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Chapter 16 The Behavior of Costs 481

equipment and delivery cars were purchased with cash. Mr. Solid has noticed that ex-
penses for utilities and supplies have been rather constant.
Mr. Solid increased his business between 1999 and 2001. Profits have more than dou-
bled since 1999. Mr. Solid does not understand why his profits have increased faster than
his volume.
A projected income statement for 2002 has been prepared by the accountant and is
shown below:

Projected Income Statement

For the Year Ended December 31, 2002

Sales $308,000
Cost of food sold $92,400
Wages & fringe benefits of restaurant help 26,650
Wages & fringe benefits of delivery persons 54,100
Rent 15,500
Accounting services 10,900
Depreciation of delivery equipment 16,000
Depreciation of restaurant equipment 8,000
Utilities 7,165
Supplies (soap, floor wax, etc.) 10,645
_______ 241,360
________
Income before taxes 66,640
Income taxes 19,992
________
Net Income $________
46,648
________

Note: The average pizza sells for $8.50. Assume that Mr. Solid pays out 30 percent of his income in income taxes.

Required:
a. What is the break-even point in number of pizzas that must be sold?
b. What is the cash flow break-even point in number of pizzas that must be sold?
c. If Mr. Solid withdraws $14,400 for personal use, how much cash will be left from
the 2002 income-producing activities?
d. Mr. Solid would like an after-tax net income of $60,000. What volume must be
reached in number of pizzas in order to obtain the desired income?
e. Briefly explain to Mr. Solid why his profits have increased at a faster rate than his
sales.
f. Briefly explain to Mr. Solid why his cash flow for 2002 will exceed his profits.

