During the manufacturing process, there is often a time when a good can either be sold as is or further produced to create a different good. For example, a brewery can make beer to sell on tap. However, with additional resources like bottles and bottle caps, the brewery can create a new product. In both situations, a viable good is created to be sold in different markets. How should a company decide whether to sell or produce further? Here are some pointers to keep in mind.
Example of Decision Point
An example of a decision point is when a farm grows various crops and produce including apples. Upon harvesting the apples and preparing them for sale, the farm is aware of the incurred expense and potential sale price. However, the farm can purchase equipment and ingredients, put forth labor, expand marketing, and produce applesauce for sale. The farm should analyze whether the decision to sell the apples outweighs the benefit of producing a new good to sell later.
Only relevant information should be included in the analysis. This includes only costs related to the production process. In the example above, any costs related to growing apples will be incurred with either decision. Therefore, these costs are called sunk costs because they will be incurred either way.
In all, there are only three informational pieces needed to make the decision. First, calculate the total revenue your company will earn by selling the unprocessed product. In this example, the farm should calculate how much money would be earned by selling apples. Second, how much revenue would be earned by selling the processed good? This would represent the total revenue from the applesauce. Finally, calculate the incremental additional costs associated with processing the goods further. These three pieces are used in different approaches.
One approach to this decision is the differential method. Only incremental items are considered — it doesn’t matter what the unprocessed goods sell for. For example, the farm can raise an additional $35,000 selling applesauce by incurring an additional $25,000 of costs. Because the incremental profit is $10,000, it is worth producing the apples further.
Another approach is to incorporate the opportunity cost of not selling at the split-off point. This incorporates the revenue forgone by not selling unprocessed goods. In this example, the total revenue that could be earned is $80,000. The additional costs of $25,000 and revenue forgone is $45,000. Subtracting total revenue from these two expenses will result in a gain of $10,000.
Finally, the decision can be made analyzing the individual projects. This compares the net revenue from the split-off point to the net revenue of the further process. For example, the revenue of the apples — same as above — is $45,000. If the apples are produced further, total revenue earned is $80,000 and costs are $25,000. This project would result in $55,000 of net income. This difference ($55,000 – $45,000) of $10,000 once again shows the project should be taken on. All three methods will report the same result as long as consistency is maintained.