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9 Managerial Decisions: Analysis of Relevant Information

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Learning Objectives

After studying Chapter 9, you will be able to:

• Describe an eight-step process for decision making.

• Understand the use of differential analysis in making basic decisions.

• Identify and use relevant costs and revenues in make or buy decisions.

• Evaluate special sales pricing decisions.

• Make decisions when there are resource constraints.

• Determine the relevant costs and revenues in sell or process further decisions.

• Evaluate decisions involving adding or deleting segments.

• Understand the basic elements of equipment replacement decisions.

• Incorporate ethical considerations in decision making.

• Explain the role of market and cost information in pricing decisions.

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Chapter Outline

9.1 The Decision-Making Process

9.2. Differential Analysis The Basic Decision Rule Incremental Analysis Versus Total Analysis An Example of Differential Analysis Policy Issues Affecting Relevant Costing Decisions

9.3 Make or Buy Decisions Key Decision Rule and Guidelines Data Analysis Format An Example Strategic and Qualitative Factors

9.4 Special Sales Pricing Decisions Key Decision Rule and Guidelines Data Analysis Format An Example Strategic and Qualitative Factors

9.5 Use of Scarce Resources Decisions Key Decision Rule and Guidelines Data Analysis Format and an Example Strategic and Qualitative Factors

9.6 Sell or Process Further Decisions Key Decision Rule and Guidelines Data Analysis Format and Examples Strategic and Qualitative Factors

9.7 Add or Delete a Segment Decisions Key Decision Rules and Guidelines Data Analysis Format and an Example Strategic and Qualitative Factors

9.8 Equipment Replacement Decisions

9.9 Ethical Considerations

9.10 Costs and Pricing Decisions Full Cost Pricing Variable Cost Pricing Market-Based Pricing

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Decisions, Decisions, Decisions

Shirley Rich operates a series of take-out rib and sandwich shops, called Rich Ribs, in the city’s suburbs. Before leaving on vacation, Shirley asked her controller, Alan Belinky, to prepare cost analyses of several decisions she has been considering. She met with Alan to outline each decision.

Decision 1: A major employer in the area called Shirley and asked whether a deal could be arranged to serve Rich Ribs at a company picnic and later perhaps regularly in its cafeteria. Shirley’s company name may or may not be identified. The company’s offering price is roughly 60% of Rich’s a la carte menu price.

Decision 2: The shop on Sherman Avenue has been showing a monthly net operating loss for the last six months. The shop’s lease expires at year-end. Also, a new mini shopping mall is opening in a growing part of the city not presently served by Shirley’s shops. Shirley could close the Sherman shop and shift the manager to the new mall shop.

Decision 3: A local bakery with an excellent reputation in the area has offered to sell breadsticks to Shirley. Rich Ribs includes a serving of breadsticks with every take-out dinner order. Right now, Shirley bakes her own breadsticks in her kitchen every day and is proud of their quality, but the bakery price offer seems very low.

Decision 4: Shirley is thinking of adding pizza to her menu, but the kitchen’s oven capacity would be stretched severely if she keeps all other menu items. She wants to use her kitchen capacity in the most profitable way.

Shirley has a “common sense feel” about the answers to these decisions, but she needs economic proof. She looks to Alan to assemble, analyze, and present the relevant information for each issue. She must then weigh all the quantitative and qualitative factors and decide.

Yes, “decisions, decisions, decisions” is a common lament. However, decision making creates action. It is the exciting part of management. Managers’ experiences and skills are applied to specific problems. The decision may be significant, such as when and where to build a new $1 billion manufacturing facility. Or it may be mundane, such as sending a customer contract by first-class mail or overnight by FedEx. In either case, consciously or subconsciously, manag- ers follow a process: define the problem, consider choices, collect and analyze relevant data, make a decision, and act.

This chapter examines groups of decisions that require particular decision rules, relevant data, and formats. These decision types occur commonly in all business activities and even in our personal lives. These groups are:

1. Make or buy—where to get resource inputs. 2. Special sales pricing—is a special sales price justifiable? 3. Use scarce resources—how to get the most out of limited resources. 4. Sell or process further—when to sell. 5. Add or delete a segment—which to do.

Other decision groups, such as replacing equipment and expanding capacity, are explored in Chapter 10.

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Section 9.2 Differential Analysis

Decisions discussed here are necessarily simplified. The real world offers much more com- plexity. Decisions are about the future, where much uncertainty exists. The discussions in this chapter, though, imply a certainty about the future. In textbook problems, we consider only a few variables that impact decision results. In reality, literally hundreds of variables are mov- ing in different directions at the same time. Therefore, an organized approach helps managers establish a process, select relevant variables, and add format to their analysis.

9.1 The Decision-Making Process Every managerial decision is made with the mission and the strategic goals of the organiza- tion in mind. Organizing to make decisions implies structure and methodology, but not arbi- trariness or rigidity. The following eight-step process is useful for decision making:

1. Define the decision issue. 2. Specify the decision objective and decision rule. 3. Identify the choices or alternatives. 4. Collect relevant data on the choices. 5. Format and analyze information about each choice. 6. Make the decision. 7. Implement the decision. 8. Evaluate the results of the decision.

This chapter focuses on those steps taken by managerial accountants. For Step 2, we outline a decision rule and guidelines. For Step 4, we define relevant data. For Step 5, we present formats for analyses. In addition to quantitative analysis, major qualitative issues that influ- ence decisions are raised. And for Step 6, we apply differential analysis to select the preferred choice, given the facts.

An important element underlying these processes is the empowerment of managers through- out the firm to make decisions. Decisions are based on a clear understanding of organiza- tional goals, training in decision analysis, sharing decision-making information, exercising the authority to act, and having an evaluation process.

9.2 Differential Analysis Differential analysis uses relevant revenues and costs to make decisions. It is the result of defining a decision rule and quantifying and formatting relevant information.

The Basic Decision Rule The basic differential analysis decision rule is:

Select the choice that yields the greatest incremental profit.

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Section 9.2 Differential Analysis

Incremental profit is the difference between the relevant revenues and the relevant costs of each choice. Relevant revenues and costs are defined as the current and future revenues and costs that differ among the choices considered. In most cases, the term “incremental” is used as a substitute for “relevant.” In choosing among choices, all past and committed costs (often referred to as sunk costs) and all costs that remain the same across all choices are irrelevant and are ignored. For instance, suppose product X has been produced at a cost of $100 and can be sold for $175. Alternatively, an additional $10 can be spent to convert product X into product Y, which would sell for $200. The incremental revenue would be $25 ($200 – $175), the incremental cost would be the additional cost of $10, and the incremental profit would be $15 ($25 – $10). The $100 cost to produce product X is a sunk cost because it has already been incurred.

A decision is frequently a choice of:

Do it, or don’t do it. or Do A, or do B, or do C, or etc.

In the first case, “don’t do it” is the status quo (i.e., the present condition); “do it” has incre- mental revenues and costs attached. In the second case, incremental revenues and costs for each choice are measured. In either case, the decision is based on which choice generates the highest incremental profit—incremental revenues minus incremental costs.

Relevant revenues are generally cash inflows, and relevant costs are generally cash outflows. Out-of-pocket costs refer to costs that are cash outflows. If cash flow and accrual numbers differ, the managerial emphasis is often on cash.

In many cases, capacity impacts decisions. Capacity costs are frequently fixed and are irrele- vant to most short-term decisions. A relevant factor is the opportunity cost of using capacity. If excess capacity exists and no alternative uses are apparent, the opportunity cost is zero— the unused capacity has no next-best use. If capacity is fully used, earnings from its alterna- tive uses and costs of acquiring additional capacity are considered.

Incremental Analysis Versus Total Analysis Differential analysis contrasts choices by comparing incremental contribution margins. Two commonly used approaches are applicable to all decision types: the incremental analysis approach and the total analysis approach. The incremental analysis approach includes only incremental revenues and incremental costs of each choice. The total analysis approach shows the results for the total entity, including the alternative and then excluding the alterna- tive. To evaluate adding a new product, the format is:

Incremental Analysis

Incremental revenue from the new product

− Incremental costs from the new product

Incremental pro�it from the new product

Total Analysis

Total �irm revenue with the new product

− Total �irm costs with the new product

Pro�it with the new product

Total �irm revenue without the new product

− Total �irm revenue without the new product

Pro�it with the new product

− Pro�it with the new product

Incremental pro�it from the new product

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Section 9.2 Differential Analysis

Clearly, the two approaches yield the same incremental profit. The incremental analysis approach has the advantage of showing only relevant amounts. All sunk and non-incremental amounts are ignored. The total analysis approach reports the firm’s gross results, with and without the decision’s impacts.

An Example of Differential Analysis MaineLine (ML) Caps is located in Augusta, Maine, with a factory in South Carolina. Steve Berman, CEO, recently purchased this small manufacturer of baseball-type hats. It produces several styles in a variety of materials, but all caps are essentially the same. The caps are mar- keted under the name ML Caps. Steve has just finished an initial budget for 2020, including this income statement:

Sales (100,000 units at $10 per unit) $1,000,000

Less production costs:

Variable production costs ($3 per unit) $300,000

Fixed factory costs 300,000 − 600,000

Gross profit $400,000

Less operating expenses:

Selling expenses (15% of sales) $150,000

Administrative expenses 150,000 − 300,000

Operating income $100,000

Steve’s factory operates at 80% of capacity. He is currently weighing several alternatives to increase capacity utilization and profits. His analysis shows the choices as:

1. Maintain the status quo. 2. Expand sales of ML Caps to 125,000 by lowering the selling price from $10 to $9 per

unit. 3. Use the remaining capacity to make an insulated cap for cold weather runners, called

CoolHat. He estimates a sales price of $8 per unit, selling expenses of 15%, variable production costs of $4 per unit, and no change in total fixed costs.

The three choices are compared in Figure 9.1 using a total analysis approach. Choice 2 increases net income to $131,250, a differential increase of $31,250. With Choice 3, the Cool- Hat, operating income increases by $70,000.

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Section 9.2 Differential Analysis

The incremental analysis approach is shown in Figure 9.2. No mention is made of the origi- nal sales of 100,000 units or fixed costs, which do not change. All choices are incremental to Choice 1, the status quo. Therefore, while Choice 1 is not shown in Figure 9.2, the other choices show the contribution margin differential to Choice 1’s $100,000 of operating income.

