The decisions necessary for improving profits involve the future and must be based on the current and future amounts. The past amounts, such as the amounts in your accounting records, are historical, sunk, and irrelevant amounts. (No decision will affect or change the past.) Those past amounts are useful only if they help you to estimate the relevant future amounts. Irrelevant amounts also include any future amounts that will not be different between alternatives. Hence, decisions to improve profits need only be concerned with the current and future revenues, costs, and expenses that will differ among alternatives.
The relevant amounts in the decision to replace a machine would be the cost to remove the old machine, the cost to purchase and set up the new machine, proceeds from the sale of the old machine, the future cost savings (such as utilities, labor, less scrap, etc.) increased sales in the future due to the new machine's features, changes in income taxes, and any other incremental changes. Ultimately the decision is whether or not the additional cash outlay today is worth the additional cash inflows in the future.
When examining the future cash flows, it is critical that you consider the time value of money. This is done by applying present value factors to the incremental cash amounts. After all, cash in the future is not as valuable as cash in the present.
When you look at the differences in the future amounts, be sure you look hard at the difference in net income. The difference in the bottom line is more important than the difference in sales. Don't strain your organization for little additional profit.
Sample Improving Profits Questions
1) Revenues and expenses that are past, and revenues and expenses that will be the same whether or not a decision is made, can be ______________ from an analysis of whether or not to take an action.
2) When a company has a limited number of machine hours available, the number of machine hours is often referred to as a __________________.
3) A manufacturer with a limited amount of hours available will maximize its profits in the short run when it produces and sells the items with the highest contribution margin per ________.
4) Costs that are partly fixed and partly variable are ___________ costs.
5) For decisions involving the ___________ run, a company might find its profit increasing when it takes actions that result in revenues increasing more than the increase in variable costs.
6) Relevant amounts for a decision are the amounts that will _____________ if an action is taken.
7) In the ________ run, companies' revenues must cover all of the costs and expenses, variable and fixed.
8) Marginal cost is used to describe the cost of the very next unit. _________________ cost is used to describe the cost of the next several units.
9) A visual aid for seeing how a mixed cost behaves is a ___________ of the cost at various levels of activity. This also allows you to see if some data is not reasonable.
10) On a per unit basis, fixed costs become _________________ as volume increases.