Summary Chapter 25

Objective 1 HOW IS RELEVANT INFORMATION USED TO MAKE SHORT-TERM DECISIONS?

Relevant Information  expected future data that differ among alternatives

Relevant Cost  a cost that is relevant to a particular decision because it is a future cost and differs among
alternatives

Irrelevant Cost  a cost that does not affect the decision because it is not in the future or does not differ among
alternatives

Sunk Cost  a cost that was incurred in the past and cannot be changed regardless of which future action is taken

Differential Analysis

A common approach to making short-term business decisions is called differential analysis. In this approach, the
emphasis is on the difference in operating income between the alternative approaches. Differential analysis is also
sometimes called incremental analysis. Instead of looking at the company’s entire income statement under each
decision alternative, we just look at how operating income would differ under each alternative. Using this approach,
we leave  out irrelevant information—the revenues and costs that will not differ between alternatives. In this
chapter, we consider several kinds of short-term business decisions

 Regular and special pricing

 Dropping unprofitable products and segments, product mix, and sales mix
 Outsourcing and processing further

As you study these decisions, keep in mind the two keys in analyzing short-term business decisions

1. Focus on relevant revenues, costs, and profits  Irrelevant information only clouds the picture and creates
information overload.
2. Use a contribution margin approach that separates variable costs from fixed costs.  Because fixed costs
and variable costs behave differently, they must be analyzed separately. Traditional income statements,
which blend fixed and variable costs together, can mislead managers. Contribution margin income
statements, which isolate costs by behavior (variable or fixed), help managers gather the cost behavior
information they need. Keep in mind that manufacturing costs per unit are mixed costs, too—so they can
also mislead managers. If you use manufacturing costs per unit in your analysis, be sure to first separate the
unit cost into its fixed and variable portions. We use these two keys in each decision.
 Summary Chapter 25

Objective 2 How does pricing affect short-term decisions?

There are three basic questions managers must answer when setting regular prices for their products or services

 What is the company’s target profit?

 How much will customers pay?
 Is the company a price-taker or a price-setter for this product or service?

Price taker or Price setter

Price-Taker  company that has little control over the prices of its products and services because they are not
unique, or competition is intense; emphasize target pricing

Price setter  A company that has control over the prices of its products and services because its products and
services are unique and there is little competition. emphasize cost-plus prizing

Obviously, managers would rather be price-setters than price-takers. To gain more control over pricing, companies
try to differentiate their products. They want to make their products unique in terms of features, service, or quality
or at least make the buyer think their product is unique or somehow better. Companies achieve this differentiation
partly through their advertising efforts. Consider Nike’s athletic shoes, Starbucks’s coffee, Kleenex’s tissues, Tylenol’s
acetaminophen, Capital One’s credit cards, Shell’s gas, Abercrombie and Fitch’s jeans—the list goes on and on. Are
these products really better or significantly different from their lower-priced competitors? It is possible. If these
companies can make customers believe that this is true, they will gain more control over their pricing because
customers Learning Objective 2 Make regular and special pricing decisions Price-Taker A company that has little
control over the prices of its products and services because its products and services are not unique or competition
is intense. Price-Setter A company that has control over the prices of its products and services because its products
and services are unique and there is little competition. M25_HORN6833_06_SE_C25.indd 1377 12/21/16 11:02 PM
1378 chapter 25 are willing to pay more for their product or service. What is the downside? These companies must
charge higher prices or sell more just to cover their advertising costs. A company’s approach to pricing depends on
whether it is on the price-taking or price-setting side of the spectrum. Price-takers emphasize a target-pricing
approach. Price-setters emphasize a cost-plus pricing approach.

Target Pricing  When a company is a price-taker, it emphasizes a target-pricing approach to managing costs and
profits. A method to manage costs and profits by determining the target full product cost. Revenue at market price -
Desired profit = Target full product cost

Target Full Product Cost  The full cost to develop, produce, and deliver the product or service.
 Summary Chapter 25

5. Attempt to differentiate its tablet computer from the competition to gain more control over sales prices (become
a price-setter)

6. A combination of the above strategies that would increase revenues and/or decrease costs by $14,000.
 Summary Chapter 25

Cost-Plus Pricing  method to manage costs and profits by determining the price Full product cost + Desired profit
= Cost-plus price.

Example: When the product is unique, the company has more control over pricing—but the company still needs to
make sure that the cost-plus price is not higher than what customers are willing to pay. Let’s go back to our Smart
Touch Learning example. This time, assume the tablet computers benefit from brand recognition due to the
company’s preloaded e-learning software so the company has some control over the price it charges for its tablets.
Using a cost-plus pricing approach, assuming the current level of sales, and a desired profit of 10% of average assets,
the cost-plus price is $506, calculated as follows:

To maximize the effectiveness of pricing decisions, our pricing decision rule is as follows:

Using a differential analysis approach, Smart Touch Learning compares the additional revenues from the special
order with the additional expenses to see if the special order will contribute to profits. These are the amounts that
will be different if the order is accepted. Exhibit 25-5.

https://www.youtube.com/watch?
v=Qwkyvq-RSAw
 Summary Chapter 25
*Video explains Cost-plus pricing and Target Costing*
 Summary Chapter 25

Objective 3 How do managers decide which products to produce and sell?

