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Decision Making

‡ Differential costs: difference between the costs of two (or more) decision alternatives ‡ Incremental costs: additional cost differential of one alternative ‡ Opportunity costs: potential benefit that must be given up when an alternative is selected .Cost considerations ‡ Sunk costs: have already been incurred and can not be changed by any current or future decision. Therefore no longer relevant.

if the order does not . Do we accept the order? ± YES.Accept or Reject We receive a special order not part of routine production/services. if the order s contribution margin (Sales VC) will cover any incremental fixed costs or opportunity costs and still provide a net margin toward other operations ± NO.

Import Distributors .

. At least initially. all of the department manager s office costs can be saved. ‡ No rent will be saved.e. since the television line is one-third of total sales. because of the noncancellable lease ‡ Inventory taxes and insurance should be saved . ‡ If the department is discontinued. it is assumed that about the same ratio of total labor (i. it is assumed that sales in the other two departments will not be affected. the full amount now allocated to the television line) can be saved if this line is discontinued.Assumptions ‡ ‡ ‡ All gross margin will be lost It is assumed that cost of goods sold was completely variable (and hence differential) with sales revenues. ‡ Even though warehouse personnel serve all three departments.

if a company loses one-third of its volume. ‡ Sales commissions should be differential. but if this is the case. If a salesperson has a minimum guarantee.‡ Since the entire warehouse probably has to be heated and lighted regardless of its degree of utilization. ‡ Note 7 to Exhibit 1 of the case states that only one-third of the imputed finance charge on inventory was out-of-pocket interest cost. it should be able to redeploy its delivery resources in a way that requires only about two-thirds of the former resources. however. . and if that amount would be higher than his or her commissions excluding television sales. if any utilities will be saved. it is doubtful that many of IDI s other administrative costs would be saved. even though each salesperson now sells all three lines. Exhibit A assumes no savings. in the medium term IDI should be able to reduce the number of salespersons so that everyone s commission again is above the guaranteed minimum. In the longer run. few. then in the short run not all of the commission expense will be differential. ‡ Delivery cost savings are highly debatable. department manager s office. ‡ Given that there was a separate expense category.

454 .384 $ 6.393 37.621 23.274 32.708 196.140 12.930) $10.Exhibit A Impact of Discontinuing Television Department Forgone gross margin Cost savings: Personnel expenses Department manager¶s office Inventory taxes and insurance Delivery costs Sales commissions Interest costs Total savings Impact on operating profit $(189.248 80.

it is advised to discontinue the department. .Conclusion Since the gross profit foregone is less than the cost that can be avoided with the discontinuance of the television department.

Forner Carpet Company .

‡ Department indirect overhead costs are demonstrably fixed. ‡ company s need for capital funds has a great bearing on the pricing decision. ‡ There may be more cash flow generated at the $3.95 per price than they were at $4.75 . because we are considering costs at two nonzero volumes.‡ In this case. the differential costs are the variable costs.

250 .152.104 $0.150 .800 $592.975 0.520 0. yd.900 $236.500 309.yds.75 75.544 $2.051 0.600 + $84.) Variable costs per unit Raw materials Materials spoilage Direct labor Dept.000 $0. direct overhead Total variable Approach I: Unit contribution * Volume =Total contribution Approach II: Revenues .000 $282.051 0.450 $ 1.150 $356.989 0.) Volume (sq.The analysis described above leads to these numbers Price (per sq.250 157.520 $2.450 $282.000 $198.066 Difference $ 2.884 *150.Variable costs = Total contribution $4.100 $198.000 $3.520 0.600 + $84.95 150.646 *75.

‡ Forner will be better off financially if the price is lowered to $3. ‡ It just happens in this case that maximizing contribution will maximize cash flow. which is usually equivalent). but differential cash flow (or differential income. because the fixed costs are nondifferential .95 ‡ It is not differential contribution in which we are interested in general.

Volume at $4.75.95. Unit Contribution @ $4.75 price and the expected sales at a price of $3. .646X = $282.95 $2.75 at which Forner will be indifferent (relative to the cash flow criterion) between the $4.000 This can be compared with the expected market share of at least 11. it can also be compared with the share Forner has gotten in the past when all companies charged the same price (35 percent).000 or ! .000/630.75 price. Assuming competitors raise their prices back to $4.75 * Volume = Contribution @ $3.590  750.9% (75.000) at the $4.600 819.093 more than estimated 750.

‡ This makes it clear that in question 2 we calculated only two of a multitude of possible endpoint values.‡ A more thorough analysis would include (1) information on different total industry volumes at different industry price structures (2) probabilities of competitors price decisions given an announced price by Forner. and (3) probabilistic estimates of Forner s market share at various industry price structures. .

2: 562.35 = 157.35 = 196. somewhat unrealistically though not totally so for a derived-demand product) that industry sales would have been the same had Forner charged $3.8841 = 1993 .114 . we have the following (approximate) pro forma contributions: 1993 .875 * $1.1: 450.Analysis of Exhibit 1 reveals that market share has been 35 percent in every period for which all companies charged the same price.000 * .384 $663.730 366.500 * $1.500 * .8612 = $296.95 in 1993. Assuming (admittedly.

they are obviously far better off.6993 = $362.340 303.Actual (approximate) contributions 1993 . This is a case can be defended in either decision The calculation for question 3 shows that with all competitors at the higher price.0 percent (not the historical 35 percent when all competitors charge the same price as Forner) to be as well off as they expect to be if they drop their price to $3.500 * $2.978 Note.95. . and if their share recovers to 35 percent. Forner would need its share to recover only to 17.2: 112.1: 135.6841 = 1993 .000 * $2.638 $665.