Chapter 7
The Use of Cost Information in
Management Decision Making
QUESTIONS
1. These are the costs and revenues that differ between decision alternatives.
2. Sunk costs are the costs that have been incurred in prior periods. They are not incremental
costs and, hence, they are not relevant in making a decision.
3. These are the costs that can be avoided if a particular action is undertaken.
4. Opportunity costs are the values of benefits foregone by selecting one decision alternative
over another. Since opportunity costs differ depending upon which decision alternative is
selected, they are relevant in evaluating decision alternatives. Alternatively, since
opportunity costs are incurred when a decision alternative is selected, they are incremental
costs related to that decision.
5. The proper (quantitative) approach to analyzing the question of dropping a product line is
to calculate the change in income that will result from dropping the product line. If income
will increase when the line is eliminated, the product line should be dropped; otherwise not.
6. Common costs which are incurred for the benefit of two or more products, such as the
company president's salary, are not sunk because they are incurred in current and future
periods. But they are still irrelevant because they usually do not differ among the decision
alternatives.
7. Qualitative advantages of making rather than buying a component usually include
exercising more control over the production process, quality, delivery schedules, and costs.
8. The amount of joint cost allocated to a product under relative sales value method cannot
exceed the product's sales value at the split-off point. Thus, products that make a positive
contribution to covering joint cost will not look unprofitable.
9. The value of time in a bottleneck department is generally quite high and equal to the
contribution margin of all throughput per hour. Therefore, you don’t want to “waste it”
setting up equipment. Since more set-ups are required with small batch sizes, it is generally
advisable to have larger batch sizes in bottleneck departments.
10. A bottleneck department is referred to as a drum because it “beats a rhythm” that
coordinates the production in other departments.
7-2
Jiambalvo Managerial Accounting
EXERCISES
E1. Consider a decision to close a production facility. In this case, heat and light,
which were fixed costs at the plant, would drop to zero. Thus, heat and light
would be an incremental cost saving with respect to the decision. Depreciation
of the facility, which is also a fixed cost, would not be an incremental cost
saving. Depreciation represents a sunk cost and sunk costs are never
incremental costs.
E2. If Adrienne drops accessories, she will lose the contribution margin (which in
this case is also the gross margin) of $31,250. The fixed costs allocated to
accessories, which total $36,270, are not likely to decline. (Keep in mind that
Adrienne has only two assistants. It is doubtful that she can do without either
one of them simply by dropping accessories.)
With the $36,270 of common fixed costs now assigned to Gowns, that product
line will show a loss and the company will be broke. This is a good example
of the “cost allocation death spiral” at work! In analyzing a decision, it is
important to determine the costs that will change (i.e., the costs that are
incremental). Allocated common costs are seldom a good measure of
incremental costs.
E3. According to this Web site, sunk costs are “Costs already incurred which
cannot be recovered regardless of future events.” Since the costs are
unaffected by the future, they are never incremental costs and are irrelevant
for decision making.
According to this Web site, opportunity costs are “The costs of passing up the
next best choice when making a decision.” Thus, opportunity costs arise from
making a decision. Because they are incremental costs (they exist because a
decision was made), they are always relevant for decision making.
Chapter 7 The Use of Cost Information in Management Decision Making
7-3
E4. In this solution, supplies and travel are assumed to vary with revenue.
Supplies as a percent of revenue
$10,000 ÷ $170,000
Travel as a percent of revenue
$1,000 ÷ $170,000
Increase in revenue
Less:
Cost of exhibit space
Increase in supplies (.0588 x $30,000)
Increase in travel (.0059 x $30,000)
Increase in profit
0.0588
0.0059
$30,000
10,000
1,764
177
$18,059
The company should exhibit at the show since the impact on profit is positive.
E5. Cost of RBG
Less cost savings:
Mailing
Printing
Salary of Pat Fisher
Incremental cost of RBG
$25,000
$12,000
3,000
1,350
16,350
$ 8,650
The incremental cost is less than $10,000, so Craig will accept the RBG offer.
