Questions 11-1 through 11-10 11–1 What are relevant costs? Provide several examples for the decision to repair or replace a piece of equipment. 11-1 Relevant costs are costs to be incurred at some future time and differ for each option available to the decision maker. Relevant costs in replacing equipment would include the cost of purchasing and installing the new equipment, the operating costs of the new equipment, and the disposal costs of the old equipment, the cost of repair of the old equipment, and so on. The purchase price of the old equipment would not be relevant to the decision. 11–2 ist at least four different decisions for !hich the relevant cost anal"sis model can #e used effectivel". 11-2 Decisions where relevant cost analysis might be used effectively include: 1. The specialorder specialorder decision !. "ake, lease, lease, or buy #. $utsourcing $utsourcing %. &ale before or after additional processing processing '. (eep or drop products or services ). *rofitability analysis: evaluating programs +. Determining the optimum shortterm product or service- mi 11-$ What is the relevant cost !hen determining !hether or not to process a product further? 11-$ The relevant cost is the incremental cost incurred for the additional processing. /n a 0oint manufacturing process, this would include on separable processing costs. 11–% ist four to six strategic factors that are often important in the ma&e-or-#u" decision. 11-% &trategic factors include: 1. The level of capacity capacity usage of the plant plant !. The time value value of money money #. uality uality %. 2unctionality onality '. Timeliness ness of delivery delivery ). Reliability lity in shipping shipping +. &ervice &ervice after the the sale 11–' (o! do short-term evaluations affect a manager)s incentives and performance? 11-' 3 11-' 3 wellknown problem in business today today is the tendency of managers to focus focus on shortterm goals and neglect the longerterm strategic goals, because their compensation is based upon shortterm accounting measures such as net income. This issue has been raised by many critics of relevant cost analysis. 3s noted throughout the chapter, it is critical that the relevant cost analysis be supplemented by a careful consideration of the longterm, strategic concerns of the firm. 4ithout strategic considerations, management could improperly use relevant cost analysis to achieve a shortterm benefit and potentially suffer a significant longterm loss. 2or eample, a firm might choose to accept a special order because of a positive relevant cost analysis, without properly considering that the nature of the special order will have a significant negative impact on the firm5s image in the marketplace, and perhaps a negative effect on sales of the other products. The important message for managers is to keep the strategic concerns in mind, and to start with the strategic ob0ectives in any decision situation. 11–* ist four or five important limitations of relevant cost anal"sis. 11-* The limitations of relevant cost analysis include: 1. 6cessive focus on shortterm shortterm decisions !. Tendency to focus focus on quantitative factors only, only, and to not include the important strategic factors #. "anagers7 tendency to to include irrelevant costs, such as sunk costs, in the decision making %. Tendency to focus focus on a single product or department in isolation of others, and there to perhaps not find the strategically correct analysis 11–+ (o! do strategic factors affect the proper use of relevant cost anal"sis? 11-+ &trategic management principles require a more integrative focus, as noted in the chapter: R 68 68 69 693 T T ; $ $& & T 3 3 3 8< &/ &/ & 2inancial 2ocus
& TR TR 3T 6= 6= /; /; ; $ $& & T 3 3 3 8< &/ &/ & ;ustomer 2ocus
ot 8inked to &trategy
8inked to the 2irm5s &trategy
*recise and uantitative
>road and &ub0ective
2ocused on on /n /ndividual
/ntegrative? ;onsiders all
*roduct or Decision &ituation &hortterm 2ocus
;ustomerrelated 2actors 8ongterm 2ocus
11–, ist some of the #ehavioral implementation and legal pro#lems to #e anticipated in the use of relevant cost anal"sis. 11-, &ome of the behavioral, implementation, and legal issues in using relevant cost analysis include: 1. The tendency of managers to focus on short term goals, and to not attend satisfactorily to longerterm strategic goals of the firm. The techniques described in relevant cost analysis can have the effect of encouraging this bias, unless specific steps are taken, such as to use the balanced scorecard in management evaluation see chapter 1@-. !. /f variable costs are given too much focus, as suggested in relevant cost analysis, managers can tend to ig nore fied costs. "oreover, some managers might replace variable costs with fied costs where possible, to improve the evaluation of their unit. The result might be higher overall costs for the firm. #. Researchers have shown a strong human tendency tendency to rely upon and use irrelevant factors such as sunk costs in decision making. Thus, the proper use of relevant cost analysis requires the management accountant to carefully eplain the techniques and to carefully present the relevant cost reports to management. %. *redatory pricing, the lowering of prices to where the effect may be to substantially damage the competition in an industry is unlawful under the provisions of the Robinson *atman 3ct. 11– (o! does the presence of one production constraint constraint affect the relevant cost anal"sis model? /!o or more production constraints? 11-
4hen there is only one production constraint and ecess demand it is generally best to produce only one of products to maimiAe income, and that is the product with the highest contribution margin per unit of scarce resource. 4hen the production process requires two or more production activities, the choice of sales mi involves a more comple analysis, and in contrast to the case of one production constraint, the solution can include both products. The determination of best product mi in this case involves mathematical programming techniques, which are employed using either a graphical analysis or a computerbased solution technique.
11–10 What is the relationship if an" #et!een the relevant cost anal"sis method and costvolume-profit volume-profit anal"sis hapter ? 11-10 Relevant cost analysis and costvolumeprofit ;9*- analysis ;hapter B- are similar in that they both rely on the distinction of variable versus fied costs and they both use the contribution margin price less unit variable cost- as the focal point of the analysis. >oth ;9* analysis and relevant cost analysis focus on the relationship of profit to volume, and therefore on the unit contribution margin for the product or service.
3rief 4xercises 11-11 through 11-20 11-11 5ales price is 6$' for a part that can #e manufactured for 6$$7 the 6$$ manuf manufac actur turing ing cost costs s inclu includes des 6' per per unit unit fix fixed ed cos cost. t. What What is is the savi savings ngs to ma&e rather than to #u"? 11-11
C#' C## C'- E C+
11-12 8dams 9urniture receives a special order for 10 sofas for a special price of 6$000. /he materials and direct la#or for each sofa amount to 6100. :n addition the setup supervision and other overhead costs amount to 61'0 per sofa. 5hould 8dams accept the special order? Wh" or !h" not? Would it ma&e a difference to "our ans!er if 8dams is at full capacit" and its current line of sofas sell for 6'00 each. 11-12 The contribution on the order is C#,FFF 1F C1FF E C!,FFF, or C!FF per sofa? Therefore, 3dams should accept the order. /f 3dams is at full capacity, capacity, then the opportunity cost for lost sales is C'FF C1FF E C%FF per sofa? the opportunity cost is higher than the contribution on the special order, C!FF? so now the special order should not be accepted. 11-1$
Wings ;iner ;iner has a #ox lunch that that it sells sells on foot#all foot#all games games da"s da"s at the the local universit". 4ach #ox lunch sells for 6*.00 !hich is made up of 62.'0 of varia#le costs and pac&aging and 62.'0 of fixed cost plus a 61 mar&up. What is the lo!est price Wings can sell its #ox lunch so that Wings !ill still ma&e a profit?
11-1$ 8owest price E variable i.e., the incremental- cost of C!.'F 11-1% Williams 8uto has a machine that installs tires. /he machine no! is in need of repair. /he machine originall" cost 610000 and the repair !ill cost 61000 #ut the machine !ill then last 2 "ears. /he varia#le la#or cost of operating the machine is 60.'0 per tire. :nstead of repairing the old machine Williams could #u" a ne! machine at a cost of 6'000 that !ould also last 2 "ears7 the la#or price per tire !ould #e reduce to 60.2' per tire. 5hould Williams repair or replace the machine if it is installing 10000 tires in the next 2 "ears?
11-1% Relevant ;osts: Repair: 9ariable ;osts: 8abo r E CF. 'F 'F G 1F 1F ,F ,F FF FF E 2ied ;osts: Repair ;ost E Total ;osts: Replace: 9ariable ;osts: 8abor E CF.!' G 1F,FFF E 2ied ;osts: ew "achine E Total ;osts E
C ', ',FFF C1,FFF C),FFF
C!,'FF C',FFF C+,'FF
Relevant ;ost Difference E C+,'FF C),FFF E C1,'FF more to replace than repair 11-1'
E C1FF,FFF E CBF,FFF E C1F C1F,F ,FFF FF--
Hamison should keep the division.
11-1* 4lecPlus 3atteries has t!o different products 888 and 88 #atteries. /he 88 #atteries have a contri#ution margin of 61 per pac&age and the 888 #atteries have a contri#ution margin of 62 per pac&age. 4lecPlus has a capacit" for 1000000 #atteries per month and #oth #atteries require the same amount of processing time. :f a special order for 10000 888 exceeds the monthl" capacit" should 4lecPlus accept the special order? 11-1* The 333 batteries have a higher contribution per unit and since both the 333 and 33 batteries batteries require the the same processing processing time, 6lec*lus should accept the the special order, and reduce the productionIsales of 33 batteries, if needed. 11-1+
;ost with machine: C!FF,FFF J C' G 1F,FFF- E C!'F,FFF ;ost without machine: C!F G 1F,FFF E C!FF,FFF Hackson would recover the cost in 1 and 1I# years C!FF,FFF J C' E C!F \ E 1#,### loads or 1#,### K 1F,FFF E 1.## years =ote> there are also ethical and sustainability issues that arise in this question.
11-1, ;urant o. manufactures glass #ottles for dair" products. /he contri#ution margin is 60.10 per #ottle. ;urant ust received notification that one of their orders for 100000 #ottles contained misprinted la#els and !ere required to recall and reprint the la#els. :f it !ill cost 60.0' per #ottle to reprint the la#els and 61000 to re-ship the #ottles !hat !ill the net contri#ution margin #e after the recall? 11-1,
Total ;ontribution "argin: CF.1F G 1FF,FFF- F.F' G 1FF,FFF- C1,FFF E C%,FFF
11-1 ance)s ;iner has a hot lunch special each !ee&da" and 5unda" afternoon. /he cost of food and other varia#le costs for the lunch is 6$.'0 and the dail" fixed costs are 61000. ance has an average of '00 customers per da". What is the lo!est price ance should charge for a special group of 200 that !ants to come on 5aturda" for a famil" reunion? What should #e the lo!est price ance charges on a normal !ee&l" #asis? 11-1 The specialorder price should cover variable costs, so it should be greater than C#.'F per meal or C#.'F G !FF E C+FF. The regular weekly lunch should cover fied and variable costs: C#.'F J C1,FFF K 'FF- E C'.'F per meal. 11-20 5!eet ;ream (otel has la#or costs that are mostl" fixed including registration des& maintenance and general repairs and cleaning. /he house&eeping staff is hired in sufficient num#ers so that it is sufficient to clean the num#er of rooms that need cleaning so that house&eeping is a varia#le cost for the num#er of occupied rooms. Which of these costs is relevant for determining the price of a room? 11-20 /n the longer term, all of these costs are relevant, but in the short term the only costs that are relevant are the variable costs, in this case housekeeping. /f a room goes unoccupied, the only cost that is saved is that of housekeeping.
3rief 4xercises 11-11 through 11-20 11-11 5ales price is 6$' for a part that can #e manufactured for 6$$7 the 6$$ manuf manufac actur turing ing cost costs s inclu includes des 6' per per unit unit fix fixed ed cos cost. t. What What is is the savi savings ngs to ma&e rather than to #u"? 11-11
C#' C## C'- E C+
11-12 8dams 9urniture receives a special order for 10 sofas for a special price of 6$000. /he materials and direct la#or for each sofa amount to 6100. :n addition the setup supervision and other overhead costs amount to 61'0 per sofa. 5hould 8dams accept the special order? Wh" or !h" not? Would it ma&e a difference to "our ans!er if 8dams is at full capacit" and its current line of sofas sell for 6'00 each. 11-12 The contribution on the order is C#,FFF 1F C1FF E C!,FFF, or C!FF per sofa? Therefore, 3dams should accept the order. /f 3dams is at full capacity, capacity, then the opportunity cost for lost sales is C'FF C1FF E C%FF per sofa? the opportunity cost is higher than the contribution on the special order, C!FF? so now the special order should not be accepted. 11-1$
Wings ;iner ;iner has a #ox lunch that that it sells sells on foot#all foot#all games games da"s da"s at the the local universit". 4ach #ox lunch sells for 6*.00 !hich is made up of 62.'0 of varia#le costs and pac&aging and 62.'0 of fixed cost plus a 61 mar&up. What is the lo!est price Wings can sell its #ox lunch so that Wings !ill still ma&e a profit?
11-1$ 8owest price E variable i.e., the incremental- cost of C!.'F 11-1% Williams 8uto has a machine that installs tires. /he machine no! is in need of repair. /he machine originall" cost 610000 and the repair !ill cost 61000 #ut the machine !ill then last 2 "ears. /he varia#le la#or cost of operating the machine is 60.'0 per tire. :nstead of repairing the old machine Williams could #u" a ne! machine at a cost of 6'000 that !ould also last 2 "ears7 the la#or price per tire !ould #e reduce to 60.2' per tire. 5hould Williams repair or replace the machine if it is installing 10000 tires in the next 2 "ears?
11-1% Relevant ;osts: Repair: 9ariable ;osts: 8abo r E CF. 'F 'F G 1F 1F ,F ,F FF FF E 2ied ;osts: Repair ;ost E Total ;osts: Replace: 9ariable ;osts: 8abor E CF.!' G 1F,FFF E 2ied ;osts: ew "achine E Total ;osts E
C ', ',FFF C1,FFF C),FFF
C!,'FF C',FFF C+,'FF
Relevant ;ost Difference E C+,'FF C),FFF E C1,'FF more to replace than repair 11-1'
E C1FF,FFF E CBF,FFF E C1F C1F,F ,FFF FF--
Hamison should keep the division.
11-1* 4lecPlus 3atteries has t!o different products 888 and 88 #atteries. /he 88 #atteries have a contri#ution margin of 61 per pac&age and the 888 #atteries have a contri#ution margin of 62 per pac&age. 4lecPlus has a capacit" for 1000000 #atteries per month and #oth #atteries require the same amount of processing time. :f a special order for 10000 888 exceeds the monthl" capacit" should 4lecPlus accept the special order? 11-1* The 333 batteries have a higher contribution per unit and since both the 333 and 33 batteries batteries require the the same processing processing time, 6lec*lus should accept the the special order, and reduce the productionIsales of 33 batteries, if needed. 11-1+
;ost with machine: C!FF,FFF J C' G 1F,FFF- E C!'F,FFF ;ost without machine: C!F G 1F,FFF E C!FF,FFF Hackson would recover the cost in 1 and 1I# years C!FF,FFF J C' E C!F \ E 1#,### loads or 1#,### K 1F,FFF E 1.## years =ote> there are also ethical and sustainability issues that arise in this question.
11-1, ;urant o. manufactures glass #ottles for dair" products. /he contri#ution margin is 60.10 per #ottle. ;urant ust received notification that one of their orders for 100000 #ottles contained misprinted la#els and !ere required to recall and reprint the la#els. :f it !ill cost 60.0' per #ottle to reprint the la#els and 61000 to re-ship the #ottles !hat !ill the net contri#ution margin #e after the recall? 11-1,
Total ;ontribution "argin: CF.1F G 1FF,FFF- F.F' G 1FF,FFF- C1,FFF E C%,FFF
11-1 ance)s ;iner has a hot lunch special each !ee&da" and 5unda" afternoon. /he cost of food and other varia#le costs for the lunch is 6$.'0 and the dail" fixed costs are 61000. ance has an average of '00 customers per da". What is the lo!est price ance should charge for a special group of 200 that !ants to come on 5aturda" for a famil" reunion? What should #e the lo!est price ance charges on a normal !ee&l" #asis? 11-1 The specialorder price should cover variable costs, so it should be greater than C#.'F per meal or C#.'F G !FF E C+FF. The regular weekly lunch should cover fied and variable costs: C#.'F J C1,FFF K 'FF- E C'.'F per meal. 11-20 5!eet ;ream (otel has la#or costs that are mostl" fixed including registration des& maintenance and general repairs and cleaning. /he house&eeping staff is hired in sufficient num#ers so that it is sufficient to clean the num#er of rooms that need cleaning so that house&eeping is a varia#le cost for the num#er of occupied rooms. Which of these costs is relevant for determining the price of a room? 11-20 /n the longer term, all of these costs are relevant, but in the short term the only costs that are relevant are the variable costs, in this case housekeeping. /f a room goes unoccupied, the only cost that is saved is that of housekeeping.
4xercise 11-21> 5pecial @rder7 @pportunit" ost
(4A> /s there sufficient capacity so that opportunity cost E AeroN ;urrent Total Total ;apacity in units- E ;urrent ;apacity Lsage in units- E 3vailable ;apacity in units- E =rant /ndustries, a manufacturer of electronic parts, has recently received an invitation to bid on a special order for !F,FFF units of one of its most popular products. =rant currently manufactures %F,FFF units of this product in its 8oveland, $hio, plant. The plant is operating at 'F percent capacity. There will be no marketing costs on the special order. The sales manager of =rant wants to set the bid at CB because she is sure that =rant will get the business at that price. $thers on the eecutive committee of the firm ob0ect, saying that =rant would lose money on the special order at that price.
$utput 8evels
"anufacturing costs: Direct materials Direct labor 2actory overhead Total manufacturing costs Lnit cost
%F,FFF
)F,FFF
C@F,FFF C1!F,FFF C!%F,FFF C%%F,FFF C11.FF
C1!F,FFF C1@F,FFF C#FF,FFF C)FF,FFF C1F.FF
&pecialorder volume units- E
!F,FFF
;urrent plant output units- E ;urrent op operating level M of capacity- E Recommended bid price, special order E ormal selling price per unit E 8ost sales *art %- E
%F,FFF 'F.FFM CB.FF C!F.FF ',FFF
Bequired 1. 4hy does the unit cost decline from C11 to C1F when production level rises from %F,FFF to )F,FFF unitsN !. /s the sales manager correctN 4hat do you think the bid price should beN #. 8ist some additional factors =rant should consider in deciding how much to bid on this special order.
