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Unformatted text preview: CHAPTER 11 DECISION MAKING AND RELEVANT INFORMATION 111 1. 2. 3. 4. 5. The five steps in the decision process outlined in Exhibit 111 of the text are Ident ify the problem and uncertaint ies Obtain informat ion Make predict ions about the future Make decisio ns by choosing among alternat ives Implement the decisio n, evaluate performance, and learn 112 Relevant costs are expected future costs that differ among the alternat ive courses o f action being considered. Historical costs are irrelevant because they are past costs and, therefore, cannot differ among alternat ive future courses of action. 113 No. Relevant costs are defined as those expected future costs that differ among alternat ive courses o f act ion being considered. Thus, future costs that do not differ amo ng the alternat ives are irrelevant to deciding which alternative to choose. 114 Quant itative factors are outcomes that are measured in numerical terms. So me quant itative factors are financial––that is, they can be easily expressed in mo netary terms. Direct materials is an example o f a quant itative financial factor. Qualitat ive factors are outcomes that are difficult to measure accurately in numerical terms. An example is emplo yee morale. 115 Two potential problems that should be avo ided in relevant cost analysis are (i) Do not assume all variable costs are relevant and all fixed costs are irrelevant. (ii) Do not use unitcost data direct ly. It can mis lead decisio n makers because a. it may include irrelevant costs, and b. comparisons of unit costs computed at different output levels lead to erroneous conclusio ns 116 No. Some variable costs may not differ amo ng the alternat ives under consideration and, hence, will be irrelevant. Some fixed costs may differ amo ng the alternatives and, hence, will be relevant. 117 No. Some of the total unit costs to manufacture a product may be fixed costs, and, hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the makeorbuy decisio n. The key co mparison is between purchase costs and the costs that will be saved if the co mpany purchases the co mponent parts from outside plus the addit ional benefits o f using the resources freed up in the next best alternat ive use (opportunit y cost). Furthermore, managers should consider nonfinancial factors such as qualit y and timely delivery when making outsourcing decisio ns. 118 Opportunity cost is the contribut ion to inco me that is forgone (rejected) by not using a limited resource in its nextbest alternat ive use. 119 No. When deciding on the quant it y of inventory to buy, managers must consider both the purchase cost per unit and the opportunit y cost of funds invested in the inventory. For example, the purchase cost per unit may be low when the quant it y o f inventory purchased is large, but the 111 benefit of the lower cost may be more than offset by the high opportunit y cost of the funds invested in acquiring and ho lding inventory. 1110 No. Managers should aim to get the highest contribution margin per unit of the constraining (that is, scarce, limit ing, or crit ical) factor. The constraining factor is what restricts or limits the production or sale of a given product (for example, availabilit y of machinehours). 1111 No. For example, if the revenues that will be lo st exceed the costs that will be saved, the branch or business segment should not be shut down. Shutting down will only increase the loss. Allocated costs are always irrelevant to the shutdown decisio n. 1112 Cost written off as depreciat ion is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the future that will then be wr itten off as depreciat ion is often relevant. 1113 No. Managers tend to favor the alternat ive that makes their performance look best so they focus on the measures used in the performanceevaluat ion model. If the performanceevaluat ion model does not emphasize maximizing operating inco me or minimizing costs, managers will most likely not choose the alternat ive that maximizes operating income or minimizes costs. 1114 The three steps in so lving a linear programming problem are (i) Determine the object ive funct ion. (ii) Specify the constraints. (iii) Co mpute the optimal solut ion. 1115 The text outlines two methods of determining the optimal so lution to an LP problem: (i) Trialanderror solut ion approach (ii) Graphical so lut ion approach Most LP applicat ions in pract ice use standard software packages that rely on the simplex method to compute the optimal so lut ion. 112 1116 (20 min.) Disposal of assets. 1. This is an unfortunate situation, yet the $75,000 costs are irrelevant regarding the decisio n to remachine or scrap. The only relevant factors are the future revenues and future costs. By ignoring the accumulated costs and deciding on the basis of expected future costs, operating inco me will be maximized (or losses minimized). The difference in favor of remachining is $2,000: (a) (b) Remachine Scrap Future revenues Deduct future costs Operating inco me Difference in favor of remachining $30,000 25,000 $ 5,000 $2,000 $3,000 – $3,000 2. This, too, is an unfortunate situation. But the $100,000 original cost is irrelevant to this decisio n. The difference in relevant costs in favor of rebuilding is $5,000 as fo llows: (a) Replace New truck Deduct current disposal price of exist ing truck Rebuild exist ing truck $105,000 15,000 – $ 90,000 $5,000 (b) Rebuild – – $85,000 $85,000 Difference in favor of rebuilding Note, here, that the current disposal price of $15, 000 is relevant, but the original cost (or book value, if the truck were not brand new) is irrelevant. 113 1117 (20 min.) Relevant and irrelevant costs. 1. Make Relevant costs Variable costs Avo idable fixed costs Purchase price Unit relevant cost $180 20 ____ $200 Buy $210 $210 Dalton Computers should reject Peach’s o ffer. The $30 of fixed costs are irrelevant because they will be incurred regardless o f this decisio n. When comparing relevant costs between the cho ices, Peach’s o ffer price is higher than the cost to continue to produce. 2. Cash operating costs (4 years) Current disposal value of old machine Cost of new machine Total relevant costs Keep $80,000 ______ $80,000 Replace Difference $48,000 $32,000 (2,500) 2,500 8,000 (8,000) $53,500 $26,500 AP Manufacturing should replace the o ld machine. The cost savings are far greater than the cost to purchase the new machine. 1118 (15 min.) Multiple choice. 1. (b) Special order price per unit Variable manufacturing cost per unit Contribut ion margin per unit = $1.50 ´ 20,000 units = $30,000 increase $1,200,000 $48 9 $57 1,140,000 60,000 25,000 $ 85,000 $6.00 4.50 $1.50 Effect on operating inco me 2. (b) Costs of purchases, 20,000 units ´ $60 Total relevant costs of making: Variable manufacturing costs, $64 – $16 Fixed costs eliminated Costs saved by not making Mult iply by 20,000 units, so total costs saved are $57 ´ 20,000 Extra costs of purchasing outside Minimum overall savings for Reno Necessary relevant costs that would have to be saved in manufacturing Part No. 575 114 1119 (30 min.) Special order, activitybased costing. 1. Award Plus’ operating inco me under the alternatives of accept ing/reject ing the specia l order are: Without One With One Time Only Time Only Special Order Special Order 7,500 Units 10,000 Units Revenues Variable costs: Direct materials Direct manufacturing labor Batch manufacturing costs Fixed costs: Fixed manufacturing costs Fixed market ing costs Total costs Operating inco me 1 Difference 2,500 Units $250,000 87,500 100,000 12,500 –– –– 200,000 $ 50,000 $1,125,000 262,500 300,000 75,000 275,000 175,000 1,087,500 $ 37,500 2 $1,375,000 350,000 2 400,000 3 87,500 275,000 175,000 1,287,500 $ 87,500 3 1 $262, 500 ´ 10,000 7, 500 $300, 000 ´ 10,000 7, 500 $75,000 + (25 ´ $500) Alternat ively, we could calculate the incremental revenue and the incremental costs of the addit ional 2,500 unit s as fo llows: Incremental revenue $100 ´ 2,500 Incremental direct manufacturing costs Incremental direct manufacturing costs Incremental batch manufacturing costs Total incremental costs Total incremental operating inco me fro m accepting the special order $262,500 ´ 2,500 7,500 $300,000 ´ 2,500 7,500 $500 ´ 25 $250,000 87,500 100,000 12,500 200,000 $ 50,000 Award Plus should accept the onetimeonly special order if it has no longterm implicat ions because accept ing the order increases Award Plus’ operating inco me by $50,000. If, however, accepting the special order would cause the regular customers to be dissat isfied or to demand lower prices, then Award Plus will have to trade off the $50,000 gain fro m accept ing the special order against the operating inco me it might lose fro m regular customers. 