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CVP – chp8

8.18

CVP, movie production. (10 min)
1

Fixed costs = €5,000,000 (production cost)
Unit variable cost = €0.20 per €1 revenue (marketing fee)
Unit contribution margin = €0.80 per €1 revenue

Break even point in revenues =

Fixed costs
Unit contribution margin per € 1 revenue

a
€5, 000, 000
€0.80

=
= €6,250,000
b
2

8.19

Espasso receives 62.5% of box-office receipts. Box-office receipts of
€10,000,000 translate to €6,250,000 in revenues to Espasso.

Revenues, 0.625  €300,000,000

€187,500,000

Variable costs, 0.20  €187,500,000
Contribution margin
Fixed costs
Operating income

37,500,000
150,000,000
5,000,000
€145,000,000

CVP, cost structure differences, movie production. (20 min)
1
a

Contract A
Fixed costs for Contract A:
Production costs
€21,000,000
Fixed salary
15,000,000
Total fixed costs
€36,000,000
Unit variable cost = €0.25 per €1 revenue marketing fee
Unit contribution margin = €0.75 per €1 revenue

Box-office receipts of €76,800,000 translate to €48,000,000 in revenues to Espasso.
b

Contract B
Fixed costs for Contract B:
Production costs
€21,000,000
Fixed salary
3,000,000
Total fixed costs
€24,000,000
Unit variable cost = €0.25 per €1 revenue fee to Artes e Media
€0.15 per €1 revenue residual to director/actors
€0.40 per €1 revenue
Unit contribution margin = €0.60 per €1 revenue
€24,000,000

Breakeven points in revenues =

€0.60

= €40,000,000

Box-office receipts of €64,000,000 translate to €40,000,000 in revenues to Espasso.

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

Difference in breakeven points
Contract A has a higher fixed cost and a lower variable cost per sales euro. In
contrast, Contract B has a lower fixed cost and a higher variable cost per sales euro.
In Contract B, there is risk sharing between Espasso and Vieira, Moura and Rebello
that lowers the breakeven point, but results in Espasso receiving less operating
income if Tornado 2 is a mega-success.
2

Revenues, 0.625 × €300,000,000
Variable costs, 0.40 × €187,500,000
Contribution margin
Fixed costs
Operating income

€187,500,000
75,000,000
112,500,000
24,000,000
€ 88,500,000

Tornado 2 has a higher breakeven point than Tornado due to having a higher level
of fixed costs and a lower unit contribution margin.

8.24

CVP, shoe stores. (20–30 min)
1
a

In number of pairs:

Fixed costs
£360,000

 40,000 pairs
Contribution margin per pair
£9.00
b

In revenues:

Fixed costs
£360,000

 £1, 200,000
Contribution margin % per pound sterling 100%  70%
2

Revenues, £30 × £35,000

£1,050,000

Variable costs, £21 × £35,000

735,000

Contribution margin

315,000

Fixed costs

360,000

Operating income (loss)

£ (45,000)

An alternative approach is that 35,000 units is 5,000 units below the breakeven
point and the unit contribution margin is £9.00:
£9.00 × 5,000 = £45,000 below the breakeven point.
3

Fixed costs: £360,000 + £81,000 = £441,000
Contribution margin per pair = £10.50
a

Breakeven point in units =

£441,000
= 42,000 pairs
£9.00

2
© Pearson Education Limited 2012

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

b
4

Breakeven point in revenues = £30 × 42,000 = £1,260,000

Fixed costs = £360,000
Contribution margin per pair = £8.70
a
b

Breakeven point in units =

£360,000
= 41,380 pairs
£8.70

Breakeven point in revenues = £30 × 41,380 = £1,241,400

3
© Pearson Education Limited 2012

Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5th Edition, Instructor’s Manual

5

Breakeven point = 40,000 pairs
Store manager receives commission on 10,000 pairs
Cost of commission = £0.30 × 10,000 = £3,000
Revenues, £30 × £50,000

£1,500,000

Variable costs
Cost of shoes

£975,000

Salespeople commission

75,000

Manager commission

3,000

1,053,000

Contribution margin

447,000

Fixed costs

360,000

Operating income

£87,000

An alternative approach is 10,000 units × £8.70 = £87,000
8.25

CVP, shoe stores. (20–25 min)
1

Because the unit sales level at the point of indifference would be the same for each
plan, the revenue would be equal. Therefore, the unit sales level sought would be
that which produces the same total costs for each plan.
Let Q = unit sales level
a

£19.50Q + £360,000 + £81,000 = £21.00Q + £360,000
£81,000 = £1.50Q
Q = 54,000 units

2
Commission plan
Sales in units

Salary plan

50,000

60,000

50,000

60,000

£1,500,000

£1,800,000

£1,500,000

£1,800,000

1,050,000

1,260,000

975,000

1,170,000

Contribution margin

450,000

540,000

525,000

630,000

Fixed costs

360,000

360,000

441,000

441,000

90,000

180,000

84,000

189,000

Revenues @ £30.00
Variable costs @ £21.00
and £19.50

Operating income (£)

The decision regarding the plans will depend heavily on the unit sales level that is
generated by the fixed salary plan. For example, as the answer to requirement (1)
shows, at identical unit sales levels in excess of 54,000 units, the fixed salary plan
will always provide a more profitable final result than the commission plan.

4
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00 (7. Datar and Rajan. 000 – 4.00 = €529.50TQ = £609.00TQ − £19.000 = £168. Horngren.000 per month plus €43.000 relevant range.000 TQ = £528. 000 = €43.000 units as the commission plan offers at 58.000.667 units (rounded) The decision regarding the salary plan depends heavily on predictions of demand.000 TQ = £609.000) = €228.00 (professional labour-hours) The linear cost function is plotted in Solution Exhibit 9. Management and Cost Accounting.000 Cost function = €228.000 ÷ £9.000 − €43.00TQ − £360.000 units b £30. Cost estimation chpt 9 9. the constant component of the cost function does not represent the fixed overhead cost of Marre-Quise. The relevant range of professional labour-hours is from 3.000 + €43. The constant component provides the best available starting point for a straight line that approximates how a cost behaves within the 3.000 to 8.Bhimani.00 per professional labour-hour.15. Instructor’s Manual 3 Let TQ = Target number of units a £30. 2 A comparison at various levels of professional labour-hours is as follows.15 Linear cost approximation.000 £10. 5th Edition.00TQ = £528.00TQ − £21. No. For instance.000 = Constant (a) 7.000 £9.667 units. The linear cost function is based on the formula of €228.000 – €400.000 = £168.00 TQ = 58.50 TQ = 58.000 ÷ £10.50TQ − £441. the salary plan offers the same operating income at 58. (25 min) 1 Difference in cost Slope coefficient (b) = Difference in labour hours €529. Total overhead cost behaviour: Month 1 Month 2 Month 3 Month 4 5 © Pearson Education Limited 2012 Month 5 Month 6 .000– 8.

000-hour level and understates costs by €15.000 €529. Datar and Rajan.000 0 0004. The linear cost function overstates costs by €8.000 €435.000 529.000 572. Horngren.000 443. 5th Edition. 6 © Pearson Education Limited 2012 .000) € (9.000 357.000) € € (8.000 5.000 €400.000 00007.15.Bhimani.000 00008.000 400.000 The data are shown in Solution Exhibit 9.000) € 0 € 5.000 00006.000 €477. Instructor’s Manual Actual total overhead costs Linear approximation Actual minus linear approximation Professional labour-hours €340.000 €(17.000-hour level.000 at the 5.000 486.000 at the 8.000 €587.000 3. Management and Cost Accounting.

