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CHAPTER 7Incremental Analysis

ASSIGNMENT CLASSIFICATION TABLE

Learning ObjectivesQuestions

BriefExercises Do It!Exercises

AProblems

BProblems

1.Identify the steps in managements decision- making process.1, 211

2.Describe the concept of incremental analysis.3, 421, 17

3.Identify the relevant costs in accepting an order at a special price.5312, 3, 4, 181A1B

4.Identify the relevant6, 7425, 6, 7,2A2B

costs in a make-or-buy decision.8, 18

5.Identify the relevant costs8, 9, 105, 639, 10, 11,3A3B

in determining whether to sell or process materials12, 18

further.

6.Identify the relevant costs to be considered in repairing, retaining or replacing equipment.11713, 14, 184A4B

7.Identify the relevant costs128415, 16,5A5B

in deciding whether to eliminate an unprofitable segment.17, 18

ASSIGNMENT CHARACTERISTICS TABLE

ProblemNumberDescription

Difficulty Level

Time Allotted (min.)

1AUse incremental analysis for special order and identify nonfinancial factors in the decision.

Simple2030

2AUse incremental analysis related to make or buy, consider opportunity cost, and identify nonfinancial factors.

Moderate3040

3ADetermine if product should be sold or processed further.Moderate3040

4ACompute gain or loss, and determine if equipment should be replaced.

Moderate3040

5APrepare incremental analysis concerning elimination of divisions.

Moderate3040

1BUse incremental analysis for special order and identify nonfinancial factors in the decision.

Simple2030

2BUse incremental analysis related to make or buy, consider opportunity cost, and identify nonfinancial factors.

Moderate3040

3BDetermine if product should be sold or processed further.Moderate3040

4BCompute gain or loss, and determine if equipment should be replaced.

Moderate3040

5BPrepare incremental analysis concerning elimination of divisions.

Moderate2030

BLOOMS TAXONOMY TABLE

Correlation Chart between Blooms Taxonomy, Learning Objectives and End-of-Chapter Exercises and Problems

Learning ObjectiveKnowledgeComprehensionApplicationAnalysisSynthesisEvaluation

1.Identify the steps in managements decision-making process.BE7-1Q7-1 Q7-2E7-1

2.Describe the concept of incremental analysis.Q7-3 Q7-4E7-1BE7-2E7-17

3.Identify the relevant costs in accepting an order at a special price.Q7-5BE7-3 DI7-1E7-2 E7-3 E7-4E7-18 P7-1A P7-1B

4.Identify the relevant costs in aQ7-6BE7-4E7-5E7-18

make-or-buy decision.Q7-7DI7-2E7-6P7-2A

E7-7P7-2B

E7-8

5.Identify the relevant costs inQ7-8BE7-5E7-9E7-18

determining whether to sell orQ7-9BE7-6E7-10P7-3A

process materials further.Q7-10DI7-3E7-11P7-3B

E7-12

6.Identify the relevant costs to be considered in repairing, retaining or replacing equipment.Q7-11BE7-7E7-13 E7-14 E7-18P7-4A P7-4B

7.Identify the relevant costs in deciding whether to eliminate an unprofitable segment.Q7-12BE7-8 DI7-4E7-15 E7-16 E7-17E7-18 P7-5A P7-5B

Broadening Your PerspectiveBYP7-1 BYP7-4 BYP7-5BYP7-2BYP7-8 BYP7-9BYP7-3 BYP7-6 BYP7-7

ANSWERS TO QUESTIONS

1. The following steps are frequently involved in managements decision-making process:(1) Identify the problem and assign responsibility.(2) Determine and evaluate possible courses of action.(3) Make a decision.(4) Review results of the decision.

2. My roommate is incorrect. Accounting contributes to the decision-making process at Steps 2 and 4. Prior to the decision, accounting provides relevant revenue and cost data for each course of action. Following the decision, internal reports are prepared to show the actual impact of the decision.

3. Disagree. Incremental analysis involves the identification of financial data that change under alternative courses of action.

4. In incremental analysis, the important point to consider is whether costs will differ (change) between the two alternatives. As a result, sometimes (1) variable costs do not change under the alternative courses of action and (2) fixed costs do change.

5. The relevant data in deciding whether to accept an order at a special price are the incremental revenues to be obtained compared to the incremental costs of filling the special order.

6. The manufacturing costs that are relevant in the make-or-buy decision are those that will change if the parts are purchased.

7. Opportunity cost may be defined as the potential benefit that may be obtained by following an alternative course of action. Opportunity cost is relevant in a make-or-buy decision when the facilities used to make the part can be used to generate additional income.

8. The decision rule in a decision to sell a product or to process it further is: Process further as long as the incremental revenue from the additional processing exceeds the incremental processing costs.

9. Joint products are products that are produced from a single raw material and a common production process. An accounting issue related to joint products is how to allocate the joint costs incurred during the production process that creates the joint products.

10. Joint costs are irrelevant to a sell-or-process-further decision because they are sunk costs and will not change whether the decision is to sell the existing product or process it further. Therefore, joint costs are ignored in this decision.

11. A sunk cost is a cost that cannot be changed by any present or future decision. Sunk costs, such as the book value of an old piece of equipment, therefore, are not relevant in a decision to retain or replace equipment.

12. Net income will be lower if an unprofitable product line is eliminated when the product line is producing a positive contribution margin and its fixed costs cannot be avoided or reduced.

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 7-1

The correct order is:

1. Identify the problem and assign responsibility.2. Determine and evaluate possible courses of action.3. Make a decision.4. Review results of the decision.

BRIEF EXERCISE 7-2

Revenues CostsNet income

Alternative A $160,000 100,000$ 60,000

Alternative B $180,000 125,000$ 55,000

Net Income Increase (Decrease)$ 20,000 (25,000)($ 5,000)

Alternative A is better than Alternative B.

BRIEF EXERCISE 7-3

RevenuesCostsVariable manufacturing ShippingNet income

Reject Order$0 0 0$0

Accept Order $75,000* 60,000** 6,000***$ 9,000

Net Income Increase (Decrease) $ 75,000(60,000) (6,000)$ 9,000

The special order should be accepted.

