CHAPTER 7
Q7-1
Examples of process costing include flour, glass, paint, and beer.
Q7-2
Examples of process costing include handling of mail, income tax returns, and
automobile registrations.
Q7-3
The central product costing problem in process costing is how each
department should compute the cost of goods transferred out and the cost of goods
remaining in the department.
Q7-4
Five key steps in process cost accounting are:
Step 1: summarize the flow of physical units
Step 2: calculate output in terms of equivalent units
Step 3: summarize the total costs to account for, which are the total debits
in work in process (that is, the costs applied to work in process)
Step 4: calculate unit costs
Step 5: apply costs to units completed and to units in ending work in
process.
Q7-5
The first two steps concentrate on what is occurring in physical or engineering
terms. The financial impact of the production process is measured in the final three
steps.
Q7-6
1 x 10,000 + 0.5 x 5,000 = 12,500 full-time-equivalent students.
Q7-7
The quotation refers to the weighted-average method.
Q7-8
Beginning inventories + Units started = Units transferred out + Ending
inventories.
Q7-9
The quotation refers to the FIFO method.
Q7-10
"Work done in current period only" is a key measurement to judging
performance for a given span of time because the resulting unit costs are unaffected by
the averaging with work done on the beginning inventory during the preceding period.
Such a measurement is used for FIFO process costing.
Q7-11
The quotation refers to the weighted-average method.
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192
Q7-12
Differences in unit costs between FIFO and weighted-average methods are
ordinarily insignificant because (a) changes in material prices, labour wage rates, and
other manufacturing costs from month to month tend to be small, and (b) changes in the
volume of production and inventory levels also tend to be small.
Q7-13
Yes. FIFO process costing isolates the production in the current period and
the costs incurred in that period. The cost per unit for work in the current period only is
relevant for assessing the efficiency of production. It can be compared either to
standards or to previous costs.
Q7-14
Transferred-in costs are accounted for operationally the same as direct
materials added at the beginning of a production process. They differ from direct
material costs because they are a combination of direct material and conversion costs
from a previous department; thus, calling them a direct-material cost is inappropriate.
Q7-15 No, but they are especially appropriate for companies with just-in-time systems.
Any company with small inventories might find backflush costing appealing.
Q7-16 When actual conversion costs exceed the amount applied, the excess in the
conversion cost account is charged directly to cost of goods sold; the treatment is
similar to accounting for under-applied overhead.
Q7-17
Examples of industries that could use operation costing include manufacturing
of clothing, automobiles, and personal computers.
Q7-18
Yes, the application of factory overhead and of conversion costs are similar.
In each instance, a budget rate is developed. However, in operation, many more
application rates are usually used.
Copyright © 2007 Pearson Education Canada
193
P7-1
(10-15 min.)
1.
Flow of Production
Started and completed
Work in process, ending inventory
Units accounted for
Work done to date
Total costs to account for (Step 3)
Divide by equivalent units (Step 4)
Unit costs
(Step 1)
Physical
Units
650,000
220,000
870,000
$4,601,200
$5.40
(Step 2)
Equivalent Units
Direct
Conversion
Materials
Costs
650,000
650,000
220,000
132,000*
870,000
$3,741,000
870,000
$4.30
782,000
$860,200
782,000
$1.10
*220,000 x 0.60
2.
Application of costs (Step 5):
To units completed and transferred,
650,000 units ($5.40)
To units still in process, end,
220,000 units:
Direct materials
Conversion costs
Work in process, end
Total costs accounted for
Totals
Details
$3,510,000
$ 946,000
145,200
$1,091,200
$4,601,200
220,000($4.30)
132,000($1.10)
P7-2 (15-20 min.)
1.
Flow of Production
Units started and completed
Work in process, end:
Materials added: 6,000 x 0.90
Conversion costs: 6,000 x 0.70
Units accounted for
Work done to date
Copyright © 2007 Pearson Education Canada
(Step 2)
Equivalent Units
(Step 1)
Physical
Units
68,000
6,000
Direct
Materials
68,000
Conversion
Costs
68,000
5,400
4,200
74,000
73,400
72,200
194
2.
Total
Costs
$602,620
Costs to account for (Step 3)
Divide by equivalent units (Step 4)
Unit costs
$8.30
Application of costs (Step 5):
To units completed and transferred,
68,000($8.30)
To units still in process, end, 6,000 units:
Direct materials
Conversion costs
Work in process, end
Total costs accounted for
Details
Direct
Conversion
Materials
Costs
$205,520
$397,100
73,400
72,200
$2.80
$5.50
$564,400
$ 15,120
23,100
$ 38,220
$602,620
5,400($2.80)
4,200($5.50)
P7-3 (10-15 min.)
1.
Flow of Production
Started and completed
Work in process, ending inventory
Direct materials added: 2,000 x 1
Conversion costs added: 2,000 x 1/2
Total accounted for
Total work done
Total costs to account for (Step 3):
Divide by equivalent units (Step 4):
Unit costs
(Step 1)
Physical
Units
17,000
2,000
2,000
1,000
19,000
$147,000
$
2.
Application of costs (Step 5):
To units completed and transferred to
Testing, 17,000 units ($8.00)
To units not completed and still in
process, Feb. 28, 2,000 units:
Direct materials
Conversion costs
Work in process, Feb. 28
Total costs accounted for
Copyright © 2007 Pearson Education Canada
(Step 2)
Equivalent Units
Direct
Conversion
Materials
Costs
17,000
17,000
8.00
Totals
19,000
$57,000
19,000
$ 3.00
18,000
$90,000
18,000
$ 5.00
Details
$136,000
$
6,000 2,000($3.00)
5,000
1,000($5.00)
$ 11,000
$147,000
195
3.
1.
2.
3.
4.
Work in process — Assembly
Direct materials inventory
Materials added to production in February.
57,000
Work in process — Assembly
Accrued payroll
Direct labour in February.
50,000
Work in process — Assembly
Factory overhead
Factory overhead applied in February.
40,000
57,000
50,000
Work in process — Testing
Work in process — Assembly
Cost of goods completed and transferred in
February from Assembly to Testing.
40,000
136,000
136,000
The WIP T-account would show:
1. Direct materials
2. Direct labour
3. Factory overhead
Costs to account for
Bal. February 28
Work in Process — Assembly
57,000 4. Transferred out
50,000
to Testing
40,000
147,000
136,000
11,000
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196
P7-4 (20-30 min.)
1.
(Step 2)
Equivalent Units
Flow of Production
Started and completed
Work in process, ending inventory
Units accounted for
Units work done to date
Total costs to account for (Step 3)
Divide by equivalent units (Step 4)
Unit costs
(Step 1)
Physical
Units
Direct
Materials
600,000
300,000
900,000
$2,370,000
$2.80
Conversion
Costs
600,000
300,000
900,000
$1,620,000
900,000
$1.80
600,000
150,000*
750,000
$750,000
750,000
$1.00
*300,000 x 0.5
2.
Application of costs (Step 5):
To units completed and transferred to
Finishing, 600,000 units ($2.80)
To units not completed and still in
process, end, 300,000 units:
Direct materials
Conversion costs
Work in process, end
Total costs accounted for
Totals
Details
$1,680,000
$ 540,000
150,000
$ 690,000
$2,370,000
300,000 ($1.80)
150,000($1.00)
3.
1.
2.
3.
Work in process — Assembly
Direct materials inventory
Materials added to production
1,620,000
Work in process — Assembly
Accrued payroll
Direct labour
475,000
Work in process — Assembly
Factory overhead
Factory overhead applied
275,000
Copyright © 2007 Pearson Education Canada
1,620,000
475,000
275,000
197
Work in process — Finishing
Work in process — Assembly
Cost of goods completed and transferred
from Assembly to Finishing
1,680,000
1,680,000
The WIP T-account would show:
1.
2.
3.
Direct materials
Direct labour
Factory overhead
Costs to account for
Balance
P7-5
Work in Process -- Assembly
1,620,000
4. Transferred out
475,000
to Finishing
275,000
2,370,000
690,000
(5 min.)
Let x
Beginning inventory + Units started
Case A: 1,500 + 6,500
x
Case B:
4,000 + x
x
P7-6
1,680,000
=
=
=
=
=
=
unknown
Units transferred + Ending inventory
x + 2,000
6,000
8,000 + 3,300
7,300
(15 min.)
Physical
Equivalent Units
Flow of Production
Units
Direct Materials Conversion Costs
Beginning work in process
1,000(50%)
Started
35,000
To Account for
36,000
Completed and transferred out
33,000
33,000
33,000
3,000
1,200
Ending work in process
3,000(40%)
Units accounted for
36,000
Work done to date
36,000
34,200
Equivalent units in beginning inventory
1,000
500
33,700
Work done in current period only
35,000
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198
P7-7
(5 min.)
Direct
Materials
Conversion
Costs
Units completed:
From beginning work in process
--3,500a
From April production
25,000
25,000
5,000b
In process, end
10,000
Total
35,000
33,500c
a
5,000 (100% - 30%)
b
10,000 x 50%
c
Alternative computation: 5,000 + 25,000 + 5,000 - (30% x 5,000)
P7-8 (10-15 min.)
(Step 1)
Physical
Units
20,000a
45,000
65,000
63,000
2,000b
65,000
Flow of Production in Units
Work in process, beginning inventory
Started
To account for
Completed and transferred
Work in process, ending inventory
Units accounted for
Work done to date
Less: Equivalent units of work from previous
periods included in beginning inventory
Work done in current period only (FIFO method)
(Step 2)
Equivalent Units
Direct
Conversion
Materials
Costs
63,000
800
63,000
200
63,800
63,200
c
16,000
47,800
18,000c
55,200
a
Degree of completion: direct materials 80%; conversion costs, 40%
Degree of completion: direct materials 40%; conversion costs, 10%
c
80% and 40% of 20,000
b
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P7-9 (10-15 min.)
(Step 1)
Physical
Units
20,000
80,000
100,000
Flow of Production
Work in process, beginning inventory*
Started
To account for
Completed and transferred out
(100,000-10,000)
90,000
Work in process, ending inventory**
10,000
Units accounted for
100,000
Work done to date
Less: Equivalent units of work from
previous periods included in beginning
inventory
Work done in February only (FIFO method)
(Step 2)
Equivalent Units
Direct
Conversion
Materials
Costs
90,000
2,000a
90,000
3,000a
92,000
93,000
16,000b
76,000
8,000b
85,000
*Degree of completion: materials, 80%; conversion costs, 40%
**Degree of completion: materials, 20%; conversion costs, 30%
a
0.20 x 10,000 and 0.30 x 10,000
b
0.80 x 20,000 and 0.40 x 20,000
P7-10 (10-15 min.)
Flow of Production
(Step 1)
Physical
Units
Beginning inventory
Started (80,000 + 5,000 - 15,000)
To account for
Completed and transferred out
Ending inventory
Units accounted for
Work done to date
Less: Equivalent units of work from previous
periods included in beginning inventory
Work in current period only
15,000 (70%)*
70,000
85,000
80,000
5,000 (60%)*
85,000
(Step 2)
Equivalent
Units
80,000
3,000
83,000
10,500**
72,500
*Degree of completion on material costs
**15,000(0.70)
Material costs per unit: ¥580,000 ÷ 72,500 = ¥8,000
Copyright © 2007 Pearson Education Canada
200
P7-11 (10-15 min.)
Units completed
Work done on ending inventory, 0.30 x 15,000
Work done to date
Less: Equivalent units of work from previous
periods included in beginning inventory, 0.75 x 10,000
Work done in current period only
45,000
4,500
49,500
7,500
42,000
Unit conversion cost = $222,600 ÷ 42,000 = $5.30.
P7-12 (30-45 min.)
1.
Flow of Production
Work in process, beginning inventory
Started
To account for
Completed and transferred out during
current period, 550 + 7,150 - 400
Work in process, ending inventory
Units accounted for
Work done to date
(Step 2)
(Step 1)
Equivalent Units
Physical
Direct
Conversion
Units
Materials
Costs
550 (40%)*
7,150
7,700
7,300
7,300
400 (20%)*
400
7,700
7,700
Costs
(Step 3)
(Step 4)
(Step 5)
Work in process, beginning inventory
Costs added currently
Total costs to account for
Divisor, equivalent units for
work done to date
Cost per equivalent unit
Totals
$
7,300
80
7,380
Details
Direct
Conversion
Materials
Costs
5,104
100,326
$105,430
$ 3,190
65,340
$68,530
$ 1,914
34,986
$36,900
$
÷ 7,700
$ 8.90
÷ 7,380
$ 5.00
13.90
Application of Costs
Completed, (7,300 units)
Work in process, ending inventory
(400 units):
Direct materials (400)
Conversion costs (80)
Total work in process
Total costs accounted for
$101,470
$
3,560
400
$ 3,960
$105,430
7,300 ($13.90)
400($8.90)
80($5.00)
*Degree of completion for conversion costs.
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2.
1.
2.
3.
Work in process, Department A
Direct materials inventory
Work in process, Department A
Various accounts
Work in process, Department B
Work in process, Department A
P7-13 (25-35 min.)
Flow of Production
Work in process, beginning inventory
Started
To account for
Completed and transferred out during current
period, 550 + 7,150 - 400
Work in process, ending inventory
Units accounted for
Work done to date (that is, done in the current
and previous periods)
Less: equivalent units of work from previous
period included in beginning inventory,
100% and 40% of 550
Work done in current period only
Costs
Work in process, beginning, $1,914 + $3,190
Costs added currently
Costs to account for (Step 3)
Divide by equivalent units (Step 4)
Costs per equivalent unit
Work in process, ending inventory
Direct materials
Conversion costs
Total work in process (400 units)
Completed and transferred out (7,300 units),
$105,430 - $4,046 = $101,384***
Total costs accounted for
Copyright © 2007 Pearson Education Canada
65,340
65,340
34,986
34,986
101,470
101,470
(Step 2)
(Step 1)
Equivalent Units
Physical
Direct
Conversion
Units
Materials
Costs
1550 (40%)*
7,150
7,700
7,300
400 (20%)*
7,700
7,300
400
7,300
80
7,700
7,380
550
7,150
Costs to
Account for
$ 5,104
100,326
$105,430
Direct
Materials
220
7,160
Details
Conversion
Costs
$65,340
$34,986
$14.0248
÷7,150
$9.1385
÷7,160
$4.8863 **
$
400 ($9.1385)
$
3,655
391
4,046
80($4.8863)
101,384***
$105,430
202
*
Degree of completion for conversion costs.
**
A sidelight: There must have been enormous inefficient use of conversion costs in the preceding
period. Why? Because the unit conversion cost of the beginning inventory was $1,914 ÷ 220 = $8.70, as
compared with a current cost of work done of $34,986 ÷ 7,160 = $4.89.
***
Check: Work in process, beginning inventory
$ 5,104
Additional costs to complete, conversion costs of 60% of 550 x $4.8863
1,612
Started and completed, 7,300 - 550 = 6,750; 6,750 x $14.0248
94,668
Total cost transferred
$101,384
P7-14 (25-30 min.)
1. and 2.
Flow of Production
Work in process, beginning inventory
Started
To account for
Completed and transferred out during
current period
Work in process, ending inventory
Units accounted for
Work done to date
(Step 1)
Physical
Units
10,000 (25%)*
80,000
90,000
70,000
20,000 (50%)*
90,000
Costs
Work in process, beginning inventory
Costs added currently
(Step 3) Total costs to account for
(Step 4) Divisor, equivalent units for
work done to date
Cost per equivalent unit
(Step 2)
Equivalent Units
Direct
Conversion
Materials
Costs
Totals
70,000
20,000
70,000
10,000
90,000
80,000
Details
Direct
Conversion
Materials
Costs
$ 175,500
1,486,500
$1,662,000
$138,000
852,000
$990,000
$ 37,500
634,500
$672,000
$
÷ 90,000
$ 11.00
÷ 80,000
$
8.40
19.40
(Step 5) Application of Costs
Completed and transferred (70,000 units)
Work in process, ending inventory
(20,000 units):
Direct materials
Conversion costs
Total work in process
Total costs accounted for
$1,358,000
70,000 ($19.40)
$ 220,000
84,000
$ 304,000
$1,662,000
20,000($11.00)
10,000($8.40)
*Degree of completion for conversion costs.
Copyright © 2007 Pearson Education Canada
203
P7-15 (25-35 min.)
(Step 2)
(Step 1)
Equivalent Units
Physical
Direct
Conversion
Units
Materials
Costs
10,000 (25%)*
80,000
90,000
Flow of Production
Work in process, beginning inventory
Started
To account for
Completed and transferred out during
current period
70,000
Work in process, ending inventory
20,000 (50%)*
Units accounted for
90,000
Work done to date
Less: Equivalent units of work from previous periods
included in beginning inventory, 100% and 25%
of 12,000
Work done in current period only
70,000
20,000
70,000
10,000
90,000
80,000
10,000
80,000
2,500
77,500
Direct
Materials
Conversion
Costs
$852,000
$634,500
÷80,000
$10.65
÷77,500
$8.1871
*Degrees of completion for conversion costs at inventory dates.
Costs
Work in process, beginning inventory
Costs added currently
Total costs to account for (Step 3)
Divide by equivalent units (Step 4)
Cost per equivalent unit
Copyright © 2007 Pearson Education Canada
Totals
$ 175,500
1,486,500
$1,662,000
$18.8371
204
Application of Costs (Step 5)
Work in process, ending inventory
Direct materials
Conversion costs
Total work in process (20,000 units)
Completed and transferred out (70,000 units);
$1,662,000 - $294,871
Total costs accounted for
Direct
Materials
Totals
$ 213,000
81,871
$ 294,871
Conversion
Costs
20,000($10.65)
10,000($8.1871)a
1,367,129b
$1,662,000
a
Equivalent units of work done x $8.1871
Check:
Work in process, beginning inventory
Additional costs to complete, conversion
costs (75% of 10,000 x $8.1871) or 7,500 x $8.1871 =
Started and completed this period,
(70,000 - 10,000) x $18.8371 =
Total cost transferred
b
$ 175,500
61,403
1,130,226
$1,367,129
P7-16 (15-20 min.)
1.
Units started and completed
Work in process, end (3,000,000 x 40%)
Units accounted for
Work done to date
(Step 1)
Physical
Units
1,800,000
1,200,000
3,000,000
(Step 2)
Equivalent Units
Materials Conversion
& Supplies
Costs
1,800,000 1,800,000
1,200,000
900,000*
3,000,000 2,700,000
* 1,200,000 x 0.75
2.
Total
Costs
Cost to account for (Step 3)
Divide by equivalent unit (Step 4)
Unit costs
3.
$5,325,000 $ 600,000
3,000,000
$1.95
$0.20
Ending work in process, 1,200,000 units:
Materials and supplies, 1,200,000 x $0.20
Conversion costs, 900,000 x $1.75
Cost of 1,200,000 returns not yet completed
Copyright © 2007 Pearson Education Canada
Details
Materials
Conversion
& Supplies
Costs
$4,725,000
2,700,000
$1.75
$ 240,000
1,575,000
$1,815,000
205
P7-17 (20 min.)
1.
Potato chips are a homogeneous product with low unit cost that must be
processed through a sequence of continuous steps (sequential processing).
Potato chips are produced to demand rather than to order. As a result, a
process-cost system is the most logical cost accounting system to use for
product-costing purposes.
2.
Activity-based accounting systems are most beneficial when products and/or
processes are characterized by diversity. Diversity can be in the volume of
product produced or the degree of complexity in the production process across
product lines. Since neither of these forms of diversity characterize the potato
chip industry, it is doubtful that activity-based accounting would pass the costbenefit test. It may be that some specialty producers of gourmet potato chips
may have sufficient diversity to warrant use of an activity-based accounting
system.
3.
Frito-Lay produces over 2,700 kilograms of potato chips each hour, 24 hours a
day. This translates into over 23.5 million kilograms per year. Since at any
point in time the work-in-process amounts to no more that one-half an hour (it
takes 30 minutes to completely produce the end product), work-in-process
accounts for about 1,350/23,500,000 or 0.006 percent of total annual
production. The implication is that work-in-process can be ignored for productcosting purposes due to its immaterial amount.
P7-18 (30-40 min.)
1.
$265 per tonne (see details below)
2.
$2,525 (see details below)
3.
This requirement cannot be answered directly from the data using the weighted
average process cost method. We must look at the equivalent units of
conversion work done in May only:
Work done through the end of May
Work done before May (3/4 x 24 tonnes)
Work done in May
Copyright © 2007 Pearson Education Canada
302 tonnes
18 tonnes
284 tonnes
206
Budget for 284 tonnes:
$16,000 + ($80 x 284) = $38,720
Budget – Actual = $38,720 - $40,670 = $1,950 unfavourable
During May, conversion costs were $1,950 (or 5%) above budget.
Flow of Production
Work in process, beginning inventory
Started
To account for
Completed and transferred out during
current period
Work in process, ending inventory
Units accounted for
Work done to date
Costs
Work in process, beginning inventory
Costs added currently
(Step 3) Total costs to account for
(Step 4) Divisor, equivalent units for
work done to date
Cost per equivalent unit
(Step 2)
Equivalent Units
Direct
Conversion
Materials
Costs
(Step 1)
Physical
Units
24 (3/4)*
288
312
297
15 (1/3)*
312
Totals
297
15
297
5
312
302
Details
Direct
Conversion
Materials
Costs
$ 6,000
75,230
$81,230
$ 2,880**
34,560**
$37,440
$
$
265
÷ 312
120
$ 3,120
40,670
$43,790
÷
$
302
145
(Step 5) Application of Costs
Completed and transferred (297 tonnes)
Work in process, ending inventory
(15 tonnes):
Direct materials
Conversion costs
Total work in process
Total costs accounted for
$78,705
$ 1,800
725
$ 2,525
$81,230
297($265)
15($120)
5($145)
*Degree of completion for conversion costs.
**$120 x 24 = $2,880; $120 x 288 = $34,560.
Copyright © 2007 Pearson Education Canada
207
P7-19 (20 min.)
1.
Flow of Production
Work in process, beginning
Started
To account for
Completed
Work in process, ending
Units accounted for
Work done to date
Costs to account for (Step 3)
Divide by equivalent units (Step 4)
Cost per equivalent unit
(Step 1)
Physical
Units
Plastic
0
60,000
60,000
40,000
40,000
20,000 (40%) 20,000
60,000
60,000
Total
Costs
$620,000
$12.00
$300,000
÷ 60,000
$5.00
(Step 2)
Equivalent Units
Softening
Conversion
Compound
Costs
40,000
0
40,000
8,000
40,000
48,000
$80,000
÷40,000
$2.00
$240,000
÷ 48,000
$5.00
2.
Application of Costs (Step 5)
Units completed (40,000 x $12)
Work in process, ending:
Material -- Plastic
Conversion costs
Total work in process, ending
Total costs accounted for
Totals
$480,000
$100,000
40,000
$140,000
$620,000
Details
20,000($5)
8,000($5)
P7-20 (20-30 min.)
1.
Step 2
Equivalent Units
(Step 1)
Physical
Flow
Flow of Production
Units started and completed
145,000
Work in process, end
5,000
Direct materials added: 5,000 x 1.00
--Cartons added: none
Conversion costs: 5,000 x .95
--Units accounted for
150,000
Work done to date
Direct
Materials
145,000
--5,000
Cartons
145,000
-----
Conversion
Costs
145,000
-----
----150,000
----145,000
4,750
--149,750
Details
Costs accounted for (Step 3)
Divide by equivalent units (Step 4)
Unit costs
Total
Costs
£3,738,000
£25.00
Copyright © 2007 Pearson Education Canada
Direct
Materials
£2,250,000
150,000
£15.00
Cartons
£290,000
145,000
£2.00
Conversion
Costs
£1,198,000
149,750
£8.00
208
2.
Application of costs (Step 5):
To units completed, 145,000 (£25.00)
Work in process, end, 5,000 units:
Direct materials
Conversion costs
Work in process, end
Total costs accounted for
3,625,000
75,000
38,000
113,000
£3,738,000
5,000(£15.00)
4,750(£8.00)
P7-21 (15-20 min.)
1.
Materials and parts inventory
Accounts payable or cash
Conversion costs
Accrued payroll, accounts payable,
accumulated amortization, etc.
2.
287,000
287,000
92,000
92,000
Finished-goods inventory
Materials and parts inventory
Conversion costs
368,000
Cost of goods sold
Finished-goods inventory
368,000
276,000
92,000
368,000
All costs incurred during April are charged to cost of goods sold in April. This
assumes that all altimeters are sold and shipped immediately upon production.
Therefore, the balance in Finished Goods Inventory is zero at the end of the
month.
3.
Because the balance in the Conversion Costs account must be zero at the end
of the month, and because only $92,000 was transferred out of the Conversion
Costs account while $94,600 was added to the account, the remaining $2,600
must be transferred to Cost of Goods Sold:
Cost of goods sold
Conversion costs
Copyright © 2007 Pearson Education Canada
2,600
2,600
209
P7-22
1.
2.
(15-20 min.)
Materials inventories
Accounts payable
46,000
Conversion costs
Accrued payroll
Miscellaneous accounts
30,000
Finished goods inventories (2,000 x $37)
Materials inventories (2,000 x $22)
Conversion costs (2,000 x $15)
74,000
Cost of goods sold (1,980 x $37)
Finished-goods inventories
73,260
Cost of goods sold
Conversion costs
To recognize actual conversion costs that were
$2,000 greater than the amount applied to the
products.
P7-23
(15 min.)
1.
Materials inventories
Accounts payable
Conversion costs
Accrued payroll and miscellaneous accounts
Cost of goods sold (1,500 x $14.20)
Materials inventories (1,500 x $10.00)
Conversion costs (1,500 x $4.20)
2.
Conversion costs
Cost of goods sold
To recognize actual conversion costs that were
$400 less than the amount applied to the products.
Copyright © 2007 Pearson Education Canada
46,000
11,000
19,000
44,000
30,000
73,260
2,000
2,000
16,000
16,000
6,300
6,300
21,300
15,000
6,300
400
400
210
P7-24 (15-20 min.)
We emphasize that more and more companies are applying direct labour and
overhead together as a single unit cost per operation.
1. Conversion costs
Direct labour
Factory overhead
Conversion costs
Total units produced:
6,000 + 4,500 + 3,000
6,000 + 4,500
Conversion cost per unit
2. Chair Costs
Direct materials
Conversion costs:
Cutting @ $13
Assembly @ $5
Finishing @ $24
Total costs
Units produced
Cost per unit
P7-25
1.