115 2. Award Plus has a capacit y of 9,000 medals. Therefore, if it accepts the special onetime order of 2,500 medals, it can sell only 6,500 medals instead of the 7,500 medals that it current ly sells to existing customers. That is, by accept ing the special order, Award Plus must forgo sales of 1,000 medals to its regular customers. Alternatively, Award Plus can reject the special order and cont inue to sell 7,500 medals to its regular customers. Award Plus’ operating inco me from selling 6,500 medals to regular customers and 2,500 medals under onetime special order follow: Revenues (6,500 ´ $150) + (2,500 ´ $100) 1 1 Direct materials (6,500 ´ $35 ) + (2,500 ´ $35 ) 2 2 Direct manufacturing labor (6,500 ´ $40 ) +(2,500 ´ $40 ) 3 Batch manufacturing costs (130 ´ $500) + (25 ´ $500) Fixed manufacturing costs Fixed market ing costs Total costs Operating inco me 1 $1,225,000 315,000 360,000 77,500 275,000 175,000 1,202,500 $ 22,500 $35 = $262, 500 7, 500 2 $40 = $300,000 7,500 3 Award Plus makes regular medals in batch sizes of 50. To produce 6,500 medals requires 130 (6,500 ÷ 50) batches. Accepting the special order will result in a decrease in operating inco me o f $15,000 ($37,500 – $22,500). The special order should, therefore, be rejected. A more direct approach would be to focus on the incremental effects––the benefits o f accept ing the special order of 2,500 units versus the costs of selling 1,000 fewer units to regular customers. Increase in operating inco me fro m the 2,500unit special order equals $50,000 (requirement 1). The loss in operating income fro m selling 1,000 fewer units to regular customers equals: Lost revenue, $150 ´ 1,000 Savings in direct materials costs, $35 ´ 1,000 Savings in direct manufacturing labor costs, $40 ´ 1,000 Savings in batch manufacturing costs, $500 ´ 20 Operating inco me lost $(150,000) 35,000 40,000 10,000 $ (65,000) Accepting the special order will result in a decrease in operating inco me of $15,000 ($50,000 – $65,000). The special order should, therefore, be rejected. 3. Award Plus should not accept the special order. Increase in operating inco me by selling 2,500 units under the special order (requirement 1) Operating inco me lost from exist ing customers ($10 ´ 7,500) Net effect on operating inco me of accept ing special order The special order should, therefore, be rejected. $ 50,000 (75,000) $(25,000) 116 1120 (30 min.) Make versus buy, activitybased costing. 1. The expected manufacturing cost per unit of CMCBs in 2009 is as fo llows: Total Manufacturing Manufacturing Costs of CMCB Cost per Unit (1) (2) = (1) ÷ 10,000 $1,700,000 $170 450,000 45 120,000 12 320,000 800,000 $3,390,000 32 80 $339 Direct materials, $170 ´ 10,000 Direct manufacturing labor, $45 ´ 10,000 Variable batch manufacturing costs, $1,500 ´ 80 Fixed manufacturing costs Avo idable fixed manufacturing costs Unavo idable fixed manufacturing costs Total manufacturing costs 2. The fo llowing table ident ifies the incremental costs in 2009 if Svenson (a) made CMCBs and (b) purchased CMCBs from Minton. Total Incremental Costs Incremental Items Make Buy Cost of purchasing CMCBs fro m Minton $3,000,000 Direct materials $1,700,000 Direct manufacturing labor 450,000 Variable batch manufacturing costs 120,000 Avo idable fixed manufacturing costs 320,000 Total incremental costs $2,590,000 $3,000,000 Difference in favor of making $410,000 PerUnit Incremental Costs Make Buy $300 $170 45 12 32 $259 $300 $41 Note that the opportunit y cost of using capacit y to make CMCBs is zero since Svenson would keep this capacit y idle if it purchases CMCBs from Minton. Svenson should cont inue to manufacture the CMCBs internally since the incremental costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted. Note that the unavo idable fixed manufacturing costs of $800,000 ($80 per unit) will cont inue to be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under either the make or the buy alternat ive and hence, are irrelevant. 117 3. Svenson should cont inue to make CMCBs. The simplest way to analyze this problem is to recognize that Svenson would prefer to keep any excess capacit y idle rather than use it to make CB3s. Why? Because expected incremental future revenues fro m CB3s, $2,000,000, are less than expected incremental future costs, $2,150,000. If Svenson keeps its capacit y idle, we know fro m requirement 2 that it should make CMCBs rather than buy them. An important point to note is that, because Svenson forgoes no contribut ion by not being able to make and sell CB3s, the opportunit y cost of using its facilit ies to make CMCBs is zero. It is, therefore, not forgoing any pro fits by using the capacit y to manufacture CMCBs. If it does not manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacit y idle. A longer and more detailed approach is to use the total alternat ives or opportunit y cost analyses shown in Exhibit 117 of the chapter. Choices for Svenson Make CMCBs Buy CMCBs Buy CMCBs and Do Not and Do Not and Make Relevant Items Make CB3s Make CB3s CB3s TOTALALTERNATIVES APPROACH TO MAKEORBUY DECISIONS Total incremental costs of making/buying CMCBs (from requirement 2) Excess of future costs over future revenues from CB3s Total relevant costs $2,590,000 0 $2,590,000 $3,000,000 0 $3,000,000 $3,000,000 150,000 $3,150,000 Svenson will minimize manufacturing costs by making CMCBs. OPPORTUNITYCOST APPROACH TO MAKEORBUY DECISIONS Total incremental costs of making/buying CMCBs (from requirement 2) $2,590,000 $3,000,000 Opportunity cost: profit contribut ion forgone because capacit y will not * * be used to make CB3s 0 0 Total relevant costs $2,590,000 $3,000,000 * $3,000,000 0 $3,000,000 Opportunity cost is 0 because Svenson does not give up anything by not making CB3s. Svenson is best off leaving the capacity idle (rather than manufacturing and selling CB3s). 118 1121 (10 min.) Inventory decision, opportunity costs. 1. Unit cost, orders of 20,000 Unit cost, order of 240,000 (0.96 ´ $9.00) Alternatives under consideration: (a) Buy 240,000 units at start of year. (b) Buy 20,000 units at start of each mo nth. Average investment in inventory: (a) (240,000 ´ $8.64) ÷ 2 (b) ( 20,000 ´ $9.00) ÷ 2 Difference in average invest ment $9.00 $8.64 $1, 036,800 90,000 $ 946,800 Opportunity cost of interest forgone fro m 240,000unit purchase at start of year = $946,800 ´ 0.10 = $94,680 2. No. The $94,680 is an opportunit y cost rather than an incremental or outlay cost. No actual transact ion records the $94,680 as an entry in the accounting system. 3. The fo llowing table presents the two alternat ives: Alternative A: Alternative B: Purchase Purchase 240,000 20,000 spark plugs at spark plugs beginning of at beginning year of each month Difference (1) (2) (3) = (1) – (2) Annual purchaseorder costs (1 ´ $200; 12 ´ $200) Annual purchase ( incremental) costs (240,000 ´ $8.64; 240,000 ´ $9) Annual interest inco me that could be earned if invest ment in inventory were invested (opportunit y cost) (10% ´ $1,036,800; 10% ´ $90,000) Relevant costs $ 200 2,073,600 $ 2,400 2,160,000 $ (2,200) (86,400) 103,680 $2,177,480 9,000 $2,171,400 94,680 $ 6,080 Column (3) indicates that purchasing 20,000 spark plugs at the beginning o f each mo nth is preferred relative to purchasing 240,000 spark plugs at the beginning o f the year because the opportunit y cost of ho lding larger inventory exceeds the lower purchasing and ordering costs. If other incremental benefit s of ho lding lower inventory such as lower insurance, materials handling, storage, obsolescence, and breakage costs were considered, the costs under Alternative A would have been higher, and Alternat ive B would be preferred even more. 119 1122 (20–25 min.) Relevant costs, contribution margin, product emphasis. 1. Cola $18.80 14.20 $ 4.60 Lemonade $20.00 16.10 $ 3.90 Punch $27.10 20.70 $ 6.40 Natural Orange Juice $39.20 30.20 $ 9.00 Selling price Deduct variable cost per case Contribut ion margin per case 2. The argument fails to recognize that shelf space is the constraining factor. There are only 12 feet of front shelf space to be devoted to drinks. Sexton should aim to get the highest daily contribution margin per foot of front shelf space: Natural Orange Juice $ 9.00 ´ 5 Contribut ion margin per case Sales (number of cases) per foot of shelf space per day Daily contribut ion per foot of front shelf space 3. Cola $ 4.60 ´ 25 Lemonade $ 3.90 ´ 24 Punch $ 6.40 ´ 4 $115.00 $93.60 $25.60 $45.00 The allocation that maximizes the daily contribut ion fro m soft drink sales is: Daily Contribution per Foot of Total Contribution Front Shelf Space Margin per Day $115.00 $ 690.00 93.60 374.40 45.00 45.00 25.60 25.60 $1,135.00 Cola Lemo nade Natural Orange Juice Punch Feet of Shelf Space 6 4 1 1 The maximum of six feet of front shelf space will be devoted to Cola because it has the highest contribution margin per unit o f the constraining factor. Four feet of front shelf space will be devoted to Lemonade, which has the second highest contribut ion margin per unit of the constraining factor. No more shelf space can be devoted to Lemonade since each o f the remaining two products, Natural Orange Juice and Punch (that have the second lowest and lowest contribut ion margins per unit o f the constraining factor) must each be given at least one foot of front shelf space. 