Solution manual cost accounting by LauderbachSHORT TERM DECISIONS AND ACCOUNTING INFORMATION

CHAPTER 5 SHORTTERM DECISIONS AND ACCOUNTING INFORMATION 5 1 "Where Do You Start?" The question emphasizes the need for decision makers to know the starting place, the circumstances from which they begin. If a person already has a car and is planning a trip to the vicinity of Monroe, the incremental costs of giving a ride to the advertiser are for the extra mileage to go to that specific town (e.g., tolls, additional gasoline, possibly an extra meal) instead of going straight home. If a person has a car but isn't planning a trip to the Monroe area, the incremental costs of giving a ride are the incremental costs of the trip (all gasoline, tolls, meals, perhaps motels). And if a person doesn't already have a car, the incremental costs of giving a ride to the advertiser include the cost of buying a car and obtaining insurance and a license, plus the costs listed in the two alternatives above Thus, the advertiser made a serious error in the wording of the offer. Note to the Instructor: This question can be used to begin discussion of decision making. After establishing the idea of incremental costs, you can cover the concept of joint costs (and allocations thereof) by directing attention to those costs that would not change with the extra passenger. The question can be used to cover the same general concepts in an executive development program by turning the situation into one of carpooling rather than one of student ridesharing. 5 2 Unit Costs The $52 is $1,800/50 plus $16. The $34 is $1,800/100 + $16. The analysis is unsound because the incremental cost of playing a round is $16. The $1,800 dues are sunk and should not affect decisions whether to play an additional round. The dues, and a perround computation of cost, are appropriate in deciding whether to continue as a member of the club or to seek an alternative place to play golf. The average cost is irrelevant to deciding whether to play a single round Note to the Instructor: So as not to lead students to consider the duesperround calculations, we didn't ask whether the dues would ever be relevant. If the person is deciding whether to remain a member of the club, dues are relevant. The point to be made with this assignment is that whether a cost is relevant depends on the particular decision to be made. 51 5 3 The Generous Management Paper, printers' labor, and ink might be expected to be variable costs, giving a total variable cost per paper of $1.20. The two other costs mentioned, salaries for editorial employees and other operating expenses, are likely to be composed of primarily fixed elements. From Chapter 2, it is known that the perunit cost amounts for those two items must be based on some particular level of output (quantity of papers produced). If there were no other considerations, and if the perunit fixed costs were based on current circulation quantities, it might be said that the subscriber was getting the paper at less than total cost per unit. Were circulation higher than at present, of course, the perunit cost would decrease. The analysis in the newspaper's advertisement ignores the revenues derived from advertisers. That is, the advertisement implies that the only revenues available to cover the listed costs are the revenues from sales of the paper. Advertising accounts for a substantial portion of total newspaper revenues. Moreover, the cost per paper includes the costs of printing the advertising in that paper. In effect, the situation is one of joint revenues, and the costs of the newspaper are joint to the two types of revenueproducing aspects of the paper, advertising and distribution and sale. The management of the newspaper is not being generous at all. For most newspapers, revenues from advertisers exceed revenues from subscribers. 5 4 Shortterm Pricing Policy The airline would gain by accepting your offer because the incremental profit from accepting is the entire $50 fare. But this is so only because the carrier is committed to making the flight. The airline knows, however, that a consequence of accepting your offer is that other potential passengers would be encouraged to follow your example. The implications of large numbers of customers following that example are many, and only a few are listed here. For example, any stated rate structure becomes irrelevant as potential passengers spurn reservation systems with the intention of negotiating fares just before departure. Further, customer dissatisfaction would increase because of delayed departures (while airline personnel negotiated with passengers about rates) and because of late flight cancellations or the inability to accommodate potential passengers who showed up with the intention of negotiating their fares. Note to the Instructor: Like question 51, this question makes the point that a company is always in some position before it faces a decision. The special order decisions discussed in this chapter assume the company has already planned for the period, much as the airline has already committed to make this flight. Just as a company considering a special order must consider the effect of accepting the order on the actions of regular or potential customers, the airline must evaluate the impact of accepting the immediately profitable offer on the actions of its potential customers. Another point that merits discussion is the timeperiod aspect of committed fixed costs. Although the text usually identifies fixed costs with a time period, that need not be the case. For example, an airline has some costs that are fixed per period and some that are fixed per flight. 52 5 5 Economic and Qualitative Factors The trustees are responsible for the church's property, reputation, and finances, so many factors, monetary and nonmonetary, are relevant to their decision. If their only objective in sponsoring the dances is to generate revenue to offset costs of the facilities, incremental revenues and costs are important. Monetary issues are far less important if the trustees are trying to increase interest in the church among young people and/or to provide an organized and supervised activity for youth. In either case, the trustees must act responsibly with the church's money, but their decision should not ignore the value of achieving nonmonetary objectives Revenues most relevant are admissions fees and perhaps receipts from sales of snacks and beverages. Incremental costs include increases in utilities during the additional hours the facility is open, cleaning services, and costs related to the entertainment. Decorating costs are also relevant. The church might engage a band, or a disk jockey. The church might also use volunteers for cleaning or music The availability of adults for supervision and oversight is important for success. If the church now has an active youth group, its members might perform many of the required tasks. In all likelihood, dances will go much better if the youth do much of the work. 56 Theory of Constraints You must elevate the constraint by making sure that the person is helped at all times and does not become a bottleneck. Whenever the person starts to fall behind, others should help him until the flow is back to normal. You must concentrate on keeping that person's flow up and not be concerned with others, until their flows begin to constrain. 