Chapter 10
Chapter 10
Relevant Information for Decision Making
Questions
1. Relevance means that a factor should be
considered in making a decision. A relevant
cost is a cost that is applicable, pertinent, or
logically related to making a decision. In
business, managers use the concept of
relevant costs in the allocation of resources.
2. Time is correlated with relevance. For
costs to be relevant they must reside in
the future; historical costs are never
relevant.
Further, the more distant in the future a
cost resides, the more likely it is to be
relevant. For example, in the long run,
certain fixed costs are likely to be
relevant; however, in the short run, most
fixed costs are not relevant.
3. Opportunity costs are benefits that are
sacrificed to pursue one decision
alternative over another. These costs are
difficult to identify because they do not
appear as costs in accounting records.
For example, in allocating scarce
resources, managers may decide to
produce Product A rather than Product B.
An opportunity cost of this decision is the
lost contribution margin on Product B.
The lost contribution margin does not
appear in the accounting records as an
expense.
4. Sunk costs are costs that have already
been incurred; i.e., they are historical
costs. Sunk costs are never relevant to
decisions because one a cost has been
incurred, it cannot be unincurred.
5. Outsourcing occurs when a firm chooses
to acquire necessary service functions or
materials from a supplier rather than
produce them in-house. The movement
favoring outsourcing is controversial
because it often involves loss of jobs to
the organization electing to outsource. In
the U.S., the outsourcing controversy is
even tenser because vendors selected in
outsourcing decisions often are foreign
companies. Thus, it can be argued that
outsourcing leads to the movement of
233
jobs from the U.S. to other countries.
6. A scarce resource is any input that
constrains production capacity. In the
short run, any constraint can be binding
and the tightest constraint changes over
time. For example, in a labor strike,
direct labor may be the most constrained
resource. If a machine breaks down, the
conversion operation performed by that
machine may be the most binding
constraint on capacity, and if a supplier
becomes bankrupt, certain materials may
become the most binding constraint.
7. The object of managing the sales mix is to
increase the contribution margin (or total
profit) realized on the sale of a portfolio of
products. The major factors that can be
manipulated to change product mix are
product prices, focus of advertising and
promotion, and the manner in which sales
personnel are compensated.
8. A special order decision involves the
analysis of a nonrecurring sale of products.
The typical circumstance involves the
opportunity to sell products outside of the
normal marketing area or to a one-time
customer. The usual analysis involves a
consideration of incremental costs and
incremental revenues as well as the effect
of the proposed sale on existing business.
9. Segment margin is sales less variable costs
and avoidable fixed costs. Segment margin
is used in decisions about whether to keep
or eliminate a product line. The costs
deducted in arriving at segment margin
include only relevant costs (total direct
variable expenses and avoidable fixed
expenses). The costs presented below the
level of segment margin to derive product
line operating results are irrelevant costs
(sunk direct fixed costs) because such costs
could not be avoided or eliminated should
the product line be discontinued.
10. Linear programming is used as an aid in
complex decisions that involve a single,
identifiable objective function and multiple
decision constraints.
234 Chapter 10

Exercises

11. a. The relevant factors include the difference between the starting salaries for
B.A.s and M.A.s, time until retirement, time to complete the M.A., and the
out-of-pocket costs to obtain the M.A.

b. The opportunity cost associated with earning the master's degree is two
years income that could have been earned with the B.A. degree ($40,400 x
2 = $80,800).

c. The out-of-pocket cost would include the cost of tuition, books, lab fees,
and other direct educational costs. It would not include room and board or
other living expenses that would be incurred irrespective of whether the
student works (with the B.A. degree) or attends school.

d. The other factors to be considered would be the qualitative factors, e.g.,

the relative satisfaction, prestige, and happiness obtained from jobs that
can be secured with each degree, and each alternative's effect on
retirement plans, free time, and travel opportunities.

