You are on page 1of 50

CHAPTER 7

Incremental Analysis
ASSIGNMENT CLASSIFICATION TABLE
Brief Exercises 1 A Problems B Problems

Learning Objectives 1. Identify the steps in managements decisionmaking process. Describe the concept of incremental analysis. Identify the relevant costs in accepting an order at a special price. Identify the relevant costs in a make-or-buy decision. Identify the relevant costs in determining whether to sell or process materials further. Identify the relevant costs to be considered in repairing, retaining or replacing equipment. Identify the relevant costs in deciding whether to eliminate an unprofitable segment.

Questions 1, 2

Do It!

Exercises 1

2.

3, 4

1, 17

3.

2, 3, 4, 18

1A

1B

4.

6, 7

5, 6, 7, 8, 18

2A

2B

5.

8, 9, 10

5, 6

3A

3B

6.

11

13, 14, 18

4A

4B

7.

12

5A

5B

ASSIGNMENT CHARACTERISTICS TABLE

Problem Number 1A Difficulty Level Simple Time Allotted (min.) 2030

Description Use incremental analysis for special order and identify nonfinancial factors in the decision. Use incremental analysis related to make or buy, consider opportunity cost, and identify nonfinancial factors. Determine if product should be sold or processed further. Compute gain or loss, and determine if equipment should be replaced. Prepare incremental analysis concerning elimination of divisions. Use incremental analysis for special order and identify nonfinancial factors in the decision. Use incremental analysis related to make or buy, consider opportunity cost, and identify nonfinancial factors. Determine if product should be sold or processed further. Compute gain or loss, and determine if equipment should be replaced. Prepare incremental analysis concerning elimination of divisions.

2A

Moderate

3040

3A 4A

Moderate Moderate

3040 3040

5A

Moderate

3040

1B

Simple

2030

2B

Moderate

3040

3B 4B

Moderate Moderate

3040 3040

5B

Moderate

2030

Correlation Chart between Blooms Taxonomy, Learning Objectives and End-of-Chapter Exercises and Problems
Knowledge Comprehension Q7-1 Q7-2 Q7-3 Q7-4 Q7-5 BE7-3 DI7-1 BE7-4 DI7-2 E7-1 BE7-2 E7-1 E7-17 E7-2 E7-3 E7-4 E7-5 E7-6 E7-7 E7-8 BE7-5 BE7-6 DI7-3 Q7-11 BE7-7 E7-9 E7-10 E7-11 E7-12 E7-13 E7-14 E7-18 BE7-8 DI7-4 BYP7-1 BYP7-4 BYP7-5 BYP7-2 BYP7-8 BYP7-9 E7-15 E7-16 E7-17 BYP7-3 BYP7-6 BYP7-7 E7-18 P7-1A P7-1B E7-18 P7-2A P7-2B E7-18 P7-3A P7-3B P7-4A P7-4B E7-18 P7-5A P7-5B Application Analysis Synthesis Evaluation

Learning Objective

*1.

*2.

BLOOMS TAXONOMY TABLE

*3.

Identify the relevant costs in accepting an order at a special price. Q7-6 Q7-7

*4.

Identify the relevant costs in a make-or-buy decision.

*5.

Identify the relevant costs in determining whether to sell or process materials further.

Q7-8 Q7-9 Q7-10

*6.

Identify the relevant costs to be considered in repairing, retaining or replacing equipment. Q7-12

*7.

Identify the relevant costs in deciding whether to eliminate an unprofitable segment.

1. The following steps are frequently involved in managements decision-making process: (1) Identify the problem and assign responsibility. (2) Determine and evaluate possible courses of action. (3) Make a decision. (4) Review results of the decision. My roommate is incorrect. Accounting contributes to the decision-making process at Steps 2 and 4. Prior to the decision, accounting provides relevant revenue and cost data for each course of action. Following the decision, internal reports are prepared to show the actual impact of the decision. Disagree. Incremental analysis involves the identification of financial data that change under alternative courses of action. In incremental analysis, the important point to consider is whether costs will differ (change) between the two alternatives. As a result, sometimes (1) variable costs do not change under the alternative courses of action and (2) fixed costs do change. The relevant data in deciding whether to accept an order at a special price are the incremental revenues to be obtained compared to the incremental costs of filling the special order. The manufacturing costs that are relevant in the make-or-buy decision are those that will change if the parts are purchased. Opportunity cost may be defined as the potential benefit that may be obtained by following an alternative course of action. Opportunity cost is relevant in a make-or-buy decision when the facilities used to make the part can be used to generate additional income. The decision rule in a decision to sell a product or to process it further is: Process further as long as the incremental revenue from the additional processing exceeds the incremental processing costs. Joint products are products that are produced from a single raw material and a common production process. An accounting issue related to joint products is how to allocate the joint costs incurred during the production process that creates the joint products. Joint costs are irrelevant to a sell-or-process-further decision because they are sunk costs and will not change whether the decision is to sell the existing product or process it further. Therefore, joint costs are ignored in this decision. A sunk cost is a cost that cannot be changed by any present or future decision. Sunk costs, such as the book value of an old piece of equipment, therefore, are not relevant in a decision to retain or replace equipment. Net income will be lower if an unprofitable product line is eliminated when the product line is producing a positive contribution margin and its fixed costs cannot be avoided or reduced.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 7-1 The correct order is: 1. 2. 3. 4. Identify the problem and assign responsibility. Determine and evaluate possible courses of action. Make a decision. Review results of the decision.

BRIEF EXERCISE 7-2 Net Income Increase (Decrease) (\$ 20,000) (25,000) (\$ 5,000)

Alternative A is better than Alternative B.

BRIEF EXERCISE 7-3 Net Income Increase (Decrease) (\$ 75,000) ( (60,000) ( (6,000) (\$ 9,000)

Revenues CostsVariable manufacturing Shipping Net income

Reject Order \$0 0 0 \$0

Accept Order \$75,000 * 60,000 ** 6,000 *** \$ 9,000

The special order should be accepted. *3,000 X \$25 **3,000 X \$20 ***3,000 X \$ 2

BRIEF EXERCISE 7-4 Net Income Increase (Decrease) \$ 50,000 0 (60,000) (\$(10,000)

Make Variable manufacturing costs Fixed manufacturing costs Purchase price Total annual cost \$50,000 30,000 0 \$80,000

The decision should be to make the part.