5 7 Special Order (5 minutes) Accepting the order increases expected profit by $70,800, as shown below. Additional contribution margin, 25,000 x ($14 $11) $75,000 Additional packing costs 4,200 Incremental profit on the order $70,800 You might ask students about the possibility of leakage of regular sales that might accompany accepting the special order. You might also ask whether the company should accept the order if profit were $3,000 or so. Some students will say that any additional profit is good, but accepting business with low margins is potentially troublesome. First, the numbers are estimates. Unit variable manufacturing costs could turn out to be higher than now expected. Second, ABC tells us that some indirect costs are likely to rise if we increase activities. While such costs might not increase if we accepted a single order, making acceptance a habit could well result in significant increases in indirect costs. Finally, why bother turning out more product for minimal increases in profit? If $3,000 or so is significant to the company, then go ahead, but if not, why go through the effort especially in view of the first two objections? 5 8 Joint Products (10 minutes) 53 Byxral and Frazinine should be processed further, and Dyzaline should be sold at the splitoff point. Byxral Dyzaline Frazinine Selling price after processing $24 $18 $8 Selling price before processing 10 10 0 Incremental revenue from processing 14 8 8 Incremental cost of processing 10 12 2 Incremental profit (loss) from processing $ 4 ($4) $6 5 9 Joint Products (Extension of 5 8) (20 minutes) 1. Frazinine should be processed further; Byxral should now be sold at splitoff, and Dyzaline should still be sold at splitoff. Analyzing Dyzaline is unnecessary because if it was unwise to process Dyzaline further when there were no fixed costs of such processing, such costs simply increase the disadvantage of further processing. Below is an analysis for Byxral and Frazinine. Byxral Frazinine 100gallon batches per period (120,000/100) 1,200 1,200 times gallons of product from each batch (given) 40 50 Gallons of product per period 48,000 60,000 Times, pergallon incremental contribution margin from additional processing (from 58) $4 $6 Total incremental contribution margin from additional processing $192,000 $360,000 Less, avoidable costs of further processing (given) 196,000 34,000 Incremental profit (loss) from further processing ( $4,000) $326,000 2. Total monthly profit is $808,000 as computed below Revenues: Byxral, 48,000 x $10 $480,000 Dyzaline, 10 x 1,200 x $10 120,000 Frazinine, 60,000 x $8 480,000 Total revenues 1,080,000 Variable costs (costs of processing Frazinine, at $2 per gallon for 60,000 gallons) 120,000 Contribution margin 960,000 Fixed costs: Avoidable costs of further processing Frazinine $34,000 Unavoidable costs of all further processing $50,000 + $60,000 + $8,000 118,000 152,000 Expected profit ignoring costs of joint process $808,000 5 10 Dropping a Segment (15 minutes) 1. $70,000. The company loses $40,000 contribution margin from hats ($90,000 $50,000) and saves nothing in fixed costs. An income statement, in thousands, shows 54 Shirts Jeans Total Sales $110 $350 $460 Variable costs 30 160 190 Contribution margin $ 80 $190 270 Fixed costs 200 Income $ 70 This income statement avoids the allocation of common fixed costs and so presents the picture more clearly. 2. $95,000, the $70,000 from requirement 1 plus the $25,000 saved fixed costs Note to the Instructor: You might wish to review the several reasons why fixed costs could fall if a segment were eliminated. The text states that the fixed costs are allocated to the segments and that they are unavoidable. However, in requirement 2, we changed the conditions. As early as Chapter 2 we pointed out that fixed costs are not fixed in the sense that they cannot change in total. Rather, they are fixed in total within the relevant range, and given the company's plans for discretionary spending. Dropping the entire hat segment could put the company in a different relevant range. For instance, if the company now has four employees whose work is common to the three segments, dropping an entire segment might allow restructuring duties so as to eliminate one person. The situation in requirement 2 could also come about if some of the allocated costs are in fact direct. The original productline income statement could well have been prepared as described, with total fixed costs allocated based on floor space even if some are direct and avoidable. This case is more likely if the product lines are not so related as they are in this assignment. For instance, an appliance dealer might decide to stop selling washers and dryers, while still carrying television sets, stereos, CD players, and other electronic products. At a minimum, such a retailer would avoid the cost of separate listings in the Yellow Pages, possibly separate advertisements in local newspapers, and maybe some costs of the service department. 3. $68,000. From the $95,000 in requirement 2 we subtract $27,000 in contribution margin lost from the other two lines Lost contribution margin from: Shirts $80,000 x .10 $ 8,000 Jeans $190,000 x .10 19,000 Total lost contribution margin $27,000 Note to the Instructor: To expand the discussion, you might ask what sorts of productline mixes would be most logical in requirement 2 and in requirement 3. That is, what types would not have, or would have, complementary effects, as illustrated in the chapter? Some students will recall the substitution principle and will comment on that. The discussion here should be openended and comments will reflect the perceptions of individual students. The important point is that students should get into the habit of being alert when evaluating decisions that could include unintended effects. That is, it's not farfetched that someone would advocate closing a department without thinking of possible adverse effects on other departments. 