Ch 25 Practice SolutionsProblems (Group A)

P25-21A Identifying relevant information and making pricing decisionsLearning Objectives 1, 22. $9,400

Deep Blue manufactures flotation vests in Charleston, South Carolina. Deep Blue’s contribution margin income statement for the month ended December 31, 2016, contains the following data:

Suppose Overboard wishes to buy 4,700 vests from Deep Blue. Deep Blue will not incur any variable selling and administrative expenses on the special order. The Deep Blue plant has enough unused capacity to manufacture the additional vests. Overboard has offered $7 per vest, which is below the normal sales price of $16.

Requirements1. Identify each cost in the income statement as either relevant or irrelevant to Deep Blue’s

decision.2. Prepare a differential analysis to determine whether Deep Blue should accept this special

sales order.3. Identify long-term factors Deep Blue should consider in deciding whether to accept the

special sales order.

SOLUTION

Requirement 1

Variable Costs: Manufacturing 150,000 Relevant Selling and Administrative 110,000 IrrelevantFixed Costs: Manufacturing 121,000 Irrelevant Selling and Administrative 85,000 Irrelevant

Requirement 2

Expected increase in revenue (4,700 vests × $7 per vest) $ 32,900Expected increase in variable manufacturing costs (4,700 vests × $5 per vest*) (23,500)Expected increase in operating income $ 9,400

*$150,000 variable manufacturing costs / 30,000 units = $5 per unit

Deep Blue should accept the special sales order because accepting the special sales order will increase operating income by $9,400. Variable selling and administrative costs and fixed costs do not change and, therefore, are not relevant. They should not be considered.

Requirement 3

In addition to considering this special order’s increase on profits, Deep Blue managers should consider whether the special order could affect regular sales in the long run. Will regular customers find out about the special order and demand a lower price? Will the special order customer come back again and again, asking for the same reduced price? Will the special order price start a price war with competitors?

P25-22A Making pricing decisionsLearning Objective 24. $4.39 per unit

Happy Gardener operates a commercial plant nursery where it propagates plants for garden centers throughout the region. Happy Gardener has $4,800,000 in assets. Its yearly fixed costs are $650,000, and the variable costs for the potting soil, container, label, seedling, and labor for each gallon-size plant total $1.90. Happy Gardener’s volume is currently 480,000 units. Competitors offer the same plants, at the same quality, to garden centers for $4.25 each. Garden centers then mark them up to sell to the public for $9 to $12, depending on the type of plant.

Requirements1. Happy Gardener’s owners want to earn a 11% return on investment on the company’s assets.

What is Happy Gardener’s target full product cost?2. Given Happy Gardener’s current costs, will its owners be able to achieve their target profit?3. Assume Happy Gardener has identified ways to cut its variable costs to $1.75 per unit. What

is its new target fixed cost? Will this decrease in variable costs allow the company to achieve its target profit?

4. Happy Gardener started an aggressive advertising campaign strategy to differentiate its plants from those grown by other nurseries. Happy Gardener does not expect volume to be affected, but it hopes to gain more control over pricing. If Happy Gardener has to spend $90,000 this year to advertise and its variable costs continue to be $1.75 per unit, what will its cost-plus price be? Do you think Happy Gardener will be able to sell its plants to garden centers at the cost-plus price? Why or why not?

SOLUTION

Requirement 1

Revenue at market price

(480,000 units × $4.25 per unit) $ 2,040,000

Less: Desired profit (11% × $4,800,000 assets) 528,000Target full product cost $ 1,512,000

Requirement 2

Current variable costs ($1.90 per unit × 480,000 units) $ 912,000Plus: Current fixed costs

650,000

Current full product cost

$ 1,562,000

Happy Gardener will not be able to achieve its target profit level because current costs of $1,562,000 exceed target full product cost of $1,512,000.

Requirement 3

Target full product cost

(calculated in Req. 1) $ 1,512,000

Less: Variable cost ($1.75 per unit × 480,000 units) 840,000Target fixed cost $ 672,000

If Happy Gardener can cut its variable costs to $1.75 per unit, then its new target fixed cost would be $672,000. This decrease in variable cost would allow Happy Gardener to achieve its target profit because current fixed costs are only $650,000.

Requirement 4

Current variable costs per unit ($1.75 per unit × 480,000 units) $ 840,000Plus: Fixed costs ($650,000 + $90,000

advertising)740,000

Full product cost 1,580,000Plus: Desired profit (11% × $4,800,000 assets) 528,000Cost-plus price $ 2,108,000Divided by volume 480,000 unitsCost-plus price per unit $4.39 per unit**Rounded

If Happy Gardener starts an advertising campaign to differentiate its plants, the new cost-plus price would be $4.39 per plant. If the advertising campaign is effective, Happy Gardener should be able to sell its plants to garden centers at this price because it is not significantly higher than the $4.25 that Happy Gardener previously charged.

