module 16 solutions

Module 16

Relevant Costs and Benefits for Decision Making

DISCUSSION QUESTIONS

Q16-1. Relevant costs differ under each alternative. Irrelevant costs are identical under each alternative.

Q16-2. In evaluating a cost reduction proposal, three alternatives are available to the management of a for-profit organization. These alternatives are:

1. Continue operations with the old facilities.2. Continue operations with new facilities3. Discontinue operations

Q16-3. Outlay costs are relevant when they differ under the decision alternatives at hand. They are irrelevant when they do not differ under the decision alternatives at hand.

Q16-4. Product-level costs are relevant for any decision that causes future product-level outlay costs to increase or decrease, such as changing the lineup of products offered or increasing or decreasing the amount of a future outlay cost for an existing product. Any product-level opportunity cost would also be relevant, such as the benefit foregone from discontinuing one product to offer a new product.

©Cambridge Business Publishers, 2013

Solutions Manual, Module 16 16-1

Q16-5. A differential analysis of relevant items is preferred to a detailed listing of all costs and revenues for several reasons:

1. Focusing only on those items that differ provides a clearer picture of the impact of the decision at hand. Management is less apt to be confused by a differential analysis than by an analysis that includes both relevant and irrelevant items.

2. Because a differential analysis contains fewer items, it is easier and quicker to prepare.

3. In complex situations, such as those encountered by multiple-product or multiple-plant firms, it is difficult to develop complete firm-wide detailed statements to analyze all decision alternatives.

Q16-6. When the acquisition of new equipment results in a technological change, cost predictions can be made from information obtained from the manufacturer, other users, trade associations, publications, and internal engineers.

Q16-7. When an organization is operating at capacity, and accepting a special order requires the reduction of regular sales, opportunity costs are relevant to the evaluation of the special order.

Q16-8. Even if buying a part appears more financially advantageous than making the part, management should not decide to buy before considering a variety of qualitative factors. Is the supplier attempting to use some temporarily idle capacity? If so, what will happen at the end of the contract period? What impact will the decision to buy have on the morale of employees? Will the outside supplier meet delivery schedules? Does the supplier meet quality standards?

Q16-9. In the decision to sell or to process further, all costs incurred prior to the split-off point are irrelevant. This is because these costs are the same under both alternatives.


16-2 Financial & Managerial Accounting for MBAs, 3rd Edition

Q16-10. To achieve short-run profit maximization, limited resources should be allocated in the manner that maximizes the contribution margin per unit of the constraining factor.

Q16-11. To support the theory of constraints, performance reports should: Measure the utilization of bottleneck resources. Measure factory throughput. Not encourage the full utilization of non-bottleneck resources. Discourage the buildup of excess inventory.



MINI EXERCISES

M16-12

1. b 5. g2. e 6. a3. f 7. c4. h 8. d

M16-13

1. g 5. e2. f 6. c3. h 7. b4. a 8. d

M16-14

Proposal 1 Proposal 21. Cost of furniture Irrelevant Irrelevant2. Cost of old generators Irrelevant Irrelevant3. Cost of new generators Relevant Irrelevant4. Operating cost of old generators Relevant Irrelevant5. Operating cost of new Relevant Irrelevant6. Police Chief's salary Irrelevant Irrelevant7. Depreciation on old generators Irrelevant Irrelevant8. Salvage value of old generators Relevant Irrelevant9. Removal cost of old generators Relevant Irrelevant10. Cost of raising dam Irrelevant Relevant11. Maintenance costs of water plant Relevant Irrelevant12. Revenues from sale of electricity Relevant Relevant



M16-15Relevant Costs Irrelevant Costs

Opportunity Outlay Outlay Sunk

1. The case will require three attorneys to stay four nights in a Chicago hotel. The predicted hotel bill is $2,400.

X

2. Taylor, Taylor, and Tower's professional staff is paid $2,000 per day for out-of-town assignments.

X

3. Last year, depreciation on Taylor, Taylor, and Tower's office was $25,000.

X

4. Round-trip transportation to Chicago is expected to cost $250 per person.

X

5. The firm has recently accepted an engagement that will require partners to spend two weeks in Cincinnati. The predicted out-of-pocket costs of this engagement are $8,500.

