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Chapter 07 - Incremental Analysis for Short-Term Decision Making

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Chapter 7Incremental Analysis for Short-Term DecisionMaking

ANSWERS TO QUESTIONS

1. The steps of the management decision making process include: The first step is to identify the decision problem, or determine why a decision

needs to be made in the first place. The second step is to determine the decision alternatives, or decide what the

potential solutions to the problem are. The third step is to evaluate the costs and benefits of the decision alternatives

that were identified in step 2. The fourth step is to make the decision based on the information gathered in step

3. The final step is to review the results of the decision with the goal of improving

future decision making.

2. Examples of costs and benefits of taking a part-time job include: Money earned in the part-time job. Costs to travel to/from job.

Opportunity costs of working would include less leisure time, giving up hobbies,losing the opportunity to work elsewhere or take additional classes, etc. Money saved by not enrolling in classes (if decision were work vs. school). Incidental costs of the job, such as training, supplies or clothing needed for the

job.

3. Tom has completed Step 5 of the decision-making process, which involvesreviewing the results of his decision.

4. For a cost to be relevant it must be a future cost that differs between decisionalternatives.

5. An avoidable cost is one that can be avoided by selecting a particular decisionalternative. It is a relevant cost because it will differ between decision alternatives.

6. An opportunity cost is what you give up when you choose to do something. Whenyou enroll in class, you forego other opportunities, such as working, leisure time,taking other classes, etc.






7. Opportunity costs should be factored into the decision-making process because theyare a relevant cost of future decisions. However, opportunity costs are difficult tomeasure because they are the costs of NOT doing something. For example, it maybe impossible to know exactly how much money was given up if you chose to enroll

in classes instead of taking a summer job. It is also difficult to put a monetary valueon opportunity costs such as leisure time or sleep.

8. Excess capacity exists when a company has not yet reached the limit on itsresources, while full capacity indicates that the limit on one or more resources hasbeen reached. If a company has excess capacity, increasing production will onlyincrease the costs that vary with production. If a company is at capacity, productioncannot be increased without incurring additional fixed costs. Opportunity costs alsoare relevant when firms are at capacity because choosing to do one thing forcesmanagers to give up something else.

9. When a company is operating at full capacity, it means the limit on one or moreresources has been reached, and making the choice to do one thing means givingup the opportunity to do something else. At full capacity, opportunity costs becomerelevant and should be incorporated into the analysis.

10. Special-order decisions involve deciding whether to accept or reject an order that isoutside the normal scope of business, often at a reduced price. Fixed overheadcosts can be ignored because these costs will remain the same regardless ofwhether the order is accepted or not, so long as the company has the capacity to fillthe order.

11. Negative consequences of accepting a special-order include the potential impact onsales made through “regular” channels, such as customers demanding the samereduced price that was given to the “special” order. If the company has limitedproduction capacity, filling the special-order may create opportunity costs includinglost revenue from regular sales, back-orders, etc.

12.Excess capacity is the difference between a company’s current level of productionand what it could produce given its current operating structure and cost. If acompany has enough excess capacity to fill a special-order without affecting“normal” sales, then there are no incremental fixed costs or opportunity costs toconsider. In this situation, only the variable costs of the order must be covered by

the sales price.

13. Examples of decisions that might be made by the manager of a local deli include:

a. A special-order would be whether to provide catering for a special event thatis outside the scope of normal sales. Relevant costs/benefits of this decision






18. When a product line is eliminated, total variable cost should decrease in directproportion to the reduction in production and sales of that product line.

19. Opportunity costs of a keep-or-drop decision include revenue given up if the product

is dropped, revenue from another product that could be produced if the item weredropped, and potential impact on other complementary products.

20. In the long run, managers can manage constrained resources by eliminating non-value-added activities such as rework or waiting, or by increasing the capacity of theconstrained resources such as hiring more workers, buying bigger or fastermachines, or leasing additional space. But all of these actions take time and mayresult in higher cost. In the short-run, managers should make decisions thatmaximize the amount of contribution margin generated by the most limited resource(i.e., the bottleneck). The reason we focus on contribution margin is that fixed costswill not change in the short-run. Therefore, we need to look at the amount of

contribution margin that is generated per unit of the constrained resource.

21. The bottleneck limits the overall output of the system and therefore limits how muchcontribution margin can be generated in a given amount of time. We focus oncontribution margin because fixed costs do not change in the short-run and aretherefore considered irrelevant.






Authors' Recommended Solution Time(Time in minutes)

Mini-exercises Exercises Problems

Cases and

Projects*No. Time No. Time No. Time No. Time

1 4 1 5 PA−1 7 1 202 3 2 6 PA−2 8 2 203 3 3 6 PA−3 6 3 254 4 4 5 PA−4 85 4 5 5 PA−5 96 3 6 6 PA−6 77 4 7 6 PA−7 88 4 8 5 PA−8 69 4 9 5 PA−9 8

10 3 10 5 PB−1 7

11 3 11 6 PB−2 812 6 PB−3 6

PB−4 8PB−5 9PB−6 7PB−7 8PB−8 6PB−9 8

* Due to the nature of cases, it is very difficult to estimate the amount of time studentswill need to complete them. As with any open-ended project, it is possible for studentsto devote a large amount of time to these assignments. While students often benefitfrom the extra effort, we find that some become frustrated by the perceived difficulty ofthe task. You can reduce student frustration and anxiety by making your expectationsclear, and by offering suggestions (about how to research topics or what companies toselect).






ANSWERS TO MINI-EXERCISES

M7−1

1. Excess Capacity.c) Exists when a company has not yet reached

the limit on its resources.

2. Identify the decision problem.(k) First step of the management decision-making process.

3. Bottleneck.(j) Resource that is insufficient to meet thedemands placed on it.

4. Special-order decision.

(a) Short-term management decision madeusing differential analysis.(e) Management decision in which fixedmanufacturing overhead is ignored as long asthere is enough excess capacity to meet the

order.

