Chapter 21 Differential Cost Analysis Learning Objectives After studying this chapter, you will be able to: Define the term differential cost and link it to short-term decisions. Distinguish costs that are relevant to short-term decision making from those that are not. List several examples of short-term decision problems for which differential cost can be computed, Compute differential cost and use it to make short-run economic decisions. (Appendix) Define linear programming and list its uses. . (Appendix) Formulate a linear programming problem and solve it using the graphic method. Managers often make decisions about the potential cost or profitability of alternative actions. The accountant facilitates this process by providing information relevant to the decisions. Different kinds of decision problems require the use of different decision mod- els, which in tum use different kinds of information. To provide relevant information, the accountant must understand the nature of the problem and the decision model being used. ‘This chapter focuses on short-term decision making. The first section defines differen- tial cost studies and relevant costs; the second section illustrates their relevance in solving short-term decision problems. Linear programming for short-term decisions is presented in the appendix. Decisions with long-term effects are discussed in Chapters 22 and 23, and the problem of uncertainty in both short- and long-term decisions is presented in Chapter 24. Differential Cost Studies A differential cost study is an analysis to determine desirability of a project or activity whose duration does not exceed one year. If an action’s expected differential benefits exceed its expected differential cost, the action should be undertaken. When alternatives that achieve the same goal are evaluated simultaneously, differential cost studies show which alternative costs the least. Revenue is the expected benefit of most, but not all, business activity. The benefit of a project can also be avoidance of a fine or other legal action. Companies sometimes engage in nonprofit activities such as helping to clean up the environment, providing aid to the needy and underprivileged, and providing educational assistance. When the expected ben- efit of a differential cost study is revenue, it is referred to as. marginal revenue or incre- mental revenue because it provides an increment or addition to the company’s total revenue for the period. Differential cost is the cost that must be incurred to complete a proposed project or to extend an activity already undertaken. It is often referred to as marginal cost by econo- mists and as incremental cost by industrial engineers. Differential cost includes all cash 21-121-2 Part 5 > Analysis of Costs and Profits expenditures required, both fixed and variable cost. Required cash outlay is referred to as out-of-pocket cost. Similarly, differential cost can be thought of as the expenditure avoided by abandoning or discontinuing the project or activity. In this sense, it is referred to as avoidable cost. Differential cost does not include sunk costs or allocated fixed costs. Sunk costs can- not be recovered; examples are the excess of a machine's book value over its salvage value. Allocated fixed costs do not change as a result of accepting or rejecting the project or act ity being evaluated; examples are plant superintendence and building depreciation. Because sunk costs cannot be recovered and because allocated fixed costs are not affected by the decision, they are not relevant to short-run decisions. Variable costs generally are relevant in differential cost studies because they must be incurred if the activity is undertaken or extended, but they can be avoided if it is not. If an addi- tional fixed cost must be incurred to undertake or extend a project, the additional cost is a dif- ferential cost. Any required out-of-pocket expenditure is relevant to the decision. For example, if a company operating at 95 percent of capacity must rent more machinery to expand produc- tion to 110 percent of capacity, then the cost of renting the additional machinery is a differen- tial cost—even though it is a fixed cost—because it is an out-of-pocket expenditure. Opportunity costs should be considered in evaluating short-term decision problems. An opportunity cost is the measurable value of the best forgone alternative, that is, the measurable value bypassed by rejecting the best altemnative use of resources. For example, money can either be spent in producing and selling a product or it can be invested in an interest-eamning asset, such as a bond. If money is spent making and selling a product, the interest that could have been earned from the bond is an opportunity cost of making and selling the product. Similarly, a machine can either be used in the manufacture of a prod- uct or it can be rented out to produce rent revenue. The rental value of the machine is an opportunity cost. Although opportunity costs are not routinely reported in financial state- ments, they should be considered in decisions. Imputed costs can also be relevant to differential cost studies. Imputed costs are hypo- thetical costs of a resource measured by its use value. Imputed costs ordinarily do not appear in accounting records and do not necessarily entail dollar outlays. An imputed cost is similar to an opportunity cost, except that an imputed cost may be an arbitrary measure. Examples of imputed cost are the losses of public goodwill from laying off workers when a project ends and from polluting the environment. Historical cost accounting generally does not give management the differential cost information needed to evaluate courses of action. A flexible budget with costs computed for different levels of capacity utilization (as in Chapter 17) can be useful in differential cost analyses. The flexible budget presented in Exhibit 21-1 for Gilbert Company shows costs at different levels of production capacity. It indicates that some costs increase pro- portionately with an increase in capacity, while other costs remain comparatively unchanged through various levels of activity. In the flexible budget in Exhibit 21-1, the $5.40 average unit cost at 60 percent of nor- mal capacity is computed by dividing total cost at that capacity by the number of units pro- duced ($324,250 = 60,000 units). The total differential cost is determined by subtracting the total estimated cost for one level of activity from that of another level. For example, $423,400 ~ $324,250 = $99,150, the differential cost between the 80 percent and 60 percent levels. The differential unit cost is computed by dividing the difference in number of units into the dif- ference in total cost. For example, 80,000 units - 60,000 units = 20,000 units, and 20,000 divided into the cost difference of $99,150 gives $4.96 differential cost per unit.Chapter 21> Differential Cost Analysis 21-3 Gilbert Company Flexible Budget for Different Rates of Output (100,000 Units = 100% Normal Capacity) Capacity (as a percent of normal) 80% = 80% © 100%» 120% Variable costs: Direct menlaching com: Direct materials. $102,000 $136,000 $170,000 $204,000 Direct labor 93,000 _124,000 _155,000 _186,000 Total... ‘$195,000 $260,000 $325,000 $390,000 Indirect manufacturing costs: Heat... $ 720 $ 960 $ 1,200 $ 1,440 Light and power 1,440 1,920 2,400 2,880 Repairs and maintenance .. 2,460 3280 4,100 4,920 Supplies. 1,260 1,680 2,100 2,520 9,120 __12,160 _ 15,200 __18,240 '$ 15,000 $ 20,000 $ 25,000 $ 30,000 $ 11,580 $ 15,440 $ 19,300 $ 23,160 6960 9,280 11,600 13,920 1,260 __1,680 __2,100 __ 2,520 ‘$19,800 $ 26,400 $ 33,000 $ 39,600 Fixed costs: Indirect manufacturing cost ‘Supervisors... $ 15,250 $ 20,500 $ 20,500 $ 25,750 Indirect labor 15,000 15,000 15,000 17,750 Setup crew... 5,000 7,500 7, 8, Depreciation : Property taxes and insurance 2,600 ___2,600 ___2,600 ___2,600 Differential cost per unit..nsns $4. EXHIBIT 21-1 Examples of Differential Cost Studies Differential cost studies are short-term, They are not useful for strategic planning because they ignore long-term effects of decisions. In the long run, all costs must be recovered or the company will not be profitable, and if it is not profitable, it will not survive for long. For long-term product pricing and product mix decisions, activity-based costing (Chapter 14) provides useful information. If a proposed project extends beyond one year, capital expenditure evaluation, as discussed in Chapters 22 and 23, should be used. However, for projects or activities that do not extend beyond the current period, differential cost studies21-4 Part 5 > Analysis of Costs and Profits provide relevant information for decisions. Examples of decisions that benefit from differ- ential cost analysis are as follow: 1. Accepting or refusing customer orders 2. Reducing the price of a single, special order 3. Reducing price in a competitive market 4. Evaluating make-or-buy alternatives 5. Expanding, shutting down, or eliminating a facility 6. Increasing, curtailing, or stopping production of certain products 7. Determining whether to sell or to process further 8. Choosing among alternative routings in product manufacture 9. Determining the maximum price to pay for raw material Accepting Additional Orders Differential cost should be considered whenever a decision involves a change in output. The differential cost of added production is the difference between the costs of produc- ing the present output and the contemplated, larger output. If capacity is available, dif ferential cost analysis may indicate the possibility of selling additional output at a price below the existing average unit cost. The additional business will be profitable as long as additional revenue exceeds differential costs of manufacturing and selling the addi- tional output. For example, assume a plant has capacity to make 100,000 units, but normal capac- ity is 80,000 units. The predetermined overhead rate is calculated to fully apply the bud- geted fixed overhead when at the 80,000-unit level; i.e., all budgeted fixed overhead is applied to the 80,000 