Week 2 - Costing & pricing in the short-term

Question 1

Special pricing decisions - 5 + 2 qualitative/strategic considerations

Should the (one-off) special order with lower price be accepted? Should the company permanently reduce capacity, or accept the long-term special order?

Answer 1

1. Are last minute orders from usual customers likely?
2. Are there no preferable alternative uses of the spare capacity? Are you able to rent the extra machines to others?
3. Is the excess capacity going to be permanent? How reliable is the co.’s prediction?
4. Will the prevailing market price p be affected? What if other existing customers also ask for discounts?
5. How will the special pricing decision affect the reputation? Value, quality of your brand might be affected.

• Public opinion. Fired employees might hold demonstrations outside office. Is the co. actually able to plan well since need to fire? Internal effects also, morale aspect of surviving employees.
• If downsize, might lose market share and potential to expand in market, might lose economies of scale.

Question 2

Decisions about special orders which appear good in the short term may prove sub-optimal in the long term. Why? 2 main reasons

Answer 2

1. Increasing the range of products via special orders increases COMPLEXITY and thus, in the long term, COSTS
   - Losing efficiency if the machines have to be adjusted each time
2. Accepting/rejecting repeated special orders should not be treated as a series of independent short-term decisions, but as a SINGLE LONG-TERM DECISION!

• Customer might have anchor bias & paid cheaper from another co., so may insist for cheaper price again

Question 3

How to choose the optimal product mix under capacity constraints?

CM per Machine hour formula

Answer 3

1. Compare CONTRIBUTION MARGIN per unit PER LIMITING FACTOR
2. & then rank products

CM per MH = CM per unit / MH needed per unit

Question 4

4 strategic factors for Product mix decisions under capacity constraints

Answer 4

1. Economies of scope (synergies)
   eg. Product A makes use of most of the engines, can diversify based on synergies
2. Costs of heterogeneity & complexity
   eg. resetting machine to produce another product is costly
3. Value to the customer & customer retention
   eg. most customers looking for product A; or biz model is to offer variety of products
4. Overall brand value & positioning
   eg. produce cheap pen + also more expensive pens

Question 5

Porter’s 2 sources of competitive advantage

Answer 5

1. Better customer value for equivalent cost
2. Equivalent customer value for a lower cost

Question 6

6 components of a business’ value chain

For supply chain,
1. Suppliers
2. Manufacturer
3. Distribution company
4. Retail company
5. Final consumer

Answer 6

1. R&D
2. Product/service/process design
3. Production
4. Marketing
5. Distribution
6. Customer service

Question 7

6 advantages of Outsourcing (make-or-buy)

Additional point from seminar
- Decentralised; access to diff. workforce, eg. Europe vs China

Answer 7

1. Build RELATIONSHIP w/ supplier, might help to decrease transaction costs.
   > But danger of becoming too dependent on a particular supplier, even if other suppliers are cheaper (see below limitation)
2. Can focus on its KEY COMPETENCIES (where the co. is adding value)
3. Can maintain a LEANER STRUCTURE
   > from Study.com, a lean structure is designed to create more customer value using fewer resources
4. The chosen supplier could provide BETTER VALUE and allow Plastik to avoid additional costs of INEFFICIENT in-house production
5. Even if it is possible in principle to operate at full capacity, the company
   needs to be aware of WASTAGE & POSSIBLE INEFFICIENCIES which can affect max. capacity available
6. INCREASED LIQUIDITY- cash could be saved & used on other areas of the biz, eg. paying off a loan, purchasing new / replacing old machinery

Question 8

5 limits of Outsourcing (make-or-buy)

Additional point from seminar
- Exposed to geographical constraints, eg. lockdown in another country

Answer 8

1. Plastik is subject to the performance risk of the supplier – how will e.g. product quality be monitored?
2. Plastik might be overly dependent on the chosen supplier and lose bargaining
   power in the value chain
   - important to put safeguards in place to prevent the supplier exploiting the relationship in future (e.g. by charging higher prices).
   - particularly relevant when the product outsourced is specific or unique and not many suppliers for it can be found in the market. Plastik may find it costly or not feasible to switch supplier in the future & might remain “locked in” the relationship w/ current supplier, giving them an opportunity to exploit Plastik’s dependence.
3. Plastik might be exposed to other costs of uncertainty as the production is not
   controlled in-house and might incur coordination problems with the supplier, eg. regarding product design and development
4. In case the subcontractor operates in a different country, the relationship
   would be subject to exchange rate risk
5. Possible difficulties with enforcing contracts might arise

Question 9

Discontinuation decisions - how to approach?

Answer 9

1. Assume (direct) COSTS are allocated on a CAUSE-EFFECT BASIS & will be ELIMINATED.
   *some rent may still incurred
2. Then calculate the PROFIT/contribution of keeping the office vs discontinuing

For this assumption to hold, OH allocation needs to be RELIABLE!
- But INDIRECT relevant costs can be very difficult to measure.
- Therefore, the ABILITY to ALLOCATE indirect costs EFFECTIVELY is crucial for the quality of these decisions (by establishing cause-effect relationships)

Question 10

3 advantages of making in-house

Answer 10

1. More CONTROL over processes & products
2. More INDEPENDENCE (how many to produce, what to produce)
3. Might want to develop EXPERTISE (although paying for add. cost) to DIVERSIFY PRODUCT MIX & to explore diff. market/higher MARKET SHARE (lead to innovation)
   > However, Plastik should not risk its established relationships with its LOYAL CUSTOMERS, eg. spare capacity needs to be kept available to satisfy last minute orders from existing customers
   > Would also want to know the product life cycle first. If the toys have a very short life cycle and demand is likely to fall quickly, not worth the disruption to production of dolls..

Question 11

3 limits of making in-house

Answer 11

1. Rigid structure
2. Possible inefficiencies
3. Might have QUALITY ISSUES
   ie. supplier may be the expert in production instead

Question 12

For Cost-volume-profit analysis, what is the formula to find the no. of units for breakeven?

Answer 12

Breakeven = Fixed costs / Contribution margin

Question 13

From Plastik case,
When doing a scenario analysis where the special order has to be accepted in FULL or rejected, what to take note of?

Answer 13

1. If the original product (dolls) has a higher CM per MH (limiting factor), capacity needs to be moved from dolls to toys.
2. Then calculate the LOST CONTRIBUTION MARGIN from dolls
   ^an opportunity cost, implicit hidden cost in our analysis

Scenario analysis:
Increase in revenues
Increase in variable costs
Increase in CM from toys
Decrease in CM from dolls
Increase in fixed costs
» Increase in operating profit