Cutting
$ 60,000
115,500
$175,500
Assembly
$30,000
37,500
$67,500
Finishing
$ 96,000
156,000
$252,000
13,500
13,500
$13
$5
10,500
$24
Standard
$108,000
Deluxe
$171,000
Unfinished
$66,000
78,000
30,000
144,000
$360,000
6,000
$60
58,500
22,500
108,000
$360,000
4,500
$80
39,000
15,000
-$120,000
3,000
$40
(20-30 min.)
Budgeted rate for conversion costs =
$220,000 + $580,000
= $40
20,000
Production per hour = 60 minutes ÷ 6 minutes per depth finder = 10 depth
finders
Cost per depth finder = $40 per machine hour ÷ 10 = $4 per depth finder
Cost of 1,000 depth finders = 1,000 x $4 = $4,000
Copyright © 2007 Pearson Education Canada
211
2.
Direct materials
Conversion costs:
Operation 1
Operation 2
Operation 3
Total manufacturing costs applied
Divide by total depth finders
Cost per depth finders
3.
Direct materials:
$57,000 x 500/1,000
($100,000 - $10,000) x 600/1,000
Conversion costs:
Operation 1:
(500/1,000 x $19,000)
(600/1,000 x $19,000)
Operation 2:
(600/1,000 x $4,000)
Total cost of work in process
Copyright © 2007 Pearson Education Canada
Standard
Depth Finders
$57,000
Deluxe
Depth Finders
$100,000
19,000
4,000
-$80,000
1,000
$80
19,000
4,000
15,000
$138,000
1,000
$138
Standard
Depth Finders
Deluxe
Depth Finders
$28,500
$54,000
9,500
11,400
-$38,000
2,400
$67,800
212
C7-1 (60-90 min)
Case Synopsis
The case involves a situation in which students must decide whether to accept
two potential contracts presented to Randy White, President. The situation
requires an analysis of the potential profitability of the contracts; however, the
joint-product relationship of these marble products makes this difficult to do. In
particular, the profits vary depending upon the production process selected and
the costs included.
Pedagogical Objectives
The case is intended to make students aware of the difficulty and subjectivity in
determining the costs of joint products. This case allows students to examine the
issue from a cost and a cash flow perspective. As a secondary issue, the case
permits some discussion of the appropriate product costs for financial reporting
purposes.
Suggested Assignment Questions
(1)
As Randy White, would you submit the suggested price in either or both of
the two price requests? Support your recommendation with any analysis
which you deem to be appropriate.
(2)
What cost would you assign to the inventory for financial reporting
purposes?
Product Costs Analysis
To determine the product costs, students must first decide on their approach to
the problem. This teaching note has selected an average 8 tonne limestone block
as the basis for the costs. From this point, the yields of various product lines are
determined in Exhibit 1. Next, the costs per average block are determined in
Exhibit 2, which total $961 or approximately $120 per quarried tonne. Given the
estimated selling prices as found in Exhibit 7A-1 of the case and the yields per
limestone block, Exhibit 3 estimates the gross revenue if all products are sold. To
achieve the desired 100 percent markup in direct costs, the products need to be
sold at the top end of the price ranges ($1,953 ÷ $961 = 203%). At the low end of
the price range a margin of 70 percent is attained ($1634 ÷ $961 = 170%).
Exhibit 4 allocates the total product costs of each limestone block to each
product line using three different bases.
Copyright © 2007 Pearson Education Canada
213
Given the selling prices are per tonne, the students will need to calculate a cost
per tonne in order to determine the profitability of the contract. In addition, the
inventory will be also costed on a per tonne basis. For example, with the paving
stones, if the total cost of $87.64 is selected (percentage of revenue basis) and
divided by the yield of 0.52 tonnes per block, a cost per tonne of $168.54 is
determined. If the student would like to exclude the common raw material costs,
the processing and cutting costs of $55.64 would equal $107.00 per tonne
($55.64 ÷ 0.52). However, as the cutting costs are also a common cost, the
student may wish to only include the incremental processing costs of $47.80 ÷
0.52 = $91.92 per tonne. These scenarios, of course, assume that all or a portion
of the common costs should be attributed to the primary product lines.
If the issue is examined from a cash flow perspective and all costs are assigned
to the products to be sold, the total production costs are $2,741,275 as
determined in Exhibit 5. However, the estimated revenues from the contracts are
$2,100,000, thus a shortfall in cash of $641,275 results.
Paving stones 2,000 tonnes @ $300
Window sills 3,000 tonnes @ $500
=
=
$600,000
1,500,000
$2,100,000
Exhibit 5 also calculates the future processing costs to be $954,770 and the
estimated tonnage of inventory in various product lines. Thus, the total product
costs would be $3,696,045. Given the estimated selling prices, future revenues
should vary between $4,432,550 and $5,259,450. Of course, there always is
some uncertainty regarding the timing and type of future contracts.
Window sills
Hearth slabs
Large units
1,154 tonnes @$450
@$550
5,615 tonnes @$550
@$650
1,500 tonnes @$550
@$650
$519,300
$634,700
3,088,250
3,649,750
825,000
$4,432,550
975,000
$5,259,450
If these products are sold, the percentage mark-up on product costs will be 77%
to 99%.
Copyright © 2007 Pearson Education Canada
214
Revenues - contacts
- future
Product costs
Profit
Profit margin as a percentage
of costs
$2,100,000
4,432,550
6,532,550
3,696,045
$2,836,505
77%
$2,100,000
5,259,450
7,359,450
3,696,045
$3,663,405
99%
If, however, the students would like to produce the orders without leaving any
processed or unprocessed inventory, the profit margins as a percentage of costs
drop well below the desired 100 percent. Exhibit 6 examines the cash flow
related to producing 3,000 tonnes of window sills only, which would also produce
683 tonnes of unprocessed paving stones. The resulting margin is only 55%.
Exhibit 7 examines the cash flows when producing 2,000 tonnes of paving stones
and no inventory. The resulting margin is only 30%. Exhibit 8 assumes that the
3,000 tonnes of window sills are produced, the inventory of 683 tonnes of paving
stones are processed, and the remaining 1,317 tonnes of paving stones are
produced with no inventory. The resulting margin is 58%. In other words, if
Arriscraft is to achieve a reasonable profit margin it must produce the orders,
while cutting all product lines. If only window sills or paving stones are produced
with no remaining inventory, the opportunity cost of forgone sales in the high
quality product lines draws down the profit margins to unacceptable levels.
This is the essence of the trade-off faced by White. Should the order be
produced at low unprofitable margins or should it be produced with an
expectation that future revenues from the inventory will provide reasonable
profits?
Additional Comments
The case instructor may want to point out to the students a number of variables
which when included would increase the complexity of the problem. For example:
•
•
•
•
the assumption of an 8 tonne average limestone block
the potential 10% to 15% variance in product block output
in reality the four product lines have a number of sub-categories
depending upon the dimensions of the final product
the yields also can vary depending upon the quality of the limestone
block.
Copyright © 2007 Pearson Education Canada
215
Exhibit 1
Yield Per Block
Limestone block
less loss due to sides
8T
1T
7T
Cutting loss 20%
Product blocks total
1.4
5.6T
Product blocks:
Large Units
Percentage of
product blocks
Product block yield
(tonnes)
Yield (%)
Net yield (tonnes)
Sill waste used for
pavers
Waste yield
Total net yield
(tonnes)
Product yields as a
percentage of total
net yield
Hearth Slabs Window Sills
10%
40%
40%
Paving
Stones
10%
0.56T
2.24T
2.24T
0.56T
5.6T
70%
0.39T
65%
1.46T
48%
1.08T
0.39T
1.46T
50%
0.28T
2.24 - 1.08 =
1.16 x 21%
= 0.24
1.08T
0.52T
3.45T
11%
42%
Copyright © 2007 Pearson Education Canada
31%
16%
Total
100%
100%
216
Exhibit 2
Costs Per Block
Raw material
Cutting costs
per tonne
Product block
yield
Cutting costs
per block
8T @ $50 =
Large units
Hearth Slabs
Window Sills
$12/T
$10/T
$15/T
Paving
Stones
$14/T
0.56T
2.24T
2.24T
0.56T
$6.72
$22.40
$33.60
$7.84
Large units
Processing
costs per
tonne
Product block
net yield
Processing
cost per
block
Total costs
$400.00
Hearth Slabs
Window Sills
70.56
Paving Stones
(a)
(b)
$115/T
$65/T
$75/T
$150/T
$180/T
0.39T
1.46T
1.08T
0.28T
0.24T
$29.25
$219.00
$194.40
$32.20
$15.60
490.45
$961.01
Copyright © 2007 Pearson Education Canada
217
Exhibit 3
Estimated Revenue Per Block
Large
Units
0.39T
Hearth
Slabs
1.46T
Window
Sills
1.08T
Paving
Stones
0.52T
Total
3.45T
(a) Low end of price range
Revenue per block
(yield x price)
$550/T
$215
$550/T
$803
$450/T
$486
$250/T
$130
$1,634
(b) Middle of price range
Revenue per block
(yield x price)
$600/T
$234
$600/T
$876
$500/T
$540
$275/T
$143
$1,793
(c) High end of price range
Revenue per block
(yield x price)
$650/T
$254
$650/T
$949
$550/T
$594
$300/T
$156
$1,953
13%
49%
30%
8%
100%
Yield per block (tonnes)
Product revenues as a
percentage of total revenues
Copyright © 2007 Pearson Education Canada
218
Exhibit 4
Allocated Costs Per Limestone Block by Product Line
Large Units
Processing costs
Cutting costs
Raw materials cost
allocation
percentage of
product block basis
percentage of total
net yield basis
percentage of
revenues basis
$29.25
6.72
$35.97
Hearth
Slabs
$219.00
22.40
$241.40
Window
Sills
$194.40
33.60
$228.00
Paving
Stones
$47.80
7.84
$55.64
Total
$490.45
70.56
$561.01
$40.00
$160.00
$160.00
$40.00
$400.00
$75.97
$44.00
$401.40
$168.00
$388.00
$124.00
$95.64
$64.00
$961.01
$400.00
$79.97
$52.00
$409.40
$196.00
$352.00
$120.00
$119.64
$32.00
$961.01
$400.00
$87.97
$437.40
$348.00
$87.64
$961.01
Assuming the cost per tonne for financial reporting purposes includes direct product
costs, the above alternatives would probably be satisfactory for financial reporting
purposes. If the paving stones were costed as a by-product at $47.80, the hearth slabs
costs of $401.40 to $437.40 per tonne would increase. This has obvious implications for
increasing or decreasing net income depending upon the user's objectives.
Copyright © 2007 Pearson Education Canada
219
Exhibit 5
Cost of Producing 2,000 Tonnes of
Paving Stones and all Product Lines
(Normal Production Process)
Cash Costs
Total limestone required:
= 2000 tonnes required = 3,846 blocks
0.52 tonnes yield
Raw material costs:
3,846 blocks x 8T/block @ $50/T
= 30,768 T @ $50/T
$1,538,400
Cutting cost 3,846 blocks @ $70.56
Processing costs
Paving stones
3,846 blocks @ $32.20
Window sills
3,846 blocks @ $194.40
Paving stones
3,846 blocks @ $15.60
from window sill waste
Total
271,374
$123,841
747,662
59,998
$2,741,275
Output
Processed product:
Paving stone 3,846 blocks x 0.52T =2,000 tonnes
Window sills 3,846 blocks x 1.08T = 4,154 tonnes
Unprocessed product
Hearth slabs 3,846 blocks x 2.24T = 8,615 tonnes
Large units 3,846 blocks x 0.56T = 2,154 tonnes
Future Costs to Finish Unprocessed Product
Hearth slabs 3,846 blocks @ $219.00
Large units 3,846 blocks @ $29.25
$842,274
112,496
954,770
Potential Processed Inventory
Window sills 4,154T - 3,000T = 1,154 tonnes
Hearth slabs 3,846 blocks x 1.46T = 5,615 tonnes
Large units 3,846 blocks x 0.39T = 1,500 tonnes
Total product costs
Copyright © 2007 Pearson Education Canada
$3,696,045
220
Exhibit 6
Costs to Produce 3,000 Tonnes
of Window Sills Only
(Amended Production Process†)
Yield to produce window sills only:
Larger units
0.56 x
80%
Hearth Slabs
2.24 x
75%
2.80
Window Sills
2.24 x
48%
(70 + 10†)
(65 + 10†)
Paving stones
0.56 x
50%
(window sill waste) (2.24 - 1.08) 21%
(2.80 - 2.13) 31%
(21 + 10†)
=
=
0.45
1.68
2.13
1.08
3.21
tonnes per block
=
=
=
0.28
0.24
0.21
0.73
tonnes per block
=
$374,000
=
45,020
=
9,556
=
540,243
=
Total limestone blocks required
=
3, 000 tonnes
3. 21tonnes yield
= 935 blocks
Cash flow
Raw materials
Cutting costs
$400 x 935
3.21 x $15 x 935
= 48.15 x 935
0.73 x $14 x 935
= 10.22 x 935
Processing costs 3.21 x $180 x 935
= 577.80 x 935
Total costs
$968,819
Revenues 3,000 tonnes @ $500
Profit (55% margin)
1,500,000
$531,181
Inventory
0.73 x 935 = 683 tonnes of paving stones
with future processing costs of
0.28 x $115 x 935 = $30,107
0.45 x $65 x 935 =
27,349
$57,456
† 10 percent increase in yield from cutting window sills from higher quality material.
Copyright © 2007 Pearson Education Canada
221
Exhibit 7
Costs to Produce 2,000 Tonnes
of Paving Stones Only
(Amended Production Process†)
Yields to produce Paving Stones only:
Large units
0.56 x 85%
(70 + 15†)
Hearth slabs
2.24 x 80%
(65 + 15†)
Window sills
2.24 x 63%
(48 + 15†)
paving stones
0.56 x 50%
0.48
1.79
1.41
0.28
3.96
tonnes per block
Total limestone blocks required:
2, 000 tonnes
= 505 blocks
3. 96 tonnes yield
Cash flow:
†
Raw materials $400 x 505 =
Cutting costs
3.96 x $14 x 505
= $55.44 x 505
=
Processing costs
3.96 x $115 x 505
= $455.40 x 505 =
Total costs
$202,000
229,977
$459,974
Revenues 2,000 tonnes @ $300
Profit (30% margin)
$600,000
$140,006
27,997
15 percent increase in yield from cutting paving stones from higher quality materials.
Copyright © 2007 Pearson Education Canada
222
Exhibit 8
Cost to Produce 3,000 tonnes of Window Sills
and 2,000 tonnes of Paving Stones Only
(Amended Production Process)
Window sill costs (Ex. 6)
(3,000 tonnes)
Paving stones costs (Ex. 6)
(683 tonnes)
$968,819
57,456
$1,026,275
Paving stones (remaining 1,317 tonnes)
(see Ex. 7 for details)
1,317 tonnes
= 333 blocks
3.96 tonnes
Raw materials
$400 x 333
Cutting costs
$55.44 x 333
Processing costs
18,462
Total costs
151,648
303,310
$1,329,585
Revenues
Profit (58% margin)
$2,100,000
$ 770,415
CL7-1
$455.40 x 333
$133,200
(45 min. or more)
The purpose of this exercise is to make students think about the characteristics
of real production processes and how to account for them. Depending on the
assumptions students make about the type of production process used in each of these
examples, they may suggest a different type of accounting system than those listed
below. These are just suggestions about what the groups might conclude.
a.
b.
c.
d.
e.
f.
Process costing, because there are large volumes of identical product.
Hybrid costing is most likely. Certain parts might be made in sufficient volumes
to use process costing, but final products are likely to be job-costed.
Process costing. Although each application is unique, it is likely that identifying
the differences and trying to account for them is not cost-efficient.
Probably job costing. It depends on how many identical couches students think
that Kroehler makes at one time. If each is unique, or if small batches are
produced, a job-costing system is most likely used.
Job costing. Major construction projects are generally treated as a single job.
Process costing. Refining oil into gasoline is a classic process-costing
environment, where there is a single continuous process.
Copyright © 2007 Pearson Education Canada
223
g.
h.
Job costing. Each order at Kinko’s is unique. The only question is whether it is
cost-benefit efficient to determine job costs for each order.
Job costing. Each ship built is a single job, although there may be parts that are
produced in a process that allows process costing.
Copyright © 2007 Pearson Education Canada
224
CHAPTER 8
Q8-1 Precision is a measure of the accuracy of certain data. It is a quantifiable term.
Relevance is an indication of the pertinence of certain facts for the problem at hand.
Ideally, data should be both precise and relevant.
Q8-2 Decisions may have both quantitative and qualitative bases corresponding to
the nature of the facts being considered before deciding. Some implications of
alternative choices can be expressed in monetary or numerical terms, such as variable
costs, initial investment, etc. Other relevant features may not be quantifiable, such as a
choice between locating in Vancouver or Toronto. The advantage of quantitative
weighing is that it is more objective and often easier than qualitative judgment.
Q8-3 The accountant's role in decision making is primarily that of a technical expert
on relevant information analysis, especially relevant costs.
Q8-4 No. Only future costs that are different under different alternatives are relevant
to a decision.
Q8-5 Past data are unchangeable regardless of present or future action and thus
would not differ under different alternatives.
Q8-6 Past costs may be bases for formulating predictions. However, past costs are
not inputs to the decision model itself.
Q8-7 The commonalty of approach is the focus on the differences between expected
outcomes of different available alternatives.
Q8-8 The lesson here is important. No matter how fixed costs are spread for unit
product costing purposes, the total fixed costs will be unchanged (even though fixed
costs per unit may change).
Q8-9 No. There is a confusion between total fixed costs and unit fixed costs.
Increasing volume will decrease unit fixed costs, but not total fixed costs.
Q8-10 Yes. The costs that make a difference when a product or department is being
deleted are the avoidable costs.
Q8-11 No. Avoidable costs are all costs (both variable and fixed) that will not continue
if an ongoing operation is changed or deleted.
Copyright © 2007 Pearson Education Canada
225
Q8-12 Four examples of limiting factors (scarce resources) are: (a) labour hours, (b)
square metres of floor space, (c) supervisory hours, (d) computer hours.
Q8-13 Marginal cost is the additional cost resulting from producing and selling one
additional unit. It changes as production volume changes, often decreasing up to a point
and then increasing. Variable cost is the accountant's approximation to marginal cost. It
remains constant over the relevant range of volume.
Q8-14 The four major factors influencing pricing decisions are: the law, customers,
competitors, and costs.
Q8-15 Customers are one of the factors influencing price decisions because: they can
buy or do without the product, they can make the product themselves, they can usually
purchase a similar product from another supplier, or they can dictate the price they are
ready to pay for a product.
Q8-16 In target costing, managers start with a market price. Then they design the
product such that its costs are low enough at that price to be profitable. Thus, the price
essentially determines the cost.
Q8-17 The variable costs of a job can be misused as a guide to pricing. However, the
adjusted markup percentages based on variable costs can have the same price result
as those based on total costs, plus they have the advantage of indicating the minimum
price at which any sale may be considered profitable even in the short-run.
Q8-18 Three examples of pricing decisions are with regard to new products, products
sold under private labels, and responding to new prices of a competitor's products.
Q8-19 Four popular markup formulas are (1) as a percentage of variable
manufacturing costs, (2) as a percentage of total variable costs, (3) as a percentage of
full costs, and (4) as a percentage of absorption costs.
Q8-20 Two long-run effects that inhibit price cutting are (a) the effects on longer-run
price structures and (b) the effects on longer-run relations with customers.
Q8-21 Full costs are more popular than variable costs for pricing because price
stability is encouraged and in the long-run all costs must be recovered to stay in
business.
Q8-22 Executives usually use full costs for setting "normal" prices and the contribution
approach for special, non-recurring orders.
Copyright © 2007 Pearson Education Canada
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P8-1
(5 min.)
All the data given are historical costs. Most students will identify the $10 and $11 prices
as relevant. They will also declare that the $5 price of popcorn is irrelevant. Press them
to see that the relevant admission prices are expected future costs that will differ
between the alternatives. The past prices are being used as a basis for predicting the
future prices.
Similarly, the past prices of popcorn were not different. Hence, they are regarded as
irrelevant under the assumption that the future prices will not differ.
P8-2 (20 min.) Some students will forget to apply the 10% wage rate increase to both
alternatives.
(1)
(2)
(A)
(B)
Historical
Information
Other
Information
Prediction Method
Predictions as inputs
to decision model
(3)
Decision Model
(1) Historical direct materials were $5.00
per unit; direct labour was $3.00 per unit.
(2) Direct material costs are expected to
fall by 5%, or $0.25 per unit. Direct labour
costs are affected by a 10% rate increase
and a 5% increase in labour time if the
new material is used.
(3) Cost comparisons per unit:
Old
New
Material Material
$5.000 $4.750
Decisions by managers
with aid of
decision model
(4)
Implementation
and Evaluation
Feedback
Copyright © 2007 Pearson Education Canada
Direct material
Direct labour
$3.00 x 110%
3.300
$3.00 x 110% x 105%
Expected future
prime cost
$8.300
3.465
$8.215
(4) The chosen action is implemented,
and the evaluation of performance
becomes a principal source of feedback.
This historical information aids the
decision process (prediction, decision, and
implementation) of future decisions.
227
P8-3
(10 min.)
Relevant costs are the future costs that differ between alternatives. Among the
irrelevant costs are the cost of tickets to the symphony, automobile costs, and babysitting cost for the first four hours. The relevant costs are:
Tickets, 2 @ $20 each
Parking
Baby-sitting, 1 extra hour @ $4
Total
Symphony
$0
0
0
$0
Game
$40
6
4
$50
Difference
$40
6
4
$50
The baseball game is $50 more costly to the Ramaswamy than is the symphony.
P8-4
1.
(10-15 min.)
Operating income would increase by $300 if the order is accepted.
Units
Sales
Purchase cost
Variable printing cost
Total variable cost
Contribution margin
Fixed cost
Operating income
2.
Without
Special
Order
2,000
$36,000
20,000
4,000
24,000
12,000
8,000
$ 4,000
Effect of
Special
Order
100
$1,500
1,000
200
1,200
300
0
$ 300
With
Special
Order
2,100
$37,500
21,000
4,200
25,200
12,300
8,000
$ 4,300
If maximizing operating income in the short run were the only goal, the order
should be accepted. However, if qualitative considerations favoring rejection are
worth more than the $300 increase in operating income, the manager would
reject the offer. For example, accepting the offer from the F. C. Strikers may
generate similar offers from other clubs who now willingly pay the $18 normal
price. Lost profits on such business might more than offset the $300 gain on this
sale. On the other hand, this might be a way of gaining the F. C. Strikers as
regular customers who will then buy other items that generate a profit well in
excess of the $300.
Copyright © 2007 Pearson Education Canada
228
P8-5
(25-30 min.)
1.
A contribution format, which is similar to Exhibit 8-3, clarifies the analysis.
Without
Special
Order
2,000,000
Units
Sales
Less variable expenses:
Manufacturing
Selling & administrative
Total variable expenses
Contribution margin
Less fixed expenses:
Manufacturing
Selling & administrative
Total fixed expenses
Operating income
$10,000,000
Effect of
Special Order
150,00
Total
Per Unit
$660,000 $4.401 $10,660,000
$ 3,600,000
800,000
$ 4,400,000
$ 5,600,000
$300,000
37,500
$337,500
$322,500
$2.002
0.253
$2.25
$2.15
$ 3,900,000
837,500
$ 4,737,500
$ 5,922,500
$ 2,400,000
2,500,000
$ 4,900,000
$ 700,000
0
0
0
$322,500
0.00
0.00
0.00
$2.15
$ 2,400,000
2,500,000
$ 4,900,000
$ 1,022,500
1 $660,000 ÷ 150,000 = $4.40
2 Regular unit cost = $3,600,000 ÷ 2,000,000 =
Emblem and assembly
Variable manufacturing costs
3 Regular unit cost = $800,000 ÷ 2,000,000 =
Less sales commissions not paid (3% of $5)
Regular unit cost, excluding sales commission
2.
With
Special
Order
2,150,000
$1.80
0.20
$2.00
$0.40
0.15
$0.25
Operating income from selling 7.5% more units would increase by $322,500 ÷
$700,000 = 46.1%. Note also that the average selling price on regular business
was $5.00. The full cost, including selling and administrative expenses, was
$4.65. The $4.65, plus the $0.20 per calculator, less savings in commissions of
$0.15 came to $4.70. The president apparently wanted $4.70 + 0.08($4.70) =
$4.70 + 0.376 = $5.076 per calculator.
Most students will probably criticize the president for being too stubborn. The
cost to the company was the forgoing of $322,500 of income in order to protect
the company's image and general market position. Whether $322,500 was a
wise investment in the future is a judgment that managers are paid for
rendering.
Copyright © 2007 Pearson Education Canada
229
P8-6 (10 min.)
1.
(a)
(b)
(c)
Variable manufacturing cost
Variable selling and administrative
cost
Total variable cost
Fixed manufacturing cost
Absorption cost
Fixed selling and administrative cost
Full cost
$10.00
Cost per Unit of Product
$10.00
$10.00
3.00
$13.00
3.00
6.00*
$16.00**
6.00
5.80*
$24.80
*
Fixed manufacturing cost, $3,000,000 ÷ 500,000 = $6.00
Selling and administrative cost, $2,900,000 ÷ 500,000 = $5.80
** This amount must be used by companies for inventory valuation in reports to
shareholders.
2.
P8-7
1.
Full cost is often called fully allocated cost.
(20 min.)
These warehouse stores attempt to maximize profits by cutting prices and
increasing turnover. Since profit is the product of contribution margin and total
sales, it can be affected by changing either. Total profit can be increased if the
added turnover brought about by a lowering of price brings in more contribution
margin than was lost by the price cut. They also try to minimize fixed costs by
limiting their investment in buildings and equipment.
Characteristics: (a) choose product lines and sizes that move quickly and avoid
stocking slow-moving items and sizes, (b) stock lower cost, lower quality items,
(c) rely on self service, (d) attempt to cut costs by providing fewer services, and
(e) build low-cost buildings in a place where property costs are not too high.
2.
Such a criterion by itself gives no indication what net income can be expected.
Sales turnover or volume must be used also, for the rate of return on assets is
determined by
Rate of return =
Contribution margin x Total sales
Average assets
If sales turnover can be assumed to be fairly constant among items, then such a
figure as a 20% average target gross profit might be meaningful.
