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.