Units of sales

Sales price Variable costs: Production costs Selling costs Total variable costs Contribution margin per unit

Choice 1 Choice 2 ML Caps Cool Hats

Choice 3

Total

100,000

$10.00

$3.00 1.50

$4.50

$5.50

$1,000,000

$300,000

$450,000

$550,000

$300,000

$100,000 $450,000

150,000

125,000

$9.00

$3.00 1.35

$4.35

$4.65

$1,125,000

$375,000

$543,750

$581,250

$300,000

$131,250 $450,000

168,750

150,000

$1,200,000

$400,000

$580,000

$620,000

$300,000

$170,000 $450,000

180,000

150,000

100,000

$10.00

$3.00 1.50

$4.50

$5.50

$1,000,000

$300,000

$450,000

$550,000

150,000

25,000

$8.00

$4.00 1.20

$5.20

$2.80

$200,000

$100,000

$130,000

$70,000

30,000

Sales Variable costs: Production costs Selling costs Total variable costs Variable contribution margin Fixed costs: Fixed factory costs Administrative costs Total fixed costs Operating Income

Figure 9.1: Total analysis approach to differential analysis

Incremental sales of ML Caps ($9 � 25,000) $225,000

Choice 2 Choice 3

Incremental production costs of ML Caps ($3 � 25,000) (75,000)

Lost revenue from price reduction [($9 � $ 10) � 100,000] (100,000)

Incremental production costs of Coolhats ($4 � 25,000) (100,000)

Sales of Coolhats ($8 � 25,000) $200,000

(18,750) (30,000)Incremental sales commissions (15% � increased revenue)

$ 31,250 $ 70,000Incremental contribution margin

Figure 9.2: Incremental analysis approach to differential analysis

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Section 9.2 Differential Analysis

Based on quantitative facts, Berman will select Choice 3. But before the decision is made, short-term qualitative issues and long-term considerations should be evaluated. Is the Cool- Hat consistent with the firm’s product plans? Will it take resources from Steve’s primary product—ML Caps? Because Steve is an avid runner, are his personal biases confusing his thinking? Are additional equipment or worker skills needed? Although supposedly a short- term decision, these issues concern Steve.

Policy Issues Affecting Relevant Costing Decisions As with all real-world issues, the decision-making path is more complex than the basic rules imply. The differential analysis model is so simple and appealing that we can easily be lulled into a false sense of objectivity.

ABC and Relevant Costs. Companies with well-developed activity-based costing systems are in more knowledgeable positions to make relevant costing decisions. With carefully selected cost drivers and cost functions, changes in costs from a change in activity can be seen more clearly.

The Timeframe. Certain assumptions are made in differential analysis. A short-term horizon is assumed, variable costs are relevant, and most fixed costs are irrelevant. However, manag- ers must recognize that all important decisions have both short-term and long-term impacts. In many cases, investments must be made that last longer than the immediate timeframe. Decisions made today often are not easily reversed tomorrow. Also, decisions made on a one- time basis or made for an immediate gain may change the options available in the long run. By selecting Choice 3 in our example above, Steve has committed all unused capacity. If ML Caps sales grow, he must somehow expand capacity or lose sales.

Strategic Planning Issues. A firm’s strategic plan looks at product offerings, pricing strate- gies, competitive positions, and financial performance goals. “Long haul” policies are imple- mented in the short run by tactics and decision guidelines. Incremental decisions are often just minor additions at the margin. The major pricing, production, and marketing decisions must follow long-term strategies that have been carefully thought through.

Often decisions are masked as an incremental decision, when they are really policymaking, long-term decisions. For example:

• Will a one-time sale at a low price become repeat business? • Will regular customers seek price breaks to compete with off-brand look-a-likes? • Will purchasing cheaper lower-quality parts eventually hurt a firm’s image as a high-

quality producer? • Will outsourcing (i.e., obtaining a product or service from a vendor rather than inter-

nally) undermine harmony that the company and its labor union have worked hard to develop?

• Will stopping and starting production of a temporarily unprofitable product cause losses of market share for an entire product line and of skilled employees who make the product?

While relevant costing is a powerful analytical tool, no decision can be made in isolation.

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Section 9.3 Make or Buy Decisions

9.3 Make or Buy Decisions The decision questions for the make or buy decisions are:

Should we make an item or purchase it from a vendor? Should we perform a service or obtain the service from an outside source?

Nearly all products and services offered on the market today result from basic make or buy decisions. A sample of these decisions includes:

The “Make” Alternative The “Buy” Alternative

Make the component part in our factory in Indiana. Buy it from a nearby supplier, a nonunion vendor in another state, a Taiwanese producer, or another division of our own company.

Operate our fleet of delivery trucks. Hire various freight companies.

Run our printing shop. Contract with local printers.

Employ our own cleaning staff. Hire a cleaning service.

Manage our facilities. Hire a facilities management company.

Cook for ourselves. Eat in the cafeteria.

Managers consider make or buy decisions for various reasons, including to:

• Reduce costs • Use or to free up capacity • Improve quality or delivery performance • Encourage greater productivity from internal operations by forcing competition

with outsiders • Get new technology • Free scarce investment funds for other uses

Key Decision Rule and Guidelines The key decision rule is:

Buy the product or service if the relevant costs of buying are less than the rel- evant costs of making; otherwise, make it.

The decision rule is still to earn the highest profit. But since make or buy decisions generally deal only with costs, the decision rule minimizes cost. If we buy from a vendor, we outsource. We are in-house sourcing if we make the item ourselves.

Relevant make costs are the direct costs of producing an item plus any opportunity costs. Direct costs include direct materials, direct labor, and variable factory overhead costs.

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Section 9.3 Make or Buy Decisions

Included also are any incremental fixed costs caused by the make decision, plus any traceable costs, such as unique tooling costs. These are called avoidable costs if the decision is to buy.

Relevant buy costs are the item’s purchase price, shipping and handling costs, and any costs incurred to get the purchased item into usable form. Inspection and testing costs are exam- ples. Another relevant cost issue is alternative uses of space vacated, if the part is now pur- chased. The space could be rented at some market rate, used by another department, or used to make other parts.

Data Analysis Format The make or buy analysis format lists the relevant costs to make and the relevant costs to buy in a two-column format, shown as follows:

Make Costs Buy Costs

Materials and direct labor $ Purchase cost plus handling costs

Variable overhead costs $

Avoidable fixed overhead costs $

Other avoidable or incremental costs

Opportunity costs of additional resources needed

$ or Incremental revenue or earnings from use of released resources

($)

Total make cost $ Total buy cost $

Using an incremental analysis approach, any costs that do not change are ignored, since they are irrelevant. Direct product costs and purchase costs can be either an additional cost on one side or a negative cost on the other. For example, if by outsourcing, office space is no longer needed and can be leased for $5,000, the revenue reduces the buy costs. Or, it can be viewed as an additional make cost, since by performing the service ourselves we incur a $5,000 oppor- tunity cost. Either way works. The bottom line is the comparison of the incremental make cost and the incremental buy cost. Select the alternative with the lower cost.

An Example Lester Corporation has bids from several suppliers for a control device, a unit used in several models of its Hibeam Line of lighting fixtures. Lester has made these devices for the past sev- eral years and needs 30,000 units for 2020 production requirements. Arday Wiring provided

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Section 9.3 Make or Buy Decisions

the lowest-cost bid at $3 per unit delivered. Quality control inspections of purchased units would cost Lester $3,000. Lester’s costs for 25,000 units made in 2019 were:

Per Unit Total Costs

Materials $1.25 $31,250

Direct labor .60 15,000

Variable overhead .50 12,500

Fixed overhead applied 1.00 25,000

Total $3.35 $83,750

All costs are direct costs, except fixed factory overhead. The only direct and avoidable fixed factory overhead is $6,000, the annual cost of leasing specialized equipment required to make the control device. If the device is purchased, Lester could return the specialized equipment, void the lease, and use the space for storage. Renting storage space would cost $4,000 next year.

The relevant make and buy costs are:

Make Costs Buy Costs

Materials ($1.25 × 30,000) $37,500 Purchase cost ($3 × 30,000) $90,000

Direct labor ($0.60 × 30,000) 18,000 Quality control costs 3,000

Variable overhead ($0.50 × 30,000) 15,000 Rent savings (4,000)

Equipment lease cost 6,000

Total make costs $76,500 Total buy costs $89,000

Net make advantage $12,500

We can make several observations:

• The variable costs on both sides are relevant. • The $6,000 cost of leasing the equipment is relevant because the equipment lease

payment is avoided under the buy choice. The remaining fixed factory overhead is unavoidable and irrelevant to the decision.

• The $4,000 rent savings is relevant because it occurs only in the buy choice. • The relevant volume is 30,000 units (the 2020 expected volume). • Comparing the 2019 make full cost of $3.35 per unit to the buy cost of $3 hides

important cost behavior patterns.

The recommendation is to continue to make the unit and save $12,500.

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Section 9.3 Make or Buy Decisions

Strategic and Qualitative Factors The make or buy decision focuses on choosing the lowest cost. But many subtleties surround the decision. In the prior example, only quantitative monetary facts were considered. Quality, delivery, labor force, and investment implications are frequently key issues.

Often, product and service quality is the highest-ranking factor and could support either the make or buy side. By making the product, we can control quality in all aspects of production. On the other hand, a particular task may require specialized knowledge. We may not have this expertise. An outside specialist may be faster and produce higher-quality output. Quality can be so important that cost differentials are ignored.

Delivery capability in just-in-time systems is critical. Again, perhaps in-house sourcing has an advantage since our production planners can schedule production on an “as needed” basis. Or the outside supplier may use delivery capability as a key competitive issue and be better able to meet complex requirements. Vendor certification programs have allowed buying firms to set benchmarks for performance and to narrow possible suppliers to a group known for high achievement.

Labor stability is another major make or buy consideration. For the United Auto Workers Union (UAW) and American auto producers, outsourcing is a major area of contention in labor negotiations. The auto companies have historically been vertically integrated. These companies, to be competitive with foreign producers and to increase internal productivity, are searching for the most efficient suppliers. Many suppliers are very efficient, more so than the automakers’ own captive divisions. The UAW, concerned about member job losses, is demanding labor contract provisions that guarantee in-house production. Also, a sense of community responsibility affects how managers decide where work—and, therefore, jobs— are located.

Global business transactions expand the decision beyond whether to make or buy. Now, if we make, where do we make? If we buy, where do we buy? Brazil, Mexico, China, Korea, and East- ern or Western Europe are possible sources. Also, many multinational firms have facilities in several countries and can shift production depending on costs, quality, materials proximity, and product demand.

Contemporary Practice 9.1: Outsourcing of Hospital Services

Financial data analysis from a sample of 315 California hospitals revealed “that the outsourcing of clinical and non-clinical services improves the current and future financial performance for hospitals. Similar results are found for for-profit and not-for-profit hospitals but weaker results are reported for governmental hospitals when current financial performance is used.”

Source: Chang, K.J. & Said, A.A. (2014). The impact of outsourcing on hospital performance. International Journal of Management Accounting Research, 7–26.

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Section 9.4 Special Sales Pricing Decisions

9.4 Special Sales Pricing Decisions The decision question for the special sales pricing decision is:

Will we benefit from special sales, generally made at prices lower than those charged to our regular customers?

