1. 5 Short-Term Decisions and Accounting Information
Prepared by
Douglas Cloud Pepperdine University

2. After reading this chapter, you should be able to:
Objectives
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.
After reading this chapter, you should be able to:
Continued

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

4. The Criterion for Short-term Decisions
Economic criterion: Take the action that you expect will give the organization the highest income (or lowest loss).
Two Subrules
1. 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. 11 4

5. Definitions
Differential revenues and costs are the expected future revenues and costs that will differ among the choices that are available.
Incremental revenues and costs
are those differential revenues and costs that actually increase. 12 5

6. Definitions
Sunk 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 13 6

7. Definitions
An opportunity cost is the benefit lost by taking one action as opposed to another.
Example: Rental income lost if facility is used for production. 14 7

8. Typical Short-Term Decisions
Drop a Segment
Make-or-Buy
Joint Product
Special Order
Factors of Limited Supply
Important: Short-term Perspective 9 9 16

9. Should the company accept the offer?
Basic Example
Gloucester 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?

10. Basic Example Differential revenues $12,000 Differential costs 0
Differential profit $12,000
Accept the offer!

11. Should the company accept the offer?
Basic Example
Third Alternative
A 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.
Should the company accept the offer?

12. Decision: Make modifications!
Basic Example
Third Alternative
Differential revenues ($20,000 – $12,000) $8,000
Differential costs ($6,000 – $0) 6,000
Differential profit $2,000
Decision: Make modifications!

13. Comparison of the three methods
Basic Example
Comparison of the three methods
Throw Out Monitors
Sell Monitors As Is
Rework and Sell
Incremental revenue $0 $12,000 $20,000
Incremental costs (6,000 )
Incremental profit (loss) $0 $12,000 $14,000

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

15. Dropping a Segment Decision
Sales $45,000 $40,000 $15,000 $100,000
Variable costs 25, , , ,000
Contribution margin $20,000 $22,000 $ 4,000 $ 46,000
Fixed costs:
Direct–all avoidable (4,000 ) (3,400 ) (1,500 ) (8,900 )
Indirect (common),
allocated on sales (9,450 ) (8,400 ) (3,150 ) (21,000 )
Income (loss) $ 6,550 $10,200 $ (650 ) $ 16,100
Clothing Shoes Jewelry Total
Should Jewelry be eliminated? 10 10 17

16. Dropping a Segment Decision
Genco’s 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.
Differential revenues:
Lost sales from jewelry $15,000
New rent revenue
Net revenue lost $14,600
Differential costs:
Variable costs saved on jewelry $11,000
Direct fixed costs saved 1,500
Indirect fixed costs saved 1,000
Total cost saving 13,500
Differential loss from dropping jewelry $ 1,100
Keep jewelry! 11 18 11

17. Complementary Effects
Decision: Substitute Music for Jewelry
Differential contribution margin— increase ($12,000 – $4,000) $8,000
Differential costs—increase in direct fixed costs ($2,700 – $1,500) 1,200
Differential profit favoring substitution $6,800

18. Complementary Effects
Complementary effects happen when a change in the sale of one product might be accompanied by a change in the sale of another.
Genco’s 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. 19 12

19. Complementary Effects
Decision: Substitute Music for Jewelry
Differential contribution margin: Increase due to selling music vs. jewelry $8,000
Increase due to higher clothing sales
(7% x $20,000 contribution margin on current sales) 1,400
Net Increase in contribution margin $9,400
Differential costs—increase in direct fixed costs ($2,700 – $1,500) 1,200
Differential profit favoring substitution $8,200

20. Loss Leader
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.
The 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.

21. Loss Leader Pizza Soft Drinks Total
Sales (200 $1.80) $360 $100 $460
Variable costs
Contribution margin $240 $ 60 $300
Wages of part-time employees
Income $220

22. Loss Leader Pizza Soft Drinks Total Sales $ 720 $ 0 $720
Variable costs 240a 100b 340
Contribution margin $480a $(100) $380
Wages of part-time employees ($80 + $40)
Income $260
a Variable costs computed at the same rate as before, one-third or 33 1/3% of selling price.
b Variable costs computed as two and one-half times the previous costs.

23. Make-or-Buy Decision Total Cost Unit Cost
Assume the following cost data relate to the decision to produce
12,000 units of a product or buy from external source:
Rental of equipment $15,000 $1.25
Equip. depreciation ,
Direct materials ,
Direct labor ,
Variable overhead ,
Fixed overhead ,
Total $99,000 $8.25
Total Cost Unit Cost
The purchase price from an outside vendor is $5.50 per unit. 13 13 20

24. Decision: Manufacture parts in-house
Make-or-Buy Decision
Differential
Make Buy Cost to Make
Rental of equip. $15, $15,000
Direct materials , ,000
Direct labor , ,000
Variable overhead 9, ,000
Purchase cost $66,000 $(66,000 )
Relevant costs $60,000 $66,000 $(6,000 )
Decision: Manufacture parts in-house
The cost to make is $5.00 per unit.
The price to buy is $5.50 per unit. 14 14 21

25. Make-or-Buy Decision Qualitative issues:
Quality of purchased components
Timely delivery
Potential price increases 24 15

26. Joint Products
When 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 yields 600 pounds of Alpha and 400 pounds of Omega. 25 16

27. Joint Products Alpha Omega Selling price at split-off $1,200 $1,600
Selling price after additional processing $3,600 $2,000
Costs of additional processing, all variable $900 $500 17 17 26

28. Joint Products Alpha Omega Differential revenues $2,400 $ 400
Differential costs
Differential profits $1,500 $(100 )
Decisions: Process Alpha further and sell Omega at the split-off point 17 27 18

29. Special Order Example Per Unit Total Sales (60,000 units) $15 $900,000
Manufacturing costs:
Materials $4 $240,000
Direct labor ,000
Overhead (1/3 variable) ,000
Total $ ,000
Gross margin $120,000
Selling and admin. expenses ,000
Operating income $ 40,000
Per Unit Total
Should the company sell a special on-time order for 20,000 at $10 per unit to a company in a new market? 19

30. Decision: Accept special order
Special Order Example
Per Unit Total
Differential revenues (20,000 units) $10 $200,000
Differential costs:
Materials $4 $80,000
Direct labor ,000
Variable overhead ,000
Total $ ,000
Incremental profit favoring acceptance $ 20,000
Decision: Accept special order 20

31. Special Order Example Differential revenues: :
New revenues (20,000 units) $200,000
Lost revenues (5,000 units x $15) (75,000 )
Total differential revenues $125,000
Differential costs:
Costs of special order $180,000
Costs 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 ,500
Differential loss, favoring rejecting order $ (8,500 ) 21

32. Resource Constraint Selling price $10 $6 Variable cost 6 4
Drive Chip Modem Chip
Selling price $ $6
Variable cost
Contribution margin $ $2
Number of units that can be made per MH
Which product should be processed assuming only 100 machine hours are available? 22

33. Resource Constraint Number of units that can be made per MH 60 150
Contribution margin per unit x $ x $2
Contribution margin per
machine hour $ $300
Drive Chip Modem Chip
Decision: Produce modem chips 23

34. Decision Making Under Environmental Constraints
Antitrust laws forbid actions that might substantially reduce competition.
Anti-dumping laws address aspects of unfair competition in international trade. 33 24

35. Decision Making Under Environmental Constraints
The 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. 34 25

36. Decision Making Under Environmental Constraints
The 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. 35 26

37. Decision Making Under Environmental Constraints
Anti-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. 36 27

38. Chapter 5
The End