CHAPTER 7

DIFFERENTIAL COST ANALYSIS FOR OPERATING DECISIONS

Questions, Exercises, and Problems: Answers and Solutions
7.1

See text or glossary at the end of the book.

7.2

Fixed costs are only fixed in the short-run so any long-run decision may have differential fixed
costs. For instance, decisions affecting capacity would include differential fixed costs.

7.3

Short-term pricing decisions are based on differential costs, any price higher than differential costs
will increase profits even if it is lower than full cost. However, in the long-term, prices must cover
the full cost of producing the product.

7.4

No. Facility-sustaining costs are fixed in the short-term; they will be incurred regardless of
production level. Therefore, they are not differential and should not be considered in a short-term
pricing decision.

7.5

Full cost information is appropriate for long-term pricing decisions.

7.6

d.

the differential costs of producing the order.

7.7

b.

depreciation of buildings.

7-1

Solutions

7.8

"Setup" or "order" costs are costs incurred each time an order is placed or a production run is
made. "Carrying" costs are the costs of keeping inventory, for example, maintaining warehouse
facilities.

Costs
Total
Costs
Carrying
Costs

Order
Costs

Optimal
Order

Order Size

7.9

The costs that are relevant for make-or-buy decisions are the differential costs.

7.10

True. The objective of the theory of constraints is to increase throughput contribution.

7.11

Any differential costs should be considered in the decision, including overtime, and costs of
additional shifts or other means of expanding capacity.

7.12

Answers will vary, but should all be short-term pricing decisions.

7.13

In the long-term full costs must be met so full-cost information is useful for decisions affecting the
long-term.

7.14

The statement is true in general short-term decisions in which there is excess capacity. However,
in any situation where the decision affects capacity, the statement would not be true.

7.15

In the short-run, sales revenues need only cover the differential costs of production and sale. So,
from a short-run perspective so long as the sale does not affect other output prices or normal sales
volume, a below cost sale may result in a net increase in income so long as the revenues cover
the differential costs. However, in the long-run all costs must be covered or management would
not reinvest in the same type of assets. If the company must continually sell below the full cost of
production then it will most likely get out of that particular business when it comes time to replace
those facilities.

7.16

Differential Costs

Solutions

7-2

Fuel
Wear and tear related to miles driven such as tires, mileage-related maintenance, lube and
oil
Parking and tolls, if any
Car wash if needed due to the trip
Risk of casualties that vary with mileage
Other costs that vary with mileage
7.17

Differential Costs
Cost of the car
Foregone interest income on funds paid for the car
Interest on debt on the car
Insurance
Maintenance that is time-related
License and taxes
These costs are different from the costs in Question 7.16. The costs in Question 7.16 are those
required to operate the car for an additional few miles. The costs that vary with the number of
cars do not vary with mileage. The costs in this question vary with the number of cars and not
with the mileage driven.

7.18

Activity-based costing may actually provide better cost information than costing systems that
allocate indirect costs based on one volume-based cost driver. Activity-based costing provides
more detailed cost data that might lead to more informed decision making regarding prices. Since
market prices are typically not available for custom orders, many companies use cost-plus pricing.
Since this company uses activity-based costing, it has the cost information necessary to use a costplus pricing approach.

7.19

In differential analysis, only alternative future cash flows are relevant for decision making. Past
costs may provide useful information, but they are essentially sunk costs and not directly relevant
to a decision.

7.20

The contribution margin per unit would be the most appropriate figure since it represents the price
minus the products variable costs. The gross margin is based on full absorption unit costs that
include allocated fixed costs, which can be misleading to the decision maker.

7-3

Solutions

7.21

Answers will vary but should include identification of differential costs. This question is directed
to having students think about the many situations in which there are make or buy decisions.

7.22

(Special order.)

Revenue.................................
Variable Costs.......................
Contribution Margin..............
Fixed Costs............................
Operating Profit.....................

Alternative
$ 41,280a
31,200c
$ 10,080
7,000
$ 3,080

Status Quo = Difference

$ 40,000b
$ 1,280
d
30,000
1,200
$ 10,000
$
80
7,000
-$ 3,000
$
80

Higher
Higher
Higher
Higher

Ciscos should accept the order because it will increase profits by $80 for the period.
a$41,280 = (2,000 jerseys X $20) + (80 jerseys X $16).
b$40,000 = 2,000 jerseys X $20.
c$31,200 = (2,000 jerseys + 80 jerseys)($12 + $3).
d$30,000 = 2,000 jerseys X ($12 + $3).
7.23

(Differential costs.)
Yes. Road-Runner should accept the special order. Operating profit will increase $5,400 as
shown below.
Special-Order Sales (400 X $30)......................................................
Less Variable Costs:
Manufacturing (400 X $15).........................................................
Sales Commissions (400 X $1.50)...............................................
Addition to Company Operating Profit..............................................

7.24

(Identify differential costs.)

The differential costs would probably include:

Solutions

a.

Product design work to design the boot.

c.

Advertising the boot.

f.

Sales commissions.

7-4

$ 12,000
$ 6,000
600
$

6,600
5,400

7.25

(Target costing and pricing.)

Price (20% X Price) = Highest acceptable costs
$50 $10

$40.

The highest acceptable manufacturing costs for which Donelan Products would be willing to
produce the lines is $40 per foot.

7.26

(Target costing and pricing.)

Price (20% X Price) = Highest acceptable costs
$6.00 $1.20 =

$4.80.

The highest acceptable manufacturing costs for which Irish Products would be willing to produce
the wheels is $4.80.

7.27

(Customer profitability analysis.)

Note: Amounts are in thousands.
Alternative
Drop
Super 6
Motel
Revenues (Fees Charged)...............
$ 350
Operating Costs:
Cost of Services (Variable)......................................
305
Salaries, Rent, and General Administration
(Fixed)...................................
55
Total Operating
Costs............................
360
Operating Profit (Loss)..................
$ (10)

Status Quo

Difference

Total
$ 580

$ 230

Lower

517

212

Lower

55

572
8

212
$ 18

Lower
Lower

Squeaky should not drop the Super 6 Motel account in the short run as profits would drop by
$18,000.

7.28

(Customer profitability analysis.)

7-5

Solutions

Note: Amounts are in thousands.

Alternative
Drop
Hospital
Revenues (Fees Charged)............... $ 1,400
Operating Costs:
Cost of Services (Variable)......................................
1,220
Salaries, Rent, and General Administration
(Fixed)...................................
200
Total Operating
Costs............................
1,420
Operating Profit (Loss).................. $
(20)

Status Quo

Difference

Total
$ 2,320

$ 920

Lower

2,068

848

Lower

200

2,268
52

848
$ 72

Lower
Lower

H & B should not drop the Hospital account in the short run as profits would drop by $72,000.

7.29

(Product mix decision.)