9.000 €38. The vertical differences between actual and predicted costs are extremely small.000 €(5.15 Linear-cost function plot of professional labour-hours on total overhead costs for Marre-Quise consultants. The good fit indicates a strong relationship between the labour-hour cost driver and overhead costs.000 35. Instructor’s Manual 3 Based on Based on linear Actual Contribution before deducting incremental overhead Incremental overhead Contribution after incremental overhead Cost function €38. overhead costs increase as labour-hours increase. Horngren. indicating a very good fit. Labour-hours appears to be an economically plausible driver of overhead costs for a catering company. Slope of the regression line. Datar and Rajan.000 € 3. Management and Cost Accounting. 5th Edition.Bhimani.000) Solution Exhibit 9.16 Regression analysis. Goodness of fit. service company. Overhead costs such as scheduling. The positive slope indicates that. hiring and training of workers and managing the workforce are largely incurred to support labour. The regression line has a reasonably steep slope from left to right. on average.16 plots the relationship between labour-hours and overhead costs and shows the regression line. (25 min) 1a Solution Exhibit 9. 7 © Pearson Education Limited 2012 .271 + €3. y = €48.93X b Economic plausibility.000 43.

the minimum bid for a 200-person cocktail party would be any amount greater than €4. the variable cost per person for a cocktail party equals: Food and beverages Labour (0.16 Regression line of labour-hours on overhead costs for Hans Mehrlich’s catering company. This amount is calculated by multiplying the variable cost per person (€21. Solution Exhibit 9.97) by the total number of people (200).00 Variable overhead (0. the prices Hans Mehrlich charges should generate enough contribution to cover fixed costs and earn a reasonable profit and (c) a judgement of how representative past historical data (used in the regression analysis) is about future costs.97 Total variable cost per person 3 €15.500–7. Datar and Rajan.394. Horngren. 5th Edition. (b) a determination of whether or not his bid will set a precedent for lower prices – overall. Instructor’s Manual 2 The regression analysis indicates that. within the relevant range of 2.Bhimani. Hans Mehrlich will consider other factors in developing his bid.00 €21.5 hours  €10 per hour) 5. including (a) an analysis of the competition – vigorous competition will limit Mehrlich’s ability to obtain a higher price.93 per labour-hour) 1.500 labour-hours.394. Management and Cost Accounting. Hans Mehrlich will be earning a contribution margin towards coverage of his fixed costs. Of course. At a price above the variable costs of €4.5 hours  €3. 8 © Pearson Education Limited 2012 .97 To earn a positive contribution margin.

Cost function 1 using number of academic programmes as the independent variable appears to perform slightly better than cost function 2 which uses number of enrolled students as the independent variable. For these reasons. ESM should continue to reduce costs by improving the efficiency of the delivery of its programmes. 3 The analysis indicates that overhead costs are related to the number of academic programmes and the number of enrolled students. Cost function 1 has a high r2 and goodness of fit. Solution Exhibit 9. Datar and Rajan.19C compares the two simple regression models estimated by Raphaël.19A Plot of number of academic programmes versus overhead costs (in thousands). which is a future source of funds. b Solution Exhibit 9. Solution Exhibit 9. 5th Edition. hurts the reputation of the school and reduces its alumni base. (30–40 min) 1a Solution Exhibit 9.19B plots the relationship between number of enrolled students and overhead costs. but it also cuts down on revenues (tuition payments). If Ecole Supérieure des Mines (ESM) has pressures to reduce and control overhead costs. Management and Cost Accounting. Reducing enrolled students may cut down on overhead costs.19A plots the relationship between number of academic programmes and overhead costs.19B 9 © Pearson Education Limited 2012 .Bhimani. Both regression models appear to perform well when estimating overhead costs. particularly those programmes that attract few students. Horngren. not for profit. a high t-value indicating a significant relationship between the number of academic programmes and overhead costs and meets all the specification assumptions for ordinary least squares regression. it may need to look hard at closing down some of its academic programmes and reducing its intake of students.19 Evaluating alternative simple regression models. 2 Solution Exhibit 9. Of course. Instructor’s Manual 9. Cost function 2 has a lower r2 than cost function 1 and exhibits positive autocorrelation among the residuals as indicated by a low Durbin–Watson statistic. ESM may prefer to downsize its academic programmes.

Bhimani. 5th Edition. Management and Cost Accounting. Datar and Rajan. Horngren. 10 © Pearson Education Limited 2012 . Instructor’s Manual Plot of number of enrolled students versus overhead costs (in thousands).

4 Specification analysis of estimation assumptions Plot of the data indicates that assumptions of linearity.20 €27. Datar and Rajan. constant variance and normality of residuals hold. constant variance.00 €24. 2 Goodness of fit r2 = 0. independence of residuals and normality of residuals hold.20 11 © Pearson Education Limited 2012 .00 €115.20 Solution given in book Relevant costs and LP 10.77 indicates that independence of residuals does not hold.20 €158. but not as good as for number of academic programmes.40 81.55 Good goodness of fit. A positive relationship between overhead costs and number of enrolled students is economically plausible at Ecole Supérieure des Mines. (20–25 min) 1 Cola Selling price per case Deduct variable costs per case Contribution margin per case Lemonade Punch Natural orange juice €108. Durbin–Watson statistic = 1.08 is significant.19C Comparison of alternative cost functions for overhead costs estimated with simple regression for Ecole Supérieure des Mines. 19.72 r2 = 0. but inferences drawn from only 12 observations are not reliable. Instructor’s Manual Solution Exhibit 9.11 Relevant costs. 5th Edition. independent variable(s) t-value of 3. Criterion Cost function 1: number of academic programmes as independent variable Cost function 2: number of enrolled students as independent variable 1 Economic plausibility A positive relationship between overhead costs and number of academic programmes is economically plausible at Ecole Supérieure des Mines.00 91.Bhimani.80 €49.40 €230. Plot of the data indicates that assumptions of linearity.53 is significant. 3 Significance of t-value of 5.20 120.00 €37. Excellent goodness of fit. but inferences drawn from only 12 observations are not reliable.60 181.81 indicates that independence of residuals holds. contribution margin and product emphasis. Management and Cost Accounting. Horngren. the Durbin–Watson statistic = 0.

000 68. which has the second highest contribution margin per unit of the constraining factor.00 2.000) Jours-Daim would be worse off by €12. Management and Cost Accounting.050.00 €151. Horngren. Datar and Rajan.20 The maximum of 6 metres of front shelf space will be devoted to Cola because it has the highest contribution margin per unit of the constraining factor.20 €246.20 246.000 if it drops the Fourbe-Riz business.12 Customer profitability.00 151. choosing customers.80 €49.00 The allocation that maximises the daily contribution from soft drink sales is: Metres of shelf space Daily contribution per metre of front shelf space Cola Lemonade Natural orange juice Punch Total contribution margin per day €675. Natural orange juice and Punch (that have the second lowest and lowest contribution margins per unit of the constraining factor). Instructor’s Manual 2 The argument fails to recognise that shelf space is the constraining factor.00 €4.20 246. since each of the remaining two products. 10.00 €6. Consuelo should aim to get the highest daily contribution margin per metre of front shelf space: Cola Contribution margin per case Sales (number of cases) per metre of shelf space per day Daily contribution per metre of front shelf space 3 Lemonade Natural orange juice Punch €27.751.20 25 24 4 5 €675.304.00 151. (20–25 min) 1 Jours-Daim should not drop the Fourbe-Riz business as the following analysis shows: Loss in revenues from dropping Fourbe-Riz €(80.Bhimani. 5th Edition.000 Total savings in costs Effect on operating income 48. 12 © Pearson Education Limited 2012 .000 20. Four metres of front shelf space will be devoted to Lemonade.000 €(12.00 €576. must be given at least one metre of front shelf space. There are only 12 metres of front shelf space to be devoted to drinks.00 576. No more shelf space can be devoted to Lemonade.00 €24.000) Savings in costs: Variable costs Fixed costs 20% × €100.00 €37.