BRIEF EXERCISE 7-5 Sell Sales price per unit Cost per unit Variable Fixed Total Net income per unit \$62.00 36.00 10.00 46.00 \$16.00 Process Further \$70.00 43.00 10.00 53.00 \$17.00 Net Income Increase (Decrease) \$8.00 ( (7.00) 0 ( (7.00) \$1.00

The bookcases should be processed further because the incremental revenues exceed incremental costs by \$1.00 per unit.

BRIEF EXERCISE 7-6 The allocated joint costs are irrelevant to the sell or process further decisions. If AB1 is processed further, the company will earn incremental revenue of \$50,000 (\$150,000 \$100,000) and only incur incremental costs of \$45,000. Therefore, the company should process AB1 further and sell AB2. If XY1 is processed further, the company will earn incremental revenue of \$35,000 (\$130,000 \$95,000) but will incur incremental costs of \$50,000. Therefore, the company should sell XY1 rather than process it further.

BRIEF EXERCISE 7-7 Net 4-Year Income Increase (Decrease) (\$ 500,000 ((300,000) 30,000 \$ 230,000

Retain Equipment Variable manufacturing costs for 4 years New machine cost Sell old machine Total \$3,000,000 (30,000) \$3,000,000

Replace Equipment \$2,500,000 300,000 (30,000) \$2,770,000

The old factory machine should be replaced. BRIEF EXERCISE 7-8 Continue Sales Variable costs Contribution margin Fixed costs Net income \$200,000 180,000 20,000 30,000 (\$ (10,000) Eliminate \$ 0 0 ( 0 20,000) \$(20,000) Net Income Increase (Decrease) \$(200,000) (180,000) (20,000) ( 10,000) \$ (10,000)

The Big Bart product line should be continued because \$20,000 of contribution margin will not be realized if the line is eliminated. This amount is greater than the \$10,000 savings of fixed costs. SOLUTIONS FOR DO IT! REVIEW EXERCISES DO IT! 7-1 Reject \$ 0 \$ 0 \$ 0 Accept \$180,000 138,000* \$ 42,000 Net Income Increase (Decrease) \$180,000 (138,000) \$ 42,000

Revenues Costs Net income

*(6,000 X \$20) + (6,000 X \$3) Given the results of the above analysis, Maize Company should accept the special order.

DO IT! 7-2 (a) Make \$ 30,000 42,000 45,000 60,000 0 \$177,000 Buy \$ 0 0 0 45,000 162,000 \$207,000 Net Income Increase (Decrease) \$ 30,000 42,000 45,000 15,000 (162,000) \$ (30,000)

Direct materials Direct labor Variable manufacturing costs Fixed manufacturing costs Purchase price Total cost

Given the results of the above analysis, Rubble Company will incur \$30,000 of additional costs if it buys the switches. (b) Make \$177,000 34,000 \$211,000 Buy \$207,000 0 \$207,000 Net Income Increase (Decrease) \$(30,000) 34,000 \$ 4,000

Total cost Opportunity cost Total cost

Yes, the answer is different: The analysis shows that net income will be increased by \$4,000 if Rubble Company purchases the switches. DO IT! 7-3 Process Further \$100 \$ 57 13 \$ 70 \$ 30 Net Income Increase (Decrease) \$25 (\$17) (3) (\$20) \$ 5

Sell Sales per unit Cost per unit Variable Fixed Total Net income per unit \$75 \$40 10 \$50 \$25

The tables should be processed further and Mesa Verde should finish the tables because the incremental revenues exceed incremental costs by \$5 per unit.

DO IT! 7-4 Net Income Increase (Decrease) \$(500,000) 370,000 (130,000) 112,000 \$ (18,000)

Eliminate \$ 0 0 0 38,000 \$(38,000)

The analysis indicates that Gator should not eliminate the gloves and mittens line because net income would decrease \$18,000.

SOLUTIONS TO EXERCISES
EXERCISE 7-1 1. 2. 3. 4. 5. 6. 7. 8. 9. False. The first step in managements decision-making process is identify the problem and assign responsibility. False. The final step in managements decision-making process is to review the results of the decision. True. False. In making business decisions, management ordinarily considers both financial and nonfinancial information. True. True. False. Costs that are the same under all alternative courses of action do not affect the decision. False. When using incremental analysis, either costs or revenues or both will change under alternative courses of action. False. Sometimes variable costs will not change under alternative courses of action, but fixed costs will.

EXERCISE 7-2 (a) Reject Order \$ 0 0 0 0 0 0 \$ 0 Accept Order \$24,000 (2,500) (7,500) (5,000) (6,000) 0 \$ 3,000 Net Income Increase (Decrease) \$24,000 (2,500) (7,500) (5,000) (6,000) 0 \$ 3,000

Revenues (\$4.80) Materials (\$0.50) Labor (\$1.50) Variable overhead (\$1.00) Fixed overhead Sales commissions Net income

(b) As shown in the incremental analysis, Gruden should accept the special order because incremental revenue exceeds incremental expenses by \$3,000. (c) It is assumed that sales of the golf discs in other markets would not be affected by this special order. If other sales were affected, Gruden would have to consider the lost sales in making the decision. Second, if Gruden is operating at full capacity, it is likely that the special order would be rejected.

EXERCISE 7-3 (a) Reject Order Revenues (15,000 X \$7.60) Cost of goods sold Operating expenses Net income \$0 0 0 \$0 Accept Order \$114,000 78,000 (1) 30,000 (2) \$ 6,000 Net Income Increase (Decrease) (\$114,000) ( (78,000) ( (30,000) (\$ 6,000)

(1) Variable cost of goods sold = \$2,600,000 X 70% = \$1,820,000.

Variable cost of goods sold per unit = \$1,820,000 350,000 = \$5.20 Variable cost of goods sold for the special order = \$5.20 X 15,000 = \$78,000.

(2) Variable operating expenses = \$840,000 X 75% = \$630,000 \$630,000 350,000 = \$1.80 per unit 15,000 X \$1.80 = \$27,000 \$27,000 + \$3,000 = \$30,000 (b) As shown in the incremental analysis, Leno Company should accept the special order because incremental revenues exceed incremental expenses by \$6,000. EXERCISE 7-4 Reject Order \$0 0 0 0 0 \$0 Accept Order \$1,187,500 (1) 500,000 187,500 250,000 937,500 \$ 250,000 Net Income Increase (Decrease) \$1,187,500 (500,000) (187,500) (250,000) (937,500) \$ 250,000

Revenues Variable costs: Direct materials Direct labor Variable overhead Total variable costs Net income

(1) [(\$2.00 + \$0.75 + \$1.00 + \$1.00) X 250,000] Klean Fiber should accept the Armys offer since it would increase net income by \$250,000.

