Short-Term Decisions and Accounting InformationPrepared by Douglas Cloud Pepperdine University5

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.ObjectivesAfter reading this chapter, you should be able to:Continued

Identify nonquantitative or long-term considerations that influence short-term decisions.Describe some of the legal constraints on managers decisions.Objectives

The Criterion for Short-term DecisionsEconomic 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.

DefinitionsDifferential 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.

DefinitionsSunk 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

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

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

Typical Short-Term DecisionsDrop a SegmentMake-or-BuyJoint ProductSpecial OrderFactors of Limited SupplyImportant: Short-term Perspective

Basic 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?

Basic ExampleDifferential revenues$12,000Differential costs 0Differential profit$12,000Accept the offer!

Basic ExampleA 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 AlternativeShould the company accept the offer?

Basic ExampleThird AlternativeDifferential revenues ($20,000 $12,000) $8,000Differential costs ($6,000 $0) 6,000Differential profit$2,000Decision: Make modifications!

Basic ExampleComparison of the three methodsThrow Out MonitorsSell Monitors As IsRework and SellIncremental revenue$0$12,000$20,000Incremental costs 0 0 (6,000)Incremental profit (loss)$0$12,000$14,000

Activity-Based EstimatesUsing ABC helps managers focus on what activities change as a result of a decision.

Dropping a Segment DecisionShould Jewelry be eliminated?

Dropping a Segment DecisionGencos 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.Keep jewelry!

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

Gencos 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.

Complementary EffectsDecision: Substitute Music for JewelryDifferential contribution marginincrease ($12,000 $4,000)$8,000Differential costsincrease in directfixed costs ($2,700 $1,500) 1,200Differential profit favoring substitution$6,800

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 LeaderThe 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.

Loss LeaderPizza Soft Drinks TotalSales (200 pizzas @ $1.80)$360$100$460Variable costs 120 40 160Contribution margin$240$ 60$300Wages of part-timeemployees 80Income$220

Make-or-Buy DecisionAssume 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 12,0001.00Direct labor 24,0002.00Variable overhead 9,000.75Fixed overhead 36,000 3.00Total $99,000$8.25The purchase price from an outside vendor is $5.50 per unit. Total Cost Unit Cost

Make-or-Buy Decision Differential Make BuyCost to MakeRental of equip. $15,000----$15,000 Direct materials 5,000----5,000 Direct labor 24,000----24,000 Variable overhead 9,000----9,000 Purchase cost$66,000$(66,000)

Relevant costs $53,000$66,000$(13,000)Decision: Manufacture parts in-house

Make-or-Buy DecisionQualitative issues:Quality of purchased componentsTimely deliveryPotential price increases

Joint ProductsWhen 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 yield

Joint ProductsAlphaOmegaSelling price at split-off$1,200$1,600Selling price after additional processing$3,600$2,000Costs of additional processing, all variable $900$500

Joint ProductsAlphaOmegaDifferential revenues$2,400$ 400Differential costs 900 500Differential profits$1,500$(100)

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

Special 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

Special Order ExampleDifferential 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 favoringacceptance $ 20,000

Per Unit TotalDecision: Accept special order

Special Order ExampleDifferential revenues: : New revenues (20,000 units) $200,000Lost revenues (5,000 units x $15) (75,000)Total differential revenues $125,000Differential costs: Costs of special order$180,000Costs 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 133,500Differential loss, favoring rejecting order $ (8,500)

Resource ConstraintSelling price $10 $6Variable cost 6 4Contribution margin $ 4 $2Number of units thatcan be made per MH60150Drive Chip Modem ChipWhich product should be processed assuming only 100 machine hours are available?

Resource Constraint Number of units thatcan be made per MH 60 150Contribution margin per unit x $4 x $2Contribution margin per machine hour $240 $300

Drive Chip Modem ChipDecision: Produce modem chips

Decision Making Under Environmental ConstraintsAntitrust laws forbid actions that might substantially reduce competition. Anti-dumping laws address aspects of unfair competition in international trade.

Decision Making Under Environmental ConstraintsThe 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.

Decision Making Under Environmental ConstraintsThe 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.

Decision Making Under Environmental ConstraintsAnti-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.

The EndChapter 5

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