Copyright © 2007 Pearson Education Canada
230
P8-8 (10 min.)
1.
Contribution margins:
Plain = $66 - $50 = $16
Fancy = $100 - $70 = $30
Contribution margin ratios:
Plain = $16 ÷ $66 = 24%
Fancy = $30 ÷ $100 = 30%
2.
a.
b.
3.
Units per hour
Contribution margin per unit
Contribution margin per hour
Total contribution for 20,000 hours
Plain
2
$16
$32
$640,000
Fancy
1
$30
$30
$600,000
For a given capacity, the criterion for maximizing profits is to obtain the greatest
possible contribution to profit for each unit of the limiting factor (scarce
resource). Moreover, fixed costs are irrelevant unless their total is affected by
the choice of products.
P8-9 (15-20 min.)
The purpose of this problem is to underscore the idea that any of a number of general
formulas might be used that, properly employed, would achieve the same target selling
prices. Desired sales =$7,500,000 + $1,500,000 = $9,000,000.
The target profit percentage would be:
1.
100% of prime costs of $4,500,000.
($9,000,000 - $4,500,000)
Computation is:
= 100%
($4,500,000)
2.
50% of the cost of jobs of $6,000,000.
($9,000,000 - $6,000,000)
= 50%
Computation is:
($6,000,000)
3.
($9,000,000 - ($3,500,000 + $1,000,000 + $900,000))
= 66 2/3%
($5,400,000)
4.
($9,000,000 - $7,500,000)
= 20%
($7,500,000)
5.
($9,000,000 - ($3,500,000 + $1,000,000 + $900,000 +$300,000))
($5,700,000)
($3,300,000)
= ($5,700,000) = 57.9%
Copyright © 2007 Pearson Education Canada
231
If the contractor is unable to maintain these profit percentages consistently, the desired
operating income of $1,500,000 cannot be attained.
P8-10 (30-40 min.)
1.
HUNTER COMPANY
Income Statement
For the Year Ended December 31, 2006
Total
Sales
Less variable expenses:
Manufacturing
Selling & administrative
Contribution margin
Less fixed expenses:
Manufacturing
Selling & administrative
Operating income
2.
$19,000,000
9,000,000
$ 5,000,000
5,000,000
$40,000,000
Per Unit
$20.00
28,000,000
$12,000,000
14.00
$ 6.00
10,000,000
$ 2,000,000
5.00
$ 1.00
Additional details are either in the statement of the problem or in the solution to
requirement 1:
Total
Per Unit
Absorption cost = full manufacturing cost
$24,000,000
$12.00
Variable cost:
Manufacturing
$19,000,000 $ 9.50
Selling and administrative
9,000,000
4.50
Total variable cost
$28,000,000
$14.00
Full cost = fully allocated cost*
Full manufacturing cost
$24,000,000
$12.00
Selling and administrative expenses
14,000,000
7.00
Full cost
$38,000,000
$19.00
Gross margin ($40,000,000 - $24,000,000)
$16,000,000
$ 8.00
Contribution margin ($40,000,000 - $28,000,000)
$12,000,000
$ 6.00
* Students should be alerted to the loose use of these words. Their meaning
may not be exactly the same from company to company. Thus, "fully allocated
cost" in some companies may be used to refer to manufacturing costs only.
3.
Hector’s analysis is incorrect. He was on the right track, but he did not
distinguish sufficiently between variable and fixed costs. For example, when
multiplying the additional quantity ordered by the $12 absorption cost, he failed
to recognize that $2.50 of the $12 absorption cost was a "unitized" fixed cost
allocation. The first fallacy is in regarding the total fixed cost as though it
fluctuated like a variable cost. A unit fixed cost can be misleading if it is used as
a basis for predicting how total costs will behave.
A second false assumption is that no selling and administrative expenses will be
affected except commissions. Shipping expenses and advertising allowances
Copyright © 2007 Pearson Education Canada
232
will be affected also -- unless arrangements with The Bay on these items differ
from the regular arrangements.
The following summary, which is similar to Exhibit 8-3, is a correct analysis. The
middle columns are all that are really necessary.
Without
Special
Order
2,000,000
Units
Sales
Less variable expenses:
Manufacturing
Selling and administrative
Total variable expenses
Contribution margin
Less fixed expenses:
Manufacturing
Selling and administrative
Total fixed expenses
Operating income
Effect of
Special Order
100,00
Total
Per Unit
$40,000,000 $1,700,000 $17.00
With
Special
Order
2,100,000
$41,700,000
$19,000,000 $ 950,000 $ 9.50 $19,950,000
9,000,000
350,000
3.50*
9,350,000
$28,000,000 $1,300,000 $13.00 $29,300,000
$12,000,000 $ 400,000 $ 4.00 $12,400,000
$ 5,000,000
0
0.00
5,000,000
0
0.00
$10,000,000
0
0.00
$ 2,000,000 $ 400,000 $ 4.00
$ 5,000,000
5,000,000
$10,000,000
$ 2,400,000
*Regular variable selling and administrative expenses,
$9,000,000 ÷ 2,000,000 =
Average sales commission at 6% of $20 =
Regular variable selling and administrative expenses, less commission
Special commission, $20,000 ÷ 100,000
Selling and administrative expenses
$4.50
1.20
$3.30
0.20
$3.50
Some students may wish to enter the $20,000 as an extra fixed cost. The final
result would be the same; in any event, the cost is relevant because it would not
exist without the special order.
Copyright © 2007 Pearson Education Canada
233
Some instructors may wish to point out that a 5% increase in volume would
cause a 20% increase in operating income, which seems like a high investment
by Hunter to maintain a rigid pricing policy.
4.
Hector is incorrect. Operating income would have declined from $2,000,000 to
$1,850,000, a decline of $150,000. Hector’s faulty analysis follows:
Old fixed manufacturing cost per unit, $5,000,000 ÷ 2,000,000 =
$2.50
New fixed manufacturing cost per unit, $5,000,000 ÷ 2,500,000 =
2.00
"Savings"
$0.50
Loss on variable manufacturing costs per unit, $9.20 - $9.50
0.30
Net savings per unit in manufacturing costs
$0.20
The analytical pitfalls of unit-cost analysis can be avoided by using the
contribution approach and concentrating on the totals:
Sales
Variable manufacturing costs
Other variable costs
Total variable costs
Without
Special
Order
$40,000,000
$19,000,000
9,000,000
$28,000,000
Effect of
Special
Order
$4,600,000a
$4,750,000b
0
$4,750,000
With
Special
Order
$44,600,000
$23,750,000
9,000,000
$32,750,000
Contribution margin
$12,000,000
$ (150,000)c
$11,850,000
a 500,000 x $9.20 selling price of special order
b 500,000 x $9.50 variable manufacturing cost per unit of special order
c 500,000 x $0.30 negative contribution margin per unit of special order
No matter how fixed manufacturing costs are unitized, or spread over the units
produced, their total of $5,000,000 remains unchanged by the special order.
Copyright © 2007 Pearson Education Canada
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P8-11 (15 min.)
1.
If fixed manufacturing cost is applied to product at $1.00 per machine hour, it
takes $0.80 ÷ $1.00, or 4/5 of an hour to produce one unit of XY-7. Similarly, it
takes $0.20 ÷ $1.00 or 1/5 of an hour to produce BD-4.
2.
If there are 100,000 hours of capacity:
XY-7:
BD-4:
100,000 hours ÷ 4/5 = 125,000 units.
100,000 hours ÷ 1/5 = 500,000 units.
Total contribution margins show that BD-4 should be produced:
XY-7
BD-4
Per Unit
$6.00 - ($3.00 + $2.00) = $1.00
$4.00 - ($1.50 + $2.00) = $0.50
Units
125,000
500,000
Total
$125,000
$250,000
P8-12 (15-20 min.)
All amounts are in thousands of British pounds.
The major lesson is that a product that shows an operating loss based on fully allocated
costs may nevertheless be worth keeping. Why? Because it may produce a sufficiently
high contribution to profit so that the firm would be better off with it than any other
alternatives.
The emphasis should be on totals:
Sales
Variable expenses
Contribution margin
Fixed expenses
Operating income
Existing
Operations
6,000
4,090
1,910
1,110
800
Replace Magic Department With
General
Merchandise
Electronic Products
-600 + 300 = 5,700 -600 + 200 = 5,600
-390 + 210a = 3,910 -390 + 100b = 3,800
-210 + 90
-100 + 0
-110 + 90
= 1,790
= 1,010
= 780
-210 + 100 = 1,800
-100 + 25 = 1,035
-110 + 75 = 765
a(100% - 30%) x 300
b(100% - 50%) x 200
Copyright © 2007 Pearson Education Canada
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The facts as stated indicate that the Magic Shop should not be closed. First, the total
operating income would drop. Second, fewer customers would come to the store, so
sales in other departments may be affected adversely.
P8-13 (10-15 min.)
1.
The key is to focus on lost revenues and avoidable costs:
Revenues, 600 hours @ SF12 per hour
Avoidable costs*:
Teacher salaries
SF 5,200
Supplies
800
Decrease in operating income
SF 7,200
6,000
SF 1,200
* In addition to the avoidable costs shown, there might be some savings in sanitary
engineering (less cleaning necessary) and amortization (less wear and tear on
equipment). Unless these savings are more than the SF 1,200 decrease in
operating income, the school will be worse off financially without the after-school
care program.
2.
Among the qualitative factors to consider are that the after-school care program
might attract students to the regular program, it provides additional compensation
to teachers, and there is a social need for such programs.
P8-14 (20 min.)
This solution may be obvious to most students. However, the use of this problem in
executive programs and regular classes has shown that some students need this
exercise before they become convinced that the "unitization" of fixed costs can be
misleading. Moreover, in decision-making in general, the use of total rather than unit
cost is nearly always less confusing.
This special order increases revenue by $390,000 and variable costs by $420,000.
Total fixed costs are unchanged at $300,000. This $300,000 is unaffected regardless of
how they are allocated to units of product. Therefore, net income will be affected only by
the changes in revenue and variable costs.
Copyright © 2007 Pearson Education Canada
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Summary of regular operations:
Revenue
Variable costs
Contribution margin
Fixed costs
Net income
Per Unit
$2.00
1.40
$0.60
1.00
$-0.40
Total
$ 600,000
420,000
$ 180,000
300,000
$-120,000
The new business would alter the picture as follows, assuming fixed costs are "spread"
on a fifty-fifty basis:
Revenue
Variable costs
Contribution margin
Fixed costs
Net income
Regular
$600,000
420,000
$180,000
150,000
$ 30,000
Special
$ 360,000
420,000
$ -60,000
150,000
$-210,000
Total
$ 960,000
840,000
$ 120,000
300,000
$-180,000
No matter how the fixed costs are spread, the total fixed costs will be $300,000 and the
total net loss will be $180,000. This is true despite the fact that fixed costs per unit have
fallen from $1.00 to $0.50. The moral is : beware of unit costs.
Some instructors may want to emphasize how the unitization of fixed costs differs. That
is, the unit cost depends on the production volume chosen as the denominator.
Total fixed costs
$300,000
Fixed costs per unit = Production volume =
= $1
300,000
or
$300,000
= $0.50
600,000
The total fixed cost is unaffected by what volume is chosen as the denominator for
computing the cost per unit.
Copyright © 2007 Pearson Education Canada
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Using the graphs like those in the chapter:
P8-15 (10-15 min.)
Pricing policies always seem to spark much student interest. This "break-even"
philosophy is similar to the "base or bulk volume" philosophy favoured by many
executives. That is, the "normal" pricing applies to the bulk or base of the business, but
price cutting can be applied to incremental business.
In the case of the auto business, this normal-incremental pricing is applied by many
dealers in the manner described in the problem. Many observers think such pricing is
nonsense, unless it is a response to changes in demand and in competitor pricing.
Why is such pricing nonsense? Because prices should be influenced by customer
demand and competition, not by where sales happen to be on a break-even graph.
Ordinarily, a pricing strategy should aim to maximize the contribution margin, all other
things being equal. Some critics maintain that it is foolhardy to cut a price to the same
potential customer just because he or she appears on, say, May 27 rather than on May
23.
As prospective customers, most rational people would shop for a car during the final two
or three days of the month.
P8-16 (10 min.)
1.
($60,000 - $36,000) ÷ $36,000 = 66.7%
2.
($60,000 - $50,000) ÷ $50,000 = 20%
3.
($60,000 - $30,000) ÷ $30,000 = 100%
4.
[$60,000 - ($30,000 + $8,000)] ÷ ($30,000 + $8,000) = 58%
Copyright © 2007 Pearson Education Canada
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P8-17 (10-15 min.)
1.
(150% x $28,000) + ($80 x 2,000 hours) = $42,000 + $160,000 = $202,000
2 & 3.
Materials and supplies, at cost
Hourly pay for consultants
Employee benefit costs for consultants
Total variable cost
Avoidable fixed costs
Minimum bid
Unavoidable fixed costs
Total cost
Desired mark-up, 20% x $168,000
Bid to achieve desired profit
$ 28,000
72,000
24,000
$124,000
9,000
$133,000
35,000
168,000
33,600
$201,600
P8-18 (10-15 min.)
1. Sales
Fully allocated operating expenses
Variable operating expenses (80% x $40,000)
Apparent change in operating income
2.
Fully
Contribution
Allocated
Approach Cost Approach
$37,000
$37,000
40,000
32,000
$ 5,000
$ (3,000)
A decision not to accept the order means that short-run income would be $5,000
lower. In effect, Transit invests $5,000 to maximize long-run benefits. Minkler
can find the contribution approach helpful because he can weigh decisions of
this sort by asking whether the probability of long-run benefits (not encouraging
price-cutting by competitors, not encouraging customers to expect lower prices)
is worth a quantifiable present investment equal to the contribution margin
($5,000 in this case).
Students should be alerted to the fact that, by itself, the contribution approach
does not say "go forth and cut prices." All it does is quantify a manager's options
more sharply.
Copyright © 2007 Pearson Education Canada
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P8-19 (15-20 min.)
1.
Extra revenue from option 1: ($30 - $15) x 30 passengers = $450
Extra costs for option 1: ($2.20 - $0.20) x 65 km + $400 = $530
Therefore, the second option (adding a car to an existing train) is more profitable
by $530 - $450 = $80.
Costs that are the same for both alternatives are irrelevant. These include the
cost of the tour guide, cost of moving the car or car and engine to the main track,
and amortization.
2.
This depends on the total additional revenues and costs for option 2:
Revenues: $30 x 30
Costs: Fuel – 65 km x $0.20/km
Tour guide
Moving car
Total additional cost
$900.00
$ 13.00
150.00
40.00
$203.00
This option is definitely profitable, generating extra profit of $900 - $203 = $697.
The cost of the tour guide and the cost of moving the car to the main track are
relevant for this decision because they would be incurred only if the agreement
with the tour agent is accepted. The amortization remains irrelevant as long as
excess cars are available.
P8-20 (15-20 min.)
1.
Items that can be displayed in 8,000 square metres
Contribution margin per item
Contribution margin per turnover of inventory
Relative number of turnovers for a given time period
Total contribution margin for a given time period
Designer
300
$120
$36,000
2
$72,000
Moderately
Priced
400
$65
$26,000
3
$78,000
Students should recognize that square metres of floor space is the limiting factor
(scarce resource). Note that the contribution margin percentage and the
contribution margin per item are greater for the designer items. Nevertheless, the
moderately priced items will generate a larger contribution margin in total. Why?
Because more moderately priced dresses are sold in any given period of time.
The analysis above implies sales of 300 x 2 = 600 designer dresses versus 400 x
3 = 1,200 moderately priced dresses. The designer items should be dropped.
Copyright © 2007 Pearson Education Canada
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2.
The solution in requirement 1 assumes that moderately priced items can outsell
designer items 3 to 2 and that the store will be 100% full of such items.
Interdependencies between the items are ignored. If these factors do not hold,
some combination of the two items may be preferable.
Additional considerations include the investment in inventories, the number of
sales personnel, the skills and training of sales personnel, and the degree of
substitutability between the types of items.
This problem could also be addressed on a unit basis. Suppose one designer
dress is displayed and sold in a given time period. How many moderately priced
dresses could be sold in the same period? First, compute how many moderately
priced dresses would be displayed:
Moderately priced dresses displayed
= 4/3 x designer dresses displayed
= 4/3 x 1 = 1 1/3
For each dress displayed, 1 1/2 moderately priced dresses would be sold in the
same time period that 1 designer dress is sold. Why? Because turnover of
designer items is 2/3 that of moderately priced dresses, which implies that
turnover of moderately priced dresses is 1 1/2 times that of designer dresses.
Therefore,
Moderately priced dresses sold = 1 1/2 x 1 1/3 x designer dresses sold
= 2 x designer dresses sold
West Coast Fashions can use a given amount of space to sell either 1 designer
dress or 2 moderately priced dresses. Contribution margins are:
Designer dresses
1 x $120 = $120
Moderately priced dresses
2 x $65 = $130
The contribution margin is greater from selling 2 moderately priced dresses than
from selling 1 designer dress.
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P8-21 (20-25 min.)
1.
Net income would be increased by $3,000 if the order were taken:
Sales
Without
the Order
Effect of
the Order
$1,100,000
$19,800
With
the Order
$1,119,800
Direct material
280,000
5,600
285,600
Direct labour
320,000
6,400
326,400
Variable overhead
240,000*
4,800
244,800
Fixed overhead
160,000
0
160,000
Total costs
1,000,000
16,800
1,016,800
Operating income
$ 100,000
$ 3,000
$ 103,000
* Variable overhead is total overhead - fixed overhead, or
$400,000 - $160,000 = $240,000. Variable overhead rate
=$240,000 ÷ $320,000 = 75% of direct labour.
2.
A contribution approach to pricing might appear as follows:
Selling price
Direct materials
$5,600
Direct labour
6,400
Variable overhead at 75% of direct labour
4,800
Total variable cost
Contribution margin
$19,800
16,800
$ 3,000
The contribution approach essentially attempts to provide a measure of the
decrease in immediate net income that would result from rejecting an order. This
is the contribution margin forgone. Traditional approaches to pricing do not
supply such a number. In part (1), the $3,000 tells the sales manager that he is
investing $3,000 now to uphold his pricing policies. He can then assess whether
preserving such policies and the long-run pricing structure is worth an
investment of such magnitude. He also may assess whether accepting marginal
business will cause this customer to seek such concessions regularly.
Alternatively, the sales manager may want to make such concessions
occasionally to attract new customers.
Copyright © 2007 Pearson Education Canada
242
A possible contribution margin formula may be illustrated as follows:
Direct material
$ 5,600
Direct labour
6,400
Variable overhead at 75% of direct labour
4,800
Total variable cost
$16,800
Markup at 30.95%* of $16,800
5,200
Target selling price
$22,000
*Normal markup percentage = ($22,000 - $16,800) ÷ $16,800 = 30.95%
Note that the markup of 30.95% is much higher than the 10% used previously
because the markup must provide for the recovery of fixed overhead as well as
the making of net income. The key to the contribution approach is its intelligent
use with full recognition that total variable cost is not total cost.
An alternative way to compute the target selling price would provide for a twostep markup:
Total variable cost
Fixed costs, 19.05%* of $16,800
Total costs
Markup, 11.9%** of $16,800
Target selling price
$16,800
3,200
$20,000
2,000
$22,000
* 160 ÷ (280 + 320 + 240) = 19.05%
** 100 ÷ 840 = 11.9%
P8-22 (15-20 min.)
1.
Tuition revenues
Costs of courses
Contribution margin
General administrative
expenses
Operating income
2.
Final Course
Year to
Enrollment
Date
30
10 More
$2,000,000 $15,000 $4,000
800,000
4,000
600
1,200,000 11,000
3,400
Grand
Totals
$2,019,000
804,600
1,214,400
400,000
0
0
$ 800,000 $11,000 $ 3,400
400,000
$ 814,400
The same general considerations influence pricing decisions in profit-seeking and
not-for-profit organizations. The exception is price-setting by many governmentowned entities, which often is heavily affected by legislative bodies. The familiar
three Cs—customers, costs, and competition—do influence price setting.
Copyright © 2007 Pearson Education Canada
243
Executive education is highly competitive; the rates for top-flight teachers are
relatively high; and customers often do without or conduct their own in-house
training. The offering of discounts is often risky. It may alienate full-paying
customers, may lead to widespread price-cutting, and may encourage the
particular customers to bargain hard regarding course after course.
The setting of tuition in private universities is similar to setting prices in private
industry. Customers may go to the competition—to other private or public
universities. Costs must be recovered if the institution is to survive. Of course,
tuition is only one part of a university's revenue. Private institutions are especially
dependent on endowment income and on donations from friends and alumni.
P8-23 (20 min.)
This is a classic problem of the application of the contribution approach.
Number of flights per month
Available seats
Seats filled
Percent filled
Revenue
Variable expenses
Contribution margin
Copyright © 2007 Pearson Education Canada
Basic
3,000
300,000
156,000
52%
$31,200,000
21,840,000
$ 9,360,000
Marginal
Total
120
3,120
12,000
312,000
2,400
158,400
20%
50.8%
$240,000
$31,440,000
120,000
21,960,000
$120,000
$ 9,480,000
244
P8-24 (15-20 min.)
1.
Total variable costs are $1.00 + $0.20 = $1.20 per boomerang.
Total fixed costs are $300,000 + $50,000 = $350,000
Volume in units
Sales @ $3.00
Total variable costs @ $1.20
Contribution margin
Fixed costs
Operating income
Operating income percentage of sales
2.
200,000
$600,000
240,000
360,000
350,000
$ 10,000
1.7%
250,000
$750,000
300,000
450,000
350,000
$100,000
13.3%
300,000
$900,000
360,000
540,000
350,000
$190,000
21.1%
Note the significant difference in predictions. For example, the correct analysis
indicates $10,000 operating income at a 200,000 volume level; the incorrect
analysis indicates $100,000 operating income. The manager's tabulation is
incorrect because it assumes that all costs are variable. The presence of a
larger proportion of fixed costs causes much wider swings in operating income
when volume deviates from the volume used to develop the full costs per
boomerang.
P8-25 (15-20 min.)
Regular selling per unit: EUR92,632.54 / 2,000 = EUR46.32 (rounded)
Total variable cost per unit: variable manufacturing costs + variable selling and
administrative costs
= EUR13.29 + EUR5.11 = EUR18.40
Contribution margin per unit: of regular sales: sales per unit – variable cost per unit
= EUR46.32 – 18.40 = EUR27.92
Special order contribution margin: EUR20.45 – EUR18.40 = EUR2.05
1. Net income would increase by 300 x EUR2.05 = EUR615.
2. The company could sell at a price equal to its variable manufacturing cost of
EUR13.29.
3. Fixed manufacturing and fixed selling and administrative expenses are irrelevant.
In addition, variable selling and administrative expenses is also irrelevant.
4. Doubling of capacity = 2,400 x 2 = 4,800 units of expected production and sales.
Additional facilities cost of EUR255,645.94 is capitalized and amortized over 5
years with no residual value.
Amortization per year: EUR255,645.94 / 5 = EUR51,129.19.
Copyright © 2007 Pearson Education Canada
245
Contribution margin per unit of
regular sales x expected sales:
EUR27.92 x 4,800
Less fixed costs:
Fixed manufacturing
Fixed selling and administrative
Amortization
Total fixed costs
Net income
Copyright © 2007 Pearson Education Canada
EUR134,016.00
EUR30,677.57
15,338.76
51,129.19
EUR97,145.52
EUR36,872.48
246
P8-26 (15-25 min.)
1.
Budgeted fixed manufacturing overhead rate = $1,000,000 ÷ 200,000 = $5
2.
Relevant items:
Additional sales
Additional manufacturing costs, 10,000 x $10
Additional selling and administrative expenses
Total relevant costs
Additional operating income
$120,000
$100,000
1,000
$101,000
$ 19,000
Fixed manufacturing costs are irrelevant because their total will be the same
regardless of the special order being accepted or rejected.
3.
4.
Students may raise many points, including:
a.
Whether the president is willing to "invest" $19,000 in forgone operating
income now to preserve a marketing policy or to prevent a general
weakening of prices among competitors.
b.
Whether accepting the order now may lead to more profitable orders from
the same customer subsequently.
Budgeted fixed manufacturing overhead rate would be $1,000,000 ÷ 100,000 =
$10. However, the additional operating income in requirement 2 would be
unaffected by how fixed costs are "unitized." (Of course, the original budgeted
operating income would have been different, but that is irrelevant in requirement
2.)
P8-27 (20-30 min.)
The SMA grader remarked: "Well done by students who used contribution margin
analysis or pro forma income statement methods, in total dollars. A number of students
attempted to force a decision by means of analysis of unit costs or by break-even
analysis, failing to consider the effect of sales volume on profits. A number of good
solutions were marred by failure to draw specific conclusions."
Copyright © 2007 Pearson Education Canada
247
Output and pricing:
Volume
50,000
60,000
70,000
80,000
Price
$25
24
23
22
VC
16
16
16
16
C/M
9
8
7
6
Total
Contribution
$450,000
480,000
490,000
480,000
The C/M per unit decreases as volume increases.
Output of 70,000 at selling price of $23 yields the largest contribution margin. However,
this is in excess of capacity.
Maximum at present capacity: 60,000 units output at $24
= Contribution margin of $480,000
To increase capacity:
Investment
Useful life
Cost per year ($200,000 ÷ 10)
$200,000
10 years
$20,000
By increasing capacity to 70,000 units, which is maximum C/M, the company gains an
additional $10,000 in C/M but incurs an additional fixed cost of $20,000.
Conclusions:
Do not invest in new capacity.
Sell at $24.
Produce 60,000 maximum capacity now.
P8-28 (15 min.)
The standard line should be produced. The major lesson here is that gross profit per
unit of product is not necessarily indicative of the relative profitability of products. In this
case the limiting factor (scarce resource) is production capacity. The most desirable
product is the one that maximizes the contribution to profit for the given production
capacity. In this case, the standard product will yield a $14 contribution per hour of
machine time, while the premium product will yield $12:
Copyright © 2007 Pearson Education Canada
248
Selling price
Variable costs
Contribution margin per unit of product
Divide by machine time per unit of product
Contribution margin per hour of machine time
Per Unit
Standard Premium
$28
$38
14
20
$14
$18
÷1
÷1.5*
$14
$12
Comparisons of gross profit percentages do not help in these instances because they
are not dependent on the scarce resource, machine time. (Of course, the rate of return
on investment may be affected by different required amounts of assets, but that
complication is not introduced here.)