Cases
Case 16–1
Hospital Supply, Inc.*
Hospital Supply, Inc., produced hydraulic hoists that The costs of manufacturing and marketing hydraulic
were used by hospitals to move bedridden patients. hoists at the company’s normal volume of 3,000 units
* Copyright © by Michael W. Maher, University of California, per month are shown in Exhibit 1.
Davis.
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482 Part 2 Management Accounting
EXHIBIT 1 Costs per Unit for Hydraulic Hoists
Unit manufacturing costs:
Variable materials
Variable labor
Variable overhead
Fixed overhead
Total unit manufacturing costs
Unit marketing costs:
Variable
Fixed
Total unit marketing costs
Total unit costs
Questions
The following questions refer only to the data given in
Exhibit 1. Unless otherwise stated, assume there is no
connection between the situations described in the
questions; treat each independently. Unless otherwise
stated, assume a regular selling price of $4,350 per
unit. Ignore income taxes and other costs not men-
tioned in Exhibit 1 or in a question itself.
1. What is the break-even volume in units? In sales
dollars?
2. Market research estimates that monthly volume
could increase to 3,500 units, which is well within
hoist production capacity limitations, if the price
were cut from $4,350 to $3,850 per unit. Assuming
the cost behavior patterns implied by the data in
Exhibit 1 are correct, would you recommend that
this action be taken? What would be the impact on
monthly sales, costs, and income?
3. On March 1, a contract offer is made to Hospital
Supply by the federal government to supply 500
units to Veterans Administration hospitals for deliv-
ery by March 31. Because of an unusually large
number of rush orders from its regular customers,
Hospital Supply plans to produce 4,000 units during
March, which will use all available capacity. If the
government order is accepted, 500 units normally
sold to regular customers would be lost to a com-
petitor. The contract given by the government would
reimburse the government’s share of March produc-
tion costs, plus pay a fixed fee (profit) of $275,000.
$550
825
420
660
____
$2,455
275
770
____
1,045
______
$3,500
______
______
(There would be no variable marketing costs in-
curred on the government’s units.) What impact
would accepting the government contract have on
March income?
4. Hospital Supply has an opportunity to enter a for-
eign market in which price competition is keen. An
attraction of the foreign market is that demand there
is greatest when demand in the domestic market is
quite low; thus, idle production facilities could be
used without affecting domestic business. An order
for 1,000 units is being sought at a below-normal
price in order to enter this market. Shipping costs
for this order will amount to $410 per unit, while
total costs of obtaining the contract (marketing
costs) will be $22,000. Domestic business would be
unaffected by this order. What is the minimum unit
price Hospital Supply should consider for this order
of 1,000 units?
5. An inventory of 200 units of an obsolete model of
the hoist remains in the stockroom. These must be
sold through regular channels at reduced prices or
the inventory will soon be valueless. What is the
minimum price that would be acceptable in selling
these units?
6. A proposal is received from an outside contractor
who will make 1,000 hydraulic hoist units per
month and ship them directly to Hospital Supply’s
customers as orders are received from Hospital Sup-
ply’s sales force. Hospital Supply’s fixed marketing
costs would be unaffected, but its variable marketing
costs would be cut by 20 percent (to $220 per unit)
for these 1,000 units produced by the contractor.
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Hospital Supply’s plant would operate at two-thirds
of its normal level, and total fixed manufacturing
costs would be cut by 30 percent (to $1,386,000).
What in-house unit cost should be used to compare
with the quotation received from the supplier?
Should the proposal be accepted for a price (i.e.,
payment to the contractor) of $2,475 per unit?
7. Assume the same facts as above in Question 6 ex-
cept that the idle facilities would be used to produce
800 modified hydraulic hoists per month for use in
hospital operating rooms. These modified hoists
Case 16–2
Prestige Telephone Company*
In April 1997, Daniel Rowe, president of Prestige
Telephone Company, was preparing for a meeting
with Susan Bradley, manager of Prestige Data Ser-
vices, a company subsidiary. Partial deregulation and
an agreement with the state Public Service Commis-
sion had permitted Prestige Telephone to establish a
computer data service subsidiary to perform data pro-
cessing for the telephone company and to sell com-
puter service to other companies and organizations.
Mr. Rowe had told the commission in 1994 that a
profitable computer services subsidiary would reduce
pressure for telephone rate increases. However, by the
end of 1996 the subsidiary had yet to experience a
profitable month. Ms. Bradley felt only more time was
needed, but Rowe felt action was necessary to reduce
the drain on company resources.
Prestige Data Services had grown out of the needs
of Prestige Telephone for computer services to plan,
control, and account for its own operations in the met-
ropolitan region it served. The realization by Prestige
that other businesses in the metropolitan region
needed similar services and that centralized service
could be provided over telephone circuits suggested
that Prestige could sell computer time not needed by
telephone operations. In addition, the state Public Ser-
vice Commission had encouraged all public utilities
under its jurisdiction to seek new sources of revenue
and profits as a step toward deregulation and to reduce
* Copyright © by the President and Fellows of Harvard
College. Harvard Business School case 197-097.
Accounting: Text and Cases, 13th Edition 497
Chapter 16 The Behavior of Costs 483
could be sold for $4,950 each, while the variable
manufacturing costs would be $3,025 per unit. Vari-
able marketing costs would be $550 per unit. Fixed
marketing and manufacturing costs would be un-
changed whether the original 3,000 regular hoists
were manufactured or the mix of 2,000 regular
hoists plus 800 modified hoists was produced. What
is the maximum purchase price per unit that Hospi-
tal Supply should be willing to pay the outside con-
tractor? Should the proposal be accepted for a price
of $2,475 per unit to the contractor?
the need for rate increases which higher costs would
otherwise bring.
Because it operated as a public utility, the rates
charged by Prestige Telephone Company for telephone
service could not be changed without the approval of
the Public Service Commission. In presenting the pro-
posal for the new subsidiary, Mr. Rowe had argued for
a separate but wholly owned entity whose prices for
service would not be regulated. In this way, Prestige
could compete with other computer service organiza-
tions in a dynamic field; in addition, revenues for use
of telephone services might also be increased. The
commission accepted this proposal subject only to
the restriction that the average monthly charge for
service by the subsidiary to the parent not exceed
$82,000, the estimated cost of equivalent services used
by Prestige Telephone Company in 1994. All accounts
of Prestige Data Services were separated from those of
Prestige Telephone, and each paid the other for ser-
vices received from the other.
From the start of operations of Prestige Data Ser-
vices in 1995 there had been problems. Equipment de-
liveries were delayed. Personnel had commanded
higher salaries than expected. And most important,
customers were harder to find than earlier estimates
had led the company to expect. By the end of 1996,
when income of Prestige Telephone was low enough
to necessitate a report to shareholders revealing the
lowest return on investment in seven years, Rowe felt
it was time to reassess Prestige Data Services. Susan
Bradley had asked for more time, as she felt the sub-
sidiary would be profitable by March. But when the