This decision evaluates added sales opportunities using contribution margin analysis. Often, one company’s make or buy problem is another company’s special sales pricing problem. Examples of special sales pricing decisions include:

• Generating discount-priced sales to use excess production capacity • Accepting sales that cover only out-of-pocket costs to keep a workforce employed

during a recession • Making a one-time sale to move stale merchandise • Responding to a request for a special product feature from a regular customer • Pricing to enter a new competitive marketplace

Clearly, knowledge of cost behavior, volumes, and capacities is a major influence on pricing and marketing.

Key Decision Rule and Guidelines The key decision rule is:

Subject to the following specific guidelines, make the special sale if we earn a positive incremental profit from the special sale.

The guidelines or assumptions necessary to allow the basic rule to work are:

• Excess capacity exists, with no alternative use of the capacity. The opportunity cost of using the capacity is zero or at least very low.

• Special sales should not interfere with regular sales. • The special sale is a one-time order and will not become repeat business.

If all of these guidelines are not met, the analysis will have additional relevant revenues and costs to consider.

The minimum price must cover out-of-pocket costs plus any opportunity cost of making the sale (lost profits from regular sales or lost production). If the assumptions are fulfilled, there is no opportunity cost incurred. The economic rule is to produce and sell until the incremen- tal revenue equals incremental cost—until a zero incremental profit is reached.

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Section 9.4 Special Sales Pricing Decisions

Data Analysis Format The format of relevant data for special sales decisions appears as follows:

Incremental revenue $

Less incremental costs:

Additional variable costs ($)

Additional direct fixed costs ($)

Incremental profits $

Only relevant revenues and costs are shown. Variable costs are often determined by using the variable costs of regular business adjusted for any changes due to the special pricing situa- tion, such as different formulas for baby foods, heavy-duty shock absorbers for police cars, and overtime police wages for a special concert on campus. Any additional supervision, prep- aration time, shipping, and packaging are relevant.

An Example Assume that Backman Corporation’s capacity is 90,000 units of a cellular phone receiver, including 15,000 units made on overtime. Backman Corporation is currently producing and selling 80,000 units per year at $8 per unit. Variable production costs are $3 per unit, and annual fixed factory overhead costs are $200,000. Variable shipping costs are $0.50 per unit; total administrative expenses are all fixed and amount to $120,000. The profit calculation is as follows:

Sales (80,000 units × $8) $640,000

Less factory and shipping costs:

Variable (80,000 units × $3.50) $280,000

Fixed overhead 200,000 −480,000

Gross profit $160,000

Less administrative expenses −120,000

Operating income $ 40,000

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Section 9.4 Special Sales Pricing Decisions

Incremental profits of $17,000 are added to the profit from regular sales to create a forecast of $57,000 for operating income. The special sale adds to Backman Corporation’s total profit even though the $6 price is $1.50 below the average cost of $7.50 (total product and adminis- trative expenses of $600,000 divided by 80,000 units). The decision rule and the criteria are met. Make the special sale.

Nonsegmented Markets. Accepting special prices is a sound policy only if the special mar- ket can be kept separate from the regular market. For example, in the preceding illustration, assume that the international market begins to affect the domestic market to the extent that the domestic price drops from $8 per unit to $7.60 per unit (a 5% drop). In this case, the firm’s profit calculation for the next period would appear as follows:

An Argentine communications company approaches Backman Corporation with an offer to buy 10,000 receivers at $6 each. Sales in Argentina should not affect Backman Corporation’s regular sales. The special units would require minor modifications and force more overtime, adding $0.80 per unit to variable costs. Additional supervision would cost $3,000. The entire lot would be packed and shipped to Argentina for $2,000. The analysis shows:

Incremental sales (10,000 units × $6) $60,000

Less incremental costs:

Incremental variable factory costs (10,000 × $3) −30,000

Additional variable factory costs (10,000 × $0.80) −8,000

Additional fixed supervision costs −3,000

Additional shipping costs −2,000

Incremental profit $17,000

Incremental profit from the Argentine sale $ 17,000

Less lost revenue from price reduction (80,000 units × $0.40) –32,000

Incremental profit (loss) $(15,000)

If the special market price influences the domestic market, profits decrease from $40,000 to $25,000 – an incremental loss of $15,000. Don’t make the special sale.

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Section 9.5 Use of Scarce Resources Decisions

No Excess Capacity. Assume that Backman Corporation’s capacity was only 85,000 units instead of 90,000 units and that the Argentine sale is all or nothing. By accepting the order, 5,000 units of regular business must be given up. The calculations are as follows:

Incremental profit from the Argentine sale $ 17,000

Less contribution margin on lost regular sales [5,000 × (8 – $3.50)] –22,500

Incremental profit $(5,500)

Losing 5,000 units of regular sales to accommodate the 10,000 unit Argentine sale will result in the company giving up profits. Don’t make the special sale.

Not a One-Time Sale. A special sale may be a sample order, with an unknown probability of larger future contracts. If repeat sales are expected, Backman Corporation must be very care- ful not to commit itself to a low-margin business.

Strategic and Qualitative Factors Product pricing is a key market positioning tool. Low-priced special sales can preempt strate- gic plans. Management should consider how a special sale fits into long-term marketing goals. Another consideration should be whether using capacity for this sale is consistent with the strategic use of production capabilities. The decision guidelines previously presented (excess capacity, segmented markets, and one-time sale) are tactical rules to help prevent subtle eco- nomic errors. If we want a premium product and price image, discount deals may tarnish it. Our dealers probably depend on our pricing and product image stability.

Accepting another one-time sale is easy to do. More of our capacity becomes allocated to low-profit business on a routine basis. If the market segmentation guideline does not apply, regular business begins to shrink and special sales expand. Fewer and fewer customers are paying prices that cover all costs, while more sales at special prices pay only a portion of the firm’s operating costs.

9.5 Use of Scarce Resources Decisions The decision question for the scarce resource decision is:

When a productive resource is limited, how do we allocate the use of the scarce resource?

The scarce or limited resource decision is an extension of the special sales pricing decision except that no excess capacity exists, but there is some constraint. Several examples of scarce resource decisions are shown in Figure 9.3.

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Section 9.5 Use of Scarce Resources Decisions

All of these examples entail the concept of contribution margin per unit of scarce resource, which is contribution margin per unit divided by the amount of scarce resource used by each unit. For example, assume that Product 28 has a $10 per unit contribution margin and needs 30 minutes on a polishing machine that is a major factory bottleneck. Then, $20 per hour ($10 ÷ 0.5 hours) is the contribution margin per hour of polishing machine time when producing Product 28.

Key Decision Rule and Guidelines The scarce resource decision rule is:

Optimize profits from a scarce resource by selecting the products or services with the highest contribution margin per unit of the scarce resource.

This rule yields the product mix that maximizes total profits. Products are ranked by their ability to generate the highest contribution margin per unit of scarce resource used. The scarce resource constraint is often a temporary situation. Over time, we can train more skilled workers, buy more equipment, or rent more space to eliminate the constraint.

Guidelines for selecting the most profitable set of products or services are:

• We must know the amount of scarce resource needed (input) to produce a unit of output.

• The product with the highest contribution margin per unit of scarce resource is selected, then the second highest, and so on until the scarce resource is used.

• Normally, the analysis uses contribution margin. • Allocated, common, or indirect fixed costs are irrelevant to the decision.

When incremental direct fixed costs exist, we should also incorporate these costs into the analysis.

Figure 9.3: Scarce resource examples

• Specialized machine time

• Shelf space in grocery store

• Salesperson time during sales calls

• A seat in a popular restaurant

• A fixed advertising budget

• Your study time

What are the most profitable products per machine hour to produce? What mix of products earns the most profit per shelf foot? Which products should the attempt to sell during the limited time allowed them? Which menu items generate the most profit per seat per dinner hour? Which media expenses generate more sales and profits? How should you allocate available study hours to earn the highest average grade?

Scarce Resource Issue

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Data Analysis Format and an Example The data analysis format uses the contribution margin per unit of output and the scarce resource needed to produce that unit. The result is a profit ranking of all products based on a contribution margin per unit of scarce resource.

As an example, the Museum Repro Company (MRC) markets reproductions of well-known sculptures. Finish work is done by four highly skilled artists. MRC cannot find additional art- ists to meet the sales demand. Data on four MRC’s pieces are:

Roman Greek Aztec Egyptian

Sales demand (units) 1,000 units 200 units 500 units 500 units

Hours of work per unit 2 5 6 10

Indirect fixed costs per unit $50 $110 $120 $200

Sales price per unit $250 $350 $600 $1,000

Variable costs per unit 150 150 240 550

Contribution margin per unit $100 $200 $360 $450

Divided by hours of work per unit ÷ 2 ÷ 5 ÷ 6 ÷ 10

Contribution margin per hour of work $50 $40 $60 $45

Priority ranking 2nd 4th 1st 3rd

Assume that the four artists each work about 2,000 hours per year. MRC will use the 8,000 hours available as follows:

Priority Piece

Hours per Unit Units

Hours Required

Remaining Available

Hours

Contribution Margin per

Hour Contribution

Margin

8,000

1st Aztec 6 × 500 = 3,000 5,000 $ 60 $180,000

2nd Roman 2 × 1,000 = 2,000 3,000 $ 50 100,000

3rd Egyptian 10 × 300 = 3,000 0 $ 45 135,000

$415,000

Sales Demand Not Met:

Egyptian 200 units

Greek 200 units

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If MRC produces all of the needed Aztec and Roman units and only 300 Egyptian units, the detail artists’ 8,000 hours are entirely used. This product mix generates the highest contribu- tion margin given the artists’ available time. Note that indirect fixed costs are ignored in the analysis, since these costs will not change regardless of the production mix.

Strategic and Qualitative Factors The qualitative issues in the scarce resource analysis are questions of product offerings. Why is MRC’s capacity limited? Is the marketplace demand driven? Scarce resource analysis can highlight possible poor pricing. In the MRC example, Egyptian and Greek prices might be raised to improve the contribution margin per hour of artist time to match or exceed Aztec’s contribution margin. Also, the basic analysis ignores the complementary aspect of various items in a product line. To compete in a market may require a complete product offering or a full menu.

Also of concern is the use of the scarce resource itself. Can steps be taken to conserve capacity, to substitute less critical resources, or to buy additional capacity? MRC can get an estimate of the value of additional capacity. In the MRC example, another employee working 2,000 hours per year would produce the following additional contribution margin:

Hours per Unit Units

Hours Required

Contribution Margin per

Hour

Additional Contribution

Margin

Egyptian 10 × 200 = 2,000 × $45 = $ 90,000

The added contribution margin is $90,000, which is after the variable labor costs have been deducted. At that price, should MRC train another detail artist? Yes.