5olution 1. Wh" does the unit cost decline from 611 to 610 !hen production level rises from %0000 to *0000 units? ;osts fall from C11 to C1F because of the fied overhead costs, which are the same in total- at each level of production, so that the perunit fied costs decrease as production level increases. 2. :s the sales manager correct? What do "ou thin& the #id price should #e? The relevant costs are: "aterials C!.FF C@F,FFF K %F,FFF8abor C#.FF C1!F,FFF K %F,FFF9ariable overhead C#.FF C#FF,FFFC!%F,FFF- K )F,FFF%F,FFFTotal 6,.00 per unit 6,.00 per unit 3lternatively, minimum bid price E C)FF,FFF C%%F,FFF- K !F,FFF units E
Thus, the bid price should be any price above this a mount. The selling price recommended by the sales 620000 manager would generate a contribution margin E
@F,FFF units %F,FFF units %0000 units 3re opportunity costs E AeroN
Ces--there is sufficient excess capacit" to accept the special order
$. ist some additional factors Drant shold consider in decising ho! much to #id on this special order. a- /s the order likely to lead to further regular business with this customerN b- /s the order in the strategic best interest of the firm, for eample, will it support or undermine =rant /ndustry5s desired image in the marketN c- 4hile =rant has enough capacity to complete the special order, will there be other costs in addition to the variable manufacturing costs in order to complete the order, that is, special tooling or setup costs, etc. 3lso, are there alternative uses of the capacity, which might produce an even greater contribution marginN %. /otal opportunit" cost if sales to regular customers of '000 units !ere lost #" accepting the special sales order?
8ost contribution margin, sales to regular customers: &elling price per unit E C!F.FF 9ariable cost per unit: Direct materials E C!.FF Direct labor E C#.FF ;ontribution margin per unit E C1'.FF 8ost sales in units- E ',FFF $pportunity cost E 6+'000
4xercise 11-22> 5pecial @rder7 @pportunit" osts 3lton, /nc. is working at full production capacity producing !F,FFF units of a unique product. "anufacturing costs per unit for the product are as follows:
Direct "aterials
CB.FF
Direct 8abor "anufacturing overhead Total manufacturing cost ;urrent capacity units- E ;urrent production volume units- E ;urrent production volume *art !- E 9ariable overhead cost per unit E Total fied overhead cost E 9ariable nonmanufacturing costs per unit E &elling price per unit E &pecialorder request units- E *ercent of nonmfg costs reimbursed by &O; E &pecial order selling price per unit E
[email protected] C1F.FF C!+.FF !F,FFF !F,FFF 1),FFF C%.FF C1!F,FFF [email protected] C%'.FF ',FFF 'F.FFM C#'.FF
Bequired *repare an 6cel spreadsheet to answer the following questions. 1. &hould 3lton produce the special order for &O;N 4hy or why notN !. &uppose that 3lton /nc. had been working at less than full capacity to produce 1),FFF units of the product when &O; made the offer. 4hat is the minimum price that 3lton should accept for the modified product under those conditionsN
5olution 1. 5hould 8lton produce the special order for 5(? Wh" or !h" not?
;urrent Revenue per unit 9ariable costs per unit: Direct materials Direct labor 9ariable factory overhead 9ariable nonmanufacturing costs Total variable costs per unit ;ontribution margin per unit
&pecial $rder C%'.FF
CB.FF [email protected] C%.FF [email protected]
;ontribution margin for ',FFF units
C#'.FF CB.FF [email protected] C%.FF C%.FF
C!B.FF C1).FF
C!'.FF C1F.FF
C@F,FFF
C'F,FFF
The difference in favor of contunuing with current production and turning down the special order is C#F,FFF C@F,FFF P C'F,FFF-. /hus the special sales order should #e turned do!n 3lternatively, the following relevant cost analysis can be used:
Revenue from the special sales order Q C#' per unit offering price- E 8ess: Relevant cost to fill the special sales order: $utofpocket costs CB J C@ J C% J C% E C!' per unit- E $pportunity costs: units of lost sales to regular customers- E cm per unit on regular sales C%'.FF P C!B.FF- E /mpact on operating income, accepting the special order E
C1+',FFF
C1!',FFF ',FFF C1).FF
C@F,FFF C#F,FFF-
2. 5uppose that 8lton :nc. had #een !or&ing at less than full capacit" to produce 1*000 units of t he product !hen 5( made the offer. What is the minimum price that 8lton should accept for the modified product under those conditions?
3t 1),FFF units of current output and !F,FFF units of capacity, 3lton does not have enough capacity to produce the entire order for &O;. >ut, the contribution margin on regular sales C1).FF per unit- eceeds the contribution margin on sales to &O; C1F.FF per unit-, so 3lton should try to reduce or delay 1,FFF units of the &O; order to get an order for %,FFF units. Then the special order could be accepted without a loss of regular sales. /f &O; insists on the full order of ',FFF units, then 3lton must figure the contribution margin on lost sales C 1).FF G 1,FFF units E C1),FFF-. This loss of contribution margin is less than the contribution margin on the special order C'F,FFF-, so the special order would still be accepted at the C#'.FF offering price. The minimum price would be C!@.!F per unit, the total variable cost per unit C!'.FF- plus the contribution margin of lost sales, allocated perunit to the special order C#.!F E C1),FFF K ',FFF units-. /n general, the minimum acceptable price E total relevant costs E outofpocket costs J opportunity costs, as shown below: @ut-of-Poc&et osts> Direct materials Direct labor 9ariable mfg overhead 9ariable nonmanufacturing costs @pportunit" ost> o. units of lost sales ;m per unitregular sales C%'.FF P CB P C@ P C% P C@Total opportunity cost o. units in special order "inimum acceptable price
CB.FF [email protected] C%.FF C%.FF
C!'.FF
1,FFF C1).FF C1),FFF ',FFF
C#.!F 62,.20
ote that instead of incurring the opportunity cost 3lton might try to reduce the order from &O; or to delay 1,FFF units of the &O; order. This way, the special order can be done without loss of regular sales. #. =oal &eek &olution Revenue from special sales order: units in special sales order E selling price per unit E Total cost from special sales order: o. of units in special order E Relevant cost to fill the order: $utofpocket costI unit E $pportunity cost: Total lost units E cmIunit, reg. sales E Revenue P relevant costs: &pecial $rder E
',FFF 62,.20
C1%1,FFF
',FFF C!'.FF 1,FFF C1).FF
C1!',FFF C1),FFF CF
4xercise 11-2$> 5pecial @rder7 Ese of @pportunit" ost :nformation &harman 3thletic =ear, /nc. &3=- is considering a special order for 1',FFF baseball caps with the logo of 6ast Teas Lniversity 6TL- to be purchased by the 6TL alumni association. The 6TL alumni association is planning to use the caps as gifts and to sell some of the caps at the alumni events in celebration of the university7s recent national championship by its baseball team. &harman7s cost per hat is C#.'F which includes C1.'F fied cost related to plant capacity and equipment. 6TL has made a firm offer of C#',FFF for the hats, and &harman, considering the price to be far below production costs, decides to decline the offer.
Bequired 1. Did &harman make the wrong decisionN 4hy or why notN !. ;onsider the management decisionmaking approach at &harman that resulted in this decision. Oow was opportunity cost included or not included in the decisionN 4hat decision biases are apparent in this decisionN
;ata &pecial order quantity E ;ost per unit E 3llocated fied costs E &pecial order offering price E
1',FFF C#.'F C1.'F C#',FFF
5olution 1' min 1. 3nalysis of special sales order: /ncremental ;ost per Lnit: 2ull cost per Lnit E 8ess: 3llocated fied cost E /ncremental ;ost per Lnit E Total /ncremental ;ost: /ncremental ;ost per Lnit E o. of Lnits in $rder E Total E $ffering price E
C#.'F C1.'F C!.FF C!.FF 1',FFF C#F,FFF C#',FFF
6ffect of special order on shortterm operating income E 6'000 Therefore, this is a missed opportunity for &harman, caused by a mistaken reliance on full cost, rather than relevent cost, data. !. Research studies have consistently found that decision makers often ignore opportunity costs. 2or this reason, it is particularly important that the development of decisionmaking skills place particular emphasis on identifying and incorporating opportunity costs. /nterestingly, a recent study found that decision makers with greater epertise in developing comparative income statements appeared to ignore fied costs more than those with less eperience.This was interpreted as resulting in part from the eperienced decision makers7 strong focus on computing and comparing net income. The problem is that the calculation of accounting net income does not include opportunity costs, thus, a focus on accounting net income could have caused the decision makers to ignore opportunity costs. $ther studies have shown that the decision maker7s cognitive style, the presence of unused capacity, or the relative amount of the opportunity cost can affect the use of opportunity cost information by the decision makers in eperimental studies. $verall, these results show that in practice, decision makers have a difficult time using opportunity cost information properly and consistently. Beferences> &andra ;. 9era"unoA, SThe 6ffects of 3ccounting (nowledge and ;ontet on the $mission of $pportunity ;osts in Resource 3llocation Decisions, The Accounting Review, Hanuary 1BB@, pp. %++!. &teve >uchheit, SReporting the ;ost of ;apacity, Accounting, Organizations and Society, 3ugust !FF#, p. '%B? Robert 6. Ooskin, S$pportunity ;ost and >ehavior, Journal of Accounting Research, &pring 1B@#, p. +@? Robert ;henhall, Deigan "orris, The 6ffect of ;ognitive &tyle and &ponsorship >ias on the Treatment of $pportunity ;osts in Resource 3llocation Decisions, Accounting, Organizations and Society 1), /ssue 1, pp. !+%).
4xercise 11-2%> 5pecial @rder 6arth >aby, /nc. 6>/- recently celebrated its tenth anniversary. The company produces organic baby products for health conscious parents. These products include food, clothing, and toys. 6arth >aby has recently introduced a new line of premium organic baby foods. 6tensive research and scientific testing indicate that babies raised on the new line of foods will have substantial health benefits. 6>/ is able to sell its products at prices higher than competitors7 because of its ecellent reputation for superior products. 6>/ distributes its products through highend grocery stores, pharmacies, and specialty retail baby stores. Hoan 3lvareA, the founder and ;6$ of 6>/ recently received a proposal from an old business school classmate, Robert >radley the vice president of =reat Deal, /nc. =D/-, a large discount retailer. "r. >radley proposes a 0oint venture between his company and 6>/, citing the growing demand for organic products and the superior distribution channels of his organiAation. Lnder this venture 6>/ would make some minor modifications to the manufacturing process of some of its bestselling baby foods and the foods would then be packaged and sold by =D/. Lnder the agreement 6>/ would receive C#.1F per 0ar of baby food and would provide =D/ a limited right to advertise the product as manufactured for =reat Deal by 6>/. Hoan 3lvareA set up a meeting with 2red &tanley, 6arth >aby7s ;2$, to discuss the profitability of the venture. "r. &tanley ran some initial calculations and determined that the direct materials, direct labor, and other variable costs needed for the =D/ order would be about C! per unit as compared to the full cost of C# materials, labor, and overhead- for the equivalent 6>/ product. Bequired
&hould 6arth >aby, /nc. accept the proposed venture from =D/N 4hy or why notN
5olution To begin the analysis, 2red &tanley, the 6arth >aby ;2$, should recogniAe that the C#.FF full cost for its product includes C1.FF of irrelevant fied overhead. $nly the variable costs of C!.FF per unit are relevant. 2rom this standpoint, =D/7s proposal makes sense, since there would be a contribution of C1.1F C#.1F price less C!.FF relevant cost- per unit sold. Oowever, the agreement with =D/ could be a potentially serious strategic liability for 6arth >aby. 6arth >aby7s reputation is built upon differentiation and product superiority, features which make it attractive to a small, but important segment of the baby products market. To sell its products through a discount retailer, even under another brand name, could harm the differentiated image of 6arth >aby7s product line, and cause it to lose market share in its usual distribution channels the highend grocery stores and specialty baby retail stores-. This is especially true given that =D/ has the limited right to market the product as Smanufactured by 6arth >aby. 2or this agreement to make sense, this Slimited right would have to be fairly strict. 6arth >aby could be trading a shortterm gain for a potential longterm competitive damage in this potential venture with =D/. /t should look for business partners that are more in line with its strategy and image.
4xercise 11-2'> Fa&e or 3u"7 ontinuation of Pro#lem -2' ;alista ;ompany manufactures electronic equipment. /n !F1!, it purchased the special switches used in each of its products from an outside supplier. The supplier charged ;alista C! per switch. ;alista7s ;6$ considered purchasing either machine U or machine < so the company can manufacture its own switches. The ;6$ decided at the beginning of !F1# to purchase "achine U. The pro0ected data for !F1# are: "achine U 3nnual fied cost 9ariable cost per switch &upplier charge per switch E
"achine <
C1#',FFF
C!F%,FFF
CF.)'
CF.#F
C!.FF
Bequired 1. 2or machine U, what is the indifference point between purchasing the machine and purchasing from the outside vendorN !. 3t what volume level should ;alista consider purchasing "achine
5olution
1. 2or machine U, what is the indifference point between purchasing the machine and purchasing from the outside vendorN 9rom -2'> Relevant outside purchase price per unit: 3nnual 2ied cost component E 9ariable component per unit- E ;ost to "ake insourcing-: 3nnual 2ied ;ost ;omponent E 9ariable component per unit- E >reakeven volume point of indifference- E V2; K
CF C!.FF C1#',FFF CF.)' V variable cost per unit E
1FF,FFF units
Thus, if anticipated volume W 1FF,FFF units per year, then purchasing "achine U made sense. 4x. -2'> This situation is different: the cost of "achine U is now a sunk cost? thus, the unit cost of CF.)' is always preferred to the outside price of C!.FF per unit, irrespective of anticipated volume even for very low volume levels-. 2. 8t !hat volume level should alista consider purchasing Fachine C?
ote that, as eplained above in 1, the C1#',FFF purchase cost of "achine U is irrelevant i.e., it is a sunk cost-. >reakeven volume level indifference point between using "achine U and purchasing "achine <-: Relevant ;ost of Lsing "achine U: 3nnual 2ied ;ost CF 9ariable ;ost per unit CF.)' Relevant ;ost of Lsing "achine <: 3nnual 2ied ;ost C!F%,FFF 9ariable ;ost per unit CF.#F >reakeven volume point of indifference- E V2; K V variable cost per unit E ',2,'+ units
ote that the indifference point is much higher than it was in B!' 1B+,1%# units per year- because of the fact that the purchase cost of "achine U is now a sunk cost and the cost of purchasing "achine < is significant. $. Esing Doal 5ee& to 5olve for the 8nnual :ndifference Golume
3nnual 9olume units- E 3nnual ;ost of Lsing "achine U: 2ied cost component per year9ariable cost component total 3nnual ;ost of Lsing "achine <: 2ied cost component per year9ariable cost component totalDifference in 3nnual Total ;ost
F
CF C!F%,FFF CF C!F%,FFF-
4xercise 11-2*> 5ell-or-Process 9urther7 Product Fix 3ac&ground ;antel ;ompany produces cleaning compounds for both commercial and household customers. &ome of these products are produced as part of a 0oint manufacturing process. 2or eample, =R#+, a coarse cleaning powder meant for commercial sale, costs C1.)F a pound to make, and sells for C!.FF per pound. 3 portion of the annual production of =R#+ is retained for further processing in a separate department where it is combined with several other ingredients to form a &il*ol, which is sold as a silver polish, at C %.FF per unit. The additional processing requires X pound of =R#+ per unit? additional processing costs amount to C!.'F per unit of &il*ol produced. 9ariable selling costs for this product average CF.#F per unit. /f production of the &il*ol were discontinued, C',)FF of costs in the processing department would be avoided. ;antel has, at this point, unlimited demand for, but limited capacity to produce, product =R#+.
;ata =R#+:
&elling price per pound E ;ost to make per pound- E &il*ol &ilver *olish-: &elling price per unit E 3ddional processing costIunit E 3mount of =R#+ needed per unit E 9ariable selling costsIunit E 3voidable fied costs E ;urrent ma. output =R#+- *art !- E
C!.FF C1.)F
C%.FF C!.'F F.!' lb. CF.#F C',)FF ',FFF lbs.
