Chapter 23:
Short-Run Decision Making:
Relevant Costing and Inventory
Management
Financial and Managerial Accounting:
The Cornerstones of Business Decisions, 2e
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1
Short-Run Decision Making
► Short-run decision making consists of choosing among
alternatives with an immediate or limited end in view.
► Accepting a special order for less than the normal selling price
to utilize idle capacity and to increase this year’s profits is an
example.
► Thus, some decisions tend to be short run in nature.
► However, it should be emphasized that short-run decisions
often have long-run consequences.
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1
The Decision-Making Model
► A decision model, a specific set of procedures that produces a
decision, can be used to structure the decision maker’s thinking and
to organize the information to make a good decision.
► The following is an outline of one decision-making model.
► Step 1. Recognize and define the problem.
► Step 2. Identify alternatives as possible solutions to the problem. Eliminate
alternatives that clearly are not feasible.
► Step 3. Identify the costs and benefits associated with each feasible
alternative. Classify costs and benefits as relevant or irrelevant, and eliminate
irrelevant ones from consideration.
► Step 4. Estimate the relevant costs and benefits for each feasible alternative.
► Step 5. Assess qualitative factors.
► Step 6. Make the decision by selecting the alternative with the greatest
overall net benefit.
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1
Relevant Costs Defined
► The decision-making approach just described emphasized the
importance of identifying and using relevant costs.
► Relevant costs possess two characteristics:
►(1) they are future costs AND
►(2) they differ across alternatives.
► All pending decisions relate to the future.
► Accordingly, only future costs can be relevant to decisions.
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1
Opportunity Costs
► Another type of relevant cost is opportunity cost.
► Opportunity cost is the benefit sacrificed or foregone when
one alternative is chosen over another.
► Therefore, an opportunity cost is relevant because it is both a
future cost and one that differs across alternatives.
► While an opportunity cost is never an accounting cost,
because accountants do not record the cost of what might
happen in the future (i.e., they do not appear in financial
statements), it is an important consideration in relevant
decision making.
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1
Sunk Costs
► A sunk cost is a cost that cannot be affected by any future
action.
► It is important to note the psychology behind managers’
treatment of sunk costs.
► Although managers should ignore sunk costs for relevant
decisions, such as whether or not to continue funding a
particular product in the future, it unfortunately is human
nature to allow sunk costs to affect these decisions.
► For example with depreciation, we allocate this sunk cost to
future periods yet none of the original cost is avoidable.
► In choosing between the two alternatives, the original cost of
equipment and their associated depreciation are not relevant
factors.
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2
Some Common Relevant Cost
Applications
►Relevant costing is of value in solving many different
types of problems. Traditionally, these applications
include decisions:
►to make or buy a component.
► to keep or drop a segment or product line.
►to accept a special order at less than the usual price.
► to further process joint products or sell them at the splitoff point.
►Though by no means an exhaustive list, many of the
same decision-making principles apply to a variety of
problems.
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2
Make-or-Buy Decisions
► Managers often face the decision of whether to make a particular
product (or provide a service) or to purchase it from an outside
supplier.
► Make-or-buy decisions are those decisions involving a choice
between internal and external production.
► One type of relevant cost that is becoming increasingly large due to
globalization and the green environmental movement concerns the
disposal costs associated with electronic waste (or e-waste).
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2
Special Order Decisions
► From time to time, a company may consider offering a product or
service at a price different from the usual price. Prices can vary to
customers in the same market, and firms often have the
opportunity to consider special orders from potential customers in
markets not ordinarily served.
► Special-order decisions focus on whether a specially priced order
should be accepted or rejected.
► These orders often can be attractive, especially when the firm is
operating below its maximum productive capacity.
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2
Keep-or-Drop Decisions
► Often, a manager needs to determine whether a segment,
such as a product line, should be kept or dropped.
► Segmented reports prepared on a variable-costing basis
provide valuable information for these keep-or-drop
decisions.
► Both the segment’s contribution margin and its segment
margin are useful in evaluating the performance of segments.
► However, while segmented reports provide useful
information for keep-or-drop decisions, relevant costing
describes how the information should be used to arrive at a
decision.
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2
Further Processing of
Joint Products
► Joint products have common processes and costs of
production up to a split-off point.
► At that point, they become distinguishable as separately
identifiable products.
► The point of separation is called the split-off point.
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3
Product Mix Decisions
► Most of the time, organizations have wide flexibility in
choosing their product mix.
► Product mix refers to the relative amount of each product
manufactured (or service provided) by a company.
► Decisions about product mix can have a significant impact on
an organization’s profitability.
► Every firm faces limited resources and limited demand for
each product.
► These limitations are called constraints.
► A manager must choose the optimal mix given the constraints
found within the firm.
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4
Cost-Based Pricing
► Demand is one side of the pricing equation; supply is the other side.
► Since revenue must cover all costs for the firm to make a profit,
many companies start with cost to determine price.
► That is, they calculate product cost and add the desired profit.
► The mechanics of this approach are straightforward. Usually, there
is a cost base and a markup.
► The markup is a percentage applied to the base cost.
► It includes desired profit and any costs not included in the base
cost.
► Companies that bid for jobs routinely base bid price on cost.
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4
Target-Costing and Pricing
► Many American and European firms set the price of a new
product as the sum of the costs and the desired profit. The
rationale is that the company must earn sufficient revenues
to cover all costs and yield a profit.
► Target costing is a method of determining the cost of a
product or service based on the price (target price) that
customers are willing to pay.
► The marketing department determines what characteristics
and price for a product are most acceptable to consumers.
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5
Inventory-Related Costs
► If the inventory is a material or good purchased from an
outside source, then these inventory-related costs are known
as ordering costs and carrying costs.
► If the material or good is produced internally, then the costs
are called setup costs and carrying costs.
► Ordering costs are the costs of placing and receiving an order.
► Carrying costs are the costs of keeping and storing inventory.
► Stockout costs are the costs of not having a product available when
demanded by a customer or the cost of not having a raw material
available when needed for production.
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5
Traditional Reasons for Carrying
Inventory
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Just-in-Time Approach to Inventory
5
Management
►The just-in-time (JIT) approach maintains that goods
should be pulled through the system by present
demand rather than being pushed through on a fixed
schedule based on anticipated demand.
►The material or subassembly arrives just in time for
production to occur so that demand can be met.
►Fast-food restaurants use this type of pull system.
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5
Comparing JIT and Traditional Inventory
Approaches: Lower Cost of Inventory
►Traditionally, inventories are carried so that a firm can
take advantage of quantity discounts and hedge against
future price increases of the items purchased.
►The objective is to lower the cost of inventory.
►JIT achieves the same objective without carrying
inventories, through long-term contracts with a few
chosen suppliers located as close to the production
facility as possible.
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5
Limitations of Just-in-Time
Approach
►JIT does have limitations.
►It is often referred to as a program of simplification—
yet this does not imply that JIT is simple or easy to
implement.
►It requires time for building sound relationships with
suppliers, insistence on immediate changes in delivery
times and quality, causes a regimented workflow and
high levels of stress among production workers, and
thorough planning and preparation.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.