7-4
Jiambalvo Managerial Accounting
E6. a. The incremental profit is $3,060 as follows:
Revenue
$75 x 120
Less cost of unprepared food and beverage
$30 x 120
$ 9,000
3,600
5,400
Lost revenue
$45 x 130
Cost savings for food and beverage
$27 x 130
Loss profit
3,510
( 2,340)
Net
$ 3,060
(5,850)
b. As indicated above, the opportunity cost of accepting the Wellsworth group is
$2,340.
c. The restaurant should consider the fact that it may hurt its business with
“regulars” who are turned away due to the closure. This could have serious
long-term effects.
E7. b, c, d, f, g, and i.
Chapter 7 The Use of Cost Information in Management Decision Making
Cost of Making
1,000 Valves
E8.
Variable costs
Material
Labor
Variable OH
Incremental
Cost (Savings)
$ 800,000
500,000
200,000
1,500,000
-0-0-0-0-
($ 800,000)
(500,000)
(200,000)
(1,500,000)
100,000
400,000
200,000
700,000
100,000
400,000
-0500,000
-0-0(200,000)
(200,000)
Fixed costs
Depr. building
Depr. equip.
Sup. salaries
Other
Cost savings on
leased space
Cost of buying valves
Total
Cost of Buying
1,000 Valves
-0-0-0$2,200,000
(50,000)
1,800,000
1,750,000
$2,250,000
7-5
(50,000)
1,800,000
1,750,000
$ 50,000
The company should make the valves—the incremental cost of buying them is
$50,000.
E9. a. True
b. False
c. True
E10. d, f, g, and h.
d. False
e. True
f. False
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Jiambalvo Managerial Accounting
E11. Incremental benefit (cost) of completing the phone:
Price
$110.00
Material
(10.00)
Direct Labor
(10.00)
Variable overhead
(5.00)
Benefit
$ 85.00
Incremental benefit of selling partially completed phone:
Price
$90.00
The company will be better off by $5 per phone if the company sells the
partially completed units.
E12. Unit cost of manufacturing pumps
Less: Allocated fixed overhead (irrelevant)
Add: Warranty cost ($22 × .40)
(Only 40% pumps are returned for repair)
Unit cost of manufacturing pumps
Unit cost of purchasing pumps
$ 83.75
(17.25)
8.80
$ 75.30
$ 92.50
The company should make the pumps.
The amount of cost savings expected by making pumps in 2003:
12,800 ($92.50 - $75.30) = $ 220,160.
Qualitative factors that should be considered in the outsourcing decision
include product quality of purchased pumps and its effect on whirlpool sales,
likely improvement in the quality of the company's self-manufactured
pumps, and strategic effects of outsourcing.
Chapter 7 The Use of Cost Information in Management Decision Making
7-7
E13.
Income Without
Home Office Furniture
Sales
Less cost of sales
Contribution margin
Less direct fixed costs:
Salaries
Other
Less allocated fixed costs
Rent
Insurance
Cleaning
President’s salary
Other
Net income
$1,200,000
720,000
480,000
150,000
50,000
20,000
5,000
6,000
120,000
10,000
$ 119,000
Based on given assumptions, net income will not change. Therefore, the
company should be indifferent between dropping or not dropping the Home
Office Furniture product line. However, strategic and other qualitative factors
should also be considered.
7-8
Jiambalvo Managerial Accounting
E14. a. What is the quality assurance program of the company that will do the
bottling? Remember the negative influence on Perrier’s sales (circa 1990)
related to traces of benzene in samples? Sales declined by 14 percent.
b. The premium brand’s cache may actually increase sales of the less costly
wines. Thus, sales of the low cost wines may decline if the premium brand
is dropped.
c. Quality may decline. Also, the talented workers who produce videos may
be a resource to software developers who have a variety of “quick
questions” related to including video in their products (this resource will
be lost if the facility is closed).