5. Differential costs.(o) Costs that change across decisionalternatives.

6. Evaluate the costs and benefits ofalternatives.

(p) Step 3 of the management decision-makingprocess.

7. Make-or-buy decision.

(a) Short-term management decision madeusing differential analysis. (h) Management decision in which relevantcosts of making a product internally arecompared to the cost of purchasing that product.

8. Sunk costs.(d) Costs that have already been incurred.(l) Costs that are irrelevant to short-termdecision making.

9. Opportunity costs.(n) Benefits given up when one alternative ischosen over another.

10. Keep-or-drop decision.

(a) Short-term management decision madeusing differential analysis.(b) Management decision in which lost revenueis compared to the reduction of coststo determine the overall effect on profit.

11. Full Capacity.(m) Exists when a company has met its limit onone or more resources.

12. Avoidable costs.(f) Costs that can be avoided by choosing oneoption over another.






M7-2

10. Identify the decision problem.6. Determine the decision alternatives.4. Evaluate the costs and benefits of the alternatives.

2. Make the decision.8. Review the results of the decision.

Items 1, 3, 5, 7, and 9 are not related to the decision-making process.

M7−3

1. Relevant2. Irrelevant3. Irrelevant4. Relevant

5. Irrelevant6. Relevant (qualitative factor)

M7−4

Req. 1a. Irrelevant. Old uniforms have to be repaired regardless of fundraising choice.b. Relevant. Only present with Option #1.c. Relevant. Only present with Option #2 .d. Irrelevant. The water is being donated so the league doesn’t pay for it either way. e. Irrelevant. The new uniforms cost $2,500 regardless of the fundraising choice.

f. Relevant. Qualitative factor. The teams presumably want new uniforms soonerrather than later.

Req. 2Other qualitative factors: Safety concerns for children selling products door-to-door as well as around moving

vehicles. Problems or delays collecting money from everyone after candy is sold. Weather affecting car washes – might cause some days to be rained out.

M7−5

Req. 1Yes, Blowing Sand should accept the offer. The offer price of $22 is more than thevariable cost of $17, resulting in $5 in additional contribution margin per fan.






Req. 2Since fixed costs will not increase, profit will increase by $50,000 (10,000 fans x $5contribution margin).

M7-6

When a company is operating at full capacity, making the choice to do one thing meansgiving up the opportunity to do something else. At full capacity, opportunity costsbecome relevant and managers would not accept a special-order for less than the pricecharged through normal channels.

M7−7

Contribution Margin Given Up $(25,000)Direct/Avoidable Fixed Costs 18,000

Net Effect of Elimination $(7,000)

Total profit will decrease by $7,000 if the Draft model is eliminated ($25,000 contributionmargin given up vs. $18,000 direct fixed costs eliminated).

M7−8

Blowing Sand should continue to make the thermostat internally. If it purchases the partfrom Flurry, Blowing Sand’s total costs would increase by $45,000 annually ($4.00 costto buy vs. $2.50 variable costs of making x 30,000 units).

M7−9

Students’ answers will vary, but should show an understanding of the terms fullcapacity, excess capacity and constrained resource as well as the impact thisconstrained resource will have on manufacturing decisions in the company for whichJoe is working.






M7−10

Since kiln time is the constrained resource, Anne must compare the CM per hour offiring time for the two types of ceramic pots.

Square Ceramic Pot:CM/unit = Sales Price – Variable Cost

= $70 – 15= $55 per square pot

CM/hr = $55 / 2.5 hours firing time= $22 of CM per hour of kiln time for the square pot

Round Ceramic Pot:CM/unit = Sales Price – Variable Cost

= $90 – 20

= $70 per round pot

CM/hr = $70 / 3.5 hours firing time= $20.00 of CM per hour of kiln time for the round pot

The square ceramic pot generates more contribution margin per hour of kiln time so Anne should choose to make the square pot.

M7-11

Rectangular Ceramic Pot:

CM/unit = Sales Price – Variable Cost= $60 – 10= $50 per rectangular pot

However, 2 rectangular pots can be fired together. So the CM will be $50 x 2 =$100 of CM generated.

CM / hr = $100 / 4 hours firing time= $25 of CM per hour of kiln time for the rectangular pot

Since two rectangular pots can be fired at the same time, Anne will generate $25 in

contribution margin per hour, which is higher than firing a single square pot ($22 perhour) or a single round pot ($20 per hour). The maximum contribution margin she canearn with 40 hours of firing time per week is $25 x 40 = $1,000.






ANSWERS TO EXERCISES

E7-1

1. The final step in management’s decision-making process is to actually make the

decision.Incorrect. The final step in the decision-making process is to review the resultsof the decision-making process.

2. In making business decisions, management will ordinarily only consider financial

information because it’s objectively determined.

Incorrect. In the decision-making process managers should incorporate a varietyof factors in addition to financial information. These factors include legal andethical issues, quality considerations, and strategic issues, among others.

3. The first step in management’s decision-making process is to determine thedecision alternatives.

Incorrect. The first step in the decision-making process is to identify the decisionproblem.

4. Relevant costing is used for short-term decision making because it focuses only

on the costs and benefits that are relevant to the decision at hand.

Correct.

5. Under incremental analysis, variable costs will change under different courses of

action, but fixed costs will not change.

Incorrect. Under incremental analysis, sometimes variable costs will not changeunder alternative courses of action, and sometimes fixed costs will change. It alldepends on the alternatives considered.

6. Decisions involve a choice among alternative courses of action.

Correct.

7. When using differential analysis, some costs will change under alternative

courses of action, but revenues will not change.

Incorrect. When using differential analysis, either costs or revenues or both will

change under alternative courses of action.






