Chapter 15

Short-term Planning Decisions

What are Relevant Costs & Revenues?

They are future costs & revenues. They are included in making decisions. Past (sunk) costs are always irrelevant.

Other cost terms:

Incremental Costs: Cost increases resulting from a change of activity.

Avoidable Costs: A cost which can be reduced or eliminated.

Opportunity Cost: Forgone profits when one activity is chosen over another.

Relevant costs/revenues are used to make the following types of

decisions: Whether to accept a special order. How many units of inventory to buy. Whether to drop (or add) a product.

Relevant costs/revenues are used to make the following types of

decisions: Whether to make or buy a product or

part. Whether to sell a product as is or to

process it further. What product mix to sell.

Economic Order Quantity (EOQ)

Inventory costs include:– Carrying Costs: storage, handling,

insurance, opportunity costs– Order Costs: costs of placing and receiving

an order.

Carrying costs

increase as the amount of inventory on hand increases

Ordering costs

increase when more orders are placed.

EOQ for a merchandiser:

take the square root of: 2SO

C

EOQ for a manufacturer:

take the square root of: 2UO C

Legend:

S = total annual sales O = order cost per order C = carrying cost per unit U = total annual raw materials used

How to decide to drop a product:

Drop only if avoidable costs are > revenue produced from the product.

Put another way - total profit would increase if product were dropped.

Should a part/product be purchased or made?

Many factors to consider:– If making, must have the “know-how”.– How will the decision affect current

business relationships?– How reliable is the supplier? Is quality an

issue? Basically, determine relevant costs of

each alternative.

Sell “as is” or process further?

Process further if incremental revenues >incremental costs of processing further.

Product Mix decisions:

What combination of products should a company produce/sell?

Where should advertising dollars go:

Using the assumptions in the book: basically, “push” that item which has the highest contribution margin per unit.– Remember, CM per unit is sales price

minus variable costs.

How many units should be produced?

When there a constraints (scarce resources), produce the unit which provides the greatest CM per the constraint.