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CHAPTER11 DECISIONMAKINGANDRELEVANTINFORMATION 111 1. 2. 3. 4. 5.

ThefivestepsinthedecisionprocessoutlinedinExhibit111ofthetextare Identifytheproblemanduncertainties Obtaininformation Makepredictionsaboutthefuture Makedecisionsbychoosingamongalternatives Implementthedecision,evaluateperformance,andlearn

112 Relevant costs are expected future costs that differ among the alternative courses of actionbeingconsidered.Historicalcostsareirrelevantbecausetheyarepastcostsand,therefore, cannotdifferamongalternativefuturecoursesofaction. 113 No. Relevant costs are defined as those expected future costs that differ among alternative courses of action being considered. Thus, future costs that do not differ among the alternativesareirrelevanttodecidingwhichalternativetochoose. 114 Quantitative factors are outcomes that are measured in numerical terms. Some quantitativefactorsarefinancialthatis,theycanbeeasilyexpressedinmonetaryterms.Direct materials isanexampleofaquantitative financial factor.Qualitative factorsareoutcomesthat aredifficulttomeasureaccuratelyinnumericalterms.Anexampleisemployeemorale. 115 Twopotentialproblemsthatshouldbeavoidedinrelevantcostanalysisare (i) Donotassumeallvariablecostsarerelevantandallfixedcostsareirrelevant. (ii)Donotuseunitcostdatadirectly.Itcanmisleaddecisionmakersbecause a. itmayincludeirrelevantcosts,and b. comparisons of unit costs computed at different output levels lead to erroneous conclusions 116 No.Somevariablecostsmaynotdifferamongthealternativesunderconsiderationand, hence,willbeirrelevant.Somefixedcostsmaydifferamongthealternativesand,hence,willbe relevant. 117 No.Someofthetotalunitcoststomanufactureaproductmaybefixedcosts,and,hence, will not differ between the make and buy alternatives. These fixed costs are irrelevant to the makeorbuydecision.Thekeycomparisonisbetweenpurchasecostsandthecoststhatwillbe savedifthecompanypurchasesthecomponentpartsfromoutsideplustheadditionalbenefitsof using the resources freed up in the next best alternative use (opportunity cost). Furthermore, managersshouldconsidernonfinancialfactorssuchasqualityandtimelydeliverywhenmaking outsourcingdecisions. 118 Opportunity cost is the contribution to income that is forgone (rejected) by not using a limitedresourceinitsnextbestalternativeuse. 119 No.Whendecidingonthequantityofinventorytobuy,managersmustconsiderboththe purchasecostperunitandtheopportunitycostoffundsinvestedintheinventory.Forexample, thepurchasecostperunitmaybelowwhenthequantityofinventorypurchasedislarge,butthe 111

benefit of the lower cost may be more than offset by the high opportunity cost of the funds investedinacquiringandholdinginventory. 1110 No. Managers should aim to get the highest contribution margin per unit of the constraining(thatis,scarce,limiting,orcritical)factor.Theconstrainingfactoriswhatrestricts orlimitstheproductionorsaleofagivenproduct(forexample,availabilityofmachinehours). 1111 No.Forexample,iftherevenuesthatwillbelostexceedthecoststhatwillbesaved,the branchorbusinesssegmentshouldnotbeshutdown.Shuttingdownwillonlyincreasetheloss. Allocatedcostsarealwaysirrelevanttotheshutdowndecision. 1112 Cost written off as depreciation is irrelevant when it pertains to a past cost such as equipment already purchased. But the purchase cost of new equipment to be acquired in the futurethatwillthenbewrittenoffasdepreciationisoftenrelevant. 1113 No.Managerstendtofavorthealternativethatmakestheirperformancelookbestsothey focusonthemeasuresusedintheperformanceevaluationmodel.Iftheperformanceevaluation model does not emphasize maximizing operating income or minimizing costs, managers will mostlikelynotchoosethealternativethatmaximizesoperatingincomeorminimizescosts. 1114 Thethreestepsinsolvingalinearprogrammingproblemare (i) Determinetheobjectivefunction. (ii) Specifytheconstraints. (iii)Computetheoptimalsolution. 1115 ThetextoutlinestwomethodsofdeterminingtheoptimalsolutiontoanLPproblem: (i) Trialanderrorsolutionapproach (ii) Graphicalsolutionapproach MostLPapplicationsinpracticeusestandardsoftwarepackagesthatrelyonthesimplexmethod tocomputetheoptimalsolution.

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1116 (20min.) Disposalofassets. 1. This is an unfortunate situation, yet the $75,000 costs are irrelevant regarding the decisiontoremachineorscrap.Theonlyrelevantfactorsarethefuturerevenuesandfuturecosts. Byignoringtheaccumulatedcostsanddecidingonthebasisofexpectedfuturecosts,operating income will be maximized (or losses minimized). The difference in favor of remachining is $2,000: (a) (b) Remachine Scrap Futurerevenues Deductfuturecosts Operatingincome Differenceinfavorofremachining $30,000 25,000 $5,000 $2,000 $3,000 $3,000

2. This,too,isanunfortunatesituation.Butthe$100,000originalcostisirrelevanttothis decision.Thedifferenceinrelevantcostsinfavorofrebuildingis$5,000asfollows: (a) Replace Newtruck Deductcurrentdisposal priceofexistingtruck Rebuildexistingtruck $105,000 15,000 $90,000 $5,000 (b) Rebuild $85,000 $85,000

Differenceinfavorofrebuilding

Note,here,thatthecurrentdisposalpriceof$15,000 isrelevant,buttheoriginal cost(orbook value,ifthetruckwerenotbrandnew)isirrelevant.

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1117 (20min.) Relevantandirrelevantcosts. 1. Make Relevantcosts Variablecosts Avoidablefixedcosts Purchaseprice Unitrelevantcost $180 20 ____ $200 Buy

$210 $210

DaltonComputersshouldrejectPeachsoffer.The$30offixedcostsareirrelevantbecausethey willbeincurredregardlessofthisdecision.Whencomparingrelevantcostsbetweenthechoices, Peachsofferpriceishigherthanthecosttocontinuetoproduce. 2. Cashoperatingcosts(4years) Currentdisposalvalueofoldmachine Costofnewmachine Totalrelevantcosts Keep $80,000 ______ $80,000 Replace Difference $48,000 $32,000 (2,500) 2,500 8,000 (8,000) $53,500 $26,500

APManufacturingshouldreplacetheoldmachine.Thecostsavingsarefargreaterthanthecost topurchasethenewmachine. 1118 (15min.) Multiplechoice. 1.(b) Specialorderpriceperunit Variablemanufacturingcostperunit Contributionmarginperunit =$1.50 20,000units =$30,000increase $1,200,000 $48 9 $57 1,140,000 60,000 25,000 $85,000 $6.00 4.50 $1.50

Effectonoperatingincome

2.(b) Costsofpurchases,20,000units $60 Totalrelevantcostsofmaking: Variablemanufacturingcosts,$64 $16 Fixedcostseliminated Costssavedbynotmaking Multiplyby20,000units,sototal costssavedare$57 20,000 Extracostsofpurchasingoutside MinimumoverallsavingsforReno Necessaryrelevantcoststhatwouldhave tobesavedinmanufacturingPartNo.575

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1119 (30min.) Specialorder,activitybasedcosting. 1. Award Plus operating income under the alternatives of accepting/rejecting the special orderare: WithoutOne WithOne TimeOnly TimeOnly SpecialOrder SpecialOrder 7,500Units 10,000Units Revenues Variablecosts: Directmaterials Directmanufacturinglabor Batchmanufacturingcosts Fixedcosts: Fixedmanufacturingcosts Fixedmarketingcosts Totalcosts Operatingincome
1

Difference 2,500Units $250,000 87,500 100,000 12,500 200,000 $50,000

$1,125,000 262,500 300,000 75,000 275,000 175,000 1,087,500 $37,500


2

$1,375,000 350,000 2 400,000 3 87,500 275,000 175,000 1,287,500 $87,500


3

$262,500 10,000 7,500

$300,000 10,000 7,500

$75,000+(25 $500)

Alternatively,wecouldcalculatetheincrementalrevenueandtheincrementalcostsofthe additional2,500unitsasfollows: Incrementalrevenue$100 2,500 Incrementaldirectmanufacturingcosts Incrementaldirectmanufacturingcosts Incrementalbatchmanufacturingcosts Totalincrementalcosts Totalincrementaloperatingincomefrom acceptingthespecialorder $262,500 2,500 7,500 $300,000 2,500 7,500 $500 25 $250,000 87,500 100,000 12,500 200,000 $50,000

Award Plus should accept the onetimeonly special order if it has no longterm implications becauseacceptingtheorderincreasesAwardPlus operatingincomeby$50,000. If, however, accepting the special order would cause the regular customers to be dissatisfiedortodemandlowerprices,thenAwardPluswillhavetotradeoffthe$50,000gain from accepting the special order against the operating income it might lose from regular customers.