Produce Product Y only, because its contribution per machine hour is greater.
Selling Price per Unit...................................................................
Variable Cost per Unit of Materials and Labor*...........................
Contribution per Unit to Overhead...............................................
Machine Hours Required per Unit................................................
Contribution per Hour Required...................................................
*Fixed costs are not differential and therefore excluded.

7.30

(Product choice.)
Alternative 1: Warehouse.

Solutions

7-6

Y
$ 30
(5)
$ 25
1
$ 25

Z
$ 55
(9)
$ 46
2
$ 23

Alternative 2: Office space.

Alternative 3: Restaurants and specialty shops.

Revenue...................................................
Variable Costs.........................................
Total Contribution Margin.......................
Fixed Costs.............................................
Operating Profit......................................

$
$
$

1
960,000
40,000
920,000
600,000
320,000

Alternative
2
$ 982,800
70,000
$ 912,800
600,000
$ 312,800

$
$
$

3
1,101,100
95,000
1,006,100
600,000
406,100

Renovation Enterprises should choose Alternative 3.

7.31

(Throughput contribution.)
With Option (a) the throughput contribution increases by $360 [= 24 units X ($25 selling price
$10 variable costs)] which is more than the additional cost of $100 per Saturday.
Option (b) would increase throughput contribution by $180 [= 12 units X ($25 selling price $10
variable costs)] which is less than the additional costs of $200.
Victorias should go with Option (a) which has a positive impact on contribution while Option (b)
has a negative effect on contribution.

7.32

(Throughput contribution.)
Increasing capacity to 15,000 is an increase of 1,560 units (=15,000 13,440 units with current
capacity). The throughput contribution increases by $85,800 [= 1,560 units ($120 selling price
$65 variable costs)]. This exceeds the additional cost of $60,000 per month by $25,800. Stay
Warm should pursue this option to alleviate the bottleneck because it provides a positive
contribution.

7.33

(Make or buy.)
a.
Variable Costs...................................

Buy
$ 300,000

7-7

Make
$ 250,000

=
=

Difference
$ 50,000

Solutions

Ol Salt should make the sails. The fixed costs are not relevant to this decision because they
will be incurred regardless of the decision.
b.
Variable Cost..............
Less Revenue.............
Net Effect on
Costs.....................

Buy
300,000
80,000

Make
=
Difference
250,000 = $ 50,000 Higher
-0=
80,000 Higher

220,000

250,000 = $

30,000

Lower

Yes, it would affect the recommendation in Part a. Ol Salt should buy in view of the rental
opportunity.

7.34

(Make or buy.)

Direct Material...................................................................................................
Direct Labor.......................................................................................................
Other Variable Costs...........................................................................................
Total................................................................................................................
a.

No, since the $200 price is greater than the incremental (variable) cost of $175. The fixed
costs are not differential.

b.

Yes. The $160 price is less than the incremental cost of $175.

7.35 (Sell or process further.)

Process
Further
Revenue
Less Additional Fixed Costs

Solutions

Variable
Cost per
100 Units
$100
50
25
$ 175

Sell

= Difference

$1,560,000a $900,000 = $660,000 higher

520,000
0 = 520,000 higher

7-8

Effect on Operating Profit

higher

$1,040,000 $900,000 = $140,000

The company should process further.

a

(0.3 x 75,000 x $32 for large grade) + (0.7 x 75,000 x $16 for medium grade)
= $720,000 + $840,000 = $1,560,000

7.36 (Sell or process further.)

Cheese

Milk

= Difference

Revenue
Less Additional
Processing Costs

$180,000 $100,000 = $80,000 higher

Effect on Operating Profit

$110,000 $100,000 = $10,000 higher

70,000

70,000 higher

The company should process further. The additional $20,000 mentioned in the
exercise should either be ignored, as in the solution here, or included in both the
cheese and milk alternatives.

7.37

(Dropping a product line.)

Machine Time per Unit........................
Contribution Margin............................
Contribution Margin per
Machine Hour..............................

Manual
0.4 hr.
$10.00
$25.00a

Electric
2.5 hr.
$ 16.00
$ 6.40b

Quartz
5.0 hr.
$ 22.00
$ 4.40c

a$25 = $10/0.4 hours.

b$6.40 = $16/2.5 hours.
c$4.40 = $22/5 hours.
Timepiece Products should drop the Quartz line.

7.38

(Dropping a product line.)

Alternative
Drop
Product C

7-9

Status Quo

= Difference

Solutions

Revenue....................................
Variable Costs...........................
Contribution Margin.................
Fixed Costs...............................
Operating Profit........................

50,000a
37,000a
13,000
10,000b
3,000

$
$
$

$ 88,000
71,000
$ 17,000
15,000
$ 2,000

$ 38,000
34,000
$ 4,000
5,000
$ 1,000

Lower
Lower
Lower
Lower
Higher

Yes. Tiger Products should drop Product C because the loss of its contribution margin is lower
than the reduction in fixed costs.
aSales and variable costs of Product C are eliminated.
bTotal fixed costs reduced by $5,000.
7.39

( Inventory

management.)
Order Average Number Inventory
Size
of Units
Carrying
a
in Units
in Inventory
Costsb

Annual
Orders

40
50
60

1,250
1,000
833.33

625
500
416.67

$3,125
2,500
2,083

Order
Costsc

Total
Costs

$4,000 $7,125
5,000
7,500
6,000 8,083

a 50,000 units/number of orders.

bAverage units in inventory x $5
c Number of orders x $100.
7.40

( Inventory

management.)
Order Average Number Inventory
Size
of Units
Carrying
in Unitsa
in Inventory
Costsb

Annual
Orders

40
50
60

2,000
1,600
1,333

1,000
800
666.67

$4,000
3,200
2,667

Order
Costsc

$2,000 $6,000
2,500
5,700
3,000 5,667

a80,000 units/number of orders.

bAverage units in inventory x $4
cNumber of orders x $50.
7.41

(Appendix 7.1) (Product choice using linear programming.)

Maximize:

Solutions

10A + 13B

7-10

Total
Costs

Subject to:

(1) 4A + 2B < 14,400 labor hours

(2) 2A + 3B < 12,000 machine hours

Units of A
4,000
3,600
3,000
a
6,000

Labor
Hours: 4A + 2B = 14,400; 4A = 14,400 2B
14,400 2B
A=
= 3,600 .5B
4
b

1,000
c

0
1,000

Machine Hours:2A + 3B = 12,000

2A = 12,000 3B
A = 6,000 1.5 B
Units of B

7,200
2,000

At (a):

B = 0, A = 6,000 1.5B = 6,000.

At (c):

A = 0, 0 = 3,600 .5B, B = 7,200.

3,0004,000

At (b): Substitute the labor hours equation into the machine hours equation: A = 3,600 .5B =
6,000 1.5B.
B = 2,400
A = 3,600 .5(2,400) = 2,400.