12. a. The only sunk cost is the purchase cost of the lettuce, $0.60 per head; or
$0.60 49,500 = $29,700

b. The unspoken alternative is to do nothing. Doing nothing might simply

mean throwing the heads of lettuce in a dumpster.

c. Do Sell to Sell to
Nothing Wholesaler Restaurant
Incremental revenue $ 0 $15,750 $21,600
Incremental costs 0 0 10,000
Incremental profit $ 0 $15,750 $11,600

Based on a comparison of the incremental profits associated with each

alternative, the company should sell the lettuce to the wholesaler.

13. a. You would explain to Sara that the purchase cost of $70 is not relevant to
any decision she can now make regarding the phone. No matter what
action she takes now, the $70 is not a recoverable cost. In deciding which
action to take, Sara should consider only those costs that can be avoided
by taking one action rather than another. Any cost that is the same across
all decision alternatives can be ignored; such a cost is not relevant.
Ignoring qualitative factors, Sara should select the alternative that
minimizes total relevant costs.
Chapter 10 235

b. Her logical choices are (1) repair the phone at an estimated cost of $55 and
(2) purchase a new phone. Accordingly, the decision would logically be
made by comparing the purchase cost of a new phone to the repair cost of
the old phone. However, Sara may want to consider differences in features
between the existing phone and replacement phones as well. She may be
willing to pay more than $55 for a new machine if it has additional features.
This would be a qualitative consideration.

14. a. The sunk cost is the original cost of the old equipment, $75,000.

b. Irrelevant future costs include $4,000 of cash operating costs and the
(nondifferential) salvage values in five years.

c. The relevant costs include the cost of the new equipment, $99,000, the
current salvage value of the old equipment, $22,000, and $13,000 of annual
cash operating savings.

d. The opportunity costs associated with keeping the old equipment include
the potential $13,000 savings in cash operating costs, and the current
$22,000 salvage value of the old equipment.

e. The incremental cost to purchase the new equipment is the difference

between the purchase cost of the new machine and the current salvage
value of the old machine, $99,000 - $22,000 = $77,000

f. Some qualitative factors to be considered would include how the new

machine would affect the quality of production relative to the old machine,
effects on employee morale if purchasing the new machine would require
layoffs, and whether current employees have the skills to operate the new
machine.

15. Incremental savings: $28,000 x 10 = $280,000

Incremental cost of software: $270,000 - $48,000 = (222,000)
Incremental profit $ 58,000

From a quantitative perspective, the new software should be purchased

because it will result in increased profits of $58,000 over the life of the
system.

16. a. Relevant cost to manufacture = $1.20

Relevant cost to buy = $1.00
Advantage of buying: 120,000 x ($1.20 - $1.00) = $24,000

b. Relevant cost to buy: $ 1.00

Avoidable variable costs (0.92)
Minimum avoidable fixed costs $ 0.08 per unit
236 Chapter 10

17. The relevant costs to make the bumpers include only the variable costs:
Direct material $42 (incl. purchased mounting hardware at $16)
Direct labor 14
Overhead ($36 1/3) 12
Total $68

Incremental profit per bumper = $120 - $68 = $52

Increased profit from released facilities: ($52 x 4,800) $ 249,600

Increased cost of production on first 150,000 units:
($16 - $12) x 150,000 (600,000)
Net profit effect of purchasing mounting hardware $ (350,400)

18. a. Cost to make: $23,000 + ($2.75 x 25,000) = $ 91,750

Cost to buy: 25,000 x $3.60 = (90,000)
Advantage of purchasing $ 1,750

b. Cost to make: $23,000 + ($2.75 x 60,000) = $188,000

Cost to buy: 60,000 x $3.60 = 216,000
Advantage of making $ (28,000)

c. Point of indifference occurs at the volume level that equates the cost to
make with the cost to buy:
$23,000 + $2.75X = $3.6X
X = approximately 27,059 units

19. a.
MP3 Players PDAs
Contribution margin $6 $10
Divide by labor time per unit 1 2
CM per unit of labor time $6 $ 5

Because the company can sell as many of either product as it can make, it
should make only MP3 Players.

