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CHAPTER 14

Decision Making: Relevant Costs and Benefits

ANSWERS TO REVIEW QUESTIONS

14-12 An opportunity cost is the potential benefit given up when the choice of one action precludes a different action. For example, one opportunity cost associated with getting a college education is the student’s forgone wages from a job that might have been held during the educational period.

14-15 In a differential-cost analysis, the decision maker determines the difference in each cost or revenue item that will occur under each of the alternatives under consideration. Then the decision maker focuses on the differences in the costs and revenues in making the decision.

14-21 Sensitivity analysis may be used to cope with uncertainty in decision making by analyzing how sensitive a decision problem is to the estimates of certain parameters. One important question that can be answered is: How much can a particular parameter estimate change before the optimal decision changes?

SOLUTIONS TO PROBLEMS

PROBLEM 14-46 (25 MINUTES)

1.

Blender Food

Processor Unit cost if purchased from an outside supplier .............................. $60 $114 Incremental unit cost if manufactured: Direct material ................................................................................... $18 $ 33 Direct labor ........................................................................................ 12 27 Variable overhead $48 – $30 per hour fixed ............................................................... 18 $96 – (2)($30 per hour fixed) ........................................................ 36 Total ................................................................................................ $48 $ 96 Unit cost savings if manufactured ..................................................... $12 $ 18 Machine hours required per unit ........................................................ 1 2 Cost savings per machine hour if manufactured $12 ÷ 1 hour ...................................................................................... $12 $18 ÷ 2 hours .................................................................................... $ 9 Therefore, each machine hour devoted to the production of blenders saves the

company more than a machine hour devoted to food processor production.

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Machine hours available ...................................................................................... 50,000 Machine hours needed to manufacture 20,000 blenders ................................. 20,000 Remaining machine hours .................................................................................. 30,000 Number of food processors to be produced (30,000 ÷ 2) ................................ 15,000 Conclusion: Manufacture 20,000 blenders

Manufacture 15,000 food processors Purchase 13,000 food processors

2. If the company’s management team is able to reduce the direct material cost per food processor to $18 ($15 less than previously assumed), then the cost savings from manufacturing a food processor are $33 per unit ($18 savings computed in requirement (1) plus $15 reduction in material cost):

Blender

Food Processor

New unit cost savings if manufactured .......................................... $12.00 $33.00 Machine hours required per unit ..................................................... 1 MH 2 MH Cost savings per machine hour if manufactured $12 ÷ 1 hour ................................................................................... $12.00 $33 ÷ 2 hours ................................................................................. $16.50 Therefore, devote all 50,000 hours to the production of 25,000 food processors. Conclusion: Manufacture: 25,000 food processors

Purchase: 3,000 food processors Purchase: 20,000 blenders

PROBLEM 14-47 (25 MINUTES)

1. Incremental unit cost if purchased: Purchase price ........................................................................................... $ 45,000 Material handling ....................................................................................... 9,000 Total ............................................................................................................ $ 54,000 Incremental unit cost if manufactured: Direct material ............................................................................................ $ 3,000 Material handling ....................................................................................... 600 Direct labor ................................................................................................. 24,000 Variable manufacturing overhead ($36,000 × 1/3) .................................. 12,000 Total ............................................................................................................ $ 39,600 Increase in unit cost if purchased ($54,000 – $39,600) ............................. $ 14,400

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2. Increase in monthly cost of acquiring part RM67 if purchased (10 × $14,400, as computed above) ........................................................... $144,000

Less: rental revenue from idle space .......................................................... 75,000 Increase in monthly cost .............................................................................. $ 69,000

3. Contribution forgone by not manufacturing alternative product ............. $156,000 Savings in the cost of acquiring RM67

(10 × $14,400 as computed in requirement 1) .......................................... 144,000 Net cost of using limited capacity to produce part RM67 ......................... $ 12,000

PROBLEM 14-48 (20 MINUTES)