1110 1123 (10 min.) Selection of most profitable product. Only Model 14 should be produced. The key to this problem is the relat ionship of manufacturing overhead to each product. Note that it takes twice as long to produce Model 9; machinehours for Model 9 are twice that for Model 14. Management should choose the product mix t hat maximizes operating inco me for a given production capacit y (the scarce resource in this situation). In this case, Model 14 will yield a $9.50 contribution to fixed costs per machine hour, and Model 9 will yield $9.00: Model 9 Selling price Variable costs per unit (total cost – FMOH) Contribut ion margin per unit Relative use of machinehours per unit of product Contribut ion margin per machine hour $100.00 82.00 $ 18.00 ÷ 2 $ 9.00 Model 14 $70.00 60.50 $ 9.50 ÷ 1 $ 9.50 1124 (20 min.) Which base to close, relevantcost analysis, opportunity costs. The future outlay operating costs will be $400 millio n regardless o f which base is clo sed, given the addit ional $100 millio n in costs at Everett if Alameda is closed. Further, one of the bases will permanent ly remain open while the other will be shut down. The only relevant revenue and cost comparisons are a. $500 millio n fro m sale o f the Alameda base. Note that the historical cost of building the Alameda base ($100 millio n) is irrelevant. Note also that future increases in the value o f the land at the Alameda base is also irrelevant. One of the bases must be kept open, so if it is decided to keep the Alameda base open, the Defense Depart ment will not be able to sell this land at a future date. b. $60 millio n in savings in fixed inco me note if the Everett base is closed. Again, the historical cost of building the Everett base ($150 millio n) is irrelevant. The relevant costs and benefits analysis favors closing the Alameda base despite the object ions raised by the California delegat ion in Congress. The net benefit equals $440 ($500 – $60) millio n. 1111 1125 (25-30 min.) Closing and opening stores. 1. Solution Exhibit 1125, Column 1, presents the relevant loss in revenues and the relevant savings in costs fro m closing the Rhode Island store. Lopez is correct that Sanchez Corporation’s operating inco me would increase by $7,000 if it closes down the Rhode Island store. Closing down the Rhode Island store results in a loss of revenues o f $860,000 but cost savings o f $867,000 (from cost of goods sold, rent, labor, utilit ies, and corporate costs). Note that by closing down the Rhode Island store, Sanchez Corporation will save none of the equipment related costs because this is a past cost. Also note that the relevant corporate overhead costs are the actual corporate overhead costs $44,000 that Sanchez expects to save by clo sing the Rhode Island store. The corporate overhead o f $40,000 allocated to the Rhode Island store is irrelevant to the analys is. 2. Solution Exhibit 1125, Column 2, presents the relevant revenues and relevant costs of opening another store like the Rhode Island store. Lopez is correct that opening such a store would increase Sanchez Corporation’s operating inco me by $11,000. Incremental revenues of $860,000 exceed the incremental costs of $849,000 (from higher cost of goods sold, rent, labor, utilit ies, and so me addit io nal corporate costs). Note that the cost of equipment written off as depreciat ion is relevant because it is an expected future cost that Sanchez will incur only if it opens the new store. Also note that the relevant corporate overhead costs are the $4,000 of actual corporate overhead costs that Sanchez expects to incur as a result o f opening the new store. Sanchez may, in fact, allocate more than $4,000 of corporate overhead to the new store but this allocat ion is irrelevant to the analysis. The key reason that Sanchez’s operating inco me increases eit her if it closes down the Rhode Island store or if it opens another store like it is the behavior of corporate overhead costs. By closing down the Rhode Island store, Sanchez can significantly reduce corporate overhead costs presumably by reducing the corporate staff that oversees the Rhode Island operation. On the other hand, adding another store like Rhode Island does not increase actual corporate costs by much, presumably because the exist ing corporate staff will be able to oversee the new store as well. SOLUTION EXHIBIT 1125 RelevantRevenue and RelevantCost Analysis of Closing Rhode Island Store and Opening Another Store Like It. (Loss in Revenues) and Savings in Costs from Closing Rhode Island Store (1) Revenues Cost of goods sold Lease rent Labor costs Depr eciation of equipment Utilities (electricity, heating) Corporate overhea d costs Total costs Effect on operating income (loss) $(860,000) 660,000 75,000 42,000 0 46,000 44,000 867,000 $ 7,000 Incre mental Revenues and (Incremental Costs) of Opening New Store Like Rhode Island Store (2) $ 860,000 (660,000) (75,000) (42,000) (22,000) (46,000) (4,000) (849,000) $ 11,000 1112 1126 (20 min.) Choosing customers. If Broadway accepts the addit io nal business from Kelly, it would take an addit io nal 500 machinehours. If Broadway accepts all o f Kelly’s and Taylor’s business for February, it would require 2,500 machinehours (1,500 hours for Taylor and 1,000 hours for Kelly). Broadway has only 2,000 hours of machine capacit y. It must, therefore, choose how much o f the Taylor or Kelly business to accept. To maximize operating inco me, Broadway should maximize contribut ion margin per unit of the constrained resource. (Fixed costs will remain unchanged at $100,000 regardless o f the business Broadway chooses to accept in February, and is, therefore, irrelevant.) The contribut ion margin per unit of the constrained resource for each customer in January is: Taylor Corporation $78,000 = $52 1,500 Kelly Corporation $32, 000 = $64 500 Contribut ion margin per machinehour Since the $80,000 of addit ional Kelly business in February is identical to jobs done in January, it will also have a contribut ion margin of $64 per machinehour, which is greater than the contribut ion margin o f $52 per machinehour fro m Taylor. To maximize operating inco me, Broadway should first allocate all the capacit y needed to take the Kelly Corporation business (1,000 machinehours) and then allocate the remaining 1,000 (2,000 – 1,000) machinehours to Taylor. Taylor Corporation $52 ´ 1,000 $52,000 Kelly Corporation $64 ´ 1,000 $64,000 Total Contribut ion margin per machinehour Machinehours to be worked Contribut ion margin Fixed costs Operating inco me $116,000 100,000 $ 16,000 1113 1127 (30–40 min.) Relevance of equipment costs. 1a. Statements of Cash Receipts and Disbursements Keep Each Year 2, 3, 4 $150,000 (110,000) (15,000) Year 1 Receipts from operations: Revenues Deduct disbursements: Other operating costs Operation of machine Purchase of “old” machine Purchase of “new” equipment Cash inflow from sale of old equipment Net cash inflow $150,000 (110,000) (15,000) (20,000)* Four Years Together $600,000 (440,000) (60,000) (20,000) Buy New Machine Each Four Year Years Year 1 2, 3, 4 Together $150,000 (110,000) (9,000) (20,000) (24,000) $150,000 (110,000) (9,000) $600,000 (440,000) (36,000) (20,000) (24,000) 8,000 $ 88,000 $ 5,000 $ 25,000 $ 80,000 8,000 $ (5,000) $ 31,000 *Some students ignore this item because it is the same for each alternative. However, note that a statement for the entire year has been requested. Obvi ousl y, the $20,000 would affect Year 1 only under both the “keep” and “buy” alternatives. The difference is $8,000 for four years taken together. In particular, note that the $20,000 book value can be o mitted fro m the co mparison. Merely cross out the ent ire line; alt hough the column totals are affected, the net difference is st ill $8,000. 1b. Again, the difference is $8,000: Income Statements Keep Buy New Machine Each Four Each Four Years Year Years Year Together 1, 2, 3, 4 Together Year 1 2, 3, 4 $150,000 $600,000 $150,000 $150,000 $600,000 110,000 5,000 15,000 130,000 440,000 20,000 60,000 520,000 110,000 6,000 9,000 125,000 110,000 6,000 9,000 125,000 440,000 24,000 36,000 500,000 * 20,000 (8,000) 12,000 512,000 $ 88,000 Revenues Costs (excluding disposal): Other operating costs Depreciat ion Operating costs of machine Total costs (excluding disposal) Loss on disposal: Book value (“cost”) Proceeds (“revenue”) Loss on disposal Total costs Operating inco me * 130,000 520,000 $ 20,000 $ 80,000 20,000 (8,000) 12,000 137,000 125,000 $ 13,000 $ 25,000 As in part (1), the $20,000 book value ma y be omitted from the comparison without changing the $8,000 difference. This adjustment would mean excluding the depreciation item of $5,000 per year (a cumulative effect of $20,000) under the “keep” alternative and excluding the book value item of $20,000 in the loss on disposal computation under the “buy” alternative. 1114 1c. The $20,000 purchase cost of the o ld equipment, the revenues, and the other operating costs are irrelevant because their amounts are commo n to both alternat ives. 2. The net difference would be unaffected. Any number may be subst ituted for the origina l $20,000 figure wit hout changing the fina l answer. Of course, the net cash outflows under both alternat ives would be high. The Auto Wash manager really blundered. However, keeping the o ld equipment will increase the cost of the blunder to the cumulat ive tune o f $8,000 over the next four years. 