Small Fry Options

Last weekend in the management accounting class one of the topics we dealt with was short term decision making. It was helpful to walk through some of the exercises on evaluating options.

The first point that makes things easier that’s kind of a “duh” moment for the process is that you limit the calculations to the relevant costs and revenues. If something (say the salary of the CEO or the property taxes on a building) is constant for all the options, you can skip it in the calculations. That speeds things up a tad. Once you identify the relevant costs and revenues you compare the alternatives and pick the one with the best outcome.

Short term decision making focuses on variable costs and revenues. Fixed costs don’t change (in the short term…Dr. Wayvon made it clear that all costs are variable in the long term) and so the focus is on those costs that will vary or change.

Here are some of the short term decision making scenarios we learned frameworks for considering:

  1. Make or Buy. Insourcing vs. outsourcing. It’s not always as clear as you’d like…and it’s important to consider only the relevant costs, not allocated costs that will exist even when outsourcing. Considering the opportunity cost is important as well, like whether the space you’re using to produce something can be used for something else like generating rental income. Also you need to consider qualitative issues (soft costs and benefits) that may not show up on the income statement, like whether the quality will be up to your standards if you outsource.
  2. Special Order. Can you sell to a new customer a quantity for 20% less than your normal price? The main relevant question here is this: do you have excess capacity? If not, the answer is easy: no special order. If you do, then you consider whether the special order still produces economic value to the organization (when again, only considering the relevant costs) to see if you should say yes. Additional concern: pricing erosion. It won’t take long for your other customers to find out you gave this deal out and they’ll want to get the lower price too, so you’ll want to make sure a special order offered doesn’t dilute the current market.
  3. Add or Drop. As long as the contribution margin lost is less than the fixed cost reduction then it’s a good decision. (I may need another post later on contribution margin)
  4. Constraint Analysis. If a limited resource exists (like welder time in the shop or hours of engineering work) then it’s constraining your options. Constraint analysis is about making the right production/process decisions to maximize your economic value while being limited by that constrained resource. Analysis here finds the contribution margin for your options per unit of constraint and you prioritize based on that in order to optimize profit within the constraint.
  5. Sell or Process Further. Let’s say you’re making chairs. If you sell the chairs unfinished and unpainted you can sell for $50. If you paint them they’ll sell for $75. By looking at the incremental revenue (increased sales per chair) and comparing it to the increased cost of the processing (average cost of painting the chair) you can make the decision easily. If increased sale price is $25 and the increased cost is $26 then it’s a bad idea to process it further instead of just selling the chair. This one made me think of upgrading a house when you’re getting ready to sell. The additional issue here is that if you’ll only sell 10 chairs unfinished but you can sell 50 if you finish them, it’s still a good deal. Likewise, upgrading the kitchen for $10,000 may only bring another $5,000 in sale price, but if it increases the chance of selling from 25% to 75% it’s well worth it.

So that’s short term decision making with management accounting, in a nutshell. I think all of these decision making frameworks will be useful to me over time in my work, and I’m glad for the thought experiments we went through during class.

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