it would take an additional 500 hours of machine time. therefore. 13 © Pearson Education Limited 2012 .000 of additional Fourbe-Riz business in February is identical to jobs done in January.000 = €64 500 Since the €80.) The contribution margin per unit of the constrained resource for each customer in January is: Harpes-à-Gonds Revenues Variable costs Contribution margin Fourbe-Riz €120. Horngren. (Fixed costs will remain unchanged at €100. Jours-Daim’s operating income in February would then be €16.000 operating income in January.000 (2.500 hours for Harpes-à-Gonds and 1.Bhimani.000 €16.000 machine-hours) and then allocate the remaining 1.000 €52.000 €78.000 Contribution margin per machine-hour = €52 1. it would require 2. it must forgo some of Harpes-à-Gonds’s business.000 Total €116.000 ÷ 1. and are therefore irrelevant. which is greater than the contribution margin of €52 per machine-hour from Harpes-à-Gonds. To maximise operating income. Jours-Daim should maximise contribution margin per unit of the constrained resource. 5th Edition.000 − 1.000 Fourbe-Riz €64 1.000 €64.000 €78. Management and Cost Accounting. Jours-Daim should first allocate all the capacity needed to take the Fourbe-Riz business (1. choose how much of the Harpes-à-Gonds or Fourbe-Riz business to accept. Harpes-à-Gonds Contribution margin per machine-hour Machine-hours to be worked Contribution margin Fixed costs Operating income €52 1.000 €32.500 machine-hours) of Harpes-à-Gonds’s January revenues and variable costs and doubling (1.000 48. greater than the €10.000 42.000 100. Instructor’s Manual 2 If Jours-Daim accepts the additional business from Fourbe-Riz.000 Alternatively. it will also have a contribution margin of €64 per machine-hour.000 hours of machine capacity.000 whatever business Jours-Daim chooses to accept in February.000 hours for Fourbe-Riz). we could present Jours-Daim’s operating income by taking two-thirds (1. Jours-Daim has only 2. To maximise operating income.000 as shown below.000 €32. If Jours-Daim accepts all of Fourbe-Riz’s and Harpes-à-Gonds’ business for February. It must.000) machine-hours to Harpes-àGonds.500 hours of machine time (1.000 ÷ 500 machine-hours) Fourbe-Riz’s January revenues and variable costs. Datar and Rajan.500 €80. If Jours-Daim accepts any additional business from Fourbe-Riz.

10.000 *Some students ignore this item because it is the same for each alternative.000) iiiii (20.000 124.000 would affect Year 1 only under both the ‘keep’ and ‘buy’ alternatives.000 64.000 €150. Horngren.000 €600.000 100.000) (440.000 €25.000) (24.000) iiiii(110.000) iiiii (9. (30–40 min) 1a Statements of cash receipts and disbursements Keep Year 1 Years 2–4 Buy new machine Four years together Year 1 Years 2–4 Four years together Receipts from operations: Sales €150. how would Harpes-à-Gonds react to Jours-Daim’s inability to satisfy its needs? Will Fourbe-Riz continue to give JoursDaim €160.000 in operating income in February is not worth jeopardising its long-term relationship with Harpes-à-Gonds.000 of business each month or is the additional €80.000) Deduct disbursements: Purchase of ‘old’ machine (20.000 96.000) €88. Other students may raise the possibility of Jours-Daim accepting all the Harpes-à-Gonds and Fourbe-Riz business for February if it can subcontract some of it to another reliable.000) iiiii(110.000) (110.000 €160. Datar and Rajan.000 28. it may in fact prefer to turn down the additional Fourbe-Riz business.000 €80.000) iiiii i(60.000 8.000) iiiii(20.000 €31. For example. note that a statement for the entire year has been requested. if Fourbe-Riz’s additional work in February is only a special order and Jours-Daim wants to maintain a long-term relationship with Harpes-à-Gonds.000 8.000 Total €240.000 €(5.000) iiiii (24. Instructor’s Manual Harpes-à-Gonds Fourbe-Riz Revenues Variable costs Contribution margin Fixed costs Operating income €80.Bhimani.000 The problem indicated that Jours-Daim could choose to accept as much of the Harpes-à-Gonds and Fourbe-Riz business for February as it wants. However.000 116.000 €150. the €20. 5th Edition. However. 14 © Pearson Education Limited 2012 .000 €150. high-quality printer.000) Operation of machine (15.000)* Purchase of ‘new’ equipment Cash inflow from sale of old equipment Net cash inflow €5.000) (20.000) (36.000 €600. Obviously.000) (15.000) (440. Management and Cost Accounting.000) iiiiiiii (9.000 of business in February a special order? For example.13 Relevance of equipment costs. some students may raise the question that Jours-Daim should think more strategically before deciding what to do.000 52.000 €16. It may feel that the additional €6.000 Other operating costs (110.

1b Again. the sales and the other costs are irrelevant because their amounts are common to both alternatives. Any number may be substituted for the original €20.000 €13.000) under the ‘keep’ alternative and excluding the book value item of €20. The Car Wash manager really blundered. Note the motivational factors here.000* (8.000) Loss on disposal – – 12.000 Loss on disposal: Book value (‘cost’) – – 20. All past costs are down the drain.000 difference.000 520.000 €600.000 137.000 €150. the net cash outflows under both alternatives would be high. Datar and Rajan. the income statements of requirement (2) would be a principal means of evaluating performance. Instructor’s Manual The difference is €8. Of course. Why? Because. The analysis in requirement (1) clearly shows that we may completely ignore the €20.000 130.000 15.000. the net difference is still €8. note that the €20. The €20. However.000 Total costs 130.000: Income statements Keep Buy new machine Four Sales Years years 1–4 together Four years together Years Year 1 2–4 €150.000 9. In particular. 5th Edition. How it is subsequently accounted for is irrelevant.000 in the loss on disposal calculation under the ‘buy’ alternative.000 – Proceeds (‘revenue’) – – (8.000 36.000 512.000 * As in requirement (1a).000 €25.000 figure without changing the final answer. Merely cross out the entire line. Nevertheless.000 Operating income €20.000 9.000 60. keeping the ‘old’ equipment will increase the cost of the blunder to the cumulative tune of €8.Bhimani.000 has been spent.000 Costs (excluding disposal): Other operating costs Depreciation Operating costs of machine Total costs (excluding disposal) 5. Nothing can change what has already been spent or what has already happened.000 110.000 20. the cumulative cash flow effects are beneficial to the company as a whole (assuming a world of no income taxes and no interest).000 €600. 1c The €20. although the column totals are affected.000 125.000 over the next 4 years.000 500. in many organisations.000 24. many managers would keep the old machine rather than replace it.000 €80. Management and Cost Accounting.000 and still have a correct analysis.000 110. because it is a past (historical) cost.000 440.000 110. the difference is €8. 3 Book value is irrelevant in decisions about the replacement of equipment.000 book value can be omitted from the comparison. This adjustment would mean excluding the depreciation item of €5. Despite the economic analysis shown here.000 €150.000 125. Note that the 15 © Pearson Education Limited 2012 . Horngren.000 440.000 6.000 6. The only relevant items are those expected future items that will differ among alternatives.000 purchase cost of the ‘old’ equipment.000 – 12.000 book value may be omitted from the comparison without changing the €8.000 per year (a cumulative effect of €20.000 €88.000) – 20.000 125. 2 The net difference would be unaffected.000 20.000 for four years taken together. A manager may be reluctant to replace simply because the large loss on disposal severely harms profitability in Year 1. the €20.