3. Book value is irrelevant in decisio ns about the replacement of equipment, because it is a past (historical) cost. All past costs are down the drain. Nothing can change what has alread y been spent or what has already happened. The $20,000 has been spent. How it is subsequent ly accounted for is irrelevant. The analysis in requirement (1) clearly shows that we may completely ignore the $20,000 and still have a correct analys is. The only relevant items are those expected future items that will differ among alternat ives. Despite the econo mic analysis shown here, many managers would keep the o ld machine rather than replace it. Why? Because, in many organizat ions, the inco me statements of part (2) would be a principal means o f evaluat ing performance. Note that the firstyear operating inco me would be higher under the “keep” alternat ive. The conventional accrual account ing model might mot ivate managers toward maximiz ing their firstyear reported operating inco me at the expense of lo ngrun cumulat ive betterment for the organization as a who le. This crit icism is often made of the accrual account ing model. That is, the action favored by the “correct” or “best” econo mic decisio n model may not be taken because the performanceevaluat ion model is either inconsistent with the decisio n model or because the focus is on only the shortrun part of the performanceevaluation model. There is yet another potential conflict between the decisio n model and the performance evaluat ion model. Replacing the machine so soon after it is purchased may reflect badly on the manager’s capabilit ies and performance. Why didn’t the manager search and find the new machine before buying the o ld machine? Replacing the o ld machine one day later at a loss ma y make the manager appear inco mpetent to his or her superiors. If the manager’s bosses have no knowledge of the better machine, the manager may prefer to keep the exist ing machine rather than alert his or her bosses about the better machine. 1115 1128 (30 min.) Equipment upgrade versus replacement. 1. Based on the analysis in the table below, TechMech will be better off by $180,000 over three years if it replaces the current equipment. Comparing Relevant Costs of Upgrade and Replace Alternatives Cash operating costs $140; $80 per desk ´ 6,000 desks per yr. ´ 3 yrs. Current disposal price One time capital costs, written off periodically as depreciation Total releva nt costs Over 3 years Upgrade Replace (1) (2) $2,520,000 $1,440,000 (600,000) 4,200,000 $5,040,000 Difference in favor of Replace (3) = (1) – (2) $1,080,000 600,000 (1,500,000) $ 180,000 2,700,000 $5,220,000 Note that the book value o f the current machine ($900,000) would eit her be written o ff as depreciat ion over three years under the upgrade option, or, all at once in the current year under the replace option. Its net effect would be the same in both alternat ives: to increase costs by $900,000 over three years, hence it is irrelevant in this analysis. 2. Suppose the capital expenditure to replace the equipment is $X. Fro m requirement 1, column (2), subst ituting for the onet ime capit al cost of replacement, the relevant cost of replacing is $1,440,000 – $600,000 + $X. From column (1), the relevant cost of upgrading is $5,220,000. We want to find X such that $1,440,000 – $600,000 + $X < $5,220,000 (i.e., TechMech will favor replacing) Solving the above inequalit y gives us X < $5,220,000 – $840,000 = $4,380,000. TechMech would prefer to replace, rather than upgrade, if the replacement cost of the new equipment does not exceed $4,380,000. Note that this result can also be obtained by taking the original replacement cost of $4,200,000 and adding to it the $180,000 difference in favor of replacement calculated in requirement 1. 3. Suppose the unit s produced and so ld over 3 years equal y. Using data fro m requirement 1, column (1), the relevant cost of upgrade would be $140y + $2,700,000, and from co lumn (2), the relevant cost of replacing the equipment would be $80y – $600,000 + $4,200,000. TechMech would want to upgrade if $140y + $2,700,000 < $80y – $600,000 + $4,200,000 $60y < $900,000 y < $900,000 ¸ $60 = 15,000 units or upgrade when y < 15,000 unit s (or 5,000 per year for 3 years) and replace when y > 15,000 units over 3 years. When production and sales vo lume is low (less than 5,000 per year), the higher operating costs under the upgrade option are more than offset by the savings in capital costs from upgrading. When production and sales vo lume is high, the higher capital costs of replacement are more than offset by the savings in operating costs in the replace option. 1116 4. Operating inco me for the first year under the upgrade and replace alternat ives are shown below: Year 1 Upgrade Replace (1) (2) Revenues (6,000 ´ $500) $3,000,000 $3,000,000 Cash operating costs $140; $80 per desk ´ 6,000 desks per year 840,000 480,000 a Depreciat ion ($900,000 + $2,700,000) ¸ 3; $4,200,000 ¸ 3 1,200,000 1,400,000 Loss on disposal of o ld equipment (0; $900,000 – $600,000) 0 300,000 Total costs 2,040,000 2,180,000 Operating Inco me $ 960,000 $ 820,000 a The book value of the current production equipment is $1,500,000 ´ 3 ¸ 5 = $900,000; it has a remaining useful life of 3 years. Firstyear operating inco me is higher by $140,000 under the upgrade alternat ive, and Dan Doria, with his oneyear horizon and operating incomebased bonus, will choose the upgrade alternat ive, even though, as seen in requirement 1, the replace alternat ive is better in the lo ng run for TechMech. This exercise illustrates the possible conflict between the decisio n model and the performance evaluation model. 1117 1129 (20 min.) Special Order. 1. Revenues fro m special order ($25 ´ 10,000 bats) 1 Variable manufacturing costs ($16 ´ 10,000 bats) Increase in operating inco me if Ripkin order accepted 1 $250,000 (160,000) $ 90,000 Direct materials + Direct manufacturing labor + Variable manufacturing overhead = $12 + $1 + $3 = $16 Louisville should accept Ripkin’s special order because it increases operating inco me by $90,000. Since no variable selling costs will be incurred on this order, this cost is irrelevant. Similarly, fixed costs are irrelevant because they will be incurred regardless of the decisio n. 2a. Revenues fro m special order ($25 ´ 10,000 bats) Variable manufacturing costs ($16 ´ 10,000 bats) 1 Contribut ion margin foregone ([$32─$18 ] ´ 10,000 bats) Decrease in operating inco me if Ripkin order accepted 1 $250,000 (160,000) (140,000) $ (50,000) Direct matls. + Direct manuf. labor + Variable manuf. overhead + Variable selling exp. = $12 + $1 + $3 + $2 = $18 Based strict ly on financial considerations, Louisville should reject Ripkin’s special order because it results in a $50,000 reduction in operating inco me. 2b. Louisville will be indifferent between the special order and continuing to sell to regular customers if the special order price is $30. At this price, Louisville recoups the variable manufacturing costs of $160,000 and the contribut ion margin given up fro m regular customers of $140,000 ([$160,000 + $140,000] ÷ 10,000 units = $30). Looked at a different way, Louisville expects the full price of $32 less the $2 saved on variable selling costs. 2c. Louisville may be willing to accept a loss on this special order if the possibilit y of future lo ngterm sales seem likely. However, Louisville shouldalso consider the effect on customer relat ionships by refusing sales fro m exist ing customers. Also, Louisville cannot afford to adopt the special order price longterm or with other customers who may ask for price concessio ns. 1118 1130 (30 min.) Contribution approach, relevant costs. 1. Average oneway fare per passenger Commissio n at 8% of $500 Net cash to Air Frisco per ticket Average number of passengers per flight Revenues per flight ($460 × 200) Food and beverage cost per flight ($20 × 200) Total contribution margin fro m passengers per flight $ $ × $ $ $ 500 (40) 460 200 92,000 4,000 88,000 480.00 (38.40) 441.60 20.00 421.60 2. If fare is Commissio n at 8% of $480 Net cash per ticket Food and beverage cost per ticket Contribut ion margin per passenger Total contribution margin fro m passengers per flight ($421.60 × 212) All other costs are irrelevant. $ $89,379.20 On the basis of quantitative factors alone, Air Fr isco should decrease its fare to $480 because reducing the fare gives Air Frisco a higher contribut ion margin fro m passengers ($89,379.20 versus $88,000). 3. In evaluat ing whether Air Frisco should charter its plane to Travel International, we compare the charter alternat ive to the so lut ion in requirement 2 because requirement 2 is preferred to requirement 1. Under requirement 2, contribut ion from passengers Deduct fuel costs Total contribution per flight $89,379.20 14,000.00 $75,379.20 Air Frisco gets $74,500 per flight fro m chartering the plane to Travel Internat ional. On the basis of quantitative financial factors, Air Frisco is better off not chartering the plane and, instead, lowering its own fares. Other qualitat ive factors that Air Frisco should consider in coming to a decisio n are a. The lower risk fro m chartering it s plane relative to the uncertaint ies regarding the number of passengers it might get on its scheduled flights. b. The stabilit y o f the relationship between Air Frisco and Travel International. If this is not a longterm arrangement, Air Frisco may lose current market share and not benefit from sustained charter revenues. 