Solution manual cost and managerial accounting 3rd by barfield relevant costing

Chapter 12 Relevant Costing Questions A relevant cost is a cost that is applicable, pertinent, or logically related to making a decision. In business, managers use the concept of relevant costs in the allocation of resources Relevant costs to be considered by the directors of a hospital in purchasing a new Xray machine would include the investment cost of the machine as well as its operating costs. Other relevant factors to the decision would be the life of the machine, productive capacity and speed of operations, repairs and maintenance, degree of technology and probability of obsolescence as well as any incremental revenues or savings to the hospital. An alternative would be to lease an Xray machine or contract with another hospital for Xray services A relevant cost is (1) associated with a decision that is under consideration, (2) important to the decision maker, and (3) bears on the future. All future costs are not relevant because some are common to all alternatives under consideration. All relevant costs are not found in the accounting records. In particular, it is unlikely that opportunity costs will be found in the accounting records An opportunity cost is a benefit that is sacrificed to pursue one alternative over another. In the case of the makeorbuy decision, an opportunity cost associated with the “make” alternative is the rental value of the production facilities This question cannot be answered out of the context of a specific case because, in some cases, quantitative factors may be more important than qualitative factors although, in others, the opposite is true. Usually, both quantitative and qualitative factors are considered when making a decision. Quantitative factors are often reviewed first because these are frequently more definitively addressable; the more subjective qualitative factors are usually addressed second In some business situations, a decision that was acceptable from a quantitative standpoint might not be chosen due to qualitative reasons; a decision that was unacceptable quantitatively would probably not even be considered 61 62 Chapter 12 Relevant Costing qualitatively 62 Chapter 12 Relevant Costing 63 It is true that a particular cost can be relevant for one purpose, but not for other purposes. One example is fixed factory overhead per unit. Fixed overhead is relevant to determining product cost for financial statement purposes, but may have little or no relevance to determining the bid price of products in a special order situation. Another example is a sunk historical cost of a fixed asset. Such a cost is relevant to determining product line operating results, but is irrelevant in deciding whether to replace that particular fixed asset. A final example is the purchase price of a machine. Before a machine is purchased, its price is relevant to the choice of which machine to buy; once the fixed asset has been acquired, its purchase price becomes a sunk cost that is no longer relevant to any decision about keeping or selling that machine No, sunk costs are never relevant in decision making because sunk costs cannot, by definition, be "undone." The only relevant item of information is the current market value of the stereo, $150. The $500 historical cost is not relevant because it is a sunk cost. There is no decision alternative that can undo the incurrence of that cost. The $375 replacement cost of the stereo is not relevant because the decision at hand does not involve an alternative of replacing the stereo. The only alternatives under consideration are (1) sell and (2) keep the stereo Kelly should consider the following factors in her decision: Insource tortillas: The incremental production costs of each unit (direct material, direct labor, variable factory overhead, and incremental or additional fixed factory overhead) Availability of production capacity Opportunity costs of using facilities for other purposes Costs of storage space Taste or quality of her tortillas as compared to Ricardo's Outsource tortillas: Net purchase cost (price less discount plus shipping, etc.) Cost of storage space Reliability of source of supply Ability to control quality of tortillas Delivery time Future bargaining position with supplier Concerns about possible future price changes 64 Chapter 12 Relevant Costing A scarce resource is any input that constrains production capacity. In the short run, any constraint can be binding and the tightest constraint changes over time. For example, in a labor strike, direct labor may be the most constrained resource. If a machine breaks down, the conversion operation performed by that machine may be the most binding constraint on capacity, and if a supplier becomes bankrupt, certain materials may become the most binding constraint 10 Sales commissions could be based on contribution margin generated by each salesperson. This policy would motivate salespersons to sell