*3,000 X $25**3,000 X $20***3,000 X $ 2

BRIEF EXERCISE 7-4

MakeBuy

Net Income Increase (Decrease)

Variable manufacturing costs Fixed manufacturing costs Purchase priceTotal annual cost

$50,000 30,000 0 $80,000

$030,000 60,000$90,000

$ 50,0000 (60,000)$(10,000)

The decision should be to make the part.

BRIEF EXERCISE 7-5

Process

Net Income

Sell Further Increase (Decrease)

Sales price per unit Cost per unitVariable$62.00

36.00$70.00

43.00$8.00

(7.00)

Fixed 10.00 10.00 0

Total 46.00 53.00 (7.00)

Net income per unit$16.00$17.00$1.00

The bookcases should be processed further because the incremental revenues exceed incremental costs by $1.00 per unit.

BRIEF EXERCISE 7-6

The allocated joint costs are irrelevant to the sell or process further decisions. If AB1 is processed further, the company will earn incremental revenue of $50,000 ($150,000 $100,000) and only incur incremental costs of$45,000. Therefore, the company should process AB1 further and sell AB2. If XY1 is processed further, the company will earn incremental revenue of$35,000 ($130,000 $95,000) but will incur incremental costs of $50,000. Therefore, the company should sell XY1 rather than process it further.

BRIEF EXERCISE 7-7

Variable manufacturing costs for 4 yearsNew machine cost Sell old machineTotal

Retain Equipment

$3,000,000

$3,000,000

Replace Equipment

$2,500,000 300,000 (30,000)$2,770,000

Net 4-Year Income Increase (Decrease)

$ 500,000(300,000) 30,000$ 230,000

The old factory machine should be replaced.

BRIEF EXERCISE 7-8

Net Income

Continue Eliminate Increase (Decrease)

Sales$200,000$0$(200,000)

Variable costs 180,000 0 180,000

Contribution margin20,0000(20,000)

Fixed costs 30,000 20,000 10,000

Net income$ (10,000)$(20,000)$ (10,000)

The Big Bart product line should be continued because $20,000 of contribution margin will not be realized if the line is eliminated. This amount is greater than the $10,000 savings of fixed costs.

SOLUTIONS FOR DO IT! REVIEW EXERCISES

DO IT! 7-1

RejectAccept


Revenues$ 0$180,000$180,000 Costs$ 0138,000*(138,000) Net income$ 0$ 42,000$ 42,000*(6,000 X $20) + (6,000 X $3)Given the results of the above analysis, Maize Company should accept the special order.

DO IT! 7-2

(a)

MakeBuy


Direct materials$ 30,000$0$ 30,000Direct labor42,000042,000 Variable manufacturingcosts45,000045,000Fixed manufacturingcosts60,00045,00015,000

Purchase price 0 162,000 (162,000)

Total cost$177,000$207,000$ (30,000)

Given the results of the above analysis, Rubble Company will incur$30,000 of additional costs if it buys the switches.

(b)

MakeBuy


Total cost$177,000$207,000$(30,000) Opportunity cost34,000034,000 Total cost$211,000$207,000$ 4,000Yes, the answer is different: The analysis shows that net income will be increased by $4,000 if Rubble Company purchases the switches.

DO IT! 7-3

Process

Net Income

Sell Further Increase (Decrease)

Sales per unit Cost per unitVariable$75

$40$100

$ 57$25

($17)

Fixed 10 13 (3)

Total$50$ 70($20)

Net income per unit$25$ 30$ 5

The tables should be processed further and Mesa Verde should finish the tables because the incremental revenues exceed incremental costs by$5 per unit.

DO IT! 7-4

Continue EliminateNet Income Increase (Decrease)

Sales$500,000$0$(500,000)

Variable costs 370,000 0 370,000

Contribution margin130,0000(130,000)

Fixed costs 150,000 38,000 112,000

Net income$ (20,000)$(38,000)$ (18,000)

The analysis indicates that Gator should not eliminate the gloves and mittens line because net income would decrease $18,000.

SOLUTIONS TO EXERCISESEXERCISE 7-11. False. The first step in managements decision-making process is identify the problem and assign responsibility.2. False. The final step in managements decision-making process is toreview the results of the decision.3. True.4. False. In making business decisions, management ordinarily considersboth financial and nonfinancial information.5. True.6. True.7. False. Costs that are the same under all alternative courses of action do not affect the decision.8. False. When using incremental analysis, either costs or revenues or bothwill change under alternative courses of action.9. False. Sometimes variable costs will not change under alternative courses of action, but fixed costs will.

EXERCISE 7-2

(a)

Revenues ($4.80) Materials ($0.50) Labor ($1.50)Variable overhead ($1.00) Fixed overheadSales commissions Net income

Reject Order $ 00000 0$ 0

Accept Order $24,000 (2,500)(7,500)(5,000)(6,000) 0 $ 3,000

Net Income Increase (Decrease) $24,000 (2,500)(7,500)(5,000)(6,000) 0 $ 3,000

(b) As shown in the incremental analysis, Gruden should accept the special order because incremental revenue exceeds incremental expenses by$3,000.(c) It is assumed that sales of the golf discs in other markets would not be affected by this special order. If other sales were affected, Gruden would have to consider the lost sales in making the decision. Second, if Gruden is operating at full capacity, it is likely that the special order would be rejected.

EXERCISE 7-3

(a)

Reject

Revenues (15,000 X $7.60)$0$114,000Cost of goods sold078,000(1)Operating expenses 0 30,000(2)Net income$0$6,000 Order

Accept Order

Net Income Increase (Decrease)$114,000 (78,000) (30,000)$6,000

(1)Variable cost of goods sold = $2,600,000 X 70% = $1,820,000.Variable cost of goods sold per unit = $1,820,000 350,000 = $5.20 Variable cost of goods sold for the special order = $5.20 X 15,000= $78,000.

(2) Variable operating expenses = $840,000 X 75% = $630,000$630,000 350,000 = $1.80 per unit 15,000 X $1.80 = $27,000$27,000 + $3,000 = $30,000

(b) As shown in the incremental analysis, Leno Company should accept the special order because incremental revenues exceed incremental expenses by $6,000.

EXERCISE 7-4

Net Income

RejectAcceptIncrease

Order Order (Decrease)

Revenues$0$1,187,500 (1)$1,187,500

Variable costs:

Direct materials0500,000(500,000)

Direct labor0187,500(187,500)

Variable overhead 0 250,000 (250,000)

Total variable costs 0 937,500 (937,500)

Net income$0$ 250,000$ 250,000

(1) [($2.00 + $0.75 + $1.00 + $1.00) X 250,000]Klean Fiber should accept the Armys offer since it would increase net income by $250,000.