55 5 11 Capacity Constraint (15 minutes) 1. Trekker because they have the highest contribution margin per unit 2. Walkers are the most profitable product, producing $140 contribution margin per hour, $28,000 contribution per month. The relative profitabilities per machinehour and in total for the three products are as follows: Walker Runner Trekker Contribution margin per unit $ 14 $ 18 $ 28 Number made in one hour* 10 6 4 Contribution margin per hour $ 140 $ 108 $ 112 Hours available 200 200 200 Total monthly contribution $28,000 $21,600 $22,400 * 60 minutes divided by machine time required Note to the Instructor: Many students will determine the total contribution for all products, as we did above. Students should be reminded that knowing the total time available is not necessary for determining the relative profitabilities. It is enough to know that there is some constraint on capacity and that all output can be sold. 3. The selling price of Trekkers, the second most profitable product per machine hour, must rise $7.00 (to $63.00) to be as profitable as Walkers. Hourly contribution margin of Walkers $140.00 Divided by number of Trekkers per hour 4 Required unit contribution margin of Trekkers $ 35.00 Plus variable cost per Trekker 28.00 Required price $ 63.00 5 12 Make or Buy (5 minutes) Fairbo should make the part. The variable costs to produce the part are Materials $ 9.00 Direct labor 10.00 Variable overhead 9.00 Total variable cost per unit $28.00 Another approach is simply to subtract the $13.00 per unit cost of fixed overhead from the $41.00 total cost per unit given in the problem. However one arrives at the $28 per unit, it's clear that internal production cost of $28 is $4 less than the $32 outside purchase cost. With a volume of 20,000 units, the total savings from making rather than purchasing the part is $80,000. 5 13 Special Order (15 minutes) 1. HiFlight should accept the order. The company has enough capacity to make the balls and the incremental revenue exceeds the incremental costs 56 Revenue from sale (80,000 x $9) $720,000 Variable costs (80,000 x $ 6) 480,000 Incremental profit $240,000 2. The answer might or might not change. The factor to consider is whether regular sales would be lost if people knew they could buy the balls at $16 instead of $21 per dozen. The maximum loss might be 80,000 dozen balls, the number that the chain could sell. In that case, the company would lose $400,000 by accepting the offer. Decline in regular sales 80,000 Contribution margin per dozen, $14 $6 $ 8 Lost contribution margin $640,000 Gain from requirement 1 240,000 Loss $400,000 More simply, if the company lost the whole 80,000 dozen, it would have traded sales at $14 for sales at $9, losing $5 per dozen. The lost sales might even be greater if the availability of the product at a lower price through the chain created ill will with regular customers Note to the Instructor: This early exercise raises the opportunity to reinforce the importance of estimating the effects of special orders on sales at regular prices. It can also be used to introduce the general idea of determining the maximum number of regular sales that could be lost for the order to be unacceptable. In this situation, Gain from order $240,000 Divided by contribution margin per unit, regular sales $ 8 Allowable lost regular sales 30,000 dozen 514 TOC (15 minutes) 1. Sandy should produce 100 more units of product C Time to produce one unit = labor charge / labor rate A: $2/$8 = .25 hours B: $4/$8 = .5 hours C: $8/$8 = 1 hour Time used for current production: A: .25  10,000 units = 2,500 B: .5  4,000 units = 2,000 C: 1  2,000 units = 2,000 Total time used 6,500 Time available is 7,000 total hours – 6,500 hours used = 500 hours Contribution margins A Selling price $20 Materials (8) Labor (2) Variable overhead (2) Variable selling (3) Contribution margin$ 5 B $30 (7) (4) (4) (3) $12 C $50 (10) (8) (8) (5) $19 Since time is not a constraint, profits will be maximized by choosing 57 the product with the highest contribution margin per unit 2. 10,000 product A, 4,000 product B, and 1,500 product C Since current demand will require 6,500 hours, time is a constraint. Sandy should choose the products with the largest contribution margin per hour A: $5/.25 = $20 / hour B: $12/.5 = $24 / hour C: $19/1 = $19 / hour Produce B first, followed in order by A and C Available hours Product B: 4,000 units  .5 = Remaining time Product A: 10,000 units  .25 = Remaining time Product C: 1,500 hours  1 = 1,500 units  1 = 6,000 2,000 4,000 2,500 1,500 1,500 5 15 Short Term Decisions (1520 minutes) 1. $280, an increase of $20. The quickest way is to work with changes. Increase in contribution margin of product A ($250 x 0.30) $75 Decrease in contribution margin of product B ($300 x 0.05) 15 Net increase in contribution margin $60 Less additional fixed costs 40 Increase in income $20 Using totals produces the same answer. Product A Product B Total Sales $585* $380 $965 Variable costs 260 95 355 Contribution margin $325 $285 610 Fixed costs ($290 + $40) 330 Income $280 * $450 x 1.30 **$400 x 0.95 The income statement doesn't show fixed costs for either product; it shows them only in total. It is plausible to use the old allocated fixed costs plus the $40 for product A, but that isn't necessary to find the new income. 2. About 11.7% ($35/$300). The increase in income just from the change in product A's sales is $35 ($75 increased contribution margin less $40 increased fixed costs). This increase divided by the $300 current contribution margin of product A gives the allowable reduction. 58 3. $620 Contribution margin from product A $250 Increase in fixed costs 60 Required contribution margin from product C $310 Divided by contribution margin percentage for product C 50% Equals required sales from product C $620 Using the totals, Required income $260 Total fixed costs ($290 + $60) 350 Required contribution margin 610 Less contribution margin from product B 300 Contribution margin required from product C $310 Divided by contribution margin percentage 50% Equals required sales from product C $620 5 16 ProductLine Emphasis (510 minutes) 1. Porter should concentrate on Local Area Connectors (LACs). Their contribution margin is 70% ($3,780/$5,400) while Internet Connectors (ICs) have a margin of 50% ($3,300/$6,600). Increasing sales of LACs by $1 million increases contribution margin by $700 thousand while the loss of contribution margin from the loss of $1 million sales of ICs is only $500 thousand. LACs have a much lower percentage of product margin to sales than do ICs, which might catch some students who struggle with cost behavior. The lower total product margin is relevant for the next requirement . 2. Porter should drop LACs in favor of the new product. Although LACs have a higher contribution margin percentage, their contribution to covering common fixed costs is, because of its relatively high direct, avoidable fixed costs, lower than that for ICs Note to the Instructor: This exercise reinforces the point that different data are relevant for different decisions. In requirement 1, neither type of fixed cost was relevant because there was no change in either type as long as the company continued selling both products. In requirement 2, however, fixed costs become relevant because they will change (in this case, be avoided altogether) if the entire product line were dropped. 