the products that benefit the company's profit the most. Recordkeeping would be a little more difficult and the sales personnel may not generate quite as many dollars of commissions this way, however. An alternative would be to stipulate groupings of products into most desirable, moderately desirable, and least desirable to be sold while setting the commissions commensurate with such classifications. The drawback would be that the salespeople would have to know the category within which each product falls and the recordkeeping would be significantly more extensive 11 Because sales volume is linked to sales price through the elasticity of demand. A greater volume change will follow a price change for a product that has high elasticity than will follow a price change for a product with low demand elasticity 12 A special order decision involves the analysis of a nonrecurring sale of products. The typical circumstance involves the opportunity to sell products outside of the normal marketing area or to a onetime customer. The usual analysis involves a consideration of incremental costs and incremental revenues as well as the effect of the proposed sale on existing business. Chapter 12 Relevant Costing 65 13 Avoidable fixed costs are those fixed costs that could be eliminated should a particular product line be discontinued. Because they are avoidable, they are relevant to a decision of whether to keep or eliminate a product line Sunk direct fixed costs, while directly associated with a particular product line, cannot be avoided even if the product line is discontinued. Because the commitment to the cost was made in the past and is irrevocable, such sunk fixed costs are irrelevant to the decision of whether to keep or eliminate a product line Common fixed costs are incurred at an organizational level above that of the segment or product line under consideration. As such, these common fixed costs are not relevant to product line continuance or discontinuance. These costs are incurred to "service" several product lines or segments. If common fixed costs could be eliminated or avoided if a product line were eliminated, then they could (under this unusual situation) be considered relevant 14 Lazlow Optical should determine whether the negative segment margin is being caused by temporary economic conditions or is likely to continue indefinitely. Additionally, the company should determine what the impact will be on the sale of its other products and whether it is necessary to keep this camera on the market so that its customers won’t turn to the offerings of competitors 15 Segment margin is more important in making decisions about whether to keep or eliminate a product line because the costs deducted in arriving at segment margin include only relevant costs (total direct variable expenses and avoidable fixed expenses). The costs presented below the level of segment margin to derive product line operating results are irrelevant costs (sunk direct fixed costs) because such costs could not be avoided or eliminated should the product line be discontinued 16 Linear programming is used as an aid in complex decisions that involve a single, identifiable objective function and multiple decision constraints 17 Usually, the objective function is expressed to either maximize profits, segment margin, or contribution margin, or minimize costs 18 The nonnegativity constraints require that physical inputs to a production activity cannot exist in negative quantities. When using a graphical approach, it is not necessary to express the nonnegativity constraints because the analysis is confined to the upper righthand quadrant, i.e., the quadrant involving only positivenumber alternatives 66 Chapter 12 Relevant Costing Chapter 12 Relevant Costing 67 19 A feasible solution satisfies all of the constraints of the linear programming problem; the optimal solution is simply the feasible solution that maximizes (or minimizes) the objective function. 20 No, resource constraints can be equalities or inequalities. While most resource constraints are inequalities, it is possible that a resource constraint can be an equality. For example, in a cost minimizing dietary formula, it might be required that dietary fiber equal 14 percent of total intake 21 Slack variables represent an unused amount of a resource. Surplus variables represent over achievement of a greater than or equal to constraint. Slack variables and surplus variables can certainly be found in the same linear programming problem All that is required for both to appear in the same problem is that both lessthan and greaterthan constraints appear in the problem Exercises 22 Consumers are interested in buying the highest quality products with the most features at the least cost. To successfully compete for the consumer’s attention, a firm must aggressively develop and defend core competencies and be willing to cooperate with other firms in noncore functions. By taking a more expansive view of cost management, firms can identify more creative approaches to obtaining quality, cost and functionality advantages over their competitors. The ideas featured in the article about the value chain demonstrate a very creative approach to managing costs, quality, and environmental impacts by cooperatively working within new value chains. 