Lecture 6: Decision Making in the Short-run

Cost-Volume-Profit analysis is a useful financial planning model that can be

used for planning profit over the short-term, measuring operating risk and analyzing
sensitivity of profits to price and cost changes in the short run. There are many
short-term decisions that deal with specific products, special orders, outsourcing
and constrained capacity and CVP analysis cant be applied for these situations. In
this module, we will learn how to estimate the costs and benefits for the decision
options in such cases.
We will begin our discussion by discussing the contexts in which these
decision making situations arise. The need for many of these decisions arises
because of temporary gap between demand for the products and services and the
available capacity to produce these products and services. The reason for the
existence of the gap between supply and demand is simple. While the capacity is
largely fixed in the short run, the demand is not. The demand fluctuates from time
to time. The capacity cant be adjusted easily in response to a fluctuating demand.
Shrewd managers will take decisions that bridge this gap as much as possible.
Capacity is the maximum value of activity that a company can sustain with
available resources. The term capacity is not necessarily restricted to plant and
equipment. It can refer to the capacity of many other resources required for
production. For example, it can be labor capacity, the available labor hours to
produce products or services or raw materials capacity which is available raw
materials for production. While increasing capacity for any productive resource is a
long-term issue, the capacity for plant and equipment, in particular, takes a really
long time to build. Not only that, the built up capacity cant be reduced in future
without incurring significant costs. Demand for products and services is constantly
changing. Actions from competitors may contribute to sudden peaks and valleys in
the demand. Therefore, there is a mismatch between demand and supply in the
short run. When demand exceeds supply, managers are confronted with decisions
such as temporary price increase, outsourcing or focusing on the most profitable
product. When supply exceed demand, managers are faced with decisions such as
running a special advertising campaign, or price reduction to induce more demand
or shifting outsourced production back into the firm, etc.
Generally speaking, there are two approaches in making these decisions. The
first approach is called Relevant cost analysis. We are already familiar with the
concept of relevant cost analysis from module 2. The idea behind this approach is
to focus only on those costs or benefits that are relevant to the decision on hand.
Why? Because, information collection and processing are costly and therefore it
helps to minimize the amount of information collected and analyzed. A cost of
benefit is considered relevant to the decision if it is bearing on the future. The
consequences of a decision are borne in the future, not in the past. Therefore, to be
relevant to a decision, a cost or benefit information must involve a future event. In

addition to being a revenue or cost that will occur in the future, a relevant cost or
benefit will differ among the decision options. Costs or benefits that are the same
across all the decision options have no bearing on the decision and therefore can be
ignored in the analysis. Since relevant information involves future events,
managers must predict the amounts of the relevant costs or benefits. In making
these predictions, managers will often use estimates of costs based on historical
data. (In module 4, we learnt how to predict costs based our understanding of cost
behavior gleaned from historical data). There is an important and subtle issue here.
Relevant costs are costs or benefits to be realized in the future. However,
managers prediction of those costs and benefits, often are based on data from the
past. The alternative to relevant cost analysis is the totals or gross approach.
When decision options involve numerous cost items, checking which costs differ
across options (and therefore whether they are relevant) can be cumbersome.
Under these circumstances, it may be easier to include all the costs into the
analysis. If done correctly, both approaches should provide the same ranking of
decision options.
Let us look at our first decision which is special order pricing. A special order
is a one-time order for the goods that you are already manufacturing, perhaps at a
price other than the current selling price or a one-time order for products that are
not being currently manufactured. A special order is something that is not expected
to recur. In addition, the special order is sufficiently insulated from the regular
business and therefore it wont affect other sales. Therefore, it is often called onetime only special order. For the purpose of making a decision whether to accept or
reject a special order, we assume that all costs can be classified as either variable
with respect to volume of output or fixed. There are two possible scenarios with
respect to capacity demand mismatch. In the first case, the capacity exceeds
demand. If the special order is rejected the status quo will continue. Hence, the
costs traceable to the special order are controllable as well as relevant costs to this
decision. The minimum acceptable price for such special order is the relevant costs
associated with the special order. Usually, the relevant costs of the special order
equal the variable costs of the special order. The second case concerns with a firm
that gets a special order when the capacity is less than demand. The firm does not
have spare capacity to meet the special order and need to create the capacity if it
decides to accept the order. The firm has to divert some of the capacity that is
being used for the existing business in order to meet the special order. The
consequence of taking such an action is to incur an opportunity cost. Recall our
definition of opportunity cost in an earlier module. Opportunity cost is the value of
the next best option. The next best option to accepting the special order is not to
accept the order or continue the status quo. The value of the status quo option is
the opportunity cost of accepting the special order. In this case, the minimum
acceptable price for the special order is the variable costs of the special order and
the opportunity cost of crating the capacity to accommodate the special order.

