Chapter 10-Short Term Business Decisions Lesson

1

Horngren’s Financial & Managerial
Accounting

Eighth Edition

Chapter 10

Short-Term Business

Decisions

2

Learning Objectives (1 of 2)

10.1 Identify information
that is relevant for making
short-term decisions

10.2 Make regular and
special pricing decisions

3

Learning Objectives (2 of 2)

10.3 Make decisions about
dropping a product, product
mix, and sales mix

10.4 Make outsourcing and
processing further decisions

4

Learning Objective 10.1

Identify information that is
relevant for making short-
term decisions

5

How Is Relevant Information Used to
Make Short-Term Decisions?

Exhibit M:10-1 How Managers Make Decisions

6

Relevant Information (1 of 2)

• When managers make decisions, they focus on

information that is relevant to the decision.

• Relevant information is expected future data that

differs among alternatives.

• Relevant costs are costs that are relevant to a

particular decision.

• Relevant revenues are revenues that are relevant to

a particular decision.

7

Multiple Choice

What is a cost?

1

the item you receive after you pay

2

giving up one thing for another

3

the amount of money paid for something

8

Relevant Information (2 of 2)

• Irrelevant costs and irrelevant revenues are costs and

revenues that do not affect a decision.

– They are not in the future or do not differ among

alternatives.

• Sunk costs are costs that were incurred in the past and

cannot be changed, regardless of which future action is
taken.

– Examples: Depreciation, original purchase price of an

asset

9

10

Multiple Choice

Income taxes are a

1

Controllable cost

2

Uncontrollable cost

11

12

Open Ended

Which cost do you think hurts a company more, sunk or out of pocket? Why?

Type response here

13

Multiple Choice

Sunk costs are...

1

Costs that were part of a cruise ship that sunk

2

Costs that will end in a product

3

What a producer pays to supply a product to a market

4

Costs that cannot be recovered

14

Multiple Choice

Marginal Cost is?

1

The highest amount that customers will pay for a good

2

The lowest amount that customers will pay for a good

3

The cost of producing one additional good

4

The cost of producing 2 additional goods

15

Multiple Choice

What is a benefit?

1

the item you receive after you pay for it

2

giving up one thing for another

3

the amount of money paid for something

16

Relevant Nonfinancial Information

Nonfinancial, or qualitative, factors play a role in managers’
decisions and, as a result, can be relevant. For example:

• Closing plants and laying off employees can hurt morale.

• The decision to outsource may reduce control over

delivery time or product quality.

• Offering discount prices to select customers may upset

regular customers and tempt them to take their business
elsewhere.

17

Multiple Choice

Should the decision to buy something be made on cost alone?

1

Yes

2

No

18

Differential Analysis (1 of 2)

• A common approach to making short-term business

decisions is called differential analysis.

• Short-term decisions include:

– Regular and special pricing
– Dropping unprofitable products and segments,

product mix, and sales mix

– Outsourcing and processing further

19

Multiple Choice

What is an example of a benefit?

1

the capital resources a company has

2

the cost of an item

3

extra time you have when you buy a leaf blower

20

Differential Analysis (2 of 2)

As you study these decisions, keep in mind the two keys in
analyzing short-term business decisions:

1. Focus on relevant revenues, costs, and profits.

2. Use a contribution margin approach that separates

variable costs from fixed costs.

21

Multiple Choice

What is a trade-off?

1

the item you receive after you pay

2

giving up one thing for another

3

the amount of money paid for something

22

Learning Objective 10.2

Make regular and special
pricing decisions

23

Multiple Choice

You want to buy a new video game and a new pair of sneakers. You only have enough money to buy one of them. If you buy the video game, what is your trade-off?

1

The money you spend on the video game

2

The video game

3

The sneakers

24

Setting Regular Prices (1 of 3)

Managers must consider three questions when setting
regular prices:

• What is the company’s target profit?

• How much will customers pay?

• Is the company a price-taker or a price-setter for this

product or service?

25

Multiple Choice

What is an example of a cost?

