Short Term
Decision Making
VINCENT JOSEPH D. DISU, CPPS, MBA
McGraw-Hill/Irwin
Short-Term Decisions
• Model cost/revenue behavior to make short-
term operating decisions
• Assume that capacity is fixed
Cannot increase or decrease the physical
facility, workers or relocate
• Impact the future long-term decisions
• Cannot be planned during the normal planning
process
Arise due to change in the business
environment and must be addressed in a
timely manner
Must be analyzed as a unique
opportunity
Cost-Volume-Profit Analysis (CVP)
• Study of how costs, revenues, and profits
change in response to changes in the volume
of goods or services provided to the
customer
What is the CVP Model?
• Cost-volume-profit model (short-term)
Use to explore relationships among costs,
volumes, and profits
• Assumptions (linearity)
Selling price is constant per unit
Variable cost is constant per unit
Fixed cost is constant in total
Number of units produced = number of units
sold
CVP Graph
Total Revenue
Profit area
Total Cost
$
Breakeven point
Loss area
Units produced and sold
How are the CVP Components
Defined Mathematically?
Total revenue
SP * Q
Total cost
VC * Q + FC
Breakeven
(SP * Q – VC * Q) – FC = 0
Where, Q = quantity produced and sold
CVP Continued
• Contribution margin
SP – VC
Breakeven = CM * Q – FC = 0
• Target profit before taxes
CM * Q – FC = P
• Target profit after taxes
CM * Q – FC = P/(1 – tax rate)
Contribution Margin Approach
is a quicker way to calculate
it?
• FC + P/CM = Q
Contribution margin approach to determine
target profit after taxes
• FC + (BTP/[1-tax rate])/CM = ATP
Sensitivity Analysis
Process of changing the key variables (but not the
assumptions) in CVP analysis to determine how
sensitive the CVP relationships are to change.
• Change in selling price • Change in fixed cost
Increase—decreases Increase—increases
breakeven breakeven
Decrease—increases Decrease—decreases
breakeven breakeven
• Change in variable • Change in tax rate
cost No impact on
Increase—increases breakeven
breakeven
4-9 Decrease—decreases
breakeven
What are Product and
Nonproduct Costs?
• Product costs
Incurred in connection with buying or making
the product.
Associated with producing the product
• Nonproduct costs
Incurred in connection with selling the product
and administering (running) the company
Associated with selling the product and
administering the company
What are the 3 Types of
Product Costs?
• Direct materials
Traceable
Worth the cost of tracing
• Direct labor
Cost of employees making the product
• Manufacturing overhead
All manufacturing costs not classified as direct
materials or labor
Indirect costs of production (indirect materials,
indirect labor, and other manufacturing costs)
What are the Activity Levels
Associated with Costs?
• Unit-related
Vary with units produced or sold
• Batch-related
Vary with batches (groups) regardless of the
number of units in the batch
• Product-sustaining
Vary with the number of product lines
• Facility-sustaining
Fixed or capacity costs
Types and Activity Levels
Product Nonproduct
Unit-related Materials Commissions
Batch-related Set ups Ordering
Product- Research & Advertising
sustaining development
Facility- Rental of CEO salary
sustaining equipment
What are the 2 Characteristics
of a Relevant Variable?
• Future
The variable must occur in the future
• Different
The variable must differ between the
alternatives considered
Relevant Variables Continued
• Sunk costs
Past, irrelevant for decision making
• Opportunity costs
Benefits foregone, relevant for decision
making
• Incremental costs/revenues
Additional cost/revenue, relevant if different
between alternatives
• Helps determine what is relevant to a
particular decision situation
What are the Types of Short-
Term Decisions
Considered?
• Accept-or-reject decisions
Special order
Base decision on incremental profit from the order
• Make-or-buy decisions
Outsourcing
Base decision on cost comparison between make and
buy
Lecture Example #1
1. A certain company sells its only product for $12 per unit. The variable costs to
produce the product are $7 per unit and it costs approximately $1 per unit for
selling and administrative costs. The fixed costs of production are $400,000 per
period and the fixed selling and administrative costs are $200,000 per year. The
company is subject to a 30 percent tax rate. Answer the following questions.
a. What is the breakeven point in units?
b. What is the breakeven point in dollars?
c. How many units must be sold to earn a profit of $70,000 before tax?
d. How many units must be sold to earn a profit of $70,000 after tax?
e. If the variable costs increase 10 percent, what increase is necessary in selling
price to maintain the same breakeven point in units?
f. If the fixed costs increase, what is the effect on breakeven? On contribution
margin per unit?
g. If the tax rate increases, what is the effect on breakeven? On contribution
margin per unit?
