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Horngren's Cost Accounting: A Managerial Emphasis, 16th
Global Edition Chapter 11 Questions and solutions
Principles of Management Accounting (University of Queensland)
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CHAPTER 11
DECISION MAKING AND RELEVANT INFORMATION
11-1 Outline the five-step sequence in a decision process.
The five steps in the decision process outlined in Exhibit 11-1 of the text are
1.
Identify the problem and uncertainties.
2.
Obtain information.
3.
Make predictions about the future.
4.
Make decisions by choosing among alternatives.
5.
Implement the decision, evaluate performance, and learn.
11-2
Define relevant costs. Why are historical costs irrelevant?
Relevant costs are expected future costs that differ among the alternative courses of action being
considered. Historical costs are irrelevant because they are past costs and, therefore, cannot differ
among alternative future courses of action.
11-3
“All future costs are relevant.” Do you agree? Why?
No. Relevant costs are defined as those expected future costs that differ among alternative
courses of action being considered. Thus, future costs that do not differ among the alternatives
are irrelevant to deciding which alternative to choose.
11-4
Distinguish between quantitative and qualitative factors in decision making.
Quantitative factors are outcomes that are measured in numerical terms. Some quantitative
factors are financial––that is, they can be easily expressed in monetary terms. Direct materials
are an example of a quantitative financial factor. Other quantitative nonfinancial factors, such as
on-time flight arrivals, cannot be easily expressed in monetary terms. Qualitative factors are
outcomes that are difficult to measure accurately in numerical terms. An example is employee
morale.
11-5
Describe two potential problems that should be avoided in relevant-cost analysis.
Two potential problems that should be avoided in relevant cost analysis are
(i) Do not assume all variable costs are relevant and all fixed costs are irrelevant.
(ii) Do not use unit-cost data directly. It can mislead decision makers because
a. it may include irrelevant costs, and
b. comparisons of unit costs computed at different output levels lead to erroneous
conclusions.
11-6
“Variable costs are always relevant, and fixed costs are always irrelevant.” Do you
agree? Why?
No. Some variable costs may not differ among the alternatives under consideration and, hence,
will be irrelevant. Some fixed costs may differ among the alternatives and, hence, will be
relevant.
11-7 “A component part should be purchased whenever the purchase price is less than its total
manufacturing cost per unit.” Do you agree? Why?
11-1
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No. Some of the total manufacturing cost per unit of a product may be fixed and, hence, will not
differ between the make and buy alternatives. These fixed costs are irrelevant to the make-or-buy
decision. The key comparison is between purchase costs and the costs that will be saved if the
company purchases the component parts from outside plus the additional benefits of using the
resources freed up in the next best alternative use (opportunity cost). Furthermore, managers
should consider nonfinancial factors such as quality and timely delivery when making
outsourcing decisions.
11-8
Define opportunity cost.
Opportunity cost is the contribution to income that is forgone (rejected) by not using a limited
resource in its next-best alternative use.
11-9 “Managers should always buy inventory in quantities that result in the lowest purchase
cost per unit.” Do you agree? Why?
No. When deciding on the quantity of inventory to buy, managers must consider both the
purchase cost per unit and the opportunity cost of funds invested in the inventory. For example,
the purchase cost per unit may be low when the quantity of inventory purchased is large, but the
benefit of the lower cost may be more than offset by the high opportunity cost of the funds
invested in acquiring and holding inventory.
11-10 “Management should always maximize sales of the product with the highest contribution
margin per unit.” Do you agree? Why?
No. Managers should aim to get the highest contribution margin per unit of the constraining (that
is, scarce, limiting, or critical) factor. The constraining factor is what restricts or limits the
production or sale of a given product (for example, availability of machine-hours).
11-11 “A branch office or business segment that shows negative operating income should be
shut down.” Do you agree? Explain briefly.
No. For example, if the revenues that will be lost exceed the costs that will be saved, the branch
or business segment should not be shut down. Shutting down will only increase the loss.
Allocated costs and fixed costs that will not be saved are irrelevant to the shut-down decision.
11-12 “Cost written off as depreciation on equipment already purchased is always irrelevant.”
Do you agree? Why?
Cost written off as depreciation is irrelevant when it pertains to a past cost such as equipment
already purchased. But the purchase cost of new equipment to be acquired in the future that will
then be written off as depreciation is often relevant.
11-13 “Managers will always choose the alternative that maximizes operating income or
minimizes costs in the decision model.” Do you agree? Why?
No. Managers often favor the alternative that makes their performance look best so they focus on
the measures used in the performance-evaluation model. If the performance-evaluation model
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does not emphasize maximizing operating income or minimizing costs, managers will most
likely not choose the alternative that maximizes operating income or minimizes costs.
11-14 Describe the three steps in solving a linear programming problem.
The three steps in solving a linear programming problem are
(i) Determine the objective function.
(ii) Specify the constraints.
(iii) Compute the optimal solution.
11-15 How might the optimal solution of a linear programming problem be determined?
The text outlines two methods of determining the optimal solution to an LP problem:
(i) Trial-and-error approach
(ii) Graphic approach
Most LP applications in practice use standard software packages that rely on the simplex method
to compute the optimal solution.
11-16 Qualitative and quantitative factors. Which of the following is not a qualitative factor
that Atlas Manufacturing should consider when deciding whether to buy or make a part used in
manufacturing their product?
a. Quality of the outside producer’s product.
b. Potential loss of trade secrets.
c. Manufacturing deadlines and special orders.
d. Variable cost per unit of the product.
SOLUTION
Choice "d" is correct. Calculating the costs of production of the part versus buying the part from an
outside source is a quantitative factor used by a company to determine the lowest cost alternative.
Choice "a" is incorrect. Whether the outsourced part can be manufactured to the required level of quality
is a qualitative factor that Atlas would consider in their decision. Choice "b" is incorrect. Loss of
confidentiality and trade secrets is a qualitative factor to consider when buying outside of the
organization. Choice "c" is incorrect. An outside supplier may not be able to meet specific deadlines or
have the same priorities as the purchaser and is a qualitative factor that needs to be considered.
11-17 Special order, opportunity cost. Chade Corp. is considering a special order brought to it
by a new client. If Chade determines the variable cost to be $9 per unit, and the contribution
margin of the next best alternative of the facility to be $5 per unit, then if Chade has:
a. Full capacity, the company will be profitable at $4 per unit.
b. Excess capacity, the company will be profitable at $6 per unit.
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c. Full capacity, the selling price must be greater than $5 per unit.
d. Excess capacity, the selling price must be greater than $9 per unit.
SOLUTION
Choice "d" is correct. At excess capacity, Chade will accept the special order as long as the sales price is
greater than the variable cost per unit. At $9 per unit for variable cost, Chade will accept the special order
at a sales price greater than $9 per unit. Choice "a" is incorrect. At full capacity, Chade will accept the
special order as long as the sales price is greater than both the variable cost per unit and the opportunity
cost (contribution margin) of the next best alternative per unit. The company will not be profitable in this
scenario unless the sales price is greater than $14 per unit ($9 variable cost + $5 contribution margin).
Choice "b" is incorrect. At excess capacity, the company must receive a selling price greater than $9 per
unit in order to be profitable. Choice "c" is incorrect. At full capacity, the selling price must be greater
than $14 per unit in order for the special order to be profitable.
11-18 Special order, opportunity cost. In order to determine whether a special order should be
accepted at full capacity, the sales price of the special order must be compared to the per unit:
a. Contribution margin of the special order.
b. Variable cost and contribution margin of the special order.
c. Variable cost and contribution margin of the next best alternative.
d. Variable cost of current production and the contribution margin of the next best alternative.
SOLUTION
Choice "d" is correct. If the selling price is greater than the variable cost per unit of the special order (at
full capacity) plus the contribution margin per unit of the next best alternative (the opportunity cost),
then the company will accept the special order. Choice "a" is incorrect. Variable costs have to be taken
into account, in addition to the contribution margin of the next best alternative. Choice "b" is incorrect.
The contribution margin of the next best alternative (rather than the special order) must be taken into
account in order to determine whether to accept the special order. Choice "c" is incorrect. The variable
costs of the special order (not the next best alternative) must be accounted for in this determination.
11-19 Keep or drop a business segment. Lees Corp. is deciding whether to keep or drop a
small segment of its business. Key information regarding the segment includes:
Contribution margin: 35,000
Avoidable fixed costs: 30,000
Unavoidable fixed costs: 25,000
Given the information above, Lees should:
a. Drop the segment because the contribution margin is less than total fixed costs.
b. Drop the segment because avoidable fixed costs exceed unavoidable fixed costs.
c. Keep the segment because the contribution margin exceeds avoidable fixed costs.
d. Keep the segment because the contribution margin exceeds unavoidable fixed costs.
SOLUTION
Choice "c" is correct. Whether to keep or drop a segment will depend on whether the contribution
margin of the segment in question exceeds avoidable fixed costs (relevant costs that wouldn’t exist if the
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segment did not exist). Unavoidable fixed costs will be incurred regardless of whether or not the
segment is kept, so they are not factored into the decision. Choice "a" is incorrect. Fixed costs need to be
broken out between avoidable and unavoidable in order to make the determination as to whether to keep
or drop a segment. Lees Corp. would only drop the segment if the contribution margin of the segment is
less than the avoidable fixed (relevant) cost. Choice "b" is incorrect. The contribution margin needs to
be compared to avoidable fixed costs in order to determine whether to keep or drop a segment. Choice
"d" is incorrect. Unavoidable fixed costs will be incurred regardless, so contribution margin of the
segment needs to be compared to the avoidable fixed costs as the key elements to determine whether to
keep or drop a segment.
11-20 Relevant costs. Ace Cleaning Service is considering expanding into one or more new
market areas. Which costs are relevant to Ace’s decision on whether to expand?
SOLUTION
Choice "a" is correct. Sunk costs are not relevant since they were incurred in the past and cannot be
recovered as a result of the company’s current decision. Variable costs are relevant as also any avoidable
fixed costs associated with the decision. Opportunity cost is the cost of foregoing the next best
alternative when making a decision. These costs are relevant since the company has alternative courses
of action. Choice "b" is incorrect. Sunk costs are not relevant since they were incurred in the past and
cannot be recovered as a result of the company’s current decision. Choice "c" is incorrect. Opportunity
cost is the cost of foregoing the next best alternative when making a decision. These costs are relevant
since the company has alternative courses of action. Choice "d" is incorrect. Sunk costs are not relevant
since they were incurred in the past and cannot be recovered as a result of the company’s current
decision. Variable costs are relevant as also any avoidable fixed costs associated with the decision.
11-21 Disposal of assets. Answer the following questions.
1. A company has an inventory of 1,250 assorted parts for a line of missiles that has been
discontinued. The inventory cost is $76,000. The parts can be either (a) remachined at total
additional costs of $26,500 and then sold for $33,500 or (b) sold as scrap for $2,500. Which
action is more profitable? Show your calculations.
2. A truck, costing $100,500 and uninsured, is wrecked its first day in use. It can be either (a)
disposed of for $18,000 cash and replaced with a similar truck costing $103,000 or (b) rebuilt
for $88,500 and thus be brand-new as far as operating characteristics and looks are
concerned. Which action is less costly? Show your calculations.
SOLUTION
(20 min.)
Disposal of assets.
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1.
This is an unfortunate situation, yet the $76,000 costs are irrelevant regarding the
decision to remachine or scrap. The only relevant factors are the future revenues and future costs.
By ignoring the accumulated costs and deciding on the basis of expected future costs, operating
income will be maximized (or losses minimized). The difference in favor of remachining is
$4,500:
(a)
(b)
Remachine
Scrap
Future revenues
Deduct future costs
Operating income
$33,500
26,500
$ 7,000
Difference in favor of remachining
$2,500
–
$2,500
$4,500
2.
This, too, is an unfortunate situation. But the $100,500 original cost is irrelevant to this
decision. The difference in relevant costs in favor of replacing is $3,500 as follows:
(a)
Replace
New truck
Deduct current disposal
price of existing truck
Rebuild existing truck
Difference in favor of replacing
(b)
Rebuild
$103,000
–
18,000
–
$ 85,000
–
$88,500
$88,500
$3,500
Note, here, that the current disposal price of $18,000 is relevant, but the original cost (or book
value, if the truck were not brand new) is irrelevant.
11-22 Relevant and irrelevant costs. Answer the following questions.
1. DeCesare Computers makes 5,200 units of a circuit board, CB76, at a cost of $280 each.
Variable cost per unit is $190 and fixed cost per unit is $90. Peach Electronics offers to
supply 5,200 units of CB76 for $260. If DeCesare buys from Peach it will be able to save $10
per unit in fixed costs but continue to incur the remaining $80 per unit. Should DeCesare
accept Peach’s offer? Explain.
2. LN Manufacturing is deciding whether to keep or replace an old machine. It obtains the
following information:
Old Machine
$10,700
10 years
7 years
Original cost
Useful life
Current age
New Machine
$9,000
3 years
0 years
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Remaining useful life
Accumulated depreciation
Book value
Current disposal value (in cash)
Terminal disposal value (3 years from now)
Annual cash operating costs
3 years
$7,490
$3,210
$2,200
$0
$17,500
3 years
Not acquired yet
Not acquired yet
Not acquired yet
$0
$15,500
LN Manufacturing uses straight-line depreciation. Ignore the time value of money and income
taxes. Should LN Manufacturing replace the old machine? Explain.
SOLUTION
(20 min.) Relevant and irrelevant costs.
1.
Relevant costs
Variable costs
Avoidable fixed costs
Purchase price
Unit relevant cost
Make
Buy
$190
10
____
$200
$260
$260
DeCesare Computers should reject Peach’s offer. The $80 of fixed costs is irrelevant because it
will be incurred regardless of this decision. When comparing relevant costs between the choices,
Peach’s offer price is higher than the cost to continue to produce.
2.
Cash operating costs (3 years)
Current disposal value of old machine
Cost of new machine
Total relevant costs
Keep
$52,500
_ _____
$52,500
Replace
$46,500
(2,200)
9,000
$53,300
Difference
$6,000
2,200
(9,000)
$ (800)
LN Manufacturing should keep the old machine. The cost savings are less than the cost to
purchase the new machine.
11-23 Multiple choice. (CPA) Choose the best answer.
1. The Dalton Company manufactures slippers and sells them at $12 a pair. Variable
manufacturing cost is $5.00 a pair, and allocated fixed manufacturing cost is $1.25 a pair. It
has enough idle capacity available to accept a one-time-only special order of 5,000 pairs of
slippers at $6.25 a pair. Dalton will not incur any marketing costs as a result of the special
order. What would the effect on operating income be if the special order could be accepted
without affecting normal sales: (a) $0, (b) $6,250 increase, (c) $28,750 increase, or (d)
$31,250 increase? Show your calculations.
2. The Sacramento Company manufactures Part No. 498 for use in its production line. The
manufacturing cost per unit for 30,000 units of Part No. 498 is as follows:
Direct materials
$5
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Direct manufacturing labor
Variable manufacturing overhead
Fixed manufacturing overhead allocated
Total manufacturing cost per unit
22
8
15
50
The Counter Company has offered to sell 30,000 units of Part No. 498 to Sacramento for $47 per
unit. Sacramento will make the decision to buy the part from Counter if there is an overall
savings of at least $30,000 for Sacramento. If Sacramento accepts Counter’s offer, $8 per unit of
the fixed overhead allocated would be eliminated. Furthermore, Sacramento has determined that
the released facilities could be used to save relevant costs in the manufacture of Part No. 575.
For Sacramento to achieve an overall savings of $30,000, the amount of relevant costs that
would have to be saved by using the released facilities in the manufacture of Part No. 575 would
be which of the following: (a) $90,000, (b) $150,000, (c) $180,000, or (d) $210,000? Show your
calculations. What other factors might Sacramento consider before outsourcing to Counter?