517 Special Order for Service Firm (5 minutes) So long as Burns and Cross cannot profitably employ the staff, there is no incremental cost associated with the audit. The monthly salaries are irrelevant because the firm will pay them regardless. The firm should accept the offer. This situation is quite common for CPAs and some will even do slacktime audits gratis for charitable or other notforprofit organizations 59 5 18 Joint Products (1520 minutes) 1. Sell M and O at splitoff. The company would probably find it better to sell O at splitoff simply to avoid the extra work and the likely effects on indirect costs of doing more work. M N O P Sales value, further processed $450 $140 $45 $20 Sales value, splitoff 120 40 35 0 Incremental revenue 330 100 10 20 Additional processing costs 360 70 10 15 Gain (loss) on added processing ($ 30) $ 30 $ 0 $ 5 2. $120 M N O P Total Sales $120 $140 $35 $20 $315 Additional processing costs 0 70 0 15 85 Margin $120 $ 70 $35 $ 5 230 Joint costs 110 Profit $120 5 19 Dropping a Product   Complementary Effects (1520 minutes) 1. $280,000. The quickest analysis is (in thousands of dollars) Lost contribution margin ($200) Saved fixed costs 240 Gain from dropping lotion 40 Current income 240 Income if lotion dropped $280 Alternatively, working with the totals of the remaining products, After Shave Cream Total Contribution margin $720 $560 $1,280 Avoidable fixed costs 300 140 440 Segment margin $420 $420 840 Joint fixed costs 560 Income $280 2. $80,000 Lost contribution margin: Lotion ($200) Blades (20% x $720) (144) Cream (10% x $560) (56) Total lost contribution margin ($400) Saved fixed costs, lotion 240 Net loss from dropping lotion (160) Current income 240 Income if lotion dropped $ 80 Note to the Instructor: This exercise illustrates the concept of complementary effects. By themselves, lotion is unprofitable; but it should be continued in the line because of its effects on the sales of the other products 520 TOC (1015 minutes) 510 The opportunity cost of their being in business for themselves is $100,000, which is $5,200 greater than their current income of $94,800. The business is also likely to be much riskier than their working as employees and earning interest on their capital, which increases the advantage of selling the business. There are, however, a number of qualitative factors to be considered. One is the satisfaction of owning (as opposed to being an employee), which could be worth a great deal. The Taylors work long hours, but they are together during working hours, which has both good and bad points. They may also have worked long hours at their other jobs. They cannot be fired if they work for themselves The future of the bistro is more critical than its past, as are the salaries the Taylors could earn now, as opposed to the salaries they used to earn; so some quantitative issues remain unresolved. They might also have incurred other jobrelated expenses (as reflected in Ellen's remark about "fighting traffic") that they do not now incurr. Whatever the Taylors' attitude about working for themselves as opposed to working for someone else, the financial consequences of their choices are important and they should be aware of those consequences Note to the Instructor: We deliberately made the income level high enough that another issue can be raised: the diminishing marginal utility of income. It's one thing to be in business for yourself at $94,800 and sacrifice $5,200; it's quite another to do so when the income from the business is, say, $26,800. The Taylors might have tastes, personal goals, and priorities that can be satisfied on much less income than they previously earned; but they need some minimum level of income for basic necessities. 5 46 Pricing Policy and Excess Capacity (15 minutes) First, assume that the KwH sold in the summer months will not increase as a result of conversion to electric heat. That is, assume that those users who are expected to convert already use as much electricity as they need in the summer. With this assumption, summer consumption per month will not exceed capacity, and the following analysis is appropriate Additional revenue from additional KwH sales at new rate (44 million KwH x $72 per 1,000 KwH) $3,168,000 Less: Loss of revenue due to reduced price for all KwH sales already being made to customers who would convert and be entitled to the lower rate for all their consumption 60 million KwH x $15 decrease per 1,000 KwH $900,000 Variable costs of additional KwH sales 44 million KwH x $46 per 1,000 Kwh 2,024,000 Loss of revenue from lower rate to customers already using electrical heating equipment 20 million KwH x $15 decrease per 1,000 KwH 300,000 3,224,000 Net loss from the new plan $ 56,000 From a strictly monetary standpoint, the proposed reduction is inadvisable Removing the original assumption, it's possible that, in the past, the users who would convert to electric heat have been conservative with their 529 use of electricity in the summer. Conversion and the lower rate may cause them to be less conservative, so that summer sales may increase. The additional demand is good for the company so long as the increase doesn't exceed available capacity. The added summer demand would help to offset the monetary disadvantage of the new plan. 5 47 Processing Decisions (2025 minutes) 1. Ayers should sell bark and shavings because the revenues of $3,000 cover the avoidable costs of $520, leaving an incremental profit of $2,480. The costs of the logs and of cutting them up are joint to the products. 2. More than $3,980. Ayers must earn $2,480, the current incremental profit, plus the additional processing costs of $1,500 to be indifferent to the two choices. Current incremental profit, sell at splitoff $2,480 Additional processing costs 1,500 Required revenue $3,980 Note to the Instructor: Another dimension is added to the assignment when you ask students whether they would accept the offer if the revenue were to be, say $4,000, giving only a $20 increase in profit. The answer is likely to be no, and exploring the reasons therefore should be useful. Some will suggest that the actual additional cost could turn out to be higher than the estimated $1,500. Some will recognize that Ayers would be accepting some risk if he rented equipment and hired additional help. The assignment does not say whether there is a fixed term or whether a month's notice (or enough for Ayers to eliminate the $1,500 additional processing costs) would be required to terminate the agreement. Most managers would not increase the size of an operation for a small additional profit. The role of expectations is also important, both here and in requirement 3. The assignment says that Ayers expects about the same results in the future. But he cannot know that the price of bark and shavings will continue at the current level. Accepting the offer could turn out to be unwise if the price of bark and shavings rose. If, however, Ayers could get a firm contract for, say, six months, he would be eliminating the risk that the price might fall. 3. Ayers should not accept the offer unless he is offered $35,530 or more. Essentially, Ayers now has the