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2. AwardPlushasacapacityof9,000medals.Therefore,ifitacceptsthespecialonetime orderof2,500medals,itcansellonly6,500medalsinsteadofthe7,500medalsthatitcurrently sellstoexistingcustomers.Thatis,byacceptingthespecialorder,AwardPlusmustforgosales of1,000medalstoitsregularcustomers.Alternatively,AwardPluscanrejectthespecialorder andcontinuetosell7,500medalstoitsregularcustomers. AwardPlusoperatingincomefromselling6,500medalstoregularcustomersand2,500 medalsunderonetimespecialorderfollow: Revenues(6,500 $150)+(2,500 $100) 1 1 Directmaterials(6,500 $35 )+(2,500 $35 ) 2 2 Directmanufacturinglabor(6,500 $40 )+(2,500 $40 ) 3 Batchmanufacturingcosts(130 $500)+(25 $500) Fixedmanufacturingcosts Fixedmarketingcosts Totalcosts Operatingincome
1

$1,225,000 315,000 360,000 77,500 275,000 175,000 1,202,500 $22,500

$35=

$262,500 7,500

$40=

$300,000 7,500

AwardPlusmakesregularmedalsinbatchsizesof50.Toproduce6,500medalsrequires130(6,50050)batches.

Accepting the special order will result in a decrease in operating income of $15,000 ($37,500 $22,500).Thespecialordershould,therefore,berejected. A more direct approach would be to focus on the incremental effectsthe benefits of acceptingthespecialorderof2,500unitsversusthecostsofselling1,000fewerunitstoregular customers. Increase in operating income from the 2,500unit special order equals $50,000 (requirement 1). The loss in operating income from selling 1,000 fewer units to regular customersequals: Lostrevenue,$150 1,000 Savingsindirectmaterialscosts,$35 1,000 Savingsindirectmanufacturinglaborcosts,$40 1,000 Savingsinbatchmanufacturingcosts,$500 20 Operatingincomelost $(150,000) 35,000 40,000 10,000 $(65,000)

Acceptingthespecialorderwillresultinadecreaseinoperatingincomeof$15,000($50,000 $65,000).Thespecialordershould,therefore,berejected. 3. AwardPlusshouldnotacceptthespecial order. Increaseinoperatingincomebyselling2,500units underthespecialorder(requirement1) Operatingincomelostfromexistingcustomers($10 7,500) Neteffectonoperatingincomeofacceptingspecialorder Thespecialordershould,therefore,berejected. $50,000 (75,000) $(25,000)

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1120 (30min.) Makeversusbuy,activitybasedcosting. 1. TheexpectedmanufacturingcostperunitofCMCBsin 2009isasfollows: Total Manufacturing Manufacturing CostsofCMCB CostperUnit (1) (2)=(1)10,000 $1,700,000 $170 450,000 45 120,000 12 320,000 800,000 $3,390,000 32 80 $339

Directmaterials,$170 10,000 Directmanufacturinglabor,$45 10,000 Variablebatchmanufacturingcosts,$1,500 80 Fixedmanufacturingcosts Avoidablefixedmanufacturingcosts Unavoidablefixedmanufacturingcosts Totalmanufacturingcosts

2. Thefollowingtableidentifiestheincrementalcostsin 2009ifSvenson(a)madeCMCBs and(b)purchasedCMCBsfromMinton. Total IncrementalCosts IncrementalItems Make Buy CostofpurchasingCMCBsfromMinton $3,000,000 Directmaterials $1,700,000 Directmanufacturinglabor 450,000 Variablebatchmanufacturingcosts 120,000 Avoidablefixedmanufacturingcosts 320,000 Totalincrementalcosts $2,590,000 $3,000,000 Differenceinfavorofmaking $410,000 PerUnit IncrementalCosts Make Buy $300 $170 45 12 32 $259 $300 $41

Notethattheopportunity costofusingcapacitytomakeCMCBs is zerosinceSvensonwould keepthiscapacityidleifitpurchasesCMCBsfromMinton. Svenson should continue to manufacture the CMCBs internally since the incremental coststo manufacture are $259 per unit compared tothe $300 per unitthat Minton has quoted. Notethattheunavoidablefixedmanufacturingcostsof$800,000($80perunit)willcontinueto be incurred whether Svenson makes or buys CMCBs. These are not incremental costs under eitherthemakeorthebuyalternativeandhence,areirrelevant.

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3. SvensonshouldcontinuetomakeCMCBs.Thesimplestwaytoanalyzethisproblemis to recognize that Svenson would prefer to keep any excess capacity idle rather than use it to make CB3s. Why? Because expected incremental future revenues from CB3s, $2,000,000, are less than expected incremental future costs, $2,150,000.If Svenson keeps its capacity idle, we knowfromrequirement2thatitshouldmakeCMCBsratherthanbuythem. Animportantpointtonoteisthat,becauseSvensonforgoesnocontributionbynotbeing abletomakeandsellCB3s,theopportunitycostofusingitsfacilitiestomakeCMCBsiszero. Itis,therefore,notforgoinganyprofitsbyusingthecapacitytomanufactureCMCBs.Ifitdoes notmanufactureCMCBs,ratherthanlosemoneyonCB3s,Svensonwillkeepcapacityidle. A longerand moredetailed approach istousethetotalalternativesoropportunitycost analysesshowninExhibit117ofthechapter. ChoicesforSvenson MakeCMCBs BuyCMCBs BuyCMCBs andDoNot andDoNot andMake RelevantItems MakeCB3s MakeCB3s CB3s TOTALALTERNATIVESAPPROACHTOMAKEORBUYDECISIONS Totalincrementalcostsof making/buyingCMCBs(from requirement2) Excessoffuturecostsoverfuture revenuesfromCB3s Totalrelevantcosts

$2,590,000 0 $2,590,000

$3,000,000 0 $3,000,000

$3,000,000 150,000 $3,150,000

SvensonwillminimizemanufacturingcostsbymakingCMCBs. OPPORTUNITYCOSTAPPROACHTOMAKEORBUYDECISIONS Totalincrementalcostsof making/buyingCMCBs(from requirement2) $2,590,000 $3,000,000 Opportunitycost:profitcontribution forgonebecausecapacitywillnot * * beusedtomakeCB3s 0 0 Totalrelevantcosts $2,590,000 $3,000,000
*

$3,000,000

0 $3,000,000

Opportunitycostis0becauseSvensondoesnotgiveupanythingbynotmakingCB3s.Svensonisbestoffleaving thecapacityidle(ratherthanmanufacturingandsellingCB3s).

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1121 (10min.) Inventorydecision,opportunitycosts. 1. Unitcost,ordersof20,000 Unitcost,orderof240,000(0.96 $9.00) Alternativesunderconsideration: (a) Buy240,000unitsatstartofyear. (b)Buy20,000unitsatstartofeachmonth. Averageinvestmentininventory: (a) (240,000 $8.64)2 (b)(20,000 $9.00)2 Differenceinaverageinvestment $9.00 $8.64

$1,036,800 90,000 $ 946,800

Opportunitycostofinterestforgonefrom240,000unitpurchaseatstartofyear =$946,800 0.10=$94,680 2. No. The $94,680 is an opportunity cost rather than an incremental or outlay cost. No actualtransactionrecordsthe$94,680asanentryintheaccountingsystem. 3. Thefollowingtablepresentsthetwoalternatives: AlternativeA: AlternativeB: Purchase Purchase 240,000 20,000 sparkplugsat sparkplugs beginningof atbeginning year ofeachmonth Difference (1) (2) (3)=(1) (2) Annualpurchaseordercosts (1 $20012 $200) Annualpurchase(incremental)costs (240,000 $8.64240,000 $9) Annualinterestincomethatcouldbeearned ifinvestmentininventorywereinvested (opportunitycost) (10% $1,036,80010% $90,000) Relevantcosts $200 2,073,600 $2,400 2,160,000 $(2,200) (86,400)

103,680 $2,177,480

9,000 $2,171,400

94,680 $6,080

Column (3) indicates that purchasing 20,000 spark plugs at the beginning of each month is preferred relative to purchasing 240,000 spark plugs at the beginning of the year because the opportunitycostofholdinglargerinventoryexceedsthelowerpurchasingandorderingcosts.If other incremental benefits of holding lower inventory such as lower insurance, materials handling,storage,obsolescence,andbreakagecostswereconsidered,thecostsunderAlternative Awouldhavebeenhigher,andAlternativeBwouldbepreferredevenmore.

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1122 (2025min.) Relevantcosts,contributionmargin,productemphasis. 1. Cola $18.80 14.20 $4.60 Lemonade $20.00 16.10 $3.90 Punch $27.10 20.70 $6.40 Natural Orange Juice $39.20 30.20 $9.00

Sellingprice Deductvariablecostpercase Contributionmarginpercase

2. Theargumentfailstorecognizethatshelfspaceistheconstrainingfactor.Thereareonly 12 feetof frontshelf spacetobedevotedtodrinks.Sextonshouldaimtogetthehighestdaily contributionmarginperfootoffrontshelfspace: Natural Orange Juice $9.00 5

Contributionmarginpercase Sales(numberofcases)perfoot ofshelfspaceperday Dailycontributionperfoot offrontshelfspace 3.

Cola $4.60 25

Lemonade $3.90 24

Punch $6.40 4

$115.00

$93.60

$25.60

$45.00

Theallocationthatmaximizesthedailycontributionfromsoftdrinksalesis: DailyContribution perFootof TotalContribution FrontShelfSpace MarginperDay $115.00 $690.00 93.60 374.40 45.00 45.00 25.60 25.60 $1,135.00

Cola Lemonade NaturalOrangeJuice Punch

Feetof ShelfSpace 6 4 1 1

ThemaximumofsixfeetoffrontshelfspacewillbedevotedtoColabecauseithasthehighest contribution margin per unit of the constraining factor. Four feet of front shelf space will be devoted to Lemonade, which has the second highest contribution margin per unit of the constraining factor. No more shelf space can be devoted to Lemonade since each of the remaining two products, Natural Orange Juice and Punch (that have the second lowest and lowestcontributionmarginsperunitoftheconstrainingfactor)musteachbegivenatleastone footoffrontshelfspace.