23 Prior to acquiring the production facilities, personnel, and other infrastructure necessary to produce a product, all costs are relevant. All costs are avoidable by simply choosing not to produce the product. After the production facilities are acquired, some costs are no longer avoidable. Costs such as depreciation and other costs incurred to maintain the machinery can no longer be avoided by deciding not to produce At this point all variable costs are avoidable and some fixed selling and administrative costs are avoidable. After products are completed, nearly all costs are unavoidable. All variable and fixed production costs are sunk and, therefore, unavoidable. Some variable selling costs may be avoidable but fixed selling expenses would be irrelevant 68 24 25 Chapter 12 Relevant Costing a The relevant factors include the difference between the starting salaries for B.A.s and M.A.s, time until retirement, time to complete the M.A., and the outof pocket costs to obtain the M.A. b The opportunity cost associated with earning the master's degree is two year's of income that could have been earned with the B.A. degree ($38,300 × 2 = $76,600) Total cost to get the master’s degree: Opportunity costs $ 76,600 Outofpocket costs 51,000 Total costs $127,600 The outofpocket cost would include the cost of tuition, books, lab fees, and other direct educational costs. It would not include room and board or other living expenses that would be incurred irrespective of whether the student works (with the B.A. degree) or attends school c The other factors to be considered would be the qualitative factors, e.g., the relative satisfaction, prestige, and happiness obtained from jobs that can be secured with each degree, and each alternative's effect on retirement plans, free time, and travel opportunities The only sunk cost is the purchase cost of the lettuce, $0.50 per head a b The unspoken alternative is to do nothing. Do nothing might simply mean throwing the heads of lettuce in a dumpster c Do Sell to Sell to Nothing Wholesaler Restaurant Incremental revenue $ 0 $12,250 $23,520 Incremental costs 0 0 10,000 Incremental benefit $ 0 $12,250 $13,520 Based on a comparison of the incremental benefit associated with each alternative, the company should sell the lettuce to the restaurant. 26 a You would explain to Bill that the purchase cost of $110 is not relevant to any decision he can now make regarding the machine. No matter what action he takes now, the $110 is not a recoverable cost. In deciding which action to take, Bill should consider only those costs that can be avoided by taking one action rather than another. Any cost that is the same across all decision alternatives can be ignored; such a cost is not relevant. Ignoring qualitative factors, Bill should select the alternative Chapter 12 Relevant Costing 69 that minimizes total relevant costs His logical choices are (1) repair the machine at an estimated cost of $55 and (2) purchase a new machine. Accordingly, the decision would logically be made by comparing the purchase cost of a new machine to the repair cost of the old machine. However, Bill may want to consider differences in features between the existing machine and replacement machines as well. He may be willing to pay more than $55 for a new machine if it has additional features. This would be a qualitative consideration b 27 If labor costs are a major competitive problem for General Motors, the company should consider ways to avoid incurrence of labor costs. Assuming that the company cannot legally or ethically remove benefits from existing employees, the company needs to develop a longterm plan to reduce labor costs. One major alternative to achieve labor cost reduction is to mechanize more operations. By mechanizing operations, GM could reduce the labor content of its products One other major strategy discussed in the article is to increase the use of outsourcing. Assuming that its potential supplier of parts and components has lower labor costs, GM could lower its costs by purchasing parts and components from vendors rather than making them internally. Traditionally GM has outsourced to a much smaller extent than its major competitors. GM could potentially obtain substantial operating cost reductions by outsourcing to a greater extent. Outsourcing decisions are made using the makeorbuy analysis discussed in the chapter. 