In this class, we will focus on short-term decisions. We will try to understand what are short-term decisions, and which are the characteristics of short-term decisions. Examples of these decisions are, for example, is it convenient to produce inside or it is better to outsource the production? How many units we should sell in order to cover the costs? Or should we produce a certain quantity of our product? Which is the best mix of production? These are examples of short-term decisions. We can identify two distinctive characteristics of these types of decisions. The first one is that the impact of this kind of decision is limited. Usually we're talking about an impact which is lower than one year. The second distinctive element of this short-term decision is represented by the fact that they do not require additional investments. So no investments are required. This means that the resources are fixed. To say it in other words, we can say that the asset side of the balance sheet is the same. We do not need to invest to deal with this short-term decisions. So these are the two distinctive characteristics when we deal with short-term decisions. Given the structure, given that we are talking about something that has an impact on a period of time, which is less than one year, and given that we do not need investments, we can say that three main elements enter the decision. These three elements are the first one, the price. The selling price of our product is the first element that characterizes short-term decision. The second component is represented by the quantity. The quantity is the volume of our activity. So how many units are we producing? How many units are we selling? While the third element that characterize this kind of decision is represented by the cost. When we deal about costs, we can identify different classifications of costs. In the moment in which we have short-term decisions, two main classifications of costs are relevant. So basically with respect to our two distinct elements, we can identify the two cost classifications that are particularly useful with respect to the short-term decisions. The first one is the distinction between variable and fixed costs. Basically, if we think of plotting the cost with respect to the quantity, we can distinguish the variable cost from the fixed one. In the moment in which the quantity increases, and then the cost increases as well, we are talking about a variable cost. So basically this is the structure of the total variable cost. If we do not produce, the total cost will be equal to zero. The more we produce, the higher the variable cost. The typical example is represented by direct material or direct labor. It is instead the opposite in the moment in which we have the fixed cost. With the fixed cost the shape is the following. Basically, whatever the quantity we are producing, the total cost will be always the same. Machine depreciation, marketing, commercial expenses, these are example of fixed costs. So this is the first classification that we need in the moment in which we deal with costs about short-term decision, but then we need to keep in mind another classification of costs when we are dealing with this decision, and this classification is the distinction between relevant versus irrelevant costs. In this case, the differentiating element is represented by the decision itself. In the moment in which the cost is influenced by the decision, we are talking about a relevant cost. This means that if we are implementing the decision, we will have this kind of cost, otherwise not the opposite instead, in the moment in which we have the irrelevant cost, this means that either we are implementing the decision or not, we will have this cost. These kind of irrelevant cost is also defined as the sunk cost, which means that it does not influence the decision itself. Just try to see this difference with a small example. Assuming that our company is realizing a product A, and we know that the quantity of this product A that is realized is equal to 50 units, then we know that the selling price of our product is €10 per unit, and then we know that the variable cost of our product is 6 Euros per unit, then we have that the total fixed costs, which is related to the marketing campaign, is €15. Our decision is about the convenience of producing 10 additional units. So our question is, is it convenient to add additional 10 units to our production? In order to deal with this kind of decision, we need to distinguish between what is relevant and what is irrelevant in terms of costs. The relevant cost is that cost that is influenced by the decision itself. In this specific case, we have that our variable cost is relevant for the decision. Why? Because in the moment in which we are producing these 10 additional unit, we will have six euros per unit multiply by our 10 additional units. So we will have €60 as additional cost. So the variable cost will be irrelevant cost because in the moment in which we are realizing this production, so in the moment in which we are implementing the decision, we will have these additional cost. That's the reason why irrelevant costs are also defined as the marginal costs or incremental costs. The opposite instead, in the moment in which we have the irrelevant classification, this means that either we are implementing or not the decision, we will have the cost. In this specific case with reference to these example, the fixed cost. So our €15 of marketing campaign will be relevant because even though we are not producing our 10 unit, we will have these €15 of fixed cost. This classification is important because when we deal with short-term decision, we need not to consider the irrelevant costs. So our focus should be only on the relevant ones. Basically, when we deal with short-term decision, the only three elements that we need are the following, the price, the quantity, and then the costs with reference to these two classification, variable and fixed, and then relevant versus sunk costs
