Short-Term Decision Making
The sell or process further decision type is mainly applicable to farms and producers of natural resources. These businesses must decide to sell farm products or natural resources as is or turn that inventory into another product. For example, if a farm has an apple orchard, the farm can sell the apples or process the apples into apple sauce, apple pie, apple juice, or apple butter.
When making the decision to sell as is or process further, any costs associated with producing the raw product should be disregarded from the decision making process. Similar to the other short-term decisions we have discussed, these costs are not relevant. Why? Remember that the definition of a relevant cost is a cost that differs among the alternatives. in the case of our apple farm, we have the cost of producing the apples, whether we sell the apples or turn them into another product. Costs incurred to produce the apples should not be considered.
What should businesses consider when making these decisions?
1. How much revenue will the company generate by selling the product unprocessed?
Calculate the total amount of revenue generated by multiplying the number of units by the price per unit.
2. How much revenue will the company generate by processing the product further?
This calculation might be a bit more difficult because the units might change. For example, if a decides to turn apples into apple sauce, it takes more than one apple to make a jar of apple sauce. It might take three apples to make a jar of sauce. Therefore, you must determine how many jars can be produced with the apples you have. Once you know that, you can then multiply by the price to calculate total revenue.
3. How much additional cost will be generated to process the produce further?
Clearly, there are additional costs associated with turning apples into apple sauce. Additional ingredients, packaging, labor, and equipment are required. All of these items mean additional costs. Total the costs associated with processing the product further.
Subtract the costs associated with processing from the revenue that could be generated from selling the processed product. Compare your net profit from the processed product to the revenue that could be generated from the raw product. Choose the option that will generate the most profit.
Let’s look at an example.
Seeds Farm, Inc. produces apples which it sells to local grocery stores. The Farm is considering turning the apples into apple butter. The local grocery stores have stated that they would be willing to pay $2.35 per jar of apple butter. The Farm produces 750,000 apples per year and sells them to the grocery stores for 15 cents each. The apples cost $90,000 to produce. Each jar of apple butter would require 5 apples. Additional costs related to the production is estimated to be $1.25 per jar. Should Seeds Farm sell the apples as is or convert the apples to apple butter?
We need to consider each of the alternatives: selling apples or making apple butter. Is any of the information in the problem irrelevant? Yes, the cost of producing the apples. Whether Seeds Farm sells the apples or sell apple butter, they will need to pay to produce the apples. Since the $90,000 is common to both alternatives, it is irrelevant.
Let’s look at how much revenue the Farm will generate if the apples are sold as is.
750,000 apples X .15 per apple = $150,000
Since the apples are being sold as is, there are no additional costs associated with this revenue.
Now let’s compute how much could be made if Seeds Farm produces apple butter. First, we will look at the revenue. Since it takes 5 apples to make each jar, figure out how many jars can be produced first.
750,000 apples / 5 apples per jar = 150,000 jars
Calculate the total revenue based on 150,000 jars.
150,000 jars X $2.35 per jar = $352,500
That is a lot more revenue, but remember there are also costs associated with generating that revenue.
150,000 jars X $1.25 per jar = $187,500
$352,500 – $187,500 = $165,000 net profit
Finally, compare your results:
The farm will make more money if it makes apple butter than if it sells apples.
Outsourcing is a hot topic in business right now. Outsourcing is when a company decides to purchase a product or service from another company rather than make the product or perform the service itself. Many companies outsource components or even their entire product to another manufacturer. When companies make the decision to outsource, there are a lot of considerations. In this post, we will look at the quantitative factors that should be considered when making outsourcing decisions. Don’t forget that there are many qualitative factors such as quality and customer experience that should also be considered as part of the final decision.