28 a The sunk cost is the original cost of the old equipment, $75,000. b Irrelevant future costs include $4,000 of cash operating costs and the (nondifferential) salvage values in five years c The relevant costs include the cost of the new equipment, $99,000, the current salvage value of the old equipment, $22,000, and $13,000 of annual cash operating savings d The opportunity costs associated with keeping the old equipment include the potential $13,000 savings in cash operating costs, and the current $22,000 salvage value of the old equipment e The incremental cost to purchase the new equipment is the difference between the purchase cost of the new machine and the current salvage value of the old machine, $99,000 $22,000 = $77,000 70 Chapter 12 Relevant Costing 75 Chapter 12 Relevant Costing 40 a If the U. S. Division had been eliminated, Webfinder Toys’ income statement would have appeared as follows: Sales Variable costs Contribution margin Fixed costs: Direct $ 480,000 Corporate 2,700,000 Operating income (loss) b $ 3,600,000 (2,088,000) $ 1,512,000 (3,180,000) $(1,668,000) United States Mexico Total Sales $7,200,000 $3,600,000 $10,800,000 Variable costs (4,740,000) (2,088,000) (6,828,000) Direct fixed costs (900,000) (480,000) (1,380,000) Segment margin $1,560,000 $1,032,000 $ 2,592,000 Corporate costs (2,700,000) Operating income (loss) $ (108,000) If the U. S. Division is eliminated, corporate income would decline by the $1,560,000 of segment margin currently being generated by that division. The common corporate costs of $2,700,000 would then need to be covered in total by the Mexico Division, which it cannot 41 a thousands Gross margin $ 600,000 Avoidable fixed and variable operating costs (725,000) Segment margin $(125,000) Yes, the company should strongly consider dropping the tubing product line because it generates a negative segment margin of $125,000 b The pretax profit of the company would rise by $125,000 (the amount of the negative segment margin of the tubing product line) if tubing were dropped 42 Objective function, MAX CM: 9.50X1 + 5.00X2 + 1.50X3 43 Objective function, MIN VC: 0.65X1 + 0.93X2 + 1.39X3 + 0.72X4 44 Objective function, MAX CM: 3.25X1 + 2.05X2 + 2.60X3 Subject to: 2.5X1 + 1.0X2 + 2.5X3 0 X3 > 0 Where: X1 = the number of pairs of pants X2 = the number of pairs of shorts X3 = the number of shirts 76 Chapter 12 Relevant Costing 45 Minimize Cost: 3.99X1 + 1.29X2 + 0.93X3 + 2.12X4 + 3.42X5 Subject to: 38X1 + 1X2 + 35X3 + 23X4 + 42X5 > 50 10X1 + 13X2 + 7X3 + 3X4 + 8X5 > 10 0X1 + 0X2 + 120X3 + 110X4 + 100X5 > 100 500X1 + 60X2 + 190X3 + 110X4 + 210X5 > 2,000 3.99X1 + 1.29X2 + 0.93X3 + 2.12X4 + 3.42X5 0 Where: X1 = pizza X2 = tuna X3 = cereal X4 = macaroni & cheese X5 = spaghetti Problems 46 47 a Cost of new machine $ (500,000) Sales value of old machine 100,000 Incremental cost of new machine $ (400,000) Operating cost savings ($190,000 × 5) 500,000 Net advantage of buying new machine $ 100,000 b The qualitative factors that should be considered include any quality differences between the output generated by the two machines, whether the company’s employees have the knowledge to operate the new machine, how acquisition of the machine would affect safety considerations, and the capacity levels of the two machines a The relevant costs include the cost to purchase the new turbine, the current market value of the old turbine, and the difference in annual operating costs between the old and new turbines b Incremental cost of new turbine: $2,000,000 $400,000 = $(1,600,000) Incremental cost savings of new turbine: ($480,000 $180,000) X 8 2,400,000 Incremental profit from buying new turbine $ 800,000 48 c The maximum amount that the company could pay: Total annual operating savings $2,400,000 Cash value of old machine 400,000 Total $2,800,000 a Relevant costs include: Variable production costs ($0.05 + $0.04 + $0.03), $0.12 per unit Annual salary of manager who can be replaced, $30,000 Vendor’s offering price, $0.13 per unit Chapter 12 Relevant Costing 49 77 b Production costs saved ($0.12 × 4,000,000) $ 480,000 Salary savings 30,000 Purchase cost of part ($0.13 × 4,000,000) (520,000) Disadvantage of outsourcing the part $ 10,000 c Other considerations include the relative quality of the part acquired from the vendor and the part produced internally, the ability of the vendor to deliver in a timely manner, the existence of competitors of the vendor, the likelihood that future volume levels will differ from present volume levels. a Cost to make: Direct materials $139.00 Direct labor $66 × .75 = 49.50 Variable overhead $43 × .75 = 32.25 Fixed overhead: Rental value of production space $114,000 ÷ 50,000 2.28 Depreciation on new machine ($5,000,000 ÷ 5) ÷ 50,000 20.00 Total unit cost to make $243.03 Cost to buy: $240.00 b If 60,000 subassemblies were required annually, the "cost to make" would change because of the lower fixed costs on a perunit basis. The depreciation would be ($5,000,000 ÷ 5) ÷ 60,000 = $16.67, and the rental value opportunity cost would decline to: $114,000 ÷ 60,000 = $1.90. This would change the overall cost to make to $139.00 + $49.50 + $32.25 + $16.67 + $1.90 = $239.32. At this volume level, the