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1123 (10min.) Selectionofmostprofitableproduct. OnlyModel14shouldbeproduced.Thekeytothisproblemistherelationshipofmanufacturing overheadtoeachproduct.NotethatittakestwiceaslongtoproduceModel9machinehoursfor Model 9 are twice that for Model 14. Management should choose the product mix that maximizes operating income for a given production capacity (the scarce resource in this situation).Inthiscase,Model14willyielda$9.50contributiontofixedcostspermachinehour, andModel9willyield$9.00: Model9 Sellingprice Variablecostsperunit(totalcost FMOH) Contributionmarginperunit Relativeuseofmachinehoursperunitofproduct Contributionmarginpermachinehour $100.00 82.00 $18.00 2 $9.00 Model14 $70.00 60.50 $9.50 1 $9.50

1124 (20min.) Whichbasetoclose,relevantcostanalysis,opportunitycosts. Thefutureoutlayoperatingcostswillbe$400millionregardlessofwhichbaseisclosed,given theadditional$100millionincostsatEverettifAlamedaisclosed.Further,oneofthebaseswill permanentlyremainopenwhiletheotherwillbeshutdown.Theonlyrelevantrevenueandcost comparisonsare a. $500millionfromsaleoftheAlamedabase.Notethatthehistoricalcostofbuilding theAlameda base($100 million) is irrelevant.Notealsothatfuture increases inthe valueofthelandattheAlamedabaseisalsoirrelevant. Oneofthebasesmustbekept open,soifitisdecidedtokeeptheAlamedabaseopen,theDefenseDepartmentwill notbeabletosellthislandatafuturedate. b. $60million insavings in fixed income noteiftheEverettbase isclosed.Again,the historicalcostofbuildingtheEverettbase($150million)isirrelevant. The relevant costs and benefits analysis favors closing the Alameda base despite the objectionsraisedbytheCaliforniadelegationinCongress.Thenetbenefitequals$440($500 $60)million.

1111

1125 (25-30min.) Closingandopeningstores. 1. SolutionExhibit1125,Column1,presentstherelevantlossinrevenuesandtherelevant savingsincostsfromclosingtheRhodeIslandstore.LopeziscorrectthatSanchezCorporations operating income would increase by $7,000 if it closes down the Rhode Island store. Closing down the Rhode Island store results in a loss of revenues of $860,000 but cost savings of $867,000 (from cost of goods sold, rent, labor, utilities, and corporate costs). Note that by closing down the Rhode Island store, Sanchez Corporation will save none of the equipment relatedcostsbecausethisisapastcost.Alsonotethattherelevantcorporateoverheadcostsare theactualcorporateoverheadcosts$44,000thatSanchezexpectstosavebyclosingtheRhode Islandstore.Thecorporateoverheadof$40,000allocatedtotheRhodeIslandstoreisirrelevant totheanalysis. 2. Solution Exhibit 1125, Column 2, presents the relevant revenues and relevant costs of opening another store like the Rhode Island store. Lopez is correct that opening such a store would increase Sanchez Corporations operating income by $11,000. Incremental revenues of $860,000exceedtheincrementalcostsof$849,000(fromhighercostofgoodssold,rent,labor, utilities, and some additional corporate costs). Note that the cost of equipment written off as depreciation is relevant because it is an expected future costthat Sanchez will incur only if it opensthenewstore.Alsonotethattherelevantcorporateoverheadcostsarethe$4,000ofactual corporate overhead costs that Sanchez expects to incur as a result of opening the new store. Sanchezmay,infact,allocatemorethan$4,000ofcorporateoverheadtothenewstorebutthis allocationisirrelevanttotheanalysis. The key reason that Sanchezs operating income increases either if it closes down the RhodeIslandstoreorifitopensanotherstorelikeitisthebehaviorofcorporateoverheadcosts. By closing down the Rhode Island store, Sanchez can significantly reduce corporate overhead costs presumably by reducing the corporate staff thatoversees the Rhode Island operation. On theotherhand,addinganotherstorelikeRhodeIslanddoesnotincreaseactualcorporatecostsby much,presumably becausetheexisting corporatestaffwill beabletooverseethe newstoreas well. SOLUTIONEXHIBIT1125 RelevantRevenue and RelevantCost Analysis of Closing Rhode Island Store and Opening AnotherStore LikeIt.
(LossinRevenues) andSavingsin Costsfrom Closing RhodeIslandStore (1) Revenues Costofgoodssold Leaserent Laborcosts Depreciationofequipment Utilities(electricity,heating) Corporateoverheadcosts Totalcosts Effectonoperatingincome(loss) $(860,000) 660,000 75,000 42,000 0 46,000 44,000 867,000 $7,000 Incremental Revenuesand (IncrementalCosts) ofOpeningNewStore LikeRhodeIslandStore (2) $860,000 (660,000) (75,000) (42,000) (22,000) (46,000) (4,000) (849,000) $11,000

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1126 (20min.) Choosingcustomers. If Broadway accepts the additional business from Kelly, it would take an additional 500 machinehours.IfBroadwayacceptsallofKellysandTaylorsbusinessforFebruary,itwould require2,500machinehours(1,500hoursforTaylorand1,000hoursforKelly).Broadwayhas only 2,000 hours of machine capacity. It must, therefore, choose how much of the Taylor or Kellybusinesstoaccept. Tomaximizeoperatingincome,Broadwayshouldmaximizecontributionmarginperunit of the constrained resource. (Fixed costs will remain unchanged at $100,000 regardless of the businessBroadwaychoosestoacceptinFebruary,andis,therefore,irrelevant.)Thecontribution marginperunitoftheconstrainedresourceforeachcustomerinJanuaryis: Taylor Corporation $78,000 =$52 1,500 Kelly Corporation $32,000 =$64 500

Contributionmarginpermachinehour

Since the $80,000 of additional Kelly business in February is identical to jobs done in January,itwillalsohaveacontributionmarginof$64permachinehour,whichisgreaterthan thecontribution marginof$52per machinehourfromTaylor.Tomaximizeoperating income, Broadway should first allocate all the capacity needed to take the Kelly Corporation business (1,000machinehours)andthenallocatetheremaining1,000(2,0001,000)machinehoursto Taylor. Taylor Corporation $52 1,000 $52,000 Kelly Corporation $64 1,000 $64,000

Total

Contributionmarginpermachinehour Machinehourstobeworked Contributionmargin Fixedcosts Operatingincome

$116,000 100,000 $16,000

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1127 (3040min.) Relevanceofequipmentcosts. 1a. StatementsofCashReceiptsandDisbursements Keep Each Year 2,3,4


$150,000 (110,000) (15,000)

Year1
Receiptsfromoperations: Revenues Deductdisbursements: Otheroperatingcosts Operationofmachine Purchaseof old machine Purchaseof newequipment Cashinflowfromsaleofold equipment Netcashinflow $150,000 (110,000) (15,000) (20,000)*

Four Years Together


$600,000 (440,000) (60,000) (20,000)

BuyNewMachine Each Four Year Years Year1 2,3,4 Together


$150,000 (110,000) (9,000) (20,000) (24,000) $150,000 (110,000) (9,000) $600,000 (440,000) (36,000) (20,000) (24,000) 8,000 $88,000

$5,000

$25,000

$80,000

8,000 $(5,000) $31,000

*Somestudentsignorethisitembecauseitisthesameforeachalternative.However,notethatastatementforthe entireyearhasbeenrequested.Obviously,the$20,000wouldaffectYear1onlyunderboththekeepandbuy alternatives.

Thedifferenceis$8,000forfouryearstakentogether.Inparticular,notethatthe$20,000 bookvalue can beomitted fromthecomparison. Merely crossouttheentire linealthoughthe columntotalsareaffected,thenetdifferenceisstill$8,000. 1b. Again,thedifferenceis$8,000: IncomeStatements Keep BuyNewMachine Each Four Each FourYears Year Years Year Together 1,2,3,4 Together Year1 2,3,4 $150,000 $600,000 $150,000 $150,000 $600,000 110,000 5,000 15,000 130,000 440,000 20,000 60,000 520,000 110,000 6,000 9,000 125,000 110,000 6,000 9,000 125,000 440,000 24,000 36,000 500,000
* 20,000 (8,000) 12,000 512,000 $88,000

Revenues Costs(excludingdisposal): Otheroperatingcosts Depreciation Operatingcostsofmachine Totalcosts(excludingdisposal) Lossondisposal: Bookvalue(cost) Proceeds(revenue) Lossondisposal Totalcosts Operatingincome
*

130,000 520,000 $20,000 $80,000

20,000 (8,000) 12,000 137,000 125,000 $13,000 $25,000

As in part (1), the $20,000 book value may be omitted from the comparison without changing the $8,000 difference.Thisadjustmentwouldmeanexcludingthedepreciationitemof$5,000peryear(acumulativeeffectof $20,000) under the keep alternative and excluding the book value item of $20,000 in the loss on disposal computationunderthebuyalternative.