units produced. If fewer units are produced, fixed overhead is underapplied. If more units are produced, fixed overhead is overapplied. If this company makes only one unit, its total cost for the period and its unit cost are equal because the one unit produced must absorb all production cost incurred during the period. The total Cost per unit is as follows: Variable cost per unit $ 5 Total fixed cost 100,000 Total cost per uni $100,005 At normal capacity, the fixed cost per unit is reduced to $1.25 ($100,000 = 80,000 units), and the total cost per unit is: Variable cost per unit $5.00 Share of fixed cost...... 1.25 Total cost per unit .. %. Notice that the differential cost of the additional 79,999 units is only the $5 per unit variable cost, because no additional fixed costs are incurred. If capacity is available to pro- duce an additional 1,000 units, the differential cost of these units would be only the $5 variable cost per unit, unless additional fixed costs are required. If the sales price is $9 per unit, a differential cost analysis comparing present operating results with the results expected after 1,000 additional units are produced and sold is as follows:‘Chapter 21 > Differential Cost Analysis us wien Present Additional Business § © Guainess $720,000 $729,000 400000 405,000 $320,000 $324,000 100.000 _100,000 son |= Sato ‘The additional business requires additional variable cost only. Because capacity is available to produce the additional 1,000 units, additional fixed cost will not be incurred. If the 1,000 units are sold at any price above the $5 variable cost each, the sale will yield @ positive contribution to short-run profit. The preceding data also can be presented to highlight the differential revenue of $9,000 and differential cost of $5,000. Present Additional Business Total Sales..... $720,000 $8,000 $729,000 Variable cost 490,000 6.000 406,000 Contribution $320,000 $4,000 $324,000 Fixed cost... 100.000 —2 100000 Broth ze ‘Szz0.000 $4000 = Sako Reducing the Price of a Special Order Differential cost analysis is an aid to management in deciding at what price the firm can afford to sell additional goods. For example, assume that during 20A Walsenberg Company manufactures 450,000 units using 90 percent of its normal capacity. The fixed factory overhead is $1,250,000, which is $2.50 for each unit manufactured when opera- tions are at 100 percent of normal capacity ($1,250,000 = 500,000 units). The variable fac- tory overhead rate is $.50 per unit. The direct materials cost is $1.80, and the direct labor cost is $1.40 per unit. Batch-level and product-level costs are zero, because only one prod- uct is produced by this company (see Chapter 14). Each unit sells for $10. Variable mar- keting expense (shipping expense and sales commission) is $.50 per unit. Fixed marketing and administrative expenses total $800,000. On the basis of tt data, the accountant would prepare an income statement such as the one presented in Exhibit 21-2. ‘The sales manager of Walsenberg Company reports that a customer has offered to pay $6 per unit for an additional 100,000 units. To make the additional units, an annual rental cost of $10,000 for additional equipment would be incurred. Using absorption cost data, the accountant might compute the gain or loss on this order as follows: Sales (100,000 unis at $0 Differential cost Direct valrals (100, 00 units at $1.80) Direct labor (100,000 units at $1.40).. Variable factory overhead (100,000 units at $.50) Fined factory overhead (100,000 units at $2.50) Variable marketing expense (100,000 units at $.50) Loss on this order...21-6 Part 5 > Analysis of Costs and Profits ‘Company Walsenberg For the Year Ending December 31, 20A Sales (450,000 units at $10). $4,500,000 Cost of goods sold: Direct materials (450,000 units at $1.80) $ 810,000 Direct labor (450,000 units at $1.40).. 630,000 Variable factory overhead (450,000 units at §.50) . 225,000 Fixed factory overhead (450,000 units at $2.50) 1.125.000 _2,790,000 1088 PHOFit eer $1,710,000 Underapplied fixed factory overhead | [(600,000 units - 450,000 units) at $2.50). 125,000 Gross profit (adjusted) $1,585,000 Less commercial expenses: Variable marketing expense (450,000 units at $.50) $225,000 Fixed marketing and administrative expenses... — 800,000 _1,025,000 Income from operations $560,000 EXHIBIT 21-2 There are two problems with the preceding calculation. First, the $10,000 additional cost of equipment rental has been ignored, and second, fixed overhead, which is not affected by the decision, has been allocated to the additional business as if it were a dif- ferential cost. The use of absorption cost data in this case would cause management to reject the offer. In this computation, all cost elements are measured at the existing unit costs, and fixed overhead is allocated on the basis of the established rate ($2.50 per unit). A second look, however, reveals the following effect of the new order on total fixed fac- tory overhead: Fixed factory overhead (at present). ate $1,250,000 Fixed factory overhead (because of additional business) 10.000 Total fixed factory overhead... $1,260,000 Fixed factory overhead charged into production: For 450,000 units (old business)... . $1,125,000 For 100,000 units (additional business) .. 250,000 _1,975,000 ‘Overapplied fixed factory overhead...... $115,000 Instead of underapplied fixed factory overhead of $125,000, the additional business would result in overapplied factory overhead of $115,000, or an increase of $240,000 in applied factory overhead. The increase of $240,000 can also be computed by subtracting the additional fixed cost that must be incurred ($10,000 equipment rental) from the amount of fixed factory overhead allocated to the additional 100,000 units produced under the absorption costing method (100,000 units x $2.50 each = $250,000). This $240,000 minus the computed $70,000 loss on the order results in a gain of $170,000. This gain is shown more clearly in the following statement, which includes only the dif- ferential costs and revenue:Chapter 21 > Differential Cost Analysis 2-7 Sales (100,000 units at $6)... $600,000 Cost of goods sold Direct materials (100,000 units at $1.80) $180,000 Direct labor (100,000 units at $1.40) 140,000 Variable factory overhead (100,000 ur 50,000 Additional fixed cost to produce this order 10,000 _380,000 $220,000 Variable marketing expense (100,000 units at $.50).. 50,000 Gain on this order 170,000 The differential cost of manufacturing and selling each additional unit can be com- puted as follows: Differential cost of goods sold _ $380,000 _ 4445 Additional units “100,000 ~ **" Variable marketing expense per uni Total differential cost per unit... $420 Because the $4.30 differential cost is less than the $6 sales price, it is clear that the effect on profit will be favorable. In practice, it is often difficult to determine whether an offer to buy additional output is really additional business. An annual sales budget does not normally specify the quan- tities to be sold to each customer because the forecasts involved are generally based on his- torical trends in product sales and economic factors expected to affect demand during the forecast period. As a consequence, it is often difficult to evaluate whether a particular offer is incremental business or a component of the original budget. If the offer is actually an offer to purchase units included in the original sales forecast, the profits expected from the differential cost analysis will not materialize. If the price reduction and quantity of units involved in the order are large, total sales revenue might not even cover total fixed costs, in which case a loss would occur for the period. If management decides that an offer to purchase at a reduced price is indeed additional business, the long-run effect of the sale on other customers and the reaction of competitors should also be considered. If regular customers become aware that the product has been sold at a reduced price, they may demand similar cost concessions. If the concessions are not granted, a loss of business could result, and if the concessions are granted, a reduced profit margin could result. The firm must also be careful not to violate the Robinson- Patman Act and other governmental pricing restrictions. If the product sold at a reduced price affects the sales of competitors, they might retaliate by cutting their prices. Such actions can result in a price war and lost profits for all concerned. Make-or-Buy Decisions Another short-term decision that involves differential cost analysis is that of deciding Whether to make or buy component parts for a finished product. The importance of the make-or-buy decision is evidenced by the fact that most manufacturing firms at some time during the course of their operations have to make such a decision. The choice of whether ‘Bernard A, Coda and Barty G. King, “Manutacturing Decision-Making Tools, Journal of Cost Management, Vol 3, No.1, p.3421-8 Part 5 > Analysis of Costs and Profits to manufacture an item internally or purchase it from outside the firm can be applied to a wide variety of decisions that are often major determinants of profitability and that can be significant to the company’s financial health, ‘The objective of a make-or-buy decision should be optimal use of the firm's produc- tive and financial resources. The decision must often be made in connection with the pos- sible use of idle equipment, idle space, and even idle labor. In such situations, a manager is inclined to consider making the item instead of buying it to use existing facilities and to avoid laying off workers. Commitments of new resources may also be involved, A make-or-buy analysis is illustrated as follows. Assume that Kiska Corporation plans to introduce a new product that requires a component part that can be purchased from an outside vendor at a cost of $5 per unit or manufactured in house. The corpora- tion has sufficient excess capacity to manufacture 10,000 units of the component part, the quantity needed during the first year. The prime costs per unit for the