1119 1131 (30 min.) Relevant costs, opportunity costs. 1. Easyspread 2.0 has a higher relevant operating income than Easyspread 1.0. Based on this analys is, Easyspread 2.0 should be introduced immediately: Easyspread 1.0 $160 $ 0 0 $160 Easyspread 2.0 $195 $30 30 $165 Relevant revenues Relevant costs: Manuals, diskettes, compact discs Total relevant costs Relevant operating income Reasons for other cost items being irrelevant are Easyspread 1.0 · Manuals, diskettes—already incurred · Development costs—already incurred · Marketing and administrative—fixed costs of period Easyspread 2.0 · Development costs—already incurred · Marketing and administration—fixed costs of period Note that total market ing and administration costs will not change whether Easyspread 2.0 is introduced on July 1, 2009, or on October 1, 2009. 2. Other factors to be considered: a. Customer sat isfact ion. If 2.0 is significant ly better than 1.0 for its customers, a customer driven organizat ion would immediately introduce it unless other factors offset this bias towards “do what is best for the customer.” b. Qualit y level o f Easyspread 2.0. It is crit ical for new software products to be fully debugged. Easyspread 2.0 must be errorfree. Consider an immediate release only if 2.0 passes all qualit y tests and can be fully supported by the salesforce. c. Importance of being perceived to be a market leader. Being first in the market with a new product can give Basil So ftware a “firstmover advantage,” e.g., capturing an init ial large share of the market that, in itself, causes future potential customers to lean towards purchasing Easyspread 2.0. Moreover, by introducing 2.0 earlier, Basil can get quick feedback fro m users about ways to further refine the so ftware while its compet itors are still working on their own first versio ns. Moreover, by locking in early customers, Basil may increase the likeliho od of these customers also buying future upgrades of Easyspread 2.0. d. Morale o f developers. These are key people at Basil So ftware. Delaying introduction of a new product can hurt their morale, especially if a co mpet itor then preempts Basil fro m being viewed as a market leader. 1120 1132 (20 min.) Opportunity costs. 1. The opportunit y cost to Wolverine of producing the 2,000 units of Orangebo is the contribution margin lost on the 2,000 units of Rosebo that would have to be forgone, as computed below: Selling price Variable costs per unit: Direct materials Direct manufacturing labor Variable manufacturing overhead Variable marketing costs Contribut ion margin per unit Contribut ion margin for 2,000 units $20 $ 2 3 2 4 11 $ 9 $ 18,000 The opportunit y cost is $18,000. Opportunit y cost is the maximum contribut ion to operating inco me that is forgone (rejected) by not using a limited resource in it s nextbest alternat ive use. 2. Contribut ion margin fro m manufacturing 2,000 units of Orangebo and purchasing 2,000 units of Rosebo fro m Buckeye is $16,000, as follo ws: Manufacture Orangebo Selling price Variable costs per unit: Purchase costs Direct materials Direct manufacturing labor Variable manufacturing costs Variable marketing overhead Variable costs per unit Contribut ion margin per unit Contribut ion margin fro m selling 2,000 units of Orangebo and 2,000 units of Rosebo $15 – 2 3 2 2 9 $ 6 $12,000 Purchase Rosebo $20 14 Total 4 18 $ 2 $4,000 $16,000 As calculated in requirement 1, Wolverine’s contribut ion margin fro m cont inuing to manufacture 2,000 units of Rosebo is $18,000. Accepting the Miami Co mpany and Buckeye offer will cost Wolverine $2,000 ($16,000 – $18,000). Hence, Wo lverine should refuse the Miami Co mpany and Buckeye Corporation’s o ffers. 3. The minimum price would be $9, the sum o f the incremental costs as computed in requirement 2. This fo llows because, if Wo lverine has surplus capacit y, the opportunit y cost = $0. For the shortrun decisio n o f whether to accept Orangebo’s o ffer, fixed costs of Wo lverine are irrelevant. Only the incremental costs need to be covered for it to be worthwhile for Wo lverine to accept the Orangebo offer. 1121 1133 (30–40 min.) Product mix, relevant costs. 1. Selling price Variable manufacturing cost per unit Variable marketing cost per unit Total variable costs per unit Contribut ion margin per unit Contributi n margin per hour of the o constraine resource (the regular machine) d Total contribution margin fro m selling only R3 or only HP6 R3: $25 ´ 50,000; HP6: $30 ´ 50,000 Less Lease costs of highprecisio n machine to produce and sell HP6 Net relevant benefit R3 $100 60 15 75 $ 25 $25 = $25 1 HP6 $150 100 35 135 $ 15 $15 = $30 0. 5 $1,250,000 - $1,250,000 $1,500,000 300,000 $1,200,000 Even though HP6 has the higher contribut ion margin per unit of the constrained resource, the fact that Pendleton must incur addit io nal costs of $300,000 to achieve this higher contribut ion margin means that Pendleton is better off using its ent ire 50,000hour capacit y on the regular machine to produce and sell 50,000 unit s (50,000 hours ¸ 1 hour per unit) o f R3. The addit io nal contribution fro m selling HP6 rather than R3 is $250,000 ($1,500,000 - $1,250,000), which is not enough to cover the addit ional costs of leasing the highprecisio n machine. Note that, because all other overhead costs are fixed and cannot be changed, they are irrelevant for the decisio n. 2. If capacit y o f the regular machines is increased by 15,000 machinehours to 65,000 machinehours (50,000 originally + 15,000 new), the net relevant benefit fro m producing R3 and HP6 is as fo llows: R3 HP6 Total contribution margin fro m selling only R3 or only HP6 R3: $25 ´ 65,000; HP6: $30 ´ 65,000 Less Lease costs of highprecisio n machine that would be incurred if HP6 is produced and sold Less Cost of increasing capacit y by 15,000 hours on regular machine Net relevant benefit $1,625,000 $1,950,000 300,000 150,000 $1,475,000 150,000 $1,500,000 1122 Invest ing in the addit ional capacit y increases Pendleton’s operating inco me by $250,000 ($1,500,000 calculated in requirement 2 minus $1,250,000 calculated in requirement 1), so Pendleton should add 15,000 hours to the regular machine. Wit h the extra capacit y available to it, Pendleton should use its ent ire capacit y to produce HP6. Using all 65,000 hours of capacit y to produce HP6 rather than to produce R3 generates addit ional contribut ion margin of $325,000 ($1,950,000 - $1,625,000) which is more than the additional cost of $300,000 to lease the high precisio n machine. Pendleton should therefore produce and sell 130,000 units o f HP6 (65,000 hours ¸ 0.5 hours per unit of HP6) and zero units of R3. 3. R3 Selling price Variable manufacturing costs per unit Variable marketing costs per unit Total variable costs per unit Contribut ion margin per unit Contributi n margin per hour of the o constraine resource (the regular machine) d $100 60 15 75 $ 25 HP6 $150 100 35 135 $ 15 S3 $120 70 15 85 $ 35 $25 $15 $35 = $25 = $30 = $35 1 0. 5 1 The first step is to compare the operating profits that Pendleton could earn if it accepted the Carter Corporation o ffer for 20,000 units wit h the operating profits Pendleton is current ly earning. S3 has the highest contribut ion margin per hour on the regular machine and requires no addit ional investment such as leasing a highprecision machine. To produce the 20,000 units o f S3 requested by Carter Corporation, Pendleton would require 20,000 hours on the regular machine result ing in contribut ion margin of $35 ´ 20,000 = $700,000. Pendleton now has 45,000 hours available on the regular machine to produce R3 or HP6. R3 Total contribution margin fro m selling only R3 or only HP6 R3: $25 ´ 45,000; HP6: $30 ´ 45,000 Less Lease costs of highprecisio n machine to produce and sell HP 6 Net relevant benefit HP6 $1,125,000 - $1,125,000 $1,350,000 300,000 $1,050,000 Pendleton should use all the 45,000 hours of available capacit y to produce 45,000 units of R3. Thus, the product mix that maximizes operating inco me is 20,000 unit s of S3, 45,000 units of R3, and zero units of HP6. This optimal mix results in a contribut ion margin o f $1,825,000 ($700,000 fro m S3 and $1,125,000 fro m R3). Relative to requirement 2, operating income increases by $325,000 ($1,825,000 minus $1,500,000 calculated in requirement 2). Hence, Pendleton should accept the Carter Corporation business and supply 20,000 unit s of S3. 1123 1134 (35–40 min.) Dropping a product line, selling more units. 