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Chapter 11 – Decision Making with a Strategic Emphasis
Chapter 11
Decision Making with a Strategic Emphasis
Teaching Notes for Cases
Case 11-1: Product-Promotion Strategies; Use of Probabilities
Question 1: Exquisite Foods Incorporated (EFI) wishes to select the most profitable marketing alternative
to promote Soufflés for Microwaves. Recommend which of the three strategies presented above should be
adopted by EFI. Support your recommendation with appropriate calculations and analysis.
Option Two:
500,000 × 0.1 = $50,000
600,000 × 0.25 = 150,000
700,000 × 0.35 = 245,000
800,000 × 0.2 = 160,000
Less Redemption: 695,000 × 0.15 × 0.25 26,062.50
Net Contribution $225,687.50
Option Three:
400,000 × 0.1 = $ 40,000
450,000 × 0.3 = 135,000
Less: coupon: 0.07 × 500,000 35,000
Less: Redemption:
490,000 × 0.50 × 0.1 = 24,500
The analysis above supports Option three.
Question 2: What selection criteria, other than profitability, should be considered in arriving at a decision
on the choice of promotion alternatives?
the effect on potential sales in future years
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Chapter 11 – Decision Making with a Strategic Emphasis
Case 11-2: Profitability Analysis; Strategy
Question 1: Prepare an analysis based on the data presented that will show which product or products
Sportway Inc. should manufacture and/or purchase to maximize profitability and show the associated
financial impact. Support your answer with appropriate calculations.
In order to maximize the company's profitability, Sportway Inc. should purchase 9,000 tackle boxes
from Maple Products, manufacture 17,500 skateboards, and manufacture 1,000 tackle boxes. This
combination of purchased and manufactured goods maximizes the contribution per direct labor hour
available, as calculated in Tables 1 and 2.
Table 1 Calculate unit contributions
Purchased Manufactured
Tackle Tackle Skate-
Boxes Boxes Boards
Selling price $86.00 $86.00 $45.00
Less:
Material 68.00 17.00 12.50
Direct labor n/a 18.75 7.50
Manufacturing overhead* n/a 6.25 2.50
Selling & administrative cost** 4.00 11.00 3.00
Contribution $14.00 $33.00 $19.50
*Calculation of variable overhead per unit (given fixed mfg. overhead is $50,000):
Tackle boxes:
Direct labor hours = $18.75 ÷ $15.00 = 1.25 hours
Overhead/DLH = $12.50 ÷ 1.25 = $10.00 (DLH = direct labor hours)
Total DLH = 8,000 × 1.25 = 10,000 hours
**For calculating contribution, $6.00 of fixed overhead cost per unit for distribution must be deducted
from selling and administrative cost.
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Chapter 11 – Decision Making with a Strategic Emphasis
Table 2
The optimal use of Sportway's available direct labor.
Unit DLH/ Total Balance Total
Item Quantity Contribution UNIT DLH of DLHs Contribution
Total DLH 10,000
Skateboards 17,500 $19.50 0.50 8,750 1,250 $341,250
Make boxes 1,000 33.00 1.25 1,250 33,000
Buy Boxes 9,000 14.00 126,000
Total Contr. 500,250
Question 2: Identify the strategic factors Sportway should consider in its product decisions.
Some of the possible strategic factors to consider are:
Re: The skateboards:
Will the sale of skateboards introduce Sportway to new markets and new customers that might
benefit other product lines?
Can Sportway compete in the skateboard market? How competitive is this market, and what are
the CSFs that are likely to lead to success for Sportway?
How reliable are the estimates used to develop the predictions for revenues and costs for the
skateboards? How reliable is the market research that predicted growth in skateboard sales.
Will the sale of skateboards affect Sportway’s image in either a positive or negative fashion. For
example, will Sportway’s current customers view Sportway as a high quality/innovative
manufacturer of skateboards?
How long is the expected growth in skateboard sales expected to continue?
Re: The purchase of tackle boxes from Maple Products:
What are the alternative uses of Sortway’s production capacity, in addition to skateboards and
tackle boxes that might produce high contributions?
