Six Decisions For Businesses
1) Accept a one-time order (special pricing decision)?
a. Minimum cost needs to be VC, unless you are told that FC will go up
2) Sell Now or Process Further?
3) Scrap or rework?
4) Eliminate a product line or segment?
5) Make or buy?
6) Constrained resource analysis
Differential or Incremental Costs
- The difference in total cost between
- The foregone contribution margin by choosing a different alternative
- This is not recording in the company’s financial ledgers
- All costs incurred in the past that cannot be changed by any decision made now or in the
- Sunk costs should not be considered in decisions and are therefore, irrelevant.
Whether or Not to Accept Additional Business
- The decision to accept additional business should be based on incremental costs and
o Incremental amounts are those that occur if the company decides to accept the
o Sunk costs are not considered for these decisions
The Make or Buy Decision
- When a company is involved in more than one activity in the entire value chain, it is
vertically integrated. A decision to carry out one of the activities in the value chain
internally, rather than to buy externally from a supplier is called a
“make or buy” decision.
o Example: Essex Company manufactures part 4A that is
used in one of its products.
o The unit product cost of this part is right:
o The special equipment used to manufacture part 4A has
no resale value.
o The total amount of general factory overhead, which is allocated on the basis of
direct labour hours, would be unaffected by this decision. o The $30 unit product cost is based on 20,000 parts produced each year.
o An outside supplier has offered to provide the 20,000 parts at a cost of $25 per
o Should we accept the supplier’s offer?
Scrap or Rework
- Costs incurred in manufacturing units of product that do not meet quality standards are
sunk costs and cannot be recovered.
- As long as rework costs are recovered through sale of the product and rework does not
interfere with normal production, we should rework rather
o Example: FasTrac has 10,000 defective units that
cost $1.00 each to make ($0.75 variable, $0.25
fixed). The units can be scrapped now and sold for
$.40 each or reworked at an additional cost of $.80
o If reworked, the units can be sold for the normal
selling price of $1.50 each. Reworking the defective
units will prevent the production of 10,000 new units
that would also sell for $1.50. Should FasTrac scrap or rework?
Sell or Process Further?
- Businesses are often faced with the decision to sell partially completed products or to
process them to completion
- All joint costs have a split off point which shows where these joint costs are allocated
- As a general rule, we process further only if incremental revenues exceed incremental
o Example: FasTrac has 40,000 units of partially finished product Q. Processing
costs to date are $30,000. The 40,000 unfinished units can be sold as is for
$50,000 or they can be processed further to produce finished products X, Y, and Z. The additional processing will cost $80,000 and result in the following
Eliminating a Segment
- If the CM is less than
the avoidable fixed costs then
you should shut it down
- If the CM is greater
than the avoidable fixed
costs then keep the line