Chapter 25Short-Term Business Decisions

Learning Objectives

1. Identify information that is relevant for making short-term decisions

2. Make regular and special pricing decisions

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Learning Objectives

3. Make decisions about dropping a product, product mix, and sales mix

4. Make outsourcing and processing further decisions

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Learning Objective 1

Identify information that is relevant for making short-term decisions

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How Is Relevant Information Used to Make Short-Term Decisions?

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Relevant Information

• When managers make decisions, they focus on information that is relevant to the decision.

• Relevant information is expected future data and differs among alternatives.

• Relevant costs are costs that are relevant to a particular decision.

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Relevant Information

• Irrelevant information does not affect the decision.

• Sunk costs are costs that were incurred in the past and cannot be changed, regardless of which future action is taken. – Depreciation– Original purchase price of an asset

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Relevant Nonfinancial Information

• Nonfinancial, or qualitative, factors play a role in managers’ decisions and, as a result, can be relevant. For example:– Closing plants and laying off employees can

hurt morale. – The decision to outsource may reduce control

over delivery time or product quality. – Offering discount prices to select customers

may upset regular customers and tempt them to take their business elsewhere.

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Differential Analysis

• A common approach to making short-term business decisions is called differential analysis.

• Short-term decisions include: – Regular and special pricing– Dropping unprofitable products and segments,

product mix, and sales mix– Outsourcing and processing further

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Learning Objective 2

Make regular and special pricing decisions

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How Does Pricing Affect Short-Term Decisions?

• Managers must consider three questions when setting regular prices: – What is the company’s target profit?– How much will customers pay?– Is the company a price-taker or a price-setter

for this product or service?

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Setting Regular Prices

• The question “Is the company a price-taker or a price-setter for this product or service?” requires consideration of whether the company is a: – Price-taker with little control over pricing– Price-setter with more control over pricing

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Setting Regular Prices

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Target Pricing

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• When a company is a price-taker, it emphasizes a target-pricing approach to managing costs and profits.

• Target pricing starts with the market price of the product and then subtracts the company’s desired profit to determine the maximum allowed target full product cost.

Target Pricing

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Target Pricing

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• In setting regular sales prices, companies must cover all of their costs—whether the costs are product or period, fixed or variable.

• The desired profit is $250,000 ($2,500,000 average assets × 10%).

Target Pricing

• What options does Smart Touch Learning have?1. Accept the lower operating income of

$236,000, which is a 9.44% return ($236,000 operating income / $2,500,000 average assets), not the 10% target return required by stockholders.

2. Reduce fixed costs by $14,000 or more.3. Reduce variable costs by $14,000 or more.

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Target Pricing

• Smart Touch Learning’s options (cont’d):4. Attempt to increase sales volume. If the

company has excess manufacturing capacity, making and selling more units would only affect variable costs; however, it would mean that current fixed costs are spread over more units.

5. Change or add to its product mix (covered later in the chapter).

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Target Pricing

• Smart Touch Learning’s options (cont’d):6. Attempt to differentiate its tablet computer

from the competition to gain more control over sales prices (become a price-setter).

7. A combination of the above strategies that would increase revenues and/or decrease costs by $14,000.

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Cost-Plus Pricing

• Price-setters emphasize a cost-plus approach to pricing.

• Cost-plus pricing starts with a company’s full product costs and adds its desired profit to determine a cost-plus price.

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Cost-Plus Pricing

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Setting Regular Prices

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Special Pricing

• A special pricing decision occurs when a customer requests a one-time order at a reduced sales price.

• Management must consider: – Does the company have the excess capacity

available to fill the order?– Will the reduced sales price be high enough to

cover the differential costs of filling the order?– Will the special order affect regular sales in the

long run?

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Special Pricing

Special Pricing

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Special Pricing

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Learning Objective 3

Make decisions about dropping a product, product mix, and sales mix

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How Do Managers Decide Which Products to Produce and Sell?

• Deciding which products to produce and sell is a major managerial decision. – If manufacturing capacity is limited, managers

must decide which products to produce. – Managers must also decide whether to drop

products, departments, or territories that are not as profitable as desired.

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Dropping Unprofitable Products and Segments

• Management’s considerations when dropping a product or business segment include: – Does the product or segment provide a positive

contribution margin?– Will fixed costs continue to exist even if the

company drops the product or segment?– Are there any direct fixed costs that can be avoided

if the company drops the product or segment?– Will dropping the product or segment affect sales of

the company’s other products?– What would the company do with the freed

manufacturing capacity or store space?

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Dropping Unprofitable Products and Segments

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The Effect of Fixed Costs

• In the short-term, many fixed costs remain unchanged in total, regardless of how they are allocated to products or other cost objects.

• Allocated fixed costs are irrelevant. • Relevant fixed costs include: – Will the fixed costs continue to exist even if the

product is dropped?– Are there any direct fixed costs of the Premium

Tablets that can be avoided if the product is dropped?

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The Effect of Fixed Costs

• Fixed costs will continue to exist and will not change.

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The Effect of Fixed Costs

• Direct fixed costs will change.

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Other Considerations

• Management considering dropping a product line or segment would consider:– Would dropping it hurt other product sales? – What could be done with the freed

manufacturing capacity?• Short-term business decisions should take

into account all costs affected by the choice of action.

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Dropping Unprofitable Products and Segments

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Product Mix

• Companies do not have unlimited resources.

• A constraint is a factor that restricts the production or sale of a product.

• Managers should consider producing and selling the products that offer the highest contribution margin per unit of the constraint.

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Product Mix

• Calculate the contribution margin per unit and the contribution margin ratio to compare products.

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Product Mix

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Product Mix

• Take into consideration the constraint to determine the true contribution margin per unit.

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Product Mix

• The total contribution margin with the constraint.

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Product Mix

• Maximize profitability by combining the constraint limitations with the limited market.

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Sales Mix

• Merchandising companies also have constraints, with display space as the most common constraint.

• Managers must choose which products to display.

• Managers consider space constraints along with the contribution margin per unit.

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Sales Mix

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Learning Objective 4

Make outsourcing and processing further decisions

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How Do Managers Make Outsourcing and Processing Further Decisions?

• Short-term management decisions include how products are produced.

• Two questions are:– Should the company outsource a component of

the finished product or make it?– Should a company sell a product as it is or

process if further?

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Outsourcing

• Many companies choose to outsource products or services.

• It is important for companies to consider opportunity costs in this decision.

• Management considers the following: – How do the company’s variable costs compare

to the outsourcing costs?– Are any fixed costs avoidable if the company

outsources?– What could the company do with the freed

manufacturing capacity?

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Outsourcing

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• Fixed costs cannot be avoided with outsourcing decision.

Outsourcing

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• Some fixed costs are avoidable.

Outsourcing

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Outsourcing

• Smart Touch Learning has three alternatives to consider: 1. Use the facilities to make the casings.2. Buy the casings and leave facilities idle

(continue to assume $12,000 of avoidable fixed costs from outsourcing casings).

3. Buy the casings and use facilities to make the new product (continue to assume $12,000 of avoidable fixed costs from outsourcing casings).

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Outsourcing

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• Outsourcing decision with opportunity cost:

Sell or Process Further

• At what point in processing should a company sell its product?

• Managers must determine: – How much revenue will the company receive if

it sells the product as is?– How much revenue will the company receive if

it sells the product after processing it further?– How much will it cost to process the product

further?

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Sell or Process Further

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Sell or Process Further

• Joint costs are costs of a production process that yields multiple results.

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Sell or Process Further

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