Other Short-Term Decisions: One-Off Contracts and Shutdown

Two questions come up again and again in a business. A customer offers an order at a price below the usual one: do we take it? And one of our products or branches is showing a loss in the accounts: do we close it? Both look like simple yes-or-no questions, and both are answered wrongly by anyone who trusts the full-cost statement.

The right answers come from relevant costs: what future cash will change if we say yes, or if we close?

This topic applies the relevant costing principles to one-off contract (special order) decisions and shutdown decisions, shows how to deal with orders when capacity is full, and adds the closely related choice of selling a joint product at the split-off point or processing it further. It also gives a framework for presenting decision advice.

Each method is worked through with a numerical example, including a comparison with the wrong full-cost answer.

Short-term decisions and relevant costs

The idea of relevant costs applies to short-term and long-term decisions alike. A short-term decision has financial consequences soon after it is taken, such as an immediate rise in profit or cash. A long-term decision usually needs capital investment, with benefits spread over several years, and the time value of money must be considered. Examination questions on this topic are short-term.

Management decisions where relevant costing is used include:

• one-off contract decisions;
• make-or-buy decisions (previous topic);
• shutdown decisions; and
• joint product further processing decisions.

One-off contract decisions

Management may have a chance to do a contract or job for a customer that is “once only” and will not be repeated. The decision is whether to accept the customer’s price, or to set a price at which an incremental profit is made. It is worth doing if the extra revenue exceeds the relevant costs of the work, including any opportunity costs.

Such decisions often arise when there is spare capacity and a chance to earn extra profit. But relevant cost analysis should not be applied to all work. A business must earn enough profit in total to cover all its fixed costs and make an overall profit. Relevant costs do not tell management what size of profit margin is needed to achieve that.

If every job were priced at relevant cost, the business would lose money overall.

Worked example: the right way and the wrong way

Kano Steel Ltd is offered a one-off payment of ₦300,000 for a special job. Details:

• Labour: 150 hours at ₦800 an hour. The employees have the skills and are on the payroll, but are idle because of a downturn.
• Material A: 120 kg are needed. The material is in common use. The stock cost ₦800 a kg originally. It would cost ₦900 a kg to replace.
• Material B: already in stock from over-buying; original cost ₦70,000; no other use. It is toxic, and if not used in this job the company must pay ₦30,000 to dispose of it.
• Storage unit: needed for two months. The company is committed to rent it for the year at ₦10,000 a month and is not using it. A neighbour has offered to rent it for ₦14,000 a month.
• Overhead: absorbed at ₦900 per labour hour (₦600 fixed, ₦300 variable). Total fixed overhead will not increase.
• Delivery: extra cash cost of ₦22,000.

A trainee adds up the accounting costs: labour 150 × ₦800 = ₦120,000; material A 120 × ₦800 = ₦96,000; material B ₦70,000; storage 2 × ₦10,000 = ₦20,000; overhead 150 × ₦900 = ₦135,000; delivery ₦22,000. Total ₦463,000. Since this is above ₦300,000, the trainee recommends rejecting the job. That is wrong. The relevant costs are:

Incremental profit = ₦300,000 − ₦173,000 = ₦127,000. The job should be accepted on financial grounds. Note how the two answers differ by ₦290,000: sunk costs, committed rent, idle labour and fixed overhead were all in the trainee’s calculation.

Other factors to consider

• Will regular customers learn of the low price and demand it?
• Is the capacity really spare, and is there a better use for it?
• Does the order bring future business, or damage the brand?
• Will accepting it cause problems if the regular demand picks up?

Special orders when capacity is full

If the company has no spare capacity, the order displaces regular work. The relevant cost then includes the contribution lost from that work (an opportunity cost).

1. The variable cost of making each is ₦1,100, so the order’s contribution is 1,000 × ₦400 = ₦400,000.
2. But the factory is full, and accepting the order means 800 regular units, each earning a contribution of ₦600, cannot be made.
3. Contribution lost.
   800 × ₦600 = ₦480,000.
4. Net effect.
   ₦400,000 − ₦480,000 = −₦80,000.
5. Reject, unless the regular customers can be served another way (for example, by outsourcing at a cost less than ₦600 a unit of lost contribution).

Where the scarce resource is a specific input (labour hours, machine hours), use the contribution per unit of the resource, as in the previous topic, to value what is given up.

Shutdown decisions

A shutdown decision is a decision whether to close down part of a company’s operations, such as a product line, a department or a branch. From a financial point of view, an operation should be closed if the benefits of closing exceed the relevant costs. If an operation is closed, the company loses its contribution but saves its directly attributable fixed costs (cash costs that would stop).

A shutdown may be long-term when it involves large costs such as redundancy payments, but in examinations it is treated as short-term.

Worked example

Company V makes four products. The budget for next year is (₦000):

Products N and Q show a loss after the share of general fixed costs. Should they be withdrawn? Compare, for each product, the contribution lost with the directly attributable fixed costs saved:

Closing N improves profit by ₦70,000 and closing Q by ₦20,000. M and O make a contribution well above their attributable fixed costs and should stay. The general fixed costs (₦700,000 in all) continue whatever is decided, so the share charged to each product is irrelevant.

After closing N and Q: contribution of M and O = ₦1,600,000; less their attributable fixed costs ₦650,000 and the whole general fixed costs of ₦700,000 = ₦250,000 profit, which is ₦90,000 more than the ₦160,000 before. ✓ Q’s closure gains only ₦20,000, so non-financial factors (customers, staff, strategy) may justify keeping it.

A product in a similar position: a product with a loss in the full-cost statement but whose contribution exceeds its attributable fixed costs should be kept, because dropping it reduces cash flow even though it shows a loss. That is exactly what happens to product N if its attributable fixed costs had been ₦100,000 instead of ₦220,000: closure would lose ₦50,000.

