Special Decisions - Key Terms
Here, we’re going to cover some key terms and then go through some practice problems to show you how to solve special decision problems. The first term that’s relevant for special decision-making is called opportunity cost. Opportunity cost is the benefit that you give up by not choosing to do something. For example, consider that you are a full-time employee making $50,000 a year, but then you decide to go back to school full-time, which is going to cost $20,000 a year
Would you say that your annual cost is going to be $20,000? Well, you have the opportunity cost of not staying at your full-time job and getting $50,000 a year. You would say that your annual cost is going to be $20,000 for these studies, plus the $50,000 opportunity cost of giving up your job. The term opportunity cost can be confusing because you’re not actually spending that $50,000. Instead, cost refers to the money that you could be making if you still had that job (i.e., the next best opportunity).
The next important term issunk cost. A sunk cost isa cost that you have already incurred and therefore it is irrelevant to your decision-making, you’ve already spent it. You can’t recover that money, and we’re not going to use that information for our future decision-making.
For example, let’s say that you are a manufacturer trying to figure out whether to make your own components or buy them and last year you invested $100,000 in machinery to make components. Wouldn’t the fact that you invested $100,000 mean that you’re just supposed to make your own components? Well, not necessarily because that’s a sunk cost. You already spent that $100,000 in the past, you can’t recover it, and you’re not going to use it in your future decision-making.
With making special decisions, it’s important to focus on the information that will change (i.e., marginal information) if you make a decision and then ignore the information that’s not going to change. For example, if we decide to sell special units at $5 per unit, that is relevant to our decision-making. If they cost $2 per unit, that is also relevant.
Then we get to certain irrelevant information that we’re not going to use for our decision-making. These are called unavoidable costs, which means that no matter what decision we have, we’re still going to have these unavoidable costs, and we’re not going to focus on them for our decision-making. We’re only going to focus on the avoidable costs.
For example, let’s say that you’re spending $10,000 a month for the rent for your manufacturing facility, and you’re deciding whether to keep or get rid of a product line. Whether you keep it or get rid of it, you’re still going to have the $10,000 of rent each month. Therefore, that is an unavoidable cost and we don’t factor it into our decision-making.
Special Decisions – Practice Question
| chair | table | Impact on Operating Income | |
|---|---|---|---|
| Sales | 180,000.00 | 48,000.00 | (48,000.00) |
| Variable Costs | (96,000.00) | (30,000.00) | 30,000.00 |
| Contribution Margin | 84,000.00 | 18,000.00 | 18,000.00 |
| Fixed Costs: | |||
| Avoidable | (36,000.00) | (12,000.00) | 12,000.00 |
| Unavoidable | (18,000.00) | (10,800.00) | - |
| Operating Income (Loss) | 30,000.00 | (4,800.00) | (6,000.00) (-$48,000 + $30,000 + $12,000) |
To understand the example better, we have added borders to the table.
What’s the special decision we’re trying to make here? Whether or not to discontinue our table’s product line. We have to look at what would change if we decided to discontinue it (i.e., the relevant information).
Let’s look at each line item individually. If we discontinue the product line, then we’ll lose sales of $48,000 and therefore decrease our operating income. We won’t have variable costs of $30,000, therefore, increasing operating income. There are $12,000 of avoidable fixed costs, meaning we’ll have $12,000 less fixed costs if we discontinue it, which would increase operating income.
The final item, the unavoidable fixed cost of $10,800 means that even if we discontinue the product line, we will still have to pay that $10,800 of fixed costs. It wouldn’t impact our operating income, so it’s not a relevant part of the decision. Sales would decrease by $48,000. Variable costs would decrease by $30,000, and avoidable fixed costs would decrease by $12,000.
The net effect is a $6,000 loss on operating income (-$48,000 decrease in sales + $30,000 in variable costs + $12,000 in avoidable fixed costs).