EXERCISE 7-5 (a) Make Direct materials (30,000 X \$4.00) Direct labor (30,000 X \$5.00) Variable overhead costs (\$150,000 X 70%) Fixed manufacturing costs Purchase price (30,000 X \$12.75) Total annual cost \$120,000 150,000 105,000 45,000 0 \$420,000 \$ Buy 0 0 Net Income Increase (Decrease) \$ 120,000 150,000 105,000 0 ( (382,500) (\$ (7,500)

0 45,000 382,500 \$427,500

(b) No, Schopp Inc. should not purchase the shades. As indicated by the incremental analysis, it would cost the company \$7,500 more to purchase the lamp shades. (c) Yes, by purchasing the lamp shades, a total cost saving of \$17,500 will result as shown below. Net Income Increase (Decrease) \$ (7,500) (25,000) \$(17,500)

Make Total annual cost (above) Opportunity cost Total cost EXERCISE 7-6 (a) 1. \$420,000 25,000 \$445,000

Direct materials Direct labor Variable overhead Fixed overhead Purchase price Total annual cost

Buy \$ 0 0 0 195,000 2,300,000 \$2,495,000

Net Income Increase (Decrease) \$ 1,000,000 800,000 120,000 405,000 (2,300,000) \$ 25,000

Yes. The offer should be accepted as net income will increase by \$25,000.

EXERCISE 7-6 (Continued) 2. Net Income Increase (Decrease) \$ 1,000,000 800,000 120,000 0 405,000 (2,300,000) \$ 25,000

Direct materials Direct labor Variable overhead Fixed overhead Opportunity cost Purchase price Totals

Buy \$ 0 0 0 600,000 0 2,300,000 \$2,900,000

Yes. The offer should be accepted as net income would be \$25,000 more. (b) Qualitative factors include the possibility of laying off those employees that produced the robot and the resulting poor morale of the remaining employees, maintaining quality standards, and controlling the purchase price in the future.

EXERCISE 7-7 (a) Make Sails \$100 80 35 0 \$215 Buy Sails \$ 0 0 0 250 \$250 Net Income Increase (Decrease) \$ 100 80 35 (250) \$ (35)

Direct materials Direct labor Variable overhead Purchase price Total unit cost

Gibbs should be making the sails, because they could save \$35 per unit or \$42,000. The president was including the fixed overhead cost in the calculation. Variable overhead = Total overhead (\$100) Fixed overhead (\$78,000 1,200) = \$35. This amount has been allocated, so Gibbs will incur the cost whether or not they make the sails. This is an example of an irrelevant cost, because it does not differ between the two alternatives.

EXERCISE 7-7 (Continued) (b) The best decision would be to rent out the space as shown below. The differential savings would be \$77,000 \$42,000 = \$35,000. Net Income Increase (Decrease) \$ 258,000 (300,000) 77,000 \$ 35,000

(Based on 1,200 units) Manufacturing cost Purchase price Opportunity cost Total annual cost (c)

Buy Sails \$ 0 300,000 0 \$300,000

Qualitative factors to consider would be (1) whether Gibbs will be able to exercise control over the future price of the product (2) whether Gibbs will be able to exercise control over the quality of the product and (3) the potential for interruptions in the supply of the product.

EXERCISE 7-8 (a) Make IMC2 \$ 65.00 45.00 6.50 72.00* 0 \$188.50 Buy IMC2 \$ 0 0 0 0 200.00 \$200.00 Net Income Increase (Decrease) \$ 65.00 45.00 6.50 72.00 (200.00) \$ (11.50)

Direct materials Direct labor Material handling Variable overhead Purchase price Total unit cost

*Variable overhead = 60% X (\$126.50 6.50) The unit should not be purchased from the outside vendor, as the per unit cost would be \$11.50 greater than if they made it.

EXERCISE 7-8 (Continued) (b) In order for Innova to make an accurate decision, they would have to know the opportunity cost of manufacturing the other product. As determined in (a), purchasing the product from outside would cost \$11,500 more (1,000 X \$11.50). Innova would have to increase their contribution margin by more than \$11,500 through the manufacture of the other product, before it would be economical for them to purchase the IMC2 from the outside vendor. Qualitative factors to consider would be (1) quality of the component (2) on-time delivery, and (3) reliability of the vendor.

(c)

EXERCISE 7-9 Net Income Increase (Decrease) \$(5) \$(7) (9) \$(2) \$(3)

Sell (Basic Kit) Sales per unit Costs per unit Direct materials Direct labor Total Net income per unit \$30 \$14 0 \$14 \$16

Process Further (Stage 2 Kit) ( )\$35( ) ( ) \$ 7 (1) ( ) 9 (2) ( ) \$16 ( ) ( ) \$19 ( )

(1) The cost of materials decreases because Rachel can make two Stage 2 Kits from the materials for a basic kit. (2) The total time to make the two kits is one hour at \$18 per hour or \$9 per unit.

EXERCISE 7-9 (Continued) Rachel should carry the Stage 2 Kits. The incremental revenue, \$5, exceeds the incremental processing costs, \$2. Thus, net income will increase by processing the kits further.

EXERCISE 7-10 (a) Sales (\$60,000 + \$15,000 + \$55,000) Joint costs Net income \$ 130,000 (100,000) \$ 30,000

(b) Sales (\$190,000 + \$35,000 + \$215,000) Joint costs Additional costs (\$100,000 + \$30,000 + \$150,000) Net income (c) Incremental revenue Incremental costs Incremental profit (loss)
(1) (1)

\$ 440,000 (100,000) (280,000) \$ 60,000

Product 10 Product 12 Product 14 \$ 130,000 \$ 20,000 \$ 160,000 (30,000) (150,000) (100,000) \$ 30,000 \$(10,000) \$ 10,000

Sales value after further processing Sales value @ split-off point

Products 10 and 14 should be processed further and product 12 should be sold at the split-off point. (d) Sales (\$190,000 + \$15,000 + \$215,000) Joint costs Additional costs (\$100,000 + \$150,000) Net income \$ 420,000 (100,000) (250,000) \$ 70,000

Net income is \$10,000 (\$70,000 \$60,000) higher in (d) than in (b) because product 12 is not processed further, thereby increasing overall profit \$10,000.