component part are expected to be $1.80 for materials and $1.20 for direct labor. The factory overhead rate is 200 percent of direct labor cost ($1.20 direct labor cost per unit x 200% = $2.40 overhead per unit); however, only 25 percent of factory overhead budgeted for the year is variable. To manufacture the component part, specialized equipment must be rented at an annual cost of $7,200. If the full absorption cost of the component part is compared to the vendor's price, management will decide to purchase the component part from the outside vendor, because the purchase price of $5 per unit is less than the full absorption cost of $5.40 per unit ($1.80 materials + $1.20 labor + $2.40 overhead). Such a decision is inappropriate, how- ever, because the full absorption cost in this situation is not equal to the differential cost. The fixed portion of the overhead charged to each unit is not relevant to the decision ($2.40 overhead per unit x 75% fixed = $1.80 per unit). In addition, the $7,200 rental of special- ized equipment, which is not included in the absorption cost computation, is an out-of- pocket fixed cost that is relevant to this decision. In the evaluation of the economic effect of the two alternatives, the differential costs of manufacturing the component part should be computed and compared to the cost of purchasing it from an outside vendor. Instead of purchasing the component part in this case, the company should manufacture it, as indi- cated by the following cost comparison: Cost to purchase the part (10,000 units at $5).. ‘$50,000 Materials (10,000 units at $1.80) $18,000 Direct labor (10,000 units at $1 12,000 Variable factory overhead (10,000 labor cost x 200% x 25% variable) 6,000 Incremental fixed factory overhead. 7,200 43,200 ‘Savings from manufacturing the part . £8,200 Studies indicate that surprisingly few firms give adequate objective study to their make- cor-buy problems despite their importance.” This important decision is also complicated by a host of factors, both financial (quantitative) and nonfinancial (qualitative), that must be con- sidered. Faced with a make-or-buy decision, management should do the following: Anthony J. Gambino, The Make-or-Buy Decision (New York: Institute of Management Accountants (formerly National Association of Accountants) and Hamilton, Ont.: The Society of Management Accountants of Canada,Chapter 21> Differential Cost Analysis 21-9 1. Consider the quantity, quality, and dependability of supply of the items as well as the technical know-how required to produce them, weighing such requirements for both the short-run and long-run period. 2, Compare the cost of making the items with the cost of buying them. 3. Consider whether, if the items are purchased rather than made, there may be other, more profitable alternative uses for the firm’s own facilities. 4. Consider differences in the required capital investment and the timing of cash flows (Chapters 22 through 24). 5. Adopt a course of action consistent with the firm’s overall policies. Custowers’ and suppliers’ reactions often play a part in these decisions. Retaliation or ill will can result from inconsistent treatment of customers and suppliers. Whether it is profitable to make or buy depends on the circumstances surrounding the individ- ual situation. The accountant should present a statement that compares the company’s cost of mak- ing the items with the vendor's price. A cost study with only the differential costs and with no allocation of existing fixed overhead indicates possible short-run cost savings. However, if management is asked to sell the items at the differential cost, it might be unwilling to do so, because, in the long run, the full cost must be covered and a reasonable profit achieved. Furthermore, if there is only a slight advantage in favor of making, pur- chasing may be the most desirable alternative because more reliance can be put on a known cost to buy rather than an estimated cost to make.* Decisions to Shut Down Facilities Differential cost analysis also is used when a business is confronted with the possibility of a temporary shutdown of manufacturing and marketing facilities. In the short run, a firm may be better off operating than not operating, as long as the products or services sold recover the variable cost and make a contribution toward the recovery of the fixed cost. A shutdown of facilities does not eliminate all costs. Depreciation, interest, property tax, and insurance continue during complete inactivity. Even if sales do not recover the variable cost and the avoidable portion of fixed cost, the firm still may be better off operating rather than temporarily closing the facility. Closing a facility and subsequently reopening it is a costly process. The shutdown can entail certain maintenance procedures to preserve machinery and buildings during the period of inactivity (such as rust inhibitors, dust covers, and security equipment). The shutdown also can entail legal expenditures and employee maintenance pay. During the shutdown period, some employees will probably be lost (those who decide not to wait until the facility is reopened to go back to work), in which case the investment in training those employees will be lost. The morale of other employees, as well as community goodwill, may be adversely affected, and recruiting and training replacement workers when the facility is later reopened will add to costs. Although difficult to quantify, the loss of established market share is also a factor to be considered. When a company leaves a market for a while, its customers tend to forget about the company’s product. As a consequence, reentering the market at a later time will probably require re-educating consumers about the company’s product. These shutdown costs should be weighed against losses from continued operations, bid, p2121-10 Part 5 > Analysis of Costs and Profits ‘An analysis of a possible temporary shutdown is illustrated as follows. Assume that Nigent Corporation has three production facilities that produce different kinds of products. The projected income statement on an absorption costing basis for the coming year, 20A, is presented in Exhibit 21-3. Plant 2 31,000 __39,000 $39,000 $ 1,000 16,000 _14,000 | $23,000 $13,000) EXHIBIT 21-3 Plant 3 appears to be unprofitable; however, an evaluation of the relative profitability of the plants is obscured because some unavoidable common fixed costs have been allo- cated to each of the plants. Assuming that $32,000 of the commercial expenses is unavoid- able common fixed cost allocated to the plants, a clearer picture of the expected operating ° efficiency of the various plants is obtained by preparing a contribution margin analysis (an income statement based on direct costing) as shown in Exhibit 21-4. Gross contribution margin.. : Less variable commercial expenses $53,500 1,500 1,000 Contribution margin .. ‘$137,000 _$65,000 _$52,000 $20,000 $ 51,500 $17,000 $14,500 $20,000 13,500 __ 5,000 __ 5500 __ 3,000 Total traceable fixed costs... $ 65,000 $22,000 $20,000 $23,000 Margin available to cover common expenses and provide a profit... $72,000 $43,000 $32,000 $ (3,000) ‘Common commercial fixed expenses. 32,000 Operating profit $40,000 EXHIBIT 21-4Chapter 21 > Differential Cost Analysis 21-11 Based on the contribution margin analysis, Plant 3 still appears to be losing money. If Plant 3 is closed during the coming period, variable costs of $20,000 will be avoided ($19,000 of variable manufacturing costs and $1,000 of variable commercial costs); how- ever, revenues of $40,000 also will be lost. This will reduce contribution margin by $20,000 ($40,000 revenue less $20,000 variable costs), If no more than $20,000 of Plant 3's traceable fixed cost can be avoided by closing, the plant should remain open. If unavoidable fixed costs such as depreciation, interest, insurance, and property taxes exceed $3,000 at Plant 3, the avoidable fixed cost will be less than the $20,000 lost contribution margin. As a result, the most profitable short-run decision is to continue operations. Even if more than $20,000 of traceable fixed cost can be avoided by shutting down Plant 3, the shutdown costs should be weighed against potential savings before a decision is made. (Shutdown cost includes the costs of closing and reopening the plant, rehiring and retraining replacement employees, and reestablishing a market for the products manufac- tured by Plant 3.) Even if all $23,000 of traceable fixed costs can be avoided, Plant 3 should be shut down only if the shutdown costs are less than $3,000. If the shutdown costs exceed $3,000, the plant should continue operations unless losses are expected for more than one period, in which case the savings from a shutdown for several periods are weighed against shutdown costs. Decisions to Discontinue Products* Even if an entire facility is not closed or eliminated, management may decide to discon- tinue certain products because they produce little or no profit. Discontinuing products requires analysis of relevant cost and revenue data. Several benefits arise from structured, continual product evaluation programs. Such a program's objective is identifying products to be eliminated or made more profitable. The benefits include the following: 1. Expanded sales 2. Increased profits 3. Reduced inventory levels 4. Executive time freed for more profitable activities 5. Scarce facilities, materials, and labor shifted to more promising projects 6. Greater management attention to why products fail, leading to policies that reduce the rate of failure Care must be taken not only to consider the profitability of the product being analyzed but also to evaluate the extent to which sales of other products will be adversely affected when one product is removed. Sometimes an unprofitable product is part of a product line that must remain complete to attract customers. The unprofitable product may be comple- mentary to more profitable ones, and customers may buy the profitable ones only as long as the unprofitable one is available from the same company. If sales decreases expected on related products are severe enough, it is desirable to retain the unprofitable product. Management needs warning signals for products that may be in trouble. Such signals include the following: eee ecctonn Setar t-te Kratchman, Richard T. Hise, ling Thomas A. Utich, Managements Decision to Discontinue a Product” ‘of Accountancy, Vol. 139, No. 8, pp. 50-54.2112 Part 5 > Analysis of Costs and Profits |. Increasing customer complaints Increasing number of shipments returned |. Declining sales volume Product sales volume decreasing as a percentage of the firm’s tota! sales Decreasing market share Malfunctioning product or introduction of a superior competing product Sales volume not up to projections Expected fe*ure sales and market potential not favorable Return on investment unacceptably low 10. Variable cost approaching or exceeding revenue 11. Costs consistently increasing as a percentage of sales 12. Increasing demands on executives’ time 13. Price that must be constantly lowered to maintain sales 14. Promotional spending that must increase continually to maintain sales yer aware Studies have shown that firms often do a poor job of identifying products that are in difficulty. Probably the major deficiency is a lack of timely, relevant data. The conditions that cause a need to evaluate products or facilities are sometimes permanent or long term. If profitable alternatives are not foreseeable, divestment may be appropriate.