* $9 ÷ $6 = 1.5 hours of machine time required per unit of premium product. This is the
key to the solution because it means that, if the full productive capacity is allocated to
one of the products, the company could produce fewer premium products than
standard products. Many students are not comfortable with this idea until an example
is explained.
Assume total fixed overhead of $360,000 and total machine hours of 60,000. The
fixed overhead rate would be $6 per hour. (This is also $6 per standard unit.) But
because $9 is charged per premium unit, the hours of machine time must be $9 ÷ $6
= 1.5 hours per unit. Therefore, only 40,000 units of the premium product could be
produced: 60,000 ÷ 1.5 = 40,000. (Proof: at $9 fixed overhead each, total fixed
overhead is $9 x 40,000 = $360,000.)
P8-29 (10-15 min.)
1.
Manufacturing cost
Gross margin, 15% x $27.00
Price
$27.00
4.05
$31.05
Belleville would not produce a motor because they would not be able to sell
them at $31.05, assuming that market research is right about the market price of
$25.00. Even with no profit margin, the cost of $27 exceeds the price of $25.
2.
Using target costing, Belleville would begin with the market price of $25.00.
From this, managers would compute the largest acceptable manufacturing cost:
Price
Less gross margin
Manufacturing cost
$25.00
3.26*
$21.74
* Price = Cost + (0.15 x Cost)
$25.00 = 1.15 x Cost
Cost = $25.00 / 1.15 = $21.74
Margin = $25.00 - $21.74 = $3.26
Copyright © 2007 Pearson Education Canada
249
3.
Belleville managers would have to determine if they could design the garagedoor-opener motor and its production process in a way that manufacturing costs
were below $21.74. Both the design specifications for the motor and the
production process would need to be looked at. If there is no way to reduce
production costs to $21.74 or below, the product should not be produced.
However, target costing forces managers to examine ways to lower the
production costs through product and process design. Instead of taking the
design and process as givens and then examining the market to see if the
product can be sold for a high enough price, Belleville managers would try to
design a product and process that meets the constraints of the market.
P8-30 (10 min.)
This problem raises issues for which there are no right answers. Determining the types
of product promotion activities that are ethically and legally appropriate is not an easy
question, and the role of price discrimination is especially difficult.
For a company to legally charge different prices to different customers, it usually must
show a cost difference in serving the customers. But many companies promote their
products by charging a zero price (i.e., giving free samples for a limited amount of the
product). Is this case any different than a breakfast cereal company sending free
samples through the mail? If so, how? Further, establishing physicians’ confidence in
the medication has a potential long-run benefit; does this justify giving the drug free to
physicians? In addition, physicians need to know how to administer the drug and how to
look for possible side effects, so are the free samples justified as an educational
investment? Or are the free drug samples essentially bribes to convince physicians to
prescribe the new drug?
What about the difference in price between hospital and retail pharmacies? GLP may
think that if a hospital pharmacy starts a patient on the new drug, he or she will stay on
it even if further purchases are from a retail pharmacy. Does this justify a price
differential? Or it may be that distribution costs are less to hospital pharmacies than to
retail pharmacies. Is this difference enough to justify a $15 difference in price?
Students are likely to disagree on the appropriateness of the policies, and some may
feel passionately about their opinion. At some time the discussion should be turned to
the effect of cost on the pricing policies. For example, a lead-in question may be
whether the eventual price of $50 is fair for a product whose production cost is only $12.
Then it can proceed to considering whether a cost differential can justify the $15
difference between the prices to hospital and retail pharmacies. Finally, the issue of
price and incentives to physicians can be addressed. This last issue may be the first
one students want to focus on, and it may be the one with the most ethical content, but
it should not be the sole issue discussed.
Copyright © 2007 Pearson Education Canada
250
P8-31 (15 min.)
1.
Assuming that total fixed costs are the same at production levels of 6,000 and
10,000 units, the analysis can focus on contribution margins:
SP@ $12:
SP@ $10:
6,000 units x ($12 - $6) = $36,000
10,000 units x ($10 - $6) = $40,000
Profits will be $40,000 - $36,000 = $4,000 higher at the $10 price.
2.
Subjective factors include image in the marketplace (higher price may give image
of quality), market penetration (satisfied customers may become repeat
customers), and effects on the sales force.
P8-32 (15 min.)
1.
Contribution margin from direct sales = $15 - $2 = $13
Contribution margin from sales to distributor = $50 - $2 = $48
Total contribution from sales to distributors = (14,000 x 10) x $48 = $6,720,000
$6,720,000 ÷ $13 = $516,924 direct sales required to be more profitable than
rental sales
2.
The cost of producing and promoting the movie is irrelevant to this decision.
3.
Total contribution from direct sales = 30 million x ($15 - $2) = $390 million
Sales at CM of $48 to get contribution of $390 million:
$390,000,000 ÷ $48 = 8,125,000 tapes
Sales per store = 8,125,000 ÷ 14,000 = 580 tapes
It is unlikely that the production company would have been able to sell 580 tapes
per video store. The decision to sell directly to consumers appears to have been
wise.
P8-33 (30-50 min.)
1.
The total amount of fixed overhead is common to all alternatives. Therefore, it is
irrelevant to this analysis. The scarce resource is hours of capacity. The objective
is to maximize the contribution per hour:
Revenue per unit
Variable cost per unit
Contribution per unit
Contribution per hour
Hours available
Total contribution
Plug-In
Subcomponents
Assemblies
Difference
$2.20
$5.30
1.40
3.30
$0.80
$2.00
$-1.20
$48.00*
$40.00**
$8.00
x 600,000
x 600,000
$28,800,000
$24,000,000
$4,800,000
* $0.80 x 60 units per hour = $48.00
** $2.00 x 20 units per hour = $40.00
Copyright © 2007 Pearson Education Canada
251
Plug-in assemblies should be dropped because it is diverting the limited
resources from a more profitable use. Note that the sales manager is incorrect.
These decisions should not be reached by "all-costs" allocations and consequent
computations of net profits or losses on units of product. Each plug-in assembly
is making a $2.00 contribution to profit and to the recovery of fixed costs, but it
takes three times as long to make a plug-in assembly.
2.
The lowest price must yield a contribution of $28,800,000. The contribution per
unit would be $28,800,000 divided by the number of units produced in one year,
or:
$28,800,000 ÷ (600,000 hours x 20 units per hour)
= $28,800,000 ÷ 12,000,000 units = $2.40 per unit
Because the contribution is currently $2.00 per unit at a selling price of $5.30, the
minimum acceptable price must be $5.70 in order to provide a unit contribution of
$2.40.
3.
Revenue per unit
Variable cost per unit
Contribution per unit
Contribution per hour
Hours available
Total contribution
Plug-In
Subcomponents
Assemblies
Difference
$2.20
$5.30
1.40
3.78*
$0.80
$1.52
$0.72
$48.00*
$30.40
$17.60
600,000
600,000
$28,800,000
$18,240,000
$10,560,000
* [3.30 + (40% x 1.20)]
Plug-in should still be dropped.
P8-34 (20 min.)
1.
Contribution margin = $800 - ($475 + $25) = $300
Total contribution = $300 x 44,000 mowers = $13,200,000
Total fixed costs = 7 years x ($900,000 + $50,000) = $6,650,000
Development costs = $5,000,000
Life cycle profit = $13,200,000 - $6,650,000 - $5,000,000 = $1,550,000
Copyright © 2007 Pearson Education Canada
252
2.
Desired profit = 0.10 x ($800 x 44,000) = $3,520,000
The life cycle profit is $3,520,000 - $1,550,000 = $1,970,000 short of what is
desired. Therefore, unless some changes can be made, Mastercraft will not enter
the riding lawn mower market.
3.
A target costing company does not quit when the first cost estimate comes in too
high. Managers establish a target cost to adjust design, production, and
marketing processes to meet the target cost. In this case, the target cost is:
Revenue
Desired profit
Target cost
$35,200,000
3,520,000
$31,680,000
Expected costs are:
Variable production costs (44,000 x $475)
Fixed production costs
Variable selling costs (44,000 x $25)
Fixed selling costs
Development costs
Total costs
$20,900,000
6,300,000
1,100,000
350,000
5,000,000
$33,650,000
If total costs can be reduced by $1,970,000 to $31,680,000 by changes in the
product's design, the production process design, or production or selling
methods, this will be a profitable product.
P8-35 (40-60 min.)
Some instructors may prefer to omit some of these requirements. Requirement 4 is
especially difficult.
1.
Contribution margin, 11,000 units x ($7 - $5) =
Fixed costs
Net income (loss)
$22,000
25,000
$ (3,000)
Sales in the unrelated market must obtain a total contribution margin large
enough to recoup the loss of $3,000 plus $900:
Total contribution margin needed
Divide by unit contribution margin in unrelated market
Total units needed to be sold
Copyright © 2007 Pearson Education Canada
$3,900
÷ $1
3,900
253
2.
Contribution margin, 20,000 units x ($7 - $5) =
Fixed costs
Net income
Desired net income
Net income on 20,000 units
Additional net income desired on 3,000 units
Additional contribution margin desired per unit is
$1,500 ÷ 3,000 = $0.50
Selling price per unit
Contribution margin per unit
Maximum price to be paid to sub-contractor
3.
$40,000
27,000
$13,000
$14,500
13,000
$ 1,500
$7.00
0.50
$6.50
Let A = increase in advertising
14,500($7) = 14,500($5) + $25,000 + A + 0.02($7) (14,500)
$101,500 = $72,500 + $25,000 + A + $2,030
A = $101,500 - $99,530 = $1,970
4.
Many students will erroneously assume a selling price of $7.
Let X = units and Y = current selling price
1.00XY
0.95XY
0.05XY
XY
Substitute
and since
= $25,000 + $5X + $12,500
= $25,000 + $5X + $ 7,750
=
$ 4,750
= $95,000
$95,000
$5X
X
XY
Y
(1)
(2)
(1) minus (2)
= $25,000 + $5X + $12,500
= $57,500
= 11,500 units
= $95,000
= $95,000 ÷ 11,500 units = $8.26
Copyright © 2007 Pearson Education Canada
254
P8-36 (40-60 min.) Some instructors may prefer to omit some requirements.
1.
NATURAL WATER COMPANY
Income Statement
For the Year Ended December 31, 2006
Sales
Variable expenses:
Direct material
Direct labour
Variable factory overhead
Variable selling:
Sales commissions
Shipping and other
Variable administration
Contribution margin
Fixed expenses:
Factory overhead
Selling
Administrative
Operating income
Totals
(in 000's of dollars)
900
Per Unit
450
90
18
$0.300
0.060
0.012
45*
90
12
50
110
40
705
195
$.60
0.030*
0.060
0.008
0.47
$0.13
200
-5
*5% of sales dollars.
2.
All of the variable costs apparently increase in relation to physical volume except
that sales commissions are related to dollar sales. Dollar sales are expected to
increase by $100,000, apparently consisting of a unit increase of 10% ($90,000
÷ $900,000) and a price increase of 1.01% ($10,000 ÷ $990,000). In addition,
fixed selling expenses are expected to increase by $28,000 or 25%.
Copyright © 2007 Pearson Education Canada
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3.
NATURAL WATER COMPANY
Budgeted Income Statements
For the Year Ended December 31, 2007
(in 000's of dollars)
Sales
Variable expenses:
Direct material @ $0.30 unit
Direct labour @ $0.06
Variable factory overhead @ $0.012
Variable selling:
Sales commissions @ 5% of sales
Shipping and other @ $0.06
Variable administrative @ $0.008
Total variable expenses
Contribution margin
Fixed expenses:
Factory overhead
Selling
Administrative
Total fixed expenses
Operating income
3(a)
3(b)
3(c)
$1,026.0a
$850.500b
$1,023.0c
540.0
108.0
21.6
405.000
81.000
16.200
495.0
99.0
19.8
51.3
108.0
14.4
843.3
182.7
42.525
81.000
10.800
636.525
213.975
102.3d
99.0
13.2
828.3
194.7
50.0
110.0
40.0
200.0
$ - 17.3
50.000
110.000
40.000
200.000
$13.975
50.0
110.0
40.0
200.0
$ - 5.3
a 1,800,000 units x $0.57
b 1,350,000 units x $0.63
c 1,650,000 units x $0.62
d Sales commissions of 10% x $1,023,000
4.
Proofs of answers to Requirements 4, 5, and 6 are at the end of this solution.
Selling price
Variable costs, excluding sales commissions
Sales commissions, 0.05 x $0.66
Contribution margin per unit
Units to be sold
Total contribution margin, 1,875,000 x $0.187
Fixed expenses, $200,000 + $130,000
Operating income
Copyright © 2007 Pearson Education Canada
$0.660
$0.440
0.033
0.473
$0.187
1,875,000
$ 350,625
330,000
$ 20,625
256
5.
The needed contribution must be high enough to make up for the loss of last year
and provide sufficient margin for this year. Therefore, the contribution needed on
the incremental business must be $15,000 if an overall target operating income
of $10,000 is to be obtained. The variable costs would be $0.47 - $0.09 = $0.38
per unit. Add the contribution margin needed per unit, $15,000 ÷ 300,000 =
$0.05; the selling price would be $0.43 per unit. A more elabourate explanation
follows:
300,000 Units
Per Unit
Total
$ ?
$ ?
Sales
Variable costs:
Per requirement (1),
$0.47 less commissions
($0.03) and shipping ($0.06) 0.38
Contribution margin
$0.05
Fixed expenses
Operating income
114,000
15,000
0
$ 15,000
From Part (1)
Regular
Business
$900,000
705,000
195,000
200,000
$ - 5,000
Grand
Total
$ ?
819,000
210,000
200,000
$ 10,000
Selling price = ($15,000 + $114,000) ÷ 300,000 = $0.43 or $0.38 + $0.05 = $0.43
Then, sales on incremental order
= $129,000 and a grand total sales
= $1,029,000.
An alternative approach is the equation technique:
Let X
Sales
$900,000 + 300,000X
300,000X
300,000X
X
6.
Let X
Sales
$0.60X
$0.60X - $0.50X
X
=
=
=
=
=
=
Desired selling price on special order
Variable expenses + Fixed expenses + Operating income
$705,000 + $0.38(300,000) + $200,000 + $10,000
$705,000 + $114,000 + $200,000 + $10,000 - $900,000
$129,000
$0.43
= Number of litres
= Variable expenses + Fixed expenses + Operating income
= ($0.47 + $0.03)X + $200,000 + $10,000
= $210,000
= 2,100,000 litres
Copyright © 2007 Pearson Education Canada
257
Proof of answers 4, 5, and 6:
4.
Sales
Variable expenses
Contribution margin
Fixed expenses
Net income
5.
Sales
300,000 @ $0.43
Variable expenses
300,000 @ $0.38
Contribution margin
Contribution margin on
regular business
Total contribution margin
Fixed expenses
Net income
=
=
Sales
Variable expenses
Contribution margin
Fixed expenses
Net income
= $1,260,000
= 1,050,000
210,000
200,000
$ 10,000
6.
1,875,000 @ $0.66 = $1,237,500
1,875,000 @ $0.473 =
886,875
1,875,000 @ $0.187 =
350,625
330,000
$ 20,625
2,100,000 @ $.60
2,100,000 @ $.50
Copyright © 2007 Pearson Education Canada
$129,000
114,000
15,000
195,000
210,000
200,000
$ 10,000
258
C8-1 (60-90 min) (SMAC)
1) Banyan has idle capacity; therefore, any price which exceeds variable costs will
contribute to fixed costs. On the other hand, fixed overhead costs are substantial and
cannot be ignored. In 2007, only 70% of capacity is expected to be used before
consideration of the four potential contracts. Since the fixed overhead rate was based
on an activity level of 75% of capacity, Banyan’s profits will be lower that the 2006
profits unless additional sales are found to cover the remaining underapplied fixed
overhead costs:
Capacity = 3,750,000 / 75% = 5,000,000 machine hours (MH)
Expected capacity utilization = 70% x 5,000,000 = 3,500,000 MH
Underapplied fixed overhead costs = (3,750,000 - 3,500,000) x $4 x 0.8 = $800,000
(standard overhead rate of $4 times fixed portion of overhead of 80%)
Therefore, Banyan requires additional sales which contribute at least $800,000 to
ensure that the 2007 profits at least match the 2006 profits. When evaluating the four
potential contracts, this target must be weighed against the president’s objective of
increasing sales volume.
Ovlov Motors
Variable costs:
Direct Material
Direct Labour
Variable factory overhead (10 x $4.00 x 0.20)*
Total variable cost per unit
Total variable cost of contract ($38.00 x 50,000)
$25.00
5.00
8.00
$38.00
$1,900,000
* New automation – 80% of factory overhead costs become fixed
The minimum price Banyan should bid is $1,900,000 or $38.00 per unit. If Banyan
wishes to cover the underapplied fixed overhead cost, the minimum bid is as follows:
$1,900,000 + $800,000 = $2,700,000 or $54.00 per unit
Banyan should examine the probability of winning the bid at the $38.00 and $54.00 unit
prices as well as other prices and calculate the expected values of the contract at the
various bid prices.
Before deciding on an appropriate bid price, Banyan must consider whether this is a
“one-time” thing or might this contract lead to repeat business. Banyan must assess the
future benefits of winning the contract and the opportunity costs of losing this contract. If
there is a possibility that this contract will lead to future business, Banyan must weigh
the consequences of setting the bid low to ensure that the contract is won versus setting
Copyright © 2007 Pearson Education Canada
259
an undesirable precedent of very low pricing. It must also consider the potential
reactions of competitors to Banyan’s actions in this matter.
Other considerations are as follows:
•
Does Banyan have any special knowledge about Ovlov such as whether it is
a good or poor credit risk?
•
How will Banyan’s current customers react to Banyan submitting a low bid
price to Ovlov? Would they expect lower prices in the future?
•
How influential is Ovlov in the industry and what is its reputation? Could
winning this contract lead to being invited to bid on contracts with other
firms?
Recommendation:
To increase the chance of winning the contract, Banyan should set the bid price at an
amount lower than the originally proposed $80.00 per unit to a minimum of $38.00 per
unit. A bid of $54.00 per unit, which would cover underapplied fixed overhead costs, is
significantly lower than the proposed bid of $80.00 per unit. Therefore, it should be
possible to set the bid price at $54.00 per unit and still have a high degree of certainty of
winning the contract.
National Auto Parts
Variable costs if the discounted price is accepted:
Direct Material
Direct Labour
Variable factory overhead (10 x $4.00 x 0.20)*
Total variable manufacturing cost per unit
Sales commission (5% x $71.76)
Total variable cost per unit
Total variable cost of contract ($40.59 x 20,000)
$24.00
5.00
8.00
37.00
3.59
$40.59
$811,800
* New automation – 80% of factory overhead costs become fixed
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Full costs if the discounted price is accepted:
Total manufacturing cost
Sales commission
Full cost per unit
$69.00
3.59
$72.59
The proposed discounted price of $71.76 is higher than the variable unit cost, but is
lower than full cost (before considering administration costs). This is an important
customer of Banyan; therefore, Banyan must consider whether future business will be
lost if it does not lower its price as requested. However, if lowering the price as
requested could set a dangerous precendent, all of Banyan’s customers may expect
similar price reductions in the future.
The presence of an offshore competitor which is offering low prices may have serious
implications on Banyan’s future in the industry. Banyan must determine whether this is a
short term loss-leader price or one which will continue in the future. Also, Banyan must
investigate whether this price includes all costs such as shipping, and the quality of the
offshore product in comparison to Banyan’s product must be determined. If the offshore
product proves to be of equal or better quality and the price is an all-inclusive long-term
price which is lower than the market prices from North American producers, Banyan
must consider the possibility of the offshore supplier gaining a substantial share of the
North American market. This would have serious implications on Banyan’s future.
However, if Banyan finds that its product quality is superior to the offshore product and
that the offshore supplier’s price does not include shipping (or other) charges, Banyan
may be able to negotiate a higher price with National Auto Parts, especially considering
their long-term relationship.
Recommendation:
Since National Auto Parts is an important customer of Banyan, a price discount should
be offered. Banyan should negotiate a price which at least covers full costs in the long
run. Since fixed costs represent such a large portion of total costs and the product in
question is a standard model with a set list price, Banyan should not set a precedent of
pricing at less than full cost. Otherwise, Banyan will soon find itself in a position of
closing up or finding alternatives to reduce its costs. Therefore, if a price which covers
full cost cannot be negotiated, Banyan should not accept the contract.
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Pacific Rim Exporter
Variable costs:
Direct material
Direct labour
Variable factory overhead (6 x $4.00 x 0.20)
Total variable manufacturing costs
Sales commission ($325,000 / 100,000)
Total variable cost per unit
Total variable cost of contract ($30.05 x
100,000)
$19.00
3.00
4.80
26.80
3.25
$30.05
$3,005,000
* New automation – 80% of factory overhead costs become fixed
Contribution margin:
Price offered by Pacific Rim Exporter
Total variable cost of contract
Total contribution margin of contract
$6,500,000
3,005,000
$3,495,000
This contract would provide Banyan with a total contribution which would easily cover
the underapplied fixed overhead cost of $800,000 leaving a substantial profit of
$2,695,000. On this basis alone, the contract appears to be very desirable.
However, there are other factors which must be considered. If the president’s
suspicions are realized, there is a danger that these alternators will compete in the
replacement parts market against Banyan’s standard alternators. The opportunity cost
of this possibility must be considered. As well, Banyan must consider whether it is
ethical to produce inferior “counterfeit” products which the president suspects will be
marketed to resemble brand name products. There is also the potential of Banyan’s
reputation being severely tarnished if customers and competitors discover that Banyan
produced the inferior “counterfeit” product.
Recommendation:
Do not accept this contract for any price. The potential loss of goodwill could have a
long-term detrimental effect on Banyan’s future profitability.
British Firm
These alternators have been sitting in inventory for three years. The costs to
manufacture these products should be treated as sunk costs and are therefore
irrelevant in evaluating the offer. Only future costs such as marketing and carrying costs
are relevant to the decision. Banyan should consider whether there are any alternative
uses for these alternators which would generate revenue greater than the British firm’s
offer. Banyan should also consider whether it will incur any additional costs by accepting
the offer.
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Recommendation:
Assuming that any additional costs incurred in accepting this offer do not exceed
$200,000 and that there are no other alternatives for disposing of or using these
alternators which would produce a higher revenue, Banyan should accept the British
firm’s offer.
2)
There would be no change in the recommendations regarding the Pacific Rim
Exporter’s offer and the British firm’s offer.
Regarding the other two potential contracts, we must first consider whether they
can both be handled by Banyan. The Ovlov contract requires 500,000 machine
hours (50,000 units x 10 MHR) and the National Auto Parts contract requires
200,000 machine hours (20,000 machine hours x 10 MHR). Therefore, Banyan
cannot handle both.
Banyan must consider the total contribution which they can expect from each of
the two options. The National Auto Parts contract would yield a total contribution
of $623,400 ($1,435,200 bid less variable costs of $811,800) at the offered price.
If a better price cannot be negotiated with National Auto Parts, Banyan must look
at the probability of winning the Ovlov contract at prices no less than $50.47 per
unit (i.e. variable cost of $38.00 x 50,000 plus $623,400 = $2,523,400;
$2,523,400 divided by 50,000 units = $50.47). Banyan should focus its efforts on
winning the Ovlov contract.
3)
Banyan utilizes an automated manufacturing system which results in a high
proportion of its manufacturing costs being fixed. Therefore, its pricing strategy
must consider full cost rather than only the variable cost. However, product cost
analysis should segregate fixed and variable costs. This would facilitate better
decision analysis.
Banyan should make better use of probability techniques in bidding. Also,
competitor’s prices should be considered in product pricing decisions.
Salesmen should not be rewarded based on a percentage of gross sales. It
would be better to base their rewards on a percentage of contribution margin or
gross profit. This way salesmen will consider costs as well as revenues in
soliciting orders.
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Banyan’s standards regarding cost allocation and target markup should be
reviewed. Cost allocation based on the previous year’s expected activity may not
be appropriate. Also, it appears that new foreign competition is entering the
market; therefore, the current markup targets may be too high and the use of
markups on costs for pricing purposes may become dysfunctional.
C8-2 (45-60 min) (Braithwaite)
Immediate Issue
Should LBP provide its customers with the increased rebates?
Basic Issues
What is the impact of a rebate decision on the contribution margin of a firm?
What are the factors that should be considered in a pricing / rebate decision?
Teaching Objectives
1.
2.
3.
To illustrate the concept of the contribution margin.
To give the student practice in the process of identifying the critical
factors in a pricing / rebate decision.
To give the student practice in cost / volume / profit (CVP) analysis and
sensitivity analysis.
Possible Assignment Questions
1.
3.
4.
Calculate the contribution margin ratio and the impact of the alternative
rebate policies.
Calculate the sales volume required to offset the reduced profits if the
rebate increases were allowed.
Identify the qualitative factors that must be considered in this decision.
Which alternative should LBP management implement?
1.
Contribution Margin Analysis
2.
Rebate/sales
Cost of sales/sales
Variable exp./sales
1998
5.9%
68.9%
16.1%
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1999
9.2%
67.0%
16.8%
2000
11.6%
63.0%
17.1%
2001
13.3%
61.4%
17.8%
264
Since 1998 cost of sales/sales has fallen while variable expenses/sales have
experienced some increases. If we first assume that further changes will be
offset by increased sales volume, then total variable costs are 61.4% + 17.8% =
79.2% say 80%. Expected 2001 sales:
(1)
2,697,106 x 4/3 = 3,596,141 (extrapolating 9 months to 12)
Sales growth
1998 - 1999
12.4%
1999 - 2000
19.8%
2000 - 2001 (exp)
24.6%
(2)
2,886,757 x 1.20 = 3,464,108 (assuming a 20% sales growth).
If we assume 2001 sales of $3,500,000, at a 20% contribution margin,
then contribution will be $700,000 in 2001 compared to $574,465 in 2000.
