Chapter 4
Short-term
Decision Making
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
CVP Continued
• Change in selling price
 Increase—decreases breakeven
 Decrease—increases breakeven
• Change in variable cost
 Increase—increases breakeven
 Decrease—decreases breakeven
• Change in fixed cost
 Increase—increases breakeven
 Decrease—decreases breakeven
• Change in tax rate
 No impact on breakeven
4-2
What are Product and Nonproduct
Costs?
• Product costs
 Incurred in connection with buying or making
the product
• Nonproduct costs
 Incurred in connection with selling the product
and administering (running) the company
4-3
What are the 3 Types of Product
Costs?
• Direct materials
 Traceable
 Worth the cost of tracing
• Direct labor
 Cost of employees making the product
• Manufacturing overhead
 Indirect costs of production (indirect materials,
indirect labor, and other manufacturing costs)
4-4
What are the Activity Levels Associated
with Costs?
• Unit-related
 Vary with units produced or sold
• Batch-related
 Vary with batches (groups) regardless of the
number of units in the batch
• Product-sustaining
 Vary with the number of product lines
• Facility-sustaining
 Fixed or capacity costs
4-5
Types and Activity Levels
Product
4-6
Nonproduct
Unit-related
Materials
Commissions
Batchrelated
Set ups
Ordering
Productsustaining
Research & Advertising
development
Facilitysustaining
Rental of
equipment
CEO salary
What are the 2 Characteristics of a
Relevant Variable?
• Future
 The variable must occur in the future
• Different
 The variable must differ between the
alternatives considered
4-7
Relevant Variables Continued
• Sunk costs
 Past, never relevant for decision making—Sunk costs
arise from past decisions and represent items that have
already been purchased. (for example, make a bad
decision and attempt to fix it by putting more money
into the project)
• Opportunity costs
4-8
 Benefits foregone, always relevant for short-term
decision making---Since accepting one alternative
means rejecting other alternatives, the opportunity cost
is the benefit provided by the next best alternatives.
(grocer accepts the soda offer and gives up the space
for potato chips.)
Relevant Variables Continued
• Incremental costs/revenues
 Additional cost/revenue, relevant if different
between alternatives—
 There are three steps in a relevant variable
analysis
• Identify the possible alternative actions
• Determine the relevant revenues, costs, and/or
profits of each alternative
• Choose the best alternative
What are the Types of Short-Term
Decisions Considered?
• Accept-or-reject decisions
 Special order
 Base decision on incremental profit from the order
• Make-or-buy decisions
 Outsourcing
 Base decision on cost comparison between make and
buy
• Keep-or-drop decisions
 Product mix
 Base decision on revenues lost versus costs saved
4-10
Lecture Example #1
1. A certain company sells its only product for $12 per unit. The variable costs
to produce the product are $7 per unit and it costs approximately $1 per unit for
selling and administrative costs. The fixed costs of production are $400,000 per
period and the fixed selling and administrative costs are $200,000 per year. The
company is subject to a 30 percent tax rate. Answer the following questions.
a. What is the breakeven point in units?
b. What is the breakeven point in dollars?
c. How many units must be sold to earn a profit of $70,000 before tax?
d. How many units must be sold to earn a profit of $70,000 after tax?
e. If the variable costs increase 10 percent, what increase is necessary in selling
price to maintain the same breakeven point in units?
f. If the fixed costs increase, what is the effect on breakeven? On contribution
margin per unit?
g. If the tax rate increases, what is the effect on breakeven? On contribution
margin per unit?
Lecture Example #1 Cont.
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Answer:
a.
SP = $12; VC = $8; CM = $4; FC = $600,000
$600,000/4 = 150,000
b.
CM = $4; SP = $12; CM % = 33.3333%
$600,000/33.3333% = $1,800,000
c.
($600,000 + $70,000)/4 = 167,500
d.
$70,000/(1 - .3) = $100,000
($600,000 + $100,000)/4 = 175,000
e.
To maintain the same breakeven point, CM must remain the same.
VC = $8.80; CM = $4; therefore SP = $12.80
f.
If fixed costs increase, breakeven increases. Fixed costs do not affect
contribution margin per unit.
g.