Contribution Margin
Points (A, B)
A
B
(6,000, 0) $60,000
$0 $60,000
(2,400, 2,400)$24,000 $31,200 $55,200
(0, 7,200)
$0 $93,600 $93,600

Total
Optimal Point

The company should produce 0 units of Product A and 7,200 units of Product B.

7.42

(Appendix 7.1) (Product mix decisions [CPA adapted].)

Problem Formulation:

7-11

Solutions

Maximize Total Contribution Margin = 4.25Z + 5.25B

Subject to:
Process 1 Constraint:
Z + 2B < 1,000
Process 2 Constraint:
Z + 3B < 1,275
Technical Labor Constraint:
B<
400
Critical
Points
a
b
c
d
e

Produce and Sell

Zeta
-01,000
450 a
75 b
-0-

Beta
-0-0275 a
400 b
400

Total Contribution
Marginc
-0$ 4,250.00*
$ 3,356.25
$ 2,418.75
$ 2,100.00

*Optimal Solution.
aZ + 2B = 1,000 [Process 1 Constraint].
Z + 3B = 1,275 [Process 2 Constraint].
Solving simultaneously:
(1,000 2B) + 3B

= 1,275
B =
275.

Z + 2(275) = 1,000
Z = 450.
bZ + 3B =
B=

1,275
400.

Solving simultaneously:
Z + 3(400) = 1,275
Z =
75.
cTotal Contribution Margin = ($4.25 X Zetas) + ($5.25 X Betas).

7.43

(Appendix 7.1) (Product mix decision.)

Each additional hour of Process 1 time yields an additional contribution of $4.25. Hence, the
opportunity cost of additional Process 1 time is $4.25. Since Hanson already pays $1.75 for
Process 1 time to produce one unit of Zeta, it would be willing to pay up to $6.00 for the
additional time to produce one unit of Zeta.

7.44

(Appendix 7.2) (Economic order quantity.)

D = 10,000 axles
Ko =$10

Solutions

7-12

Kc = 0.20 X $100 = $20

2 X $10X 10,000
= 100
$20

N= =

10, 000
= 100
100

Annual ordering costs = $1,000 (= 100 X $10).

7.45

(Appendix 7.2) (Economic order quantity.)

a.

2DK o
Kc

Ko = $15
Kc = $4
D = 30,000
Q

b.

7.46

2 X $15X 30,000
= 474
$4

Number of Orders per Year =

D
30,000
=
= 63
Q
474

(Radios Inc.; Special order with lost sales.)

Assume that all radios are sold.

Revenue.........................................

Alternative Status Quo = Difference

$ 209,000a
$ 300,000b $ 91,000 Lower

7-13

Solutions

Variable Costs................................
Contribution Margin......................
Fixed Costs....................................
Operating Profit.............................

$
$

60,000c
149,000
61,000e
88,000

$
$

69,000d
231,000
61,000e
170,000

$
$

9,000 Lower
82,000 Lower
-82,000 Lower

Radios Inc. should turn down the contract unless there are non-pecuniary benefits that will offset
the $82,000 reduction in profits.
a$209,000 = (10,000 units X $15) + (10,000 units X $3.40) + $25,000.
b$300,000 = 20,000 units X $15.
c$60,000 = (10,000 units X $3.45) + (10,000 units X $2.55).
d$69,000 = 20,000 units X $3.45.
e$61,000 = 20,000 units X ($0.85 + $2.20).
7.47

(Special order.)
The company should have accepted the special order. Profits would increase by $400,000.
Alternative
Status Quo
Difference
Order
Order Not
Incremental
Accepted
Accepted
Cash Flows
a
b
Revenues............................ $
66,500,000 $
64,000,000 $ 2,500,000 Higher
c
Variable Costs....................
40,500,000
38,400,000d
2,100,000 Higher
e
e
Fixed Costs........................
9,600,000
9,600,000
-0Operating Profit................. $
16,400,000 $
16,000,000 $
400,000 Higher
a$66,500,000 = ($400 160,000 regular sales units) + ($250 10,000 special order units).
b$64,000,000 = $400 160,000 units.
c$40,500,000 = [($160 + $80) 160,000 regular sales units] + [($160 + $50) 10,000 special order units].
d$38,400,000 = ($160 + $80) 160,000 regular sales units.
e$9,600,000 = $60 160,000 units = total fixed costs under both the alternative and the status quo.

Solutions

7-14

7.48

(Pricing decisions.)
a.

Sales Revenue....................
Less Variable Costs:
Materials.......................
Labor.............................
Variable Overhead............................
Total Variable
Cost.....................
Contribution Margin...........
Less Fixed Costs................
Operating Profit.................

Alternative
20,400
Quarts
$ 61,000a

Status Quo
20,000
Quarts
$ 60,000b

Difference

$ 1,000 Higher

20,400
10,200

20,000
10,000

400 Higher
200 Higher

5,100

5,000

100 Higher

35,700
25,300
20,000
$ 5,300

35,000
25,000
20,000
$ 5,000

700 Higher
300 Higher
0
300 Higher

a$61,000 = (20,000 quarts $3.00 per quart) + (400 quarts $2.50 per
quart).
b$60,000 = 20,000 quarts $3.00 per quart.
b. The lowest price for which the ice cream could be sold without reducing profits is
$1.75 per quart, which would just cover the variable costs of the ice cream.

7-15

Solutions

7.49

(Special order.)
On the basis of the data in the question, it would not pay Nancy to accept the order.
New Sales (10,000 Units $6).................................................... $
Less Standard Sales.....................................................................
Differential Revenue.....................................................................
Differential Costsa.......................................................................
Net Advantage to Special Units....................................................

60,000
12,500
$
$

47,500
49,050
(1,550)

Other factors must be considered such as the reliability of the cost estimates and the importance of
this valued customer.
aDifferential cost of the order is:
Costs Incurred to Fill Order*
Material (10,000 Units $2)......................................................................
Labor (10,000 Units $3.60).....................................................................
Special Overhead........................................................................................

$
$

Costs Reduced for Standard Products

Material......................................................................................................
Labor..........................................................................................................
Other..........................................................................................................
Total Differential Costs..........................................................................

$
$
$

20,000
36,000
2,000
58,000
4,000
4,500
450
8,950
49,050

*Depreciation, rent, heat, and light are not affected by the order. Power might be dependent upon
the particular requirements of the special units. It is assumed here that the same amount of
power will be used in each case.

7.50 (Multiple choicespecial order.)

Solutions

7-16

a.

(4) $8,000 = $8 per unit 1,000 units.

b.

(2) $6,000 = ($4 + $2) 1,000 units.

c.

(1) $0. Total fixed costs do not change as a result of the special order.

d.