EXERCISE 7-5

(a)

MakeBuy


Direct materials (30,000 X $4.00) Direct labor (30,000 X $5.00)Variable overhead costs ($150,000 X 70%)Fixed manufacturing costs Purchase price (30,000 X $12.75)Total annual cost

$120,000 150,000

105,00045,000 0$420,000

$00

045,000 382,500$427,500

$ 120,000150,000

105,0000 (382,500)$(7,500)

(b) No, Schopp Inc. should not purchase the shades. As indicated by the incremental analysis, it would cost the company $7,500 more to purchase the lamp shades.

(c) Yes, by purchasing the lamp shades, a total cost saving of $17,500 will result as shown below.

Net Income Increase Make Buy (Decrease)

Total annual cost (above)$420,000$427,500$ (7,500)

Opportunity cost 25,000 0 25,000

Total cost$445,000$427,500$ 17,500

EXERCISE 7-6

(a) 1.

MakeBuy


Direct materials$1,000,000$0$ 1,000,000 Direct labor800,0000800,000Variable overhead120,0000120,000Fixed overhead600,000195,000405,000 Purchase price02,300,000(2,300,000) Total annual cost$2,520,000$2,495,000$25,000

Yes. The offer should be accepted as net income will increase by $25,000.

EXERCISE 7-6 (Continued)

2.

MakeBuy


Direct materials$1,000,000$0$ 1,000,000 Direct labor800,0000800,000Variable overhead120,0000120,000Fixed overhead600,000600,0000Opportunity cost405,0000405,000 Purchase price02,300,000(2,300,000)Totals$2,925,000$2,900,000$25,000

Yes. The offer should be accepted as net income would be $25,000 more.

(b) Qualitative factors include the possibility of laying off those employees that produced the robot and the resulting poor morale of the remaining employees, maintaining quality standards, and controlling the purchase price in the future.

EXERCISE 7-7

(a) Net IncomeIncrease Make SailsBuy Sails(Decrease)Direct materials$100$0$ 100 Direct labor80080Variable overhead35035Purchase price0250(250)Total unit cost$215$250$ (35)Gibbs should be making the sails, because they could save $35 per unit or $42,000. The president was including the fixed overhead cost in the calculation. Variable overhead = Total overhead ($100) Fixed overhead ($78,000 1,200) = $35. This amount has been allocated, so Gibbs will incur the cost whether or not they make the sails. This is an example of an irrelevant cost, because it does not differ between the two alternatives.

EXERCISE 7-7 (Continued)(b) The best decision would be to rent out the space as shown below. The differential savings would be $77,000 $42,000 = $35,000.

Net Income

PerMakeIncrease

(Based on 1,200 units) Unit Sails Buy Sails (Decrease)

Manufacturing cost$215$258,000$0$ 258,000

Purchase price$2500300,000(300,000)


Total annual cost$335,000$300,000$ 35,000

(c) Qualitative factors to consider would be (1) whether Gibbs will be able to exercise control over the future price of the product (2) whether Gibbs will be able to exercise control over the quality of the product and(3) the potential for interruptions in the supply of the product.

EXERCISE 7-8

(a)

Net Income

Increase

Make IMC2Buy IMC2 (Decrease)

Direct materials$ 65.00$0$65.00

Direct labor45.00045.00

Material handling6.5006.50

Variable overhead72.00*072.00

Purchase price 0 200.00 (200.00)

Total unit cost$188.50$200.00$ (11.50)

*Variable overhead = 60% X ($126.50 6.50)

The unit should not be purchased from the outside vendor, as the per unit cost would be $11.50 greater than if they made it.


(b) In order for Innova to make an accurate decision, they would have to know the opportunity cost of manufacturing the other product. As determined in (a), purchasing the product from outside would cost$11,500 more (1,000 X $11.50). Innova would have to increase their contribution margin by more than $11,500 through the manufacture of the other product, before it would be economical for them to purchase the IMC2 from the outside vendor.

(c) Qualitative factors to consider would be (1) quality of the component(2) on-time delivery, and (3) reliability of the vendor.

EXERCISE 7-9

Sales per unit Costs per unitDirect materials Direct laborTotal

Net income per unit

Sell (Basic Kit)$30

$14 0$14

$16

Process Further (Stage 2 Kit) $35

$ 7 (1) 9 (2)$16

$19

Net Income Increase (Decrease) $ 5

$ 7 (9)$(2)

$ 3

(1) The cost of materials decreases because Rachel can make two Stage 2 Kits from the materials for a basic kit.

(2) The total time to make the two kits is one hour at $18 per hour or$9 per unit.


Rachel should carry the Stage 2 Kits. The incremental revenue, $5, exceeds the incremental processing costs, $2. Thus, net income will increase by processing the kits further.

EXERCISE 7-10

(a)Sales ($60,000 + $15,000 + $55,000)$ 130,000

Joint costs (100,000)

Net income$ 30,000

(b)Sales ($190,000 + $35,000 + $215,000)$ 440,000

Joint costs(100,000)

Additional costs ($100,000 + $30,000 + $150,000) (280,000)

Net income$ 60,000

(c)

Product 10Product 12Incremental revenue(1)$ 130,000$ 20,000Product 14$ 160,000

Incremental costs(100,000)(30,000) (150,000)

Incremental profit (loss)$ 30,000$(10,000)$ 10,000

(1)Sales value after further processing Sales value @ split-off point

Products 10 and 14 should be processed further and product 12 should be sold at the split-off point.

(d)Sales ($190,000 + $15,000 + $215,000)$ 420,000

Joint costs(100,000)

Additional costs ($100,000 + $150,000) (250,000)

Net income$ 70,000

Net income is $10,000 ($70,000 $60,000) higher in (d) than in (b) because product 12 is not processed further, thereby increasing overall profit $10,000.

