10.
short-term decisions
Short-term decisions made by a business include;
a. Make vs buy decision
b. Further processing decision
c. Minimum price decisions – One-off contract
d. Shut down decision
Each of these decisions is based on the relevant costing principles. A relevant cost must be the future incremental cash flow.
1. Future -They must occur in the future, e.g., any future costs or revenue.
2. Incremental/specific -Only extra/additional costs occurring as a result of the decision should be considered, e.g.,
extra costs or revenues.
Opportunity costs (the next best alternative use of a resource) should be included.
3. Cash flows – Only cash items are relevant to the decision. This means that costs or charges that do not reflect
additional cash spending should be ignored for decision-making.
Relevant costs may also be:
(a) Opportunity costs. The value of a benefit is compromised when one course of action is chosen over an alternative.
The opportunity cost is represented by the potential benefit forgone from the best rejected course of action.
Opportunity costs are relevant for decision-making and typically arise when there are multiple possible uses of a
scarce resource.
(b) Avoidable costs. These are the specific costs of an activity or sector of a business that would be avoided if that
activity or sector did not exist. Avoidable costs are usually associated with shutdown decisions.
Non-relevant costs
a. Sunk costs are costs already incurred. They are not relevant in decision-making and are therefore ignored.
b. Committed costs have already been committed to and so are not relevant to the decision. They are unavoidable in
the future. E.g., the cost of materials under a long-term contract.
c. Notional costs are non-cash items or accountancy entries.
d. Fixed costs are allocated, and general fixed costs are not specific to a decision. Avoidable fixed costs/ incremental
fixed costs would be relevant.
MAKE VS. BUY DECISIONS
Businesses may be faced with the decision whether to make components for their own products themselves, or to concentrate
their resources on assembling the products, obtaining the components from outside suppliers instead of making them 'in-
house'.
There are two types of make vs. buy decisions:
1. Make or buy decisions with no limiting factors
2. Make or buy decisions with limiting factors
NB: In a make or buy decision with no limiting factors, the relevant costs are the differential costs between the two
options.
Make or buy with a limiting factor
In the presence of a limiting factor, use the following step-by-step approach to determine the units to be bought in:
1. Calculate the savings per unit of each product.
Saving per unit = Purchase price – VC to make.
2. Calculate the savings per unit of the limiting factor (LF).
3. Rank products giving priority to products with higher savings per unit of limiting factor.
4. Allocate the scarce resource until it is fully utilized.
5. Any products with unsatisfied demand can be satisfied by buying from an external source.
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Illustration
A company manufactures four components (L, M, N, and P), which are incorporated into different products. All the
components are manufactured using the same general-purpose machinery. The following information is available.
L M N P
$ $ $ $
Direct material 12 18 15 8
Direct labor 25 15 10 8
Variable overhead 8 7 5 4
Fixed overhead 10 6 4 3
Total 55 46 34 23
Purchase price from outside supplier $57 $55 $54 $50
Hours Hours Hours Hours
Machine hours per unit 3 5 4 6
Manufacturing requirements show a need for 1,500 units of each component per week. The maximum number of general-
purpose machinery hours available per week is 24,000.
What number of units should be purchased from the outside supplier?
OTHER ISSUES TO CONSIDER IN MAKE VS. BUY DECISIONS
1. Reliability of the external supplier
The business should consider whether the outside company can be relied upon to meet the requirements in terms of:
✓ quantity required
✓ quality required
✓ delivering on time
✓ price stability.
2. Specialist skills
The external supplier may possess some specialist skills that are not available in-house.
3. Alternative use of the resource
Outsourcing will free up resources that may be used in another part of the business.
4. Social
The company should consider whether outsourcing will result in a reduction of the workforce, leading to redundancy
costs, which need to be considered.
5. Legal
The business ought to consider whether outsourcing will affect any contractual obligations with suppliers or employees
6. Confidentiality
The business should consider the possibility of loss of confidentiality, especially if the external supplier performs
similar work for rival companies.
