CHAPTER 7 DIFFERENTIAL COST ANALYSIS FOR OPERATING DECISIONS Questions, Exercises, and Problems: Answers and Solutions 7.1 See text or glossary at the end of the book. 7.2 Fixed costs are only fixed in the short-run so any long-run decision may have differential fixed costs. For instance, decisions affecting capacity would include differential fixed costs. 7.3 Short-term pricing decisions are based on differential costs, any price higher than differential costs will increase profits even if it is lower than full cost. However, in the long-term, prices must cover the full cost of producing the product. 7.4 No. Facility-sustaining costs are fixed in the short-term; they will be incurred regardless of production level. Therefore, they are not differential and should not be considered in a short-term pricing decision. 7.5 Full cost information is appropriate for long-term pricing decisions. 7.6 d. the differential costs of producing the order. 7.7 b. depreciation of buildings. 7-1 Solutions
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
CHAPTER 7
DIFFERENTIAL COST ANALYSIS FOR OPERATING DECISIONS
Questions, Exercises, and Problems: Answers and Solutions
7.1 See text or glossary at the end of the book.
7.2 Fixed costs are only fixed in the short-run so any long-run decision may have differential fixed costs. For instance, decisions affecting capacity would include differential fixed costs.
7.3 Short-term pricing decisions are based on differential costs, any price higher than differential costs will increase profits even if it is lower than full cost. However, in the long-term, prices must cover the full cost of producing the product.
7.4 No. Facility-sustaining costs are fixed in the short-term; they will be incurred regardless of production level. Therefore, they are not differential and should not be considered in a short-term pricing decision.
7.5 Full cost information is appropriate for long-term pricing decisions.
7.6 d. the differential costs of producing the order.
7.7 b. depreciation of buildings.
7-1 Solutions
7.8 "Setup" or "order" costs are costs incurred each time an order is placed or a production run is made. "Carrying" costs are the costs of keeping inventory, for example, maintaining warehouse facilities.
CostsTotal Costs
Carrying Costs
Order Costs
Order SizeOptimal Order
7.9 The costs that are relevant for make-or-buy decisions are the differential costs.
7.10 True. The objective of the theory of constraints is to increase throughput contribution.
7.11 Any differential costs should be considered in the decision, including overtime, and costs of additional shifts or other means of expanding capacity.
7.12 Answers will vary, but should all be short-term pricing decisions.
7.13 In the long-term full costs must be met so full-cost information is useful for decisions affecting the long-term.
7.14 The statement is true in general short-term decisions in which there is excess capacity. However, in any situation where the decision affects capacity, the statement would not be true.
7.15 In the short-run, sales revenues need only cover the differential costs of production and sale. So, from a short-run perspective so long as the sale does not affect other output prices or normal sales volume, a “below cost” sale may result in a net increase in income so long as the revenues cover the differential costs. However, in the long-run all costs must be covered or management would not reinvest in the same type of assets. If the company must continually sell below the full cost of production then it will most likely get out of that particular business when it comes time to replace those facilities.
7.16 Differential Costs
Solutions 7-2
Fuel
Wear and tear related to miles driven such as tires, mileage-related maintenance, lube and oil
Parking and tolls, if any
Car wash if needed due to the trip
Risk of casualties that vary with mileage
Other costs that vary with mileage
7.17 Differential Costs
Cost of the car
Foregone interest income on funds paid for the car
Interest on debt on the car
Insurance
Maintenance that is time-related
License and taxes
These costs are different from the costs in Question 7.16. The costs in Question 7.16 are those required to operate the car for an additional few miles. The costs that vary with the number of cars do not vary with mileage. The costs in this question vary with the number of cars and not with the mileage driven.
7.18 Activity-based costing may actually provide better cost information than costing systems that allocate indirect costs based on one volume-based cost driver. Activity-based costing provides more detailed cost data that might lead to more informed decision making regarding prices. Since market prices are typically not available for custom orders, many companies use cost-plus pricing. Since this company uses activity-based costing, it has the cost information necessary to use a cost-plus pricing approach.
7.19 In differential analysis, only alternative future cash flows are relevant for decision making. Past costs may provide useful information, but they are essentially sunk costs and not directly relevant to a decision.
