Should the company drop a product, add a line or accept a special order? These are the decisions Case Study requirements love, because the answer depends on knowing which numbers matter and which do not. This topic covers product mix, the relevant costs for short-term decisions and how to weigh them against long-term goals.
In 30 seconds
Product mix decisions add, drop or reshape product lines. In short-term decisions use only relevant figures: future cash flows that change because of the decision, ignoring sunk costs, non-cash items and costs common to all options. Opportunity cost applies only to scarce resources. Long-term decisions commit large sums and shape strategy, so test short-term choices against long-term objectives.
A product with a negative contribution may still be worth keeping if it supports other lines.
What a product mix is
A product mix is the set of all product lines and items a manufacturer plans to produce. It has four characteristics.
| Characteristic | Meaning |
|---|---|
| Width | How many different product lines the company carries |
| Length | The total number of items in the mix |
| Depth | How many variants are offered of each product in a line |
| Consistency | How closely the lines are related in end use, production, distribution or another way |
Product mix and profitability decisions are about adding or removing a product, adding a line, lengthening an existing line or bringing out new variants of a brand. Cost information should guide them. Review the existing lines. Weigh adding and deleting lines. Decide the emphasis between new and existing lines and between internal development and external acquisition.
Judge how adding or removing a line affects the others, and forecast the effect of future external change.
Decision making
Effective decision making is the process through which alternatives are selected and then managed through implementation to achieve business objectives. It follows a systematic process with clear steps. A successful business needs right decisions in the short term and the long term.
Short-term decisions
Short-term decisions are usually operating or tactical decisions made repeatedly in many areas. They are simpler than long-term decisions for two reasons. The time value of money is not considered, and fixed costs, which are incurred whatever is decided, are usually left out unless the decision creates a new fixed cost. The main approach is to use relevant cash flows.
| Relevant item | Rule |
|---|---|
| Cash flows | Only actual cash flows count. Ignore depreciation, interdivisional charges and other notional charges |
| Future costs and revenues | Past figures are only a guide. Money already spent is a sunk cost and is not relevant |
| Incremental items | Only changes caused by the decision count. Items common to all alternatives are ignored |
| Opportunity cost | The benefit lost by choosing one option over another. It applies only to scarce resources. If a resource is not scarce there is no sacrifice |
Typical short-term decisions are output levels, product mix with a capacity limit, special pricing, special orders, make or buy, replacing equipment and discontinuing a product. The Case Study assumes you know the techniques from earlier subjects, so the skill tested is choosing the right one and explaining the result.
Long-term decisions
Long-term decisions affect the overall objectives of the firm. They respond to the competitive situation in its social, economic and political setting. They involve major capital spending on equipment and facilities, and policies that shape the company, based on its vision and mission.
Balancing the two
A short-term gain can harm the long term, and a short-term sacrifice can help it. The key is to consider the impact of each short-term decision on long-term objectives so that the trade-off is deliberate. The balanced scorecard is one tool for doing this.
Worked example: November 2014, Mago Pharmaceuticals
The case gave information on three product lines. Fixed costs of ₦60 thousand were allocated by sales, and the case said none would be eliminated if a line stopped. Figures are in ₦ thousand.
| Item | Riagol | Tiagol | Ziagol | Total |
|---|---|---|---|---|
| Sales | 285 | 200 | 260 | 745 |
| Direct materials | 145 | 125 | 135 | 405 |
| Labour | 60 | 60 | 75 | 195 |
| Variable overheads | 30 | 20 | 25 | 75 |
| Contribution | 50 | (5) | 25 | 70 |
- Profit now. Total contribution is 70 and fixed costs are 60, so the three lines earn 10.
- If Tiagol stops. Its negative contribution of 5 disappears, but the fixed costs of 60 remain.
Profit becomes 75 − 60 = 15. - Judgement. On the numbers alone, Tiagol should be discontinued, because it loses money even before any fixed cost is charged.
- Other factors. Tiagol serves women. Dropping it may weaken the whole brand and the other two lines. Management should first ask whether a price rise or cost cut can make the contribution positive, whether the freed capacity has a better use and how customers and the market would react.
The suggested solution in the past paper reaches the same decision, with the same note that other factors must be considered.
Worked example: a special order
A company has spare capacity. A customer offers ₦420 a unit for 1,000 units. Variable cost is ₦300 a unit, and fixed costs are already covered. Contribution is 120 × 1,000 = ₦120,000, so the order adds profit if it does not draw sales from regular customers at a higher price. If capacity were scarce, the contribution lost on the regular sales would be the opportunity cost and would have to be deducted.
Common mistakes
- Dropping a product because it shows a loss after allocated fixed costs, when those costs do not go away.
- Including sunk costs, depreciation or common costs in a short-term decision.
- Charging an opportunity cost where a resource is not scarce.
- Basing the decision on the numbers alone and ignoring effects on other lines.
- Making a short-term choice without testing it against long-term goals.
Quick revision
- Mix: width, length, depth, consistency.
- Relevant: future, cash, incremental, opportunity cost on scarce resources.
- Ignore: sunk, notional and common costs.
- Drop a line only if contribution is negative or a better use exists and no wider harm follows.
- Balance short-term and long-term effects.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria exam. Try each one before you open the answer.
Question 1. Which item is NOT relevant to a short-term decision?
- Extra materials needed for an order
- Money already spent on a design
- Overtime paid for the order
- Lost sales on regular products
Show the answer
B. Money already spent is a sunk cost.
Question 2. The width of a product mix is:
- The number of variants of each product
- The number of different product lines
- The total number of items
- How closely lines are related
Show the answer
B. Depth is the number of variants, and length is the total number of items.
Question 3. Opportunity cost applies:
- To every resource
- Only to scarce resources
- Only to cash
- Only to fixed costs
Show the answer
B. If a resource is not scarce, using it sacrifices nothing.
Question 4. A line has a contribution of minus ₦5,000 and none of the fixed costs can be avoided. Dropping the line changes profit by:
- Minus ₦5,000
- No change
- Plus ₦5,000
- Plus the fixed costs
Show the answer
C. The loss of 5,000 is removed, and the fixed costs remain.
Question 5 (6 marks). Distinguish between short-term and long-term decisions and explain why they must be considered together.
Model answer
Show the model answer to Question 5
Short-term decisions (2 marks). They are operating or tactical decisions made repeatedly. They ignore the time value of money and usually exclude fixed costs, and use relevant cash flows only.
Long-term decisions (2 marks). They are strategic, involve large sums and major capital spending and respond to the competitive, social, economic and political setting to achieve the vision and mission.
Considered together (2 marks). A short-term decision can harm long-term profit. A short-term sacrifice can support it, so each short-term choice should be tested against long-term objectives, for example with the balanced scorecard.
The next topic covers project appraisal, flexing the numbers and sensitivity analysis.
Pathfinder on Product mix, profitability and short-term and long-term decisions
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
The solution shows a negative contribution for one line, and the key adds other factors to consider. Rework it using the worked example in this topic.
Revise first: Worked example: November 2014, Mago Pharmaceuticals
The requirement asks for the mix that maximises margin when staff time is the limit. Use the relevant cost rules to set out the contribution by service.
Revise first: Decision making
Source: ICAN Pathfinder, Case Study. Diets covered: November 2014 and November 2015.
Spotted a mistake? Tell us and we will check it.