Contemporary Practice 9.2: Differential Analysis at Starbucks

“In 2002, Starbucks was trying to decide whether to spend $40 million system-wide to add 20 hours of labor per week to each store in order to speed up service. Looking at it purely from the cost perspective, that $40 million would shave seven cents a share off earnings.” However, in a study of customer satisfaction, Starbucks found that speed of service is very important and that highly satisfied customers spend 9% more money than customers who are just simply satisfied. Starbucks, therefore, decided to spend the $40 million, apparently concluding that the incremental revenues from highly satisfied customers would more than offset the incremental labor cost of $40 million

Source: Chittum, R. (2006, October 30). Price points. The Wall Street Journal, R-7.

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Section 9.6 Sell or Process Further Decisions

9.6 Sell or Process Further Decisions The decision question for the sell or process further decision is:

Should the product be sold as is, or should it be processed further and then sold?

A common sell or process further decision deals with a product that can be sold now or pro- cessed further and sold later as a different product. In other cases, processing further can spawn multiple products from a common input. These are called joint products, and the fur- ther processing becomes a decision at the split-off point. Until this point, the common input is a single product. An example of a split-off point in a refining process is where the decision to process crude oil into joint products of gasoline, heating oil, and motor oil is made. The deci- sion is to sell the crude oil or to refine and sell the joint products.

Key Decision Rule and Guidelines The key decision rule is:

Process further if the incremental revenue from processing further is greater than the incremental costs of processing further.

The basic guidelines are:

• All relevant additional processing costs are assumed to be incremental. • Costs incurred prior to the split-off point are common to both sell and process fur-

ther choices and are irrelevant to the process further decision. • The decision is independent of product costing. Product costing attaches all product

costs to units, including common and past costs. In process further decisions, only future revenues and costs are relevant.

• The decision assumes that products are either sold as is or processed further. If capacity allows, we could do both if both generate positive contribution margins.

The decision task is to always look at future costs and revenues and not past ones. We are in the present moment with something of value and looking into the future. We can sell it now. Or, we can do additional work, spend more money, and sell in the future. Past costs cannot be changed and are common to both choices.

While common or joint costs may be irrelevant in process further decisions, they are real costs, must be incurred, and should be attached to products as they flow through production processes. Chapter 5 discusses product cost procedures when products are produced from common processes.

Data Analysis Format and Examples Assume, for example, that Tipton Company’s unfinished hardwood desks for home offices sell for $180, with a manufacturing cost of $100. The company can stain the desks at an additional

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cost of $30 each, yielding a desk that sells for $225. Due to market demand, the company could only sell 500 stained desks. The data format shows:

Revenue from sale of stained desks (500 units × $225) $112,500

Less revenue from sale of unstained desks (500 units × $180) − 90,000

Incremental revenue $ 22,500

Less cost of staining (500 units × $30) − 15,000

Incremental contribution margin from processing further $7,500

The decision is obvious: stain and sell 500 desks because the incremental contribution mar- gin from processing further is positive.

Four important assumptions were made. First, the desk’s manufacturing cost is assumed to be irrelevant, because the cost of desks is the same for unstained or stained desks. Second, the company is assumed to have capacity to process desks further without losing sales of other products. Third, the process further costs are assumed to be avoidable costs. And fourth, if the desks are not processed further, they can be sold unstained.

Joint Products—Process All or None. Assume that Kilgore Corporation produces an indus- trial wax with a sales value of $4 per gallon. The manufactured cost is $3.25 per gallon. Kilgore can convert 60,000 gallons of industrial wax through a process that yields equal amounts of three high-quality auto waxes: Super Gloss, Shiner, and Deep Glow. Costs of converting indus- trial wax into the three products are $40,000. The market values of the three waxes are $6, $5, and $4.80 per gallon, respectively. Should Kilgore process further?

Quantity Price Revenue

Super Gloss 20,000 gallons × $6.00 = $120,000

Shiner 20,000 × 5.00 = 100,000

Deep Glow 20,000 × 4.80 = 96,000

Total revenue after processing $316,000

Less revenue lost from industrial wax ($4 × 60,000 gallons) −240,000

Incremental revenue from processing further $ 76,000

Less cost of processing further − 40,000

Incremental contribution margin $ 36,000

The decision is to process further. Notice that the industrial wax production cost is not included since it is a sunk cost.

Joint Products—Which Products Should Be Processed Further? If processing costs are variable and if each auto wax can be produced independently, what should be done? Assume

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that additional variable processing costs per gallon were $1, $1.25 and $0.40, respectively. The analysis on a per-gallon basis is:

Process Further

Price Industrial Wax Price

Additional Revenue

Additional Processing

Costs

Additional Contribution

Margin

Process Further Decision

Super Gloss

$6.00 − $4.00 = $2.00 − $1.00 = $1.00 Yes

Shiner 5.00 − 4.00 = 1.00 − 1.25 = (0.25) No

Deep Glow

4.80 − 4.00 = 0.80 − 0.40 = 0.40 Yes

Super Gloss and Deep Glow should be produced, but Shiner has a negative incremental con- tribution margin and should not be made. If Kilgore has a limited supply of industrial wax, it should make Super Gloss first and then Deep Glow.

Strategic and Qualitative Factors The short-term version of this decision assumes further processing stages can be shut down or started up with few impacts. Rarely is this the case. Fixed costs will continue, skilled labor may be difficult to keep available, and product market shares may be difficult to maintain. Thus, the best short-run quantitative choice may not achieve the planned results, or the long- run damages may overwhelm the short-run benefits.

In many processing operations, significant capacity costs exist. In real life, metals commod- ity prices often determine whether copper, zinc, and gold mines operate or temporarily sus- pend production. In beef cattle, pork, and poultry operations, prices of retail and wholesale products and processing costs are constantly monitored and forecast at each stage to make optimal sell versus process further decisions.

9.7 Add or Delete a Segment Decisions The decision question for adding or deleting a segment is:

Is the firm more profitable with or without the segment?

Examples of this decision include:

• Opening or closing a retail branch store • Adding or eliminating a product or an entire product line • Adding or eliminating a specialized service in a hospital • Combining purchasing departments in two plants into one unit

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In each of these examples, the answer depends on whether the firm is better off with or with- out the particular segment and hinges on the direct or segment contribution margin, which excludes allocated common costs. The analysis must resist the temptation to focus on net income of the segment. Also, the decision must consider the strategic value of the segment to the firm’s long-term success.

Key Decision Rules and Guidelines The key decision rules are:

Add the segment if the firm’s profits are higher after adding it. Drop the segment if the firm’s profits are higher after eliminating it.

These rules assume that the following guidelines are in place:

• Segment evaluations use direct contribution margin. • Segment eliminations focus on lost revenue and avoidable costs. • Segment additions focus on incremental revenues and costs.

Figure 9.4 shows two income statements for Hodes Clothiers and its three departments. One format shows operating income for each department, after allocating common indirect expenses equally to the three departments. The other shows direct contribution margin for the three departments. Amounts are in thousands.

Figure 9.4: Department performance for Hodes Clothiers—a merchandiser

Operating Income Approach

Dept A Dept B Dept C Totals Dept A Dept B Dept C Totals

Contribution Margin Approach

Sales Cost of sales Variable sales commissions* Total variable costs

Gross margin

Variable contribution margin

Direct expenses* Direct fixed expenses*

Direct contribution margin

Common indirect expenses Total operating expenses

Operating income

* Each department pays sales commissions of 10% on all sales. The variable sales commissions are part of each department’s direct expenses. Other direct expenses are fixed costs.

$400 200

$500 320

$100 60

$1,000 580

$200 $180 $40 $420

$80 $90 $20 $190

$70 $40 $(30) $80

$130 $140 $70 $340 50 50 50 150

$160 $130 $30 $320

$120 $90 $20 $230

40 40 10 90

$400 $200

40 $240

$500 $320

50 $370

$100 $60

10 $70

$1,000 $580

100 $680

150

$80

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Section 9.7 Add or Delete a Segment Decisions

Department C appears to be losing $30,000 under the operating income format. Using this format, the firm is attempting to evaluate its segment’s performance based on its operating income. But is Department C a loser? By reorganizing the data into a contribution margin for- mat, Department C shows a $20,000 contribution to common expenses and profits. This dif- ference results from the fact that no indirect costs are eliminated if Department C is deleted.

The operating income format often hides the expense behavior (variable and fixed) and trace- ability (direct and indirect). The contribution margin format generally presents a clearer story.

Data Analysis Format and an Example Hodes’ president sees the net loss for Department C and considers eliminating the depart- ment. Assume that deleting Department C has no impact on Departments A and B or on indi- rect expenses. An incremental analysis in thousands shows:

Department C revenue lost $(100)

Department C cost of sales avoided 60

Department C variable selling expenses avoided 10

Department C direct fixed expenses avoided 10

Lost direct contribution margin from Department C $(20)

Hodes would lose $20,000 in profits if Department C is dropped. Department C should be kept unless a higher earning alternative exists.

Strategic and Qualitative Factors This decision is tied to the scarce resource decision. To drop or add a segment is rarely an iso- lated decision. What will replace the dropped segment? What does the new segment replace? The opportunity cost is generally not zero. It must be quantified and then compared to the incremental change in contribution margin. In the previous example, a Department D and its incremental revenues and expenses could replace Department C, or Departments A and B could expand.

While complementary and substitution effects have been presented already, the subtle impacts on other products and departments are often difficult to measure. While direct con- tribution margin is used, certain direct costs may be neither entirely avoidable nor control- lable by the decision maker.

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Section 9.8 Equipment Replacement Decisions

Many companies are “downsizing,” which includes a variety of strategies. Simple cost reduc- tion should mean eliminating expenses that are contributing least to organizational goals. Seeking out waste and nonvalue-adding activities should be part of normal budgeting and cost control systems. Major organizational restructuring may include the elimination of prod- uct lines, entire factories, or a layer of management. Each of these is a version of the delete a segment decision. The same analytical process applies.

9.8 Equipment Replacement Decisions The basic question for an equipment replacement decision asks:

Is greater benefit received from acquiring new equipment or continuing to use the old equipment?

To answer this question, expenses incurred or revenues earned from using the old and the new equipment must be known. New equipment has two relevant measures: the incremental investment in new equipment and the increased contribution margin earned from the new equipment. Decision rules that include multiyear investment analyses are discussed in Chap- ter 10. For illustration purposes here, we assume new equipment is rented and not purchased.

For example, a printing department has reached an activity level that requires two Model 310 printers. These machines have a total annual rental cost of $500,000. Operating costs add another $100,000 per machine. A larger and faster Model 420 would have more capacity than two Model 310s. A Model 420 rents for $480,000 per year and has an operating cost of $150,000 per year. With this simplified data, the analysis is:

Rent of two Model 310s avoided $500,000

Operating costs of two Model 310s avoided 200,000

Rent of Model 420 incurred −480,000

Operating costs of Model 420 incurred −150,000

Savings from renting Model 420 $ 70,000

The quantitative analysis says rent Model 420. We also get more capacity, which actually is another quantifiable benefit.