EXERCISE 7-11

To determine whether each of the three joint products should be sold as is, or processed further, we must determine the incremental profit or loss that would be earned by each. The allocated joint costs are irrelevant to the decision since these costs will not change whether or not the products are sold as is or processed further. LarcoMarcoNarco

Incremental revenue Incremental cost Incremental profit (loss)

$100,000* (110,000)$ (10,000)

$100,000** (85,000)$ 15,000

$395,000*** (250,000)$145,000

From this analysis we see that Marco and Narco should be processed further because the incremental revenue exceeds the incremental costs, but Larco should be sold as is.*$300,000 $200,000 **$400,000 $300,000 ***$800,000 $405,000

EXERCISE 7-12

(a) The costs that are relevant in this decision are the incremental revenues and the incremental costs associated with processing the material past the split-off point. Any costs incurred up to the split-off point are sunk costs, and therefore, irrelevant to this decision.(b) Revenue after further processing:Product D$60,000 (4,000 units X $15.00 per unit) Product E$97,200 (6,000 units X $16.20 per unit) Product F$45,200 (2,000 units X $22.60 per unit)Revenue at split-off:Product D$40,000 (4,000 units X $10.00 per unit) Product E$69,600 (6,000 units X $11.60 per unit) Product F$38,800 (2,000 units X $19.40 per unit)

D E F

Incremental revenue$20,000$27,600$ 6,400

Incremental cost (14,000) (20,000) (9,000)

Increase (decrease) in profit$ 6,000$ 7,600$(2,600)

Products D and E should be processed further.(c) The decision would remain the same. It does not matter how the joint costs are allocated because joint costs are irrelevant to this decision.

EXERCISE 7-13

(a)Cost$100,000

Accumulated depreciation (25,000*)

Book value75,000

Sales proceeds 40,000

Loss on sale$ 35,000

*One years depreciation: ($100,000 $0) 4 years

(b)

Retain Scanner

Replace Scanner


Annual operating costs$315,000*$225,000**$90,000 New scanner cost110,000(110,000) Old scanner salvage(40,000)40,000Total$315,000$295,000$ 20,000

*(3 years X $105,000)**[3 years X ($105,000 $30,000)]

Yes. Benson Hospital should replace the old scanner because it will result in a savings of $20,000 over the next four years.

(c) As shown in (a) above, replacing the old scanner will result in reporting a loss of $35,000. Reluctance to report losses of this nature is the usual reason for not recognizing that a poor decision was made in the past. The remaining book value of the old scanner ($75,000) is a sunk cost. It will be deducted in the future, if the scanner is retained, or written off now if it is replaced. However, if it is replaced now, that cost will be partially offset by the salvage value that Dyno is willing to pay ($40,000).

EXERCISE 7-14

Operating costs New machine cost Salvage value (old)Total

Retain Machine$125,0000 0$125,000

Replace Machine (1)$100,00025,000 (6,000)$119,000

Net Income Increase (Decrease) (2)$ 25,000(25,000) 6,000$ 6,000

(1) $25,000 X 5.(2) $20,000 X 5.

The current machine should be replaced. The incremental analysis shows that net income for the five-year period will be $6,000 higher by replacing the current machine.

EXERCISE 7-15

Net Income

Increase

Continue Eliminate (Decrease)

Sales Variable costsCost of goods sold$100,000

61,000$0

0$(100,000)

61,000

Operating expenses 26,000 0 26,000

Total variable 87,000 0 87,000

Contribution margin Fixed costsCost of goods sold 13,000

15,000 0

15,000 (13,000)

0

Operating expenses 24,000 24,000 0

Total fixed 39,000 39,000 0

Net income (loss)$(26,000)$(39,000)$ (13,000)

Judy is incorrect. The incremental analysis shows that net income will be$13,000 less if the Huron Division is eliminated. This amount equals the contribution margin that would be lost through discontinuing the division.

(Note: None of the fixed costs can be avoided.)

EXERCISE 7-16(a)$30,000 + $70,000 $40,000 = $60,000(b) TinglerShockerTotal

SalesVariable expenses Contribution margin Fixed expensesNet income

$300,000 150,000 150,000 142,500*$7,500

$500,000 200,000 300,000 267,500**$ 32,500

$800,000 350,000 450,000 410,000$ 40,000

*$30,000 + [($300,000 $800,000) X $300,000]**$80,000 + [($500,000 $800,000) X $300,000](c) As shown in the analysis above, Cawley should not eliminate the Stunner product line. Elimination of the line would cause net income to drop from $60,000 to $40,000. The reason for this decrease in net income is that elimination of the product line would result in the loss of $55,000 of contribution margin while saving only $35,000 of fixed expenses.

EXERCISE 7-17

Calculation of contribution margin per unit:

C D E

Selling price per unit$95$75$115

Less: variable costs/unit 50 40 40

Contribution margin/unit$45$35$ 75

Fixed costs = $22 X (9,000 + 20,000) = $638,000

Company profit with Products C and D:

Units sold C 9,000 D 20,000 Total

Sales revenue$855,000$1,500,000$2,355,000

Less: Variable costs 450,000 800,000$1,250,000

Contribution margin$405,000$ 700,0001,105,000

Less: Fixed costs 638,000

Net income$ 467,000


Company profit with Products C and E:

CETotal Units sold9,900*10,000

Sales revenue$940,500 $1,150,000 $2,090,500 Less: Variable costs495,000 400,000 895,000 Contribution margin$445,500 $ 750,0001,195,500 Less: Fixed costs638,000Net income$ 557,500

*Product C sales increase by 10%, (9,000 X 110%)

Yes they should introduce Product E since net profit would increase by$90,500 ($557,500 $467,000). EXERCISE 7-181. Irrelevant. Unavoidable costs will be incurred regardless of the decision made.

2. Relevant.

3. Irrelevant. This is a sunk cost and all sunk costs are irrelevant.

4. Irrelevant. These are sunk costs.

5. Relevant.

6. Relevant.

7. Relevant.

8. Relevant.

9. Irrelevant. If there is no change in the direct materials charge regardless of the decision made, the cost is irrelevant.

10. Relevant.

SOLUTIONS TO PROBLEMS

PROBLEM 7-1A

(a)

Reject Order

Accept Order


Revenues (10,000 X $27)$0$270,000$ 270,000

Cost of goods sold Selling and administrativeexpenses0

0220,000

20,000(1)

(2)(220,000)

(20,000)

Net income$0$ 30,000$ 30,000

(1)Variable costs = $3,600,000 $960,000 = $2,640,000;$2,640,000 120,000 units = $22.00 per unit; 10,000 X $22.00 = $220,000.