The company should make 120,000 MP3 Players.

b. The company should consider the need to provide a market assortment of

goods and the possibility of customer preferences permanently changing
to PDAs not made by Elkhorn Digital. This is acknowledging the possible
long-term consequences to a short-term problem solution.

20. a. Individual Estate Corporate

Sales price $350 $1,200 $750
Variable costs (50) (200) (150)
Contribution margin $300 $1,000 $600
Chapter 10 237

Contribution margin per hour of professional time:

Individual: $300 2 = $150
Estate: $1,000 8 = $125
Corporate: $600 5 = $120

According to the CM generated per hour of professional time, Ms. Jones

would prefer to satisfy demand for services in the following order:
individual taxation, estate taxation, and corporate taxation. Because all of
Ms. Jones time could be consumed in providing individual income tax
services, all of her time should be dedicated to providing that service.

b. Contribution margin: 2,500 x $150 $375,000

Fixed costs (50,000)
Pretax income $325,000

c. Ms. Jones should carefully consider the relationship between the three
services she offers. For example, much of the demand for individual and
estate tax services may be generated by the services she provides
corporate clients. It may be because of the quality of her corporate tax
services that demand is generated to provide individual income and estate
tax services. Accordingly, there may be long-term negative consequences
to providing only individual income tax services.

d. Ms. Jones could overcome the time constraint in one of two generic ways.
First, she could employ accountants in her firm to do work in all service
lines. Secondly, she could engage in a joint venture or partnership with
other firms to provide the full array of services to clients.

21. a. Only the variable production costs are relevant to this decision:
$440 + $60 + $50 = $550.

b. Incremental revenue: $580 x 200 $116,000

Incremental costs: $550 x 200 (110,000)
Incremental profit $ 6,000

Profits would increase by $6,000 if this special order was accepted

22. a. The relevant costs include the lost contribution margin associated with the
20 units of regular production that would be sacrificed to accept the
special order, and the variable production costs for the three special
stands:
Normal sales price (20 x $275) $ 5,500
Variable costs (20 x $145) (2,900)
Lost contribution margin $ 2,600
Production costs (3 x $860) 2,580
Total costs $ 5,180
238 Chapter 10

b. Additional sales $ 3,600

Less total relevant costs (5,180)
Incremental loss $(1,580)

23. a. Grooming Training Total

Revenue $600,000 $800,000 $1,400,000
Labor costs (160,000) (288,000) (448,000)
Material costs (80,000) (96,000) (176,000)
CM $360,000 $416,000 $ 776,000
Fixed costs (200,000) (180,000) (380,000)
Income before taxes $160,000 $236,000 $ 396,000

b. Contribution margin $360,000 $416,000

Divide by sales 600,000 800,000
Contribution margin % 60% 52%

If $1 spent on advertising could increase revenue by either service by $20,

it should be spent on Grooming because it has a higher contribution
margin percent.

c. Grooming Training
Revenue per hr. $30 $50
Variable costs per hr. (12) (24)
CM per hr. $18 $26

Because $1 will yield $26 in CM if spent on training, but yield only $18 in
CM if spent on grooming, the $1 should be spent advertising the
companys training services.

24. a. Sales 90,000 x $50 $4,500,000

Variable costs ($9 + $7) x 90,000 (1,440,000)
Contribution margin $3,060,000
Fixed costs (300,000)
Projected profit $2,760,000

b. New sales (90,000 x 1.20) x ($50 x 0.90) $ 4,860,000

New variable costs (90,000 x 1.20) x $16 (1,728,000)
New contribution margin $ 3,132,000
Old contribution margin (3,060,000)
Change in profit $ 72,000

c. Change in CM $3,060,000 x 0.25 $765,000

Change in fixed costs (220,000)
Change in profit $545,000
Chapter 10 239

25. a. If the U. S. Division had been eliminated, Tanner Oils income statement
would have appeared as follows:

Sales $ 3,600,000
Variable costs (2,088,000)
Contribution margin $ 1,512,000
Fixed costs:
Direct $ 480,000
Corporate 2,700,000 (3,180,000)
Operating income (loss) $(1,668,000)

b. United States Mexico Total

Sales $7,200,000 $3,600,000 $10,800,000
Variable costs (4,740,000) (2,088,000) (6,828,000)
Direct fixed costs (900,000) (480,000) (1,380,000)
Segment margin $1,560,000 $1,032,000 $ 2,592,000
Corporate costs (2,700,000)
Operating income (loss) $ (108,000)

If the U. S. Division is eliminated, corporate income would decline by the

$1,560,000 of segment margin currently being generated by that division.
The common corporate costs of $2,700,000 would then need to be covered
in total by the Mexico Division, which it cannot do.

26. a. Gross margin GL Services $ 600,000

Avoidable fixed and variable operating costs (725,000)
Segment margin $(125,000)
Yes, the company should strongly consider dropping the GL service line
because it generates a negative segment margin of $125,000.
b. The pretax profit of the company would rise by $125,000 (the amount of the
negative segment margin of the GL service line) if the GL area was
dropped.

27. Objective function, MAX CM: 9.50X1 + 5.00X2 + 1.50X3

28. Objective function, MIN VC: 0.65X1 + 0.93X2 + 1.39X3 + 0.72X4

29. Objective function, MAX CM: 3.25X1 + 2.05X2 + 2.60X3

Subject to: 2.5X1 + 1.0X2 + 2.5X3 < 800
2.5X1 + 2.0X2 + 1.0X3 < 4,000

Where: X1 = the number of pairs of pants

X2 = the number of pairs of shorts
X3 = the number of shirts
240 Chapter 10

30. Minimize Cost: 3.99X1 + 1.29X2 + 0.93X3 + 2.12X4 + 3.42X5

Subject to: 38X1 + 1X2 + 35X3 + 23X4 + 42X5 > 50
10X1 + 13X2 + 7X3 + 3X4 + 8X5 > 10
0X1 + 0X2 + 120X3 + 110X4 + 100X5 > 100
500X1 + 60X2 + 190X3 + 110X4 + 210X5 > 2,000

Where: X1 = pizza
X2 = tuna fish
X3 = cereal
X4 = macaroni & cheese
X5 = spaghetti

Problems

31. a. Cost of new machine $ (700,000)

Sales value of old machine 100,000
Incremental cost of new machine $ (600,000)
Operating cost savings ($130,000 x 5) 650,000
Net advantage of buying new machine $ 50,000

b. The qualitative factors that should be considered include any quality

differences between the output generated by the two machines, whether
the companys employees have the knowledge to operate the new machine,
how acquisition of the machine would affect safety considerations, and the
capacity levels of the two machines.

32. a. The relevant costs include the cost to purchase the new turbine, the
current market value of the old turbine, and the difference in annual
operating costs between the old and new turbines.

b. Incremental cost of new turbine: $2,000,000 - $400,000 $(1,600,000)

Incremental cost savings of new turbine:
($480,000 - $180,000) x 8 2,400,000
Incremental profit from buying new turbine $ 800,000

c. The maximum amount that the company could pay:

Total annual operating savings $2,400,000
Cash value of old machine 400,000
Total $2,800,000

d. Some of the factors to consider would include the reliability of the

technologies, the difference in lives of the technologies, the environmental
impacts of the technologies, and relative risks of using the two
technologies.
Chapter 10 241

33. a. Relevant costs include:

Variable production costs: ($0.04 + $0.03 + $0.02) or $0.09 per unit
Annual salary of manager who can be replaced: $50,000
Vendors offering price: $0.13 per unit
b. Production costs saved ($0.9 x 4,000,000) $ 360,000
Salary savings 50,000
Purchase cost of part ($0.13 x 4,000,000) (520,000)
Disadvantage of outsourcing the part $(110,000)

c. Other considerations include the relative quality of the part acquired from
the vendor and the part produced internally, the ability of the vendor to
deliver in a timely manner, the existence of competitors of the vendor, the
likelihood that future volume levels will differ from present volume levels.