The quantitative factors for make or buy and outsourcing decisions are very similar to the factors considered for keep or drop decisions. Here are some factors you should consider:
1. Compare the variable costs to the outsourced price
With make or buy decisions, we will once again use a contribution margin approach. Separate variable product costs from fixed product costs. How do the variable costs of producing the product compare to the cost of purchasing the product from another company. At first glance, it may appear that the cost of the outsourced product is higher because the variable costs of making the product are lower. However, all costs should be considered.
2. Can fixed costs be reduced if production is outsourced?
Typically, fixed costs are the determining factor in outsourcing decisions. When fixed costs are avoidable, typically the company can save money by outsourcing. However, when fixed costs cannot be avoided, the company is paying to have the product made at a higher cost than the variable costs, plus it is still incurring all of the fixed costs it would have had if the product was still being made in-house. Look to see which, if any fixed costs can be reduced or eliminated.
Once you have identified the costs that cannot be eliminated, those costs are irrelevant to your decision. Remember that relevant costs are costs that differ among the alternatives. Therefore, if a fixed cost will be paid whether or not the company outsources, it is irrelevant. When calculating the current cost to make the product, add any fixed costs that can be eliminated to the variable costs identified in step 1. This total is the controllable cost. Compare this cost to the outsource cost. If the controllable cost is lower than the outsource cost, the company should consider continuing to make the product. If the controllable cost is more than the outsource cost, it might be wise to outsource.
3. Are there alternative uses for freed capacity?
Similar to keep or drop decisions, companies should look for ways to use freed capacity. If the company decides to outsource a component, will that free up space and manpower to make more units of the primary product? Additional units means additional revenue or other ways to minimize costs. For example, maybe the company is paying for a lot of overtime because of space limitations. By outsourcing a component, that frees up space and labor, allowing the company to reduce overtime. Idle capacity means costs being paid without the potential for revenue generation. Companies should look to minimize capacity that is not in use.
If there are no alternative uses for the freed capacity and fixed costs cannot be reduced, it most likely does not make sense to outsource. Outsourcing should only be used if overall costs can be reduced and if there are no qualitative factors that outweigh the cost savings.
Resources are finite. A business only has so many man hours, so many square feet, and so much machinery. Over the long term, a company can expand its capacity but in the short term, it must make important decisions in order to maximize profit. Constrained resources require businesses to make decisions about which products to make and in what quantities.
How does a company decide which product is given priority over constrained resources? We must look at how each product uses the constrained resource and maximize contribution margin per hour. Let’s look at an example.
Example #1 – Unlimited Demand
KLI Desks, Inc. makes two types of office desks, Executive and Standing. Both desks require time in the Painting Department, but there are only 172 hours per month available currently in that department. The company can sell as many of each desk as it can make. What is the optimal product mix that would maximize profit each month?
At first glance, it would be tempting to make the standing desk, since it has a higher contribution margin per unit, but with the constraint of the painting department hours will that give KLI Desks the highest monthly contribution margin? To determine if that is true, we don’t need to calculate the contribution margin for all 172 hours. We just need to calculate the contribution margin for one hour for each product and determine which is higher.
If the Executive desk takes 15 minutes to paint, we can make 4 per hour (60/15). We can make 3 of the Standing desk per hour (60/20). Multiply the number of desks that can be made each hour by the contribution margin per desk.
Although the Executive Desk has a lower contribution margin per unit, the increased product per hour results in a higher contribution margin per hour. Therefore, we would only produce Executive desks.
What if demand for the desks was limited?
Example #1 – Limited Demand
KLI Desks, Inc. makes two types of office desks, Executive and Standing. Both desks require time in the Painting Department, but there are only 172 hours per month available currently in that department. The company can only sell 500 of each desk per month. What is the optimal product mix that would maximize profit each month?
This example is a bit different than the last example because we cannot sell an unlimited number of desks. We can only sell 500 of each desk per month. Therefore, we do not want to make more than 500 of either desk. We know from the previous problem that we should make Executive desks first. How many hours would it take to make 500 Executive desks?
500 desks / 4 desks per hour = 125 hours required
There are 172 hours available each month which means we can make some Standing desks but how many?