advantage is slightly in favor of making c If 75,000 subassemblies were required annually, the "cost to make" would again change due to the lower fixed costs on a perunit basis. The depreciation would be ($5,000,000 ÷ 5) ÷ 75,000 = $13.33, and the rental value opportunity cost would decline to $114,000 ÷ 75,000 = $1.52. This would change the overall cost to make to $139.00 + $49.50 + $32.25 + $13.33 + $1.52 = $235.60. At this volume level, the advantage is significantly in favor of making Qualitative considerations: Quality control systems in place by potential supplier Reliability of the supplier Risk of future price increases by supplier Lead time to receive orders Number of competing suppliers d      78 Chapter 12 Relevant Costing  50 a Labor relations in supplier's plants Maximize the contribution per unit of the scarce resource (direct labor hours): Desks Chairs Footstools Sales per unit $900 $680 $240 VC per unit (720) (570) (186) CM per unit $180 $110 $ 54 Hours per hour ÷12 ÷11 ÷3 CM per hour $15 $10 $18 Since footstools yield the greatest contribution margin per direct labor hour, the company should devote all of its capacity to their production in the absence of market or other restrictions. Profit can be determined as follows: Production of footstools = 34,000  3 = 11,333 (rounded) Contribution margin 11,333 × $54 $611,982 Fixed costs (225,000) Pretax income $386,982 b In part (a), it was determined that footstools are the most profitable product, so the company will devote 50 percent of its time to that product. Chairs yield the lowest contribution margin per hour, so 20 percent of the time should be devoted to them. This would leave 30 percent of the time to manufacture desks Production levels: Footstools (34,000 × .50)  3 5,667 (rounded) Desks (34,000 × .30)  12 850 Chairs (34,000 × .20)  11 618 (rounded) Contribution margin: Footstools (5,667 × $54) $306,018 Desks (850 × $180) 153,000 Chairs (618 × $110) 67,980 Total $526,998 Less Fixed costs (225,000) Pretax income $301,998 c Yes. These products are related, and as such, probably sell in fairly fixed ratios. For example, it is reasonable to assume that one chair is sold for each desk sold. However, the footstools’ sales may be somewhat independent of the other two products d The company’s tax rate is irrelevant because it does not change across the choices under consideration in this decision Chapter 12 Relevant Costing 51 a 79 Plan 1: New commission on scarves = 0.11($40 $22) = $1.98 New commission on handkerchiefs = 0.11($10 $5) = $0.55 New CM on scarves = ($40 $1.98 $22 $4)95,000 = $1,141,900 New CM on handkerchiefs = ($10 $0.55 $5 $0.50)115,000 = $454,250 Income from scarves = $1,141,900 $580,000 = $561,900 Income from handkerchiefs = $454,250 $180,000 = 274,250 Total Plan 1 income $836,150 Plan 2: New FC for scarves = $580,000 + $25,000 = $605,000 New sales for scarves = 119,000 units; CM = $12 × 119,000 = $1,428,000 New sales for handkerchiefs = 91,000 CM = 91,000 × $4 = $364,000 Income from Scarves = $1,428,000 $605,000 = $ 823,000 Income from Handkerchiefs=$364,000 $180,000 = 184,000 Total Plan 2 income $1,007,000 Plan 3 New sales for scarves = 94,000 units CM = $16.75 × 94,000 = $1,574,500 New sales for handkerchiefs = 90,000 units CM = $6.85 × 90,000 = $616,500 Income from scarves = $1,574,500 $580,000 = $ 994,500 Income from handkerchiefs=$616,500 $180,000= 436,500 Total Plan 3 income $1,431,000 b Plan 3 should be adopted because it maximizes total income relative to the existing price and cost structure and Plans 1 and 2 80 52 Chapter 12 Relevant Costing a Fish Chicken Total Sales $4,000,000 $1,800,000 $5,800,000 Variable costs Merchandise sold (2,400,000) (1,300,000) (3,700,000) Commissions (400,000) (150,000) (550,000) Delivery costs (600,000) (105,000) (705,000) CM $ 600,000 $ 245,000 $ 845,000 Avoidable fixed costs Allocated corporate (15,000) (15,000) Manager's salary (80,000) (75,000) (155,000) Segment margin $ 520,000 $ 155,000 $ 675,000 Unavoidable direct fixed costs Delivery costs (15,000) (15,000) Depreciation (200,000) (100,000) (300,000) Product line results $ 320,000 $ 40,000 $ 360,000 Common costs (100,000) ( 85,000) (185,000) Net income (loss) $ 220,000 $ (45,000) $ 175,000 b According to the segment margin of $155,000, the Chicken Division generates $155,000 of income above its avoidable expenses. Additional computations are necessary to determine whether the chicken product line should be kept: Chicken segment margin $155,000 Opportunity cost, rent (85,000) Net advantage to keeping chicken line $ 70,000 c To the extent the two product lines enhance each other’s sales, the company should be concerned. Some customers who prefer to purchase both fish and chicken from the same vendor may seek another vendor that has a broader product offering d Layoffs could adversely affect morale and trust between employees and managers. If cordial relations existed between managers and workers prior to the layoffs, the