The analysis prepared by the engineering, manufacturing, and accounting departments of Cincinnati Flow Technology (CFT) was not correct. However, their recommendation was correct, provided that potential labor-cost improvements are ignored. An incremental cost analysis similar to the following table should have been prepared to determine whether the pump should be purchased or manufactured. In the following analysis, fixed factory overhead costs and general and administrative overhead costs have not been included because they are not relevant; these costs would not increase, because no additional equipment, space, or supervision would be required if the pumps were manufactured. Therefore, if potential labor cost improvements are ignored, CFT should purchase the pumps because the purchase price of $102 is less than the $108 relevant cost to manufacture. Incremental cost analysis: Cost of

10,000 Unit Assembly Run Per Unit

Purchased components ................................................................... $ 180,000 $ 18Assembly labor ................................................................................. 450,000 45Variable manufacturing overhead ................................................... 450,000 45 Total relevant cost ......................................................................... $1,080,000 $108

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PROBLEM 14-49 (25 MINUTES) 1. Per-unit contribution margins:

Standard Enhanced Selling price………………………………….. $375.00 $495.00 Less: Variable costs:

Direct material………………………… $42.00 $67.50 Direct labor…………………………….. 22.50 30.00 Variable manufacturing overhead … 36.00 48.00 Sales commission $375 x 10%; $495 x 10%…………. Total unit variable cost……………….

37.50 138.00

49.50 195.00

Unit contribution margin…………………… $237.00 $300.00 2. The following costs are not relevant to the decision:

• Development costs—sunk • Fixed manufacturing overhead—will be incurred regardless of which product is

selected • Sales salaries—identical for both products • Market study—sunk

3. Martinez, Inc. expects to sell 10,000 Standard units (40,000 units x 25%) or 8,000

Enhanced units (40,000 units x 20%). On the basis of this sales forecast, the company would be advised to select the Standard model.

Standard Enhanced Total contribution margin:

10,000 units x $237; 8,000 units x $300…. $2,370,000 $2,400,000 Less: Marketing and advertising……………… 195,000 300,000 Income……………………………………………... $2,175,000 $2,100,000

4. The quantitative difference between the profitability of Standard and Enhanced is

relatively small, which may prompt the firm to look at other factors before a final decision is made. These factors include:

- Competitive products in the marketplace - Data validity - Growth potential of the Standard and Enhanced models - Production feasibility - Effects, if any, on existing product sales - Break-even points

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PROBLEM 14-51 (25 MINUTES)

1. Yes, the order should be accepted because it generates a profit of $68,100 for the firm. Note: The fixed administrative cost is irrelevant to the decision, because this cost will be incurred regardless of whether Mercury accepts or rejects the order.

Selling price………………………………………………… $31.50 Less: Direct material ($16.40 - $4.20)…………………... $12.20

Direct labor………………………………………….. 4.50 Variable manufacturing overhead

(.5 hours x $15.00*)……………………………..

7.50

24.20 Unit contribution margin…………………………………. $ 7.30 Total contribution margin (11,000 units x $7.30)…….. $80,300 Less: Additional setup costs…………………………… $7,400

Special device………………………………………. 4,800 12,200 Net contribution to profit…………………………………. $68,100 * Fixed manufacturing overhead: $1,500,000 ÷ 60,000

machine hours = $25.00 per hour Variable manufacturing overhead: $40.00 - $25.00 =

$15.00

2. No, Mercury lacks adequate machine capacity to manufacture the entire order.

Planned machine hours (5,000 hours x 3 months)…… 15,000 Current usage (15,000 hours x 70%)…………………….. 10,500 Available hours……………………………………………… 4,500 Required machine hours (11,000 units x .5 hours)…… 5,500

3. Options include the following:

• Sacrificing some current business in the hope that a long-term relationship with Venus can be established and proves to be profitable

• Acquiring more machine capacity • Outsourcing some units • Working overtime