34. a. Cost to make:

Direct materials $139.00
Direct labor ($66 x .75) 49.50
Variable overhead ($43 x .75) 32.25
Fixed overhead:
Rental value of production space ($114,000 50,000) 2.28
Depreciation on new machine ($5,000,000 5) 50,000 20.00
Total unit cost $243.03
Cost to buy: $240.00

b. If 60,000 subassemblies were required annually, the "cost to make" would

change because of the lower fixed costs on a per-unit basis. The
depreciation would be ($5,000,000 5) 60,000 = $16.67, and the rental
value opportunity cost would decline to: $114,000 60,000 = $1.90. This
would change the overall cost to make to $139.00 + $49.50 + $32.25 +
$16.67 + $1.90 = $239.32. At this volume level, the advantage is slightly in
favor of making.
c. If 75,000 subassemblies were required annually, the "cost to make" would
again change due to the lower fixed costs on a per-unit basis. The
depreciation would be ($5,000,000 5) 75,000 = $13.33, and the rental
value opportunity cost would decline to $114,000 75,000 = $1.52. This
would change the overall cost to make to $139.00 + $49.50 + $32.25 +
$13.33 + $1.52 = $235.60. At this volume level, the advantage is
significantly in favor of making.

d. Qualitative considerations:
Quality control systems in place by potential
supplier
Reliability of the supplier
Risk of future price increases by supplier
Lead time to receive orders
Number of competing suppliers
Labor relations in supplier's plants
242 Chapter 10

35. a. Maximize the contribution per unit of the scarce resource (direct labor
hours):

Racing Touring Basic

Sales per unit $1,800 $1,360 $480
VC per unit (1,440) (1,140) (372)
CM per unit $ 360 $ 220 $108
Hours per bike 24 22 6
CM per hour $15 $10.00 $18.00

Since Basic cycles yield the greatest contribution margin per direct labor
hour, the company should devote all of its capacity to their production in the
absence of market or other restrictions. Profit can be determined as follows:
Production of Basic cycles = 34,000 6 = 5,667 (rounded)

Contribution margin 5,667 x $108 $612,036

Fixed costs (450,000)
Pretax income $162,036

b. In part (a), it was determined that Basic cycles are the most profitable
product, so the company will devote 50 percent of its time to that product.
Touring cycles yield the lowest contribution margin per hour, so 20 percent
of the time should be devoted to them. This would leave 30 percent of the
time to manufacture Racing cycles.

Production levels:
Basic (34,000 x .50) 6 2,833 (rounded)
Racing (34,000 x .30) 24 425
Touring (34,000 x .20) 22 309 (rounded)

Contribution margin:
Basic (2,833 x $108) $305,964
Racing (425 x $360) 153,000
Touring (309 x $220) 67,980
Total $526,944
Less Fixed costs (450,000)
Pretax income $ 76,944

c. Yes. The demand in this market is likely fragmented, with particular

consumers preferring a cycle suited for a particular purpose. However,
there is likely enough demand for the Basic cycle to absorb the entire
production capacity of the company.

d. The companys tax rate is irrelevant because it does not change across the
choices under consideration in this decision.
Chapter 10 243

36. a. Plan 1:
New commission on belts = 0.11($40 - $22) = $1.98
New commission on key fobs = 0.11($10 - $5) = $0.55

New CM on belts: ($40 - $1.98 - $22 - $4) 95,000 = $1,141,900

New CM on key fobs: ($10 - $0.55 - $5 - $0.50)115,000 = $454,250

Income from belts: ($1,141,900 - $580,000) $561,900

Income from key fobs: ($454,250 - $180,000) 274,250
Total Plan 1 income: $836,150