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1c. The $20,000 purchase cost of the old equipment, the revenues, and the other operating costsareirrelevantbecausetheiramountsarecommontobothalternatives. 2. Thenetdifferencewouldbeunaffected.Anynumbermaybesubstitutedfortheoriginal $20,000figurewithoutchangingthe finalanswer.Ofcourse,thenetcashoutflowsunder both alternativeswouldbehigh.TheAutoWashmanagerreallyblundered.However,keepingtheold equipmentwill increasethecostofthe blundertothecumulativetuneof$8,000overthe next fouryears. 3. Bookvalueisirrelevantindecisionsaboutthereplacementofequipment,becauseitisa past (historical) cost. All past costs are down the drain. Nothing can change what has already beenspentorwhathasalreadyhappened.The$20,000hasbeenspent.Howitissubsequently accountedforisirrelevant.Theanalysisinrequirement(1)clearlyshowsthatwemay completely ignorethe$20,000andstillhaveacorrectanalysis.Theonlyrelevantitemsarethoseexpected futureitemsthatwilldifferamongalternatives. Despitetheeconomicanalysisshownhere,manymanagerswouldkeeptheoldmachine ratherthanreplace it.Why?Because, in manyorganizations,the incomestatementsofpart(2) wouldbeaprincipalmeansofevaluatingperformance.Notethatthefirstyearoperatingincome wouldbehigherunderthekeepalternative.Theconventionalaccrualaccountingmodelmight motivatemanagerstowardmaximizingtheirfirstyearreportedoperatingincomeattheexpense oflongruncumulativebettermentfortheorganizationasawhole.Thiscriticismisoftenmade oftheaccrualaccountingmodel.Thatis,theactionfavoredbythecorrectorbesteconomic decision model may not be taken because the performanceevaluation model is either inconsistent with the decision model or because the focus is on only the shortrun part of the performanceevaluationmodel. There is yetanotherpotentialconflict betweenthedecision modelandtheperformance evaluationmodel.Replacingthemachinesosoonafteritispurchasedmayreflectbadlyonthe managers capabilities and performance. Why didnt the manager search and find the new machinebeforebuyingtheoldmachine?Replacingtheoldmachineonedaylateratalossmay makethe managerappear incompetenttohisorhersuperiors.Ifthe managers bosses have no knowledge of the better machine, the manager may prefer to keepthe existing machine rather thanalerthisorherbossesaboutthebettermachine.

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1128 (30min.)

Equipmentupgradeversusreplacement.

1. Basedontheanalysisinthetablebelow,TechMechwillbebetteroffby$180,000over threeyearsifitreplacesthecurrentequipment.
ComparingRelevantCostsofUpgradeand ReplaceAlternatives Cashoperatingcosts $140$80perdesk 6,000desksperyr. 3yrs. Currentdisposalprice Onetimecapitalcosts,writtenoffperiodicallyas depreciation Totalrelevantcosts Over3years Upgrade Replace (1) (2) $2,520,000 $1,440,000 (600,000) 4,200,000 $5,040,000 Difference infavorofReplace (3)=(1)(2) $1,080,000 600,000 (1,500,000) $ 180,000

2,700,000 $5,220,000

Note that the book value of the current machine ($900,000) would either be written off as depreciationoverthreeyearsundertheupgradeoption,or,allatonceinthecurrentyearunder the replace option. Its net effect would be the same in both alternatives: to increase costs by $900,000overthreeyears,henceitisirrelevantinthisanalysis. 2. Suppose the capital expenditure to replace the equipment is $X. From requirement 1, column (2), substituting for the onetime capital cost of replacement, the relevant cost of replacing is $1,440,000 $600,000 + $X. From column (1), the relevant cost of upgrading is $5,220,000.WewanttofindXsuchthat $1,440,000 $600,000+$X <$5,220,000(i.e.,TechMechwillfavorreplacing) SolvingtheaboveinequalitygivesusX<$5,220,000$840,000=$4,380,000. TechMech would prefer to replace, rather than upgrade, if the replacement cost of the new equipmentdoesnotexceed$4,380,000.Notethatthisresultcanalsobeobtainedbytakingthe original replacement cost of $4,200,000 and adding to it the $180,000 difference in favor of replacementcalculatedinrequirement1. 3. Supposetheunitsproducedandsoldover3yearsequaly.Usingdatafromrequirement 1,column(1),therelevantcostofupgradewouldbe$140y+$2,700,000,andfromcolumn(2), the relevant cost of replacing the equipment would be $80y $600,000 + $4,200,000. TechMechwouldwanttoupgradeif $140y+$2,700,000 <$80y $600,000+$4,200,000 $60y<$900,000 y <$900,000 $60=15,000units orupgradewheny<15,000units(or5,000peryearfor3years)andreplacewheny>15,000 unitsover3years. Whenproductionandsalesvolumeislow(lessthan5,000peryear),thehigheroperating costs under the upgrade option are more than offset by the savings in capital costs from upgrading.Whenproductionandsalesvolumeishigh,thehighercapitalcostsofreplacementare morethanoffsetbythesavingsinoperatingcostsinthereplaceoption.

1116

4. Operatingincomeforthefirstyearundertheupgradeandreplacealternativesareshown below: Year1 Upgrade Replace (1) (2) Revenues(6,000 $500) $3,000,000 $3,000,000 Cashoperatingcosts $140$80perdesk 6,000desksperyear 840,000 480,000 a Depreciation($900,000 +$2,700,000) 3$4,200,000 3 1,200,000 1,400,000 Lossondisposalofoldequipment(0$900,000 $600,000) 0 300,000 Totalcosts 2,040,000 2,180,000 OperatingIncome $ 960,000 $ 820,000
a

Thebookvalueofthecurrentproductionequipmentis$1,500,000 3 5=$900,000ithasaremaining usefullifeof3years.

Firstyearoperatingincomeishigherby$140,000undertheupgradealternative,andDanDoria, with his oneyear horizon and operating incomebased bonus, will choose the upgrade alternative,eventhough,asseeninrequirement1,thereplacealternativeisbetterinthelongrun forTechMech.Thisexerciseillustratesthepossibleconflictbetweenthedecisionmodelandthe performanceevaluationmodel.

1117

1129 (20min.) SpecialOrder. 1. Revenuesfromspecialorder ($25 10,000bats) 1 Variablemanufacturingcosts($16 10,000bats) IncreaseinoperatingincomeifRipkinorderaccepted


1

$250,000 (160,000) $ 90,000

Directmaterials+Directmanufacturing labor+Variablemanufacturingoverhead=$12 + $1 + $3 =$16

Louisville should accept Ripkins special order because it increases operating income by $90,000. Since no variable selling costs will be incurred on this order, this cost is irrelevant. Similarly,fixedcostsareirrelevantbecausetheywillbeincurredregardlessofthedecision. 2a. Revenuesfromspecialorder ($25 10,000bats) Variablemanufacturingcosts($16 10,000bats) 1 Contributionmarginforegone([$32$18 ] 10,000bats) DecreaseinoperatingincomeifRipkinorderaccepted
1

$250,000 (160,000) (140,000) $(50,000)

Directmatls.+Directmanuf.labor+Variablemanuf.overhead+Variablesellingexp.=$12 + $1 + $3 + $2 =$18

Basedstrictlyonfinancialconsiderations,LouisvilleshouldrejectRipkinsspecialorderbecause itresultsina$50,000reductioninoperatingincome. 2b.Louisvillewillbeindifferentbetweenthespecialorderandcontinuingtoselltoregular customersifthespecialorderpriceis$30.Atthisprice,Louisvillerecoupsthevariable manufacturingcostsof$160,000andthecontributionmargingivenupfrom regularcustomersof $140,000([$160,000+$140,000]10,000units=$30). Lookedatadifferentway,Louisville expectsthefullpriceof$32lessthe$2savedonvariablesellingcosts. 2c.Louisvillemaybewillingtoacceptalossonthisspecialorderifthepossibilityoffuture longtermsalesseemlikely.However,Louisvilleshouldalsoconsidertheeffectoncustomer relationshipsbyrefusingsalesfromexistingcustomers.Also,Louisvillecannotaffordtoadopt thespecialorderpricelongtermorwithothercustomerswhomayaskforpriceconcessions.

1118

1130 (30min.) Contributionapproach,relevantcosts. 1. Averageonewayfareperpassenger Commissionat8%of$500 NetcashtoAirFriscoperticket Averagenumberofpassengersperflight Revenuesperflight($460200) Foodandbeveragecostperflight($20200) Totalcontributionmarginfrompassengersperflight $ $ $ $ $ 500 (40) 460 200 92,000 4,000 88,000 480.00 (38.40) 441.60 20.00 421.60

2.

Iffareis Commissionat8%of$480 Netcashperticket Foodandbeveragecostperticket Contributionmarginperpassenger Totalcontributionmarginfrompassengersperflight ($421.60212) Allothercostsareirrelevant.

$89,379.20

On the basis of quantitative factors alone, Air Frisco should decrease its fare to $480 because reducing the fare gives Air Frisco a higher contribution margin from passengers ($89,379.20versus$88,000). 3. In evaluating whether Air Frisco should charter its plane to Travel International, we compare the charter alternative to the solution in requirement 2 because requirement 2 is preferredtorequirement1. Underrequirement2,contributionfrompassengers Deductfuelcosts Totalcontributionperflight $89,379.20 14,000.00 $75,379.20

AirFriscogets$74,500perflightfromcharteringtheplanetoTravelInternational.Onthebasis of quantitative financial factors, Air Frisco is better off not chartering the plane and, instead, loweringitsownfares. OtherqualitativefactorsthatAirFriscoshouldconsiderincomingtoadecisionare a. The lower risk from chartering its plane relative to the uncertainties regarding the numberofpassengersitmightgetonitsscheduledflights. b. ThestabilityoftherelationshipbetweenAirFriscoandTravelInternational.Ifthisis not a longterm arrangement, Air Frisco may lose current market share and not benefitfromsustainedcharterrevenues.