opportunity to sell the grade B lumber at the splitoff point rather than process it further. Revenue after further processing $41,000 Less further processing costs: Trimming $ 860 Sanding 3,380 Shipping 2,430 6,670 Margin from further processing 34,330 Plus new shipping costs 1,200 Minimum price at splitoff $35,530 530 5 48 Evaluating a Decision   Costs of Activities (15 minutes) Sales $320,000 Variable cost of sales* 199,000 Gross margin 121,000 Incremental operating expenses** 45,000 Profit $ 76,000 * Variable cost of sales = $86,000 + $41,000 + $72,000. The $72,000 is 60% of $120,000 **Incremental operating expenses = $27,000 + $12,000 + $6,000. The $6,000 is $22,000 less the $16,000 administrative charge The $27,000 salary seems incremental as the person spends 80% of her time on this account. The $12,000 is for a parttime clerk who works only on this account, which is clearly incremental. The administrative charge is almost certainly not incremental. There is room for disagreement about some items. There is also some question whether the company could lose regular sales in the future. It has operated close to capacity in the past six months, so might reach capacity in the next six. Before making a decision, the sales manager should inquire further about the needs for meeting regular sales. 5 49 Relevant Range (30 minutes) 1. Yes. Income will increase by $200,000 if the order is accepted Selling price $60 Variable costs: Materials ($900,000/45,000) $20 Direct labor ($810,000/45,000) 18 Overhead ($540,000/45,000) 12 50 Unit contribution margin $ 10 Volume 20,000 Total additional contribution margin $200,000 2. Yes. Ipswick will earn $80,000 on the order. Contribution margin falls to $4 per unit. Original contribution margin (above) $ 10.00 Commission at 10% of $60 6.00 Contribution margin $ 4.00 Volume 20,000 Increase in contribution margin $80,000 3. No. The company will lose $200,000 Lost regular sales (10,000 x $100) $1,000,000 Variable costs saved on 10,000 units: Manufacturing costs (above) $50 Selling ($100 x 10%) 10 Total unit variable cost $60 Total costs saved for 10,000 units ($60 x 10,000) 600,000 Lost contribution margin (400,000) Contribution margin on special order (requirement 1) 200,000 Net loss in contribution margin $ (200,000) 531 4. Yes. The company will gain $93,000 Sales (20,000 x $60) $1,200,000 Costs: Basic costs, requirement 1 (20,000 x $50) $1,000,000 Premium labor and overhead costs* 60,000 1,060,000 Additional contribution 140,000 Additional fixed costs 47,000 Additional profit $ 93,000 * Direct labor cost $18 Variable overhead cost 12 Total $30 Premium at 20% $ 6 Units at premium cost (45,000 + 20,000 55,000) 10,000 Total premium cost $60,000 5 50 Value of New Products   Complementary Effects (25 minutes) 1. (a) $12,000 ($40,000 x 60%) $12,000 (b) $ 6,000 ($60,000 x 40%) $18,000 2. The beer and wine department should be added because, as shown below, it would contribute more to the company than does the hardware department, despite the higher incremental segment profit from the latter. With With Beer Hardware and Wine Grocery sales $630,000* $648,000** Cost of sales 252,000 259,200 Gross profit 378,000 388,800 Other variable costs, 20% 126,000 129,600 Contribution margin 252,000 259,200 Fixed costs 140,000 140,000 Income 112,000 119,200 Incremental profit, added department (requirement 1) 12,000 6,000 Income for store $124,000 $125,200 * $600,000 x 105% **$600,000 x 108% 3. The major lesson is that a decision will often affect segments of the company other than the one being considered. The effects of an action on the entire company must be considered, not just those directly associated with the segment. The problem also shows that the product with the higher gross profit rate is not always the most profitable or the one most important to maintain. 5 51 Special Orders   Effects on Existing Sales (25 minutes) 1. Accepting the order brings additional contribution margin of $300,000 [30,000 x ($30 $20)]. 532 2. The order should still be accepted, as it will increase profit by $30,000 Lost sales (90,000 units x 10%) 9,000 Contribution per unit ($50 $20) $30 Contribution lost $270,000 Gain from accepting the order (requirement 1) 300,000 Net gain $ 30,000 3. Regular sales must decline more than $500,000, or 10,000 units ($500,000/$50 per unit), before acceptance of the order would be unwise Gain in contribution from the order (requirement 1) $300,000 Contribution percentage on regular sales $2,700,000/$4,500,000 60% Regular sales with contribution margin of $300,000 that can be earned on the special order ($300,000/60%) $500,000 4. The special order is for only one year. Suppose some of the regular customers buy from the discounter, and the discounter stocks another brand in the future. If the regular customer is satisfied with his purchase from the discounter, he may return a second year. Hence, future sales by Hunt will be hurt, since the regular customer will be lost for more than a year. Some customers might, at the lower price offered by the discounter, buy more units than might ordinarily be the case. If so, again, the possibility exists that future sales will suffer. 5 52 Alternative Uses of Product (35 minutes) 1. 7,000 jars ($5,600 avoidable fixed costs divided by $0.80 contribution margin per jar) Contribution margin per jar: Selling price $4.00 Cost of Grit 337 ($1.60/4) $0.40 Other variable production costs 2.50 Variable selling costs 0.30 3.20 Contribution margin per jar $0.80 2. 8,000 jars. One way to approach this requirement is as a further processing decision. The additional fixed processing costs are $5,600 and the advantage to further processing is $0.70 per jar, as computed below. Dividing the $5,600 fixed processing costs by the $0.70 advantage for further processing yields 8,000 jars. Sales value of Grit 337 per 1/4 pound ($2.00/4) $0.50 Additional processing costs per jar 2.50 Additional selling costs 0.30 Total $3.30 Advantage of further processing, per jar ($4.00 $3.30) $0.70 The following schedule shows that at 8,000 jars the company is indifferent between the alternatives. The cost of Grit 337 is ignored because it is the same under both alternatives. Revenue from polish (8,000 x $4.00) $32,000 533 Variable costs, excluding cost of Grit 337 ($2.50 + $0.30) x 8,000 $22,400 Avoidable fixed costs 5,600 28,000 Net revenue from polish $ 4,000 Lost sales of Grit 337 [(8,000/4) x $2.00] $ 4,000 Thus, the loss of 2,000 pounds of Grit 337 at $2.00 per pound equals the net revenue from 8,000 jars of polish. 