° For an illus- tration of product abandonment, assume Plant 3 of Nigent Corporation produces three products—tape cleaner, disk cleaner, and cleaning solvent—using three production lines, and the expectations for the year 20A are as presented in Exhibit 21-5. Direct Costing Basis For the Year 20 Plant3 Tape Disk Total Cleaner Cleaner $40,000 19,000 7,000 5,500 $21,000 $ 9,000 $ 8,500 $ 3,500 400 i é | | e lod Bs Gross contribution margit Less variable commercial expenses. 41,000 Contribution margin... -.nmn $20,000 Less traceable fixed COStS nnn 15,000 Margin available to cover Plant 3 ‘and company common cost. 8 af $8,100 $3,300 3700 __7,300 $ 8,600 —4,000 $5,000 $4,600 $ 4,400 E Plant 3 common fixed cost .. 8,000 Margin available to cover company COMMON COSE «reese se = $(3,000) | EXHIBIT 21-5 “For an expanded development of this topic, see Douglas M. Lambert, The Product Abandonment Decision (Montvale, N.J: Institute of Management Accountants (formerly National Association of Accountants), and Hamiton, Ont. The Society of Management Accountants of Canada, 1985).Chapter 21 > Differential Cost Analysis 21-13 The contribution margin from expected sales of cleaning solvent is $3,300, compared to traceable fixed cost of $7,300. It therefore appears that the contribution margin available to cover company common costs will be improved by $4,000 if cleaning solvent is discon- tinued. However, a portion of the $7,300 of fixed cost traceable to cleaning solvent may not be avoidable. If the unavoidable amount is less than $4,000, the profitability of oper- ating Plant 3 will be improved by dropping cleaning solvent from the product line. On the other hand, if the unavoidable amount exceeds $4,000, dropping cleaning solvent from the product line will reduce profits even further. Even if the unavoidable cost is less than $4,000, before cleaning solvent is dropped from the product line, management should evaluate the potential effect on the sales of the other two products, tape cleaner and disk cleaner, as discussed previously. Additional Applications of Differential Cost Analysis In the following examples, differential cost analysis is applied to managing an oil refinery. These hypothetical cases illustrate methods for solving problems and can be generalized for other industry settings. il refining requires management to choose between alternatives at various points dur- ing processing. Refining separates, extracts, and chemically converts crude oil’s compo- nents using heat, pressure, and catalysts. Basic petroleum products are obtained through physical changes caused by a wide temperature range. Across a range of 300 degrees (275° F to 575° F), components called fractions, ends, cuts, or products appear as vapors and are then condensed into liquids. The mildest heat first drives off the lightest fractions, such as naphtha and gasoline; successively heavier fractions, such as kerosene and fuel oil, appear as the heat is increased. Vaporizing crude oil and then condensing the vapors to obtain var- ious products is referred to as primary distillation. Some products, such as gasoline, are marketable with little additional work. Others undergo further processing to make them more salable. Heavier fractions such as kerosene and fuel oil are subjected to cracking, which causes them to yield more valuable products, such as gasoline. Cracking uses high temperatures and pressures, sometimes in the pres- ence of a catalyst, to subject a heavy fraction to destructive distillation and convert it to a lighter chemical with a lower boiling point. The heaviest fractions from primary distilla- tion are known as residuum or heavy bottoms. This residuum, after further processing, treating, and blending, forms lubricating oils, wax, and asphalt. Managers of refineries must decide what to do with each fraction, at what stage each ‘one should be sold, whether fractions should be bought from other refineries and at what price, and whether to enlarge the plant to handle greater volume. Accountants aid other managers by providing flexible budgets for the departments that further process the frac- tions, called secondary departments. These departmental flexible budgets are called cost analysis budgets. They differ from the flexible budgets used for control in the following ways: all expenses are included, both controllable and non-controllable; budgeted expenses of service departments are allocated to operating departments at corresponding capacity levels; and their aim is to discover the amounts of departmental differential cost. “Adapted from a study prepared by John L. Fox, later published in NAICIA Buetin, Vl. 31, No.4, pp. 400-41 uncer hate, Cost Anis Biapato Evahnte Opersing haerabwes te Ov Raines PP M091921d Part 5 > Analysis of Costs and Profits ‘The amounts of each expense at each production level are computed on separate work sheets where expenses are separated into fixed and variable parts. This separation is nec- essary in estimating expenses for different levels of production. Cost analysis budgets are prepared for the following secondary departments: Treating, Filters and Burners, Cracking, Solvent Dewaxing, Solvent Extraction, Wax Specialties, Canning, and Barrel House. The cost analysis budget for cracking fuel oil in the Cracking Department is shown in Exhibit 21-6. Cracking Department Cost Analysis Budget Normal Capacity (100%) 100,000 gallons of throughput of fuel oil Shut-Down 60% 80% 100% 120% Prime costs... $5,000 $12,000 $14,000 $ 16,000 $ 18,000 Traceable overhead 2,000 _ 4,000 _ 5,000 _ 5,000 _ 11,000 $7,000 $16,000 $19,000 $ 21,000 $ 29,000 60,000 80,000 100,000 120,000 Differential gallons. 60,000 20,000 20,000 20,000 Total differential cos $9,000 $3,000 $ 2,000 $ 8,000 Differential cost per unit. $ 1500 $1500 $ 1000 $ .4000 ‘Average cost per unit... $ 2667 $ 2375 $ 2100 $ .2417 Cracking analysis budget: Present operations, 80% of normal capacity Differential cost (80% to 100%) = $.10 per gallon of input Cracking yields: 75% gasoline; 15% residual fuel oil; 10% loss EXHIBIT 21-6 Sell or Process Further. A refiner has on hand 20,000 gallons of fuel oil and must decide whether to sell it as fuel oil or crack it into gasoline and residual fuel oil. Current prices per gallon are: Fuel oil Gasoline... $1.40 1.68 The company is operating at 80 percent of capacity. Based on a cost analysis budget for the Cracking Department, processing an additional 20,000 gallons will result in a dif ferential cost of 10 cents per gallon. Differential income is calculated as follows: Net potential revenue from cracking: Gasoline (15,000 gallons at $1.68) $25,200 Fuel oll (3,000 gallons at $1.40) 4200 $29,400 Less differential cost (20,000 gallons at $.10) 2,000 Net potential revenue without racking (20,000 gallons at $1.40)......00 Loss from cracking The calculation shows it is more profitable to sell the 20,000 gallons of fuel oil rather than to process the oil further.Chapter 21 > Differential Cost Analysis 2 Choice of Alternative Routings. A refiner must decide whether to treat and sell 10,000 gallons of raw kerosene or crack it for its gasoline content. Pertinent information from a cost analysis budget is as follows: Current prices per gallon: Keroeene $1.20 1.68 1.40 85% 5% 10% Differential costs per gallon of kerosene: Cracking. $ .12 per gallon Treating :08 per gallon Using these amounts, the refiner can prepare the following analysis: Net potential revenue from cracking kerosene: Gasoline (8,500 gallons at $1.68) $14,280 Fuel oil (500 gallons at $1.40). 700 $14,980 Less differential cost (10,000 gallons at $.12) Net potential revenue from treating raw kerosene: Total revenue (10,000 gallons at $1.20) 1,200 $13,780 $12,000 —800 Less differential cost (10.000 gallons at $.08) ... 