Plan 2:
New FC for belts: $580,000 + $25,000 = $605,000

New sales for belts: 119,000 units

CM: ($12 x 119,000) = $1,428,000

New sales for key fobs: 91,000 units

CM: (91,000 x $4) = $364,000

Income from belts: ($1,428,000 - $605,000) $ 823,000

Income from key fobs: ($364,000 - $180,000) 184,000
Total Plan 2 income: $1,007,000

Plan 3
New sales for belts: 94,000 units
CM: ($17 x 94,000) = $1,598,000

New sales for key fobs: 90,000 units

CM: $7 x 90,000 = $630,000

Income from belts: ($1,598,000 - $580,000) $ 1,018,000

Income from key fobs: ($630,000 - $180,000) 450,000
Total Plan 3 income: $1,468,000

b. Plan 3 should be adopted because it maximizes total income relative to the

existing price and cost structure and Plans 1 and 2.
 244 Chapter 10

37. a. Ice Cream Steaks Total

Sales $8,000,000 $3,600,000 $11,600,000
Variable costs
Merchandise sold (4,800,000) (2,600,000) (7,400,000)
Commissions (800,000) (300,000) (1,100,000)
Delivery costs (1,200,000) (210,000) (1,410,000)
CM $1,200,000 $ 490,000 $ 1,690,000
Avoidable fixed costs
Allocated corporate (30,000) (30,000)
Manager's salary (160,000) (150,000) (310,000)
Segment margin $1,040,000 $ 310,000 $ 1,350,000
Unavoidable direct fixed costs
Delivery costs (30,000) (30,000)
Depreciation (400,000) (200,000) (600,000)
Product line results $ 640,000 $ 80,000 $ 720,000
Common costs (200,000) (170,000) (370,000)
Net income (loss) $ 440,000 $ (90,000) $ 350,000

b. Based on segment margin, the Steaks Division generates $310,000 of

income above its avoidable expenses. Additional computations are
necessary to determine whether the steaks product line should be kept:

Steaks segment margin $310,000

Opportunity cost, rent (17,000)
Net advantage to keeping steaks line $293,000

c. To the extent the two product lines cross-fertilize each others sales, the
company should be concerned. Some customers who prefer to purchase
both ice cream and steaks from the same vendor may seek another vendor
that has a broader product offering.

d. Layoffs could adversely affect morale and trust between employees and
managers. If cordial relations existed between managers and workers prior
to the layoffs, the culture could be destroyed by the layoffs. The
consequence might be a loss of key employees, a drop in profits, and a
decline in customer service.

38. Note that in the following solutions, the fact that the total allocated fixed costs
will decline from $1,000,000 to $500,000 can be ignored because this change
is not differential across the three alternatives.
 Chapter 10 245

a. Georgia factory expansion:

Sales $4,200,000
Fixed costs:
Factory $ 672,000
Administration 242,000 $ 914,000

Variable costs $1,344,000

Alloc. home office costs 350,000 1,694,000 (2,608,000)
Est. net profit from operations $1,592,000
Tennessee factory estimated:
Net profit from operations 1,080,000
Home office expense allocated to
Florida factory (200,000)
Estimated net profit from operations $2,472,000

b. Estimated net profit from operations:

Tennessee factory $1,080,000
Georgia factory 820,000
Estimated royalties to be received (30,000 X $8) 240,000
$2,140,000
Less home office expense allocated to
Florida factory (200,000)
Estimated profit from operations $1,940,000

c. Estimated net profit from operations:

Tennessee factory $1,080,000
Georgia factory 820,000
$1,900,000
Less home office expense allocated to
Florida factory (200,000)
Estimated profit from operations $1,700,000

(AICPA adapted)