1119

1131 (30min.) Relevantcosts,opportunitycosts. 1. Easyspread2.0hasahigherrelevantoperatingincomethanEasyspread1.0.Basedonthis analysis,Easyspread2.0shouldbeintroducedimmediately: Easyspread1.0 $160 $0 0 $160 Easyspread2.0 $195 $30 30 $165

Relevantrevenues Relevantcosts: Manuals,diskettes,compactdiscs Totalrelevantcosts Relevantoperatingincome

Reasonsforothercostitemsbeingirrelevantare Easyspread1.0 Manuals,diskettesalreadyincurred Developmentcostsalreadyincurred Marketingandadministrativefixedcostsofperiod Easyspread2.0 Developmentcostsalreadyincurred Marketingandadministrationfixedcostsofperiod Note that total marketing and administration costs will not change whether Easyspread 2.0 is introducedonJuly1,2009,oronOctober1,2009. 2. Otherfactorstobeconsidered: a. Customer satisfaction. If 2.0 is significantly better than 1.0 for its customers, a customer driven organization would immediately introduce it unless other factors offsetthisbiastowardsdowhatisbestforthecustomer. b. Quality level of Easyspread 2.0. It is critical for new software products to be fully debugged.Easyspread2.0 mustbeerrorfree.Consideran immediatereleaseonly if 2.0passesallqualitytestsandcanbefullysupportedbythesalesforce. c. Importanceofbeingperceivedtobeamarketleader.Beingfirstinthemarketwitha new product can give Basil Software a firstmover advantage, e.g., capturing an initial large share of the market that, in itself, causes future potential customers to leantowardspurchasingEasyspread2.0.Moreover,by introducing2.0earlier,Basil cangetquickfeedbackfromusersaboutwaystofurtherrefinethesoftwarewhileits competitors are still working on their own first versions. Moreover, by locking in early customers, Basil may increase the likelihood of these customers also buying futureupgradesofEasyspread2.0. d. Moraleofdevelopers.ThesearekeypeopleatBasilSoftware.Delayingintroduction ofanewproductcanhurttheirmorale,especiallyifacompetitorthenpreemptsBasil frombeingviewedasamarketleader.

1120

1132 (20min.) Opportunitycosts. 1. The opportunity cost to Wolverine of producing the 2,000 units of Orangebo is the contribution margin lost on the 2,000 units of Rosebo that would have to be forgone, as computedbelow: Sellingprice Variablecostsperunit: Directmaterials Directmanufacturinglabor Variablemanufacturingoverhead Variablemarketingcosts Contributionmarginperunit Contributionmarginfor2,000units $20 $2 3 2 4

11 $9 $18,000

The opportunity cost is $18,000. Opportunity cost is the maximum contribution to operating income that is forgone (rejected) by not using a limited resource in its nextbest alternativeuse. 2. Contributionmarginfrommanufacturing2,000unitsofOrangeboandpurchasing2,000 unitsofRosebofromBuckeyeis$16,000,asfollows: Manufacture Orangebo Sellingprice Variablecostsperunit: Purchasecosts Directmaterials Directmanufacturinglabor Variablemanufacturingcosts Variablemarketingoverhead Variablecostsperunit Contributionmarginperunit Contributionmarginfromselling2,000units ofOrangeboand2,000unitsofRosebo $15 2 3 2 2 9 $6 $12,000 Purchase Rosebo $20 14

Total

4 18 $2 $4,000 $16,000

As calculated in requirement 1, Wolverines contribution margin from continuing to manufacture 2,000 units of Rosebo is $18,000. Accepting the Miami Company and Buckeye offer will cost Wolverine $2,000 ($16,000 $18,000). Hence, Wolverine should refuse the MiamiCompanyandBuckeyeCorporationsoffers. 3. The minimum price would be $9, the sum of the incremental costs as computed in requirement2.This follows because, if Wolverine hassurpluscapacity,theopportunitycost= $0.FortheshortrundecisionofwhethertoacceptOrangebosoffer, fixedcostsof Wolverine are irrelevant. Only the incremental costs need to be covered for it to be worthwhile for WolverinetoaccepttheOrangebooffer.

1121

1133 (3040min.) Productmix,relevantcosts. 1. Sellingprice Variablemanufacturingcostperunit Variablemarketingcostperunit Totalvariablecostsperunit Contributionmarginperunit Contributi margin perhourof the on constraine resource(theregularmachine) d Totalcontributionmarginfromselling onlyR3oronlyHP6 R3:$25 50,000HP6:$30 50,000 Less Leasecostsofhighprecisionmachine toproduceandsellHP6 Netrelevantbenefit R3 $100 60 15 75 $25 $25 =$25 1 HP6 $150 100 35 135 $15 $15 =$30 0.5

$1,250,000 - $1,250,000

$1,500,000 300,000 $1,200,000

Even though HP6 has the higher contribution margin per unit of the constrained resource, the fact that Pendleton must incur additional costs of $300,000 to achieve this higher contribution margin means that Pendleton is better off using its entire 50,000hour capacityon the regular machinetoproduceandsell50,000units(50,000hours 1hourperunit)ofR3.Theadditional contribution from sellingHP6ratherthan R3 is$250,000($1,500,000 -$1,250,000),which is not enough to cover the additional costs of leasing the highprecision machine. Note that, because all other overhead costs are fixed and cannot be changed, they are irrelevant for the decision. 2. If capacity of the regular machines is increased by 15,000 machinehours to 65,000 machinehours(50,000originally+15,000new),thenetrelevantbenefitfromproducingR3and HP6isasfollows: R3 HP6 Totalcontributionmarginfromsellingonly R3oronlyHP6 R3:$25 65,000HP6:$30 65,000 LessLeasecostsofhighprecisionmachine thatwouldbeincurredifHP6isproducedandsold LessCostofincreasingcapacityby 15,000hoursonregularmachine Netrelevantbenefit

$1,625,000

$1,950,000 300,000

150,000 $1,475,000

150,000 $1,500,000

1122

Investing in the additional capacity increases Pendletons operating income by $250,000 ($1,500,000 calculated in requirement 2 minus $1,250,000 calculated in requirement 1), so Pendletonshouldadd15,000hourstotheregularmachine.Withtheextracapacityavailableto it,PendletonshoulduseitsentirecapacitytoproduceHP6.Usingall65,000hoursofcapacityto produce HP6 rather than to produce R3 generates additional contribution margin of $325,000 ($1,950,000 -$1,625,000)whichismorethantheadditionalcostof$300,000toleasethehigh precision machine. Pendleton should therefore produce and sell 130,000 units of HP6 (65,000 hours 0.5hoursperunitofHP6)andzerounitsofR3. 3. R3 Sellingprice Variablemanufacturingcostsperunit Variablemarketingcostsperunit Totalvariablecostsperunit Contributionmarginperunit Contributi marginperhourof the on constraine resource(theregularmachine) d $100 60 15 75 $25 HP6 $150 100 35 135 $15 S3 $120 70 15 85 $35

$ 25 $ 15 $ 35 =$25 =$30 =$35 1 05 . 1

The first step is to compare the operating profits that Pendleton could earn if it accepted the Carter Corporation offer for 20,000 units with the operating profits Pendleton is currently earning.S3hasthehighestcontributionmarginperhourontheregularmachineandrequiresno additionalinvestmentsuchasleasingahighprecisionmachine.Toproducethe20,000unitsof S3 requested by Carter Corporation, Pendleton would require 20,000 hours on the regular machineresultingincontributionmarginof $35 20,000=$700,000. Pendletonnowhas45,000hoursavailableontheregularmachinetoproduceR3orHP6. R3 Totalcontributionmarginfromsellingonly R3oronlyHP6 R3:$25 45,000HP6:$30 45,000 LessLeasecostsofhighprecisionmachine toproduceandsellHP6 Netrelevantbenefit HP6

$1,125,000 - $1,125,000

$1,350,000 300,000 $1,050,000

Pendletonshoulduseallthe45,000hoursofavailablecapacitytoproduce45,000unitsofR3. Thus, the product mix that maximizes operating income is 20,000 units of S3, 45,000 units of R3, and zero units of HP6. This optimal mix results in a contribution margin of $1,825,000 ($700,000 from S3 and $1,125,000 from R3). Relative to requirement 2, operating income increases by $325,000 ($1,825,000 minus $1,500,000 calculated in requirement 2). Hence, PendletonshouldaccepttheCarterCorporationbusinessandsupply20,000unitsofS3.

1123

1134 (3540min.) Droppingaproductline,sellingmoreunits. 1. The incremental revenue losses and incremental savings in cost by discontinuing the Tablesproductlinefollows: Difference: Incremental (LossinRevenues) andSavingsinCosts fromDropping TablesLine Revenues Directmaterialsanddirectmanufacturinglabor Depreciationonequipment Marketinganddistribution Generaladministration Corporateofficecosts Totalcosts Operatingincome(loss) $(500,000) 300,000 0 70,000 0 0 370,000 $(130,000)

DroppingtheTablesproductlineresultsinrevenuelossesof$500,000andcostsavings of $370,000. Hence, Grossman Corporations operating income will be $130,000 lower if it drops theTablesline. Notethat,bydroppingtheTablesproductline,HomeFurnishingswillsavenoneofthe depreciation on equipment, general administration costs, and corporateoffice costs, but it will savevariablemanufacturingcostsandallmarketinganddistributioncostsontheTablesproduct line. 2. Grossmans will generate incremental operating income of $128,000 from selling 4,000 additionaltablesand,hence,shouldtrytoincreasetablesales.Thecalculationsfollow: IncrementalRevenues (Costs)andOperatingIncome $500,000 (300,000) * (42,000) (30,000) ** 0 ** 0 $128,000

Revenues Directmaterialsanddirectmanufacturinglabor Costofequipmentwrittenoffasdepreciation Marketinganddistributioncosts Generaladministrationcosts Corporateofficecosts Operatingincome


*

Notethattheadditionalcostsofequipmentarerelevantfuturecostsforthesellingmoretablesdecisionbecause they represent incremental future costs that differ between the alternatives of selling and not selling additional tables. Currentmarketinganddistributioncostswhichvarieswithnumberofshipments=$70,000$40,000=$30,000. As the sales of tables double, the number of shipments will double, resulting in incremental marketing and distributioncostsof(2 $30,000) $30,000=$30,000. ** General administration and corporate office costs will be unaffected if Grossman decides to sell more tables. Hence,thesecostsareirrelevantforthedecision.