1

What you gain from buying a Transformer

2

What you pay to buy some Shopkins

3

How much you get for an allowance

26

Setting Regular Prices (2 of 3)

The question “Is the company a price-taker or a price-setter
for this product or service?” requires consideration of
whether the company is a:

• Price-taker with little control over pricing

• Price-setter with more control over pricing

27

Multiple Choice

Which do people compare in order to make choices?

1

Costs & Benefits

2

Supply & Demand

3

Buying & Selling

4

Apples & Oranges

28

Setting Regular Prices (3 of 3)

Exhibit M:10-2 Price-Takers Versus Price-Setters

Companies Are Price
Takers for a Product When:

• Product lacks uniqueness

• There is intense

competition

• Pricing approach

emphasizes target pricing

Companies Are Price Setters
for a Product When:

• Product is more unique

• There is less competition

• Pricing approach emphasizes

cost plus pricing

29

Multiple Choice

Does it take a long time to save up for expensive things?

1

Yes

2

No

30

Target Pricing (1 of 6)

• When a company is a price-taker, it emphasizes a target-

pricing approach to managing costs and profits.

• Target pricing starts with the market price of the product

and then subtracts the company’s desired profit to
determine the maximum allowed target full product cost.

31

Multiple Choice

Which function of marketing determines how much gross profit a business will make on a good or service?

1

Pricing

2

Distribution

3

Promotion

4

Risk Management

32

Multiple Choice

Pricing techniques that help create an illusion for customers.

1

Price

2

Sales Revenue

3

Break-Even Point

4

Demand Elasticity

5

Psychological Pricing

33

Multiple Choice

It is most typical for producers who use captive-product pricing to set the price of the main product ________ and set ________ on the supplies necessary to use the product.

1

low; low markups

2

high; low markups

3

low; high markups

4

high; high markups

5

moderately; moderate markups

34

Multiple Choice

With target costing, marketers will first ________ and then ________.

1

build the marketing mix; identify the target market

2

identify the target market; build the marketing mix

3

design the product; determine its cost

4

use skimming pricing; use penetrating pricing

5

determine a selling price; target costs to ensure that the price is met

35

Multiple Choice

Why might someone save up for an item?

1

They have the money to buy it now

2

It is expensive

3

They don't like it

36

Target Pricing (2 of 6)

Exhibit M:10-3 Smart Touch Learning’s Budgeted Income Statement

37

Target Pricing (3 of 6)

• In setting regular sales prices, companies must cover all costs—

whether the costs are product or period, fixed or variable.

• The desired profit is

(

)


$250,000 $2,500,000 average assets 10% .

• The target full product cost at the current sales volume of 2,400

tablets is calculated as follows:

38

Target Pricing (4 of 6)

What options does Smart Touch Learning have?

1. Accept the lower operating income of $236,000, which

is a 9.44% return on investment ($236,000 operating
income / $2,500,000 average assets), not the 10%
target return required by stockholders.

2. Reduce fixed costs by $14,000 or more.

3. Reduce variable costs by $14,000 or more.

39

Target Pricing (5 of 6)

Smart Touch Learning’s options (continued):

4. Attempt to increase sales volume. If the company

has excess manufacturing capacity, making and
selling more units would only affect variable costs;
however, it would mean that current fixed costs are
spread over more units.

5. Change or add to its product mix (covered later in

the chapter).

40

Target Pricing (6 of 6)

Smart Touch Learning’s options (continued):

6. Attempt to differentiate its tablet computer from the

competition to gain more control over sales prices
(become a price-setter).

7. A combination of the above strategies that would

increase revenues and/or decrease costs by $14,000.

41

Cost-Plus Pricing (1 of 3)

• Price-setters emphasize a cost-plus approach to pricing.

• Cost-plus pricing starts with a company’s full product

costs and adds its desired profit to determine a cost-plus
price.

42

Cost-Plus Pricing (2 of 3)

Using a cost-plus pricing approach, assuming the current
level of sales, and a desired profit of 10% of average
assets, the cost-plus price is $506, calculated as follows:

43

Cost-Plus Pricing (3 of 3)

For cost-plus pricing decisions, the decision rule follows:

44

Special Pricing (1 of 4)

• A special pricing decision occurs when a customer requests a

one-time order at a reduced sales price.