SOLUTION
(15 min.)
1. (b)
Multiple choice.
Special order price per unit
Variable manufacturing cost per unit
Contribution margin per unit
Effect on operating income
$6.25
5.00
$1.25
= $1.25  5,000 units
= $6,250 increase
2. (b) Costs of purchases, 30,000 units  $47
Total relevant costs of making:
Variable manufacturing costs, $5 + $22 + $8
Fixed costs eliminated
Costs saved by not making
Multiply by 30,000 units, so total
costs saved are $43  30,000
Extra costs of purchasing outside
Minimum overall savings for Sacramento
Necessary relevant costs that would have
to be saved in manufacturing Part No. 575
$1,410,000
$35
8
$43
1,290,000
120,000
30,000
$
150,000
Before outsourcing to Counter, Sacramento must consider the consequence of increasing its
dependence on Counter. Sacramento would want to be sure about the quality of Counter’s
product and the reliability of its delivery schedules over a long-run period. Sacramento would
also want Counter to continuously reduce costs. To achieve all these goals, Sacramento may
want to build close partnerships and alliances with Counter.
11-24 Special order, activity-based costing. (CMA, adapted) The Gold Plus Company
manufactures medals for winners of athletic events and other contests. Its manufacturing plant
has the capacity to produce 11,000 medals each month. Current production and sales are 10,000
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medals per month. The company normally charges $150 per medal. Cost information for the
current activity level is as follows:
Variable costs that vary with number of units produced
$ 350,000
Direct materials
375,000
Direct manufacturing labor
100,000
Variable costs (for setups, materials handling, quality control, and so on)
that vary with number of batches, 200 batches * $500 per batch
Fixed manufacturing costs
300,000
Fixed marketing costs
275,000
Total costs
$1,400,000
Gold Plus has just received a special one-time-only order for 1,000 medals at $100 per medal.
Accepting the special order would not affect the company’s regular business. Gold Plus makes
medals for its existing customers in batch sizes of 50 medals (200 batches × 50 medals per batch
= 10,000 medals). The special order requires Gold Plus to make the medals in 25 batches of 40
medals.
Required:
1. Should Gold Plus accept this special order? Show your calculations.
2. Suppose plant capacity were only 10,500 medals instead of 11,000 medals each month. The
special order must either be taken in full or be rejected completely. Should Gold Plus accept
the special order? Show your calculations.
3. As in requirement 1, assume that monthly capacity is 11,000 medals. Gold Plus is concerned
that if it accepts the special order, its existing customers will immediately demand a price
discount of $10 in the month in which the special order is being filled. They would argue that
Gold Plus’s capacity costs are now being spread over more units and that existing customers
should get the benefit of these lower costs. Should Gold Plus accept the special order under
these conditions? Show your calculations.
SOLUTION
(30 min.) Special order, activity-based costing.
1.
Direct materials cost per unit ($350,000  10,000 units) = $35 per unit
Direct manufacturing labor cost per unit ($375,000  10,000 units) = $37.50 per unit
Variable cost per batch = $500 per batch
Gold Plus’ operating income under the alternatives of accepting/rejecting the special
order are:
Revenues
Variable costs:
Direct materials
Direct manufacturing labor
Without OneWith OneTime Only
Time Only
Special Order Special Order
10,000 Units
11,000 Units
$1,500,000
$1,600,000
350,000
375,000
385,0001
412,5002
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Difference
1,000 Units
$100,000
35,000
37,500
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Batch manufacturing costs
Fixed costs:
Fixed manufacturing costs
Fixed marketing costs
Total costs
Operating income
100,000
112,5003
12,500
300,000
275,000
1,400,000
$ 100,000
300,000
275,000
1,485,000
$ 115,000
––
––
85,000
$ 15,000
1
$350,000 + ($35  1,000 units)
$375,000 + ($37.50  1,000 units)
3
$100,000 + ($500  25 batches)
2
Alternatively, we could calculate the incremental revenue and the incremental costs of the
additional 1,000 units as follows:
Incremental revenue $100  1,000
$100,000
Incremental direct manufacturing costs
$35  1,000 units
35,000
Incremental direct manufacturing costs
$37.50  1,000 units
37,500
Incremental batch manufacturing costs
$500  25 batches
12,500
Total incremental costs
85,000
Total incremental operating income from
accepting the special order
$ 15,000
Gold Plus should accept the one-time-only special order if it has no long-term implications
because accepting the order increases Gold Plus’ operating income by $15,000.
If, however, accepting the special order would cause the regular customers to be
dissatisfied or to demand lower prices, then Gold Plus will have to trade off the $15,000 gain
from accepting the special order against the operating income it might lose from regular
customers.
2.
Gold Plus has a capacity of 10,500 medals. Therefore, if it accepts the special one-time
order of 1,000 medals, it can sell only 9,500 medals instead of the 10,000 medals that it currently
sells to existing customers. That is, by accepting the special order, Gold Plus must forgo sales of
500 medals to its regular customers. Alternatively, Gold Plus can reject the special order and
continue to sell 9,500 medals to its regular customers.
Gold Plus’ operating income from selling 9,500 medals to regular customers and 1,000
medals under one-time special order follow:
Revenues (9,500  $150) + (1,000  $100)
$1,525,000
Direct materials (9,500  $35) + (1,000  $35)
367,500
Direct manufacturing labor (9,500  $37.50) + (1,000  $37.50)
393,750
Batch manufacturing costs (1901  $500) + (25  $500)
107,500
Fixed manufacturing costs
300,000
Fixed marketing costs
275,000
Total costs
1,443,750
Operating income
$ 81,250
1
Gold Plus makes regular medals in batch sizes of 50. To produce 9,500 medals requires 190 (9,500 ÷ 50) batches.
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Accepting the special order will result in a decrease in operating income of $18,750
($100,000 – $81,250). The special order should, therefore, be rejected.
A more direct approach would be to focus on the incremental effects––the benefits of
accepting the special order of 1,000 units versus the costs of selling 500 fewer units to regular
customers. Increase in operating income from the 1,000-unit special order equals $15,000
(requirement 1). The loss in operating income from selling 500 fewer units to regular customers
equals:
Lost revenue, $150  500
Savings in direct materials costs, $35  500
Savings in direct manufacturing labor costs, $37.50  500
Savings in batch manufacturing costs, $500  10
Operating income lost
$(75,000)
17,500
18,750
5,000
$(33,750)
Accepting the special order will result in a decrease in operating income of $18,750 ($15,000 –
$33,750). The special order should, therefore, be rejected.
NOTE: Even if operating income had increased by accepting the special order, Gold Plus
should consider the effect on its regular customers of accepting the special order. For example,
would selling 1,000 fewer medals to its regular customers cause these customers to find new
suppliers that might adversely impact Gold Plus’s business in the long run.
3.
Gold Plus should not accept the special order.
Increase in operating income by selling 1,000 units
under the special order (requirement 1)
Operating income lost from existing customers ($10  10,000)
Net effect on operating income of accepting special order
$ 15,000
(100,000)
$ (85,000)
The special order should, therefore, be rejected.
11-25 Make versus buy, activity-based costing. The Svenson Corporation manufactures
cellular modems. It manufactures its own cellular modem circuit boards (CMCB), an important
part of the cellular modem. It reports the following cost information about the costs of making
CMCBs in 2017 and the expected costs in 2018:
Svenson manufactured 8,000 CMCBs in 2017 in 40 batches of 200 each. In 2018, Svenson
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anticipates needing 10,000 CMCBs. The CMCBs would be produced in 80 batches of 125 each.
The Minton Corporation has approached Svenson about supplying CMCBs to Svenson in
2018 at $300 per CMCB on whatever delivery schedule Svenson wants.
Required:
1. Calculate the total expected manufacturing cost per unit of making CMCBs in 2018.
2. Suppose the capacity currently used to make CMCBs will become idle if Svenson purchases
CMCBs from Minton. On the basis of financial considerations alone, should Svenson make
CMCBs or buy them from Minton? Show your calculations.
3. Now suppose that if Svenson purchases CMCBs from Minton, its best alternative use of the
capacity currently used for CMCBs is to make and sell special circuit boards (CB3s) to the
Essex Corporation. Svenson estimates the following incremental revenues and costs from
CB3s:
On the basis of financial considerations alone, should Svenson make CMCBs or buy them
from Minton? Show your calculations.
SOLUTION
(30 min.)
1.
Make versus buy, activity-based costing.
The expected manufacturing cost per unit of CMCBs in 2018 is as follows:
Direct materials, $170  10,000
Direct manufacturing labor, $45  10,000
Variable batch manufacturing costs, $1,500  80
Fixed manufacturing costs
Avoidable fixed manufacturing costs
Unavoidable fixed manufacturing costs
Total manufacturing costs
Total
Manufacturing
Costs of CMCB
(1)
$1,700,000
450,000
120,000
Manufacturing
Cost per Unit
(2) = (1) ÷ 10,000
$170
45
12
320,000
800,000
$3,390,000
32
80
$339
2.
The following table identifies the incremental costs in 2015 if Svenson (a) made CMCBs
and (b) purchased CMCBs from Minton.
Incremental Items
Total
Incremental Costs
Make
Buy
Per-Unit
Incremental Costs
Make
Buy
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Cost of purchasing CMCBs from Minton
Direct materials
Direct manufacturing labor
Variable batch manufacturing costs
Avoidable fixed manufacturing costs
Total incremental costs
$3,000,000
$1,700,000
450,000
120,000
320,000
$2,590,000 $3,000,000
Difference in favor of making
$300
$170
45
12
32
$259
$300
$41
$410,000
Note that the opportunity cost of using capacity to make CMCBs is zero because Svenson would
keep this capacity idle if it purchases CMCBs from Minton.
Svenson should continue to manufacture the CMCBs internally because the incremental
costs to manufacture are $259 per unit compared to the $300 per unit that Minton has quoted.
Note that the unavoidable fixed manufacturing costs of $800,000 ($80 per unit) will continue to
be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under
either the make or the buy alternative and, hence, are irrelevant.
3.
Svenson should continue to make CMCBs. The simplest way to analyze this problem is
to recognize that Svenson would prefer to keep any excess capacity idle rather than use it to
make CB3s. Why? Because expected incremental future revenues from CB3s, $2,000,000, are
less than expected incremental future costs, $2,150,000. If Svenson keeps its capacity idle, we
know from requirement 2 that it should make CMCBs rather than buy them.
An important point to note is that, because Svenson forgoes no contribution by not being
able to make and sell CB3s, the opportunity cost of using its facilities to make CMCBs is zero.
It is, therefore, not forgoing any profits by using the capacity to manufacture CMCBs. If it does
not manufacture CMCBs, rather than lose money on CB3s, Svenson will keep capacity idle.
A longer and more detailed approach is to use the total alternatives or opportunity cost
analyses shown in Exhibit 11-7 of the chapter.
Choices for Svenson
Make CMCBs
Buy CMCBs
and Do Not
and Make
Relevant Items
Make CB3s
CB3s, if Profitable
TOTAL-ALTERNATIVES APPROACH TO MAKE-OR-BUY DECISIONS
Total incremental costs of
making/buying CMCBs (from
requirement 2)
$2,590,000
$3,000,000
0
0
$2,590,000
$3,000,000
Because incremental future costs
exceed incremental future revenues
from CB3s, Svenson will make zero
CB3s even if it buys CMCBs from
Minton
Total relevant costs
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Svenson will minimize manufacturing costs and maximize operating income by making CMCBs.
OPPORTUNITY-COST APPROACH TO MAKE-OR-BUY DECISIONS
Total incremental costs of
making/buying CMCBs (from
requirement 2)
Opportunity cost: profit contribution
forgone because capacity will not
be used to make CB3s
Total relevant costs
$2,590,000
$3,000,000
0*
$2,590,000
0
$3,000,000
*
Opportunity cost is zero because Svenson does not give up anything by not making CB3s.
Svenson is best off leaving the capacity idle (rather than manufacturing and selling CB3s).
11-26 Inventory decision, opportunity costs. Best Trim, a manufacturer of lawn mowers,
predicts that it will purchase 204,000 spark plugs next year. Best Trim estimates that 17,000
spark plugs will be required each month. A supplier quotes a price of $9 per spark plug. The
supplier also offers a special discount option: If all 204,000 spark plugs are purchased at the start
of the year, a discount of 2% off the $9 price will be given. Best Trim can invest its cash at 10%
per year. It costs Best Trim $260 to place each purchase order.
Required:
1. What is the opportunity cost of interest forgone from purchasing all 204,000 units at the start
of the year instead of in 12 monthly purchases of 17,000 units per order?
2. Would this opportunity cost be recorded in the accounting system? Why?
3. Should Best Trim purchase 204,000 units at the start of the year or 17,000 units each month?
Show your calculations.
4. What other factors should Best Trim consider when making its decision?
SOLUTION
(10 min.)
1.
Inventory decision, opportunity costs.
Unit cost, orders of 17,000
Unit cost, order of 204,000 (0.98  $9.00)
$9.00
$8.82
Alternatives under consideration:
(a) Buy 204,000 units at start of year.
(b) Buy 17,000 units at start of each month.
Average investment in inventory:
(a) (204,000  $8.82) ÷ 2
(b) (17,000  $9.00) ÷ 2
Difference in average investment
$899,640
76,500
$823,140
Opportunity cost of interest forgone from 204,000-unit purchase at start of year
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= $823,140  0.10 = $82,314
2.
No. The $82,314 is an opportunity cost rather than an incremental or outlay cost. No
actual transaction records the $82,314 as an entry in the accounting system.
3.
The following table presents the two alternatives:
Alternative A: Alternative B:
Purchase
Purchase
204,000
17,000
spark plugs at spark plugs
beginning of
at beginning
year
of each month Difference
(1)
(2)
(3) = (1) – (2)
Annual purchase-order costs
(1  $260; 12  $260)
Annual purchase (incremental) costs
(204,000  $8.82; 204,000  $9)
Annual interest income that could be earned
if investment in inventory were invested
(opportunity cost)
(10%  $899,640; 10%  $76,500)
Relevant costs
3,120
$ (2,860)
1,799,280
1,836,000
(36,720)
89,964
$1,889,504
7,650
$1,846,770
82,314
$42,734
$
260
$
Column (3) indicates that purchasing 17,000 spark plugs at the beginning of each month is
preferred relative to purchasing 204,000 spark plugs at the beginning of the year because the
opportunity cost of holding larger inventory exceeds the lower purchasing and ordering costs.
4.
If other incremental benefits of holding lower inventory such as lower insurance,
materials handling, storage, obsolescence, and breakage costs were considered, the costs under
Alternative A would have been higher, and Alternative B would be preferred even more.
11-27 Relevant costs, contribution margin, product emphasis. The Beach Comber is a takeout food store at a popular beach resort. Sara Miller, owner of the Beach Comber, is deciding
how much refrigerator space to devote to four different drinks. Pertinent data on these four
drinks are as follows:
Miller has a maximum front shelf space of 12 feet to devote to the four drinks. She wants a
minimum of 1 foot and a maximum of 6 feet of front shelf space for each drink.
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Required:
1. Calculate the contribution margin per case of each type of drink.
2. A coworker of Miller’s recommends that she maximize the shelf space devoted to those
drinks with the highest contribution margin per case. Do you agree with this
recommendation? Explain briefly.
3. What shelf-space allocation for the four drinks would you recommend for the Beach
Comber? Show your calculations.
SOLUTION
(20–25 min.)
Relevant costs, contribution margin, product emphasis.
1.
