Decision Making in Short

Term
 Features of Short-term Decisions

• Not possible to change capacity levels in the short term

• Capacity cost is committed (i.e., fixed) and not controllable
over this horizon
• In long-term, we pick capacity level based on pattern of expected demand
• Best strategy accounts for the opportunity cost of excess supply and excess demand
• Actual demand may lead to excess demand or to excess supply
• Short-term goal is to put available capacity to best use
• Maximize contribution margin derived from available capacity
Demand Supply Imbalance
 Short Term Decisions
Accepting/rejecting an order
Make Vs Buy
Outsourcing
Product mix
Limiting factor
Pricing of Product
Relevance of Costs
• For short term decisions we need to filter the costs
which are relevant to the decision.
• Every decisions has options to choose from.
• Sometimes maintaining status-quo or doing nothing
can be an option.
• A Relevant cost is that cost which changes among the
options
• An Irrelevant cost is the cost that does not change
among the options.
Dilemma of Townhall Committee
• Your company is organizing the annual townhall
event. For this a band needs to be called. The
committee is in a dilemma whether to call Supersonic
or Sunburn. Following information is available:
Supersonic Sunburn
Costs of artist 7,00,000 9,50,000
Travel & stay cost 1,50,000 1,50,000
Stage set up 2,00,000 3,00,000
Poster printing 15,000 15,000
Suggest which of the following costs are relevant?
The mobile puzzle
•You are planning to buy a new mobile phone. You have shortlisted two phones.
The prices at Amazon are:

One plus 11R Rs.39,999

Samsung S21 FE Rs.36,000

You already own a phone (Poco F2) which you purchased a year back for Rs. 20,000.
Amazon has an exchange offer under which it will pay you Rs. 5,000 for Poco F2 if
you buy any one of the two phones.

From financial point of view, which cost are important for you to consider?
Sunk Cost
• Sunk cost is a cost that
• has been already incurred in past, and,
• Cannot be changed with the current decision now.

• Sunk costs are always irrelevant to decisions.

• For example, the amount of Rs.20,000 paid to buy

Poco F2 will not affect the decision of choosing
between One Plus and Samsung
Opportunity Cost
• Opportunity Cost is the cost of the next best alternative.
• In other words, the money lost for not opting for the next best
alternative is the opportunity cost.
• Cordell Company makes and sells 1,000,000 seat covers at $40 per unit.
Total manufacturing cost is $30,000,000, or $30 per unit. Following is
the complete cost structure to manufacture 1,000,000 seat covers.
Direct Material $14,000,000
Direct Labour $6,000,000
Variable Manf. Overheads $4,000,000
Fixed Manf. Overheads $6,000,000
Variable Selling Overheads $2,000,000
Fixed Selling Overheads $4,000,000
Variable Admin Overheads $200,000
Fixed Admin overheads $1,800,000
Cordell has received a special order to supply 1,00,000 seat covers at $26.
The company has idle capacity for 1,00,000 units. The special order will
not effect Cordell’s regular business; will not affect the fixed costs; and
will not require additional variable selling and administrative expenses.
Should the company accept the order?
 Special Sales Order
•Only variable manufacturing cost are affected by this
decision at a rate of $24 per unit ($24,000,000 /
$1,000,000)

•All other variable and fixed costs are unaffected by the

decision and therefore not relevant.
Special Sales Order

Special order sales price/unit $26

Increase in manufacturing costs/unit 24
Additional operating profit/unit $ 2

Based on the preceding analysis,

should Cordell accept the order?

