MOS 372 - Short Term Decision Making
Where We’re At
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Obtaining Information
Costs and their behaviour
Cost allocation methods
Variance analysis
Costing systems
Key criteria in collecting data generally:
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1. Relevance – Is the date pertinent to the problem?
Knowing what is important/useful is crucial!
2. Accuracy – Information must be precise
3. Timeliness – The information must be available
at the time of the decision
Now, we want to start using this information to
make decisions…
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Assumptions of Differential
Costing and Analysis
Differential Concept
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Cost construction (what you include in a
“cost” when making decisions) is crucial
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Relevant costs deal with the future
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e.g. full cost vs. differential cost
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Avoidable Cost/Differential cost definition:
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These are potentially avoidable
Actual historical costs (i.e. money that has been
spent) are NOT relevant unless they affect future
cash flows
Importance of time span (or lack thereof)
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Assumptions (continued)
Costs That are Never Relevant
Taxes aren’t relevant (not yet)
 All costs and revenues will remain the same
for the foreseeable future (in terms of the
analysis undertaken)
 The costs materially differ between
alternatives
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© John Siambanopoulos
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Sunk Costs
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Future Costs (that aren’t differential)
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MOS 372 - Short Term Decision Making
Fixed Overhead
Usually Fixed O/H isn’t differential, therefore
not relevant
 Be careful of “allocated” overhead
 BUT NOT ALWAYS!
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Why should we NOT use full costs
(this would include allocated
overhead) to figure out problems
between different alternatives?
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When should we use full costs?
Try to look at marginal or incremental differences
If there is a net benefit BEFORE allocating fixed
costs, what should you do?
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Alternative Analysis
Types of Alternative Choices
Goal: To minimize cost or maximize profit
Steps
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2.
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5.
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Define the problem
Select possible solutions or alternatives
Measure the quantitative factors & consequences
Evaluate the the qualitative factors
Make a decision
Cost Minimization (costs)
 Method change (change in process,
addressing a bottleneck)
 Operations planning & scheduling
 Make or buy (outsourcing)
 Order quantity/size (order a large volume
for better terms or…)
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Types of Alternative Choices
(cont’d)
Types of Alternative Choices
(cont’d)
Profit Maximization (costs & revenues)
 Pricing decisions
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Using scarce resources (utilizing idle capacity)
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Discontinuing/adding a product, service, or
department
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© John Siambanopoulos
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Profit Maximization
 Accepting or rejecting a special offer (custom
orders, etc.)
 Sell or process further (joint products)
 Other marketing tactics (e.g. change in
advertising)
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MOS 372 - Short Term Decision Making
Other Issues
Total or Incremental Approach?
Sales (5,000 units @ $40 per unit)
Less variable expenses:
Direct materials (5,000 units @ $14 per unit)
Direct labour (5,000 units @ $8 and $5 per unit)
Variable overhead (5,000 units @ $2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Other
Rent on new machine
Total fixed expenses
Net operating income
Current
Situation
$
200,000
Situation
With New
Machine
$
200,000
Differential
Costs and
Benefits
-
70,000
40,000
10,000
120,000
80,000
70,000
25,000
10,000
105,000
95,000
15,000
15,000
62,000
62,000
18,000
62,000
3,000
65,000
30,000
(3,000)
(3,000)
12,000
$
$
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Using decision trees
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Sensitivity
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The “Just One” Fallacy
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E.g. one more person at the grocery store
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Utilization of a Constrained
Resource
Other Issues (cont’d)
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Qualitative aspects (strategic benefits, loss leader
product, competitive advantage, etc.)
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Short-term decision vs long-term investments
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Legal pricing issues
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Predatory pricing
Discriminatory pricing
Dumping
Usually the product, segment, etc. that makes
the most contribution ($ and %) is considered
the best
 However, contribution doesn’t take into
account the effect of that product’s usage of
various resource (e.g machine’s available
time for operation)
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Profitability Index
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Pitfalls to Avoid
Compare the relative contribution of different
options vs. their use of the resource
Product
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Selling price per unit
Less variable expenses per unit
Contribution margin per unit
Current demand per week (units)
Contribution margin ratio
Processing time required
on machine A1 per unit
© John Siambanopoulos
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$
60
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$ 24
2,000
40%
1.00 min.
$
50
35
$ 15
2,200
30%
0.50 18min.
1. Sunk costs - Irrelevant
2. Unitized fixed costs – OK for product pricing
but they aren’t truly variable and not differential
(still must be paid); therefore remove
3. Allocated fixed costs – Identify avoidable costs
4. Opportunity costs – Identify and include
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