 5,000
Other Fixed Costs 25,000 30,000
Operating Income (4,800)
The contribution margin is $25,200, and the eliminated fixed costs are $0.

Dropping an unprofitable segment

SCENARIO 2:
No fixed costs can be eliminated by closing this store.

DECISIONS:
Fixed costs saving ($0) are less than lost contribution margin (25,200) so the company would be
$25,200 worse off closing the segment.

Dropping an unprofitable segment

SCENARIO 3:
Depreciation expense and ½ of the Other fixed costs can be eliminated by closing this store.

This is very likely because some of the fixed costs are common company wide costs that get
allocated to each store. Thus eliminating a store doesn’t eliminate those costs. It just means that
all the remaining stores have a little bit more fixed costs allocated to them. So lets compare
eliminated fixed costs with eliminated contribution margin.

Apu’s Quik-E-Mart
Income Statement
Year Ended Dec. 31, 2017
Sales Revenue 99,000
Less: Variable Costs
COGS 55,000
Salaries Expense 17,800
Utilities Expense 1,000 73,800
Contribution Margin 25,200
Less: Fixed Costs
Depreciation Expense 5,000
Other Fixed Costs $12,500 25,000 30,000
Operating Income (4,800)

Again the contribution margin is $25,200, and the fixed costs are $5,000 for depreciation
expense and $12,500 for the other fixed costs.

Dropping an unprofitable segment

SCENARIO 3:
Depreciation expense and ½ of the Other fixed costs can be eliminated by closing this store.

DECISIONS:
Fixed costs savings ($5,000 + $12,500) are less than lost contribution margin ($25,200) so the
company be $7,700 worse off closing the segment.

So remember when making these decisions to compare eliminated fixed costs with eliminated
contribution margin.

D. SELL “AS-IS” OR PROCESS FURTHER

Some companies have products that have option to sell product at a given point in production or
to process further and sell at a higher price.

Example:
PINEAPPLES

SELL AS WHOLE PINEAPPLE PROCESS FURTHER

Pineapples can be sold as whole pineapple or processed further into canned, sliced, or pineapple
chunks.

Decision Rule:
Process further as long as the incremental revenue from such processing exceeds the incremental
processing costs.

Let’s look at an example.

Example: Peter, Bjorn, and John have a furniture making business. The cost to manufacture an
unfinished table is $35. The selling price per unfinished is $50. They have unused capacity that
can be used to finish the tables and sell them at $60 per unit. For a finished table, direct materials
will increase $2 and direct labor costs will increase $4. Variable manufacturing overhead costs
will increase by $3. No increase is anticipated in fixed manufacturing overhead.
What should they do?

Incremental Analysis

Revenues:
Increase in Revenue $ 10
Costs:
Increase in Direct Materials $ 2
 Increase in Direct Labor $ 4
Increase in VOH $ 3
Net Increase $ 1

We need to perform incremental analysis in this situation. Basically we’re looking to see if the
changes in revenues are greater than the changes in costs. Revenues increase $10. Costs increase
$9. So the net increase is $1.

Decision Rule:
Process further as long as the incremental revenue from such processing exceeds the incremental
processing costs.

Example: Process further increases operating profits.

So the decision rule in dealing with these types of short-term business decisions is to process
further when incremental revenues exceed incremental costs. In our example, finishing the tables
would increase operating income.