SOLUTIONS TO SEATWORK #1

STRATEGIC COST MANAGEMENT

SISC

Problem 1 (Close or Retain a Store)

Requirement 1
The simplest approach to the solution is:
Gross margin lost if the store is closed ......................................................... P(228,000)
Less costs that can be avoided:
Direct advertising ..................................................................................... P36,000
Sales salaries ........................................................................................... 45,000
Delivery salaries ....................................................................................... 7,000
Store rent ................................................................................................. 65,000
Store management salaries (new employee would not be hired to fill vacant
position at another store) .................................................................... 15,000
General office salaries ............................................................................. 8,000
Utilities ..................................................................................................... 27,200
Insurance on inventories (2/3 × P9,000) .................................................. 6,000
Employment taxes* .................................................................................. 9,000 218,200
Decrease in company net operating income if the Ortigas Store is closed .. P( 9,800)
*Salaries avoided by closing the store:
Sales salaries ..................................................................................................................... P45,000
Delivery salaries ................................................................................................................. 7,000
Store management salaries ............................................................................................... 15,000
General office salaries........................................................................................................ 8,000
Total salaries ...................................................................................................................... 75,000
Employment tax rate .......................................................................................................... × 12%
Employment taxes avoided ................................................................................................ P 9,000

Requirement 2
The Ortigas Store should not be closed. If the store is closed, overall company net operating income
will decrease by P9,800 per quarter.

Requirement 3
The Ortigas Store should be closed if P200,000 of its sales are picked up by the Makati Store. The net
effect of the closure will be an increase in overall company net operating income by P76,200 per
quarter:
Gross margin lost if the Ortigas Store is closed....................................................................................... P(228,000)
Gross margin gained at the Makati Store:
P200,000 × 43% ................................................................................................................................. 86,000
Net loss in gross margin .......................................................................................................................... (142,000)
Costs that can be avoided if the Ortigas Store is closed (part 1)............................................................. 218,200
Net advantage of closing the Ortigas Store ............................................................................................. P 76,200
Problem 2 (Shutting Down or Continuing to Operate a Plant)

Requirement 1
Product KK-8 yields a contribution margin of P14 per gallon (P35 – P21 = P14). If the plant closes,
this contribution margin will be lost on the 22,000 gallons (11,000 gallons per month × 2 = 22,000
gallons) that could have been sold during the two-month period. However, the company will be able to
avoid certain fixed costs as a result of closing down. The analysis is:

Contribution margin lost by closing the plant for two months (P14 per gallon × 22,000 gallons) P(308,000)
Costs avoided by closing the plant for two months:
Fixed manufacturing overhead cost (P60,000 × 2 months = P120,000) ................. P120,000
Fixed selling costs (P310,000 × 10% × 2 months) .................................................. 62,000 182,000
Net disadvantage of closing, before start-up costs ...................................................... (126,000)
Add start-up costs ........................................................................................................ (14,000)
Disadvantage of closing the plant ................................................................................ P(140,000)

No, the company should not close the plant; it should continue to operate at the reduced level of 11,000
gallons produced and sold each month. Closing will result in a P140,000 greater loss over the two-
month period than if the company continues to operate. Additional factors are the potential loss of
goodwill among the customers who need the 11,000 gallons of KK-8 each month and the adverse effect
on employee morale. By closing down, the needs of customers will not be met (no inventories are on
hand), and their business may be permanently lost to another supplier.

Alternative Solution:
Difference—Net
Operating Income
Plant Kept Open Plant Closed Increase (Decrease)
Sales (11,000 gallons × P35 per gallon × 2) ........................................ P 770,000 P 0 P(770,000)
Less variable expenses (11,000 gallons × P21 per gallon × 2) ........... 462,000 0 462,000
Contribution margin ............................................................................. 308,000 0 (308,000)
Less fixed costs:
Fixed manufacturing overhead cost (P230,000 × P170,000 × 2) .. 460,000 340,000 120,000
Fixed selling cost (P310,000 × 2; P310,000 × 90% × 2) ................ 620,000 558,000 62,000
Total fixed cost ..................................................................................... 1,080,000 898,000 182,000
Net operating loss before start-up costs .............................................. (772,000) (898,000) (126,000)
Start-up costs ....................................................................................... (14,000) (14,000)
Net operating loss ................................................................................ P (772,000) P(912,000) P(140,000)

Requirement 2
Ignoring the additional factors cited in part (1) above, Kristin Company should be indifferent between
closing down or continuing to operate if the level of sales drops to 12,000 gallons (6,000 gallons per
month) over the two-month period. The computations are:
Cost avoided by closing the plant for two months (see above) ............................................ P182,000
Less start-up costs ............................................................................................................... 14,000
Net avoidable costs .............................................................................................................. P168,000