EXERCISE 7-11 To determine whether each of the three joint products should be sold as is, or processed further, we must determine the incremental profit or loss that would be earned by each. The allocated joint costs are irrelevant to the decision since these costs will not change whether or not the products are sold as is or processed further. Larco Incremental revenue Incremental cost Incremental profit (loss) \$100,000* (110,000) \$ (10,000) Marco \$100,000 ** (85,000 ) \$ 15,000 Narco \$395,000 *** (250,000 ) \$145,000

From this analysis we see that Marco and Narco should be processed further because the incremental revenue exceeds the incremental costs, but Larco should be sold as is. *\$300,000 \$200,000 EXERCISE 7-12 (a) The costs that are relevant in this decision are the incremental revenues and the incremental costs associated with processing the material past the split-off point. Any costs incurred up to the split-off point are sunk costs, and therefore, irrelevant to this decision. Revenue after further processing: Product D\$60,000 (4,000 units X \$15.00 per unit) Product E\$97,200 (6,000 units X \$16.20 per unit) Product F\$45,200 (2,000 units X \$22.60 per unit) Revenue at split-off: Product D\$40,000 (4,000 units X \$10.00 per unit) Product E\$69,600 (6,000 units X \$11.60 per unit) Product F\$38,800 (2,000 units X \$19.40 per unit) Incremental revenue Incremental cost Increase (decrease) in profit D \$20,000 (14,000) \$ 6,000 E \$27,600 (20,000) \$ 7,600 F \$ 6,400 (9,000) \$(2,600) **\$400,000 \$300,000 ***\$800,000 \$405,000

(b)

Products D and E should be processed further. (c) The decision would remain the same. It does not matter how the joint costs are allocated because joint costs are irrelevant to this decision.

EXERCISE 7-13 (a) Cost Accumulated depreciation Book value Sales proceeds Loss on sale \$100,000 (25,000*) 75,000 40,000 \$ 35,000

*One years depreciation: (\$100,000 \$0) 4 years (b) Retain Scanner \$315,000* Replace Scanner \$225,000** 110,000 (40,000) \$295,000 Net Income Increase (Decrease) \$ 90,000 (110,000) 40,000 \$ 20,000

Annual operating costs New scanner cost Old scanner salvage Total

\$315,000

*(3 years X \$105,000) **[3 years X (\$105,000 \$30,000)] Yes. Benson Hospital should replace the old scanner because it will result in a savings of \$20,000 over the next four years. (c) As shown in (a) above, replacing the old scanner will result in reporting a loss of \$35,000. Reluctance to report losses of this nature is the usual reason for not recognizing that a poor decision was made in the past. The remaining book value of the old scanner (\$75,000) is a sunk cost. It will be deducted in the future, if the scanner is retained, or written off now if it is replaced. However, if it is replaced now, that cost will be partially offset by the salvage value that Dyno is willing to pay (\$40,000).

EXERCISE 7-14 Net Income Increase (Decrease) (\$ 25,000 ( (25,000) ( 6,000 (\$ 6,000

Operating costs New machine cost Salvage value (old) Total (1) \$25,000 X 5. (2) \$20,000 X 5.

Retain Replace Machine Machine \$125,000 (1) (\$100,000) (2) 0 ( 25,000) 0 ( (6,000) \$125,000 (\$119,000)

The current machine should be replaced. The incremental analysis shows that net income for the five-year period will be \$6,000 higher by replacing the current machine.

EXERCISE 7-15 Net Income Increase (Decrease) \$(100,000) (61,000) (26,000) (87,000) (13,000) ( 0) ( 0) ( 0) \$ (13,000)

Sales Variable costs Cost of goods sold Operating expenses Total variable Contribution margin Fixed costs Cost of goods sold Operating expenses Total fixed Net income (loss)

Continue \$100,000) ( 61,000) (26,000) (87,000) (13,000) (15,000) (24,000) (39,000) \$(26,000)

Eliminate \$( 0) ( ( ( ( 0) 0) 0) 0)

(15,000) (24,000) (39,000) \$(39,000)

Judy is incorrect. The incremental analysis shows that net income will be \$13,000 less if the Huron Division is eliminated. This amount equals the contribution margin that would be lost through discontinuing the division. (Note: None of the fixed costs can be avoided.)

EXERCISE 7-16 (a) (b) Sales Variable expenses Contribution margin Fixed expenses Net income \$30,000 + \$70,000 \$40,000 = \$60,000 Tingler \$300,000 150,000 150,000 142,500* \$ 7,500 Shocker \$500,000 200,000 300,000 267,500** \$ 32,500 Total \$800,000 350,000 450,000 410,000 \$ 40,000

*\$30,000 + [(\$300,000 \$800,000) X \$300,000] **\$80,000 + [(\$500,000 \$800,000) X \$300,000] (c) As shown in the analysis above, Cawley should not eliminate the Stunner product line. Elimination of the line would cause net income to drop from \$60,000 to \$40,000. The reason for this decrease in net income is that elimination of the product line would result in the loss of \$55,000 of contribution margin while saving only \$35,000 of fixed expenses.

EXERCISE 7-17 Calculation of contribution margin per unit: C \$95 50 \$45 D \$75 40 \$35 E \$115 40 \$ 75

Selling price per unit Less: variable costs/unit Contribution margin/unit

Fixed costs = \$22 X (9,000 + 20,000) = \$638,000 Company profit with Products C and D: C 9,000 \$855,000 450,000 \$405,000 D 20,000 \$1,500,000 800,000 \$ 700,000 Total

Units sold Sales revenue Less: Variable costs Contribution margin Less: Fixed costs Net income

\$2,355,000 \$1,250,000 1,105,000 638,000 \$ 467,000

EXERCISE 7-17 (Continued) Company profit with Products C and E: C 9,900* \$940,500 495,000 \$445,500 E 10,000 \$1,150,000 400,000 \$ 750,000 Total

Units sold Sales revenue Less: Variable costs Contribution margin Less: Fixed costs Net income

\$2,090,500 895,000 1,195,500 638,000 \$ 557,500

*Product C sales increase by 10%, (9,000 X 110%) Yes they should introduce Product E since net profit would increase by \$90,500 (\$557,500 \$467,000). EXERCISE 7-18 1. Irrelevant. Unavoidable costs will be incurred regardless of the decision made. 2. Relevant. 3. Irrelevant. This is a sunk cost and all sunk costs are irrelevant. 4. Irrelevant. These are sunk costs. 5. Relevant. 6. Relevant. 7. Relevant. 8. Relevant. 9. Irrelevant. If there is no change in the direct materials charge regardless of the decision made, the cost is irrelevant. 10. Relevant.