E7−2

Req. 1Relevant Irrelevant Sunk Cost Qualitative

$450 spent on application fee X X

$8,000 per year tuition X$60,000 salary with master’s degree X$600 per month current rent X$25,000 current salary XTime spent with family and friends X X$50,000 new salary X$5,000 moving expenses X$800 rent per month in new location XCultural activities in new location X X

Ability to have MLB season tickets X X

Req. 2

a. Rent will be $200 more per month if she accepts the job offer.b. For the next two years, salary will be $25,000 ($50,000 - $25,000) more per year ifshe accepts the job offer.c. After two years, salary will be $10,000 ($60,000 - $50,000) more per year if shecompletes the master’s degree. d. Moving expenses are not differential (relevant) since the employer pays the cost.

E7-3

1. __Sunk costs____ are costs that have already been incurred and are not

relevant to future decisions.

2. _Capacity________ is a measure of the limit placed on a specific resource.

3. An _opportunity cost__ is the forgone benefit of choosing to do one thing instead

of another.

4. Monthly utility costs are estimated to be $1,200 regardless of the course of

action; in this case the utility costs are considered a/an irrelevant cost____.

5. When a company has not yet reached the limit on its resources it has _excess

capacity.

6. A _relevant cost__ has the potential to influence a particular decision and will

change depending on the alternative a manager selects.

7. At _full capacity_ opportunity costs become relevant and should be incorporated

into the analysis.






8. When managers are forced to choose one alternative over another due to limited

employee time and equipment availability, the business manager is facing

__opportunity_ costs.

E7−4

Req. 1The special-order would increase profit by $150, as shown below:

Incremental revenue (1,000 X $5) $5,000Incremental variable costs [1,000 x ($1.50 + $0.60 + $2.25)] ( 4,350)Modification costs ( 500)Incremental profit $ 150

Req. 2Yes, net income will increase by $150 if the order is accepted.

Req. 3The special-order would decrease profits by $350, as shown below:

Incremental revenue (1,000 X $4.50) $4,500Incremental variable costs [1,000 x ($1.50 + $0.60 + $2.25)] ( 4,350)Modification costs ( 500)Incremental profit $ (350)

Req. 4If MSI is operating at capacity, the indifference price is equal to the market price thecompany would receive by selling to existing customers ($12.00 per unit) plus anyincremental costs to modify the program for the special order ($500). Thus, the

minimum price is (($12 x 1,000) + $500) / 1,000 units = $12.50.

Req. 5Reasons to accept a special-order that does not immediately increase profits includefuture potential sales to the school system, the ability to market the product to otherschool systems, development of similar history programs for other states, etc.






E7−5

Req. 1Relevant cost of making ($9 + $4 + $2) x 10,000 $150,000Relevant cost of buying ($16 x 10,000) 160,000

Differential cost of making versus buying $ 10,000 (favors making)

Req. 2 All other factors equal, MSI should continue to make the hand-held control modulesbecause it is $10,000 less expensive than buying.

Req. 3If there were $35,000 in potential profit that could be earned under the buy option, thiswould change the decision so that it now favors buying the control modules. The$35,000 can either be ADDED to the cost of making or SUBTRACTED from the buyoption, as shown below.

Relevant Cost of Making Cost of Buying Difference$150,000 + $35,000 = $185,000 $160,000 $25,000$150,000 $160,000 - $35,000 = $125,000 $25,000

Yes, this would change the recommendation to buying (outsourcing) because it is$25,000 less expensive to buy than to make.






E7−6

Req. 1Incremental Effect of Eliminating the Post Office Polka:

Decrease in Sales Revenue $(15,000)

Decrease in Variable Costs 10,000Direct (Avoidable) Fixed Costs 3,500Effect on Profit $ ( 1,500) (Decreased Profit)

Req. 2MSI should not eliminate the product line because it would lose $15,000 in revenue andonly save $13,500 in costs, resulting in a $1,500 reduction in profit.

Req. 3If MSI could avoid $3,700 of common fixed costs, it would save $2,200 by eliminatingthe Post Office line.

Incremental Effect of Eliminating the Post Office Polka:Decrease in Sales Revenue $ (15,000)Decrease in Variable Costs 10,000

Avoidable Fixed Costs ($3,500 + $3,700) 7,200Effect on Profit $ 2,200 (Increased Profit)

Yes, this would change the recommendation. In this case, MSI should eliminate theproduct because the decrease in revenue is more than offset by the decrease in cost.






E7-7

Req. 1

CD Only CD with Instructions Materials Incremental

Sales Revenue 50,000 x $20.00 =$1,000,000 50,000 x $35 = $1,750,000 $ 750,000Variable Costs 50,000 x $ 6.25 = (312,500) 50,000 x $13 = (650,000) (337,500)Contribution Margin $ 687,500 $1,100,000 $ 412,500

Additional Development Costs (65,000) (65,000)Differential Profit $ 687,500 $1,035,000 $ 347,500

Req. 2MSI should process the program further to include instructional materials because it willincrease the company’s short-term profit by $347,500 (= $1,035,000 - $687,500).

Req. 3

CD Only CD with Instructions Materials IncrementalSales Revenue 50,000 x $20.00 =$1,000,000 32,000 x $35 = $1,120,000 $ 120,000Variable Costs 50,000 x $ 6.25 = (312,500) 32,000 x $13 = (416,000) (103,500)Contribution Margin $ 687,500 $ 704,000 $ 16,500

Additional Development Costs (65,000) (65,000)Differential Profit $ 687,500 $ 639,000 $ (48,500)

In this case, MSI should not process the programs further because it will lower MSI’snet income by $48,500 (= $639,000 - $687,500).

E7−8

Qualitative factors to consider include: Special-order decision: employee morale if layoffs result from excess capacity

downtime, whether the customer would continue to expect reduced prices in thefuture, whether the special-order would draw resources from other products to thepoint that their quality or delivery time would be affected.

Make-or-buy decision: quality, reliability of supplier, ability to change design asneeded, ability to lock in price, employee morale if layoffs occur, costs of re-trainingwork force for reassignment.

Keep-or-drop decision: employee morale if layoffs result from eliminating a segment,customer dissatisfaction if a popular item is dropped, potential effects on relatedproduct lines.