X

6. The firm has a maintenance contract on its computer equipment that will cost $2,200 next year.

X

7. If the firm accepts the engagement in Chicago, it will have to decline a conflicting engagement in Miami that would have provided a net cash flow of $15,000.

X

8. The firm's variable overhead is $80 per client hour. X

9. The firm pays $250 per year for Tower's subscription to a law journal.

X

10. Last year, the firm paid $3,500 to increase the insulation in its building.

X



M16-16

Replace Keep DifferenceOperating costs

Old ($40,000 6 years) $240,000New ($26,000 6 years) $156,000 $ 84,000

Cost of new machine 55,000 _______ (55,000)Total costs $211,000 $240,000 $ 29,000

Advantage of replacement $ 29,000

The cost of the old machine is “sunk” and is, therefore, not relevant to the decision -- unless it can be sold for some amount. Assuming the old machine is completely obsolete and cannot be sold, the advantage of buying the new machine is $29,000, the operating cost savings of $84,000 less the $55,000 cost of the new machine.

M16-17

The current production volume is 100,000 units ($4,400,000/$44).

The variable production costs are ($3,200,000 $800,000)/100,000 = $24.

Hence, at a unit selling price of $30, the order provides a contribution of $6 per unit and a total contribution of $75,000 ($6 12,500).

Even if it is profitable, the large sale to the hospital supply company may take away some of the attention of management from regular customers, and it may upset regular customers who learn of the lower price, resulting in pressure to lower overall prices.



M16-18

Relevant cost analysis

Increase in revenues:Sell complete sailboats $6,000Sell sailboat hulls (5,000) $ 1,000

Costs of masts, sales, and rigging (1,500)Advantage (disadvantage) of further processing $ (500)

An alternative analysis treats the selling price of the uncompleted hulls as an opportunity cost:

Revenues from complete sailboats $ 6,000Costs:

Outlay costs of masts, sails, and rigging $1,500Opportunity cost of not selling hull 5,000 (6,500)

Advantage (disadvantage) of further processing $ (500)



EXERCISES

E16-19

a. Contribution from special order [($17 – $15 + $0.50 – 0.75) x 2,500 bags] $4,375Opportunity cost ($23 - $15) x 400 bags -3,200Profit from accepting order $1,175

b. Expansion into a new areaLarger market shareLost sales to regular customersPressure from regular customers to receive the same priceUnhappy regular customers

c. For a long-term relationship, management must consider all of the factors raised in (b). They must also realize that in the long run all costs are variable. Hence, the profitability of the order might better be based on current average costs with an adjustment for shipping expenses. When this is done, the long-run average profit (loss) is:

Total revenue $17 2,500 $42,500Total cost ($18.10 – 0.50 + 0.75) 2,500 (45,875 ) Long-term loss on additional sales $ (3,375)

Other considerations include the possibility of small crops in future years and the risk of changes in costs.



E16-20

a. Current variable costs ($4.00 750) $ 3,000Fixed costs 1,200Total costs $ 4,200Number of meals 750 Current average cost per meal $ 5.60

b. The per-meal revenue from the Girl Scouts is $5.00 ($150/30). By subtracting the current average cost per meal from this amount, he concluded the restaurant would lose $0.60 per meal.

This analysis is incorrect. Because the restaurant has excess capacity, the analysis should emphasize the contribution the sale would make toward covering fixed costs and providing a profit. The per-unit contribution is $1.00, ($5.00 $4.00). The total contribution is $30, [$150 ($4.00 30)], or ($1.00 30).

This analysis assumes that there is no impact on other sales.

c. The restaurant owner should not accept.

At a superficial level it appears the 300 customers would be profitable because it would provide a daily contribution of $150, [300($4.50 $4.00)]. However, with a current capacity of 800 meals per day it would be necessary to reduce the sales to other customers by 250 meals per day:

Capacity 800 meals per dayCurrent sales (750) meals per dayAvailable 50 meals per daySize of new order (300) meals per dayReduction in regular sales 250 meals per day

This introduces an opportunity cost equal to the net cash flow that could be realized from the 250 regular sales. The net daily disadvantage of the proposed action is $600:

Daily contribution from special order $ 150Daily opportunity cost [250($7 $4)] (750)Net advantage (disadvantage) $ 600

The situation might be even worse if other customers demand similar special deals.