E15. a. Allocation based on physical output:
Product A
Product B
Total
20 pounds (1/3)
40 pounds (2/3)
60 pounds
This indicates that $333 of the $1,000 joint cost will be allocated to Product
A and $667 will be allocated to Product B.
b. Sales of Product A are $1,000 (20 pounds × $50) while sales of Product B
are $400 (40 pounds × $10). Since product B is showing a loss ($400
selling price and $667 cost), a manager might think that it should not be
sold. However, the joint cost is not avoidable (unless the company drops
both joint products). And product B contributes $400 toward covering
joint costs and earning a profit.
Chapter 7 The Use of Cost Information in Management Decision Making
7-9
E16. a. Allocation based on relative sales values:
Product A (20 pounds × $50)
Product B (40 pounds × $10)
$1,000 (.7143)
400 (.2857)
$1,400
This indicates that $714 of the $1,000 joint cost will be allocated to Product
A and $286 will be allocated to Product B.
b. The only time the allocated cost of a joint product will be greater than its
price will be if the total revenue of all joint products is less than the joint
costs (in which case the company should drop all of the joint products).
E17. Allocation using physical quantity method:
Superior grade = $600 × (4,000 ÷ 6,000) = $400
Economy grade = $600 × (2,000 ÷ 6,000) = $200
Allocation using relative sales value method:
Relative Sales Values:
Superior grade = 4,000 lbs. × $ 0.25 = $1,000
Economy grade = 2,000 lbs. × $ 0.10 = $200
Cost Allocation
Superior grade = $600 × (1,000 ÷ 1,200) = $500
Economy grade = $600 × (200 ÷ 1,200) = $100
7-10
Jiambalvo Managerial Accounting
E18. Selling price per unit
Less variable costs per unit:
Direct material
Direct labor
Variable overhead
Contribution margin per unit
$20.00
$4.00
1.00
.50
Times number of incremental units
Incremental profit before cost of additional worker
Less cost of additional worker
Financial impact of hiring additional worker
5.50
14.50
5,000
72,500
50,000
$22,500
Chapter 7 The Use of Cost Information in Management Decision Making
7-11
PROBLEMS
P1. Extrapolating from the information provided, a $1,428,571 incremental profit
will be generated even if sales are only $6,000,000:
Incremental sales
Less cost of goods sold
3/7 x $6,000,000
Less cost of TV ads
Net
$6,000,000
2,571,428
2,000,000
$1,428,571
Still, it would be unethical for Sandra to bias her estimate of incremental sales
simply because she “knows” (or thinks she knows) that the president will not
go for the ads unless the revenue estimate is biased upwards. Sandra wasn’t
hired to provide biased information to the president—she was hired to provide
honest estimates that the president can use to make decisions.
It may be that the president knows of some incremental costs (including
opportunity costs) of which Sandra is unaware, and that’s the reason the
president wants a high revenue figure. In this case, Sandra’s bias may actually
lead to a decline in shareholder value.
P2. a. Cost savings
Salary of gardeners
Plant materials
Fertilizer
Fuel
Proceeds from sale of equipment
Less cost of Highline
Net benefit of outsourcing in year 1
$185,000
65,000
5,000
4,000
$ 259,000
20,000
279,000
250,000
$ 29,000
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Jiambalvo Managerial Accounting
In the second year, savings will decrease by $20,000 since the proceeds
from the sale of equipment only pertain to the first year. Still, there will be
a net benefit of $9,000 in year two.
b. The University should consider the impact on employee morale related to
firing 3 gardeners, especially if they are long time employees. Also, the
current gardeners may be very familiar with the University’s plants and
trees and the care by Highline may be inferior, even though they assert that
it will be comparable to the past.
P3.
Materials
Labor to form
Labor to install
Misc. variable costs
Allocated fixed costs
Penalty
Total
Do not buy
Prefabricated
Buy
Prefabricated
Difference
$30,000
2,000
8,000
1,000
2,500
5,000
$48,500
$34,000
-0-*
9,000
1,000
2,500
-0$46,500
$4,000
(2,000)
1,000
-0-0(5,000)
($2,000)
Bradley should buy the prefabricated duct-work which will result in a net
incremental benefit of $2,000.
