ACCT20001 Chap.10 Long Term Decisions
Long Term Decisions
The previous chapter held capacity constant and asked what to do inside it. Lengthen the horizon and that constraint dissolves. A business cannot avoid this month's lease, but to keep trading across years it has to replace machines, renew leases and reinvest, so a cost that looks immovable this month is not immovable at all on that timescale.
Every cost is avoidable at some horizon, and the decision being taken sets which horizon applies. The subject's own roadmap gives the two questions this week answers: how the firm should price its products, and how activity based management can bring down costs that only move over a long horizon.
The pricing half connects directly back to the three product costs met early in the semester, because a price has to recover what the product actually consumed, and the inventoriable figure carries none of the research, design, marketing, selling or administration the product also used.
The cost management half rests on a shape worth internalising: cost is committed long before it is incurred, so by the time a product reaches the factory floor its materials, tolerances and part count have already fixed most of what it will cost to make. A cost reduction programme aimed at the production line is working where almost nothing remains negotiable.
What this chapter covers
- 01
Why fixed costs stop being fixed once the horizon lengthens
- 02
Cost committed early against cost incurred late, and what the gap implies
- 03
Why long-run cost management is a design activity rather than housekeeping
- 04
Pricing on full value chain cost rather than on inventoriable cost
- 05
What happens arithmetically when the wrong cost base is marked up
- 06
Why full cost is a starting point and not an obligation for every price
- 07
Activity based management: attacking the driver rather than the total
- 08
Why an activity saving only becomes a cash saving when capacity moves
- 09
Naming the horizon as part of the answer
Show what a mark-up on the wrong cost base does to a price
- 2Build the full value chain cost by adding the downstream and upstream functions to production cost: $118 plus $22 plus $19 plus $6, which is $165.
- 1Apply the mark-up to that base: $165 plus 20 per cent, which is $198.
- 1Apply the same mark-up to the inventoriable base instead: $118 plus 20 per cent, which is $141.60.
- 1State the consequence: $141.60 is $23.40 below what the unit costs the firm across the whole chain, so every sale would reduce profit while appearing to carry a margin.
Key terms
- Committed cost
- Cost fixed by decisions already taken, particularly during design, long before the money is actually spent.
- Incurred cost
- Cost as it is actually spent, which for most products happens well after the decisions that determined it.
- Activity based management
- The use of activity and driver information to redesign products or processes so that they demand fewer units of an expensive activity.
- Installed capacity
- Resources put in place to support a level of activity, which continue to cost money until they are withdrawn or redeployed.
- Cost-plus pricing
- Setting a price by applying a mark-up to a stated cost base, where the choice of base decides whether the price recovers what the product consumed.
- Non-value-adding activity
- Work that consumes resources without adding usefulness the customer would pay for, and therefore a candidate for removal.
- Product life cost
- The whole cost a product causes across its life, from research and design through production to customer service.
Long Term Decisions FAQ
If a price above incremental cost adds contribution, why is a low price a problem?
Because the two statements answer different horizons. Over a few weeks, using idle capacity at a price above incremental cost genuinely adds contribution and is defensible. Over years, a business whose sales are made below full value chain cost cannot fund the design, marketing and service its products consume, and cannot replace the capacity it is using up.
A strong answer names the horizon and treats the low price as a one-off rather than as policy.
Why do computed activity savings so often fail to show up in the accounts?
Because an activity rate is a pool of committed resources divided by a driver quantity. Reducing the driver reduces the allocated cost immediately and reduces the pool not at all, since the salaries, systems and space in that pool were installed to provide a level of capacity.
Until the capacity is withdrawn or redeployed, the firm has bought idle resource rather than a saving, so a complete answer names what happens to the freed capacity.
Does every price have to recover fully allocated cost?
No, and the subject says so directly: profitable firms must earn revenues in excess of full cost overall, but individual prices need not each be set on fully allocated cost, and direct plus partially allocated cost with a mark-up can achieve a similar result. What is examinable is that you know which base you have used and can say why it suits the decision in front of you.
What does it mean to say cost is committed before it is incurred?
It means the decisions that determine most of a product's cost are taken during design, while most of the spending happens later in production. Choosing a part count, a tolerance or a material fixes how many set-ups, inspections and orders the product will require for the rest of its life.
By the time the item reaches the factory floor, the room to negotiate has largely gone, which is why long-run cost management sits with designers rather than with production supervisors.
Exam move
Approach this chapter through the horizon question, because almost every item here is answerable two ways and the mark depends on saying which way you took. Open every answer by naming the horizon and then stay inside it rather than drifting between the incremental and the full-cost comparison halfway through.
Practise the pricing arithmetic in both directions: build a full value chain cost from components, and also work backwards from a proposed price to the cost base it implicitly assumes.
For activity based management questions, always write the second half of the answer, the sentence about released capacity, since an activity calculation presented as a saving without it is incomplete and the marker is looking for exactly that sentence.
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