Strategic Cost Management
CHAPTER 3: ACTIVITY RESOURCE AND USAGE MODEL AND TACTICAL DECISION MAKING
CORNERSTONE 3.1 The HOW and WHY of Structuring a Make-or-Buy Decision
Information:
Talmadge Company produces 100,000 units of Part 34B, used in one of its snow blower engines, each year.
An outside supplier has offered to supply the part for $4.75. The unit cost is:
Direct Materials
Direct Labor
Variable overhead (power)
Fixed overhead
Total Unit Cost
$ 0.50
2.40
0.90
1.05
$ 4.85
Overhead is applied on the basis of machine hours; Part 34B requires 30,000 machine hours per year.
Why?
The make-or-buy situation requires the company to focus on relevant costs and benefits. The problem is
set up with relevant costs and benefits organized under column headings for each alternative. The
difference between the alternatives gives the quantitative advantage or disadvantage for each alternative.
Required:
1.
What are the alternatives for Talmadge Company?
The alternatives are to make the part in house or buy the part externally.
2. Assume that none of the fixed cost is avoidable. List the relevant costs) of internal production and of
external purchase.
The relevant costs of making the part are direct materials, direct labor, and variable factory overhead. The
relevant cost of buying the part is the purchase price.
3. Which alternative is more cost effective and by how much?
Direct Materials
Direct Labor
Variable Overhead
Purchase Price
Totals
Make
$ 50,000
240,000
90,000
0
$ 380,000
Buy
$0
0
0
475,000
$ 475,000
Difference
$ 50,000
240,000
90,000
(475,000)
$ (95,000)
Because the fixed overhead is not relevant, the analysis shows a $95,000 advantage in favor of making the
part in house.
4. What if $60,000 of fixed overhead is supervision for Part 34B that is avoided if the part is purchased?
Which alternative is more cost effective and by how much?
Direct Materials
Direct Labor
Variable Overhead
Supervision
Purchase Price
Totals
Make
$ 50,000
240,000
90,000
60,000
0
$ 440,000
Buy
$0
0
0
0
475,000
$ 475,000
Difference
$ 50,000
240,000
90,000
60,000
(475,000)
$ (35,000)
Now, supervision (part of fixed overhead) is relevant; the analysis shows a $35,000 advantage in favor of
making the part in house.
Strategic Cost Management
CHAPTER 3: ACTIVITY RESOURCE AND USAGE MODEL AND TACTICAL DECISION MAKING
CORNERSTONE 3.2 The HOW and WHY of Structuring a Keep-or-Drop Product Line
Decision
Information:
Dester Company makes three types of GPS Devices. The Basic GPS model is an entry-level automotive GPS
device: it is sold through discounters and Amazon.com. The Runner's GPS is a miniaturized model that allows
the runner to track mileage, steps, and heart rate while running; it is sold through athletic stores and on sports
gear websites. The Chart Plotter is a specialized GPS device for sailors: it can be customized with maps of
the sea floor and specific geographic areas of coast line and deep water. It is sold via the Web on dedicated
GPS sites. Dester Company is considering dropping the Basic GPS line and keeping the Runner's GPS and
Chart Plot-ter. The segmented income statement is presented below.
Sales
Less: Variable Cost
Contribution Margin
Less: Direct Fixed Cost
Advertising
Supervision
Product Margin
Less: Common Fixed Expenses
Operating Income
Basic GPS
$ 450,000
(324,000)
$ 126,000
Runners GPS
$ 980,000
(372,000)
$ 608,000
Chart Plotter
$ 1,670,000
(601,600)
$ 1,068,400
Total
$ 3,100,000
(1,297,600)
$ 1,802,400
(85,000)
(60,000)
$ (19,000)
(124,000)
(115,000)
$ 369,000
(130,000)
(135,000)
$ 803,400
(339,000)
(310,000)
$ 1,153,400
(915,000)
$ 238,400
Why?
Companies need to consider whether a segment or product line should remain. This problem requires a
look at the relevant costs and benefits of dropping the segment.
Required:
1. List the alternatives being considered.
The two alternatives are to keep the Basic GPS line or to drop it.
2. List the relevant benefits and costs for each alternative.
The relevant benefits and casts of keeping the Basic GPS line include sales of $450,000, variable costs of
$324,000, advertising cost of $85.000, and supervision cost of $60,000. All common fixed costs are
irrelevant. None of the relevant benefits and costs of keeping the Basic GPS line would occur under the drop
alterative.