E16-21

a. The variable costs of manufacturing and selling can be determined using the high-low method:

Variable costs per unit = ($3,060,000 $2,745,000) = $5.25(240,000 180,000)

Now we can determine the unit contribution margin and the total contribution from accepting the order.

Unit selling price $ 9.00Unit variable costs (5 .25) Unit contribution margin $ 3.75Size of order 60,000 Financial impact of accepting $225,000

Accepting the order will increase profits by $225,000, rather than reducing profits by $225,000, as the general manager indicated. The general manager incorrectly compared the selling price to the average unit cost of 240,000 units, rather than the incremental unit cost.

b. If SafeRide, Inc. were operating at capacity, there would be an opportunity cost associated with accepting the order. This opportunity cost would be equal to the net benefits of the regular business that SafeRide would have to turn away. Assuming a normal selling price of $20, the net disadvantage of accepting the order is $660,000:

Contribution from special order $ 225,000Opportunity cost [60,000 ($20 $5.25)] (885,000 ) Net advantage (disadvantage) of accepting order $(660,000 )

E16-22

Cost to make: Variable costs (10,000 units $24.00) $240,000Fixed costs (10,000 units $5.00) 50,000Rent income (opportunity cost) 25,000 $315,000

Cost to buy (10,000 units $32.00) (320,000)Advantage (disadvantage) of buying $ (5,000)

Making has an advantage of $5,000.



E16-23

a. Mountain Air should make the electric motor.Difference

Cost Cost (Effect of to to Buying Make Buy on Income)

Purchase price ($5.00 10,000) $50,000 $(50,000)Manufacturing costs:

Direct mat. ($2 10,000) $20,000 20,000Direct labor ($1.50 0.50 10,000) 7,500 7,500Variable overhead ($2* 0.50 10,000) 10,000 _______

10,000Total $37,500 $50,000 $(12,500)

Advantage of making $12,500

*Total factory overhead $ 7 per unit Fixed factory overhead ($50,000/10,000) (5) per unit Variable factory overhead $ 2 per unit

b. Mountain Air should buy the electric motor.Difference

Cost Cost (Effect of to to Buying Make Buy on Income)Purchase price $50,000 $(50,000)Manufacturing costs:

Outlay $37,500 37,500Opportunity 20,000 _______ 20,000

Total $57,500 $50,000 $ 7,500

Advantage of buying $ 7,500

c. Management should consider a number of nonquantitative factors in deciding whether to make or buy the motors. They should consider the quality of their own and the supplier's motors. They should also consider the dependability of the supplier. Does Mini Motor have a track record of meeting its commitments? They should also attempt to determine if Mini Motor will extend the contract to supply motors for a



number of years or whether it is attempting to use some temporarily idle capacity.



E16-24

Relevant cost analysis

Essentially, this is a make-or-buy decision with the costs of making being the cost of office billing and the cost of buying being the cost of the billing service. Note that there is an opportunity cost associated with office billing. This cost is based on the value of the two hours per week that would otherwise be available to see patients.

DifferenceCost Cost (Effect of

to to Buying Make Buy on Income)Contract price $10,000 $(10,000)Cost of office billing:

Outlay:Bookkeeper's wages and fringe benefits

(10 hours 50 weeks $12) $ 6,000 6,000Rent on storage space

(12 months $100) 1,200 1,200Opportunity cost:

Value of Dr. Rahavey’s time(2 hours 3 patients 50 weeks $30) 9,000 _______ 9,000

Total $16,200 $10,000 $ 6,200

Advantage of outsourcing $ 6,200



E16-25

Information is provided about the cost of raw material D and the cost of processing this material into E and F. However, students should recognize that these are joint costs incurred prior to the decision point. Consequently, they are irrelevant to a decision to sell product F or to process it further.

Revenues from G $12Costs:

Outlay cost of additional processing $ 4Opportunity cost of not selling F 5 (9)

Advantage of further processing $ 3

Product F should be processed further into product G.