5 53 Processing Decision (35 minutes) 1. This requirement presents a furtherprocessing decision, though not obviously so. Each new month is a splitoff point, with another month on the lot being the further processing. The following analysis shows that three months is the optimal holding period. Cost Holding period Revenue at $260 + ($52 x in months Weight $0.50/lb. months held) Profit 1 640 $320 $312 $ 8 2 770 385 364 21 3 890 445 416 29 4 990 495 468 27 2. This requirement is a capacity problem. The lot can be kept full every month, so the question is how best to use it. As shown in the schedule below, the animals should be kept for two months. Contribution margin per unit of capacity Holding Periods One Month Two Months Three Months Total number of animals per year 12 months/months held 12 6 4 Times contribution margin per animal (from requirement 1) $ 8 $ 21 $ 29 Equals total contribution per unit of capacity $96 $126 $116 An alternative approach is to use totals, working with the annual results from each holding period. Holding Periods One Month Two Months Three Months Animals per year: 5,000 x 12 60,000 5,000 x 6 30,000 5,000 x 4 20,000 Contribution margins $8 $21 $29 Total annual contribution margin $480,000 $630,000 $580,000 5 54 Special Order (35 minutes) 1. Income will fall by $4,500. Critical to the analysis is determining the lost sales at the normal price. Lost regular sales: Maximum capacity for twomonth period (7,500 x 2 x 2) 30,000 cases 534 Special order 10,000 Available for regular sales 20,000 Expected sales (6,000 x 2 x 2) 24,000 Lost regular sales if order accepted 4,000 cases 535 The analysis proceeds as follows. Variable cost is $6.25 per case. Materials $2.50 Direct labor 3.00 Variable overhead (1/2 hour x $1.50) 0.75 Total variable cost $6.25 Contribution margin on the special order is therefore $1.25 ($7.50 $6.25) and $4.25 on regular sales ($10.50 $6.25). Contribution margin on special order (10,000 x $1.25) $12,500 Contribution margin on lost regular sales (4,000 x $4.25) 17,000 Net loss on special order ($ 4,500) An alternative is Gain in revenue from special order: Revenue from special order (10,000 x $7.50) $75,000 Lost revenue from 4,000 cases (4,000 x $10.50) 42,000 Net gain in revenue 33,000 Incremental costs of special order: Cost of operating at capacity for two months 15,000 cases x 2 months x $6.25 per case $187,500 Cost of operating at expected sales level 12,000 cases x 2 months x $6.25 150,000 Net additional cost 37,500 Net loss ($33,000 $37,500) $ 4,500 2. $7.95. A simple way to find this is to divide the loss of $4,500 by the 10,000 units of the special order and add the $0.45 ($4,500/10,000) to the original price of $7.50. Another approach uses the basic idea of target pricing from Chapter 2. Required contribution margin [4,000 x ($10.50 $6.25)] $17,000 Divided by volume on special order 10,000 Equals perunit required contribution margin $1.70 Plus variable cost per case 6.25 Equals required price $7.95 5 55 Services of an Athlete   Jumping Leagues (5060 minutes) Note to the Instructor: There is no single, best answer for either requirement of this case. What individual owners will consider a fair way to share the cost of attracting Jones to the CCSL, or keeping Jones in the NSL, depends on the riskaversion preferences of the owners. The additional confounding factor in requirement 2 is that soldout games could be either home or away games for Jones' team, so the potential loss for individual teams other than Jones' is not determinable even if the homeaway split of gate receipts were known (which it is not) and unequal Nevertheless, the preliminary calculations for each requirement permit some conclusions about proposals that are unreasonable. You can also conclude that proposals failing to address the potential impact of an injury that sidelines Jones are deficient. Moreover, you can assess the reasonableness of any assumptions students make to deal with missing information and determine whether students recognize that their proposals incorporate assumptions. You might want to point out that the two 536 requirements underscore the idea that someone facing a decision always has a starting point. In requirement 1, none of the teams currently risks losing if Jones misses a game. In requirement 2, all of the teams currently face that risk 1. Preliminary calculationspotential gain for CCSL Potential Gain for League Total additional admissions (10,000 persons x 10 games) 100,000 Contribution margin per admission ($20 $4) $16 Additional contribution for 10 games $1,600,000 Potential for the Titans Contribution from home games: Contribution, per admission at home ($20 $6 $4) $10 Additional admissions expected per home game 10,000 Additional contribution expected per home game $100,000 Number of home games 5 Total added contribution from home games $500,000 Contribution from away games: Visiting team's receipt for each admission $6 Additional admissions expected per away game 10,000 Additional contribution expected per away game $60,000 Number of away games 5 Total additional contribution from away games 300,000 Total additional contribution from all games $800,000 The potential for the CCSL is $1,600,000 and for the Titans is $800,000, so the other five teams have the potential for $800,000, or $160,000 each on average. The Titans will not try to sign Jones without help from the other teams because his $1,000,000 salary demand exceeds the additional contribution. Moreover, the entire analysis depends on Jones being able to play in every game. Any injury that temporarily sidelines him, if the fans know about it prior to the game, could reduce the contribution The potential to the Titans is five times that to each of the other teams, so the owners might believe it fair for the Titans to pay half of the salary ($500,000) and the others to split the remainder equally ($100,000 each). The Titans then stand to gain $300,000 ($800,000 $500,000) and the others $60,000 ($160,000 $100,000). The Titans take more risk because they are exposed to Jones being sidelined for all of their games, while each of the other teams is exposed only twice Note, however, that each team's paying in proportion to its potential gain appears fair only if Jones will play every game. If he misses a game, only one other team is affected. The Titans do not care which other team is affected, but the other teams do. For the affected team, a $60,000 gain turns into a $40,000 loss for a home game or breakeven for an away game. The other owners probably would not consider such a split fair because of that risk. One possible solution is for the teams to share the risk, so that if Jones misses a game, all of the other teams share the loss. Thus, if Jones misses a Titan's home game, costing the other team $60,000, each of the others pays $12,000 toward Jones’ salary. If Jones misses a Titan's away game, the others share $100,000, or $20,000 each 537 Such a plan is a starting point for discussions. Because everyone can benefit from acquiring Jones, the incentive is to find a solution. 