1124

3.SolutionExhibit1134,Column1,presentstherelevantlossofrevenuesandtherelevant savingsincostsfromclosingtheNorthernDivision.Asthecalculationsshow,Grossmans operatingincomewoulddecreaseby$140,000ifitshutdowntheNorthernDivision(lossin revenuesof$1,500,000versussavingsincostsof$1,360,000). Grossmanwillsavevariablemanufacturingcosts,marketinganddistributioncosts,anddivision generaladministrationcostsbyclosingtheNorthernDivisionbutequipmentrelateddepreciation andcorporateofficeallocationsareirrelevanttothedecision.Equipmentrelatedcostsare irrelevantbecausetheyarepastcosts(andtheequipmenthaszerodisposalprice).Corporate officecostsareirrelevantbecauseGrossmanwillnotsaveanyactualcorporateofficecostsby closingtheNorthernDivision.Thecorporateofficecoststhatusedtobeallocatedtothe NorthernDivisionwillbeallocatedtootherdivisions. 4. Solution Exhibit 1134, Column 2, presents the relevant revenues and relevant costs of openingtheSouthernDivision(adivisionwhoserevenuesandcostsareexpectedtobeidentical to the revenues and costs of the Northern Division). Grossman should open the Southern Divisionbecauseitwouldincreaseoperatingincomeby$40,000(increaseinrelevantrevenues of $1,500,000 and increase in relevant costs of $1,460,000). The relevant costs include direct materials, direct manufacturing labor, marketing and distribution, equipment, and division general administration costs but not corporate office costs. Note, in particular, that the costof equipment written off as depreciation is relevant because it is an expected future cost that GrossmanwillincuronlyifitopenstheSouthernDivision.Corporateofficecostsareirrelevant becauseactualcorporateofficecostswillnotchangeifGrossmanopenstheSouthernDivision. ThecurrentcorporatestaffwillbeabletooverseetheSouthernDivisionsoperations.Grossman will allocatesomecorporateofficecoststotheSouthernDivisionbutthisallocationrepresents corporateofficecoststhatarealreadycurrentlybeingallocatedtosomeotherdivision.Because actualtotalcorporateofficecostsdonotchange,theyareirrelevanttothedivision. SOLUTIONEXHIBIT1134 RelevantRevenue and RelevantCost Analysis for Closing Northern Division and Opening SouthernDivision Incremental (LossinRevenues) Revenuesand andSavingsin (IncrementalCosts) CostsfromClosing fromOpening NorthernDivision SouthernDivision (1) (2) $(1,500,000) $1,500,000 825,000 0 205,000 330,000 0 1,360,000 $(140,000) (825,000) (100,000) (205,000) (330,000) 0 (1,460,000) $40,000

Revenues Variabledirectmaterialsanddirect manufacturinglaborcosts Equipmentcostwrittenoffasdepreciation Marketinganddistributioncosts Divisiongeneraladministrationcosts Corporateofficecosts Totalcosts Effectonoperatingincome(loss)

1125

1135 (3040min.) Makeorbuy,unknownlevelofvolume. 1. Thevariablecostsrequiredtomanufacture150,000starterassembliesare Directmaterials Directmanufacturinglabor Variablemanufacturingoverhead Totalvariablecosts $200,000 150,000 100,000 $450,000

Thevariablecostsperunitare$450,000150,000=$3.00perunit. LetX=numberofstarterassembliesrequiredinthenext12months. Thedatacanbepresentedinbothalldataandrelevantdataformats: AllData RelevantData Alternative Alternative Alternative Alternative 1: 2: 1: 2:Buy Make Buy Make Variablemanufacturingcosts $3X $ 3X Fixedgeneralmanufacturingoverhead 150,000 $150,000 Fixedoverhead,avoidable 100,000 100,000 Division2managerssalary 40,000 50,000 40,000 $50,000 Division3managerssalary 50,000 50,000 Purchasecost,ifboughtfrom TidnishElectronics 4X 4X Total $340,000 $200,000 $190,000 $50,000 +$3X +$4X +$3X +$4X Thenumberofunitsatwhichthecostsof makeandbuyareequivalentis Alldataanalysis: or Relevantdataanalysis: $340,000+$3X =$200,000+$4X X =140,000 $190,000+$3X =$50,000+$4X X =140,000

Assumingcostminimizationistheobjective,then If production is expected to be less than 140,000 units, it is preferable to buy units fromTidnish. If production is expected to exceed 140,000 units, it is preferable to manufacture internally(make)theunits. Ifproduction isexpectedtobe140,000units,Oxfordshouldbe indifferent between buyingunitsfromTidnishandmanufacturing(making)theunitsinternally.

1126

2. The information on the storage cost, which is avoidable if selfmanufacture is discontinued, is relevant these storage charges represent current outlays that are avoidable if selfmanufacture is discontinued. Assume these $50,000 charges are represented as an opportunitycostofthemakealternative.Thecostsofinternalmanufacturethatincorporatethis $50,000opportunitycostare Alldataanalysis: Relevantdataanalysis: $390,000+$3X $240,000+$3X

Thenumberofunitsatwhichthecostsofmakeandbuyareequivalentis Alldataanalysis: Relevantdataanalysis: $390,000+$3X X $240,000+$3X X =$200,000+$4X =190,000 =$50,000+$4X =190,000

Ifproduction isexpectedtobe lessthan190,000, it ispreferabletobuyunits fromTidnish.If productionisexpectedtoexceed190,000,itispreferabletomanufacturetheunitsinternally.

1127

1136 (30min.) Makeversusbuy,activitybasedcosting,opportunitycosts. 1. Relevantcostsunderbuyalternative: Purchases,10,000 $8.20 Relevantcostsundermakealternative: Directmaterials Directmanufacturinglabor Variablemanufacturingoverhead Inspection,setup,materialshandling Machinerent Totalrelevantcostsundermakealternative $82,000

$40,000 20,000 15,000 2,000 3,000 $80,000

The allocated fixed plant administration, taxes, and insurance will not change if Ace makes or buys the chains. Hence, these costs are irrelevant to the makeorbuy decision. The analysisindicatesthatAceshouldmakeandnotbuythechainsfromtheoutsidesupplier. 2. Relevantcostsunderthemakealternative: Relevantcosts(ascomputedinrequirement1) Relevantcostsunderthebuyalternative: Costsofpurchases(10,000 $8.20) Additionalfixedcosts Additionalcontributionmarginfromusingthespace wherethechainsweremadetoupgradethebicyclesby addingmudflapsandreflectorbars,10,000 ($20$18) Totalrelevantcostsunderthebuyalternative $80,000

$82,000 16,000

(20,000) $78,000

Ace should now buy the chains from an outside vendor and use its own capacity to upgradeitsownbicycles. 3. Inthisrequirement,thedecisiononmudflapsandreflectorsisirrelevanttotheanalysis. Costofmanufacturingchains: Variablecosts,($4+$2+$1.50=$7.50) 6,200 a Batchcosts,$200/batch 8batches Machinerent

$46,500 1,600 3,000 $51,100 $50,840

Costofbuyingchains,$8.20 6,200
a

$2,000 10batches

Inthiscase,Aceshouldbuythechainsfromtheoutsidevendor.

1128

1137 (60min.) Multiplechoice,comprehensiveproblemonrelevantcosts. Youmaywishtoassignonlysomeoftheparts. PerUnit Fixed

Manufacturingcosts: Directmaterials Directmanufacturinglabor Variablemanufac.indirectcosts Fixedmanufac.indirectcosts Marketingcosts: Variable Fixed

Total $1.00 1.20 0.80 0.50 $1.50 0.90

Variable

$3.50

$0.50

$3.00

2.40 $5.90

0.90 $1.40

1.50 $4.50

1. (b)$3.50

ManufacturingCosts Variable $3.00 Fixed 0.50 Total $3.50

2.(e)

Noneoftheabove.Decreaseinoperatingincomeis$16,800.
Old 240,000 $6.00 240,000 $3.00 240,000 $1.50 Differential $1,440,000 +$91,200* 720,000 +72,000 360,000 + 36,000 1,080,000 + 108,000 360,000 16,800 120,000 216,000 336,000 $24,000 $16,800 New 264,000 $5.80 $1,531,200 264,000 $3.00 264,000 $1.50 792,000 396,000 1,188,000 343,200 120,000 216,000 336,000 $7,200

Revenues Variablecosts Manufacturing Marketingandother Variablecosts Contributionmargin Fixedcosts Manufacturing Marketingandother Fixedcosts Operatingincome *Incrementalrevenue: $5.80 24,000 Deductpricereduction $0.20 240,000

$0.50 20,000 12mos.= $0.90 240,000

$139,200 48,000 $91,200

1129

3.

