Lesson 9.3: Short-Term Decision-Making

Introduction

Welcome to Lesson 9.3 of Foundation Accounting, students! In this lesson, we will explore the crucial topic of short-term decision-making in business. The ability to make timely and effective decisions can significantly influence a company’s success. Our objectives include understanding relevant costs and revenues, opportunity costs, make-or-buy decisions, and the effect of these decisions on maximizing the company's contribution margin. 🔍

Learning Objectives

By the end of this lesson, you will be able to:

• Identify relevant costs and revenues, and understand the meaning of opportunity cost in decision-making.
• Analyze make-or-buy decisions and special pricing or one-off order decisions.
• Perform limiting factor analysis to maximize contribution.
• Understand the implications of discontinuance (shut-down) decisions.
• Explain why relevant-costing decisions use contribution rather than absorption profit.

Relevant Costs and Revenues

Relevant costs are the costs that will be directly affected by a specific decision. These costs are crucial in the context of short-term decision-making. Let's break this down:

Example of Relevant Costs

Suppose students runs a bakery that produces cookies and cakes. If the bakery receives an order specifically for 100 extra cakes, the costs to consider would be:

1. Ingredients: The cost of flour, sugar, and eggs needed for these additional cakes is relevant since it will change due to this order.
2. Labor: If you need to hire part-time help to fulfill the order, that cost is also relevant.
3. Fixed costs: However, existing rent and general utilities are not relevant costs, as they remain the same regardless of this order.

Opportunity Cost

Opportunity cost is the potential benefit lost when you choose one alternative over another. Let's tie this into the example:

If you decide to take the extra cake order, but you could have used that time to make profit from selling more cookies, the foregone profit from cookie sales represents your opportunity cost. Hence, understanding opportunity costs is key for informed decisions.

Make-or-Buy Decisions

When a company needs a product, it faces a make-or-buy decision. This is evaluating whether to produce an item internally or purchase it from an external supplier.

Example: Make-or-Buy

Let’s say students's bakery is considering whether to make its cake boxes or buy them from a supplier:

• Cost to make the boxes: $300 for materials and labor.
• Cost to buy the boxes: $400 from the supplier.

In this scenario, since making the boxes saves $100, it would be smart to make them. However, if making costs more, students would need to consider the implications on quality, time, and other factors.

Special Pricing and One-Off Order Decisions

Occasionally, businesses receive one-off requests that may not align with regular pricing structures. Here, special pricing comes into play.

Special Pricing Example

Imagine a local event wants to place a bulk order of cookies at a lower price:

• Regular price per cookie: $2
• Special offer price: $1.50 per cookie

Despite the lower price, if the variable costs of making each cookie is $1, then selling at $1.50 creates a contribution of $0.50 per cookie, which can be beneficial, especially if there is excess capacity. Therefore, students should assess whether the contribution suffices to warrant the lower pricing.

Limiting Factor Analysis

When resources are in short supply, businesses must make strategic decisions that maximize their contribution margin.

Example: Limiting Factor

If students can only bake 200 cookies a day due to oven capacity but has orders totaling 300 cookies, the limiting factor is the oven.

• Contribution per cookie: $2 revenue - $1 variable cost = $1 contribution per cookie.

In this case, students should fulfill orders that maximize the contribution while considering opportunity costs. Prioritization based on contribution per unit can lead to more profitable decision-making.

Discontinuance Decisions

Sometimes, a company must decide whether to continue or discontinue products or services. Discontinuance decisions should weigh only relevant costs and revenues.

Example: Product Discontinuation

Suppose students's bakery finds that it consistently loses money on a specific cake:

• Current contribution: $1,000 loss per year
• Fixed costs: $500 related to that cake

Since the cake contributes to a loss, students should consider discontinuing it unless there are strategic reasons to keep it (like brand presence).

Contribution vs. Absorption Profit

Understanding why relevant-costing decisions use contribution rather than absorption profit is essential:

• Contribution profit considers only variable costs and is directly tied to decision-making.
• Absorption profit includes all fixed and variable costs, making it less relevant for short-term decisions.

In short-term decision making, focusing on contribution helps in assessing real profitability and guides students towards more effective decisions that could enhance the bakery's financial health. 💡

Conclusion

Short-term decision-making is a fundamental aspect of accounting that influences a business’s immediate financial outcomes. By understanding relevant costs, opportunity costs, make-or-buy decisions, and limiting factors, students can make informed choices that support optimal business operations.

Study Notes

• Relevant costs are directly impacted by specific decisions.
• Opportunity cost is the profit lost from choosing one alternative over another.
• Make-or-buy decisions evaluate whether to produce internally or purchase from a supplier.
• Special pricing strategies can lead to beneficial contributions if managed correctly.
• Limiting factors determine how to maximize contribution in resource-constrained situations.
• Discontinuance decisions focus on whether to keep or eliminate unprofitable products.
• Relevant costing emphasizes contribution over absorption profit for short-term decision-making.