[MUSIC] In this class, we will focus on the evaluation of short-term decisions. We will try to understand what is the approach that we can use in order to understand if a certain decision is convenient or not. Given that we are talking about a profit company, devaluation of decision is based on the idea that this specific kind of decision is able to contribute to the generation of economic value. So if the decision generates cash in the future, then the decision is convenient. Because of this the traditional formula that we use to evaluate the cash generated by a decision is the NPV formula, something almost common. So we have that the net present value at a certain moment of time equals the sum from the time zero until infinite of the cash flow of a certain moment of time minus the investment at a certain moment of time discounted. 1 plus k at the power of T. All of the decisions are evaluated in terms of their ability to generate cash in the future. So that in the moment in which this value is higher than zero we can say that the decision generates cash. And so it is convenient. We are lucky because given that we have short-term decision. This formula can be simplified because of the characteristics of short-term decisions. The first characteristic is that the impact of this kind of decision is limited. So we are talking about a decsion that has an impact on a time horizon which is lower than one year. Because of these we do not need to discount and we do not need to some cash flows of different years, because we are just focusing on one year. And so the formula becomes simple as you can see. The second characteristic of short-term decision is that resources are fixed, which means that we do not need Investments. If we do not need Investments, this component of the formula disappears. As you can see now the formula is much simpler, so we can say that the only element that remains of this formula is the cash flow. The cash flow of a specific year. And the cash flow equals the cash flow in minus the cash flow out. So the cash that enters minus the cash that is paid. But if you remember another characteristic of certain decisions is that we are dealing just with price, costs and volume. So we can approximate the cash flow that enters with the revenues and then the cash flow that goes out as the operating costs. So this formula will become cash flow in as revenues. And the cash flow out minus costs, operating costs. Given that this NPV has become as revenues minus cost, we cannot talk about Net Present Value. But these name is simply something that is related to our income statement and it is defined as earning before interest and taxes. It is also called as net operating income. So basically in the moment in which To we need to evaluate short-term decisions. The approach is always the same. The decision is convenient if it is able to generate cash. From a theoretical perspective, we should use the NPV. Given that we have some characteristics of short-term decisions that are the following, the NPV formula can be simplified. And we can say that these kind of short-term decisions can just be evaluated in terms of net operating income that the decision is able to generate. Where these net operating income is calculated as the difference between the sales revenues minus the operating cost. This is something which is not new, because it is related to all of the details that we have within the income statement. So basically we can go back to our income statement and then use again this data but from a different perspective. Let's see how. If we look at this structure, this is the income statement by function. Basically, if we have an income statement by function, we start from the sales revenue, minus the cost of goods sold. Then we have the gross profit minus the selling, general, and administrative expenses, so that we have the operating income. When we deal with short-term decisions still we are using this data, because we have the revenues, we have the costs, and then we have the operating income. The difference is that we are classifying the costs in a different way. Rather than using the cost of goods sold and the selling, general, and administrative costs. We go back, actually we use the distinction between variable and fixed costs. So, let's see the difference in the moment in which we have short-term decision. Our starting point still is the same. We have revenue, sales revenues minus variable cost. If we deduct from the sales revenues the variable cost. We obtain what is defined as contribution margin. So rather than having the gross profit, the revenue minus these variable cost is the contribution margin. It is defined as contribution because it represents the contribution of our sales to cover the variable cost. That's the reason why we are talking about contribution, the ability of our sales production of covering the variable cost. If from the contribution margin, we deduct the fixed cost. We obtain something which again is not new, that is the net operating income. So we can see that the final result is the same, and the starting point still is the same. What changes is just the classification of the cost. We need to distinguish between variable and fixed cost. And this is particularly useful because of the contribution margin, that is the distinctive element of short-term decision. As I said, this contribution margin, which is simply the difference between the revenue and the variable costs. It's just the contribution of our sales revenue of covering our variable cost. In the moment in which this is positive, this means that our sales revenue are also able of covering portion of the fixed cost. Another detail is that we can calculate the contribution margin also per unit. If we are calculating the contribution margin per unit, we need to consider the difference between the price, which is the unitary price, minus the unitary variable cost. This difference gives right what is defined as contribution margin per unit. If you look at these they are exactly the same. Basically, if we multiply the price by the quantity we have the revenue. If we multiply the unitary variable cost by the quantity, we have total variable cost. While if we multiply the unitary contribution margin wide by the quantity, we have the total contribution margin. The idea of the unitary contribution margin is particularly relevant if we want to understand that if a product is profitable. In the moment in which considered difference between the selling price of one unit of our product and the unitary variable cost. If this value is higher than zero, we are saying that one unit of our product is able to cover the variable cost. And if this is positive, still we can say that the production is also able to cover part of the fixed cost. So that's the reason why when we deal with the short-term decision, the idea of the contribution margin is particularly relevant in the moment in which we want to understand if our product is profitable. But keep in mind that the distinction of this structure with respect to the traditional income statement by function just relies in how costs are classified.