culture could be destroyed by the layoffs. The consequence might be a loss of key employees, a drop in profits, and a decline in customer service Chapter 12 Relevant Costing 53 a 81 Note that in the following solutions, the fact that the total allocated fixed costs will decline from $1,000,000 to $500,000 can be ignored because this change is not differential across the three alternatives Georgia factory expansion Sales $4,200,000 Fixed costs: Factory $ 672,000 Administration 242,000 $ 914,000 Variable costs* $1,344,000 Alloc. home office costs 350,000 1,694,000 (2,608,000) Est. net profit from operations $1,592,000 Tennessee factory estimated net profit from operations 1,080,000 Home office expense allocated to Florida factory (200,000) Estimated net profit from operations $2,472,000 * ($2,800,000  $50)  $16  $1.50 = $1,344,000 b Estimated net profit from operations: Tennessee factory $1,080,000 Georgia factory 820,000 Estimated royalties to be received (30,000 X $8) 240,000 $2,140,000 Less home office expense allocated to Florida’s factory (200,000) Estimated profit from operations $1,940,000 c Estimated net profit from operations: Tennessee factory $1,080,000 Georgia factory 820,000 $1,900,000 Less home office expense allocated to Florida factory (200,000) Estimated profit from operations $1,700,000 (AICPA adapted) 54 a Sales $1,100,000 Variable costs (825,000) Contribution margin $ 275,000 Units sold = ($1,100,000  $10)100 = 11,000,000 Contribution margin per unit= $275,00011,000,000 = $.025 Required unit sales = (($350,000 + $50,000)  $.025) = 16,000,000 units 82 Chapter 12 Relevant Costing b Plan A (000 omitted) Ohio New Jersey Total Sales $1,700 $2,000 $3,700 Variable costs: Direct material $ 425 $ 500 $ 925 Direct labor 510 500 1,010 Factory overhead 340 350 690 Total $1,275 $1,350 $2,625 Contribution margin $ 425 $ 650 $1,075 Direct fixed costs: Overhead $ 350 $ 450 $ 800 Promotion costs 170 50 220 Total $ 520 $ 500 $1,020 Segment margin $ (95) $ 150 $ 55 Allocated fixed costs 55 100 155 Operating income (loss) $ (150) $ 50 $ (100) Plan B Sales $3,100,000 Variable costs: Direct material $775,000 Direct labor 775,000 Variable overhead 542,500 (2,092,500) Contribution margin $1,007,500 Fixed costs: Factory overhead $450,000 Promotion costs 100,000 Allocated costs 155,000 (705,000) Operating income $ 302,500 Plan C Sales $2,000,000 Royalties 137,500 Variable costs: Direct material $500,000 Direct labor 500,000 Variable overhead 350,000 (1,350,000) Contribution margin $ 787,500 Fixed costs: Factory overhead $450,000 Promotion costs 100,000 Allocated costs 155,000 (705,000) Operating income $ 82,500 Chapter 12 Relevant Costing 83 Cases 55. a For May, it would appear that store 2 is more profitable Although store 2 had lower sales than store 1, it is clear that store 1 incurred more expense. For example, store 1 spent twothirds of the entire district advertising budget; this was 10 times more than store 2 spent. Store 1 also incurred more expense for rent and would have been allocated more district level costs because of its higher sales b Store 1 is generating the most revenue. This is given in the first bulleted statement c The incentive for Store 1 is to generate as much revenue as possible. The bonus scheme for that store does not take into account any expenses. Consequently, the manager of the store can benefit from the advertising without bearing any advertising costs d Store 1 would have more incentive. Since store 2 is evaluated on net income, any expenditure for maintenance will reduce the net income that might otherwise have been recorded. Store 1 would want to spend an adequate amount for maintenance so that no machine malfunction or downtime occurs that might interfere with sales. e Both bonus schemes have some problems. The bonus scheme based on sales volume is not likely to increase profits in either the short or long term because no incentive is given to the manager to be conscious of the costs that are incurred to generate revenues. The bonus based on net income is more promising. The only detrimental aspect of this performance measure is that it is short term oriented. It encourages managers to take actions that may generate shortterm profits at the expense of longterm profits. For example, a manager may forgo maintenance activities to reduce costs in the short term However, the longterm implications of this act may be higher costs resulting from broken machinery 84 56 Chapter 12 Relevant Costing a Potpourri Co. should price the regular compound at $22 per case and the heavyduty compound at $30 per case. The contribution margin is the highest at these prices as shown below Regular Compound Selling price per case $ 18 $ 20 $ 21 $ 22 $ 23 Variable cost per case 16 16 16 16 16 Contribution margin/case $ 2 $ 4 $ 5 $ 6 $ 7 Volume in cases (000 omitted) 120 100 90 80 50 Total contribution margin (000 omitted) $240 $400 $450 $480 $350 HeavyDuty Compound Selling price per case $ 25 $ 