Short-Term Decisions and Accounting Information

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Short-Term Short-Term Decisions and Decisions and Accounting Accounting InformationInformation

Prepared by Douglas Cloud

Pepperdine University

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Explain why decision making requires information not included in regular accounting reports.

Determine what costs and revenues are relevant to decisions.

Analyze the quantitative factors relevant to typical decisions.

Explain the importance of complementary effects to decisions of a segment of a larger entity.

ObjectivesObjectives

After reading this After reading this chapter, you should chapter, you should

be able to:be able to:

ContinuedContinued

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Identify nonquantitative or long-term considerations that influence short-term decisions.

Describe some of the legal constraints on managers’ decisions.

ObjectivesObjectives

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The Criterion for Short-The Criterion for Short-term Decisionsterm Decisions

Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss).

Two Subrules1. The only revenues and costs that are relevant in

making decisions are the expected future revenues and costs that will differ among the available choices.

2. Revenues and costs that have already been earned or incurred are irrelevant in making decisions.

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DefinitionsDefinitions

Differential revenues and costs are the expected future

revenues and costs that will differ among

the choices that are available.

Incremental revenues and

costsare those

differential revenues and

costs that actually increase.

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Sunk costs are costs that have already been incurred and therefore will be the same no matter which alternative a manager selects.

Examples:– Book value of equipment – Original purchase price of building


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Example: Rental income lost if facility is used for production.

An opportunity cost is the benefit lost by taking one action as opposed to another.


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Important: Short-term Perspective

Typical Short-Term DecisionsTypical Short-Term Decisions

Drop a Segment

Make-or-Buy

Joint Product

Special Order

Factors of Limited Supply

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Basic ExampleBasic ExampleGloucester Visuals recently manufactured 100

specialized workstation monitors for a customer that has since gone bankrupt. A rival company

has offered to buy the monitors for $12,000. The cost to manufacture the monitors was $17,000.

Should the company accept the offer?

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Basic ExampleBasic Example

Differential revenues $12,000Differential costs 0Differential profit $12,000

Accept the offer!Accept the offer!

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A competitor offers to pay $20,000 for the monitors provided that Gloucester disguises the original logo

and makes a few other modifications. The production manager estimated the incremental cost

of the modifications at $6,000.

Third Alternative

Should the company accept the offer?

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Basic ExampleBasic ExampleThird Alternative

Differential revenues ($20,000 – $12,000) $8,000Differential costs ($6,000 – $0) 6,000Differential profit $2,000

Decision: Make Decision: Make modifications!modifications!

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Comparison of the three methods

Throw Out Monitors

Sell Monitors As Is

Rework and Sell

Incremental revenue $0 $12,000 $20,000Incremental costs 0 0 (6,000 )Incremental profit (loss) $0 $12,000 $14,000

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Activity-Based Estimates

Using ABC helps managers focus on what

activities change as a result of a decision.

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Dropping a Segment Decision

Should Jewelry be eliminated?

Sales $45,000 $40,000 $15,000$100,000

Variable costs 25,000 18,000 11,000 54,000

Contribution margin $20,000 $22,000 $ 4,000$ 46,000

Fixed costs:Direct–all avoidable (4,000 ) (3,400 ) (1,500 )

(8,900 )Indirect (common), allocated on sales (9,450 ) (8,400 ) (3,150 )

(21,000 )Income (loss) $ 6,550 $10,200 $ (650 )

$ 16,100

Clothing Shoes Jewelry Total

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Dropping a Segment DecisionGenco’s analysis shows that dropping jewelry would reduce

common costs by $1,000. If jewelry is dropped, the available space can be rented for $400 per month.

Differential revenues:Lost sales from jewelry $15,000New rent revenue 400Net revenue lost $14,600

Differential costs:Variable costs saved on jewelry $11,000Direct fixed costs saved 1,500Indirect fixed costs saved 1,000Total cost saving 13,500

Differential loss from dropping jewelry $ 1,100

Keep jewelry!

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Complementary EffectsComplementary Effects

Decision: Substitute Music for Jewelry

Differential contribution margin—increase ($12,000 – $4,000) $8,000Differential costs—increase in directfixed costs ($2,700 – $1,500) 1,200Differential profit favoring substitution $6,800

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Complementary EffectsComplementary Effects

Complementary effects happen when a change in the sale of one product might be accompanied by a change in the sale of another.

Genco’s managers believe that some people coming to shop for music are also likely to buy clothing. After reviewing the results of market studies, the managers estimate that

clothing sales will increase 7 percent if music is substituted for jewelry.

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Complementary EffectsComplementary EffectsDecision: Substitute Music

for JewelryDifferential contribution margin:Increase due to selling music vs. jewelry $8,000

Increase due to higher clothing sales (7% x $20,000 contribution margin on current sales) 1,400Net Increase in contribution margin $9,400

Differential costs—increase in directfixed costs ($2,700 – $1,500) 1,200Differential profit favoring substitution $8,200

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A loss leader is a special case of complementary effects where a product or line shows a negative profit in the sense that its contribution margin

does not cover its avoidable fixed costs.