*When the workers are reassigned to the other project, they will still be paid
$2,000. However, I assume that $2,000 of wages that would ultimately have
been paid to other workers on that project will no longer need to be paid.
Thus, there is a net $2,000 benefit.
Chapter 7 The Use of Cost Information in Management Decision Making
P4. Incremental cost of purchasing containers
(100,000 packages × $1.75)
Cost savings:
Direct material
(.10 × $6.50 × 100,000)
Direct labor
(.2 × $3.50 × 100,000)
Variable overhead*
(.15 × $1 × 100,000)
Leased space savings
Supervisor salary
Net benefit
7-13
$175,000
$65,000
70,000
15,000
15,000
70,000
235,000
$ 60,000
The company should purchase the containers—there is an expected net benefit
of $60,000.
*Fixed overhead is $2 per package ($200,000 ÷ 100,000 packages). Therefore,
variable overhead is $1 ($3 total overhead - $2 fixed overhead).
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Jiambalvo Managerial Accounting
P5. a.
Sales
Less:
Variable costs already
incurred
Fixed costs already
incurred
Variable reprocessing costs
Total
Reprocess
and Sell
Sell
to United
Difference
$10,000
$7,000
($3,000)
5,000
5,000
-0-
3,000
2,000
3,000
-0-
-02,000
($1,000)
($1,000)
$ -0-
The company should repeat the coloring process—the net incremental benefit
of this action is $1,000 compared to selling the carpet to United Home
Discount Store for $7 per square yard.
b. A payment by United of $9 per square yard (rather than $7), would result
in $2,000 of additional income [($9 - $7) × 1,000 square yards]. In this
case, selling to United would result in a $1,000 net benefit. However, the
company should consider an important qualitative factor. Selling
“defective” carpeting, with the Carpets Unlimited brand identified, may
more than offset the relatively small incremental benefit of $1,000.
Chapter 7 The Use of Cost Information in Management Decision Making
ZylexA
$9.75
P6.
Selling price
Less:
Material
Labor
Variable overhead
Contribution margin
Time to produce in minutes
Contribution margin per minute
Incremental revenue ($13.50 - 9.75)
Less:
Incremental material cost
Incremental labor cost
Incremental variable overhead
Incremental profit (loss)
Incremental time to produce in minutes
Incremental loss per minute
7-15
$2.25
1.80
2.60
6.65
$3.10
20 minutes
$0.155
ZylexB
$3.75
$1.90
.70
1.20
3.80
($0.05)
10 minutes
($.005)
There is no question that ZylexA has to be produced, because the company
cannot make ZylexB without starting with ZylexA. The question is, “If you
have a unit of ZylexA, should you take up production time converting it into
ZylexB or should you just make more ZylexA?”
The analysis indicates that production of ZylexB actually reduces profit at a
rate of $.005 per minute. Thus, no ZylexB should be produced.
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Jiambalvo Managerial Accounting
P7. a. Effect of dropping communications products:
Lost contribution margin
$(191,000)
Savings of direct salaries
56,000
Net effect
$(135,000)
The company will be worse off by $135,000 if it drops communications
products.
b. Conceivably, dropping communications products would decrease sales of
other products. Most likely, some customers come into the store to buy
communications products and end up buying audio or video products. This
adds further weight to the argument for keeping communications.
P8. Contribution margin of Fescue
($1.90 - $.40)
Contribution margin of Bermuda
($2.65 – $1.00)
$1.50 per square yard
$1.65 per square yard
Dedicating an additional 50,000 square yards to Bermuda grass would lead to
an additional $7,500 of profit [($1.65 - 1.50) × 50,000]. Thus, the president’s
decision to stick with an equal mix has a $7,500 opportunity cost.
Chapter 7 The Use of Cost Information in Management Decision Making
7-17
P9. a. Effect of dropping Model 301 Pump:
Lost revenue ($13,000 × 500)
($6,500,000)
Cost savings
Material ($6,000 × 500)
$3,000,000
Direct labor ($4,000 × 500)
2,000,000
Direct fixed costs
500,000
5,500,000
Net effect
($1,000,000)
The Model 301 pump should not be dropped—dropping would reduce profit
by $1,000,000.
b. The Model 301 pump has relatively high direct labor cost per unit. Since
all overhead costs are in one cost pool allocated using direct labor costs,
the relatively high direct overhead costs associated with other models will
be transferred to the Model 301! Also, Model 301 will receive a relatively
large share of common overhead costs.
