Chapter 25
Short-Term
Business
Decisions
Learning Objectives
1. Identify information that is
relevant for making shortterm 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 pricetaker 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
• 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.
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Target Pricing
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Target Pricing
• 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%).
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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
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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
• Fixed costs cannot be avoided with
outsourcing decision.
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Outsourcing
• Some fixed costs are avoidable.
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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
• Outsourcing decision with opportunity
cost:
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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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