Lecture 6

Decision Making in the

Short-run
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Contexts for short-term decision

making
These decisions are typically taken when there is
gap between supply and demand.
Capacity is the maximum volume of activity that a
company can sustain with available resources.
Sometimes firms face excess demand. Decisions
during those times include price increase, expand
capacity by outsourcing production and focus on the
most profitable product.
Sometimes firms face excess supply. Decisions
include price reduction, running special promotions,
accepting special orders and producing in house
instead of outsourcing.

Two approaches
Relevant

cost analysis (We discussed this

topic earlier).
What information is relevant?
expected

revenue or expected cost

differ among the decision options.
Totals

or gross approach
Both the approaches, if done correctly,
should give the same results.
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Decision 1: Special order pricing

When

capacity exceeds demand

Relevant

costs usually will be the variable

costs associated with the special order.

When

demand exceeds capacity

Relevant

costs usually will be the variable

costs associated with the special order and
the opportunity cost of creating the capacity
for the special order.

Evaluating short-term
promotional decisions
A relevant

cost analysis is usually called

for.
We dont need to know what the status
quo is. We need to know what will change
if the special promotion is run.
Analyze incremental revenue and
incremental costs. Estimate the net
benefit from the short-term promotion. A
positive net benefit will favor the
implementation of the promotion.
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Make versus buy decision

Make-or-buy-decision (also called outsourcing
decision) entails a choice between producing a
product or service in-house or purchasing it from
an outside supplier.
Firms may resort to outsourcing for cost or
efficiency or capacity reasons. Be careful about
what costs are avoidable or un-avoidable.
Similarly, firms may shift production from outside
the firm to in-house for cost, or efficiency, or
strategic or capacity reasons. Again, pay attention
to what costs are incremental.
Beware of unit-cost data.

Product portfolio decisions with

scarce resources
Identify

the appropriate criterion for ranking the

products in terms of profitability
The criterion for such ranking is usually the
contribution margin per unit of scarce resource.
Allocate as much of scarce resource as
possible for the most profitable product. The
next profitable product is allocated as much of
the scarce resource as possible. This process
is repeated until the scarce resource is
completely used up.
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Decisions involving joint costs

A joint

production process results in two or

more products, called joint products.
The point in the production process where
the joint products are identified as separate
products is called the split-off point.
The costs incurred prior to the split-off point
are called joint costs.
For any decision, such as processing a joint
product further, the joint costs are irrelevant
and therefore these costs are not to be taken
into account in making these decisions.
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Adding or dropping a product

line
Often,

businesses want to expand or

contract their operations to improve
profitability.
Beware of product profitability reports.
Pay particular attention to avoidable costs
and unavoidable costs. Unavoidable
costs include many common costs.
Finally, keep in mind that relevant costs
are not always variable in nature.
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