Short-Run Decision Making: Relevant costing and Inventory Management

Short-Run Decisions

Short-run decisions are small-scale actions that serve a larger purpose. Decisions are made using a decision model. This is used to structure the thinking process and organizes information. It consists of choosing among alternatives with an immediate or limited end in view. The decision-making model consists of six steps:

1. Define the problem
2. Identify the alternatives
2. Identify the costs and benefits associated with each feasible alternative
4. Total the relevant costs and benefits for each alternative
5. Assess the qualitative factors
6. Select alternative with the greatest benefit

Relevant Costs

Relevant costs, as mentioned in step 4 above, are future costs that differ across alternatives. The can consist of both variable and fixed costs. Additional fixed costs associated with an alternative are relevant. Changes in supply and demand for resources must be considered. Costs which fluctuate with changes in supply and demand across alternatives are relevant costs. Relevant costs are also known as incremental costs. One type of relevant cost is opportunity cost. Opportunity cost is the benefit sacrificed or foregone when one alternative is chosen over another.

Make-or-Buy Decisions

Make-or-buy decisions are decisions involving a choice between internal and external production. There are four steps in this decision process.

1. Identify feasible alternatives
2. Identify which costs are relevant (Fixed overhead costs are most likely irrelevant since they will not differ)
3. Compare the total relevant costs of manufacturing with the cost of buying
4. Make a choice

Special Order Decisions

Special order decisions focus on whether a specially priced order should be accepted or rejected. Orders can be attractive, especially when the firm is operating below maximum productive capacity.

Keep-or-Drop Decisions

Keep-or-Drop decisions are decisions to keep or drop a segment such as a product line. Variable costing segment financial reports provide information such as contribution margin and segment margin. Relevant costing provides structure to the decision making.

Further Processing of Joint Products

Joint products include both common processes and costs up to split-off point. A split-off point is the point at which separate products become distinguishable. Common costs are not relevant to the decision making.

Product Mix Decisions

Organizations have wide flexibility in choosing their product mix. Mix has significant impact on profitability. The goal is maximizing total profit. Fixed cost will not change with mix, therefore it is not relevant. The focus should be on maximizing total contribution margin. Limitations on resources are called constraints.

Cost-Based Pricing

Most companies start with cost to determine price. The advantage of this is the ease of use. The standard formula for cost-based pricing is:

Price = Product cost + Markup

Markup is a percentage of base cost. It includes costs not in the base cost and desired profit.

Target Costing and Pricing

Target costing and pricing is determining price based on what customers are willing to pay. the company then must design and develop the product. the cost must be low enough to allow for the desired profit.

Ordering Costs

Ordering costs are costs of placing and receiving an order. Examples are order processing costs, cost of insurance for shipment, and unloading costs.

Carrying Costs

Carrying costs are the costs of carrying inventory. Examples are insurance, inventory taxes, obsolescence, and opportunity costs of funds tied up in inventory, handling costs, and storage space.

Stockout Costs

Stockout costs occur when demand is not known. These are the costs of not having the product available when demanded by a customer, and raw material not being available when needed for production. Examples are lost sales, costs of expediting, and costs of interrupted production.

Justin In Time (JIT)

Just in time (JIT) is when goods are pushed through the system by present demand rather than being pushed through on a fixed schedule based on anticipated demand. Each operation produces only what is necessary to satisfy the demand of the succeeding operation. This reduces all inventories to very low levels, and reduces inventory costs.