Selling price
Deduct variable cost per case
Contribution margin per case
Cola
$19.10
14.40
$ 4.70
Lemonade
$20.25
15.90
$ 4.35
Punch
$27.10
21.50
$ 5.60
Natural
Orange
Juice
$39.50
29.80
$ 9.70
2.
The argument fails to recognize that shelf space is the constraining factor. There are only
12 feet of front shelf space to be devoted to drinks. Sexton should aim to get the highest daily
contribution margin per foot of front shelf space:
Contribution margin per case
Sales (number of cases) per foot
of shelf space per day
Daily contribution per foot
of front shelf space
3.
Cola
$ 4.70

10
$47.00
Lemonade
$ 4.35

24
$104.40
Punch
$ 5.60

25
$140.00
Natural
Orange
Juice
$ 9.70

22
$213.40
The allocation that maximizes the daily contribution from soft drink sales is:
Natural Orange Juice
Punch
Lemonade
Cola
Feet of
Shelf Space
6
4
1
1
Daily Contribution
per Foot of
Front Shelf Space
$213.40
140.00
104.40
47.00
Total Contribution
Margin per Day
$1,280.40
560.00
104.40
47.00
$1,991.80
The maximum of six feet of front shelf space will be devoted to Natural Orange Juice because it
has the highest contribution margin per unit of the constraining factor. Four feet of front shelf
space will be devoted to Punch, which has the second highest contribution margin per unit of the
constraining factor. No more shelf space can be devoted to Punch because each of the remaining
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two products, Lemonade and Cola (that have the second lowest and lowest contribution margins
per unit of the constraining factor), must each be given at least one foot of front shelf space.
11-28 Selection of most profitable product. Isochlorine is produced in a chemical process that
isvery threatening to the environment. As a result of this, the government has limited the yearly
production. Company Soleil uses isochlorine to produce four cosmetic products A, B, C, and D.
Soleil has a inventory of 2,000 kg of isochlorine at a value of $20,000:
As a result of production restrictions imposed on their supplier, Soleil will not be able to
purchase additional isochlorine during the coming period.
Although Soleil, by means of its commercial campaign, suggests that its main goal is to
let people experience the sanitary effects of its cosmetic products, the management is only
interested in profit maximization.
The management of Soleil must decide how to use the scarce material. The following
information is available concerning the next period:
Product
Sales
A
B
C
D
3,000
8,000
4,000
5,000
Selling price per
unit
$ 70
$ 60
$100
$ 80
Labor hours per
unit
1.0
1.2
2.0
1.0
Material per
unit (Grams)
500
300
600
800
The labor tariff per hour is $30. Labor costs are linear variable. Sales provision is 10% of the
selling price. Which product(s) must Soleil produce during the next period? What is the
contribution margin for thenext period? Show your calculations.
SOLUTION
(10 min.)
Selection of most profitable product.
Product
Material
Labor
Costs
Sellingprice
Sales
provision
Net selling
price
CMPP
CM per kg.
Material
Priority
A
5
30
35
70
7
B
3
36
39
60
6
C
6
60
66
100
10
D
8
30
38
80
8
63
54
90
72
28
56
15
50
24
40
34
42.5
1
2
4
3
Product A
Product B
Product A +B
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Sales
CM
Total CM
Used material
Ending material
CM Max
Sales (restricted)
CM restricted
3000
28
84000
1500
500
84000
3000
84000
8000
15
120000
2400
–1900
120000
1666
24,990
204000
108,990
11-29 Theory of constraints, throughput margin, relevant costs. The Pierce Corporation
manufactures filing cabinets in two operations: machining and finishing. It provides the
following information:
Annual capacity
Annual production
Fixed operating costs (excluding direct materials)
Fixed operating costs per unit produced
($540,000 ,90,000; $270,000 ,90,000)
Machining
110,000 units
90,000 units
$540,000
$6 per unit
Finishing
90,000 units
90,000 units
$270,000
$3 per unit
Each cabinet sells for $70 and has direct material costs of $30 incurred at the start of the
machining operation. Pierce has no other variable costs. Pierce can sell whatever output it
produces. The following requirements refer only to the preceding data. There is no connection
between the requirements.
Required:
1. Pierce is considering using some modern jigs and tools in the finishing operation that would
increaseannual finishing output by 1,150 units. The annual cost of these jigs and tools is
$35,000. Should Pierce acquire these tools? Show your calculations.
2. The production manager of the Machining Department has submitted a proposal to do faster
setups that would increase the annual capacity of the Machining Department by 9,000 units
and would cost $4,000 per year. Should Pierce implement the change? Show your
calculations.
3. An outside contractor offers to do the finishing operation for 9,500 units at $9 per unit, triple
the $3 perunit that it costs Pierce to do the finishing in-house. Should Pierce accept the
subcontractor’s offer? Show your calculations.
4. The Hammond Corporation offers to machine 5,000 units at $3 per unit, half the $6 per unit
that it costsPierce to do the machining in-house. Should Pierce accept Hammond’s offer?
Show your calculations.
5. Pierce produces 1,700 defective units at the machining operation. What is the cost to Pierce
of the defective items produced? Explain your answer briefly.
6. Pierce produces 1,700 defective units at the finishing operation. What is the cost to Pierce of
the defective items produced? Explain your answer briefly.
SOLUTION
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(25 min.) Theory of constraints, throughput contribution, relevant costs.
1.
Finishing is a bottleneck operation. Therefore, producing 1,150 more units will generate
additional contribution (throughput) margin and operating income.
Increase in contribution (throughput) margin ($70 – $30)  1,150
Incremental costs of the jigs and tools
Increase in operating income investing in jigs and tools
$46,000
35,000
$11,000
Pierce should invest in the modern jigs and tools because the benefit of higher contribution
(throughput) margin of $46,000 exceeds the cost of $35,000.
2.
The Machining Department has excess capacity and is not a bottleneck operation.
Increasing its capacity further will not increase contribution (throughput) margin. There is,
therefore, no benefit from spending $4,000 to increase the Machining Department's capacity by
9,000 units. Pierce should not implement the change to do setups faster.
3.
Finishing is a bottleneck operation. Therefore, getting an outside contractor to produce
9,500 units will increase contribution (throughput) margin.
Increase in contribution (throughput) margin ($70 – $30)  9,500
Incremental contracting costs $9  9,500
Increase in operating income by contracting 9,500 units of finishing
$380,000
85,500
$294,500
Pierce should contract with an outside contractor to do 9,500 units of finishing at $9 per unit
because the benefit of higher throughput margin of $380,000 exceeds the cost of $85,500. The
fact that the cost of $9 per unit is three times Pierce's finishing cost of $3 per unit is irrelevant.
4.
Operating costs in the Machining Department of $540,000, or $6 per unit, are fixed costs.
Pierce will not save any of these costs by subcontracting machining of 5,000 units to Hammond
Corporation. Total costs will be greater by $15,000 ($3 per unit  5,000 units) under the
subcontracting alternative. Machining more filing cabinets will not increase contribution
(throughput) margin, which is constrained by the finishing capacity. Pierce should not accept
Hammond’s offer. The fact that Hammond’s costs of machining per unit are half of what it costs
Pierce in-house is irrelevant.
5.
The cost of 1,700 defective units in the Machining Operation is $30 per unit  1,700
units = $51,000. Because the Machining Operation has a capacity of 110,000 units, it can still
produce and transfer 90,000 good units to the Finishing Operation. There is, therefore, no
opportunity cost of producing defective units in the Machining Operation.
6.
The cost of 1,700 defective units in the Finishing Operation is:
Cost of direct materials used in the defective units $30 per unit  1,700 units
$ 51,000
Opportunity cost, lost contribution (throughput) margin $40 per unit  1,700 units
68,000
Total cost of defective unit in the Finishing Operation
$119,000
Alternatively, the cost of 1,700 defective units in the Finishing Operation equals the revenues
lost by selling 1,700 fewer units = $70 per unit  1,700 units = $119,000. The cost of the
defective unit at a bottleneck operation is much higher than at a non-bottleneck operation
because of the opportunity cost of lost contribution margin at the bottleneck operation.
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11-30 Closing and opening stores. Sanchez Corporation runs two convenience stores, one in
Connecticut and one in Rhode Island. Operating income for each store in 2017 is as follows:
The equipment has a zero disposal value. In a senior management meeting, Maria Lopez, the
management accountant at Sanchez Corporation, makes the following comment, “Sanchez can
increase its profitability by closing down the Rhode Island store or by adding another store like
it.”
Required:
1. By closing down the Rhode Island store, Sanchez can reduce overall corporate overhead
costs by $44,000. Calculate Sanchez’s operating income if it closes the Rhode Island store. Is
Maria Lopez’s statement about the effect of closing the Rhode Island store correct? Explain.
2. Calculate Sanchez’s operating income if it keeps the Rhode Island store open and opens
another store with revenues and costs identical to the Rhode Island store (including a cost of
$22,000 to acquire equipment with a one-year useful life and zero disposal value). Opening
this store will increase corporate overhead costs by $4,000. Is Maria Lopez’s statement about
the effect of adding another store like the Rhode Island store correct? Explain.
SOLUTION
(2530 min.) Closing and opening stores.
1.
Solution Exhibit 11-30, Column 1, presents the relevant loss in revenues and the relevant
savings in costs from closing the Rhode Island store. Lopez is correct that Sanchez Corporation’s
operating income would increase by $7,000 if it closes down the Rhode Island store. Closing
down the Rhode Island store results in a loss of revenues of $860,000 but cost savings of
$867,000 (from cost of goods sold, rent, labor, utilities, and corporate costs). Note that by closing
down the Rhode Island store, Sanchez Corporation will save none of the equipment-related costs
because this is a past cost. Also note that the relevant corporate overhead costs are the actual
corporate overhead costs $44,000 that Sanchez expects to save by closing the Rhode Island store.
The corporate overhead of $40,000 allocated to the Rhode Island store is irrelevant to the
analysis.
2.
Solution Exhibit 11-30, Column 2, presents the relevant revenues and relevant costs of
opening another store like the Rhode Island store. Lopez is correct that opening such a store
would increase Sanchez Corporation’s operating income by $11,000. Incremental revenues of
$860,000 exceed the incremental costs of $849,000 (from higher cost of goods sold, rent, labor,
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utilities, and some additional corporate costs). Note that the cost of equipment written off as
depreciation is relevant because it is an expected future cost that Sanchez will incur only if it
opens the new store. Also note that the relevant corporate overhead costs are the $4,000 of actual
corporate overhead costs that Sanchez expects to incur as a result of opening the new store.
Sanchez may, in fact, allocate more than $4,000 of corporate overhead to the new store, but this
allocation is irrelevant to the analysis.
The key reason that Sanchez’s operating income increases either if it closes down the
Rhode Island store or if it opens another store like it is the behavior of corporate overhead costs.
By closing down the Rhode Island store, Sanchez can significantly reduce corporate overhead
costs presumably by reducing the corporate staff that oversees the Rhode Island operation. On
the other hand, adding another store like Rhode Island does not increase actual corporate costs by
much, presumably because the existing corporate staff will be able to oversee the new store as
well.
SOLUTION EXHIBIT 11-30
Relevant-Revenue and Relevant-Cost Analysis of Closing Rhode Island Store and Opening
Another Store Like It.
Incremental
(Loss in Revenues)
Revenues and
and Savings in
(Incremental Costs)
Costs from Closing
of Opening New Store
Rhode Island Store Like Rhode Island Store
(1)
(2)
Revenues
Cost of goods sold
Lease rent
Labor costs
Depreciation of equipment
Utilities (electricity, heating)
Corporate overhead costs
Total costs
Effect on operating income (loss)
$(860,000)
660,000
75,000
42,000
0
46,000
44,000
867,000
$ 7,000
$ 860,000
(660,000)
(75,000)
(42,000)
(22,000)
(46,000)
(4,000)
(849,000)
$ 11,000
11-31 Choosing customers. Rodeo Printers operates a printing press with a monthly capacity
of 4,000 machine-hours. Rodeo has two main customers: Trent Corporation and Julie
Corporation.
Data on each customer for January are:
Trent Corporation Julie Corporation Total
Revenues
$210,000
$140,000
$350,000
Variable costs
84,000
85,000
169,000
Contribution margin
126,000
55,000
181,000
Fixed costs (allocated)
102,000
68,000
170,000
Operating income
$ 24,000
$ (13,000)
$ 11,000
Machine-hours required
3,000 hours
1,000 hours
4,000 hours
Julie Corporation indicates that it wants Rodeo to do an additional $140,000 worth of printing
jobs during February. These jobs are identical to the existing business Rodeo did for Julie in
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January in terms of variable costs and machine-hours required. Rodeo anticipates that the
business from Trent Corporation in February will be the same as that in January. Rodeo can
choose to accept as much of the Trent and Julie business for February as its capacity allows.
Assume that total machine-hours and fixed costs for February will be the same as in January.
Required:
What action should Rodeo take to maximize its operating income? Show your calculations. What
other factors should Rodeo consider before making a decision?
SOLUTION
(20 min.)
Choosing customers.
If Rodeo accepts the additional business from Julie, it would take an additional 1,000 machinehours. If Rodeo accepts all of Julie’s and Trent’s business for February, it would require 5,000
machine-hours (3,000 hours for Trent and 2,000 hours for Julie). Rodeo has only 4,000 hours of
machine capacity. It must, therefore, choose how much of the Trent or Julie business to accept.
To maximize operating income, Rodeo should maximize contribution margin per unit of
the constrained resource. (Fixed costs will remain unchanged at $170,000 regardless of the
business Rodeo chooses to accept in February and are, therefore, irrelevant.) The contribution
margin per unit of the constrained resource for each customer in January is:
Trent
Julie
Corporation
Corporation
$126,000
$55,000
= $42
= $55
3,000
1,000
Contribution margin per machine-hour
Because the $140,000 of additional Julie business in February is identical to jobs done in
January, it will also have a contribution margin of $55 per machine-hour, which is greater than
the contribution margin of $42 per machine-hour from Trent. To maximize operating income,
Rodeo should first allocate all the capacity needed to take the Julie Corporation business (2,000
machine-hours) and then allocate the remaining 2,000 (4,000 – 2,000) machine-hours to Trent.
Contribution margin per machine-hour
Machine-hours to be worked
Contribution margin
Fixed costs
Operating income
Trent
Corporation
$42
 2,000
$84,000
Julie
Corporation
$55
 2,000
$110,000
Total
$194,000
170,000
$ 24,000
An alternative approach is to use the opportunity cost approach. The opportunity cost of
giving up 1,000 machine-hours for the Trent Corporation jobs is the contribution margin forgone
of $42 per machine-hour  1,000 machine-hours equal to $42,000. The contribution margin
gained from using the 1,000 machine-hours for the Julie Corporation business is the contribution
margin per machine-hour of $55  1,000 machine-hours equal to $55,000.
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The net benefit is:
Contribution margin from Julie Corporation business
Less: Opportunity cost (of giving up Trent Corporation business)
Net benefit
$55,000
(42,000)
$13,000
Although taking the Julie Corporation business over the Trent Corporation business will
maximize Rodeo’s profits in the short run, Rodeo’s managers must also consider the long-run
effects of this decision. Will Julie Corporation continue to demand the same level of business
going forward? Will turning down the Trent business affect customer satisfaction? If Rodeo turns
down the Trent business, will Trent continue to place orders with Rodeo or seek alternative
suppliers? Rodeo’s managers need to consider these long-run effects and then decide whether it
should accept Julie’s business at the cost of Trent’s. In other words, choosing customers is a
strategic decision. If it sees long-run benefit in working with Trent, Rodeo’s managers must also
look for ways to increase the profitability of the business it does with Trent by increasing prices
or reducing costs.