1. The incremental revenue losses and incremental savings in cost by discont inuing the Tables product line fo llows: Difference: Incremental (Loss in Revenues) and Savings in Costs from Dropping Tables Line Revenues Direct materials and direct manufacturing labor Depreciat ion on equipment Marketing and distribut ion General administration Corporate office costs Total costs Operating inco me ( loss) $(500,000) 300,000 0 70,000 0 0 370,000 $(130,000) Dropping the Tables product line results in revenue losses of $500,000 and cost savings of $370,000. Hence, Grossman Corporation’s operating inco me will be $130,000 lower if it drops the Tables line. Note that, by dropping the Tables product line, Home Furnishings will save none o f the depreciat ion on equipment, general administration costs, and corporate office costs, but it will save variable manufacturing costs and all market ing and distribut ion costs on the Tables product line. 2. Grossman’s will generate incremental operating inco me o f $128,000 fro m selling 4,000 addit ional tables and, hence, should try to increase table sales. The calculat ions fo llow: Incremental Revenues (Costs) and Operating Income $500,000 (300,000) (42,000)* (30,000)† * 0 * * 0 * $128,000 Revenues Direct materials and direct manufacturing labor Cost of equipment written off as depreciat ion Marketing and distribut ion costs General administration costs Corporate office costs Operating inco me * Not e that the additional costs of equipment are relevant future costs for the “selling more tables decision” because they represent incremental future costs that differ bet ween the alternatives of selling and not selling additional tables. † Current marketing and distribution costs which varies with number of shipments = $70,000 – $40,000 = $30,000. As the sales of tables double, the number of shipments will double, resulting in incremental marketing and distribution costs of (2 ´ $30,000) – $30,000 = $30,000. ** General administration and corporate offi ce costs will be unaffected i f Grossman decides to sell more tables. Hence, these costs are irrelevant for the decision. 1124 3.Solution Exhibit 1134, Column 1, presents the relevant loss of revenues and the relevant savings in costs fro m closing the Northern Divis io n. As the calculat ions show, Grossman’s operating inco me would decrease by $140,000 if it shut down the Northern Divis io n (loss in revenues of $1,500,000 versus savings in costs of $1,360,000). Grossman will save variable manufacturing costs, market ing and distribution costs, and divis io n general administration costs by closing the Northern Divis io n but equipmentrelated depreciat ion and corporate office allocat ions are irrelevant to the decisio n. Equipmentrelated costs are irrelevant because they are past costs (and the equipment has zero disposal price). Corporate office costs are irrelevant because Grossman will not save any actual corporate office costs by closing the Northern Divis io n. The corporate office costs that used to be allocated to the Northern Divisio n will be allocated to other divisio ns. 4. Solution Exhibit 1134, Column 2, presents the relevant revenues and relevant costs of opening the Southern Divis io n (a divisio n whose revenues and costs are expected to be ident ica l to the revenues and costs of the Northern Divisio n). Grossman should open the Southern Divisio n because it would increase operating income by $40,000 (increase in relevant revenues of $1,500,000 and increase in relevant costs of $1,460,000). The relevant costs include direct materials, direct manufacturing labor, market ing and distribut ion, equipment, and divisio n general administration costs but not corporate office costs. Note, in particular, that the cost of equipment written off as depreciat ion is relevant because it is an expected future cost that Grossman will incur only if it opens the Southern Divisio n. Corporate office costs are irrelevant because actual corporate office costs will not change if Grossman opens the Southern Divis io n. The current corporate staff will be able to oversee the Southern Divisio n’s operations. Grossman will allo cate some corporate office costs to the Southern Divis io n but this allocat ion represents corporate office costs that are already current ly being allocated to some other divisio n. Because actual total corporate office costs do not change, they are irrelevant to the divisio n. SOLUTION EXHIBIT 1134 RelevantRevenue and RelevantCost Analys is for Closing Northern Divisio n and Opening Southern Divisio n Incremental (Loss in Revenues) Revenues and and Savings in (Incremental Costs) Costs from Closing from Opening Northern Division Southern Division (1) (2) $(1,500,000) $1,500,000 825,000 0 205,000 330,000 0 1,360,000 $ (140,000) (825,000) (100,000) (205,000) (330,000) 0 (1,460,000) $ 40,000 Revenues Variable direct materials and direct manufacturing labor costs Equipment cost written off as depreciat ion Marketing and distribut ion costs Divisio n general administration costs Corporate office costs Total costs Effect on operating inco me ( loss) 1125 1135 (30–40 min.) Make or buy, unknown level of volume. 1. The variable costs required to manufacture 150,000 starter assemblies are Direct materials Direct manufacturing labor Variable manufacturing overhead Total variable costs $200,000 150,000 100,000 $450,000 The variable costs per unit are $450,000 ÷ 150,000 = $3.00 per unit. Let X = number of starter assemblies required in the next 12 months. The data can be presented in both “all data” and “relevant data” formats: All Data Relevant Data Alternative Alternative Alternative Alternative 1: 2: 1: 2: Buy Make Buy Make Variable manufacturing costs $ 3X – $ 3X – Fixed general manufacturing overhead 150,000 $150,000 – – Fixed overhead, avo idable 100,000 – 100,000 – Divisio n 2 manager’s salary 40,000 50,000 40,000 $50,000 Divisio n 3 manager’s salary 50,000 – 50,000 – Purchase cost, if bought from Tidnish Electronics – 4X – 4X Total $340,000 $200,000 $190,000 $50,000 + $ 3X + $ 4X + $ 3X + $ 4X The number of units at which the costs of make and buy are equivalent is All data analys is: o r Relevant data analys is: $340,000 + $3X = $200,000 + $4X X = 140,000 $190,000 + $3X = $50,000 + $4X X = 140,000 Assuming cost minimizat ion is the object ive, then • If production is expected to be less than 140,000 units, it is preferable to buy unit s fro m Tidnish. • If production is expected to exceed 140,000 units, it is preferable to manufacture internally (make) the units. • If production is expected to be 140,000 units, Oxford should be indifferent between buying unit s from Tidnish and manufacturing (making) the units internally. 1126 2. The informat ion on the storage cost, which is avoidable if selfmanufacture is discontinued, is relevant; these storage charges represent current outlays that are avo idable if selfmanufacture is discontinued. Assume these $50,000 charges are represented as an opportunit y cost of the make alternative. The costs of internal manufacture that incorporate this $50,000 opportunit y cost are All data analys is: Relevant data analys is: $390,000 + $3X $240,000 + $3X The number of units at which the costs of make and buy are equivalent is All data analys is: Relevant data analys is: $390,000 + $3X X $240,000 + $3X X = $200,000 + $4X = 190,000 = $50,000 + $4X = 190,000 If production is expected to be less than 190,000, it is preferable to buy units fro m Tidnish. I f production is expected to exceed 190,000, it is preferable to manufacture the units internally. 1127 1136 (30 min.) Make versus buy, activitybased costing, opportunity costs. 1. Relevant costs under buy alternat ive: Purchases, 10,000 ´ $8.20 Relevant costs under make alternat ive: Direct materials Direct manufacturing labor Variable manufacturing overhead Inspect ion, setup, materials handling Machine rent Total relevant costs under make alternat ive $82,000 $40,000 20,000 15,000 2,000 3,000 $80,000 The allocated fixed plant administration, taxes, and insurance will not change if Ace makes or buys the chains. Hence, these costs are irrelevant to the makeorbuy decisio n. The analys is indicates that Ace should make and not buy the chains from the outside supplier. 2. Relevant costs under the make alternat ive: Relevant costs (as computed in requirement 1) Relevant costs under the buy alternat ive: Costs of purchases (10,000 ´ $8.20) Addit io nal fixed costs Addit io nal contribut ion margin from using the space where the chains were made to upgrade the bicyc les by adding mud flaps and reflector bars, 10,000 ´ ($20 – $18) Total relevant costs under the buy alternat ive $80,000 $82,000 16,000 (20,000) $78,000 Ace should now buy the chains fro m an outside vendor and use its own capacit y to upgrade its own bicycles. 3. In this requirement, the decisio n on mud flaps and reflectors is irrelevant to the analys is. Cost of manufacturing chains: Variable costs, ($4 + $2 + $1.50 = $7.50) ´ 6,200 a Batch costs, $200/batch ´ 8 batches Machine rent $46,500 1,600 3,000 $51,100 $50,840 Cost of buying chains, $8.20 ´ 6,200 a $2,000 ¸ 10 batches In this case, Ace should buy the chains fro m the outside vendor. 