(4) Decrease $0.25:

e.
7.51

Fixed Costs per Unit Without the

Special Order ($10,000 + $8,000)
8,000 Units.......................................................
Fixed Costs per Unit with the Special
Order ($10,000 + $8,000) 9,000
Units.................................................................
Decrease as a Result of Special Order..................

2.25

2.00
0.25

(1) Increase it.

(Customer profitability analysis)

Differential revenue from new accounts = $170 7,000 = $1,190,000.
Differential costs of new accounts:
Acquisition costs = $180,000 - $20,000 costs that are not differential = $160,000
Transaction processing costs = ($150 - $10 non-differential costs) 7,000 = $980,000
Differential operating income = $1,190,000 - $160,000 - $980,000 = $50,000.
The effect of offering these accounts has a small positive impact on operating income.
Management should consider the likely positive effect of
attracting these students as long term customers of the bank, which
makes the offer to students even more attractive.

7.52 (Customer profitability analysis)

7-17

Solutions

a. First compute cost driver rates.

Transportation costs = $.80 per mile = $800,000/1,000,000 miles.
Processing an order = $1 per minute = $100,000/100,000 minutes.
Marketing management = 10% of sales = $700,000/$7,000,000 in sales.
Special requirementsforeign = $500 per car = $100,000/200 cars.
Next apply costs driver rates to customers. For each customer and each cost driver, multiply the
cost driver rate by the cost driver volume given in the problem.
Customer X: ($.80 400 miles) + ($1 30 minutes) + ($10% $600 sales)
= $320 + $30 + $60
= $410.

Customer Y: ($.80 2,200 miles) + ($1 35 minutes) + ($10% $2,000 sales)

= $1,760 + $35 + $200
= $1,995.

Customer Z: ($.80 1,300 miles) + ($1 80 minutes) + ($10% $1,500 sales) + $500
= $1,040 + $80 + $150 + $500
= $1,770.

b. Using the sales dollars given in the problem, compute the profitability as follows:
X: $600 $410 = $190.
Y: $2,000 - $1,995 = $5.
Z: $1,500 -$1,770 = $(270).
If these customers are representative of all customers (and that is questionable), then the company has
a big problem with its shipments to foreign locations and a small problem with domestic national
shipments. Management should consider ways to manage costs (e.g., outsource shipments to Mexico or
Canada), or raise prices on unprofitable shipments or drop unprofitable product lines or some
combination of these suggestions.

Solutions

7-18

7.53 (Throughput contribution)

Note: The status quo gives a contribution of $24,000 per hour [= ($200 - $120) 300 units].
Option a. Adding capacity adds $400 per hour to contribution but costs only $200 per hour [$400 =
($200 - $120) 5 units], adding $200 per hour to increase contribution to $24,200 per hour. This is a
good option.
Option b. Outsourcing some of the food preparation would increase the contribution per hour by $180.
This is also a good option. Here are the calculations:
Alternative
Status Quo
Difference
Output

310 units

300 units

10 units

Revenue ($200 per unit)

$62,000

$60,000

$2,000 higher

Variable costs ($122 for alternative

and $120 for the status quo)
$37,820

$36,000

$1,820 higher

Contribution margin

$24,180

$24,000

$180 higher

If both options are taken, then the company would still get the contribution margin for Option b +
the contribution from Option a for the five additional units, less the $200 cost for additional
capacity. Here are the calculations, starting with Option b:
Option b

Option a

[310 units ($200 - $122)] + {[5 units ($200 - $120)] - $200} = $24,380.
Compare this contribution to the $24,000 status quo or the $24,180 for Option b alone or the
$24,200 for Option a alone. Consequently, we recommend that the company take both Options a
and b.

7-19

Solutions

7.54 (Throughput contribution)

Note: The status quo gives a contribution of $104,000 per day [= ($240 - $110) 800 units].
Option a. Outsourcing 80 units of packaging increases output to 880 units per day. This adds $10,400
contribution per day but costs only $8,000 for a net gain of $2,400 per day. [$10,400 = ($240 - $110)
80 units.] This is a good option that increases contribution from $104,000 per day to $106,400 per day.
Option b. Renting equipment increases output by 50 units per day. This adds $6,500 contribution per day
but costs only $4,000 for a net gain of $2,500 per day. [$6,500 = ($240 - $110) 50 units.] This is a
good option that increases contribution from $104,000 per day to $106,500 per day.
If the company tries both options, it encounters a capacity constraint in cooking. Cooking is limited to
900 units per day. Therefore the company can increase output by only 100 units per day. Assuming that
the company takes both options, then its contribution increases by 100 units for an increase in
contribution of $13,000 [= ($240 - $110) 100 units.] The cost of taking both options is $12,000 (=
$8,000 for option a + $4,000 for option b). The net gain in contribution is only $1,000 which is less than
the net gain for either options a or b. Therefore we recommend that the company take Option b, although
both a and b give similar improvements in contribution.

7.55

Spectra, Inc.; make or buy.)

Direct Material...................................................................................................
Direct Labor.......................................................................................................
Other Variable Costs...........................................................................................
Total................................................................................................................

7.56

Solutions

Variable
Cost per
500 Units
$ 80
90
25
$ 195

a.

No, since the $200 price is greater than the incremental (variable) cost of $195.

b.

Yes. The $180 price is less than the incremental cost of $195.

c.

$195 plus the incremental cash inflow which can be generated from the alternative use of the
facilities.

(Sell or process further.)

7-20

a. Like many sell or process further problems in the real world, this problem is easier than it
appears if one just cuts to the chase. The costs of producing product X up to the split-off
point are sunk. The costs of producing y and z are not differential to this decision and are
therefore not relevant to the decision to sell X or process it further. If processed further,
product X would generate a contribution after split-off of $322,000 [= ($4.30 - $2.00)
140,000 pounds]. At present, product X has sales at split-off of $280,000. Processing
further increases contribution by $42,000 =($322,000 - $280,000).
b. The memo would make the points in part a above. Management should not attempt to
incorporate sunk costs into this decision or be concerned about the costs of products Y
and Z. Our recommendation to process further does assume that product X will not
cannibalize (i.e., reduce) sales of products Y and Z.

7.57

(Hayley and Associates; dropping a product line.)

Status quo:
Alternative:

Keep all three services, audit, tax, and consulting.

Drop consulting, increase tax.

Alternative Status Quo = Difference

Sales Revenue......................... $ 1,100,000a $ 1,200,000d $ 100,000
Variable Costs.........................
800,000b
900,000e
100,000
Contribution Margin............... $
300,000
$
300,000
$
-0c
f
Fixed Costs.............................
182,000
190,000
8,000
Operating Profit...................... $
118,000
$
110,000
$
8,000

Lower
Lower
Lower
Higher

a$1,100,000 = (1.50 X $400,000) + $500,000.

b$800,000 = (1.50 X $300,000) + $350,000.
c$182,000 = (1.2 X $60,000) + $80,000 + (.6 X $50,000).
d$1,200,000 = $300,000 + $400,000 + $500,000.
e$900,000 = $250,000 + $300,000 + $350,000.
f$190,000 = $50,000 + $60,000 + $80,000.
The report should show the above analysis and state that dropping consulting and increasing tax
work would increase profits by $8,000.

