Chapter 6

1. Chapter 6 Decision Making in the Short Term

2. Features of Short-term Decisions Not possible to change capacity levels in the short term Capacity cost is committed (i.e., fixed) and not controllableover this horizon In long-term, we pick capacity level based on pattern of expected demand Best strategy accounts for the opportunity cost of excess supply and excess demand Actual demand may lead to excess demand or to excess supply Short-term goal is to put available capacity to best use Maximize contribution margin derived from available capacity LO1: Understand the factors that trigger short term decisions

3. Demand Supply Imbalance LO1: Understand the factors that trigger short term decisions

4. Long-term Linkages • Firms anticipate the imbalance • Increase controllability of some costs by changing cost structure (e.g., outsourcing) • Manage demand volatility (e.g., seasonal pricing, adding off-cycle products) • “Move” capacity across period (e.g., store inventory) • Yet, some imbalance is inevitable LO1: Understand the factors that trigger short term decisions

5. Contexts for Short term Decisions LO1: Understand the factors that trigger short term decisions

6. The maximum volume of activity that a company can sustain with available resources is capacity. This is a long-term business decision for management. Test Your Knowledge! Capacity is best demonstrated in which of the following? • The raw materials available to management at any point in time • The maximum inventory that can be sold in a given year • The maximum volume of activity that a company can sustain with available resources • The total inventory available to sell in any given period

7. Application: Culinary Creations • Calculate bid to serve charity dinner at $26 per meal • Wednesday • 150 meals served • No loss of regular business • Excess supply • Saturday • 200 meals served • Will lose 120 regular clients that pay $36 per meal • Excess demand LO1: Understand the factors that trigger short term decisions

8. Culinary Creations: Cost Data • Using the high-low method, calculate • Variable cost as $12.50 per meal • Fixed cost per quarter as $131,250 LO1: Understand the factors that trigger short term decisions

9. $37,500 1 3,000 2 $12.50 3 $243,750 4 $112,500 5 6 $131,250 1 $243,750 - $206,250 = $37,500 2 9,000 – 6,000 = 3,000 persons 3 $37,500 / 3,000 = $12.50 4 $243,750 5 $12.50 x 9,000 = $112,500 6 $243,750 – 112,500 = $131,250

10. Calculate Incremental Value LO1: Understand the factors that trigger short term decisions

11. Opportunity Costs Differ • Wednesday • Excess capacity exists • Can do charity dinner without sacrificing other revenue • Opportunity cost of capacity used = 0 • Saturday • There is excess demand for capacity • Charity dinner means cutting back on regular business • Opportunity cost of capacity used is positive (lost contribution) LO1: Understand the factors that trigger short term decisions

12. Alternate: Relevant Cost Analysis • Can also analyze the problem by focusing on relevant costs • Use Wednesday as baseline and evaluate Saturday LO2: Evaluate decision options using alternate approaches

13. It costs less in total variable costs if we cater on Saturday because Culinary serves 70 fewer customers. ($3,020) – ($875) x $26 = $1,300 (120) x = ($4,320) $625 x $12.50 = $1,500 ($875) ($2,145)

14. Gross and Incremental Approach • Two equivalent approaches for evaluating decision option • Incremental or differential approach: Using one option as benchmark, add incremental costs and benefits to determine incremental value • Totals or Gross approach: Add costs and benefits for every option to determine total value. LO2: Evaluate decision options using alternate approaches

15. LO2: Evaluate decision options using alternate approaches

16. Gross Approach Compare value of π1 = [(A+B)-(D+E)] and π2 = [A+C)-(D+F)] Choose decision alternative 2 if π2 > π1, or (C-B) – (F-E) > 0. Incremental Approach (using alternative 1 as the benchmark) Choose decision alternative 2 if π2 - π1 = (C-B) – (F-E) > 0. LO2: Evaluate decision options using alternate approaches

17. Application: Superior Cereal • Let us apply the two approaches to the same problem • Superior Cereal • Has 50,000 unsold boxes; two options considered • Emphasize institutional sales • Sell 25,000 at regular price of $2 per box , 25,000 to institutions at $1 per box • Give rebate • Sell 23,000 at regular price, 22,000 with rebate of $0.50 per box and 5,000 to institutions. Campaign costs $5,000 • Which is the better option? LO3: Solve short-term decisions such as make versus buy and special-order pricing