3. Which alternative is more cost effective and by how much?
Sales
Less: Variable Cost
Contribution Margin
Less: Direct Fixed Cost
Advertising
Supervision
Product Margin
Keep
Drop
$ 450,000
(324,000)
$ 126,000
$0
0
$0
Differential
Amount to Keep
$ 450,000
(324,000)
$ 126,000
(85,000)
(60,000)
$ (19,000)
0
0
$0
(85,000)
(60,000)
$ (19,000)
There is a $19.000 loss if the Basic GPS line is kept.
Strategic Cost Management
CHAPTER 3: ACTIVITY RESOURCE AND USAGE MODEL AND TACTICAL DECISION MAKING
4. What if dropping the Basic GPS line would mean a 10 percent loss of volume for the Runner's GPS
device and a 2 percent loss in volume for the Chart Plotter? Which alterative would he more cost
effective and by how much?
Sales
Less: Variable Cost
Contribution Margin
Less: Direct Fixed Cost
Advertising
Supervision
Product Margin
Less: Common Fixed Expenses
Operating Income
Basic GPS
$0
0
$0
Runners GPS
$ 882,000
(334,800)
$ 547,200
Chart Plotter
$ 1,636,000
(589,568)
$ 1,047,032
Total
$ 2,518,600
(924,368)
$ 1,594,232
0
0
$0
(124,000)
(115,000)
$ 308,200
(130,000)
(135,000)
$ 782, 032
(254,000)
(250,000)
$ 1,090,232
(915,000)
$ 175,232
Difference in income = Income with all three lines - Income with only two lines
= $238,400 - $175,232 = $63,168
Because of the impact that dropping the Basic GPS line has on the sales of the other two lines, the analysis
shows that dropping the line will actually decrease income by $63,168. Therefore, the Basic GPS line should
be kept. However, it would be a good idea to consider ways to make production more efficient.
Strategic Cost Management
CHAPTER 3: ACTIVITY RESOURCE AND USAGE MODEL AND TACTICAL DECISION MAKING
CORNERSTONE 3.3 The HOW and WHY of Structuring a Special-Order Decision
Information:
Polarcreme, Inc., an ice-cream company, is operating at 80 percent of its productive capacity, 10 million onequart units. An ice-cream distributor from a different geographic region has offered to buy 2 million units of
premium ice cream at $1.75 per unit, provided its own label can be attached to the product. Normal selling
price is $2.50 per unit. Cost information for the premium ice cream follows:
Total of 8,000,000 Units
Unit Cost
$ 7,600,000
2,000,000
1,600,000
160,000
240,000
400,000
$ 0.95
0.25
0.20
0.02
0.03
0.05
320,000
480,000
400,000
1,600,000
$14,800,000
0.04
0.06
0.05
0.20
$1.85
Variable Cost:
Direct Materials
Direct Labor
Packaging
Commissions
Distribution
Other variable costs
Non-unit-level costs:
Purchasing ($8 x 40,000 purchase orders)
Receiving ($6 x 80,000 receiving orders)
Setting up ($8,000 x 50 setups)
Fixed costs
Total costs
The special order will not require commissions or distribution (the buyer will pick up the order at Polarcreme's
factory). The order will require 10,000 purchase orders, 20,000 receiving orders, and 13 setups. In addition,
a one-time cost for the special order's label template will be required at $24,500.
Why?
A special order is "special" because the price is lower than normal. Companies need to consider all relevant
costs and benefits when considering a special order.
Required:
1.
List the alternatives being considered.
The two alternatives are to accept or reject the special order.
2. List the relevant benefits and costs for each alternative.
The relevant benefits and costs of accepting the order include revenue, direct materials, direct labor,
packaging, other variable costs, purchasing, receiving, setting up, and the cost of the label template. No fixed
costs will be affected. If the order is rejected, the net benefit is zero.