E7−9Req. 1CM / unit = Sales Price – Variable Cost

= $32 – ($6 + 3 + 2 + 2)= $19.00 CM / unit for special-order units

Additional CM = 2,000 units x $19= $38,000 additional CM

Ironwood should accept the special-order because it will increase CM by $38,000.

Req. 2Current CM / unit = Sales Price – Variable Cost

= $37.50 – ($6 + 3 + 2)= $26.50 CM / unit

If Ironwood is at full capacity, it should not accept the special-order because it would begiving up sales that generate $26.50 / unit in CM in order to sell units that only generate$19.00 in CM.

Req. 3For the two choices to be equivalent, Ironwood would have to earn as much CM from thespecial-order units as it does from its current sales.

Current Variable Cost/unit $11.00 Add’l VC / unit for Special-Order 2.00

CM necessary to be equivalent 26.50Special-Order Price $39.50 per unit

Alternatively,Current Price / unit $37.50+ Add’l VC / unit 2.00

Special-Order Price / unit $39.50

So the price per unit of the special-order would have to be $39.50 for Ironwood to beindifferent to the choice.






E7−10

Contribution Margin per Direct Labor Hour:Product A: ($35 – 17) = $18 CM / 1.25 DL hours = $14.40 CM per DL hourProduct B: ($45 – 21) = $24 CM / 2 DL hours = $12 CM per DL hour

Product C: ($75 – 32) = $43 CM / 2.5 DL hours = $17.20 CM per DL hour

Thus, Cordova’s preference would be to produce Product C because it generates themost CM per unit of the constrained resource, DL hours. Cordova’s second choicewould be Product A and last choice would be Product B which produces the least CMper DL hour.

E7-11

From E7-10, Cordova’s preferred order of production is Product C, Product A, ProductB.

Product Demand DLH/unit DLH Available DLH Consumed Units Produced DLH RemainingC 4,000 2.5 40,000 10,000 4,000 30,000 A 18,000 1.25 30,000 22,500 18,000 7,500B 12,000 2.0 7,500 7,500 3,750* 0

* 7,500 / 2

Cordova cannot meet full demand for Product B as there are only 7,500 DLH available.It can produce 3,750 units of Product B with the 7,500 available hours.

Cordova’s production is 18,000 units of A, 4,000 units of C, and 3,750 units of B.






E7-12

1. Irrelevant because the cost will not change regardless of the decision made, in

either case the brakes must be repaired.

2. Irrelevant because the cost will be incurred regardless of the decision made, the

fixed overhead is unavoidable.

3. Irrelevant because the price charged for the product will not change across

decision alternatives.

4. Relevant.

5. Irrelevant because it’s a sunk cost, the cost is incurred regardless of the decision

whether to sell as is or process further.

6. Irrelevant because these costs will be incurred even if the company drops one of

its tire models.

7. Relevant.

8. Irrelevant because the flight crew must work regardless of whether the specialorder is accepted or not.

9. Relevant.

10. Relevant.






ANSWERS TO GROUP A PROBLEMS

PA7−1

Req. 1

The special-order would increase profit by $750, as shown below:Incremental revenue (1,500 x $11.00) $16,500Incremental variable costs [1,500 x ($5 + $2 + $3.50)] ( 15,750)Incremental profit $ 750

An alternative way to answer this question is to compare the sales price of $11.00 to thevariable cost per unit of $10.50 ($5 + $2 + $3.50). Since the offer price is greater thanthe variable cost per unit, each unit will add $0.50 in contribution margin ($11.00 -$10.50). Since fixed costs will not increase (because the company has excesscapacity), the total increase in profit is $750 (1,500 units x $0.50 unit contribution

margin).

Req. 2

Yes, Mohave should accept the special-order since net income will increase by $750 ifthe order is accepted.

Req. 3

Total profit would decrease by $3,000:Incremental revenue (2,000 x $9.00) $18,000

Incremental variable costs [2,000 x ($5 + $2 + $3.50)] ( 21,000)Incremental loss $( 3,000)

An alternative way to answer this question is to compare the new sales price of $9.00 tothe variable cost per unit of $10.50 ($5 + $2 + $3.50). Since the offer price is less thanthe variable cost per unit, each unit will result in a loss of $1.50 in contribution margin.Since fixed costs will not increase (because the company has excess capacity), the totaldecrease in profit is $3,000 (2,000 units x $1.50 loss in unit contribution margin).

Req. 4If Mohave was at full capacity, then the special-order sales price would have to be

$19.00. At that price, Mohave is indifferent as to where it sells the units because theCM and income generated by the units is the same.






PA7−2

Req. 1

Relevant cost of making ($3 + $2 + $1 + ($2 x 40%)) x 8,000 $ 54,400

Relevant cost of buying ($7.50 x 8,000) 60,000Differential cost of making versus buying $ 5,600 (favors making)

Req. 2

Based strictly on the quantitative analysis, Mohave should continue to make the bags asthe relevant cost of making ($54,400) is less than the cost of buying ($60,000).

Req. 3

If there were $10,000 in potential profit that could be earned under the buy option, this

would change the decision so that it now favors buying the tote bags. The $10,000 caneither be ADDED to the cost of making or SUBTRACTED from the buy option, asshown below.

Relevant Cost of Making Cost of Buying Difference$54,400 + $10,000 = $64,400 $60,000 $4,400$54,400 $60,000 - $10,000 = $50,000 $4,400

Either way, it is $4,400 less expensive to buy than to make.






PA7−3

Req. 1

Mohave’s revised income statement if they drop the Azul line is shown below:

Indigo Verde TotalSales Revenue $60,000 x 110% = $66,000 $60,000 x $115% = $69,000 $135,000Variable Costs 34,000 x 110% = 37,400 31,000 x 115% = 35,650 73,050Contribution Margin 26,000 x 110% = 28,600 29,000 x 115% = 33,350 61,950Less: Direct Fixed Costs 1,900 2,500 4,400Segment Margin 26,700 30,850 57,550Common Fixed Costs* 21,804 22,796 44,600Profit $ 4,896 $ 8,054 $ 12,950

* It is not necessary to reallocate the fixed costs to calculate the incremental effect on profit. These costsare irrelevant since they will not change.