Instructor’s Manual first-year operating income would be higher under the ‘keep’ alternative. This criticism is often made of the accrual accounting model.15 presents a graphical summary of the relationships. Datar and Rajan. Y) Total contribution margin 1 (0. and Y = Units of desktop computers. 3) 200 (2) + 100 (3) = 700 4 (0. 2) 200 (2) + 100 (2) = 600 3 (2. 0) €200 (0) + €100 (0) = €0 2 (2. The X − Y < 0 line is the one going upward at 45° angle from the origin. 16 © Pearson Education Limited 2012 . The conventional accrual accounting model might motivate managers towards maximising their first-year reported operating income at the expense of long-run cumulative betterment for the organisation as a whole. 5th Edition. Using the trial-and-error method: Trial Corner (X.Bhimani. 10. The salesmix constraint here is somewhat unusual.15 Optimal production plan. 6) 200 (0) + 100 (6) = 600 The optimal solution that maximises operating income is two printers and three computers. (30 min) 1 Let X = Units of printers. Management and Cost Accounting. Objective: Maximise total contribution margin of €200X + €100Y Constraints: For production line 1: For production line 2: Sales of X and Y: Negative production impossible: 6X + 4Y 10X X − Y X Y 2 < 24 < 20 < 0 > 0 > 0 Solution Exhibit 10. That is. Horngren. either because the performance–evaluation model is inconsistent with the decision model or because the focus is only on the short-run part of the performance–evaluation model. the action favoured by the ‘correct’ or ‘best’ economic decision model may not be taken. computer manufacturer.

Management and Cost Accounting. Customers may not be attracted if Vierund-Zwanzig carries only the product line with the highest unit contribution margins. 17 © Pearson Education Limited 2012 .200 square metres of grocery products and 800 square metres of dairy products. The optimal solution is 3.) 3 Solution Exhibit 10.000 > 1.Bhimani. (30–40 min) 1 Let G = floor space of grocery products carried.16 Optimal sales mix for a retailer. Instructor’s Manual Solution Exhibit 10. Fiordi-Ligio Srl. 5th Edition. sensitivity analysis. 10. Datar and Rajan. (Marketing and economics courses examine this issue under the label of interdependencies in the demand for products.15 Graphic solution to find optimal mix. The LP formula of the decision is: Maximise: €10G + €3D Subject to: €10G + €3D €10G €3D < 4.000 > 1800 2 Vier-und-Zwanzig may wish to maintain its reputation as a full-service food store carrying both grocery and dairy products. Horngren. D = floor space of dairy products carried.16 presents the graphic solution.

000) + €3 (800) = €12.200 and D = 800. Instructor’s Manual The trial-and-error solution approach is: Trial Corner (G.400* €10 (1. Solution Exhibit 10.16. €5. 3.000* €8 (1.000* €10 (3. D) 1 2 3 (1.16 Graphic solution to find optimal mix. Datar and Rajan.200.000) + €5 (800) = €12. Trial Corner (G.600* * Optimal solution is still G = 3.000) = €23. 4 The optimal mix determined in requirement (3) will not change if the contribution margins per square metre change to grocery products.000) (3.200) + €5 (800) = €29.000) (3.200 and D = 800.000) + €5 (3. we demonstrate this using the trial-and-error solution approach.200. D) TCM = €8G + €5D 1 2 3 (1.000) + 3 (3.400* .000* €8 (3. Vier-und-Zwanzig. by drawing lines parallel to the line through G = 500 and D = 800 (the equal contribution line for €4. 3.200) + 3 (800) = € 34. * Optimal solution is G = 3.Bhimani.000. 5th Edition.000. 800) TCM = €10G + €3D €10 (1. 18 © Pearson Education Limited 2012 . The student can also verify. Horngren. is the point G = 3. where the equal contribution line intersects the feasible region. 800) (1. 800) (1. Management and Cost Accounting. To avoid cluttering the graphic solution in Solution Exhibit 10.200 and D = 800.000) = 19.000) that the furthest point. 800) €8 (1.000.000. €8 and dairy products.

740 0.08 × 3.200 0.100 1.750 0.240 €0.054 Layered carrot cake €0. 3) Packaging (€0. 31).560 €1. product cost cross-subsidisation. 3) Cooling (€0.100 0.Bhimani.140 €1.200 €0.100 2.280 0.000 0. (30–40 min) The idea for Exercise 11.13 came from ‘ABC Minicase: Let them Eat Cake’. Management and Cost Accounting.140 €0. 8) Cooking (€0.13 Activity-based costing. 7) Unit total manufacturing cost €0.14 × 2.600 0.054 €2. Instructor’s Manual ABC chpt 11 11.000 units = €1.740 1. 1) Unit total manufacturing cost 2 Unit direct manufacturing cost Direct materials Direct manufacturing labour Unit indirect manufacturing cost Mixing (€0.054 per 1 Kg unit of cake Raisin cake Unit direct manufacturing cost Direct materials Direct manufacturing labour Unit indirect manufacturing cost Manufacturing overhead (€1.900 0.154 Layered carrot cake €0.054 €1.900 0.150 €3. Datar and Rajan.250 . in Cost Management Update (Issue No.780 €1. Horngren. 5) Creaming/icing (€0.800 200.200 €1.794 Raisin cake €0.520 19 © Pearson Education Limited 2012 €0.25 × 0. 1 Budgeted MOH rate in 2011 = €210.2 × 3.420 0.054 × 1.600 0.320 0.054 €1. 5th Edition.04 × 5.060 0.

0 100. Instructor’s Manual 3 The unit product costs in requirements 1 and 2 differ only in the assignment of indirect costs to individual products. The existing costing system erroneously assumes equal usage of activity areas by 1 kg of raisin cake and 1 kg of layered carrot cake. Starkuchen has more accurate product margins with ABC. d Process improvements. a sizeable reduction in creaming/icing will have a marked reduction on layered carrot cake costs.0 61. Actual production of layered carrot cake is 100% more than budgeted. b Product emphasis.0 The ABC system recognises the substantial difference in usage of individual activity areas between raisin cake and layered carrot cake.0% Layered carrot cake 14.5 0.5% 60.0 70.15) 19.9 7.9% (€0.0 30.5 4.20/€0. Horngren. 5th Edition.0 62. One explanation could be the underpricing of layered carrot cake. For example. The percentage breakdown of total indirect costs for each product is: Raisin cake Mixing Cooking Cooling Creaming/icing Packaging 25. ABC provides a road map on how a change in product design can reduce costs.32/€2. 20 © Pearson Education Limited 2012 . 4 Uses of activity-based cost numbers include: a Pricing decisions.7 34.0 30. Raisin cake is currently overcosted while layered carrot cake is undercosted.0 37.Bhimani. Improvements in how activity areas are configured will cause a reduction in the costs of products that use those activity areas.5 100. Starkuchen can use the ABC data to decide preliminary prices for negotiating with its customers. Starkuchen can reduce raisin cake’s cost by sizably reducing its cooking time or packaging time. Datar and Rajan.78) 35.5% 40. The assumed usage of indirect-cost areas under each costing system is: Existing system Layered Raisin cake carrot cake Mixing Cooking Cooling Creaming/icing Packaging 50% 50 50 50 50 50% 50 50 50 50 ABC system Layered Raisin cake carrot cake 38.7 0. c Product design.6% (€0.0% Starkuchen can reduce the cost of either cake by reducing its usage of each activity area.9 26. Similarly. Management and Cost Accounting. Starkuchen can use this information for deciding which products to push (especially if there are production constraints).8 100.