11.200 Gain from cracking rather than treating. $2,580 In this situation, the more profitable alternative is to crack the kerosene. Price to Pay for an Intermediate Stock. A refiner is offered 10,000 gallons of cylinder stock and needs to know how high a price it can pay and still make a profit. The stock will be processed into conventional bright stock and then sold; further processing would require use of the blending unit for making finished motor oil, which is currently working at full capacity. Available information is as follows: Cylinder stock will yield: 90% bright stock 5% petrolatum 5% loss Current prices: bright stock, $1 per gallon; petrotatum—no market Differential costs of processing 10,000 gallons of cylinder stock are: Solvent dewaxing Solvent extracting Filtering... Total... $.06 per gallon 06 03 $18 per gallon21-16 Part 5 > Analysis of Costs and Profits Using this information, a bargaining margin can be determined: Revenue—bright stock (9,000 gallons at $1 $9,000 Differential cost (10,000 gallons at $.15) 1,509 Margin $1500 Margin per gallon of cylinder stock. £2 ‘The refiner can bargain for the purchase of cylinder stock, knowing a purchase price of 75 cents per gallon is a maximum price-—to pay more will produce a loss, to pay less will result in a gain. Management can decide how much profit is required to justify the pur- chase, thus lowering the maximum price to pay. Opportunity costs also enter this decision: if available capacity has another, more profitable use, then the cylinder stock should not be purchased. Proposed Construction of Additional Capacity. A refiner discovers that present capacity will not satisfy the demand for finished neutrals. The refiner is certain that adding capacity to the solvent dewaxing and solvent extracting units would be profitable. Additional wax distillate stock can be purchased at the current price. Before construction begins, the accountant presents the following information. Unit differential cost: Capacity from 100% (normal) to 120%, an increase of 10,000 gallons of capacity Solvent Dewaxing Department—S.10 per gallon Solvent Extracting Department—$.10 per gallon Yield from wax distillate: 90% Viscous neutral 1.5% Paraffin (8 pounds per gallon) 8.5% Loss ‘Current market prices: iscous neutrals—$1.50 per gallon Paratfin—$.24 per pound Wax distillate stock—no published price; management expects to pay $1.20 per gallon. This information is used to prepare the following analysis: Differential revenue: 9,000 gallons viscous neutrals at $1.50 1,200 pounds paraffin at $.24.... 88 $13,788 Less cost of wax distillate stock (10,000 gallons at $1.20) ... 12,000 Margin to apply against differential costs ..... $1,788 Differential costs: Solvent Dewaxing Department (10,000 gallons at $.10) $ 1,000 Solvent Extracting Department (10,000 gators ats. $10) 1,009 _2,000 Potential loss trom differential production ......... S212) ‘The analysis indicates that the proposed addition to capacity is not justified.Chapter 21 > Differential Cost Analysis 21:17 Summary Appendix: This chapter focuses on short-term decisions. The first section defined differential cost as out-of-pocket or avoidable cost and discussed the irrelevance of sunk costs and allocated common fixed costs in short-term decisions. To determine the desirability of an activity, the analyst compares expected differential cost and expected benefit. If the expected ben- efit is revenue, the project should be undertaken only when incremental revenue exceeds differential cost. For decisions not affecting revenue, differential cost should be mini- mized. Differential cost analysis was illustrated for accepting or refusing customer orders; for price-cutting on a special order or in a competitive market; for choosing to make or buy; to expand, shut down, or eliminate a facility; to increase, curtail, or stop production of a product; and to sell or process further; for choosing among alternative routings; and for finding a maximum price to be paid for materials. Linear Programming Short-term resource allocation is complex when several products are involved and many limits or constraints are imposed. One approach is to make an educated guess about the appropriate levels of inputs and outputs. After modeling the production process, the deci- sion maker tests different decisions and selects the one(s) with the best outcome. In con- trast to this trial and error approach, linear programming permits the decision maker to find the optimal solution to a short-term resource allocation problem without guessing. Maximization of Contribution Margin Contribution margin (CM) is often used as a measure of management performance. To max- imize profit, management maximizes total CM. Linear programming is used to maximize CM as follows. Assume a machine shop makes two models of a product, standard and deluxe. Each unit of the standard model requires 2 houts of grinding and 4 hours of polish- ing. Each unit of the deluxe model requires 5 hours of grinding and 2 hours of polishing. The manufacturer has three grinders and two polishers, so each 40-hour work week provides 120 hours of grinding capacity and 80 hours of polishing capacity. The standard model sells for $9, and the deluxe for $12. Variable costs of making and selling one unit total $6 and $8 for the standard and deluxe models, respectively. Consequently, the amounts of CM from mak- ing and selling a standard unit and a deluxe unit are $3 and $4, respectively. Demand for each product exceeds the company’s total capacity. To maximize total CM, management must decide how many units of each model to produce with the present capacity. ‘The relevant information is as follows: Grinding Polishing Sales Variable Contribution ‘Time (in hours) Time (in hours) Price Cost Margin 2 4 $9 $6 3 5 2 12 8 4 120 8021-18 Part 5 > Analysis of Costs and Profits The problem is expressed mathematically as follows: 1, Total CM from making and selling the two models is called the objective func- tion and is written mathematically: let x and y represent the quantities of the stan- dard and deluxe models, respectively, to be made and sold. Because CM of $3 is expected from each standard unit and $4 from each deluxe unit, total CM will equal 3x + 4y. Therefore, the objective function is: Maximize CM = 3x+ 4y 2. Next, resource limits, called constraints, are expressed in mathematical form, In the illustration, sales demand exceeds capacity, so grinding time and polishing time are the only constraints. There are 120 hours of grinding time available. It takes 2 hours of grinding to make a standard unit and 5 hours of grinding to make a deluxe unit, so the grinding constraint is expressed mathematically as follows: 2x + 5y < 120 Eighty hours of polishing time are available. It takes 4 hours of polishing to make a unit of the standard model and 2 hours for a unit of the deluxe model. The pol- ishing constraint is expressed mathematically as follows: 4x4 2y< 80 Both constraints in this example are less-than-or-equal-to relationships; that is, the amount of constraint used must be less than or equal to the amount available. Other situations involve equal-to constraints, where all of the available constraint must be used, and greater-than-or-equal-to constraints, where the amount of con- straint used must be at least a specified amount. Those types of constraints can exist in either maximization or minimization problems and are illustrated in the minimization problem in the next section When a problem inyolves only two variables, a graph can be used to determine the opti- mal solution. In this example, the maximum quantity of each model is determined as follows: Production Quantity Production Operation ‘Standard Model (x) Grinding... : 120 hrs. POLISHING nnn 80 hrs. The smallest quantity in a column is the maximum that can be made with the capac- ity available. The company can make at most 20 units of the standard model, which would give a CM of $60 (20 units x $3 CM per unit). The company can make at most 24 units of the deluxe model, which would give a CM of $96 (24 units x $4 CM per unit). Some com- bination of standard and deluxe models may give the best results of all. The possible combinations of the two models are found by plotting the constraints on a graph. Once graphically displayed, the combinations are evaluated to find the one that gives the greatest CM. Because there is a linear relationship between usage of each con- straint and quantity of each mode! produced, the polishing and grinding constraints can be drawn as a straight line. The line connects the two points representing the maximum num- ber of units of each model that can be produced with each constraint. These points are:Chapter 21 > Differential Cost Analysis 21-19 When x= 0: y < 24 for the grinding constraint Ys 40 for the polishing constraint When y= 0: x s 60 for the grinding constraint Xx 20 for the polishing constraint A graph of the constraints is in Figure 21-1. The feasible area, bounded by the lines AB, BC, CD, and DA, represents all the combinations of standard and deluxe models that can be produced. Any combination outside the feasible area cannot be produced because there is not enough constraint available. The best feasible solution is always found at a comer of the feasible area. In the illus- trated graph, the comers are A, B, C, and D. To find which corner is best, each comer is evaluated as follows: A(x=0,y=0) = ($3)(0) +($4)(0) =$ OCM 8 , y= 24) = ($3)(0) + ($4)(24) = $ 96 CM © (x= 10, y= 20) = ($3)(10) + ($4)(20) = $110 CM D(x=20, y=0) = ($3)(20) + ($4)(0) = $ 60CM Total CM is maximized when 10 standard models and 20 deluxe models are produced and sold. This is the combination represented by corner C. The fact that the optimal solution is always at a comer can be demonstrated graphically. In Figure 21-1, notice that the largest quantities for each product combination occur at the farthest distances from point A; that is, the farthest away from 0 units of each product. Consequently, the maximum CM is found at some point on the line defined by points B, C, and D (called line BCD). To determine which point is best, the analyst constructs a series of CM lines as shown in Figure 21-2. All combinations of standard and deluxe represented by points on the same CM line will give the same total CM, ‘Total CM will increase the far- ther the CM line is from point A. The slope of a CM line is found by multiplying -1 by a ratio. The ratio is the CM from one unit of the product designated by the horizontal axis, divided by the CM from one unit of the product designated by the vertical axis. In this illustration, the slope is -3/4, Because total CM is $3x'+ $4y, a CM line representing any specified total CM is drawn by connecting two points: the point on the horizontal axis indicating the quantity of x required to yield the specified CM, and a point on the vertical axis indicating the quantity of y required to yield the same CM. The following points are computed for the CM ines on the graph in Figure 21-2. Total