While renting or leasing equipment is a common financing alternative, purchasing is the basic method of acquiring new assets. An investment is made today, and benefits are earned over the asset’s life. Evaluating all aspects of these decisions is a Chapter 10 task.

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Section 9.10 Costs and Pricing Decisions

9.9 Ethical Considerations The fundamental ethical issue in incremental decision making is validity of estimates of future revenues and costs. “Show me a proposal, and I can make it look good or bad” epitomizes the ethical problem facing many managerial accountants. However, the objective approach of “just give me the facts,” is often easier said than done. Facts are often estimates of the future. Biases, known or unrealized, can easily influence these estimates. What does the boss want the analysis to show? How can I make this project look good enough to get approved? These are pressures and influences that can destroy the basic “level playing field” decision-making process. Steps can be taken to reduce the likelihood that decision analyses are not subverted by biases, intentional or unintentional, and include:

• In-depth management reviews of assumptions and supporting data before a deci- sion is made to ensure management’s conspicuous attention to objectivity

• Development of managerial attitudes that support critical evaluations and avoid “kill the messenger bearing bad news” attitudes

• Creation of known criteria that emphasize the importance of validating relevant revenue and cost data estimates

• Post-decision audits to validate past estimates of future results

In many cases, managerial attitudes toward objective assessments begin at the top of the organization and “trickle down” to the lowest management levels.

9.10 Costs and Pricing Decisions One of the most difficult and critical decisions facing a manager is pricing. A firm’s pricing policy is a major part of its overall strategic positioning. A great pricing debate centers on whether prices are based on market conditions (supply and demand) or on production costs (recovery of costs). Certain environments tend to emphasize one or the other as shown in Figure 9.5.

Figure 9.5: Characteristics that encourage certain pricing behaviors

Market-Driven Prices– Common Conditions and Products:

Consumer products Service activities Highly competitive markets Few distribution layers Primarily direct costs Adaptable capacity New products Commodities

Cost-Based Prices– Common Conditions and Products:

Industrial and durable goods Capital intensive industries Regulated industries Many distribution layers Many indirect costs Government contracting (low bidder) Intermediate products Entrenched industries

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Section 9.10 Costs and Pricing Decisions

In spite of the characteristics shown in Figure 9.5, market prices are still strongly influenced by cost functions. For example, competitive copy center pricing near college campuses pushes the per-copy price close to actual cost, given volume and cost behavior. In addition, conditions do change. The natural gas industry has moved from a regulated industry to a highly price- competitive situation, while becoming even more capital intensive.

Global competitiveness has introduced market price as a starting point in product design and costing—a target market price minus a desired markup equals an allowable product cost.

In cost-based pricing, markup pricing methods are widely used. To arrive at the price, a cost is computed, and a markup, stated as a percentage of cost, is added. The purpose of the markup is to cover nonproduct costs and generate a profit. The term “cost” as used in this method is ambiguous until carefully defined.

Full Cost Pricing The most widely used markup pricing approach is full cost. Full cost pricing is a price com- monly based on total manufacturing costs, including fixed and variable product costs. Proper treatment of fixed cost presents a problem in full cost pricing. As volume increases, the fixed cost and full cost per unit decrease. If price follows cost, price goes down, which further spurs demand. Unfortunately, volume decreases create serious distress. Per-unit full costs increase, forcing up prices. Demand falls more, costs go up again, and so on. Full cost pricing has the following potential problems:

• A full cost per unit is accurate at only one level of volume. • Seldom does a full cost reflect incremental costs when volume changes. • To calculate a full cost, often arbitrary cost allocations are made. • Given a market framework in which price is set where incremental cost equals incre-

mental revenue, full cost-based pricing almost guarantees a “wrong” price.

However, full costing does offer some countering benefits:

• Using full costs causes all products to bear a “fair share” of all common costs that must be covered.

• Full cost includes long-term cost patterns in pricing strategies. • For certain ranges of activity (perhaps the relevant range), the per-unit full cost may

change very little as volume increases or decreases. • Being the long-term, low-cost provider is a very effective competitive strategy, par-

ticularly when cost includes both product and nonproduct costs.

Variable Cost Pricing Another pricing approach uses variable cost as the cost base. One advantage is that difficul- ties with allocating indirect and fixed costs are avoided. Also, if reasonably accurate estimates of demand given various prices exist, it may be possible to find a price that maximizes profits in a classic supply–demand economic sense.

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If variable cost is used, any added markup must be large enough to cover all fixed costs and to provide a profit. A danger always exists that variable cost may be thought of as full cost. Prices that cover only a portion of total costs will, in the long run, lead to serious financial problems.

Market-Based Pricing If prices are market driven, the debate over full or variable costs does not disappear. Market price minus cost yields a profit measure: (1) using full cost, a gross margin, or a net profit and (2) using variable cost, a version of contribution margin. These margins can be linked to return on investment in evaluating the performance of existing investments (more in Chapter 11) and in making new investments (more in Chapter 10). Prices are nearly always part of return-on-investment analyses. Thus, even when prices are not cost based, costs influence how managers view product profitability, attack market segments, and decide whether to enter or exit markets.

Summary & Resources

Chapter Summary Managers in any organization make decisions; some are short run, while others have long-run implications. This chapter creates a structured approach to make and implement decisions involving costs and revenues.

Differential analysis can be applied to a wide variety of decisions. The basic rule is to select the choice that gives the greatest incremental profit. Incremental profit is the difference between the relevant revenues and the relevant costs of each choice. Relevant revenues and costs are defined as the current and future values that differ among the choices considered.

The decision groups examined are make or buy, special sales pricing, scarce resources, sell or process further, and delete or add a segment. For each decision group, a key decision rule and guidelines are stated, and a format for analyzing relevant data is developed. While the basic decision assumes a short-term timeframe, the real-world applications often include long- term elements. Qualitative issues affect every decision, with strategic and policy concerns looming in the background.

Cost information is relevant to pricing analyses regardless of whether prices are market driven or cost based. Finally, full cost and variable cost pricing approaches give a different base for determining a markup for cost-based prices.

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contribution margin per unit of scarce resource The contribution margin per unit of output divided by the quantity of scarce or limiting resource inputs used by a unit.

differential analysis The revenue and cost differences among alternatives.

full cost pricing The pricing method that adds a markup to the full cost of a product (generally the total manufactured cost).

incremental analysis approach An approach to decision making that uses only the changed revenues and costs and elimi- nates all irrelevant data from the analysis.

incremental profit The difference between the relevant revenues and the relevant costs of each choice.

in-house sourcing The decision to make a product or service instead of buying it from a vendor.

markup The amount or percentage of cost or sales price that is added to the cost to cre- ate a selling price.

markup pricing method A method of pric- ing that takes a percentage of cost or sales price and adds it to the cost to determine a sales price.

opportunity cost The sacrificed returns or benefits forgone because an alternative was rejected.

outsource The decision to purchase a product or service from a vendor instead of making or providing it in-house.

out-of-pocket costs Any cost that is incre- mental and that is to be paid in cash.

relevant buy costs An item’s purchase price plus any costs to get the purchased item delivered and into usable form.

relevant make costs The direct costs of producing an item plus any opportunity costs.

relevant revenues and costs The revenues and costs that differ among the choices considered.

sunk costs Costs that have already been incurred.

total analysis approach An analysis that shows the total profit associated with each alternative rather than just the change in profit.

Key Terms

Problem for Review Calderone Company, of Milano, Italy, sells a consumer electronics product called Teris at a price of €35 (euros) per unit. Teris costs per unit are:

Prime costs €15

Overhead 15 (60% of which is fixed)

Total costs €30

A special order for 20,000 units was received from Chou Distributors, an import/export firm in Beijing, China, a new market area for the company. Additional shipping costs on this sale are €4 per unit.

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Questions:

1. If Calderone is operating at full capacity, what is the minimum price per unit that should be set for the Beijing order? Comment.

2. If Calderone has excess capacity, what is the minimum price? Comment.

Solution:

This is a special pricing problem. Calderone must determine whether:

• Excess capacity exists—”no” for Part 1 and “yes” for Part 2. • The order will not interfere with regular business—probably will not since the order

is from an importer in Beijing and the firm has no other business in China. • A positive contribution margin exists—will depend on the price selected.

For Part 1, Calderone must take sales from regular customers and, thus, must earn at least the same contribution margin from Beijing sales as from regular sales. Since the Beijing sale will cost €4 per unit more in shipping costs, the selling price should be at least €39 per unit (€35 + €4).

For Part 2, the price should cover only incremental costs of the additional units: €15 for prime costs (i.e., direct materials and direct labor costs), €6 for variable overhead (0.40 × €15), and €4 for shipping costs. The minimum price must, therefore, be greater than €25 to earn a posi- tive contribution margin.

Questions for Review and Discussion

1. Why is identifying decision alternatives one of the most important steps in the decision-making process?

2. Hedy Silber, owner of several small local businesses, said recently, “The general rule I follow in making short-run decisions is that variable costs are almost always rel- evant and fixed costs are almost always irrelevant.” Do you agree? Why, or why not?

3. Why is the timeframe—short-term or long-term—important in decision making? 4. The president of Lor Company said, “Accounting data are useful for predicting the

results of various choices, but, in my company, the final decision often depends on other factors.” Explain this statement.

5. Identify the guidelines that should be met for a special sales pricing decision. Explain why they are important. What happens when each is violated?

6. If capacity is scarce, how can opportunity costs be used to decide whether a product should be sold now (an intermediate product) or finished and sold as a completed product?

7. Explain how a special sales decision in one firm might be a make or buy decision in another firm.

8. If a restaurant owner considers adding a new main course and deleting another for profitability purposes, what decision rule should be applied? What type of decision is this?

9. Pat Brittain of Quick Supplies says she prefers the incremental analysis method because it eliminates all unnecessary data. Candace Soler of Office Managers, Inc. prefers the total analysis approach because she can see the “big picture.” Comment.

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The company needs to expand its operations to serve 9,000 requests per month. Fixed costs would increase $15,000 because of the expansion.

Question:

Prepare both a total analysis approach and an incremental analysis approach to evaluate the decision. Compare the results.

9-2. Make or Buy Analysis. Miller Company needs 20,000 units of a certain part to use in its production cycle. If Miller buys the part from Thomas Company instead of making it, Miller could rent the released facilities as storage to another manufactur- ing firm for $10,000. Sixty percent of the fixed overhead applied will continue to be incurred regardless of what decision is made. The following information is available:

10. The marketing vice president of Hartman Fabrics says that product prices should always be set by supply and demand in the marketplace to ensure high sales levels. The controller says that product prices should always be based on cost to ensure profitability. Who’s right? Explain.