How reliable is Sportway’s information that Maple is a reliable producer of quality products?
How will Sportway’s customers react, if at all, to know that the tackle boxes are not
manufactured by Sportway?
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Chapter 11 – Decision Making with a Strategic Emphasis
Case 11-3: Special Order; Profitability Analysis; Strategy; Ethics
This case is presented as a somewhat longer, real-world example of textbook problems on
contribution margin analysis and relevance in decision-making. The approach taken by Superior Valve's
managers was very traditional. Both operating and selling and general administration costs were separated
into two cost pools: costs expected to vary with short-run changes in production levels, and costs
expected not to vary with those changes. Variable overhead costs were applied to individual products on
the basis of direct labor cost. Fixed costs in each functional category were designated as either
discretionary or committed, and some committed fixed costs were assigned to product lines (but not
individual products) using arbitrary allocation bases.
The case does not mention any search for fundamental cost drivers or any attempt to identify the
activities caused by changes in those drivers. Students should question Jerry Conrad's belief that the full
absorption costs computed for his division's products were accurate, which can lead to a discussion of the
symptoms that often accompany a poorly designed or obsolete cost system. You might use this discussion
to introduce the activity-based approach to contribution margin analysis, in which costs are traced to
resources consumed by unit-level activities, batch-level activities, product-sustaining activities, product
line activities, plant-level activities, and, if desired, activities associated with individual customers,
distribution channels, or other cost objects. This approach gives managers much better insights into the
nature of their costs than those provided by the traditional volume-based system used at Superior Valve. It
also allows them to better match the revenue-generating and cost-causing activities of their organizations.
Question 1: Assume that inventories will not change during the year. Prepare budgeted
contribution approach product line income statements for the year ending 6/30/2013. Categorize
fixed costs as either discretionary or committed.
Figure 1 (p. 11-7) shows contribution approach income statements for each product line based on
the data given in the case. An additional line, perhaps labeled "contribution to committed fixed costs and
operating income," could be shown after discretionary fixed costs. For purposes of analysis, this
statement is an improvement over the full absorption statement that it replaces in the management
reporting system. However, there is reason to question the accuracy of the cost attributions.
Field studies have demonstrated that many "fixed" costs are driven by diversity in products,
product lines, customers, and distribution channels. Superior Valve had a small number of product lines
but offered made-to-order valves as well as a full line of products within the standard Hydro-Con and
Question 2: Should Jerry Conrad decide to accept the Wadsworth Company special order? If so,
what will be the new Hydro-Con return on sales?
The Superior Valve staff conducted the following relevant income analysis of the Wadsworth Company
order:
Revenue (6,000 × $160) $960,000
Marginal costs:
Material $390,000
Direct labor 72,000
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Chapter 11 – Decision Making with a Strategic Emphasis
Variable overhead 180,000
Adjustments 60,000
Variable other operating cost 24,000
Commission 48,000
Total relevant cost 774,000
Contribution Margin $186,000
If the order were accepted, the Hydro-Con return on sales would increase from 12.5% ($2 million $16
million) to 12.9% ($2.186 million $16.960 million).
These figures indicated that the Wadsworth order represents an opportunity to increase Hydro-Con
operating income by more than 9%. From the financial perspective, to accept the order is apparently the
proper decision. However, its contribution to operating income may be considerably less than $186,000.
Because the order represents a new application for Hydro-Con valves, acceptance may add another model
to the product line, thereby increasing diversity.
Research has shown that short-run incremental business makes disproportionate demands on a company's
support resources, so that costs that appear to be fixed in the short-run tend to increase. This is
Question 3: Should the Superior Valve Division eliminate the Made to Order product line if there
were no alternative uses for its production capacity?