$2 × 100,000 = $200,000 additional profit

Special Sales Order
Cordell Company
Contribution Form of the Income Statement
For the Year Ended December 31, 2007 (000)

Without Effect of
special order special order special orde
1,000,000 units Total Per Unit 1,100,000 u
Sales $40,000,000 $2,600,000 $26 $42,600,000
Less: Variable expenses
Manufacturing $24,000,000 $2,400,000 $24 $26,400,000
Selling and administrative 2,200,000 2,200,000
Total variable expenses 26,200,000 $2,400,000 $28,600,000
Contribution margin $13,800,000 $ 200,000 $14,000,000
Less: Fixed expenses
Manufacturing $ 6,000,000 $
Selling and administrative 5,800,000 5,800,000
Total fixed expenses 11,800,000 1
Operating income $ 2,000,000 $
Example:
Pieco Engineering company has received at once –off export order for its sole product that
would require the use of half of the factory’s total capacity of 4 lakh units per annum. The
condition of the export order is that it has to be accepted in full. Order cannot be accepted
in part.
The factory is currently operating at 60% level to meet its domestic demand. As against the
current price of Rs.6.00 per unit, the export order offer is Rs.4.70 per unit which is less
than the total cost of current production. The cost break down is given below:
Direct material Rs.2.50 per unit
Direct Labour Rs.1.00 per unit
Variable expenses Rs.0.50 per unit
Fixed expenses Rs.1.00 per unit
Total cost Rs.5.00 per unit

The company has three options except for rejecting the offer:

i. Accept the export order and cut back the domestic sales as necessary.
Option II:
Remove the capacity constraint by installing necessary balancing equipment and also by
working overtime to meet both domestic as well as export demand. This will increase
fixed overheads by Rs.15,000 annually and additional amount of overtime work would
amount to Rs.40,000

Option III:
Meet the domestic and export requirement in full by appointing a sub-contractor to
manufacture the additional requirement. The company will have to supply the raw
materials, pay a conversion charge @ Rs.2.00 per unit and hire a supervisor at a salary of
Rs.3,000 for checking the quality of the product and controlling operations at the
manufacturing unit.
Example
B&B Flooring produced 8,000 yards of its economy-grade
carpet. In the coloring process, there was a pigment
defect and the resulting color faded. The carpet normally
sells for $18 per yard, and has a $6 of variable cost per
yard and $3 of fixed cost per yard allocated to the carpet.
The company realizes that it cannot sell the faded carpet
for $18 per yard through its normal channels, unless the
coloring process is repeated. The incremental cost of the
coloring process is $4 per yard. Ace Apartments is willing
to buy the carpet in its current faded condition for $13
per yard. Should B&B repeat the coloring process or sell
the carpet to Ace Apartments?
Make Vs Buy
• Fresh Nectars (FN), a juice making company, require bottles to pack juices. Company’s Cost of Making
12-ounce Bottles is as below:
Total Per Unit
Direct Material $ 60,000 $ 0.06
Direct Labor $ 20,000 $ 0.02
Variable Factory Overheads $ 40,000 $ 0.04
Fixed Factory Overheads $ 80,000 $ 0.08
Total $ 200,000 $ 0.20

• Another manufacturer offers to supply bottles at $0.18

• If the company buys the bottles, some facilities can be released and $50,000 of fixed
overheads will be saved OR the company may use it to manufacture another line of juices
which is expected to generate $55,000 as contribution but in such a case the company will
not be able to save any fixed cost.
• Should FN make or buy bottles?
Sanders Toys is beginning to manufacture Bungey Wagons. The product
will be sold to toy store chains for $25 each. Management allocates
$12,000 of fixed manufacturing overhead costs to Bungey Wagons. The
manufacturing cost for each wagon at the expected production of 10,000
wagons is as follows:

Direct material $ 13.00

Direct labor 4.00
Overhead ($1.20 fixed and $2.00 variable) 3.20
Total $20.20

The company has contacted a number of suppliers to determine whether

it is better to buy or manufacture the wheels. The lowest quote for a set of
4 wheels needed for each wagon is $3.15. It is estimated that purchasing
the wheels from a supplier will save 10 percent of direct materials, 20
percent of direct labor, and 15 percent of variable overhead. Sanders Toys’
manufacturing space is highly constrained. By purchasing the wheels, the
company will not have to lease additional manufacturing space that
currently cost $8,000 per year.
 Outsourcing
In order to keep the campus lush green, GIM incurs substantial cost on
horticulture activities. Currently the cost incurred is as below:
(Rs. )
Salary of three full time gardeners 5,40,000
Salary of one supervisor 3,00,000
Plant material 1,60,000
Fertilizer 65,000
Fuel 20,000
Other cost (Fixed alloctaed) 30,000
Total 11,15,000

