Lecture 8 - Relevant Costing Flashcards
What are short term decisions?
Short term:
- Cost and inputs normally do not vary
- E.g. equipment or leases
- Less likely to have a lasting implication on future profitability
- E.g. special orders, make or buy, product mix
Long term decisions
Decisions made under little/no constraints – all costs/inputs can potentially be varied.
- Likely to have major lasting implications on future profitability.
E.g. long run pricing, activity-based management, outsourcing.
What is relevant costs?
The costs that differ between alternatives.
Relevant costs/revenues are those expected in the future that differ between alternatives.
- Costs that are already incurred or committed to/revenue earned promised is not relevant.
- SUNK COSTs.
And costs that are the same across all alternatives don’t need to be considered.
e.g. Decision to buy a new house, the percentage of land tax will be the same between alternatives.
List 4 qualitative factors that are relevant.
- Quality of your products/services
- Strategic implications to your business (e.g. creation of new competitors; positive impact of getting new/large customer)
- Brand management
- Customer relationships
- Employee relationship/morale
Always take into account – specific ‘internal’ considerations.
What is a special order?
When a company faces the decision whether to accept or reject a special order to sell products/services to a customer, that they typically do not service.
Key attributes:
- One-off
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Usually no impact on long-run demand or pricing from your regular customers because it is a one-time order that is from outside normal market/channels.
- Could have long run implications (e.g. if order is fulfilled well, could lead onto future special sales)
- Usually uses idle capacity to fulfil special order.
If no excess capacity, management must decide between regular vs special order, and the opportunity costs associated with this.
Relationship between special order and fixed costs.
Typically, fixed costs are (sunk) thus not normally relevant.
- In short run cannot change capacity – thus will not differ between alternatives.
However,
- Special orders may require additional fixed costs
E.g. special equipment to fulfil the order.
What is the lowest acceptable price for a special order?
Lowest acceptable price (per unit) = price that would make you indifferent between accepting vs not accepting the special order.
Excess capacity:
Lowest price with excess capacity = incremental cost/unit = variable cost/unit (since fixed cost is usually unchanged)
Without excess capacity:
- Need to drop a regular order
- Lowest acceptable price = price that would give the same total CM as the least profitable regular order
- Assuming you drop the least profitable.
E.g. CM =$1,000 = (Price-VC/unit) * units sold
4 Qualitative factors of special orders
- SO may have a positive reputational impact if one-off customer is a big player in the marketplace (long term relationship)
- SO may adversely affect existing customer relationships if they find out that special order was priced lower than regular orders
- (is not a relevant consideration if the exam says no long run price implications)
- SO may adversely affect existing relationship with regular customers whose orders had to be dropped to fulfil the SO (if no excess capacity)
- The increase in capacity utilisation by taking on a SO may improve morale of employees.
Decision between make or buy (outsourcing).
What part of the cost is relevant?
For outsourcing (a long-term decision, due to contract)
- Typically both fixed and variable costs are relevant
For make or buy (a short term decision)
- Typically, only variable costs
- FC are already paid à do not differ between alternative.
This decision also involves opportunity cost if the firm is operating at full capacity.
- i.e. CM + opportunity cost of producing internally rather than buying.
Is depreciation a relevant cost?
Depreciation is not typically considered a relevant cost, as it is not a future cost.
However can be relevant if the expense is a good indicator of how much it would cost to replace the equipment, if it is no longer required due to outsourcing (so long as it is not required by the alternative production)
Why would a firm be willing to accept a higher price for long-term outsourcing compared to the ‘make or buy’ decision?
As outsourcing is long term, it involves all costs (fixed – depreciation)
- Therefore, these costs can be changed (i.e. driven to 0)
- In addition,
- labour: contracts re-negotiated
- rent: downsize operations
- depreciation: Not a future cost (therefore not relevant)
However, the depreciation expense could be an indicator of how much it would cost to replace the equipment (and should be factored in)
5 qualitative factors for make or buy/ outsourcing.
-
Quality of products supplied by the external entity
- Warranty - What happens if the wheel fails?
-
Reliability and timeliness: Ability for external supplier to deliver on time
- Logistics – shipping overseas.
-
Reputational risk impact (if any) on existing customers if they found out that we do not make the (major/important) components ourselves
- E.g. Nike – child labour
- Long-term competitor
- Can increase motivation for employees (allow them to focus on more interesting processes) – own employees don’t have to do mechanical work.
What is a product mix decision?
Why does it exist?
Identifying the mix of products, we want to produce.
The decision arises due to capacity constraints (which cannot be resolved in the short term)
- E.g. limited labour hours, limited machine hours.
Which products would you want to sell/priorities?
The products with the highest contribution margin, per the unit of constraint.
- Therefore, highest CM is not always the top priority, especially if it uses a significant amount of the constrained resource.
4 qualitative factors to consider for product mix
- Customers – deprioritised
- Strategy – How important are these customers? (long term repercussions, brand perception)
- Product – is the prioritised product easy to sell?
- Structural constraints
