Chapter 11 – Decision Making with a Strategic Emphasis
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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 One: Expected Value (EV) = $230,000
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
Option Three:
400,000 × 0.1 = $ 40,000
450,000 × 0.3 = 135,000
500,000 × 0.35 = 175,000
550,000 × 0.2 = 110,000
490,000 × 0.50 × 0.1 = 24,500
Net Contribution $254,000
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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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
*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
Total overhead = 10,000 hours × $10 = $100,000
from selling and administrative cost.
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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
Buy Boxes 9,000 14.00 ⎯ ⎯ ⎯ 126,000
Total Contr. 500,250
Less: contribution from manufacturing 8,000 boxes (8,000 × $33.00) 264,000
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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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
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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
Variable overhead 180,000
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
that traditional marginal income analysis fails to accurately reflect the magnitudes and costs of demands
for those resources, managers are less likely to make good decisions on pricing and resource allocation.
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
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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:
As before, these numbers are questionable. The costs saved annually by eliminating the MTO line may
very well exceed $4,690,000 at the current volume level. By decreasing diversity in product lines,
products, customers, and perhaps distribution channels, the division would save the costs of product line,
product-sustaining, and batch-level activities as well as unit-level-activities attributable to made-to-order
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
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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
Cont. margin $ 8,685,000 $ 983,333 $ 9,668,333
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
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
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
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FIGURE 1
Superior Valve Division
Contribution Margin by Product Line
($000)
Hydro-Con % Pneu-trol % MTO %
Units 80,000 260,000 100.0 20,000
Revenue $16,000 100.0 $13,000 100.0 $5,000 100.0
Variable Costs
Material $65.00 $5,200 $15.00 $3,900 $65.00 $1,300
Direct Labor 12.00 960 4.75 1,235 50.00 1,000
Variable Ovhead 30.00 2,400 6.50 1,690 50.55 1,011
Fixed Costs
Discretionary:
Mfg. $ 5.00 $ 400 $ 225 $ 100 $ 725
Other Op. 5.00 400 200 100
SGA 2.00 160 100 25 285
Total $22.00 $ 1,760 11.0 $2,205 17.0 $1,045 20.9
Total Fixed $34.00 $ 2,720 17.0 $2,730 21.0 $1,270 25.4
Operating Income $25.00 $ 2,000 12.5 $1,235 9.5 $ (735) (14.7)
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
through cost advantage together with low investment in new products or manufacturing equipment.
Additional support for this strategy comes from the fact that the division is operating at excess capacity
(from the case information, including the tables, we know that sales of Hydro-Con, Pneu-trol and MTO
are 80,000 units, 260,000 units, and 20,000units respectively, which is considerable less than the capacity
figures in Table B).
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In this environment, the key strategic factors are to maintain profitability and a cost advantage through:
1) a cost system that will properly support the divisions efforts at cost advantage
2) a cost system that will properly support the division’s decision making regarding pricing
(especially for special orders) and regarding withdrawal of products from the market
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 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
particularly if there have been shifts in product mix. Thus, an activity-based costing approach would be
called for in this context. The more accurate product costs from ABC would support the strategic
objectives noted in part 5 above.
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
division’s responsibility for any employees who would have to be let go, or who would choose to leave if
Chapter 11 – Decision Making with a Strategic Emphasis
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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.
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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
Purchased Manufactured Manufactured
In-line Skates In-line Skates Snowboard Bindings
Total Units 6,000 1,000 12,000
Per Unit Total Per Unit Total Per Unit Total
Selling price $98 $588,000 $98 $98,000 $60 $720,000
Variable costs
Material 75 450,000 20 20,000 20 240,000
Machine cost – – 24 24,000 8 96,000
Profit $13 $78,000 $21 $21,000 $12 $144,000
Machine hours per unit – 1.5 0.5
Contribution per machine hour – $22 $40
Supporting calculations:
(1)Manufacturing overhead
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Manufactured in-line skates
Machine hours = $24.00 per pair ÷ $16 per hour = 1.5 hours per pair
Manufacturing capacity = 5,000 pairs × 1.5 hours per pair = 7,500 hours
Overhead per machine hour = $18.00 per pair ÷ 1.5 hours per pair = $12.00 per hour
Total overhead = 7,500 hours × $12.00 per hour = $90,000
Total variable overhead = $90,000 (total) − $30,000 (fixed) = $60,000 (variable)
Variable overhead per machine hour = $60,000 ÷ 7,500 hours = $8.00 per hour
(2)Selling & administrative cost
Each unit has $6.00 allocated fixed cost. Variable cost = total cost – fixed cost
Total Cost Fixed Cost Variable Cost
Purchased in-line skates $10 $6 $4
Manufactured in-line skates 15 6 9
Manufactured snowboards 14 6 8
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Case 11-5: Garden Patch Foods
Required: Assume that you are a staff accountant at Garden Patch Foods and CFO Ty Brown has
asked you to help him prepare the requested report for the president. Specifically, he wants you to
run the numbers that have been gathered by him and Bill to estimate the financial impact of the
options available to the company (remember that status quo is always an option). Additionally, he
wants you to identify any nonfinancial issues that need to be considered, especially in light of the
fact that the company intends to continue growing through acquisition. Information systems and
internal control issues should be considered as part of these nonfinancial issues to the extent you
believe they are relevant.