11-32 Relevance of equipment costs. Papa’s Pizza is considering replacement of its pizza oven
with a new, more energy-efficient model. Information related to the old and new pizza ovens
follows:
Old oven—original cost
$60,000
Old oven—book value
$50,000
Old oven—current market value
$42,000
Old oven—annual operating cost
$14,000
New oven—purchase price
$75,000
New oven—installation cost
$ 2,000
New oven—annual operating cost
$ 6,000
The old oven had been purchased a year ago. Papa’s Pizza estimates that either oven has a
remaining useful life of five years. At the end of five years, either oven would have a zero
salvage value. Ignore the effect of income taxes and the time value of money.
Required:
1. Which of the costs and benefits above are relevant to the decision to replace the oven?
2. What information is irrelevant? Why is it irrelevant?
3. Should Papa’s Pizza purchase the new oven? Provide support for your answer.
4. Is there any conflict between the decision model and the incentives of the manager who has
purchasedthe “old” oven and is considering replacing it a year later?
5. At what purchase price would Papa’s Pizza be indifferent between purchasing the new oven
and continuingto use the old oven?
SOLUTION
(20 min.) Relevance of equipment costs.
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1.
The current market value and annual operating costs of the old oven, and the purchase
price, installation cost, and annual operating costs of the new oven are relevant when deciding
whether to replace the oven because these are future costs that would differ between the
alternatives of keeping or replacing the old oven.
2.
The original cost and book value of the old oven are irrelevant because they are ariations
of the same past (sunk) cost. All past costs are irrelevant because past costs will be the same
whether Papa’s Pizza keeps or replaces the oven. No decision can change what has already been
incurred in the past.
3.
Papa’s Pizza should purchase the new oven, based on the following calculations:
Keep the old oven
Operating costs for 5 years
($14,000 × 5)
Cost of keeping the old oven
$(70,000)
$(70,000)
Replace the old oven
Current market value of old oven
Purchase price of the new oven
Installation cost of the new oven
Operating costs for 5 years
($6,000 × 5)
Net cost of the new oven
$ 42,000
(75,000)
(2,000)
(30,000)
$(65,000)
The cost of replacing the old oven is $65,000, while the cost of continuing to operate the old
oven is $70,000.
4.
The manager may be reluctant to replace because it might reflect badly on him for having
purchased the old oven in the first place if the new oven was available a year earlier.
5.
At a purchase price of $80,000, Papa’s Pizza would be indifferent between purchasing the
new oven and continuing to use the old oven ($75,000 current purchase price + $5,000 savings
above). Note that a cost of $80,000, the cost of replacing the old oven would be $70,000, equal
to the cost of keeping the old oven.
11-33 Equipment upgrade versus replacement. (A. Spero, adapted) The TechGuide Company
produces and sells 7,500 modular computer desks per year at a selling price of $750 each. Its
current production equipment, purchased for $1,800,000 and with a five-year useful life, is only
two years old. It has a terminal disposal value of $0 and is depreciated on a straight-line basis.
The equipment has a current disposal price of $450,000. However, the emergence of a new
molding technology has led TechGuide to consider either upgrading or replacing the production
equipment. The following table presents data for the two alternatives:
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All equipment costs will continue to be depreciated on a straight-line basis. For simplicity, ignore
income taxes and the time value of money.
Required:
1. Should TechGuide upgrade its production line or replace it? Show your calculations.
2. Now suppose the one-time equipment cost to replace the production equipment is somewhat
negotiable. All other data are as given previously. What is the maximum one-time equipment
cost that TechGuide would be willing to pay to replace rather than upgrade the old
equipment?
3. Assume that the capital expenditures to replace and upgrade the production equipment
are as given in the original exercise, but that the production and sales quantity is not
known. For what production and sales quantity would TechGuide (i) upgrade the
equipment or (ii) replace the equipment?
4. Assume that all data are as given in the original exercise. Dan Doria is TechGuide’s manager,
and his bonus is based on operating income. Because he is likely to relocate after about a
year, his current bonus is his primary concern. Which alternative would Doria choose?
Explain.
SOLUTION
(30 min.)
Equipment upgrade versus replacement.
1.
Based on the analysis in the table below, TechGuide will be better off by $337,500 over
three years if it replaces the current equipment.
Over 3 years
Difference in
Comparing Relevant Costs of Upgrade and
Upgrade
Replace
favor of Replace
Replace Alternatives
(1)
(2)
(3) = (1) – (2)
Cash operating costs
$150; $75 per desk  7,500 desks per yr.  3
yrs.
$3,375,000 $1,687,500
$1,687,5000
Current disposal price
(450,000)
450,000
One time capital costs, written off periodically
as
depreciation
3,000,000
4,800,000
(1,800,000)
Total relevant costs
$6,375,000 $6,037,500
$ 337,500
3
= $1,080,000 would either be
5
written off as depreciation over three years under the upgrade option or all at once in the current
year under the replace option. Its net effect would be the same in both alternatives: to increase
costs by $1,080,000 over three years; hence, it is irrelevant in this analysis.
Note that the book value of the current machine, $1,800,000 
2.
Suppose the capital expenditure to replace the equipment is $X. From requirement 1,
column (2), substituting for the one-time capital cost of replacement, the relevant cost of
replacing is $1,687,500 – $450,000 + $X. From column (1), the relevant cost of upgrading is
$6,375,000. We want to find X such that
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$1,687,500 – $450,000 + $X < $6,375,000 (i.e., TechGuide will favor replacing)
Solving the above inequality gives us X < $6,375,000 – $1,237,500 = $5,137,500.
TechGuide would prefer to replace, rather than upgrade, if the replacement cost of the new
equipment does not exceed $5,137,500. Note that this result can also be obtained by taking the
original replacement cost of $4,800,000 and adding to it the $337,500 difference in favor of
replacement calculated in requirement 1.
3.
Suppose the units produced and sold over 3 years equal y. Using data from requirement 1,
column (1), the relevant cost of upgrade would be $150y + $3,000,000, and from column (2), the
relevant cost of replacing the equipment would be $75y – $450,000 + $4,800,000. TechGuide
would want to upgrade when
$150y + $3,000,000 < $75y – $450,000 + $4,800,000
$75y < $1,350,000
y < $1,350,000  $75 = 18,000 units
That is, upgrade when y < 18,000 units (or 6,000 per year for 3 years) and replace when y >
18,000 units over 3 years.
When production and sales volume is low (less than 6,000 per year), the higher operating
costs under the upgrade option are more than offset by the savings in capital costs from
upgrading. When production and sales volume is high, the higher capital costs of replacement are
more than offset by the savings in operating costs in the replace option.
4.
Operating income for the first year under the upgrade and replace alternatives are shown
below:
Year 1
Upgrade
Replace
(1)
(2)

Revenues (7,500 $750)
$5,625,000
$5,625,000
Cash operating costs
$150; $75 per desk  7,500 desks per year
1,125,000
562,500
a
Depreciation ($1,080,000 + $3,000,000) 3; $4,800,000 3
1,360,000
1,600,000
Loss on disposal of old equipment (0; $1,080,000 –
$450,000)
0
630,000
Total costs
2,485,000
2,792,500
Operating Income
$3,140,000
$2,832,500
a
The book value of the current production equipment is $1,800,000 5  3 = $1,080,000; it
has a remaining useful life of 3 years.
First-year operating income is higher by $307,500 ($3,140,000 – $2,832,500) under the upgrade
alternative, and Dan Doria, with his one-year horizon and operating income-based bonus, will
choose the upgrade alternative, even though, as seen in requirement 1, the replace alternative is
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better in the long run for TechGuide. This exercise illustrates the possible conflict between the
decision model and the performance evaluation model.
11-34 Special order, short-run pricing. GamesAhoy Corporation produces cricket bats for kids
that it sellsfor $36 each. At capacity, the company can produce 50,000 bats a year. The costs of
producing and selling 50,000 bats are as follows:
Cost per Bat
$13
5
2
6
3
2
$31
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Fixed manufacturing overhead
Variable selling expenses
Fixed selling expenses
Total costs
Total Costs
$ 650,000
250,000
100,000
300,000
150,000
100,000
$1,550,000
Required:
1. Suppose GamesAhoy is currently producing and selling 40,000 bats. At this level of
production and sales,its fixed costs are the same as given in the preceding table.
FieldTactics Corporation wants to place a one-time special order for 10,000 bats at $23
each. Slugger will incur no variable selling costs for thisspecial order. Should
GamesAhoy accept this one-time special order? Show your calculations.
2. Now suppose GamesAhoy gger is currently producing and selling 50,000 bats. If
GamesAhoy accepts FieldTactics’ offer it will have to sell 10,000 fewer bats to its regular
customers. (a) On financial considerations alone, should GamesAhoy accept this one-time
special order? Show your calculations. (b) On financial considerations alone, at what
price would GamesAhoy be indifferent between accepting the special order and
continuing to sell to its regular customers at $36 per bat. (c) What other factors should
GamesAhoy consider in deciding whether to accept the one-time special order?
(20 min.) Special order, short-run pricing
1.
Revenues from special order ($23 10,000 bats)
Variable manufacturing costs ($201 10,000 bats)
Increase in operating income if Bench order accepted
$230,000
(200,000)
$ 30,000
1
Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable
manufacturing overhead cost per unit = $13 + $5 + $2 = $20
GamesAhoy should accept FieldTactics’ special order because it increases operating income by
$30,000. Because no variable selling costs will be incurred on this order, this cost is irrelevant.
Similarly, fixed costs are irrelevant because they will be incurred regardless of the decision.
$230,000
2a. Revenues from special order ($23 10,000 bats)
Variable manufacturing costs ($20 10,000 bats)
(200,000)
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Contribution margin foregone ([$36─$231] 10,000 bats)
(130,000)
Decrease in operating income if Bench order accepted
$(100,000)
1
Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable
manufacturing overhead cost per unit + Variable selling expense per unit = $13 + $5 + $2 + $3 =
$23
Based strictly on financial considerations, GamesAhoy should reject FieldTactics’ special order
because it results in a $100,000 reduction in operating income.
2b.
GamesAhoy will be indifferent between the special order and continuing to sell to regular
customers if the special order price is $33. At this price, GamesAhoy recoups the variable
manufacturing costs of $200,000 and the contribution margin given up from regular customers of
$130,000 ([$200,000 + $130,000] ÷ 10,000 units = $33). That is, at the special order price of
$33, Slugger recoups the variable cost per unit of $20 and the contribution margin per unit given
up from regular customers of $13 per unit.
An alternative approach is to recognize that GamesAhoy needs to earn $100,000 more
than the revenues of $230,000 in requirement 2a, so that the decrease in operating income of
$100,000 becomes $0. GamesAhoy will be indifferent between the special order and continuing
to sell to regular customers if revenues from the special order = $230,000 + $100,000 = $330,000
or $33 per bat ($330,000  10,000 bats)
Looked at a different way, GamesAhoy needs to earn the full price of $36 less the $3
saved on variable selling costs.
2c.
GamesAhoy may be willing to accept a loss on this special order if the possibility of
future long-term sales seem likely at a higher price. Moreover, GamesAhoy should also consider
the negative long-term effect on customer relationships of not selling to existing customers.
GamesAhoy cannot afford to sell bats to customers at the special order price for the long term
because the $23 price is less than the full manufacturing cost of the product of $31. This means
that in the long term, the contribution margin earned will not cover the fixed costs and result in a
loss. GamesAhoy will then be better off shutting down.
11-35 Short-run pricing, capacity constraints. Fashion Fabrics makes pants from a special
material. The fabric is special because of the way it fits many body types. The pants sell for
$142. A well-known retail establishment has asked Fashion Fabrics to produce 3,000 shorts from
the same fabric. The factory has unused capacity, so Barbara Brooks, the owner of Fashion
Fabrics, calculates the cost of making a pair of shorts from the fabric. Costs for the pants and
shorts are as follows:
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Required:
1. Suppose Fashion Fabrics can acquire all the fabric that it needs. What is the minimum price
the company should charge for the shorts?
2. Now suppose that the fabric is in short supply. Every yard of fabric Fashion Fabrics uses to
make shorts will reduce the pants that it can make and sell. What is the minimum price the
company should charge for the shorts?
SOLUTION
(15-20 min.) Short-run pricing, capacity constraints.
1. Per pair of shorts:
Fabric (3 yards  $12 per yard)
Variable direct manufacturing labor
Variable manufacturing overhead
Fixed manufacturing cost allocated
Total manufacturing cost
$36
10
4
9
$59
If Fashion Fabrics can get all the fabric it needs and has sufficient production capacity, then the
minimum price it should charge per pair of shorts is the variable cost per pair of shorts = $36 +
$10 + $4 = $50 per pair of shorts.
2.
If the fabric is in short supply, then the fabric used for 2 shorts displaces 1 pant (6 yards
of fabric per pant versus 3 yards of fabric per short).
We calculate the contribution margin per pair of pants = Selling price – Variable costs
= $142 − $100a = $42
a
Direct materials, $72 + Variable direct manufacturing labor, $20 + Variable manufacturing
overhead, $8
Pants require 6 yards of fabric so the contribution margin per unit of the constrained resource is
$42 ÷ 6 yards = $7 per yard
The minimum price Fashion Fabrics should charge for a pair of shorts is the variable cost per
pair of shorts plus the contribution margin from 3 yards of fabric, or,
$50 + (3  $7 per yard) = $71 per pair of shorts
That is, if fabric is in short supply, Fashion Fabrics should not agree to produce any shorts unless
the buyer is willing to pay at least $71 per pair of shorts.
Another way to calculate the opportunity cost of producing a pair of shorts is to recognize that
every time Fashion Fabrics uses fabric to produce a pair of shorts, it gives up the opportunity to
produce 0.5 pants. So,
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Opportunity cost of a pair of shorts = 0.5 × Contribution margin from producing a pair of pants
= 0.5 × $42 = $21.
The minimum price Fashion Fabrics should charge for a pair of shorts is the variable cost per
pair of shorts plus the opportunity cost of not producing 0.5 pants = $50 + $21 = $71.
11-36 International outsourcing. Cuddly Critters, Inc., manufactures plush toys in a facility in
Queensland, Brisbane. Recently, the company designed a group of collectible resin figurines to
go with the plush toy line. Management is trying to decide whether to manufacture the figurines
themselves in existing space in the Queensland facility or to accept an offer from a
manufacturing company in Indonesia. Data concerning the decision are:
Expected annual sales of figurines (in units)
Average selling price of a figurine
Price quoted by Indonesian company, in Indonesian Rupiah (IDR),
for each figurine
Current exchange rate
Variable manufacturing costs
Incremental annual fixed manufacturing costs associated with the new
product line
Variable selling and distribution costsa
Annual fixed selling and distribution costsa
400,000
$5
27,300 IDR
9,100 IDR = $1
$2.85 per unit
$200,000
$0.50 per unit
$285,000
a
Selling and distribution costs are the same regardless of whether the figurines are manufactured in Cleveland
or imported.
1. Should Cuddly Critters manufacture the 400,000 figurines in the Queensland facility or
purchase themfrom the Indonesian supplier? Explain.
2. Cuddly Critters believes that the dollar may weaken in the coming months against the
Indonesian rupiah and does not want to face any currency risk. Assume that Cuddly Critters
can enter into a forward contract today to purchase 27,300 IDRs for $3.40. Should Cuddly
Critters manufacture the 400,000 figurines in the Queensland facility or purchase them from
the Indonesian supplier? Explain.
3. What are some of the qualitative factors that Cuddly Critters should consider when deciding
whetherto outsource the figurine manufacturing to Indonesia?
SOLUTION
(20 min.)
1.
International outsourcing.
27,300 IDR
$3 .
9,100 IDR/$
Cost of purchasing 400,000 figurines from Indonesian supplier = $3 400,000 figurines =
$1,200,000.
