Short-Term Decision-Making

We now introduce two important concepts that must be considered when estimating costs: short term versus long term, and the relevant range.

Short Term Versus Long Term

Question: When identifying cost behavior patterns, we assume that management is using the cost information to make short-term decisions. Why is this short-term decision making assumption so important?

Answer: Variable, fixed, and mixed cost concepts are useful for short-term decision making and therefore apply to a specific period of time. This short-term period will vary depending on the company's current production capacity and the time required to change capacity. In the long term, all cost behavior patterns will likely change.

For example, suppose Bikes Unlimited's production capacity is 8,000 units per month, and management plans to expand capacity in two years by renting a new production facility and hiring additional personnel. This is a long-term decision that will change the cost behavior patterns identified earlier. Variable production costs will no longer be $60 per unit, fixed production costs will no longer be $20,000 per month, and mixed sales compensation costs will also change. All these costs will change because the estimates are accurate only in the short term.

The Relevant Range

Question: Another important concept we use when estimating costs is called the relevant range. What is the relevant range and why is it so important when estimating costs?

Answer: The relevant range is the range of activity for which cost behavior patterns are likely to be accurate. The variable, fixed, and mixed costs identified for Bikes Unlimited will only be accurate within a certain range of activity. Once the firm goes outside that range, cost estimates are not necessarily accurate and often must be reevaluated and recalculated.

For example, assume Bikes Unlimited's mixed sales compensation costs of $10,000 per month plus $7 per unit is only valid up to 4,000 units per month. If unit sales increase beyond 4,000 units, management will hire additional salespeople and the total monthly base salary will increase beyond $10,000. Thus the relevant range for this mixed cost is from zero to 4,000 units. Once the company exceeds sales of 4,000 units per month, it is out of the relevant range, and the mixed cost must be recalculated.

We discuss the relevant range concept in more detail later in the chapter. For now, remember that the accuracy of cost behavior patterns is limited to a certain range of activity called the relevant range.

Computer Application

Using Excel to Create Charts

Managers typically use computer applications on a daily basis to perform a variety of functions. For example, they often use Excel to generate tables, graphs, and charts. You could use Excel to create the charts shown in Figure 5.1 "Total Variable Production Costs for Bikes Unlimited", Figure 5.2 "Total Fixed Production Costs for Bikes Unlimited", and Figure 5.3 "Total Mixed Sales Compensation Costs for Bikes Unlimited". Here's how:

1. Enter the data. Open a new Excel document and enter the data in two columns: one column for the x-axis (horizontal axis), and one column for the y-axis (vertical axis). Let's suppose you want to create the chart shown in Figure 5.1 "Total Variable Production Costs for Bikes Unlimited". In that case, the x-axis represents units produced, and the y-axis represents total variable costs. An excerpt from your Excel document would appear as follows:

2. Create the chart. After you have entered the data, highlight the appropriate data cells (including headings and labels) and click on Insert, Chart, Scatter. Choose Scatter with Smooth Lines and Markers. The chart that results is linked to your data points. If you change the data, the chart changes, too. (In earlier versions of Excel, the chart wizard walks you through the steps necessary to create the chart.)
3. Format the chart. Now that you have created the chart, select it and use Chart Tools to format it with background shading, text inserts, font size, chart size, and other more advanced features. If you want to display the chart within some other document (e.g., a Word document), you can copy it (highlight the chart and select Edit, Copy from the menu bar) and paste it into the document (select Edit, Paste or Paste Special).

The Excel document created by following these three steps would look like the one shown in Figure 5.1 "Total Variable Production Costs for Bikes Unlimited".

How Cost Behavior Patterns Are Used

Question: How do managers use cost behavior patterns to make better decisions?

Answer: Accurately predicting what costs will be in the future can help managers answer several important questions. For example, managers at Bikes Unlimited might ask the following:

• We expect to see a 5 percent increase in unit sales next year. How will this affect revenues and costs?
• We are applying for a loan with a bank, and bank managers think our sales estimates are high. What happens to our revenues and costs if we lower estimates by 20 percent?
• What happens to revenues and costs if we add a racing bike to our product line?
• How will costs behave in the future if we increase automation in the production process?

The only way to accurately predict costs is to understand how costs behave given changes in activity. To make good decisions, managers must know how costs are structured (fixed, variable, or mixed). The next section explains how to estimate fixed and variable costs, and how to identify the fixed and variable components of mixed costs.

Business in Action 5.2

Budget Cuts at an Elementary School District

A school district outside Sacramento, California, was faced with making budget cuts because of a reduction in state funding. To reduce costs, the school district's administration decided to consider closing one of the smaller elementary schools in the district. According to an initial estimate, closing this school would reduce costs by $500,000 to $1,000,000 per year. However, further analysis identified only $100,000 to $150,000 in cost savings.

Why did the analysis yield lower savings than the initial estimate? Most of the costs were committed fixed costs (e.g., teachers' salaries and benefits) and could not be eliminated in the short term. In fact, teachers and students at the school being considered for closure were to be moved to other schools in the district, and so no savings on teachers' salaries and benefits would result. The only real short-term cost savings would be in not having to maintain the classrooms, computer lab, and library (nonunion employees would be let go) and in utilities (heat and air conditioning would be turned off).

The school district ultimately decided not to close the school because of the large committed fixed costs involved, as well as a lack of community support, and budget cuts were made in other areas throughout the district.