7-18
Jiambalvo Managerial Accounting
P10. a.
Yards of carpet
Sales
Less variable costs
Less fixed costs
Profit (loss)
b. Yards of carpet
Sales
Less variable costs
Less fixed costs
Profit (loss)
Standard
30,000
$450,000
270,000
206,250
($ 26,250)
Deluxe
50,000
Total
80,000
$1,000,000
600,000
343,750
$ 56,250
$1,450,000
870,000
550,000
$ 30,000
Deluxe
50,000
$1,000,000
600,000
550,000
($ 150,000)
c. In many if not most cases, common costs will not be reduced when a
product or product line is dropped. The costs are simply “passed on” to the
remaining products, which may in turn appear unprofitable!
Chapter 7 The Use of Cost Information in Management Decision Making
P11. a. Joint cost ($20 + $80)
Allocation based on weight
Veneer (10 lbs. ÷ 70 lbs.) × $100
Peeler (60 lbs. ÷ 70 lbs.) × $100
$100.00
$ 14.29
85.71
$100.00
Profit per sheet of Veneer:
Selling price
Cost
Profit per sheet
$140.00
14.29
$125.71
Profit per Peeler:
Selling price
Cost
Profit (loss) per sheet
$40.00
85.71
($45.71)
Total profit for both joint products
($125.71 - $45.71)
7-19
$80.00
b. No. The product is making a contribution of $40 toward covering joint
cost.
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Jiambalvo Managerial Accounting
c. Allocation based on relative sales value:
Veneer ($140 ÷ $180) × $100
Peeler ($40 ÷ $180) × $100
Profit per sheet of Veneer:
Selling price
Cost
Profit per sheet
Profit per Peeler:
Selling price
Cost
Profit (loss) per sheet
Total profit for both joint products
($62.22 + $17.78)
$ 77.78
22.22
$100.00
$140.00
77.78
$ 62.22
$40.00
22.22
$17.78
$80.00
d. The relative sales value is preferred because it will not make a joint
product appear unprofitable (unless for all joint products, the sum of the
sales values is less than the joint costs).
Chapter 7 The Use of Cost Information in Management Decision Making
7-21
P12. a. Allocation based on relative sales values at the split-off point:
Sales value of 100 pounds of orange peels
Sales value of 300 pints of juice
(300 × $.30)
Total
$300
90
$390
Joint cost ($400 + $40)
$440
Allocation to peels ($300÷ $390) × $440
$338
Allocation to juice ($90 ÷ $390) × $440
Total
102
$440
Profit per 100-pound box of candied peels:
Selling price
Less joint cost
Less cost of sugar coating and packaging
Profit
$500
338
50
$112
Profit per pint of juice:
Selling price
Less joint cost per pint
($102 ÷ 300)
Less cost of pasteurizing and packaging
($150 ÷ 300)
Profit
.50
$0.16
b. Incremental revenue of sugar coating:
($500 - $300)
Incremental cost
Net incremental benefit of sugar coating
$200
50
$150
c. Incremental revenue of packaged juice
($300 - $90)
Incremental cost
Net incremental benefit of pasteurizing
and packaging
$1.00
.34
$210
150
$ 60 ÷ 300 = $.20/pint
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Jiambalvo Managerial Accounting
P13. a. Allocation based on weight:
Type
Salmon
Halibut
Flounder
Weight (lbs.)