Bequired
1. ;alculate the minimum number of units of &il*ol that would have to be sold in order to 0ustify further processing of =R#+. !. 3ssume that the cost data reported for =R#+ is obtained at a level of output equal to ',FFF pounds., which is the maimum that the company can produce at this time. *repare an income statement under each of the following scenarios: a- all available capacity is used to produce =R#+, but no &il*ol? b- %,FFF units of &il*ol are produced, with the balance of capacity devoted to the productionIsale of =R#+? Y @,FFF units of &il*ol are produced, with the balance of capacity devoted to the sale of =R#+? and d- 1F,FFF units of &il*ol are produced, with the balance of capacity devoted to the sale of =R#+. 5olution
1. The key is to identfiy the relevant costs and revenues associated with any =R#+ diverted for production of &il*ol: :ncremental 9ixed osts 5ilPol H C',)FF :ncremental ontri#ution FarginIEnit 5old> &elling price per unit E C%.FF 8ess: Relevant ;osts: $pportunity cost: lost revenue from =R#+: C!.FF =R#+ selling priceIlb. E ;oversion rate E F.!' CF.'F $utof*ocket ;osts: C!.'F 3dditional processingIunit E CF.#F 9ariable selling costIunit E C!.@F ;ontribution "arginIunit of &ilver *olish &old E CF.+F Thus, to 0ustify diversion of =R#+ to produce &il*ol thereby incurring additional fied costs of C',)FF-, ,000 units of &il*ol we would have to sell at least C',)FF K CF.+F per unit E 2. omparative :ncome 5tatement--;ifferent Product Fixes
&ales: =R#+: *ounds &elling price per pound Revenue from =R#+ &il*ol: Lnits &elling price per unit Revenue from &ale of &il*ol Total &ales Revenue ;osts: =R#+ ',FFF lbs. G C1.)FIlb./ncremental ;osts&il*ol: 3voidable 2ied ;osts 9ariable costs: *rocessing costs Q C!.'FIunit&elling costs Q CF.#FIunitTotal ;osts $perating /ncome Total Revenue P Total ;osts-
Lnits of &il*ol *roducedI&old F
%,FFF
',FFF C!.FF C1F,FFF
@,FFF
1F,FFF
%,FFF C!.FF C@,FFF
#,FFF C!.FF C),FFF
!,'FF C!.FF C',FFF
F %,FFF C%.FF C%.FF CF.FF C1),FFF C1F,FFF C!%,FFF
@,FFF C%.FF C#!,FFF C#@,FFF
1F,FFF C%.FF C%F,FFF C%',FFF
C@,FFF
C@,FFF
C@,FFF
C@,FFF
F
C',)FF
C',)FF
C',)FF
CF.FF C1F,FFF CF.FF C1,!FF C@,FFF C!%,@FF C!,FFF C@FF-
C!F,FFF C!,%FF C#),FFF C!,FFF
C!',FFF C#,FFF C%1,)FF C#,%FF
ote that at volume levels below @,FFF units, it is not worthwhile to incur the additional fied processing costs of C',)FF. The breakeven volume, as indicated by the answer to 1 above, is @,FFF units of &il*ol.
4xercise 11-2+> Product Profita#ilit" 8nal"sis 3ac&ground >arbour ;orporation, located in >uffalo, ew arbour allocates fied costs to products on the basis of sales revenue. 4hen the president of >arbour saw the income statement, he agreed that T! should be dropped. /f this is done, sales of T1 are epected to increase by 1F percent net year? the firm7s cost structure will remain the same. ;ata T1
T!
&ales
C!FF,FFF
C!)F,FFF
9ariable cost of goods sold ;ontribution margin 6penses 2ied corporate costs 9ariable selling and administration 2ied selling and administration Total epenses $perating income
C+F,FFF C1#F,FFF
C1#F,FFF C1#F,FFF
C)F,FFF C!F,FFF C1!,FFF CB!,FFF C1@%,FFF
C+',FFF C'F,FFF C!1,FFF C1%),FFF C1),FFF-
*ro0ected increase in sales of T1 of T! is dropped E *art #: Reduction in total fied costs E
10.00J C%',FFF
Bequired 1. 2ind the epected change in annual net income by dropping T! and selling only T1. !. >y what percentage would sales from T1 have to increase in order to make up the financial loss from dropping T!N #. 4hat is the required M increase in sales from T1 to compensate for lost margin from T! if total fied costs can be reduced by C%',FFFN %. 4hat strategic factors should be consideredN
5olution 1. ;hange in annual income: *roduct T1: 8ast year5s contribution margin E C!FF,FFF P C+F,FFF P C!F,FFF E ;ontribution margin ratio M- E *roduct T!: 8ast year5s contribution margin E C!)F,FFF P C1#F,FFF P C'F,FFF E ;ontribution margin ratio M- E /ncremental ;" from T1 if T! is dropped E C11F,FFF G F.1F E
C11F,FFF F.'' C@F,FFF F.#1 C11,FFF
The net effect of discontinuing T! is the incremental ;" for T1 reduced by the ;" lost from T!: E C11,FFF P C@F,FFF E !. Required M increase in sales for T1, to compensate for the loss of T!: 8oss of ;", T!
6*000
E =ain in ;", T1
C@F,FFF E UM G C11F,FFF UE +2.+$J hec&> 8ast year5s total ;" E *ro0ected 1.+!+#M G C11F,FFF- E
C1BF,FFF C1BF,FFF
#. Required M increase in sales for T1 to compensate for the loss of T! accompanied by a decrease in total fied costs by C%',FFFN 8oss of ;", T! C@F,FFF P C%',FFF U E C#',FFF K C11F,FFF E hec&> 8ast year5s total operating income E *ro0ected E
E =ain in ;", T1 E UM G C11F,FFF $1.,2J C1)@,FFF C1)@,FFFC1@%,FFF P C1),FFF- J #1.@!M G C11F,FFFP C@F,FFF J C%',FFF
%. The following strategic factors should be considered: a- what will be the effect on the firm5s image if T! is droppedN b- will this result in an unfavorable reaction from key customers of T1 and of other product linesN c- can the production capacity released by T! be used for new productsN
4xercise 11-2,> Product-Fix 8nal"sis 3ac&ground &andalwood ;ompany produces various lines of highend carpeting in its 3shville, ; plant. This question pertains to two different grades of carpet in its &ymphony line: commercial and residential. The former sells for C1) per square yard, while the latter sells for C!' per square yard wholesale-. 9ariable costs are C1F per square yard and C1' per square yard for the commercial and residential grade products, respectively. $n average, it takes 1! labor hours to produce 1FF square yards of commercial carpeting, and 1@ labor hours for each 1FF square yards of residential carpeting. The number of available labor hours at the plant is limited to %,)FF hours per week. ;urrent sales forecasts indicate that weekly sales for the commercial line and the residential line, respectively, are #F,FFF square yards and @,FFF square yards. 2ied manufacturing costs, allocated to products on the basis of %,)FF total labor hours per week, amount to C1.'F and C!.!' for each square yard of commercial versus residential carpet, respectively.
*roduct
;ata
&elling price per square yard 9ariable costs per square yard 3llocated fied mfg. costs per square yard 8abor hours per 1FF square yards 4eekly sales forecasts square yards4eekly labor hour constraint total%,)FF
;ommercial Residential C1).FF C!'.FF C1F.FF C1'.FF C1.'F C!.!' 1! 1@ #F,FFF @,FFF
Bequirements 1. 4hat is the gross profit margin- for each of the two products, in total and per square yard N !. 4hat is the contribution margin for each of the two products, in total and per square yardN #. =iven the labor constraint and the product demand constraints, what is the optimum product mi, on a weekly basis, for each of the two productsN &how calculations.%. /n general, what is the rule to be followed when attempting to determine the optimum short term product or service- miN '. 4hat is the primary role of the management accountant in terms of addressing the short term product or service- mi problemN
5olutions 1. Dross profit calculations #" product and per square "ard Product
&ales Q C1), C!'8ess: ;=&: 9ariable Q C1F, C1'2ied QC1.'F, C!.!'=ross profit margin-
ommercial Besidential C%@F,FFF C!FF,FFF C#FF,FFF C%',FFF C1#',FFF
C1!F,FFF C1@,FFF C)!,FFF
6%.'0
6+.+'
=ross profit per square yard
ote that the above profitability measures are not pertinent to the shortterm productmi decision because they include an allocated portion of fied costs which, in this eample, are not relevant they are ZsunkZ i.e., in total, they are independent of product mi-. 2. ontri#ution margin #" product and per square "ard
&ales Q C1), C!'8ess: 9ariable costs Q C1F, C1';ontribution margin ;ontribution margin per square yard
Product ommercial Besidential C%@F,FFF C!FF,FFF C#FF,FFF C1!F,FFF C1@F,FFF C@F,FFF 6*.00
610.00
ote that the above profitability measures are not relevantIuseful for determining the optimum shortterm product mi because they do not relate to the relevant demands of the two products in terms of the scare resource labor hours-. $. @ptimum product mix given la#or-hour constraint and demand constraints
;ontribution margin per square yard 8abor hours per square yard ;ontribution margin per labor hour
Product ommercial Besidential C).FF C1F.FF F.1! F.1@ C'F.FF C''.')
@ptimum Fix> Residential =rade ;arpet: Total demand E @,FFF sq yds. G F.1@ hr.Isq. yd. E ;ommercial =rade ;arpet balance of production-:
Oours &q.
%,)FF hours P 1,%%F hours E #,1)F hours K F.1! hourIsq. yd E %,)FF@A
%. onceptual esson
=ote the #uiltin chec&
conditional :9 statement.
The primary conceptual lesson is that neither of the profit measures reported in 1 or ! are useful for determining the shortterm optimum product mi in the presence of resource constraints labor hours in the present eample-. 2or this purpose it is necessary to allocate available labor hours on the basis of the contribution margins epressed on a perlaborhour basis. /n the present case, the residentialgrade carpet is the more profitable of the two product lines when measured on this basis. Thus, labor hours should be devoted to the production of this product up to whatever is needed to meet weekly demand. 3ny remaining labor hours should be used to produce commercial carpet. 2inally, note that in this case the contribution margin per labor hour figures are much closer than either of the alternative profitability measures. >asing production decisions solely on these alternative profitability figures could lead to a suboptimal deployment of available capacity. '. Primar" Bole of the Fanagement 8ccountant The primary role of the management accountant in this contet is to develop accurate estimates of the contribution margins for each each product and to work with engineers to determine labor hour consumption of each product. Together, these inputs allow us to provide an optimum short term product mi.
4xercise 11-2> 5olar Panels--ease vs. 3u"? 3ac&ground 3s indicated in the Real4orld 2ocus R42- item on page UUU, consumers including businesses and local governments- interested in using solar power generally have an option to purchase or to lease the solar panels. To adequately address the questions below, you will have to first do some research on the web. *lease remember to document the website or other source- from which you obtained information related to this eercise .
Bequirements 1. /n general, what are the relevant costs associated with the lease decision and the purchase decision as regards the acquisition of solar panelsN !. 4hat are the primary nonfinancial considerations associated with this particular leasevs.purchase decisionN 3ddress this question from the standpoint of individual consumers, businesses, and society at large i.e., the environment-.
5olutions 1. Relevant ;osts8easing vs. *urchasing: &olar
*anels a. Purchase 1- original cost, including installation !- annual maintenance contractN #- annual maintenance epenseN %- future repair epenseN '- financial incentives: i. 2ederal income ta credits see: http:IIwww.energysavers.govIfinancialI+FF1F.html ii. &tate and local financial incentives see: http:IIwww.dsireusa.orgI iii. 2inancing incentivesIsubsidies iv. Ltility rebates v. loan guarantee programs in short, there is an almost bewildering array of financialincentive programs available at both the government [federal and state\ level and at the level of the local utility provider#. ease> 1- 8ease terms: i. fied payment plan per month ii. 9ariablecost payment plan also known as Z*ower *urchase 3greementsZ or **3s-generally, these are slightly below current charges per kilowatt hour by the local utility iii. "iedcost agreements: monthly fied charge plus variable charge based on usage iv. 6cess electricity generated during the dayin some cases, consumers receive a credit, which is used to offset nighttime electic consumption
!- ;ancellation feeIpenalty if lease is terminated before its epiration date#- *rice escalation: i. what is the annual increase in the contractual rate paidN ii. /s there a limit, during the term of the lease, to the monthly chargeN %- 8ength of the leaseN =ote> in a leasing arrangement, the lessor third party- receives any financial incentives rebates, ta credits, etc.- associated with the installation
!. $ther considerations: a. /ndividual i. Riskby leasing, the basic risk is that the cost of purchasing- solar panels would fall in the future andIor the level of government subsidy for such would increase significantly which effectively reduces the cost-: with the lease, the lessee is locked in to the agreement until the epiration of the lease ii. Lnder a lease, capital is not tied up iii. The availability of solar power may increase the value of the home andIor make the home more marketable? note that this applies to the ZpurchaseZoption only iv. 3re ma0or appliances in the home already Zenergy starZ rated i.e., energy efficient-N /n many cases upgrading appliances would be a worthwhile first step prior to installing solar energy panes v. &olar energy could conceivably be used in the future to charge electic cars. b. >uisnesses 1. use of solargenerated power may make businesses more competitive due to decreased operating costs!. a leasing contract would allow the buinessIorganiAation to more accurately predict electric energy costs because the costs are specfied in the lease itself#. under a leasing arrangement, capital that could be used elsewhere in the organiAation- is not tied up %. use of solar i.e., renewable- energy could help the business comply with =reenhouse =as 6missions ==6- legislation, both current and future under Zcap and tradeZ rules, for eample, a business could trade its credits based on the amount of solar energy the business generated during the perio '. /mageare the customers more likel to buy from a business that is viewed as more Zenvironmentally responsibleZN c. &ociety: i. ;leaner airIlower levels of pollutantsIreduction in level of =reenhouse =as 6missions ==6ii. Decreased reliance on foreign sources of energyIenergy independence iii. "ore diverse Zenergy portfolioZ decreased risk-
4x. 11-$0> Belevant ost 4xercises $T6 TO6 L&6 $2 Z;$D/T/$38 /2Z &T3T6"6T& TOR$L=O$LTPart a> Fa&e-or-3u" ;ecision
;ata :nput 5u#contractor 3id> Part @P, umber of units &ubcontractor bid price 9ull production cost i nformation>
!,FFF givenC1!F,FFF given
1ostIEnit
Direct materials Direct labor
[email protected] [email protected] given-
9ariableoverhead
C1).FF given-
4hat does thismeanN
Allocatedfied overhead
C%.FF given6**.00
5olution
Belevant ost to Fanufacture i.e. to Kma&eK> Direct materials Direct labor 9ariable overhead
[email protected] perunit [email protected] perunit C1).FF perunit
Total relevant costIunit
6*2.00 per unit 6*0.00 per unit
Belevant cost to #u"
Ae" question> is the fixed overhead
ð
avoidable ? Qualitative onsiderations>
a. Oow does the quality of productcompare, insourcing vs. outsourcingN b.Reliability i. e., ontime delivery performance-N c. 2inancial condition of the supplierN 4ith the supplier be in businessNd.
3re there alternativei.e., better- uses of theavailable capacityN
e.
4ill outsourcing allow Sinformation leakage regarding your product a negative if eventually in the hands of your competitors-N
f.
4ill outsourcing cause an increasein unemploymentN 3ttendant costs: increased payroll taes? negative goodwill.
Part #> ;isposal of 8ssets
4hat does the term Z:>9ZmeanN
;ata :nput /nventory of discontinued units
!,FFF given-
et b ook v al ue >9 - o fi nve nt or y 3dditional i.e., incremental - cost to remachine parts 6stimated sales value of remachined parts ;urrent disposal value of parts Zas isZ-
C' F, FF F gi ve nC!',FFFgivenC#F,FFFgivenC!,'FFgiven-
5olution
ote the use ofaconditional/2 statement
:ncremental Revenues from 9urther Processing> 6stimated sales value of remachined p arts ;urrent disposal value of parts
C#F,FFF C!,'FF C!+,'FF
/ncrementalrevenuefrom remachining :ncrementalCostsremachining
C!',FFF
;ifference
infavor of remachining
62'00
ote the use of the 3>& value
What qualitativeIstrategic factors might affect the decision?
function.