27 $ 30 $ 32 $ 35 Variable cost per case 21 21 21 21 21 Contribution margin/case $ 4 $ 6 $ 9 $ 11 $ 14 Volume in cases (000 omitted) 175 140 100 55 35 Total contribution margin (000 omitted) $700 $840 $900 $605 $490 b 1. Potpourri Co. should continue to operate during the final six months of 2003 because any shutdown would be temporary. The company clearly intends to remain in the business and expects a profitable operation in 2004. This is a shortrun decision analysis problem. Therefore, the fixed costs are irrelevant to the decision because they cannot be avoided in the short run. The products do have a positive variable contribution margin so operations should continue Potpourri Co Cincinnati Plant Pro Forma Contribution Statement for the Final Six Months of 2003 ($000 omitted) Heavy Regular Duty Sales $1,150 $1,225 Variable costs Selling & admin. $ 200 $ 245 Manufacturing 600 490 Total variable costs $ 800 $ 735 Contribution margin $ 350 $ 490 Total $2,375 $ 445 $1,090 $1,535 $ 840 85 Chapter 12 Relevant Costing Potpourri Co. should consider the following qualitative factors when making the decision to keep the Cincinnati Plant open or to close it: * The effect on employee morale * The effect on market share * The disruption of production and sales due to shut down * The effect on the local community (CMA adapted) 57 a The manufacturing overhead rate is $18 per standard direct labor hour and the standard product cost includes $9 of manufacturing overhead per pressure valve. Accordingly, the standard direct labor hour per finished valve is .5 hour ($9 ÷ $18). Therefore, 30,000 units per month would require 15,000 direct labor hours b Per unit $19.00 Totals for 120,000 Units $2,280,000 Incremental revenue Incremental costs Variable cost Direct material $ 5.00 $ 600,000 Direct labor 6.00 720,000 Variable overhead 3.00 360,000 Total variable costs $14.00 $1,680,000 Fixed overhead Supervisory and clerical costs (4 months × $12,000) 48,000 Total incremental costs $1,728,000 Incremental profit before tax $ 552,000 Shipping, sales commission, and fixed factory overhead (direct and allocated) are irrelevant to the incremental analysis c The minimum unit price that Hydraulic Engineering could accept without reducing net income must cover variable costs plus the additional fixed costs Variable unit cost $14.00 Additional fixed cost ($48,000 ÷ 120,000) .40 Minimum unit price $14.40 86 Chapter 12 Relevant Costing d Hydraulic Engineering should consider the following factors before accepting the Prince Industries order * The effect of the special order on Hydraulic Engineering's sales at regular prices * The possibility of future sales to Prince Industries and the effects of participating in the international market * The company's relevant range of activity and whether or not the special order will cause volume to exceed this range * The impact on local, state, and federal taxes * The effect scheduled maintenance of equipment (CMA adapted) Reality Check 58 a Cost cutting does not automatically result in a drop in quality. Particularly when cost cuts result from simplifying processes and removing complexity that can result in errors, cost cutting can actually improve quality. However, when costs are cut without a careful consideration of how the cuts will impact the consumer, a decline in quality is likely to occur b The purpose of managing costs is to achieve organizational objectives effectively and efficiently. One of the objectives of businesses is to generate profits. Generation of profits, in turn, relies on the business’s ability to satisfy consumers by delivering products and services at the price and quality level demanded by consumers. The dependence of the business on the expectations of the consumer requires the business to consider the consumer viewpoint in managing costs and making decisions. In other words, what the consumer wants is relevant to management decision making. Thus, not harming the longterm survival of the firm requires managers to always consider the consumer effect of decisions. This cannot be accomplished unless managers have welldeveloped information systems that encompass sufficient information about customers. Chapter 12 Relevant Costing 59 60 87 a Some of the costs that GTE may have considered include  loss of goodwill associated with firing workers,  training costs of new employees when rehiring becomes necessary,  quality costs that differ between experienced workers and new employees, and  other costs that may vary with the number of workers who report to work each day b AT&T gets the immediate benefit of experienced employees, lower training costs, lower quality costs, and less cost of supervision. Additionally, AT&T gets the temporary benefit of a larger workforce without permanent expansion in the size of the workforce. This is a significant benefit because to obtain workers of similar quality AT&T might normally have to offer longterm employment. Another significant