7.58

(Dropping a machine from service.)

7-21

Solutions

Disagree. Assuming all expenses except depreciation are variable, the number 2 machine should
be dropped. Depreciation expense will be incurred whether or not a machine is operating, it is a
sunk cost, and so should not be considered when deciding which machines to operate. (We ignore
tax consequences in this solution.) Only variable costs requiring future cash outlays are relevant
in this decision.
CASH OUTFLOWS20X5
No. 1
Labor.............................................. $ 15,000
Materials.........................................
4,000
Maintenance....................................
500
Total............................................. $ 19,500

7.59

No. 3
$ 18,000
5,000
500
$ 23,500

No. 4
$ 21,000
2,500
400
$ 23,900

Cost estimate for bidding.

a.

Solutions

No. 2
$ 19,000
4,500
500
$ 24,000

One

7-22

Four

Eight

Seminars
80
Participants
$
600
8,000
5,000

Seminars
144
Participants
$
600
14,400
8,800

900
$ 5,200

3,750
$ 17,350

6,600
$ 30,400

1,040
$ 6,240

3,470
$ 20,820

6,080
$ 36,480

One
Seminar
25
Participants
Revenues......................................... $ 6,240
Less:
Startup costs..............................
600
Materials....................................
2,500
Direct labor................................
1,200
Contribution Margin....................... $ 1,940

Four
Seminars
80
Participants
$ 20,820

Eight
Seminars
144
Participants
$ 36,480

One
Seminar
25
Participants
Revenues......................................... $ 6,240
Less:
Startup costs..............................
600
Materials....................................
2,500
Direct labor................................
1,200
Contribution Margin....................... $ 1,940

Four
Seminars
80
Participants
$ 20,820

Startup costs..................................
Materials.......................................
Direct labor...................................
Fixed costs (75% of direct
labor)........................................
Total costs............................
Profit margin (20% above
cost)..........................................
Bid price........................................
b.

c.

Seminar
25
Participants
$
600
2,500
1,200

600
8,000
5,000
7,220

600
8,000
5,000
7,220

600
14,400
8,800
$ 12,680
Eight
Seminars
144
Participants
$ 32,102a
600
14,400
8,800
$ 8,302

Disagree. Eight seminars provide a greater contribution to fixed costs and profits even with
the lower price.
a $32,102 = .88 x $36,480

7.60 (LLP; differential cost analysis in a service organization.)

a.

Variable Costs = $200 + $40 = $240 per Hour.

Total Fixed Costs = ($160 + $100) X 5,000 Hours = $1,300,000.

7-23

Solutions

To break even, set profit to zero, and solve for X.

$0 = ($600 $240)X $1,300,000
X = $1,300,000/$360 = 3,611 Hours.
b.

Alternative
Status Quo =
a
Revenue.................. $ 3,000,000
$ 3,000,000b
Variable
Costs..................
960,000c
1,200,000d
Contribution
Margin................ $ 2,040,000
$ 1,800,000
Fixed
Costs..................
1,000,000
1,300,000
Operating
Profit.................. $ 1,040,000
$
500,000

Differential
$
--

240,000

Lower

240,000

Higher

300,000

Lower

540,000

Higher

a$3,000,000 = $750 X 4,000 hours.

b$3,000,000 = $600 X 5,000 hours.
c$960,000 = $240 X 4,000 hours.
d$1,200,000 = $240 X 5,000 hours.
Profits would increase by $540,000.
c.

Solutions

Since the additional 1,000 hours are within the firms capacity of 6,000 hours, Columbo
Connections would want to cover its variable costs of $240 at a minimum. Therefore, the
minimum price would be slightly higher than $240.

7-24

7.61

(Troy Manufacturing; comprehensive differential costing problem.)

This problem gives students a good understanding of the fixed/variable cost dichotomy. It is
worthwhile to emphasize to students that fixed costs may be unitized (i.e., allocated to
individual units of product) for certain purposes, and that this allocation procedure may make
such costs appear to be variable. Indeed, many students treat the per unit fixed costs as though
they were variable costs, despite the fact that they are clearly labeled fixed.
This problem can be used to introduce the concept of opportunity cost. Part b. can be used
in this way, as can Part d. if you suggest a scrap value for the obsolete hoists.
a.

Recommendation: Lowering prices reduces operating profit. Other factors, such as the
reduction of available capacity and the impact on market share, could also affect the decision.

(Alternative) (Status Quo)

After Price
Before Price
Reduction
Reduction
Price.............................. $
900 $
1,000
Quantity........................
3,500
3,000
Revenue......................... $
Variable Maufacturing Costs..............
Variable Nonmanufacturing
Costs........................
Contribution Margin............................ $
Fixed Manufacturing Costs..................
Fixed Nonmanufacturing Costs.........
Income........................... $

3,150,000 $

3,000,000 $ 150,000 Increase

1,050,000

900,000

150,000 Increase

350,000

300,000

50,000 Increase

1,750,000 $

1,800,000 $50,000 Decrease

600,000

600,000

300,000
850,000 $

300,000
-900,000 $50,000 Decrease

7-25

--

Note
Equality

Solutions

7.61 continued.
b.

Recommendation: Dont accept contract.

Income without the government contract for 4,000 units = $1,500,000.

$1,500,000 = ($600 per unit contribution margin 4,000 units) ($600,000 + $300,000 fixed
costs). The $600 contribution margin = sales price variable mfg. cost variable nonmfg cost.
Income with the government contract = $1,325,000 as shown below.
With Government Contract
Regular
Government
Revenue.............................................. $ 3,500,000
$ 275,000a
$
Variable Manufacturing
Costs...............................................
1,050,000
150,000
Variable Nonmanufacturing
Costs...............................................
350,000
-Contribution Margin........................... $ 2,100,000
$ 125,000
$
Fixed Manufacturing Costs................
Fixed Nonmanufacturing
Costs...............................................
Income................................................
$

Total
3,775,000
1,200,000
350,000
2,225,000
600,000
300,000
1,325,000

aGovernment revenue (500 X $300) + (1/8 X $600,000) + $50,000 = $275,000, assuming the
governments share of March fixed manufacturing costs is 12.5% (= 500 units /4,000 units).
Alternatives are to get 1/6 X $600,000 fixed manufacturing costs, which would increase revenue
from $275,000 to $300,000; or get no reimbursement for fixed manufacturing costs, which would
reduce revenue to $200,000.