Quantity of xs Quantity of ys cM Required when y = 0 Required when x = 0 $48 $ 48CM=$3=16 units $ 48CM+$4=12 units 60 60CM: 3=20 units 60CM+ 4=15 units a4 84CM+ 3=28 units 840M 4=21 units 96 96CM+ 3=32 units 96CM+ 4=24 units 110 W10CM+ 3=36%units 100M 4=27'% units Notice in Figure 21-2 that the CM line is farthest from point. A when it intersects point C. Full use of available resources occurs only at the point where all the constraint equa- tions intersect, which is point C in this example. Full use of available resources does not necessarily give the optimal solution, though. For example, if CM from a unit of x is $1 instead of $3, the optimal solution is at point B instead of point C: $1(0) + $4(24) = $96 of CM at point B, but only $1(10) + $4(20) = $90 of CM at point C. Total CM at each cor- ner point must be computed and compared,21-20 Part 5 > sis of Costs and Profits If CM changes for one or both products, the slope of each CM line changes. If the change in slope is large enough, the optimal solution shifts to a different comer. If the slope of each CM line were equal to the slope of line BC, all points on line BC would be equally profitable. Notice that impossible for any point on line BC to be more profitable than both point B and point C. <¢—— Polishing Constraint, 4x+ 2y = 80 Hours DELUXE MODELS) 8 / o 1 2 0 0 5 w 7 (STANDARD MODELS) FIGURE 21-1 Graph Depicting Feasible Area FIGURE 21-2 Graph Depicting CM Lines and Optimal SolutionChapter 21 > Diterential Cost Analysis m2 Minimization of Cost In addition to maximizing contribution margin, linear programming can be used to mini- mize cost. Cost minimization is illustrated as follows. Assume a pharmaceutical firm is planning to produce exactly 40 gallons of a mixture in which the two ingredients, x and y, cost $8 per gallon and $15 per gallon, respectively. No more than 12 gallons of x can be used, though, and to ensure quality at least 10 gallons of y must be used. The firm wants to minimize cost. The objective function can be written as: Minimize cost = 8x + 15y ‘Subject to the following constraints: x+y=40 xs12 yz 10 ‘The optimal solution in this example is easy to see, because x is cheaper than y. The max- imum amount of x should be used (12 gallons), and the other 28 gallons required to make a 40-gallon total should consist of the more expensive y. In complex problems, solutions are not obvious, especially if there are many ingredients with many different types of constraints. ‘The graphic method can be applied to minimization problems. As with maximization, the constraints define the feasible area when graphed. Constraints in this example are graphed in Figure 21-3. FIGURE 21-3 Graph Depicting Feasible SolutionsChapter 21 > Differential Cost Analysis — constraints (21-18) feasible area (21-19) simplex method (21-22) Discussion Questions Q2i-t Q21-2 Q21-3 Q21-4 Qai-s Q21-6 Q21-7 Q21-8 Qai-9 Q21-10 Qat-L1 Q21-12 Q21-13 Q2i-14 Exercises E21-1 Give a broad definition of the term differential cost. What equivalent terms are used, and by whom? Distinguish between marginal cost and marginal costing (direct costing). Differential costs are also called incremental costs. Why are incremental costs important in decisions? Differential costs do not correspond to any possible accounting category. Explain. In what why is a flexible budget useful in preparing differential cost analyses? Why are historical costs usually irrelevant for decision making? Why is variable cost so important in differential cost studies? What are sunk costs? Explain how a fixed cost can be relevant in a decision. Define opportunity costs. (Appendix) What is linear programming? (Appendix) What kind of unit costs are used in linear programming? (Appendix) Examine the graph in Figure 21-1 and answer the following questions: (a) The area bounded by the lines AB, BC, CD, and AD is called the feasible area. Why? (b) The triangles BCF and CDE are not part of the feasible area. Why? (c) Which point in the feasible area designates the optimal solution? How can it be identified? (Appendix) What is the simplex method? Analysis of New Business. Hooper Insecticide Company is currently producing and selling 30 000 kilograms of Sta Ded monthly. This volume is 70% of capacity for Sta Ded. A whole- saler outside the company’s marketing area offers to buy 5 000 kilograms of this product per month on a two-year contract at $1.80 per kilogram, provided the present pinkish color can be changed to green. The product will be marketed under the wholesaler’s brand name.21-22 Key Terms Part 5 > Analysis of Costs and Profits The feasible area is confined to just the points on line AB. Any point on line AB rep- resents a total quantity of 40 gallons, of which more than 10 gallons will be y and at most 12 gallons will be x. As in maximization, the optimal solution will be on a corer of the feasible area. In this example, the only “corners” are points A and B. The corner points are evaluated to find the one that minimizes the objective function, cost. The values at the corners are: A(x= 0,y=40) B (x= 12, y=28) $8(0) + $15(40) = $600 total cost $8(12) + $15(28) = $516 total cost To minimize cost, the company should use 12 gallons of x and 28 gallons of y, for a total cost of $516. Simplex Method Linear programming problems with more than two constraints can be solved fairly easily with a graph. If there are more than two variables in the objective function, however, a graphical solution is generally not practical. A three-variable objective function requires a three-dimensional graph, which is certainly much more difficult than a two-dimensional graph. Four or more variables would require a four- or more-dimensional graph, which is not physically tractable. Fortunately, linear programming with any number of variables can be done algebraically by the simplex method. Based on matrix algebra, the simplex method algebraically evaluates each comer of the feasible area. Evaluation begins at the origin (point A in the above maximization example) and systematically moves from one comer to another until the optimal solution is found. Moves are selected to provide the largest improvement in the objective function, per unit of constraint. When the objective function can no longer be improved, the optimal solution has been found.” differential cost study (21-1) marginal revenue (21-1) incremental revenue (21-1) differential cost (21-1) marginal cost (21-1) incremental cost (21-1) out-of-pocket cost (21-2) avoidable cost (21-2) sunk costs (21-2) opportunity cost (21-2) imputed costs (21-2) cost analysis budgets (21-13) linear programming (21-17) objective function (21-18) —____ "An illustration ofthe simplex method is beyond the scope of this text. For a detailed discussion of the simplex method, see Dennis Grawoig, Decision Mathematics (New York: McGraw-Hil, 1967), pp. 54-72.21-24 E21-2 Part 5 >> Analysis of Costs and Profits To change the color, the company must purchase a mixing machine ut a cost of $3,000, The machine will have no value at the end of the two-yenr contract period. Ingredients to change the color in the finished product will cost $.01 per kilogram of product. Marketing expense will not be increased if the new business in accepted, but additional administrative expense of $150 per month is estimated. No additional cont for supervision or property tax is contemplated. Additional payroll taxes will be $210. A monthly income statement for the current operations is as follows: Sales. $72,000 Cost to manufacture: ty tax. Payroll taxes Cost of goods produced and sold 40.775 $22,225 15,500 L022 Required: Prepare a differential cost analysis to show whether the company should accept the proposed new business. Differential Cost Analysis. The Budgeting Department of Vester Manufacturing Corporation prepared the following schedule of factory overhead at various levels of production, 40% of 60% of 80% of 100% of Capacity Capacity Capacity Units of product.......... 100,000 150,000 200,000 260,000 Variable factory overhead $ 50,000 $ 75,000 $100,000 $126,000 Fixed factory overhead...... 90,000 100,000 118,000 126,000 The company manufactures gaskets for natural gas pipelines. In recent months, legisla- tion unfavorable to gas transmission firms has been pending in the legislature, and customer orders have been minimal. For example, in December only 150,000 gaskets were manufac- tured, representing 60% of capacity. At that level of production, direct materials and direct labor cost $150,000 and $112,500, respectively. Economic indicators point to higher future production costs, so management is considering stepping up January production to 100% of capacity (an additional 100,000 units) to build up inventory while costs are low. Required: (1) Determine the cost of the additional 100,000 units of product. (2) Compute the total cost of producing 250,000 units in January. (3) Determine the sales price required for January production to achieve a 20% markup on production cost.21-26 E21-6 Part 5 > Analysis of Costs and Profits an annual cost of $40,000. Alternatively, the company can purchase the required num- ber of pistons of equal quality from Wichita Machine Works, an outside supplier, at a contract price of $4.40 each. The projected cost of manufacturing 80,000 pistons at the Tuscon plant is as follows: Direct materials Direct labor. ‘ n Allocated factory overhead Total cost of 80,000 pistons... ‘The Tuscon plant uses a predetermined factory overhead rate computed on the basis of absorption costing, Budgeted factory overhead used as the basis for determining the rate was composed of 80% fixed cost and 20% variable cost. Required: Determine whether Creed Corporation should manufacture the pistons in its Tuscon plant or purchase them from Wichita Machine Works. Decision to Drop a Product. The Grable Company manufactures and sells three products, Mift, Tift, and Lift. For the coming year, sales are expected to be as follows: Product Sales Price Quantity Total Sales $10 5,000 $50,000 6 7,000 42,000 15 3,000 45,000 $137, 200 At the expected sales quantity and mix, the manufacturing cost per unit is as follows: Mitt Tit Lift $2 $2 $4 2 1 3 1 1 2 a a 3 & & &2 Variable marketing expense is $1 per unit for Mift and Tift and $2 per unit for Lift. Budgeted fixed marketing expenses for the coming year are $3,000, and budgeted fixed administrative expenses are $6,000. The sales manager has recommended dropping Tift from the product line and using the production capacity currently committed to the production of Tift to produce more Mift. The production manager reports that 4,000 additional units of Mift can be produced with the pro- duction capacity now used in manufacturing Tift. To sell 4,000 additional units of Mift, the sales manager believes that the advertising budget will have to be increased by $5,000. Required: (1) Should the sales manager's proposal be accepted? Support your answer by computing the change in profitability that would result from this action. (2) In addition to the factors mentioned by the production manager and the sales manager, what other factors should be considered? CGA-Canada (adapted). Reprint with permission.Chapter 21 > Differential Cost Analysis 21-25 E21-3 E21-4 E21-5 Special Order. Over the past few months, Wilson Tech Company produced and sold 10,000 units of Wartex each month. Monthly costs for Wartex are as follows: Direct materials. $ 20,000 Direct labor... 