Cost to purchase each figurine from Indonesian supplier =
Costs of
=
Variable

Quantity of
+
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Incremental fixed
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manufacturing
figurines in
Cleveland
facility
manufacturing
cost per unit
figurines
produced
manufacturing
costs
= ($2.85  400,000 units) + $200,000
= $1,340,000
Variable and fixed selling and distribution costs are irrelevant because they do not differ between
the two alternatives of purchasing the figurines from the Indonesian supplier or manufacturing
the figurines in Queensland.
Cuddly Critters should purchase the figurines from the Indonesian supplier because the
cost of $1,200,000 is less than the relevant cost of $1,340,000 to manufacture the figurines in
Cleveland.
2.
If Cuddly Critters enters into a forward contract to purchase 27,300 IDRs for $3.40, each
figurine acquired from the Indonesian supplier will cost $3.40.
Total cost of purchasing 400,000 figurines from Indonesian supplier = $3.40  400,000
figurines = $1,360,000.
Cost of manufacturing 400,000 figurines in Queensland (see requirement 1) =
$1,340,000.
As in requirement 1, selling and distribution costs are irrelevant.
Cuddly Critters should manufacture the figurines in Queensland because the relevant cost
of $1,340,000 to manufacture the figurines in Queensland is less than the cost of $1,360,000 to
enter into the forward contract and purchase the figurines from the Indonesian supplier.
3.
In deciding whether to purchase figurines from the Indonesian supplier, Cuddly Critters
should consider factors such as (a) quality, (b) delivery lead times, (c) fluctuations in the value of
the Indonesian Rupiah relative to the dollar, and (d) the negative public and media reaction to not
providing jobs in Queensland and instead supporting job creation in Indonesia.
11-37 Relevant costs, opportunity costs. Gavin Martin, the general manager of Oregano
Software, must decide when to release the new version of Oregano’s spreadsheet package,
Easyspread 2.0. Development of Easyspread 2.0 is complete; however, the diskettes, compact
discs, and user manuals have not yet been produced. The product can be shipped starting July 1,
2017.
The major problem is that Oregano has overstocked the previous version of its
spreadsheet package, Easyspread 1.0. Martin knows that once Easyspread 2.0 is introduced,
Oregano will not be able to sell any more units of Easyspread 1.0. Rather than just throwing
away the inventory of Easyspread 1.0, Martin is wondering if it might be better to continue
to sell Easyspread 1.0 for the next three months and introduce Easyspread 2.0 on October 1,
2017, when the inventory of Easyspread 1.0 will be sold out.
The following information is available:
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Development cost per unit for each product equals the total costs of developing the software
product divided by the anticipated unit sales over the life of the product. Marketing and
administrative costs are fixed costs in 2017, incurred to support all marketing and
administrative activities of Oregano Software. Marketing and administrative costs are
allocated to products on the basis of the budgeted revenues of each product. The preceding
unit costs assume Easyspread 2.0 will be introduced on October 1, 2017.
Required:
1. On the basis of financial considerations alone, should Martin introduce Easyspread 2.0 on
July 1, 2017, or wait until October 1, 2017? Show your calculations, clearly identifying
relevant and irrelevant revenues and costs.
2. What other factors might Gavin Martin consider in making a decision?
SOLUTION
(30 min.)
Relevant costs, opportunity costs.
1.
Easyspread 2.0 has a higher relevant operating income than Easyspread 1.0. Based on this
analysis, Easyspread 2.0 should be introduced immediately:
Relevant revenues
Relevant costs:
Manuals, diskettes, compact discs
Total relevant costs
Relevant operating income
Easyspread 1.0
$165
Easyspread 2.0
$215
$ 0
$38
0
$165
Reasons for other cost items being irrelevant are
Easyspread 1.0
 Manuals, diskettes—already incurred
 Development costs—already incurred
 Marketing and administrative—fixed costs of period
Easyspread 2.0
 Development costs—already incurred
 Marketing and administration—fixed costs of period
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$177
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Note that total marketing and administration costs will not change whether Easyspread 2.0 is
introduced on July 1, 2017, or on October 1, 2017.
2
2. Other factors to be considered:
a. Customer satisfaction. If 2.0 is significantly better than 1.0 for its customers, a
customer-driven organization would immediately introduce it unless other factors
offset this bias toward “do what is best for the customer.”
b. Quality level of Easyspread 2.0. It is critical for new software products to be fully
debugged. Easyspread 2.0 must be error-free. Consider an immediate release only if
2.0 passes all quality tests and can be supported fully by the salesforce.
c. Importance of being perceived to be a market leader. Being first in the market with a
new product can give Oregano Software a “first-mover advantage,” e.g., capturing an
initial large share of the market that, in itself, causes future potential customers to
lean toward purchasing Easyspread 2.0. Moreover, by introducing 2.0 earlier,
Oregano can get quick feedback from users about ways to further refine the software
while its competitors are still working on their own first versions. Moreover, by
locking in early customers, Oregano may increase the likelihood of these customers
also buying future upgrades of Easyspread 2.0.
d. Morale of developers. These are key people at Oregano Software. Delaying
introduction of a new product can hurt their morale, especially if a competitor then
preempts Oregano from being viewed as a market leader.
11-38 Opportunity costs and relevant costs. Jason Wu operates Exclusive Limousines, a fleet
of 10 limousines used for weddings, proms, and business events in Washington, D.C. Wu charges
customers a flat fee of $250 per car taken on contract plus an hourly fee of $80. His income
statement for May follows:
All expenses are fixed, with the exception of driver wages and benefits and fuel costs, which are both
variable per hour. During May, the company’s limousines were fully booked. In June, Wu expects
that Exclusive Limousines will be operating near capacity. Shelly Worthington, a prominent
Washington socialite, has asked Wu to bid on a large charity event she is hosting in late June. The
limousine company she had hired has canceled at the last minute, and she needs the service of five
limousines for four hours each. She will only hire Exclusive Limousines if they take the entire job.
Wu checks his schedule and finds that he only has three limousines available that day.
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Required:
1. If Wu accepts the contract with Worthington, he would either have to (a) cancel two prom
contracts each for one car for six hours or (b) cancel one business event for three cars
contracted for two hours each. What are the relevant opportunity costs of accepting the
Worthington contract in each case? Which contract should he cancel?
2. Wu would like to win the bid on the Worthington job because of the potential for lucrative
future business. Assume that Wu cancels the contract in requirement 1 with the lowest
opportunity cost, and assume that the three currently available cars would go unrented if the
company does not win the bid. What is the lowest amount he should bid on the Worthington
job?
3. Another limousine company has offered to rent Exclusive Limousines two additional cars for
$300 each per day. Wu would still need to pay for fuel and driver wages on these cars for the
Worthington job. Should Wu rent the two cars to avoid canceling either of the other two
contracts?
SOLUTION
(30 min.) Opportunity costs and relevant costs
1. If Wu cancels the two prom contracts, the opportunity cost of accepting the Worthington job
would be $886.40, as follows:
Lost revenue (2 × $250) + (12 hrs. × $80)
$1,460.00
Less variable costs
Driver wages and benefits* ($35 × 12 hrs.)
420.00
Fuel costs** ($12.80 × 12 hrs.)
153.60
Opportunity cost
$ 886.40
*Driver wages and benefits are $35/hour ($43,750 ÷ 1,250 hours)
** Fuel costs are $12.80/hour ($16,000 ÷ 1,250 hours)
If Wu cancels the business event contract, the opportunity cost would be $943.20, as
follows:
Lost revenue (3 × $250) + (6 hrs. × $80)
Less variable costs
Driver wages and benefits* ($35 × 6 hrs.)
Fuel costs** ($12.80 × 6 hrs.)
Opportunity cost
$1,230.00
210.00
76.80
$ 943.20
*Driver wages and benefits are $35/hour ($43,750 ÷ 1,250 hours)
** Fuel costs are $12.80/hour ($16,000 ÷ 1,250 hours)
Wu should cancel the prom contracts because the opportunity cost would be lower by $56.80
($943.20 – $886.40).
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2. If Wu cancels the two prom contracts, opportunity cost equals $886.40. In addition, variable
costs of the 20-hour Worthington job would be (20 hrs. × $35) + (20 hrs. × $12.80) = $956.
Therefore, the minimum amount Wu would bid is $1,842.40 ($886.40 + $956).
3. Yes, it would be in Wu’s best interest to lease the additional cars for a total of $600 because it
is less than the opportunity cost of $886.40.
11-39 Opportunity costs. (H. Schaefer, adapted) The Wild Orchid Corporation is working at full
production capacity producing 13,000 units of a unique product, Everlast. Manufacturing cost per
unit for Everlast is:
Manufacturing overhead cost per unit is based on variable cost per unit of $8 and fixed costs of
$78,000 (at full capacity of 13,000 units). Marketing cost per unit, all variable, is $4, and the
selling price is $52.
A customer, the Apex Company, has asked Wild Orchid to produce 3,500 units of Stronglast,
a modification of Everlast. Stronglast would require the same manufacturing processes as
Everlast. Apex has offered to pay Wild Orchid $40 for a unit of Stronglast and share half of the
marketing cost per unit.
Required:
1. What is the opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast?
(Assume that no overtime is worked.)
2. The Chesapeake Corporation has offered to produce 3,500 units of Everlast for Wild Orchid
so that Wild Orchid may accept the Apex offer. That is, if Wild Orchid accepts the
Chesapeake offer, Wild Orchid would manufacture 9,500 units of Everlast and 3,500 units of
Stronglast and purchase 3,500 units of Everlast from Chesapeake. Chesapeake would charge
Wild Orchid $36 per unit to manufacture Everlast. On the basis of financial considerations
alone, should Wild Orchid accept the Chesapeake offer? Show your calculations.
3. Suppose Wild Orchid had been working at less than full capacity, producing 9,500 units of
Everlast, at the time the Apex offer was made. Calculate the minimum price Wild Orchid
should accept for Stronglast under these conditions. (Ignore the previous $40 selling price.)
SOLUTION
(20 min.)
Opportunity costs.
1.
The opportunity cost to Wild Orchid of producing the 3,500 units of Stronglast is the
contribution margin lost on the 3,500 units of Everlast that would have to be forgone, as
computed below:
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Selling price
Variable costs per unit:
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Variable marketing costs
Contribution margin per unit
$
52
$
24
28
$10
2
8
4
$98,000
Contribution margin for 3,500 units ($28  3,500 units)
The opportunity cost is $98,000. Opportunity cost is the maximum contribution to
operating income that is forgone (rejected) by not using a limited resource in its next-best
alternative use.
2.
Contribution margin from manufacturing 3,500 units of Stronglast and purchasing 3,500
units of Everlast from Chesapeake is $105,000, as follows:
Manufacture
Stronglast
Selling price
Variable costs per unit:
Purchase costs
Direct materials
Direct manufacturing labor
Variable manufacturing costs
Variable marketing overhead
Variable costs per unit
Contribution margin per unit
Contribution margin from selling 3,500 units
of Stronglast and 3,500 units of Everlast
($18  3,500 units; $12  3,500 units)
$
40
$
–
10
2
8
2
22
18
$63,000
Purchase
Everlast
$
Total
52
36
$
4
40
12
$42,000
$105,000
As calculated in requirement 1, Wild Orchid’s contribution margin from continuing to
manufacture 3,500 units of Everlast is $98,000. Accepting the Apex Company and Chesapeake
offer will benefit Wild Orchid by $7,000 ($105,000 – $98,000). Hence, Wild Orchid should
accept the Apex Company and Chesapeake Corporation’s offers.
3.
The minimum price would be any price greater than $22, the sum of the incremental costs
of manufacturing and marketing Stronglast as computed in requirement 2. This follows because,
if Wild Orchid has surplus capacity, the opportunity cost = $0. For the short-run decision of
whether to accept Apex’s offer, fixed costs of Wild Orchid are irrelevant. Only the incremental
costs need to be covered for it to be worthwhile for Wild Orchid to accept the Apex offer.
11-40 Make or buy, unknown level of volume. (A. Atkinson, adapted) Denver Engineering
manufactures small engines that it sells to manufacturers who install them in products such as
lawn mowers. The company currently manufactures all the parts used in these engines but is
considering a proposal from an external supplier who wishes to supply the starter assemblies
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used in these engines.
The starter assemblies are currently manufactured in Division 3 of Denver Engineering. The
costs relating to the starter assemblies for the past 12 months were as follows:
Over the past year, Division 3 manufactured 150,000 starter assemblies. The average cost for
each starter assembly is $10 ($1,500,000  150,000).
Further analysis of manufacturing overhead revealed the following information. Of the total
manufacturing overhead, only 25% is considered variable. Of the fixed portion, $300,000 is an
allocation of general overhead that will remain unchanged for the company as a whole if
production of the starter assemblies is discontinued. A further $200,000 of the fixed overhead is
avoidable if production of the starter assemblies is discontinued. The balance of the current fixed
overhead, $100,000, is the division manager’s salary. If Denver Engineering discontinues
production of the starter assemblies, the manager of Division 3 will be transferred to Division 2
at the same salary. This move will allow the company to save the $80,000 salary that would
otherwise be paid to attract an outsider to this position.
Required:
1. Tutwiler Electronics, a reliable supplier, has offered to supply starter-assembly units at $8 per
unit. Because this price is less than the current average cost of $10 per unit, the vice president
of manufacturing is eager to accept this offer. On the basis of financial considerations alone,
should Denver Engineering accept the outside offer? Show your calculations. (Hint:
Production output in the coming year may be different from production output in the past
year.)
2. How, if at all, would your response to requirement 1 change if the company could use the
vacated plant space for storage and, in so doing, avoid $100,000 of outside storage charges
currently incurred? Why is this information relevant or irrelevant?
SOLUTION
(30–40 min.)
1.
Make or buy, unknown level of volume.
The variable costs required to manufacture 150,000 starter assemblies are
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Total variable costs
$400,000
300,000
200,000
$900,000
The variable costs per unit are $900,000 ÷ 150,000 = $6.00 per unit.
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Let X = number of starter assemblies required in the next 12 months.
The data can be presented in both “all data” and “relevant data” formats:
Variable manufacturing costs
Fixed general manufacturing overhead
Fixed overhead, avoidable
Division 2 manager’s salary
Division 3 manager’s salary
Purchase cost, if bought from
Tutwiler Electronics
Total costs
All Data
Relevant Data
Alternative Alternative Alternative Alternative
1:
2:
1:
2: Buy
Make
Buy
Make
$
6X
–
$
6X
–
300,000
$300,000
–
–
200,000
–
200,000
–
80,000
100,000
80,000
$100,000
100,000
–
100,000
–
–
$680,000
+ $ 6X
8X
$400,000
+ $ 8X
–
$380,000
+ $ 6X
8X
$100,000
+ $ 8X
The number of units at which the costs of make and buy are equivalent is
All data analysis:
or
Relevant data analysis:
$680,000 + $6X = $400,000 + $8X
2X = 280,000
X = 140,000
$380,000 + $6X = $100,000 + $8X
2X = 280,000
X = 140,000
Assuming cost minimization is the objective, then
• If production is expected to be less than 140,000 units, it is preferable to buy units
from Tutwiler.
• If production is expected to exceed 140,000 units, it is preferable to manufacture
internally (make) the units.
• If production is expected to be 140,000 units, Denver should be indifferent between
buying units from Tutwiler and manufacturing (making) the units internally.
2.