P25-23A Making dropping a product decisionsLearning Objective 32b. $(31,000)

Members of the board of directors of Safety Step have received the following operating income data for the year ended May 31, 2016:

Members of the board are surprised that the industrial systems product line is not profitable. They commission a study to determine whether the company should drop the line. Company accountants estimate that dropping industrial systems will decrease fixed cost of goods sold by $84,000 and decrease fixed selling and administrative expenses by $11,000.

Requirements1. Prepare a differential analysis to show whether Safety Step should drop the industrial

systems product line.2. Prepare contribution margin income statements to show Safety Step’s total operating income

under the two alternatives: (a) with the industrial systems line and (b) without the line. Compare the difference between the two alternatives’ income numbers to your answer to Requirement 1.

3. What have you learned from the comparison in Requirement 2?

SOLUTION

Requirement 1

Expected decrease in revenue $ (340,000)Expected decrease in total variable costs ($35,000 + $63,000) $ 98,000Expected decrease in fixed costs ($84,000 + $11,000) 95,000Expected decrease in total costs 193,000Expected decrease in operating income $ (147,000)

Safety Step should not drop the Industrial Systems product line. If the Industrial Systems product line is dropped, operating income will decrease by $147,000. Revenues will decline by $340,000, but expenses will only decline by $193,000.

Requirement 2(a) with the Industrial Systems product line:

SAFETY STEPContribution Margin Income Statement

For the Year Ended May 31, 2016Product Line

TotalIndustrialSystems

HouseholdSystems

Sales Revenue $ 710,000 $ 340,000 $ 370,000Variable Costs: Manufacturing 81,000 35,000 46,000 Selling and Administrative Expenses 138,000 63,000 75,000Total Variable Costs 219,000 98,000 121,000Contribution Margin 491,000 242,000 249,000Fixed Costs: Manufacturing 309,000 240,000 69,000 Selling and Administrative Expenses 66,000 41,000 25,000Total Fixed Costs 375,000 281,000 94,000Operating Income (Loss) $ 116,000 $ (39,000) $ 155,000

P25-23A, cont.Requirement 2, cont.

(b) without the Industrial Systems product line:

SAFETY STEPContribution Margin Income Statement

For the Year Ended May 31, 2016Household

SystemsSales Revenue $ 370,000Variable Costs: Manufacturing 46,000 Selling and Administrative 75,000Total Variable Costs 121,000Contribution Margin 249,000Fixed Costs: Manufacturing ($240,000 − $84,000) + $69,000 225,000 Selling and Administrative ($41,000 − $11,000) + $25,000 55,000Total Fixed Costs 280,000Operating Income (Loss) $ (31,000)

The difference between Contribution Margin Income Statement (a) and Contribution Margin Income Statement (b) is a decrease of $147,000 [$116,000 – ($31,000)]. This matches the answer from Requirement 1.

Requirement 3

This demonstrates that the differential analysis approach in Requirement 1 yields the same result as the longer approach in Requirement 2 that compares total operating income under the two alternatives.

P25-24A Making product mix decisionsLearning Objective 32. CM, Deluxe $1,680

Brill, located in Port St. Lucie, Florida, produces two lines of electric toothbrushes: deluxe and standard. Because Brill can sell all the toothbrushes it can produce, the owners are expanding the plant. They are deciding which product line to emphasize. To make this decision, they assemble the following data:

After expansion, the factory will have a production capacity of 5,000 machine hours per month. The plant can manufacture either 58 standard electric toothbrushes or 28 deluxe electric toothbrushes per machine hour.

Requirements1. Identify the constraining factor for Brill.2. Prepare an analysis to show which product line to emphasize.

SOLUTION

Requirement 1

The constraining factor for Brill is machine hours.

Requirement 2

DeluxeToothbrush

StandardToothbrush

(1) Toothbrushes produced per hour 28 58(2) Contribution margin per toothbrush $ 60 $ 37Contribution margin per machine hour [(1) × (2)]

$ 1,680 $ 2,146

When facing a constraint concerning which products to emphasize, the decision rule is to emphasize the product with the highest contribution margin per unit of the constraint. Standard toothbrushes have a higher contribution margin per machine hour, $2,146, than deluxe

toothbrushes, $1,680. Brill will earn more profit by producing standard toothbrushes; therefore, this product should be emphasized.