Dropping Unprofitable Products and Segments:

Questions to consider 

 Does the product or segment provide a positive contribution margin?

 Will fixed costs continue to exist, even if the company drops the product or segment?
 Are there any direct fixed costs that can be avoided if the company drops the product or segment?
 Will dropping the product or segment affect sales on the company’s other products?
 What would the company do with the freed manufacturing capacity or storage space?

The first question management should ask is “Does the product provide a positive contribution margin?” If the
product has a negative contribution margin, then the product is not even covering its variable costs. Therefore, the
company should drop the product  However, if the product has a positive contribution margin, then it is helping
to cover some of the company’s fixed costs. In Smart Touch Learning’s case, the Premium Tablets provide a positive
contribution margin of $90,000. Smart Touch Learning’s managers now need to consider fixed costs.

by using activity-based costing, or by using some other method. However, in the short term, many fixed costs remain
unchanged in total regardless of how they are allocated to products or other cost objects. Therefore, allocated fixed
costs are irrelevant except for any amounts that will change because of the decision that is made. What is relevant
are the following:

1. Will the fixed costs continue to exist even if the product is dropped?
2. Are there any direct fixed costs of the Premium Tablets that can be avoided if the product is dropped?

Fixed Costs Will Continue to Exist and Will Not Change  Fixed costs that will continue to exist even after a
product is dropped are often called unavoidable fixed costs. Unavoidable fixed costs are irrelevant to the decision
because they will not change if the company drops the product

Product Mix
Constraint  A factor that restricts the production or sale of a product.

Companies do not have unlimited resources. Constraints that restrict the production or sale of a product vary from
company to company. For a manufacturer like Smart Touch Learning, the production constraint may be labor hours,
machine hours, or available materials. For a merchandiser, the primary constraint is display space.

 What constraints would stop the company from making (or displaying) all the units the company can sell?
 Which products offer the highest contribution margin per unit of the constraint?
 Would emphasizing one product over another affect fixed costs?

However, in order to determine which product to emphasize, we cannot make the decision based only on
contribution margin per unit. Instead, we must determine which product has the highest contribution margin per
unit of the constraint. To determine which product to emphasize, follow the decision rule:

Check out the calculations on Objective 3 for more details.

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Objective 4 How do managers make outsourcing and Processing further Decisions

Outsourcing  Many companies choose to outsource products or services. For example, a hotel chain may
outsource its reservation system. This allows the company to concentrate on its primary function—serving the needs
of its guests—rather than purchasing and operating an extensive computerized reservation system. By outsourcing,
the hotel chain is taking advantage of another company’s expertise, which allows it to focus on its core business
functions

Some of the questions managers must consider when deciding whether to outsource include:

 How do the company’s variable costs compare with the outsourcing costs?
 Are any fixed costs avoidable if the company outsources?
 What could the company do with the freed manufacturing capacity?

Exhibit 25-15 shows that even with the $12,000 reduction in fixed costs, it would still cost Smart Touch Learning less
to make the casings than to buy them from Crump Casings. The net savings from making the casings is $2,400.
Exhibit 25-15 also shows that outsourcing decisions follow our two key guidelines for short-term business decisions:
(1) Focus on relevant data (differences in costs in this case) and (2) use a contribution margin approach that
separates variable costs from fixed costs.

Opportunity Cost  the benefit given up by choosing an alternative course of action. In this case, Smart Touch
Learning’s opportunity cost of making the casings is the $30,000 profit it gives up if it does not free its production
facilities to make the new product.

At what point in processing should a company sell its product? Many companies, especially in the food processing
and natural resource industries, face this business decision. Companies in these industries process a raw material
(milk, corn, livestock, crude oil, and lumber, M25_HORN6833_06_SE_C25.indd 1396 12/21/16 11:02 PM Short-Term
Business Decisions 1397 to name a few) to a point before it is saleable. For example, a dairy processor pasteurizes
raw milk before it is saleable. The company must then decide whether it should sell the pasteurized milk as is or
process it further into other dairy products, such as reduced-fat milk, butter, sour cream, cheese, and other dairy
products

Questions managers consider when deciding 

 How much revenue will the company receive if it sells the product as is?
 How much revenue will the company receive if it sells the product after processing it further?
 How much will it cost to process the product further?

Joint Costs  A cost of a production process that yields multiple products.

 Summary Chapter 25

By analyzing only the relevant costs in Exhibit 25-17, managers see that they can increase profit by $36,000 if they
add the USB ports. The $48,000 additional revenue ($1,248,000 - $1,200,000) outweighs the additional $12,000 cost
of the extra processing. Thus, the decision rule is as follows:

Recall that our keys to decision making include: (1) Focusing on relevant information and (2) using a contribution
margin approach that separates variable costs from fixed costs. The analysis in Exhibit 25-17 includes only those
future costs and revenues that differ between alternatives. We assumed Smart Touch Learning already has the
equipment and labor necessary to add the additional feature to the tablets. Because fixed costs would not differ
between alternatives, they were irrelevant. However, if Smart Touch Learning has to acquire equipment to add the
feature, the extra fixed costs would be relevant. Once again, we see that fixed costs are relevant only if they differ
between alternatives