Net avoidable costs P168,000

=
Contribution margin per gallon P14 per gallon
= 12,000
gallons
Verification: Operate at 12,000
Gallons for Two Close for Two
Months Months
Sales (12,000 gallons × P35 per gallon)........................................................... P 420,000 P 0
Less variable expenses (12,000 gallons × P21 per gallon) .............................. 252,000 0
Contribution margin .......................................................................................... 168,000 0
Less fixed expenses:
Manufacturing overhead (P230,000 and P170,000 × 2 months) ................. 460,000 340,000
Selling (P310,000 and P279,000 × 2 months) ............................................. 620,000 558,000
Total fixed expenses ......................................................................................... 1,080,000 898,000
Start-up costs ................................................................................................... 0 14,000
Total costs ......................................................................................................... 1,080,000 912,000
Net operating loss ............................................................................................. P (912,000) P(912,000)

Problem 3 (The Economists’ Approach to Pricing)

Requirement (1)
The postal service makes more money selling the souvenir sheets at the lower price, as shown below:
P500 Price P600 Price
Unit sales ................................................................. 50,000 40,000

Sales P25,000,000 P24,000,000

Cost of goods sold @ P60 per unit .......................... 3,000,000 2,400,000
Contribution margin .................................................. P22,000,000 P21,600,000

Requirement (2)

The price elasticity of demand, as defined in the text, is computed as follows:

In(1 + % change in quantity sold)

d =
In(1 + % change in price)
40,000 – 50,000
In(1 + )
50,000
=
600.00 – 500.00
In(1 + )
500.00

In(1 – 0.2000)
=
In(1 + 0.2000)
In(0.8000)
=
In(1.2000)

= –0.2231
0.1823
= –1.2239
 Requirement (3)

The profit-maximizing price can be estimated using the following formulas:

Profit-maximizing –1
=
markup on variable cost 1+ d
–1
= = 4.4663
1 + (–1.2239)
Profit-maximizing Profit-maximizing Variable cost
= 1 + x
price markup on variable cost per unit

= (1 + 4.4663) x P60 = P328

This price is much lower than the price the postal service has been charging in the past. Rather than
immediately dropping the price to P328, it would be prudent for the postal service to drop the price a
bit and observe what happens to unit sales and to profits. The formula assumes that the price elasticity
of demand is constant, which may not be true.

The critical assumption in the calculation of the profit-maximizing price is that the percentage increase
(decrease) in quantity sold is always the same for a given percentage decrease (increase) in price. If this
is true, we can estimate the demand schedule for souvenir sheets as follows:
Price* Quantity Sold§
P600 40,000
P500 50,000
P417 62,500
P348 78,125
P290 97,656
P242 122,070
P202 152,588
P168 190,735
P140 238,419
P117 298,024

*
The price in each cell in the table is computed by taking 5/6 of the price just above it in the table. For
example, P500 is 5/6 of P600 and P417 is 5/6 of P500.
§
The quantity sold in each cell of the table is computed by multiplying the quantity sold just above it in
the table by 50,000/40,000. For example, 62,500 is computed by multiplying 50,000 by the fraction
50,000/40,000.

The profit at each price in the above demand schedule can be computed as follows:

Price Sales Cost of Sales

(a) Quantity Sold (b) (a) × (b) P60 × (b) Contribution Margin
P600 40,000 P24,000,000 P2,400,000 P21,600,000
P500 50,000 P250,00,000 P3,000,000 P22,000,000
P417 62,500 P26,062,500 P3,750,000 P22,312,500
P348 78,125 P27,187,500 P4,687,500 P22,500,000
P290 97,656 P28,320,200 P5,859,400 P22,460,800
P242 122,070 P29,540,900 P7,324,200 P22,216,700
P202 152,588 P30,822,800 P9,155,300 P21,667,500
P168 190,735 P32,043,500 P11,444,100 P20,599,400
P140 238,419 P33,378,700 P14,305,100 P19,073,600
P117 298,024 P34,868,800 P17,881,400 P16,987,400
 The contribution margin is plotted below as a function of the selling price:

23,000,000

22,000,000

21,000,000
Contribution Margin

20,000,000

19,000,000

18,000,000

17,000,000
100.00 200.00 300.00 400.00 500.00 600.00

Selling Price
The plot
confirms that the profit-maximizing price is about P328.

Requirement (4)

If the postal service wants to maximize the contribution margin and profit from sales of souvenir sheets,
the new price should be:
Profit-maximizing price = 5.4663 × P70 = P383
Note that a P100 increase in cost has led to a P55 (P383 – P328) increase in the profit-maximizing
price. This is because the profit-maximizing price is computed by multiplying the variable cost by
5.4663. Since the variable cost has increased by P100, the profit-maximizing price has increased by
P100 × 5.4663, or P55.
Some people may object to such a large increase in price as “unfair” and some may even suggest that
only the P10 increase in cost should be passed on to the consumer. The enduring popularity of full-cost
pricing may be explained to some degree by the notion that prices should be “fair” rather than calculated
to maximize profits.