E16-26

a. X Y ZUnit contribution margin $ 60 $ 50 $ 30Labor hours per unit 4 2 4 Contribution per labor hour $ 15 $ 25 $7.5

1. Product Z has the highest unit selling price.2. Product X has the highest unit contribution margin.3. Product Y has the highest contribution per labor hour.

The weekly contribution obtained with the use of each criterion is:

Highest Highest Highest Unit Contribution Contribution Selling Price per Unit per Labor Hour

Z X YLabor hours available 220 220 220Labor hours per unit 4 4 2 Weekly production 55 55 110Unit contribution margin $30 $60 $50 Weekly contribution $1,650 $3,300 $5,500



E16-26 (concluded)

b. To achieve short-run profit maximization, a for-profit organization should allocate limited resources in a manner that maximizes the contribution per unit of constraining factor.

c. The decision to produce 12 units of Z will result in a weekly opportunity cost of $1,200. This is the net benefits that would have been derived from producing 20 units of Y.

Labor hours to produce 12 units of Z (12 units 4 hours per unit) 48Labor hours per unit of Y 2 Required reduction in the production of Y 24Unit contribution margin for Y $50 Opportunity cost $1,200

Producing 12 units of Z will reduce profits by $840 from their maximum possible amount.

Contribution from Z (12 units $30) $ 360Opportunity cost (1,200 ) Net disadvantage of producing 12 units of Z $ (840)

This can also be computed as the difference between the hourly contribution of Y and Z times the 48 labor hours that would be required to product 12 units of Z, or ($25 - $7.50) 48 = $840.

d. First, there may not be enough demand to allocate all limited resources to the most profitable product. Second, even if there is sufficient demand, it may be advisable to produce and sell some less profitable products for the sake of offering a full line of products and giving customers alternatives. Third, less profitable products may be offered if they are complimentary to the more profitable products. In some cases, what appears to be the main and most profitable product is actually the secondary product in terms of profits. For example, The warehouse retailers, such as Sam’s and Costco, essentially break even on the merchandise they sell in their stores, and make most of their profit on membership fees. Similarly, some retailers earn more profit on warranty programs sold than on the products for which the warranties are offered.



E16-27

a. Maria’s time is a limited resource and our objective is to maximize the sales commissions from the use of this resource.

Large Small Business Business IndividualAverage monthly sales per customer $ 2,500 $ 1,500 $ 600Commission/sales ratio 0.05 0.08

0.10 Commission per customer $ 125 $ 120 $ 60Hours per customer 5 3 2.5 Commission per hour $ 25 $ 40 $ 24

To maximize her commission per hour, Maria should visit small businesses first. However, she has only 35 small businesses, requiring 3 hours each, for a total of 105 hours per month. This leaves 55 hours per month to call on large businesses and individuals. Because large businesses have a higher commission per hour, she should call on them next. However, she has only 8 large businesses, requiring 5 hours each, for a total of 40 hours per month. This leaves 15 hours per month to call on individuals. At 2.5 hours per visit, she can call on 6 individual customers.

b. With this plan, Maria's monthly commissions should total $5,560:

Small businesses (35 $120) $4,200Large businesses (8 $125) 1,000Individual customers (6 $60) 360Total commissions $5,560

With 80 individual customers, calling on 6 per month will result in each customer being visited every 13.3 months. Maria will likely lose many of these customers, or she may try to maintain individual customers using alternative contact methods, such as phone or Internet contact in place of personal visits. The above analysis should be regarded not as the final solution, but as a decision aid in determining how to allocate a scarce resource.



E16-27 (concluded)

c. First, it is likely that not all customers in a particular category require the same amount of time, but the times given in the problem were averages. It is typical that not all customers are equal in their demands on vendors.

Accordingly, Maria may want to keep selected customers because individual customers may actually be profitable, even though the category is generally not very profitable. Other reasons for keeping a customer that is not highly profitable may be that customer’s relationship may with a highly profitable customer, or the potential to move the customer from a lower-profit category to a higher-profit category.