SOLUTIONS TO PROBLEMS
PROBLEM 7-1A

(a) Reject Order Revenues (10,000 X \$27) Cost of goods sold Selling and administrative expenses Net income \$0 0 0 \$0 Accept Order \$270,000 220,000 (1) 20,000 (2) \$ 30,000

Net Income Increase (Decrease) \$ 270,000 ( (220,000) ( (20,000) \$ 30,000

(1) Variable costs = \$3,600,000 \$960,000 = \$2,640,000; \$2,640,000 120,000 units = \$22.00 per unit; 10,000 X \$22.00 = \$220,000. (2) Variable costs = \$405,000 \$225,000 = \$180,000; \$180,000 120,000 units = \$1.50 per unit; 10,000 X (\$1.50 + \$0.50) = \$20,000. (b) Yes, the special order should be accepted because net income will increase by \$30,000. (c) Unit selling price = \$22.00 (variable manufacturing costs) + \$2.00 variable selling and administrative expenses + \$4.00 net income = \$28. (d) Nonfinancial factors to be considered are: (1) possible effect on domestic sales, (2) possible alternative uses of the unused plant capacity, and (3) ability to meet customers schedule for delivery without increasing costs.

PROBLEM 7-2A

(a) Make CISCO Direct materials (8,000 X \$4.80) Direct labor (8,000 X \$4.30) Indirect labor (8,000 X \$.43) Utilities (8,000 X \$.40) Depreciation Property taxes Insurance Purchase price Freight and inspection (8,000 X \$.35) Receiving costs Total annual cost \$38,400 34,400 3,440 3,200 3,000 700 1,500 0 0 0 \$84,640 Buy CISCO \$ 0 0 0 0 900 200 600 80,000 2,800 1,300 \$85,800

Net Income Increase (Decrease) (\$38,400) ( 34,400) ( 3,440) ( 3,200) ( 2,100) ( 500) ( 900) ( (80,000) ( (2,800) ( (1,300) (\$ (1,160)

(b) The company should continue to make CISCO because net income would be \$1,160 less if CISCO were purchased from the supplier. (c) The decision would be different. Because of the opportunity cost of \$3,000, net income will be \$1,840 higher if CISCO is purchased as shown below: Net Income Increase Make CISCO Buy CISCO (Decrease) Total annual cost \$85,800 \$(1,160) \$84,640 Opportunity cost 0 (3,000) 3,000 \$87,640 \$85,800 \$(1,840) Total cost (d) Nonfinancial factors include: (1) the adverse effect on employees if CISCO is purchased, (2) how long the supplier will be able to satisfy the Shatner Manufacturing Companys quality control standards at the quoted price per unit, and (3) whether the supplier will deliver the units when they are needed by Shatner.

PROBLEM 7-3A

(a) (1)

Table Cleaner Not Processed Further Sales: FloorShine (600,000 30) X \$20 Table Cleaner (300,000 25) X \$18 Total revenue Costs: CDG Additional costs of FloorShine Total costs Gross profit

\$400,000 216,000 \$616,000 210,000 240,000 450,000 \$166,000

(2)

Table Cleaner Processed Further Sales: FloorShine Table Stain Remover (300,000 25) X \$14 Table Polish (300,000 25) X \$14 Total revenue Costs: CDG Additional costs of FloorShine TCP Total costs Gross profit

\$400,000 168,000 168,000 \$736,000 210,000 240,000 100,000 550,000 \$186,000

(3) If the table cleaner is processed further overall company profits will be \$20,000 higher. Therefore, management made the wrong decision by choosing to not process table cleaner further.

PROBLEM 7-3A (Continued) (b) Dont Process Table Cleaner Further \$216,000 0 \$216,000 Process Table Cleaner Further \$336,000 100,000 \$236,000 Net Income Increase (Decrease) \$120,000 (100,000) \$ 20,000

Incremental revenue Incremental costs Totals

When trying to decide if the table cleaner should be processed further into TSR and TP, only the relevant data need be considered. All of the costs that occurred prior to the creation of the table cleaner are sunk costs and can be ignored. The decision should be made by comparing the incremental revenue from further processing to the incremental costs.

PROBLEM 7-4A (a) Cost Accumulated depreciation Book value Sales proceeds Loss on sale *\$120,000 5 years = \$24,000 (b) (1) Revenues (\$240,000 X 4 yrs.) Less costs: Variable costs (\$35,000 X 4) Fixed costs (\$23,000 X 4) Selling & administrative Depreciation Net income *(\$29,000 X 4) (2) Revenues Less costs: Variable costs (\$10,000 X 4) Fixed costs (\$8,500 X 4) Selling and administrative Depreciation Operating income Less: Loss on old elevator Net income (c) Retain Old Elevator \$140,000 92,000
.

444,000 \$516,000

Replace Old Elevator \$960,000 \$ 40,000 34,000 116,000 160,000

350,000 610,000 71,000 \$539,000 Net Income Increase (Decrease) \$ 100,000 58,000 (160,000) 25,000 \$ 23,000

Variable operating costs Fixed operating costs New elevator cost Salvage on old elevator Totals

\$232,000

Replace Old Elevator \$ 40,000 34,000 160,000 (25,000) \$209,000

PROBLEM 7-4A (Continued) (d) TO: Ron Richter FROM: Student SUBJECT: Relevant Data for Decision to Replace Old Elevator When deciding whether or not to replace any old equipment, the analysis should only include cost data relevant to the replacement decision. The \$71,000 loss that would be experienced if we replace the old elevator with the newer model is related to a sunk cost, namely the cost of the old elevator. Sunk costs are irrelevant in decision making. The loss occurs when comparing the book value of the old elevator to the cash proceeds that would be received. The book value of \$96,000 would be deducted as depreciation expense over the next four years if the elevator were retained. If the elevator is replaced with the newer model, the book value will be expensed in the current year, less the cash proceeds received on disposal. Therefore, the \$96,000 book value will be expensed under either alternative, making it irrelevant. MEMO

