Business Decisions and Cost Behavior

Business Decisions and Cost Behavior

In the short-term, variable cost varies with unit of production whereas fixed cost remains fixed.   So, short-term business decisions are made on the basis of the variable cost. In that case, Marginal Costing is the most appropriate method that can be used to make short-term decisions.

Contribution Analysis

•      Contribution per unit is the sales price per unit minus the variable cost per unit.

•      It measures the contribution made by each unit of output to the fixed cost and profit of the organization.

•      “The greater the contribution earned the greater the profit.”

•      In the short-term, many business decisions are made on the basis of ‘contribution’ not on the basis of ‘profit’.

Accepting a special order to use up spare capacity (Decide on whether to accept or reject low profit margin orders)

•      Special order in terms of price.

•      Accept the special order if it covers the VC or it gives positive contribution (Assuming that the business is not operating at full capacity).

•      The company should be careful about two things –

•      The long-term effects

•      The opportunity cost

Abandonment of a line of business (Cancel or Continue?)

•      In the short-term it is worth continuing the production if the product provides positive contribution towards the FC.

•      But in the long run the product must be able to cover the FC of production. Besides, two more questions to be considered in the long-term –

•      How much FC could be avoided in the longer-term if the production of the product or line of business ceased to exist?

•      Would it be a more effective use of resources to concentrate only on one product or single line of business?

Deciding on Product Mix (Which one to Produce?)

•      Produce that product which gives the highest contribution per unit.

•      Profit-Volume (Contribution-Sales) Ratio can also be used to make decision on product mix.

•      Profit-Volume (Contribution-Sales) Ratio

•      This ratio calculates contribution as a percentage of sales value.

•      Profit-Volume Ratio = (Contribution per unit * 100) / Sales Price per unit

•      This ratio indicates the ‘earning capacity’ of the product or business as a whole.

•      Profit-Volume graph not only shows the break-even point but also shows the actual profit/loss at different level of sales.

•      Produce that product or continue that business which has the highest ‘earning capacity’.

Existence of a limiting factor (Shortages of Inputs)

•      Limiting factor means scare resource or the item which is restricted in availability is called the limiting factor.

•      Contribution analysis shows that maximization of profit will occur in the short run if the activity is chosen which gives the highest contribution per unit of limiting factor.

In-house Activity Vs Bought-in Contracts (Manufacture or Purchase?)

•      Making the product on your own or buying the product ready-made.

•      Decision should be based on comparison between marginal costs of both the two options and also ‘lost contribution’ should be considered in this regard, if there is any.

•      Again, company should be careful about the long-term impacts of such decisions.