PROBLEMS

P16-28

Differential analysis is used to solve this problem.

a. Profit increase from reduced labor costs (10,000 $5) $ 50,000Profit decrease from increased variable overhead (10,000 $2) (20,000)Profit decrease from increased fixed overhead (22,000)Increase in monthly profit $ 8,000

b. Profit increase from increased sales if there were nochanges in prices or costs (5,000 $10) $ 50,000

Profit decrease from reduced selling price of allunits (15,000 $5) (75,000)

Profit decrease from increase in fixed factory overhead (2,800)Profit decrease from increase in fixed selling & admin costs (2,500)Decrease in monthly profit $ (30,300)

c. Profit decrease from increased cost of raw materials(10,000 $12) $(120,000)

Profit increase from decrease in direct labor (10,000 $4) 40,000Profit increase from decrease in variable factory

overhead (10,000 $1) 10,000Profit increase from decrease in fixed factory overhead 15,000Decrease in monthly profit $ (55,000)

d. Profit decrease from decreased sales if there wereno changes in prices or costs (1,000 $10) $ (10,000)

Profit increase from increased selling price of all units(9,000 $4) 36,000

Increase in monthly profit $ 26,000

e. Profit increase resulting from price change (see d) $ 26,000Profit increase from reduced labor costs (9,000 $5) 45,000Profit decrease from increased variable overhead (9,000 $2) (18,000)Profit decrease from increased fixed overhead (22,000)Increase in monthly profit $ 31,000



P16-29

Differential analysis is used to solve this problem.

a. Increase in monthly profit [(900 $(0.20)] $ 180

b. Increase from discontinuing A [900 $(0.20)] $ 180Decrease from lost sales of B (100 $1.50) (150)Increase in monthly profit $ 30

c. Contribution with higher selling price of A[(900 – 150) ($5.50 – 5.20) $225

Former negative contribution of A [900 ($0.20)] 180Increase in monthly profit $405

d. Decrease from reduced sales of B with no changein prices (200 $1.50) $(300)

Increase from increased selling price of B[(1,400 200) ($8.00 $7.50)] 600

Decrease from increased sales of A [140 $(0.20)] (28)Increase in monthly profit $272

e. Contribution from new product D (600 $0.30) $180Former negative contribution of A [900 ($0.20)] 180Increase in monthly profit $360

f. Decrease from reduced sales of C with no changesin prices (200 $2) $(400)

Increase from increased selling price of C[(900 200) ($4.50 $4.00)] 350

Increase from increased sales of B with no changesin prices (300 $1.50) 450

Decrease from reduced selling price of B[(1,400 + 300) ($7.00 $7.50)] (850)

Decrease in monthly profit $(450)



P16-30

a. The president fell into the trap of being influenced by the sunk cost of the old machine. The book value of the old machine is the result of a past decision that cannot be changed. This $30,000 will show up as a deduction from revenues under both the keep and replace alternatives. In one case, it will be written off as depreciation over a number of years. In the other case, it will be written off as a loss on disposal.

b. Differential Analysis of Replacement Decision:

Six-Year Totals (1) (2) (1) – (2) Difference Keep Replace (Effect of Old with New Replacement Machine Machine on Income)Annual operating costs:

Old ($45,000 6) $270,000New ($25,000 6) $150,000 $120,000

Cost of new machine ________ 90,000 (90,000)Total $270,000 $240,000 $ 30,000

Advantage of replacement $ 30,000

c. A limitation of the model presented in this chapter is that it does not take into account the time value of money. This is actually a capital budgeting decision, which will be discussed in Chapter 12. That chapter will discuss how to convert all future cash flows into current dollars (or present values), which will give an even more precise calculation of the net cost or benefits of replacing the machine. There is always a risk that the new equipment will not perform as claimed by the manufacturer, so the company may want to get some guarantees or assurances as to its performance. One way to deal with uncertainly is to calculate the model under multiple scenarios, where the savings is projected at pessimistic, expected, and optimistic levels to see how sensitive the outcome of the model is to variances in the projected benefits.



P16-31

a. Increase in revenues $52,000Increase in costs:

Direct materials $10,000Direct labor 12,000Variable factory overhead 13,500*Variable selling and administrative ($20 300) 6,000 (41,500)Increase in profits $10,500

*Budgeted annual overhead is 25 percent fixed ($100,000/$400,000). The variable overhead associated with the 300 Northern Cycles is $13,500 ($18,000 0.75).

b. Fixed costs do not vary with volume, and in the absence of specific information, it is assumed that fixed costs do not vary between decision alternatives. Therefore, they are irrelevant, and should be omitted from the analysis.

c. 1. An opportunity cost is the net benefit of the alternative action. The alternative action is to sell the scooters at a price of $64,000. With incremental costs of $41,500, this action would provide net benefits of $22,500. This is the opportunity cost.