Percent
10,000
10,000
20,000
40,000
25%
25%
50%
100%
Salmon
Revenue
(10,000 lbs. × $4.00)
Cost (.25 × $54,000)
Profit
$40,000
13,500
26,500
Halibut
Revenue
(10,000 lbs. × $3.00)
Cost (.25 × $54,000)
Profit
30,000
13,500
16,500
Flounder
Revenue
(20,000 lbs. × $1.00)
Cost (.50 × $54,000)
Profit (loss)
20,000
27,000
( 7,000)
Total profit
($26,500 + $16,500 - $7,000)
$36,000
Chapter 7 The Use of Cost Information in Management Decision Making
b. Allocation based on relative sales value:
Type
Salmon
Halibut
Flounder
Sales Value
$40,000
30,000
20,000
$90,000
Percent
44.444%
33.334%
22.222%
100.000%
Salmon
Revenue
(10,000 lbs. × $4.00)
Cost (.44444 × $54,000)
Profit
$40,000
24,000
16,000
Halibut
Revenue
(10,000 lbs. × $3.00)
Cost (.33333 × $54,000)
Profit
$30,000
18,000
12,000
Flounder
Revenue
(20,000 lbs. × $1.00)
Cost (.22222 × $54,000)
Profit (loss)
$20,000
12,000
8,000
Total profit
($16,000 + $12,000 + $8,000)
$36,000
7-23
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Jiambalvo Managerial Accounting
c. Incremental revenue
Revenue of paste
(10,000 lbs. × $3)
Original revenue of flounder
(20,000 lbs. × $1)
Incremental revenue
Incremental cost
Net incremental benefit
$30,000
20,000
10,000
7,000
$3,000
Given that there is a net incremental benefit of $3,000, Robert should convert
the flounder into fish paste. Note that the joint costs allocated to the fish are
not relevant to the analysis. These costs are not incremental costs. They exist
whether or not the flounder is converted into fish paste.
Chapter 7 The Use of Cost Information in Management Decision Making
7-25
P14. a. Allocation based on weight:
Type
Copper
Gold
Weight (lbs.)
50,000
100
50,100
Percent
99.80%
00.20%
100.00%
Copper
Revenue
(50,000 lbs. × $0.68)
Cost (.9980 × $400,000)
Profit (loss)
$ 34,000
399,200
($365,200)
Gold
Revenue
(100lbs. × 16 × $270)
Cost (.0020 × $400,000)
Profit
$432,000
800
$431,200
Total profit
(-$365,200 + $431,200)
$66,000
The drawback of this method is that it may make a product (like copper), that
is making a positive contribution toward covering joint cost, show a loss
suggesting that it should be dropped.
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Jiambalvo Managerial Accounting
b. Allocation based on relative sales value:
Type
Copper
Gold
Sales Value
$ 34,000
432,000
$466,000
Percent
7.30%
92.70%
100.00%
Copper
Revenue
(50,000 lbs. × $0.68)
Cost (.0730 × $400,000)
Profit
$34,000
29,200
$ 4,800
Gold
Revenue
(100lbs. × 16 × $270)
Cost (.9270 × $400,000)
Profit
$432,000
370,800
$ 61,200
Total profit
($4,800 + $61,200)
$66,000
c. If the joint cost is any value greater than $466,000, then, with the relative
sales value approach to allocation, both copper and gold will show a loss.
Chapter 7 The Use of Cost Information in Management Decision Making
P15. a. Additional units in 8 hour shift
Times average contribution margin
Additional profit per 8 hour shift with
larger batch sizes
$
7-27
500
40
$20,000
b. Larger batch sizes may reduce flexibility to respond quickly to new
orders. Also, an error in the production process may result in a larger
number of defects compared to a small batch size.
P16. a. Based on the company president’s comment that the two workers will be
sitting around for 30 hours per week, it appears that they will be working
for 10 hours per week. The machine packages 2,000 bottles per hour but
it is 10 percent faster than the workers. Thus, the workers will be packing
1,818 bottles per hour (2,000 ÷ 1.1 = 1,818).
With a contribution margin of $0.50 per bottle, the workers will be
generating an incremental profit of $9,090 per week.
1,818 bottles per hour x 10 hours per week x $0.50 = $9,090 per week
With 52 weeks per year, this amounts to $472,680—much higher than
the $100,000 salary of the two workers combined.