Exercises

9-1. Incremental Versus Total Analysis Approaches. Levetan Company currently handles 8,000 information requests per month. Financial data for last month are:

Sales $240,000

Variable costs 144,000

Fixed costs 60,000

Questions:

1. Which alternative is more desirable for Miller and by what amount? 2. What assumptions about cost behavior might be troublesome by either buying or

making?

Cost to Miller to make the part:

Direct materials $ 4

Direct labor 16

Variable overhead 8

Fixed overhead applied 10

$38

Cost to buy the part from the Thomas Company:

$36

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Question:

What should the company do? Identify several assumptions you have made in order to decide.

9-4. Pricing for Special Sales. Wittenstein Company sells Product A for $30 per unit. The per-unit cost on the full capacity of 200,000 units is:

9-3. Sell or Process Further. Mr. Ed, Inc. produces three products (X, Y, and Z) in a single process that costs $30,000. They can each be sold as is or processed further into another product. Quantities, market values, and additional costs are:

Products Gallons Market Value Now Additional Costs Market Value After

X 10,000 $1.00 per gallon $10,000 $3.20 per gallon

Y 10,000 2.00 per gallon 20,000 3.75 per gallon

Z 10,000 3.00 per gallon 15,000 5.00 per gallon

The overhead is one-third variable and two-thirds fixed.

A Japanese firm has offered to buy 20,000 units. Additional shipping costs of this order would be $3 per unit. Wittenstein has sufficient existing capacity to manufac- ture the additional units. Wittenstein’s sales manager wants to earn an incremental profit of $50,000 from this sale.

Question:

What is the minimum price per unit Wittenstein should charge?

9-5. Department Profits. Mandel Sales runs several small department stores. The Toledo store showed the following “poor” results in thousands:

Direct materials $10

Direct labor 5

Overhead 12

Manufacturing costs $27

Dept 1 Dept 2 Dept 3 Dept 4 Totals

Sales $700 $1,000 $800 $1,500 $4,000

Cost of goods sold (350) (500) (450) (800) (2,100)

Gross margin $350 $500 $350 $700 $1,900

Direct expenses (100) (400) (400) (300) (1,200)

Common expenses (100) (300) (100) (300) (800)

Net income $150 $(200) $(150) $100 $(100)

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Paul Forman offers to buy 1,000 hats with special boxing insignias for $7 per hat. Attaching special insignias will cost Rothouse $200.

Question:

What should Rothouse do? Explain.

9-7. Sales Priorities With Scarce Resources. The Chief Wahoo Cooperative employs highly skilled Native American artists to produce sand paintings for sale in craft stores. The artists make large, medium, and small paintings. The sales and produc- tion data are:

Question:

Comment on the impact of each of the following actions.

a. Delete Department 2. b. Delete Department 3. c. Delete Departments 2 and 3. d. Replace Departments 2 and 3 with a new Department 5 that would earn a posi-

tive direct contribution margin of $25. e. Reallocate the common expenses.

9-6. Special Hat Sales. Rothouse Corp. can make 10,000 caps per year. Rothouse can sell 9,000 caps per year to NASCAR racing fans for $10 per hat. The cost per hat based on making 10,000 caps is:

Prime costs $5.00

Overhead costs 3.00 (Overhead is two-thirds fixed at that volume.)

Large Medium Small

Sales price $80 $50 $25

Materials and artists’ time costs 38 25 16

Hours per piece 1 0.5 0.2

Question:

If artists’ time is scarce, what size priorities should be set by the cooperative?

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9-8. Eliminating a Department. Mason Mill Department Store has five departments – A, B, C, D, and E. Department E’s future is being evaluated using the data below:

All Others Department E Total

Sales $ 4,500,000 $ 500,000 $5,000,000

Cost of sales 2,200,000 300,000 2,500,000

Gross margin $ 2,300,000 $ 200,000 $2,500,000

Rent and services $ 800,000 $ 200,000 $1,000,000

Direct salaries 450,000 50,000 500,000

Advertising expenses 450,000 50,000 500,000

Total expenses $1,700,000 $300,000 $2,000,000

Net profit (loss) $600,000 $(100,000) $500,000

Rent and services are corporate committed fixed expenses and are allocated evenly to the five departments. Sixty percent of the advertising expenses varies with sales; the other 40% will not change regardless of the decision and is allocated using sales dollars.

Question:

Comment on the following statements:

a. Department E is earning $150,000 in variable contribution margin for ABCDE. b. Department E is earning $100,000 in direct contribution margin for ABCDE. c. The company’s overall profitability without Department E would be $600,000.

9-9. Sell at Split-Off Versus Process Further. Rifki Refining produces naphtha, kero- sene, and other distillates from a joint process costing $120,000 for a certain volume of crude oil. From this process, 1,000 barrels of naphtha can be produced and are allocated $35,000 of joint costs. This can be sold at the split-off point for $60 per barrel or further processed into other products and sold for $85 per barrel. The pro- cessing cost for further refining 1,000 barrels of naphtha is $20,000.

The other distillates can be sold now for $80,000 or processed further for $40,000 and sold for $110,000. Kerosene can be sold for $60,000 at the split-off point. Kero- sene is also allocated $35,000 of the joint costs. Other distillates are allocated the remaining joint costs.

Questions:

1. Which products should be sold at the split-off point or processed further? 2. What is the most the company can pay for crude oil and not lose money on the refin-

ing process?

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9-10. Make or Buy Indifference Point. Charlie Rodgers contacted a Malaysian manufac- turer that will charge $40 per unit plus $200,000 for special equipment and dies for a lens assembly for an overhead projector. But he thinks he can make it himself for the following costs:

Prime costs $21

Other variable costs 3

Total variable costs $24

Charlie knows that incremental salaries, equipment rentals, and other fixed costs to make the assembly will run $360,000 per year. Common costs of manufacturing are applied to products at 60% of prime costs. Charlie plans to sell these projectors for $150 per unit.

Question:

Find the sales volume in units where Rodgers will be indifferent between making the lens assembly or buying it.

9-11. Process or Sell Decision. Weinmann Meat Company produces a meat product that can be sold after the slaughtering process, or it can be smoked and then sold. For next month the company has scheduled production of 40,000 pounds which, if sold unsmoked, would bring a selling price of $2.30 per pound. Costs associated with producing the unsmoked product are $1.20 per pound plus fixed facilities costs of $30,000 for the month. If 40,000 pounds are produced, the entire slaughtering capacity will be used.

If the 40,000 pounds are smoked, smoking capacity, which would otherwise be idle, will be used entirely also. The additional variable costs, mainly for heat and smoking ingredients, are estimated to be $0.40 per pound, and the selling price of the smoked product is $3.30 per pound. The monthly committed fixed costs on the portion of the facility used for smoking the meat amount to $8,000, and avoidable fixed costs are $5,000.

Question:

Prepare an analysis to help the manager decide whether the 40,000 pounds should be smoked or not be smoked.

9-12. Equipment Replacement. Last week Deutsch Enterprises purchased a new irriga- tion system called Spray costing $60,000. Its annual cash operating costs are esti- mated to be $35,000. It has a four-year useful life and no residual value. Today, a salesman has offered Deutsch a new system called Sprinkle that will cost $60,000 and will also have a four-year useful life with no residual value. The Spray equip- ment can be used as a trade-in for a $10,000 allowance. The annual cash operating costs of Sprinkle are estimated to be $20,000. Sales of $400,000 and other operating expenses of $180,000 per year will be the same under either alternative.

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Question:

Ignoring the time value of money to be discussed in Chapter 10, should Deutsch purchase the Sprinkle system? Explain.

9-13. Managerial Accounting Decisions. In the following vignettes, make a recommen- dation to your boss—the person described in each situation. And, suggest any other issues your boss should consider beyond the data provided.

a. Cleaver Corp. incurs the following annual costs in making one part for its products:

Total Costs for 20,000 Units

Prime costs $200,000

Variable factory overhead 200,000

Fixed factory overhead 300,000

Haskell Co. offers the same part for $25 per unit. If the parts are purchased from Haskell, plant space currently used by Cleaver for making the parts can be rented for $30,000 a year. Also, $100,000 of fixed factory overhead could be avoided if the part is purchased.

Question:

Make or buy?

b. Barney Fyfe is thinking of making a key part for his main product. He forecasts 40,000 units as being required. His make costs are shown below. Mayberry Corp. offers to make this part for $5 per unit.

Question:

Make or buy?

Purchased materials costs $60,000

Variable labor and overhead 40,000

Common fixed overhead 70,000

Avoidable direct fixed overhead 50,000

Unavoidable direct fixed overhead 30,000

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c. Arthur Fonzarelli is considering an outside cleaning service for his office building. He knows that Cunningham’s Maidens will clean for a contract price of $25 per hour with hours estimated to be 2,000 per year plus supplies of $5,000. Fonza- relli knows his current annual costs are $40,000 for a full-time cleaner, $12,000 for equipment rental and supplies used, and $10,000 for allocated corporate com- mon expenses based on square feet used by the cleaning department.

Question:

Make or buy?

9-14. Special Sales Pricing. Yuen Company, in Washington, D.C., is selling 80,000 pairs of jade earrings at $10 per pair. The variable cost is $6 per pair, and the annual fixed cost is $120,000. A Virginia discount house has offered to buy 10,000 additional pairs of the product which would be slightly modified for the Virginia market, but the modifications would not affect production costs. The discount house will pay $7 per pair.

Questions:

1. If the two markets can be distinguished, should the order be accepted (assuming capacity exists and has no other use)? Explain.

2. The manager feels that the two markets might not be distinguished and that the lower price would cause regular sales to fall by 5,000 pairs. Should Yuen accept the discount house offer? Explain.

3. If the discount house offer is raised to $9 per pair and competition resulting from the special sale causes the regular price to drop to $9.50 to maintain the same regu- lar sales volume, should Yuen accept the discount house offer? Explain.

9-15. Ethics of Product Pricing. Pepper Pike Resources (PPR) provides office equipment systems development and maintenance services. Its customers are a wide array of businesses. Maintenance services are provided through an annual contract with a fixed annual fee plus additional charges for “emergency calls” on an as-needed basis. PPR won a competitive bid with the City of Beachwood to maintain a large number of office workstations. The contract is for three years and calls for routine mainte- nance checks to be done quarterly as part of the annual fee, emergency calls billed at the “full” cost per hour of service representatives, and parts replaced for free except for major hardware components. The per-hour rate will be updated annually.

It is now a year and a half into the contract. The city controller is concerned with the growing cost of machine maintenance. After examining the situation, the controller has found:

1. Emergency calls have doubled in the past six months and are growing. 2. The “full” cost service rate has gone from $25 per hour last year to $32 per hour this

year. 3. Office workers are complaining about too much downtime.

