Short-Term Commercial Decision Making
P1 tests relevant costing under constraints: special orders, make-or-buy, further processing and shutdown. The exam rewards disciplined exclusion of irrelevant costs and correct ranking when a resource is scarce, usually within a marginal-costing framework.
Relevant costing rules
A relevant cost is future, incremental and cash-based. Exclude sunk costs, committed costs, non-incremental fixed overheads and apportioned costs. Include opportunity cost: the contribution forgone from the next-best use of a resource.
CVP and break-even
Contribution = sales − variable costs. Break-even units = fixed costs ÷ contribution per unit. Margin of safety = (budgeted sales − break-even sales) ÷ budgeted sales. Target profit units = (fixed costs + target profit) ÷ contribution per unit. CVP assumes constant price, constant variable cost per unit and fixed costs within the relevant range.
Scarce resources
Rank products by contribution per unit of the limiting factor, not contribution per unit. Where several constraints bind, linear programming finds the optimal mix; where one constraint binds, allocate the scarce resource to the highest-ranked product first, then the next, until demand or capacity is exhausted.
Worked example
Product A: contribution £30, uses 3 kg, demand 200 units. Product B: contribution £40, uses 5 kg, demand 100 units. Available material 1,000 kg. Contribution per kg: A £10; B £8. Rank A first. A uses 200 × 3 = 600 kg, leaving 400 kg for B = 80 units. Contribution = (200 × £30) + (80 × £40) = £6,000 + £3,200 = £9,200. Producing B first would give 100 × 5 = 500 kg, leaving 500 kg for 166 units of A, contribution = £4,000 + £4,980 = £8,980, which is worse.
Specific decisions
- Special order: accept if incremental revenue exceeds incremental cost and spare capacity exists without disrupting regular sales.
- Make-or-buy: compare relevant variable cost plus avoidable fixed cost plus opportunity cost with the external purchase price.
- Further processing: process further if incremental revenue exceeds incremental cost.
- Shutdown: continue if contribution exceeds avoidable fixed costs.
Traps
- Using absorption cost per unit, which includes irrelevant fixed overhead.
- Ignoring opportunity cost when capacity is scarce.
- Ranking by contribution per unit rather than per scarce resource.
- Assuming a special order will not affect the regular selling price.
- Treating a sunk cost as relevant because it feels significant.