Regular selling price $64,000Incremental costs (41,500 ) Opportunity cost $22,500

2. With identical costs and a $12,000 lower selling price ($64,000 $52,000), accepting Northern Cycles’ offer will reduce profits by $12,000. Alternatively, this amount can be derived as follows:

Profit on Northern Cycles’ offer $ 10,500Less opportunity cost (22,500 ) Increase (decrease) in profits $ 12,000

d. Mobile Solutions should be aware of possibly undercutting the price that other regular customers pay for the same product and how those customers might react, and it should be alert to possible violation of laws that regulate such practices.



P16-32

Glacier's management undoubtedly believes the promotion is good advertising and that it will have long-run benefits that are not easily quantified. The problem focuses on the short-run net costs or benefits of the promotion under a variety of possible situations. Management might want this type of information to help them evaluate the desirability of continuing or modifying the promotion.

a. Incremental revenues from coupon sales (500 $3) $ 1,500Incremental costs:

Ice cream (500 20 $0.40) $ 4,000Coupons 60 (4,060)

Loss $(2,560)

Each coupon redeemed cost Glacier $0.40. The sales of coupons will provide revenues to absorb this cost. The break-even point for coupon redemptions occurs when the cost of coupon redemptions absorbs all of the revenues from coupon sales.

b. Incremental revenues from coupon sales (500 $3) $1,500Less cost of coupons (60 ) Contribution assuming no coupons are redeemed $1,440Cost per redemption $0.40 Coupon redemptions for break-even 3,600

In effect, the break-even computation is being reversed. Instead of the normal:

Break-even point = Fixed costs/Unit contribution margin,

we have:

Break-even point = Revenues/Unit loss of redemption

Break-even redemption rate = 3,600/(500 pkgs. 20 coupons/pkg.) = 0.36 or 36 percent



P16-32 (concluded)

c. The sale of an additional cone with each redemption reduces the net loss per redemption, and this increases the number of coupons that can be redeemed before all coupon sales are absorbed.

Loss per redemption:Loss on coupon redeemed $0.40Less contribution from addition sale ($0.60 $0.40) (0.20)Net loss per redemption $ 0.20

Incremental revenues from coupon sales (500 $3) $1,500Less cost of coupons (60 ) Contribution assuming no coupons are redeemed $1,440Net loss per redemption $0.20 Coupon redemptions for break-even 7,200

Break-even redemption rate = 7,200/(500 20) = 0.72, or 72 percent

d. Incremental revenues from coupon sales (500 $3) $1,500Less cost of coupons (60)Sixty percent of the coupons are redeemed:*

One-fourth of which have no effect on sales:Cost of redemption (6,000 0.25 $0.40) (600)

One-fourth of which result in additional salesof 2 single-scoop cones:Cost of redemption (6,000 0.25 $0.40) $(600)Contribution of additional sales

[6,000 0.25 2 ($0.60 $0.40)] 600 0One-fourth of which result in addition sales

of 3 single-scoop cones:Cost of redemption (6,000 0.25 $0.40) $(600)Contribution of additional sales

[6,000 0.25 3 ($0.60 $0.40)] 900 300One-fourth of which come out of regular sales:

Cost of redemption (6,000 0.25 $0.40) $(600)(Opportunity cost of loss of regular sales

[6,000 0.25 ($0.60 $0.40)] (300) (900)Profit $ 240

*(500 20 0.60 = 6,000)



P16-33

Unit selling price $50Unit variable costs (20 ) Unit contribution margin $30

a. Contribution with a higher selling price[($52 $20)] (5,000 units 1,200 units)] $121,600

Former contribution with lower price[($50 $20) 5,000 units] (150,000 )

Decrease in monthly profit $ 28,400

b. Profit increase from increased sales if there were nochanges in prices or costs (2,000 units $30.00) $ 60,000