However, if instructors wanted to show how the costs would be reallocated to the two product lines, thecomputations are below:

Indigo’s share of the common fixed costs = $44,600 x ($66,000 / $135,000) = $21,804Verde’s share of the common fixed costs = $44,600 x ($69,000 / $135,000) = $22,796

Since the company was earning $8,000 in net income WITH the Azul model, thedecision to drop it will increase net income by $4,950 ($12,950 – $8,000).

An alternative approach is to calculate the change in contribution margin that will resultfrom dropping the Azul model, as follows:

Change in Contribution MarginContribution Margin Gained on Indigo $26,000 x 10% = $ 2,600Contribution Margin Gained on Verde $29,000 x 15% = 4,350Contribution Margin Lost on Azul (4,000)Net Decrease in Contribution Margin 2,950Change in Direct Fixed Costs 2,000Net Change in Profit if Azul is Eliminated $ 4,950

Req. 2

Based strictly on this financial analysis, Mohave should eliminate the Azul model.

Req. 3

If none of the fixed overhead costs could be avoided by dropping the Azul model, thecompany should eliminate the model because it would increase profit by $2,950, asshown below:






Change in Contribution MarginContribution Margin Gained on Indigo $26,000 x 10% = $ 2,600Contribution Margin Gained on Verde $29,000 x 15% = 4,350Contribution Margin Lost on Azul (4,000)Net Decrease in Contribution Margin 2,950

Change in Fixed Costs 0Net Change in Profit if Azul is Eliminated $ 2,950

PA7−4

Req. 1

Rosa Umbrella Decorated Umbrella IncrementalSales Revenue 10,000 x $8.00 = $80,000 10,000 x $19 = $190,000 $ 110,000Variable Costs 10,000 x $4.50 = (45,000) 10,000 x $12 = (120,000) (75,000)Contribution Margin $ 35,000 $ 70,000 $ 35,000

Additional Development Costs (10,000) (10,000)Differential Profit $ 35,000 $60,000 $ 25,000

Req. 2

Mohave should add the decorations to the Rosa umbrella because it will increase profitby $25,000.

Req. 3

Rosa Umbrella Decorated Umbrella IncrementalSales Revenue 10,000 x $8.00 = $80,000 8,000 x $19 = $152,000 $ 72,000

Variable Costs 10,000 x $4.50 = (45,000) 8,000 x $12 = ( 96,000) (51,000)Contribution Margin $ 35,000 $ 56,000 $ 21,000

Additional Development Costs (10,000) (10,000)Differential Profit $ 35,000 $46,000 $ 11,000

In this case, Mohave should still add the decorations to the Rosa umbrella because itwill increase profit by $11,000..






PA7-5

Ben’s conclusion and analysis are both flawed as shown in the following schedule. Thecompany’s net income will decrease by $30,000 if the North East division is eliminatedbecause the contribution margin of the division will be lost if the division is eliminated.

Continue Eliminate Net IncomeIncrease (Decrease)

Sales $200,000 $(200,000)Variable COGS 120,000 120,000Variable op. exp. 50,000 50,000CM 30,000 (30,000)Fixed COGS 33,000 33,000Fixed op. exp. 46,000 46,000Net operating income (loss) $(49,000) $(79,000) $(30,000)






PA7−6Req. 1Priority based on Contribution Margin per Direct Labor Hour:

Table A: ($38 – 9) = $29 CM / 0.5 DL hours = $58 CM per DL hour (Rank #2)

Table B: ($42 – 12) = $30 CM / 0.5 DL hours = $60 CM per DL hour (Rank #1)Table C: ($56 – 17) = $39 CM / 1 DL hours = $39 CM per DL hour (Rank #3)

Req. 2

Product Demand DLH/unit DLH Available DLH Consumed Units Produced DLH RemainingB 20,000 0.5 36,000 10,000 20,000 26,000 A 50,000 0.5 26,000 25,000 50,000 1,000C* 30,000 1 1,000 1,000 1,000* 0

* 1,000 / 1

Blossom cannot meet full demand for Table C due to the limited direct labor hours

available. When demand for Tables B and A is met, there are 1,000 direct labor hoursremaining (36,000 – 10,000 – 25,000 = 1,000). Because each unit of Table C requires1 direct labor hour, it can produce 1,000 units of Table C with the 1,000 remaininghours.

Req. 3Contribution Margin per Machine Hour:

Product A: ($38 – 9) = $29 CM / 4 MHrs = $7.25 CM per MH (Rank #3)Product B: ($42 – 12) = $30 CM / 2.5 MHrs = $12.00 CM per MH (Rank #2)Product C: ($56 – 17) = $39 CM / 2.0 MHrs = $19.50 CM per MH (Rank #1)

Req. 4From Req. 3, the preferred order of production is Table C, Table B, Table A.

Product Demand MH/unit MH Available MH Consumed Units Produced MH RemainingC 30,000 2.0 230,000 60,000 30,000 170,000B 20,000 2.5 170,000 50,000 20,000 120,000 A 50,000 4.0 120,000 120,000 30,000* 0

* 120,000 / 4.0

Blossom cannot meet full demand for Table A due to the limited machine hoursavailable. When demand for Tables C and B is met, there are 120,000 machine hours

remaining (230,000 – 60,000 – 50,000 = 120,000). Because each unit of Table Arequires 4 machine hours, it can product 30,000 units of Table A with the 120,000remaining hours (120,000 / 4 = 30,000).






PA7-7

Req. 1

The relevant costs and benefits in this decision are the incremental revenues and the

incremental costs incurred by Chino Company after the split-off point. The $400,000 in

joint costs is a sunk cost and is not relevant to the sell-or-process further decision.

