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This application of short-term decision making techniques will consider using the following example:
T.O. Wood Ltd manufactures and sells three products, X, Y and Z. The internally prepared product profitability statement for the company is shown in Table 1. Fixed overhead costs are absorbed as a percentage of labour costs and have been rounded to the nearest £100,000. Products X and Z are machine intensive while Product Y is labour intensive. Management is considering whether to drop Product Y because it is making a loss, the assumption being that they could increase the total profit of the company by £100,000 by dropping Product Y. Do you agree?
| X £'000 |
Y £'000 |
Z £'000 |
Total £'000 |
|
|---|---|---|---|---|
| (a) Revenues | 1,500 | 1,600 | 800 | 3,900 |
| (b) Material costs | 500 | 400 | 100 | 1,000 |
| (c) Labour costs | 400 | 800 | 300 | 1,500 |
| (d) Fixed costs | 300 | 500 | 200 | 1,000 |
| (e) Total costs | 1,200 | 1,700 | 600 | 3,500 |
| (f) Profit/(Loss) | 300 | -100 | 200 | 400 |
With reference to line (d), Product Y is absorbing 50% of the total fixed costs many of which may not be avoided even if the company were to drop Product Y. In such a situation where there is a limited differential effect upon fixed costs in continuing or dropping Product Y, they are not relevant in making the decision.
On the assumption that fixed costs are not avoidable in the short-term we have rearranged the contents of Table 10.1 to show a distinction between those costs likely to be avoidable and those that are not.
| X £'000 |
Y £'000 |
Z £'000 |
Total £'000 |
|
|---|---|---|---|---|
| Revenues | 1,500 | 1,600 | 800 | 3,900 |
| Material costs | 500 | 400 | 100 | 1,000 |
| Labour costs | 400 | 800 | 300 | 1,500 |
| Total variable costs | 900 | 1,200 | 400 | 2,500 |
| Contribution | 600 | 400 | 400 | 1,400 |
| Fixed costs | 1,000 | |||
| Profit | 400 | |||
| Contribution / Revenue % | 40 | 25 | 50 |
In the rearranged Table 2, the value of retaining Product Y is shown assuming that no fixed costs are avoidable. Product Y can be seen to contribute £400,000 towards the fixed costs. If dropped, T.O. Wood Ltd would lose this contribution, with the result being a reduction in the total contribution by £400,000. Furthermore, this £400,000 reduction in contribution would completely wipe out the £400,000 profit currently obtained from making all three products.
This example illustrates one issue which must be considered in short-term decision analysis that arises from the allocation of fixed costs. Where fixed costs have been identified with products, as in this example, it is tempting, but usually wrong, to assume that they will necessarily disappear when a product is dropped. In fact, in many organisations all that is known with any certainty is the total fixed costs likely to be incurred. Their allocation across products or services is frequently heavily dependent upon judgement.