(c)$3,500

Ifthisorderwerenotlanded,fixedmanufacturingoverheadwouldbeunderallocatedby $2,500,$0.50perunit 5,000units.Therefore,takingtheorderincreasesoperatingincomeby $1,000plus$2,500,or$3,500. Anotherwaytopresentthesameideafollows: Revenueswillincreaseby(5,000 $3.50=$17,500)+$1,000 Costswillincreaseby5,000 $3.00 Fixedoverheadwillnotchange Changeinoperatingincome $18,500 (15,000) $3,500

Note that this answer to (3) assumes that variable marketing costs are not influenced by this contract.These5,000unitsdonotdisplaceanyregularsales. 4.(a) $4,000less($7,500$3,500) GovernmentContract Asabove $3,500 RegularChannels Sales,5,000 $6.00 Increaseincosts: Variablecostsonly: Manufacturing, 5,000 $3.00 $15,000 Marketing, 5,000 $1.50 7,500 Fixedcostsarenotaffected Changeinoperatingincome

$30,000

22,500 $7,500

5.(b)

$4.15

Differentialcosts: Variable: Manufacturing Shipping Fixed:$4,00010,000

$3.00 0.75

$3.75 10,000 0.40 10,000 $4.15 10,000

$37,500 4,000 $41,500

Sellingpricetobreakevenis$4.15perunit. 6. (e) $1.50, the variable marketing costs. The other costs are past costs and therefore, are irrelevant.

1130

7. (e) None of these. The correct answer is $3.55. This part always gives students trouble. Theshortcutsolutionbelowisfollowedbyalongersolutionthatishelpfultostudents. Shortcutsolution: The highest price to be paid would be measured by those coststhat could be avoided by haltingproductionandsubcontracting: Variablemanufacturingcosts Fixedmanufacturingcostssaved $60,000240,000 Marketingcosts(0.20 $1.50) Totalcosts Longerbutclearersolution: ComparativeAnnualIncomeStatement Present Difference Proposed Revenues Variablecosts: Manufacturing,240,000 $3.00 Marketingandother,240,000 $1.50 Variablecosts Contributionmargin Fixedcosts: Manufacturing Marketingandother Totalfixedcosts Operatingincome
*

$3.00 0.25 0.30 $3.55

$1,440,000 720,000 360,000 1,080,000 360,000 120,000 216,000 336,000 $24,000

$1,440,000
* 852,000 288,000 1,140,000 300,000

+132,000 72,000

60,000

$0

60,000 216,000 276,000 $24,000

Thissolutionisobtainedbyfillingintheaboveschedulewithalltheknownfiguresandworkingfromthebottom up and from the top down to the unknown purchase figure. Maximum variable costs that can be incurred, $1,140,000$288,000=maximumpurchasecosts,or$852,000.Divide$852,000by240,000units,whichyieldsa maximumpurchasepriceof$3.55.

1138 (25min.) Closingdowndivisions. 1. DivisionA Sales Variablecostsofgoodssold ($450,000 0.90$390,000 0.95) VariableS,G&A ($100,000 0.60$120,000 0.80) Totalvariablecosts Contributionmargin $530,000 405,000 60,000 465,000 $65,000 DivisionD $450,000 370,500 96,000 466,500 $(16,500)

1131

2. DivisionA Fixedcosts ofgoodssold ($450,000$405,000$390,000$370,500) FixedS,G& A ($100,000$60,000$120,000 $96,000) Totalfixedcosts Fixedcostssavingsifshutdown ($85,000 0.60$43,500 0.60) $45,000 40,000 $85,000 $51,000 DivisionD $19,500 24,000 $43,500 $26,100

DivisionAscontributionmarginof$65,000morethancoversitsavoidablefixedcosts of$51,000.Thedifferenceof$14,000helpscoverthecompanysunavoidablefixedcosts. Since$51,000ofDivisionAsfixedcostsareavoidable,theremaining$34,000isunavoidable andwillbeincurredregardlessofwhetherDivisionAcontinuestooperate.DivisionAs $20,000lossistherestoftheunavoidablefixedcosts($34,000$14,000).IfDivisionAis closed,theremainingdivisionswillneedtogeneratesufficientprofitstocovertheentire$34,000 unavoidablefixedcost.Consequently,DivisionAshouldnotbeclosedsinceithelpsdefray $14,000ofthiscost. Incontrast,DivisionDearnsanegativecontributionmargin,whichmeansitsrevenues arelessthanitsvariablecosts.DivisionDalsogenerates$26,100ofavoidablefixedcosts. Basedstrictlyonfinancialconsiderations,DivisionDshouldbeclosedbecausethecompanywill save$42,600($26,100+$16,500). Analternativesetofcalculationsisasfollows: DivisionA Totalvariablecosts Avoidablefixedcostsifshutdown Totalcostsavingsifshutdown Lossofrevenuesifshutdown Costsavingsminuslossofrevenues $465,000 51,000 516,000 530,000 $(14,000)

DivisionD $466,500 26,100 492,600 450,000 $42,600

DivisionAshouldnotbeshutdownbecauselossofrevenuesifDivisionAisshutdownexceeds costsavings.DivisionDshouldbeshutdownbecausecostsavingsfromshuttingdownDivision Dexceedslossofrevenues. 3.BeforedecidingtocloseDivisionD,managementshouldconsidertherolethattheDivisions productlineplaysrelativetootherproductlines.Forinstance,if theproductmanufacturedby DivisionDattractscustomerstothecompany,thendroppingDivisionDmayhaveadetrimental effectontherevenuesoftheremainingdivisions.Managementmayalsowanttoconsiderthe impactonthemoraleoftheremainingemployeesifDivisionDisclosed.Talentedemployees maybecomefearfuloflosingtheirjobsandseekemploymentelsewhere.

1132

1139 (25min.) Productmix,constrainedresource. 1. Sellingprice Variablecosts: Directmaterials(DM) Laborandothercosts Totalvariablecosts Contributionmargin 1 Poundsof DMperunit Contributionmarginperlb.
1

A110 $84 24 28 52 $32 8lbs. $4 perlb.


=

B382 $ 56 15 27 42 $ 14 5lbs. $2.80perlb.

C657 $70 9 40 49 $21 3 lbs. $ 7 perlb.

A110:

Directmaterialcostperunit CostperpoundofBistide

$24 $3

= 8lb.perunit

B382:

Directmaterialcostperunit CostperpoundofBistide Directmaterialcostperunit CostperpoundofBistide

$15 $3 $9 $3

= 5lb.perunit

C657:

= 3lb.perunit

First,satisfyminimumrequirements.
A110 B382 Minimumunits 200 200 Timespoundsperunit 8 lb. perunit 5 lb.perunit Poundsneededtoproduceminimumunits 1,600lb. 1,000lb. C657 200 3 lb.perunit 600 lb. Total

3,200lb.

Theremaining1,800pounds(5,0003,200)shouldbedevotedtoC657becauseithasthe highestcontributionmarginperpoundofdirectmaterial.SinceeachunitofC657requires3 poundsof Bistide,theremaining1,800poundscanbeusedtoproduceanother600unitsof C657.Thefollowingcombinationyieldsthehighestcontributionmargingiventhe5,000pounds constraintonavailabilityofBistide. A110:200units B382:200units C657:800units(200minimum+600extra)

1133

2.ThedemandforWestfordsproductsexceedsthematerialsavailable.Assumingthatfixed costsarecoveredbytheoriginalproductmix,Westfordshouldbewillingtopayuptoan additional $7perpound(thecontributionmarginperpoundofC657)foranother1,000pounds 1 ofBistide.Thatis,Westfordshouldbewillingtopay$3+$7=$10perpound ofBistide . This costassumesthatsufficientdemandexiststosellanother333units(1000pounds3poundsper unit)ofC657.Ifnot,then themaximumpricefallstoanadditional$4perpound(the contributionmarginperpoundofA110)sothatWestfordcanproduceupto125moreunitsof A110(1,000pounds8poundsperunit).Inthiscase,Westfordwouldbewillingtopay$3+ $4=$7perpound. Ifthereisinsufficientdemandtosellanother125unitsofA110,thenthe maximumpriceWestfordwouldbewillingtopayfallstoanadditional$2.80perpound(the contributionmarginperpoundofB382).Westfordwouldbewillingtopay$2.80+$3=$5.80 perpoundof Bistide.
1

Analternativecalculationfocusesoncolumn3forC657ofthetableinrequirement1. Sellingprice Variablelaborandothercosts(excludingdirectmaterials) Contributionmargin Dividedbypoundsofdirectmaterialperunit DirectmaterialcostperpoundthatWestfordcanpay withoutcontributionmarginbecomingnegative

$70 40 $30 3 lbs. $10

1134

1140 (3040min.) Optimalproductmix. 1. LetDrepresentthebatchesofDellasDelightmadeandsold. LetBrepresentthebatchesof BonnysBourbonmadeandsold. ThecontributionmarginperbatchofDellasDelightis$300. Thecontributionmarginperbatch ofBonnysBourbonis$250. TheLPformulationforthedecisionis: Maximize $300D+$250B Subjectto 30D+15B 660(MixingDepartmentconstraint) 15B 270(FillingDepartmentconstraint) 10D+15B 300(BakingDepartmentconstraint) 2. SolutionExhibit1140presentsagraphicalsummaryoftherelationships.Theoptimal corneristhepoint(18, 8)i.e.,18 batchesof DellasDelightsand8of BonnysBourbons. SOLUTIONEXHIBIT1140 GraphicSolutiontoFindOptimalMix,DellaSimpson,Inc.
DellaSimpsonProductionModel
50

