Putting It Together: Short-Term Decision Making

Person in hiking boots with a mountain in the backgroundLet’s revisit the Tuff Boots scenario.

Remember that the average unit product cost to produce a pair of boots is $90, and the company makes 10,000 pairs of boots each year, selling them for $129 each. Vice-president Abby Kerr believes the company could save substantial amounts of money by having an outside supplier make the boots rather than doing it in-house. A supplier in China has made an initial commitment to provide boots for $70 each.

Let’s say Abby takes her idea to the president, Carl Less, who has a background in managerial accounting and notes that it is not accurate to assume the company will eliminate $900,000 ($90 per unit cost times 10,000 units), in total production costs by outsourcing production. The average unit cost includes factory equipment lease payments along with supervisors’ salaries and factory rent. He also notes that the equipment lease is for several years and that the company is locked into a long-term lease for the factory building. There is also a collective bargaining agreement with the hourly staff, not to mention the ethical dilemma that would be posed in letting go of a significant number of salaried workers, like production supervisors.

In fact, qualitative (non-financial) factors may outweigh the quantitative factors in making a decision. For example, assume management at Tuff Boots sees a decline in the market for hiking boots. Outsourcing production makes it easier to quickly reduce costs in the face of a downturn by simply ordering fewer boots from the supplier. Continuing to make boots internally takes away this flexibility since the significant fixed costs associated with manufacturing are difficult to reduce in the short run if production declines.

But outsourcing has its potential drawbacks as well. The outsourced (cheaper) product may not be of the same quality. The supplier may not be reliable. Employee morale overall may suffer if employees in one segment of a company are fired. This can lead to an unhappy and inefficient workforce in other areas of the company, causing costs to rise or sales to fall.

So, financial analysis and differential analysis are tools to use to inform the decision-making process, but they have to be used in conjunction with all of the other tools and management skills that companies rely upon to be profitable.