The information on the storage cost, which is avoidable if self-manufacture is
discontinued, is relevant; these storage charges represent current outlays that are avoidable if
self-manufacture is discontinued. Assume these $100,000 charges are represented as an
opportunity cost of the make alternative. The costs of internal manufacture that incorporate this
$100,000 opportunity cost are
All data analysis:
Relevant data analysis:
$780,000 + $6X
$480,000 + $6X
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Alternatively stated, we would add the following line to the table shown in requirement 1
causing the total costs line to change as follows:
All Data
Alternative 1: Alternative 2:
Make
Buy
Outside storage
charges
Total costs
Relevant Data
Alternative 1: Alternative 2:
Make
Buy
$100,000
$0
$100,000
$0
$780,0001 + 6X
$400,000 + 8X
$480,0002 + 6X
$100,000 + 8X
1
$780,000 = $680,000 + $100,000
2
$480,000 = $380,000 + $100,000
The number of units at which the costs of make and buy are equivalent is
All data analysis:
Relevant data analysis:
$780,000 + $6X = $400,000 + $8X
2X = 380,000
X = 190,000
$480,000 + $6X = $100,000 + $8X
2X = 380,000
X = 190,000
If production is expected to be less than 190,000, it is preferable to buy units from Tutwiler. If
production is expected to exceed 190,000, it is preferable to manufacture the units internally.
11-41 Make versus buy, activity-based costing, opportunity costs. The Lexington Company
produces gas grills. This year’s expected production is 20,000 units. Currently, Lexington makes
the side burners for its grills. Each grill includes two side burners. Lexington’s management
accountant reports the following costs for making the 40,000 burners:
Lexington has received an offer from an outside vendor to supply any number of burners
Lexington requires at $14.80 per burner. The following additional information is available:
a. Inspection, setup, and materials-handling costs vary with the number of batches in which the
burners are produced. Lexington produces burners in batch sizes of 1,000 units. Lexington
will produce the 40,000 units in 40 batches.
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b. Lexington rents the machine it uses to make the burners. If Lexington buys all of its burners
from the outside vendor, it does not need to pay rent on this machine.
Required:
1. Assume that if Lexington purchases the burners from the outside vendor, the facility where
the burners are currently made will remain idle. On the basis of financial considerations
alone, should Lexington accept the outside vendor’s offer at the anticipated volume of 40,000
burners? Show your calculations.
2 For this question, assume that if the burners are purchased outside, the facilities where the
burners are currently made will be used to upgrade the grills by adding a rotisserie
attachment. (Note: Each grill contains two burners and one rotisserie attachment.) As a
consequence, the selling price of grills will be raised by $48. The variable cost per unit of the
upgrade would be $38, and additional tooling costs of $160,000 per year would be incurred.
On the basis of financial considerations alone, should Lexington make or buy the burners,
assuming that 20,000 grills are produced (and sold)? Show your calculations.
3. The sales manager at Lexington is concerned that the estimate of 20,000 grills may be high
and believes that only 16,000 grills will be sold. Production will be cut back, freeing up work
space. This space can be used to add the rotisserie attachments whether Lexington buys the
burners or makes them in-house. At this lower output, Lexington will produce the burners in
32 batches of 1,000 units each. On the basis of financial considerations alone, should
Lexington purchase the burners from the outside vendor? Show your calculations.
SOLUTION
(30 min.)
1.
Make versus buy, activity-based costing, opportunity costs.
Relevant costs under buy alternative:
Purchases, 40,000  $14.80
$592,000
Relevant costs under make alternative:
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Inspection, setup, materials handling
Machine rent
Total relevant costs under make alternative
$320,000
160,000
80,000
8,000
12,000
$580,000
The allocated fixed plant administration, taxes, and insurance will not change if
Lexington makes or buys the burners. Hence, these costs are irrelevant to the make-or-buy
decision. The analysis indicates that it is less costly for Lexington to make rather than buy the
burners from the outside supplier.
2.
Relevant costs under the make alternative:
Relevant costs (as computed in requirement 1)
$580,000
Relevant costs under the buy alternative:
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Costs of purchases (40,000  $14.80)
Additional tooling costs
Additional contribution margin from using the space
where the burners were made to upgrade the grills by
adding rotisserie attachments, 20,000  ($48 – $38)
Total relevant costs under the buy alternative
$592,000
160,000
(200,000)
$552,000
Lexington should buy the side burners from an outside vendor and use its own capacity to
upgrade its grills.
3.
In this requirement, the decision on making the rotisserie attachments is irrelevant to the
analysis because the rotisserie attachments increase operating income and they will be
made whether the burners are purchased or made.
Relevant cost of manufacturing burners:
Variable costs, ($8 + $4 + $2 = $14)  32,000
Batch costs, $200/batcha 32 batches
Machine rent
Relevant cost of buying burners, $14.80  32,000
$448,000
6,400
12,000
$466,400
473,600
a
$8,000  40 batches = $200 per batch
In this case, Lexington should make the burners.
11-42 Product mix, constrained resource. Wechsler Company produces three products: A130,
B324, and C587. All three products use the same direct material, Brac. Unit data for the three
products are:
The demand for the products far exceeds the direct materials available to produce the products.
Brac costs $9 per pound, and a maximum of 5,000 pounds is available each month. Wechsler
must produce a minimum of 200 units of each product.
Required:
1. How many units of product A130, B324, and C587 should Wechsler produce?
2. What is the maximum amount Wechsler would be willing to pay for another 1,200 pounds of
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Brac?
SOLUTION
(25 min.) Product mix, constrained resource.
1.
Selling price
Variable costs:
Direct materials (DM)
Labor and other costs
Total variable costs
Contribution margin
Pounds of DM per unit
Contribution margin per lb.
A130
$252
B324
$ 168
C587
$210
72
84
156
$ 96
÷8 lbs.
$ 12 per lb.
45
81
126
$ 42
÷5 lbs.
$8.40 per lb.
27
120
147
$ 63
÷ 3 lbs.
$ 21 per lb.
First, satisfy minimum requirements.
Minimum units
Times pounds per unit
Pounds needed to produce minimum
units
A130
200
×8 lb. per
unit
1,600
lb.
B324
200
×5 lb. per
unit
1,000
lb.
C587
200
×3 lb. per
unit
600 lb.
Total
3,200
lb.
The remaining 1,800 pounds (5,000 – 3,200) should be devoted to C587 because it has the
highest contribution margin per pound of direct material. Because each unit of C587 requires 3
pounds of Brac, the remaining 1,800 pounds can be used to produce another 600 units of C587.
The following combination yields the highest contribution margin given the 5,000 pounds
constraint on availability of Brac.
A130: 200 units
B324: 200 units
C587: 800 units (200 minimum + 600 extra)
2. The demand for Wechsler’s products exceeds the materials available. Assuming that fixed
costs are covered by the original product mix, Wechsler would be willing to pay up to an
additional $21 per pound (the contribution margin per pound of C587) for another 1,200 pounds
of Brac. That is, Wechsler would be willing to pay $9 + $21 = $30 per pound of Brac for the
pounds of Brac that will be used to produce C587.1 If sufficient demand does not exist for 400
units (1,200 pounds ÷ 3 pounds per unit) of C587, then the maximum price Wechsler would be
willing to pay is an additional $12 per pound (the contribution margin per pound of A130) for the
pounds of Wechsler that will be used to produce A130. In this case Wechsler would be willing to
pay $9 + $12 = $21 pound. If all the 1,200 pounds of Brac are not used to satisfy the demand for
C587 and A130, then the maximum price Wechsler would be willing to pay is an additional
$8.40 per pound (the contribution margin per pound of B324) for the pounds of Brac that will be
used to produce B324. Wechsler would be willing to pay $8.40 + $9 = $17.40 per pound of
Brac.
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1
An alternative calculation focuses on column 3 for C587 of the table in requirement 1.
Selling price
$210
Variable labor and other costs (excluding direct materials)
120
Contribution margin
$ 90
Divided by pounds of direct material per unit
÷3
lbs.
Direct material cost per pound that Wechsler can pay
without contribution margin becoming negative
$ 30
11-43 Product mix, special order. (N. Melumad, adapted) Gormley Precision Tools makes
cutting toolsfor metalworking operations. It makes two types of tools: A6, a regular cutting tool,
and EX4, a high-precisioncutting tool. A6 is manufactured on a regular machine, but EX4 must
be manufactured on both the regularmachine and a high-precision machine. The following
information is available:
Additional information includes the following:
a. Gormley faces a capacity constraint on the regular machine of 50,000 hours per year.
b. The capacity of the high-precision machine is not a constraint.
c. Of the $1,100,000 budgeted fixed overhead costs of EX4, $600,000 are lease payments for
the high-precisionmachine. This cost is charged entirely to EX4 because Gormley uses the
machine exclusively to produce EX4. The company can cancel the lease agreement for the
high-precision machine at any time without penalties.
d. All other overhead costs are fixed and cannot be changed.
Required:
1. What product mix—that is, how many units of A6 and EX4—will maximize Gormley’s
operating income? Show your calculations.
2. Suppose Gormley can increase the annual capacity of its regular machines by 15,000
machine hours at a cost of $300,000. Should Gormley increase the capacity of the regular
machines by 15,000 machine-hours? By how much will Gormley’s operating income
increase or decrease? Show your calculations.
3. Suppose that the capacity of the regular machines has been increased to 65,000 hours.
Gormley has been approached by Clark Corporation to supply 20,000 units of another cutting
tool, V2, for $240 per unit. Gormley must either accept the order for all 20,000 units or reject
it totally. V2 is exactly like A6 except that its variable manufacturing cost is $140 per unit. (It
takes 1 hour to produce one unit of V2 on the regular machine, and variable marketing cost
equals $30 per unit.) What product mix should Gormley choose to maximize operating
income? Show your calculations.
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SOLUTION
(30–40 min.)
Product mix, relevant costs.
1.
A6
Selling price
Variable manufacturing cost per unit
Variable marketing cost per unit
Total variable costs per unit
Contribution margin per unit
Contribution margin per hour of the
constrained resource
Total contribution margin from selling only A6
or only EX4
A6: $50  50,000; EX4: $60  50,000
Less Lease costs of high-precision machine
to produce and sell EX4
Net relevant benefit
$
200
120
30
150
50
EX4
$
300
200
70
270
30
$
$50
= $50
1
$
$30
= $60
0.5
$2,500,000
$3,000,000
0
$2,500,000
600,000
$2,400,000
Even though EX4 has the higher contribution margin per unit of the constrained resource, the
fact that Gormley must incur additional costs of $600,000 to achieve this higher contribution
margin means that Gormley is better off using its entire 50,000-hour capacity on the regular
machine to produce and sell 50,000 units (50,000 hours  1 hour per unit) of A6. The additional
contribution from selling EX4 rather than A6 is $500,000 ($3,000,000  $2,500,000), which is
not enough to cover the additional costs of leasing the high-precision machine. Note that,
because all other overhead costs are fixed and cannot be changed, they are irrelevant for the
decision. Gormley produces 50,000 units of A6, which increases operating income by
$2,500,000.
2.
If capacity of the regular machines is increased by 15,000 machine-hours to 65,000
machine-hours (50,000 originally + 15,000 new), the net relevant benefit from producing A6 and
EX4 is as follows:
A6
EX4
Total contribution margin from selling only
A6 or only EX4
A6: $50  65,000; EX4: $60  65,000
Less Lease costs of high-precision machine
that would be incurred if EX4 is produced and sold
Less Cost of increasing capacity by
15,000 hours on regular machine
Net relevant benefit
$3,250,000
$3,900,000
600,000
300,000
$2,950,000
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$3,000,000
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Adding 15,000 machine-hours of capacity for regular machines and using all the capacity to
produce EX4 increases operating income by $3,000,000.
Investing in the additional capacity increases Gormley’s operating income by $500,000
($3,000,000 calculated in requirement 2 minus $2,500,000 calculated in requirement 1), so
Gormley should add 15,000 hours to the regular machine. With the extra capacity available to it,
Gormley should use its entire capacity to produce EX4. Using all 65,000 hours of capacity to
produce EX4 rather than to produce A6 generates additional contribution margin of $650,000
($3,900,000  $3,250,000), which is more than the additional cost of $600,000 to lease the highprecision machine. Gormley should therefore produce and sell 130,000 units of EX4 (65,000
hours  0.5 hours per unit of EX4) and zero units of A6.
3.
Selling price
Variable manufacturing costs per unit
Variable marketing costs per unit
Total variable costs per unit
Contribution margin per unit
A6
EX4
V2
$200
120
30
150
$ 50
$300
200
70
270
$ 30
$240
140
30
170
$ 70
$30
$70
$50
Contribution margin per unit of the constrained resource 1 = $50; 0.5 = $60; 1 = $70
The first step is to compare the operating profits that Gormley could earn if it accepted the
Clark Corporation offer for 20,000 units with the operating profits Gormley is currently
earning. V2 has the highest contribution margin per hour on the regular machine and
requires no additional investment such as leasing a high-precision machine. To produce the
20,000 units of V2 requested by Clark Corporation, Gormley would require 20,000 hours
on the regular machine resulting in contribution margin of $70 20,000 = $1,400,000.
Gormley now has 45,000 hours available on the regular machine to produce A6 or EX4.
Total contribution margin from selling only
A6 or only EX4
A6: $50  45,000; EX4: $60  45,000
Less Lease costs of high-precision machine
to produce and sell EX4
Net relevant benefit
A6
EX4
$2,250,000
$2,700,000

$2,250,000
600,000
$2,100,000
Gormley should use all the 45,000 hours of available capacity to produce 45,000 units of A6. Thus, the
product mix that maximizes operating income is 20,000 units of V2, 45,000 units of A6, and zero units
of EX4. This optimal mix results in a contribution margin of $3,650,000 ($1,400,000 from V2 and
$2,250,000 from A6). Relative to requirement 2, operating income increases by $650,000 ($3,650,000
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minus $3,000,000 calculated in requirement 2). Hence, Gormley should accept the Clark Corporation
business and supply 20,000 units of V2.
11-44 Theory of constraints, throughput margin, and relevant costs. Rush Industries
manufactureselectronic testing equipment. Rush also installs the equipment at customers’ sites
and ensures that it functions smoothly. Additional information on the manufacturing and
installation departments is as follows (capacities are expressed in terms of the number of units
of electronic testing equipment):
Rush manufactures only 275 units per year because the installation department has only enough
capacity to install 275 units. The equipment sells for $45,000 per unit (installed) and has direct
material costs of $20,000. All costs other than direct material costs are fixed. The following
requirements refer only to the preceding data. There is no connection between the requirements.
Required:
1. Rush’s engineers have found a way to reduce equipment manufacturing time. The new
method would cost an additional $50 per unit and would allow Rush to manufacture 20
additional units a year. Should Rush implement the new method? Show your calculations.
2. Rush’s designers have proposed a change in direct materials that would increase direct
material costs by $2,000 per unit. This change would enable Rush to install 310 units of
equipment each year. If Rush makes the change, it will implement the new design on all
equipment sold. Should Rush use the new design? Show your calculations.
3. A new installation technique has been developed that will enable Rush’s engineers to install 7
additional units of equipment a year. The new method will increase installation costs by
$55,000 each year. Should Rush implement the new technique? Show your calculations.
4. Rush is considering how to motivate workers to improve their productivity (output per hour).
Oneproposal is to evaluate and compensate workers in the manufacturing and installation
departments onthe basis of their productivities. Do you think the new proposal is a good
idea? Explain briefly.
SOLUTION
(20 min.)
Theory of constraints, throughput contribution, relevant costs.
1.
It will cost Rush $50 per unit to reduce manufacturing time. But manufacturing is not a
bottleneck operation; installation is. Therefore, manufacturing more equipment will not increase
sales and throughput margin. Rush Industries should not implement the new manufacturing
method.
2.
Increase in throughput margin, $25,000  35 units,
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Additional relevant costs of new direct materials, $2,000  310 units,
620,000
Increase/(Decrease) in operating income
$ 255,000
The benefits from higher margin exceeds the additional incremental costs by $225,000 and,
therefore, Rush Industries should implement the new design.