The analysis conducted by the Superior Valve Division staff indicated that the MTO product line should
not be eliminated unless its dedicated capacity could be reallocated to one of the standard lines. Although
the division's return on sales would increase by 0.2% if the line were dropped, operating income would
decrease by $310,000:
Total Less Division
Division MTO w/o MTO
Revenue $34,000,000 $5,000,000 $29,000,000
Variable Costs 24,780,000 4,465,000 20,315,000
Cont. Margin $ 9,220,000 $ 535,000 $ 8,685,000
Fixed costs:
product-sustaining, and batch-level activities as well as unit-level-activities attributable to made-to-order
products. Costs associated with handling custom orders and designing and producing customized valves
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Chapter 11 – Decision Making with a Strategic Emphasis
do not vary proportionally with the number of valves produced in an order. Some of these may be
classified as "committed fixed" costs in the division's marginal income system.
To improve the profitability of the MTO product line, Jerry Conrad and his staff should consider
conducting a multi-level activity analysis of the costs of producing customized products. They then could
determine whether certain types of customized valves, certain customers, or certain distribution channels
were profitable and others were not. This activity-based information would enable the Superior Valve
management to accept only those orders with sufficient revenue to cover the costs of resources devoted to
handling the order and designing and producing valves to customer specifications
Question 4: If all resulting standard products could be sold, how should the MTO capacity be
allocated? (Assume only the capacity currently being used to produce 20,000 MTO units would be
used to produce additional standard products.)
In addressing this question, the division staff conducted the following analysis:
Hydro-Con Pneu-trol MTO
Cont. margin/unit $59.00 $15.25 $26.75
Mach. hrs./unit 6 2 5
Cont. margin/mach.hr. $9.833 $7.625 $5.350
Additional units produced with MTO capacity 16,667 50,000 (20,000)
If MTO capacity were used to produce Hydro-Con:
Division Additional Adjusted
w/o MTO Volume Division
Revenue $29,000,000 $3,333,333 $32,333,333
Division operating income would increase by $673,333, or 26.9%, from the $2,500,000 budgeted with
MTO.
If MTO capacity were used to produce Pneu-trol:
Division Additional Adjusted
w/o MTO Volume Division
Revenue $29,000,000 $2,500,000 $31,500,000
Cont. margin $ 8,685,000 $ 762,500 $ 9,447,500
Division operating income would increase by $452,500, or 18.1%, from the amount budgeted with MTO.
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Chapter 11 – Decision Making with a Strategic Emphasis
The analysis suggests that the MTO line should be dropped and its dedicated machinery retooled to
produce additional Hydro-Con units. However, the computations are based on the familiar assumption,
stated in this case, that fixed costs will not increase as volume of output increases, in this instance even up
to the stated maximum capacities for each product line. Indeed, in budgeting no additional fixed costs for
Superior Valve was a fast-growing division with an organizational infrastructure that was undoubtedly
growing to meet increasing needs. The blanket assumption regarding cost behavior is unlikely to hold for
many of the division's "fixed" costs. A comprehensive activity analysis of those costs that do not vary
proportionally with units of production or sales volume would enable Jerry Conrad and his staff to better
predict the increases or decreases in those costs that would result from various changes in their drivers.
The managers then would have the information needed to consider a wide variety of actions to raise the
overall profitability of the division.
FIGURE 1
Superior Valve Division
Contribution Margin by Product Line
($000)
Hydro-Con % Pneu-trol % MTO
% Total %
Units 80,000 260,000 100.0 20,000
360,000
Revenue $16,000 100.0 $13,000 100.0 $5,000
100.0 $34,000 100.0
Variable Costs
Material $65.00 $5,200 $15.00 $3,900 $65.00 $1,300
$10,400
Direct Labor 12.00 960 4.75 1,235 50.00 1,000
3,195
Variable Ovhead 30.002,400 6.50 1,690 50.55 1,011
5,101
Adjustments 10.00 800 2.00 520 27.70 554
1,874
Var. Other Op. 4.00 320 1.50 390 5.00 100
810
Discretionary:
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Chapter 11 – Decision Making with a Strategic Emphasis
Mfg. $ 5.00 $ 400 $ 225 $ 100 $
725
Other Op. 5.00 400 200 100
700
SGA 2.00 160 100 25
285
Total 12.00 $ 960 6.0 $ 525 4.0 $ 225
4.5 $1,710 5.0
Committed:
Mfg. $ 9.00 $720 $1,075 $ 420
$2,215
Other Op. 11.00 880 970 550
2,400
SGA 2.00 160 160 75
Question 5: Identify the strategic factors that Superior Valve should consider.