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A meeting with the PPR representative found that all routine maintenance has been performed on schedule. Also, while some personnel costs have increased, the main reason for the jump in service rate was a change made in how certain fringe benefit costs were assigned to service personnel. The PPR rep also mentioned the aging nature of the equipment and the need to upgrade the entire system.

Question:

Comment on possible implications of each of the controller’s findings.

9-16. Product Combination Decision. Data concerning the four product lines of Tritt Corporation are as follows:

Product Line

A B C D

Selling price per unit $300 $250 $130 $70

Variable cost per unit 250 80 50 40

Hours required for each unit 5 10 4 2

Maximum market potential (units) No limit 6,000 8,000 4,000

Total fixed costs $100,000

Total hours available 96,000 hours

Questions:

1. Based on this data, choose the best product combination. 2. How would the answer change if the company were required to deliver 2,000 units

of each product line to a major distributor? The maximum market potential includes the distributor’s units.

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9-17. Markup Pricing. Assume that the following cost analysis has been performed for a specific customer order for Sandy Springs Products, Inc. The president, Phil Cuba, is experimenting with different pricing strategies. He thinks 100,000 units can be sold. Fixed costs have been allocated using various activity bases.

Per Unit Total

Variable manufacturing costs $4.25 $425,000

Direct fixed manufacturing costs 1.50 150,000

Indirect fixed manufacturing costs 3.75 375,000

Total manufacturing costs $9.50 $950,000

Variable selling expenses $1.80 $180,000

Indirect fixed selling expenses 1.45 145,000

Total selling expenses $3.25 $325,000

Questions:

What markup percentage is required to earn $120,000 if the price is set:

1. Assuming that the order is a one-time sale? 2. Assuming that the order will become part of the regular product line?

Problems 9-18. Changing Product Lines. Shelley Greenberg, president of Buckeye Department

Store, thinks that the Paint Department should be dropped. She wants to add a Pea- nut Butter Boutique in the same space. Data for next year in thousands are:

Paint All Other

Departments

Proposed Peanut Butter

Boutique

Sales $10,000 $90,000 $20,000

Cost of sales –(6,000) (54,000) (15,000)

Gross margin $4,000 $36,000 $5,000

Direct expenses (1,000) (14,000) (3,000)

Allocated expenses (4,000) (16,000) (1,000)

Operating income ($1,000) $ 6,000 $1,000

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Allocated expenses are common costs and are assigned by a mathematical formula.

Question:

Ignoring your attitude toward peanut butter, what should Greenberg do to maximize profits? Explain.

9-19. Sell or Process Further. Comet Company produces Green Awfully Sticky Stuff (GASS) at a cost of $30,000 per batch. A batch of GASS can be sold as is for $50,000 or processed through Department A where Products A and AA are made. Or the GASS batch can be processed through Department B where Products B and BB are made. Costs and revenues of processing further in Departments A and B are:

Incremental Costs Products Market Value

Department A $20,000 A $13,000

Department B $150,000 B $100,000

BB $95,000

Questions:

1. What should be done with a batch of GASS that Comet has on hand? Show calcula- tions to support your decision.

2. If the cost to produce a batch of GASS increased to $60,000, would you decide to continue to produce GASS?

9-20. Dropping a Product. Dick Price, an old prospector, runs a side business. He buys rattlesnakes from “snake hunters” in west Texas, paying an average of $10 per snake. Each snake comes complete. He produces canned snake meat, cures hides, and makes souvenir rattles. At the end of a recent season, Dick is evaluating his financial results:

Meat Hides Rattles Total

Sales $30,000 $8,000 $2,000 $40,000

Cost of snakes 18,000 4,800 1,200 24,000

Gross profit $12,000 $3,200 $800 $16,000

Processing expenses $6,000 $900 $600 $7,500

Common expenses 4,000 600 400 5,000

Operating expenses $10,000 $1,500 $1,000 $12,500

Operating income (loss) $2,000 $1,700 $ (200) $3,500

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Cost of snakes assigned to each product is based on a ratio of cost to revenue. Process- ing expenses are direct costs and avoidable. Common expenses are allocated on the basis of direct processing expenses and are Dick’s basic living expenses. Dick has a phi- losophy of “every tub on its own bottom” and is determined to cut his losses on rattles.

Questions:

1. Is he really “losing” money on rattles? Explain. 2. An old miner has offered to buy every rattle “as is,” without processing, for $0.50 per

rattle. Will this eliminate the “loss” problem and improve Dick’s profitability?

9-21. Make or Buy Decision. Neiditch Automotive Systems developed a new windshield cleaning system for the original-equipment auto market. The system requires an electronic motor that the firm does not currently produce but is available from sup- pliers. The best bid is from CGY Electronics at $23 per unit for any volume within the firm’s relevant range.

Neiditch’s production manager believes that the motor can be made in-house, although additional space and machinery would be required. The firm now leases, for $80,000 per year, space that could be used to make the new motors. However, another subsystem is now assembled in this space. Neiditch would have to lease additional space ,which rents for $175,000 per year in an adjacent building, for the assembly process. It is suitable for assembly work but not for motor production. Additional equipment needed would rent for $200,000 per year.

The controller has developed the following unit costs based on the expected demand of 100,000 units per year:

Prime costs $14.00

Rent for space .80

Machinery rental 2.00

Variable overhead 4.00

Allocated fixed overhead 6.00

Total costs $26.80

Question:

Should Neiditch make or buy the motors?

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9-22. Process Further Situations. Read the following cases.

Situation # 1: Ruth Baker purchased the champion cow at the county 4-H fair. The city government has demanded that she get rid of it and stop violating the city’s noise and odor ordinance because of the mooing. It cost $2,000 and weighed a ton! Her best options are shown below. What is her best alternative use for the cow? (Ignore vegetarian preferences!)

Option A: Sell the whole cow to the Jordan’s Meat Market for $2,500. Option B: Make hamburger. Processing costs of $200, revenue of $2,600. Option C: Fatten cow, make Kobe beef (a Japanese delicacy). Processing costs of

$3,900, revenue of $5,800. Option D: Feed cow (cost $1,000, including fines), take cow to football games—no

revenue, but a lot of fun.

Situation # 2: Tinman Juice Company presses Michigan cherries, producing raw cherry juice. The cost of producing a “batch” of cherry juice is $10,000, including the cost of the cherries. From one batch comes 10,000 gallons of juice. This can be sold on the cherry juice market for $15,000. The owner is considering various “all natural” products that would give alternative uses for the juice. Estimated revenues, costs, and volumes for each option are:

Option Additional Costs Product Outputs Quantities Market Value

A $4,000 Cough medicine 2,000 gallons $6 per gallon

Coffee substitute 1,000 gallons $4 per gallon

Cherry drink power 500 pounds $10 per round

B $15,000 Frozen concentrate 14,000 cans $2 per can

C $20,000 Muscle ointment 2,000 cases $15 per case

Hair growth grease 1 pound $500 per ounce

Questions:

1. What decisions would maximize profits for each firm? 2. As the financial advisor, how would you rank the four alternatives (juice only, option

A, option B, and option C)? Show your computations.

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9-23. Special Sales Pricing. Koizumi Company manufactures study lamps in Osaka, Japan. Next year’s budget estimates sales to be 500,000 lamps at ¥1,700 each. Variable costs are ¥900 per lamp, and fixed costs are budgeted at ¥300 million or ¥600 per lamp. Recently, a purchasing agent from Decatur Superstores in the U.S.A. offered to buy 100,000 lamps at a price of ¥1,350 each. By working overtime and adding extra shifts, Koizumi would have sufficient capacity. Additional overtime premiums would be ¥7.5 million. Additional supervision costs are ¥2 million. Total selling and admin- istrative expenses will not change if the order is accepted.

Koizumi’s finance manager argues, “With the extra volume, the full cost of regular sales would be reduced from ¥1,500 per unit to ¥1,400. At this level Koizumi would make an extra ¥100 per unit on all regular sales but still lose money on the special sales because of overtime costs and the lower price.” He thinks that the “economics of the deal” are too risky and that it violates the firm’s strategic pricing policies that have helped Koizumi create a reputation for quality.

Questions:

1. Is the finance manager’s quantitative analysis sound? Explain your decision. 2. What does the finance manager mean by “too risky?” 3. Why might this be a violation of the firm’s pricing policies?

9-24. Evaluating a Segment. The Klein family has developed an extensive bakery busi- ness in Atlanta and now has 90 shops. Annually, several new outlets are opened, and old ones are closed. Nathaniel, the controller, reviews the performance of each location and of all store managers. He is currently evaluating Store 54, operated by a relatively experienced manager. Business statistics for the company and Store 54 data are:

Average Store

Percentages Store 54

Sales 100% $400,000

Expenses:

Cost of baked goodies 35% $150,000

Store salaries and wages 20 110,000

Store occupancy costs 30 120,000

Home office expenses 10 50,000

Total expenses 95% $430,000

Net income 5% $(30,000)

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The store’s lease is a three-year commitment for $30,000 per year. If Store 54 is closed, a nearby Klein store would attract $50,000 of Store 54’s lost gross margin. Store 54’s manager has a five-year personal services contract for $30,000 per year and could be transferred to a new store. All other salaries and occupancy costs can be eliminated. Home office expenses are allocated evenly among the 90 stores.

Questions:

1. Should Store 54 be closed now? Why, or why not? 2. If Store 54 gets a 6-month reprieve, in which areas should the manager attempt to

improve?

9-25. Evaluating a Special Order. Huang Automotive in Taiwan is presently operating at 75% of practical capacity and producing annually about 200,000 units of a power steering system component. Huang recently received an offer from a Korean truck manufacturer to purchase 40,000 components at NT$225 (new Taiwanese dollars) per unit. Flexible budgets for production of 200,000 and 250,0000 units are:

200,000 Units 250,000 Units

Direct materials NT $18,000,000 NT $22,500,000

Direct labor 6,000,000 7,500,000

Factory overhead 24,000,000 27,000,000

Total costs NT $48,000,000 NT $ 57,000,000

Cost per unit NT $240 NT $228

Peter Wu, vice president of sales, thinks accepting the order will get the company’s “foot in the door” of an expanding international market, even if the company loses a little on this order.

T. J. Chan, Vice President of Engineering, feels that any new market should first show its profitability and that this offer is below last year’s cost per unit of NT$240. “This guarantees a loss on the order,” he says.

Lili Zhang, treasurer, has made a quick computation which indicates that accepting the order will actually increase dollars of gross margin.

Questions:

1. Estimate Huang’s variable cost per unit. 2. Show how Mr. Chan and Ms. Zhang are analyzing the situation. Using the given facts,

what does the incremental analysis of the Korean sale show? 3. What major nonquantitative factors might affect the decision to accept or reject the

special order?