(2)Variable costs = $405,000 $225,000 = $180,000;$180,000 120,000 units = $1.50 per unit; 10,000 X ($1.50 + $0.50) = $20,000.

(b) Yes, the special order should be accepted because net income will increase by $30,000.

(c) Unit selling price = $22.00 (variable manufacturing costs) + $2.00 variable selling and administrative expenses + $4.00 net income = $28.

(d) Nonfinancial factors to be considered are: (1) possible effect on domestic sales, (2) possible alternative uses of the unused plant capacity, and(3) ability to meet customers schedule for delivery without increasing costs.

PROBLEM 7-2A

(a)

Direct materials

Make CISCOBuy CISCO


(8,000 X $4.80)Direct labor (8,000 X $4.30)Indirect labor

$38,400 34,400

$0$38,400

034,400

(8,000 X $.43)3,44003,440

Utilities (8,000 X $.40)3,20003,200

Depreciation3,0009002,100

Property taxes700200500

Insurance1,500600900

Purchase price080,000(80,000)

Freight and inspection

(8,000 X $.35)02,800(2,800)

Receiving costs 0 1,300 (1,300)

Total annual cost$84,640$85,800$ (1,160)

(b) The company should continue to make CISCO because net income would be $1,160 less if CISCO were purchased from the supplier.

(c) The decision would be different. Because of the opportunity cost of$3,000, net income will be $1,840 higher if CISCO is purchased as shown below:

Make CISCO

Buy CISCONet Income Increase (Decrease)

Total annual cost$84,640$85,800$(1,160)


Total cost$87,640$85,800$ 1,840

(d) Nonfinancial factors include: (1) the adverse effect on employees if CISCO is purchased, (2) how long the supplier will be able to satisfy the Shatner Manufacturing Companys quality control standards at the quoted price per unit, and (3) whether the supplier will deliver the units when they are needed by Shatner.

PROBLEM 7-3A

(a) (1)Table Cleaner Not Processed Further

Sales:FloorShine (600,000 30) X $20$400,000

Table Cleaner (300,000 25) X $18 216,000

Total revenue$616,000

Costs:

CDG210,000

Additional costs of FloorShine 240,000

Total costs 450,000

Gross profit$166,000

(2) Table Cleaner Processed Further

Sales:FloorShine$400,000

Table Stain Remover (300,000 25) X $14168,000

Table Polish (300,000 25) X $14 168,000

Total revenue$736,000

Costs:

CDG210,000

Additional costs of FloorShine240,000

TCP 100,000

Total costs 550,000


(3) If the table cleaner is processed further overall company profits will be $20,000 higher. Therefore, management made the wrong decision by choosing to not process table cleaner further.

PROBLEM 7-3A (Continued)

(b) Dont ProcessTable Cleaner Further

Process Table Cleaner Further


Incremental revenue$216,000$336,000$120,000 Incremental costs0100,000(100,000)Totals$216,000$236,000$ 20,000

When trying to decide if the table cleaner should be processed further into TSR and TP, only the relevant data need be considered. All of the costs that occurred prior to the creation of the table cleaner are sunk costs and can be ignored. The decision should be made by comparing the incremental revenue from further processing to the incremental costs.

PROBLEM 7-4A

(a)

Cost

$120,000


Book value96,000

Sales proceeds (25,000)

Loss on sale$ 71,000

*$120,000 5 years = $24,000

(b) (1)Retain Old ElevatorRevenues ($240,000 X 4 yrs.)$960,000 Less costs:Variable costs ($35,000 X 4)$140,000 Fixed costs ($23,000 X 4)92,000Selling & administrative116,000*Depreciation96,000444,000 Net income$516,000*($29,000 X 4)

(2)Replace Old ElevatorRevenues$960,000Less costs:Variable costs ($10,000 X 4)$ 40,000

Fixed costs ($8,500 X 4)34,000

Selling and administrative116,000

Depreciation 160,000350,000

Operating income610,000

Less: Loss on old elevator 71,000

Net income$539,000

(c)

Retain Old Elevator

Replace Old Elevator


Variable operating costs$140,000$ 40,000$ 100,000 Fixed operating costs92,00034,00058,000New elevator cost160,000(160,000) Salvage on old elevator.(25,000)25,000Totals$232,000$209,000$ 23,000


(d)MEMO

TO: Ron Richter FROM: StudentSUBJECT: Relevant Data for Decision to Replace Old Elevator

When deciding whether or not to replace any old equipment, the analysis should only include cost data relevant to the replacement decision. The$71,000 loss that would be experienced if we replace the old elevator with the newer model is related to a sunk cost, namely the cost of the old elevator. Sunk costs are irrelevant in decision making.

The loss occurs when comparing the book value of the old elevator to the cash proceeds that would be received. The book value of $96,000 would be deducted as depreciation expense over the next four years if the elevator were retained. If the elevator is replaced with the newer model, the book value will be expensed in the current year, less the cash proceeds received on disposal. Therefore, the $96,000 book value will be expensed under either alternative, making it irrelevant.

PROBLEM 7-5A

(a)

Sales

Division I $250,000

Division II$200,000

Variable costs

Cost of goods sold150,000172,800

Selling and administrative 30,000 42,000

Total variable expenses 180,000 214,800

Contribution margin$ 70,000$ (14,800)

(b)(1)

Division I

Continue

EliminateNet Income Increase (Decrease)

Contribution margin (above) Fixed costsCost of goods sold$ 70,000

50,000$0

25,000$(70,000)

25,000

Selling and administrative 45,000 22,500 22,500

Total fixed expenses 95,000 47,500 47,500

Income (loss) from operations$(25,000)$(47,500)$(22,500)

(2)

Division II

Continue


Contribution margin (above) Fixed costsCost of goods sold$(14,800)

19,200$0

9,600$14,800

9,600



Income (loss) from operations$(52,000)$(18,600)$33,400

Division II should be eliminated as its negative contribution margin is$14,800. Income from operations would increase $33,400 if Division II is eliminated.

Division I should be continued because it is producing positive contribution margin of $70,000. Income from operations will decrease$22,500 by discontinuing this division.