Alternatively, compare throughput margin under each alternative.
With the modification, throughput margin is $23,000  310
Current throughput margin is $25,000  275
Increase/(Decrease) in operating income
$7,130,000
6,875,000
$ 255,000
The throughput margin resulting from the proposed change in direct materials is greater than the
current throughput margin. Therefore, Nebraska Industries should implement the new design.
3.
Increase in throughput margin, $25,000  7 units
Increase in relevant costs
Increase in operating income
$ 175,000
55,000
$ 120,000
The additional throughput margin exceeds incremental costs by $120,000, so Rush Industries
should implement the new installation technique.
4.
Motivating installation workers to increase productivity is worthwhile because
installation is a bottleneck operation, and any increase in productivity at the bottleneck will
increase throughput margin. On the other hand, motivating workers in the manufacturing
department to increase productivity is not worthwhile. Manufacturing is not a bottleneck
operation, so any increase in output will result only in extra inventory of equipment. Rush
Industries should encourage manufacturing to produce only as much equipment as the
installation department needs, not to produce as much as it can. Under these circumstances, it
would not be a good idea to evaluate and compensate manufacturing workers on the basis of
their productivity.
11-45 Theory of constraints, contribution margin, sensitivity analysis. Talking Toys (TT)
produces dollsin two processes: molding and assembly. TT is currently producing two models:
Chatty Chelsey and Talking Tanya. Production in the molding department is limited by the
amount of materials available. Production in the assembly department is limited by the amount
of trained labor available. The only variable costs are materials in the molding department and
labor in the assembly department. Following are the requirements and limitations by doll model
and department:
The following requirements refer only to the preceding data. There is no connection between the
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requirements.
Required:
1. If there were enough demand for either doll, which doll would TT produce? How many of
these dolls would it make and sell?
2. If TT sells three Chatty Chelseys for each Talking Tanya, how many dolls of each type would
it produce and sell? What would be the total contribution margin?
3. If TT sells three Chatty Chelseys for each Talking Tanya, how much would production and
contribution margin increase if the molding department could buy 900 more pounds of
materials for $8 per pound?
4. If TT sells three Chatty Chelseys for each Talking Tanya, how much would production and
contribution margin increase if the assembly department could get 65 more labor hours at
$12 per hour?
SOLUTION
11-45 (30-35 min.) Theory of constraints, contribution margin, sensitivity analysis.
1.
Assuming only one type of doll is produced, the maximum production in each department
given their resource constraints is:
Chatty Chelsey
Talking Tanya
Molding
Department
36,000 lbs
= 18,000
2 lbs
36,000 lbs
= 12,000
3 lbs
Assembly
Department
8,500 hours
= 34,000
1/4 hours
8,500 hours
= 25,500
1/3hours
Contribution Margin
$39 − 2 × $8 – 1/4 × $12
= $20
$50 − 3 × $8–1/3 × $12
= $22
For both types of dolls, the constraining resource is the availability of material because this
constraint causes the lowest maximum production.
If only Chatty Chelsey is produced, TT can produce 18,000 dolls with a contribution margin of
18,000 ×$20 = $360,000
If only Talking Tanya is produced, TTcan produce 12,000 dolls with a contribution margin of
12,000 ×$22 = $264,000.
TT should produce Chatty Chelseys.
2.
As shown in Requirement 1, available material in the Molding department is the limiting
constraint.
If TT sells three Chatty Chelseys for each Talking Tanya, then the maximum number of
Talking Tanya dolls the Molding Departmentcan produce (where the number of Talking Tanya
dolls is denoted as T) is:
(T ×3 lbs.) + ([3 × T] × 2 lbs.) = 36,000lbs.
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3T + 6T = 36,000
9T = 36,000
T = 4,000
The Molding Department can produce 4,000 Talking Tanya dolls, and 3 ×4,000
(or 12,000) Chatty Chelsey dolls.
Because TT can only produce 4,000 Talking Tanyas and 12,000 Chatty Chelseys before it runs
out of ingredients, the maximum contribution margin (CM) is:
Contribution margin
from Chatty Chelsey
+
Contribution margin
from Talking Tanya
= 12,000 × $20 + 4,000 × $22
= $240,000 + 88,000
= $328,000
3.
With 900 more pounds of materials, TT would produce more dolls. Using the same
technique as in Requirement 2, the increase in production is:
(T×3 lbs.) + ([3×T] ×2 lbs.) = 900 lbs.
3T + 6T = 900
T = 100
TT would produce 100 extra Talking Tanya dolls and 300 extra Chatty Chelsey dolls.
Contribution margin would increase by
Contribution margin + Contribution margin = 300  $20 + 100  $22
from Chatty Chelsey from Talking Tanya
= $6,000 + $2,200
= $8,200
4.
With 65 more labor hours, production would not change. The limiting constraint is
pounds of material, not labor hours. TT already has more labor hours available than it needs.
11-46 Closing down divisions. Ainsley Corporation has four operating divisions. The budgeted
revenues and expenses for each division for 2017 follows:
Closing down any division would result in savings of 40% of the fixed costs of that division. Top
management is very concerned about the unprofitable divisions (A and B) and is considering
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closing them for the year.
Required:
1. Calculate the increase or decrease in operating income if Ainsley closes division A.
2. Calculate the increase or decrease in operating income if Ainsley closes division B.
3. What other factors should the top management of Ainsley consider before making a
decision?
SOLUTION
(25 min.) Closing down divisions.
1. and 2.
Sales
Variable costs of goods sold
($440,000  0.90; $930,000  0.80)
Variable S,G & A
($96,000  0.50; $202,500  0.50)
Total variable costs
Contribution margin
Fixed costs of goods sold
($440,000  0.10; $930,000  0.20)
Fixed S,G & A
($96,000  0.50; $202,500  0.50)
Total fixed costs
Fixed costs savings if shutdown
($92,000  0.40; $287,250  0.40)
Division A
Division B
$504,000
$948,000
396,000
48,000
444,000
$ 60,000
744,000
101,25
0
845,250
$102,750
Division A
Division B
$ 44,000
$186,000
48,000
$ 92,000
101,250
$287,250
$ 36,800
$114,900
Division A’s contribution margin of $60,000 more than covers its avoidable fixed costs of
$36,800. The difference of $23,200 helps cover the company’s unavoidable fixed costs.
Because $36,800 of Division A’s fixed costs are avoidable, the remaining $55,200 is unavoidable
and will be incurred regardless of whether Division A continues to operate. Division A’s $32,000
loss is the rest of the unavoidable fixed costs ($55,200 – $23,200). If Division A is closed, the
remaining divisions will need to generate sufficient profits to cover the entire $55,200
unavoidable fixed cost. Consequently, Division A should not be closed because it helps defray
$23,200 of this cost.
Division B earns a positive contribution margin of $102,750. Division B also generates
$114,900 of avoidable fixed costs. Based strictly on financial considerations, Division B should
be closed because the company will save $12,150 ($114,900 –$102,750). Division B is currently
incurring $114,900 in fixed costs that it could have avoided while earning only $102,750 in
contribution margin.
An alternative set of calculations is as follows:
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Division A
Division B
Total variable costs
Avoidable fixed costs if shutdown
Total cost savings if shutdown
Loss of revenues if shutdown
$444,000
36,800
480,800
(504,000)
$845,250
114,900
960,150
(948,000)
Cost savings minus loss of revenues
$ (23,200)
$ 12,150
Division A should not be shut down because loss of revenues if Division A is shut down exceeds
cost savings by $23,200. Division B should be shut down because cost savings from shutting
down Division B exceeds loss of revenues by $12,150.
3.
Before deciding to close Division B, management should consider the role that the
Division’s product line plays relative to other product lines. For instance, if the product
manufactured by Division B attracts customers to the company, then dropping Division B may
have a detrimental effect on the revenues of the remaining divisions. Management may also
want to consider the impact on the morale of the remaining employees if Division B is closed.
Talented employees may become fearful of losing their jobs and seek employment elsewhere.
11-47 Dropping a product line, selling more tours. Mechum River Anglers, a division of Old
Dominion Travel, offers two types of guided fly fishing tours, Basic and Deluxe. Operating
income for each tour type in 2017 is as follows:
Basic
Deluxe
Revenues (500 × $900; 400 × $1,650)
$450,000
$660,000
Operating costs
Administrative salaries
120,000
100,000
Guide wages
130,000
380,000
Supplies
50,000
100,000
Depreciation of equipment
25,000
60,000
Vehicle fuel
30,000
24,000
Allocated corporate overhead
45,000
66,000
Total operating costs
400,000
730,000
Operating income (loss)
$50,000
$(70,000)
The equipment has a zero disposal value. Guide wages, supplies, and vehicle fuel are
variable costs with respect to the number of tours. Administrative salaries are fixed costs
with respect to the number of tours. Brad Barrett, Mechum River Anglers’ president, is
concerned about the losses incurred on the deluxe tours. He is considering dropping the
deluxe tour and offering only the basic tour.
Required:
1. If the deluxe tours are discontinued, one administrative position could be eliminated, saving
the company $50,000. Assuming no change in the sales of basic tours, what effect would
dropping the deluxetour have on the company’s operating income?
2. Refer back to the original data. If Mechum River Anglers drops the deluxe tours, Barrett
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estimates that sales of basic tours would increase by 50%. He believes that he could still
eliminate the $50,000 administrative position. Equipment currently used for the deluxe tours
would be used by the additional basic tours. Should Barrett drop the deluxe tour? Explain.
3. What additional factors should Barrett consider before dropping the deluxe tours?
SOLUTION
(30 min.) Dropping a product line, selling more tours
1.
Barrett should not drop the deluxe tours, as follows:
Lost revenues from deluxe tours
Avoidable operating costs from dropping deluxe tours:
Administrative salaries
Guide wages
Supplies
Vehicle fuel
Total avoidable costs
Lost operating income from dropping deluxe tours
$(660,000)
50,000
380,000
100,000
24,000
554,000
$(106,000)
Note: Equipment depreciation, allocated corporate costs, and unavoidable administrative salaries
are irrelevant to the decision.
2.
Barrett should drop the deluxe tours, as follows:
Change in revenues
Change in operating costs:
Administrative salaries
Guide wages
Supplies
Vehicle fuel
Total change in operating costs
Change in operating income
Basic
$225,000
Deluxe
$(660,000)
Total
$(435,000)
0
65,000
25,000
15,000
105,000
$120,000
(50,000)
(380,000)
(100,000)
(24,000)
(554,000)
$(106,000)
(50,000)
(315,000)
(75,000)
(9,000)
(449,000)
$ 14,000
3.
Barrett should consider if it is possible to increase the number of deluxe tours sold, or if it
is possible to reduce the costs of those tours before dropping them. He could also investigate the
possibility of increasing the price of the deluxe tours if customers would tolerate it.
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11-48 Optimal product mix. (CMA adapted) Della Simpson, Inc., sells two popular brands of
cookies: Della’s Delight and Bonny’s Bourbon. Della’s Delight goes through the Mixing and
Baking departments, and Bonny’s Bourbon, a filled cookie, goes through the Mixing, Filling, and
Baking departments.
Michael Shirra, vice president for sales, believes that at the current price, Della Simpson can
sell all of its daily production of Della’s Delight and Bonny’s Bourbon. Both cookies are made in
batches of 3,000. In each department, the time required per batch and the total time available
each day are as follows:
Revenue and cost data for each type of cookie are as follows:
Required:
1. Using D to represent the batches of Della’s Delight and B to represent the batches of Bonny’s
Bourbon made and sold each day, formulate Shirra’s decision as an LP model.
2. Compute the optimal number of batches of each type of cookie that Della Simpson, Inc.,
should make and sell each day to maximize operating income.
SOLUTION
(30–40 min.)
1.
Optimal product mix.
Let D represent the batches of Della’s Delight made and sold.
Let B represent the batches of Bonny’s Bourbon made and sold.
The contribution margin per batch of Della’s Delight is $300.
The contribution margin per batch of Bonny’s Bourbon is $250.
The LP formulation for the decision is:
Maximize
$300D + $250 B
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Subject to
30D + 15B  660 (Mixing Department constraint)
15B  270 (Filling Department constraint)
10D + 15B  300 (Baking Department constraint)
2.
Solution Exhibit 11-48 presents a graphical summary of the relationships. The optimal
corner is the point (18, 8) i.e., 18 batches of Della’s Delights and 8 batches of Bonny’s Bourbons.
SOLUTION EXHIBIT 11-48
Graphic Solution to Find Optimal Mix, Della Simpson, Inc.
Della Simpson Production Model
50
45
0, 44
Mixing Dept. Constraint
40
35
Equal Contribution
Margin Lines
30
Optimal Corner (18,8)
25
20
Filling Dept. Constraint
3, 18
B (batches of Bonny's Bourbons)
0, 18
15
10
Feasible Region
5
Baking Dept. Constraint
0
0
5
10
15
20
22, 0
25
D (batches of Della's Delight)
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30
35
40
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We next calculate the optimal production mix using the trial-and-error method.
The corner point where the Mixing Dept. and Baking Dept. constraints intersect can be
calculated as (18, 8) by solving:
30D + 15B = 660 (1) Mixing Dept. constraint
10D + 15B = 300 (2) Baking Dept. constraint
Subtracting (2) from (1), we have
20D
= 360
or D
= 18
Substituting in (2)
(10  18) + 15B = 300
that is,
15B = 300  180 = 120
or
B = 8
The corner point where the Filling and Baking Department constraints intersect can be calculated
as (3,18) by substituting B = 18 (Filling Department constraint) into the Baking Department
constraint:
10 D + (15 18) = 300
10 D = 300  270 = 30
D= 3
The feasible region, defined by five corner points, is shaded in Solution Exhibit 11-43. We next
use the trial-and-error method to check the contribution margins at each of the five corner points
of the area of feasible solutions.
Trial
1
2
3
4
5
Corner (D,B)
(0,0)
(22,0)
(18,8)
(3,18)
(0,18)
Total Contribution Margin
($300  0) + ($250  0) = $0
($300  22) + ($250  0) = $6,600
($300  18) + ($250  8) = $7,400
($300  3) + ($250  18) = $5,400
($300  0) + ($250  18) = $4,500
The optimal solution that maximizes contribution margin and operating income is 18 batches of
Della’s Delights and 8 batches of Bonny’s Bourbons.
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11-49 Dropping a customer, activity-based costing, ethics. Justin Anders is the
management accountant for Carey Restaurant Supply (CRS). Sara Brinkley, the CRS sales
manager, and Justin are meeting to discuss the profitability of one of the customers,
Donnelly’s Pizza. Justin hands Sara the following analysis of Donnelly’s activity during the
last quarter, taken from CRS’s activity-based costing system:
Sara looks at the report and remarks, “I’m glad to see all my hard work is paying off with
Donnelly’s. Sales have gone up 10% over the previous quarter!”
Justin replies, “Increased sales are great, but I’m worried about Donnelly’s margin, Sara. We
were showing a profit with Donnelly’s at the lower sales level, but now we’re showing a loss.
Gross margin percentage this quarter was 40%, down five percentage points from the prior
quarter. I’m afraid that corporate will push hard to drop them as a customer if things don’t turn
around.”
“That’s crazy,” Sara responds. “A lot of that overhead for things like order processing,
deliveries, and sales calls would just be allocated to other customers if we dropped
Donnelly’s. This report makes it look like we’re losing money on Donnelly’s when we’re not.
In any case, I am sure you can do something to make its profitability look closer to what we
think it is. No one doubts that Donnelly’s is a very good customer.”