The deal would be a good one if the company had no opportunity costs. The $50,000 fee and
reimbursement for (nondifferential) fixed costs would normally flow to the bottom line. But in this
case, the company gives up the contribution from 500 units to regular customers making the deal a
bad one.

Solutions

7-26

7.61 continued.
c.

Minimum Price = (Variable Manufacturing Costs + Shipping Costs + Marketing

Costs)/Units = ($300,000 + $75,000 + $4,000)/1,000 = $379 per unit.
At this price per unit, the $379,000 of differential costs caused by the 1,000 unit order will
just be recovered.
Some students solve for this price using the breakeven formula:
=X
= 1,000 Units
$4,000 = 1,000P $375,000
$379,000 = 1,000P
$379 = P

d.

The manufacturing costs are sunk; therefore, any price in excess of the differential costs of
selling the hoists will add to income. In this case, those differential costs are apparently the
$100 per unit variable marketing costs, since the hoists are to be sold through regular
channels; thus, the minimum price is $100. (If the instructor wishes to reinforce the concept
of opportunity cost, the general answer to this question is that the price should exceed the
sum of 1) the differential marketing costs and 2) the potential scrap proceeds, which are an
opportunity cost of selling the hoists rather than scrapping them.)

7-27

Solutions

7.61 continued.
e.

Alternative
1,000 Units
Contracted
Total Revenue............................................. $ 3,000,000
Total Variable Manufacturing
Costs.....................................................
600,000
Total Variable Nonmanufacturing Costs................................................
280,000
Total Contribution Margin.......................... $ 2,120,000
Total Fixed Manufacturing
Costs.....................................................
420,000
Total Fixed Nonmanufacturing
Costs.....................................................
300,000
Payment to Contractor......................
X
Profit............................................ $ 1,400,000 X
$1,400,000

Status Quo
All Production
In-house
$ 3,000,000
900,000
300,000
1,800,000

600,000
300,000
-900,000

X = $900,000
X = $500,000 or $500 per unit maximum purchase price.

Therefore, a $600 purchase price is not acceptable; it would decrease income by $100,000 [=
($600 $500) X 1,000].
A shorter (but more difficult) approach uses the concept of opportunity costs:
Variable Manufacturing Cost......................................................................
Variable Nonmanufacturing Opportunity Cost
($100 $80)..........................................................................................
Fixed Manufacturing Opportunity Cost......................................................
Equivalent In-house Cost............................................................................

300

20
180*
500

*($600,000 $420,000) 1,000 units.

f.

Revenue............................
Var. Mfg. Costs.................
Var. Nonmfg. Costs...........
Contrib. Margin.............
Fixed Mfg. Costs..............
Fixed Nonmfg. Costs........
Payment to Contractor......
Profit.............................

Alternative
Contract 1,000 Regular Bicycles and
3,000 Regular
Produce 800 Low Impact Bicycles
Bicycles
Regular
Regular Low Impact
(In)
(Out)
Bicycles
Total
$2,000,000 $1,000,000 $960,000 $3,960,000
600,000
-560,000
1,160,000
200,000
80,000
80,000
360,000
$1,200,000 $ 920,000 $320,000 $2,440,000
600,000
300,000
-X
-X
$1,540,000 X

Status Quo

Produced
In-house
$3,000,000
900,000
300,000
$1,800,000
600,000
300,000
-$ 900,000

Maximum payment = $640,000 (= $1,540,000 $900,000). Now the proposal should be accepted at a price
of $600.

Solutions

7-28

7.62

(KM; alternative concepts of cost [CMA adapted].)

a.

(1) Costs incurred to fill order:

Material.........................................................................................
Labor.............................................................................................
Special Machine............................................................................
Power.............................................................................................
Total..............................................................................................
Costs reduced for regular products:
Material.........................................................................................
Labor.............................................................................................
Other..............................................................................................
Power.............................................................................................
Total..............................................................................................
Net differential costs.........................................................................
(2) Sales of regular product....................................................
Less:
Material......................................................................... $
Labor.............................................................................
Power............................................................................
Other.............................................................................
Opportunity cost of special order..............................

b.

Special
Order
Sales................................. $ 7,000
Less differential
costs.............................
6,250
Decrease in contribution margin...............

3,000
2,000
1,000
250
6,250

$
$

1,500
2,000
200
150
3,850

2,400

$ 10,000
1,500
2,000
150
200

3,850
6,150

Standard
$ 10,000

Differential
$ 3,000 Lower

3,850

2,400 Higher
$ 5,400 Lower

The special order should not be accepted because the contribution margin decreases.

7-29

Solutions

7.63

(Leastan Company; department closing.)

We recommend that the dry goods department be continued. If the department is abandoned, the
following costs will be saved for sure:
Commissions................................................. $ 15,000
State Taxes....................................................
1,500
Insurance on Inventory..................................
2,000
Interest on Inventory......................................
2,500
Total Operating Costs Saved......................... $ 21,000
Presumably, the payroll and direct labor costs will also be saved, but we cannot be so sure about
supervision costs. Closing down the department may not save all supervisory costs, because we
may not be able to release a supervisor.
Clearly, the rent will not decline and most of the administrative and general office costs will
continue as before. Depreciation on the equipment will not necessarily continue because the
company can dispose of the equipment. There may be some cash receipts from equipment
disposal. At any rate, the depreciation is not a cash outlay. The fact that rent payments for the
company will continue unreduced is sufficient for us to recommend continuation.
To summarize, the Dry Goods Department contributes $25,000 to overhead:
Gross Margin .....................................................................................
$
Total Differential Operating Costs (see above)....................................................
Payroll (Assumed Variable) Cost Saved..............................................................
Contribution to Overhead................................................................................... $

Solutions

7-30

62,500
(21,000)
(16,500)
25,000

7.64

(Biggs Company; sell or process further [CMA adapted].)

Revenue Increase Arising from Producing Product D
Sale of Product D
100,000 pounds @ $30.00................... $ 3,000,000
Less: Sales of B Lost
100,000 pounds @ $20.25...................
2,025,000
$
975,000
Cost Increase Arising from Producing Product D
Direct Labor
$ 5.50
Variable Overhead
2.00
Fixed Overhead
1.75
$
9.25
Cost per Unit, $9.25 100,000 pounds............................................
925,000
Differential Profit from Producing Product D................................... $
50,000
Relying on the economic information given in the problem, the company should produce Product
D. Note that the fixed costs attributable to Product D are differential because they did not appear
in the

7.65

(Liquid Chemical Co.; make or buy.)

7-31

Solutions

Working this case requires knowledge of how to calculate discounted cash flows.
a.

b.

Solutions

The four alternatives are:

Alternative A: It is the status quo, i.e., Liquid Chemical Co. will continue making
the containers and performing maintenance.

Alternative B: Liquid Chemical Co. will continue making the containers, but will
outsource the maintenance contracting Packages, Inc.