1.3ny other better- use of the capacity that will be devoted to this taskN !.*erception in the market]will consumers matter that remachined parts make their way into the marketN #.ReliabilityIquality of the remachined parts in the minds of the consumer-N Part c> 8sset Beplacement
CBF,FFF givenCB,FFF givenCB!,FFF givenC+',FFF given-
;ata :nput
$riginal cost of asset boat;urrent disposal (salvage value of boat ;ost of new boat Refurbishing cost old boat-
ote the use ofaconditional/2 statement
CB!,FFF CB,FFF C@#,FFF C+',FFF
5olution
6,000 in favorofrefurbishing
et cost of new boat: =ross cost of new boat 8ess: ;urrent salvage value of old boat !et cost of new boat Refurbishing costold boat Difference
CB!,FFF C+',FFF CB,FFF
C@%,FFF 6,000
3lternative presentation format: ;ostto buy a replacement boat E
Total cost of refurbishing: $utofpocket cost E *lus: $pportunity cost E Difference Qualitativeonsiderations> 1.*ersonal preference ultility function- for new vs. refurbished assetN !.&afetyIreliability of refurbished boat vs. new boatN @ther quantiative onsiderations> 1.Disposal value of each option, at end of useful lifeN !./ncome ta consequences e.g., casualty loss writeoff-, if anyN Part d> 5ell or Process 9urther? pleasesee diagrambelow-
;ata :nput
Hoint production costs E 62%0000
:tem
8
Lnits produced
&ales values L split-off point Relative sales values L split-off point 3llocation of 0oint costs L lt im at e s al es v al ue s gi ve n& ep ar ab le p r oc es si ng c os t s g iv en -
1!,FFF C!%F,FFF )FM C 1% %, FF F C !@ F, FF F 6 2, 00 0
3
@,FFF C1FF,FFF !'M C )F ,F FF C1!F,FFF 6 20 0 00
%,FFF C)F,FFF 1'M C #) ,F FF C+F,FFF 6 12 0 00
/otal
!%,FFF C%FF,FFF 1FFM 62%0000 C%+F,FFF 6* 0 00 0
&eparable 2inal &ales Hoint
;osts 3
;osts
9alue 3
&eparable 2inal&ales
;ost s>
&plit of f
*oint
9a lue >
2inal &ales
&epara bl e
;osts;
9alue;
5olution
1.Definitions: a. "oint production process: process in which more than output emerges from a common resource input
e.g., barrel of crude oil# . " o in t c o s t s$ in a 0oint production process, these are costs incurred before the splitoff point? that is,
these costs are 0oint or common to the outputs? since these costs are nontraceable, they must be allocated to outputs c.
separa #leprocessingcosts : in a 0oint production process these are the costs incurred after the splitoff
d.
split%o ff point : point in a 0 oint production process where products with individual identities emerge? cost incurred prior to the splitoff point are called "oint costs, while those incurred after the splitoff point are called separa#le processing costs
point? as such, these costs are traceable to individual products and incremental to the decision to process products beyond the split off point
!.4hich products, if any, should be processed further and then soldN :ncremental Bevenue>Lltimate sales values given-&alesvalueQsplitoffgiven-
&ncremental revenue
:ncremental ost given:ncrem. Bevenue -:ncrem. ost
8 3 C!@F,FFF C1!F,F FF
C+F,FFF
C!%F,FFF C1FF,F FF C % FF , F F C ! FF , FF C ! @, F FF C ! F, F FF 6 12 0 00 60
C)F,FFF C1F,FFF C 1 !, F FF 62000
Deaton ;orp. is indifferent about the further processing for >since the net benefit isAero. There would be a positive benefit for further processing of 3C1!,FFFand a loss from further processing of ; C!,FFF-. ote that the 0oint production costs of C!%F,FFF are sunk with respect to the decision whether individual products should be sold at the splitoff point or processed further and then sold. #.2or financial reporting and ta purposes, accountants need to value inventory on a Zfull costZ basis. Thus, in the present case for incomestatement preparation purposes and for purposes of preparing an endof period balance sheet, a portion of the 0oint production cost of C!%F,FFF must be assinged to each unit sold during the period and each unit on hand at the end of the period. There are alternative ways to allocate 0oint production costs to outputs. Regardless of how these costs are handled for f inancial reporting and ta purposes, they are i rrelevant to the sellorprocess further decision. Parte> Fa&e-or-3 u" sourcin g decision ;ata :nput 9olume of parts units- required *urchase priceIunit from outisde supplier M of fied overhead that is unavoida#le 'ull "anufacturing ;ost per Lnit *roduced:
!F,FFFperyear 60.00 %FM
Direct materials Direct labor 9ariableoverhead 2ied overhead Total
C#'.FF C1).FF C!%.FF C!F.FF
NN
6'.00 5olution
Belevant ost to KFa&eK H K8voida#le Ffg. ostsK> Direct materials Direct labor 9ariableoverhead
C#'.FF C1).FF
Avoida#l e fied overhead
otethe useof a
C!%.FF C1!.FF
8voida#le manufacturing costs
conditional
6,+.00
4xternalpurchasepriceIunit
/2 statement
60.00
;ifference 6$.00 in favor of producing internally What qualitative factors might affect the decision here? a. 3re there alternative better- uses for the available capacityN b. uality of the supplier5s product: how does it compare to the quality of internal productionN c. Reliabilityontime delivery performance of the supplierN d.2uture price trends: is the supplier price likely to be lower or greater- in the long runN e.$utsourcing may allow information about the design of the product to leak out t o competitors. f.6mploymentrelated considerations: if we outsource, what happens to our labor force and costs such as unemployment insurance, goodwill, etc.N Partf> 5election of FostProfita#le Product ;ata :nput Product 5ales price per unit
9lash
osts> Direct materials Direct labor C!'Ihr.9ari abl eoverhead based on D8Os2ied overhead based on D8Os"arketing costs all fixed Total cost per unit
lash
C!'F
C1%F
C'F C1FF C'F C!F
C!' C'F C!' C1F C1F
C1F C!#F
@perating profit per unit
C1!F
C !F
D ir ec t l ab or co st Ih r. g vi en - E Direct labor hoursIunit given-
C! F
C !' .F F !.F
1.F
5olution
1.The comment Z2lash and ;lash are processed through the same production departmentsZ can be taken to mean that capacityrelated i.e., fied manufacturing- costs in total are unrelated to shortterm fluctuations in product mi. 2or shortterm product planning, therefore, the total fied costs are not relevant. !.*roduct *reference: ProductMMM 9lash
&elling price per unit 9ariable costs per unit
lash
C!'F C!FF
;ontributionmargincm- perunit
D8Os the scarce resource- per unit ;ontribution margin per D8O
!.FF 6 2' .0 0
Thus, based on the above, we should
C'F
C1%F C1FF C%F
1.FF 6 %0 .0 0
produce as much ;83&Oas possible
otethe use of aconditional /2statement ;lashreturnsthehighestamountperD8O,the scareresource.Therefore,theoptimumshorttermproduct miwouldconsistof producing;lashupto eternaldemand.3nyremainingD8Oswouldthenbedevotedto
the production of 2lash. Part g> 5pecial-order pricing ;ata :nput uncheon:nformation> 3verage of patronsIday &elling price per lunch 6 st im at ed v ar ia bl e co st p er l un ch ;urrent capacity per day 2ied costs per day /our-3us:nformation> umber of patrons /ncremental fied costs $ffer price from the tour group
)FF C '. FF C!.FF +FF patrons C1,!FF 'F CF C#.'F per meal
5olution 5hould the o!ner accept the special #id-price from the tour groups?
"inimum selling price per unit E incremental costs
(variable + fxed + opportunity):
@ut-of-poc&et costs> 9ariable out%of%poc(etcosts permeal 2ied out%of%pocetcosts per meal
@pportunit" costs /ncrementalcosts >idpricefromtour group
C!.FF
CF CF
62.00 6$.'0
Thisisa general model forstructuringthe specialsales order decision.
What if the tour compan" !ere a#le to guarantee 200 patrons at l east once per month for 6$.00 per meal? umber of patrons per month
!FF 6$.00
&pecialorder price offered by tour company /ncremental costs per tourbus meal: 9a ri ab e l o ut o f po ck et c os ts p er m ea l 2i ed o ut of po ck et c ost sp er m ea l
given-
C !. FF C F. FF ote the use ofaconditional/2 statement
$pportunitycost permeal:
ost sales customers 8ost cm per customer Total lost ;" $p por tun ti yc ost p er t ou r bus me al /ncrementalcostspertourbusmeal
Therefore, the special %busload offeris ote the use ofaconditional/2 statement
100
C#.FF
C#FF.FF
C 1. 'F 6$.'0
$T financially attractive
Pro#lem 11-$1> 5pecial @rder7 5tr ateg" :nternational 4illiams ;ompany, located in southern 4isconsin, manufactures a variety of industrial valves and pipe fittings that are sold to customers in nearby states. ;urrently, the company is operating at about +F percent capacity and is earning a satisfactory return on investment. =lasgow /ndustries 8td. of &cotland has approached management with an offer to buy 1!F,FFF units of a pressure valve. =lasgow /ndustries manufactures a valve that is almost identical to 4illiams7 pressure valve? however, a fire in =lasgow /ndustries7 valve plant has shut down its manufacturing operations. =lasgow needs the 1!F,FFF valves over the net four months to meet commitments to its regular customers? the company is prepared to pay C!1 each for the valves. 4illiams7 product cost for the pressure valve, based on current attainable standards, is
Direct materials Direct labor F.' hr per valve"anufacturing overhead 1I# variableTotal manufacturing cost
C) C@ CB
C!#
3dditional costs incurred in connection with sales of the pressure valve are sales commissions of ' percent and freight epense of C1 per unit. Oowever, the company does not pay sales commissions on special orders that come directly to management. 2reight epense will be paid by =lasgow. /n determining selling prices, 4illiams adds a %F percent markup to product costs. This provides a C#! suggested selling price for the pressure valve. The marketing department, however, has set the current selling price at C#F to maintain market share. *roduct management believes that it can handle the =lasgow /ndustries order without disrupting its scheduled production. The order would, however, require additional fied factory overhead of C1!,FFF per month in the form of supervision and clerical costs. /f management accepts the order, 4illiams will manufacture and ship #F,FFF pressure valves to =lasgow /ndustries each month for the net four months. &hipments will be made in weekly consignments, 2$> shipping point.
;ata ;urrent level of capacity ultiliAation M-
&pecialorder chacteristics: of units offer price per unit;ost datapressure valve: Direct materials per unitDirect labor: Oours per unit D8 cost per unit "anufacturing overhead per unit M of overhead that is variable 3dditional fied manufacturing costs: *ermonth charge Duration of months 3dditional information: normal markup M over manufacturing cost &uggested selling price per unit "arketing department suggested price per unit sales commission, sales to regular customers freight charge, per unit , sale s to reg. custo mers monthly productionIshipment of product lost sales per month *art '-
+FM 1!F,FFF C!1.FF
C).FF F.' [email protected] CB.FF ##.####M C1!,FFF %.FF
%F.FFM C#!.FF C#F.FF '.FFM C1.FF #F,FFF ',FFF
Bequired
1. Determine how many additional direct labor hours D8Os- will be required each month to fill the =lasgow order. !. *repare an analysis showing the impact on operating income of accepting the =lasgow order. #. ;alculate the minimum unit price that 4illiams5 management could accept for the =lasgow order without reducing operating income. %. Lse the )oal See option in 6cel to solve for the minimum unit price determined in # above. '. &uppose now that if the =lasgow order were accepted sales of ',FFF units per month to regular customers would be precluded at a selling price of C#F per unit-. 3ll other facts are as given above. 4hat is the revised breakeven selling price per unit for the =lasgow special sales orderN ). /dentify the strategic factors that 4illiams should consider before accepting the =lasgow order. +. /dentify the factors related to international business that 4illiams should consider before accepting the =lasgow order. 5olution
1. 3dditional D8Os needed each month to fill the =lasgow order: of D8Os per unit produced E of units valves- needed, per month E additional D8Os needed, per month E
F.' #F,FFF 61'000
!. 3nalysis of the impact of the =lasgow order on operating income:
/ncremental revenue /ncremental costs 9ariable costs Direct materials Direct labor 9ariable overhead Total variable costs 2ied overhead &upervisory and clerical costs % mos. Q 1!,FFFTotal incremental costs /ncremental operating income
Total for *er Lnit 1!F,FFF units C!1.FF C!,'!F,FFF C).FF [email protected] C#.FF C1+.FF
C+!F,FFF CB)F,FFF C#)F,FFF C!,F%F,FFF C%@,FFF C!,F@@,FFF 6%$2000
$R: 1!F,FFF units G C!1 P C1+-Iunit P C%@,FFF E 6%$2000 increased operating income #. The minimum perunit price that 4illiams ;ompany could accept, without reducing operating income E incremental cost variable, fied, plus oppportunity [if any\-. The C#F.FF suggested selling price is irrelevant for evaluating the special sales order.
/ncremental variable cost, per unit: Direct materials Direct labor 9ariable overhead
C).FF [email protected] C#.FF
/n cr eme nta l fi e d cos ts, pe r u ni t C %@, FF F K 1! F,F FF un its"inimum selling price per unit
C1+.FF F .% F 61+.%0
%. Lsing )oal See to &olve for the "inimum &elling *rice *er Lnit: 2ourmonth volume in units&elling price per unit /n cr eme nta l rev en ue , spe ci al s al es or de r /ncrementalcosts: 9ariable, per unit 9ariable, total 2ied, total % mos. Q C1!,FFFImonth$pportunity cost Total incremental cost, full order Difference: /ncr. Revenue P /ncremental ;osts
1!F,FFF C1+.%F C !,F @@, FF F C1+.FF C!,F%F,FFF C%@,FFF CF C!,F@@,FFF CF
'. &olving for a minimum selling price when there are opportunity costs: /ncremental variable cost, per unit: Direct materials C).FF Direct labor [email protected] 9ariable overhead C#.FF /ncremental fied costs, per unit C%@,FFF K 1!F,FFF units$pportunity ;ost: To ta l l ost sa les i n u nit s- % G ' ,F FF u nit s! F, FF F Regular selling price per unit C#F.FF 8ess: variable costs per unit-: Direct materials C).FF Direct labor [email protected] 9ariable manufacturing overhead C#.FF &ales commissions 'M of sales CC1.'F 2reight charge per unitC1.FF Total variable cost per unit C1B.'F ;on tr ib ut io n mar gi n p er un it, re gul ar sal es C 1F .' F Total lost contrib utio n margin !F,FFF unit sC!1F,FFF 8ost ;" per unit of special sales order 1!F,FFF units"inimum selling price per unit
C1+.FF F.%F
1.+' 61.1'
). 4illiams ;ompany should consider the following strategic factors before accepting the =lasgow /ndustries order: a. The effect of the special order on 4illiams5 sales at regular pricesN That is, what is the possibility of price erosionNb. The possibility of future sales to =lasgow /ndustries and the effects of participating in the international marketplace. c.The company5s Zrelevant rangeZ of activity, and whether or not the special order would cause total output volume to eceed this range thereby triggering the need for additional capacityrelated costs-. d. The impact of the transaction on local, state, and federal taes. e. The effect on machinery or the schedule maintenance of equipment used by 4illiams. f. The strategic advantage of the longterm commitment from =lasgow in recognition of help provided by the 4illiams ;ompany. g. 4hich firm would handle warranty, repair, service and the likeN h. The ethical and competitive issues of helping a competitor in distress. +.The international issues that 4illiams ;ompany should consider include: a. 4hat customs duties and importIeport restrictions might affect the special order any future business with =lasgowN b. 4hile this special order will be completed in the relatively short time of a few months, foreign echange rates might change significantly in this period. 4hat does the special order agreement sayif anythingregarding the sales price, in dollars or poundsIeuroN c."ight the =lasgow special order introduce 4illiams to new markets in &cotland or elsewhere in >ritain or in 6uropeN /f 4illiams is not now significantly involved in global sales, how might the company use this opportunity to increase its presence in foreign marketsN
Pro#. 11-$2> 5pecial 5ales @rder ;ata :nput ;urrent manufacturing capacity E ;urent production output E ormal sales price per unit E urrent Product osts>
10000 +'00 61+'.00
units per month givenunits per month givengiven-
Garia#le osts> "anufacturing: 8abor C#+',FFF "aterial C!)!,'FF "arketing C1@+,'FF Total 9ariable ;osts 9ixed osts> "anufacturing C!+',FFF "arketing C1+',FFF Total 2ied ;osts /otal i.e. 9ull Fanufacturing ost :nformation regarding the special sales order> umber of units $ffer price, per unit
C@!',FFF
C%'F,FFF C1,!+',FFF
2'00 6100.00
5olution 1. alculate #oth the old i.e. prior to the special order average cost per unit and the recalculated average cost per unit including the effect of the special sales order. 8re either of these t!o figures relevant for evaluating !hether to accept or reect the special order? 4xplain. $ld prior to special order- average cost per unit: Total ;ostImonth C1,!+',FFF Total $utputImonth +,'FF 3verage costIunit 61+0.00 Recalculated 3verage ;ost, including &pecial &ales $rder: $ld Total ;ostImonth C1,!+',FFF &pecial$rder ;osts: Direct manufacturing labor C1!',FFF "aterial C@+,'FF Total ;osts C1,%@+,'FF Total $utput units1F,FFF ew average costIunit 61%,.+' either of the above two cost figures are relevant to the decision at hand: both include sunk costs in the form of fied manufacturing overhead and fied marketing costs, both of which are ZsunkZ with respect to the decision at hand. That is, these costs will likely be the same in total- regardless of whether or not we accept the special sales order. 3s such, they are not relevant to this decision. 2. 5hort-term profit impact of accepting the special sales order> /ncremental cost for &pecial $rder umber of units in special order /ncremental costIunit
C!1!,'FF !,'FF 6,'.00
6ffect on short%term profit of accepting the special order: /ncremental Revenues /ncremental ;osts /ncremental operating profit loss-
C!'F,FFF C!1!,'FF 6$+'00
$. 3rea&even price on special sales order> The breakeven selling price is the price that would leave the operating profit for the company unchanged. 3lternatively, the breakeven price can be defined as the sum of Zrelevant costs,Z that is, incremental variable costs, incremental fied costs if any-, and opportunity cost if any-. /n the present case, relevant cost includes only incremental variable costs, as follows: Relevant ;osts: /ncremental Direct manufacturing labor /ncremental "aterial Total /ncremental ;ost umber of Lnits >reakeven selling price per unit 4.
C1!',FFF C@+,'FF C!1!,'FF !,'FF 6,'.00
;iscuss at least three other considerations that ath" 5enna should include in her anal"sis of the special order.
a- is the order likely to lead to further regular business with this customerN b- is the order in the strategic best interest of the firm, for eample: will it support or undermine the company5s desired image in the marketN c- while 3ward *lus has 0ust enough capacity to complete the special order, will there be other costs in addition to the variable manufacturing costs in order to complete the order for eample, special tooking or setup costs, etc.d- see part ' below 4xplain ho! ath" 5enna should tr" to resolve the ethical conflict arising out of the controllerNs insistence that the compan" avoid competitive #idding. Befer to the :F8Ns Statement of Ethical Professional Practice go to the follo!ing site>
5.
http:IIwww.imanet.orgI*D2sI&tatementM!FofM!F6thics^web.pdf
$bviously, the controller 8e*enn- has a conflict of interest in the sourcing of raw materials for the company. ;athy has the ethical responsibility under the /"3 to bring this matter to the attention of the appropriate person in the company. &ince 8a*enn is the controller, the appropriate person for ;athy to contact is likely to be the 9ice*resident of 2inance, the ;hief 2inancial $fficer ;2$-, a member of top management, or the audit committee if 3ward *lus has one.
