Production Economics and Decisions

Production Economics and Decisions

From the scenario for Katrina’s Candies, determine the relevant costs for the expansion decision, and distinguish between the short run and the long run costs. Recommend the key decision-making criteria that Katrina’s Candies should use for expansion decisions in the short run and in the long run. Determine under what conditions, a company should or should not continue to produce the good or service.

Although several costs are appropriate for financial reporting purposes, they are not always appropriate for decision making purposes (McGuigan, et al., 2014). According to our text, “the relevant cost in economic decision making is the opportunity cost of the resources rather than the historical outlay of funds required to obtain the resources” (McGuigan, et al., 2014, p. 285). Relevant cost refers to the incremental and avoidable cost of implementing a business decision. In the case of Katrina’s Candies, the focus should be on the extent of cash outflows that should result from that expansion decision rather than other costs that will not affect the company’s future cash flows. For example, if an individual purchases a discount card from a company that would entitle them to a 10% discount and only saves $1.00 on their next purchase but finds the same item at another company for less, the money they already spend would be irrelevant (sunk cost).

Opportunity and incremental costs would be relevant in the case of Katrina’s Candies expansion decision. Incremental costs are those expenditures which will be incurred or avoided as a result of making a decision. In this case, the relevant cost is the incremental or different costs between the alternatives being considered. Opportunity costs would be the cash inflow that will be sacrificed as a result of the decision management makes (Accounting Simplified, 2013).

In short run costs, there are both fixed and variable costs (changes with output), but in long run costs there are no fixed costs. Fixed cost includes things firms cannot change (e.g., capital costs and rent for land). Other costs that can be changed with output are variable. In other words, they are the cost you have to pay when you produce nothing (but are still in business) (IA State, n.d.). In the case of Katrina’s Candies, short run can be defined as the time period when at least one of the factors of production is completely fixed. For example, it could mean that the company has reached full capacity in their current warehouse or factory site. The long run could be viewed as the time period when all the factors of production can be changed. In this case, Sabrina’s Candies can now look to expand without any problems (Pearson, 2009).

The most optimal outcome should be the key decision-making criteria for Katrina’s Candies.

Accounting Simplified. (2013). Relevant cost and decision making. Retrieved from

Relevant Cost of Decisions

IA State. (n.d.). Chapter 7 costs. Retrieved from

http://www2.econ.iastate.edu/classes/econ301/jintanakul/Notes/Ch7.pdf

McGuigan, J.R., Moyer, R.C., & Harris, F.H. (2014). Managerial economics:

Applications, strategies, and tactics. (13th Ed.). Stanford, CT: Cenage

Learning

Pearson. (2009). Topic 3 costs: in the short and long run. Retrieved from

http://wps.pearsoned.co.uk/ema_uk_he_boakes/104/26857/6875577.cw/cont

ent/index.html

https://www.boundless.com/economics/textbooks/boundless-economics-textbook/production-9/production-cost-64/short-run-and-long-run-costs-242-12340/

Relevant costs are those that are avoidable or can be eliminated by choosing one alternative over another. Relevant costs are also known as differential, or incremental, costs. In general, variable costs are relevant in production decisions because they vary with the level of production. Likewise, fixed costs are generally not relevant, because they typically do not change as production changes. However, variable costs can remain the same between two alternatives, and fixed costs can vary between alternatives. For example, if the direct material cost of a product is the same for two competing designs, the material cost is not a relevant factor in choosing a design. However, other qualitative factors relating to the material, such as durability, may still be relevant. Likewise, fixed costs can be relevant if they vary between alternatives. Consider rent paid for a facility to store inventory. Although the rent is a fixed cost, it is relevant to a decision to reduce inventory storage costs through justin-time production techniques if the cost of the rent can be avoided (by subleasing the space, for example) by choosing one alternative over another.
The costs which should be used for decision making are often referred to as “relevant costs”. CIMA defines relevant costs as ‘costs appropriate to aiding the making of specific management decisions’.
To affect a decision a cost must be:
a) Future: Past costs are irrelevant, as we cannot affect them by current decisions and they are common to all alternatives that we may choose.
b) Incremental:   Meaning, expenditure which will be incurred or avoided as a result of making a decision. Any..

Freeman,

I concur that a large part of deciding whether the Katrina’s Candies should continue or discontinue producing goods and services is calculating and assessing the opportunity cost (the value you receive from pursuing a course of action versus the value you would have received from the alternative you did not choose) (Grimsley, 2016). In other words, you are weighing the cost of that missed opportunity. Though opportunity costs are usually defined in terms of money, you have to also factor in time and other finite resources involved. Many people overlook opportunity cost which causes them to lose out on value-maximizing opportunities.

Grimsley, S. (2016). Opportunity cost: Formula and analysis. Retrieved from

http://study.com/academy/lesson/opportunity-cost-formula-analysis.html

http://www.referenceforbusiness.com/management/Ob-Or/Opportunity-Cost.html

http://www.investopedia.com/financial-edge/0812/the-role-of-opportunity-cost-in-financial-decision-making.aspx