• Management must consider:

– Does the company have the excess capacity available to

fill the order?

– Will the reduced sales price be high enough to cover the

differential costs of filling the order?

– Will the special order affect regular sales in the long run?

45

Special Pricing (2 of 4)

Exhibit M:10-4 Smart Touch Learning’s Budgeted Income Statement—
Traditional and Contribution Margin Formats

46

Special Pricing (3 of 4)

Exhibit M:10-5 Differential Analysis of Special Pricing Decision

47

Special Pricing (4 of 4)

For special pricing decisions, the decision rule follows:

48

Learning Objective 10.3

Make decisions about
dropping a product, product
mix, and sales mix

49

How Do Managers Decide Which
Products to Produce and Sell?

Deciding which products to produce and sell is a major
managerial decision.

• If manufacturing capacity is limited, managers must

decide which products to produce.

• Managers must also decide whether to drop products,

departments, or territories that are not as profitable as
desired.

50

Dropping Unprofitable Products and
Segments (1 of 2)

Management’s considerations when dropping a product or
business segment include:
• Does the product or segment provide a positive contribution

margin?

• Will fixed costs continue to exist, even if the company drops the

product or segment?

• Are there any direct fixed costs that can be avoided if the

company drops the product or segment?

• Will dropping the product or segment affect sales of the

company’s other products?

• What would the company do with the freed manufacturing

capacity or store space?

51

Exhibit M:10-6 Budgeted Income
Statement by Product

52

The Effect of Fixed Costs (1 of 3)

• In the short term, many fixed costs remain unchanged in

total, regardless of how they are allocated to products or
other cost objects.

• Allocated fixed costs are irrelevant.

• The following questions help determine what is relevant:

1. Will the fixed costs continue to exist even if the

product is dropped?

2. Are there any direct fixed costs of the Premium

Tablets that can be avoided if the product is
dropped?

53

The Effect of Fixed Costs (2 of 3)

Exhibit M:10-7 Differential Analysis of Dropping a Product When Fixed
Costs Will Not Change

54

The Effect of Fixed Costs (3 of 3)

Exhibit M:10-8 Differential Analysis of Dropping a Product When Fixed
Costs Will Change

55

Other Considerations

• Managers considering dropping a product line or

segment would consider:

– Would dropping it hurt other product sales?
– What could be done with the freed manufacturing

capacity?

• Short-term business decisions should take into account

all costs affected by the choice of action.

56

Dropping Unprofitable Products and
Segments (2 of 2)

When deciding whether to drop products or segments, the
decision rule follows:

57

Product Mix (1 of 6)

• Companies do not have unlimited resources.

• A constraint is a factor that restricts the production or

sale of a product.

• Managers should consider producing and selling the

products that offer the highest contribution margin per
unit of the constraint.

58

Product Mix (2 of 6)

Calculate the contribution margin per unit and the contribution
margin ratio to compare products.

Exhibit M:10-9 Smart Touch Learning’s Contribution Margin per
Unit

59

Product Mix (3 of 6)

To determine which product to emphasize, the decision rule
follows:

60

Product Mix (4 of 6)

Take into consideration the constraint to determine the true
contribution margin per unit.

Exhibit M:10-10 Smart Touch Learning’s Contribution Margin per
Machine Hour

61

Product Mix (5 of 6)

Exhibit M:10-11 Total Contribution Margin with Machine
Hour Constraint

62

Product Mix (6 of 6)

Maximize profitability by combining the constraint limitations
with the limited market.

Exhibit M:10-12 Total Contribution Margin with Machine
Hour Constraint and Limited Market

63

Sales Mix (1 of 3)

• Merchandising companies also have constraints, display

space being the most common constraint.

• Managers must choose which products to display.

• Managers consider space constraints along with the

contribution margin per unit.

64

Sales Mix (2 of 3)

• Bragg Company operates gift shops in airports and has

only 48 linear feet of bookshelves in each store.