(c) GUTIERREZ COMPANY CVP Income StatementFor the Quarter Ended March 31, 2014

Divisions

IIIIIVTotal

Sales$250,000$500,000$450,000$1,200,000

Variable costs

Cost of goods sold150,000240,000187,500577,500

Selling and

administrative 30,000 30,000 30,000 90,000

costs 180,000 270,000 217,500 667,500Contribution margin 70,000 230,000 232,500 532,500Fixed costsCost of goods sold (1)53,20063,20065,700182,100Selling andadministrative (2) 48,000 33,000 23,000 104,000Total fixedcosts 101,200 96,200 88,700 286,100Total variable

Income (loss) from operations

$(31,200)

$133,800

$143,800

$ 246,400

(1) Divisions fixed cost of goods sold plus 1/3 of Division IIs unavoidable fixed cost of goods sold [$192,000 X (100% 90%) X 50% = $9,600]. Each divisions share is $3,200.

(2) Divisions fixed selling and administrative expense plus 1/3 of Division IIs unavoidable fixed selling and administrative expenses [$60,000 X (100% 70%) X 50% = $9,000]. Each divisions share is $3,000.

(d) Income from operations with Division II of $213,000 (given) plus incremental income of $33,400 from eliminating Division II = $246,400 income from operations without Division II.

PROBLEM 7-1B

(a)

Revenues (10,000 X $30) Cost of goods sold Selling and administrativeexpenses Net income

Reject Order $0 0

0$0

Accept Order $300,000 240,000 (1)

25,000 (2)$ 35,000

Net Income Increase (Decrease) $ 300,000(240,000)

(25,000)$35,000

(1)Variable costs = $3,060,000 $900,000 = $2,160,000;$2,160,000 90,000 units = $24 per unit; 10,000 X $24 = $240,000.

(2)Variable costs = $360,000 $180,000 = $180,000;$180,000 90,000 units = $2.00 per unit; 10,000 X ($2.00 + $0.50) = $25,000.

(b) Yes, the special order should be accepted because net income will be increased by $35,000.

(c) Unit selling price = $24 (variable manufacturing costs) + $2.50 (variable selling and administrative expenses) + $5.50 (net income) = $32.00.

(d) Nonquantitative factors to be considered are: (1) possible effect on domestic sales, (2) possible alternative uses of the unused plant capacity, and (3) ability to meet customers schedule for delivery without increasing costs.

PROBLEM 7-2B

(a)

Make FIZBEBuy FIZBE


Direct materials (5,000 X $4.75)$23,750$0$ 23,750

Direct labor (5,000 X $4.60)23,000023,000

Indirect labor (5,000 X $.45)2,25002,250

Utilities (5,000 X $.35)1,75001,750

Depreciation2,0009001,100

Property taxes700200500

Insurance1,500600900

Purchase price056,000(56,000)

Freight and inspection

(5,000 X $.30)01,500(1,500)

Receiving costs 0 500(500)

Total annual cost$54,950$59,700$ (4,750)

(b) The company should continue to make FIZBE because net income would be $4,750 less if FIZBE were purchased from the supplier.

(c) The decision would be different. Because of the opportunity cost of$6,000, net income will be $1,250 higher if FIZBE is purchased as shown below:

Make FIZBE

Buy FIZBE Net Income Increase (Decrease)

Total annual cost$54,950$59,700$(4,750)


Total cost$60,950$59,700$ 1,250

(d) Nonfinancial factors include: (1) the adverse effect on employees if FIZBE is purchased, (2) how long the supplier will be able to satisfy the Gill Corporations quality control standards at the quoted price per unit, and (3) will the supplier deliver the units when they are needed by Gill?

PROBLEM 7-3B

(a) (1)General-Purpose Cleaner Not Processed Further

SalesShineBrite (750,000 25) X $15$450,000

General-Purpose Cleaner (250,000 20) X $20Total revenue 250,000$700,000

CostsNPR200,000

Additional costs for ShineBrite Total costs 300,000 500,000


(2) General-Purpose is Processed Further

SalesShineBrite (750,000 25) X $15$450,000

Premium Cleaner (250,000 20) X $16200,000

Premium Stain Remover (250,000 20) X $16Total revenue 200,000$850,000

CostsNPR200,000

Additional costs for ShineBrite300,000

PSTTotal costs 140,000 640,000


(3) If the general-purpose cleaner is processed further overall company profits will be $10,000 higher. Therefore, management made the wrong decision by choosing to not process the general-purpose cleaner further.

PROBLEM 7-3B (Continued)

(b) Dont ProcessG-P Cleaner Further

Process G-P Cleaner Further


Incremental revenue$250,000$400,000$150,000 Incremental costs0140,000(140,000)Totals$250,000$260,000$ 10,000

When trying to decide if the general-purpose cleaner should be processed further into PC and PSR, only the relevant data need be considered. All of the costs that occurred prior to the creation of the general-purpose cleaner are sunk costs and can be ignored. The decision should be made by comparing the incremental revenue from further processing to the incremental costs.

PROBLEM 7-4B

(a)

Cost

$210,000


Book value168,000

Sales proceeds (58,000)

Loss on sale$110,000

*$210,000 5 years = $42,000

(b) (1)Retain Old EquipmentRevenues ($360,000 X 4 yrs.)$1,440,000 Less costs:Variable costs$200,000

Fixed costs120,000

Selling & administrative180,000

Depreciation 168,000 668,000

Net income$ 772,000

(2)Replace Old EquipmentRevenues$1,440,000Less costs:Variable costs$ 48,000 Fixed costs20,000Selling and administrative180,000Depreciation250,000498,000 Operating income942,000Less: Loss on old equipment110,000Net income$ 832,000

(c)

Retain Old Equipment

Replace Old Equipment


Variable costs$200,000$ 48,000$152,000Fixed costs120,00020,000100,000New equipment cost250,000(250,000) Salvage on old equipment.(58,000)58,000Totals$320,000$260,000$ 60,000


(d)MEMO

TO: Gene Simmons FROM: StudentSUBJECT: Relevant Data for Decision to Replace Old Equipment

When deciding whether or not to replace any old equipment, the analysis should only include cost data relevant to the replacement decision. The$110,000 loss that would be experienced if we replace the old equipment with the newer equipment is related to a sunk cost, namely the cost of the old equipment. Sunk costs are irrelevant in decision making.

