11 - Short Term Planning Decisions

Question 1

How do relevant costs and revenues contribute to sound decision-making?

Answer 1

Both merchandising and manufacturing companies make short-term inventory-planning decisions. Regardless of the type of inventory-planning decisions they make, one factor that these companies consider is the profit impact of the decision. They can determine the profit impact of the decision by analysing relevant costs and revenues.

Question 2

What are relevant costs?

Answer 2

Future costs that will change as a result of a decision.

Question 3

What are sunk costs?

Answer 3

A cost that has already been incurred and that cannot be recovered.

Question 4

What are relevant revenues?

Answer 4

Future revenues that will change as a result of a decision.

Question 5

What types of costs and revenues are relevant to decision-making?

Answer 5

Relevant costs and revenues are future costs and revenues that will change as a result of a decision. If they do not change from one
decision alternative to another, costs and revenues are not considered relevant to the decision.

They will not sway the decision one way or another. By considering only relevant costs and revenues, managers eliminate the possibility of misusing irrelevant information and thereby making incorrect decisions.

To identify relevant costs and revenues, managers first identify the business activities necessary to carry out the decision and then estimate the costs and/or revenues that are affected by these activities. These costs and revenues can include incremental costs and revenues, avoidable costs, and opportunity costs.

Question 6

What are some irrelevant costs?

Answer 6

1. Historical costs
   - Irrelevant to decision
   - Used for predicting future costs
2. Sunk costs
   - Costs already incurred
   - Unavoidable, therefore irrelevant to decision
3. Future costs that do not differ between alternatives
   - Unavoidable, therefore irrelevant to decision

Question 7

What are some relevant costs?

Answer 7

1. Expected future costs & revenues that differ between alternatives
   - Avoidable
   - Eliminated (in whole or part) by choosing one alternative over another

Question 8

What two questions must a manager ask to identify the relevant costs and/or revenues?

Answer 8

1. What activities are necessary for the business to carry out the decision?
2. By how much will the costs and/or revenues be affected if the business undertakes the activities?

Question 9

What two large groups of costs can immediately be eliminated from consideration when understanding which activities are necessary for the business to carry out the decision?

Answer 9

1. No cost incurred prior to making the decision is relevant.
2. Future costs that a business will incur for activities that are not necessary to carry out the decision are not relevant.

Question 10

What are incremental costs?

Answer 10

Cost increases resulting from the performance of an additional activity.

Question 11

What are avoidable costs?

Answer 11

Costs that must be incurred to perform an activity at a given level, but that can be avoided if that activity is reduced or discontinued.

Question 12

What are opportunity costs?

Answer 12

Profits that a business forgoes by following a particular course of action.

Question 13

What is the difference between incremental costs, avoidable costs, and opportunity costs?

Answer 13

Incremental costs are cost increases resulting from a higher volume of activity or from the performance of an additional activity. Avoidable costs are the costs that a business must incur to perform an activity at a given level, but that it can avoid if the business reduces or discontinues the activity. Opportunity costs are the profits that a business forgoes by following a particular course of action rather than an alternative action.

Question 14

How does a business determine when to drop a product?

Answer 14

A business determines when to drop a product by estimating whether the costs that it would not have to incur – that is, the avoidable costs – would be greater than the revenues that it would not earn if production and sale of the product were discontinued.

They would also consider the customer’s interest in the product, its safety record, the impact the product has on the environment, and other similar issues.

Question 15

What is a make-or-buy decision, and what issues does a business consider in this decision?

Answer 15

In a make-or-buy decision, a business’s managers decide whether producing a part would be less costly than purchasing it from an outside supplier.

In making this decision, the business’s managers compare the relevant incremental costs of producing the part with the relevant costs of purchasing the part.

In addition to cost factors, they should consider the quality of the produced part versus the quality of the purchased part, the reliability of the supplier, and the business’s desired long-term business relationship with the supplier.

Question 16

How does a business determine whether to sell a product ‘as is’ or to process it further?

Answer 16

A business determines whether to sell a product or to process it further by comparing the ‘profit’ from selling the product ‘as is’ with the ‘profit’ from using the product as a direct material in the manufacture of another product.

This analysis involves subtracting the relevant costs from the relevant revenues under each alternative and selecting the alternative (sell or process further) that provides the higher ‘profit’.

The business also considers customers’ potential responses to the product when it is processed further, the effects on the environment of processing it further, whether the business’s current or potential employees have the skills to process it further, whether it will have to lay off employees and other similar issues.