Why pricing and production are extent decisions and not decisions that should be tackled with break-even analysis.

Full Answer Section

What Could Have Been Done Differently?

• Focus on Relevant Costs: Analyze long-term costs like warranty repairs and potential customer churn instead of just upfront production costs.
• Consider Long-Term Value: Invest in higher quality materials to create a more durable product, leading to customer satisfaction and repeat business.

Extent vs. Break-Even Analysis

Pricing and Production Decisions:

These decisions are classified as extent decisions because they determine the scale or level of activity within the business. Break-even analysis, which focuses on finding the point where total cost equals total revenue, is not ideal for these decisions. Here's why:

• Break-even analysis assumes a fixed selling price. Pricing decisions should consider market competition, customer demand, and profit margins.
• Break-even analysis focuses on total cost, not cost per unit. Production decisions often involve cost variations based on economies of scale or production inefficiencies.

Investment Decisions:

Investment decisions can involve both extent and timing considerations. Break-even analysis may have some limited use in evaluating an investment's potential profitability, but it shouldn't be the sole factor. Here's why:

• Break-even analysis doesn't consider the time value of money. Investment decisions involve cash flows over time, and factors like discounting future cash flows are crucial.
• Break-even analysis doesn't account for risk. Investments have inherent risks, and a more comprehensive analysis considering potential returns and risk tolerance is necessary.

Alternatives for Extent and Investment Decisions:

• Cost-volume-profit (CVP) analysis: Expands on break-even analysis by considering different price and production levels.
• Capital budgeting techniques: Techniques like Net Present Value (NPV) and Internal Rate of Return (IRR) consider the time value of money and risk to evaluate investment options.

Sample Answer

Here's an example of a firm making a decision based on irrelevant costs:

Scenario: A company developing a new fitness tracker prioritized cutting production costs by using lower quality materials. They reasoned that a cheaper product would be more competitive.

Outcome: The lower quality materials resulted in frequent product malfunctions and a high customer return rate. The company incurred significant costs for repairs, replacements, and lost customer trust. Additionally, brand reputation suffered due to negative reviews.