PROBLEM 7-5A

(a) Sales Variable costs Cost of goods sold Selling and administrative Total variable expenses Contribution margin (b) (1)
Division I Contribution margin (above) Fixed costs Cost of goods sold Selling and administrative Total fixed expenses Income (loss) from operations

Division II \$200,000 172,800 42,000 214,800 \$ (14,800)

Net Income Increase (Decrease) \$(70,000) 25,000 22,500 47,500 \$(22,500) Net Income Increase (Decrease) \$14,800 ( 9,600 9,000 18,600 \$33,400

Eliminate \$( 0)

(25,000) (22,500) (47,500) \$(47,500)

(2)
Division II Contribution margin (above) Fixed costs Cost of goods sold Selling and administrative Total fixed expenses Income (loss) from operations Continue \$(14,800) (19,200 ( 18,000 ( 37,200 \$(52,000) Eliminate \$( 0)

( 9,600) ( 9,000) (18,600) \$(18,600)

Division II should be eliminated as its negative contribution margin is \$14,800. Income from operations would increase \$33,400 if Division II is eliminated. Division I should be continued because it is producing positive contribution margin of \$70,000. Income from operations will decrease \$22,500 by discontinuing this division.

PROBLEM 7-5A (Continued) (c) GUTIERREZ COMPANY CVP Income Statement For the Quarter Ended March 31, 2014
Divisions I Sales Variable costs Cost of goods sold Selling and administrative Total variable costs Contribution margin Fixed costs Cost of goods sold (1) Selling and administrative (2) Total fixed costs Income (loss) from operations \$250,000 150,000 30,000 180,000 70,000 53,200 48,000 101,200 III \$500,000 240,000 30,000 270,000 230,000 63,200 33,000 96,200 IV \$450,000 187,500 30,000 217,500 232,500 65,700 23,000 88,700 \$143,800 Total \$1,200,000 577,500 90,000 667,500 532,500 182,100 104,000 286,100 \$ 246,400

\$(31,200) \$133,800

(1) Divisions fixed cost of goods sold plus 1/3 of Division IIs unavoidable fixed cost of goods sold [\$192,000 X (100% 90%) X 50% = \$9,600]. Each divisions share is \$3,200. (2) Divisions fixed selling and administrative expense plus 1/3 of Division IIs unavoidable fixed selling and administrative expenses [\$60,000 X (100% 70%) X 50% = \$9,000]. Each divisions share is \$3,000. (d) Income from operations with Division II of \$213,000 (given) plus incremental income of \$33,400 from eliminating Division II = \$246,400 income from operations without Division II.

PROBLEM 7-1B

(a) Reject Order Revenues (10,000 X \$30) Cost of goods sold Selling and administrative expenses Net income \$0 0 0 \$0 Accept Order

Net Income Increase (Decrease)

\$ 300,000 \$300,000 240,000 (1) ( (240,000) 25,000 (2) ( (25,000) \$ 35,000 \$ 35,000

(1) Variable costs = \$3,060,000 \$900,000 = \$2,160,000; \$2,160,000 90,000 units = \$24 per unit; 10,000 X \$24 = \$240,000. (2) Variable costs = \$360,000 \$180,000 = \$180,000; \$180,000 90,000 units = \$2.00 per unit; 10,000 X (\$2.00 + \$0.50) = \$25,000. (b) Yes, the special order should be accepted because net income will be increased by \$35,000. (c) Unit selling price = \$24 (variable manufacturing costs) + \$2.50 (variable selling and administrative expenses) + \$5.50 (net income) = \$32.00. (d) Nonquantitative factors to be considered are: (1) possible effect on domestic sales, (2) possible alternative uses of the unused plant capacity, and (3) ability to meet customers schedule for delivery without increasing costs.

PROBLEM 7-2B

(a)
Make FIZBE Direct materials (5,000 X \$4.75) Direct labor (5,000 X \$4.60) Indirect labor (5,000 X \$.45) Utilities (5,000 X \$.35) Depreciation Property taxes Insurance Purchase price Freight and inspection (5,000 X \$.30) Receiving costs Total annual cost \$23,750 23,000 2,250 1,750 2,000 700 1,500 0 0 0 \$54,950 Buy FIZBE \$ 0 0 0 0 900 200 600 56,000

Net Income Increase (Decrease) (\$ 23,750 ( 23,000 ( 2,250 ( 1,750 ( 1,100 ( 500 ( 900 ( (56,000) ( (1,500) (500) (\$ (4,750)

1,500 500 \$59,700

(b) The company should continue to make FIZBE because net income would be \$4,750 less if FIZBE were purchased from the supplier. (c) The decision would be different. Because of the opportunity cost of \$6,000, net income will be \$1,250 higher if FIZBE is purchased as shown below: Net Income Increase (Decrease) \$(4,750) 6,000 \$ 1,250

Make FIZBE Total annual cost Opportunity cost Total cost \$54,950 6,000 \$60,950

(d) Nonfinancial factors include: (1) the adverse effect on employees if FIZBE is purchased, (2) how long the supplier will be able to satisfy the Gill Corporations quality control standards at the quoted price per unit, and (3) will the supplier deliver the units when they are needed by Gill?

PROBLEM 7-3B

(a) (1)

General-Purpose Cleaner Not Processed Further Sales ShineBrite (750,000 25) X \$15 General-Purpose Cleaner (250,000 20) X \$20 Total revenue Costs NPR Additional costs for ShineBrite Total costs Gross profit

\$450,000 250,000 \$700,000 200,000 300,000 500,000 \$200,000

(2)

General-Purpose is Processed Further Sales ShineBrite (750,000 25) X \$15 Premium Cleaner (250,000 20) X \$16 Premium Stain Remover (250,000 20) X \$16 Total revenue Costs NPR Additional costs for ShineBrite PST Total costs Gross profit

\$450,000 200,000 200,000 \$850,000 200,000 300,000 140,000 640,000 \$210,000

(3) If the general-purpose cleaner is processed further overall company profits will be \$10,000 higher. Therefore, management made the wrong decision by choosing to not process the general-purpose cleaner further.

PROBLEM 7-3B (Continued) (b) Dont Process G-P Cleaner Further \$250,000 0 \$250,000 Process G-P Cleaner Further \$400,000 140,000 \$260,000 Net Income Increase (Decrease) \$150,000 (140,000) \$ 10,000

Incremental revenue Incremental costs Totals

When trying to decide if the general-purpose cleaner should be processed further into PC and PSR, only the relevant data need be considered. All of the costs that occurred prior to the creation of the general-purpose cleaner are sunk costs and can be ignored. The decision should be made by comparing the incremental revenue from further processing to the incremental costs.