Lecture Example #1 Cont.
• Answer:
• a. SP = $12; VC = $8; CM = $4; FC = $600,000
• $600,000/4 = 150,000
• b. CM = $4; SP = $12; CM % = 33.3333%
• $600,000/33.3333% = $1,800,000
• c. ($600,000 + $70,000)/4 = 167,500
• d. $70,000/(1 - .3) = $100,000
• ($600,000 + $100,000)/4 = 175,000
• e. To maintain the same breakeven point, CM must remain the same.
• VC = $8.80; CM = $4; therefore SP = $12.80
• f. If fixed costs increase, breakeven increases. Fixed costs do not affect
contribution margin per unit.
• g. Tax rate increases do not affect breakeven or contribution margin per
unit.
Lecture Example #2
• 2. A company has been approached by a supplier with an offer to provide 25,000 units
of a production part for $9 per unit. If the company accepts the offer its direct materials
costs are expected to decrease by 60 percent, its direct labor costs are expected to
decrease by 30 percent, and its unit-related overhead is expected to decrease by 20
percent. A recent per unit cost report when 25,000 units were produced is shown below:
Direct materials $10
Direct labor 2
Manufacturing overhead 8
Total cost $20
• An analysis of manufacturing overhead reveals that overhead consists of unit-related
and facility-sustaining overhead. Facility-sustaining overhead consists of depreciation
and other fixed items and is approximately $150,000 per period. If the company
accepts the supplier’s offer, it will use the released production facilities to produce
another product with an expected contribution of $60,000 per period. Should the
company accept or reject the supplier’s offer?
Lecture Example #2 Cont.
Answer:
Total overhead $8 * 25,000 = $200,000
Less facility-sustaining overhead 150,000
Unit-related overhead $ 50,000
Unit-related overhead per unit $50,000/25,000 = $2
Relevant variables Make Buy
Direct materials $10.00 $ 4.00 ($10 * .4)
Direct labor 2.00 1.40 ($2 * .7)
Unit-related overhead 2.00 1.60 ($2 * .8)
Purchase price -0- 9.00
Relevant cost per unit $14.00 $16.00
* Number of units 25,000 25,000
Total relevant unit cost $350,000 $400,000
Opportunity cost 60,000 -0-
Total relevant cost $410,000 $400,000 BUY
Lecture Example #3
3. A company has been approached by a customer with an offer to buy 10,000 units of
product but the customer wants a discount of 25 percent off the normal selling price.
The company has the capacity to fill the customer’s order. A recent profit report is
shown below:
Sales (500,000 units) $6,000,000
Cost of goods sold 4,200,000
Gross margin $1,800,000
Selling and administrative cost 1,000,000
Profit $ 800,000
Unit-related cost of goods sold is 40 percent of the current selling price while unit-related
selling and administrative costs are 10 percent of the current selling price. To fill the
customer’s order, one additional production run will be required at a cost of $6,000. An
additional purchase order will be required at a cost of $500, and shipping costs to the
customer will be $800. Should the company accept the customer’s order?
Lecture Example # 3 Cont.
Answer:
Current selling price = $6,000,000/500,000 = $12
Unit-related cost of goods sold = $12 * .4 =
$4.80
Unit-related selling and administrative cost = $12 * .1 = $1.20
Proposed selling price = $12 * .75 = $9
Relevant variables Accept Reject
Proposed selling price $9.00 $0.00
Cost of goods sold 4.80 0.00
Selling and administrative 1.20 0.00
Contribution margin $3.00 $0.00
* Number of units requested 10,000 10,000
Total contribution margin $30,000 $0
Additional batch costs:
Production run ( 6,000) -0-
Ordering ( -0-
500)
Shipping ( -0-
800)
Relevant profit $22,700 $0
ACCEPT