The loss occurs when comparing the book value of the old equipment to the cash proceeds that would be received. The book value of $168,000 would be deducted as depreciation expense over the next four years if the equipment were retained. If the equipment is replaced with the newer model the book value will be expensed in the current year, less the cash proceeds received on disposal. Therefore, the $168,000 book value will be expensed under either alternative, making it irrelevant.

PROBLEM 7-5B

(a)

Division III

Division IV

SalesVariable expensesCost of goods sold$310,000

189,000$170,000

140,400

Selling and administrative 45,000 49,000

Total variable expenses 234,000 189,400

Contribution margin$ 76,000$ (19,400)

(b)(1)

Division III

Continue


Contribution margin (above) Fixed expensesCost of goods sold$ 76,000

81,000$0

40,500$(76,000)

40,500



Income (loss) from operations$(35,000)$(55,500)$(20,500)

(2)

Division IV

Continue


Contribution margin (above) Fixed expensesCost of goods sold$(19,400)

15,600$0

7,800$19,400

7,800



Income (loss) from operations$(56,000)$(18,300)$37,700

Division III should be continued as contribution margin ($76,000) is greater than the savings in fixed costs ($55,500) that would result from elimination. Therefore, income from operations would decrease $20,500 if Division III is eliminated.Division IV should be eliminated because it is producing negative contribution margin ($19,400). Income from operations will increase $37,700 by discontinuing this division.


(c) PANDA COMPANYCVP Income StatementFor the Quarter Ended March 31, 2014

Divisions

IIIIIITotal

Sales$510,000$400,000$310,000$1,220,000

Variable expenses

Cost of goods sold210,000200,000189,000599,000

Selling and

administrative 24,000 40,000 45,000 109,000

Total variable

expenses 234,000 240,000 234,000 708,000

Contribution margin 276,000 160,000 76,000 512,000

Fixed expenses

Cost of goods sold (1)92,60052,60083,600228,800

Selling and

administrative (2) 39,500 43,500 33,500 116,500

Total fixedexpenses 132,100 96,100 117,100 345,300

Income (loss) from operations$143,900$ 63,900$ (41,100 )$ 166,700

(1) Divisions fixed cost of goods sold plus 1/3 of Division IVs unavoidable fixed cost of goods sold [$156,000 X (100% 90%) X 50% =$7,800]. Each divisions share is $2,600.

(2) Divisions fixed selling and administrative expenses plus 1/3 of Division IVs unavoidable fixed selling and administrative expenses [$70,000 X (100% 70%) X 50% = $10,500]. Each divisions share is $3,500.

(d) Income from operations with Division IV of $129,000 (given) plus incremental income of $37,700 from eliminating Division IV = $166,700 income from operations without Division IV.

BYP 7-1DECISION-MAKING AT CURRENT DESIGNS

Situation #1

(a) Current Designs should accept the special order based on the following calculations:

Reject OrderAccept Order


Revenues$0$25,000*$25,000 Costs0(19,000)**(19,000) Net Income$0$ 6,000$ 6,000*(100 X $250)**(($80 + $60 + $20) X 100) + ($1,000 + $2,000)

(b) Assuming that Current Designs is currently operating with excess capacity, it should accept the order based on the calculations shown in part (a). If Current Designs is currently operating at full capacity, it would have to weigh its options. If it displaced production of regular kayaks in order to fill this order, it would have to consider the opportunity costs associated with this decision. The opportunity cost, when operating at full capacity, would be the lost contribution margin from regular sales given up in order to fulfill the special order. Alternatively, rather than reject the special order, it might consider temporarily expand- ing the plants capacity by adding an additional production shift to handle the special order. If this option were considered, it would have to identify all additional incremental costs (for example, overtime pay) that would be incurred.

BYP 7-1 (Continued)

Situation #2

(a) Current designs should not replace the Rotomold oven based on the following calculations:

Retain Oven

Replace Oven


Variable manufacturing costs$110,500*$ 97,500**$13,000 New oven cost0250,000(250,000) Proceeds from scrapping old oven0(10,000)10,000 Total$110,500$337,500($ 227,000)

*(17,000 therms/year X $0.65/therm X 10 years)**(15,000 therms/year X $0.65/therm X 10 years)

(b) Even with the cost of natural gas increasing at a faster than expected rate, Current Designs still should not replace the Rotomold oven as the rate increase does not cover the cost of the new oven based on the following calculations:

Retain Oven

Replace Oven


Variable manufacturing costs$144,500*$127,500**$17,000 New oven cost0250,000(250,000) Proceeds from scrapping old oven0(10,000)10,000 Total$144,500$367,500($ 223,000)

*(17,000 therms/year X $0.85/therm X 10 years)**(15,000 therms/year X $0.85/therm X 10 years)

BYP 7-1 (Continued)

Situation #3

(a) Current Designs should make the seats based on the following calculations:

MakeBuy


Direct materials$ 60,000$0$60,000Direct labor45,000045,000Variable manufacturing costs36,000036,000Fixed manufacturing costs20,00015,0005,000 Purchase price ($50 X 3,000)0150,000(150,000) Total annual cost$161,000$165,000($4,000)

(b) When the opportunity cost of $20,000 is considered, Current Designs should buy the seats based on the following calculations:

Make

Buy Net Income Increase (Decrease)

Total annual cost$161,000$165,000($ 4,000)


Total cost$181,000$165,000$16,000

BYP 7-2DECISION-MAKING ACROSS THE ORGANIZATION

Retain Old MachinePurchase New MachineNet Income Increase (Decrease)

SalesCosts and expenses Cost of goods sold$6,000,000

4,500,000(1)

(3)$6,600,000

4,620,000(2)

(4)$ 600,000

(120,000)

Selling expenses900,000990,000(90,000)

Administrative expenses500,000565,000(65,000)

Purchase price 150,000(5) (150,000)

Total costs and expenses 5,900,000 6,325,000 (425,000)

Net income$ 100,000$ 275,000$ 175,000

(1) 12,000 X $100 X 5 years = $6,000,000.(2) $6,000,000 X 110% = $6,600,000.(3) $6,000,000 X (100% 25%) = $4,500,000.(4) $6,600,000 X (100% 30%) = $4,620,000. (5) $140,000 + $4,000 + $6,000 = $150,000.

The new machine should be purchased. The incremental analysis shows that net income will increase from $100,000 to $275,000 over the five years with the new machine.