P25-25A Making outsourcing decisionsLearning Objective 41. $(9,600)

Wild Ride manufactures snowboards. Its cost of making 1,900 bindings is as follows:

Suppose Lancaster will sell bindings to Wild Ride for $16 each. Wild Ride would pay $2 per unit to transport the bindings to its manufacturing plant, where it would add its own logo at a cost of $0.50 per binding.

Requirements1. Wild Ride’s accountants predict that purchasing the bindings from Lancaster will enable the

company to avoid $2,400 of fixed overhead. Prepare an analysis to show whether Wild Ride should make or buy the bindings.

2. The facilities freed by purchasing bindings from Lancaster can be used to manufacture another product that will contribute $3,200 to profit. Total fixed costs will be the same as if Wild Ride had produced the bindings. Show which alternative makes the best use of Wild Ride’s facilities: (a) make bindings, (b) buy bindings and leave facilities idle, or (c) buy bindings and make another product.

SOLUTION

Requirement 1

Binding CostsMake

Outsource Difference

(Make – Outsource)Variable costs: Direct materials $ 17,600 $ 17,600 Direct labor 3,500 3,500 Variable manufacturing overhead 2,050 2,050Fixed costs 2,400 2,400Purchase costs ($16/unit × 1,900 units) $ 30,400 (30,400)Transportation ($2/unit × 1,900 units) 3,800 (3,800)Logo cost ($0.50/unit × 1,900 units) 950 (950)Total differential cost of bindings $ 25,550 $ 35,150 $ (9,600)

Wild Ride should continue to make the bindings in-house because the differential costs of outsourcing the bindings ($35,150) exceed the differential costs of making the bindings ($25,550) by $9,600.

P25-25A, cont.Requirement 2

Outsource Bindings

Binding CostsMake Facilities

IdleMake New

ProductVariable costs: Direct materials $ 17,600 Direct labor 3,500 Variable manufacturing overhead 2,050Fixed costs 2,400 $ 2,400Purchase costs ($16/unit × 1,900 units) $ 30,400 30,400Transportation ($2/unit × 1,900 units) 3,800 3,800Logo cost ($0.50/unit × 1,900 units) 950 950Expected profit from new product (3,200)Total differential net cost of bindings $ 25,550 $ 35,150 $ 34,350

In order to make the best use of their facilities Wild Ride should make the bindings in-house. The net differential cost of making the bindings in-house is $25,550, but buying the bindings and leaving the facilities idle, or buying the bindings and manufacturing another product, have higher net costs.

P25-26A Making sell or process further decisionsLearning Objective 43. $(12,200)

Rouse Petroleum has spent $205,000 to refine 62,000 gallons of petroleum distillate, which can be sold for $6.30 per gallon. Alternatively, Rouse can process the distillate further and produce 56,000 gallons of cleaner fluid. The additional processing will cost $1.80 per gallon of distillate. The cleaner fluid can be sold for $9.00 per gallon. To sell the cleaner fluid, Rouse must pay a sales commission of $0.10 per gallon and a transportation charge of $0.15 per gallon.

Requirements1. Diagram Rouse’s decision alternatives, using Exhibit 25-18 as a guide.2. Identify the sunk cost. Is the sunk cost relevant to Rouse’s decision?3. Should Rouse sell the petroleum distillate or process it into cleaner fluid? Show the expected

net revenue difference between the two alternatives.

SOLUTION

Requirement 1

Joint costs of

producing62,000

gallons of petroleum distillate

$(205,000)

Revenues fromselling as is$390,600

(62,000 gal. × $6.30/gal.)

Cost ofprocessing

further$(125,600)

(62,000 gal. × $1.80/gal.) + [56,000 gal. ×

($0.10/gal. + $0.15/gal.)]

Revenues from processing

further$504,000

(56,000 gal. × $9.00/gal.)

Requirement 2

The sunk cost is the $205,000 Rouse Petroleum has spent to refine the 62,000 gallons of petroleum distillate. Sunk costs are always irrelevant to sell or process further decisions.

Requirement 3

Costs SellProcessFurther Difference

Expected revenue from selling 62,000 gallons at $6.30 each $ 390,600Expected revenue from selling 56,00 gallons at $9.00 each $ 504,000 $ 113,400Additional cost of processing (62,000 gal. × $1.80/gal.) + [56,000 gal. × ($0.10/gal. + $0.15/gal.)]

(125,600) (125,600)

Total net revenue $ 390,600 $ 378,400 $ (12,200)

Rouse Petroleum should sell the petroleum distillate and not process further. If Rouse sells as petroleum distillate, net revenue will be $390,600. If Rouse processes further, the net revenue will only be $378,400. Profits will decrease by $12,200 by processing further.