DKr 68 × 12 Assembly.125 416 2. ABC provides a more refined model to forecast costs of Starkuchen and to explain why actual costs differ from budgeted costs. Manufacturing labour costs are included in the individual indirect manufacturing (overhead) cost pools. b Manufacturing personnel – decisions about productivity and cost management can focus on ways to reduce the indirect-cost rates (such as decisions on how to make more efficient use of machines). 5th Edition. a Henriksen uses a more automated production approach with the result that manufacturing labour provides support to the machines.757 Total manufacturing costs = DKr 5. b Henriksen uses a less sophisticated information tracking system for manufacturing labour than its competitors.16 Cost planning and flexible budgeting.757 DKr 5.16 presents costing overviews of the previous job-costing system and the refined activity-based job-costing system. Management and Cost Accounting. 3 A direct cost is a cost that is related to the particular cost object and that can be traced to it in an economically feasible way. DKr 8 × 50 Machining. 21 © Pearson Education Limited 2012 . Datar and Rajan. Henriksen may differ from its competitor in several ways. 4 The refined activity-based costing system can provide information to: a Product designers – the indirect-cost rates in each of the four indirect-cost areas can guide decisions about how much (say) machine-hours to use versus assembly-line-hours when designing packaging machines. Activity-based job-costing system.000 DKr 400 816 1. 2 Direct manufacturing costs: Direct materials Indirect manufacturing costs: Materials handling. DKr 104 × 4 Total manufacturing costs DKr 3.850.757  50 = DKr 287. Instructor’s Manual e 11. DKr 75 × 15 Inspection.Bhimani. Horngren. (40 min) 1 Solution Exhibit 11. c Marketing personnel – the ABC approach can help guide pricing decisions and negotiations with potential customers on ways to manufacture a lower-cost packaging machine.

5th Edition.16 Job Costing Systems for Henriksen 11. Datar and Rajan.17 Activity-based job costing. Horngren. Management and Cost Accounting. Instructor’s Manual Solution Exhibit 11. (15 min) 1 An overview of the product-costing system is: 22 © Pearson Education Limited 2012 .Bhimani.

3. €2. There are general conditions under which ABC is most likely to operate and are:  where there is a requirement to apportion costs (e.000 750.500 €1.500 22.g. 23 © Pearson Education Limited 2012 . Horngren.000 = €242.000. Pilot Paper 2.00 × 7. Datar and Rajan. 5th Edition.50 110. Traditional methods of product costing were often volume related (e.25 236.500.500 ÷ 5.25 2 Executive chair Upstream costs Manufacturing costs Downstream costs Total costs 11.212.125 Unit costs Executive chair: €1.000.000 €25.000 35. €20 × 7.00 €412.125 ÷ 100 = €571.000 25.50 Chairman chair: €57.750 187.19 €60. 3. Instructor’s Manual Direct manufacturing costs: Direct materials Direct manufacturing labour. (45 min) a General Activity-based costing (ABC) focuses the mindset of the organisation from processes to activities and in this way. Management and Cost Accounting.500 12.000 10.00 571.g. 500 Direct manufacturing costs Indirect manufacturing costs: Materials handling.50 Chairman chair €146. 500 Indirect manufacturing costs Total manufacturing costs €600.25 × 100.4.500 462.Bhimani.000 150.00 242. but this did not develop with the growth in activities that had no relation to volume or in multiproduct businesses.125 €57. hours of labour used).500 Cutting. €25.00 €953.212.000 875 250.000 8.500.50 × 100.500 Assembly. €0. provides a framework to enable management to manage costs by altering activities undertaken. Financial Management and Control.25 Question from the Association of Chartered Certified Accountants. in a multiproduct business).

5th Edition. Instructor’s Manual  where there are significant overheads to apportion and  where the availability of sophisticated information retrieval systems allows management to track product costs as they pass through a production system. Management and Cost Accounting. Horngren.Bhimani. 24 © Pearson Education Limited 2012 . Datar and Rajan.

000 = €241. it becomes easier for management to discern which products are profitable against those that are not. In addition. The significance of overheads and the ABC method of charging costs Since ABC is a cost apportionment system. In extending the range of absorption bases. therefore. Datar and Rajan.833) − €220. Horngren. (22–25 min) 1 Payback period = €220. Cost drivers are then chosen that reflect the events that create costs when the activities are undertaken. Information systems A basic requirement for any cost allocation system is information availability. otherwise there are no costs to apportion between products. Instructor’s Manual Multiproduct businesses The main issue is that there has to be at least two products in the business. Also. This raises issues of information capture and it is in new technology that answers to this are most likely to be found. the impact of management decisions is potentially more easily seen under ABC than it is under traditional volume-related absorption methods. 11. ABC is often claimed to rest on a more accurate information base than absorption costing and hence.833 Net present value = €50.650 25 © Pearson Education Limited 2012 . 5th Edition. These costs are then collected into cost pools where there are common cost drivers. ABC is able to more closely track costs to the causes of the costs.000 = €21. products are allocated costs on the basis of the activities they use. focusing only on those costs that are traceable to manager decisions. NB 11.000 (4. This is particularly so for ABC systems that rely heavily on activity information. Finally. Management and Cost Accounting. ABC requires the monitoring of activities that have not involved monitoring previously. which then links to management decisions. ABC absorbs costs into products in a wider variety of ways than traditional absorption methods that rely mostly on labour and/or machine-hours. thereby providing a more fair outcome than absorption costing.18 solution given in the book CIA chpt 13 13. be apportioned on the basis of those activities.Bhimani.000 ÷ €50.19 for info that could assist with any written parts. ABC is based on the premise that it is activities that lead to costs being incurred and that costs should. Allied to this is that there is reduced cross-subsidisation of products: with costs accurately identified with products. there is no issue for ABC to resolve. For a single product company. all costs of the business are identifiable with the product and product probability is directly related to the profitability of the business as a whole.650 − €220.4 years 2 The table for the present value of annuities (Appendix B.12 Comparison of approaches to capital budgeting. Table 4) shows 10 periods at 16% = 4. it is principally beneficial when there is a high proportion of overhead costs – if a business incurs only direct costs. b ABC can enable the exclusion of non-controllable costs.000 = 4. Other advantages of ABC in multiproduct business relate to the accurate valuation of stock and facilitating the effective management of stock levels with multiple products.

400 On the 10-year line in the table for the present value of annuities (Appendix B. 4.400 is between a rate of return of 18% and 20%. 26 © Pearson Education Limited 2012 . Datar and Rajan.Bhimani.000F €220. find the column closest to 4.000 = Present value of annuity of €50.000 = 4.000 F= €50.000 at X% for 10 years or what factor (F) in the table of present values of an annuity (Appendix B. 5th Edition. Table 4) will satisfy the following equation. Management and Cost Accounting. €220.400. Instructor’s Manual 3 Internal rate of return (IRR): €220.000 = €50. Horngren. Table 4).