Req. 2

PantsRevenue at split-off: $120,000 (6,000 x $20)Revenue after processing: 180,000 (6,000 x $30)Incremental revenue: $ 60,000Less incremental costs: 28,450

Increase (decrease) in profit: $ 31,550Decision: Process further

ShirtsRevenue at split-off: $278,400 (12,000 x $23.20)Revenue after processing: 388,800 (12,000 x $32.40)Incremental revenue: $ 110,400Less incremental costs: 64,400Increase (decrease) in profit: $ 46,000Decision: Process further

CoatsRevenue at split-off: $155,200 (4,000 x $38.80)Revenue after processing: 172,800 (4,000 x $43.20)Incremental revenue: $ 17,600Less incremental costs: 18,300Increase (decrease) in profit: $ (700)Decision: Sell at split-off point

Req. 3

The decisions reached in part “b” would not change. The joint costs are sunk costs and

are not relevant to the sell-or-process further decision.






PA7-8

Req. 1

Incremental Analysis of the Special Order for 20,000 Coffee Cups:

Per cup TotalIncremental revenue $8.00 $ 160,000Less: Incremental costsVariable COGS* 4.10 82,000Variable op. exp.** 0.30 6,000Endorsement fee*** 3.00 60,000Incremental profit $0.60 $ 12,000

*$492,000 x 80% = $393,600 / 96,000 = $4.10**$36,000 x 80% = $28,800 / 96,000 = $0.30***$60,000 / 20,000 = $3

Req. 2

Yes, Camino should accept the special order because company profits will increase by

$12,000 and the company has excess capacity of 24,000 units (96,000 / .8 = 120,000 –

96,000 = 24,000).

Req. 3

If Camino is operating at capacity, the company would need to receive its normal sales

price of $10 ($960,000 / 96,000) plus the incremental $3 endorsement fee per cup for a

total of $13 per cup.






PA7-9

Req. 1

Incremental Analysis of Make-or-Buy for Awnings:

Make Buy Net incomeincrease (decrease)

Direct materials $ 70,000 $ 70,000Direct labor 50,000 50,000Variable OH 40,000 40,000Fixed OH 32,000 $ 32,000Purchase price 180,000 (180,000)Total $192,000 $212,000 $(20,000)

Req. 2

Old Camp should continue to manufacture the awnings because purchasing theawnings will cost the company an additional $20,000.

Req. 3

If Old Camp were able to produce net income of $22,000 from the released capacity, itshould purchase the awnings as shown below:

Make Buy Net income

increase (decrease)Total (from “b”) $ 192,000 $212,000 $ (20,000)Opportunity cost 22,000 22,000Variable OH $ 214,000 $212,000 $ 2,000






ANSWERS TO GROUP B PROBLEMS

PB7−1

Req. 1

The special-order would increase profit by $80, as shown below:Incremental revenue (80 x $65) $ 5,200Incremental variable costs [80 x ($30 + $22 + $12)] (5,120)Incremental profit $ 80

An alternative way to answer this question is to compare the sales price of $65 to thevariable cost per unit of $64 ($30 + $22 + $12). Since the offer price is greater than thevariable cost per unit, each unit will add $1 in contribution margin ($65 - $64). Sincefixed costs will not increase (because the company has excess capacity), the totalincrease in profit is $80 (80 units x $1 unit contribution margin).

Req. 2

Yes, Greenview should accept the special-order since net income will increase by $80 ifthe order is accepted.

Req. 3

Total profit would decrease by $400:Incremental revenue (100 x $60) $ 6,000Incremental variable costs [100 x ($30 + $22 + $12)] ( 6,400)

Incremental profit $( 400)

An alternative way to answer this question is to compare the sales price of $60 to thevariable cost per unit of $64 ($30 + $22 + $12). Since the offer price is less than thevariable cost per unit, each unit will result in $4 less in contribution margin ($60 - $64).Since fixed costs will not increase (because the company has excess capacity), the totaldecrease in profit is $400 (100 units x $4 decrease in unit contribution margin).

Req. 4If Greenview was at full capacity, then the special-order sales price would have to be$99.00. At that price, Greenview is indifferent as to where it sells the units because the

CM and short-term income generated by the units is the same.






PB7−2

Req. 1

Relevant cost of making ($4 + $1 + $2 + ($3 x 30%)) x 1,000 $ 7,900

Relevant cost of buying ($9 x 1,000) 9,000Differential cost of making versus buying $ 1,100 (favors making)

Req. 2

All other things held constant, Greenview should continue to make the chair pads as therelevant cost of making ($7,900) is less than the cost of buying ($9,000).

Req. 3

There would have to be more than $1,100 in additional profit generated from another

product line for Greenview to be indifferent between making and buying the chair pads.






PB7−3

Req. 1

Greenview’s revised income statement if they drop the Blanco model is shown below:

Sunrise Noche TotalSales Revenue $110,000 x 110% = $121,000 $77,000 x 105% = $80,850 $201,850Variable Costs 77,000 x 110% = 84,700 52,000 x 105% = 54,600 139,300Contribution Margin 33,000 x 110% = 36,300 25,000 x 105% = 26,250 62,550Less: Direct Fixed Costs 3,200 2,400 5,600Segment Margin 33,100 23,850 56,950Common Fixed Costs* 20,142 13,458 33,600Profit $ 12,958 $ 10,392 $ 23,350

* It is not necessary to reallocate the fixed costs to calculate the incremental effect on profit.These costs are irrelevant since they will not change.

However, if instructors wanted to show how the costs would be reallocated to the two productlines, the computations are below:

Sunrise’s share of the common fixed costs = $33,600 x ($121,000 / $201,850) = $20,142 Noche’s share of the common fixed costs = $33,600 x ($80,850 / $201,850) = $13,458

Since the company was earning $23,300 in net income WITH the Blanco model, thedecision to drop it will increase net income by $50 ($23,300 - $23,350).