45

0,44
MixingDept.Constraint

40

B(batchesofBonny'sBourbons)

35

EqualContribution MarginLines OptimalCorner(18,8)

30

25

20

3,18 0,18

FillingDept.Constraint

15

10

FeasibleRegion
5

BakingDept.Constraint

0 0 5 10 15 20

22,0

25

30

35

40

D(batchesofDella'sDelight)

1135

Wenextcalculatetheoptimalproductionmixusingthetrialanderrormethod. The corner point where the Mixing Dept. and Baking Dept. constraints intersect can be calculatedas(18,8) by solving: 30D+15B = 660(1)MixingDept.constraint 10D+15B = 300(2)BakingDept.constraint Subtracting(2)from(1),wehave 20D = 360 or D = 18 Substitutingin(2) (10 18)+15B = 300 thatis, 15B = 300 -180=120 or B = 8 ThecornerpointwheretheFillingandBakingDepartmentconstraintsintersectcanbecalculated as (3,18) by substituting B = 18 (Filling Department constraint) into the Baking Department constraint: 10D+(15 18) = 300 10D = 300 -270=30 D = 3 Thefeasibleregion,definedby5cornerpoints,isshadedinSolutionExhibit1140.Wenextuse thetrialanderrormethodtocheckthecontributionmarginsateachofthefivecornerpointsof theareaoffeasiblesolutions. Trial 1 2 3 4 5 Corner(D,B) (0,0) (22,0) (18,8) (3,18) (0,18) TotalContributionMargin ($300 0)+($250 0)=$0 ($300 22)+($250 0)=$6,600 ($300 18) +($250 8)=$7,400 ($300 3) +($250 18)=$5,400 ($300 0)+($250 18)=$4,500

Theoptimalsolutionthatmaximizescontributionmarginandoperatingincomeis18batchesof DellasDelightsand8batchesof BonnysBourbons.

1136

1141 (30min.) Makeversusbuy,ethics. 1. Directmaterialsperunit=$195,000 30,000=6.50 Directmanufacturinglaborperunit=$120,000 30,000=$4 Variablemanufacturingoverheadfor30,000units=40%of$225,000=$90,000 Variablemanufacturingoverheadasapercentageofdirectmanufacturinglabor= $90,000 $120,000=75% Fixedmanufacturingoverhead=60%of$225,000=$135,000 SOLUTIONEXHIBIT1141A
Manufacturing Costsfor Manufacturing 32,000Units Costsfor withPorter 30,000Units Estimates (1) (2) Purchasingcosts($17.30/unit 32,000units) Directmaterials($6.50/unit 30,00032,000 units) Directmanufacturinglabor($4/unit 30,00032,000units) Plantspacerental(orpenaltytoterminate) Equipmentleasing(orpenaltytoterminate) Variableoverhead(75%ofdirectmanufacturing labor) Fixedmanufacturingoverhead Totalmanufacturingorpurchasingcosts $195,000 120,000 84,000 36,000 90,000 135,000 $660,000 $208,000 128,000 84,000 36,000 96,000 135,000 $687,000 Purchase Costsfor 32,000Units withPorter Estimates (3) $553,600

10,000 5,000 135,000 $703,600

On the basis of Porters estimates, Solution Exhibit 1141A suggests that in 2009, the cost to purchase 32,000 units of MTR2000 will be $703,600, which is greater than the estimated $687,000coststomanufactureMTR2000inhouse.Basedsolelyonthesefinancialresults,the 32,000unitsofMTR2000for2009shouldbemanufacturedinhouse. 2. SOLUTIONEXHIBIT1141B Manufacturing Costsfor 32,000Units with HartEstimates (4) Purchasingcosts($17.30/unit 32,000units) Directmaterials($208,000 1.08) Directmanufacturinglabor($128,000 1.05) Plantspacerental(orpenaltytoterminate) Equipmentleasing(orpenaltytoterminate) Variableoverhead(75%ofdirectmfg.labor) Fixedmanufacturingoverhead Total manufacturingorpurchasingcosts $224,640 134,400 84,000 36,000 100,800 135,000 $714,840 Purchase Costsfor 32,000Units with HartEstimates (5) $553,600

10,000 3,000 135,000 $701,600

1137

BasedsolelyonthefinancialresultsshowninSolutionExhibit1141B,Hartsestimatessuggest that the 32,000 units of MTR2000 should be purchased from Marley. The total cost from Marleywouldbe$701,600,or$13,240lessthaniftheunitsweremadebyPaibec. 3. At least four other factors that Paibec Corporation should consider before agreeing to purchaseMTR2000fromMarleyCompanyincludethefollowing: Infutureyears,Paibecwillnotincurtherentalandleasecontractterminationcostson itsannualcontactsthatitwillincurin2009.Thiswillmakethepurchaseoptioneven moreattractive,inafinancialsense.Butthen,Marleysownlongevity,itsabilityto provide the required units of MTR2000, and its demanded price should be considered,sinceterminatingthecontractsmaymakethemakeversusbuydecisiona longtermoneforPaibec. ThequalityoftheMarleycomponentshouldbeequalto,orbetterthan,thequalityof the internally madecomponent.Otherwise,thequalityofthe finalproductmightbe compromisedandPaibecsreputationaffected. Marleys reliability as an ontime supplier is important, since late deliveries could hamperPaibecsproductionscheduleanddeliverydatesforthefinalproduct. Layoffs may result if the component is outsourced to Marley. This could impact Paibecsotheremployeesandcauselaborproblemsoraffectthecompanysposition inthecommunity.Inaddition,theremaybelaborterminationcosts,whichhavenot beenfactoredintotheanalysis. 4. ReferringtoStandardsofEthicalConductforManagementAccountants,inExhibit1 7,Lynn HartwouldconsidertherequestofJohnPortertobeunethicalforthefollowingreasons. Competence Prepare complete and clear reports and recommendations after appropriate analysis of relevantandreliableinformation.Adjustingcostnumbersviolatesthecompetencestandard. Integrity Refrain from either actively or passively subverting the attainment of the organizations legitimate and ethical objectives. Paibec has a legitimate objective of trying to obtain the componentatthelowestcostpossible,regardlessofwhetheritismanufacturedinternallyor outsourcedtoMarley. Communicate unfavorable as well as favorable information and professional judgments or opinions. Hart needs to communicate the proper and accurate results of the analysis, regardlessofwhetherornotitfavorsinternalproduction. Refrain from engaging in or supporting any activity that would discredit the profession. FalsifyingtheanalysiswoulddiscreditHartandtheprofession.

1138

Credibility Communicate information fairlyandobjectively. Hart needstoperformanobjective make versusbuyanalysisandcommunicatetheresultsfairly. Disclose fully all relevant information that could reasonably be expected to influence an intended users understanding of the reports, comments, and recommendations presented. Hartneedstofullydisclosetheanalysisandtheexpectedcostincreases. Confidentiality Notaffectedbythisdecision. Hart should indicatetoPorterthatthecostsshe hasderivedunderthe makealternativeare correct.IfPorterstillinsistsonmakingthechangestolowerthecostsofmakingMTR2000 internally,Hart shouldraisethe matterwithPorters superior,after informingPorterofher plans.If,aftertakingallthesesteps,thereisacontinuedpressuretounderstatethecosts,Hart shouldconsiderresigningfromthecompany,ratherthanengageinunethical conduct.

1139

1142 (30min.)Productmix,constrainedresource. 1. Units (1) 1,800 4,500 39,000 MachineHrsPerUnit (2)= Var.Mach.Cost/Unit$200/Hour $600$200=3 $500$200=2.5 $200$200=1 MachineHrs Demanded (3)=(1)(2) 5,400 11,250 39,000 55,650

Nealy Tersa Pelta Total 2.

Sellingprice Variablecosts: Directmaterials Variablemachining Salescommissions(5%,5%,10%) Totalvariablecosts Contributionmargin perunit

Nealy $3,000 750 600 150 1,500 $1,500

Tersa $2,100 500 500 105 1,105 $ 995

Pelta $800 100 200 80 380 $420

3.Total machine hoursneededtosatisfydemandexceedthe machine hoursavailable(55,650 needed>50,000available).ConsequentlyMarionTaylorneedstoevaluatetheseproductsbased onthecontributionmarginpermachinehour. Nealy $1,500 3MH $ 500 Tersa $995 2.5MH $398 Pelta $420 1MH $420

Unitcontributionmargin Machinehours(MH) perunit UnitcontributionmarginperMH

Basedonthisanalysis,MarionTaylorshouldproducetomeetthedemandforproductswiththe highestunitcontributionmargin permachinehour,firstNealy,thenPelta,andfinallyTersa.The optimalproductmixwillbeasfollows: Nealy Pelta Tersa Total 1,800units = 5,400MH 39,000units = 39,000MH 2,240(5,600MH2.5MH/unit)units = 5,600MH(50,0005,40039,000) 50,000MH

4.TheoptimalproductmixinPart3satisfiesthedemandforNealyandPeltaandleavesonly 2,260 units (4,500 2,240) of Tersa unfilled. These remaining units of Tersa require 5,650 machinehours(2,260units 2.5MHperunit).ThemaximumpriceMarionTayloriswillingto pay for extra machine hours is $398, which is the unit contribution per machine hour for additionalunitsofTersa.Thatis,totalcostpermachinehourfortheseunitswillbe$398+$200 (variablecostpermachinehour)=$598permachinehour.

1140