2,886,757 x [1 - (63.0% + 17.1%)]
= 2,886,757 x 19.9% = 574,465
Without any increases in fixed expenses, profits before taxes would be
expected to rise by about $125,000 ($700,000 - $574,465)
Rebates- 2000
$335,250
Rebates- expected 2001 : 3,500,000 x 0.133
= 465,500
15% rebate increase = $70,000
7.5% rebate increase = $35,000
Thus, profits before taxes would rise by about $55,000 ($125,000 $70,000) if the full 15% rebate increase was given, or $90,000 ($125,000 $35,000) if one-half of the increase was allowed.
2.
Given a 20% contribution margin additional sales of $350,000 would be
required to offset the $70,000 increased rebates or $175,000 for the
$35,000 increased rebates. In other words, sales would need to increase
by 10% to offset a 15% increase in rebates.
3.
Some intangibles that must be considered in this decision are:
• Response of the competition
• Price sensitivity of the customer
• Effort involved on the part of LBP to serve the customer
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265
•
•
•
•
•
Customer location in terms of other customers on delivery route.
Is the customer isolated from others on the delivery route?
Is payment collection from the customer difficult?
Delivery frequency
Does the customer adhere to the ordering guidlines set out by
LBP or does he/she require special attention to ensure the order
is on time each day?
Is there a great deal of physical labour involved in delivery
(stairways, long distance to refigerated storage from delivery
truck, etc.)?
Alternative selected by LBP
LBP management elected to grant rebate increases intermediate to those
requested such that the total rebates paid increased by 7.5%. Management felt
that the level of service they provided was superior to that which could be
provided by the competition, and that an intermediate increase would show
enough good faith on their part that the vast majority of present customers would
stay with LBP. At the time of the decision no organized sales effort was in place
for any of the other enterprises so it was doubtful sales volume could be
increased significantly to offset the rebate increase. LBP decided that costs, and
thus service, must be cut somewhat to offset the rebate increase. Wherever
possible LBP decreased delivery frequency to customers getting rebate
increases (eg. 2 days per week as opposed to 3 days per week). If customers
getting increases had been operating on credit with LBP then they were switched
over to a COD basis, or at the least a 1 week term, to improve cash flow. All
rebate decisions were made individually for each specific customer that was
requesting an increase, due to the variability inherent in each situation. The
factors outlined in Question 3 were considered for each customer and a decision
made based on that particular situation. Customers who were the easiest to
serve were more likely to receive rebate increase.
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C8-3 (90-120 min ) (SMAC)
REPORT ON
SUPERGRIP CORPORATION LIMITED
ACTION PLAN FOR FISCAL 2006/2007
INTRODUCTION
Supergrip Corporation has been losing its market share on high volume economy and
15 cm pliers and its operating results are deteriorating despite the recent automation of
the production process. The main problem areas identified from an analysis of the
2005/2006 operating results were the product selling prices and the mix of sales. The
causes of these problems must be identified and corrected in order to prevent further
declines in market share and income.
IDENTIFICATION AND ANALYSIS OF ISSUES
1.
Cost Allocation Method
As the vice-president of production has indicated, the recent automation of the
production process has resulted in a substantial decrease in direct labour costs,
20% decline per year for the last 5 years. Direct labour now accounts for only
6.5% to 7.5% of the total manufacturing costs. Because direct labour represents
such a small percentage of total costs, it is no longer an appropriate base for
allocating indirect manufacturing costs.
From the initially proposed budget, it can be seen that 90% of $3,275,000 (i.e.
$2,947,500) of the overhead costs are fixed manufacturing costs. This represents
more than half of the total manufacturing costs. While still arbitrary and
potentially misleading, machine hours appears to be a much more reasonable
basis for allocating both fixed and variable overhead costs since most of these
costs are machine related (e.g. amortization).
Using this base, fixed and variable overhead rates can be determined as follows:
Fixed overhead rate =
$2,947,500 / 200,000 machine hours
=
$14.7375 per machine hour
Variable overhead rate
=
=
Copyright © 2007 Pearson Education Canada
$327,500 / 200,000 machine hours
$1.6375 per machine hour
267
The fixed selling and administrative costs are currently allocated to products
based on total budgeted manufacturing costs. Selling and administration costs
have no direct relationship with manufacturing costs. They are much more
closely related to sales; therefore, either sales revenue or sales volume should
be used as the allocation base.
Using sales revenue as the allocation base would result in allocating more costs
to those products with higher prices and less to those with lower prices. This
policy would be difficult to administer if prices are based on full costs since costs
and prices are interdependent.
Using unit sales as an allocation base would result in an equal cost being
charged to each unit of each product. Assuming an equal amount of time is spent
administering each product, this allocation base would be appropriate.
2.
Product Pricing
Superficially, it appears that the standard pricing policy of total cost plus 10% is
not appropriate for SCL as evidenced from last year’s results. A closer
examination of the situation reveals that the problem with the pricing policy was
caused by using inappropriate cost allocation bases as described in the previous
section. The method of allocating costs, particularly fixed costs, has a dramatic
effect on product prices. Three options to correct this situation are as follows: 1)
remove the cost allocation problem by basing prices on variable costs, 2) ignore
all costs by following a market-based pricing policy, or 3) use more appropriate
cost allocation bases in implementing full-cost pricing.
The following factors must be considered in choosing an appropriate pricing
policy:
1.
2.
3.
4.
5.
6.
7.
desired target profit margin of 10%
prices of competitors
other factors relating to competitive advantages such as product
quality, quality of service, credit terms to customers, and brand-name
loyalty
production capacity
cost/volume/profit maximization
market share maximization
motivation of salespeople and effectiveness of marketing effort.
In analyzing the option to base pricing on variable costs, the markups on variable
costs using our standard prices and those of our two main competitors were
calculated to see if any standard markup could be found (see Exhibit 1). This
analysis indicated that there is no consistency in markup rates on variable costs
for each product. Therefore, in order to use this pricing policy, a different
standard markup would have to be set for each product. The main drawback of
this pricing policy is that it does not consider the long-term desire to achieve a
10% target profit margin or at least cover full costs.
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268
The second option of following a market-based pricing policy appears to be
reasonable given the competitive market for pliers. The market would determine
the range of prices and SCL could choose the best prices within the range after
considering competitive advantage and marketing effort factors. For example,
given that SCL’s product and service quality are better than our main
competitors’, we can set prices equal to the highest prices charged by these
competitors. Or, for market share maximization, SCL may set prices equal to the
lowest prices charged by these competitors. Other factors such as production
capacity and cost/volume/profit maximization may be considered in deciding
whether to set prices in the lower side of the range or the higher side of the range
of market prices. The major drawback to this option is that it does not consider
the objective of achieving a target profit margin of 10%.
The third option, use more appropriate cost allocation bases in implementing fullcost pricing, would allow SCL to consider its target profit margin in setting prices.
Using the cost allocation method determined in the previous section, the prices
required to achieve a 10% profit margin can be calculated (see Exhibit 2). Note
that a markup of 10% only creates a profit margin of 9%. The standard prices
should be calculated by dividing total costs by 0.9 or adding a markup of 11.11%
in order to achieve a 10% profit margin.
The following schedule compares the current standard prices with the new ones
calculated in Exhibit 2:
Product
Custom
Economy
15 cm
20 cm
Chain
Total Cost
$11.64
6.34
8.34
21.88
59.92
New Standard
Price
$13.00
7.25
9.50
24.50
66.75
Old Standard
Price
$9.00
7.50
11.25
14.50
35.75
% Price
Change
+ 44%
- 3%
- 16%
+ 69%
+ 87%
It is clear from this schedule that SCL has been overpricing the Economy and 15
cm pliers which explains why sales volume has steadily decreased for these
products. The underpricing of the other three products explains why sales for
these products have exceeded expectations.
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Besides satisfying SCL’s desired profit margin target, these new prices are also
in line with those of our main competitors (see Exhibit 2). Other marketing factors
may be considered in the same manner as the option of following market-based
pricing.
In the long run, SCL should set prices according to full-cost pricing using the
most appropriate cost allocation bases as possible. If this policy results in prices
which are not competitive, SCL should consider dropping the unprofitable
products from its product line.
For the short-term pricing, production capacity and cost/volume/profit analysis
must be conducted (see Exhibit 3). From this analysis, the optimum pricing in the
short-run agrees with the long-term new standard prices.
3.
New Product Proposal
SCL salespeople have proposed adding a set of six wrenches to the product line
at a price of $14.00 per unit. The analysis prepared by the vice-president of sales
inappropriately used the old cost allocation bases and included irrelevant costs.
Exhibit 4 provides an incremental revenue over cost analysis assuming that SCL
has enough excess capacity to produce the required volume to satisfy sales
demand. This analysis reveals that adding this product to the line will result in an
incremental contribution to profits of $251,090 to $400,890 before considering
production capacity.
Production of the wrench set will require between 9,000 and 14,000 machine
hours and we know from Exhibit 3 that there will be no available machine hours
in fiscal 2006/2007. Therefore, either the capacity must be expanded, or
production of one or more products must be cut back or eliminated to free some
machine hours for the production of the wrench set. It is again necessary to
examine product profitability in relation to machine hours (see Exhibit 5).
From Exhibit 5, it is evident that the wrench set is more profitable to SCL than
any of the pliers in the existing product line. Therefore, the wrenches should be
added to the product line. Using the existing capacity, the opportunity cost of
dropping the chain pliers from the product line, and/or cutting back the production
of 20 cm pliers is as follows:
Opportunity cost of producing 36,000 wrench sets:
Lost CM from chain pliers = 3,000 x $51.34
Copyright © 2007 Pearson Education Canada
=
$154,020
270
Opportunity cost of producing 56,000 wrench sets:
Lost CM from chain pliers = 3,000 x $51.34
Lost CM from 20 cm pliers = 5,000 x $17.66
=
=
$154,020
$ 88,300
$242,320
These costs are exceeded by the incremental contributions from producing the
wrench set (i.e., $251,140 for 36,000 wrench sets and up to $400,940 for 56,000
wrench sets). This supports the recommendation to add the wrench set to the
product line.
4.
Option to Lease Casting Machines
Preceding analyses indicated that the current production equipment would not
provide sufficient production capacity to fill demand for SCL’s products next year.
From Exhibit 6, it is seen that the cost of leasing casting machinery as proposed
by the vice-president of manufacturing will be far exceeded by the incremental
contribution which the extra capacity will generate. Therefore, the option to lease
the casting machinery should be accepted.
5.
Production Mix Planning
It can be seen from previous analyses that should the recommendations
regarding cost allocation, pricing, addition of wrench set to product line, and
option to lease casting machinery be accepted, there will not be enough capacity
to fill the expected demand for all of SCL’s products. Therefore, a set production
mix plan is necessary.
As indicated in Exhibit 5, the wrench set yields the highest contribution margin
per machine hour. Consequently, the opportunity cost of not producing enough
wrench sets to fill demand is higher than for any other product and, therefore,
production of 56,000 wrench sets should be planned for fiscal 2006/2007. With
205,000 machine hours available, SCL should set its production mix plan as
follows:
Product
Wrench sets
15 cm pliers
Economy pliers
Custom pliers
20 cm pliers
Chain pliers
Total production
Units to Produce
56,000
480,000
120,000
4,000
39,000
–
699,000
Copyright © 2007 Pearson Education Canada
Machine Hours Required
14,000
120,000
30,000
2,000
39,000
–
205,000
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Should we find that demand for wrench sets is less than expected, more of the
20 cm pliers can be produced. Chain pliers should be eliminated from our
product line unless we find that it is essential to offer a full product line in order to
achieve maximum market share.
6.
Management Reporting System
For internal reporting purposes, it is recommended that the operating budget and
other operating statements be prepared in a contribution margin format. The
current format, as evidenced by the fiscal 2006/2007 budget prepared by my
predecessor, is an absorption costing format. This format can lead to confusion
since it attempts to allocate fixed costs to individual products. While this format is
required for external reporting purposes and is useful for showing the total or full
cost of products, it can be misleading for managerial decision purposes. The
reason for this is that any change in the cost allocation bases (e.g., machine
hours per this report or direct labour costs per the original budget) would result in
an over or under application of the fixed costs which is not useful for planning
and controlling costs. Alternatively, the application rates would have to be
changed each time the allocation base changes which can be cumbersome and
time consuming.
A contribution margin format, segmented by product (for example, see Exhibit 7),
is more useful for managerial decision analysis and performance evaluation. It is
much easier to analyze the effects of any changes to the market or operating
environments using a contribution reporting format. Flexible budgets can easily
be prepared and compared to actual results at various times of the year which is
very useful for cost control and performance evaluation. The format also allows
easily prepared sensitivity analysis for planning purposes.
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272
Other Issues:
7.
Revised Operation Budget
Assuming that all of the recommendations in this report are accepted, the
summarized operating budget for the 2006/2007 fiscal year would be revised as
follows (see Exhibit 7 for supporting detailed calculations and a full segmented
operating budget):
Revenue
Variable costs:
Direct materials
Direct labour
Variable overhead
Sales commissions
Contribution margin
Fixed costs:
Overhead
Selling & administrative
Net income
8.
$7,221,500
$1,815,170
459,130
336,200
412,700
$3,008,990
213,544
3,023,200
4,198,300
3,222,534
$975,766
Sales Commissions
The current sales commissions were negotiated with the salespeople two years
ago. At that time, using the old cost allocation bases, it was felt that 20 cm pliers
and chain pliers were the most profitable, therfore, a higher commission was
assigned to them. From my previous analyses and recommendations, it can be
seen that these two products are the least profitable. It is therefore
recommended that sales commissions be renegotiated such that the salespeople
are motivated to sell more of the products which are most profitable to SCL.
FINAL RECOMMENDATIONS AND CONCLUSIONS
For fiscal 2006/2007, it is recommended that the strategies reflected in the
revised budget in Exhibit 7 be adopted in order to maximize profit. In the longrun, however, SCL will need to carefully monitor the market environment and
make adjustments to its pricing, product line, manufacturing capacity and
marketing effort accordingly. The use of such tools as probability analysis and
capital building will be very useful in preparing a long-term plan.
Copyright © 2007 Pearson Education Canada
273
EXHIBIT 1
Variable Cost-Based Pricing
Markup Analysis
Direct materials
Direct labour
Variable overhead‡
Sales commissions
Total variable costs
Standard price
Standard
contribution margin
Markup on variable
costs
Competitor A's
price
Contribution
margin
Markup on variable
costs
Competitor B's
price
Contribution
margin
Markup on variable
costs
‡ Variable
Custom
$2.13
0.47
0.47
Economy
$1.10
0.50
0.50
15 cm
$2.75
0.65
0.65
20 cm
$3.35
0.75
0.75
Chain
$ 7.34
2.06
2.06
0.55
$3.62
0.35
$2.45
0.55
$4.60
1.10
$5.95
1.10
$12.56
$9.00
$5.38
$7.50
$5.05
$11.25
$6.65
$14.50
$8.55
$35.75
$23.19
145%
144%
185%
149%
206%
$12.25
$6.90
$9.00
$24.50
$67.00
$8.63
$4.45
$4.40
$18.55
$54.44
96%
312%
433%
238%
182%
$13.00
$7.40
$9.50
$23.00
$65.00
$9.38
$4.95
$4.90
$17.05
$52.44
287%
418%
259%
202%
107%
overhead was calculated as 10% of the current standard total overhead.
Copyright © 2007 Pearson Education Canada
274
EXHIBIT 2
Full-Cost Pricing Analysis
Custom
Economy
$ 2.13
0.47
$1.10
0.50
$2.75
0.65
$ 3.35
0.75
$ 7.34
2.06
Variable overhead*
0.82
0.41
0.41
1.64
4.91
Sales commissions
0.55
0.35
0.55
1.10
1.10
Total variable costs
3.97
2.36
4.36
6.84
15.41
Fixed overhead**
7.37
3.68
3.68
14.74
44.21
Fixed selling &
administration†
0.30
0.30
0.30
0.30
0.30
Total cost
New standard price‡
$11.64
$13.00
$6.34
$7.25
$8.34
$9.50
$21.88
$24.50
$59.92
$66.75
Competitor A price
$12.25
$6.90
$9.00
$24.50
$67.00
Competitor B price
$13.00
$7.40
$9.50
$23.00
$65.00
Direct materials
Direct labour
15 cm
*
Variable overhead rate per machine hour of $1.6375
**
Fixed overhead rate per machine hour of $14.7375
†
Budgeted fixed selling and administration costs
Expected sales volume using competitive pricing
‡
=
_______________$195,000_____________
4,000 + 120,000 + 480,000 + 39,000 + 3,000
=
$195,000 / 646,000
=
$0.30 per unit
20 cm
Chain
Calculated as total cost divided by 0.9 or an average markup of 11.11% on total
costs to achieve a 10% profit margin and rounded up to the nearest quarter (i.e.,
$0.25).
Copyright © 2007 Pearson Education Canada
275
EXHIBIT 3
Production Capacity Analysis
Product
Custom Pliers
Economy Pliers
15 cm Pliers
20 cm Pliers
Chain Pliers
Price
Volume
$13.00
7.25
9.50
24.50
66.75
4,000
120,000
480,000
39,000
30,000
Machine
Hours Per
Unit
1/2
1/4
1/4
1
3
Total
Required
Machine
Hours
2,000
30,000
120,000
39,000
9,000
Total required production capacity in
machine hours
200,000
Total available machine hours
200,000
Cost/Volume/Profit Analysis
Using the recommended new standard prices and expected sales volumes, the total
contribution margin is calculated as follows:
New price
Variable cost
Unit contrib.
margin
Sales volume
Total contribution
Custom
$13.00
3.97
$ 9.03
Economy
$7.25
2.36
$4.89
15 cm
$9.50
4.36
$5.14
20 cm
$24.50
6.84
$17.66
Chain
$66.75
15.41
$51.34
4,000
$36,120
120,000
$586,800
480,000
$2,467,200
39,000
$688,740
3,000
$154,020
Total contribution margin = $3,932,880
Copyright © 2007 Pearson Education Canada
276
To see if this is the most profitable combination of prices and volumes, calculate total
contribution using the originally budgeted prices as follows:
Custom
5.38
Economy
$
5.05
15 cm
$
6.65
20 cm
$
8.55
Chain
Unit contrib.
margin
Sales volume
$
$
23.19
20,000
100,000
300,000
70,000
10,000
Total contribution
$ 107,600
$505,000
$1,995,000
$598,500
$231,900
Total
$3,438,000
Comparing the total contributions for each product, it appears that Supergrip can gain
higher profit by setting the price for custom pliers at $9.00 per unit and chain pliers at
$35.75 each. However, this would require an additional (16,000 x 0.5) + (7,000 x 3) =
8,000 + 21,000 = 29,000 machine hours which are not available. To check whether
production of some other product should be cut back to allow extra production of
custom and chain pliers, the contribution margins per machine hours should be
compared:
Economy
15 cm
20 cm
Custom
Custom
Chain
Chain
Price
CM
MH/Unit
CM/Machine
hour
Rank
$7.25
9.50
24.50
9.00
13.00
66.75
35.75
$4.89
5.14
17.66
5.38
9.03
51.34
23.19
0.25
0.25
1
0.5
0.5
3
3
$19.56
20.56
17.66
10.76
18.06
17.11
7.73
2
1
4
6
3
5
7
From the above, it is seen that economy, 15 cm and 20 cm pliers rank higher than the
custom and chain pliers at the $9.00 and $35.75 respective prices.
Therefore, the best pricing policy in the short-term, according to cost/volume/profit
analysis, is to use the recommended new standard prices.
Copyright © 2007 Pearson Education Canada
277
EXHIBIT 4
Incremental Contribution Analysis of Wrench Set Proposal
Direct materials
Direct labour
Variable overhead ($1.6375 x 0.25)
Sales commission
Variable costs per unit
$4.00
1.00
0.41
1.10
$6.51
36,000 units
56,000 units
Total variable costs
Increased advertising costs
$234,360
18,550
$364,560
18,550
Incremental costs
$252,910
$383,110
Incremental revenue
( @ $14.00 )
$504,000
$784,000
Incremental contribution
$251,090
$400,890
EXHIBIT 5
Product Profitability Analysis
Custom
Pliers
Short-term price
Economy
Pliers
15 cm
Pliers
20 cm
Pliers
Chain
Pliers
Wrench
Set
$13.00
$ 7.25
$ 9.50
$24.50
$66.75
$14.00
3.97
2.36
4.36
6.84
15.41
6.51
Contribution
margin per unit
$ 9.03
$ 4.89
$ 5.14
$17.66
$51.34
$ 7.49
Machine hours
per unit
1/2
1/4
1/4
1
3
1/4
$18.06
$19.56
$20.56
$17.66
$17.11
$29.96
4
3
2
5
6
1
Variable cost
Contribution
margin per
machine hour
Profitability
ranking
Copyright © 2007 Pearson Education Canada
278
Available machine hours
Requirement for 56,000 wrench sets @ 0.25 MHR
200,000
14,000
Remaining available machine hours
Requirement for 480,000 15 cm pliers @ 0.25 MHR
186,000
120,000
Remaining available machine hours
Requirement for 120,000 economy pliers @ 0.25 MHR
66,000
30,000
Remaining available machine hours
Requirement for 4,000 custom pliers @ 0.50 MHR
36,000
2,000
Remaining available machine hours
34,000
With the remaining machine hours, 34,000 20 cm pliers should be produced. If only
36,000 wrench sets are produced, 5,000 machine hours are made available and 5,000
extra 20 cm pliers can be produced for a total of 39,000 20 cm pliers.
EXHIBIT 6
Analysis of Option to Lease Casting Machines
The casting machines will provide an additional 5,000 machine hours per year at a cost
of $60,000 per year. Because demand for the wrench sets is uncertain, analysis of this
leasing option will be conducted for two scenarios:
36,000 Wrench Sets
The extra 5,000 machine hours ÷ 3 MHR could be used to produce 1,666 chain
pliers for an additional contribution of $51.34 x 1,666 = $85,532. This produces
an increase in profits of $85,532 - $60,000 = $25,532.
56,000 Wrench Sets
The extra 5,000 machine hours ÷ 3 MHR could be used to produce 5,000 more
20 cm pliers for an additional contribution of $17.66 x 5,000 = $88,300. This
produces an increase in profits of $88,300 - $60,000 = $28,300.
Copyright © 2007 Pearson Education Canada
279
EXHIBIT 7
Supergrip Corporation Limited
Supporting Calculations for the Revised Operating Budget
For the Year Ending May 31, 2007
Custom
Pliers
Variable costs
Economy
Pliers
15 cm Pliers
20 cm Pliers
Wrench Set
$3.97
$2.36
$4.36
$6.84
$6.51
Fixed
overhead†
7.34
3.67
3.67
14.67
3.67
Fixed selling &
administration‡
0.31
0.31
0.31
0.31
0.31
$11.62
$6.34
$8.34
$21.82
$10.49
$13.00
$7.25
$9.50
$24.50
$14.00
4,000
120,000
480,000
39,000
56,000
Total cost
Total
New standard
Budgeted price
Sales volume
†
($2,947,500 + $60,000) ÷ 205,000 = $14.67/machine hour
‡
($195,000 + $18,550) ÷ 699,000 = 0.3055 ≈ 0.31/unit
Copyright © 2007 Pearson Education Canada
699,000
280
Supergrip Corporation Limited
Projected Income Statement
For the Year Ending May 31, 2007
Custom
Pliers
Economy
Pliers
15 cm Pliers
20 cm Pliers
Wrench Set
Total
$52,000
$870,000
$4,560,000
$955,500
$784,000
$7,221,500
Direct
materials
8,520
132,000
1,320,000
130,650
224,000
1,815,170
Direct
labour
1,880
60,000
312,000
29,250
56,000
459,130
Variable
overhead
3,280
49,200
196,800
63,960
22,960
336,200
Sales
commission
2,200
42,000
264,000
42,900
61,600
412,700
Total variable
costs
15,880
283,200
2,092,800
266,760
364,560
3,023,200
Contribution
margin
36,120
586,800
2,467,200
688,740
419,440
4,198,300
Overhead
29,340
440,400
1,761,600
572,130
205,520
3,008,990
Selling &
admin.
1,222
36,660
146,640
11,914
17,108
213,544
Total fixed
costs
30,562
477,060
1,908,240
584,044
222,628
3,222,534
Net income
$ 5,558
$109,740
$ 558,960
$104,696
$196,812
$ 975,766
Profit margin
%
10.7%
12.6%
12.3%
11.0%
25.1%
13.5%
Contribution
margin %
69.5%
67.4%
54.1%
72.1%
53.5%
58.1%
Sales revenue
Variable costs:
Fixed costs:
Copyright © 2007 Pearson Education Canada
281
C8-4 (60-90 min) (CICA)
REPORT TO WOOD BROTHERS
Feasibility of Operations
If Fence Company Ltd. is to succeed in business, then its fencing operations
must be profitable. The snow-removal activities are secondary, so I have not tried
to quantify the revenue that may result from them. Instead, I have assumed that
the revenue from snow removal will cover variable expenses only. Fixed costs,
however, have been computed on the basis of a full year of expenses.
I have used contribution-margin analysis to calculate your break-even point and
have compared that to your capacity to see whether you currently have the
resources you need to cover all of your costs.
The contribution approach separates costs into their fixed and variable
components. Fixed costs are costs that do not change regardless of how much
business the company is doing. Variable costs, on the other hand, change in
direct proportion to changes in levels of activity (how much business the
company is doing). The difference between sales and variable costs is called the
contribution margin. It is the amount available to recover fixed costs. Contribution
margin is a useful tool for planning and tells you how income is affected when
selling prices are changed, when different levels of output are produced, and
when changes in costs are made. To use it, however, assumptions have to be
made regarding different selling prices, levels of output, and so on.
Exhibit I shows my analysis of your contribution margin on the various orders you
receive, i.e., one-house, two-house, and four-house orders. My assumptions are
stated in the exhibit. As you can see, the biggest contribution, $1.66 per linear
metre, is achieved on the two-house orders.
Exhibit II shows my calculation of your fixed costs. Please study my assumptions
in this exhibit to ensure that you agree with them. Based on my assumptions, you
have total fixed costs of approximately $102,000.
Using these figures, we can calculate your break-even point. Break-even is the
point at which the company covers all its expenses, so there is neither any profit
nor any loss. One problem in using break-even analysis is that an assumption
has to be made about the sales mix between the different orders. I have
assumed that the two-house order is most typical of your sales. As the two-house
order contributes the biggest margin, the break-even in metres calculated below
is the least you should sell to achieve a break-even position. If you want me to, I
can re-calculate the break-even metres using different assumptions.