39. a. Sales $1,100,000

Variable costs (825,000)
Contribution margin $ 275,000

Units sold: ($1,100,000 $10) x 100 = 11,000,000 units

Contribution margin per unit: $275,000 11,000,000 = $.025
Required unit sales: ($350,000 + $50,000) $.025 = 16,000,000 units
246 Chapter 10

b. Plan A (000 omitted)

Ohio New Jersey Total
Sales $1,700 $2,000 $3,700
Variable costs:
Direct material $ 425 $ 500 $ 925
Direct labor 510 500 1,010
Factory overhead 340 350 690
Total $1,275 $1,350 $2,625
Contribution margin $ 425 $ 650 $1,075
Direct fixed costs:
Overhead $ 350 $ 450 $ 800
Promotion costs 50 50 100
Total $ 400 $ 500 $ 900
Segment margin $ 25 $ 150 $ 175
Allocated fixed costs 71 84 155
Operating income (loss) $ (46) $ 66 $ 20

Plan B
Sales $3,100,000
Variable costs:
Direct material $775,000
Direct labor 775,000
Variable overhead 542,500 (2,092,500)
Contribution margin $1,007,500
Fixed costs:
Factory overhead $450,000
Promotion costs 100,000
Allocated costs 155,000 (705,000)
Operating income $ 302,500

Plan C
Sales $2,000,000
Royalties 137,500
Variable costs:
Direct material $500,000
Direct labor 500,000
Variable overhead 350,000 (1,350,000)
Contribution margin $ 787,500
Fixed costs:
Factory overhead $450,000
Promotion costs 100,000
Allocated costs 155,000 (705,000)
Operating income $ 82,500

40. a. For May, it would appear that store 2 is more profitable. Although store 2
had lower sales than store 1, it is clear that store 1 incurred more expense.
For example, store 1 spent two-thirds of the entire district advertising
budget; this was 10 times more than store 2 spent. Store 1 also incurred
more expense for rent and would have been allocated more district level
Chapter 10 247

costs because of its higher sales.

b. Store 1 is generating the most revenue. This is given in the first bulleted
statement.

c. The incentive for Store 1 is to generate as much revenue as possible. The

bonus scheme for that store does not take into account any expenses.
Consequently, the manager of the store can benefit from the advertising
without bearing any advertising costs.

d. Store 1 would have more incentive. Since store 2 is evaluated on net

income, any expenditure for maintenance will reduce the net income that
might otherwise have been recorded. Store 1 would want to spend an
adequate amount for maintenance so that no machine malfunction or
downtime occurs that might interfere with sales.

e. Both bonus schemes have some problems. The bonus scheme based on
sales volume is not likely to increase profits in either the short or long term
because no incentive is given to the manager to be conscious of the costs
that are incurred to generate revenues. The bonus based on net income is
more promising. The only detrimental aspect of this performance measure
is that it is short-term oriented. It encourages managers to take actions
that may generate short-term profits at the expense of long-term profits.
For example, a manager may forgo maintenance activities to reduce costs
in the short term. However, the long-term implications of this act may be
higher costs resulting from broken machinery.

41. a. Clean-N-Brite should price the regular compound at $22 per case and the
heavy-duty compound at $30 per case. The contribution margin is the
highest at these prices as shown below.

Regular Compound
Selling price per case $ 18 $ 20 $ 21 $ 22 $ 23
Variable cost per case 16 16 16 16 16
Contribution margin/case $ 2 $ 4 $ 5 $ 6 $ 7
Volume in cases
(000 omitted) 120 100 90 80 50
Total contribution margin
(000 omitted) $240 $400 $450 $480 $350

Heavy-Duty Compound
Selling price per case $ 25 $ 27 $ 30 $ 32 $ 35
Variable cost per case 21 21 21 21 21
Contribution margin/case $ 4 $ 6 $ 9 $ 11 $ 14
Volume in cases (000 omitted) 175 140 100 55 35
Total contribution margin (000 omitted) $700 $840 $900 $605 $490
b. 1. Clean-N-Brite should continue to operate during the final six months
of 2006 because any shutdown would be temporary. The company
clearly intends to remain in the business and expects a profitable
operation in 2007. This is a short-run decision analysis problem.
248 Chapter 10

Therefore, the fixed costs are irrelevant to the decision because they
cannot be avoided in the short run. The products do have a positive
variable contribution margin so operations should continue.