Pro#lem 11-$$> 5pecial @rder 3ac&ground =reen =low /nc. ==/- manufactures lawn fertiliAer and because of its very high quality often receives special orders from agricultural research groups. 2or each type of fertiliAer sold, each bag is carefully filled to have the precise mi of components advertised for that type of fertiliAer. ==/7s operating capacity is !!,FFF onehundredpound bags per month, and it currently is selling !F,FFF bags manufactured in !F batches of 1,FFF bags each. The firm 0ust received a request for a special order of ',FFF one hundredpound bags of fertiliAer for C1!',FFF from 3*3;, a research organiAation. T he production costs would be the same, although delivery and other packaging and distribution services would cause a onetime C!,FFF cost for ==/. The special order would be processed in two batches of !,'FF bags each. The following information is provided about ==/7s current operations:
;ata &ales and production cost data for !F,FFF bags, per bag: &ales price 9ariable manufacturing costs 9ariable marketing costs 2ied manufacturing costs 2ied marketing 8dditionalinformation> $perating capacity per month;urrent monthly productionIsales level >atch siAe ;urrent number of batches per month :nformation regarding special order> o. of bags 1FF lbs. each$ffering price total sales revenue$netime charge for the order
!!,FFF !F,FFF 1,FFF !F
C#@.FF C1'.FF C!.FF C1!.FF C!.FF
bags 1FF lbs. eachbags bags batches
',FFF C1!',FFF C!,FFF
=ote> o marketing costs would be associated with the special order. &ince the order would be used in research and consistency is critical, 3*3; requires that ==/ fill the entire order of ',FFF bags. Bequired 1. 4hat is the total relevant cost of filling this special orderN !. 4hat would be the change in operating income if the special order is acceptedN #. 4hat is the breakeven selling price per unit i.e., the selling price that would result in a Aero effect on operating income-N %. &upport your answer to # above by preparing comparative income statements, on a contribution basis, with the special sales order at the breakeven price- and without the special sales order. '. &uppose that after ==/ accepts the special order it finds that unepected production delays will not allow it to supply all ',FFF units from its own plants and meet the promised delivery date. /t can provide the same material purchasing the material in bulk from a competing firm. The materials would then be packaged in ==/ bags to complete the order. ==/ knows the competitor5s materials are very good quality, but it cannot be sure that the quality meets its own eacting standards. There is not enough time to carefully test the competitor5s product in an effort to determine product quality. 4hat should ==/ doN 5olution 1. /n general, relevant cost equals the sum of outofpocket costs variable J fied- plus opportunity costs if any-. /n this case, the total relevant cost is C1%F,FFF, as follows: @ut-of-Poc&et osts> 9ariable costs: "anufacturing cost C1' per unit2ied costs: $neTime *acking _ Delivery ;ost @pportunit" ost> o. of lost unit sales if any;" per unit, regular sales: &elling price, per unit 9ariable manufacturing cost 9ariable selling cost
C+',FFF C!,FFF #,FFF C#@.FF C1'.FF C!.FF
C)#,FFF
C!1.FF
/otal Belevant ost
61%0000
!. 6ffect on shortterm operating income of accepting the special sales order: $ffering price, special order 8ess: relevant costs see above/ncome effect of accepting special sales order
C1!',FFF C1%F,FFF 61'000
&ince the relevant costs of C1%F,FFF eceed the price of the special order C1!',FFF-, there would be a loss of C1',FFF if the special order were accepted. Therefore, ==/ should not accept the order. ote that if ==/ had available capacity, the only relevant cost would be the variable manufacturing and the delivery costs, totaling C++,FFF? in this case, the special order should be accepted. #. >reakeven selling price per unit: The breakeven selling price per unit is defined as the selling price that 0ust covers relevant costs, both outofpocket and opportunity if any-. /n the present case, we have: Total relevant cost answer to part 1 aboveD iv ided b y o f uni ts in t he s pe cia l sa les ord er >reakeven selling price per unit
C1%F,FFF ' ,FFF 62,.00
3ny price above [email protected] per unit would increase shortterm operating income. %. ;omparative /ncome &tatements, ;ontribution >asis: ;urrent &ituation &ales: Regular QC#@Iunit&pecial order Q C!@Iunit8ess: 9ariable ;osts: "anufacturing QC1'Iunit"arketing Q C!Iunit;ontribution "argin 8ess: 2ied ;osts: "anufacturing "arketing $neTime *ackingIDelivery $perating /ncome
C+)F,FFF CF C#FF,FFF C%F,FFF
C!%F,FFF C%F,FFF CF
C+)F,FFF
C#%F,FFF C%!F,FFF
C!@F,FFF 61%0000
;urrent &ituation J &pecial &ales $rder C)%),FFF C1%F,FFF C+@),FFF C##F,FFF C#%,FFF
C#)%,FFF C%!!,FFF
C!%F,FFF C%F,FFF C!,FFF C!@!,FFF 61%0000
Thus, if the special sales units are sold at [email protected] per unit, the operating income for the company will be unaffected. 3ny price above [email protected] per unit would increase operating income, will a price below [email protected] would have the opposite effect. '. There are both ethical and strategic issues for ==/. 2rom a strategic view, ==/ would suffer severe damage to its reputation if 3*3; were to have any problems with the purity of the special order. $ne of the reasons 3*3; has requested the special order from ==/ is because of its reputation for quality. /t is clear that ==/ competes on differentiation, with quality being a critical success factor. 3lso, there is an ethical issue. The use of a competitor5s materials would deceive 3*3;, who is epecting the hightestquality product from ==/. To take into account both strategic and ethical issues, ==/ should make it clear to 3*3; that is will need to fill a portion of the order from competitor5s stock. ==/ might request that the shipment be delayed untilit can provide all of the product from its own stock. 3lternativey, it might offer to reduce the price, or to perform careful tests of its own on the competitor5s materials.
Pro#lem 11-$%> 5pecial @rder7 83 osting ontinuation of Pro#lem 11-$$ 3ac&ground
3ssume the same information as for *roblem 11##, ecept that the C1! fied manufacturing overhead consists of C@ per unit batchrelated costs and C% per unit facilitieslevel fied costs. 3lso, assume that each new batch causes increased costs of C',FFF per batch? the remainder of the batchlevel costs consists of tools and supervision labor that do not vary with the number of batches. The remaining fied costs do not vary with the number of units produced or the number of batches.
;ata
&ales and production cost data for !F,FFF bags, per bag &ales price 9ariable manufacturing costs 9ariable marketing costs 2ied manufacturing costs 2ied marketing 3dditional information: $perating capacity per month;urrent monthly production level >atch siAe ;urrent number of batches per month /nformation regarding special order: o. of bags 1FF lbs. each$ffering price total sales revenue$netime charge for the order >reakdown of C1! perunit fied overhead cost: >atchrelated costs 2acilitieslevel fied ovherhead costs /ncremental costs per batch
C#@.FF C1'.FF C!.FF C1!.FF C!.FF
!!,FFF bags 1FF lbs. each!F,FFF bags 1,FFF bags !F batches ',FFF C1!',FFF C!,FFF [email protected] C%.FF C',FFF
Bequired
1. 4hat is the total fied manufacturing cost for the periodN >reakdown this total into its components. !. ;alculate the relevant unit and total cost of the special order, including the new information about batchrelated costs. #. /f accepted, how would the special order affect ==/5s operating incomeN &how calculations.5olution 1. Total fied manufacturing overhead, broken down into its components:
Total batchrelated ;osts C@Iunit G !F,FFF units/ncremental costs C',FFFIbatch G !F batches- E onincremental batchrelated costs plug figure2acilitiesrelated fied overhead costs C%Iunit G !F,FFF units- E Total fied manufacturing overhead costs !. Relevant cost of special sales order:
C1)F,FFF C1FF,FFF C)F,FFF C@F,FFF C!%F,FFF
o. of incremental batches, special order E !!,FFF!F,FFF-I1,FFF E E [current capacity in units- P current usage in units-\ K 1,FFF unitsIbatch Relevant cost for the special order: 9ariable manufacturing cost C1'Iunit G ',FFF units- E /ncremental batchrelated ovh costs ! batches G C',FFFIbatch- E $netime delivery cost E ;" on lost sales opportunity cost-: &ales C#@Iunit G #,FFF units- E 8ess: variable costs C1' J C!- G #,FFF units E 8ess: cost for three batches QC',FFF per batch- E Total relevant cost for the special order #. 6ffect of the special sales order on operating income:
!
C+',FFF C1F,FFF C!,FFF C11%,FFF C'1,FFF C1',FFF
C%@,FFF 61$'000
&ales revenue from special sales order E
C1!',FFF
Relevant cost of the special sales order from ! above- E The shortterm financial impact on operating profit E Therefore, the company should reect the order
C1#',FFF 610000
Eses :9 5tatement in 4xcel
1. 3ssuming "artens plans to meet the epected demand for !F,FFF attic fans, how many should it manufacture and how many should it purchase from Oarris *roductsN 6plain your reasoning with calculations. !. /denpendent of *art 1 above, assume that >eth Hohnson, "arten5s product manager, has suggested that the company could make better use of its fan department capacity by manufacturing marine pumps instead of fans. Hohnson believes that "artens could epect to use the production capacity to produce and sell !',FFF pumps annually, at a price of C)F per pump. Hohnson5s estimate of the costs to manufacture the pumps is presented below. /f Hohnson5s suggestion is not accepted, "artens would sell !F,FFF attic fans instead. &hould "artens manufacture pumps or attic fansN /nformation on the sales price, costs, and volume for the marine pumps follows. &elling price per pump ;ost per unit: 6lectric motor $ther parts Direct labor C1'Ihr"anufacturing overhead &elling and administrative cost *rofit per pump o. of pumps units-
C'.'F C+.FF C+.'F CB.FF C!F.FF
#. 4hat are some of the longrun considerations in "artens5 decisions in *arts 1 and ! aboveN 5olution 1. Oow many fans should be manufactured by "artens and how many should be purchased from Oarris *roductsN Total ;ost C+!.FF
&elling price per unit ;ost per unit: 6lectric motor $ther parts Direct labor C1'.FFIhr."anufacturing overhead &elling and adm. cost ;ontribution per unit * *
Relevant ;osts to "anufacture C+!.FF
Relevant ;osts to *urchase C+!.FF
Relevant ;osts for *umps C)F.FF
C%).FF C).FF [email protected] C1'.FF C1'.FF ` C!F.FF C)%.FF ``
C).FF [email protected] C1'.FF C'.FF C1%.FF 62%.00
C1%.FF 612.00
C'.'F C+.FF C+.'F C'.FF C1%.FF 621.00
$f the total per unit manufacturing overhead of C1', C1F is fied C1FF,FFFI1F,FFF units- and the remaining C' is variable. $f the total per unit selling and administrative cost, C) is given as fied, and the remaining C1% is variable.
&ince the perunit contribution margin from selling manufactured fans C!%.FF- W the perunit contribution margin from selling purchased fans C1!.FF-, "artens should sell as many manufactured fans as possible, as follows: ;onribution margin from manufactured fans 1',FFF units G C!%.FFIunit;ontribution margin from purchased fans ',FFF units G C1!.FFIunitTotal 8ns!er> o. of units, manufactured o. of units, purchased fans Total fans produced !. &hould "artens manufacture pumps or the attic fansN
1'000 '000 !F,FFF
Total contribution margin for the marine pumps: *erunit contribution margin E
C!1.FF
C#)F,FFF C)F,FFF C%!F,FFF
5olution
1. =ian3uto is in a highgrowth, highly competitive industry. 3utomakers are increasingly outsourcing the of parts and entire brake or seating systems to lowcost producers throughout the world. /n orth 3meri these plants are located in "eico and throughout 8atin 3merica. To be competitive in this business, =i continue to be costcompetitive, and also to rovide the customer service and reliability that is epected o =ian3uto can also look for additional ways to be competitive by assisting the automakers in improving t parts, developing modular manufacturing systems, and improving the quality of the parts produced. ;ontinuing to obtain covers from its own Denver ;over *lant would allow =ian3uto to maintain its curre control over the quality of the covers and the timing of their delivery. (eeping the Denver ;over *lant o allows =ian3uto more fleibility than purchasing the coverings from outside suppliers. =ian3uto could m alter the coverings5 design and change the quantities produced, especially if longterm contracts are req outside suppliers. =ian3uto should also consider the economic impact that closing Denver cover will ha community and how this might affect =ian3uto5s other operations in the region. $ther items that should be considered by =ian3uto before making a decision include: a. The disposal value or alternate uses of the plant and associated equipment. b. 3ny income ta implications, including ta rebates applicable to gainIloss on the sale of plant, dep ta shields, depreciation and investment ta credit recapture, etc. c. *ro0ected supplier prices in the future. d. ;ost to manufacture coverings at the Denver *lant in future years. e. 6thical issues involved in the termination of %FF employees. f. 2ederal and state statutes regarding employee layoffs and terminations, as well as plant closings g. &hould =ian3uto continue to manufacture the covers, but in a new, costefficent plantN The locati be anywhere in the world. !. The following are avoidable costs, and therefore are relevant to the plantclosing decision: "aterials 8abor: Direct &upervision /ndirectplant Differential pension epense Term charges on cancelled D" purchases 6mployment assistance T$T38
C#!,FFF C!#,FFF C#,FFF C%,FFF
C#F,FFF C1,FFF C%,@FF C1,FFF 6*,,00
The following costs are not relevant to the decision since they are unavoida#le-: Depreciationequipment C',FFF Depreciationbuilding C#,FFF ;ontinuing pension epense C%,FFF P C1,FFFC#,FFF *lant manager and staff C!,FFF C),FFF ;orporate allocation C1B,FFF
purchase it from "arley ;ompany for !F1#. !. /dentify and briefly discuss the strategic factors that "idwest should consider in this decision. #. >y referring to the specific ethical standards for management accountants outlined in ;hapter 1, assess the ethical issues in Hohn *orter7s request of 8ynn Oardt.
5olution 1. The following relevant cost analysis per unit, and total for #!,FFF units- shows that the "idwest Division should purchase the parts, for a saving of C1',%%F C'+',F%F P C''B,)FF-. ost per unit
/otal ost
ost to purchase F/B-2000 from Farle"> >id price from "arley 6quipment lease penalty [C#),FFF K 1!- G ! G1\ Total cost to purchase ost for Fid!est to Fa&e F/B-2000> Direct material C1B',FFF K #F,FFF- G 1.F@ Direct labor C1!F,FFF K #F,FFF- G 1.F' 2actory space rental C@%,FFF K #!,FFF units-` 6quipment leasing costsC#),FFF K #!,FFF units-` 9ariable manufacturing overhead Total cost to make Belevant ost ;ifferential
C1+.#FFF CF.1@+' 61+.%,+'
C''#,)FF ),FFF
C+.F! C%.!F C!.)# C1.1# C#.FF 61+.+
C!!%,)%F 1#%,%FF @%,FFF #),FFF B),FFF 6'+'0%0
60.%,2'
61'%%0
6''*00
`Total production required in !F1# is #!,FFF units? #F,FFF units in !F1!. Lnit variable costs are based on !F1! costs and units? fied costs in total are the same in !F1# as in !F1!. !. &trategic factors that the "idwest Division and *aibec ;orporation should consider before agreeing to purchase "TR!FFF from "arley ;ompany include the following: · · ·
·
The quality of the "arley component should be equal to, or better than, the quality of the internally made component, or else the quality of the final product might be compromised and *aibec5s reputation affected. "arley5s reliability as an ont ime supplier is important, since late deliveries could hamper *aibec5s production schedule and delivery dates for the final product. 8ayoffs may result if the component /s outsourced to "arley, This could impact "idwest5s and *aibec5s other employees and cause labor problems or affect the company5s position in the community, /n addition, there may be termination costs which have not been factored into the analysis. =iving up production capability risks dependence upon "arley7s future pricing.
#. Referring to the specific standards for ethical practice by a management accountant http:IIwww.imanet.orgI*D2sI&tatement M!FofM!F6thics^web.pdf -, 8ynn Oardt should consider the ethical standards of competence, integrity, and ob0ectivity: ;ompetence ·
*repare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information. Hohn has asked 8ynn to ad0ust and falsify her report and leave out some manufacturing overhead costs.
/ntegrity ·
· ·
Refrain from either actively or passively subverting the attainment of the organiAation5s legitimate and ethical ob0ectives, *aibec has a legitimate ob0ective of trying to obtain the component at the lowest cost possible, regardless of whether it is manufactured by "idwest or outsourced to "arley. ;ommunicate unfavorable as well as favorable information and professional 0udgments. Oardt needs to communicate the proper and accurate results of the analysis, regardless of whether or not it is favorable to "idwest. Refrain from engaging in or supporting any activity that would discredit the profession. 2alsifying the analysis would discredit Oardt and the profession.
;redibility · ·
;ommunicate information fairly and ob0ectively. Oardt needs to perform an ob0ective makeorbuy analysis and communicate the results ob0ectively. Disclose all relevant information that could reasonably be epected to influence an intended user7s understanding of the reports, comments, and recommendations presented. Oardt needs to fully disclose the analysis and the epected cost increases.
Pro#lem 11-$,> @utsourcing all enters 3ac&ground "erchants7 >ank ">- is a l arge regional bank operating in )#% locations in the &outheast L.&. "> has grown steadily over the last !F years, because of the region7s growth and the bank7s prudent and conservative business practices. The bank has been able to acquire less successful competitors in recent years, further enhancing its growth. Lntil !FF', the bank operated a call center for customer inquiries out of a single location in 3tlanta, =3. "> understood the importance of the call center for overall customer satisfaction and made sure that the center was managed effectively. Oowever, in early !FF%, it became clear that the cost of running the center was increasing very rapidly, along with the firm7s growth, and that some issues were arising about the quality of the service. To improve the quality and dramatically reduce the cost of the service, "> moved its called center to >angalore, /ndia, where it is now run by an eperienced outsourcing firm, aftel, which offers similar services to other banks like ">.