$102,000 = 61,446 linear metres
$1.66
Copyright © 2007 Pearson Education Canada
282
Based on my assumptions, the amount of fencing that must be installed to breakeven is 61,446 linear metres. This is more than your anticipated production of
50,000 linear metres.
Using the information you have given me, I have calculated the maximum
number of metres that you can install. My assumptions, along with calculations,
are shown in Exhibit III. The maximum footage that can be installed in 2007 is
36,000 linear metres. This is less than your anticipated level of 50,000 linear
metres. Incremental / fixed costs to increase capacity to 50,000 linear metres we
estimated to be $19,500 (Exhibit V). Assuming that all sales are two-house jobs
(i.e., the maximum contribution), the contribution to fixed costs will be:
50,000 x $1.66 = $83,000
This will result in a loss of:
Contribution to fixed costs
less fixed costs
Net loss
$83,000
121,500
($38,500)
In conclusion, my analysis show that Fence Company Ltd. will face a severe
shortage of cash in the fall and may even face bankruptcy. Clearly, the operation
is not feasible based upon the proposed pricing policy and the projected costs
and level of output.
Ways to Improve Operations
Fence Company Ltd. can increase the contribution to fixed costs in several ways.
It can increase prices, decrease its variable costs, decrease commissions and/or
volume discounts, or increase its level of output. If fixed costs can be reduced
then the break-even point may also be reduced.
Increase prices
The contribution-margin analysis reveals that Fence Company Ltd. has a serious
pricing problem. FC achieves its greatest contribution margin on sales of twohouse installations. The savings from doing four-house instead of only one
(economies of scale) do not appear to justify a volume discount or higher
commissions. However, the cost figures do not accurately capture the economies
of scale that may be present on volume orders, such as:
•
•
•
More efficient use of labour and less idle time.
Less travel time and gas for transport of wood.
Possible reduced wastage on volume orders.
More accurate cost figures would be useful. We do not know how much of
FC’s business will be single houses vs. bulk orders, etc. Therefore, the previous
analysis (which uses the highest contribution margin of two-house fences) is
Copyright © 2007 Pearson Education Canada
283
suspect at best, unless the pricing and commission structure is altered to give a
uniform contribution margin.
Exhibit IV shows my analysis of the price increase that would be required
to break even at 50,000 linear metres for each of the one-house, two-house, and
four house orders. For the two-house orders the price would have to be $12.38
per metre. This price is only slightly lower than the anticipated price of $13.00.
Whether or not such a price can actually be charged will depend on the market
conditions prevailing in 2007. Market prices would have to be analyzed to
estimate the effect of a price increase on demand.
Decrease commission rate
An alternative to increasing the price is to decrease the commission. Assuming
that one salesperson sells all of the budgeted output of 50,000 linear metres,
then the salesperson will receive gross commission income of:
50,000 x $12 x 0.06 = $36,000
This is a high level of remuneration, given that it represents about six months'
work. The commission rate could be decreased to perhaps 3%, plus a small
bonus based on performance.
The feasability of decreasing the commission rate will depend upon negotiations
with the salesperson and the arrangements made in the previous year. Possibly
one of the Wood brothers could take on the job of selling, to save the entire
commission.
The rates of commission should be linked to the contribution margins obtained on
the sales. An increased commission on volume sales is unnecessary, since the
salesperson will try to sell in bulk wherever possible anyway. The salesperson
should not be allowed to give discounts if commission is based on gross
revenue. (Salespeople will generally give discounts readily rather than lose
sales.) The giving of the discount costs the salesperson only a small amount in
remuneration because his commission is based on gross revenue, but it costs
FC a great deal as a percentage of the contribution margin. By tying the
salesperson's commission to the contribution margin, the problem of harmful
discounting will disappear, while the salesperson will earn the same amount
overall. In short, salespersons will become more aware of profitability.
Copyright © 2007 Pearson Education Canada
284
Increase capacity
Assuming that the prices and commission remain the same as planned, the level
of output can be increased. Exhibit V shows my analysis of the required level of
output and the additional costs that will be incurred to achieve that output. The
increased output will be achievable if:
•
Sufficient sales can be made without reducing price.
•
Work crews can be hired.
•
Quality can be maintained without increased supervision.
•
FC has financial resources to cope with this higher volume of
business.
•
The warehouse capacity is sufficient.
Feasability of FC revised
Exhibit VI provides my analysis of the overall impact of the changes suggested
above. Assuming the selling price is increased to $13.00 per linear metre and
output is projected to be 62,000 metres, FC will make a profit of
$63,880. The Wood brothers will be able to draw a salary of about $93,880, as
$30,000 of remuneration is included in the fixed costs.
I cannot tell how likely it is that FC will be able to achieve an increased output at
the assumed prices, as I have only a limited knowledge of the industry. However,
FC's ability to produce at the increased level, charging a price that will not only
produce a profit but will also be acceptable to customers, will determine the
company's success. Thus the various options discussed above must be
considered in light of the realities of FC's business world.
Copyright © 2007 Pearson Education Canada
285
Inventory Control, Purchasing, Scheduling, and Costing
A systematic way of scheduling jobs must be devised. Customers should be
given firm dates and, wherever possible, transportation of wood and machinery
should be kept to a minimum. Installation of fences should be done on an areaby-area basis to reduce transportation costs and supervision. FC should
purchase in bulk to take advantage of discounts. The company should also try to
avoid having excess wood on hand due to costs of financing this inventory and
storage problems. Trade-offs may have to be made when deciding on inventory
levels, but they cannot be quantified without further information.
The wood allocated to each job should be accounted for by each team and given
to them before the job starts. The team supervisor should complete a form
showing the wood allocated, the wood remaining, the time spent on the job by
employees, the amounts of supplies such as glue, stain, etc. used, and any tools
broken. The teams should be controlled through site inspection and analysis of
the costs.
Costs per metre for various jobs and teams should be reviewed and compared.
Eventually, standard costs can be determined for each order on the basis of the
above information. Once standard costs are known, it will be possible to use this
information in planning future prices and levels of output.
The standards could serve as a benchmark: actual costs incurred on a job can
be compared with the standards to identify any inefficiencies and ways of
controlling them in the future. Standard costs will also be useful for financial
reporting.
Copyright © 2007 Pearson Education Canada
286
EXHIBIT I
Contribution Margin Analysis
Present Situation
1 House
(100 metres)
Selling price†
2 Houses
(200 metres)
4 Houses
(400 metres)
$1,200
$2,400
$4,800
-
-
480
60
144
384
1,140
2,256
3,936
Cost of wood &
incidentals*
770
1,540
3,080
Cost of labour°
132
264
528
Transportation of
machinery
120
120
120
Total variable expenses
1,022
1,924
3,728
Contribution margin
$118
$332
$208
Contribution margin per
metre
$1.18
$1.66
$0.52
Less: Volume discount
Sales commission‡
Net revenue
Note:
It is assumed that two houses will require 200 metres of fencing and other supplies, but this will
not be the case exactly since they will usually have a common boundary. The total linear metres
will depend upon the exact circumstances.
Assumptions in contribution-margin analysis
†
It is assumed that the salesperson will generally discount to $12 per metre since his
commission is based on gross revenue, not on contribution margin.
‡
The sales commission has been based on the gross revenue before volume
discount. The proposed commision scheme is unclear. Basing commission on gross
revenue after volume discount would increase gross revenue and contribution
margin by $38. The contribution margin per metre would be about $0.62.
*
Costs of wood and incidentals have been adjusted for inflation by 10% to reflect
assumed price increases.
°
Cost of labour is computed as follows:
Three men can build 100 metres per eight-hour day; therefore, time per 100 metres
is 3 x 8 = 24 hours.
Average labour rate was $5 per hour last year; therefore, assume $5.50 per hour this
year: ($5.00 + 10% increase).
24 hours x $5.50 = $132 per 100 metres
Copyright © 2007 Pearson Education Canada
287
EXHIBIT II
Fixed Costs for the Year
April 1, 2007 to March 31, 2008
Salary to owners
Warehouse lease
Tools
Truck rental–
April:
May to September:
October to November:
December to March:
Secretary
Machine
Gas and repairs
Telephone
Total fixed costs
$30,000
30,000
3,000†
$
500
7,500
1,000
4,000
13,000
12,000‡
4,800
8,000†
1,200†
$102,000
No provision has been made for insurance, office supplies, advertising, idle time, heat,
light, power and property taxes at the warehouse, interest expense, and miscellaneous.
†
Based on 2006 figures unadjusted
‡
Approximate estimate only
Note:
Fixed costs will probably exceed $102,000 due to inflation and items not included.
Copyright © 2007 Pearson Education Canada
288
EXHIBIT III
Capacity of Operations
Months
# of Teams
Work Days
Max. in metres
April
1
20
2,000
May - September
3
100
30,000
October & November
1
40
4,000
36,000
Assumptions
•
No provision for idle time or inclement weather; optimum projected crew
efficiency is 100 metres per crew-day.
•
Crews do not work overtime and work only a five-day week. If these
assumptions are incorrect, the labour costs must be revised upwards.
•
Same number of crews is assumed as last year; otherwise, the cost of gas
and repairs and of tools and truck rental must be increased. (These costs are
not truly fixed costs.)
EXHIBIT IV
Increase Price
Fixed costs
Capacity
Contribution per metre to break-even
Price increase required
$2.04 – 1.66 =
Current price
Selling price to break even
$102,000
50,000 metres
$2.04
$0.38
$12.00
$12.38
Sensitivity analysis
1 house:
4% discount
$2.78 – 1.18 = 1.67 + 12.00 = $13.67
0.96
4 house:
8% discount
$2.78 – 0.52 = 2.76 + 12.00 = $14.76
0.82
Copyright © 2007 Pearson Education Canada
289
EXHIBIT V
Increase Capacity
Break-even capacity
fixed costs
$102,000
C/M per metre
$1.66
Additional fixed costs (to double capacity)
truck
machine - May–September
gas & maintenance
tools
=
Previous fixed costs
Total fixed costs
Adjusted break-even capacity on 2-house contracts
=
fixed costs
$121,500
C/M per metre
$1.66
61,446 metres
$
7,500
3,000
6,000
3,000
$ 19,500
102,000
$121,500
73,193 metres
This will be attainable with six crews during the period May-September and three crews
in October and November. The fixed costs may vary slightly from those given above,
since this is a circular calculation.
EXHIBIT VI
Feasability of FC-Revised
Sales price is assumed to be $13 per linear metre. Output is projected to be
62,000 metres with six crews, as previously described.
Sales
$806,000
Cost of wood & incidentals
(477,400)
Cost of labour
(81,840)
Cost of transportation of machinery (based on 200
metre jobs)
(37,200)
$209,560
Commission to salesperson (adjusted to 3%)
24,180
Contribution to fixed costs
$185,380
Fixed costs
(121,500)
Profit for the period before income taxes
C8-5 (30-45 min) (CGAC)
Sales (annual) 5,000,000 units (excluding returns)
Current system
5,025,126a
Spoilage cost:
=
25,126
200
x
$17.50
Lost variable costs
Inspection cost $0.10 x 5,025,126
External failure cost
Copyright © 2007 Pearson Education Canada
$63,880
=
=
$
$
439,705
502,513
290
1) Replacement of products
5,000,000
= 10,000 x $17.50
500
2) Lost customers (potential)
5 x 10,000 x ($33.00 – $17.50 – $0.10 – $4.95)
Annual cost of spoilage
(including opportunity cost)
Purchase of new CAD/CAM system
Spoilage cost:
5,014,327b
350
=
=
$
175,000
=
$
522,500
$ 1,639,718
$ 200,000
14,327
x
$17.50
Inspection cost $0.065 x 5,014,327
External failure cost
1) Replacement of products
5,000,000
= 5,556 x $17.50
900
2) Lost customers (potential)
5 x 5,556 x ($33.00 – $17.50 - $0.065 – $4.95)
Therefore, the new system saves in the cost of quality
a
If 200 units produced = 199 good units
x units produced = 5,000,000 units
199x = 200 (5,000,000)
x = 5,025,126
=
$
$
250,722
325,931
$
97,230
$ 291,273
$ 1,165,156
$ 474,562
Therefore 5,025,126 units must be produced to obtain 5,000,000 good units.
b
If 350 units produced = 349 good units
x units produced = 5,000,000 units
349x = 350 (5,000,000)
x = 5,014,327
Therefore 5,014,327 units must be produced to obtain 5,000,000 good units.
C8-6 (30 min.)
Variable overhead allocation rate = EUR6.09 – EUR3.56 = EUR2.53
St. Tropez does not have adequate plant capacity to manufacture the order of 20,000
jewellery cases from Lyon Inc. without subcontracting. The order from Avignon Co.
yields St. Tropez a positive contribution margin.
The calculations showing that St. Tropez does not have the necessary plant capacity in
the third quarter to produce the order for 20,000 jewellery cases are as follows:
Annual plant capacity
90,000 machine hours
Monthly plant capacity
7,500 machine hours
Estimated monthly capacity use 0.8 x 7,500
6,000 machine hours
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Excess capacity per month
1,500 machine hours
Period involved, third quarter
x 3 months
Total excess capacity available
4,500 machine hours
Machine hours required to produce 20,000 jewellery cases on the Lyon special
order:
= Number of cases x machine hours per case
= 20,000 x 0.25 = 5,000 hours.
The Lyon Inc. order for 20,000 jewellery cases would require 5,000 machine hours, but
only 4,500 machine hours are available in the third quarter.
For the Avignon special order case, St. Tropez has excess capacity to produce the
cases:
Excess capacity available 4,500 machine hours.
Machine hours required:
7,500 units to produce x 0.50 machine hours to produce each case =
3,500 machine hours required.
Budgeted fixed overhead is irrelevant to this analysis, as it would have been incurred
regardless of whether the machines were operational or idle.
Additional relevant costs are the additional set-up costs and special device costs.
Contribution margin analysis is as follows:
Units for Avignon special order
7,500
Selling price per unit
EUR12.95
Variable costs per unit:
Raw materials
EUR6.47
Direct labour
4.57
Variable overhead
2.53
Total variable costs per unit
13.57
Contribution margin per unit
EUR(0.62)
The order should not be accepted.
CL8-1 (60 min. or more)
The purpose of this problem is to provide students an opportunity to investigate the
means by which prices are set. By allowing teams an opportunity to share their findings,
students will become aware of the wide range of practices that can be used both within
a company and across companies. In addition, the problem provides students an
opportunity to discuss with a manager a management accounting issue, and thus
develop a better appreciation for the relevance of management accounting to current
business practices.
Copyright © 2007 Pearson Education Canada
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CHAPTER 9
Q9-1 An opportunity cost, which represents a foregone benefit, does not entail a
disbursement of cash at any time, whereas an outlay cost does entail a disbursement
sooner or later.
Q9-2 The $800 represents an opportunity cost. It is the amount forgone by rejecting an
opportunity. It signifies that the value to the owner of keeping those strangers out of the
summer house for that two-week period is at least $800.
Q9-3 Accountants do not ordinarily record opportunity costs in accounting records
because those records are traditionally concerned with real transactions rather than
possible transactions. It is impossible to record data on all lost opportunities.
Q9-4 Basically, incremental costs and differential costs are indistinguishable. They are
synonyms. However, incremental costs are ordinarily linked with increases in the
volume of activity, as distinguished from broader uses of the term.
Q9-5 No. Incremental cost has a broader meaning. It is the addition to total costs by
the adoption of some course of action. Another term, marginal cost, is used by
economists to indicate the addition to costs from the manufacture of one additional unit.
Of course, marginal cost is indeed the incremental cost of one unit.
Q9-6 The decline in costs would be called differential or incremental savings.
Q9-7 Not necessarily. Qualitative factors can favour either making or buying. Often
factors such as product quality and assurance of delivery schedules favour making.
However, sometimes establishing long-term relationships with suppliers is an important
qualitative factor favouring the purchase of components.
Q9-8 The choice in many cases is not really whether to make or buy. Instead, the
choice is how best to use available capacity.
Q9-9 The split-off point is where the individual products produced in a joint process
become separately identifiable. Costs before the split-off point are irrelevant for
decisions about the individual products. They affect the decision about whether to
undertake the entire production process, but they do not influence decisions about what
to do with the individual products.
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Q9-10 Yes. Techniques for assigning joint-product costs to individual products are
useful only for product costing, not for deciding on further processing after the split-off
point. The product must be considered separately at that point apart from its historical
cost. The proper basis of the decision on further processing is a comparison of
incremental revenue versus incremental expense between the alternatives of selling at
the split-off point and processing further.
Q9-11 No. Once inventory has been purchased, the price paid is a sunk cost. It is true
that selling at a price less than $5,000 would produce a reported loss. However, a sale
at any price above $0 is economically beneficial provided that the only alternative is to
scrap the inventory.
Q9-12 No. Sunk costs are irrelevant to the replacement decision.
Q9-13 Past costs are often indispensable for formulating predictions, but past costs by
themselves are not the predictions that are the inputs to decision models. Clear thinking
is enhanced by these distinctions.
Q9-14
a. Book value of old equipment is irrelevant to a replacement decision because it
does not change under any alternative and cannot be realized.
b. Disposal value of old equipment is relevant to a replacement decision because it
can either be realized (by replacement) or forgone (by continued use).
c. Cost of new equipment is relevant to a replacement decision because it can be
incurred (by replacement) or avoided (by continued use).
Q9-15 Some expected future costs may be irrelevant because they will be the same
under all feasible alternatives.
Q9-16 The statement is correct in terms of total variable costs.
Q9-17 Two reasons why units costs should be analyzed with care in decision making
are:
1. Most unit costs are stable only over a certain range of output, and care must be
taken to see that allowances are made when alternatives are considered
outside that range.
2. Some unit costs are an allocation of fixed costs; thus when a higher volume of
output is being considered, unit cost will decrease proportionately, and vice
versa.
Copyright © 2007 Pearson Education Canada
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Two other reasons are mentioned in the text:
3. Some unit costs are based on both relevant and irrelevant factors and should be
broken down further before being considered.
4. Unit costs must be reduced to the same base (denominator) before comparing
or combining them.
Q9-18 Sales personnel sometimes neglect to point out that the unit costs are based on
outputs far in excess of the volume of their prospective customer.
Q9-19 An inconsistency between a decision model and a performance evaluation
model occurs when a decision about whether to replace a piece of equipment is based
on the cash flow effects over the life of the equipment but a manager's performance
evaluation is based on the first year's reported income. The loss on disposal of the
equipment is irrelevant for decision purposes, but it affects the first year income, hence
the performance evaluation.
Q9-20 The wide use of income statements to evaluate performance may overly
influence managers to maximize short-run performance that may hurt long-run
performance.
Copyright © 2007 Pearson Education Canada
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P9-1 (10 min.)
1.
Variable cost
Fixed cost
Total cost
$ 90,000
110,000
$200,000
Cost per unit, $200,000 ÷ 10,000 = $20.
2.
Variable cost
Fixed cost
Total cost
$180,000
110,000
$290,000
Cost per unit, $290,000 ÷ 20,000 = $14.50.
3.
The two unit costs are equally accurate (or, more appropriately, equally
inaccurate). Unit costs that include unitized fixed costs are always suspect. A unit
cost that includes fixed costs will be accurate at only one volume; using it at any
other volume will be misleading.
P9-2 (10 min.)
The $9 million is gone. It is irrelevant for decision purposes. The relevant comparison is:
Sell
Division
Investment required
Income generated
0
$4 million
Hold
Division
0
$500,000 yearly*
*This assumes that the division has truly "turned around" and will now make a net
profit of $500,000 per year for the foreseeable future.
The $4 million is relevant because Lake Superior is forgoing the opportunity to invest it
elsewhere for some return. If projects or divisions of comparable risk can be expected to
generate more than $500,000 yearly, the division should be sold.
Copyright © 2007 Pearson Education Canada
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P9-3
(15-20 min.)
1.
Make
Total
Per Unit
Buy
Total
Per Unit
EUR5 112,000 EUR25.56
Purchase cost
Direct material
EUR2,812,105.35* EUR14.06
Direct labour
971,454.57
4.86
Factory overhead,
variable
562,421.07
2.81
Factory overhead, fixed
avoided
511,291.88
2.56
Total relevant costs
EUR4,857,272.87 EUR24.29 EUR5 112,000 EUR25.56
Difference in favour of making EUR254,727.13 EUR1.27
* EUR2,556,459.41 x 110%
The numerical difference in favour of making the component is EUR254,727.13
or EUR1.27 per unit.
2.
Buy and Leave
Capacity Idle
Buy and Rent
0
0
EUR127,822.97
EUR(4,857,272.87) EUR(5,112,000)
(5,112,000.00)
EUR(4,857,272.87) EUR(5,112,000) EUR(4,984,177.03)
Make
Rent revenue
Component costs
Net relevant costs
The net relevant costs indicate that making the components will still yield the
best results. The net costs of making the components are EUR126,904.16 less
than those of buying the components and renting out the idle capacity
(EUR4,857,272.87 – EUR4,984,177.03).
P9-4
(15-20 min.)
The first tabulation is probably easier to understand, but the choice of a tabulation is a
matter of taste:
Revenues
Expenses
Income effects per year
Copyright © 2007 Pearson Education Canada
(a)
Expand
Laboratory
Testing
$320,000
290,000
$ 30,000
(b)
Expand
Eye
Clinic
$500,000
480,000
$ 20,000
(c)
Rent to
Gift
Shop
$11,000
0
$11,000
297
Treating the gift shop as the foregone (rejected) alternative, the tabulation is:
(a)
Expand
Laboratory Testing
$320,000
Revenue
Expenses:
Outlay costs
Opportunity cost,
rent foregone
Income effects per year
$290,000
11,000
(b)
Expand
Eye Clinic
$500,000
$480,000
301,000
$ 19,000
11,000
491,000
$ 9,000
The numbers favour laboratory testing, which will generate a contribution to hospital
income that is $10,000 greater than the eye clinic’s.
The numbers have been analyzed correctly under both tabulations. Both answer the key
query: What difference does it make? As a general rule, we prefer using the first
tabulation. It is a straightforward presentation.
P9-5 (15 min.) Table is in thousands of dollars.
1,2.
(a)
Sales
Beyond
Split-Off
(b)
Sales
at
Split-Off
(a)-(b)
Incremental
Sales
A
230
56
174
B
330
28
302
C
175
54
121
Increase in overall operating income from further
processing of A, B, and C
(c)
Separable
Costs
Beyond
Split-Off
190
300
100
(a)-(b)-(c)
Incremental
Gain or
(Loss)
(16)
2
21
7
The incremental analysis indicates that Products B and C should be processed further,
but Product A should be sold at split-off. The overall operating income would be
$44,000, as follows:
Sales: $56,000 + $330,000 + $175,000
Joint cost of goods sold
Separable cost of goods sold:
$300,000 + $100,000
Operating income
Copyright © 2007 Pearson Education Canada
$561,000
$117,000
400,000
517,000
$ 44,000
298
Compare this with the present operating income of $28,000. That is, $230,000 +
$330,000 + $175,000 - ($190,000 + $300,000 + $100,000 + $117,000) = $28,000. The
extra $16,000 of operating income comes from eliminating the $16,000 loss resulting
from processing Product A beyond the split-off point.
P9-6
(15 min.)
1.
It is easiest to analyze total costs, not unit costs.
Make
Purchase
Direct materials
$300,000
Avoidable overhead costs:
Indirect labour
30,000
Supplies
20,000
Allocated occupancy cost
0
Purchase cost
$345,000
Total relevant costs
$350,000
$345,000
The difference in favour of purchasing is $350,000 - $345,000 = $5,000.
2.
Because the quantitative difference is small, qualitative factors may dominate the
decision. As described in Chapter 4, companies using a just-in-time system need
assurance of both quality and timeliness of supplies of materials, parts, and
components. A small, local company may not be reliable enough for Sony. In
essence, Sony may be willing to "invest" $5,000, the quantitative advantage of
purchasing, in order to have more control over the supply of the components.
The division manager may have made the right decision for the wrong reason.
He incorrectly ignored avoidable fixed costs, leading to a mistaken belief that
making the components was less costly by $0.45 per unit or $45,000 in total. The
$50,000 of avoidable fixed costs makes the purchase option less costly by
$5,000. If the manager's decision is to make the component, it should be
because forgoing profits of $5,000 has a long-run qualitative benefit of more than
$5,000, not because the bid is greater than the variable cost.
Copyright © 2007 Pearson Education Canada
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P9-7
(15-20 min.)
1.
Cash operating costs
Old equipment, book value:
Periodic write-off as
amortization
or
lump-sum write-off
Disposal value
New equipment, acquisition cost
Total costs
Three Years Together
Keep
Replace
Difference
$42,000
$22,500
$19,500
18,000
—
—
18,000*
-3,000*
15,000**
$52,500
—
$60,000
3,000
-15,000
$ 7,500
* In a formal income statement, these two items would be combined as “loss on
disposal” of $18,000 - $3,000 = $15,000.
** In a formal income statement, written off as straight-line amortization of
$15,000 ÷ 3 = $5,000 for each of three years.
2.
Cash operating costs
Disposal value of old equipment
New equipment, acquisition cost
Total relevant costs
Three Years Together
Keep
Replace
Difference
$42,000
$22,500
$19,500
—
-3,000
3,000
—
15,000
-15,000
$42,000
$34,500
$ 7,500
This tabulation is clearer because it focuses on only those items that affect the
decision.
3.
The prospective benefits of the replacement alternative:
3 x ($14,000 - $7,500) =
Deduct initial net cash outlay required,
$15,000 - $3,000 =
Difference in favour of replacement
$19,500
12,000
$ 7,500
Of course, the new equipment is likely to be faster, thus saving operator time.
The latter is important, but it is not quantified in this problem.
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P9-8
(10 min.)
1.
The replacement alternative would be chosen because the county would have
$7,500 more cash accumulated in three years.
2.
The keep alternative would be chosen because the higher overall costs of
photocopying for the first year would be shown for the replacement alternative
(under accrual accounting):
First Year
Keep
Replace
$14,000
$7,500
6,000
5,000
-15,000
$20,000
$27,500
Cash operating costs
Amortization
Loss on disposal
Total costs
Thus, the performance evaluation model might motivate the manager to make a
decision that would be undesirable in the long run.
P9-9
(10-15 min.)
1.