35,000 Variable factory overhead 10,000 Fixed factory overhead ... 45,000 Variable marketing expenses (shipping and sales commissions) 20,000 Allocated marketing and administrative expenses. — 90,000 Total costs $180,000 The normal sales price is $25 per unit. One of the company’s salespersons has been negotiating a contract with a prospective customer who has offered to purchase 15,000 units of Wartex for $12.50 per unit. The salesperson does not expect any repeat business from this customer after this sale and does not believe that this sale will affect the normal sales of Wartex. The company has a production capacity sufficient to produce only 15,000 units of Wartex. As a consequence, the company would have to rent additional equipment at a cost of $5,000 and pay overtime in the amount of $10,000 to manufacture the addi- tional quantity of Wartex required. Required: Prepare a differential cost analysis showing whether the company should accept this special order. Make or Buy. Huntington Products manufactures 10,000 units of Part M-1 annually for use in its production. The following costs are reported: Direct material ead Fixed factory overnead.. Lufkin Company has offered to sell Huntington 10,000 units of Part M-1 annually for $18 per unit. If Huntington accepts the offer, some of the facilities presently used to man- ufacture Part M-1 could be rented to a third party at an annual rental of $15,000. ‘Additionally, $4 per unit of the fixed factory overhead applied to Part M-1 would be totally eliminated. Required: Should Huntington accept Lufkin’s offer? Explain. (AICPA adapted) Make or Buy. Creed Corporation is considering manufacturing a new engine designated as model VX4. The engine will be a different size from any produced by Creed, and the company expects to sell 20,000 units a year. At the present time the company has the capacity to produce the projected quantity of all of the parts required for 20,000 units of VX4 except for the pistons. Each model VX4 engine requires 4 pistons, so 80,000 pis- tons will be required annually. Pistons are manufactured in the company’s Tuscon plant, which is presently operating at full capacity. None of the company’s other plants has the equipment or the expertise necessary to manufacture pistons. To manufacture the num- ber of pistons required, the company can expand facilities at the Tuscon plant by renting additional machinery at an annual cost of $30,000 and hiring an additional supervisor atClegg 21 De ‘Deirealel Cont Aneta ne E21-7 E21-8 Sell or Process Further. Twister Company produces a variety of cleaning compounds and solutions for both industrial and household use. One of its products, a coarse cleaning pow- der called Grit 337, has a variable manufacturing cost of $1.60 and sells for $2 per pound. A small portion of this product’s annual production is retained for further processing in the Mixing Department, where it is combined with several other ingredients to form a paste that is marketed as a silver polish selling for $4 per jar. The further processing Tequires one fourth of a pound of Grit 337 per jar; other ingredients, labor, and variable factory overhead associated with further processing cost $2.50 per jar, and unit variable marketing cost is $.30. If a decision is made to cease silver polish production, $5,600 of fixed Mixing Department costs will be avoided. Required: Calculate the minimum number of jars of silver polish that must be sold to jus- tify further processing Grit 337. (ICMA adapted) Minimum Bid Price. Hall Company specializes in packaging bulk drugs in standard dosages for local hospitals. The company has been in business since 20A and has been profitable since its second year of operation. D. Greenway, director of cost accounting, installed a standard cost system after joining the company in 20E. Wyant Memorial Hospital has asked Hall to bid on the packaging of one million doses of medication at full cost plus a return on full cost of no more than 9% after income taxes. Wyant defines cost as including all variable costs of performing the service, a reasonable amount of nonvariable overhead, and reasonable administrative costs. The hospital will supply all packaging materials and ingredients. Wyant has indicated that any bid over $.015 per dose will be rejected. Greenway accumulated the following information prior to the preparation of the bid. Direct tabor..... $ 5.00 per hour Variable factory $ 2.00 per direct labor hour Fixed factory overhead. $ 5.00 per direct labor hour Administrative costs $1,000 for the order Production rate. 1,000 doses per direct labor hour Hall Company is subject to an effective income tax rate of 40%. Required: (1) Calculate the minimum bid price per dose that Hall Company can bid for the Wyant Memorial Hospital job and not reduce Hall’s net income. (2) Calculate the bid price per dose using the full cost criterion and the maximum allow- able return specified by Wyant Memorial Hospital. (3) Without prejudice to your answer to requirement 2, assume that the price per dose that Hall Company calculated using the cost-plus criterion specified by Wyant Memorial Hospital is greater than the maximum bid of $.015 per dose specified by Wyant. What factors should Hall Company consider before deciding whether to submit a bid at the maximum price of $.015 per dose? (4) What factors should Wyant Memorial Hospital have considered before deciding whether to employ cost-plus pricing? (ICMA adapted)21-28 E21-9 E21-10 Part 5 > Analysis of Costs and Profits Alternative Cash Collection Methods. WashTech Corporation is a franchiser of auto- matic car washes in the southeast. The company has 420 franchisees that operate 7 days per week. The average gross revenue for each location is $500 per day. The company col- lects 25% of the gross revenue as its franchise fee. Each franchisee mails a check each day to the company headquarters in Miami. The check is supposed to be mailed by noon each day. Many of the franchisees are lax, however, and payments are forwarded an average of 2 days late. Once mailed, the checks take an average of 1¥ days in the mail and another 3 days to be processed in the company’s receivables department. Management is considering a change in the company’s cash collection method and is considering two proposals, denoted a and b. The company has a 15% before-tax opportu- nity cost of funds and is subject to an income tax rate of 40%. (a) Use local messenger services to collect and mail checks. This will save the 2 days of late check forwarding. The messenger service costs $20,000 per year. (b) Combine messenger service with a lock-box arrangement for a combined savings of 5 days. Costs of this proposal are $20,000 per year for messenger service plus $15,000 that must be left on deposit as a compensating balance required by the bank servicing the lock-box. Required: Compute the annual change in the company’s before-tax income that will result from the each of the two proposals. (ICMA adapted) Choice of Production Method. PrintBoard Company is evaluating the use of AZ-17 Photo Resist for the manufacture of printed circuit boards. The major advantages of this process over the present silk-screen method include: (a) Anticipated reduced manufacturing cycle time and cost due to elimination of the need for silk circuit screens and shorter operator time to produce circuit boards. (b) Improved ease of registration between front and back patterns. (©) The ability to achieve finer line widths and closer spacing between circuit paths. The proposed AZ-17 process is as follows: (a) Fabricate through the completion of the drilling and copper plating of inside holes. (b) Pressure spray AZ-17 Photo Resist on one side, over bake for 10 minutes, and repeat for other side. (c) Use the photo negative and expose each side for seven minutes in a Nu-Are Printer. (d) Develop in AZ-17 Developer and proceed through normal operations for making printed circuit board. Total direct labor time for the proposed AZ-17 process is 30 minutes, The original silk- screen method uses a wire mesh stencil film, screening ink, and frames. The direct labor time to prepare the screen for each circuit board is 1% hours. The direct labor time to screen patterns on the printed wire board is 20 minutes. The hourly direct labor rate is $6.50. The monthly cost for materials and for equipment rental and operation needed for the proposed process is $4,000 greater than for the silk-screen method, excluding the direct labor. The company manufactures 20,000 circuit boards annually. Required: Compute the annual savings or added cost from changing from the silk-screen method to the new AZ-17 process, (Round all computations to the nearest dollar.)Chapter 21 > Differential Cost Analysis 21-29 E21-11 (Appendix) Linear