5-1

Short-Term

5
Decisions and
Accounting
Information
Prepared
Preparedby
by
Douglas
DouglasCloud
Cloud
Pepperdine
PepperdineUniversity
University
 5-2

Objectives
Objectives
 Explain why decision making requires information
not included inAfter
After reading
reading
regular this
this reports.
accounting
 Determine whatchapter,
chapter, you should
yourevenues
costs and should are relevant to
decisions. be
be able
able to:
to:
 Analyze the quantitative factors relevant to typical
decisions.
 Explain the importance of complementary effects
to decisions of a segment of a larger entity.

Continued
Continued
 5-3

Objectives
Objectives
 Identify nonquantitative or long-term
considerations that influence short-term
decisions.
 Describe some of the legal constraints on
managers’ decisions.
 5-4

The
The Criterion
Criterion for
for Short-
Short-
term
term Decisions
Decisions
Economic criterion: Take the action that you
expect will give the organization the highest
income (or lowest loss).
Two
Two Subrules
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.
 5-5

Definitions
Definitions
Differential
Differential revenues
revenues
and
and costs
costs are
are the
the
Incremental
Incremental
expected future
expected future revenues and
revenues revenues and
revenues and
and costs
costs costs costs
that
that will
will differ
differ among
amongare are those
those
the
the choices
choices that
that are
aredifferential
differential
available.
available. revenues
revenues andand
costs
costs that
that actually
actually
increase.
increase.
 5-6

Definitions
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
 5-7

Definitions
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.
 5-8

Typical
Typical Short-Term
Short-Term Decisions
Decisions
 Drop a Segment
 Make-or-Buy
 Joint Product
 Special Order
 Factors of Limited Supply
Important: Short-term Perspective
 5-9

Basic
Basic Example
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
Should the
the company
company
accept
accept the
the offer?
offer?
 5-10

Basic
Basic Example
Example
Differential revenues $12,000
Differential costs 0
Differential profit $12,000

Accept
Accept the
the offer!
offer!
 5-11

Basic
Basic Example
Example
Third
Third Alternative
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
Should the
the company
company
accept
accept the
the offer?
offer?
 5-12

Basic
Basic Example
Example
Third
Third Alternative
Alternative

Differential revenues ($20,000 – $12,000) $8,000

Differential costs ($6,000 – $0) 6,000
Differential profit $2,000

Decision:
Decision: Make
Make
modifications!
modifications!
 5-13

Basic
Basic Example
Example
Comparison
Comparison of
of the
the three
three methods
methods
Throw Out Sell Monitors Rework
Monitors As Is and Sell
Incremental revenue $0 $12,000 $20,000
Incremental costs 0 0 (6,000 )
Incremental profit (loss) $0 $12,000 $14,000
 5-14

Activity-Based
Activity-Based Estimates
Estimates
Using
Using ABC
ABC helps
helps
managers
managers focus
focus on
on what
what
activities
activities change
change as
as aa
result
result of
of aa decision.
decision.
 5-15

Dropping a Segment Decision

Clothing Shoes Jewelry Total
Sales $45,000 $40,000 $15,000 $100,000
Variable costs 25,000 18,000 11,000 54,000
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

Should
Should Jewelry
Jewelry be
be eliminated?
eliminated?
 5-16

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 400
Net revenue lost Keep
Keep jewelry!
jewelry! $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
 5-17

Complementary
Complementary Effects
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
 5-18

Complementary
Complementary Effects
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.
 5-19

Complementary
Complementary Effects
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
 5-20

Loss
Loss Leader
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.
 5-21

Loss
Loss Leader
Leader
Pizza Soft Drinks Total
Sales (200 pizzas @ $1.80) $360 $100 $460
Variable costs 120 40 160
Contribution margin $240 $ 60 $300
Wages of part-time
employees 80
Income $220
 5-22

Loss
Loss Leader
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) 120
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.
 5-23

Make-or-Buy
Make-or-Buy Decision
Decision
Assume the following cost data relate to the decision to produce
12,000 units of a product or buy from external source:
Total Cost Unit Cost
Rental of equipment $15,000 $1.25
Equip. depreciation 3,000 .25
Direct materials 12,000 1.00
Direct labor 24,000 2.00
Variable overhead 9,000 .75
Fixed overhead 36,000 3.00
Total $99,000 $8.25

The purchase price from an outside vendor is $5.50 per unit.

 5-24

Make-or-Buy
Make-or-Buy Decision
Decision
Differential
Make Buy Cost to Make
Rental of equip. $15,000 ---- $15,000
Direct materials 12,000 ---- 12,000
Direct labor 24,000 ---- 24,000
Variable overhead 9,000 ---- 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.
 5-25

Make-or-Buy
Make-or-Buy Decision
Decision

Qualitative issues:

 Quality of purchased components

 Timely delivery

 Potential price increases

 5-26

Joint
Joint Products
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.
 5-27

Joint
Joint Products
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
 5-28

Joint
Joint Products
Products
Alpha Omega
Differential revenues $2,400 $ 400
Differential costs 900 500
Differential profits $1,500 $(100 )
Decisions: Process Alpha further and sell Omega at
the split-off point
 5-29

Special
Special Order
Order Example
Example
Per Unit Total
Sales (60,000 units) $15 $900,000
Manufacturing costs:
Materials $4 $240,000
Direct labor 3 180,000
Overhead (1/3 variable) 6 360,000
Total $13 780,000
Gross margin $120,000
Selling and admin. expenses 80,000
Operating 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?
 5-30

Special
Special Order
Order Example
Example
Per Unit Total
Differential revenues (20,000 units) $10 $200,000
Differential costs:
Materials $4 $80,000
Direct labor 3 60,000
Variable overhead 2 40,000
Total $9 180,000
Incremental profit favoring
acceptance $ 20,000

Decision: Accept special order

 5-31

Special
Special Order
Order Example
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 133,500
Differential loss, favoring rejecting order $ (8,500)
 5-32

Resource
Resource Constraint
Constraint
Drive Chip Modem Chip
Selling price $10 $6
Variable cost 6 4
Contribution margin $ 4 $2
Number of units that
can be made per MH 60 150

Which product should be processed assuming only 100

machine hours are available?
 5-33

Resource
Resource Constraint
Constraint

Number of units that Drive Chip Modem Chip

can be made per MH 60 150
Contribution margin per unit x $4 x $2
Contribution margin per
machine hour $240 $300

Decision: Produce modem chips

 5-34

Decision
Decision Making
Making Under
Under
Environmental
Environmental Constraints
Constraints
Antitrust laws forbid
actions that might
substantially reduce
competition.
Anti-dumping laws
address aspects of
unfair competition in
international trade.
 5-35

Decision
Decision Making
Making Under
Under
Environmental
Environmental Constraints
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.
 5-36

Decision
Decision Making
Making Under
Under
Environmental
Environmental Constraints
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.
 5-37

Decision
Decision Making
Making Under
Under
Environmental
Environmental Constraints
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.
 5-38

Chapter 5

The
The End
End
5-39