Clean-N-Brite
Cincinnati Plant
Pro Forma Contribution Statement
for the Final Six Months of 2006
($000 omitted)

Heavy
Regular Duty Total
Sales $1,150 $1,225 $2,375
Variable costs
Selling & admin. $ 200 $ 245 $ 445
Manufacturing 600 490 $1,090
Total variable costs $ 800 $ 735 $1,535
Contribution margin $ 350 $ 490 $ 840

2. Clean-N-Brite should consider the following qualitative factors when

making the decision to keep the Cincinnati Plant open or to close it:
The effect on employee morale.
The effect on market share.
The disruption of production and sales due to shut-down.
The effect on the local community.
(CMA adapted)

42. a. The manufacturing overhead rate is $18 per standard direct labor hour
and the standard product cost includes $9 of manufacturing overhead
per pressure valve. Accordingly, the standard direct labor hour per
finished valve is .5 hour ($9 $18). Therefore, 30,000 units per month
would require 15,000 direct labor hours.
Chapter 10 249

b. Totals for Per unit 120,000 Units

Incremental revenue $19.00 $2,280,000
Incremental costs:
Variable cost:
Direct material $ 5.00 $ 600,000
Direct labor 6.00 720,000
Variable overhead 3.00 360,000
Total variable costs $14.00 $1,680,000
Fixed overhead:
Supervisory and clerical costs
(4 months $12,000) 48,000
Total incremental costs $1,728,000
Incremental profit before tax $ 552,000

Shipping, sales commission, and fixed factory overhead (direct and

allocated) are irrelevant to the incremental analysis.

c. The minimum unit price that Hydraulic Engineering could accept

without reducing net income must cover variable costs plus the
additional fixed costs.

Variable unit cost $14.00

Additional fixed cost ($48,000 120,000) .40
Minimum unit price $14.40

d. Hydraulic Engineering should consider the following factors before

accepting the Prince Industries order.
The effect of the special order on Hydraulic Engineering's sales at
regular prices.
The possibility of future sales to Prince Industries and the effects
of participating in the international market.
The company's relevant range of activity and whether or not the
special order will cause volume to exceed this range.
The impact on local, state, and federal taxes.
The effect scheduled maintenance of equipment.
(CMA adapted)

43. a. Ethical issues to consider: whether the competitor is exploiting the

workers; whether the competitor is displacing the domestic workforce;
whether the competitor is violating the rights of other companies to fair
competition; the effects of the various stakeholders including the
customers (competitors and Karlsons) of using the illegal workers and
on not using the illegal workers. In addition, there exists the legal issue
that hiring illegal aliens is unlawful. Karlsons Computers is
considering knowingly and willfully becoming an accomplice by
purchasing from this supplier.
250 Chapter 10

b. The short-run advantages are buying at a lower price to be more

profitable, being able to sell at a lower price and therefore sell more
computers, having a competitive advantage, and pleasing the
customers who will appreciate the lower prices. The potential
disadvantages are longer run: damage to the business community and
to the socioeconomic balance; damage to the companys reputation;
possible fines and/or imprisonment if co-conspiracy could be proven; ill
effects on workers who are exploited; and disadvantages to domestic
workers who are unable to obtain jobs.

c. Ms. Karlson should investigate further the hiring practices of the

supplier or allow the proper authorities to do so. If she is satisfied that
the supplier is following legal practices, Ms. Karlson should perform the
necessary cost analysis for a make-or-buy decision. If the supplier is
found to be hiring illegal aliens, Ms. Karlson should continue to make
her own keyboards.