Loss LeaderLoss Leader

The manager of a local pizzeria prepares the income statement shown on Slide 5-20, based

on a normal week, for the 11 a.m. to 2 p.m. period. All costs are incremental.

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Pizza Soft Drinks TotalSales (200 pizzas @ $1.80) $360 $100 $460Variable costs 120 40 160Contribution margin $240 $ 60 $300Wages of part-time

employees 80Income $220

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Pizza Soft Drinks TotalSales $ 720 $ 0 $720Variable costs 240a 100b 340Contribution margin $480a $(100) $380Wages of part-time

employees ($80 + $40) 120Income $260

a Variable costs computed at the same rate as before, one-third or 33 1/3% of selling price.b Variable costs computed as two and one-half times the previous costs.

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Assume the following cost data relate to the decision to produce12,000 units of a product or buy from external source:

Rental of equipment $15,000 $1.25Equip. depreciation 3,000 .25Direct materials 12,000 1.00Direct labor 24,000 2.00Variable overhead 9,000 .75Fixed overhead 36,000 3.00

Total $99,000$8.25

The purchase price from an outside vendor is $5.50 per unit.

Make-or-Buy DecisionMake-or-Buy Decision

Total Cost Unit Cost

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Differential

Make BuyCost to Make

Rental of equip. $15,000 ----$15,000

Direct materials 12,000 ----12,000

Direct labor 24,000 ----24,000

Variable overhead 9,000 ----9,000

Purchase cost $66,000$(66,000 )

Relevant costs $60,000 $66,000$(6,000 )

Decision: Manufacture parts in-houseThe cost to make is $5.00 per unit.The price to buy is $5.50 per unit.


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Qualitative issues:

Quality of purchased components

Timely delivery

Potential price increases


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Joint Products

When a single manufacturing process invariably produces two or more separate products, the products are called joint products.

QBT, a chemical company, operates a joint process that

results in two products. Each 1,000 pounds of material

yields 600 pounds of Alpha and 400 pounds of Omega.

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Alpha Omega

Selling price at split-off $1,200 $1,600

Selling price afteradditional processing $3,600 $2,000

Costs of additionalprocessing, all variable $900 $500

Joint Products

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Alpha Omega

Differential revenues $2,400$ 400

Differential costs 900 500

Differential profits $1,500$(100)

Joint Products

Decisions: Process Alpha further and sell Omega at the split-off point

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Special Order ExampleSpecial Order Example

Sales (60,000 units) $15 $900,000Manufacturing costs: Materials $4 $240,000 Direct labor 3 180,000 Overhead (1/3 variable) 6 360,000 Total $13 780,000Gross margin $120,000Selling and admin. expenses 80,000Operating income $ 40,000

Should the company sell a special on-time order for 20,000 at $10 per unit to a company in a new market?

Per Unit Total

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Differential revenues (20,000 units) $10 $200,000Differential costs: Materials $4 $80,000 Direct labor 3 60,000 Variable overhead 2 40,000 Total $9 180,000Incremental profit favoring

acceptance $ 20,000

Special Order ExampleSpecial Order ExamplePer Unit Total

Decision: Accept special order

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Differential revenues: : New revenues (20,000 units) $200,000

Lost revenues (5,000 units x $15) (75,000)Total differential revenues $125,000

Differential costs: Costs of special order $180,000

Costs from not making regular sales:Variable manufacturing cost 5,000 x $9 ($4 + $3 + $2) (45,000)

Commissions (5,000 x $0.30) (1,500)Total differential costs 133,500

Differential loss, favoring rejecting order $ (8,500)

Special Order ExampleSpecial Order Example

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Resource ConstraintResource Constraint

Selling price $10 $6Variable cost 6 4Contribution margin $ 4 $2Number of units that

can be made per MH 60 150

Drive Chip Modem Chip

Which product should be processed assuming only 100 machine hours are available?

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Number of units that

can be made per MH 60 150Contribution margin per unit x $4 x $2Contribution margin per

machine hour $240 $300

Resource ConstraintResource Constraint

Drive Chip Modem Chip

Decision: Produce modem chips

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Decision Making Under Environmental Constraints

Antitrust laws forbid actions that might substantially reduce competition. Anti-dumping laws address aspects of unfair competition in international trade.

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The Sherman Act, Clayton Act, Robinson-Patman Act, and the statutes of many states prohibit predatory pricing.

Predatory pricing is pricing below cost in the short term to drive competitors out of business and eventually to raise prices.


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The Robinson-Patman Act forbids charging different prices to different customers unless there are intrinsic cost differences in serving the different customers; in other words, this act forbids discriminatory pricing.The Federal Trade Commission (FTC) is the regulatory agency responsible for enforcing the act.


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Anti-dumping laws prevent unfair competitive practices in international trade by prohibiting a company in one country from selling its products in another country at less than fair value.

The International Trade Administration, part of the Commerce Department, deals with charges of dumping in the United States.


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The End

Chapter 5Chapter 5

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Short-Term Decisions and Accounting Information