An alternative approach is to calculate the change in contribution margin and fixed coststhat will result from dropping the Blanco model, as follows:

Change in Contribution MarginContribution Margin Gained on Sunrise $33,000 x 10%= $ 3,300Contribution Margin Gained on Noche $25,000 x 5%= 1,250Contribution Margin Lost on Blanco (7,500)Net Decrease in Contribution Margin (2,950)Decrease in Direct Fixed Costs 3,000Net Change in Profit if Blanco is Eliminated $ 50

Req. 2

Based strictly on this financial analysis, Greenview should eliminate the Blanco model.

Req. 3

If $3,800 in fixed overhead costs could be avoided by dropping the Blanco model, thecompany should drop the line because it will have an $850 increase in profit, as shownbelow:






Change in Contribution MarginContribution Margin Gained on Sunrise $33,000 x 10% = $ 3,300Contribution Margin Gained on Noche $25,000 x 5% = 1,250Contribution Margin Lost on Blanco (7,500)Net Decrease in Contribution Margin (2,950)

Decrease in Direct Fixed Costs 3,800Net Change in Profit if Blanco is Eliminated $ 850

PB7−4

Req. 1

Unfinished Bookcases Finished Bookcases IncrementalSales Revenue 8,000 x $50.00 = $ 400,000 8,000 x $80.00 = $ 640,000 $ 240,000

Variable Costs 8,000 x $19.50 = (156,000) 8,000 x $36.50 = (292,000) (136,000)Contribution Margin $ 244,000 $ 348,000 $ 104,000 Additional Development Costs (75,000) (75,000)Differential Profit $ 244,000 $ 273,000 $ 29,000

Req. 2

Greenview should process the bookcase further because it will increase the company’snet income by $29,000 (= $273,000 - $244,000).

Req. 3

Unfinished Bookcases Finished Bookcases IncrementalSales Revenue 8,000 x $50.00 = $ 400,000 6,500 x $80.00 = $ 520,000 $ 120,000Variable Costs 8,000 x $19.50 = (156,000) 6,500 x $36.50 = (237,250) (81,250)Contribution Margin $ 244,000 $ 282,750 $ 38,750

Additional Development Costs (75,000) (75,000)Differential Profit $ 244,000 $ 207,750 $ (36,250)

In this case, Greenview should not process the bookcase further because it will lowercompany net income by $36,250 ($207,750 - $244,000).






PB7-5

Barb’s conclusion and analysis are both flawed as shown in the following schedule.The company’s net income will decrease by $111,000 if the Colorado division is

eliminated because the contribution margin of the division will be lost if the division iseliminated.

Continue Eliminate Net IncomeIncrease(Decrease)

Sales $300,000 $(300,000)Variable COGS 83,000 83,000Variable op. exp. 106,000 106,000CM 111,000 (111,000)Fixed COGS 70,000 70,000Fixed op. exp. 90,000 90,000Net income (loss) $(49,000) $ (160,000) $(111,000)






PB7−6

Req. 1

Contribution Margin per pound of beeswax:

Candle X: ($18 – 5) = $13 CM / 1.5 lbs = $8.67 CM per lb. (Rank #1)Candle Y: ($20 – 7) = $13 CM / 2 lbs = $6.50 CM per lb (Rank #2)Candle Z: ($24 – 11.50) = $12.50 CM / 2 lbs = $6.25 CM per lb (Rank #3)

Req. 2

From Req. 1, the preferred order of production is Candle X, Candle Y, Candle Z.Product Demand Lbs/unit Lbs Available Lbs Consumed Units Produced Lbs Remaining

X 22,000 1.5 50,000 33,000 22,000 17,000Y 8,000 2.0 17,000 16,000 8,000 1,000Z 15,000 2.0 1,000 1,000 500* 0

* 1,000 / 2

Prospector cannot meet full demand for Candle Z due to the limited amount of beeswaxavailable. When the demand for Candles X and Y is met, there are 1,000 pounds ofbeeswax remaining (50,000 – 33,000 – 16,000 = 1,000). Because each unit of CandleZ requires 2 pounds of beeswax, it can produce 500 units of Candle Z with the 1,000available pounds.

Req. 3

Contribution Margin per Direct Labor Hour:Candle X: ($18 – 5) = $13 CM / 5.0 DLH = $2.60 CM per DLH (Rank #1)

Candle Y: ($20 – 7) = $13 CM / 6 DLH = $2.16 CM per DLH (Rank #3)Candle Z: ($24 – 11.50) = $12.50 CM / 5.0 DLH = $2.50 CM per DLH (Rank #2)

Req. 4

From Req. 3, the preferred order of production is Candle X, Candle Z, Candle Y.

Product Demand DLH/unit DLH Available DLH Consumed Units Produced DLH RemainingX 22,000 5.0 215,000 110,000 22,000 105,000Z 15,000 5.0 105,000 75,000 15,000 30,000Y 22,000 6.0 30,000 30,000 5,000* 0

* 30,000 / 6

Prospector cannot meet full demand for Candle Y due to the limited direct labor hours.When demand for Candles X and Z is met, there are 30,000 direct labor hoursremaining (215,000 – 110,000 – 75,000 = 30,000). Because each unit of Candle Yrequires 6 direct labor hours, it can produce 5,000 units of Candle Z with the 30,000direct labor hours remaining.






PB7-7

Req. 1

The relevant costs and benefits in this decision are the incremental revenues and the

incremental costs incurred by Golden Trophy Inc. after the split-off point. The $360,000

in joint costs is a sunk cost and is not relevant to the sell-or-process further decision.

Req. 2

Trophy ARevenue at split-off: $472,500 (4,500 x $105)Revenue after processing: 498,600 (4,500 x $110.80)Incremental revenue: $ 26,100

Less incremental costs: 46,200Increase (decrease) in profit: $( 20,100)Decision: Sell at split-off point

Trophy BRevenue at split-off: $570,400 (6,200 x $92.00)Revenue after processing: 734,700 (6,200 x $118.50)Incremental revenue: $ 164,300Less incremental costs: 85,500Increase (decrease) in profit: $ 78,800Decision: Process further

Trophy CRevenue at split-off: $121,814 (980 x $124.30)Revenue after processing: 143,570 (980 x $146.50)Incremental revenue: $ 21,756Less incremental costs: 22,450Increase (decrease) in profit: $( 694)Decision: Sell at split-off point

Req. 3

The decisions reached in part “b” would not change. The joint costs are sunk costs andare not relevant to the sell-or-process further decision.