Alternative C: Liquid Chemical Co. will buy containers from Packages, Inc., but will
perform the maintenance.

Alternative D: It is the completely outsourcing alternative. Packages, Inc. will make

the containers and provide the necessary maintenance.

The incremental cash flow analyses were conducted assuming a five-year time horizon.
Appendices I, II, III, and IV present the cash flow analyses for Alternatives A, B, C, and D
respectively, as well as more detailed information on the calculations. General considerations
for the incremental cash flows are provided below.

All cash flows occur at the end of the year.

The last day of Year 0 is when the decision on the alternatives is made. It can also be
considered the first day of Year 1.

The company has an after-tax cost of capital of 10% per year and uses an income tax
rate of 40% for decisions like this.

Cash flows were not adjusted for inflation.

200 tons of GHL were purchased at the beginning of Year 0 (= $1,000,000/$5,000). 40

tons were consumed during Year 0 (expense of $200,000 = 40 tons X $5,000/ton),
leaving 160 tons in stock at the beginning of Year 1.

Rent on the container department and the proportion of general administrative overhead
allocated to the container department are the same independent of the alternative.
Therefore, they are not considered in the cash flow analyses.

7-32

7.65 continued.
The table below presents the net present values for the four alternatives. Note that all net
present values are negative, so the more attractive alternative for Liquid Chemical Co. is the
one with the smallest negative value, i.e., Alternative C. It means that, considering our
assumptions and the available information regarding costs, Liquid Chemical Co. should buy
containers from Packages, Inc., and keep performing the maintenance.
Alternative A
Make
Containers;
Perform
Maintenance
NPV ($)
c.

2,735,502

Alternative B
Make
Containers;
Buy
Maintenance
3,082,945

Alternative C
Buy
Containers;
Perform
Maintenance
2,619,684

Alternative D
Buy
Containers;
Buy
Maintenance
2,712,251

Although Alternative C seems to be the more attractive, its net present value is not
significantly different from the net present values of Alternatives A and D. This situation
requires a careful examination of facts and assumptions made. A brief discussion of some
points that should be reevaluated, as well as additional information that should be taken into
account, is presented below.
Administrative Overhead: A proportion of general administrative overhead is allocated to
the container department. Is this cost proportional to the number of employees in the
container department? Apparently the answer is yes, and in this case it is not the best
estimate because it is not considering the real administrative resources consumed by the
container department.
Quality of Outsource Services: Quality issues are always important when a company is
considering outsourcing some services. In this case, it is assumed that Packages, Inc. will
perform maintenance and/or make containers with a quality at least as good as Liquid
Chemicals quality. Due to the importance of quality, Liquid Chemical Co. should carefully
evaluate Package Inc.s ability to meet quality requirements imposed by Liquid Chemical.
Container Contract Terms: Does Packages Inc. have the ability to meet Liquid Chemicals
future container needs?
Time Horizon and Inflation: Is the price locked in for five years regardless of inflation?
Employees: The effect of eliminating some employees may have a detrimental effect on the
morale of remaining employees.

7-33

Solutions

7.65 continued
Incremental Cash FlowAlternative A:
Make Containers and Perform Maintenance
0
Buy GHL
Tax Savings on
Purchase
Cash Flow on
Purchase
Other Materials
Labor: Supervisor
Labor: Workers
Rent: Warehouse
Maintenance
Other Expenses
Managers Salary
Total Costs
Tax Savings
Cash Flow due
to Costs

Year of Operation
2
3

5
$ (240,000)
96,000

$ (500,000) $ (500,000)

$ (144,000)
$ (500,000) $ (500,000) $ (500,000)

(50,000)
(450,000)

(50,000)
(450,000)

(50,000)
(450,000)

(50,000)
(450,000)

(50,000)
(450,000)

(85,000)
(36,000)
(157,500)

(85,000)
(36,000)
(157,500)

(85,000)
(36,000)
(157,500)

(85,000)
(36,000)
(157,500)

(85,000)
(36,000)
(157,500)

(80,000)
(80,000)
$(1,358,500) $(1,358,500)
543,400
543,400

(80,000)
(80,000)
(80,000)
$(1,358,500) $(1,358,500) $(1,358,500)
543,400
543,400
543,400

$ (815,100) $ (815,100)

$ (815,100) $ (815,100) $ (815,100)

Tax Effects of
Depreciation

60,000

60,000

60,000

60,000 $

--

Tax Effects
of GHL
Costs

80,000

80,000

80,000

80,000 $

--

Total Cash
Flow
Discount Rate
Factor
PV
NPV

$ (675,100) $ (675,100)
10%
1.0000
0.9091
0.8264
$
-- $ (613,727) $ (557,934)
$(2,735,502)

$ (675,100) $ (675,100) $ (959,100)

0.7513
0.6830
0.6209
$ (507,213) $ (461,102) $ (595,526)

Considerations:

Under this alternative, GHL consumption is 40 tons per year. At the end of Year 4 the GHL stock is zero, and a purchase of
40 tons is necessary. At that time, the price will be $6,000 per ton.

There is no cash outflow due to GHL consumption from Year 1 to Year 4, just accounting expenses because the product is
in stock. Due to these GHL expenses, there is tax savings of $80,000 per year (= 40 tons X $5,000/ton X 40%) from Year 1
to Year 4.

It uses straight-line depreciation, resulting in depreciation expense of $150,000 per year (= $1,200,000/8 years). It generates
a cash inflow of $60,000 per year (= $150,000 X 40%) from Year 1 to Year 4 because the book value of the machinery at the
beginning of Year 1 is $600,000.

Solutions

7-34

7.65 continued
Incremental Cash FlowAlternative B:
Make Containers and Buy Maintenance
0
Buy GHL
Tax Savings on
Purchase
Cash Flow on
Purchase
Other Materials
Labor: Supervisor
Labor: Workers
Rent: Warehouse
Maintenance
Other Expenses
Managers Salary
Maintenance
Contract
Total Costs
Tax Savings
Cash Flow due
to Costs

Year of Operation
2
3

5
$ (120,000)
48,000

$ (450,000) $ (450,000)

$ (72,000)
$ (450,000) $ (450,000) $ (450,000)

(50,000)
(360,000)

(50,000)
(360,000)

(50,000)
(360,000)

(50,000)
(360,000)

(50,000)
(360,000)

(85,000)
(36,000)
(92,500)

(85,000)
(36,000)
(92,500)

(85,000)
(36,000)
(92,500)

(85,000)
(36,000)
(92,500)

(85,000)
(36,000)
(92,500)

(80,000)

(80,000)

(80,000)

(80,000)

(80,000)

(375,000)
(375,000)
$(1,528,500) $(1,528,500)
611,400
611,400

(375,000)
(375,000)
(375,000)
$(1,528,500) $(1,528,500) $(1,528,500)
611,400
611,400
611,400

$ (917,100) $ (917,100)

$ (917,100) $ (917,100) $ (917,100)

Tax Effects of
Depreciation

60,000

60,000

60,000

60,000 $

--

Tax Effects
of GHL
Costs

72,000

72,000

72,000

72,000 $

32,000

Total Cash
Flow
Discount Rate
Factor
PV
NPV

$ (785,100) $ (785,100)

$ (785,100) $ (785,100) $ (957,100)

10%
1.0000
0.9091
0.8264
$
-- $ (713,727) $ (648,843)
$(3,082,945)

0.7513
0.6830
0.6209
$ (589,857) $ (536,234) $ (594,284)

Under this alternative, GHL consumption is 36 tons per year (= 40 X 90%). At the end of Year 4 the GHL stock is 16 tons,
and a purchase of 20 tons is necessary. At that time, the price will be $6,000 per ton.