172 total hours – 125 hours for Executive desks = 47 hours remaining
47 hours X 3 Standard desk per hour = 141 Standard desks
We can make 500 Executive desks and 141 Standard Desks to maximize profit. This is only because we can not sell more than 500 of either desk per month.
When working with optimal product mix, determine which product will give you the highest contribution margin per hour of constrained resource. Then look to see if there are other constraints, for example, a limit to the number of units of either product that could be sold.
Optimal Product Mix
Sometimes when a business sees that a product, department, or location is losing money, the first reaction is to shut it down. Discontinuing operations is a decision that should only be taken after careful consideration and number crunching.
When deciding to keep or drop a part of the company, the first thing to do is to create an income statement broken into segments. For example, if a product is unprofitable, create a product line income statement. If there is a location that is not profitable, create an income statement for that location. Use a contribution margin income statement to separate variable costs from fixed costs.
This is the kind of income statement that would make a company think about dropping a product. Overall, the company has a loss of $4,000 and it appears that Product A has a $38,000 loss. On the surface, it might look like dropping Product A and only producing Product B would result in a profit of $34,000. But is that correct?
Here are some things to consider when evaluating if a company should keep or drop a segment (product, department, or location):
1. Does the segment have a positive contribution margin?
If we look at Product A, it does have a positive contribution margin. This is important because the product is covering all of it’s variable costs and it is contributing toward foxed costs. While the contribution margin is not high enough to cover all of the fixed costs, increasing sales of Product A would increase contribution margin and lower the loss.
If the segment has a positive contribution margin, continue the evaluation.
2. Can any of the fixed costs be avoided if the segment was discontinued?
There are two types of fixed costs that should be considered, direct fixed costs and common fixed costs.
Direct fixed costs are fixed costs that can be directly traced to the segment. Just because a fixed cost is direct does not mean that it is avoidable. There may be depreciation, contractual obligations, and other costs that the company will not be able to cut even if the segment is discontinued. If the fixed costs cannot be avoided, losses will increase if the segment is discontinued because the segment will no longer be contributing to the total contribution margin.
Common fixed costs are organization sustaining fixed costs that are allocated to the segment. These fixed costs will continue even if the segment has been eliminated; they will just be allocated to the remaining segments.
Let’s say, in our example, that none of the direct fixed costs are avoidable. What happens to the loss if Product A is discontinued?
Since there are no longer sales from Product A, we eliminate the revenue and the variable costs from Product A. We also lose $85,000 in contribution margin that was helping to offset some of the fixed costs. The loss increased by $85,000 (the amount of contribution margin that was eliminated). What would happen if we could eliminate all of the direct fixed expenses?
If all of the direct fixed costs could be eliminated, now we see positive results. Notice that the common fixed cost is still $99,000.
Make sure to carefully examine fixed costs to see which, if any, could be cut.
3. Can the freed up capacity be used for another purpose?
If the segment was discontinued, could the company use the machinery and employees for another purpose? Could the company make additional units of another product or make a new product? Assessing these alternatives helps the company decide if there is something more profitable it could do instead. Idle capacity makes it less likely that fixed costs could be eliminated.
4. Will discontinuing a segment have adverse effects on the sale of other products?
Imagine that Product A is a cereal bowl and Product B is a matching plate. Do you think that discontinuing Product A would hurt the sales of Product B? I think it would. Before discontinuing a product make sure that sales of remaining products would not be adversely affected.
Let’s say that we could eliminate all the direct fixed costs from Product A but sales of Product B would fall 15%. Should we drop Product A? If we remove Product A and it’s direct fixed costs but lower the sales and variable costs of Product B by 15%, the results are not good.
The loss is larger now than it was when the company was making Product A. The negative impact on sales of Product B outweighs the savings from discontinuing Product A.
Make sure to look at the adverse effects on other segments of the company before deciding to drop a segment.