2. Preliminary calculationspotential loss to NSL Lost contribution on games not sold out: Contribution margin per admission $20 No. of admissions lost per game 8,000 Contribution lost per game $160,000 Average number of games not sold out 6 Lost admissions for 6 games $960,000 Lost contribution on games sold out: Contribution margin per admission $20 No. of admissions lost per game No. of lost ticket requests 8,000 No. of unfilled ticket requests for sellout games 3,000 5,000 No. of actual ticket sales lost Contribution lost per game $100,000 Average number of games sold out 6 Lost admissions for 6 games $600,000 Total lost contribution ($960,000 + $600,000) $1,560,000 Savings if Jones leaveshis salary 600,000 Net decline in profits for league $960,000 As with the analysis for the CCSL, this one does not consider injuries Because the sellouts could be any combination of home and away games, we cannot determine the potential loss to any given team from Jones being hurt. The NSL can match the $1,000,000 offer because it stands to lose $1,560,000 before considering his salary, leaving $560,000 ($1,560,000 $1,000,000) net if the league keeps Jones at $1,000,000. The question of sharing the salary depends on the split of revenues If the teams split contribution margin equally, then the Lumberjacks stand to lose $780,000 ($1,560,000 x 50%) and the others $780,000, or an average of $130,000. Working in the sellouts complicates matters because the other teams could lose $160,000 (from two nonsellouts) to $100,000 (two sellouts). (Jones’ contribution for a nonsellout is $160,000 per game, split 5050, so it is $80,000 for each of the two games and similarly for nonsellouts.) The Lumberjacks stand to lose $180,000 ($780,000 $600,000 salary) if Jones moves, the others $130,000 each. So a split of the $400,000 increase in salary along the lines of the relative losses is not unreasonable Potential Loss Percentage of Total Added Salary Payment Lumberjacks $180,000 18.75% $ 75,000 Others 780,000 81.25% 325,000 Total $960,000 $400,000 It appears that the $1,000,000 salary is only a starting point. Both leagues have incentives to sign Jones, with the CCSL being able to pay up to $1,600,000 and the NSL $1,560,000. Because these amounts are close, and because of all of the estimates and nonquantifiable factors, it is difficult to predict which league will win. Civic pride and other factors could also become involved 5 56 Dropping a Segment (30 minutes) 538 It will cost Mr. Johnson $18,930 to act in accordance with his views about smoking Tobacco Drugs Sundries Total Lost sales $31,000 $8,960* $3,600** $43,560 Cost of sales 10,500 3,780* 1,050** 15,330 Lost gross profit $20,500 $5,180 $2,550 28,230 Less: Gross profit gained on greeting card sales 5,000 Reduced carrying costs 300 Clerk's salary 4,000 Total operating expenses 9,300 Net reduction in profit before taxes $18,930 * 7% reduction in sales of prior periods (5% due to dropping tobacco and 2% due to the pharmacist's having to handle greeting card sales) **10% reduction The above analysis does not recognize the positive effects either (a) for persons who might benefit from being unable to obtain tobacco products or (b) of the example provided by Mr. Johnson. Nor does it include a measurement of Mr. Johnson's satisfaction in having abided by his convictions. Note to the Instructor: In addition to raising the problem of quantifying the factors mentioned above, the case is interesting in that the owner's decision will be heavily affected by nonquantitative factors, and that the concepts introduced in managerial accounting can be used to present the owner with some quantified implications of the decision. We're not suggesting that owners and other managers should make decisions based solely on quantifiable considerations, or even that there is (or should be) a limit to how far they will (or should) go in exercising their convictions. We suggest only that owners and other managers are better off with this information than without it. In any event, we've found that the case generates lively class discussion when students are prompted to suggest other personal beliefs that might present a problem to the owners and/or managers of other businesses. For example, one might have convictions about the morality of lotteries or birth control or be dedicated to the preservation of the environment. Each opportunity to act on these convictions is likely to have financial implications, and it is true that one cannot do everything one might want to do. The question of value hierarchies comes into play here. What is Mr. Johnson willing to have his family forgo to exercise his convictions? (Will the expected drop in income mean not being able to fulfil a desire to send his children to college? Will it mean reducing financial assistance he provides to his parents or to charitable organizations he regularly supports?) It may not be possible to measure the degree of one's convictions on various issues, but it is true that there are different degrees. Would Mr. Johnson be willing to change his line of business altogether in order to abide by his conviction with respect to tobacco? (Would the country tolerate the expenditures and consequent taxation required to ensure that no traffic deaths could be attributed to faulty roads?) 539 5 57 Alternative Uses of Space (45 minutes) The analysis involves comparing the incremental profit that can be expected from the two alternatives for using the space now occupied by the boutique with the revenue expected if the lease with the boutique chain were renewed. The expected revenue if the lease is renewed follows. Revenue, first ten months this year $400,000 Expected revenue, last two months [($400,000/10) x 2 x 2] 160,000 Boutique sales, current year (estimated) 560,000 Sales increase expected next year, 10% 56,000 Sales expected for boutique next year $616,000 Percentage rental expected from lease, 5% $ 30,800 Base rental provided in contract 36,000 Expected revenue from leased department $ 66,800 The expected incremental profits from the two alternatives are computed below InHouse Operation Expanded Shoe of Boutique Department Sales: Projected sales of $380,000 x 90% $342,000 Projected sales of $200,000 $200,000 Variable costs: Cost of goods sold ($171,000/$380,000) x $342,000 (153,900) (100% 45%) x $200,000 (110,000) Sales commissions ($200,000 x 10%) ( 20,000) Expected contribution from sales 188,100 70,000 Fixed costs (given) (104,000) Lost contribution margin Customers coming especially to Clothes Horse $616,000 x 40% x 20% x (45% 8%) ( 18,234) ( 18,234) Regular customers of the store $616,000 x 60% x 2 x 10% x (45% 8%) ( 27,350) ( 27,350) Incremental profit $ 38,516 $ 24,416 Some students will probably approach the analysis by computing the cost of abandoning the leased department. That cost is $112,384, the expected rental fee ($66,800) plus the cost of the lost sales $45,584 ($18,234 + $27,350). For an inhouse use of the space to be advisable, the promised profit would have to exceed $112,384, and neither of the available alternatives promises that level of return One could conclude that the most profitable use of the space now occupied by the leased department (Clothes Horse) would be to renew the lease. Revenues from the lease would be $66,800, while the most profitable of the alternative use would be an inhouse operation of the boutique, which could result in a return of only $38,516. The estimates made of the shopping habits of customers now frequenting the boutique must be carefully considered. Were the observed habits typical? Without regard to the lost contribution margins (computed as a result of the firm's observations of shopping habits of boutique customers), the inhouse operation of the boutique would produce an incremental profit of $84,100 ($188,100 $104,000). Of some importance also is management's conclusion 540 that the sales estimate for the inhouse boutique is overly optimistic. If Rausch's estimate is correct, the incremental profit produced by an inhouse boutique operation is $59,416 [($380,000 x 55%) fixed costs of $104,000 lost contribution margin of $45,584]; and once again, the estimate of lost contribution margin becomes critically important. 