Profit decrease from reduced selling price of allunits [(5,000 units + 2,000 units) $7.50] (52,500)

Profit decrease from increased direct labor costsof the last 1,000 units [1,000 units ($7.00 0.60)] (4,200 )


c. Increase in revenues (1,000 units $45) $ 45,000Increase in costs:

Direct materials (1,000 $8.00) $ 8,000Direct labor (1,000 $7.00) 7,000Factory overhead (1,000 $2.00) 2,000Selling and administrative 1,000 (18,000)

Increase in profits $ 27,000

d. Increase in revenues (2,500 units $45.00) $112,500Increase in costs:

Direct materials (2,500 $8.00) $20,000Direct labor (2,500 $7.00) 17,500Factory overhead (2,500 $2.00) 5,000Selling and administrative 1,500Opportunity cost of lost regular sales

[(5,000 units + 2,500 units 6,000-unit capacity) $30.00] 45,000 (89,000)




P16-33 (concluded)

e. Difference Cost Cost (Effect of to to Buying Make Buy on Income)Cost to buy (5,000 units $4) $20,000 $(20,000)Cost to make:

Direct materials($8.00 0.10 5,000 units) $ 4,000 4,000

Direct labor($7.00 0.10 5,000 units) 3,500 3,500

Variable factory overhead($2.00 0.10 5,000 units) 1,000 1,000

Fixed factory overhead 1,500 1,500Opportunity cost 2,000 2,000Total $12,000 $20,000 $(8,000)

Advantage of making $8,000

f. Reduction in costs (5,000 units $5.00) $ 25,000Decrease in revenues:

With inserts (5,000 units $50.00) $250,000Without inserts (5,000 $45.00) (225,000) (25,000)

Advantage (disadvantage) of selling without inserts $( -0- )



P16-34

Tour selling price $50.00Tour variable costs (40 .00) Tour contribution margin $10 .00

a. Profit decrease from reduced tours if there were nochanges in prices or costs (150 tours $10.00) $ (1,500)

Profit increase from increase in selling price [(600 tours 150 tours) $12.00] 5,400


b. Profit increase from increased tours with no changes in prices or costs (300 tours $10.00) $ 3,000

Profit decrease from reduced fee for alltours [(600 tours + 300 tours) $7.00] (6,300)

Profit decrease from increased costs of the last100 tours [100 tours ($46 $40)] 600

Decrease in monthly profit $(3,900 )

c. Increase in revenues (75 tours $45) $3,375Increase in costs:

Food (75 tours $5) $ 375Guide salary (75 tours $25) 1,875Supplies (75 tours $2) 150Administrative 200 (2,600)

Increase in profits $ 775

d. Increase in revenues (300 tours $40) $12,000Increase in costs:

Food (300 tours $5) $ 1,500Guide salary (300 tours $25) 7,500Supplies (300 tours $2) 600Administrative 200Opportunity cost of lost regular sales

(600 tours + 300 tours 800 tour capacity) $10] 1,000 (10,800)




P16-34 (concluded)

e. Difference Cost Cost (Effect of

to to "Buying" "Make" "Buy" on Income)

Cost to "buy" (600 tours $7.50) $4,500 $(4,500)Cost to "make":

Food (600 tours $5) $ 3,000 3,000Equipment rental ($5,000 $1,800) 3,200 ______ 3,200

Total $ 6,200 $ 4,500 $1,700

Advantage of "buying" $1,700

Here "buying" refers to accepting the offer of the Alberta outdoor supply company.

f. Increase in revenues:Full service (600 tours $75) $45,000Current service (600 tours $50) (30,000) $15,000

Additional costs Variable (600 tours $12) $ 7,200Fixed 1,000 (8,200)

Advantage of selling without inserts $ 6,800



P16-35

a. Although there is not adequate information to give a definitive response, the president’s analysis is likely incorrect. All three divisions most likely share some common costs (such as the president’s salary) that are unavoidable in the short run, even if a section is eliminated. Also, the cataract section’s expenses may include depreciation on specialized equipment not easily sold if the section is discontinued.

b. If the cataract section is not currently making a contribution toward covering common and fixed costs, profits should increase if that sector is dropped.

c. If the cataract section is currently making a contribution toward covering common and fixed costs, profits may actually decline if the sector is dropped.