7.20 The contribution margin per unit would be the most appropriate figure since it represents the price minus the product’s variable costs. The gross margin is based on full absorption unit costs that include allocated fixed costs, which can be misleading to the decision maker.
7-3 Solutions
7.21 Answers will vary but should include identification of differential costs. This question is directed to having students think about the many situations in which there are make or buy decisions.
H & B should not drop the Hospital account in the short run as profits would drop by $72,000.
7.29 (Product mix decision.)
Produce Product Y only, because its contribution per machine hour is greater.
Y Z Selling Price per Unit................................................................ $ 30 $ 55Variable Cost per Unit of Materials and Labor*......................... (5 ) (9 )Contribution per Unit to Overhead............................................. $ 25 $ 46 Machine Hours Required per Unit............................................. 1 2Contribution per Hour Required................................................ $ 25 $ 23
*Fixed costs are not differential and therefore excluded.
7.30 (Product choice.)
Solutions 7-6
Alternative 1: Warehouse.Alternative 2: Office space.Alternative 3: Restaurants and specialty shops.
Renovation Enterprises should choose Alternative 3.
7.31 (Throughput contribution.)
With Option (a) the throughput contribution increases by $360 [= 24 units X ($25 selling price – $10 variable costs)] which is more than the additional cost of $100 per Saturday.
Option (b) would increase throughput contribution by $180 [= 12 units X ($25 selling price – $10 variable costs)] which is less than the additional costs of $200.
Victoria’s should go with Option (a) which has a positive impact on contribution while Option (b) has a negative effect on contribution.
7.32 (Throughput contribution.)
Increasing capacity to 15,000 is an increase of 1,560 units (=15,000 – 13,440 units with current capacity). The throughput contribution increases by $85,800 [= 1,560 units × ($120 selling price – $65 variable costs)]. This exceeds the additional cost of $60,000 per month by $25,800. Stay Warm should pursue this option to alleviate the bottleneck because it provides a positive contribution.
a. No, since the $200 price is greater than the incremental (variable) cost of $175. The fixed costs are not differential.
b. Yes. The $160 price is less than the incremental cost of $175.
7.35 (Sell or process further.) Process
Further – Sell = Difference
Revenue $1,560,000a – $900,000 = $660,000 higher
Solutions 7-8
Less Additional Fixed Costs 520,000 – 0 = 520,000 higher
Effect on Operating Profit $1,040,000– $900,000 = $140,000 higher
The company should process further.
a (0.3 x 75,000 x $32 for large grade) + (0.7 x 75,000 x $16 for medium grade) = $720,000 + $840,000 = $1,560,000
7.36 (Sell or process further.)
Cheese – Milk = Difference
Revenue $180,000 – $100,000 = $80,000 higher
Less Additional
Processing Costs 70,000 – 0 = 70,000 higher
Effect on Operating Profit $110,000 – $100,000 = $10,000 higher
The company should process further. The additional $20,000 mentioned in the exercise should either be ignored, as in the solution here, or included in both the “cheese” and “milk” alternatives.
7.37 (Dropping a product line.)
Manual Electric QuartzMachine Time per Unit...................... 0.4 hr. 2.5 hr. 5.0 hr.Contribution Margin........................... $10.00 $ 16.00 $ 22.00Contribution Margin per
Machine Hour............................. $25.00a $ 6 .40 b $ 4 .40 c
Problem Formulation:Maximize Total Contribution Margin = 4.25Z + 5.25BSubject to:
Process 1 Constraint: Z + 2B < 1,000Process 2 Constraint: Z + 3B < 1,275Technical Labor Constraint: B < 400
Critical Produce and Sell Total Contribution
Points Zeta Beta Marginc
a -0- -0- -0-b 1,000 -0- $ 4,250.00*
c 450 a 275 a $ 3,356.25
d 75 b 400 b $ 2,418.75e -0- 400 $ 2,100.00
*Optimal Solution.
aZ + 2B = 1,000 [Process 1 Constraint].
Z + 3B = 1,275 [Process 2 Constraint].
Solving simultaneously:(1,000 – 2B) + 3B = 1,275
B = 275.
Z + 2(275) = 1,000Z = 450.
bZ + 3B = 1,275B = 400.
Solving simultaneously:Z + 3(400) = 1,275
Z = 75.
cTotal Contribution Margin = ($4.25 X Zetas) + ($5.25 X Betas).
7.43 (Appendix 7.1) (Product mix decision.)
Each additional hour of Process 1 time yields an additional contribution of $4.25. Hence, the opportunity cost of additional Process 1 time is $4.25. Since Hanson already pays $1.75 for Process 1 time to produce one unit of Zeta, it would be willing to pay up to $6.00 for the additional time to produce one unit of Zeta.
7.44 (Appendix 7.2) (Economic order quantity.)
D = 10,000 axles
Solutions 7-12
Ko =$10
Kc = 0.20 X $100 = $20
N = = = 100
Annual ordering costs = $1,000 (= 100 X $10).
7.45 (Appendix 7.2) (Economic order quantity.)
a.
Ko = $15
Kc = $4
D = 30,000
b. Number of Orders per Year =
7.46 (Radios Inc.; Special order with lost sales.)
Variable Costs.............................. 60,000 c 69,000 d 9,000 LowerContribution Margin..................... $ 149,000 $ 231,000 $ 82,000 Lower
Fixed Costs.................................. 61,000 e 61,000 e -- Operating Profit........................... $ 88,000 $ 170,000 $ 82,000 Lower
Radios Inc. should turn down the contract unless there are non-pecuniary benefits that will offset the $82,000 reduction in profits.
a$209,000 = (10,000 units X $15) + (10,000 units X $3.40) + $25,000.b$300,000 = 20,000 units X $15.c$60,000 = (10,000 units X $3.45) + (10,000 units X $2.55).d$69,000 = 20,000 units X $3.45.e$61,000 = 20,000 units X ($0.85 + $2.20).
7.47 (Special order.)
The company should have accepted the special order. Profits would increase by $400,000.
Alternative Status Quo DifferenceOrder Order Not Incremental
a$61,000 = (20,000 quarts × $3.00 per quart) + (400 quarts × $2.50 per quart).
b$60,000 = 20,000 quarts × $3.00 per quart.
b. The lowest price for which the ice cream could be sold without reducing profits is $1.75 per quart, which would just cover the variable costs of the ice cream.
7-15 Solutions
7.49 (Special order.)
On the basis of the data in the question, it would not pay Nancy to accept the order.
New Sales (10,000 Units × $6).................................................. $ 60,000Less Standard Sales................................................................... 12,500 Differential Revenue................................................................. $ 47,500
Differential Costsa.................................................................... 49,050 Net Advantage to Special Units................................................. $ (1,550 )
Other factors must be considered such as the reliability of the cost estimates and the importance of this valued customer.
aDifferential cost of the order is:
Costs Incurred to Fill Order*Material (10,000 Units × $2)................................................................... $ 20,000Labor (10,000 Units × $3.60).................................................................. 36,000Special Overhead.................................................................................... 2,000
$ 58,000
Costs Reduced for Standard ProductsMaterial.................................................................................................. $ 4,000Labor...................................................................................................... 4,500Other....................................................................................................... 450
$ 8,950 Total Differential Costs...................................................................... $ 49,050
*Depreciation, rent, heat, and light are not affected by the order. Power might be dependent upon the particular requirements of the special units. It is assumed here that the same amount of power will be used in each case.
7.50 (Multiple choice—special order.)
Solutions 7-16
a. (4) $8,000 = $8 per unit × 1,000 units.
b. (2) $6,000 = ($4 + $2) × 1,000 units.
c. (1) $0. Total fixed costs do not change as a result of the special order.
d. (4) Decrease $0.25: Fixed Costs per Unit Without theSpecial Order ($10,000 + $8,000) ÷ 8,000 Units..................................................... $ 2.25
Fixed Costs per Unit with the SpecialOrder ($10,000 + $8,000) ÷ 9,000 Units............................................................... 2.00
Decrease as a Result of Special Order................. $ 0.25
e. (1) Increase it.
7.51 (Customer profitability analysis)
Differential revenue from new accounts = $170 × 7,000 = $1,190,000.
Differential costs of new accounts: Acquisition costs = $180,000 - $20,000 costs that are not differential = $160,000Transaction processing costs = ($150 - $10 non-differential costs) × 7,000 = $980,000
The effect of offering these accounts has a small positive impact on operating income. Management should consider the likely positive effect of attracting these students as long term customers of the bank, which makes the offer to students even more attractive.
7.52 (Customer profitability analysis)
7-17 Solutions
a. First compute cost driver rates.Transportation costs = $.80 per mile = $800,000/1,000,000 miles.Processing an order = $1 per minute = $100,000/100,000 minutes.Marketing management = 10% of sales = $700,000/$7,000,000 in sales.Special requirements—foreign = $500 per car = $100,000/200 cars.
Next apply costs driver rates to customers. For each customer and each cost driver, multiply the cost driver rate by the cost driver volume given in the problem.
If these customers are representative of all customers (and that is questionable), then the company has a big problem with its shipments to foreign locations and a small problem with domestic national shipments. Management should consider ways to manage costs (e.g., outsource shipments to Mexico or Canada), or raise prices on unprofitable shipments or drop unprofitable product lines or some combination of these suggestions.
Solutions 7-18
7.53 (Throughput contribution)
Note: The status quo gives a contribution of $24,000 per hour [= ($200 - $120) × 300 units].
Option a. Adding capacity adds $400 per hour to contribution but costs only $200 per hour [$400 = ($200 - $120) × 5 units], adding $200 per hour to increase contribution to $24,200 per hour. This is a good option.
Option b. Outsourcing some of the food preparation would increase the contribution per hour by $180. This is also a good option. Here are the calculations:
Alternative Status Quo Difference
Output 310 units 300 units 10 units
Revenue ($200 per unit) $62,000 $60,000 $2,000 higher
Variable costs ($122 for alternativeand $120 for the status quo) $37,820 $36,000 $1,820 higher
Contribution margin $24,180 $24,000 $180 higher
If both options are taken, then the company would still get the contribution margin for Option b + the contribution from Option a for the five additional units, less the $200 cost for additional capacity. Here are the calculations, starting with Option b:
Option b Option a
[310 units × ($200 - $122)] + {[5 units × ($200 - $120)] - $200} = $24,380.
Compare this contribution to the $24,000 status quo or the $24,180 for Option b alone or the $24,200 for Option a alone. Consequently, we recommend that the company take both Options a and b.
7-19 Solutions
7.54 (Throughput contribution)
Note: The status quo gives a contribution of $104,000 per day [= ($240 - $110) × 800 units].
Option a. Outsourcing 80 units of packaging increases output to 880 units per day. This adds $10,400 contribution per day but costs only $8,000 for a net gain of $2,400 per day. [$10,400 = ($240 - $110) × 80 units.] This is a good option that increases contribution from $104,000 per day to $106,400 per day.
Option b. Renting equipment increases output by 50 units per day. This adds $6,500 contribution per day but costs only $4,000 for a net gain of $2,500 per day. [$6,500 = ($240 - $110) × 50 units.] This is a good option that increases contribution from $104,000 per day to $106,500 per day.
If the company tries both options, it encounters a capacity constraint in cooking. Cooking is limited to 900 units per day. Therefore the company can increase output by only 100 units per day. Assuming that the company takes both options, then its contribution increases by 100 units for an increase in contribution of $13,000 [= ($240 - $110) × 100 units.] The cost of taking both options is $12,000 (= $8,000 for option a + $4,000 for option b). The net gain in contribution is only $1,000 which is less than the net gain for either options a or b. Therefore we recommend that the company take Option b, although both a and b give similar improvements in contribution.
7.55 Spectra, Inc.; make or buy.)
VariableCost per 500 Units
Direct Material................................................................................................ $ 80Direct Labor.................................................................................................... 90Other Variable Costs....................................................................................... 25
a. No, since the $200 price is greater than the incremental (variable) cost of $195.
b. Yes. The $180 price is less than the incremental cost of $195.
c. $195 plus the incremental cash inflow which can be generated from the alternative use of the facilities.
7.56 (Sell or process further.)
Solutions 7-20
a. Like many sell or process further problems in the real world, this problem is easier than it appears if one just cuts to the chase. The costs of producing product X up to the split-off point are sunk. The costs of producing y and z are not differential to this decision and are therefore not relevant to the decision to sell X or process it further. If processed further, product X would generate a contribution after split-off of $322,000 [= ($4.30 - $2.00) × 140,000 pounds]. At present, product X has sales at split-off of $280,000. Processing further increases contribution by $42,000 =($322,000 - $280,000).
b. The memo would make the points in part a above. Management should not attempt to incorporate sunk costs into this decision or be concerned about the costs of products Y and Z. Our recommendation to process further does assume that product X will not cannibalize (i.e., reduce) sales of products Y and Z.
7.57 (Hayley and Associates; dropping a product line.)
Status quo: Keep all three services, audit, tax, and consulting.Alternative: Drop consulting, increase tax.
The report should show the above analysis and state that dropping consulting and increasing tax work would increase profits by $8,000.
7.58 (Dropping a machine from service.)
7-21 Solutions
Disagree. Assuming all expenses except depreciation are variable, the number 2 machine should be dropped. Depreciation expense will be incurred whether or not a machine is operating, it is a sunk cost, and so should not be considered when deciding which machines to operate. (We ignore tax consequences in this solution.) Only variable costs requiring future cash outlays are relevant in this decision.
c. Since the additional 1,000 hours are within the firm’s capacity of 6,000 hours, Columbo Connections would want to cover its variable costs of $240 at a minimum. Therefore, the minimum price would be slightly higher than $240.
This problem gives students a good understanding of the fixed/variable cost dichotomy. It is worthwhile to emphasize to students that fixed costs may be “unitized” (i.e., allocated to individual units of product) for certain purposes, and that this allocation procedure may make such costs appear to be variable. Indeed, many students treat the per unit fixed costs as though they were variable costs, despite the fact that they are clearly labeled “fixed.”
This problem can be used to introduce the concept of opportunity cost. Part b. can be used in this way, as can Part d. if you suggest a scrap value for the obsolete hoists.
a. Recommendation: Lowering prices reduces operating profit. Other factors, such as the reduction of available capacity and the impact on market share, could also affect the decision.
(Alternative) (Status Quo)After Price Before PriceReduction Reduction
aGovernment revenue (500 X $300) + (1/8 X $600,000) + $50,000 = $275,000, assuming the government’s “share” of March fixed manufacturing costs is 12.5% (= 500 units /4,000 units). Alternatives are to get 1/6 X $600,000 fixed manufacturing costs, which would increase revenue from $275,000 to $300,000; or get no reimbursement for fixed manufacturing costs, which would reduce revenue to $200,000.
The deal would be a good one if the company had no opportunity costs. The $50,000 fee and reimbursement for (nondifferential) fixed costs would normally flow to the bottom line. But in this case, the company gives up the contribution from 500 units to regular customers making the deal a bad one.
Solutions 7-26
7.61 continued.
c. Minimum Price = (Variable Manufacturing Costs + Shipping Costs + Marketing Costs)/Units = ($300,000 + $75,000 + $4,000)/1,000 = $379 per unit.
At this price per unit, the $379,000 of differential costs caused by the 1,000 unit order will just be recovered.
Some students solve for this price using the breakeven formula:
= X
= 1,000 Units
$4,000 = 1,000P – $375,000
$379,000 = 1,000P
$379 = P
d. The manufacturing costs are sunk; therefore, any price in excess of the differential costs of selling the hoists will add to income. In this case, those differential costs are apparently the $100 per unit variable marketing costs, since the hoists are to be sold through regular channels; thus, the minimum price is $100. (If the instructor wishes to reinforce the concept of opportunity cost, the general answer to this question is that the price should exceed the sum of 1) the differential marketing costs and 2) the potential scrap proceeds, which are an opportunity cost of selling the hoists rather than scrapping them.)
7-27 Solutions
7.61 continued.
e. Alternative Status Quo1,000 Units All ProductionContracted In-house
Total Revenue.......................................... $ 3,000,000 $ 3,000,000Total Variable Manufacturing
costs............................ 6,250 3,850 2,400 HigherDecrease in contri-
bution margin.............. $ 5,400 Lower
The special order should not be accepted because the contribution margin decreases.
7-29 Solutions
7.63 (Leastan Company; department closing.)
We recommend that the dry goods department be continued. If the department is abandoned, the following costs will be saved for sure:
Commissions............................................... $ 15,000State Taxes.................................................. 1,500Insurance on Inventory................................. 2,000Interest on Inventory.................................... 2,500 Total Operating Costs Saved........................ $ 21,000
Presumably, the payroll and direct labor costs will also be saved, but we cannot be so sure about supervision costs. Closing down the department may not save all supervisory costs, because we may not be able to release a supervisor.
Clearly, the rent will not decline and most of the administrative and general office costs will continue as before. Depreciation on the equipment will not necessarily continue because the company can dispose of the equipment. There may be some cash receipts from equipment disposal. At any rate, the depreciation is not a cash outlay. The fact that rent payments for the company will continue unreduced is sufficient for us to recommend continuation.
To summarize, the Dry Goods Department contributes $25,000 to overhead:
7.64 (Biggs Company; sell or process further [CMA adapted].)
Revenue Increase Arising from Producing Product DSale of Product D 100,000 pounds @ $30.00.................. $ 3,000,000Less: Sales of B Lost 100,000 pounds @ $20.25.................. 2,025,000
$ 975,000Cost Increase Arising from Producing Product D
Direct Labor $ 5.50Variable Overhead 2.00 Fixed Overhead 1.75
$ 9.25 Cost per Unit, $9.25 × 100,000 pounds.......................................... 925,000 Differential Profit from Producing Product D................................. $ 50,000
Relying on the economic information given in the problem, the company should produce Product D. Note that the fixed costs attributable to Product D are differential because they did not appear in the
7.65 (Liquid Chemical Co.; make or buy.)
7-31 Solutions
Working this case requires knowledge of how to calculate discounted cash flows.
a. The four alternatives are:
• Alternative A: It is the “status quo,” i.e., Liquid Chemical Co. will continue making the containers and performing maintenance.
• Alternative B: Liquid Chemical Co. will continue making the containers, but will outsource the maintenance contracting Packages, Inc.
• Alternative C: Liquid Chemical Co. will buy containers from Packages, Inc., but will perform the maintenance.
• Alternative D: It is the completely outsourcing alternative. Packages, Inc. will make the containers and provide the necessary maintenance.
b. The incremental cash flow analyses were conducted assuming a five-year time horizon. Appendices I, II, III, and IV present the cash flow analyses for Alternatives A, B, C, and D respectively, as well as more detailed information on the calculations. General considerations for the incremental cash flows are provided below.
• All cash flows occur at the end of the year.
• The last day of Year 0 is when the decision on the alternatives is made. It can also be considered the first day of Year 1.
• The company has an after-tax cost of capital of 10% per year and uses an income tax rate of 40% for decisions like this.
• Cash flows were not adjusted for inflation.
• 200 tons of GHL were purchased at the beginning of Year 0 (= $1,000,000/$5,000). 40 tons were consumed during Year 0 (expense of $200,000 = 40 tons X $5,000/ton), leaving 160 tons in stock at the beginning of Year 1.
• Rent on the container department and the proportion of general administrative overhead allocated to the container department are the same independent of the alternative. Therefore, they are not considered in the cash flow analyses.
Solutions 7-32
7.65 continued.
The table below presents the net present values for the four alternatives. Note that all net present values are negative, so the more attractive alternative for Liquid Chemical Co. is the one with the smallest negative value, i.e., Alternative C. It means that, considering our assumptions and the available information regarding costs, Liquid Chemical Co. should buy containers from Packages, Inc., and keep performing the maintenance.
Alternative A Alternative B Alternative C Alternative DMake Make Buy Buy
c. Although Alternative C seems to be the more attractive, its net present value is not significantly different from the net present values of Alternatives A and D. This situation requires a careful examination of facts and assumptions made. A brief discussion of some points that should be reevaluated, as well as additional information that should be taken into account, is presented below.
Administrative Overhead: A proportion of general administrative overhead is allocated to the container department. Is this cost proportional to the number of employees in the container department? Apparently the answer is yes, and in this case it is not the best estimate because it is not considering the real administrative resources consumed by the container department.
Quality of Outsource Services: Quality issues are always important when a company is considering outsourcing some services. In this case, it is assumed that Packages, Inc. will perform maintenance and/or make containers with a quality at least as good as Liquid Chemical’s quality. Due to the importance of quality, Liquid Chemical Co. should carefully evaluate Package Inc.’s ability to meet quality requirements imposed by Liquid Chemical.
Container Contract Terms: Does Packages Inc. have the ability to meet Liquid Chemical’s future container needs?
Time Horizon and Inflation: Is the price locked in for five years regardless of inflation?
Employees: The effect of eliminating some employees may have a detrimental effect on the morale of remaining employees.
7-33 Solutions
7.65 continued
Incremental Cash Flow—Alternative A: Make Containers and Perform Maintenance
• Under this alternative, GHL consumption is 40 tons per year. At the end of Year 4 the GHL stock is zero, and a purchase of 40 tons is necessary. At that time, the price will be $6,000 per ton.
• There is no cash outflow due to GHL consumption from Year 1 to Year 4, just “accounting” expenses because the product is in stock. Due to these GHL expenses, there is tax savings of $80,000 per year (= 40 tons X $5,000/ton X 40%) from Year 1 to Year 4.
• It uses straight-line depreciation, resulting in depreciation expense of $150,000 per year (= $1,200,000/8 years). It generates a cash inflow of $60,000 per year (= $150,000 X 40%) from Year 1 to Year 4 because the book value of the machinery at the beginning of Year 1 is $600,000.
Solutions 7-34
7.65 continued
Incremental Cash Flow—Alternative B: Make Containers and Buy Maintenance
• Under this alternative, GHL consumption is 36 tons per year (= 40 X 90%). At the end of Year 4 the GHL stock is 16 tons, and a purchase of 20 tons is necessary. At that time, the price will be $6,000 per ton.
• Due to lower GHL consumption, during Year 5 there is still an “accounting” expense of $80,000 (= 16 tons X $5,000/ton). It will generate tax savings of $32,000 (= $80,000 X 40%) at Year 5.
• When the department contracts external maintenance, it decreases materials costs by 10%, and reduces employee expenses by 20%. Other expenses total $92,500.
• There is no severance pay or pension under this alternative.
• Under this alternative, GHL consumption is 4 tons per year (40 X 10%), or 20 tons over five years. Therefore, Liquid Chemical can sell 140 tons (= 160 – 20) at the end of Year 0 at $4,000 per ton.
Market Price = $560,000 Loss on Sale = $ 140,000Book Value = $700,000 Tax Savings on Sale = $ 56,000
• Machinery is not necessary for maintenance, and can also be sold at the end of Year 0.Market Price = $200,000 Loss on Sale = $ 400,000Book Value = $600,000 Tax Savings on Sale = $ 160,000
• When the department performs maintenance and buys containers, it decreased materials costs by 90%, and reduces employees by 80%. Other expenses total $65,000.
• In this case, there is a severance pay of $16,000 (= $20,000 X 0.8). The supervisor is still necessary, but Mr. Duffy can be transferred to another department.
• Tax effects on GHL consumption are computed based on an expense of $20,000 per year (= 4 tons X $5,000/ton). It results in savings of $8,000 per year (= $20,000 X 40%).
7-37 Solutions
7.65 continuedIncremental Cash Flow—Alternative D: Buy Containers and Buy Maintenance
See following page for considerations.Considerations:
Solutions 7-38
• Under this alternative, there is no GHL consumption. Therefore, Liquid Chemical can sell 160 tons at the end of Year 0 at $4,000 per ton.
Market Price = $640,000 Loss on Sale = $160,000Book Value = $800,000 Tax Savings on Sale = $ 64,000
• Machinery is not necessary for maintenance, and can also be sold at the end of Year 0.Market Price = $200,000 Loss on Sale = $400,000Book Value = $600,000 Tax Savings on Sale = $160,000
• There is a severance pay of $20,000 at Year 0, and a pension payment of $30,000 per year from Year 1 to Year 5.