1128 1137 (60 min.) Multiple choice, comprehensive problem on relevant costs. You may wish to assign only so me of the parts. Per Unit Fixed Manufacturing costs: Direct materials Direct manufacturing labor Variable manufac. indirect costs Fixed manufac. indirect costs Marketing costs: Variable Fixed Total $1.00 1.20 0.80 0.50 $1.50 0.90 Variable $3.50 $0.50 $3.00 2.40 $5.90 0.90 $1.40 1.50 $4.50 1. (b) $3.50 Manufacturing Costs Variable $3.00 Fixed 0.50 Total $3.50 2. (e) None of the above. Decrease in operating inco me is $16,800. Old 240,000 ´ $6.00 240,000 ´ $3.00 240,000 ´ $1.50 Differential $1,440,000 + $ 91,200* 720,000 + 72,000 360,000 + 36,000 1,080,000 + 108,000 360,000 – 16,800 120,000 216,000 336,000 $ 24,000 –– –– –– – $ 16,800 New 264,000 ´ $5.80 $1,531,200 264,000 ´ $3.00 264,000 ´ $1.50 792,000 396,000 1,188,000 343,200 120,000 216,000 336,000 $ 7,200 Revenues Variable costs Manufacturing Marketing and other Variable costs Contribution margin Fixed costs Manufacturing Marketing and other Fixed costs Operating income *Incremental revenue: $5.80 ´ 24,000 Deduct price reduction $0.20 ´ 240,000 $0.50 ´ 20,000 ´ 12 mos. = $0.90 ´ 240,000 $139,200 48,000 $ 91,200 1129 3. (c) $3,500 If this order were not landed, fixed manufacturing overhead would be underallocated by $2,500, $0.50 per unit ´ 5,000 units. Therefore, taking the order increases operating inco me by $1,000 plus $2,500, or $3,500. Another way to present the same idea fo llows: Revenues will increase by (5,000 ´ $3.50 = $17,500) + $1,000 Costs will increase by 5,000 ´ $3.00 Fixed overhead will not change Change in operating inco me $18,500 (15,000) – $ 3,500 Note that this answer to (3) assumes that variable market ing costs are not influenced by this contract. These 5,000 units do not displace any regular sales. 4. (a) $4,000 less ($7,500 – $3,500) Government Contract As above $3,500 Regular Channels Sales, 5,000 ´ $6.00 Increase in costs: Variable costs only: Manufacturing, 5,000 ´ $3.00 $15,000 Marketing, 5,000 ´ $1.50 7,500 Fixed costs are not affected Change in operating inco me $30,000 22,500 $ 7,500 5. (b) $4.15 Different ial costs: Variable: Manufacturing Shipping Fixed: $4,000 ÷ 10,000 $3.00 0.75 $3.75 ´ 10,000 0.40 ´ 10,000 $4.15 ´ 10,000 $37,500 4,000 $41,500 Selling price to break even is $4.15 per unit. 6. (e) $1.50, the variable market ing costs. The other costs are past costs and therefore, are irrelevant. 1130 7. (e) None of these. The correct answer is $3.55. This part always gives students trouble. The shortcut solut ion below is fo llowed by a lo nger solution that is helpful to students. Shortcut solut ion: The highest price to be paid would be measured by those costs that could be avo ided by halt ing production and subcontracting: Variable manufacturing costs Fixed manufacturing costs saved $60,000 ÷ 240,000 Marketing costs (0.20 ´ $1.50) Total costs Longer but clearer solut ion: Comparative Annual Income Statement Present Difference Proposed Revenues Variable costs: Manufacturing, 240,000 ´ $3.00 Marketing and other, 240,000 ´ $1.50 Variable costs Contribut ion margin Fixed costs: Manufacturing Marketing and other Total fixed costs Operating inco me * $3.00 0.25 0.30 $3.55 $1,440,000 720,000 360,000 1,080,000 360,000 120,000 216,000 336,000 $ 24,000 $ – $1,440,000 * 852,000 288,000 1,140,000 300,000 +132,000 – 72,000 – 60,000 $ 0 60,000 216,000 276,000 $ 24,000 This solution is obtained by filling in the above schedule with all the known figures and working “from the bottom up” and “from the top down” to the unknown purchase figure. Maximum variable costs that can be incurred, $1,140,000 – $288,000 = maximum purchase costs, or $852,000. Divide $852,000 by 240,000 units, which yields a maximum purchase price of $3.55. 1138 (25 min.) Closing down divisions. 1. Division A Sales Variable costs of goods sold ($450,000 ´ 0.90; $390,000 ´ 0.95) Variable S,G & A ($100,000 ´ 0.60; $120,000 ´ 0.80) Total variable costs Contribut ion margin $530,000 405,000 60,000 465,000 $ 65,000 Division D $450,000 370,500 96,000 466,500 $(16,500) 1131 2. Division A Fixed costs of goods sold ($450,000 ─ $405,000; $390,000 ─ $370,500) Fixed S,G & A ($100,000 ─ $60,000; $120,000 ─ $96,000) Total fixed costs Fixed costs savings if shutdown ($85,000 ´ 0.60; $43,500 ´ 0.60) $45,000 40,000 $85,000 $51,000 Division D $19,500 24,000 $43,500 $26,100 Divisio n A’s contribut ion margin o f $65,000 more than covers its avo idable fixed costs of $51,000. The difference of $14,000 helps cover the company’s unavo idable fixed costs. Since $51,000 of Divisio n A’s fixed costs are avoidable, the remaining $34,000 is unavo idable and will be incurred regardless of whether Divis io n A continues to operate. Divisio n A’s $20,000 loss is the rest of the unavo idable fixed costs ($34,000 ─ $14,000). If Divisio n A is closed, the remaining divis io ns will need to generate sufficient profits to cover the entire $34,000 unavo idable fixed cost. Consequent ly, Divisio n A should not be closed since it helps defray $14,000 of this cost. In contrast, Divis io n D earns a negat ive contribut ion margin, which means its revenues are less than its variable costs. Divisio n D also generates $26,100 of avo idable fixed costs. Based strict ly on financial considerations, Divisio n D should be closed because the company will save $42,600 ($26,100 + $16,500). An alternative set of calculat ions is as fo llows: Division A Total variable costs Avo idable fixed costs if shutdown Total cost savings if shutdown Loss of revenues if shutdown Cost savings minus loss of revenues $465,000 51,000 516,000 530,000 $ (14,000) Division D $466,500 26,100 492,600 450,000 $ 42,600 Divisio n A should not be shut down because loss of revenues if Divis io n A is shut down exceeds cost savings. Divis io n D should be shut down because cost savings fro m shutting down Divisio n D exceeds loss of revenues. 3. Before deciding to close Divisio n D, management should consider the role that the Divisio n’s product line plays relative to other product lines. For instance, if the product manufactured by Divisio n D attracts customers to the company, then dropping Divis io n D may have a detrimental effect on the revenues of the remaining divisio ns. Management may also want to consider the impact on the morale o f the remaining emplo yees if Divisio n D is closed. Talented emplo yees may beco me fearful o f losing their jobs and seek emplo yment elsewhere. 1132 1139 (25 min.) Product mix, constrained resource. 1. Selling price Variable costs: Direct materials (DM) Labor and other costs Total variable costs Contribut ion margin 1 Pounds of DM per unit Contribut ion margin per lb. 1 A110 $84 24 28 52 $32 ÷8 lbs. $ 4 per lb. = B382 $ 56 15 27 42 $ 14 ÷5 lbs. $2.80 per lb. C657 $70 9 40 49 $21 ÷ 3 lbs. $ 7 per lb. A110: Direct material cost per unit Cost per pound of Bistide $24 $3 = 8 lb. per unit B382: Direct material cost per unit Cost per pound of Bistide Direct material cost per unit Cost per pound of Bistide = $15 $3 $9 $3 = 5 lb. per unit C657: = = 3 lb. per unit First, satisfy minimum requirements. A110 B382 Minimum units 200 200 Times pounds per unit ×8 lb. per unit ×5 lb. per unit Pounds needed to produce minimum units 1,600 lb. 1,000 lb. C657 200 ×3 lb. per unit 600 lb. Total 3,200 lb. The remaining 1,800 pounds (5,000 ─ 3,200) should be devoted to C657 because it has the highest contribution margin per pound of direct material. Since each unit of C657 requires 3 pounds of Bist ide, the remaining 1,800 pounds can be used to produce another 600 units of C657. The fo llowing co mbinat ion yields the highest contribut ion margin given the 5,000 pounds constraint on availabilit y of Bist ide. A110: 200 units B382: 200 units C657: 800 units (200 minimum + 600 extra) 1133 2. The demand for West ford’s products exceeds the materials available. Assuming that fixed costs are covered by the original product mix, Westford should be willing to pay upto an addit ional $7 per pound (the contribution margin per pound of C657) for another 1,000 pounds 1 of Bist ide. That is, Westford should be willing to pay $3 + $7 = $10 per pound of Bist ide . This cost assumes that sufficient demand exists to sell another 333 units (1000 pounds ÷ 3 pounds per unit) of C657. If not, then the maximum price falls to an addit ional $4 per pound (the contribution margin per pound of A110) so that Westford can produce up to 125 more units of A110 (1,000 pounds ÷ 8 pounds per unit). In this case, Westford would be willing to pay $3 + $4 = $7 per pound. If there is insufficient demand to sell another 125 units of A110, then the maximum price West ford would be willing to pay falls to an additional $2.80 per pound (the contribution margin per pound of B382). West ford would be willing to pay $2.80 + $3 = $5.80 per pound of Bistide. 1 An alternative calculation focuses on column 3 for C657 of the table in requirement 1. Selling price Variable labor and other costs (excluding direct materials) Contribution margin Divided by pounds of direct material per unit Direct material cost per pound that Westford can pay without contribution margin becoming negative $70 40 $30 ÷3 lbs. $10 1134 1140 (30–40 min.) Optimal product mix. 1. Let D represent the batches of Della’s Delight made and so ld. Let B represent the batches of Bonny’s Bourbon made and so ld. The contribut ion margin per batch of Della’s Delight is $300. The contribut ion margin per batch of Bonny’s Bourbon is $250. The LP formulat ion for the decisio n is: Maximize $300D + $250 B Subject to 30D + 15B £ 660 (Mixing Depart ment constraint) 15B £ 270 (Filling Depart ment constraint) 10D + 15B £ 300 (Baking Depart ment constraint) 2. Solution Exhibit 1140 presents a graphical summary of the relat ionships. The optimal corner is the point (18, 8) i.e., 18 batches of Della’s Delights and 8 of Bonny’s Bourbons. SOLUTION EXHIBIT 1140 Graphic Solut ion to Find Optimal Mix, Della Simpson, Inc. Della Simpson Production Model 50 45 0, 44 Mixing Dept. Constraint 40 B (batches of Bonny's Bourbons) 35 Equal Contribution Margin Lines Optimal Corner (18,8) 30 25 20 3, 18 0, 18 Filling Dept. Constraint 15 10 Fea sible Region
