Short-Term Decisions
Short-Term Decisions
The relevance test
Include a revenue or cost only when it is:
- future; and
- different between alternatives.
Then add opportunity cost and operational constraints.
| Item | Usually relevant? | Test |
|---|---|---|
| Incremental materials and labour | Yes | Will the decision change them? |
| Avoidable fixed cost | Yes | Can the resource spending be removed? |
| Allocated common overhead | No, unless avoidable | Does total company cash change? |
| Historical carrying amount | No, unless it changes disposal/tax cash flow | Is it sunk? |
| Forgone contribution from scarce capacity | Yes | What alternative use is displaced? |
Case 1: special order with idle capacity
A distributor offers £380 for 1,000 bikes. Northstar’s full production cost is £420, but:
- variable production cost is £300 per bike;
- special packaging is £20 per bike;
- fixed factory spending will not change;
- idle capacity is genuinely available.
| Incremental effect | £ |
|---|---|
| Revenue: 1,000 × £380 | 380,000 |
| Variable production: 1,000 × £300 | (300,000) |
| Special packaging: 1,000 × £20 | (20,000) |
| Incremental benefit | 60,000 |
The order passes the numerical screen despite price being below full cost. Before accepting, test channel conflict, normal-price leakage, credit risk, quality, delivery capacity and future expectations.
Case 2: make or buy
Northstar needs 5,000 control units.
| Make cost per unit | £ | Relevant? |
|---|---|---|
| Direct material | 18 | Yes |
| Direct labour | 12 | Yes under stated staffing facts |
| Variable overhead | 6 | Yes |
| Allocated fixed overhead | 10 | Only £3 is avoidable |
| Relevant make cost | 39 | 18 + 12 + 6 + 3 |
Supplier price is £40. With no alternative use, making saves £1 per unit, or £5,000.
If buying releases capacity that can earn £4 contribution per unit equivalent, making has a £4 opportunity cost:
Buying then saves £3 per unit, or £15,000. The capacity assumption reverses the answer.
Case 3: bottleneck
Machine capacity is scarce:
| Product | Unit contribution | Machine hours | Contribution per machine hour |
|---|---|---|---|
| City | £240 | 2 | £120 |
| Cargo | £360 | 4 | £90 |
After satisfying unavoidable commitments and demand limits, prioritise City because it earns more contribution per bottleneck hour. Unit contribution alone would give the wrong ranking.
Case 4: keep or drop
A segment reports a £30,000 loss after £70,000 common fixed cost is allocated:
- contribution margin: £120,000;
- avoidable segment fixed cost: £80,000;
- allocated common fixed cost: £70,000, unchanged if dropped.
Dropping loses £120,000 contribution and saves £80,000. Company profit falls £40,000. A reported segment loss is not proof that closure helps.
Decision memo
Use five lines:
- recommendation;
- quantified incremental effect;
- capacity/opportunity-cost assumption;
- qualitative constraint;
- trigger that would reverse the recommendation.
Quick check
In the special-order case, normal production later fills all capacity and would earn £90 contribution per constrained hour. What must change in the analysis?