Accounting and Financial Management

Tutorial 10 Contribution analysis for decision-making 2

MAKE OR BUY?

Sonic Company

(a)
Net Income
Increase
Make Buy (Decrease)
Direct Materials (100,000 × $16) $1,600,000 $ 0 $1,600,000
Direct Labour (100,000 × $18) 1,800,000 0 1,800,000
Variable Manufacturing Costs ($1,800,000 × 50%) 900,000 0 900,000
Purchase Price (100,000 × $40) 0 4,000,000 (4,000,000)
Total annual cost $4,300,000 $4,000,000 $ 300,000

(b) The filters should be purchased from the outside supplier. As indicated, the company's net income
would increase by up to $300,000 by purchasing the filters.

Sharifah Ltd

(a) Relevant Costs to Make

Direct materials 12.00
Direct labour 8.25
Variable manufacturing overhead 1.50
Fixed manufacturing overhead, traceable 3.00
Total relevant cost to make 24.75
Purchase price 30.00
Saving if made 5.25
× 180,000 units $945,000

Decision: The company should make the component.

(b) Non-financial considerations

– Better control over quality of the switches.
– The company’s expertise in making the switches.
– Reliability of supply of materials and labour to make the switches.
– Long-term relationship with suppliers of switches.
– How long will the idle capacity be available for – does the company expect the reduction in
output to be short-term or long-term?
– etc.

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Accounting and Financial Management

RETAINING OR REPLACING EQUIPMENT

Net income
increase
Retain machine Replace machine (decrease)
Operating costs (annual cost × 5 years) $120,000 $100,000 $20,000
New machine cost (depreciation) 0 21,000 (21,000)
Salvage value (old) 0 (5,000) 5,000
$120,000 $116,000 $4,000

The current machine should be replaced. The incremental analysis shows that net income for the
five-year period will be $4,000 higher by replacing the current machine.

DROPPING OR RETAINING A SEGMENT

(a) & (b)

Division A Division B
Sales $504,000 $948,000
Variable costs of goods sold
($440,000 × 0.85; $930,000 × 0.75) 374,000 697,500
Variable S, G & A
($96,000 × 0.45; $202,500 × 0.45) 43,200 91,125
Total variable costs 417,200 788,625
Contribution margin $ 86,800 $159,375

Division A Division B
Fixed costs of goods sold
($440,000  0.15; $930,000  0.25) $ 66,000 $232,500
Fixed S, G & A
($96,000  0.55; $202,500  0.55) 52,800 111,375
Total fixed costs $118,800 $343,875
Fixed costs savings if shutdown
($118,800 × 0.55; $343,875 × 0.55) $ 65,340 $189,131

Division A Division B
Lost contribution $(86,800) $(159,375)
Avoidable fixed cost 65,340 189,131
Difference $(21,460) $ 29,756

Division A’s contribution margin of $86,800 more than covers its avoidable fixed costs of $65,340. The
difference of $21,460 helps cover the company’s unavoidable fixed costs.

Because $65,340 of Division A’s fixed costs are avoidable, the remaining $53,460 is unavoidable and
will be incurred regardless of whether Division A continues to operate. Division A’s $32,000 loss is the
rest of the unavoidable fixed costs ($53,460 – $21,460).

If Division A is closed, the remaining divisions will need to generate sufficient profits to cover the entire
$53,460 unavoidable fixed cost. Consequently, Division A should not be closed because it helps defray
$21,460 of this cost. Closing Division A will reduce overall company profit by $21,460.

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Accounting and Financial Management

Division B is currently incurring $171,938 in fixed costs that it could have avoided while earning only
$159,375 in contribution margin. Based strictly on financial considerations, Division B should be
closed because the company will save $12,563.

An alternative set of calculations is as follows:

Division A Division B
Total variable costs $417,200 $788,625
Avoidable fixed costs if shutdown 65,340 189,131
Total cost savings if shutdown 482,540 977,756
Loss of revenues if shutdown (504,000) (948,000)
Cost savings minus loss of revenues $ (21,460) $ 29,756

Division A should not be shut down because loss of revenues if Division A is shut down exceeds cost
savings by $21,460. Division B should be shut down because cost savings from shutting down Division
B exceeds loss of revenues by $29,756.

(c) Before deciding to close Division B, management should consider the role that the Division’s
product line plays relative to other product lines. For instance, if the product manufactured by Division
B attracts customers to the company, then dropping Division B may have a detrimental effect on the
revenues of the remaining divisions. Management may also want to consider the impact on the morale
of the remaining employees if Division B is closed. Talented employees may become fearful of losing
their jobs and seek employment elsewhere.

Regal Cycle Company

Total Cost
Assigned to
Racing Bikes Avoidable
$ $
Fixed expenses:
Advertising, traceable 6 6
Depreciation of special equipment 8 -
Salaries of product-line managers 10 10
Allocated common fixed expenses 12 -
Total fixed expenses 36 16

$
Contribution lost if the racing bikes line is discontinued (27)
Less fixed costs that can be avoided if the racing bikes line is discontinued 16
Decrease in overall company net operating income (11)

The fixed costs that are avoidable by dropping the racing bikes line ($16,000) are less than the
contribution that will be lost ($27,000). Therefore, based on the data given, the racing bikes line
should not be discontinued.

The decision may different if the company can find a more profitable use for the special equipment
that is currently used for the racing bikes.

Alternative presentation of analysis using a comparative format for product-line analysis:

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Difference: Net
Operating
Income
Keep Drop Increase
Racing Bikes Racing Bikes (Decrease)
$ $ $
Sales 60 0 (60)
Variable manufacturing and selling expenses 33 0 33
Contribution 27 0 (27)
Fixed expenses:
Advertising, traceable 6 0 6
Depreciation of special equipment 8 8 0
Salaries of product-line managers 10 0 10
Allocated common fixed expenses* 12 12 0
Total fixed expenses 36 20 16
Net operating income (loss) (9) (20) (11)

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