Points to check in a shutdown decision

• Which fixed costs are truly avoidable? Only cash costs that would stop count.
• Can the resources freed (space, people, machines) be used profitably elsewhere? If so, their contribution is a benefit of closing.
• Effect on other products: closing may reduce sales of complementary products.
• One-off closure costs: redundancy pay, contract termination charges.
• Non-financial effects: staff morale, customer relations, reputation, strategic fit.

Joint products: sell now or process further

Further processing decisions for joint products follow the same logic. At the split-off point, the common costs are sunk. The decision depends only on the extra revenue from processing further and the extra cost of doing it.

1. Extra revenue.
   ₦42 − ₦30 = ₦12 a kg.
2. Extra cost = ₦8.
3. Net gain.
   ₦4 a kg × 10,000 = ₦40,000.
4. Process further.
5. The share of joint costs apportioned to S is irrelevant: it is the same either way.

A framework for decision advice

1. State the decision and the options.
2. List the relevant items: future, incremental, cash. Say which items you have excluded and why (sunk, committed, absorbed, depreciation).
3. Calculate the incremental profit (or the net cash flow difference) for each option.
4. State assumptions, such as spare capacity, and whether costs would change.
5. Recommend on financial grounds.
6. Add non-financial factors that might alter the decision.

The ideas in more depth

Why the full-cost answer is wrong

A full cost includes absorbed fixed overhead, depreciation and past costs, none of which change with the decision. Including them makes the cost of a marginal job look higher than the actual cash effect, so profitable opportunities are rejected.

In shutdown decisions, the apportionment of general fixed costs makes a product look loss-making even when it contributes to those costs, and closing it just moves the general costs to the remaining products.

Death spiral of full-cost closure

If a firm repeatedly closes products because they show a loss after apportionment, the general fixed costs are spread over fewer and fewer products, making the remaining ones look worse, so more are closed. This can destroy a viable business. Only avoidable costs should decide.

Limits of relevant costing

• It looks at the short term. It ignores the time value of money, which matters for long-term decisions.
• Estimates of future costs and revenues are uncertain.
• It does not show whether the business as a whole will cover its fixed costs.
• It ignores non-financial factors unless they are added.

Relevant cost of a decision and the minimum price

The total relevant cost of a contract is the minimum price at which the firm is no worse off. A quotation should be above this by a margin that reflects risk, the effect on other work, and the need to contribute to overheads. For a regular product, the price must cover the full cost in the long run.

Worked example: a contract and a shutdown

1. Department E.
   Contribution = ₦1,100,000 − ₦700,000 = ₦400,000.
   Attributable fixed costs saved by closing = ₦420,000.
   Closing would raise profit by ₦420,000 − ₦400,000 = ₦20,000, so on financial grounds close it (unless the freed resources or other benefits change this).
   The ₦90,000 share of general fixed costs is irrelevant, because it continues.
   Here the full-cost statement agrees with the decision, since E loses ₦400,000 − ₦420,000 − ₦90,000 = ₦110,000, but for the wrong reason: the correct gain from closing is only ₦20,000, not ₦110,000.
2. Contract. Labour: nil (spare capacity).
   Cloth: 200 × ₦340 = ₦68,000.
   Extra cash costs ₦15,000.
   Relevant cost = ₦83,000.
   Incremental profit = ₦250,000 − ₦83,000 = ₦167,000.
   Accept.

Relevant costs and pricing

Relevant costing gives a minimum price for a contract: the total relevant cost, below which the firm is worse off. Above it, every extra naira is incremental profit. A firm negotiating with a customer can therefore see how much room there is. In the Kano Steel example, the minimum price is ₦173,000 and the offer is ₦300,000, so there is ₦127,000 of room.

A sensible response might be to ask for more, since the minimum is far below the offer. Conversely, a customer who offers ₦160,000 is offering less than the relevant cost, and the firm should decline or renegotiate.

Relevant costs do not give a maximum price. That comes from what the customer will pay and what competitors charge. A good quotation lies between the two, higher if capacity is tight or the job is risky, lower if capacity is idle and the firm wants the work.

Replacement and abandonment decisions

Relevant costing also guides short-term choices between continuing and stopping a use of an asset. A machine that earns ₦15,000 a year for two more years (₦30,000 in all) and could be sold now for ₦25,000 is worth selling only if the ₦25,000 beats the ₦30,000 of net cash it would earn, which it does not, so it should be kept.

The maintenance contract of ₦20,000 a year is committed in both cases, so it does not affect the choice. If the machine could be sold for ₦35,000, selling would be better by ₦5,000.

Common mistakes in the exam

• Including sunk costs (original cost of stock) in a contract evaluation.
• Charging idle labour at full cost, or absorbing fixed overhead into the cost of the order.
• Ignoring an opportunity cost, such as lost rent or lost contribution.
• Forgetting that a disposal cost saved is a benefit.
• Deciding a shutdown on the profit after apportioned fixed costs instead of comparing contribution forgone with fixed costs saved.
• Treating all fixed costs as avoidable.
• Not stating the assumption about spare capacity.
• Giving only numbers, with no recommendation or non-financial comments.

Quick revision

• One-off contract: accept if revenue > relevant costs. Incremental profit = revenue − relevant cost.
• Spare capacity: idle labour and fixed overhead cost nil. Full capacity: add the contribution lost.
• Shutdown: close if fixed costs saved > contribution lost. Ignore apportioned general fixed costs.
• Further processing: process if extra revenue > extra cost. Joint cost is irrelevant.
• Present advice with assumptions and non-financial factors.

Practice questions

These are original questions written in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one before you open the answer.

Section A style: multiple choice

Section B style: written questions

A further written question

Model answers

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