18. GROSS APPROACH LO3: Solve short-term decisions such as make versus buy and special-order pricing

19. INCREMENTAL APPROACH LO3: Solve short-term decisions such as make versus buy and special-order pricing

20. Example: Make vs. Buy • Premier Piston Rings • Can buy 25 jigs from vendor at $6,500 per jig • Can make jigs internally • 200 machine hours per jig • Materials $4,000 per jig • Tooling costs $25,000 • Has spare capacity of 3,750 machine hours • Makes 8 rings per hour with contribution of $5 per ring • Excess demand situation • Need 5,000 hours ….only have 3,750 hours! LO3: Solve short-term decisions such as make versus buy and special-order pricing

21. Using Incremental Approach • Notice the lost contribution from rings not made • This is the opportunity cost of the capacity used to make the jigs

22. ($4,000) 1 $33,000 2 ($20,000) 3 $9,000 0 $9,000 $4,000 1 Incremental revenue from supermarket sales – full price $2 x ($2,000) = ($4,000) 2 Incremental revenue from supermarket sales – rebate $1.50 x 22,000 = $33,000 3 Institutional sales = $1 x (20,000) = ($20,000)

23. $50,000 1 $162,500 $0 $100,000 $0 2 $0 $25,000 1 $5 x 10,000 rings 2 $4,000 x 25 jigs

24. Rationing Scare Resource • Must “ration” capacity among competing demands • Opportunity cost of capacity is the contribution from the demand not filled • Approach with one binding resource • Rank order demands by CM per unit capacity • Give priority to demands with higher CM per unit capacity LO4: Determine the best use of a resource in short supply.

25. Theory of Constraints • Use linear programming if there are multiple constraints • Idea is similar to Theory of constraints • Popularized by Eli Goldratt • Identify the bottleneck process (the constraint) and manage it! LO4: Determine the best use of a resource in short supply.

26. Allocating Resource: Aero Toys • Cannot fill the demand • Need 12,000 production hours • Must ration capacity among products LO4: Determine the best use of a resource in short supply.

27. Contribution Per Unit Resource Panel A: Determine Contribution Per Unit of Scarce Resource LO4: Determine the best use of a resource in short supply.

28. Allocate Capacity Panel B: Allocation of Time Among Products LO4: Determine the best use of a resource in short supply.

29. For short term decisions, special orders required additional production and take care of excess supply. Test Your Knowledge! Which of the following short-term decisions deal with excess capacity? • Special order • Product mix • Make or buy • Increasing prices

30. Qualitative Issues Short-term decisions may have long-term consequences Quality Business development Technological capability Often, qualitatively considered LO5: Consider the qualitative and longer-term aspects of short-term decisions

31. Non-financial Considerations LO5: Consider the qualitative and longer-term aspects of short-term decisions

32. Appendix A Joint Cost Allocations

33. What are Joint Costs? • Products and services produced simultaneously from the same input • Minerals from ore • Different cuts of meat from livestock processing • Different grades of fuel from refining crude oil • Need to allocate the cost of the common input to the joint products • Primary role of the allocation is to value inventory • Has limited role in decision making Appendix A: Joint Cost Allocation

34. Joint Cost Allocations Appendix A: Joint Cost Allocation

35. Sell Now Or Process Further • The joint cost is not controllable because it is a sunkcost for this decision. • The allocation has no value! Appendix A: Joint Cost Allocation

36. Heritage Farms: Solution • The joint cost is controllable for decision regarding whether to stay in business • No role for joint cost allocation in decision of whether to stay in business or not Appendix A: Joint Cost Allocation

37. Appendix B Decisions To Add/Drop A Product

38. Add or Drop Segment • A segment could be a product / department / store / branch • Usually, a segment has traceable revenues, variable costs, and fixed costs • These costs are controllable for the add/drop decision • But, usually the head office also incurs some costs that are common across segments • This cost is often allocated to individual segments • Should we consider this cost in the add/drop decision? Appendix B: Segment Add/Drop Decisions