094 18% IRR rate 20% Difference Internal rate of return 4 = 18% + = 18% + (0.Bhimani.62% Accounting rate of return based on net initial investment: Net initial investment = €220.000 €50 €5.311) (2%) = 18. 27 © Pearson Education Limited 2012 . can produce results that differ markedly from the internal rate of return.73% Note how the accrual accounting rate of return. Datar and Rajan. relevant costs. 000 28. 000 = 220.302 0.000 €3. Horngren.13 Special order. whichever way calculated.000.000 300.000 Notes a The costs of plastic cars are irrelevant because these cars have already been purchased and so entail no incremental cash flow.494 4.494 – 4. 5th Edition.400 4. 000  22.300. Instructor’s Manual Interpolation is necessary: Present-value factors 4.000 Estimated useful life = 10 years Annual straight-line depreciation = €220. (30 min) 1 Relevant cash inflow from accepting the special order Relevant cash flows Per car (1) Incremental revenues (cash inflows) Incremental costs (cash outflows) Neon paint Boxes Direct manufacturing labour Total incremental costs Net incremental benefit Total (2) = (1)  100. 000 = 220.192 – 0. 13. c Allocated plant manager's salary is irrelevant because it will not change whether or not the special order is accepted.000 800.000 6 3 8 17 €33 600.000 1. Management and Cost Accounting. b VAT depreciation is irrelevant because it is a past cost.000 ÷ 10 = €22.700. capital budgeting.000 ARR = 50. 000 = 12.

0 is between a rate of return of 24% and 26%.273.300. €40.889 Net present value = €40. Horngren.000 = €35. internal rate of return.798) = 3.15 Net present value.000 = €1.0 On the 6-year line in the table for the present value of annuities (Appendix B. Instructor’s Manual d Variable marketing costs are not deducted because they will not be incurred on the special order. Management and Cost Accounting.000 €120. Therefore. These costs would continue to be incurred whether Euro-Jouets prices the cars at €50 or €59. If it must offer the same €50 price to its other customers.000F €120.9276 (€59 − €9. Table 4). sensitivity analysis. You can verify that Euro-Jouets generates positive contribution margin at a price of €50 and so should continue to sell to its existing customers. Euro-Jouets would just be indifferent between accepting and rejecting Mille-Fontaines’ special order.000 = €155.340. find the column closest to 3. Table 4) will satisfy the following equation.000 per year for 4 years from its existing customers.0724) per car to its existing customers.560 − €120. 5th Edition. The net relevant benefit of accepting the special order is €3. Euro-Jouets will lose cash flow of €9 × 130.300. 000 X =  (130. Note that whatever incremental costs Euro-Jouets incurs on sales to its existing customers is irrelevant. 13.000) (2.889) − €120.660 = €26. 000 F = €40. e Fixed marketing costs are irrelevant because they will not change whether or not the special order is accepted. (20–30 min) 1a The table for the present value of annuities (Appendix B. Table 4) shows 16 periods at 14% = 3.000 3.170.170. Euro-Jouets should accept the special order. Then €X (130.273. Table 4.560 b Internal rate of return: €120.000 at X% for 6 years or what factor (F) in the table of present values of an annuity (Appendix B.170.000 − €3.0724 At a price of €49.000 × 2. From Appendix B. 2 Let the Euro discount from the current €59 price offered to existing customers be €X.660.798)  = €9. 000 = 3. Datar and Rajan. 000)(2. 3.798 = €3.000 (3.000 = = Present value of annuity of €40. 28 © Pearson Education Limited 2012 . the present value of a stream of €1.000 payments for 4 years discounted at 16% is €1.0. 300.Bhimani.

000 3.000  0.889) Then we want = €120.30% Let the minimum annual cash savings be €X.Bhimani.135 0.000  4.000 recovery of working capital at end of year 8: €8. a form of which is described in requirement 2.600 (€30. Horngren.885 – 0.000 2.000 8. working capital. Instructor’s Manual Interpolation is necessary: Present-value factors 3. evaluation of performance.000  0.530 2.351 €115.351 Present value of €8.000  4.305 11. Datar and Rajan.975 10.190 (118. First.639 Present value of €30.000 €11. the approaches in requirement 1 would be preferred.000)  0.190 29 © Pearson Education Limited 2012 118. initial investment Additional working capital investment Net present value 129.16 When the manager is uncertain about future cash flows. 3 13. would want annual cash savings of at least €30.020 – 3.856 Carmelo.590 Gross present value Deduct net initial investment Net present value 120. €X (3.000 €120.000 per year for 8 years at 14%): €25. try a 16% discount rate: €25. DCF.020 24% IRR rate 26% Difference Internal rate of return 2 = 24% + = 24% + (0.313 .344 1 €108. This amount of cash savings would justify the investment in financial terms. 5th Edition. Management and Cost Accounting.808 Gross present value Deduct net initial investment Special-purpose machine.020 3. accounting (20–30 min) rate of return. SA.000 terminal disposal price of machine at end of year 8: €30. Calculating the minimum cash flows necessary to make the project desirable gives the manager a feel for whether the investment is worthwhile or not.148) (2%) = 24.000) €2. 1a Summary of cash inflows and outflows (in thousands) is: 8 Present value of annuity of savings in cash-operating costs (€25.313 €110. If the manager were quite certain about the future cash-operating cost savings.856 for the net present value of the investment to equal zero.000 + €8. the manager would want to do sensitivity analysis.000 1b Use a trial and error approach.889 X = = €30.

000 − €30.71% If your decision is based on the DCF model. Management and Cost Accounting.000)  0. 5th Edition.000 + €8.000  4.000 Net initial investment Annual depreciation (€110.078 €101.000 = €118. try an 18% discount rate: €25.71% return on the initial investment. However. 000 = 12. 000  €10.266 10. 30 © Pearson Education Limited 2012 . which is below the required rate. Datar and Rajan.54% internal rate of return exceeds the 14% required rate of return.000) ÷ 8 years = €10.108 Gross present value Deduct net initial investment Net present value 112.190  5. 000 Accounting rate of return 3 = €118. the purchase would be made because the net present value is positive and the 16. Your reluctance to make a ‘buy’ decision would be quite natural unless you are assured of reasonable consistency between the decision model and the performance evaluation method.269) (2%) = 16. 942 = 16% + (. you may believe that your performance may actually be measured using accrual accounting.000) €(5.000 + €8.190   (2%)  2.000 €25. Instructor’s Manual Second.950 (€30. Horngren.058 (118. This approach would show a 12.Bhimani.942) By interpolation:  16%   Internal rate of return = 2.54% 2 The accounting rate of return based on net initial investment: = €110.

6151 6.636 Cash outflows NKr 3.300 7. payback. Datar and Rajan.000) 0. net present value.1894 (NKr24.9414 5.1 1.636NKr1.1692 NKr24. Horngren.0244 NKr23. An alternative approach to determine the NPV of the Monteiro contract is as follows: Total Present present value value of NKr 1 discounted at 12% (in millions) End of year Sketch of relevant cash flows Year 1 (start) 1.2643 The net present value of the Monteiro contract is NKr1.200 7. Management and Cost Accounting.0008 6.100 2.797 0.000 0.000 5.300 7.1894 31 © Pearson Education Limited 2012 .17 Sporting contract.712 0.500 6.Bhimani.9115 4.6737 1.900 PV discount factor 1.600 8.700 PV of cash inflows NKr 0 5.8 NKr 1. Recurring operating cash flows Year 1 (end) Year 2 (end) Year 3 (end) Year 4 (end) 1.1976 5.300 9.600 8. (30 min) 1a Summary of cash inflows and outflows (in millions) is as follows: Cash outflows Year 1 (start) Year 1 (end) Year 2 (end) Year 3 (end) Year 4 (end) Year 0: Year 1 (start) 1: Year 1 (end) 2: Year 2 (end) 3: Year 3 (end) 4: Year 4 (end) NKr 3.100 1.0749) million.2643 − NKr23.200 7.0000) 2.2816 1.0749 Cash inflows NKr 0 5.893 0.100 9.000 5. Initial signing bonus NKr(3.500 6.700 NKr (3.0) 0.4792 6.800 1.0000 4.000NKr(3. Instructor’s Manual 13.0893 NKr0. 5th Edition.1448 Net present value 0.800 PV of cash outflows NKr 3.300 9.100 9.900 Cash inflows Net cash inflows NKr 0 5.