It is also possible that the other sections obtain additional customers as a result of the existence of the cataract section. In any case, it is unlikely that profits will increase by $35,000 if the cataract sector is dropped. To determine the financially advantageous decision, management must perform a differential analysis of the relevant costs (and revenues) that will differ if the cataract section is discontinued.



MANAGEMENT APPLICATIONS

MA16-36

a. By changing its sales strategy to increase emphasis on customer service, it is necessary for Ladbrecks to establish control systems that promote this behavior and reward employees who perform consistently with the new strategy. Setting up a compensation plan that creates incentive to provide increased customer support is a logical and effective management control mechanism.

b. Figure 1 in the case indicates that sales increased approximately 8% beginning in month 25, compared with the previous months. Based on this assumption, and using the income statement for a typical store, the sales would have increased by $800,000, from $10,000,000 to $10,800,000.

c. The increase occurred quite abruptly beginning in the month that the incentive plan was implemented. Although there was some fluctuation from month to month after the plan was rolled out, the fluctuation was around a significantly higher average sales amount.

d. Wage expense increased from an average of about 8% of sales to about 10% of sales.

e. As a percent of sales cost of sales was not affected. It remained at about 63% of sales. This suggests that the increased sales on average were for goods that had a markup approximately equal to the average sales prior to the incentive plan.

f. Figure 4 indicates that inventory turnover did not change significantly between the months prior to, and after, the rollout of the incentive plan. This means, indeed, that a higher level of inventory was required to support the higher level of sales.

g. With an inventory turnover of 4, the additional inventory needed by the typical store to generate sales of 800,000, with cost of sales of 63%, or $504,000, is $504,000 ÷ 4 = $126,000.



MA16-36 (continued)

h. Before Plan After Plan Change

Sales $10,000,000 $10,800,000 $800,000Cost of sales 6,300,000 6,804,000 504,000Gross profit 3,700,000 3,996,000 296,000

Employee salaries 800,000 1,080,000 280,000Profit before fixed charges 2,900,000 2,916,000 16,000

Less implicit inventory costs* 189,000 204,120 15,120Profit after fixed charges $2,711,000 $2,711,880 $ 880

Inventory costs calculation:Sales $10,000,000 $10,800,000 $800,000Cost of sales % 63% 63% 63%Cost of sales $ $ 6,300,000 $6,804,000 $504,000Inventory turnover ÷ 4 ÷ 4 ÷ 4Total inventory $ 1,575,000 $1,701,000 $126,000Inventory fixed charge % 12 % 12% 12%Inventory fixed charge $ $ 189,000 $ 204,120 $ 15,120

Using incremental analysis:

Additional sales ($10,000,000*.08) $800,000Additional cost of sales ($800,000*.63) (504,000 ) Additional gross profit 296,000Additional employee salaries

On base sales (10,000,000*.02) (200,000)On new sales (800,000*.10) (80,000 )

Increased profit before fixed charges 16,000Less implicit inventory costs (126,000*.12) (15,120 ) Increased profit after fixed charge $ 880



MA16-36 (concluded)

i. Workers with lower wages and tenure are receiving bonuses. The plan targeted sales for bonuses based on wage rate of employee, hours worked and a multiplier as follows:

TARGET SALES = WAGE RATE * HOURS * 12.5

BONUS = .08 (ACTUAL SALES - TARGET)

Therefore, workers with lower wage rates (wages had been based on seniority) have lower sales targets for receiving a bonus.

Avg. Wage Rate Avg. Years

Employees getting bonus $ 5.65 7.87

Employees not getting bonus $ 8.66 18.12

One implication of this effect is that workers with many years of service are overpaid relative to their own productivity. Plan allows them to retain old high wages and boosts wages of lower paid employees.

j. Arguments for keeping the plan are:* Small profit increase* Large sales increase* Presumed increase in customer service* Future wages will be linked to productivity* Plan should encourage skilled employees to stay and encourage

unskilled employees to leave.

Arguments for discontinuing the plan are:* Many disgruntled employees- high turnover * Competition among employees* Huge increase in wages upon plan’s implementation* Plan consuming much time of administration



module 16 solutions

Documents