PROBLEM 7-4B

(a)

Cost Accumulated depreciation Book value Sales proceeds Loss on sale *\$210,000 5 years = \$42,000

\$210,000 (42,000*) 168,000 (58,000) \$110,000

(b) (1) Revenues (\$360,000 X 4 yrs.) Less costs: Variable costs Fixed costs Selling & administrative Depreciation Net income (2) Revenues Less costs: Variable costs Fixed costs Selling and administrative Depreciation Operating income Less: Loss on old equipment Net income (c) Retain Old Equipment \$200,000 120,000
.

\$ 48,000 20,000 180,000 250,000

498,000 942,000 110,000 \$ 832,000 Net Income Increase (Decrease) \$152,000 100,000 (250,000) 58,000 \$ 60,000

Variable costs Fixed costs New equipment cost Salvage on old equipment Totals

\$320,000

Replace Old Equipment \$ 48,000 20,000 250,000 (58,000) \$260,000

PROBLEM 7-4B (Continued) (d) TO: Gene Simmons FROM: Student SUBJECT: Relevant Data for Decision to Replace Old Equipment When deciding whether or not to replace any old equipment, the analysis should only include cost data relevant to the replacement decision. The \$110,000 loss that would be experienced if we replace the old equipment with the newer equipment is related to a sunk cost, namely the cost of the old equipment. Sunk costs are irrelevant in decision making. The loss occurs when comparing the book value of the old equipment to the cash proceeds that would be received. The book value of \$168,000 would be deducted as depreciation expense over the next four years if the equipment were retained. If the equipment is replaced with the newer model the book value will be expensed in the current year, less the cash proceeds received on disposal. Therefore, the \$168,000 book value will be expensed under either alternative, making it irrelevant. MEMO

PROBLEM 7-5B

(a) Sales Variable expenses Cost of goods sold Selling and administrative Total variable expenses Contribution margin (b) (1)
Division III Contribution margin (above) Fixed expenses Cost of goods sold Selling and administrative Total fixed expenses Income (loss) from operations

Division IV \$170,000 140,400 49,000 189,400 (\$ (19,400)

Net Income Increase (Decrease) \$(76,000) 40,500 15,000 55,500 \$(20,500) Net Income Increase (Decrease) \$19,400 7,800 10,500 18,300 \$37,700

Eliminate \$ 0

(40,500 15,000 55,500 \$(55,500)

(2)
Division IV Contribution margin (above) Fixed expenses Cost of goods sold Selling and administrative Total fixed expenses Income (loss) from operations Continue \$(19,400) (15,600) 21,000) 36,600) \$(56,000) Eliminate \$ 0

7,800 10,500 18,300 \$(18,300)

Division III should be continued as contribution margin (\$76,000) is greater than the savings in fixed costs (\$55,500) that would result from elimination. Therefore, income from operations would decrease \$20,500 if Division III is eliminated. Division IV should be eliminated because it is producing negative contribution margin (\$19,400). Income from operations will increase \$37,700 by discontinuing this division.

PROBLEM 7-5B (Continued) (c) PANDA COMPANY CVP Income Statement For the Quarter Ended March 31, 2014
Divisions I Sales Variable expenses Cost of goods sold Selling and administrative Total variable expenses Contribution margin Fixed expenses Cost of goods sold (1) Selling and administrative (2) Total fixed expenses Income (loss) from operations \$510,000 210,000 24,000 234,000 276,000 92,600 39,500 132,100 \$143,900 II \$400,000 200,000 40,000 240,000 160,000 52,600 43,500 96,100 \$ 63,900 III \$310,000 189,000 45,000 234,000 76,000 83,600 33,500 Total \$1,220,000 599,000 109,000 708,000 512,000 228,800 116,500

117,100 345,300 \$ (41,100) \$ 166,700

(1) Divisions fixed cost of goods sold plus 1/3 of Division IVs unavoidable fixed cost of goods sold [\$156,000 X (100% 90%) X 50% = \$7,800]. Each divisions share is \$2,600. (2) Divisions fixed selling and administrative expenses plus 1/3 of Division IVs unavoidable fixed selling and administrative expenses [\$70,000 X (100% 70%) X 50% = \$10,500]. Each divisions share is \$3,500. (d) Income from operations with Division IV of \$129,000 (given) plus incremental income of \$37,700 from eliminating Division IV = \$166,700 income from operations without Division IV.

BYP 7-1

DECISION-MAKING AT CURRENT DESIGNS

Situation #1 (a) Current Designs should accept the special order based on the following calculations: Net Income Increase (Decrease) \$25,000 (19,000) \$ 6,000

Revenues Costs Net Income

Reject Order \$0 0 \$0

Accept Order \$25,000* (19,000)** \$ 6,000

*(100 X \$250) **((\$80 + \$60 + \$20) X 100) + (\$1,000 + \$2,000) (b) Assuming that Current Designs is currently operating with excess capacity, it should accept the order based on the calculations shown in part (a). If Current Designs is currently operating at full capacity, it would have to weigh its options. If it displaced production of regular kayaks in order to fill this order, it would have to consider the opportunity costs associated with this decision. The opportunity cost, when operating at full capacity, would be the lost contribution margin from regular sales given up in order to fulfill the special order. Alternatively, rather than reject the special order, it might consider temporarily expanding the plants capacity by adding an additional production shift to handle the special order. If this option were considered, it would have to identify all additional incremental costs (for example, overtime pay) that would be incurred.