Next, let us consider how to evaluate a short term sales promotion. This may
be in the form of running an advertising campaign or discounting the price to
stimulate the demand or focusing on a particular segment of the market or issuing a
rebate coupon effectively offering discount to selected customers. Relevant cost
analysis will be suitable for this kind of decisions. Notice that we dont have to
know the costs incurred and revenues generated currently. All we need to know is
the incremental costs of the decision option and incremental revenues you will
generate if you adopt a particular decision option. For this reason, we call this
analysis as incremental analysis. Some people call this approach as differential
analysis since the analysis focuses on costs and revenues that are different
between the status quo and the decision option. If the differential revenue exceeds
differential costs, the value or net benefit of the decision options is positive. A
positive value would usually imply that the short term sales promotion is desirable
from a profit maximization stand point.
When a firm must decide whether to meet its needs internally or to
acquire goods or services from external sources it faces a make or buy decision. If
Heinz grows its own tomatoes for manufacturing its famous Heinz ketchup then it is
meeting its needs by pursuing the option of manufacturing in house. On the other
hand, if it procures tomatoes from farmers, we would say that it is pursuing the
option of buying. Housing contractors who their own site preparation and
foundation work choose the option of make. There are those who hire
subcontractors are choosing the option of buying. In a nutshell, make or buy
decision is a broad ranging decision area for businesses, and this is a decision thats
often described by the term outsourcing the acquisition of goods or services from
an outside provider.
Whether to make or buy depends on cost factors and on non-quantitative
factors such as dependability of suppliers and the quality of purchased materials, so
on and so forth. The decision may be a onetime choice between making and
buying, but managers usually base such decisions on the long run reputation of
suppliers. The make or buy decision is often part of a companys long run strategy.
Some companies choose to integrate vertically in an effort to control activities that
lead to the production of the final product. Other companies prefer to rely on
outsiders for some inputs and specialize in only certain steps of the total production
process. Outsourcing is a growing area because many firms are choosing to
concentrate on their core activities leaving other non-core tasks to organizations
that have expertise in performing those tasks. Its not uncommon, for instance, for
a physician to outsource all dealings with insurance companies. Thats an example
of outsourcing. Whether to rely on outsiders for a substantial amount of goods or
services often depends on relevant cost comparisons and other factors that are not
easily quantified such as suppliers dependability and quality.
In our limited context, we want to approach this make or buy decision just as
a financial decision. We are not going to be incorporating the dependability of

supplies and the quality of purchased materials, et cetera. Not because they are
unimportant, its because we dont want to over-complicate the analysis by bringing
in these things. If we know how to take a make or buy decision based on purely
financial considerations, then thats one layer of analysis for the decision-making.
We can expand our analysis by adding additional layers such as reputation of
supplier, quality of outsourced materials, so on and so forth. In this type of analysis,
you need to be very careful about distinguishing avoidable costs from non-avoidable
costs. For example, if you are shifting part of production from in house to outside
suppliers, some costs will cease to exist and we call these costs as avoidable
costs in the sense that these costs will be avoided if the organization suspends the
production activity. However, there may be some costs that the firm will continue to
incur even if the production activity is suspended. Such costs are called
unavoidable costs. The avoidable costs (these need not necessarily be just
variable costs) will be relevant to the decision while the unavoidable costs (not all
fixed costs are unavoidable) will not be relevant to the decision. Financial
efficiency, quality reasons, strategic motivations or capacity reasons are often the
most important reasons motivating firms to shift production to or from in-house to
or from outside suppliers. Unit-cost data means total overall cost per unit of
product produced. While this may be a very useful number in cost analysis, it can
potentially mislead decision makers when irrelevant costs are included and when
unit costs at different output levels are compared. You need to be careful about the
use of unit-cost data in such analyses.
Now, we are going to look at a decision that involves the efficient allocation
of limited resources. Organizations typically have limited resources such as
available machine capacity. Sometimes, we have constraints on availability of raw
materials or direct labor hours. Now, if a firm has constraints on the availability of
productive resources, the firm often has to choose between sales orders or between
different products or brands. Managers need to decide which orders they can fill
and which orders they need to decline because of the limited availability of the
resources. In making such decisions, managers much often determine which
product or which service from among the products or services in that portfolio is the
most profitable. Then common sense tells you that the manager should be
allocating the limited resources on a priority basis to this profitable product. And
once the demand for this most profitable product has been met, if any limited
resources are still available then the manager has to allocate it to the next
profitable product. Therefore this decision involves the managers arriving at the
rank ordering of all their products in that portfolio in terms of profitability. Incorrect
profitability ranking will lead to inefficient allocation of limited resources and will
result in reduced profits. Profitability ranking should be based on contribution
margin per unit of scarce resource. The scarce resource should be allocated by
giving preference to profitable products.

Let us look at another decision thats frequently taken in manufacturing firms.

This has to do with joint costs or joint products. Joint costs are the costs of a single
production process that yields multiple products simultaneously. If you get more
than a product with the same production process, then you have joint products. In
any joint production process the split off point is the juncture where one or more
products become separately identifiable. For example, look at the process like a
coal distillation process. This process yields coal, natural gas and other products.
The production of coal and natural gas is a joint production process. Industries
abound in which single production process simultaneously yields two or more
products. In such production processes, the joint costs incurred before the split-off
point are not traceable to individual products. Therefore, for any decision after the
split-off point, the joint costs are irrelevant and should be ignored.
Let us look at the last decision for this module. This is called add or drop a
product line decision. Sometimes as mangers you need to take decision to drop a
product or a service or close down a department or drop a customer. What does
usually motivate the managers to think of dropping a part of business? Usually this
is done because the product that is being dropped is not profitable. The first thing
that I want you to caution is about the use of product profitability reports in such
decisions. You need to keep in mind that the profit reports often include costs that
are not relevant to this decision. For example, those costs that are not unavoidable
(i.e. those costs that will persist even after dropping the product) are unavoidable in
this context. The net benefit of dropping a product is the difference between
avoidable costs (i.e. those costs that will not be incurred when the product is
dropped) and the revenue from the product. If this is positive, then the product may
be dropped based on financial considerations especially if there is not strategic
reason to continue to offer that product line. Finally, keep in mind that while most
variable costs tend to be relevant costs for this decision, it is possible that some
variable costs may be irrelevant and some fixed costs may be relevant for this
decision.