5 58 Product Processing (45 minutes) Note to the Instructor: This is a difficult case because it seems to be a simple question of product profitability but is actually a further processing question, though it reverses the usual jointproducts problem. The managers' past insistence on viewing the company as a paneling manufacturer has caused it to forgo profits. The company operates three processes, plywood, veneer, and gluing. It can make three products, plywood, veneer, and paneling. The special feature of the operation is that the third product is the result of combining the other two. The schedule below shows the contribution margins of each product and process. Per 1,000 square foot Product & Process Product Process Plywood Veneer Total Paneling Gluing Selling prices $81 $74 $155 $178 $23 Variable costs: Materials 18 16 34 34 0 Direct labor 25 20 45 55 10 Variable overhead* 20 16 36 44 8 Total variable costs 63 52 115 133 18 Contribution margin $18 $22 $ 40 $ 45 $ 5 Capacity ** 1,200 1,000 1,000*** 1,300 Used 1,000 1,000 1,000 1,000 * 80% of direct labor ** in thousands of square feet *** Capacity in veneer limits paneling capacity The company was right to process veneer and plywood into paneling; the incremental revenue of $23 exceeded the incremental cost of $18. But the company gave up $36,000 by not making another 200,000 feet of plywood and whatever it might have made using the 300,000 feet of unused gluing capacity The managers appear to be realizing that changes in operations might be desirable. But their responses to complaints from workers and from the manager of the gluing process suggest a lack of understanding of the company's cost structure The schedule draws attention to the gluing operation as a potentially profitable furtherprocessing opportunity. The managers need to understand the break points in prices where it becomes more profitable to sell the two products separately. A $5 increase in the price of either intermediate product or decline in the price of paneling makes the company indifferent between paneling and the two intermediate products. Thus a drop of $12 in the price of paneling, to $164, as Chen mentioned, makes the company better off selling the products separately. A complete evaluation of the CEO's proposal requires knowing the cost of obtaining additional capacity. (The $2,000 figure was the authorization, not a statement about the cost.) We can, however, determine how much the 541 company could pay for additional capacity at various product prices At prevailing prices, adding capacity to plywood, which already has excess capacity, adds $18 contribution margin per 1,000 square feet of capacity. So additional capacity is desirable if it costs less than $18 per 1,000 feet. Increasing veneer capacity is profitable if it costs less than $27 per 1,000 feet Gain, contribution margin on 1,000 feet of paneling $45 Loss, contribution margin on 1,000 feet of plywood 18 Net gain $27 Of course, the loss applies only when veneer capacity exceeds 1,200,000 feet, the current capacity in plywood. 559 Product Mix with Production Constraints (40 minutes) 1. 40 units of X and 70 units of Y. Step 1 of the theory of constraints is to identify the constraint. This can be accomplished most readily by calculating the load factors for each station as follows: time per unit X Y total for product X (40 units) Y (80 units) Total  available time Load factor A B 4+5+15=24 C 15+18=33 D 20 E 28+6=34 4+5=9 9+6=15 18 8+8+9=25 A 2,720 2,720 2,400 113% B 960 720 1,680 2,400 70% C 1,320 1,200 2,520 2,400 105% D 800 1,440 2,240 2,400 93% E 320 2,000 2,320 2,400 97% The question becomes which station is the constraint, A or C, since both have load factors in excess of 100%. Station A can support a maximum production of 2,400/34 = 70 units of Y while Station C can support 2,400/15 = 160 units of Y. Station A is the constraint. Notice that Station A is not a constraining factor on product X, so 70 units of Y can be produced. This will use 15  70 = 1,050 minutes on Station C, leaving 2,400 – 1,050 minutes = 1,350 minutes for production of X. A total of 1,350/33 = 40 units of X can be produced 2. Station A should serve as the “drum” of the production process. Buffers should be maintained immediately prior to this station so that there is no downtime due to lack of product. Management cannot be complacent about the other workstations, however. Notice that the load factors for station C at the actual product mix is also at 99%. Management will need to maintain a buffer before this station as well, as any shortage would cause station C to become the constraint. Stations D and E have load factors of 86%. There is little margin of error at these stations so management must be diligent total for product X (40 units) Y (70 units) Total  available time Load factor A 2,380 2,380 2,400 99% B 960 630 1,590 2,400 66% 542 C 1,320 1,050 2,370 2,400 99% D 800 1,260 2,060 2,400 86% E 320 1,750 2,070 2,400 86% Note to Instructor This problem can be used to illustrate Goldratt’s concept of a “critically constrained resource,” one that has the potential to become the constraint if care is not taken. Any downtime at station C would cause the constraint to shift from station A. Any prolonged problems at either stations D or E could also cause the constraint to shift 543 ... relevance of volume to makeorbuy decisions. If there are no avoidable costs and no opportunity cost, volume has no effect on the decision because all costs are variable. But if there are either avoidable fixed costs or ... Revenues most relevant are admissions fees and perhaps receipts from sales of snacks and beverages. Incremental costs include increases in utilities during the additional hours the facility is open, cleaning services, and costs related to the entertainment. Decorating costs are also ... Paper, printers' labor, and ink might be expected to be variable costs, giving a total variable cost per paper of $1.20. The two other costs mentioned, salaries for editorial employees and other operating expenses, are

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