⏱️Managerial Accounting Unit 10 – Short–Term Decision Making

Key Concepts

• Short-term decision making involves analyzing costs and benefits to make informed choices
• Relevant costs and benefits are those that differ between alternatives and impact the decision
• Fixed costs remain constant regardless of activity level while variable costs change proportionally
• Contribution margin represents the amount each unit sold contributes to covering fixed costs and generating profit
• Break-even point is the sales volume at which total revenue equals total costs, resulting in zero profit
• Sensitivity analysis assesses how changes in key variables (selling price, variable costs) affect profitability
• Opportunity costs represent the forgone benefits of choosing one alternative over another
• Sunk costs are irrelevant for decision making as they have already been incurred and cannot be changed

Cost Behavior Analysis

• Classifying costs as fixed or variable is crucial for understanding how they behave with changes in activity level
• Fixed costs (rent, salaries) remain constant within a relevant range of activity
• Variable costs (materials, commissions) change in direct proportion to the level of activity
• Mixed costs contain both fixed and variable components (utilities with a base charge and usage fee)
• High-low method uses the highest and lowest activity levels to estimate fixed and variable costs
• Scattergraph method plots costs against activity levels to visually identify the fixed and variable components
• Regression analysis uses statistical techniques to determine the best-fit line for cost behavior
  • Provides more accurate estimates than the high-low method by considering all data points

Relevant Costs and Benefits

• Relevant costs are future costs that differ between alternatives being considered
• Irrelevant costs are those that remain the same regardless of the decision made
• Opportunity costs are relevant as they represent the forgone benefits of the next best alternative
• Sunk costs are irrelevant as they have already been incurred and cannot be changed by the decision
• Incremental costs and benefits are the additional amounts incurred or earned by choosing one alternative over another
• Avoidable costs can be eliminated by not pursuing a particular course of action
• Unavoidable costs will be incurred regardless of the decision made and are thus irrelevant
  • Include committed costs (long-term lease agreements) and sunk costs

Break-Even Analysis

• Break-even point is the sales volume at which total revenue equals total costs, resulting in zero profit
• Calculated using the formula: $Break-even\ quantity = \frac{Fixed\ costs}{Selling\ price\ per\ unit - Variable\ cost\ per\ unit}$
• Contribution margin per unit is the difference between selling price and variable cost per unit
• Break-even analysis assumes a linear cost function, constant selling prices, and stable product mix
• Helps determine the minimum sales volume required to avoid losses and assess profitability at different activity levels
• Margin of safety is the excess of actual or budgeted sales over the break-even volume
  • Represents the buffer against unexpected declines in sales or increases in costs
• Target profit analysis extends break-even analysis to determine the sales volume needed to achieve a desired profit level

Contribution Margin Approach

• Contribution margin is the amount each unit sold contributes to covering fixed costs and generating profit
• Calculated as selling price per unit minus variable cost per unit
• Contribution margin ratio expresses the contribution margin as a percentage of sales
  • $Contribution\ margin\ ratio = \frac{Contribution\ margin\ per\ unit}{Selling\ price\ per\ unit}$
• Helps prioritize products or services with higher contribution margins to maximize profitability
• Facilitates cost-volume-profit (CVP) analysis to assess the impact of changes in sales volume, selling prices, or costs on profitability
• Assists in making decisions such as accepting special orders, make-or-buy, or product mix optimization
• Contribution margin income statement separates fixed and variable costs to highlight the contribution margin

Decision-Making Scenarios

• Special order decisions involve evaluating whether to accept a one-time order at a discounted price
  • Relevant costs include incremental production costs and opportunity costs of using limited capacity
• Make-or-buy decisions compare the costs of producing in-house versus purchasing from an external supplier
  • Relevant costs include variable production costs, incremental fixed costs, and any opportunity costs
• Product mix decisions optimize the allocation of limited resources to maximize overall profitability
  • Rank products based on their contribution margin per unit of the constrained resource
• Sell-or-process-further decisions evaluate whether to sell a product at its current stage or process it further
  • Relevant costs include incremental processing costs and the opportunity cost of selling at the current stage
• Pricing decisions consider the impact of price changes on demand, revenue, and profitability
  • Elasticity of demand measures the responsiveness of quantity demanded to changes in price

Limitations and Considerations

• Short-term decision making focuses on the near future and may not consider long-term strategic implications
• Cost behavior assumptions (linearity, relevant range) may not always hold true in reality
• Non-quantitative factors (quality, customer satisfaction) are difficult to incorporate into the analysis
• Sensitivity analysis is crucial to assess the impact of changes in key assumptions on the decision outcome
• Opportunity costs can be subjective and challenging to quantify accurately
• Sunk costs may influence decision makers psychologically, leading to the sunk cost fallacy
• Incremental analysis may not capture the full picture, especially when considering multiple products or services
• Interdependencies between products or departments can complicate the analysis and require a more holistic approach

Practical Applications

• Pricing decisions for new products or services considering costs, competition, and target profit margins
• Outsourcing decisions for components or services based on cost comparisons and strategic considerations
• Capacity expansion decisions evaluating the incremental costs and benefits of adding new equipment or facilities
• Product line profitability analysis to identify and prioritize high-margin products for resource allocation
• Cost reduction initiatives focusing on areas with the highest potential for savings without compromising quality
• Production planning and scheduling based on contribution margins and resource constraints
• Performance evaluation and incentive systems incorporating contribution margin targets and efficiency measures
• Capital budgeting decisions incorporating opportunity costs and sunk costs appropriately