When deciding if a company should drop an unprofitable segment, the company should create a segment contribution margin income statement. If the contribution margin is positive, the company should consider direct and common fixed costs, what to do with freed capacity, and the effect on sales of other products.
Keep or Drop Decision Making
When launching a new product or service, one of the hardest decisions a business must make is the price of the product. Every other component of the product launch could be perfect, but if the price is too high, customers won’t buy. If the price is too low, the company may sell a lot of product but won’t be maximizing profit.
How does a company decide how to price its product? First, the company must take three things into consideration:
1. Is the company a price-maker or a price-taker?
A price-marker is a company that can set its prices. Typically, the product is more unique and there is less competition. One of the most famous price-makers is Apple. Apple does not fit the traditional definition of a price-maker. There is a lot of competition in the cell phone, tablet, and computer markets and there are lots of similar products on the market. What makes Apple unique is its brand loyalty. Many Apple fans would never consider purchasing a non-Apple product. The customer believes that Apple’s products are unique, and therefore, would not consider the alternatives that are on the market. That allows Apple to charge higher prices for its products. Price-makers typically use a cost-plus pricing approach. Cost-plus pricing is when the company calculates the cost of its product and adds a percentage mark-up to cover operating expenses and profit.
A price-taker is a company that has little control over its prices. Typically, the product is not unique and/or there is a lot of competition. Most commodities, like gasoline and milk, are price-takers. When searching for gasoline to fill up our cars, we typically look for the gas station with the lowest price. Most people are very sensitive about gasoline and will use apps on their phones to search out the lowest price in their area. Price-takers must use a target costing approach to pricing. Target costing forces a company to look at its desired profit, the price the market will bare, and attempt to cut costs to achieve the profit desired.
2. What is the desired company profit?
All businesses have profit pressures. Owners demand a return on their investment, whether the company is large or small. In small businesses, profit determines the owner’s salary. That salary is what the owner takes home to support his or her household. Most small business owners know how much they need to bring home, and therefore, how much profit their business needs to make. Publicly traded companies have target profit projections to keep share price up and to pay dividends (if applicable). If companies miss these target profit projections, it could affect the share price and shareholder willingness to purchase or hold stock in the company.
3. How much will customers pay?
Even if a company is a price-maker, there is a price point at which customers will start to question the value they are receiving, and sales will decline. Companies are looking for a sweet spot to maximize profits, where price and demand are at their highest points to generate the most revenue.
Cost-plus pricing is what most of us think of when we think of setting the price for a product. Price-makers compute total costs, add desired profit and calculate the amount of revenue needed to hit their projections.
Once total desired revenue is calculated, the company can divide total revenue by the number of units it projects it will sell to calculate price per unit.
While there may be some pricing pressures, price-makers have much more control over final pricing decisions.
Target costing is an approach where a price-taker must control costs. Therefore, the calculation looks a bit different than that you are familiar with. Typically, we say that revenue less expenses is profit. When doing target costing calculations, we have no control over price and little control over desired profit. Therefore, we must learn to control costs. That causes us to look at the calculation a bit differently. Rather than profit being the result of the calculation, cost is the result:
Notice that, in this case, we are using the two things we have little control over, revenue and desired profit, to calculate the item that we do have control over, cost. On paper, this looks a lot easier than it is. A company’s desire to cut costs could lead to lower quality and poor customer service which could lower revenue and create a vicious downward spiral. It is important to look at costs and quality when using the target costing approach to pricing.
Rather than cutting costs, the company could also decide other approaches. The company could try to differentiate itself from competitors. We see this time and time again from companies that sell bottled water. Water is water, right? Many companies have convinced us that it is not. A second approach would be to accept a lower profit. This approach might not work for the long term but could be a good short-term strategy while looking at other alternatives.
When setting price, it is important to understand where the company fits in the marketplace. If the company is a price-maker, it should use the cost-plus approach. If the company is a price-taker, the target costing approach should be used.