7. Customer reaction
Take into consideration whether customers attach importance to the products being made in-house rather than
outsourced ones.
BENEFITS OF OUTSOURCING
1. Greater flexibility
2. Lower investment risk
3. Improved cash flow
4. Concentrates on core competence
5. Enables more advanced technologies to be used without making an investment
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LIMITATIONS OF OUTSOURCING
1. Possibility of choosing the wrong supplier
2. Loss of visibility and control over the process
3. Possibility of increased lead times
FURTHER PROCESSING DECISIONS
Joint products arise where the manufacture of one product inevitably results in the manufacture of other products.
The specific point at which individual products become identifiable is known as the split-off point.
Costs incurred before the split-off point are called joint costs and must be shared between the joint products produced. They
can be shared based on;
a. Sales value of production
b. Production units
c. Net realizable value
NB: NRV should be used in situations where the sales value at the split-off point is not known (either the product is not
saleable or the examiner doesn’t tell us).
Further processing decision
When deciding whether to process a particular product further or to sell after split-off, only future incremental cash flows
should be considered:
i. Any difference in revenue and any extra costs.
ii. Joint costs are sunk at this stage and thus not relevant to the decision. However, if we are considering the
viability of the whole process, then the joint costs would be relevant.
Illustration
A firm makes three joint products, X, Y, and Z, at a joint cost of $400,000. Joint costs are apportioned on the basis of
weight. Products X and Z are currently processed further.
Product Weight at Further processing costs Sales
split-off (variable)
(tons) $000 $000
X 600 800 980
Y 200 – 120
Z 200 400 600
An opportunity has arisen to sell all three products at the split-off point for the following prices.
X $200,000
Y $120,000
Z $160,000
Which of the products (if any) should the firm process further?
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RELEVANT COST OF MATERIAL
All historic cost is always a sunk cost and are never relevant unless it is the same as the current purchase price. In the
diagram, we assume that it is possible to buy more materials if required. This may not always be the case.
If a material is in short supply, then the only way a proposal can be undertaken would be by denying another part of the
organization that resource. Therefore;
Relevant cost = Normal materials cost + Lost contribution in the other department.
RELEVANT COST OF LABOR
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RELEVANT COSTS ASSOCIATED WITH NON-CURRENT ASSETS
The purchase price of any new machinery that needs to be bought is a relevant cost. If an existing machine is to be used in
the project that would otherwise have been sold, then there is an opportunity cost equal to the proceeds foregone.
Scrap/disposal proceeds on new assets bought are also a relevant cost.
If the asset is to be rented (or hired), the rental costs over the period of use are relevant.
If we need to take an existing machine from another department and it is not replaced (either by choice or because a
replacement is not available), then there is an opportunity cost equal to the lost contribution from the other department that
would need to be included.
Depreciation is not a cash flow and, therefore, is never relevant.
Profit or loss on disposal incorporates accumulated depreciation, so it is not relevant. Consider only the cash element (the
scrap proceeds).
The original purchase price of existing machinery is a sunk cost. The NBV of existing machinery is a combination of the
original price (sunk) and accumulated depreciation (not a cash flow).
IMPLICATIONS OF MINIMUM CONTRACT PRICE
When a business is presented with a one-off contract, it should apply relevant costing principles to establish the cash flows
associated with the project in order to help set a price.
The minimum contract price = the total net relevant cash flow associated with the contract
The minimum price is effectively a break-even price; therefore, the firm will neither make a profit nor a loss. If the contract
price does not cover these cash flows, then it should be rejected because the company will make a loss if accepted and vice
versa.
The minimum price may be acceptable for a one-off contract, but not for pricing all contracts or products, because fixed
costs can be ignored when considering one contract.
The minimum price obtained using relevant costing may be much lower than typical market prices. In this case, the firm may
be reluctant to accept this price if it might affect the prices of other contracts in the future.
A company may be willing to accept a loss on this contract if it increases the chances of winning subsequent contracts (albeit
at what price)
end
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