The allocated fixed costs is the proportionate costs of resources such as

administrative manager’s time etc. allocated to horticulture.
GIM is considering to outsource the entire horticulture process to an agency. The
lowest quote it has received is Rs. 8,00,000. If GIM decides to outsource, the
agency will bring its own gardeners and pay for all material (plant material,
fertilizers etc.). However, GIM will still require the supervisor to oversee the
activities.

Should the horticulture activities be outsourced?

Product Mix
• Product mix decisions require managers to decide on the ratio in
which these products must be sold in order to maximize profits.
• These decisions are required because demand as well manufacturing
facilities are limited.
• Otherwise, companies would have sold infinite quantities of their
product.
 Product Mix

Veejay Ltd., makes and sells two products, Vee and Jay. The
budgeted selling price of Vee is Rs.1,800 and that of Jay is
Rs.2,160. Variable costs associated with producing and selling
the Vee are Rs.900 and with Jay Rs.1,800. Annual fixed
production and selling costs of Veejay Ltd. are Rs.88,000.

The company has two production/sales options. The Vee and Jay
can be sold either in the ratio of one Vees to three Jays or in the
ratio of one Vee to two Jays.

What will be the optimal mix and why?

Optimal Use of Limited Resources
Nike produces two different athletic shoes, Air Court and Air Max. These are
produced by one production facility.
Air Court Air Max
Selling Price per pair $ 80 $ 120
Variable Cost per pair $ 60 $ 84
Contriution per pair $ 20 $ 36
Contirbution Margin Ratio 25% 30%

• Assume that the capacity of the factory is determined by machine time, and
the maximum available capacity is 10,000 machine hours.
• The Facility can produce 10 pairs of Air Court or 5 pairs of Air Max per hour.
• Which product is more profitable?
Optimal Use of Limited Resources
A firm manufactures five products using the same raw material. By examining
the following information and assuming the total demand for five units is
limited to 7,000 units, show which product(s) is/are to be chosen so that profit
can be maximized.
Products
A B C D E
Demand (units) 1,500 2,500 1,600 2,000 2,200
Last years sales 1,500 2,500 1,500 2,000 2,000
Selling price per unit 4.00 3.50 1.50 1.00 3.00
Marginal cost per unit 3.00 2.00 1.25 0.75 2.50
Contribution per unit 1.00 1.50 0.25 0.25 0.50
Raw material required in Kgs. 2 8 3 5 2

If raw material is the scarce resource and only 5,000 Kgs. of raw material is available
per annum, which product should get the priority?
Vikram ltd. produces four products using 3 different machines. Machine capacity
is limited to 3,000 hours for each machine. The following information is available
for last month:

A B C D
Contribution per unit 1,500 1,200 1,000 600
Machine hour requirement:
Machine 1 10 6 2 1
Machine 2 10 9 3 1.5
Machine 3 10 3 1 0.5
Estimated demand (units) 200 200 200 200

You are required to identify the constrained resource and the optimal mix.
Pricing
% of Variable cost

Cost Plus Pricing % of manufacturing cost

Pricing % Full cost

Target Cost = Competitive

Target Pricing
Price – Desired Profit
Target Costing and Pricing
Five Step Process:
-Determine the market price
-Determine the desired profit
-Calculate the target cost at market price
less desired profit
-Use Value engineering to identify ways to
reduce product cost
-Use Kaizen costing and operational control to
further reduce costs.
Example
• The marketing department at Surge Electronics has determined that
there is a demand for a new small appliance, which would likely sell
for $36. Surge Electronics currently produces a similar product for
$38, using a full-cost approach. Surge Electronics would like to earn a
10% profit on sales on the new appliance. What is the target cost for
the small appliance if Surge Electronics plans to introduce it?