4.3 Short-Term Operating Decisions
Key Takeaways
- Make-or-buy: compare the avoidable cost of making (including opportunity cost of freed capacity) with the outside purchase price.
- Accept a special order when there is idle capacity and the price exceeds incremental cost per unit; existing fixed costs are ignored.
- Sell-or-process-further: process further only if incremental revenue beyond split-off exceeds incremental processing cost; joint costs are sunk.
- Keep-or-drop: drop a segment only if avoidable fixed cost savings exceed the contribution margin lost.
- Allocated common fixed costs are unavoidable and never decide whether a segment stays or goes.
Make-or-Buy (Insource vs. Outsource)
A make-or-buy decision compares the avoidable cost of producing a component internally with the price to buy it outside. Relevant making costs are direct materials, direct labor, variable overhead, and any avoidable fixed overhead. Unavoidable allocated overhead is excluded.
If making frees no other use of capacity, compare avoidable cost vs. price directly. If insourcing ties up capacity that could earn contribution elsewhere, add that opportunity cost to the cost of making.
Worked Example: Make-or-Buy
A firm makes 10,000 units of Part X. Per-unit costs to make: materials $6, labor $4, variable overhead $3, allocated fixed overhead $5. A supplier offers Part X at $16. Of the $5 fixed overhead, $2 is avoidable if the firm stops making it.
- Avoidable cost to make = $6 + $4 + $3 + $2 = $15 per unit
- Buy price = $16 per unit
Making is cheaper by $1/unit, or $10,000 total — keep making. If the freed space could earn $20,000 of contribution from another product, the opportunity cost ($2/unit) makes buying cheaper. Note the $3 unavoidable fixed overhead is irrelevant.
Special-Order Pricing
A special order is a one-time order at below normal price. Accept it when:
- There is idle capacity (the order does not displace regular sales), and
- The price exceeds the incremental cost per unit.
With idle capacity, fixed costs do not change and are irrelevant — only variable (and any order-specific) costs matter. Accepting at a price above variable cost adds contribution and profit.
Without idle capacity, accepting the order displaces regular units; add the opportunity cost (lost contribution on bumped sales) to the incremental cost floor.
Worked Example: Special Order
Normal price is $50; variable cost is $30; fixed cost is $12/unit at normal volume. A customer offers $38 for 2,000 units, and the plant has idle capacity. A special $1/unit shipping cost applies.
- Incremental cost = $30 + $1 = $31
- Offer = $38 → contribution = $7/unit × 2,000 = +$14,000
Accept: the $12 fixed cost is already covered by regular volume and is irrelevant. The order raises profit $14,000. If, instead, the plant were full and each order unit displaced a $20-CM regular unit, the floor becomes $31 + $20 = $51 and $38 would be rejected.
Sell-or-Process-Further
In joint production, costs incurred up to the split-off point are joint costs — sunk and irrelevant to whether you sell now or process further. The decision rule:
Process further only if incremental revenue (from further processing) > incremental processing cost.
Example
Product Y sells for $15 at split-off. Processed into Y-Plus it sells for $26, with $7 of added processing cost per unit.
- Incremental revenue = $26 − $15 = $11
- Incremental cost = $7 → net benefit = +$4/unit
Process further. The joint cost allocated to Y (say $9) is irrelevant — it is the same either way.
Keep-or-Drop a Segment
To decide whether to drop a product line, segment, or store, compare the contribution margin that would be lost against the fixed costs that would be avoided.
Keep the segment if lost CM > avoidable fixed cost. Drop it if avoidable fixed cost savings > lost CM.
| Item | Amount |
|---|---|
| Segment contribution margin (lost if dropped) | $120,000 |
| Avoidable fixed costs (saved if dropped) | $90,000 |
| Unavoidable allocated fixed (continues) | $50,000 |
Dropping saves $90,000 but sacrifices $120,000 of CM — a $30,000 decline in profit, so keep it. The $50,000 allocated cost is irrelevant; it merely shifts to other segments. A reported segment "loss" driven by allocated overhead is a classic trap — the line may still be contributing.
Capacity Is the Common Thread
Across all four short-term decisions, the pivotal question is whether spare capacity exists. Capacity determines whether an opportunity cost enters the analysis.
| Decision | With idle capacity | At full capacity |
|---|---|---|
| Special order | Floor = incremental variable cost | Add lost CM on displaced sales |
| Make-or-buy | Compare avoidable cost vs. price | Add CM the freed capacity could earn |
| Accept new business | Take if price > variable cost | Take only if CM beats displaced work |
When capacity is available, fixed costs are unchanged and irrelevant, so the price floor is simply incremental variable cost. When capacity is constrained, every accepted unit bumps an existing one, so the opportunity cost of the displaced contribution is added to the floor. Spotting which world you are in is usually worth the whole question.
A Special-Order Caution: Long-Run Pricing
Special-order math justifies accepting a price above incremental cost in the short run, but the exam tests whether you understand the limits. Repeatedly pricing at variable cost will not cover fixed costs or provide profit over the long run, so special-order logic should not set normal prices.
Other qualitative cautions on special orders:
- Price discrimination / customer reaction: regular customers may demand the lower price if they learn of it, eroding normal-margin sales.
- Robinson-Patman concerns: large price differences to similar buyers can raise legal issues in the U.S.
- Capacity for the future: locking idle capacity into a low-margin order can crowd out higher-margin business later.
The correct answer accepts the order on the numbers but flags that it is a one-time, idle-capacity decision — not a pricing policy.
A segment shows: sales $400,000, variable costs $260,000, and fixed costs $160,000 (of which $95,000 is avoidable if the segment is dropped and $65,000 is allocated corporate cost). Should the segment be kept or dropped?
A plant with idle capacity receives a special order of 1,000 units. Variable manufacturing cost is $22/unit, variable selling is normally $5/unit but is avoided on this order, and allocated fixed cost is $8/unit. What is the minimum acceptable price per unit?