Programming—Maximization. Fountainhead Company manufac- tures two types of display boards that are sold to office supply stores. One board is hard- finished marking board that can be written on with a water-soluble felt-tip marking pen and then wiped clean with a cloth. The other is a conventional cork-type tack board. Both boards pass through two manufacturing departments. All raw materials (board base, board covering, and aluminum frames) are cut to size in the Cutting Department. Both types of boards are the same size and use the same aluminum frame. The boards are assembled in either the Automated Assembly Department or the Labor Assembly Department. The Automated Department is a capital intensive assembly operation. This department has been in operation for 18 months and was intended to replace the Labor Assembly Department. However, business expanded so rapidly that both assembly opera- tions are needed and used. The final results of the two assembly operations are identical. The only difference between the two is the proportion of machine time versus direct labor in each department and, thus, different costs. However, workers have been trained for both operations so that they can be switched between the two operations. The company produced and sold 600,000 marking boards and 900,000 tack boards last year. Management estimates that the total unit sales volume for the coming year will increase 20% if the units can be produced. The company has contracts to produce and sell 30,000 units of each board each month, Sales, production, and cost incurrence are uniform throughout the year. The company has a monthly maximum labor capacity of 30,000 direct labor hours in the Cutting Department and 40,000 direct labor hours for the assembly oper- ations (Automated Assembly and Labor Assembly Departments combined). It takes 12 minutes of labor in the Cutting Department for both kinds of boards. The Automated Assembly Department requires 3 minutes of labor for each board, regardless of type, and the Labor Assembly Department requires 15 minutes of labor per board. Data regarding the two products and their manufactures follow: Marking Tack Board Sales price per unit. $60.00 $45.00 Variable marketing expenss 3.00 3.00 Material Base... 6.00 6.00 ‘Covering. 14.50 7.75 Frame. 8.25 8.25 Direct labor Cutting Department... 2.00 2.00 ‘Automated Assembly Department “60 “60 Labor Assembly Department, 3.00 3.00 Variable factory overhead: Cutting Department... 2.45 2.45 ‘Automated Assembly 3.30 3.30 Labor Assembly Department, 2.25 2.25 Machine Hour Data Automated Labor Cutting Assembly Assembly tment Department Department j 05 02 25,000 5,000 1,500 300,000 60,000 18,000 Machine hours required per board Monthly machine hours available ‘Annual machine hours availablE21-12 E21-13 E21-14 E21-15 Part 5 > Analysis of Costs and Profits Required: Assuming the company wants to maximize profits, give the linear program- ming objective function and constraints. (ICMA adapted) (Appendix) Graphical Linear Programming—Maximization. Folders Office Supply makes two types of paper pads, legal and regular. A box of legal pads requires 20 minutes to produce and a box of regular pads requires 10 minutes to produce. Two people work on the production line, which operates 7.5 hours per day, 5 days a week. The company can sell any combination of boxes of legal and regular pads up to a maximum of 300 boxes of pads per week. The legal pads have a contribution margin of $18 a box and the regular pads have a contribution margin of $12 a box. Required: Using the graphic method, determine the quantity of legal and regular pads that should be produced daily to maximize total contribution margin. CGA-Canada (adapted). Reprint with permission. (Appendix) Graphical Linear Programming—Maximization. Berle Inc. manufactures two kinds of leather belts—Belt A (a high-quality belt) and Belt B (of a lower quality). The respective contribution margins are $4 and $3 per belt. Production of Belt A requires twice as much time as Belt B. If all belts are of the Belt B type, the company can produce 1,000 per day. The leather supply is sufficient for only 800 belts per day (both Belt A and Belt B combined). Belt A requires a fancy buckle, and only 400 buckles per day are available for this belt. Required: Using the graphic method, determine the quantity of each type of belt that will maximize the total contribution margin. (Appendix) Graphical Linear Programming—Minimization. Ajax Company produces three products, A, B, and C, using materials X and Y. Material X costs $3 per ton and Y costs $4 per ton. The amount of materials required per ton of product and the required weight per ton of product are as follows: Pounds of Pounds of Pounds of Product Product Product C Material X 4 7 15 Material Y ... : 8 2 5 Minimum weight required 32 14 15 Required: Using the graphic method, determine the number of tons of each material needed to meet the requirements at minimum cost. (Appendix) Graphical Linear Programming—Minimization. Cecille Paper Company uses softwood and hardwood pulp as basic materials for producing converter-grade paper. Hardwood is 80% pulp fiber and 20% pulp binder, while softwood is 50% pulp fiber and 50% pulp binder. The cost per pound for hardwood and softwood is $.50 and $.40, respectively. The company’s quality control expert specifies that in order for the product to meet quality standards, each batch must contain at least 12,000 pounds of pulp fiber and at least 6,000 pounds of pulp binder. Because of equipment limitations, the size of a batch cannot exceed 24,000 pounds.Chapter 21> Ditterential Cost Analysis 21-31 The Production Department recently received a new standard from the Cost Department, allowing $8,200 per batch. The production manager feels that this amount is too low, because such costs have never been less than $8,400. Required: Using the graphic method, determine the hardwood and softwood mix neces- sary to minimize the cost per batch. Problems P21-1 Special Order Analysis. The Sommers Company, located in southern Wisconsin, manu- factures several types of industrial valves and pipe fittings that are sold to customers in nearby states. Currently, the company is operating at about 70% of capacity and is earning a satisfactory return on investment. Management has been approached by Glasgow Industries Ltd. of Scotland with an offer to buy 120,000 units of a pressure valve. Glasgow Industries manufactures a valve that is almost identical to Sommers’ pressure valve; however, a fire in Glasgow's valve plant has shut down its manufacturing operations, Glasgow needs the 120,000 valves over the next four months to meet commitments to its regular customers; the company is pre- pared to pay $19 each for the valves, FOB destination. Sommers’ product cost for the pressure valve, based on currently attainable standards, is: $ 5.00 6.00 Applied factory overhead Total standard cost per unit.. Factory overhead is applied to production at the rate of $18 per standard direct labor hour. The overhead rate is comprised of the following components: Variable factory overhead .......... $6.00 Fixed factory overhead: Directly traceable to the product... 8.00 Allocated common cost... 4.00 Applied factory overhead rate... $18.00 Additional costs incurred in connection with sales of the pressure valve include sales commissions of 5% and shipping expense of $1,00 per unit. However, the company will not pay sales commission on the Glasgow special order because it came directly to the company and no salespersons were involved in obtaining the order. To determine the sales prices of its products, Sommers adds a 40% markup on prod- uct cost. This results in a $28 suggested selling price for the pressure valve. The Marketing Department, however, has set the current selling price at $27 to maintain the company’s market share. Production management believes that it can handle the Glasgow order without disrupt- ing its scheduled production. However, the order will require additional fixed factory over- head of $12,000 per month in the form of supervision and clerical costs. If management accepts the order, 30,000 pressure valves will be manufactured and shipped to Glasgow each month for the next four months. Shipments will be made weekly, FOB destination21-32, P21-2 Part 5 > Analysis of Costs and Profits Required: (1) Prepare a differential cost analysis showing the impact of accepting the Glasgow Industries order. (2) Calculate the minimum unit price that Sommers’ management can accept for the Glasgow order without reducing net income. (3) Identify factors than price that Sommers’ management should consider before accept- ing the Glasgow order. (ICMA adapted) Special Order Analysis, Framar Inc. manufactures automation machinery according to ‘customer specifications. The company is relatively new and has grown each year. Framar operated at about 75% of practical capacity during its most recent fiscal year ended September 30, with the following operating results (000s omitted): Sales... Less sales commissions. Net sales..... Direct materials ... Direct labor. 38 Income tax (40%). Net income... St ke | $25,000 2,500 $22,500 $ 6,000 7,500 Framar management has developed a pricing formula based on current operating costs, which are expected to prevail for the next year. This formula was used in developing the following bid for APA Inc.: Direct materials cost Direct labor cost... - Factory overhead calculated at 50% of direct labor. Corporate overhead calculated at 10% of direct labor Total cost, excluding sales commission ‘Add 25% for profit and tax... ‘Suggested price (with profit) before sales commission 0... Suggested total price (suggested price divided by 9 to adjust for 10% sales commission) . Required: (1) Compute the impact on net income if APA accepts the bid. (2) Determine the suggested decision if APA is willing to pay only $127,000. (3) Calculate the lowest price Framar can quote without reducing current net income. (4) Determine the effect on the most recent fiscal year’s profit if all work is done at prices similar to APA's $127,000 counteroffer. (ICMA adapted)