The aftel contract was for five years, and in late !FF@ it was time to consider whether to renew the contract, change to another call center service provider in /ndia or elsewhere-, or bring the call center back to 3tlanta. &ome important factors to consider in the decision: 3t the time of the decision in late !FF@ the value of the dollar had been increasing relative to most other currencies. The financial crisis of !FF@ had been affecting the banking business, and the outlook for growth for "> was not as rosy as it had been for the last few years. Top management and economic advisors for the bank have basically no idea what the right forecast for the coming five years was. 3t the time of the decision, the employment rate in 3tlanta had fallen to the point that there was a good supply of talented employees who could have been recruited into the call center if the center were relocated back to 3tlanta. The bank had 0ust completed a new headquarters building in 3tlanta and had a good bit of space in the building that "> had yet to lease. The outlook for the 3tlanta economy was such that "> did not epect to lease much of this space for at least three years. /f the call center were returned to 3tlanta, it would occupy a space that would be rented for C1FF,FFF per month, if there were a company that wanted to lease the space. /f renewed, the aftel contract would cost C%,!FF,FFF per year for the net five years. The cost of salaries to staff the call center in 3tlanta were epected to be C!,#FF,FFF per year, the equipment would be leased for C@'F,FFF per year, telecommunication services were epected to cost C'FF,FFF per year, administrative costs for the call center were epected to be C)FF,FFF per year, and the call center7s share of corporate overhead was epected to be C%FF,FFF per year.
· ·
·
·
· ·
;ata
3nnual ;ost of aftel contract ;all ;enter 3tlanta- ;osts: ;ost of salaries ;ost of equipment ;ost of telecom. &ervice 3dministrative ;osts &hare of corporate overhead 8ease opportunity cost
%,!FF,FFF !,#FF,FFF @'F,FFF 'FF,FFF )FF,FFF %FF,FFF 1FF,FFF
Bequired 1. &hould "> return the call center to 3tlanta or renew the contract with aftelN Develop your answer for both a oneyear and a fiveyear time horiAon. ;onsider the strategic contet of the decision as an integral part of y our answer. Oint: using discounted cash flow is not required but would improve your answer? "> uses a discount rate of )M.!. 4hat are the global issues that should be considered in the decisionN #. 4hat ethical issues, if any, should be considered in the decisionN
5olution
1. The corporate overhead cost is irrelevant since in total it will not change whether or not the call center is returned to 3tlanta. That is, this is considered an unavoidable cost. =aftel 8nnual osts aftel ;ontract 8ease $pportunity cost, asis *resent9alue >asis Discount factors, at )M:
9irst $ Crs
C%,!FF,FFF C%,!FF,FFF
Present Galue
8tlanta Crs %-'
C!,#FF,FFF C@'F,FFF C'FF,FFF C)FF,FFF
C1FF,FFF 1FF,FFF !,#FF,FFF @'F,FFF 'FF,FFF )FF,FFF
C%,!'F,FFF
C%,%'F,FFF
9actor *J %.!1!FF F.+B!FB F.+%+!) %.!1!#) %.!1!#) %.!1!#) %.!1!#)
Present Galue =aftel C1+,)BF,%FF 61+*0%00
8tlanta
C+B,!FB +%,+!) B,)@@,%#+ #,'@F,'FB !,1F),1@! !,'!+,%1@ 61,0'*%,1
6*'0000 6$**0,1
F.+B!FB#))#! F.+%+!'@1+!B %.!1!#)#+@')
The analysis above calculates the annual cost for each year for aftel, and for each of the first three years and for years % and ' for the 3tlanta option. The present value factor for an annuity for ' years at )M is used to discount the amounts applicable to all five years, while singlesum discount factors are used for the lease opportunity cost in years % and '. &ee the spreadsheet for calculation of the present value factors and the present value annuity factor.The analysis shows that the aftel contract would save "> C'F,FFF per year in each of the first three years, and C1'F,FFF in years % and '. 4hen analyAed on a presentvalue basis, the comparison is a total for all five years for the aftel contract of C1+,)BF,FFF versus C 1@,F'),%@1 for the 3tlanta location, a difference of C#)),F@1 in favor of the aftel option. 4hether you consider the unad0usted or the presentvalue analysis, it is clear that the aftel contract has the lower cost. >ut the difference is not great relative to total cost, so that strategic issues are important in making the final decision. &ome of these strategic issues are discussed in parts ! and # below. /n addition: ·
&ince customer service is very important for ">7s success, would the location of the call center in 3tlanta or at aftel provide better quality customer serviceN This is the dominant strategic question, especially since the cost difference is not significant relative to total cost.
·
&ince the banking business was, at the time, forecast to be in troubled times for the net several months, would it not have been important to retain the admittedly small cost advantage of the aftel contractN
·
=iven the difficult times ahead for the banking industry, is it not especially important now to differentiate your company from others, and customer service is one important way to do that. /f customer service in 3tlanta can be carefully managed so that it provides the very high quality service, this could be an important competitive advantage.
!. 3t the time of the decision late !FF@-, the value of the dollar had been increasing relative to most other currencies. This means that the cost to "> of the service by eftal would be less in currencyad0usted terms if the contract is in /ndia7s currency, the Rupee. $ther global issues include the importance to "> of maintaining strong business relationships with firms li ke eftal that can provide valuable services as "> grows. #. The ethical issues in the decision here include the consideration of a community obligation that "> had for providing 0obs, when possible, in a local economy that is suffering from high unemployment.
Pr. 10-',IPr. 11-$> 5ustaina#ilit" ;ata Product
5elling Price
;ommercial /ndividual >atch siAe E
4lectricit" Faterials ost per a#or per five- per fivepound of laundr" pound #atch pound #atch
C!'.FF C!1.FF
C1.FF CF.'F
C%.FF C%.FF
;ost of ew ;leaning ;ompound E 6stimated possible- fine e.g., 6*3- E 3ssumed level of cost decrease per month E Bequirement O1> 5hort-/erm 9inancial 8nal"sis
3udgeted 3atches per Cear
C1.'F +,'FF C1.FF #,FFF ' pounds of laundry
C!.!' per pound of laundry C)F,FFF 1.000J applied to labor and electricity-
6stimated fine e.g., 6*36ta processing cost based on new compound: 6stimated batches per year;ommercial of pounds of laundry per batch Total estimated laundry, in pounds /ncreased ;leaning compound costIpound` 6stimated batches per year/ndividual of pounds of laundry per batch 6stimated laundry, per year in pounds/ncreased cost of cleaning compoundIpound` $ne
C)F,FFF
+,'FF ' #+,'FF C1.!' #,FFF ' 1',FFF C1.+'
C%),@+'
C!),!'F
C+#,1!' 61$12'
Therefore, based on the above shortterm financial analysis, it does not ma&e sense to s!itch to the ne! cleaning compound Bequirement O2> 8ssume the 5!itch to the =e! ompound and the :ntroduction of ontinuous:mprovement Aaien 3udgeting
6stimated increase in processing cost, per year with new compound from above- E 6stimated annual cost savings, per (aiAen budget: $riginal "onthly *rocessing ;osts other than materials-: ;ommercial: 8 ab or C %. FF Ib at ch + ,' FF b at ch es Iy ea r K 1 ! m on th sI ye ar 6 le ct ri ci ty C1 .' FI ba tc h + ,' FF b at ch es Iy ea r K 1! m on th sI ye ar /ndividual: 8a bor C%. FF Ib atc h # ,F FF b atch es Iye ar K 1! mo nth sIye ar6lectricity C1.FFIbatch #,FFF batchesIyear K 1! monthsIyearTotal "onth ly *rocessing ;osts $ther than "ateria $riginal 3nnual *rocessing ;osts other than materials-
Revised 8evel of "onthly *rocessing ;osts other than materials-: Fonth a#or 4lectricit" 1 C#,%)'.FF C1,1+'.)# ! C#,%#F.#' C1,1)#.@+ # C#,#B).F' C1,1'!.!# % C#,#)!.FB C1,1%F.+1 ' C#,#!@.%+ C1,1!B.#F ) C#,!B'.1@ C1,[email protected] + C#,!)!.!# C1,1F).@# @ C#,!!B.)1 C1,FB'.+) B C#,1B+.#1 C1,F@%.@F 1F C#,1)'.#% C1,F+#.B' 11 C#,1##.)@ C1,F)#.!1 1! C#,1F!.#' C1,F'!.'@ 6$$*+.*% Total
6+$12'
C !, 'F F. FF C B# +. 'F C 1,F FF .F F C!'F.FF C%,)@+.'F C'),!'F.FF
C'!,+!%.'! C#,'!'.%@ C)B,'BB.'! 6'.'2
Thus, strictly speaking, it is better to incur the fine rather than change to the new cleaning compound, even after implementing (aiAen budgeting. Bequirement $ a. ;etermine the Fonthl" ost-Beduction Bate that !ould 4quate the net increase in "ear-one total processing costs materials la#or electricit" !ith the anticipated fine 5tep @ne> ;efine the 3rea&even ost 4quation
Dif ference between th e fin e and net increase in yearone processin g costs
CB,'BB.'!
5tep /!o> Bun Doal 5ee&
5tep /hree> 5olution
/n other words, in order to be indifferent between incurring the fine C)F,FFF- and incurring etra processing costs per year, after implementing (aiAen budgeting, the monthly rate of cost decrease must be %.1)%M. 3t this level, the yearone (aiAenbased cost savings would be C1#,1!', while the net yearone processing cost increase would be C)F,FFF C+#,1!' C1#,1!'-an amount eactly equal to the estimated fine. ote, however, that such a dramatic increase in productivity is highly questionable. #. /he cost per pound for the ne! compound that !ould equate the anticipated fine !ith the net "ear-one costs assuming no Aaien #udgeting plan i.e. no reduction per month in processing costs other than material> 5tep @ne> 5et Ep ost 4quation
;ost differential: anticipated fine and net oneyear processing costs, with no (aiAen budgeting plan E 5tep /!o> Bun Doal 5ee&
61$12'
5tep /hree> Besults
/n other words, if the price of the new compound were to be reduced from C!.!' per pound of laundry to C!.FF per pound of laundry, with no other changes, then the owner would be indifferent between incurring the estimated fine and using the new higherpriced- compound. $f course, other considerations may affect the ultimate decision. %. @perational hanges =eeded to 4nsure Aaien ost 5avings
The reduction in labor time might be realiAed by improving the efficiency of operations, including a decrease in machine downtime. /t is probably the case that line employees i.e., operating personnel- may have suggestions for ways to improve operational efficiency e.g., changes that would reduce idle time as well as processing time. /n order to achieve aggressive cost reductions in labor, it may be necessary to institute some type of employee incentive program. &avings in electricity consumption may be more difficult to achieve. &ome reduction would likely accompany the plannedfor reduction in labor cost. Oowever, ultimately to improve electicity consumption it may be necessary to invest in more modern technology, particularly given recent and anticipated- increases in utility rates. 2inally, as the present eample shows, effective (aiAen budgeting may require collaborative work with individualsIcompanies across the value chain. David Duncan is more likely to achieve his costreduction goals through working with his suppliers. 3s indicated above, if the cost of the new compound could be decreased by only CF.!' per pound of laundry processed, David would be indifferent solely on an epected cost basis- between incurring the fine C)F,FFF- and the increased processing cost associated with the the use of the new cleaning compound C)F,FFF as well-. '. @ther qualitative onsiderations that Fight 8ffect the Eltimate ;ecision> * 4hat impact, perhaps negative, will the (aiAen budgeting approach have on
employee moraleN reduction have a negative effect on service qualityN * 4ill the use of the new, environmentally friendly cleaning compound have a beneficial effect on the image of the business and therefore on salesN * 4ould the use of the new cleaning compound have a beneficial impact on employee healthIworking conditionsN 3lternatively, would continued use of the eisting compound require special handling costs or preventative measures e.g., to guard employee health and safety-N * 4ould incurring a fine rather than incurring increased operating costs- negatively affect the image of the business, and therefore future service demandN 4ould negative media coverage reduce demandN* Does the eisiting cleaning compound create a haAardous work environment for employees the problem is silent on this issue-N * /f the eisting cleaning compound is considered haAardous to employee wellbeing, is there an effect on employee absenteeismN * Duncan5s business essentially consists of two service linesIsegments: commercial and individual. /s there a differential effect on marketing activity for these two groupsN That is, do these groups differ in their response to either positive or negative media coverageN* 4ould it make more sense for Duncan to invest in new technology, which might bring the company into full compliance with current emission requirementsN * 4ill the quest to achieve aggressive levels of cost
Bequired 1. Lsing 6cel or an equivalent spreadsheet, develop an analysis that can help Oal decide about the future of the 4eldon l &hould the 4eldon line be droppedN 4hy or why notN !. Lsing the spreadsheet you developed in *art 1, determine whether your answer would change if sales of 4eldon epected to fall by @F percent. #. 3gain using the spreadsheet in *art 1, determine whether the 4eldon line should be discontinued if the resources devote 4eldon could be used to increase sales by 1F percent in each of the other two lines. %. 3gain using the spreadsheet in *art 1 and using =oal &eek in 6cel or an equivalent, determine the sales increase decrease- in the sales of the *arker line that would be necessary if the 4eldon line were discontinued to maintain the fir overall profit in *art 1. 2or an illustration of =oal &eek, seek 6hibit B.' in ;hapter B. '. =iven your answers to *arts 1- through %- above, consider the overall competitive environment facing O*2 and make y recommendations regarding the firm7s strategic position and direction at this time.
5olution
1.