Due to lower GHL consumption, during Year 5 there is still an accounting expense of $80,000 (= 16 tons X $5,000/ton). It
will generate tax savings of $32,000 (= $80,000 X 40%) at Year 5.

When the department contracts external maintenance, it decreases materials costs by 10%, and reduces employee expenses
by 20%. Other expenses total $92,500.

There is no severance pay or pension under this alternative.

7-35

Solutions

7.65 continued
Incremental Cash FlowAlternative C:
Buy Containers and Perform Maintenance

Sell Machinery
Tax Savings on
Sale
Cash Flow on
Sale
Sell GHL
Tax Savings on
on Sale
Cash Flow on
Sale
Other Materials
Labor: Supervisor
Labor: Workers
Rent: Warehouse
Severance Pay
Other Expenses
Managers Salary
Container Contract
Total Costs
Tax Savings
Cash Flow due
to Costs

0
200,000

Year of Operation
2
3

160,000
$
$

360,000
560,000
56,000

616,000
$ (50,000) $

(50,000)

(50,000)
(90,000)
(85,000)
-(65,000)

(16,000)

(50,000) $

(50,000) $

(50,000)

(50,000)
(90,000)

(50,000)
(90,000)

(50,000)
(90,000)

(50,000)
(90,000)

(85,000)
-(65,000)

(85,000)
-(65,000)

(85,000)
-(65,000)

(85,000)
-(65,000)

--

--

--

--

--

(1,250,000) (1,250,000)
(16,000) $(1,590,000) $(1,590,000)
6,400
636,000
636,000

(1,250,000) (1,250,000) (1,250,000)

$(1,590,000) $(1,590,000) $(1,590,000)
636,000
636,000
636,000

(9,600) $ (954,000) $ (954,000)

$ (954,000) $ (954,000) $ (954,000)

Tax Effects of
Depreciation

--

--

--

-- $

--

Tax Effects
of GHL
Costs

8,000

8,000

8,000

8,000 $

8,000

Total Cash
Flow
Discount Rate
Factor
PV
NPV

966,400 $ (946,000) $ (946,000)

10%
1.0000
0.9091
0.8264
$ 966,400 $ (860,000) $ (781,818)
$(2,619,684)

$ (946,000) $ (946,000) $ (946,000)

0.7513
0.6830
0.6209
$ (710,744) $ (646,131) $ (587,392)

(See Following Page for Considerations)

Solutions

7-36

7.65 continued
Considerations:

Under this alternative, GHL consumption is 4 tons per year (40 X 10%), or 20 tons over five years.
Therefore, Liquid Chemical can sell 140 tons (= 160 20) at the end of Year 0 at $4,000 per ton.
Market Price =
$560,000
Loss on Sale =
$ 140,000
Book Value =
$700,000
Tax Savings on Sale =
$ 56,000

Machinery is not necessary for maintenance, and can also be sold at the end of Year 0.
Market Price =
$200,000
Loss on Sale =
$ 400,000
Book Value =
$600,000
Tax Savings on Sale =
$ 160,000

When the department performs maintenance and buys containers, it decreased materials costs by 90%,
and reduces employees by 80%. Other expenses total $65,000.

In this case, there is a severance pay of $16,000 (= $20,000 X 0.8). The supervisor is still necessary, but
Mr. Duffy can be transferred to another department.

Tax effects on GHL consumption are computed based on an expense of $20,000 per year (= 4 tons X
$5,000/ton). It results in savings of $8,000 per year (= $20,000 X 40%).

7-37

Solutions

7.65 continued
Incremental Cash FlowAlternative D:
Buy Containers and Buy Maintenance

Sell Machinery
Tax Savings on
Sale
Cash Flow on
Sale
Sell GHL
Tax Savings on
on Sale
Cash Flow on
Sale
Other Materials
Labor: Supervisor
Labor: Workers
Rent: Warehouse
Severance Pay
Pension
Other Expenses
Managers Salary
Container Contract
Maintenance
Contract
Total Costs
Tax Savings
Cash Flow due
to Costs

0
200,000

Year of Operation
2
3

160,000
$
$

360,000
640,000
64,000

704,000
$

--

--

--$

---

--(30,000)
--

(20,000)

--(30,000)
--

--

(1,250,000)

---

--(30,000)
--

--

--

--

---

---

--(30,000)
--

--

(1,250,000)

-- $

--

(1,250,000)

(1,250,000)

--(30,000)
--(1,250,000)

(375,000)
(375,000)
(20,000) $(1,655,000) $(1,655,000)
8,000
662,000
662,000

(375,000)
(375,000)
(375,000)
$(1,655,000) $(1,655,000) $(1,655,000)
662,000
662,000
662,000

(12,000) $ (993,000) $ (993,000)

$ (993,000) $ (993,000) $ (993,000)

Tax Effects of
Depreciation

--

--

--

-- $

--

Tax Effects
of GHL
Costs

--

--

--

-- $

--

Total Cash
Flow
Discount Rate
Factor
PV
NPV

$ 1,052,000 $ (993,000) $ (993,000)

10%
1.0000
0.9091
0.8264
$ 1,052,000 $ (902,727) $ (820,661)
$(2,712,251)

See following page for considerations.

Considerations:

Solutions

7-38

$ (993,000) $ (993,000) $ (993,000)

0.7513
0.6830
0.6209
$ (746,056) $ (678,232) $ (616,575)

Under this alternative, there is no GHL consumption. Therefore, Liquid Chemical can sell 160 tons at the
end of Year 0 at $4,000 per ton.
Market Price = $640,000
Loss on Sale =
$160,000
Book Value = $800,000
Tax Savings on Sale = $ 64,000

Machinery is not necessary for maintenance, and can also be sold at the end of Year 0.
Market Price = $200,000
Loss on Sale =
$400,000
Book Value = $600,000
Tax Savings on Sale = $160,000

There is a severance pay of $20,000 at Year 0, and a pension payment of $30,000 per year from Year 1 to
Year 5.

This page is intentionally left blank

7-39

Solutions