The Superior Valve Division is an established business which has been part of the parent company for
many years. Its products are at the mature phase of the product life cycle, and one product line, the made-
to-order hydraulic controls (MTO), is being considered for withdrawal from the market. For the case
information, it does not appear that innovation is important in this market. While sales are fast growing,
the parent company has not invested significantly in the division, and profits have been “variable.” It
appears the parent company has a “harvest” strategy for the division, and the division is profitable
Consistent with the harvest strategy, there is a focus on cost reduction, as reflected in the use of standard
costing and the effort to classify costs as variable and fixed, and for the fixed cost, whether they are
committed or discretionary.
In this environment, the key strategic factors are to maintain profitability and a cost advantage through:
Question 6: What changes, if any, should be made to the division’s cost system? Why?
The suggested solutions for questions 1-4 above have pertinent comments regarding the division’s attempt
to classify costs and analyze cost behavior. Division management’s assumptions in the case regarding cost
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Chapter 11 – Decision Making with a Strategic Emphasis
behavior are incomplete and potentially misleading. In particular, what is needed is an activity analysis
that takes into account the complexity of the manufacturing environment and performs a proper
identification of cost drivers. Superior Valve products appear to have considerable diversity in the use of
Question 7: What ethical issues, if any, should the division consider in connection with the decision
to eliminate MTO?
The MTO line is a significant part of Superior Valve’s operations, as noted in the data in Tables A and B.
Thus, closing the line could be very disruptive to plant employees and supervisors, even if the capacity is
re-oriented for production to other products. The potential ethical issues would be to consider the
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Chapter 11 – Decision Making with a Strategic Emphasis
Case 11-4: OmniSport, Inc.
Required: To maximize OmniSport Inc.'s profitability, recommend which product or products
should be manufactured and/or purchased. Prepare an analysis based on the data presented that
will show the associated financial impact. Support your answer with appropriate calculations and
strategic considerations.
In order to maximize OmniSport Inc.'s profitability, OmniSport should manufacture 12,000 snowboard
bindings, manufacture 1,000 pairs of skates, and purchase 6,000 pairs of skates from Colcott Inc. This
combination of manufactured and purchased goods maximizes the contribution per available machine
hour, which is the limiting resource, as shown below.
Since snowboard bindings have a higher contribution per machine hour than in-line skates, OmniSport
should manufacture the maximum number of snowboard bindings. Since the contribution per
manufactured pair of in-line skates is higher than the contribution from a purchased pair of in-line skates,
total contribution will be maximized by using the remaining manufacturing capacity to produce in-line
skates and then purchasing the remaining required skates. This optimal combination is calculated below.
Strategic issues relevant to OmniSport include being sure that it maintains the quality reputation that it
has developed in prior years. While Colcott has been a steady supplier of quality products for some time,
it is important that OmniSport continue to insist on quality and regularly check to make sure that its
outsourced products are up to OmniSport’s high quality standards.
Also, the fact that demand continues to exceed production capacity at the firm should cause OmniSport to
consider plant expansion. Factors to consider here include the desired level of operating leverage for the
firm – that is, how sure is OmniSport that sales will continue to increase before making an investment in
additional plant capacity.
OmniSport Inc.
Contribution Analysis
Machine Total
Hours Machine Machine Total
Per Hours Hour Unit Product
Quantity Unit Used Balance Contribution Contribution
Machine hours available 7,500
Snowboard bindings 12,000 0.5 6,000 1,500 $20 $240,000
In-line skates-manufacture 1,000 1.5 1,500 - 33 33,000
In-line skates-purchase 6,000 - - - 19 114,000
Total contribution 387,000
Less original contribution of (5,000 pairs of skates × $33.00 per pair) (165,000)
Improvement in contribution $222,000
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