44 years Other factors Aspelund might consider include: a Uncertainty over the predicted cash inflows for 2012 to 2015.200 0. 32 © Pearson Education Limited 2012 .800 4. would be £7. Solution Exhibit 13.800 3: Year 3 (end) 1.000. A key factor here is the possible risk of injury to Monteiro or a diminishing of his soccer ability.000 = 2.800 NKr3.000 10. Datar and Rajan. Management and Cost Accounting. Horngren.500 – £1.500 – £18. the direct manufacturing labour cost with the automatic machine would be £10.Bhimani.800 – Year Payback period = 2 years + 2 13. being 75% of direct manufacturing labour cost.000 7.800 5.000 10.000 7. 5th Edition.000 – 4: Year 4 (end) 1.100 2. b Increase in number of championships Aalesund Fotballklubb wins.000 15. Instructor’s Manual 1b Payback period: Net cash inflows Cumulative net cash inflows 0: Year 1 (start) – – 1: Year 1 (end) NKr0.500. This analysis is as follows: Moulding machine (1) Sales (irrelevant) Costs: Direct materials  Direct manufacturing labour*  Variable overhead*  Fixed overhead (irrelevant)  Marketing and administrative costs  (irrelevant)  Total relevant operating cash  outflows  Automatic machine (2) Increment (3) – – – £10. c Increase in community pride that accompanies a championship team.000 – £9. variable overhead.000 – £26.423 net present-value advantage over the moulding machine. (30–40 min) 1 The first step is to analyse all relevant operating cash flows and align them with the appropriate alternative.000 20. d Aspelund's own personal prestige of being president of a championship club. relevant costs.100 2.100 NKr0. Equipment replacement.20 indicates that the automatic machine has a £9.500 *Because the automatic machine produces twice as many units per hour.20 Cash investment yet to be recovered at end of year  NKr 0. e The effect the signing would have on Aalesund Fotballklubb’s ability to sign other players.800    NKr1. sensitivity analysis.900 2: Year 2 (end) 2.500 – – £45.

Management would have been much happier if the £50. Datar and Rajan. but the original mistake should not be compounded by keeping the old machine. Horngren. with a little luck or foresight. Management and Cost Accounting. In the light of subsequent events. 33 © Pearson Education Limited 2012 .Bhimani. But nothing can be done to alter the past. nobody will deny that the original £50. 5th Edition. The question is whether the company will nevertheless be better off buying the new machine. Instructor’s Manual Note: The book value of the old machine is irrelevant and thus is completely ignored.000 had never been spent in the first place.000 investment could have been avoided.

500) £(26. Datar and Rajan.690£18.708) Difference in favour of replacement (A − B) £(45.000) Current disposal price of old equipment 5.500 £18.000 Recurring operating cash costs Present value of net cash outflows B.000) £(45.516 (2.20 Net present-value analysis of purchasing new automatic machine. Horngren. Instructor’s Manual Solution Exhibit 13.Bhimani.285) Moulding machine Terminal disposal price of old equipment 4 years hence £1.500 £18.690 Present value of net cash outflows £(119.500 .500) £(26. Management and Cost Accounting.000) 3 4 1 2 3 4 Recurring operating cash savings 49.000) 1. (71.000£(39.600 Recurring operating cash costs (121.500) £(26.285)2.690 £(26. Sketch of relevant cash flows 0 1 2 3 4 Automatic machine Net initial investment £(44.765 2.600) Net present value £9.000 £(39.500 Difference in terminal disposal prices of machines (1.0001.000 £5.000 £(44.342 0. 5th Edition.000) 1.000) 2 Current disposal price of old machine Net initial investment £5.423 34 © Pearson Education Limited 2012 £18.000) £(45. Presentvalue Total discount present factor value at 18% End of year A.500) £(110.423 An alternative analysis of cash inflows and outflows (in thousands) is: Presentvalue Total discount present factor value at 18% End of year Sketch of relevant cash flows 0 1 Initial machine investment £(44.050) 2.000) £(45.000) £9.516 £2.342) 0.

000 cost of the automatic machine to determine the net initial investment in the automatic machine.690 (see Table 4 of Appendix B). If it switches to the new machine. obtaining £3. £3.503 is the amount of the annual difference in savings that will eliminate the £9. 2 The uniform payback formula can be used because the operating savings are uniform: Net initial investment Payback period =  Uniform increase in annual cash inflow P= £44. £2.600 appears as a cash outflow in year 4 in the sketch of relevant cash flows.997.690X = £40. Hence. (Rounding errors may affect the calculation slightly.500 The £5.600 on disposal of its machine at the end of year 4.) Because the annual operating savings are equal. 3 This is an example of sensitivity analysis: Note that the net initial investment and the difference in terminal disposal prices of machines are unaffected and hence.500 to £14. an alternative way to get the same answer is to divide the net present value of £9.997 If the annual savings fall by £3. 5th Edition.342 X = £14.423 of net present value.Bhimani. 2.000 – £5. it will receive £2. 35 © Pearson Education Limited 2012 . are included in the equation at the present values that we calculated earlier.690. Datar and Rajan. Hence.1 years £18.423 by 2.600 in terminal disposal price.503.000 current disposal price of the moulding machine is deducted from the £44. Instructor’s Manual Note the cash outflow of £2.000 = 2. The present value of an annuity of £1 received at the end of each year for 4 years is 2. Horngren. by investing in the new machine instead of continuing with the old one. it will receive £0 on disposal at the end of year 4.503.600 from the difference in terminal disposal prices of machines. the toy manufacturer forgoes £2. Management and Cost Accounting. The relevant cash flow equals the difference in terminal disposal prices of the two machines. If the toy manufacturer continues to use the old machine. from the estimated £18. the point of indifference will be reached.

436) * Recurring operating cash flows are as follows: Cost of maintaining software programs and CIM equipment €(1. 5th Edition. sensitivity. Dinamica should invest in CIM. On the basis of this financial analysis.000) 5 1.216) = 12. Datar and Rajan.216 20.384 million An annuity stream of €2. the net present value of the €3 million annuity stream for 10 years discounted at 14% is €3 × 5. 3 Let the annual cash flow from additional revenues be €X.384 million for 10 years discounted at 14% gives an NPV of €2. Then we want the present value of this cash flow stream to overcome the negative NPV of €(12.080) €(12.0 On the basis of this formal financial analysis. 36 © Pearson Education Limited 2012 . Horngren.000 4 1.436) million.21 Capital budgeting. Management and Cost Accounting. Manuel estimates additional cash revenues net of cash operating costs of €3 million a year as a result of higher quality and faster production resulting from CIM. Taking these revenue benefits into account.Bhimani. Relevant cash flows Presentvalue discount factors at 14% Total present value 1 Initial investment in CIM today €(45) 2a Current disposal price of old production line 2b Current recovery of working capital (€6 − €2) 3 Recurring operating cash savings 4a Higher terminal disposal price of machines 4b Reduced recovery of working capital €4* each year for 10 years (€14 − €0) in year 10 (€2 − €6) in year 10 1.436) million. (25 min.5 Annual recurring operating cash flows €4. Dinamica should not invest in CIM – it has a negative net present value of €(12.212 (€15.5) Reduction in lease payments due to reduced floor-space requirements 1.436) calculated in requirement 1.270 3. X (5.648 − €12.216 = 12. 2 Requirement 1 only looked at cost savings to justify the investment in CIM. Instructor’s Manual 13.000 €(45. the net present value of the CIM investment is €3. Table 4.000 4.436 (rounded). We consider the differences in cash flows if the machine is replaced.216 = €15.270 Net present value of CIM investment (1.) 1 The net present-value analysis of the CIM proposal is as follows. From Appendix B. All values in millions.000 5.864 14 0.780 (4) 0.000 4 5.436 X = €2.384 × 5. computer-integrated manufacturing (CIM).648. Hence.0 Fewer product defects and reduced reworking 4.