Independent
Practice
Operating revenues
Operating expenses
Income effects per year
$320,000
220,000
$100,000
Employee
Difference
$90,000
-$90,000
$230,000
220,000
$ 10,000
Choose Independent Practice
Revenues
$320,000
Expenses:
Outlay costs
$220,000
Opportunity cost of employee compensation
90,000
310,000
Income effects per year
$ 10,000
Each tabulation produces the key difference of $10,000. As a general rule, we
favour using the first tabulation. It offers a straightforward presentation of inflows
and outflows under sharply stated alternatives.
2.
Revenue
Expenses:
Outlay costs
Opportunity cost of accounting practice
Income effects per year
Copyright © 2007 Pearson Education Canada
Choice as Employee
$ 90,000
$
0
100,000
100,000
$ (10,000)
301
If the employee alternative is selected, the key difference in favour of becoming
a sole practitioner is again $10,000. Bridgeman is sacrificing $10,000 to avoid
the risks of an independent practice.
P9-10 (10-15 min.)
Alternatives Under Consideration
(1)
Sell, Rent, and
Invest in Bonds
Revenue
Less: Outlay cost
Income effects per year
$16,000
18,000
$ (2,000)
(2)
Hold
Present Home
$
6,000
$ (6,000)
(1) - (2)
Difference
$16,000
12,000
$ 4,000
Advantage of selling home is $(2,000) - $(6,000) = $4,000. Obviously, if rent is much
higher, the advantage may become negative.
The above analysis does not contain explicit opportunity costs. If opportunity costs were
a part of the analysis, the following presentation applies (whereby the interest on
investment in bonds is not listed as a separate alternative but is regarded as a forgone
alternative):
Alternative Chosen:
Hold Present Home
Opportunity cost
Outlay cost
Income effects per year
$ (2,000)
(6,000)
$ 4,000
As before, the advantage of selling the home and renting is $4,000.
P9-11 (20 min.)
1.
The key to this question is what will happen to the fixed overhead costs if
production of the boxes is discontinued. Assume that all $60,000 of fixed costs
will continue. Then, Sunshine State will lose $36,000 by purchasing the boxes
from National Boxes Inc.
Payment to National Boxes Inc, 80,000 x $2.40
Costs saved, variable costs
Additional costs
Copyright © 2007 Pearson Education Canada
$192,000
156,000
$ 36,000
302
2.
Some subjective factors are:
•
•
•
•
3.
Might National Boxes Inc. raise prices if Sunshine State closed down its boxmaking facility?
Will sub-contracting the box production affect the quality of the boxes?
Is a timely supply of boxes assured, even if the number needed changes?
Does Sunshine State sacrifice proprietary information when disclosing the box
specifications to National Boxes Inc.?
In this case the fixed costs are relevant. However, it is not the amortization on the
old equipment that is relevant. It is the cost of the new equipment. Annual cost
savings by not producing the boxes now will be:
Variable costs
Investment avoided (annualized)
Total saved
$156,000
100,000
$256,000
The payment to National Boxes Inc. is $256,000 - $192,000 = $64,000 less than
the savings, so Sunshine State would be $64,000 better off subcontracting the
production of the boxes.
P9-12 (10-15 min.)
The purpose of this problem is to sharpen the student's concept of "opportunity cost."
Daily fees are $140 x 6 hours, or $840.
1.
The difference in annual income is $241,920 - $221,760 = $20,600:
Work, $840 x 6 days x 48 weeks
Don't work on every other Saturday:
$840 x 5 days x 24 weeks
$840 x 6 days x 24 weeks
Totals
2.
(a)
Work
$241,920
$241,920
(b)
Don't Work
$100,800
120,960
$221,760
The calculation in (1) seems awkward and unnecessary. The opportunity cost is
the maximum amount forgone by not working on every other Saturday, which is
$840 x 1 days x 24 weeks, or $20,160. This is really the key number because it
answers the crucial question, "What difference does it make?" Opportunity cost is
defined as the maximum available contribution to profit forgone by using limited
resources for a particular purpose.
Copyright © 2007 Pearson Education Canada
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3.
If she has already decided to take the day off, her opportunity cost is zero
because in any case she would not see patients. Note that opportunity cost is a
"situation-specific" concept. If one of the possible alternatives is not even allowed
into the feasible set by the decision maker, its financial effects are irrelevant. On
the other hand, if she decided to repair her car instead of keeping the
appointments with patients on a working Saturday, her opportunity cost for the
day would be $840; for half a day, $420.
P9-13 (10 min.)
Product M should not have been processed further. The only valid approach is to
concentrate on the separable costs and revenues beyond split-off:
Sell at
Process
Split-off
Further as
as M
Super M Difference
Revenues, 2,500,000 litres @ 30¢ & 38¢
$750,000 $950,000 $200,000
Separable costs beyond split-off
-225,000
225,000
Income effects for April
$750,000 $725,000 $ (25,000)
The joint costs do not differ between alternatives and are irrelevant to the question of
whether to sell or process further. The next table (not required) confirms the results (in
thousands):
Alternative 1
Revenues
Joint costs
Separable costs
Total costs
Income effects
L
M
$1,000 $750
Total
$1,750
$1,600
--$1,600
$ 150
Alternative 2
Super
Differential
L
M
Total
Effects
$1,000 $950 $1,950
$200
$1,600
--225
225
225
$1,825
$225
$ 125
$ (25)
P9-14 (5-10 min.)
1.
The only relevant item is the $250 to be received for the calendars. No additional
costs will be incurred. Therefore, profit will be $250 higher if the offer is accepted
than if it is rejected.
2.
The amount paid for the calendars is irrelevant. Even if $1 million had been paid
for the calendars, the added profit from selling them for $250 is $250. The $900
paid is a past cost, a sunk cost, that will not be affected by the decision.
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P9-15 (15-20 min.)
1.
The difference in total costs over the five years is $2,000 in favour of keeping the
old machine, computed as follows:
Annual cash operating costs
Old machine (book value):
Amortization
or
Lump-sum write-off
Disposal value
New machine: Acquisition cost
Total costs
2.
Keep
$22,500
Five Years Together
Replace
Difference
$10,000
$12,500
5,000
--
5,000
---$27,500
5,000
-2,000
12,500
$25,500
-5,000
2,000
-12,500
$ -2,000
The loss on disposal of the old machine combines the lump-sum write-off (an
irrelevant item) with the disposal value (a relevant item), $5,000 - $2,000 =
$3,000 loss on disposal. Because of the inclusion of an irrelevant item, this
amount does not affect the computation in requirement 1. It is best to keep the
lump-sum write-off and the disposal value separate, as is done in the table in
requirement 1.
P9-16 (15-25 min.)
1.
With Air Canada
Personnel
Revenue for October 20:
$100 x 50
$50 x 50
-$2,500
Without Air Canada
Personnel
$5,000
--
Opportunity cost is a slippery term, so we are reluctant to be overly rigid about its
definition during classroom sessions. The strict definition would be that the
opportunity cost is $5,000--the maximum profit (in this instance, revenue,
because the variable costs of servicing the rooms would be identical) forgone by
rejecting the best forsaken alternative. Nevertheless, some students will insist
that the $5,000- $2,500 = $2,500 difference between the alternatives is the
opportunity cost.
On December 28, the opportunity cost would be 10 x $80 = $800.
Copyright © 2007 Pearson Education Canada
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2.
The simplest approach is:
Let X = % of occupancy
Then $90X = $50
X = $50 ÷ $90 = 55.6%
A longer approach follows. To be indifferent, International would have to
generate the same rent as the Air Canada contract which is $50 x 50 rooms x
365 days = $912,500.
Let Y = Number of rooms per day @ $90
$90(Y)365 = $912,500
$32,850Y = $912,500
Y = 27.78 rooms per day
Percentage of occupancy of the 50 rooms
= 27.78 ÷ 50
= 0.5556
= 55.56%
To check the answer:
$90 x 0.5556(50) x 365 = $912,573 (higher than $912,500 because
of rounding of 27.77 rooms to 27.78)
P9-17 (10-15 min.)
1.
Contribution margin from Air Canada: ($50 - $10)(50)(365) = $730,000
General contribution margin: ($90 - $10)(50)(365)(0.53) = $773,800
International should reject the contract.
Compare the answers to P9-16 and P9-17. Note that the answer to requirement
2 of P9-16 (55.56%) implies that the answer to P9-17 should be to accept the
contract. Why? Because general occupancy (53%) is expected to be less than
the indifference point. However, when variable costs are considered,
International should reject the contract.
2.
Let X = occupancy rate
($90 - $10)(50)(365)(X) = $730,000
$1,460,000X = $730,000
X = 0.50 or 50% occupancy rate
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P9-18 (10-15 min.)
1.
Tim Horton’s should process the beans because it generates more profit than
selling them as-is.
Sell as is:
$2.75 x 1,000 = $2,750
Reprocess: Revenue, $3.70 x 1,000
Reprocessing cost
Shipping cost (1,000 x $0.20)
Total
$3,700
(600)
(200)
$2,900
2.
Sell as is (1,000 x $2.75)
Reprocess (see #1)
Advantage to reprocessing
$2,750
2,900
$ 150
3.
The costs of buying and roasting the original beans are irrelevant because they
are sunk costs.
P9-19 (15-25 min.)
1.
Alternative
Without
With
Contract
Contract
Contribution margin:
(200 rooms x 365 days)($85 - $10)(0.85)
(200 - 40)(365)($85 - $10)(0.95)
(40)(365)($50 - $10)
Total contribution margin
Difference in favour of contract
2.
$4,653,750
$4,161,000
584,000
$4,653,750
$4,745,000
$ 91,250
Let X = contribution margin per room
(40)(365)(X) + $4,161,000 = $4,653,750
14,600X = $492,750
X = $33.75
Add back variable cost: $33.75 + $10.00 = $43.75
Note how this room rate is the "point of indifference." The manager has
$50.00 - $43.75 = $6.25 of leeway to bargain on contract rates.
Copyright © 2007 Pearson Education Canada
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P9-20 (10-20 min.)
The basic message here is that airlines can maintain the same revenue per kilometre
even in the face of switching by some passengers to lower fares.
1.
Revenue, 75 @ $0.12
Revenue
72 @ $0.12
6 @ $0.072*
Total per airplane kilometre
Without
Discount
$9.00
$9.00
With
Discount
$8.64
.43
$9.07
* (60% x $0.12)
Note that a minor (4%) gain in passengers will be beneficial. Note, too, that
airlines have negligible variable costs of adding a few passengers in otherwise
empty seats.
Some instructors may want to use the language of "opportunity costs" here, but
such language is not really necessary and may be confusing. For example, some
observers would say that the three passengers who switch cause an opportunity
cost of 3 x $0.12 or $0.36 that is more than offset by the added revenue of 6 x
$0.072 or $0.43.
2.
Let X = number of passengers who switch
Revenue with discount
= Revenue without discount
50(0.60)($0.12) = X($0.12)
50($0.072) = $0.12(X)
$3.60
= $0.12(X)
X
= $3.60 ÷ $0.12 = 30 passengers
Check:
Revenue, 75 @ $0.12
Revenue:
(75 - 30) @ $0.12
50 @ $0.072
Total per airplane kilometre
Without
Discount
$9.00
$9.00
With
Discount
$5.40
3.60
$9.00
Therefore, if at least 21 of the 50 discount passengers are "new,” that is, they
would not have flown without the discount, there is more revenue with the
discount plan.
Copyright © 2007 Pearson Education Canada
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P9-21 (25-40 min.)
1.
Sets result in a 20% sales increase to 1,500 dresses (1,250 x 1.20 = 1,500)
Total Number of
Complete sets
Dress and scarf
Dress and handbag
Dress only
Total units if accessories
are introduced
Unit sales if accessories
are not introduced
Incremental sales
Incremental contribution
margin per unit
Total incremental
contribution margin
Percent
of Total
70%
6
15
9
Dresses
1,050
90
225
135
Scarves
1,050
90
100%
1,500
1,140
1,275
1,250
250
--1,140
--1,275
EUR40B
EUR20C
EUR650A
Handbags
1,050
Total
225
EUR162,500 EUR45,600
EUR25,500 EUR233,600
A
(1,050 – 400) = EUR650
(140 – 100) = EUR40
C
(50 – 30) = EUR20
B
Additional costs
Additional cutting cost (1,500 x EUR36)
EUR54,000
Additional material cost (250 x EUR300)
75,000
Lost remnant sales (1,250 x EUR25)
31,250
Incremental cutting for extra dresses (250 x EUR100)
25,000
Incremental profit
2.
185,250
EUR48,350
Nonquantitative factors that could influence management in its decision to
manufacture matching scarves and handbags include:
•
•
•
•
•
accuracy of forecasted increase in dress sales.
accuracy of forecasted product mix.
company image from dress manufacturer only to a more extensive supplier
of women's apparel.
competition from other manufacturers of women's apparel.
whether there is adequate capacity (labour, facilities, storage, etc.).
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P9-22 (10-20 min.)
The point of requirement 2 is to emphasize that the essence of make or buy is how to
best utilize facilities.
1.
Direct material
Direct labour
Variable factory overhead
Fixed factory overhead that can
be avoided by not making
Total relevant costs
Difference
2.
Make
Total
Per Unit
$400,000
$8
300,000
6
150,000
3
100,000
$950,000
$100,000
2
$19
$ 2
Buy
Total
Per Unit
$1,050,000
$21
Buy and
Buy and Leave
Buy
Use Facilities
Facilities Idle and Rent
for Oil Filters
- $
- $
65,000 $
-
Make
Rent revenue
$
Contribution from other
products
Obtaining of parts
(950,000)
Net relevant costs
$(950,000)
(1,050,000)
$(1,050,000)
(1,050,000)
$ (985,000)
200,000
(1,050,000)
$ (850,000)
The analysis indicates that buying the parts and using the vacated facilities for
the production of other products is the alternative that should yield the best
results in this instance. The advantage over making the parts is $950,000 $850,000 = $100,000.
P9-23 (15-30 min.)
1.
Sales: 10,000 units x 12 months x $12
Less expenses:
Direct materials
$ 4.10
Direct labour
.60
Overhead ($0.70 + $0.80)
1.50
Selling ($3.00 + $1.10)
4.10
10,000 x 12 x $10.30
Operating income [or: (10,000 x 12) ($12 - $10.30)]
Copyright © 2007 Pearson Education Canada
$1,440,000
1,236,000
$ 204,000
310
2.
Sales
(10,000 units x 12 months x 120%) x $11 = 144,000 x $11
Less variable expenses:
($4.10 + $0.60 + $0.70 + $3.00)(144,000)
Contribution margin
Less fixed expenses: ($0.80 + $1.10)(120,000)
Operating income
$1,584,000
1,209,600
$ 374,400
228,000
$ 146,400
(A common student error is to use 144,000 units at old fixed costs per unit.)
3.
Fixed cost to obtain order: $6,000 ÷ 5,000
Direct materials
Direct labour
Variable overhead
Variable selling expenses: 60% of $3.00
Minimum price for special order
$1.20
4.10
0.60
0.70
1.80
$8.40
4.
The variable selling expenses only
$3.00
P9-24 (15-20 min.)
1.
The salesman’s analysis is faulty because it includes amortization on the old
equipment, which is irrelevant. Moreover, both the total and unit costs are based
on an annual volume of 40,000 units, which may not necessarily be accurate.
2.
New
Machine
Units
20,000
Variable costs
$ 80,000
Straight-line amortization
60,000
Total cost
$140,000
Unit cost
$7.00
Let X = Number of units
$60,000 + $4X = $6X
2x = 60,000 units
X = 30,000 units
3.
Copyright © 2007 Pearson Education Canada
Old
Machine
20,000
$120,000
—
$120,000
$6.00
311
P9-25 (30-40 min.)
Problem 9-26 is an extension of this problem. The two problems make a good
combination.
1.
Operating inflows for each year, old machine:
$910,000 – ($810,000 + $60,000)
Operating inflows for each year, new machine:
$910,000 – ($810,000 + $25,000*)
*$60,000 - $35,000
$40,000
$75,000
Cash flow statements (in thousands of dollars):
Keep
Receipts, inflows from operations
Disbursements:
Purchase of “old” equipment
Purchase of “new” equipment:
Total costs less proceeds
from disposal of “old”
equipment
($99,000 - $16,000)
Net cash inflow (outflow)
(A)
(B)
Year
1
40(A)
Buy
Three
Three
Years
Years
Year Years
Years
2 & 3 Cumulative 1 2 & 3 Cumulative
40
120
75(B) 75
225
(87)*
—
(87)
(87)
—
(87)
—
(47)
—
40
—
33
(83)
(95)
—
75
(83)
55
= $910,000 – 810,000 – 60,000 = $40,000
= $910,000 – 810,000 – 60,000 + 35,000 = 75,000
* Assumes that the outlay of $87,000 took place on January 2, 2006, or sometime
during 2006. Some students will ignore this item, assuming correctly that it is irrelevant
to the decision. However, note that a statement for the entire year was requested.
The difference for three years taken together is $22,000 ($55,000 - $33,000). Note
particularly that the $87,000 book value can be omitted from the comparison. Merely
cross out the entire line; although the column totals will be affected, the net difference
will still be $22,000.
Copyright © 2007 Pearson Education Canada
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2.
Income statements (in thousands of dollars):
Keep
Sales
Expenses:
Other expenses
Operating of machine
Amortization
Total expenses
Loss on disposal:
Proceeds (“revenue”)
Book value (“expense”)
Loss
Total charges
Net income
Years
1, 2 & 3
910
Buy
Three
Three
Years
Year Years Years
Cumulative
1 2 & 3 Cumulative
2,730
910 910
2,730
810
60
29
899
2,430
180
87*
2,697
810
25
33
868
810
25
33
868
2,430
75
99
2,604
—
—
—
899
11
—
—
—
2,697
33
(16)
87
71
939
(29)
—
—
—
868
42
(16)
87*
71
2,675
55
* As in part (1), the $87,000 book value can be omitted from the comparison without
changing the $22,000 difference. This would mean dropping the amortization item of
$29,000 per year (a cumulative effect of $87,000) under the “keep” alternative, and
dropping the book value item of $87,000 in the loss on disposal computation under the
“buy” alternative.
Difference for three years together, $55,000 - $33,000 = $22,000.
Note the motivational factors here. A manager may be reluctant to replace
simply because the large loss on disposal will severely harm the profit
performance in Year 1.
3.
The net difference for the three years taken together would be unaffected
because the item is a past cost. Any number may be substituted for the original
$87,000 figure without changing this answer.
For example, examine how the results would change in part (1) by inserting
$1 million where the $87,000 now appears (in thousands of dollars):
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Receipts
Disbursements:
Purchase of old equipment
Purchase of new equipment:
Gross price
Disposal proceeds of “old”
Net cash outflow
Keep:
Buy:
Three Years Three Years
Cumulative Cumulative Difference
120
225
105
99
(16)
(1,000)
(1,000)
—
(880)
(83)
(858)
0
(83)
22
In sum, this may be a horrible situation. The manager really blundered. But
keeping the old equipment will compound the blunder to the cumulative tune of
$22,000 over the next three years.
4.
Diplomatically, Lee should try to convey the following. All of us tend to indulge
in the erroneous idea that we can soothe the wounded pride of a bad purchase
decision by using the item instead of replacing it. The fallacy is believing that a
current or future action can influence the long-run impact of a past outlay. All
past costs are down the drain. Nothing can change what has already
happened.
The $87,000 has been spent. Subsequent accounting for the item is irrelevant.
The schedules in parts (1) and (2) clearly show that we may completely ignore
the $87,000 original outlay and still have a correct analysis. The important point
is that the $87,000 is not an element of difference between alternatives and,
therefore, may be safely ignored. The only relevant items are those expected
future items that will differ between alternatives.
5.
The $87,000 purchase of the original equipment, the sales, and the other
expenses are irrelevant because they are common to both alternatives. The
relevant items are the following (in thousands of dollars):
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Operating of machine (3 x $60; 3 x $25)
Incremental cost of new machine:
Total cost
Less proceeds of old machine
Incremental cost
Total relevant costs
Three Years Together
Keep
Buy
$180
$ 75
$99
(16)
—
$180
Difference in favour of buying
83
$158
$ 22
P9-26 (10 min.)
This problem extends problem 9-25. It should not be assigned without also assigning
9-25.
1.
The “replace” alternative would be chosen because it enhances cumulative
wealth.
2.
The division would show lower income for the first year under the “replace”
alternative. The manager who wants to show better short-run performance will
oppose replacement.
3.
The answers to the first two parts probably would be unaffected. The point is that
decision models and performance evaluation models may conflict in not-for-profit
organizations too. Moreover, the money in the budget appropriation may have
been spent. In addition, there is a higher likelihood of unfavourable publicity and
also a danger of cuts in subsequent budget appropriations.
P9-27 (15-30 min.)
1.
Cost Comparison–Replacement of Equipment
Relevant Items Only
Cash operating costs
Disposal value of old equipment
Amortization—new equipment
Total relevant costs
Three Years Together
Keep
Replace
Difference
$30,000
$18,000
$12,000
-3,000
3,000
12,000
-12,000
$30,000
$27,000
$ 3,000
The advantage of replacement is $3,000 for the three years together.
Copyright © 2007 Pearson Education Canada
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2.
Cost Comparison–Replacement of Equipment
Including Relevant and Irrelevant Items
Cash operating costs
Old equipment (book value):
Periodic write-off as amortization
or
Lump-sum write-off
Disposal value
New equipment, acquisition cost
Total costs
Three Years Together
Keep
Replace
Difference
$30,000
$18,000
$12,000
9,000
—
—
$39,000
—
9,000*
-3,000*
12,000**
$36,000
3,000
-12,000
$ 3,000
* In a formal income statement, these two items would be combined as “loss on
disposal” of $9,000 - $3,000 = $6,000.
** In a formal income statement, written off as straight-line amortization of $12,000 ÷ 3 =
$4,000 for each of the three years.
3.
Cash operating costs
Amortization
Loss on disposal ($9,000 - $3,000)
Total charges against revenue
Keep
$10,000
3,000
—
$13,000
Replace
$6,000
4,000
6,000
$16,000
Assuming the manager is evaluated on the basis of the division’s profitability, the
performance evaluation model for the first year indicates a difference in favour of
keeping: $16,000 - $13,000 = $3,000. As indicated earlier in this solution, such a
decision would result in $3,000 less income over the next three years together.
However, many managers would adhere to the short-run view and not replace
the equipment.
P9-28 (15 min.)
Marketing management misjudged the life of the old freight cars. This may raise
questions about the accuracy of the estimated useful life of the new freight cars.
However, the unexpired costs of the old freight cars are not relevant to this decision.
The conceptual error being made by the operating manager is the failure to distinguish
between two decisions: the original decision and the current decision. Instead, he is
mixing the two so that neither is evaluated correctly.
Copyright © 2007 Pearson Education Canada
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The current decision should be influenced solely by expected future outlays, including
the capital investment, and revenues. The book value of the old equipment is per se
irrelevant. The current decision should not carry the burden of past blunders.
The past decision should be audited. In this instance, hindsight reveals that marketing
management was overly optimistic. The key question is whether unwarranted optimism
is being used again to justify additional outlays.
Some instructors may wish to point out how decisions such as these might be affected
by the long-term relationships with a big customer at this and other locations. Many
decisions have such interdependencies.
P9-29 (35-50 min.)
Requirement 2 of this problem usually gives trouble to students; because Requirement
2 takes considerable class time for a clear explanation, you may prefer to assign
Requirement 1 only.
1.
There are several ways to approach this problem. Probably the easiest is to
concentrate on the difference in the total contribution margin. The total fixed
costs of $780,000, before considering the increase in advertising, will be
unaffected and may be ignored. Production and sales will decline by 10%, from
60,000 to 54,000 units:
Sales at $90 and $98, respectively
Variable costs at $70*
Contribution margin
*$35 + $12 + $8 + $15
60,000
Units
$5,400,000
4,200,000
$1,200,000
54,000
Units
$5,292,000
3,780,000
$1,512,000
Difference
$312,000
Advertising may be increased by $312,000 without affecting the current
operating income level of $420,000 (contribution margin of $1,200,000 minus
fixed expenses of $780,000).
2.
If the total fixed costs do not change, the company will need a total contribution
margin of $1,200,000 from the two products together. How many units of the
new product can be sold? The clue to the production capacity of the plant is in
how fixed factory overhead was unitized: $300,000 ÷ $6 per unit = 50,000 units
of expected sales.
Copyright © 2007 Pearson Education Canada
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New product budget @ 50,000 units:
Sales at $40
Variable costs at $30*
Contribution margin, new product
$2,000,000
1,500,000
$ 500,000
*Direct material
Direct labour
Variable factory overhead
Variable selling expense, 10% x $40
Total variable costs per unit
$6
12
8
4
$30
Therefore, the needed contribution margin on the old product is $1,200,000 $500,000, or $700,000.
Sales, 60,000 units at $90
Contribution margin needed
Total variable costs that can be sustained
Variable selling costs at $9*
Maximum that may be paid to the supplier
$5,400,000
700,000
$4,700,000
540,000
$4,160,000
*$15 less 40% = $9 or 60% ($15 x 60,000) = $540,000
Maximum unit purchase price, $4,160,000 ÷ 60,000 = $69.33.
If students do not accept the above analysis, the following proof may be helpful
(in thousands):
Old
Sales
Variable costs
Contribution margin
Fixed manufacturing costs
Fixed selling costs
Total fixed costs
Operating income
$5,400
4,200
$1,200
300
480
$ 780
$ 420
New
Product 1
Product 2
$5,400
4,700*
$ 700
380**
$ 380
$ 320
$2,000
1,500
$ 500
300
100**
$ 400
$ 100
Difference
$2,000
2,000
$
$
$
-
*An alternate approach to this whole solution is to use the above format and solve
toward the unknown purchases figure. The $4,700,000 is the maximum allowable
variable cost. Because $540,000 of the $4,700,000 represents selling expense, the
remainder, $4,160,000 must be the maximum that may be paid to the supplier.
Copyright © 2007 Pearson Education Canada
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**This allocation uses the $2.00 unit cost figure for the new product and assigns the
remaining fixed costs to the old product. Note, however, that how the total fixed
selling costs are allocated is irrelevant because total fixed costs are unaffected by
allocation methods or by how such costs are assigned to products.
P9-30 (15 min.)
1.
2.