BYP 7-3MANAGERIAL ANALYSIS

MakeBuy Trans- Tech Buy Omega Sales Revenue$ 14.50$ 14.50$ 14.50Variable Manufacturing Cost:Circuit Board2.0000Plastic Case0.8000Alarms (4 @ $.15 each)0.6000Labor3.0000Overhead0.5000Purchase Cost010.005.00Fixed Manufacturing Cost: 1.00* 1.00Total Manufacturing Cost 6.90 11.00 6.00Profit per Unit$7.60$3.50$8.50Total Profit$38,000$17,500$42,500(a)

*The $5,000 cost that will continue to be incurred, even if the product is not manufactured, divided by the 5,000 units.

The company will make the most profit if the clocks are purchased from Omega Company. The company will make $4,500 less if the clocks are manufactured by MiniTek. The company will make $25,000 less if the clocks are purchased from Trans-Tech.

(b) There are several important nonfinancial factors described in the case. Other factors might be identified as well. The factors described are: The company is having serious difficulty manufacturing the clocks. Therefore, it would probably be willing to have someone else manufacture the clocks, even if it cost more to do so. The most promising company appears to be Omega; however, there is a serious question about Omegas ability to remain in business. However, the company could purchase just this one order from Omega, and then continue to search for another manufacturer, or stop manufacturing the clocks. Trans-Techs stringent requirements for preferred customer status, in the form of large sales requirements, appear to limit the possibilities for MiniTek to use it as a supplier. However, if MiniTek does desire to continue to offer the clocks because of their popularity, then perhaps Trans-Tech could be used in the future.

BYP 7-3 (Continued)

(c) Many answers are possible, depending upon each students assessment of the seriousness of the issues mentioned in (b). One answer would be: The company should use Omega to manufacture the Kmart order. After that, the company should not offer the clocks any longer. Espe- cially since the clocks are no longer very profitable, it does not seem like a good idea to keep spending money to modify the process.

BYP 7-4REAL-WORLD FOCUS

(a) Before building the special-order new ceiling fans, company management must consider the effect of the new lines on current production capacity, existing and available channels of distribution, the effect on manufacturing efficiency, the effect on sales of current lines of product, and the supply of materials and labor.

(b) Incremental analysis would provide a financial comparison of income with the special-order ceiling fans to income without the special orders.

BYP 7-5REAL-WORLD FOCUS

(a) The types of outsourcing services that the company provides assis- tance on are:

Information technology outsourcing, finance and accounting, human re- source outsourcing, business process outsourcing, procurement, and call centers.

(b) Insourcing means to take work that is currently being performed by an outside service provider back in-house. For example, collections of accounts receivable might currently be performed by a collection agency, and you might decide to establish a collection group within your company.

(c) Some of the benefits of insourcing include: Greater control over resources Greater ability to control intellectual property Increased visibility of accountability within the organization

BYP 7-6COMMUNICATION ACTIVITY

To:Preston ThiesePlant Manager From:Hank JewelProduction ManagerI have spent considerable time thinking about the dilemma created by the new PDD1130 machine. Clearly, it is far superior to our existing machine. There is no question that it would save us tremendous amounts of money. I hope I am not overstepping my bounds here, but I just reviewed a chapter in my managerial accounting text on incremental analysis which has made me think we need to reconsider this decision.

The key to incremental analysis is identifying relevant costs. Relevant costs are those costs that vary depending on the course of action taken. In our situation, a relevant cost would be the savings that we would experience were we to purchase the new machine. The book value of the existing machine is not a relevant cost since it would not be changed by purchasing or not purchasing the new machine. Costs incurred in the past that do not change are referred to as sunk costs. Sunk costs are irrelevant to incremental analysis.

I would really like to lay out an analysis of our options to decide the proper course of action. I am concerned that by using the old machine for a couple of years the profitability of the plant could be impacted negatively.

BYP 7-7ETHICS CASE

(a) Many factors need to be considered when determining whether to close a division. The loss of jobs can have a devastating impact on a community and on the morale of remaining employees. From a financial perspective, closing a division that is reporting losses will not necessarily increase the reported net income of the company. The reason: if fixed costs that have been allocated to a division that is closed are reallocated to the remaining divisions, the companys net income might actually decrease. This sounds like it would most likely be the case at Peters.

(b) It is not unusual to reevaluate fixed cost allocations periodically. However, the allocation should be based on the underlying economics of the situation rather than the motives of individuals.

(c) Blake should explain to the board of directors that the change in income is due to a reallocation and that closing the plumbing division is not advisable. In this case, being honest is not only the ethical thing to do, but it will also maximize the companys net income.

BYP 7-8ALL ABOUT YOU

(a) Chronic homelessness is defined as being on the streets for a year or more.

(b) Homelessness costs cities money because the chronic homeless have frequent jail time, shelter costs, emergency room visits and hospital stays. Some costs per city per homeless person are: New York $40,000; Dallas$50,000; San Diego $150,000.

(c) The first step is to try to identify the size of the problem by doing street counts. From this count, benchmarks can be set, enabling a reward system for meeting goals. Next is to identify what the homeless people want. What do they think they need to help them address their problem? They typically want adequate housing with some privacy.

(d) It has been estimated that in New York this approach costs about $22,000 per year. New York has documented an 88% success rate (defined as not returning to the streets for five years).

(e) In terms of incremental analysis, two alternatives are to either continue with the current situation, with the costs presented in part (b) or to imple- ment the approach outlined in part (d). From a purely financial perspective the approach in (d) appears to have significant merit. Also (d) does not even take into account the intangible benefits of improving the quality of life for this segment of the population.

BYP 7-9CONSIDERING YOUR COSTS AND BENEFITS

Discussion guide: This is a very difficult decision. All of the evidence suggests that your short-term and long-term prospects will be far greater with some form of posthigh-school degree. Because of this, we feel strongly that you should make every effort to continue your education. Many of the discussions provided in this text present ideas on how to get control of your individual financial situation. We would encourage you to use these tools to identify ways to reduce your financial burden in order to continue your education. We also want to repeat that even taking only one course a semester is better than dropping out. Your instructors and advisors frequently provide advice to students who are faced with the decision about whether to continue with their education. If you are in this situation, we would encourage you to seek their advice since the implications of this decision can be long-lasting.

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