ACCT20001 Lecture Notes - Lecture 9: Longrun, Opportunity Cost, Rip Curl
16 May 2018
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Relevant costs and Decision Making
The Decision time horizon
Short term vs Long term decisions:
•Just because decisions may be classified as short-term, this does not exclude them form a
long-term view
•Most important to understand which are the relevant cost/revenues to consider given the specific
facts of the situation when making the decision
Relevant Costs
•Relevant costs/revenues are those:
1. Expected in the future that
2. Differ between alternatives
•Costs already incurred or committed to / revenues already earned or promised are not relevant in
‘short-term’ decision making
•Costs/Revenues that are the same across all alternatives being considered are not relevant
Qualitative factors can be relevant
•Relevant factors to consider can include those which are difficult to measure numerically
•Some of the more common qualitative facts to consider include impact of the decision on:
-Quality of your products/services
-Strategic implications to your business (e.g. creation of new competitor, positive impact of
getting new/large customer, risks)
-Customer relationships
-Employee relationship / morale
Short Term
Long Term
Decisions made under constraints - where some
costs/inputs cannot be varied due to its nature (e.g.
equipment) or commitment already made (e.g.
lease)
Decision made under little/no constraints - all costs/
inputs can potentially be varied
Less likely to have major lasting implications on
future profitability
Likely to have major lasting implications on future
profitability
Examples: Special orders, make or buy, product mix
Examples: long-run pricing, activity-based
management, outsourcing
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Example 1: Special Orders
•Company faces the decision whether to accept or reject a special order to sell products/services
to a customer
•Some of the typical characteristics of a special order:
-One-off
-Usually no impact on long-run demand or pricing from your regular customers because it is a
one time order that is outside normal markets/channels
-Usually uses idle capacity, otherwise then they may have to choose which order to fulfil
(regular vs special order) - Opportunity cost
Special Order and Fixed Costs
•Fixed cost is typically not relevant for special order
-There is usually excess capacity which can be used to fulfil the order - therefore do not need
to incur additional fixed costs
-If there is insufficient capacity, the time frame to satisfy the order does not allow additional
capacity to be added. Need to decide if should drop regular order to take on special order
-Therefore fixed costs are typically not relevant because they will not differ between the
alternatives of accepting vs not accepting the special order
•However need to consider facts in the situation (or question) to determine if fixed costs can be
ignored
-If special order causes additional fixed costs to be incurred, then this additional (or
incremental) fixed cost will be relevant when making decisions
Lowest acceptable price for Special Orders
•Lowest acceptable price (per unit) = price that would make you indifferent between accepting vs
not accepting the special order
-Lowest price with excess capacity = incremental cost/unit = variable cost / unit (since fixed
cost is usually unchanged)
-Lowest price without excess capacity - then need to drop a regular order if we decide to
accept special order
•Therefore lowest acceptable price of a special order = price that would give same total CM as the
least profitable regular order
-e.g say total CM for least profitable regular order = $1,000 [=(Price - VC/unit) x units sold]
-Lowest acceptable special order price = price that would give the special order a total CM of
$1000
Special Order (SO) & qualitative factors to consider
•SO may have positive reputational impact if one-off customer is a big player in the marketplace
•SO may adversely affect existing customer relationships if they find out that special order was
priced lower than regular orders
•SO may adversely affect existing relationship with the regular customer whose order had to be
dropped to fulfil the SO (if no excess capacity)
•The increase in capacity utilisation by taking on a SO may improve morale of employees
Illustration: Lloyd Bikes
•Police want special order of 20 bikes
•Regular retail price of bikes including racks = $1,600 (cost=$800)
•Racks retail $500 (cost = $250)
•Police are only willing to pay $750 per bike, need delivered in one week
•20 hours of mechanic labour required
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Questions:
1. Accept based on quantitative factors alone?
•Financial analysis suggests we can make a margin of $50 per bike
•Allows us to use mechanics time that would otherwise be idle
•Any contribution is good given we have idle capacity
2. Qualitative factors?
•Would our regular customers find out that we are effectively giving the police a substantial price
discount
-If they did, would they demand a price discount?
-This is a long-run pricing implication to consider
•Positive reputational impact if special order is from an important customer
-May allow new customer to emerge - whole state police force may want to order bikes
•May increase employee morale - reducing their idle time
Special Orders: Relevant vs Irrelevant costs
•Alternatives being considered
1. Take up special order
2. Reject special order
•Relevant costs to consider
-Cost of bicycle
-Cost of rack
•Irrelevant costs to ignore:
-Mechanic labour: they work fixed 80 hours per week and have 20 idle capacity in total
-Sales assistants: police ordered through Lloyd directly
-Store rent: paid irrespective of special order
-Equipment depreciation: arses from cost incurred in the past
Special order vs Standard Order
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Document Summary
Decisions made under constraints - where some costs/inputs cannot be varied due to its nature (e. g. equipment) or commitment already made (e. g. costs/inputs cannot be varied due to its nature (e. g. equipment) or commitment already made (e. g. lease) Decision made under little/no constraints - all costs/ inputs can potentially be varied. Less likely to have major lasting implications on future pro tability. Likely to have major lasting implications on future pro tability. Relevant costs: relevant costs/revenues are those, expected in the future that, differ between alternatives, costs already incurred or committed to / revenues already earned or promised are not relevant in. Short-term" decision making: costs/revenues that are the same across all alternatives being considered are not relevant. Qualitative factors can be relevant: relevant factors to consider can include those which are dif cult to measure numerically, some of the more common qualitative facts to consider include impact of the decision on:
