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Managerial Accounting Solutions, Schneider/Sollenberger, 4th Edition, Chapter 10, Page 10-1

CHAPTER 10 SOLUTIONS

Solutions to Questions for Review and Discussion

1. The basic differential analysis decision rule is: From the alternative decisions that could be

made, select the choice that yields the greatest incremental profit from the relevant revenues

and costs. Incremental profit is the difference between the relevant revenues and costs of each

choice relative to a "status quo" position. Relevant revenues and costs are defined as the

current and future values that differ among the choices being considered.

2. The managerial accountant is involved in all eight steps, as follows:

Define the decision issue: The decision maker must understand the strategic, competitive,

and organizational factors to identify the real decision issues and not merely the surface

problems. The accountant often helps clarify the issue.

Specify the decision objective and decision rule: The basic decision is based on selecting

the choice with the highest incremental profit to the firm. The accountant can define the

objective and the rule, given the context of the decision.

Identify the choices: The decision maker must narrow the many possible decision alternatives

to a specific set of choices. The accountant may advise the decision maker on the feasibility

and the financial implications of alternative choices.

Collect relevant data on alternatives: Many times, the decision maker will strive to collect all

available information for a choice. However, the decision maker should be looking only for

relevant information about a decision choice. Also, a cost-benefit relationship exists with regard

to data collection. Collecting data is expensive and time consuming. At a certain point, the cost

of collecting more information is greater than the benefit derived from that information.

Managerial accountants play a major role in this step, because they are very familiar with the

types and value of information necessary to make decisions.

Format and analyze information about each alternative: Organization of the data simplifies

the decision task. Specific formats can help the decision maker better compare and analyze

the relevant information regarding each choice. The managerial accountant's role is to

organize the relevant quantitative data for analysis.

Make the decision: Given the decision rule and relevant information about the choices, select

the choice which provides the greatest benefit. While making the decision, it is important not to

forget the qualitative factors regarding the choices. Too often the decision maker focuses only

on the quantitative analysis and makes a poor decision. The decision is the responsibility of the

manager and not the accountant. The managerial accountant advises, and the manager

decides.

Implement the decision: Although this step may seem obvious, much time and thought need

to be spent implementing a decision. The accountant's role may be to evaluate costs and

benefits of implementation alternatives, to design and implement information systems and

controls, and to prepare reports.


Evaluate the decision: Valuable information that will aid in making future decisions can be

obtained from evaluating a decision. The accountant collects, analyzes, and reports the results.

3. Irrelevant cost data:

1. Any past cost

2. Any present or future cost that is committed and cannot be avoided

3. Any present or future cost that does not differ among the alternatives considered

Relevant cost data:

1. The cost must be a present or future value and

2. The cost must change among the alternatives considered

4. Identifying choices is an important step because it determines which choices will be considered.

This, in turn, affects the outcome of the decision. At one extreme, the choices may be so

numerous that an exhaustive list would be almost impossible to evaluate. At the other extreme,

the choices selected may be so few that some profitable alternatives may be overlooked. The

key to identifying the appropriate choices is properly defining the problem, being cautious not to

define it too broadly or too narrowly.

In addition to defining the problem carefully, some simplifying assumptions may be necessary

to proceed in a practical manner. However, a manager does not want to overlook important

choices, either through the simplifying process or by not pursuing choices beyond the most

obvious ones.

5. This statement is generally true but should not be relied upon as a fact. While variable costs

are usually relevant in the short term, a variable cost that does not differ between decision

alternatives in the future would not be relevant to that decision and should not be included in

the analysis. Also, any additional, or incremental, fixed costs related to a decision choice are

relevant; and a wrong decision could be made if they are excluded from the analysis.

When volume or activity change, we expect total variable costs to change. But we must

examine the fixed costs to determine whether the decision will cause these costs to change in

some way.

6.

(a) An incremental analysis approach includes only incremental revenues and costs of each

choice. The choice with the highest additional benefit is chosen. A total analysis approach

shows the results for the entire entity, including the alternative and then excluding the

alternative. The decision is made by comparing total profit in each scenario.

(b) An opportunity cost is the sacrificed returns or benefits foregone because an choice was not

selected. Out-of-pocket costs refer to actual cash outflows resulting from the decision made.

7. While most relevant costing decisions are viewed as short-term decisions, many of them will

have long-term effects that should be considered before making a decision. Decisions made

today cannot be easily reversed in the future. For example, if we decide today to buy a part

from an outside supplier instead of making it ourselves, it is unlikely that tomorrow we will

reverse that decision and begin making the part again. Also, a profitable special order

accepted today may result in lower sales of regular units in the future. Short-term thinking for

near-term profit should be analyzed carefully because the decision may end up damaging the


overall business strategy in the future. Incremental decision making is the basic thinking

framework. But as the timeframe is extended, more factors must be included in the analysis.

8. Basically, agree. Looking at the basic facts, a rational person can add the benefits and subtract

the costs. The alternative selected is the one with the largest positive contribution margin. But,

this simple approach is also dangerous and would probably cause experienced managers to

disagree. While the relevant dollars and cents are an important part of the decision-making

process, many nonquantitative factors are important and must be considered. For example, the

numbers may show that it is cheaper for a company to buy a part instead of making it; but the

numbers do not show that the quality and delivery problems may cause additional costs. Also,

a short-term money-making choice may damage customer relations in an important segment of

our normal market. We start with the basic common sense set of facts and move to more

sophisticated analyses that consider many more variables.

9. Any analysis using accounting data reflects the quantitative aspects of the decision-making

process. If only quantitative factors are important, the result of the analysis directs us to the

decision. However, in many situations qualitative factors exist that cannot be quantified yet

which must be considered in the decision. Common "other factors" include quality of parts or

products, delivery dependability, market segmentation, customer service, response time of

vendors, and long-term financial stability of vendors or customers.

10.

(a) Make or buy: Hiring management consultants to analyze our operations vs. using inhouse staff

and managers to evaluate our current system.

(b) Special sales: Licensing a Japanese manufacturer to produce and distribute our mouthwash

products in the Pacific rim.

(c) Scarce resources: Using mainframe computer time during the normal work day.

(d) Sell or process further: Buying a new computer system – sold in the box as received from the

manufacturer or setup with additional software installed.

(e) Add or delete a segment: Deciding whether to expand or drop a cardiac care specialization in a

hospital.

11. The guidelines that should be followed are:

1. Excess capacity should exist, with no alternative use of the capacity. This allows the

opportunity cost of using the capacity to be zero or at least very low. If the capacity can be

used, then the decision must include the opportunity cost of using the capacity.

2. The special sale should not interfere with regular business. The special sale is in a market

segment different than our other business. The sale will then be incremental revenue. If

the sale does interfere with regular business, we are often merely substituting lower priced

"special sales" for normal priced regular sales.

3. The expectation is that this is a one-time deal, will not become regular business, and will not

share the general overhead burden of regular sales. If the special sale becomes repeat

business, we have probably added a product with a lower contribution margin to our product

line. Therefore, it must share the common overhead in evaluating its use of resources.

12. The decision rule:

If the out-of-pocket costs of buying the product or service are less than the out-of-pocket costs

of making the product or service, buy it. If not, make it.

Relevant make costs are the direct costs of producing the item plus any opportunity costs.


Relevant buy costs are the part's purchase price plus shipping and handling costs, and any

costs incurred to get the purchased item into usable form.

13. An opportunity cost is defined as the return or benefit associated with the best choice not

selected. In this case, the scarce capacity should be used where the incremental profit is

greatest. Thus, the opportunity cost (sell now or process further) should be less than the

incremental profit from the other alternative (process further or sell now).

If a product is completely processed and sold, the company will have to give up the revenue

from the sale of the product in its unfinished state. The proceeds from the sale of the

unfinished product are the opportunity costs of further processing. The product should be

completely processed if the revenue from the sale of the finished product is greater than the

combination of the sacrifice of revenue from the sale of unfinished product and the additional

costs to process the unfinished product to a finished form.

14. Key assumptions:

$200 tax returns generate more contribution margin per hour of tax return preparer time than do

$80 tax returns.

Not enough $200 tax return customers exist to use the preparer's total time available.

The tax return preparers cannot handle all customers who want returns prepared.

Memo:

To: Receptionist

From: Decision maker

Subject: Scheduling of tax return customers

Since tax returns are due on April 15, time is a scarce resource. Priority should be given to

$200 tax return customers. Prepare a wait list of $80 tax return customers and, if any time is

available, schedule these customers after the $200 customers are scheduled.

15. If Company A is considering buying a part from Company B instead of making the part itself,

then Company A is facing a make-or-buy decision; and Company B is facing a potential special

sales decision. For both companies to be satisfied, the negotiated price of the part must be

less than Company A's cost to make the part and more than Company B's cost to make the

part. Company A wants to save money by buying the part from Company B, and Company B

wants to make money by selling the part to Company A.

Something to consider in this case is that a special sales decision is usually a one-time deal

and does not become part of regular business. On the other hand, make-or-buy decisions are

usually for a longer time horizon. Company A above would probably not be very interested in

purchasing the part from Company B only once and then going back to making the part itself or

finding a new seller.

16. If the subassembly is a critical part of a larger component that the company manufactures, the

company may be willing to make it at a higher cost rather than purchase it from an outside

supplier for many reasons. For example, the company must have the subassembly on time to

keep the manufacturing process running. The outside supplier may not be able to meet the

company's strict delivery requirements, and it is more economical to make the subassembly

part itself than to risk the possibility of shutting down the line for lack of subassemblies. Also,


the quality of the subassembly purchased from an outside supplier may be substandard, forcing

the company to incur substantial rework costs that are greater than the cost savings associated

with purchasing the subassembly. And, the subassembly may have technology included that

the company does not want outsiders to see or to access.

17.The restaurant should add the new main course if its profits are higher after adding the new

course and dropping the other course. This is an add or delete a segment decision. This may

also have attributes of a scarce resource problem. Limited menu space may cause the

manager to choose between the two selections – better use of limited capacity.

18. Incremental analysis looks at the differences between various choices as related to the status

quo alternative. The incremental analysis approach is "clearer" since it shows only the costs

and revenues that change across the choices considered. Total analysis includes all of the

costs and revenues associated with each of the alternatives. It has the advantage of showing

the total revenues, costs, and profits associated with each alternative rather than just the

changes between alternatives. The form of analysis selected by a manager will depend on

personal preference and on how costly the selected form of analysis is compared with the

benefits to the user. Regardless of which method is chosen, the incremental contribution

margin will always be the same.

19. Several reasons exist why a company may not want to accept the offer. First, the company

must be able to isolate its market for the special sale from the market for regular sales -- such

as a foreign market or an isolated sector of the domestic market. Secondly, the company may

have a high-quality image; and accepting the special sale would hurt that image and possibly

damage regular sales. Or, the company may have a future plan in mind for the excess capacity

and does not want to commit to a special sale that may become repeat business at a lower

contribution margin.

20. The markup must be sufficient to cover any costs not included in the cost per unit and to

provide a profit. If full costs are used, the unit cost frequently includes only the manufacturing

variable costs and an allocated share of the manufacturing fixed costs. Therefore, the markup

must cover selling and administrative costs and provide for a profit. In cases where full costs

are interpreted to mean all costs of the company (manufacturing, selling, and administrative),

the markup provides only for profit.

If variable costs are used, the assumption is that all variable costs are included in the unit cost.

For this situation, the markup must cover all other costs and provide for a profit. It may be

defined to mean, however, that only manufacturing variable costs are included. In this case,

any selling and administrative variable costs must be covered also.

21. Neither person is totally correct. Pricing is one of the most difficult and critical decisions faced

by a company. In some markets, for instance an agricultural product, the price is set by the

market; and the producers have no control over it. In other markets, for instance rate-regulated

industries, the price is almost solely determined by cost; and demand is ignored. However, in

most circumstances both cost and demand should be considered in the pricing decision. A

middle ground probably does exist, but the challenge facing most companies today is finding it.

Depending on cost in a market-driven situation may cause the price to be out of line with

competition. If too high, no sales exist. If too low, excess sales and the loss of additional

contribution margin occur.

Depending on market-driven prices may cause losses to incur if the market price is below what

is needed to earn a satisfactory profit.


Solutions to Exercises

10-1.

(1) Total analysis approach:

Before Expansion After Expansion

(8,000 units) (9,000 units)

Sales ($30 per unit) $240,000 $270,000

Variable costs ($18 per unit) 144,000 162,000

Contribution margin $96,000 $108,000

Fixed costs 60,000 75,000

Net income $36,000 $33,000

Expanding operations causes a decrease of $3,000 in net income.

(2) Incremental analysis approach:

Incremental sales ($30 x 1,000 units) $30,000

Incremental variable cost ($18 x 1,000 units) 18,000

Incremental variable contribution margin $12,000

Incremental fixed cost 15,000

Incremental net income ($3,000)

The results are the same. Part (1) includes all firm revenues (including the first 8,000 units).

Part (2) includes only the revenue and costs of the additional 1,000 units.

10-2. The minimum price on the special sale of 20,000 units must be sufficient to cover all of the

relevant costs as well as the $50,000 desired profit:

Direct materials $10.00

Direct labor 5.00

Variable overhead ($12 x 1/3) 4.00

Shipping costs 3.00

Desired incremental profit ($50,000 20,000 units) 2.50

Selling price $24.50

10-3.

(1) Make Costs Buy Costs

Direct Materials (20,000 x $4) $ 80,000 | Purchase cost (20,000 x $36) $720,000

Direct Labor (20,000 x $16) 320,000 | Additional money saved

Variable Overhead (20,000 x $8) 160,000 | from renting facilities -10,000

Fixed O/d (20,000 x $10) x 0.4 80,000 |

Total make costs $640,000 | Total buy costs $710,000

Net make advantage $70,000 |

(2) Assumptions about cost behaviors may be troublesome by either buying or making because a

cost’s behavior may change relative to what decision is ultimately made.

Variable make costs are subject to external market forces. Fixed overhead make costs must

be controlled. Often unforeseen costs may be incurred to support the new (or continuing)


manufacturing activity. Stace may or may not be highly skilled in making this part – quality

might be a serious problem if this is a new production area.

Buying costs are also uncertain. Vaz may be bidding low to get the business. Then, over time

Vaz may try to raise the price. Also, is Vaz a stable supplier? Or, will additional costs be

incurred to ensure dependable and timely deliveries?

10-4.

(1) The firm is concerned with selling now or processing further. If the net incremental revenue

from processing further is greater than the sales value of HiEnergy, the product should be

processed further.

Sales Value Additional Costs Net Incremental Revenue Priority

HiEnergy $ 80 $80 3rd

GoGetEm 100 $15 85 ($100 – $15) 2nd

ReallyGo 110 35 75 ($110 – $35) Don't process

SuperGo 130 40 90 ($130 – $40) 1st

The firm should process further and sell SuperGo and then GoGetEm. All remaining capacity

should be used to produce HiEnergy. Since the net incremental revenue for HiEnergy is

greater than that for ReallyGo, ReallyGo should not be made.

(2) If the HiEnergy market is limited and once the demand for SuperGo, GoGetEm, and HiEnergy

has been covered, ReallyGo should be sold. The incremental revenue is $75, versus a cost of

$50 to produce it.

10-5. Zelenski products:

Product X Product Y Product Z

Market value after $3.20 $3.75 $5.00

Minus market value now 1.00 2.00 3.00

Increase in value $2.20 $ 1.75 $2.00

Gallons 10,000 10,000 10,000

Additional revenue $22,000 $17,500 $20,000

Minus additional costs 10,000 20,000 15,000

Net benefit(loss) $12,000 ($2,500) $ 5,000

Assuming that all three products are produced from the common process, Zelenski should

process Products X and Z further. Product Y loses $2,500 in processing further.

If the initial process can produce either Product X or Y or Z, the picture is very different.

Product X Product Y Product Z

Market value after $3.20 $3.75 $5.00

Gallons 10,000 10,000 10,000

Total revenue $32,000 $37,500 $50,000

Minus additional costs (10,000) (20,000) (15,000)

Net benefit(loss) $22,000 $17,500 $35,000


Only Product Z covers the initial production costs of $30,000 and its process further costs.

The key assumptions:

All three products are produced in the initial process (a total of 30,000 gallons).

Process further all products that earn additional profits beyond the split-off point.

10-6. Artists' priorities:

Large Medium Small

Sale price $80 $50 $25

Materials and artists' time costs 38 25 16

Contribution margin per piece $42 $25 $ 9

Time per piece 1 hour 0.5 hour 0.2 hour

Pieces per hour 1 2 5

Contribution margin per hour* $42 $50 $45

* CM piece x Pieces per hour = Contribution margin per hour

Order of priority: Medium, small, large.

10-7.

Make Costs Buy Costs

Ingredients Purchase cost

(5,000 x Y2) Y10,000 (5,000 x Y3) Y15,000

Labor & overhead Additional contribution

(5,000 x Y1) 5,000 margin from the

Fixed making costs 4,000 extra space (3,000)

Total make costs Y19,000 Total buy costs Y12,000

Net buy advantage Y7,000

Mr. Li would be better off quantitatively if he purchased the dumplings. He should be

concerned with maintaining the same quality and taste in the purchased ones. Notice that the

fixed making costs could be placed on either side – as an additional make cost or as a cost

savings on the buy side. In this case the variable make and the buy costs are equal. The

avoidable fixed and the contribution margin for the extra space create the buy advantage.

10-8.

(1) Without special order:

Sales (10,000 gallons x $1.30) $13,000

Minus costs (10,000 gallons x $1.10) 11,000

Profit $2,000

With special order:

Regular sales (9,000 gallons x $1.30) $11,700

Special sales (3,000 gallons x $1.00) 3,000

Total sales $14,700

Minus costs:

Ingredients and labor (12,000 gallons x $0.60) $ 7,200


Variable overhead (12,000 gallons x $0.20) 2,400

Fixed overhead (10,000 gallons x $0.30) 3,000

Total costs $12,600

Profit $2,100

Clouse should accept the special sale since it increases profits by $100.

(2) Regular customers could find out about the special price and either demand the lower price or

arrange to buy the supermarket brand. Furthermore, Clouse may not want to run the plant at

full capacity. At full capacity, Clouse cannot grow, take on seasonal flavors, or consider other

special deals. The incremental profit is very small and hardly worth the extra effort.

10-9. Common costs are incurred regardless of the decision made. If a segment is dropped, the

common costs are simply redistributed to the remaining segments. Therefore, the direct

contribution margin should be used to evaluate each segment.

Dept 2 Dept 3 Total

Gross margin $500 $350 $850

Less direct expenses (400) (400) (800)

Direct contribution margin $100 ($50) $ 50

(a) The company should not delete Department 2 since it would lose $100 in profits. The common

costs would simply be reallocated to the remaining departments.

(b) The company could delete Department 3 since it is incurring a $50 loss before common costs

are even considered.

(c) By deleting both segments, the company is losing a net $50 profit. Delete Department 3 but

keep Department 2.

(d) It would be more beneficial to keep the two departments since they are producing a profit of

$50 versus the $25 profit in a new department. Delete Department 3 and add Department 5, if

possible.

(e) Reallocating the common expenses would not help since common expenses are not considered

in the decision-making process.

10-10.

(1) If the special sale is a one-time sale, the price must cover only the variable and direct costs:

Materials and variable supplies $ 4.25

Variable selling expenses 1.80

Direct fixed manufacturing costs 1.50

Total incremental costs $ 7.55

To make $120,000 (or $1.20 per unit on 100,000 units) on the sale, the markup on incremental

costs is 16 percent ($1.20 $7.55).

(2) If the sales are going to become regular business, the price must cover all costs:

Total manufacturing costs $ 9.50

Total selling expenses 3.25

Total costs $12.75

The markup on total costs is now 9.4 percent ($1.20 $12.75).


10-11.

Revenue (9,000 caps x $10) $90,000

Costs:

Prime costs (9,000 caps x $5) $45,000

Overhead cost breakdown:

10,000 caps x $3 $30,000

Minus fixed costs 20,000

Variable costs $10,000

Divided by units 10,000

Variable cost per cap $1

Variable overhead (9,000 caps x $1) 9,000

Fixed overhead 20,000

Total costs $74,000

Profit $16,000

Special Sale

Revenue (1,000 caps x $7) $ 7,000

Costs:

Prime costs (1,000 caps x $5) $ 5,000

Variable overhead (1,000 caps x $1) 1,000

Insignia cost 200

Total special sale costs $ 6,200

Additional profit $ 800

A.J. should accept the special sale since he will make an additional $800 profit. He should be

aware of the qualitative concerns of special sales – alternative use of excess capacity, low profit

level on this sale, and interference with regular sales.

10-12. Ballou Corporation:

Product A Product B Product C

Incremental revenues:

Product A: ($60,000 – $45,000) $15,000

Product B: ($98,000 – $75,000) $23,000

Product C: ($62,000 – $30,000) $32,000

Minus incremental costs:

Product A: (20,000)

Product B: (20,000)

Product C: (18,000)

Incremental benefit (loss) ($5,000) $3,000 $14,000

Ballou Corporation should process Product B and C further since incremental revenue for each

of these products will exceed the incremental costs of processing further. Product A should be

sold at the split-off point since incremental costs exceed the incremental revenue.

10-13. Hinds Copies course packet cost estimate:

Variable cost per packet = Change in cost = $2,400 – $2,000 = $400 = $2 per unit

Change in units 600 – 400 200


Total cost (600 units x $4) $2,400

Minus variable costs (600 units x $2) 1,200

Total fixed costs $1,200

Number of packets needed:

600 students x 80% purchase rate 480

Complimentary 30

Total needed 510

Incremental costs: Variable costs (510 packets x $2) $1,020

Jo Ann must charge enough to have revenue of at least $1,020 to cover her costs in making the

packets. Notice that fixed costs are ignored since they are common fixed. Any incremental fixed

costs of this order would have to be included. Since she will sell 480, she must charge at least

$2.125 per packet ($1,020 480). Notice that this price will only cover incremental costs and

contribute nothing to paying common costs and to increasing profits. $2.125 is the answer to

question, but it is probably an unacceptable price for her business unless this price gives her a

competitive short-run advantage that will have a long-run impact on other sales that provide a more

favorable profit.

10-14. Ryan's courses:

Current Grade Hours/0.5 Grade Priority Study Hours Final Grade

Course 1 2.0 5 2 20 4.0

Course 2 3.0 4 1 8 4.0

Course 3 1.0 6 3 12 2.0

Course 4 1.0 8 4 0 1.0

Ryan should prioritize based on the lowest hour effort per 0.5 grade increase. Ryan should

study Course 2, then Course 1, and then Course 3. The 40 hours are now committed and Ryan

is stuck with a 1.0 in Course 4. But, his grade average would be 2.75.

10-15. Murphy Farms sprinkle system:

Costs to Run Costs to Run

Old System New System

Rent $25,000 $10,000

Variable operating costs:

200 acres x $100 20,000

200 acres x $ 40 8,000

Fixed operating costs 20,000 30,000

Total costs $65,000 $48,000

Since the costs are less under the new system, Murphy should change to the new system.

Notice that contribution margin is not used since it is the same under both choices.

10-16.

(1) Service plan:

Able Baker Charlie

Services required 500 500 500

Time per service x 0.8 x 0.5 x 0.2

Time used 400 250 100


After the service requirements are met, the remaining 1,250 hours (2,000 – 400 – 250 – 100)

should be used for the services that have the highest contribution margin per hour:

Able Baker Charlie

Revenue per service $50 $40 $30

Variable cost per service (30) (25) (20)

Contribution margin per service $20 $15 $10

Time per service 0.8 hour 0.5 hour 0.2 hour

Contribution margin per service

hour (contribution margin per

service divided by hours

per unit) $25 $30 $50

Priority: Highest profitability 3rd

2nd

1st

Contribution margin generated $10,000 + $7,500 + $67,500 = $85,000

($25 x 400)($30 x 250)($50 x 1,350)

Charlie service should be performed to the limit of demand. The remaining 1,250 hours can be

used to perform 6,250 Charlie services (1,250 0.2). A total of 6,750 Charlie services in 1,350

hours plus 500 Able services in 400 hours and 500 Baker services in 250 hours are performed.

(2) Assuming that Soma can only sell 3,000 of each services gives the following results:

Number Remaining Contribution

of Hours Available Margin Contribution

Priority Service Hours Per Services Required Hours Per Hour Margin

2,000

1st Charlie 0.2 3,000 600 1,400 $50 $ 30,000

2nd Baker 0.5 2,800 1,400 0 $30 42,000

Total hours used 2,000 $ 72,000

The priorities are the same as in Part (1): 1st, Charlie; 2

nd, Baker; and 3

rd, Able.

10-17. The numbers show that, by using ASF, Inc. services, the subsidy will drop 60 percent. This

is due to a 10 percent reduction in food and preparation costs. Gramlich should be concerned

over the quality if the food services are performed by the outside company. Also, the

employees may choose to go elsewhere and eat since the cafeteria is not company operated.

The $300,000 overhead costs would be replaced with a management fee of $200,000. This

seems beneficial but might result in the elimination of employees. The company may want to

survey its employees and see how they feel about having an outside team prepare their food.

A major benefit to the company is that day-to-day management is transferred to a professional

food service company. Gramlich can focus on its primary business, not cafeteria management.

Key issues of concern:

Can the cost savings be achieved in food and preparation areas?

Will lower prices allow revenues to hold at $750,000?

Will current employees be displaced?


Will the quality of food and service remain high?

Will the cafeteria continue to be viewed as an employee benefit?

What are the views of employees toward an outside service?

Data needed:

Careful review of ASF's cost and revenue estimates.

Views of employees from a survey.

Review of Gramlich cost data.

10-18. The solution to this exercise is found by comparing the incremental revenue with the

additional processing cost. The joint costs are irrelevant because they do not differ between the

alternatives to sell now or to process further.

(1) Analysis of 1,000 barrels of naphtha:

Revenue after processing ($85 per barrel) $85,000

Minus revenue at split-off ($60 per barrel) (60,000)

Incremental revenue $25,000

Minus additional processing cost (20,000)

Advantage of further processing $5,000

The 1,000 barrels of naphtha should be processed further since it is worth an additional $5,000

of profit for the company.

Analysis of other distillates:

Revenue after processing $110,000

Minus revenue at split-off (80,000)

Incremental revenue $30,000

Minus additional processing cost (40,000)

Advantage of further processing ($10,000)

The other distillates should be sold at the split-off point for $80,000 since further processing

decreases profits by $10,000.

Analysis of kerosene: Kerosene must be sold at the split-off point.

(2) Solving for the price of crude oil:

Revenues:

Naphtha (sold after further processing) $85,000

Kerosene (sold at split-off) 60,000

Other distillates (sold at split-off) 80,000

Total revenue $225,000

Minus costs:

Additional processing of naphtha ($20,000)

Joint costs of process (120,000)

Total costs ($140,000)

Net income $85,000

The maximum amount Silver Bullet could pay for crude oil is $85,000. At that price, the

company breaks even and would not lose money on refining.


10-19. To analyze the statements about Department E, first prepare a segment contribution

margin income statement for the department. Rent and services and half of the advertising

expenses should be ignored since they are common costs and they will not change regardless

of the decision made. Department E

Sales $500,000

Minus cost of sales 300,000

Variable contribution margin $200,000

Minus direct expenses:

Direct salaries ($50,000)

Advertising (25,000)

Total direct expenses ($75,000)

Direct segment contribution margin $125,000

(a) Not true; Department E is earning $200,000 in variable contribution margin.

(b) Not true; Department E is earning $125,000 in direct contribution margin.

(c) Not true; if Department E were eliminated, the overall profitability would fall by $125,000.

(Department E's direct contribution margin) to $375,000.

10-20. To find the indifference point between making the lens and lens holder assembly or buying

it, set the cost to make equal to the cost to buy:

Make costs Buy costs

Prime costs per unit $21 Purchase price per unit $40

Other variable costs per unit 3

Total variable costs $ 24

Fixed costs $360,000 Fixed costs $200,000

Make costs = Buy costs

24 x (units) + 360,000 = 40 x (units) + 200,000

Units = 10,000

If volume is below 10,000, buy the lens assembly. If volume is above 10,000, make the lens

assembly.

10-21.

(1) Product priorities: Product Line

A B C D

Selling price per unit $300 $250 $130 $ 70

Variable cost per unit 250 80 50 40

Contribution margin per unit $ 50 $170 $ 80 $ 30

Hours required for each unit 5 10 4 2

Contribution margin per hour of production

time (contribution margin per unit

divided by hours per unit) $10 $17 $20 $15

Priority: Highest unit profitability 4th 2

nd 1

st 3

rd


Remaining Contribut’n

Hours Hours Available Margin Contribution

Priority Piece Per Unit Units Required Hours Per Hour Margin

96,000

1st Piece C 4 8,000 32,000 64,000 $ 20 $ 640,000

2nd Piece B 10 6,000 60,000 4,000 17 1,020,000

3rd Piece D 2 2,000 4,000 0 15 60,000

Totals 96,000 $1,720,000

Given the above calculations, the best product combination is to produce in the following

order:

1st: 8,000 units of Piece C

2nd

: 6,000 units of Piece B

3rd: 2,000 units of Piece D

(2) If the company has to deliver 2,000 units of each product to a major contributor, the product

combination becomes: Remaining Contribution



96,000

Required Piece A 5 2,000 10,000 86,000 $10 $100,000

Required Piece B 10 2,000 20,000 66,000 17 340,000

Required Piece C 4 2,000 8,000 58,000 20 160,000

Required Piece D 2 2,000 4,000 54,000 15 60,000

Totals 42,000 $660,000

Now that the distributor's needs are met, the company can produce pieces C, B, D, and A in

that order with the remaining hours:

Remaining Contribut’n



54,000

1st Piece C 4 6,000 24,000 30,000 $20 $480,000

2nd

Piece B 10 3,000 30,000 0 17 510,000

Total hours used for regular sales 54,000 $990,000

Totals 96,000 $1,650,000

The best product combination is now:

Piece A 2,000 units

Piece B 5,000 units

Piece C 8,000 units

Piece D 2,000 units

Notice that the company's total contribution margin has fallen from $1,720,000 to $1,650,000

due to the commitment to the distributor.


10-22. Incremental analysis approach:

Incremental revenue from additional processing

[($3.30 – $2.30) x 40,000 units] $40,000

Minus: Incremental costs from additional processing

($0.40 x 40,000 units) (16,000)

Avoidable fixed costs (5,000)

Incremental contribution from additional processing $19,000

Total analysis approach: Product Sold Product Sold

Unprocessed Processed

Sales revenue:

40,000 units x $2.30 $92,000

40,000 units x $3.30 $132,000

Minus costs:

Variable cost of unprocessed meat

(40,000 units x $1.20) ($48,000) ($48,000)

Additional variable processing costs

(40,000 units x $0.40) (16,000)

Fixed costs, unprocessed product (30,000) (30,000)

Fixed costs, committed processing (8,000) (8,000)

Fixed costs, avoidable processing (5,000)

Total costs ($86,000) ($107,000)

Total profit (loss) $6,000 $25,000

The total profit is $19,000 greater if the product is processed further (using either approach).

10-23. Probability Hours Expected Value

50% 15 7.5 hours

20 20 4.0

20 40 8.0

10 100 10.0

100% 195 29.5 hours

The expected value of the number of hours each month is 29.5.

Option 1: $3,000 x 12 months = $36,000 plus direct expenses

(Note that expected hours are below 400 hours per year.)

Option 2: $130 x 29.5 x 12 months = $46,020 plus direct expenses

Option 3: $90,000 inclusive of direct support costs

The best alternative is Option 1, pay the retainer. However, this method ignores the increased

cost levels when hour usage exceeds the 400 hour per year limit. A preferred look follows.

Another view:

If each level of activity is costed, Option 1's expected cost changes as follows:


Hours per month Option 1 Cost Option 2 Cost Option 3 Cost

15 $36,000 + expenses $23,400 + expenses $90,000

20 36,000 + expenses 31,200 + expenses 90,000



Expected value: $ 45,600 + expenses $ 46,020 + expenses $90,000

The recommended action is now Option 2 until 40 hours is reached; then Option 1 is preferred.

Only if 100 hours are required will Option 3 be attractive.

10-24. Incremental analysis approach:

Costs Costs

Today Years 1 Through 4

Purchase Spray ($60,000)

Trade-in of Sprinkle 10,000

Operating costs: Spray $35,000

Sprinkle 20,000

Annual savings $15,000

Times useful life in years x 4

Total costs ($50,000) $60,000

Changing to the new Sprinkle system is worth an additional $10,000 to the company.

Note: Some students may ask about the impacts of the time value of money. Agree that this

analysis is incomplete and that in Chapters 11 and 12 we will incorporate time into the

analysis.

10-25.

(1) Harrell Company: Department A Department B

Incremental revenues:

Department A: ($72,000 + $13,000) $85,000

Department B: ($100,000 + $95,000) $195,000


Department A (20,000)

Department B (150,000)

Incremental benefit $65,000 $45,000

GASS has a value of $50,000 before processing further. It should be processed further into

Products A and AA since profits will increase by $15,000 ($65,000 – $50,000).

(2) Yes, assuming that a small profit of $5,000 would be considered enough to make GASS and its

subsequent products. If we already had made GASS, the $60,000 is a past cost and therefore

irrelevant. If we are making a new batch and it costs $60,000, we would earn a profit only if we

made GASS and then processed it through Department A. GASS by itself would lose money

($60,000 of cost versus $50,000 of revenue). Processing through Department B would lose

even more money. Only Department A products would earn a profit.


10-26.

A. Darichuk: Make Buy

Prime costs $200,000 | Purchase cost $500,000

Variable o/h 200,000 |

Avoidable Fixed o/h 100,000 | Rent on space (30,000)

Total make cost $500,000 | Total buy cost $470,000

Buy and save $30,000.

B. Pleiness: Make Buy

Materials costs $60,000 | Purchase cost $200,000

Var labor & o/h 40,000 |

Avoid direct fixed o/h 50,000 |

Total make cost $150,000 | Total buy cost $200,000

Make and save $50,000.

C. Ferguson: Make (He cleans) (Fischer’s Maidens) Buy

Employee $40,000 | Cleaners labor cost $50,000

Supplies & equipment 12,000 | Supplies 5,000

Do-it-yourself $52,000 | Hire cleaner $55,000

Clean yourself and save $3,000. Ignore irrelevant allocated common costs of $10,000.

10-27. A segment contribution margin should be created. Ignoring common costs is important

since they are incurred regardless of the decision made.

Paint Peanut Butter

Sales $10,000 $20,000

Minus cost of sales (6,000) (15,000)

Gross margin $4,000 $ 5,000

Minus direct expenses (1,000) (3,000)

Segment contribution margin $3,000 $ 2,000

The paint department is actually more profitable than the peanut butter boutique. The only

reason that the peanut butter boutique looks better is that it has less allocated common costs

attached to it. However, these costs do not disappear. Therefore, by switching to peanut

butter, the overall profits will decrease by $1,000 ($3,000 – $2,000).

10-28.

(1) A special sale should be accepted if it provides a positive contribution margin, if excess

capacity exists, if the market can be segmented, and if no other use of the excess capacity

exists.

Regular Sales Special Sales

Sales HK$10 HK$7

Variable costs (6) (6)

Contribution margin HK$ 4 HK$1

The special sale has a positive contribution margin, and the problem statement satisfies the


other criteria. Even though the contribution margin of the special sale is not as large as the

regular sales, the sale should be accepted since it will increase overall company profits by

HK$10,000 (10,000 pairs x HK$1 per pair).

(2) Market is not segmented, and regular sales drop by 5,000 units:

Lost regular contribution margin

(5,000 pairs x HK$4 per pair) (HK$20,000)

Additional contribution margin on special order

(10,000 pairs x HK$1 per pair) 10,000

Net disadvantage of accepting special order (HK$10,000)

As a result of the market not being segmented, the company loses $10,000 of profits and

should not accept the order. The contribution margin on the lost sales is twice as large as the

incremental sales contribution margin.

(3) Price drops on regular pairs to keep sales level, and special order price increases:

Additional contribution margin on special order

(10,000 pairs x HK$3 per pair) HK$ 30,000

Minus lost contribution margin on regular sales

(80,000 pairs x HK$0.50 per pair) (HK$40,000)

Net disadvantage of accepting special order (HK$10,000)

Again, the company should not accept the special order since overall profits will fall by $10,000.

The HK$0.50 per pair drop in price affects the entire regular sales.

10-29.

(1) Slowik, Inc. make or buy:


Prime costs $ 80,000 Purchase cost

Variable overhead 60,000 (100,000 units x $2.20) $220,000

Leased equipment costs 30,000 Inspection costs 5,000

Released space saving -46,000

Total make costs $170,000 Total buy costs $179,000

Net make advantage $9,000

Notice that the $30,000 of leased equipment could be considered a negative buy cost and that

the $46,000 of released space could be considered a make opportunity cost. The numbers

shift sides, but the net difference is the same.

The make advantage is $9,000. The out-of-pocket costs for materials, labor, overhead, and

direct equipment costs are less than the buy costs. The savings from the alternative use of the

released space makes the decision close.

(2) The buy alternative must be evaluated for quality, delivery, and warranty issues. The financial

strength of the supplier is also important. The assumed use of the released space is important

since Slowik has employees who may need to be retrained or even replaced. The fixed

manufacturing overhead expense should be examined to determine whether other costs could

be eliminated.


10-30. To analyze each of the proposed actions, first calculate each store's direct contribution

margin (statement figures in thousands):

Main Street King Street Queen Street

Sales $200 $175 $190

Minus product cost of sausages (120) (100) (110)

Variable contribution margin $80 $75 $80

Minus direct store expenses (60) (85) (35)

Direct contribution margin $20 ($10) $45

(a) If Main Street is eliminated, the company would lose $20,000 of contribution margin; and the

total loss would increase to $25,000 ($5,000 + $20,000).

(b) If King Street is eliminated, the company would save the $10,000 lost contribution margin; and

total profits would increase to $5,000 ($5,000 loss + $10,000).

(c) If Main and King Street stores are eliminated, the company would lose $20,000 contribution

margin from Main but save the $10,000 lost from King for a total change of a $10,000 loss. The

total loss would increase to $15,000 ($5,000 + 10,000).

(d) If all stores are closed, the implied new profit would be 0. But, it is likely that not all

administrative expenses can be avoided even with no stores. We would probably have a loss

for some time.

(e) If the new store will have zero net income, total profits will increase by the direct contribution

margin of the new fourth store. Since the new store has zero net income, it would have a

positive direct contribution margin of $15,000 to cover its portion of the allocated expenses.

Assuming that the $60,000 of allocated administrative expenses were divided equally among

the 4 stores, this would be $15,000 each. Total profits would be $10,000 ($5,000 loss +

$15,000).

10-31. Bidding on public contracts has numerous troublesome aspects. Bidding is often very

competitive. Multiyear contracts with renegotiation in subsequent years may allow the

successful bidder to raise prices to recoup costs. Also, in these types of service areas, the

successful bidder may expect to get other business as contract add-ons to make the overall

contract profitable. This could be happening in the VR/Dermit contract. The open end in the

contract is the emergency service. If the current $32 per hour rate is profitable to VR, needed

maintenance may be ignored as part of the routine quarterly checks saving VR personnel and

parts costs. Thus, the equipment may be deteriorating, causing more emergencies.

The hourly rate may also be a problem. The basis of determining the rate has been changed.

It is not known whether this is specified in the contract. VR could have changed the allocation

method to load more fringe overhead onto the maintenance personnel, particularly to the

emergency repair persons' time. Thus, the supposedly emergency time may actually become

the main source of revenue to VR.

The downtime may be a result of inadequate routine maintenance. Whether the routine

maintenance needed is more than provided in the basic contract cannot be determined. An

analysis of the emergency calls should be done.

The suggestion by VR that the equipment may be aging and need replacement implies that VR

would like to sell, design, implement, and maintain a new and probably more expensive system.

An inherent conflict of interest may exist.

The City of Dermit is in a difficult spot. More careful contract negotiations may be needed.

Monitoring VR more carefully may be needed.


10-32.

(1) a. If the offer is a one-time basis, the price must cover only the relevant "out-of-pocket" costs:

Direct materials $200

Direct labor 100

Total costs $300

Since the supermarket is willing to pay $420 for the order, it is profitable on a one-time basis.

This assumes that overhead expenses are common costs and will not increase from this job.

(1) b. If the job is to become part of regular business, then the price must cover all costs,

including overhead. Use the office manager's cost plus pricing policy to price the job:

Direct materials $200

Labor and overhead 200 ($100 direct labor x 2)

Total costs $400

Mark-up (20%) 80

Price $480

Using the office manager's pricing policy, the order does not appear to be profitable since the

price would have to be $480 instead of $420. The order does not meet the manager's 20

percent mark-up policy. However, the total costs under the manager's policy are only $400 so

the order is contributing $20 a week to profits. Since the order is a weekly, it would be a stable

source of cash flow and revenue for the company and should probably be accepted unless the

business is operating at capacity with more profitable business.

(2) Some qualitative factors the company should consider are:

a. Does a more profitable use of capacity exist? If not now, are other options likely in the

future?

b. How will this order affect regular print jobs? Since this is a weekly job, what will be the

effect on other print jobs? Will they have to be delayed?

c. Supermarket advertising usually has a lot of color. Are the materials and labor estimates

accurate? Or, will the business cost more than anticipated?

d. Might this work attract other customers or other business from the supermarket?

Solutions to Problems

10-33.

(1) Passengers needed to make $30,000 profit:

Revenue – Flight costs – Fixed costs – Variable costs – Profit = 0

$55X = ($2,000 x 200) – $60,000 – $5X – $30,000

$50X = $490,000

X = 9,800 passengers or 49 per flight or 32.67% of capacity


(2) $56X = ($2,000 x 200) – $60,000 – $5X – $30,000

$51X = $490,000

X = 9,608 passengers or 48 per flight or 32.03% of capacity

The impact is almost exactly 1 person per flight.

(3) Flight costs: This is implied to be fixed per flight. But more likely this is a mixed cost since

flights and conditions vary. Probably not all flight crews are paid the same wage or salary.

Maintenance costs may be included here or in fixed costs.

Fixed costs: We don't know what expenses are included here, but mixed expenses are likely

included.

Variable costs: These change as one more passenger is added. These costs seem low unless

the flights are very short with little or no food service included.

10-34.

(1) While costs of goods sold is usually variable and direct, in this problem it is a common cost for

the three products. Even if Bob eliminates rattles from production, he must still purchase whole

snakes for processing meats and hides. Since every snake has a rattle, Bob is still purchasing

it even though he doesn't process it.

Incremental analysis approach:

Lost revenue ($2,000)

Saved processing costs 600

Lost profit ($1,400)

Total analysis approach: With Rattles Without Rattles

Sales $40,000 $38,000

Minus cost of snakes (24,000) (24,000)

Gross profit $16,000 $14,000

Minus:

Processing costs ($7,500) ($6,900)

Common costs (5,000) (5,000)

Operating expenses $12,500 $11,900

Income(loss) $3,500 $ 2,100

Lost profit ($1,400)

Leverenz should continue to process rattles since they are contributing $1,400 to profits.

(2) Sell rattles to old miner:


Leverenz is buying 2,400 snakes ($24,000 $10 per snake).

Sell rattles to miner (2,400 rattles x $0.50) $1,200

Minus lost contribution of rattles to profits (1,400)

Net disadvantage of selling to miner ($ 200)


10-35. Total analysis approach:

Total With Total Without

Department 2 Department 2

Sales $400,000 $320,000

Minus costs:

Cost of goods sold $210,000 $166,000

Sales salaries 60,000 52,000

Fixed administrative cost 90,000 90,000

Total costs $360,000 $308,000

Net income before taxes $ 40,000 $ 12,000

Plus space rental income 12,000

Total profit $ 40,000 $ 24,000

Total profits are larger by $16,000 if Department 2 is kept, so the department should not be

discontinued.


Lost sales of Department 2 ($80,000)

Space rental income 12,000

Saved costs:

Cost of goods sold 44,000

Sales salaries 8,000

Total profit(loss) ($16,000)

The profits of the company will decline by $16,000 if Department 2 is eliminated. Same

answer under either approach.

10-36.


Prime costs $14 | Purchase cost

Plus variable overhead 4 | (100,000 units x $23) $2,300,000

Variable make cost per unit $18 |

x units needed x 100,000 |

Total variable costs $1,800,000 |

Space rental 175,000 |

Additional equipment 200,000 |

Total make costs $2,175,000 | Total buy costs $2,300,000

Net make advantage $125,000

They should make the motors.

Assumptions:

The costs behave as indicated.

The estimated volume is accurate.

It is feasible to produce the same quality motor in the facility.

10-37.

#1 Baker: Value Now Costs to Process Value Then Net Value Then Rank

Option A: $2,500 1st

Option B: $200 $2,600 $2,400 2nd

Option C: 3,900 5,800 1,900 3rd


Option D: 1,000 0 (1,000) Avoid

Choice: Sell cow, make more money, have less fun, and avoid legal problems!

#2 Vehlewald: Value Now Costs to Process Value Then Net Value Then Rank

Juice only $15,000 3rd

Option A: $4,000 $21,0001 $17,000 2

nd

Option B: 15,000 28,000 13,000 4th

Option C: 20,000 38,0002 18,000 1

st

1 (

$6 x 2,000 + $4 x 1,000 + $10 x 500) 2

($15 x 2,000 + 16 x $500)

10-38.

(1) Finance manager's analysis:

Regular Production With Special Order

(500,000 units) (600,000 units)

Sales ¥1,700 ¥1,700

Variable costs (900) (900)

Contribution margin ¥800 ¥800

Fixed costs (600) (500) ($300,000,000/600,000 units)

Net profit ¥200 ¥300

Full cost ¥1,500 ¥1,400

The finance manager is correct in stating that the full cost of producing an average unit does

decline if the special sale is accepted and included in total units sold. However, that is only

because the fixed costs are now spread over an additional 100,000 units. The finance

manager's analysis will result in the correct net additional profit. But it is an indirect route to

analyzing the special sale benefits.

Special sale:

Full cost per unit ¥1,400

Minus selling price per unit (1,350)

Lost gross margin per unit ¥50

x number of units x 100,000

Lost gross margin (¥5,000,000

Plus: Additional overtime (7,500,000)

Additional supervision (2,000,000)

Net loss on special units (14,500,000)

Additional profit (500,000 units x ¥100) 50,000,000

Net additional profit ¥35,500,000

To analyze the special sale directly, determine if it contributes enough to cover its own relevant

costs:

Selling price (¥1,350 x 100,000) ¥135,000,000

Minus variable costs (¥900 x 100,000) (90,000,000)

Contribution margin ¥45,000,000

Minus: Additional overtime (7,500,000)

Additional supervision (2,000,000)

Net profit ¥35,500,000


By using the finance manager's logic, the company would be giving up the opportunity to make

an additional ¥35,500,000 from the special order.

(2) The finance manager feels the special order may be "too risky" because it might violate some

of the basic rules of special sales decisions. For example, he may think that the order might

become part of regular business and violate the one-time deal rule. He might also be worried

that the special units will interfere with regular business. Perhaps the special pricing attracts

off-price merchandisers putting our product in discount stores and in competition with our

regular lamps. Our premium product image may be hurt in the long run as a result.

(3) The firm may have strict policy that disallows any price discrimination among customers. Or it

may state that all products must be priced to cover their fair share of total overhead costs. Or

as a premium product producer, accepting business outside this premium price level is

inconsistent with marketing strategies.

10-39.

(1) Close Store 54:

Lost sales $400,000

Minus saved cost of baked goods (150,000)

Lost gross margin $250,000

Gross margin picked up by other store (50,000)

Saved salaries (80,000)

Saved occupancy costs (90,000)

Incremental disadvantage of closing Store 54 $30,000

Store 54 should not be closed since doing so would result in overall profits declining by

$30,000. Committed manager's salary of $30,000 should be viewed as a committed cost and a

cost of the new store. The $30,000 of committed occupancy costs are a sunk cost, at least for

three years. No information is given about the possibility of subletting the store to another

retailer.

(2) The manager should focus attention on those areas over which the manager has control,

particularly the areas where performance is below the company average:

Cost of baked goods: These are variable and under the manager's control.

This cost is 37.5 percent of sales and higher than the company average of 35 percent.

Maybe the store is wasting ingredients or merely selling a different product mix.

Store wages: The wages are variable and controllable by the manager. The

cost is 27.5 percent of sales and above the company average of 20 percent.

Store occupancy costs: While some of these costs are committed and noncontrollable by the

manager (the 3-year lease, for instance), the manager probably does have some control

over certain occupancy costs. Utilities are probably included in this category.

Notice that home office expenses are above the average of 10 percent. This is an issue that

the manager should debate with the corporate controller. It is not controllable and should not

be part of Store 54 expenses or its manager's performance report.

10-40.

(1) To calculate Huang Automotive's variable cost per unit, simply divide the change in dollars from


one activity level to another by the change in units between activity levels.

Direct materials = NT$22,500,000 – NT$18,000,000

250,000 – 200,000 units

= NT$90 per unit

Direct labor = NT$7,500,000 – NT$6,000,000

250,000 – 200,000 units

= NT$30 per unit

Factory overhead = NT$27,000,000 – NT$24,000,000

250,000 – 200,000 units

= NT$60 per unit plus NT$12,000,000 of fixed costs

Huang Automotive's variable cost per unit and fixed costs are:

Variable Fixed

Direct materials NT$ 90 per unit

Direct labor 30 per unit

Factory overhead 60 per unit NT$12,000,000

Total NT$180 per unit NT$12,000,000

(2) T. J. Chan is using the cost per unit of NT$240 from last year which includes the fixed costs of

NT$12,000,000 on a per unit basis at a volume of 200,000 units. The special sale only has to

cover the variable costs, as no additional fixed costs exist, to be profitable. The selling price of

NT$225 per unit on the special sale means the sale is contributing NT$45 to overall profits

(NT$225 – NT$180).

Lili Zhang has determined that the added units will generate a positive contribution margin and,

therefore, more profit (NT$225 – NT$180).

As stated earlier, the special sale only has to cover the variable costs. It is actually contributing

NT$45 to profits. This problem illustrates how misleading calculating fixed costs on a per unit

basis can be.

(3) Peter Wu mentioned that the special sale will get the company's "foot in the door" of the

international market. This business can be used to establish Huang as a quality and

dependable producer. If this is the case, this special sale will probably become reoccurring

business and would then have to cover its share of the fixed costs. Another qualitative issue

would be alternate uses of the excess capacity that exists. Is this special sale the best use of

that capacity?

10-41. Best product combination: Products

A B C D

Selling price per unit $13 $20 $ 5 $25

Minus variable cost per unit (6) (5) (2) (16)

Contribution margin per unit $ 7 $15 $ 3 $ 9

Times units produced per hour x 4 x 2 x 8 x 3

Contribution margin per hour

(contribution margin per unit

times units per hour) $28 $30 $24 $27


Priority 2nd

1st 4

th 3

rd

Minimum production requirements: Remaining Contribution



6,000

Required Piece A 1/4 1,000 250 5,750 $28 $ 7,000

Required Piece C 1/8 2,000 250 5,500 24 6,000

Required Piece D 1/3 1,200 400 5,100 27 10,800

Hours needed for minimum production 900 $23,800

Maximum sales limits with remaining hours: Remaining Contribution



5,100

1st Piece B 1/2 5,000 2,500 2,600 $30 $75,000

2nd Piece A 1/4 4,000 1,000 1,600 28 28,000

3rd Piece D 1/3 4,800 1,600 0 27 43,200

Hours used for maximum sales 5,100 $146,200

Totals for all production 6,000 $170,000

Number produced:

Piece A 5,000 units

Piece B 5,000 units

Piece C 2,000 units

Piece D 6,000 units

10-42.

(1) Select an alternative:

(a) Produce 600 additional units for European producers:

Additional contribution margin

($1,800 + $800) x 600 units $1,560,000

Minus:

Additional freight cost per unit

($550 x 600 units) $330,000

Increased fixed costs 150,000

International selling costs 200,000 (680,000)

Increase in profits $880,000

(b) Produce laser lathe:

Selling price $15,500

Minus variable costs:

Prime costs $4,500

Variable overhead 2,000

Variable selling 500 (7,000)

Contribution margin per unit $8,500


Times number of units x 200

Total contribution margin $1,700,000

Minus fixed costs:

Fixed overhead $700,000

Fixed selling expenses 250,000 (950,000)

Increase in profits $750,000

(c) Lease facilities:

Fixed lease payment ($30,000 per month x 12) $360,000

Variable lease payment ($15,000,000 x 2%) 300,000

Lease revenue $660,000

Management should select Alternative (a) since it provides the greatest additional profit for the

company. All three alternatives have significant risks. Lack of knowledge of the European

customer base and competition increases the uncertainty involved. However, Harris will be

marketing a known product. In the case of the smaller laser lathe, the production costs are

uncertain; and the acceptance in the market is also unknown. The third alternative depends on

the ability of the Olson firm to generate sales and commissions equal to nearly half the

proposed total lease income.

(2) The opportunity cost of selecting the European option is not producing the small laser. This

option would generate $750,000. This is the opportunity cost of the European decision.

10-43.

(1) The company has three alternative to analyze: (a) produce Pre only, (b) produce Pre and

Post, and (c) produce Post only and purchase Pre. Each of these is examined in order:

(a) Produce Pre only:

Selling price $3.00

Minus direct materials and labor (1.95)

Contribution margin per pound $1.05

Times number pounds produced

(300,000 hours x 10 pounds per hour) x 3,000,000 pounds


(b) Produce Pre and Post:

Selling price $6.80

Minus:

Costs to produce Pre (from above) (1.95)

Direct materials and labor (1.90)

Total costs ($3.85)


Times number of pounds produced

(300,000 hours x 10 pounds per 3 hours) x 1,000,000 pounds



(c) Produce Post only and purchase Pre:

Selling price $6.80

Minus:

Purchase price of Pre (3.25)

Direct materials and labor (1.90)

Total costs ($5.15)


Times number of pounds produced

(300,000 hours x 10 pounds per 2 hours) x 1,500,000 pounds


Ms. Bailey is incorrect. She included fixed costs in her analysis. Fixed costs should not be

included in the analysis, as shown above, because they do not vary among the three

alternatives. She is looking in the right direction, however. A decision rule based on internal

costs and market prices is needed to optimize profits.

(2) Given the above analysis, it is in the best interests of the company to produce Pre only since it

gives the highest contribution margin.

(3) Assuming that Bucien can sell all of either product produced and that the internal cost functions

remain constant, the decision on whether to produce and what to produce will depend on the

market prices.

To produce or not to produce for the long run:

Contribution margin from production must in the long run cover $1,800,000, the fixed costs

of the operation (3,000,000 x $0.60 fixed cost per pound). Select the product or

combination with the highest contribution margin per ton hour. Multiply the contribution

margin per pound times the production capacity for that product or combination. If the

current market prices generate a contribution margin greater than $1,800,000, the firm

earns a profit.

To produce or not to produce in the short run:

Current market prices must generate a positive contribution margin, covering direct

materials and labor costs. Any market price below this level will mean variable costs are

not being recovered from revenue.

To select which products to produce:

Using current market prices, the product that generates the highest contribution margin

per ton hour should be produced.

10-44. To begin this problem, first prepare a contribution margin income statement (in thousands):

Product J Product K Product L

Dollars % Dollars % Dollars %

Sales SFr300 100% SFr500 100% SFr800 100%

Variable costs (90) 30 (200) 40 (400) 50

Contribution margin SFr210 70% SFr300 60% SFr400 50%


Fixed costs, separable (90) 30 (100) 20 (120) 15

Direct contribution margin SFr120 40% SFr200 40% SFr280 35%

Joint costs (60) 20 (100) 20 (160) 20

Net profit SFr 60 20% SFr100 20% SFr120 15%

(1) The new product, M, would have to cover not only its own costs but also the direct contribution

margin of Product J (SFr120,000) which it is replacing:

SFr104,000 + SFr120,000 = 32,000 units

SFr12 – SFr5

(2) Alter K: Increased revenue (SFr500 x 120%) SFr600

Minus variable cost (SFr600 x 55%) (330)

Contribution margin SFr270

Minus fixed costs (SFr100 + SFr40) (140)

Direct contribution margin SFr130

The company should not make these changes since the direct contribution margin decreases

by SFr70 (SFr200 – SFr130).

(3) Rankings:

Product J Product K Product L

Total sales 3rd 2

nd 1

st

Variable contribution

margin percentage 1st 2

nd 3

rd

Direct contribution

margin percentage 1st (tied) 1

st (tied) 2

nd

Net profit percentage 1st (tied) 1

st (tied) 2

nd

Total sales is used for market penetration and market share analysis. Variable contribution

margin percentage is used for break-even analysis and other cost, volume, and profit analyses.

Direct contribution margin percentage is used to evaluate the profitability of the product. Net

profit (after joint and allocated costs) is useful as a total for the firm but tells little about each

product.

10-45.

(A-1) Drop Product 111:

Selling price $12

Minus variable cost (7)

Contribution margin $5 per unit

Product 111 should be dropped when its contribution margin becomes negative. Also, if an

alternative use of the capacity exists that generates a higher contribution margin per hour of

capacity used, drop Product 111. However, since no alternative use exists for the use of

Product 111's capacity, the product should not be dropped since it is contributing $75,000 to

profits (15,000 units x $5 per unit).


(A-2) Drop Product 111 and calculate effects on Product 110:

After Before

Selling price $22 $22

Minus variable cost (14) (14)

Contribution margin $8 $8

Minus fixed costs (10) ($350,000 35,000 units) (7) ($350,000 50,000 units)

Net profit ($2) $1

The net profit per unit of Product 110 drops from $1 per unit to a loss of $2 per unit due to the

allocation of more fixed expenses. If Product 111 is dropped, Products 110 and 112 must

absorb more overhead, lowering their respective net profits per unit but leaving their

contribution margins per unit unchanged.

(A-3) Drop Product 111 and increase sale of Product 112:

If Product 111 is dropped, Product 112 must cover the lost contribution margin of $75,000 from

Product 111:

$75,000 = 6,819 additional units

$27 – $16

(B-1) Replace Product 111 with Product 113:

The sales manager is both right and wrong. The total fixed cost will not change; only the fixed

cost per unit will change. Fixed costs should always be analyzed as a total and not converted

to a per unit basis. Since Product 113 takes only half as long to produce as Product 111, twice

as many units could be produced (2 x 15,000 units); and, if added, the total contribution of this

product will be $60,000 ($2 per unit x 30,000 units), compared with the total contribution of

$75,000 ($5 per unit x 15,000 units) from Product 111. This assumes we can sell 30,000 units

of Product 113. Examine total profits:

Profit with Profit with

Product 111 Product 113

Contribution margin:

Product 110 ($8 x 10,000) $ 80,000 $ 80,000

Product 111 ($5 x 15,000) 75,000

Product 112 ($11 x 25,000) 275,000 275,000

Product 113 ($2 x 30,000) 60,000

Total $430,000 $415,000

Minus fixed cost (350,000) (350,000)

Net profit $80,000 $65,000

The company will lose $15,000 in profits if Product 113 replaces 111.

(B-2) For Product 113 to be as profitable as 111, the price must increase:

Selling price = (Total variable costs + Lost contribution margin) Units

Selling price = [($6 x 30,000 units) + $75,000] 30,000 units

Selling price = $8.50 per unit


10-46.

(1) Adding departments:

Garden Supplies Beer and Wine

Revenue $40,000 $60,000

Minus variable costs (16,000) (36,000)

Variable contribution margin $24,000 $24,000

Minus incremental fixed costs (12,000) (18,000)

Segment contribution margin $12,000 $ 6,000

Plus added grocery contribution margin 12,000 19,200

($240,000 x 5%; x 8%)

Incremental net income $24,000 $25,200

(2) Based on this analysis, the beer and wine department yields the highest incremental net

income. Several qualitative factors must be evaluated by White:

What is his attitude toward alcohol and selling alcohol?

What is the small town's attitude toward his selling alcohol?

Have all insurance costs and other operating expenses been considered?

What are the competitive niches in the small town, particularly given the invasion of the

discount store?

10-47. Memo:

To: Production planning and purchasing

From: Analyst

The attached analysis examines the selection of parts for production in Department 8. The

capacity in Department 8 is not sufficient to make all the parts needed in our production of

building products. We must out-source some amount of the work. We have obtained "best

quotes" from qualified suppliers for four of the parts we are considering for out-sourcing. Given

that quality and delivery questions are answered in a satisfactory manner, the decision should

be based on the most productive use of Department 8 capacity. This means using the

purchase price and calculating a contribution margin per hour of production time. Complicating

factors are setup costs and batch sizes for each part.

This is a make or buy decision with a scarce resource constraint and batch setup costs. The

following analysis will find the variable contribution margin per hour for producing internally.

Then, batch setup costs are added to extend the analysis to direct contribution margin per hour.

Batch setup costs are variable by setup but are fixed relative to the number of units produced

in each batch. The analysis then finds the optimal combination of internal production. The

purchase requirements for the remaining parts are also presented.

Iron Steel Steel Assembly

Variable contribution margin: Frames Frames Housing Unit

# 10 # 11 # 12 # 13

Outside prices per unit $10.00 $11.00 $32.00 $18.00

Minue: Materials cost per unit -5.00 -6.00 -18.00 -8.00

Variable labor cost per unit -1.50 -1.00 -5.00 -3.00

Contribution margin per unit $3.50 $4.00 $9.00 $7.00

Hours required per unit 1 hour 4 hours 5 hours 2 hours

Variable contribution margin per hour $3.50 $1.00 $1.80 $3.50


It is at this point that Iron Frames and the Assembly Unit are tied for the highest priority ranking

for production. However, first we must consider the setup costs per batch before ranking the

products:

Iron Steel Steel Assembly

Direct contribution margin per hour: Frames Frames Housing Unit

# 10 # 11 # 12 # 13

Units required 80,000 40,000 15,000 100,000

Batch size (in units) 10,000 10,000 3,000 5,000

Number of batches required 8 4 5 20

Estimated setup cost per batch x $4,000 x $3,000 x $3,000 x $2,000

Total setup costs $32,000 $12,000 $15,000 $40,000

Pro-forma income statement: Iron Steel Steel Assembly

Frames Frames Housing Unit

# 10 # 11 # 12 # 13

Units required 80,000 40,000 15,000 100,000

Hours required per unit x 1 hour x 4 hours x 5 hours x 2 hours

Total hours required 80,000 160,000 75,000 200,000

Contribution margin per hour x $3.50 x $1.00 x $1.80 x $3.50

Total contribution margin $280,000 $160,000 $135,000 $700,000

Less total setup costs -32,000 -12,000 -15,000 -40,000

Direct contribution margin $248,000 $148,000 $120,000 $660,000

Divided by number of hours 80,000 160,000 75,000 200,000

Direct contribution margin per hour $3.10 $0.93 $1.60 $3.30

Priority rankings 2nd

4th 3

rd 1

st

Internal production priorities: Remaining Contribution

Hours Production Hours Available Margin Contribution


300,000

1st # 13 2 100,000 200,000 100,000 $3.30 $660,000

2nd

# 10 1 80,000 80,000 20,000 $3.10 248,000

3rd # 12 5 4,000 20,000 0 $1.60 32,000

Total hours used 300,000 $940,000

The company should produce: # 13 100,000 units

# 10 80,000 units

# 12 4,000 units

The company would have to purchase the remaining units needed:

# 12 11,000 units (15,000 – 4,000)

# 11 40,000 units

The contribution from this combination would be:

Savings from producing internally:

# 10 Iron frames (80,000 units x $3.50) $ 280,000

# 12 Steel housing (4,000 units x $9) 36,000

# 13 Assembly unit (100,000 units x $7) 700,000


Total savings from producing internally $1,016,000

Less batch costs:

# 10 Iron frames (8 batches x $4,000) ($32,000)

# 12 Steel housing (2 batches x $3,000) (6,000)

# 13 Assembly unit (20 batches x $2,000) (40,000)

Total batch costs ($78,000)

Net savings from producing internally $938,000

10-48.

(a) Most companies have specific policies about gifts from customers and vendors to company

personnel. Often, these types of activities appear innocent, but the intent is clearly to influence

the purchasing agent decisions. This may or may not actually influence the choice made.

These types of activities are viewed as traditional marketing in some firms and as clearly

inappropriate in many other firms and industries.

(b) This is a corporate social responsibility issue. Separating personal and business-related

problems is difficult. Employees have been successful in obtaining financial settlements and

workmen's compensation payments in similar cases. Corporate personnel policies should

encourage identification of problems like this. Alcohol and drug abuse, induced by job stress or

other factors, should be confronted and handled in a professional way. Sales policies should

not encourage excesses that Don's friend apparently experienced.

(c) This is solid customer service. Perhaps Don's firm would not meet the competition. But this

type of service will likely be rewarded with sales, assuming all other factors are equal.

(d) This is a "small potatoes" issue, probably. But it creates an aura of expected benefits that is

unprofessional. It implies that to get our business, we expect donuts. Or, our decisions are for

sale for the price of donuts. Traditions like this grow innocently in organizations as an esprit de

corps issue and gradually may include outsiders who willingly or unwillingly can pay the bill.

(e) See the Contemporary Practice item in the chapter. This "match it or your out" approach may

result in Don losing this business, but much more needs to be known before Don responds or

gives in. The existence of a comparable offer must be known. Is it comparable? Are other

factors involved? Is Don being blackmailed?

Solutions to Cases

CASE 10A – Kahn Products

(1) Make or buy:


Direct materials €1,050,000 Purchase cost (50,000 units x €23) €1,150,000

Direct labor 225,000 Rework and scrap 150,000

Variable overhead 180,000 Warranty claims (€660,000 x 25%) 165,000

Replacement parts (€127,788 x 50%)1 63,894

Total make costs €1,455,000 Total buy costs €1,528,894

Net make advantage €73,894


The quantitative analysis shows that the company should make the part since making costs

€73,894 less than buying the part.

1

We initially purchase 50,000 units of which 10 percent will fail, forcing us to purchase an

additional 5,000 units (50,000 x 10%). Unfortunately, 10 percent of these additional units

will fail, causing us to purchase 500 more units, of which 10 percent will fail, and so on. The

10 percent failure rate will force us to purchase an additional 5,556 units [(50,000 units

0.90) – 50,000]. Since we split the cost on the extra units with the supplier, the replacement

parts' cost is €63,894 [5,556 units x (€23 2)].

(2) Bernie Steer makes a completely invalid point. Since the problem states that the company will

be using excess capacity to make the necessary part, the excess capacity is a free good. The

overhead to which Steer refers will be incurred regardless of whether the part is made internally

or is purchased outside. It is an irrelevant cost to this decision.

(3) This is a case of arguing over pennies while the big dollars are squandered. The issue here is

qualitative and quantitative. Get the problem fixed, and spend whatever it takes to get the

failure rate to zero.

Effects of this decision on:

The factory: If the part is to be made, production overhead for planning and control will be

increased somewhat. Purchasing, materials handling, quality control, and other areas will

see some increase in workloads. Perhaps with better quality parts, overall productivity will

increase. Rework and scrap savings might pay for most of any higher materials costs.

Sales: JUST FIX IT! Sales will not care if the problem is fixed by making the part on the inside

or purchasing it outside. They want to get a quality product to the customer.

Customers: Product failure will not be tolerated. Dependability must be achieved at whatever

cost.

Profits:

Short term: Either have suppliers upgrade the materials or bring the part inside. The 10

percent failure rate in production is probably more expensive than the €150,000 scrap and

rework costs show. Higher quality (either from inside or outside) will probably increase

efficiency and cover the higher materials cost.

Long term: Low quality results in no customers, no profits, and no firm.

CASE 10B – Little Bears’ House

(1) Since the center is operational, all of these decisions are based on incremental data. That is,

we look for incremental revenues and costs:

(a) Class sizes meeting the new child/instructor ratios would result in additional classes: two for the

2-3 age group, one for the 3-4 age group, one for the 4-5 age group, and one for the 5-6 age

group.

The incremental costs will be instructors' salaries ($1,600 per instructor, one instructor per


class) and payroll expenses (10 percent of instructors' salaries plus $200 per person) for each

new section:

Percentage

New Increase

Instructor Average over

to Student Total Number of Incremental Tuition Current

Age Ratio Children New Classes Costs Increase Tuition

2-3 5:1 20 2 $3,9201 $196.00 61%

3-4 8:1 15 1 1,9602 130.67 47

4-5 8:1 15 1 1,9602 130.67 47

5-6 10:1 30 1 1,9602 65.33 25

1 Salaries (2 instructors x $1,600) $3,200

Staff benefits [($3,200 x 10%) + (2 x $200)] 720

Incremental costs $3,920

2 Salaries (1 instructor x $1,600) $1,600

Staff benefits [($1,600 x 10%) + (1 x $200)] 360

Incremental costs $1,960

The question is whether or not the parents would accept these increases. This is a good

opportunity for discussion.

(b) Since Rivera does not want to create a new class unless the number of students on the waiting

list is greater than the number of students required for the class, only one new class would be

created. It would be in the 5-6 age group where the number of students on the waiting list is 11

and the required students for the class is 10.

Incremental revenue ($260 x 10 students) $2,600


Instructor's salary $1,600

Staff benefits [(10% x $1,600) + $200] 360

Food ($1.25 x 10 students x 22 days) 275

Variable supplies ($1 x 10 students) 10 2,245

Incremental profit $355

Creating a new class is profitable, since total profits would increase by $355.

(c) If class sizes are reduced as in Part (1) a., five new classes would have to be created, but the

classes in the 3-4 and 4-5 age groups would each have one spot open in them allowing two

new students from the waiting list to join these classes. And if new classes are created from

the waiting list, two more new classes would be necessary: one for the 2-3 age group and one

for the 5-6 age group. The additional classes created from the waiting list would bring in 15

new students (5 in the 2-3 age group and 10 in the 5-6 age group):

Incremental revenue:

Increased fees, old students:

2-3 age group ($196 x 20) $3,920

3-4 age group ($130.67 x 15) 1,960

4-5 age group ($130.67 x 15) 1,960

5-6 age group ($ 65.33 x 30) 1,960


New students:

2-3 age group ($516 x 5 students) 2,580

3-4 age group ($410.67 x 1 student) 411

4-5 age group ($410.67 x 1 student) 411

5-6 age group ($325.33 x 10 students) 3,253

Total incremental revenue $16,455


Instructors (7 new classes x $1,600) $11,200

Staff benefits [(10% x $11,200) + $1,400] 2,520

Food ($1.25 x 17 students x 22 days) 468

Variable supplies ($1 x 17 students) 17

Total incremental costs (14,205)

Incremental profit $2,250

This alternative increases profits by $2,250.

(d) New infant care:

Incremental revenue ($516 x 5 students) $ 2,580

Incremental costs:

Instructor $1,600

Staff benefits [(10% x $1,600) + $200] 360

Variable supplies ($1 x 5 students) 5 1,965

Incremental profit $615

The infant care class is profitable since it contributes $615 to net income.

(2) Memo:

To: Ms. Rivera and Ms. Dong

From: Analyst

The detailed analyses performed for the numerous alternatives we discussed are attached. As

the quantitative analyses were being developed, several qualitative issues came to the fore and

are identified here.

Given the four alternatives attached, Alternative C is the best since it contributes the most to

net income, $2,250. However, this assumes that the parents would be willing to pay the

proposed tuition increases.

Problem areas:

Tuition: What will tuition increases do to demand? Most of the percentage increases are

above acceptable levels based on the survey. Will current parents leave after the new

higher fees are imposed?

Waiting list: Is the waiting list dependable? Is demand in the surrounding area able to support

the growth that the waiting list implies?

Infant care: This introduces a new type of care. Are all costs of infant care included?

Teacher availability: Are trained teachers available at $1,600 per month?

Other cost behaviors: With the number of classes doubling, will other overheads increase, i.e.,

the need for more supervisory staff?


The analyses depend heavily on your assumptions about class sizes and cost patterns. As

these change, the analyses must be updated on an ongoing basis.