# Short term decisions

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Short term decisions are decisions where the financial consequences occur soon after the decision is taken. For example, a short-term decision may result

Short-term decisions are decisions where the financial consequences occur soon after the decision is taken. For example, a short-term decision may result in an immediate increase in profit (additional net cash inflows), or an increase in annual profits and cash flows.

It is often assumed that marginal costs are relevant costs for the purpose of decision-making.

## Limiting factor decisions

It is often assumed in budgeting that a company can produce as many units of its products (or services) as is necessary to meet the available sales demand. Sales demand is therefore normally the factor that sets a limit on the volume of production and sales in each period.

Sometimes, however, there could be a shortage of a key production resource, such as an item of direct materials, or skilled labor, or machine capacity. In these circumstances, the factor setting a limit to the volume of sales and profit in a particular period is the availability of the scarce resource, because sales are restricted by the amount that the company can produce.

Decision-making techniques for limiting factor situations are based on the following assumptions:

• The objective is to maximize profit and this is achieved by maximizing contribution;
• Marginal costs (variable costs) are the only relevant costs to consider in the model; and
• Fixed costs will be the same whatever decision is taken; therefore, fixed costs are not relevant to the decision.

### Identifying limiting factors

Identify the limiting factor by calculating the budgeted availability of each resource and the amount of the resource that is needed to meet the available sales demand.

### Maximizing profit when there is a single limiting factor

When there is just one limiting factor (other than sales demand), total profit will be maximized in a period by maximizing the total contribution earned with the available scarce resources.

The approach is to select products for manufacture and sale according to the contribution per unit of scarce resource in that product.

Step 1: Calculate the contribution per unit of each type of good produced.

Step 2: Identify the scarce resource.

Step 3: Calculate the amount of scarce resource used by each type of good produced.

Step 4: Divide the contribution earned by each good by the scarce resource used by that good to give the contribution per unit of scarce resource for that good.

Step 5: Rank the goods in order of the contribution per unit of scarce resource.

Step 6: Construct a production plan based on this ranking. The planned output and sales are decided by working down through the priority list until all the units of the limiting factor (scarce resource) have been used.

## Make-or-buy decisions: outsourcing

A make-or-buy decision is a decision about:

• whether to make an item internally or to buy it from an external supplier, or
• whether to do some work with internal resources, or to contract it out to another organization such as a sub- contractor or an outsourcing organization.

The economic basis for the decision whether to make internally or whether to buy externally (outsource production) should be based on relevant costs. The preferred option from a financial viewpoint should be the one that has the lower relevant costs.

A financial assessment of a make-or-buy decision typically involves a comparison of:

• the costs that would be saved if the work is outsourced or sub-contracted, and
• the incremental costs that would be incurred by outsourcing the work.

### Make-or-buy decisions with scarce resources

A different situation arises when an entity is operating at full capacity, and has the opportunity to outsource some production in order to overcome the restrictions on its output and sales. For example, a company might have a restriction, at least in the short-term, on machine capacity or on the availability of skilled labor. It can seek to overcome this problem by outsourcing some work to an external supplier who makes similar products and which has some spare machine time or labor capacity.

The decision is about which items to outsource, and which to retain in-house. The profit-maximizing decision is to outsource those items where the costs of outsourcing will be the least.

To identify the least-cost outsourcing arrangement, it is necessary to compare:

• the additional costs of outsourcing production of an item with
• the amount of the scarce resource that would be needed to make the item in-house.

Costs are minimized (and so profits are maximized) by outsourcing those items where the extra cost of outsourcing is the lowest per unit of scarce resource ‘saved’.

## One-off contract decisions (Accept or reject an order decisions)

Management might have an opportunity to carry out a contract or job for a customer, where the job is ‘once only’ and will not be repeated in the future. The decision is therefore to decide whether to agree to do the job at the price offered by the customer, or to decide a selling price at which an incremental profit would be made.

If it is a one-off contract, rather than regular production work, it would be worthwhile undertaking the contract if the extra revenue from the contract is higher than the relevant costs of doing the work (including any opportunity costs).

The incremental profit from the one-off contract is the revenue that would be obtained minus the relevant costs.

## Shutdown decisions

Part of a business, for example a department or a product, may appear to be unprofitable.  A shutdown decision is a decision about whether or not to shut down a part of the operations of a company. From a financial viewpoint, an operation should be shut down if the benefits of shutdown exceed the relevant costs.

The quantifiable cost or benefit of closure

The relevant cash flows associated with closure should be considered. For example:

• the lost contribution from the area that is being closed (= relevant cost of closure)
• savings in specific fixed costs from closure (= relevant benefit of closure) known penalties and other costs resulting from the closure, e.g. redundancy, compensation to customers (= relevant cost of closure)
• any known reorganisation costs (= relevant cost of closure)
• any known additional contribution from the alternative use for resources released (= relevant benefit of closure).

If the relevant benefits are greater than the relevant costs of closure then closure may occur. However, before a final decision is made the business should also consider the non-quantifiable factors.

Non-quantifiable costs and benefits of closure

Some of the costs and benefits discussed above may be non- quantifiable at the point of making the shut-down decision:

• penalties and other costs resulting from the closure (e.g. redundancy, compensation to customers) may not be known with certainty
• reorganisation costs may not be known with certainty
• additional contribution from the alternative use for resources released may not be known with certainty.

## Joint product further processing decisions

Joint products are products manufactured from a common process. In some instances, a company might have a choice between:

• selling the joint product as soon as it is output from the common process, or
• processing the joint product further before selling it (at a higher price).

The financial assessment should compare:

• the revenue that will be obtained (less any selling costs) from selling the joint product as soon as it is output from the common process, and
• the revenue that will be obtained if the joint product is processed further, less the incremental costs of further processing and then selling the product.

Applying relevant costing, the costs of the common process are irrelevant to the decision, because these costs will be incurred anyway, whatever the decision. The decision should be to further process the joint product if the extra revenue from further processing exceeds the extra (relevant) costs of the further processing.

## Minimum selling price decisions

The minimum pricing approach is useful in the situation of intense competition, surplus production capacity, clearance of old stocks, getting special orders and/or improving market share of the product. In these situations, the selling price is the lowest price that a company may sell its product at – usually the price will be the Total Relevant Costs of Manufacturing.