Sales ($400 + $600 + $100)
Joint costs:
Raw materials
Processing
Total joint costs
Profit
$1,100
$700
100
Sales ($860 + $850 + $175)
Costs:
Joint costs ($700 + $100)
$800
Frozen dinner costs ($350 + $120) 470
Salisbury steak costs
200
Tanning costs
80
Total costs
Profit
800
$300
$1,885
1,550
$ 335
Although it is more profitable to process all three products further than it is to sell
them all at the split-off point, it is important to look at the economic benefit from
further processing of each individual product.
3.
Steaks to frozen dinners:
Additional revenue from processing further ($860 - $400)
Additional cost for processing further
Increase (decrease) in profit from processing further
$460
470
$ (10)
Hamburger to Salisbury steaks:
Additional revenue from processing further ($850 - $600)
Additional cost for processing further
Increase (decrease) in profit from processing further
$250
200
$ 50
Untanned hides to tanned hides:
Additional revenue from processing further ($175 - $100)
Additional cost for processing further
Increase (decrease) in profit from processing further
Copyright © 2007 Pearson Education Canada
$75
80
$ (5)
319
Only the hamburger should be processed further, because it is the only product
whose additional revenue for processing further exceeds the additional cost.
4.
The resulting profit would be $350:
Sales ($400 + $850 + $100)
Costs:
Joint costs
Further processing of hamburger
Total cost
Profit
$1,350
$800
200
1,000
$ 350
P9-31 (15-20 min.)
The purpose of this problem is to identify the relevant and irrelevant costs for a
particular decision. Relevant costs include:
Additional advertising revenue (1.7 x $40,000 x 15)
$1,020,000
Additional script cost [(15 x $24,000) - (10 x $20,000)]
(160,000)
Savings from availability of star for special
40,000
Salary for star of “Mr. Right”
(120,000)
Value of available set ($80,000 - $50,000)
30,000
Additional per-show set expenses [($20,000 - $10,000) x 15]
(150,000)
Severance pay
(8,000)
Additional start-up cost ($150,000 - $60,000)
(90,000)
Additional production crew costs [($80,000 - $50,000) x 15]
(450,000)
Additional corporate overhead [($80,000-$50,000) x 15 x 10%]
(45,000)
Total monetary advantage from switching shows
$ 67,000
The costs that are irrelevant because either they are sunk (i.e., cannot be changed) or
because they do not differ between alternatives are:
•
•
•
•
•
•
•
•
Development expenses for both programs
Script costs for “Law and Order” that have already been paid
Salary for the star of “Law and Order,” except for the savings that result from
having him available for the springtime special
Original investment in the set; the opportunity cost (the $30,000 value in its
next best alternative use) is relevant
Salaries for production crew members who will be profitably used elsewhere
The $60,000 of the $150,000 set-up costs that would be incurred next year
Allocations of corporate overhead; actual changes in overhead caused by
the switch are relevant
Costs paid in the process of decision making
Copyright © 2007 Pearson Education Canada
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Because there is a $67,000 monetary advantage to changing from “Law and Order” to
“Desperately Seeking Mr. Right,” the switch should be made unless there are subjective
factors favouring not switching that are worth at least $67,000.
P9-32 (20 min.)
NOTE: The numbers in this case are a slight modification of those given in an article in
the New York Times, November 21, 1994.
1.
Attendance
Revenue
Expenses
Net profit (loss)
On Broadway
400
$176,000
206,000
$ (30,000)
Off Broadway
400
$128,000
82,000
$ 46,000
Attendance
Revenue
Expenses
Net profit
On Broadway
750
$330,000
206,000
$124,000
Off Broadway
375
$120,000
82,000
$ 38,000
2.
3.
a.
b.
$206,000 ÷ $55 = 3,745.45 weekly attendance, rounded to 3746
3,746 ÷ 8 = 468.25 per show attendance, rounded to 469
$82,000 ÷ $40 = 2,050 weekly attendance
2,050 ÷ 8 = 256.25 per show attendance, rounded to 257
4.
Attendance
Revenue
Expenses
Net profit
On Broadway
600
$264,000
206,000
$ 58,000
Off Broadway
400
$128,000
82,000
$ 46,000
Total profit for a 26-week run:
On Broadway: ($58,000 x 26) - $1,295,000 = $213,000
Off Broadway: ($46,000 x 26) - $ 440,000 = $756,000
5.
Total profit for a 100-week run:
On Broadway: ($58,000 x 100) - $1,295,000 = $4,505,000
Off Broadway: ($46,000 x 100) - $ 440,000 = $4,160,000
6.
a.
b.
$1,295,000 ÷ 58,000 = 22.3 weeks
$ 440,000 ÷ 46,000 = 9.6 weeks
Copyright © 2007 Pearson Education Canada
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7.
Let X be the length of run in weeks at which on-Broadway profit equals offBroadway profit:
$58,000 X - $1,295,000 = $46,000 X - 440,000
$12,000 X = $855,000
X = 71.25 weeks
8.
Mr. Simon’s decision depends on both his predictions of attendance on
Broadway versus off Broadway and his attitude toward risk. The on-Broadway
production has more risk because of its bigger up-front investment. If the
attendance figures in requirements 4 and 5 are accurate (400 off Broadway and
600 on Broadway), the off-Broadway alternative is better for any runs less than
71.25 weeks. Because this is a long run and many successful shows have
shorter runs than 50 weeks, it appears that the off-Broadway alternative might
be best. However, if attendance on Broadway can exceed 600 per show,
especially if it approaches the capacity of 1,000 per show, there is much more
money to be made on Broadway.
There is a trend for non-musical plays to be produced off Broadway because of
the large investment required on Broadway. Many plays do not last beyond a
few weeks, and even filling a theatre to capacity would require more than a 5week run just to recoup the initial investment. ($55 x 1,000 x 8 - $206,000 =
$234,000 weekly profit; $1,295,000 ÷ $234,000 = 5.5 weeks to break even.)
There is less risk off Broadway, especially because it takes many fewer theatregoers to reach the break-even point. For example, at capacity operations it
takes 5.5 x 8 x 1,000 = 44,000 attendees to break even on Broadway. Off
Broadway it requires only a little more than half that number:
($40 x 500 x 8) - $82,000 = $78,000 weekly profit
$440,000 ÷ $78,000 = 5.6 weeks to break even
5.6 x 8 x 500 = 22,400 attendees to break even.
P9-33 (15-20 min.)
1.
The opportunity cost of the land is 10% x $150,000,000 = $1,500,000.
2.
Costs saved by closure of the tomato farm:
Variable production costs
$ 550,000
Shipping costs
200,000
Saved fixed costs
300,000
Opportunity cost of land
1,500,000
Total
$2,550,000
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Cost of purchasing tomatoes:
8,000,000 kg x $0.25/kg = $2,000,000
Net savings to Agribiz from closing the tomato farm and buying tomatoes on the
market is $2,550,000 - $2,000,000 = $550,000.
3.
The main ethical issue involves the impact of the plant closure on employees and
the community.
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C9-1
(30-40 min.)
1.
Minnetonka Corporation should make the bindings.
Cost saved by manufacturing the bindings:
Material, 20% x $30
Labour, 10% x $35
Overhead, 10% x $5*
Total
Cost to purchase a pair of bindings
$ 6.00
3.50
0.50
$10.00
$10.50
*Total overhead $15 per pair.
Allocated fixed overhead $10 per pair ($100,000 ÷ 10,000).
Variable overhead $5 per pair.
2.
Minnetonka Corporation would not pay more than $10 each because that is the
cost to make the product internally.
3.
At a volume of 12,500 pairs, Minnetonka should buy the bindings. The cost of
buying 12,500 pairs is $131,250. The cost of making 12,500 pairs is:
12,500 x $10
Added fixed costs
Total
Buying the pairs of bindings will save
$125,000
10,000
$135,000
$ 3,750
Making the bindings saves variable costs of $0.50 per pair. If sales exceed
$10,000 ÷ $0.50 = 20,000 pairs, it is cheaper to make the bindings.
4.
Minnetonka Corporation needs 12,500 pairs. The cost to buy 12,500 pairs is
$131,250. The cost to make 10,000 and buy 2,500 is:
Cost to make 10,000 pairs
Cost to buy 2,500 pairs
Total
$100,000
26,250
$126,250
Therefore, Minnetonka should choose this latter course of action, which saves
$5,000.
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5.
There are many nonquantifiable factors that Minnetonka should consider in
addition to the economic factors calculated above. Among such factors are:
1.
2.
3.
4.
5.
6.
The quality of the purchased bindings as compared to Minnetonkaproduced bindings.
The reliability of delivery to meet production schedules.
The financial stability of the supplier.
Development of an alternate source of supply.
Alternate uses of binding manufacturing capacity.
The long-run character and size of the market.
C9-2
(30-45 min.)
1.
The $10,000 disposal value of the old equipment is irrelevant because it is the
same for either choice. This solution assumes that the direct department fixed
overhead is avoidable. You may want to explicitly discuss this assumption.
Cost Comparison for Make or Buy Decision
At 60,000 Units
Normal Volume
Make
Buy
Outside purchase cost at $1.00
$60,000
Direct material at $0.30
$18,000
-Direct labour and variable overhead at $0.10
6,000
-Amortization ($188,000 - $20,000) ÷ 7
24,000
-Direct departmental fixed overhead* at
$0.10 or $6,000 annually
6,000
-Totals
$54,000**
$60,000
*Past records indicate that $0.05 of the old unit cost was apportioned fixed overhead
that probably will be unaffected regardless of the decision. This assumption could be
challenged. This total of $3,000 ($0.05 x 60,000 units) could be included under both
alternatives, causing the total costs to be $57,000 and $63,000, and the unit costs to
be $0.95 and $1.05, respectively. Note that such an inclusion would have no effect on
the difference between alternatives.
**On a unit basis, which is very dangerous to use unless proper provision is made for
comparability of volume:
Direct material
$0.30
Direct labour and variable overhead
0.10
Amortization, $24,000 ÷ 60,000
0.40
Other fixed overhead*, $6,000 ÷ 60,000
0.10
Total unit cost
$.90
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Note particularly that the machine sales representative was citing a $0.24
amortization rate that was based on 100,000 unit volume. She should have used
a 60,000 unit volume for the Rohr Company.
Also, this analysis assumes that any idle facilities could not be put to alternative
profitable use. The data indicate that manufacturing rather than purchasing is the better
decision--before considering required investment.
2.
At 50,000 Units
Make
Buy
Outside purchase cost at $1.00
$50,000
Direct material at $.30
$15,000
-Direct labour and variable
overhead at $.10
5,000
-Amortization
24,000
-Other direct fixed overhead
6,000
-Totals
$50,000
$50,000
At 70,000 Units
Make
Buy
$70,000
$21,000
-7,000
24,000
6,000
$58,000
---$70,000
At 70,000 units, the decision would not change. At 50,000 units, Rohr would be
indifferent. The general approach to calculating the point of indifference is:
Let X = Point of indifference in units
Total costs of making = Total costs of buying
$0.30X + $0.10X + $24,000 + $6,000 = $1.00X
$0.60X = $30,000
X = 50,000 units
3.
Other factors would include: Dependability of estimates of volume needed, need
for quality control, possible alternative uses of the facilities, relative merits of
other outside suppliers, ability to renew production if price is unsatisfactory, and
the minimum desired rate of return. Factors that are particularly applicable to the
evaluation of the outside supplier include: short-run and long-run outlook for
price changes, quality of goods, stability of employment, labour relations, and
credit standing.
C9-3 (60-90 min) (Braithwaite)
Immediate Issue:
Does Sheraton take Alitalia business and bump full rack rate customers during
the busy season?
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326
What Happened?
The management of the hotel decided to accept the proposal. The major reason
for their decision was their critical need for a steady and certain cash flow to
service the debt and pay the municipal taxes. As it turned out one of their major
competitors, the Hotel Meridien, came along at the last minute with an offer of
$39.00 per room, which Sheraton would not match, so Hotel Meridien got the
Alitalia business.
Quantitative Analysis
Assume Alitalia will only prevent room sales on 115 nights
Additional Room Revenue:
40 rooms x 365 days x $42 =
$613,200
Additional Food & Beverages (F & B) revenue (assuming
crew will spend 1/2 of regular customers)
Food:
Bev:
40 x 365 x $17(1 - 0.36) x 0.5 =
40 x 365 x $13(1 - 0.32) x 0.5 =
79,424
64,532
143,956
$757,156
Additional Costs:
a) Opportunity costs
Lost room revenue by taking Alitalia (assuming 115 sold out nights)
115 days x 40 rooms x $105
$483,000
Lost food contribution
(assuming crew spends 1/2 of regular customers)
115 x 40 x $17(1 - 0.36) x 0.5
25,024
Lost beverage contribution:
115 x 40 x $13(1 - 0.32) x 0.5
20,332
$528,336
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327
(b)
Labour costs on days there are vacancies available: i.e., 250 days
(365 - 115)
Require 1 extra front desk clerk/day
1 clerk x 8 hrs. x 250 days x $9.20/hr. =
$18,400
Require additional housekeeping for 250 days for the 40 Alitalia rooms;
each room takes 1/2 hour to clean
40 x 250 x $8.60 x 1/2 =
(c)
(d)
(e)
(f)
$43,000
Total wage cost
Benefits at 35%
$61,400
$21,490
Total additional labour cost
$82,890
Laundry/Linen
Actual cost of $0.75 per occupied room
250 days x 40 rooms x $0.75 =
$7,500
Utilities
Actual cost of $1.00 per occupied room
250 days x 40 rooms x $1.00 =
$10,000
Amenities
Actual cost of $2.25 per occupied room
250 days x 40 rooms x $2.25 =
$22,500
Crew Allowance interest
Must have $25,000 available every day; receive reinbursement from
Alitalia after 7 days; Float must consist of 7 x $25,000 = $175,000
Assume 12% interest
$175,000 x 12% =
$21,000
Summary I : assuming 50% F & B contribution from crew:
1) Additional revenue
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$757,156
328
2) Additional costs:
Revenue forgone
Labour cost
Amenities/linen/utilities
Interest on crew allowance float
3) Additional revenue > add. costs
$528,336
82,890
40,000
21,000
$672,226
$ 84,930
Decision: Go
Summary 2: assuming no food & beverages from crew.
Less F & B income
$ 84,930
143,956
$ (59,026)
Decision: Go
What other factors should be considered in the decision?
•
How good is the estimate of 115 nights? What is the size of the potential
error? Do we need to do some sensitivity analysis here?
•
What is a reasonable estimate for F & B expenditures by airline crew
members? What information does head office have on the expenditure
patterns of airline crews? If not, is there any information available that would
allow Georges to put some reliable estimates on what he might expect if he
accepted this proposal?
•
Can he expect any additional business from Alitalia flights? If so how much?
Can he expect to get full rack rate on this type of business?
•
Are there any promotional benefits to Sheraton from this contract?
•
Can he increase the Hotel's share of the crew's F & B expenditures? Can he
structure the deal to ensure that he gets a certain percentage of their F & B
business?
•
How important is it to Sheraton to have a steady cash flow throughout the
year vs seasonal peaks and valleys?
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329
Qualitative Analysis
The Alitalia proposal was a great opportunity for the Sheraton Centre. It guaranteed
room occupancy throughout the year, but it was viewed as attractive because it filled
rooms during the low season (October to April). It is important for any hotel to fill their
rooms even at a low rate in order to cover their expenses. The contract, if accepted,
also required the hotel to have clean rooms immediately upon check-in; to distribute the
allowance as instructed; and to control the crew's wake up calls. These services are
standard tasks for the Sheraton Centre; however, due to the off hours of arrival and
departure of this type of clientele the hotel had to spend more time servicing the Alitalia
crew. For instance, when flight schedules were changed it also meant changes in wake
up calls and allowance distributions. During the summer months this can pose an
inconvience to the hotel staff as they perceive these guests to be less valuable than
those who pay the rack rate. On the other hand, was the Sheraton Centre willing to
accept this airline crew who will be treasured during the low season as they will be the
only revenue-generating guests at the hotel?
It must be noted that airline crews spend fewer dollars during their stay at a hotel than
do regular guests (tourists). This occurs because their usual stay is a sleepover for one
night. If they are grounded for several days, then they prefer to explore the city of
Montreal; hence, food and beverage purchases are made outside the hotel.
By accepting the proposal the Sheraton Centre had to provide Alitalia the best service
or else risk the renewal of the contract. If the Sheraton Centre satisfies the Alitalia crew,
they then would have more negotiating power when renewing the contract (i.e., the
room rate can be increased). In the hotel business it is easier to renew existing
contracts than to solicit for new ones. The demands crew members impose on the hotel
staff are not extreme if properly coordinated and understood by the employees. It can
be assumed that the Alitalia crew will not spend as much on food and beverage as a
regular guest, nevertheless the rooms would be filled which is better than nothing when
winter occupancy is between 45% - 55%.
C9-4
(45-60 min) (ICAO)
To:
Maxim Auto Parts (MAP)
From: Management Consultant
Re:
Alternative courses of action for seat division
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330
At your request, I have prepared an analysis of the alternatives available for the seat
division. From our discussion, it appears that the following alternatives are available:
• continue as is
• lease land and building for 5 years and then sell at the end of the fifth year
and subcontract production of seats
Since the penalty to get out of the contract is prohibitively high, only the first two
alternatives were considered. This analysis, as shown in Exhibit 1 attached, shows that
the company's best course of action is to continue as is until the contract expires in five
years.
EXHIBIT 1
Analysis of Alternative Courses of Action
In order to make a choice between continuing as is or leasing the land and
building and subcontracting the seats, the incremental costs and benefits of the
second alternative are considered. Present value of costs/benefits is used for
analysis.
Incremental (cost)/benefit analysis
(removing time value of money)
Rental Income (5 years X $1,000,000/yr)
Sale of Equipment ($500,000 - $100,000)
Incremental (cost)/benefit from operations over term of contract remaining
(Exhibit 2)
Increment (cost)/benefit of leasing building
Copyright © 2007 Pearson Education Canada
$5,000,000
$400,000
(7,150,000)
$(1,750,000)
331
EXHIBIT 2
Incremental (cost)/benefit of leasing land and purchasing seats for remainder of contract
Year (in 000's)
Seats purchased from
supplier 100,000 X $95
1
(9,500)
2
(9,500)
3
(9,500)
4
(9,500)
5
(9,500)
7,680
7,780
7,880
7,980
8,080
150
150
150
150
150
30
35
40
45
50
_______
_______
_______
_______
_______
(1,640)
(1,535)
(1,430)
(1,325)
(1,220)
Variable production costs
saved
variable COGS
(note 1)
factory overhead saved
(75%)
non-transportation
costs saved (note 2)
head office (note 3)
capital investment
charge (note 4)
amortization (note 4)
sales commission
(note 5)
interest (note 6)
Net cash flow
Total cash flow
(cost)/benefit
$(7,150)
Notes:
1.
2.
3.
4.
5.
6.
Assuming that variable costs of goods sold would continue to increase
at about $100,000/year
Assuming transportation costs of $90,000 per year with no increase,
and that non-transportation costs would increase by $5,000/year
Allocated costs, will be incurred in any case, and is then irrelevant to
analysis
Non-cash cost, therefore irrelevant to analysis
Sales commission will be paid in either course of action
Company would be unable to settle bank loan until sale at end of 5 years,
therefore interest will still be incurred.
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C9-5 (60-90 min) (ICAO)
MEMO
to:
Controller
from: Assistant Controller
RE:
ETL OFFER
Please find attached my analysis as to whether the company should make or buy the
P12 engine for its vacuum cleaner models and whether the P12 engine should be used
in models 3 and 4A.
In order to compare the alternatives, the production cost of our P12 engine needs to be
divided into variable and fixed costs as shown in Schedule I. Amortization and divisional
overhead expenses are excluded, as there is no opportunity cost of using the machines
and overhead would be incurred regardless of the decision to make or buy the engines.
Schedule II identifies the four options available and indicates the volume of P12 engines
required for each alternative.
The fixed and variable costs are used in my contribution margin analysis in
Schedule III.
These analyses approach the decision from a quantitative aspect only, and based on
these results, I recommend that the models be converted to the P12 engine. The
engines should continue to be manufactured internally.
Qualitative aspects should also be considered for both the manufacturing and
purchasing side of the decision.
Arguments favouring manufacturing include:
1.
Manufacturing gives PVL more control over its production process (i.e., delivery
time and modifications) and would make it easier to deal with problems at its own
facilities than to deal with a vendor.
2.
A foreign manufacturer may not meet our quality standards. Since our reputation
is based on quality, it is important that we ensure quality standards.
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333
3.
Ceasing to manufacture the P12 would inevitably affect the number of employees
PVL has.
4.
The contract is only for five years and there is no guarantee that price won't be
increased considerably after five years.
5.
If ETL proves to be unreliable, it could be disastrous. Vacuums cannot be built
without engines. If ETL did not supply the engines on time, there would be a
major loss of revenue.
6.
It is difficult to enforce a contract signed with a foreign manufacturer. If ETL
backs out of the contract at a later date, PVL may not be able to enforce it.
7.
Since contract amounts are payable in Korean Won, there is an exposure to
foreign currency exchange risk. Hedging could be considered to reduce this risk.
8.
Imports are subject to duty and freight charges. These costs are not guaranteed
under contract. If these costs increase, the numeric analysis would be affected
and may no longer be valid.
Arguments favouring purchasing include:
1.
Purchasing is generally cheaper at the lower volume levels, even with the
penalty, due to the high fixed costs of manufacturing. Purchasing would reduce
PVL's exposure to losses if sales dropped.
2.
It is likely that foreign manufacturers will be able to produce cheaper components
in the long term due to lower labour costs, fewer environmental restrictions, etc.
As a result, purchasing components is consistent with long-term cost reduction
strategies.
3.
We need to assess whether PVL has the capacity to go to 10,000 units, as some
equipment is already operating at a 70% utilization rate.
Based on the above, I recommend that the contract with ETL not be entered into, as the
negatives outweigh the positives.
Schedule III demonstrates that conversion of models 3 and 4a to the P12 engine and
inhouse production is the best option for PVL (option 4 in the schedule). This option
provides the highest contribution margin to the company.
The following qualitative factors should also be considered.
1.
Use of P12 in other models would reduce the number of components that PVL
uses. This would result in reduced purchasing costs.
2.
If the P12 engine was used in more models, it would make repairs easier for
repair technicians to deal with one engine than multiple engines. Also, PVL's
dealers would have less parts to stock in inventory.
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334
3.
If PVL uses the P12 in four of its models, it would only need to worry about
having one engine in inventory for production purposes. This would result in less
stockouts and production delays.
4.
Use of the P12, in other words, would reduce the number of engines PVL has.
This may make production of non-standard models more difficult, since other
engines may not be in stock.
Therefore, I recommend that we convert to the P12 in models 3 and 4a.
Copyright © 2007 Pearson Education Canada
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Schedule I
Pandagan Vacuums Limited
Variable and Fixed Costs for P12 Engine
Variable
Materials
Labour
Inspection - $ 40,000 ÷ 500 units = $80 per unit
Assembly
Testing
$
1,200.00
80.00
500.00
150.00
Overhead
Repairs and maintenance
Other - ($1,200,000 x 50%) ÷ 4,000
$
200.00
150.00
2,280.00
Fixed costs
Inspection supervisor
Management salaries
Rent (at 50% representing opportunity cost)
Other ($1,200,000 x 50%)
$
80,000
960,000
400,000
600,000
$ 2,040,000
Schedule II
Pandagan Vacuums Limited
Product/Engine Composition Analysis
Product Composition Options:
1)
Status quo – Use P12 engine in models 3a and 4. Continue to use P10 engine in
model 3 and P14 engine in model 4a.
2)
Use P12 in models 3a, 4 and 4a. Continue to use P10 engine in model 3.
3)
Use P12 in models 3, 3a and 4. Continue to use P14 in model 4a.
4)
Use P12 in models 3, 3a, 4 and 4a.
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336
Option 1
Option 2
Option 3
Option 4
4,000
2,000
2,000
1,500
4,000
2,000
2,000
1,200
4,800
2,000
2,000
1,500
4,800
2,000
2,000
1,200
–
2,000
2,000
–
4,000
–
2,000
2,000
1,200
5,200
4,800
2,000
2,000
–
8,800
4,800
2,000
2,000
1,200
10,000
P10
Model 3
4,000
4,000
–
–
P14
1,500
–
1,500
–
Sales:
Model 3
Model 3a
Model 4
Model 4a
Engine Requirements:
P12
Model 3
Model 3a
Model 4
Model 4a
Schedule III
Pandagan Vacuums Limited
Contribution Margin Analysis
Option 1
Option 2
Option 3
$80,000,000
50,000,000
80,000,000
75,000,000
285,000,000
$80,000,000
50,000,000
80,000,000
60,000,000
270,000,000
$96,000,000
50,000,000
80,000,000
75,000,000
301,000,000
$ 96,000,000
50,000,000
80,000,000
60,000,000
286,000,000
Cost excluding engine and divisional overhead:
Model 3
52,000,000
52,000,000
Model 3a
31,200,000
31,200,000
Model 4
46,000,000
46,000,000
44,280,000
Model 4a
55,350,000
173,480,000
184,550,000
62,400,000
31,200,000
46,000,000
55,350,000
194,950,000
62,400,000
31,200,000
46,000,000
44,280,000
183,880,000
Revenue
Model 3
Model 3a
Model 4
Model 4a
Option 4
Engine Costs
Manufacturing:
P12
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Variable ($2,280)
Fixed
9,120,000
2,040,000
11,160,000
11,856,000
2,040,000
13,896,000
20,064,000
2,040,000
22,104,000
22,800,000
2,040,000
24,840,000
10,000,000
500,000
10,500,000
13,000,000
22,000,000
25,000,000
Lower of above
10,500,000
13,000,000
22,000,000
24,840,000
P10 ($3,000)
P14 ($5,000)
12,000,000
7,500,000
30,000,000
12,000,000
25,000,000
7,500,000
29,500,000
24,840,000
214,550,000
198,480,000
224,450,000
208,720,000
$ 70,450,000
$ 71,520,000
$ 76,550,000
$ 77,280,000
Purchasing:
Purchase cost ($2,500)
Penalty
Total cost
Contribution
CL9-1 (60 min. or more)
This exercise provides experience searching the literature of a particular subject as well
as developing a better understanding of outsourcing decisions. Students will research
the literature individually and then share their findings with their group.
Requirements 2 and 3 help develop critical thinking. The articles are not likely to answer
these questions directly, but students will probably be able to infer answers from the
information given.
The short report in requirement 4 will help develop an ability to select the most
important points from the literature and report them in a way that is helpful to others.
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