5 Baking Dept. Constrai nt 0 0 5 10 15 20 22, 0 25 30 35 40 D (batches of Della's Delight) 1135 We next calculate the optimal production mix using the trialanderror method. The corner point where the Mixing Dept. and Baking Dept. constraints intersect can be calculated as (18, 8) by so lving: 30D + 15B = 660 (1) Mixing Dept. constraint 10D + 15B = 300 (2) Baking Dept. constraint Subtracting (2) fro m (1), we have 20D = 360 or D = 18 Subst ituting in (2) (10 ´ 18) + 15B = 300 that is, 15B = 300 - 180 = 120 o r B = 8 The corner point where the Filling and Baking Department constraints intersect can be calculated as (3,18) by subst ituting B = 18 (Filling Department constraint) into the Baking Department constraint: 10 D + (15 ´ 18) = 300 10 D = 300 - 270 = 30 D = 3 The feasible regio n, defined by 5 corner po ints, is shaded in So lution Exhibit 1140. We next use the trialanderror method to check the contribut ion margins at each of the five corner points of the area of feasible so lutions. Trial 1 2 3 4 5 Corner (D,B) (0,0) (22,0) (18,8) (3,18) (0,18) Total Contribution Margin ($300 ´ 0) + ($250 ´ 0) = $0 ($300 ´ 22) + ($250 ´ 0) = $6,600 ($300 ´ 18) + ($250 ´ 8) = $7,400 ($300 ´ 3) + ($250 ´ 18) = $5,400 ($300 ´ 0) + ($250 ´ 18) = $4,500 The optimal so lut ion that maximizes contribution margin and operating inco me is 18 batches o f Della’s Delights and 8 batches of Bonny’s Bourbons. 1136 1141 (30 min.) Make versus buy, ethics. 1. Direct materials per unit = $195,000 ¸ 30,000 = 6.50 Direct manufacturing labor per unit = $120,000 ¸ 30,000 = $4 Variable manufacturing overhead for 30,000 units = 40% of $225,000 = $90,000 Variable manufacturing overhead as a percentage of direct manufacturing labor = $90,000 ¸ $120,000 = 75% Fixed manufacturing overhead = 60% of $225,000 = $135,000 SOLUTION EXHIBIT 1141A Manufacturing Costs for Manufacturing 32,000 Units Costs for with Porter 30,000 Units Estimates (1) (2) Purchasing costs ($17.30/unit ´ 32,000 units) Direct materials ($6.50/unit ´ 30,000; 32,000 units) Direct manufacturing labor ($4/unit ´ 30,000; 32,000 units) Plant space rental (or penalty to ter minate) Equipment leasing (or penalty to ter minate) Variable over head (75% of direct ma nufacturing labor) Fixed ma nufacturing over head Total manufacturing or purchasing costs $195,000 120,000 84,000 36,000 90,000 135,000 $660,000 $208,000 128,000 84,000 36,000 96,000 135,000 $687,000 Purchase Costs for 32,000 Units with Porter Estimates (3) $553,600 10,000 5,000 135,000 $703,600 On the basis of Porter’s estimates, Solution Exhibit 1141A suggests that in 2009, the cost to purchase 32,000 units of MTR2000 will be $703,600, which is greater than the est imated $687,000 costs to manufacture MTR2000 inhouse. Based solely on these financial results, the 32,000 units of MTR2000 for 2009 should be manufactured inhouse. 2. SOLUTION EXHIBIT 1141B Manufacturing Costs for 32,000 Units with Hart Estimates (4) Purchasing costs ($17.30/unit ´ 32,000 units) Direct materials ($208,000 ´ 1.08) Direct manufacturing labor ($128,000 ´ 1.05) Plant space rental (or penalt y to terminate) Equipment leasing (or penalt y to terminate) Variable overhead (75% of direct mfg. labor) Fixed manufacturing overhead Total manufacturing or purchasing costs $224,640 134,400 84,000 36,000 100,800 135,000 $714,840 Purchase Costs for 32,000 Units with Hart Estimates (5) $553,600 10,000 3,000 135,000 $701,600 1137 Based so lely on the financial results shown in Solution Exhibit 1141B, Hart’s est imates suggest that the 32,000 units of MTR2000 should be purchased from Marley. The total cost from Marley would be $701,600, or $13,240 less than if the units were made by Paibec. 3. At least four other factors that Paibec Corporation should consider before agreeing to purchase MTR2000 fro m Marley Co mpany include the fo llowing: · In future years, Paibec will not incur the rental and lease contract terminat ion costs on its annual contacts that it will incur in 2009. This will make the purchase option even more attractive, in a financial sense. But then, Marley’s own lo ngevit y, its abilit y to provide the required unit s of MTR2000, and its demanded price should be considered, since terminat ing the contracts may make the makeversusbuy decisio n a lo ngterm one for Paibec. · The qualit y of the Marley component should be equal to, or better than, the qualit y o f the internally made co mponent. Otherwise, the qualit y of the final product might be compro mised and Paibec’s reputation affected. · Marley’s reliabilit y as an ont ime supplier is important, since late deliveries could hamper Paibec’s production schedule and delivery dates for the final product. · Layo ffs may result if the component is outsourced to Marley. This could impact Paibec’s other emplo yees and cause labor problems or affect the co mpany’s posit io n in the co mmunit y. In addit ion, there may be labor termination costs, which have not been factored into the analys is. 4. Referring to “Standards o f Ethical Conduct for Management Accountants,” in Exhibit 1 7, Lynn Hart would consider the request of John Porter to be unethical for the fo llowing reasons. Competence · Prepare complete and clear reports and reco mmendat ions after appropriate analys is o f relevant and reliable informat ion. Adjust ing cost numbers vio lates the competence standard. Integrity · Refrain fro m eit her act ively or passively subverting the attainment of the organizat ion’s legit imate and ethical object ives. Paibec has a legit imate object ive of trying to obtain the component at the lowest cost possible, regardless of whether it is manufactured internally or outsourced to Marley. · Communicate unfavorable as well as favorable informat ion and pro fessio nal judgments or opinio ns. Hart needs to communicate the proper and accurate results of the analysis, regardless of whether or not it favors internal production. · Refrain fro m engaging in or supporting any activit y that would discredit the professio n. Falsifying the analysis would discredit Hart and the professio n. 1138 Credibility · Communicate information fairly and objectively. Hart needs to perform an object ive make versusbuy analysis and communicate the results fairly. · Disclose fully all relevant informat ion that could reasonably be expected to influence a n intended user’s understanding o f the reports, comments, and reco mmendat ions presented. Hart needs to fully disclo se the analys is and the expected cost increases. Confidentiality · Not affected by this decisio n. Hart should indicate to Porter that the costs she has derived under the make alternat ive are correct. If Porter still insists on making the changes to lower the costs of making MTR2000 internally, Hart should raise the matter with Porter’s superior, after informing Porter of her plans. If, after taking all these steps, there is a continued pressure to understate the costs, Hart should consider resigning from the co mpany, rather than engage in unethical conduct. 1139 1142 (30 min.) Product mix, constrained resource. 1. Units (1) 1,800 4,500 39,000 Machine Hrs Per Unit (2) = Var. Mach. Cost/Unit ÷ $200/Hour $600 ÷ $200 = 3 $500 ÷ $200 = 2.5 $200 ÷ $200 = 1 Machine Hrs Demanded (3) = (1) × (2) 5,400 11,250 39,000 55,650 Nealy Tersa Pelta Total 2. Selling price Variable costs: Direct materials Variable machining Sales commissio ns (5%, 5%, 10%) Total variable costs Contribut ion margin per unit Nealy $3,000 750 600 150 1,500 $1,500 Tersa $2,100 500 500 105 1,105 $ 995 Pelta $800 100 200 80 380 $420 3. Total machine hours needed to satisfy demand exceed the machine hours available (55,650 needed > 50,000 available). Consequent ly Marion Taylor needs to evaluate these products based on the contribution margin per machine hour. Nealy $1,500 ÷3 MH $ 500 Tersa $995 ÷2.5 MH $398 Pelta $420 ÷1 MH $420 Unit contribut ion margin Machinehours (MH) per unit Unit contribut ion margin per MH Based on this analysis, Marion Taylor should produce to meet the demand for products with the highest unit contribut ion margin per machine hour, first Nealy, then Pelta, and finally Tersa. The optimal product mix will be as fo llows: Nealy Pelta Tersa Total 1,800 units = 5,400 MH 39,000 units = 39,000 MH 2,240 (5,600 MH ÷ 2.5 MH/unit) units = 5,600 MH (50,000 ─ 5,400 ─ 39,000) 50,000 MH 4. The optimal product mix in Part 3 sat isfies the demand for Nealy and Pelta and leaves only 2,260 units (4,500 ─ 2,240) of Tersa unfilled. These remaining units o f Tersa require 5,650 machine hours (2,260 units ´ 2.5 MH per unit). The maximum price Marion Taylor is willing to pay for extra machine hours is $398, which is the unit contribution per machine hour for addit ional units of Tersa. That is, total cost per machinehour for these units will be $398 + $200 (variable cost per machinehour) = $598 per machinehour. 1140 ...
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