• The following chart shows the average sales price; cost of

purchasing the books, which is a variable cost; and
contribution margin for hardcover and paperback books:

Blank

Hardcover Books

Paperback Books

Sales Price

$ 28.00

$ 12.00

Variable Cost

19.60

7.20

Contribution Margin

$ 8.40

$ 4.80

65

Sales Mix (3 of 3)

When considering the constraint, we see that Bragg can
generate more profits per foot of shelving if paperback
books are displayed:

Exhibit M:10-13 Total Contribution Margin with Display
Space Constraint

66

Learning Objective 10.4

Make outsourcing and
processing further decisions

67

How Do Managers Make Outsourcing
and Processing Further Decisions?

• Short-term management decisions include how products

are produced.

• Two questions are:

– Should the company outsource a component of the

finished product or make it?

– Should a company sell a product as it is or process it

further?

68

Outsourcing (1 of 9)

• Outsourcing allows a company to take advantage of

another company’s expertise, which allows it to focus on
its core business functions.

• Outsourcing decisions are often called make-or-buy

decisions because managers must decide whether to buy
a component product or service or produce it in-house.

• The heart of these decisions is how best to use available

resources.

69

Outsourcing (2 of 9)

• Smart Touch Learning is deciding whether to make the casings

for its tablet computers in-house or to outsource them.

• Smart Touch Learning’s cost to produce 2,400 casings is as

follows:

Direct materials

$ 15,600

Direct labor

7,200

Variable manufacturing overhead

13,200

Fixed manufacturing overhead

19,200

Total manufacturing cost

$ 55,200

Number of casings

divided by 2,400

Cost per casing

$ 23

 2,400

70

Outsourcing (3 of 9)

• In deciding whether to outsource, managers must assess fixed

and variable costs separately.

• Management considers the following:

– How do the company’s variable costs compare to the

outsourcing costs?

– Are any fixed costs avoidable if the company outsources?
– What could the company do with the freed manufacturing

capacity?

71

Outsourcing (4 of 9)

Exhibit M:10-15 Differential Analysis for Outsourcing Decision When
Fixed Costs Will Not Change

72

Outsourcing (5 of 9)

Exhibit M:10-16 Differential Analysis for Outsourcing Decision When
Fixed Costs Will Change

73

Outsourcing (6 of 9)

The decision rule for outsourcing follows:

74

Outsourcing (7 of 9)

• Suppose Smart Touch Learning has an opportunity to use

its freed-up facilities to make another product, which has
an expected profit of $30,000.

• Smart Touch Learning must consider its opportunity

cost—the benefit given up by choosing an alternative
course of action.

• In this case, Smart Touch Learning’s opportunity cost of

making the casings is the $30,000 profit it gives up if it
does not free its production facilities to make the new
product.

75

Outsourcing (8 of 9)

Smart Touch Learning has three alternatives to consider:

1. Use the facilities to make the casings.

2. Buy the casings and leave facilities idle (continue to

assume $12,000 of avoidable fixed costs from
outsourcing casings).

3. Buy the casings and use facilities to make the new

product (continue to assume $12,000 of avoidable fixed
costs from outsourcing casings).

76

Outsourcing (9 of 9)

Exhibit M:10-17 Differential Analysis for Outsourcing Decision When
Fixed Costs Will Change and Opportunity Cost Exists

77

Sell or Process Further (1 of 4)

• At what point in processing should a company sell its

product?

• Managers must determine:

– How much revenue will the company receive if it sells

the product as is?

– How much revenue will the company receive if it sells

the product after processing it further?

– How much will it cost to process the product further?

78

Sell or Process Further (2 of 4)

• Smart Touch Learning can sell its tablet computers as is or add

front-accessible USB ports to the tablets.

• The cost to add the USB ports is $5.

• Tablets with the USB port sell for $20 more than tablets without

the USB port.

Exhibit M:10-18 Differential Analysis for Sell or Process Further Decision

79

Sell or Process Further (3 of 4)

Joint costs are costs of a production process that yields
multiple products.

Exhibit M:10-19 Joint Costs

80

Sell or Process Further (4 of 4)

The decision rule when deciding whether to sell or process
further follows:

81

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Chapter 10-Short Term Business Decisions

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