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9-26. Scarce Resources and Minimum Requirements. Data for four products produced by Eden Enterprises are given below:

Product A Product B Product C Product D

Selling price per unit $13 $20 $5 $25

Variable cost per unit 6 5 2 16

Allocated costs per unit 4 8 1 3

Units produced per hour 4 units 2 units 8 units 3 units

Maximum sales limit 5,000 units 5,000 units 10,000 units No limit

Minimum requirements 1,000 units None 2,000 units 1,200 units

Total capacity is 6,000 hours. Minimum requirements meet existing sales commit- ments. Marketing has provided a “best estimate” of maximum sales expected for each product.

Question:

Based on the above data, choose the best product combination.

9-27. Alternative Uses of Capacity. Rhoton Equipment built a new facility five years ago but is using only 60% of its capacity to produce several machining equipment prod- uct lines. Management would like to use the excess capacity and has three possibili- ties. Only one of the three can be selected.

a. Rhoton could produce an additional 600 units per year of its most popular machine and focus marketing efforts on European metal parts producers. Management estimates that additional freight costs would amount to $550 per machine and fixed factory overhead would increase by $150,000. To cover the additional cost, the selling price per machine on European sales would be increased by $800 per machine. Incremental international selling costs would be about $200,000 per year. Rhoton has earned a contribution margin of $1,800 on each unit in the past.

b. Rhoton could produce and market a smaller model of an existing laser lathe. The capacity could be used to produce 200 units per year that would sell for $15,500 each. Management has estimated the following unit variable costs.

Prime costs $4,500

Variable overhead 2,000

Variable selling 500

Total costs $7,000

The new lathe would add fixed costs of $700,000 to fixed overhead expenses and $250,000 to fixed selling expenses.

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c. Benedek Testing Company has offered to lease the facilities at $30,000 per month plus 2% of the net revenues generated from the facilities by Benedek. Net rev- enues are estimated at $15,000,000 per year.

Questions:

1. Which of the three alternatives should management select? Show calculations to substantiate your decision. Comment on the relative riskiness.

2. What is the opportunity cost of this decision?

9-28. Contribution Margins. Zehnder Company, a Swiss firm, sells three products. Finan- cial data for a typical month are (in thousands of Swiss francs):

Products

J K L Total

Sales SFr 300 SFr 500 SFr 800 SFr 1,600

Variable costs 90 200 400 690

Contribution margin SFr 210 SFr 300 SFr 400 SFr 910

Fixed costs:

Separable and avoidable SFr 90 SFr 100 SFr 120 SFr 310

Joint, allocated on sales dollar basis 60 100 160 320

Total fixed costs SFr 150 SFr 200 SFr 280 SFr 630

Profit SFr 60 SFr 100 SFr 120 SFr 280

Questions:

1. The firm is considering the introduction of a new Product M to replace Product J. Product M sells for SFr12 per unit, has variable costs of SFr5 per unit, and has separable fixed costs of SFr104,000. How many units of Product M must be sold to maintain the existing income of SFr280,000?

2. Revenues of Product K could increase by 20% by reducing variable contribution margin to 45% and increasing separable and avoidable fixed costs by SFr40,000. Should Zehnder do this? Show your logic.

3. Rank each product by total sales, variable contribution margin percentage, direct contribution margin percentage, and net profit percentage. Comment on how Zehnder might use each ranking.

9-29. Adding a Department. Mayer’s Grocery Store is a small-town operation being threatened by a national discount store outlet being built nearby. Mayer Shamis, the owner, is studying the addition of a department to sell either garden supplies or beer and wine. He has talked to several other owners of similar stores and has reached the following conclusions:

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1. A garden supplies department would generate sales of $40,000 per year with a gross profit of 60%. No other variable costs would be added. Additional fixed costs would be $12,000. Grocery sales would increase by 5% because of increased traffic through the store.

2. A beer and wine department would generate sales of $60,000 per year with a gross profit of 40%. No other variable costs would be added, but fixed costs would increase by $18,000. Grocery sales would increase by 8%.

The income statement for a typical year for grocery sales alone is as follows:

Sales $600,000

Cost of goods sold (variable) 240,000

Gross profit $360,000

Other variable costs 110,000

Contribution margin $250,000

Fixed costs 170,000

Operating income $80,000

Questions:

1. Re-compute the effects on income of adding each department. 2. Which department should be added? What qualitative issues appear important?

9-30. Outsourcing Decision. Gomer Corporation operates its own cafeteria for employees. The cafeteria prices are only 75% of the full costs of preparation. Management feels this is an important employee benefit. Pyle, Inc. is offering to operate the cafeteria and promising to increase the quality of menu items, reduce prices, and reduce the needed subsidy. Pyle would use Gomer’s existing facilities and even transfer some of the current cafeteria employees to its staff. Pyle submitted a formal bid based on comparable services. As Gomer’s controller, you have summarized the next year’s budget for cafeteria operations and Pyle’s numbers from its proposal as follows:

Internally Managed

Pyle, Inc. Managed

Food costs $ 500,000 $450,000

Preparation costs 200,000 180,000

Administrative overhead 300,000

Management fee _______ 200,000

Total cafeteria costs $1,000,000 $830,000

Cafeteria revenue 800,000 750,000

Operating subsidy $ 200,000 $ 80,000

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Question:

Comment on the numbers. Outline key issues that are of concern to you. What data will you need to collect and analyze to resolve the issues?

9-31. Elimination of a Department. The Breezy General Store is currently divided into three departments. Over the past several months, sales and profit have declined, although the situation is now considered stable. Department 2 has begun to show a loss, and the owner, Janie Feldman, is thinking of discontinuing it. The space could be rented to a chain shoe store, which would pay a flat fee of $12,000 a month.

Below is last month’s income statement, considered to be typical. Sales salaries are fixed but traceable to each department and could be avoided if the department were eliminated. Total fixed administrative costs (allocated equally to all departments) are common costs.

Department 1 Department 2 Department 3 Total

Sales $185,000 $80,000 $135,000 $400,000

Costs:

Cost of goods sold $96,000 $44,000 $70,000 $210,000

Sales salaries 28,000 8,000 24,000 60,000

Administrative expenses 30,000 30,000 30,000 90,000

Total costs $154,000 $82,000 $124,000 $360,000

Operating income $31,000 $(2,000) $11,000 $40,000

Question:

Prepare an analysis to show Janie whether Department 2 should be discontinued and the space rented.

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Summary & Resources

Case: Middlehurst House

Middlehurst House is a daycare center/preschool that operates as a partnership of George Friedman and Bill Compton. The center is in a city that has a large base of two-income families who have a need for quality day care. The two men started the center this year. Compton contributed $40,000 to get the business started—to purchase equipment and to operate through the early months. Friedman, who previously managed another center, is the director of the center and draws $2,000 per month for his services. Partnership profits and losses, after Friedman’s salary, are split 75% for Compton and 25% for Friedman.

Middlehurst House operates from 6 a.m. to 6 p.m., Monday through Friday. It is in a single building that has a capacity limit of 120 children and meets city and state regulations. At present, the center has six classes, all at maximum sizes, structured as follows:

Class sizes are determined by state law, which sets a limit on the number of children per instructor. The center uses one instructor per classroom.

Tuition is charged monthly. Minor adjustments are made on an individual basis. In October, the most recent month with data available, revenues were $21,500 ($22,600 less $1,100 adjustments). Monthly revenues should be rather stable since classes are full most of the time. Expenses for October were:

Fixed expenses are the salary of the part-time cook and occupancy and other administrative expenses. The salary of the director is fixed—as a partnership, this is in reality a distribution of profits, but it is included in expenses for comparative purposes.

Food is $1.25 per student per day. Staff benefits are 10% of salaries plus $200 per person for benefit programs for instructors and the part-time cook. Variable supplies are $1 per student per month. Salaries for instructors average $1,600 per instructor per class.

Age Group Number of

Classes Children per

Class Total Children

Monthly Tuition per

Child

2 to 3 2 10 20 $320

3 to 4 1 15 15 280

4 to 5 1 15 15 280

5 to 6 2 15 30 260

Salaries for instructors $ 9,600

Salary of director 2,000

Salary of part-time cook 900

Food expenses 2,200

Staff benefits expenses 2,450

Supplies expenses 600

Occupancy and other administrative expenses 3,250

Total expenses $21,000

(continued)

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Summary & Resources

Case: Middlehurst House (continued)

Friedman wants to increase the quality of service by decreasing class sizes and also by expanding student enrollments. These alternatives are interrelated. Friedman thinks that class sizes are too large and that children are not getting the individual attention they require. Friedman surveyed parents of all 80 students to measure their support for a tuition increase tied to a reduction in class size. For children ages 2 to 5, most parents would support a 25% tuition increase, and nearly 50% would support a 50% increase. Of the 5-to-6 age group parents, nearly three fourths did not want any increase. The remainder said they would support a 25% increase but no more.

Proper class size is very subjective. However, Friedman feels that he could achieve a child/ instructor ratio of 6 to 1 for the 2-to-3 age group, an 8 to 1 ratio for the 3-to-4 and 4-to-5 age groups, and a 10 to 1 ratio for the 5-to-6 age group.

The center has easily maintained the 80-student level, with each class full. Friedman keeps in touch with waiting-list parents to make certain each is still interested. This list provides children when someone leaves the center. The current waiting list is as follows:

Friedman does not start a new class unless more students are on the waiting list than are required per class. Obviously, enough students are on the 5-to-6 age group waiting list to start a new class. Lately, however, he has wondered if the center could make a profit by starting classes with fewer than the requisite number, taking the chance that new students would appear and could be added immediately.

Information from his various inquiries implies that a potential market for quality infant care (0 to 24 months) exists. Friedman doesn’t think this expansion would be profitable. However, he has never done an analysis of the situation and has not thought about an appropriate tuition. He believes that the infant/instructor ratio in his center should be no higher than 5 infants to one instructor. The center would have no food costs for the infants.

Compton will only agree to Friedman’s suggested changes if the center will continue to operate at or above the current profit level.

Questions: 1. Look at each decision separately, as incremental to the current situation, and

evaluate the marginal profit: a. If class size is decreased (keeping the same 80 students), what increase in

tuition is necessary to keep the current monthly profit level? b. Without regard to (a), is it profitable to create the new class from the waiting

list? Explain. c. Use the new fee structure as found in (a). Is it profitable to move to smaller class

sizes, if new full classes are created and filled to their new maximums using the waiting list? Show calculations.

d. Is a class for infant care profitable if tuition is the same as the proposed class tuition for the 2-to-3 age group?

2. Write a brief memo to Friedman and Compton highlighting any concerns that underlie the analyses you have performed in Part 1.

Age Group Number of

Children Age Group Number of

Children

2 to 3 5 4 to 5 4

3 to 4 7 5 to 6 11

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