Tax rate increases do not affect breakeven or contribution margin per unit.
Lecture Example #2
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2.
A company has been approached by a supplier with an offer to provide 25,000
units of a production part for $9 per unit. If the company accepts the offer its direct
materials costs are expected to decrease by 60 percent, its direct labor costs are
expected to decrease by 30 percent, and its unit-related overhead is expected to
decrease by 20 percent. A recent per unit cost report when 25,000 units were produced
is shown below:
Direct materials
$10
Direct labor
2
Manufacturing overhead
8
Total cost
$20
An analysis of manufacturing overhead reveals that overhead consists of unit-related
and facility-sustaining overhead. Facility-sustaining overhead consists of depreciation
and other fixed items and is approximately $150,000 per period. If the company
accepts the supplier’s offer, it will use the released production facilities to produce
another product with an expected contribution of $60,000 per period. Should the
company accept or reject the supplier’s offer?
Lecture Example #2 Cont.
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Answer:
Total overhead
$8 * 25,000 = $200,000
Less facility-sustaining overhead
150,000
Unit-related overhead
$ 50,000
Unit-related overhead per unit $50,000/25,000 = $2
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Relevant variables
Direct materials
Direct labor
Unit-related overhead
Purchase price
Relevant cost per unit
* Number of units
Total relevant unit cost
Opportunity cost
Total relevant cost
BUY
Make
$10.00
2.00
2.00
-0$14.00
25,000
$350,000
60,000
$410,000
Buy
$ 4.00 ($10 * .4)
1.40 ($2 * .7)
1.60 ($2 * .8)
9.00
$16.00
25,000
$400,000
-0$400,000
Lecture Example #3
3. A company has been approached by a customer with an offer to buy 10,000 units of
product but the customer wants a discount of 25 percent off the normal selling price.
The company has the capacity to fill the customer’s order. A recent profit report is shown
below:
Sales (500,0000 units)
Cost of goods sold
Gross margin
Selling and administrative cost
Profit
$6,000,000
4,200,000
$1,800,000
1,000,000
$ 800,000
Unit-related cost of goods sold is 40 percent of the current selling price while unit-related
selling and administrative costs are 10 percent of the current selling price. To fill the
customer’s order, one additional production run will be required at a cost of $6,000. An
additional purchase order will be required at a cost of $500, and shipping costs to the
customer will be $800. Should the company accept the customer’s order?
Lecture Example # 3 Cont.
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Answer:
Current selling price = $6,000,000/500,000 = $12
Unit-related cost of goods sold = $12 * .4 = $4.80
Unit-related selling and administrative cost = $12 * .1 = $1.20
Proposed selling price = $12 * .75 = $9
Relevant variables
Proposed selling price
Cost of goods sold
Selling and administrative
Contribution margin
* Number of units requested
Total contribution margin
Additional batch costs:
Production run
Ordering
Shipping
Relevant profit
ACCEPT
Accept
$9.00
4.80
1.20
$3.00
10,000
$30,000
Reject
$0.00
0.00
0.00
$0.00
10,000
$0
( 6,000)
( 500)
( 800)
$22,700
-0-0-0$0
Lecture Example #4
4. A merchandising company currently sells three products—A, B, and C. Product profit
reports for the last period are shown below:
Sales
Less: cost of goods sold
Gross margin
Less: selling and
administrative costs
Profit
Product A Product B Product C
$100,000
$200,000
$150,000
60,000
120,000
90,000
40,000
80,000
60,000
50,000
60,000
55,000
($10,000)
$20,000
$5,000
A cost analysis reveals that cost of goods sold varies proportionately with sales
(60%). Selling and administrative costs are $120,000 plus 10% of sales. The
$120,000 of facility-sustaining selling and administrative cost will continue
regardless of how many product lines the company maintains.
Should the company keep or drop its existing product lines?
Lecture Example #4 Cont.
Answer:
If Product A is dropped:
Revenues lost
Costs saved:
Cost of goods sold
Selling & administrative
$100,000
$60,000
10,000
$70,000
Since the revenues lost exceed the costs saved, the company should
keep Product A.