Required:
1. Assume that Sara is partly correct in her assessment of the report. Upon further
investigation, it is determined that 10% of the order processing costs and 20% of the
delivery costs would not be avoidable if CRS were to drop Donnelly’s. Would CRS benefit
from dropping Donnelly’s? Show your calculations.
2. Sara’s bonus is based on meeting sales targets. Based on the preceding information regarding
gross margin percentage, what might Sara have done last quarter to meet her target and
receive her bonus? How might CRS revise its bonus system to address this?
3. Should Justin rework the numbers? How should he respond to Sara’s comments about
making Donnelly’s look more profitable?
SOLUTION
(25 min.)
Dropping a customer, activity-based costing, ethics.
1. CRS would not benefit from dropping Donnelly’s Pizza because it would lose $43,680 in
revenues and save $43,344 in costs resulting in a $336 decrease in operating income.
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Difference:
Incremental
(Loss in Revenues)
and Savings in Costs from
Dropping Donnelly’s Pizza
Revenues
Cost of goods sold
Order processing ($14,000 – 10% × $14,000)
Delivery ($3,500 – 20% × $3,500)
Rush orders
Sales calls
Total costs
Effect on operating income (loss)
$(43,680)
26,180
12,600
2,800
924
840
43,344
$ (336)
2. The drop in gross margin percentage indicates that Sara may be giving Donnelly’s Pizza
excessive discounts, perhaps in excess of company guidelines. If CRS awards bonuses based on
sales rather than some measure of operating income, it may encourage sales representatives to
lower margins in order to increase sales. CRS may want to consider basing bonuses on customer
margin. The company may also want to enforce more stringent discounting guidelines.
3. Justin could suggest that Sara approach Donnelly’s Pizza about reducing the number of
different orders that they place. If the orders could be placed less frequently, the company could
reduce both order processing and delivery costs. Sara could also investigate the causes of the
rush orders to see if they could be avoided.
Justin should not rework the numbers. Referring to “Standards of Ethical Conduct for
Management Accountants,” in Exhibit 1-7, Justin Anders should consider the request of Sara
Brinkley to be unethical for the following reasons.
Competence
 Prepare complete and clear reports and recommendations after appropriate analysis of
relevant and reliable information. Adjusting cost numbers violates the competence standard.
Integrity
 Refrain from either actively or passively subverting the attainment of the organization’s
legitimate and ethical objectives. Justin has the responsibility to act in the best interests of
CRS.

Communicate unfavorable as well as favorable information and professional judgments or
opinions. Justin needs to communicate the proper and accurate results of the analysis,
regardless of whether or not it pleases Sara Brinkley.

Refrain from engaging in or supporting any activity that would discredit the profession.
Falsifying the analysis would discredit Justin and the profession.
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Credibility
 Communicate information fairly and objectively. Justin needs to perform an objective
analysis of Donnelly’s Pizza profitability and communicate the results fairly.

Disclose fully all relevant information that could reasonably be expected to influence an
intended user’s understanding of the reports, comments, and recommendations presented.
Justin needs to fully present an accurate analysis.
Confidentiality
 Not affected by this decision.
Justin should indicate to Sara that the costs he has derived are correct. If Sara still insists on
making the changes to lower the costs to serve Donnelly’s Pizza, Justin should raise the
matter with Sara’s superior, after informing Sara of his plans. If, after taking all these steps,
there is a continued pressure to understate costs, Justin should consider resigning from the
company rather than engage in unethical conduct.
11-50 Equipment replacement decisions and performance evaluation. Susan Smith manages
the Wexford plant of Sanchez Manufacturing. A representative of Darnell Engineering
approaches Smith about replacing a large piece of manufacturing equipment that Sanchez uses in
its process with a more efficient model. While the representative made some compelling
arguments in favor of replacing the 3-year-old equipment, Smith is hesitant. Smith is hoping to
be promoted next year to manager of the larger Detroit plant, and she knows that the accrualbasis net operating income of the Wexford plant will be evaluated closely as part of the
promotion decision. The following information is available concerning the equipmentreplacement decision:
Sanchez uses straight-line depreciation on all equipment. Annual depreciation expense for the
old machine is $180,000 and will be $270,000 on the new machine if it is acquired. For
simplicity, ignore income taxes and the time value of money.
Required:
1. Assume that Smith’s priority is to receive the promotion and she makes the equipment-
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replacement decision based on the next one year’s accrual-based net operating income.
Which alternative would she choose? Show your calculations.
2. What are the relevant factors in the decision? Which alternative is in the best interest of the
company over the next 2 years? Show your calculations.
3. At what cost would Smith be willing to purchase the new equipment? Explain.
SOLUTION
(30 min.)
Equipment replacement decisions and performance evaluation.
1.
Operating income for the first year under the keep and replace alternatives are shown
below.
Year 1
Cash operating costs
Depreciation
($540,000  2; $900,000 ÷ 5)
Loss on disposal of old machine
($360,000 – $216,000; $0)
Total costs
Replace
With New
Machine
(1)
$ 800,000
Keep Old
Machine
(2)
$ 995,000
Cost
Difference
by Replacing
(3) = (1) – (2)
$(195,000)
270,000
180,000
90,000
144,000
$1,214,000
0
$1,175,000
144,000
$ 39,000
First-year costs are lower by $39,000 under the keep machine alternative, and Susan Smith, with
her one-year horizon and operating income-based bonus, will choose to keep the machine.
2.
Based on the analysis in the table below, Sanchez Manufacturing will be better off by
$66,000 over two years if it replaces the current equipment.
Comparing Relevant Costs of
Replace and Keep Alternatives
Cash operating costs
Current disposal price
One time capital costs, written off
periodically as depreciation
Total relevant cashflow
Over 2 Years
Replace
Keep
(1)
(2)
$1,600,000
$1,990,000
(216,000)
0
540,000
$1,924,000
0
$1,990,000
Cash Outflow
By Replacing
(3) = (1) – (2)
$(390,000)
(216,000)
540,000
$ (66,,000)
Note that the book value of the current machine ($360,000) would either be written off as
depreciation over two years under the keep option, or, all at once in the current year under the
replace option. Its net effect would be the same in both alternatives: to increase costs by
$360,000 over two years; hence, it is irrelevant in this analysis.
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This problem illustrates the conflict between the decision model and the performance
evaluation model. From the perspective of Sanchez Manufacturing, the old machine should be
replaced. Over the longer two-year horizon, replacing the old machine with the new equipment
saves Sanchez Manufacturing $66,000. From a performance evaluation perspective, Susan Smith
prefers to keep the old machine because operating income in the first year will be $39,000 higher
if she keeps rather than replaces the old machine. Chapter 23 describes methods that companies
use to reduce the conflict between the decision model and the performance evaluation model.
3.
Smith would be willing to purchase the new equipment if the effect on operating income
in the first year would be zero or positive, that is, if the cost of operating the new equipment in
the first year were equal to or lower than the cost of operating the old machine.
From requirement 1, the cost difference in the first year from replacing the old machine
needs to be reduced by $39,000. This means that depreciation on the new equipment must be
$39,000 less than it is, so $270,000 – $39,000 = $231,000.
The new equipment is being depreciated over a two-year period with zero residual value
so the cost of the equipment equals $231,000  2 = $462,000. If the new equipment can be
purchased for $462,000 or less, Susan Smith will be willing to purchase it because the
performance evaluation model would be consistent with the decision model.
Note that over the two-year period, Sanchez Manufacturing will be better off purchasing
the new equipment for $462,000 by $144,000, as the following presentation of the analysis done
in requirement 2 shows:
Cash Outflow
by Replacing
Cash operating costs
Current disposal price
One-time capital costs, written off periodically as depreciation
Total relevant cash flow
–$390,000
–$216,000
+$462,000
–$144,000
Try It 11-1 Solution
The relevant revenues and costs are the expected future revenues and costs that differ as a result
of Rainier accepting the special offer:
Revenues ($60 per hour × 1,000 hours)
$60,000
Variable landscaping costs ($50 per hour 1,000 hours)
Increase in operating income by accepting the one-time special order
50,000
$10,000
The fixed landscaping costs and all marketing costs (including variable marketing costs) are
irrelevant in this case because these costs will not change in total whether the special order is
accepted or rejected. In this example, by focusing only on the relevant amounts, the manager
avoids a misleading implication: to reject the special order because the $60-per-hour selling price
is lower than the landscaping cost per hour of $62, which includes both relevant variable
landscaping costs and irrelevant fixed landscaping costs.
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Try It 11-2 Solution
Rainier could use either the Total Alternatives Approach or the Opportunity-Cost Approach to
make a decision.
Total Alternatives Approach
The two options available to Rainier are
1. Do 8,000 hours of landscaping work for its current customers and 2,000 hours of work for
Victoria
2. Do 9,000 hours of landscaping work for its current customers
The table below presents the relevant revenues and relevant costs, those future revenues and
costs that differ between the alternatives. It shows that Rainier is better off rejecting Victoria’s
offer because it reduces operating income by $12,000.
Current customers: 8,000 hours
Victoria:
2,000 hours
Current customers: 9,000 hours
Relevant revenues
($80×8,000+$60×2,000)
$760,000
($80×9,000)
$720,000
Relevant costs
Variable landscaping costs
500,000
($50×10,000)
450,000
($50×9,000)
Variable marketing costs
(5%×$760,000)
38,000
36,000
(5%×$720,000)
Total relevant costs
Relevant operating income
538,000
486,000
$222,000
$234,000
The Opportunity Cost Approach
In the opportunity-cost approach, the options are defined as follows
1. Accept Victoria’s offer for 2,000 hours of landscaping work
2. Reject Victoria’s offer
The analysis focuses only on the Victoria offer.
We first calculate the opportunity cost of accepting Victoria’s offer.
There is no opportunity cost for the first 1,000 hours of equipment time since Rainier has 10,000
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hours of equipment time and its current customers require only 9,000 hours.
For using the next 1,000 hours of equipment time on the Victoria offer, Rainier will have to forgo
contribution margin on the 1,000 hours of services it would have sold to its existing customers.
Revenue from 1,000 hours of landscaping for existing customers ($80 × 1,000 hours)
Variable costs of landscaping ($50 × 1,000 hours)
$80,000
50,000
Variable marketing costs (5% × $80,000)
4,000
Contribution margin from 1,000 hours of landscaping from serving existing customers $26,000
The opportunity cost of accepting Victoria’s offer is $26,000.
We next focus only on Victoria’s offer and the effect on operating income from accepting it.
Accept Victoria’s offer
Incremental future revenues
Reject Victoria’s offer
$120,000 ($60 × 2,000 hours)
$0
100,000 ($50 × 2,000 hours)
0
6,000 (5% × $120,000)
0
Incremental future costs
Variable landscaping costs
Variable marketing costs
Opportunity cost of using
1,000 hours of equipment for
the Victoria offer and forgoing
the profit contribution on
existing customers
Total relevant costs
Effect on operating income of
accepting Victoria’s offer
26,000
0
132,000
0
$ (12,000)
$0
The opportunity cost approach yields the same conclusions as the total alternatives approach.
Rainier’s operating income decreases by $12,000 if it accepts Victoria’s offer. Note that by
considering only the incremental revenues and incremental costs, it would appear that Rainier
should accept Victoria’s offer because incremental revenues exceeds incremental costs of the
Victoria offer by $14,000 ($120,000 − $106,000). But there is an opportunity cost of $26,000 by
using the equipment for Victoria’s business because the next-best use of this equipment by
Rainier would result in using 1,000 hours to service existing customers that would increase
operating income by $26,000. Unless the contract with Victoria results in more than $26,000 in
operating income, Rainier should reject the offer.
Try It 11-3 Solution
This problem is one of making product (or customer)-mix decisions with capacity constraints.
Rainier’s managers should choose the product with the highest contribution margin per unit of
the constraining resource (equipment hours). That’s the resource that restricts or limits the sale
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of Rainier’s services.
Contribution margin from regular customers:
Revenues ($80 × 9,000 hours)
$720,000
Variable landscaping costs (including materials and labor), which vary
with the number of hours worked ($50 per hour × 9,000 hours)
Variable marketing costs (5% of revenue)
450,000
36,000
Total variable costs
486,000
Contribution margin
$234,000
Contribution margin per hour of equipment time from regular customers
($234,000÷9,000 hours)
$26 per hour
Contribution margin from Hudson Corporation:
Revenues ($70 × 4,000 hours)
$280,000
Variable landscaping costs (including materials and labor), which vary
with the number of hours worked ($45 per hour × 4,000 hours)
Variable marketing costs (5% of revenue)
180,000
14,000
Total variable costs
194,000
Contribution margin
$ 86,000
Contribution margin per hour of equipment time from Hudson Corporation
($86,000 ÷ 4,000 hours)
$21.50 per hour
To maximize operating income, Rainier should allocate as much of its capacity to customers who
generate the most contribution margin per unit of the constraining resource (equipment). That is,
Rainier should first allocate equipment capacity to existing customers ($26 per hour) and only
the balance to Hudson Corporation ($21.50 per hour). Rainier maximizes total contribution
margin by allocating 9,000 hours of equipment capacity to existing customers yielding
contribution margin of $234,000 ($26 per hour × 9,000 hours) and only the balance 1,000 hours
to Victoria Corporation yielding contribution margin of $21,500 ($21.50 per hour × 1,000 hours)
for a total contribution margin of $255,500 ($234,000 + $21,500).
Try It 11-4 Solution
1.
Irving should close down the Oakland store (see Exhibit Try It 11-4, Column 1). Closing
down the store results in a loss of revenues of $1,700,000 but cost savings of $1,720,000 (from
cost of goods sold, rent, labor, utilities, and corporate costs). Note that by closing down the
Oakland store, Irving Corporation will save none of the equipment-related costs because this is a
past cost. Also note that the relevant corporate overhead costs are the actual corporate overhead
costs $85,000 that Irving expects to save by closing the Rhode Island store. The corporate
overhead of $75,000 allocated to the Rhode Island store is irrelevant to the analysis.
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2.
Exhibit Try It 11-4, Column 2, presents the relevant revenues and relevant costs of
opening another store like the Oakland store and shows that it increases Irving’s operating
income by $15,000. Incremental revenues of $1,700,000 exceed the incremental costs of
$1,685,000 (from higher cost of goods sold, rent, labor, utilities, and some additional corporate
costs). Note that the cost of equipment written off as depreciation is relevant because it is an
expected future cost that Irving will incur only if it opens the new store. Also note that the
relevant corporate overhead costs are the $10,000 of actual corporate overhead costs that Irving
expects to incur as a result of opening the new store. Irving may, in fact, allocate more than
$10,000 of corporate overhead to the new store, but this allocation is irrelevant to the analysis.
The key reason that Irving’s operating income increases either if it closes down the
Oakland store or if it opens another store like it is the behavior of corporate overhead costs. By
closing down the Oakland store, Irving can significantly reduce corporate overhead costs
presumably by reducing the corporate staff that oversees the Oakland operation. On the other
hand, adding another store like Oakland does not increase actual corporate costs by much,
presumably because the existing corporate staff will be able to oversee the new store as well.
EXHIBIT TRY-IT 11-4
Relevant-Revenue and Relevant-Cost Analysis of Closing Oakland Store and Opening Another
Store Like It.
Incremental
(Loss in Revenues)
Revenues and
and Savings in
(Incremental Costs)
Costs from Closing
of Opening New Store
Oakland Store
Like Oakland Store
(1)
(2)
Revenues
Cost of goods sold
Variable operating costs
Lease rent
Depreciation of equipment
Corporate overhead costs
Total costs
Effect on operating income (loss)
$(1,700,000)
1,310,000
170,000
155,000
0
85,000
1,720,000
$
20,000
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$1,700,000
(1,310,000)
(170,000)
(155,000)
(40,000)
(10,000)
(1,685,000)
$ 15,000