Dinamica should consider how difficult the CIM equipment would be to modify if there is a major change in CIM technology.000) 2a Current disposal price of old production line 5 1. Purchase costs from outsider. (20 min) 1 2 The company as a whole will not benefit if Division C buys on the outside market. TP – chpt 18 18. Datar and Rajan.076) The use of too short a time horizon such as 5 years biases against the adoption of CIM projects.433 13.000 2b Current recovery of working capital (€6 − €2) 4 1.000 4.519 8. b Accuracy of the costs of implementing and maintaining CIM. d Potential obsolescence of the CIM equipment.000 The company will benefit if C purchases from the outside supplier: 37 © Pearson Education Limited 2012 . including: a Sensitivity to different estimates of recurring cash savings or revenue gains.000 value 1 Initial investment in CIM today €(45.000 units  €135 €135.299 16 0. CIM may be the best approach to remain competitive against other low-cost producers in the future. Instructor’s Manual 4 Relevant Present-value Total cash discount present flows factors at 14% €(45) 1.000 3a Recurring operating cash savings €4 3b Recurring cash flows from additional revenues of €3 each year for 5 years 4 3. 1. 1. f Strategic factors. c Benefits of greater flexibility that results from CIM and the opportunity to train workers for the manufacturing environment of the future.000 units  €120 120. 5th Edition. Management and Cost Accounting.000 Net cost (benefit) to company as a whole by buying from outside €15. e Alternative approaches to achieve the major benefits of CIM such as changes in process or implementation of just-in-time systems.Bhimani.000 5.741) each year for 5 years Net present value of CIM investment (2.433 10. Manuel should consider other factors. Before finally deciding against CIM in this case.000 Deduct: Savings in variable costs by reducing Division A output.304 (4) 0.732 4a Higher terminal disposal price of machines (€20 − €4) in year 5 4b Reduced recovery of working capital (€2 − €6) in year 5 3 3. Horngren.519 €(5.13 Transfer-pricing dispute.

Management and Cost Accounting. Horngren.000 units  €135 Deduct: Savings in variable costs.000 €(3.000 units  €120 Net cost (benefit) to company as a whole by  buying from outside 38 © Pearson Education Limited 2012 €115.     1. 1.000) . Datar and Rajan.000 units  €120     Savings due to A’s equipment     and facilities being assigned     to other operations Net cost (benefit) to company as a whole by  buying from outside 3 €135. 5th Edition.000 €(5.000 units  €115 Deduct: Savings in variable costs by reducing     Division A output.Bhimani. 1.000 138.000 120.000 €120.000) The company will benefit if C purchases from the outside supplier: Purchase costs from outsider. Instructor’s Manual Purchase costs from outsider. 1.000 18.

000 3.000 120.000 A’s sales to other customers. Horngren.000 units Division fixed costs: €8c  400. 1.000 20. (5 min) The company as a whole would benefit in this situation if C purchased from outside suppliers.000 Metals Division Revenues: €150  400.000. 1.000 Variable marketing costs. 1.000 units to other customers.000.000 units  €120 Net cost to company as a whole by buying from outside €135.000 units €60. 5th Edition.000 Deduct: Division variable costs: €52b  400.000 €30. Instructor’s Manual The three requirements are summarised below (in thousands): (1) Total purchase costs from outsider Total relevant costs if purchased from Division A Total incremental (outlay) costs if purchased from A Total opportunity costs if purchased from A Total relevant costs if purchased from A Operating income advantage (disadvantage) to company as a whole by buying from A (2) (3) €135 €135 €115 120 – 120 120 18 138 120 – 120 €15 €(3) €(5) Goal congruence would be achieved if the transfer price is set equal to the total relevant costs of purchasing from Division A.800.000.000 units. 18.000 units Variable costs Contribution margin from A selling to other customers 18.000 €2.000 €15. Purchase costs from outside supplier.000 units €120.000 20. Management and Cost Accounting. Datar and Rajan.000 units operating 39 © Pearson Education Limited 2012 profit.000 on divisional Internal transfers at 110% of full costs (Method B) Mining Division Revenues: €90  400.17 Effect of (30 min) alternative transfer-pricing methods 1 Internal transfers at market prices (Method A) 5. .000 units €36.000 units  €155 €155.000 3.200.000.000 €60. €66a  400.000 125.400. €5  1.200.000 disadvantage to the company as a whole by purchasing from the outside supplier would be more than offset by the €30.000 €26. The €15.800.400.000 units  €135 Deduct variable cost savings.000 Division operating income €12.14 Transfer-pricing problem.000 contribution margin of A’s sale of 1.000 Deduct: Variable manufacturing costs. €120  1.Bhimani.

000 36.200.000.200.000 Division operating income a b c €66 = €60  110%.000. Instructor’s Manual Deduct: Transferred-in costs: 36. Horngren.000 6.000 26.000 Division fixed costs: €15e  400. 1%  €2.000 units 6. Management and Cost Accounting.000 units Division variable costs: €36d  400.000. 5th Edition.Bhimani.400.000 132.000 €3. Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labour + 75% of Manufacturing overhead = €12 + €16 + 75% × €32 = €52.000 €24. Fixed cost per unit = 25% of Manufacturing overhead = 25% × €32 = €8.000 €90  400.000 14.000 40 © Pearson Education Limited 2012 .000. Datar and Rajan.000.000) Method A (Internal transfers at market prices) Method B (Internal transfers at 110% of full costs) €120. d Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labour + 40% of Manufacturing overhead = €6 + €20 + 40% × €25 = €36 e Fixed cost per unit in Metals Division = 60% of Manufacturing overhead = 60% × €25 = €15 2 Bonus paid to division managers at 1% of divisional operating income will be as follows: Mining Division manager’s bonus (1%  €12.000) Metals Division manager’s bonus (1%  €3.000 €13. €66  400.000 units.000 units 14.600.000.400. 1%  €13.400.400.600.

Management and Cost Accounting. Using market prices for transfers in these conditions leads to goal congruence. The Metals Division manager will prefer Method B because this method gives €132. Division managers acting in their own best interests make decisions that are also in the best interests of the company as a whole.000 under Method A. 5th Edition.000 of bonus rather than €24. 3 Arturo Tuzón.000 of bonus rather than €36.Bhimani.000 under Method B (transfers at 110% of full costs). the manager of the Mining Division will appeal to the existence of a competitive market to price transfers at market prices. Instructor’s Manual The Mining Division manager will prefer Method A (transfer at market prices) because this method gives €120. Tuzón will further argue that setting transfer prices based on cost will cause him to pay no attention to controlling costs since all costs incurred will be recovered from the Metals Division at 110% of full costs. Horngren. Datar and Rajan. 41 © Pearson Education Limited 2012 .