The first step in the solution is to construct a contribution income statement. Par&er *er Lnit
&ales units &ales dollars C%'B.FF Garia#le osts 8abor 1!'.FF Raw "aterials @@.'F *ower !#.'F 9ariable ;osts C!#+.FF ontri#ution Fargin C!!!.FF 9ixed osts Repairs 2actory 6quipment $ther 2actory ;osts &elling 6pense $ffice 6pense 3dministrative 6pense $ther &_3 6penses Total 2ied ;osts $perating *rofit 8oss-
Total 1'F,FFF C)@,@'F,FFF
1@,+'F,FFF 1#,!+',FFF #,'!',FFF #',''F,FFF C##,#FF,FFF
Girginian Total ##',FFF #)'.FF C1!!,!+',FFF
*er Lnit
[email protected] )).FF 1'.)F C1BB.)F C1)'.%F
#B,'#F,FFF !!,11F,FFF ',!!),FFF )),@)),FFF C'',%FB,FFF
Weldon *er Lnit Total
/otal
!%@.FF
1)',FFF C%F,B!F,FFF
C!#!,F%',FFF
)!.FF [email protected] 1#.@F C1'#.@F 6%.20
1F,!#F,FFF 1!,@+F,FFF !,!++,FFF C!',#++,FFF 61''%$000
)@,'1F,FFF %@,!'',FFF 11,F!@,FFF C1!+,+B#,FFF C1F%,!'!,FFF +,B)!,'FF !1,++',FFF @,%+#,+'F !!,B#',FFF 1F,B!F,FFF 1+,@+',FFF %,!!',FFF CB%,1)),!'F C1F,F@',+'F
The analysis shows that all three lines have a positive contribution margin, including the 4eldon line. The shortterm financial effect of dropping the 4eldon line would be a loss of contribution margin of C1','%#,FFF. 2or a longerterm perspective, Oal should epecte the 4eldon line to cover its full operating costs, including fied costs sub0ect to strategic considerations, as discussed below in *art '-. Thus, there should be a consideration of sales trends and alternative uses of the plant5s capacity. 2or eample, if sales in the 4eldon line are epected to fall, and there are attractive alternative uses of the plant5s capacity, then the 4eldon line might be discontinued now, suffering a shortterm loss as noted above-, for the purpose of securing a longerterm gain. !. &ince the 4eldon line has a positive contribution margin of CB%.!F per unit, the total contribution margin will be positive regardless of the level of sales beyond Aero, of course-, and the analysis in *art 1 above will continue to favor keeping the line at least in the short run-. Oowever, Oal and Hoan might want to consider alternative uses of the plant facilty if 4eldon sales continue to fall. #. The 1FM sales increase has total sales of 1)',FFF units for the *arker line and #)@,'FF units for the 9irginian line. The analysis for dropping 4eldon shows a decrease in operating profit of C),)+!,1FF C1F,F@',+'F C#,%1#,)'F-. &o, in the short run it would be better to retain 4eldon as long as other more attractive uses of 4eldon5s line do not eist-. Par&er *er Lnit
&ales units &ales dollars Garia#le osts 8abor Raw "aterials *ower Total 9ariable ;osts ontri#ution Fargin 9ixed osts Repairs 2actory 6quipment $ther 2actory ;osts &elling 6pense $ffice 6pense 3dministrative 6pense $ther &_3 6pense Total 2ied ;osts $perating *rofit 8oss-
C%'B.FF
Total 1)',FFF +',+#',FFF
1!'.FF @@.'F !#.'F C!#+.FF C!!!.FF
!F,)!',FFF 1%,)F!,'FF #,@++,'FF C#B,1F',FFF C#),)#F,FFF
Girginian *er Lnit Total #)@,'FF C#)'.FF 1#%,'F!,'FF
[email protected] )).FF 1'.)F C1BB.)F C1)'.%F
%#,%@#,FFF !%,#!1,FFF ',+%@,)FF C+#,''!,)FF C)F,B%B,BFF
Weldon Total *er Lnit F C!%@.FF
C!1F,!#+,'FF
)!.FF [email protected] 1#.@F C1'#.@F CB%.!F
)%,1F@,FFF #@,B!#,'FF B,)!),1FF C11!,)'+,)FF CB+,'+B,BFF
%. Required change in sales for the *arker line to compensate for the loss of the 4eldon line using =oal &eek-: 5tep O1> Refer to the ;ontribution /ncome &tatement in *art # above cells >1F#:/1!!-. 6nter a Aero into cell D1F'? enter # #',FFF into cell 21F'. 3fterwards, you should see the following:
/otal
+,B)!,'FF !1,++',FFF @,%+#,+'F !!,B#',FFF 1F,B!F,FFF 1+,@+',FFF %,!!',FFF CB%,1)),!'F 6$%1$*'0
1. ;alculate the contribution margin for each type of paint and total firmcontribution under each of the following scenarios: &cenario 3 ;urrent production, including the 9irginia contract &cenario > 4ithout either the 9irginia contract or the promotion t o epand sales of commercial paint &cenario ; 4ithout the 9irginia contract but with the promotion to epand sales of the commercial paint
!. Determine whether scenario > or ; per *art 1 above- should be chosen by "eyer and eplain why, including a consideration of the strategic contet. 5olution 1. 2irst, calculate the contribution margin for traffic paint and for commercial paint. The first step here is to determine the unit cost of late, as follows: 2or Traffic *aint E %'F G C#!- K 1,FFF E 2or ;ommercial *aint E #!' G C#!- K 1,FFF E The contribution margin per unit of output for each product is determined as follows: /raffic &elling priceIgallon Direct materials costs: 8ate ;amelcarb &ilica *igment $ther ingredients Direct labor cost 2reight Total variable cost ;ontribution margin
C1%.%FFF C1F.%FFF
ommercial
C!F.FF
C!%.FF
C1%.%F CF.+) CF.+% CF.!% CF.1! CF.B! C1.') C1@.+% 61.2*
C1F.%F C1.F@ C1.F% CF.+) CF.F) C1.+F CF.@) C1'.BF 6,.10
Lsing the above contribution margin per unit figures, the total contribution margin for each scenario can be determined as follows, where total traffic paint E #%!,FFF gallons i.e., #@F,FFF gallons G F.BF-, and total commercial paint E #@,FFF gallons i.e., #@F,FFF gallons #%!,FFF gallons-. The loss of the 9irginia contract would reduce the traffic paint to !'%,FFF gallons i.e., #%!,FFF gallons @@,FFF gallons-. 3 doubling of commercial paint using the promotion- would result in +),FFF gallons i.e., #@,FFF gallons G !-. =allons of $uput Traffic *aint ;ommercial *aint Totals 5cenario 8 @riginal units Traffic ;ommercial ;" &avings on materials handling costs 8ess cost of promotional campaign Total
#%!,FFF #@,FFF #@F,FFF
FIunit C1.!) [email protected]
&cenario 3 &cenario > &cenario ; #%!,FFF !'%,FFF !'%,FFF #@,FFF #@,FFF +),FFF #@F,FFF !B!,FFF ##F,FFF 5cenario 3 @riginal F C%#F,B!F C#F+,@FF 6+$,+20
Enits !Io Girginia !'%,FFF #@,FFF !B!,FFF
F !Io Girginia C#!F,F%F #F+,@FF 6*2+,%0
5cenario Enits !ith promotion !'%,FFF +),FFF ##F,FFF
C@F,FFF 6+0+,%0
=ote> The C'F,FFF fied costs traceable to the 9irginia contract are ignored in the above formulation since these costs cannot be eliminated within a year. !. The proposed promotional campaign without the 9irginia contract, scenario ;, has the greatest contribution margin, as shown in the calculations above. &trategic issues for the decision between scenario > and scenario ; include the reliability of the pro0ected salesvolume increase in commercial paint and the assumption that the volume of commercial paint can be doubled without increasing fied costs, other than the cost of the promotion. 3 strategic opportunity, on the other hand, is that the company "eyer *aint- can move from a relatively low contribution margin product line traffic paint- to a relatively high contribution product line commercial paint-. &uppose, for eample, that the sales of commercial paint increase by only #FM rather than 1FFM an increase to %B,%FF rather than +),FFF gallons-. ote that scenario ; would now be the least profitable
F !ith promotion C#!F,F%F )1',)FF 6$'*%0 C@F,FFF C1!F,FFF 6,'*%0
1. 6plain whether either contest is desirable or not. &upplement your analysis by determining the total co =liders and for Tableand;hair sets under each of the following assumptions: actual sales volume at a usage, and actual costs? and, actual sales volume at budgeted selling prices, budgeted resource usage !. 6plain the strategic issues guiding your choice about these contests. 5olution
>udgeted &ales 3ctual &ales &ales &hortfall &ales 9alue of &hortfall Direct material Direct labor rate per hr Direct labor hrs per unit Direct labor cost &ales commission ;ontribution margin ;ost of *riAe 6cess of ;" over cost
5econd contest> 9irst contest> Dliders Total *er Lnit %,FFF !,)FF 1,%FF [email protected] C11!,FFF C1).FF C!!,%FF C11.FF !.'F C!+.'F C#@,'FF C1'.FF C!1,FFF C!1.'F C#F,1FF C1),'FF 61$*00
hair and 5tool *er Lnit
C)1.FF C11.FF CB.'F #.!' C#F.@@ C1F.FF CB.1#
Total @,FFF ),BFF 1,1FF C)+,1FF C1!,1FF
C##,B)# C11,FFF C1F,F#@ C1!,'FF 62%*$
The =lider contest has a C1#,)FF positive contribution margin net of the estimated cost of the and&tool contest has a negative contribution of C!,%)#. ote that the above solution used act cost information. The analysis below compares the contribution margin for each product based on actual sales a usage to the product contribution margins based on actual sales at #udgeted cost and #udg shows that if Oillside had controlled usage and cost of materials and labor, it would have improv amount far eceeds the C1#,)FF potential improvement from increasing the sales of =liders usin Thus, strategically, it is important for Oillside to focus on cost management as well as improving s
3ased on 8ctual 5ales Golume 8ctual Besource Esage and 8ctual ost ;ata Dliders hair and 5tool *er Lnit Total Total *er Lnit >udgeted &ales %,FFF @,FFF !,)FF 3ctual &ales ),BFF &ales &hortfall 1,%FF 1,1FF [email protected] C!F@,FFF C)1.FF C%!F,BFF 3ctual &ales
Direct material
C1).FF
C%1,)FF
C11.FF
C+',BFF
Total
constraints in determining your answer. #. 4ithout regard to your answer to *art !, assume that Donna decides to sell %F,FFF units at C!FF per unit a !%,FFF units at C1@F per unit. *repare a budgeted income statement for Dim8ok showing whether her deci will achieve Dim8ok5s profit ob0ectives. %. 3ssess Dim8ok5s competitive strategy. '. /ndentify strategic success factors that are associated with Dim8ok strategy. 5olution 1. The dollar value of the present level of Dim8ok5s fied costs per year is calculated as follows: *rofit target based on !FM of annual fied costs E \ Total fied costs E C@FF,FFF K F.!F E
C@FF,FFF 6%000000
!. Dim8ok must sell *%000 units in order to achieve both profit ob0ectives, viA., a !FM return on fied assets C!F per unit sold. &upporting ;alculations: 2irst, the solution must consider the following constraints: ● %F,FFF unit capacity for the current facility ● C1,FFF,FFF additional fied charge for production up to @F,FFF units ● a sales discount of C!F per unit for sales beyond %F,FFF units ● a variable cost decrease of C!F per unit after the prodution of )F,FFF units &econd, the calculation of profit with the current facility at the capacity level of %F,FFF units will not me ob0ectives, as demonstrated by the following calcuations:
Contribuon margin per unit belo the !",""# unit level $ %&"" selling price ' (%" vc per unit + % E C1FF contribution per unit, up to %F,FFF units sold
6100.00
;alculation of the number of units to achieve the desired profit ob0ectives = 2ied charges J Desired profit- K ;ontribution margin per unit = C%,FFF,FFF J C@FF,FFF- K C1FF per unit E \
%@,FFF
required number of units eceeds current capacity by
@,FFF
Third: Thus, in order to achieve the profit targets, Dim8ok must increase plant capacity, thereby incurri additional C1,FFF,FFF in fied costs. This, in turn, increases the profit target based on fied costs total of C1,FFF,FFF i.e., F.!F G [C%,FFF,FFF J C1,FFF,FFF\-, as follows: ;apacity epansion requires increase in 2; per year E ew profit target based on new 2; per year Q!FM- E /ncrease in profit target based on 2;s E
C1,FFF,FFF C1,FFF,FFF C!FF,FFF
The perunit contribution margin for production in the range of %F,FF1 to )F,FFF units, with the se reduced C!F to C1@F per unit- is as follows: The perunit contribution margin for production in the %F,FF1 to )F,FFF units range, with a r selling price C1@F- per unit is C@F, as follows: E C1@F selling price C@F vc per unit J C!F profit per unit- E
[email protected]
Rcalculation of the number of units to achieve overall profit ob0ectives: operting income E ;" 2; C1,FFF,FFF E [C1FFIunit G %F,FFF units- J C@FU %F,FFF units--\ C',FFF,FFF UE *'000 units )',FFF units eceeds the )F,FFFunit critical level supplier5s contract-? therefore, variable costs are reduced by C!F per unit for production in ecess of )F,FFF units 2ourth: The contribution margin for production in the range of )F,FFF units @F,FFF units, with the vari per unit reduced to C)F per unit from C@F per unit- is determined as follows: E C1@F selling price per unit C)F vc per unit J C!F profit per unit-
C1FF.FF
2inally, calculation of the number of units U- needed to achieve overall profit ob0ectives: operating income E ;" 2; C1,FFF,FFF E [C1FF G %F,FFF- J C@F G !F,FFF- J C1FFU )F,FFF-\ C',FFF,FFF
#.
U E C),FFF,FFF J C),FFF,FFF C%,FFF,FFF C1,)FF,FFF- K C1FF per unit E ;imo& ;ivision
*%000
Pro 9orma :ncome 5tatement Revenue: %F,FFF units G C!FFIunit E !%,FFF units G C1@FIunit E 9ariable ;osts: )F,FFF units G C@FIunit E %,FFF units G C@F C!F-Iunit E ;ontribution "argin ;"2ied ;osts $perating /ncome
C@,FFF,FFF C%,#!F,FFF C%,@FF,FFF C!%F,FFF
C1!,#!F,FFF
C',F%F,FFF C+,!@F,FFF C',FFF,FFF 622,0000
The dual profit ob0ectives [!FM of 2;- J C!F per unit sold-\ are met, as shown below: E F.!F G C',FFF,FFF- J C!F G )%,FFF units-E C1,FFF,FFF J C1,!@F,FFF E
622,0000
Pro#lem 11-%%> Product Profita#ilit" 8nal"sis 5carce Besources 3ac&ground &antana ;ompany produces a variety of consumer electronic products. Lnit selling prices and costs for three models in one of its product lines are given below. 9ariable overhead cost is charged to products on the basis of direct labor hours D8Os-? fied overhead is allocated on the basis of machine hours. ;ata &elling priceIunit D" costIunit D8 costIunit 9ariable overhead costIunit 2ied overhead costIunit D8 rateIhour
=o 9rills Fodel C#' CB C1F C# C# C!F.FF
5tandard @ptions C)F C11 C!F C) C)
5uper Fodel C@F C1% C#F CB C)
Bequired 1. 4hat is fundamentally different about the fied versus variable overhead assigned to productsN 3nswer the question within the contet of the relevance of this difference to the determination of shortterm product mi.!. ;alculate for each product both the gross profit per unit and the contribution margin per unit. 3re either of these profitability measures useful for planning the optimum shortterm product miN 4hy or why notN #. /f the company has ecess machine capacity but a limited amount of labor time, how should the optimum short term product mi be determinedN %. 3ssume now that machine hours, not D8Os, is the limiting resource. Oow, if at all, would this affect the product mi decisionN '. Oow can the optimum product mi be determined when there are only two products, and one or more constraintsN ). Oow can the optimum product mi be determined when there are more than two products, and one or more constraintsN +. 4hat is the primary role of the management accountant in terms of planning the optimum shortterm product miN 5olution 1. 2ied manufacturing overhead costs, in total are by definition capacityrelated costs and as such are not epected to change in the short run. Thus, in total, shortterm fied costs should be independent of production volume and production mi. $n the other hand, variable overhead costs, by definition, are somehow related to volume andIor mi of products produced. Thus, these costs will normally be relevant to the shortterm productmi decision. !. =ross profit per unit and contribution margin per unit, by product:
&elling priceIunit 8ess: ;=& D" costIunit D8 costIunit 9ariable overhead costIunit 2ied overhead costIunit Dross ProfitIunit *lus: 2ied overheadIunit ontri#ution marginIunit
=o 9rills Fodel C#'
5tandard @ptions C)F
5uper Fodel C@F
CB C1F C# C# 610 C# 61$
C11 C!F C) C) 61+ C) 62$
C1% C#F CB C) 621 C) 62+
either of the above profit figures is useful in terms of determining the optimum shortterm product mi. /n the absence of production constraints, and assuming all perunit contribution margins are positive, we should produce each product up to its level of demand. /n the presence of resource constraints or limitations-, logic dictates that we allocate available resources Zto their most profitable use.Z /n this case, this means on the basis of the contribution margin per unit of the scarce resources-. These amounts are provided in *arts # and % below. #. /n the presence of a single resource constraint, we should focus on those products that provide the greatest contribution margin per unit of the scare resource, in this situation, labor time. The calculations follow. ;" per unit K D8OsIunit of output` ;" per D8O *roduct *rofitability Rankings E
=o 9rills Fodel C1#.FF F.'F C!).FF
5tandard Fodel C!#.FF 1.FF C!#.FF
5uper Fodel C!+.FF 1.'F [email protected]
1
2
$
`Direct labor cost per unit E C1F, C!F, and C#F, respectively. The above amounts are derived from the fact that the labor cost per hour is C!F.FF given-. %. /f machine hours represent the scarce resouce, then the allocation of machine hours to products should be based on the contribution margin per machine hour. 3s seen from the calculations below, the product profitability rankings differ from those determined in *art # above. ;" per unit Relative machine hoursIunit ;" per relative hour
*roduct Rankings E
=o 9rills Fodel C1#.FF 1.FF C1#.FF
5tandard Fodel C!#.FF !.FF C11.'F
5uper Fodel C!+.FF !.FF C1#.'F
2
$
1
ote how these are calculated.
ote that while we do not know the number of machine hours per unit, we do know the relative number of machine hours across the three products: this information comes from the allocated fied manufacturing cost data. '. /f there are only two products and one or more constraints-, we could solve the productmi problem using the graphical approach presented in the chapter see 6hibits 11.1B and 11.!1-. $ne alternative is to evaluate the total profitability at each of the corner points associated with the feasible region and to choose the product mi corner point- that maimiAes shortterm profit. 3nother alternative is to us a set of isoprofit lines combination of the two products that results in a given level of profit-. 6tend the isoprofit line up to the right until it 0ust touches a point in the feasible set region-: this point mi of the two products- defines the optimum product mi. ). /n the case where there are more than two products and one or more constraints-, the graphical approach is not practical. /n this case, the use of dedicated software Zconstrained optimiAationZ- such as the &olver routine in 6cel should be used for shortterm production planning. +. The primary role of the management accountant in terms of shortterm profit planning is to generate accurate estimates of the contribution margins for each product or service-. 4hether a simple or a comple decision contet, the general solution to the productmi problem is to allocate scare resources on the basis of the contribution margin of each productIservice per unit of scarce resource. /f these estimates are in error, then resolution of the shortterm optimum product mi may be compromised.
Pro#lem 11-%'> Profita#ilit" 8nal"sis7 inear Programming 8ppendix 3ac&ground Oome &ervice ;ompany offers monthly service plans to provide prepared meals that are delivered to customers7 homes and need only
be heated in a microwave or conventional oven. Oome &ervice offers two monthly plans, premier cuisine and haute cuisine. The premier cuisine plan provides froAen meals that are delivered twice each month? the premier generates a contribution of C1'F for each
monthly service plan sold. The haute cuisine plan provides freshly prepared meals delivered on a daily basis and generates a contribution of C1FF for each monthly plan sold. Oome &ervice7s strong reputation enables it to sell all meals that it can prepare. 6ach meal goes through food preparation and cooking steps in the company7s kitchens. 3fter these steps, the premier cuisine
meals are flash froAen. The time requirements per monthly meal plan and hours available per month follow: *reparation Oours required: *remier cuisine Oaute cuisine Oours availableImonth
# 1 @F
;ooking
! # 1!F
2reeAing
1 F %'
2or planning purposes, Oome &ervice ;ompany uses linear programming to determine the most favorable mi of *remier and Oaute ;uisine meals to produce. Bequired
1. Lsing the &olver function in 6cel, determine the most profitable product mi for Oome &ervice ;ompany given the eisting constraints and product contribution margins. !. =enerate and interpret the information contained in the Z&ensitivity ReportZ associated with the solution associated with *art 1 above. #. Lsing the &olver function in 6cel, determine the most profitable product mi for Oomer &ervice ;ompany given the eisting contribution margins and all constraints ecept the preparation time constraint. 5olution
1. &olve for all three constraints: the solution is 1+ units of *remier and !B units of Oaute, as shown in 6hibit 11%';, cells >' and >). The &olver set up for this solution is shown in 6hibit 11%'3. The completed dialog bo Z&olver *arametersZ- is presented in 6hibit 11%'>. 4xhi#it 11-%'8> Pro#lem 5et Ep
=ote> 2ormulas for total contribution margin must be entered into cells =' and =) cell =+ contains the sum of the individual product contribution margins-. 3s well, formulas for capacity usage must be entered into cells O':H). 3 separate formula for the use of each resource is entered in cells O+:OB. 4xhi#it 11-%'3> 5olver dialog !indo! K5olver ParametersK
4xhi#it 11-%'> @ptimum 5olution
!. &ensitivity Report
=otes--5ensitivit" Beport> 1. Reduced costs: these pertain to the two decision variables *remier and Oaute-. /f all such variables are in the optimum solution as in the present case-, then these values will be Aero. Technically, the Zreduced costZ for a variable not in the optimum solultion represents the amount by which the perunit contribution margin would have to change in order for the variable to enter the optimal solution. !. 2or each decision variable, the Z3llowable /ncreaseZ and Z3llowable DecreaseZ provide a range over the ob0ective function coefficents here, perunit contribution margins- over which the optimum solution holds. 2or eample, the current optimum solution holds as long as the contribution margin per unit is within the range C)).!) C#FF.FF. #. 2or each constraint *rep, ;ook, and 2reeAe- the 2inal 9alue represents the amount of the resource used under the optimum solution. /f you look at cell O+ and /+ you see that the entire time allotment for *rep and ;ook are used up under the optimum solution. 3s such, each of these two constraints has a Zshadow price,Z which represents the maimum amount Oome &ervice ;ompany would be willing to pay for one additional unit here, hour- of each constraint.
