Short-term Decision Making and Performance Measurement
Relevant costing
Short-term decisions use relevant costs: future, incremental cash flows that differ between alternatives. Sunk costs, committed costs and allocated fixed overheads are irrelevant. Opportunity cost must be included, for example the contribution lost when a scarce resource is diverted. Common decisions include special orders, make or buy, shutdown, and acceptance of a contract with a limiting factor.
Limiting factors and performance measurement
When a single resource is scarce, rank products by contribution per unit of the limiting factor, not by contribution per unit. Linear programming extends this to multiple constraints. For performance measurement, candidates must understand ROI, residual income (RI), the balanced scorecard perspectives (financial, customer, internal process, learning and growth), and transfer pricing methods such as market price, cost-plus and negotiated prices.
Traps in questions
- Including sunk costs such as research already spent.
- Treating allocated head-office overhead as relevant to a shutdown decision.
- Ranking by unit contribution instead of contribution per scarce resource.
- Using ROI alone when it encourages managers to reject profitable investments below the current divisional ROI.
- Confusing profit with cash in decision making.
Worked example
A scarce material is limited to 1,000 kg. Product A has contribution £10 and uses 2 kg, giving £5 per kg. Product B has contribution £12 and uses 4 kg, giving £3 per kg. Product A ranks first, so produce A up to demand before using remaining material on B.
Rule of thumb
For a limiting factor, calculate contribution per unit of the constraint and rank highest first. For any decision, ask: is the cost future, incremental and different?