Make-or-buy and other short-term decisions

Q: What are the three criteria for a cost to be considered relevant in short-term decision making?

A relevant cost must be future , incremental , and a cash flow .

Q: Which costs are considered irrelevant and should be ignored in short-term decision calculations?

You should ignore sunk costs , committed costs , and general fixed overheads .

Q: How is the financial comparison made in a basic make-or-buy decision?

Compare the Relevant Cost of Making ($ ext{Variable Costs} + ext{Specific Fixed Costs} $) against the Relevant Cost of Buying ($ ext{Purchase Price} $).

Q: How does opportunity cost affect a make-or-buy decision when a company is at full capacity?

Opportunity cost must be added to the cost of making the product in-house.

Q: What qualitative factors should be considered in a make-or-buy or outsourcing decision?

Consider supplier reliability , product quality , delivery lead times , and confidentiality .

Q: What are the primary benefits and risks of outsourcing a business function?

Benefits include cost savings and focusing on core competencies ; risks include loss of control and confidentiality issues .

Q: What is the rule for deciding whether to shut down a loss-making department?

Keep the department open if its Contribution is greater than its Avoidable Fixed Costs .

Q: What criteria are used to determine if a special order should be accepted at a low price?

Accept if the price exceeds incremental costs , the company has spare capacity , and there is no negative impact on regular customers.

Performance Management (PM) · ACCA · 4 min read

Introduction: Making the Best Choice in the Short Term

Welcome! In this chapter, we are diving into the heart of decision-making. As a management accountant, you will often be asked: "Should we make this part ourselves or buy it from someone else?" or "Should we close down this struggling department?"

These are short-term decisions. The goal here isn't to look ten years into the future, but to look at the immediate impact on our cash flow and profit. Don't worry if this seems a bit overwhelming at first—once you master the concept of relevant costing, these decisions become much clearer!

1. The Golden Rule: Relevant Costing

Before we decide whether to "make or buy," we must remember what costs actually matter. In Performance Management, we only care about Relevant Costs. For a cost to be relevant, it must be:

1. Future: Costs that have already been paid (Sunk Costs) are ignored.
2. Incremental: Extra costs that happen only if we make a specific decision.
3. Cash Flow: Not "paper" costs like depreciation.

Quick Review: What to Ignore?
- Sunk Costs: Money already spent (e.g., last year's research costs).
- Committed Costs: Money we are legally obligated to pay regardless of our decision (e.g., a non-cancelable lease).
- Fixed Cost Overheads: General company costs (like the CEO's salary) that don't change because of this one decision.

2. Make-or-Buy Decisions

A Make-or-Buy decision occurs when a company has to decide whether to manufacture a component in-house or purchase it from an external supplier.

The Simple Calculation

To make the right choice, compare the Relevant Cost of Making against the Relevant Cost of Buying.

$ \text{Relevant Cost of Making} = \text{Variable Production Costs} + \text{Specifically Attributable Fixed Costs} $

$ \text{Relevant Cost of Buying} = \text{Purchase Price from Supplier} $

Example: The Pizza Shop Analogy
Imagine you own a pizza shop. Should you make your own pizza dough or buy it pre-made?
- To Make: Flour and water cost \$1.00. You need to hire a part-time baker for \$2.00 per batch. Total = \$3.00.
\n- To Buy: A local bakery sells it to you for \$2.50.
- Decision: Buy it! You save \$0.50 per batch.

Wait! What about Opportunity Cost?

If you choose to make a product, you might be using machines that could have been used for something else. This "lost benefit" is an Opportunity Cost and must be added to the cost of making.

$ \text{True Cost of Making} = \text{Relevant Production Costs} + \text{Opportunity Cost} $

Summary Table: Factors to Consider

- Quantitative: Comparing the actual dollars and cents.
- Qualitative: Is the supplier reliable? Is their quality as good as ours? Can they deliver on time?

3. Outsourcing: The Bigger Picture

Outsourcing is a specialized version of "Make-or-Buy." It usually involves moving an entire function (like IT, HR, or Accounting) to an external provider.

Why Outsource?
- To save costs (the provider might have better economies of scale).
- To focus on "Core Competencies" (doing what you are best at).
- To improve quality by using specialists.

The Risks:
- Loss of control over the process.
- Risk of the supplier increasing prices once you are "locked in."
- Confidentiality issues (giving outsiders your data).

Did you know?
Many major companies outsource their customer service to different countries to take advantage of lower labor costs and 24/7 time zones. This is a massive "Buy" decision!

4. Shutdown Decisions

Sometimes a product or a branch looks like it is losing money. Should we shut it down? Be careful! Accounting "Net Profit" can be deceiving.

The Contribution Rule

A department should usually stay open as long as it earns a Positive Contribution (Revenue minus Variable Costs). This contribution helps pay for the company's general fixed costs.

The Step-by-Step Logic:
1. Identify the Contribution of the department.
2. Identify the Avoidable Fixed Costs (costs that disappear if we close).
3. If $ \text{Contribution} > \text{Avoidable Fixed Costs} $, keep it open!
4. If $ \text{Contribution} < \text{Avoidable Fixed Costs} $, closing it will increase the company's total profit.

Common Mistake: Students often think that if a department shows a "Net Loss" in the accounts, it must be closed. This is wrong! Most of the time, the department is being "charged" with general head-office costs that will still exist even if the department is gone. Focus only on Avoidable costs.

5. Other Short-Term Decisions: Special Orders

Sometimes a customer offers to buy your product at a very low price—lower than your normal selling price. Should you accept?

Accept if:
- The price offered is higher than the Incremental Cost of producing it.
- You have Spare Capacity (unused machines/labor).
- It won't upset your regular customers who are paying full price.

Key Takeaways and Memory Aids

Memory Aid: "F.I.C."
When deciding if a cost is relevant, ask if it is: Future, Incremental, and Cash flow.

Summary Checklist for the Exam:
- Ignore sunk costs and general fixed overheads.
- Include variable costs and specific fixed costs.
- Add opportunity costs if the company is at full capacity.
- Check qualitative factors (reliability, quality, staff morale).
- Contribution is king in shutdown decisions!

Don't worry if this seems tricky at first. The secret is to always ask yourself: "If I make this decision, how much extra cash will actually leave or enter the bank account?" Keep it simple!

Quick check

Can you answer these now?

Open each question to check the key ideas from this chapter.

What are the three criteria for a cost to be considered relevant in short-term decision making?

A relevant cost must be future, incremental, and a cash flow.

Which costs are considered irrelevant and should be ignored in short-term decision calculations?

You should ignore sunk costs, committed costs, and general fixed overheads.

How is the financial comparison made in a basic make-or-buy decision?

Compare the Relevant Cost of Making ($ \text{Variable Costs} + \text{Specific Fixed Costs} $) against the Relevant Cost of Buying ($ \text{Purchase Price} $).

How does opportunity cost affect a make-or-buy decision when a company is at full capacity?

Opportunity cost must be added to the cost of making the product in-house.

What qualitative factors should be considered in a make-or-buy or outsourcing decision?

Consider supplier reliability, product quality, delivery lead times, and confidentiality.

What are the primary benefits and risks of outsourcing a business function?

Benefits include cost savings and focusing on core competencies; risks include loss of control and confidentiality issues.

What is the rule for deciding whether to shut down a loss-making department?

Keep the department open if its Contribution is greater than its Avoidable Fixed Costs.

What criteria are used to determine if a special order should be accepted at a low price?

Accept if the price exceeds incremental costs, the company has spare capacity, and there is no negative impact on regular customers.

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