39. Fair Value Stores: Drop Toys? • Closing the toys department could be a mistake • The allocation is NOT relevant • We only should consider controllable costs and benefits Appendix B: Segment Add/Drop Decisions

40. Fair Value: Correct Analysis • Only consider costs that are avoided by closing toys line • Problem does not consider potential gain / loss of revenue in other departments Appendix B: Segment Add/Drop Decisions

41. Exercise 6.29 Framing and solving short-term decisions using controllable cost and gross approaches (LO1, LO2). Ajay Singh offers gift-wrapping services at the local mall. Ajay wraps each package, regardless of size, in the customer’s choice of wrapping paper and bow for a price of $3. Ajay’s variable costs total $1 per package wrapped, and his fixed costs amount to $600 per month. Due to the anticipated increase in demand over the holiday season, Ajay is considering hiring a helper, at a cost of $8.50 per hour, to help him wrap packages. With the helper, Ajay estimates that he can wrap 110 packages in a 10-hour day. Without the helper, Ajay estimates that he can wrap 60 packages in a 10-hour day. Ajay plans on operating his business for thirty 10-hour days during the holiday season. • Required: • Does Ajay’s decision deal with excess supply or excess demand? • Using the gross approach, determine whether Ajay should hire the helper. • Using controllable cost analysis, determine whether Ajay should hire the helper. • Assume Ajay’s fixed costs were $1,000 rather than $600. Would this affect Ajay’s decision to hire a helper?

42. Exercise 6.29 (Continued) • Does Ajay’s decision deal with excess supply or excess demand? Ajay’s decision deals with excess demand. Due to the holidays, Ajay expects a surge in gift-wrapping needs. To handle this surge, Ajay is considering hiring a helper. This is akin to a manufacturing firm outsourcing some production in periods of high demand.

43. Exercise 6.29 (Continued) • Using the gross approach, determine whether Ajay should hire the helper. Let us calculate profit = revenues – variable costs – fixed costs. We can construct the entire CVP model for Ajay. We then compare the profit under each option, selecting the option with the higher profit. With the information provided, we have:

44. Exercise 6.29 (Continued) • Using the gross approach, determine whether Ajay should hire the helper. Comparing the total profit, we find that Ajay’s profit increases by $450 ($3,450 – $3,000) for the season, if he hires the helper. Accordingly, if he wishes to maximize profit then Ajay should hire the helper. In constructing the income statement for each option, we could leave out the non-controllable fixed costs of $600. While the absolute profit numbers would change, the difference in profit would be preserved. Thus, the gross approach provides decision makers some flexibility in terms of what is included and excluded from the income statement.

45. Exercise 6.29 (Continued) • Using controllable cost analysis, determine whether Ajay should hire the helper. Under this approach, we compute only the incremental revenues and costs associated with a particular decision option relative to the status quo. Since operating without the helper is the status quo, we have:

46. Exercise 6.29 (Continued) • Using controllable cost analysis, determine whether Ajay should hire the helper. Again, we see that Ajay increases monthly profit by $450 if he hires a helper. The difference in profit derived with controllable cost analysis exactly equals the difference in profit under the gross approach. This underscores the equivalence of the two approaches. However, controllable cost analysis usually requires fewer calculations.

47. Exercise 6.29 (Concluded) • Assume Ajay’s fixed costs were $1,000 rather than $600. Would this affect Ajay’s decision to hire a helper? Assuming Ajay seeks to maximize profit, the change in fixed costs will not alter his decision to hire the helper. The fixed costs are equal under each option and, as a result, they are not relevant for this particular problem. Moreover, we see that (by inspection) controllable costs analysis ignores fixed costs as they are non-controllable. However, even though the gross approach uses fixed costs, they “wash” because they are included in the total cost for both options. Note: The magnitude of the fixed costs would be relevant if Ajay were deciding whether to pursue this business venture. This relevance is because Ajay would not incur the fixed costs if he did not pursue the venture. Generally, we need to define the time frame for the decision before we can classify a cost as a fixed cost. Consequently, the relevance of a fixed cost depends on the decision’s horizon. Ajay’s costs are fixed for the short-term decision of whether to hire a helper, but are not fixed for the longer-term decision of whether to stay in the gift-wrapping business.