3. Which alternative is more cost effective and by how much?
Sales
Direct Materials
Direct Labor
Packaging
Other variable costs
Purchasing ($8 x 10,000 purchase orders)
Receiving ($6 x 20,000 receiving orders)
Setting up ($8,000 x 13 setups)
Label Template
Net Benefit
Accept
Reject
$ 3,500,000
(1,900,000)
(500,000)
(400,000)
(100,000)
(80,000)
(120,000)
(104,000)
(24,500)
$ 271,500
$0
0
0
0
0
0
0
0
0
$0
Differential Amount to
Accept
$ 3,500,000
(1,900,000)
(500,000)
(400,000)
(100,000)
(80,000)
(120,000)
(104,000)
(24,500)
$ 271,500
There is a $271,500 increase in operating income if the special order is accepted.
Strategic Cost Management
CHAPTER 3: ACTIVITY RESOURCE AND USAGE MODEL AND TACTICAL DECISION MAKING
4. What if accepting the special order upset a regular customer who was considering expanding into
the new geographical region and decided, then, to take their regular annual order of 2 million units of
premium ice cream to another company? Which alternative would be better?
In this case, the regular order, at $2.50 per unit, would be better than the special order at $1.75 per unit and
the company would be better off rejecting the special order. Even though the special order avoids the
commission and distribution charge, those total only $0.05 per unit, and the company would be better off
making the additional $0.75 in price with the regular customer, not to mention avoiding the $24,500 for the
special label template.
Strategic Cost Management
CHAPTER 3: ACTIVITY RESOURCE AND USAGE MODEL AND TACTICAL DECISION MAKING
CORNERSTONE 3.4 The HOW and WHY of Structuring a Sell at Split-Off or Process
Further Decision
Information:
Delrio Company grows and sells fresh and canned food products. The San Juan farm grows and harvests
tomatoes. Each plot yields 1.500 pounds of tomatoes, referred to as a load of the 1,500 pounds. 1,000 pounds
are Grade A tomatoes and 500 are Grade B. The cost of growing and harvesting the tomatoes is $200 per
load. Delrio can sell the 1,000 pounds of Grade A tomatoes in a load to grocers for $0,40 per pound.
Alternatively, the tomatoes could be processed into hot sauce. Each bottle of hot sauce sells for $1.50 and
requires one pound of tomatoes. The cost of additional processing averages $1 per bottle; this amount
includes the remaining ingredients, bottles, labor, and needed processing activities.
Why?
Because joint costs are incurred prior to the split-off point, they are sunk costs in determining whether to
sell a product at split-off or process it further. Only the sales value at split-off the further processing costs,
and the eventual sales value are relevant to this decision.
Required:
1.
List the alternatives being considered.
The two alternatives are to sell the Grade A tomatoes at split-off or process them further.
2. List the relevant benefits and costs for each alternative.
The relevant benefits and costs of selling at split-off versus processing the tomatoes further include
revenue from sale to grocers and revenue from selling the hot sauce less the additional (further)
processing costs. The $200 per load cost of growing and harvesting the tomatoes is sunk and need not
be considered.
3. Which alternative is more cost effective and by how much?
Sales
Further processing cost
Total
Sell at Split-Off
Process Further
$ 400
0
$ 400
$ 1,500
(1,000)
$ 500
Differential Amount to
Process Further
$ 1,100
(1,000)
$ 100
There is a $100 per load advantage to processing the Grade A tomatoes into hot sauce.
4. What if the best of the Grade A tomatoes, Premium A's, could be sold to grocers for 50.80 per pound?
Of the 1,000 pounds of Grade A tomatoes in a load, about 30 percent are Premium A's. The grocers,
however, will not buy the Premium A's unless they are also sold the regular Grade A tomatoes. (They
will deal with another supplier instead.) It will cost an additional $50 per load to separate the Premium
A's from the regular Grade A's. Which alternative would be better?
In this case, 300 of the Grade A tomatoes (Premium A's) are sold for $0.80 and the remaining 700 pounds
are sold for $0.40. The total revenue at split-off would be $520 (S240 + $280). (You might think that the
original alternative still exists--sell all of the Grade A tomatoes at split-off for $0.40 per pound, While that
alternative does exist. it is so clearly dominated by the new alternative with the higher-priced Premium A's
that it can be safely ignored. The firm will no longer consider it.)
Sales
Further processing cost
Total
Sell at Split-Off
Process Further
$ 520
50
$ 470
$ 1,500
(1,000)
$ 500
Differential Amount to
Process Further
$ 980
(950)
$ 30
There is a $30 per load advantage to processing the Grade A tomatoes into hot sauce.