benefit that AT&T gets is the knowledge of the GTE workers. These workers may have ideas that will be helpful in making longterm improvements in the AT&T operations c The quality of operations should be enhanced for both companies. The GTE workers obtain ideas on new ways to do their production tasks and AT&T gets a similar infusion of ideas. Thus, an important information exchange would occur that should enhance the quality of both operations. Also, AT&T is able to avoid hiring inexperienced workers, and accordingly, avoids quality problems associated with inexperience and lack of skills a Ethical issues to consider: whether the competitor is exploiting the workers; whether the competitor is displacing the domestic workforce; whether the competitor is violating the rights of other companies to fair competition; the effects of the various stakeholders including the customers (competitor’s and Karlson’s) of using the illegal workers and on not using the illegal workers. In addition, there exists the legal issue that hiring illegal aliens is unlawful Karlson’s Computers is considering knowingly and willfully becoming an accomplice by purchasing from this supplier 88 61 Chapter 12 Relevant Costing b The shortrun advantages are buying at a lower price to be more profitable, being able to sell at a lower price and therefore sell more computers, having a competitive advantage, and pleasing the customers who will appreciate the lower prices. The potential disadvantages are longer run: damage to the business community and to the socioeconomic balance; damage to the company’s reputation; possible fines and/or imprisonment if coconspiracy could be proven; ill effects on workers who are exploited; and disadvantages to domestic workers who are unable to obtain jobs c Mr. Karlson should investigate further into hiring practices of the supplier or allow the proper authorities to do so. If he is satisfied that the supplier is following legal practices, Mr. Karlson should perform the necessary cost analysis for a make orbuy decision. If the supplier is found to be hiring illegal aliens, Karlson should continue to make his own keyboards a In varying degrees, an organization may incur a number of costs in meeting equal opportunity requirements. Some of these follow. Because the pool of people having the education and skills to meet an organization’s needs in any subset of the population is unlikely to be as extensive as in the general population, the hiring search often necessitates a greater expenditure of time and cost. If an organization hires someone to fulfill equal opportunity requirements who is not fully qualified, the entity must incur costs to further train that person. During the training period, the person may perform in a less thanoptimal manner and the entity often has to incur costs to correct errors and deficiencies made. Another cost may involve preparing reports to demonstrate compliance with an equal opportunity requirement Chapter 12 Relevant Costing b Americans tend to have very strong views on the ethical qualities of quota systems. An impartial view would recognize both positive and negative ethical factors. The most negative ethical aspect of quota systems is their tendency to deny jobs to highly qualified job candidates. This has the effect of denying employment to individuals because of reasons not related to the job. Further, when an employer is forced to hire individuals who are not the most qualified, the cost of doing business rises for that employer Alternatively, quota systems serve a positive role in labor markets by helping historically disadvantaged groups obtain access to jobs. From a longerterm perspective, such access to jobs should lower certain costs to society: welfare, crime, etc. Further, by allowing disadvantaged groups unequal access to jobs in the present, a system that is more equitable to all may be obtainable in the future c Quota systems may lower the average quality of American products because employers are forced to hire less qualified employees. However, longer term, the overall quality of American products may rise because average skill levels of Americans may rise as target groups gain access to jobs and the opportunity to improve their job skills 89 ...62 Chapter 12 Relevant Costing qualitatively 62 Chapter 12 Relevant Costing 63 It is true that a particular cost can be relevant for one purpose, but not for other purposes. One example is fixed ... confined to the upper righthand quadrant, i.e., the quadrant involving only positivenumber alternatives 66 Chapter 12 Relevant Costing Chapter 12 Relevant Costing 67 19 A feasible solution satisfies all of the constraints of the ... analysis involves a consideration of incremental costs and incremental revenues as well as the effect of the proposed sale on existing business. Chapter 12 Relevant Costing 65 13 Avoidable fixed costs are those fixed costs that could be

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