Reference no: EM131068945
Accounting DQ
This chapter covers various incremental analysis decisions. For short-run decisions (such as whether to accept special orders), the fixed cost component generally is not differential and should not be considered. The use of full cost for some short-run decisions will erroneously render the alternative option less attractive, creating what is known as "the full-cost fallacy." Consider the following example of a special order decision in which fixed costs are unitized:
Example: On a particular month, U-Develop receives a special order from an out-of-town merchant who is willing to pay $4,000 for 10,000 photo prints developed, or $0.4 per print. An analysis of U-Develop's cost structure shows that it incurs variable cost of $0.36 per print and $1,500 monthly fixed cost. U-Develop can handle the special order without affecting its regular business.
The full cost of the special order is calculated by an employee as follows.
$1,500 + $0.36 x 10,000 / 10,000 = $0.51 per print.
By unitizing the fixed cost, the full cost calculation gives the impression that the special order is not a profitable one as the unit cost of $0.51 per print is higher than the unit price offered of $0.4. However, since the monthly fixed cost of $1,500 remains the same with or without the special order, the differential cost relevant for this decision context is the variable cost of $0.36 per print. Therefore, the special order should be accepted, netting an additional profit of $400 (= ($0.4 - $0.36) × 10,000 prints) for the month. The "full-cost fallacy" is avoided.
In the long run, however, all costs must be covered or the company will fail.
Any thoughts?
Author's Corner Video "Incremental Analysis"
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Author's Corner Video "Relevant, Opportunity, and Sunk Costs"
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Author's Corner Video "Conclusion"
In this video, the author provides a very good review of all the key concepts presented during this course and how they all tie together to help a manager make more informed financial and business decisions. Please share what you will take-a-way from this course and how you will utilize what you have learned in the future.
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