BYP 7-1 (Continued) Situation #2 (a) Current designs should not replace the Rotomold oven based on the following calculations:
Net Income Increase (Decrease) \$ 13,000 (250,000) 10,000 (\$ 227,000)

Variable manufacturing costs New oven cost Proceeds from scrapping old oven Total

*(17,000 therms/year X \$0.65/therm X 10 years) **(15,000 therms/year X \$0.65/therm X 10 years)

(b) Even with the cost of natural gas increasing at a faster than expected rate, Current Designs still should not replace the Rotomold oven as the rate increase does not cover the cost of the new oven based on the following calculations:
Net Income Increase (Decrease) \$ 17,000 (250,000) 10,000 (\$ 223,000)

Variable manufacturing costs New oven cost Proceeds from scrapping old oven Total

*(17,000 therms/year X \$0.85/therm X 10 years) **(15,000 therms/year X \$0.85/therm X 10 years)

BYP 7-1 (Continued) Situation #3 (a) Current Designs should make the seats based on the following calculations: Net Income Increase (Decrease) \$ 60,000 45,000 36,000 5,000 (150,000) (\$ 4,000)

Direct materials Direct labor Variable manufacturing costs Fixed manufacturing costs Purchase price (\$50 X 3,000) Total annual cost

Buy 0 0 0 15,000 150,000 \$165,000 \$

(b) When the opportunity cost of \$20,000 is considered, Current Designs should buy the seats based on the following calculations: Net Income Increase (Decrease) (\$ 4,000) 20,000 \$16,000

BYP 7-2

DECISION-MAKING ACROSS THE ORGANIZATION

Retain Old Machine Sales Costs and expenses Cost of goods sold Selling expenses Administrative expenses Purchase price Total costs and expenses Net income (1) (2) (3) (4) (5) \$6,000,000 (1) 4,500,000 (3) 900,000 500,000 5,900,000 \$ 100,000

Purchase New Machine \$6,600,000 (2) 4,620,000 (4) 990,000 565,000 150,000 (5) 6,325,000 \$ 275,000

Net Income Increase (Decrease) (\$ 600,000 ( (120,000) ( (90,000) ( (65,000) ( (150,000) ( (425,000) (\$ 175,000

12,000 X \$100 X 5 years = \$6,000,000. \$6,000,000 X 110% = \$6,600,000. \$6,000,000 X (100% 25%) = \$4,500,000. \$6,600,000 X (100% 30%) = \$4,620,000. \$140,000 + \$4,000 + \$6,000 = \$150,000.

The new machine should be purchased. The incremental analysis shows that net income will increase from \$100,000 to \$275,000 over the five years with the new machine.

BYP 7-3

MANAGERIAL ANALYSIS

(a) Make Sales Revenue Variable Manufacturing Cost: Circuit Board Plastic Case Alarms (4 @ \$.15 each) Labor Overhead Purchase Cost Fixed Manufacturing Cost: Total Manufacturing Cost Profit per Unit Total Profit \$ 14.50 2.00 0.80 0.60 3.00 0.50 0 6.90 \$ 7.60 \$38,000

Buy Omega \$ 14.50 0 0 0 0 0 5.00 1.00 6.00 \$ 8.50 \$42,500

*The \$5,000 cost that will continue to be incurred, even if the product is not manufactured, divided by the 5,000 units. The company will make the most profit if the clocks are purchased from Omega Company. The company will make \$4,500 less if the clocks are manufactured by MiniTek. The company will make \$25,000 less if the clocks are purchased from Trans-Tech. (b) There are several important nonfinancial factors described in the case. Other factors might be identified as well. The factors described are: The company is having serious difficulty manufacturing the clocks. Therefore, it would probably be willing to have someone else manufacture the clocks, even if it cost more to do so. The most promising company appears to be Omega; however, there is a serious question about Omegas ability to remain in business. However, the company could purchase just this one order from Omega, and then continue to search for another manufacturer, or stop manufacturing the clocks. Trans-Techs stringent requirements for preferred customer status, in the form of large sales requirements, appear to limit the possibilities for MiniTek to use it as a supplier. However, if MiniTek does desire to continue to offer the clocks because of their popularity, then perhaps Trans-Tech could be used in the future.

BYP 7-3 (Continued) (c) Many answers are possible, depending upon each students assessment of the seriousness of the issues mentioned in (b). One answer would be: The company should use Omega to manufacture the Kmart order. After that, the company should not offer the clocks any longer. Especially since the clocks are no longer very profitable, it does not seem like a good idea to keep spending money to modify the process.

BYP 7-4

REAL-WORLD FOCUS

(a) Before building the special-order new ceiling fans, company management must consider the effect of the new lines on current production capacity, existing and available channels of distribution, the effect on manufacturing efficiency, the effect on sales of current lines of product, and the supply of materials and labor. (b) Incremental analysis would provide a financial comparison of income with the special-order ceiling fans to income without the special orders.

BYP 7-5

REAL-WORLD FOCUS

(a) The types of outsourcing services that the company provides assistance on are: Information technology outsourcing, finance and accounting, human resource outsourcing, business process outsourcing, procurement, and call centers. (b) Insourcing means to take work that is currently being performed by an outside service provider back in-house. For example, collections of accounts receivable might currently be performed by a collection agency, and you might decide to establish a collection group within your company. (c) Some of the benefits of insourcing include: Greater control over resources Greater ability to control intellectual property Increased visibility of accountability within the organization

BYP 7-6

COMMUNICATION ACTIVITY

To: From:

Preston ThiesePlant Manager Hank JewelProduction Manager

I have spent considerable time thinking about the dilemma created by the new PDD1130 machine. Clearly, it is far superior to our existing machine. There is no question that it would save us tremendous amounts of money. I hope I am not overstepping my bounds here, but I just reviewed a chapter in my managerial accounting text on incremental analysis which has made me think we need to reconsider this decision. The key to incremental analysis is identifying relevant costs. Relevant costs are those costs that vary depending on the course of action taken. In our situation, a relevant cost would be the savings that we would experience were we to purchase the new machine. The book value of the existing machine is not a relevant cost since it would not be changed by purchasing or not purchasing the new machine. Costs incurred in the past that do not change are referred to as sunk costs. Sunk costs are irrelevant to incremental analysis. I would really like to lay out an analysis of our options to decide the proper course of action. I am concerned that by using the old machine for a couple of years the profitability of the plant could be impacted negatively.

BYP 7-7

ETHICS CASE

(a) Many factors need to be considered when determining whether to close a division. The loss of jobs can have a devastating impact on a community and on the morale of remaining employees. From a financial perspective, closing a division that is reporting losses will not necessarily increase the reported net income of the company. The reason: if fixed costs that have been allocated to a division that is closed are reallocated to the remaining divisions, the companys net income might actually decrease. This sounds like it would most likely be the case at Peters. (b) It is not unusual to reevaluate fixed cost allocations periodically. However, the allocation should be based on the underlying economics of the situation rather than the motives of individuals. (c) Blake should explain to the board of directors that the change in income is due to a reallocation and that closing the plumbing division is not advisable. In this case, being honest is not only the ethical thing to do, but it will also maximize the companys net income.

BYP 7-8