#. Results after removing the preparation time constraint: the constraint to remove from the Z&olver *arametersZ dialog bo is
4xhi#it 11-%';> @ptimal 5olution after removal of P reparation /ime onstraint
*roblem 11%) 3lso B'F-: ;9* 3nalysis? &ustainability? Lncertainty? Decision Tables 3ac&ground 4ith gasoline prices increasing rapidly in recent years, consumers have moved to high milespergallon mpg- vehicles, in particular hybrid vehicles that rely on a battery as well as a gasoline engine for even greater mpg. The new vehicles save money on gas, but also reduce t he motorist5s Zcarbon footprintZ in an environment of global warming. To encourage the purchase of fuelefficient vehicles such as hybrids, t he government may provide incentives, include income ta credits, which represent dollarfordollar reductions in the ta liability of the individual in the year of purchase. 3sboth a costconscious and an environmentally conscious consumer, you are currently evaluating whether to purchase a hybrid vehicle. 3ssume that you have narrowed your decision down to two choices, a gasolinepowered vehicle or its equivalent hybrid e.g., 2ord 6scape versus 6scape hybrid-. Relevant information regarding each of these two vehicles, as well as additional information pertinent to your decision isgiven below. ;ata
/ax redit
1ost
=asoline model Oybrid model
C1+,FFF C1B,FFF
mpg
CF C'FF
6stimated usage in years-, both models E 6stimated miles driven per year E
!#.F !+.F
% 1',FFF
Bequired
1.=enerate a cost function for each decision alternative, where the dependent variable, <, is Zlifetime costZ and the independent variable, , isZlifetime miles driven.Z !.;alculate the breakeven price for gas per gallon- between the gasolinepowered model and the hybrid model. /gnore the time value of money in your calculation.#.*repare a graph for lifetime cost <- for each of the t wo autos as a function of price per gallon of gas U-, based on )F,FFF lifetime miles for each auto. Lse the following value of U price per gallon of gas- to generate each cost function: U C!.+' C#.FF C#.!' C#.'F C#.+' C#.@@ C%.FF C%.!' C%.'F C%.+' C'.FF %.This decision problem is similar to the choiceofcoststructure variable vs. fied- discussed in the chapter. Oere, the issue is whether to pay an upfront primium eta fied cost- for the hybrid model, in echange for lower variable costs over the life of the vehicle. /n a typical ;9* model, we were able, at any output level U- to calculate a measure of profit sensitivity, which we called the degree of operating leverage D$8-. /n the present contet, which involves only costs for each vehicle over a fouryear period, we cannot calculate D$8, but we might calculate an analogous measure: the ratio of M change in lifetime cost to M change in miles. Refer to this as a pseudoD$8. ;alculate the pseudo D$8 measure for each decision alternative, from a base of )F,FFF lifetime miles. To calculate the percentage change figures, use )!,FFF miles. 4hat information is conveyed in the two measures you calculatedN '.
ifetime Files ;riven +F,FFF )F,FFF 'F,FFF
=ote> /nitial cost difference E ;ost of Oybrid net of rebate- P ;ost of gasolinepowered model ).The following probabilities p- apply to the set of possible events price of gas, per gallon- listed above in #-: F.F'? F.F'? F.F'? F.F'? F.1'? F.!'? F.1'? F.1F? F.1F? and F.F'.
is the outcomes probability. 6vent C!.+' C#.FF C#.!' C#.'F C#.+' C#.@@ C%.FF C%.!' C%.'F C%.+'
i
1 ! # % ' ) + @ B 1F
p
F.F1 F.F' F.F' F.F' F.1' F.1' F.1' F.!F F.1F F.FB
+.3s noted in the preceding analyses, in some plausible scenarios the lifetime cost of each of the two decision alternatives is very closein some cases they are practically indistinguishable. 4hat nonfinancial qualitative- factors and other quantitative factors beyond those considered above- might be relevant to your decisionN 6plain.
5olution
1.ifetime cost functions> let C Hl ifetime cost and v H cost per gallon of gas Begular model> 8ifetime ;ost <- E 2ied ;ost J 9ariable ;ost 8ifetime ;ost <- E C1+,FFF J v G [)F,FFF miles K!#.F mpg\8ifetime ;ost <- E C1+,FFF J !,)F@.+ gals. G v("#rid model> 8ifetime ;ost <- E 2ied ;ost J 9ariable ;ost 8ifetime ;ost <- E C1B,FFF C'FF- J v G [)F,FFF miles K !+.F mpg\8ifetime ;ost <- E C1@,'FF J !,!!!.! gals. G v2.3rea&even gas price point of cost indifference> let KvK H #rea&even price per gallon 8ifetime;ost=as "odel
E
8ifetime ;ostOybrid "odel
C1+,FFF J!,)F@.+ gals. Gv - E C1@,'FF J!,!!!.! gals. vv E [C1@,'FF C1+,FFF\ K [!,)F@.+ gals. !,!!!.! gals.\ E C1,'FF K #@).' gals. E 6$.,, per gallon
$. ifetime cost graph> Dasoline-Po!ered Fodel versus ("#rid Fodel Rprice
ifetime ost
per gal.
Das Fodel
C!.+'F C#.FFF C#.!'F C#.'FF C#.+'F C%.FFF C%.!'F C%.'FF C%.+'F C'.FFF
C!%,1+% C!%,@!) C!',%+@ C!),1#F C!),+@# C!+,%#' C!@,F@+ C!@,+#B C!B,#B1 C#F,F%#
("#rid
C!%,)11 C!',1)+ C!',+!! C!),!+@ C!),@## C!+,#@B C!+,B%% C!@,'FF C!B,F') C!B,)11
ifetime osts> Das-Po!ered vs. ("#rid Fodel C#F,FFF C!B,'FF C!B,FFF C!@,'FF C!@,FFF C!+,'FF C!+,FFF C!),'FF C!),FFF C!','FF C!',FFF C!%,'FF
;olumn6
C!%,FFF
C!.+'F
C #.FFF C#.!'F
C#.'FF
;olumn
2
C#.+'F C %.FFF
C % . !' F C % . 'F F
C % . +' F C ' . F FF
>ased on the above analysis and graph, we see that for these two alternatives gaspowered vs. hybrid model-, and )F,FFF miles total usage over a fouryear period, the lifetime costs are close, that is, they are insensitive to the predicted cost of gas per gallon. %. Pseudo ;@ measure sensitivit" of change in total cost to change in activit" miles driven 3lternative 8ifetime "ileage 3ssumption E $ ri gi na l3 ss um pt io n 8 if et im e " il ea ge E 3ssumed pricepergallon of gas E ifetim e ost @ption =as *owered ;ar Oybrid "odel
L *2000 miles C!+,+@# C!+,)@'
)!,FFF ) F, FF F C%.FF ifeti me ost J h a ng e L *0000 miles 1o s t C!+,%#' 1.!)+@M C!+,#@B 1.F@1@M
J ha ng e
P s eu d o
F il ea ge
;@
#.###M #.###M
F.#@F F.#!'
The above pseudo D$8 measure for the gaspowered car indicate t hat from a baseline of )F,FFF lifetime miles, for each 1M change in lifetime miles driven, lifetime cost changes by F.#@M. The relevant measure for the hybrid, from this base, is F.#!'M. 4hat this tells us is that for this particular eample, the lifetime cost for >$TO alternatives is approimately equally sensitive to change in miles driven. '.;ecision /a#le> #rea&even gas price per gallon for different com#inations of intial cost differential h"#rid - gas model and lifetime miles driven.
3ase ase
/ ni ti al ;os t Differential C!,'FF C!,'FF C!,'FF C!,FFF C!,FFF C!,FFF C1,'FF 61'00 C1,'FF C1,FFF C1,FFF C1,FFF C'FF C'FF C'FF
>reakeven =as *rice pergallonC'.'%' C).%)B C+.+)# C%.%#) C'.1+' C).!1F C#.#!+ 6$.,,1 C%.)'@ C!.!1@ C!.'@@ C#.1F' C1.1FB C1.!B% C1.''#
8i fe ti me "i les Driven +F,FFF )F,FFF 'F,FFF +F,FFF )F,FFF 'F,FFF +F,FFF *0000 'F,FFF +F,FFF )F,FFF 'F,FFF +F,FFF )F,FFF 'F,FFF
2or eample, for the base case C1,'FFF intial cost differencen and )F,FFF lifetime mil es driven- the breakeven cost per gallon of gas isC#.@@1 as found earlier i n part !-. 3st his price, and all other things equal, you would be indifferent between the hybrid model and the gasolinepowered model. otice from the above table that the higher the initial cost differential for the hybrid versus the gasolinepowered model, the greater the breakeven point in terms of cost per gallon of fuel.
umber of ilfetime miles assumed E
i
1 ! # % ' ) + @ B 1F
)F,FFF 6vent
C!.+' C#.FF C#.!' C#.'F C#.+' C#.@@ C%.FF C%.!' C%.'F C%.+'
3ction DecisionOybrid =as "odel
p
F.F1 F.F' F.F' F.F' F.1' F.1' F.1' F.!F F.1F F.FB &umE
C!%) C1,!'@ C1,!@) C1,#1% C%,F!' C%,F)B C%,1F@ C','@B C!,@'F C!,)1' 6 2+ $ *0
C!%! C1,!%1 C1,!+% C1,#F+ C%,F1+ C%,F)B C%,11' C',)1+ C!,@+% C!,)%' 6 2+ % 01
To minimiAe the epected lifetime cost, we should choose the hybrid model. Oowever, these epected values are so close that they are effectively equal, given uncertainty in the price of gas. Thus, if total miles driven over the lifetime of each vehicle % years- is )F,FFF, then the epected lifetime cost of both actions given the assumed probability distribution- is approimately equal. 2inally, note that basing the decision solely on epected value in this case, lifetime cost- ignores the risk preferences of the decisionmaker. The decision table presented above in part ' can be used to facilitate this discussion. +. Qualitative and other quantiative considerations> student ans!ers !ill li&el" differ. 3elo! are representative considerations. ualitative ;onsiderations a.safety recorddoes this differ between the two modelsN b.reliabilitydoes this differ between the t wo modelsN in some cases, the reliability of new models isconsiderably less than the reliability of older, more established modelsc.as noted in con0unction with the discussion of decision tables above-, we have not given eplicity consideration to the decision maker5s attitude toward risk associated with the inputs to the decision model d.Zcarbon footprintZ issueit istrue that from an operating standpoint, the carbon footprint of the hybrid would be less than it is for the related gasolinepowered model. Oowever, what this comparison ignores is the total carbon footprintfrom manufacture, through operation use-, through disposal. /t is possible, for eample, that when one considers the relatively energy consumption needed to build the hybrid model, depending on total miles driven, its carbon footprint might be larger than it is for the related gasolinepowered model. e. relationship between mpg and lifetime miles driven: ignored thus far in the analysis is the fact that the latter might be a function of the former. $ur analysis has, in fact, assumed that these two variables are unrelated i.e., we assumed in the base case that for both decision alernatives lifetime miles driven E)F,FFF-. Oowever, it is entirely possible that people who purchase the more fuelefficient hybrid model drive more. 3dditional uantitative ;onsiderations a. useful lifewhat is the estimated useful life for each vehicleN this would be important if the buyer intended to use the vehicle beyond the fouryear planning horiAonb. estimated salvageIdisposal value at the end of the fouryear planning horiAondoes this amount differ between t he two modelsN c. related to point b above, what is the estimated salvage value at the end of each of years 1 through #N important as a potential ZbailoutZ considerationd. other operating epenses e.g., insurance, repairsImaintenance-how do these compare for the two vehiclesN 4hat is the estimated battery life for the hybridN 4hat is the likelihood that the battery would have to be replaced during the fouryear ownership periodN e. time value of money discount rate-the underlying decision here islongterm in nature. 3s such, the decisionmaker should consider the present i.e., discounted- value of costs associated with each decision alternative similar to the approach taken in capital budgeting decisionsf. the given mpg figures are based on some type of average driving or mi between city and highway miles driven-. /s the
would be used more frequently in this contet. $n the other hand, if most of the driving will be highway driving, the fuel efficiency gap between the hybrid and the gasolinepowered model closes.$nce the hybrid gets to highway speed it is being propelled mostly by the gasoline engine.
Pro#lem 11-%+> ;ecision-Fa&ing ognitive 3iases 3ac&ground $btain from your library a copy of the following article: D. (ahneman, D. 8ovallo, and $. &ibony, S>efore ig Decision, *arvard +usiness Review , Hune !F11, pp. '1)F. S6ven highly eperienced, superbly competent, and wellintentioned managers are fallible p. )F-. This article discusses a variety of cognitive biases associated with the decisionmaking process. &uch biases can diminish the quality of decisions. The authors maintain* that understanding these biases may decrease their effect and offer a checklist designed to facilitate decision quality control. Bequirements 1. 4hat is meant by the term Scognitive biasN !. 4hat is the specific decisionmaking contet addressed by the authors of this articleN #. 4hat are the three ma0or categories of the decision qualitycontrol checklist recommended by the authorsN %. 4hat are the specific cognitive biases discussed by the authors of this articleN 5olution 1. The term Zcognitive biasZ refers to factors that distort reasoning in business, that is, that diminish the quality of decisions. &uch biases, it is maintained, result from the fact that in the real world managers often rely on heuristics rules of thumb- to make decisions.
4e can define heuristics as Zmental shortcutsZ that are used in 0udgment, estimation, and decisionmaking. 6vidence from cognitive psychology over a number of years suggests that the use of such heuristics can lead to predictable, systematic errors and biases, of the sort discussed in this article. !. The decisionmaking contet used as the basis of discussion in this article is a managerI eecutive who must make a decision based on recommendations to himIher from a decision making team. The article offers a systematic framework that, according to the authors, can be used to vet the quality of proposals submitted for evaluation. This framework consists of a checklist of 1! items divided into three categories. Lse of the checklist is designed to allow the managerIeecutive to detect 1! different cognitive biases.
#. The three ma0or categories comprising the checklist are: ` uestions managersIeecutives should ask themselves * uestions that should be addressed to the decisionmaking team * uestions focused on evaluating the proposal under consideration %. &pecific questions within each of the three ma0or categories on the checklist: uestions "anagersI6ecutives &hould 3sk Themselves a. /s there reason to suspect bias driven by selfinterest of the recommending team i.e., is the proposal motivated by selfinterestas measured in financial terms, reputational effect, organiAational power, or career options-N Does the proposal include only a single realistic optionthe one that the recommending team prefersN b. Oas the team Zfallen in love withZ its own proposalN ;heck for what is called an Zaffect hueristicZ that is, the tendency of the decision team to minimiAe the r isks and costs of a proposed course of action that it favors, and to do the opposite for a proposal it does not favor-. 6ssentially, this bias is rooted in emotional effects. c. ;heck for Zgroupthink,Z that is, the tendency of a team to minimiAe conflict by converging on a decisionIrecommendation because it appears to be gathering support. Thus, it is appropriate to ask: Z4ere there dissenting opinions within the teamNZ
uestions to be asked of the team making the recommendation a. /s the proposalIrecommendation sub0ect to Zsaliency biasZ i.e., undue reliance on an analogy to a memorable successa salient analogy-N 3s the authors note p. ''-, the use of a single or 0ust a few analogies almost always leads to faulty inferences b. ;onfirmation bias did the team seek out only evidence that helped support its recommendation andIor ignore or underweight evidence that contradicted the recommendationN- Does the proposal include more than one recommended optionN c. 3vailability bias i.e., the tendency of individualsIteams to base 0udgments only on readily available information-. The key here is to think critically about the data that are needed to make an informed decision and not simply to rely on information that is available. d. 3nchoring bias achoring refers to the tendency to make 0udgments consistent with some prior cue or anchor, regardless of the relevance of that anchor-. 3 strategy to deal with this possible bias is to reanchor with figures generated by other models or benchmarksa kind of sensitivity analysis. e. Oalo effect Zguilt by associationZ or false inferences based on reputational effects-. f. &unk;ost 2allacyI6ndowment 6ffect people have a tendency to become committed to
a previously selected course of action or pro0ect beyond the point prescribed by a rationalIoptimal model-. This is particularly true when these individuals have made large investments via prior decisions i.e.,Zsunk costsZ- or when they feel the need to 0ustify past decisions that have had bad outcomes i.e., Zescalation of commitmentZ-. 6valuating the *roposal /tself a. /s the basecase scenario overly optimisticN Does the proposal include potential competitor reactionsN b. The Zdisaster effectZ: is the worstcase scenario overly optimistic i.e., not Zbad enoughZ-N The authors5 discussion of a ZpremortemZ is an interesting way to deal with this potential problem.c. 8oss aversion: is the recommending team being overly cautiousN *ut another way, is the proposed paln creative or ambitious enoughN