PB7-8

Req. 1

Incremental Analysis of the Special Order for 25,000 Pillows:

Per pillow TotalIncremental revenue $10.00 $250,000Less: Incremental costsVariable COGS* 6.75 168,750Variable op. exp.** 1.50 37,500Endorsement fee*** 2.00 50,000Incremental profit $(0.25) $ (6,250)

*$1,036,800 x 75% = $777,600 / 115,200 = $6.75**$230,400 x 75% = $172,800 / 115,200 = $1.50***$50,000 / 25,000 = $2

Req. 2

No, Shasta should not accept the special order because company profits will decrease

by $6,250. Although the company has excess capacity of 28,800 units (115,200 / .8 =

144,000 – 115,200 = 28,800), this special order would cost the company more than the

special order price offered by Honeysuckle Community College.

Req. 3

If Shasta is operating at capacity, the company would need to receive its normal sales

price of $12 ($1,382,400 / 115,200) plus the incremental $2 endorsement fee per pillow

for a total of $14 per pillow.






PB7-9

Req. 1

Incremental Analysis of Make-or-Buy for Glass Screens

Make Buy Net incomeincrease (decrease)

Direct materials $200,000 $ 200,000Direct labor 160,000 160,000Variable OH 120,000 120,000Fixed OH 48,000 $ 48,000Purchase price 520,000 (520,000)Total $528,000 $568,000 $(40,000)

Req. 2

Gold Dust should continue to manufacture the glass screens because purchasing thescreens will cost the company an additional $40,000.

Req. 3

If Gold Dust were able to produce net income of $38,000 from the released capacity, itshould still continue to make the glass screens as shown below:

Make Buy Net income

increase (decrease)Total (from “b”) $528,000 $568,000 $ (40,000)Opportunity cost 38,000 38,000Variable OH 566,000 $568,000 $ (2,000)






ANSWERS TO SKILLS DEVELOPMENT CASES

S7−1

Req. 1

PED = % Change in Demand% Change in Price

PED = [(24,000,000 – 25,000,000) / 25,000,000][($16.00 – $10.00] / $10.00

PED = 4% Decrease in Demand60% Increase in Price

PED = -0.067

The absolute value of PED is less than one, indicating that Netflix’s demand wasrelatively inelastic to the change in price. In this case, a 60% increase in price onlyresulted in a 4% decrease in demand. Note that PED is negative because there is aninverse relationship between price and demand, as is the case for most goods andservices.

Req. 2

Old Pricing Plan New Pricing Plan

Revenue

(25,000,000 x $10) $ 250,000,000

Streaming video revenue

(21,000,000 x $8) $ 168,000,000Variable costs

(25,000,000 x ($5 x $0.40)) 50,000,000

DVD-by-mail

(15,000,000 x $8) 120,000,000

Contribution margin $ 200,000,000 Total Revenue $ 288,000,000

Variable Costs

(15,000,000 x (5 x $0.40)) 30,000,000

Contribution Margin $ 258,000,000

Increase in Contribution Margin $ 58,000,000






S7−1 (Continued)

Assuming fixed costs remain constant in the short-run, the pricing change would boostshort-term profits by $58,000,000.

Req. 3 Answers will vary.

Req. 4 Answers will vary. As an additional assignment, you could ask students to researchwhat happened to Netflix’s stock price in the days and months after the price change.

Req. 5This was most likely not an attempt to boost short-term profits, but rather a strategicdecision on the part of Netflix to focus their future direction on streaming video rather

than DVD by mail.


S7−2 Req. 1No, WTS won’t see an immediate impact of $582,000 in cost savings because some ofthese expenses won’t be fully eliminated.

Req. 2

Scholarships: Probably only partially eliminated since schools often continue thescholarship commitments to student athletes for a period of time or until they transfer toother colleges.

Coaches’ Salaries: Fully eliminated for any coach who immediately finds a position atanother college. Only partially eliminated (or perhaps not eliminated) for any coach whostays with WTS in another capacity. For example, the men’s diving coach may also bethe coach for women’s diving and the swim teams that are all being retained.

Team Travel: Fully eliminated.

Venue maintenance: Partially eliminated or not eliminated. Presumably, the venue foreach cancelled sport is also used by another sport (lacrosse field also used by soccerteams, softball field also used by baseball team, pool also used by swim teams).

Equipment: Partially eliminated if some of the equipment is used by other teams.




Team Support: This category could include items such as weight rooms, trainers,academic tutoring, etc. Most of these items are shared with other teams so would onlybe partially eliminated at best.

S7−2 (Continued)


Req. 4Sports such as football and basketball generally bring in the most revenue and aremuch more likely to be “profitable” for the university. They are also the most visiblesports on a national level and can sometimes help advertise a school by getting itsname out to a wider audience. For example, small schools that make it into the NCAAbasketball tournament get recognition on a national level that they wouldn’t otherwisereceive. These sports are also the ones most likely to be followed and supported by

college alumni.

Req. 5 Answers will vary. In conjunction with the “reactions” section of this requirement, somestudents may bring up the Title IX (“Title 9”) Education Amendment of 1972. A numberof people feel that this amendment forces the elimination of men’s sports and may givewomen’s sports an unfair “protection” from budget cuts. Therefore, you should do someresearch of your own in order to lead this discussion effectively.

S7−3

Answers will vary, but students should demonstrate an understanding of both sides ofthe decision – Walmart’s focus on profits and the impact on consumers, especiallythose in more rural areas.

S7−4

Student answers will vary, but students should demonstrate an understanding of boththe company and the employee/consumer/community sides of the issue.

Solutions Chapter 7 (3)

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Transcript of Solutions Chapter 7 (3)