Decisions in practice are determined by a combination of financial and nonfinancial factors, the most
critical of which may be managers’ interpretation of, and willingness to accept, risk. For example, in this
scenario risks include: (1) the long-term viability of the business process outsourcing provider; (2) the
ability of new technology solutions to function as planned, for either shared-services or outsourced
arrangements; and (3) the lack of employee acceptance of the shift in corporate culture from a
decentralized service operation to a centralized shared-services operation. Because different managers
may interpret facts differently and accept different levels of risk, there can be no single correct solution to
this case. Therefore, we intentionally do not include as part of these Teaching Notes a suggested memo
because that implies a correct answer. What we do provide are examples of the financial analyses that
were used by the company on which the case is based and a list of nonfinancial issues for each alternative.
Students may present similar analyses using different numbers if their assumptions about cost savings
percentages differ from those we made in developing the suggested solutions. Significant consideration
should be given during the grading process to the justifications the students present for their assumptions.
It is possible that the greatest learning from this case will not be in correctly laying out cash flows, but
rather in learning to deal with the ambiguity of projections.
When used in the undergraduate cost accounting course, a grading scale was developed by first weighting
three components of the report: financial analysis, nonfinancial analysis, and written communication.
Grading of the financial analysis, weighted 40 percent, concentrated on the reasonableness of the
assumptions, accuracy of the calculations, and presentation format. The nonfinancial analysis, weighted
50 percent, focused on the clarity and completeness of the discussions regarding outsourcing and shared-
services arrangements and identification of benefits and risks associated with GPF’s implementation. The
written communication component, weighted 10 percent, assessed the report for appropriate audience
orientation, grammar, and spelling. Allocation of points within each of these sections varied and should
reflect the preferences of the individual instructor. In the executive M.B.A. managerial accounting course,
the case was used as a vehicle for class discussion and was not graded.
All suggested analyses include only the first year’s results because the financial results are compelling
after just one year. Other analyses such as payback period, net present value, and return on investment
would also be acceptable. Such analyses would require attention to additional areas of uncertainty such as
the appropriate discount rate, the length of the PayOut contract, future increases in invoice volume and
related volume-based PayOut fees, future increases in PayOut’s base service fees, and future
technological advances influencing hardware replacement.
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OPTION #1: MAINTAIN THE STATUS QUO
This option does not result in increased costs to the company except for the opportunity cost of not
choosing the other options.
Nonfinancial Issues
Advantages
• It is the easiest to implement.
• It will be perceived as the least risky of all of the options.
Disadvantages
• It leaves all of the current redundancies in support functions unchanged.
• Any future expansions by GPF will increase the redundancies.
• GPF retains technological risks associated with hardware and software obsolescence.
• It does not accommodate GPF.s long-term plans and goals.
• Financial risk is increased due to the reduction in capital available for future investment.
OPTION #2: IMPLEMENT A SHARED-SERVICES ARRANGEMENT
The numbers provided in the case make it impossible to calculate a precise financial impact of
this option. Exhibit 1 provides one solution for the first two years. For the cost savings on purchases,
three different base numbers could be used: (1) $3,234,883.the total of the 15 categories of analyzed
purchases that are common between the three divisions; (2) $8,021,576.the total of all nonstrategic
purchases; or (3) $6,593,838.total nonstrategic purchases less the four categories of purchases for which
the company has long-term contracts (rent, insurance, workers. compensation, and group health). The best
number to use is the $3,234,883, not because it is the most conservative (which some students will argue),
but because initially the company will concentrate on those areas of purchases, which have the volume to
support discounts. The case points out that these 15 categories are the ones that are consistent across the
three divisions. It is possible that as the company develops the shared-services arrangement it will begin
to analyze the remaining purchasing categories, but that is not likely to happen in the near future due to
their lack of experience with this type of arrangement. Students may point out that over time GPF may
develop the expertise necessary to expand the arrangement to other expense categories.
Once the students select a base for nonstrategic purchases, they will have to decide what level of cost
savings can be achieved. Five percent savings results in an incremental cost in the first year, but would be
positive in the future as the outlay for the systems upgrade would not occur. Net present value analysis is
not necessary since recovery of the investment would presumably happen before the end of the second
year. With respect to labor savings, the numbers in Exhibit 1 use the greatest number of people required
(for conservatism) at the highest salary. We assumed that the persons paid the most either had the greatest
amount of experience or were the high performers. Again, students may have ranges or use different
numbers. The important part is how they choose to justify the use of the numbers. Regardless of the
numbers and assumptions used, a shared-services arrangement will more than likely have a positive
impact on the bottom line. Among the many nonfinancial issues students may identify are the following.
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Nonfinancial Issues
Advantages
• It provides leverage for negotiating prices with larger consolidated volume and supplier
concentration.
• GPF retains control over these operations and does not have to rely on outside parties.
• It accommodates growth by acquisition without the addition of staff positions.
• It provides opportunity to reduce redundancies in processing.
• It provides an opportunity for reengineering operations to allow for better evaluation of future
business process outsourcing options.
Disadvantages
• GPF retains technological risks associated with hardware and software obsolescence.
• Personnel will have to be let go. There will likely be an additional financial impact of severance
packages.
• If personnel are not let go, the labor savings will not be achieved.
• GPF may never develop the expertise or buying power to achieve the maximum savings that an
outsourced provider could achieve.
• Financial risk is increased due to the reduction in capital available for future investment.
• Data must be exported from three different systems, reformatted, and imported to the new system.
• Data must be cleaned up before it is consolidated in the new system.
• Employees must be trained on the new system.
• Time and effort must be dedicated to the testing, implementation, and conversion of the new
system.
• Unspecified transition/conversion costs in dollars, time, and errors may occur.
• Ongoing maintenance of hardware and software must be performed.
• Longer lead times may be experienced when local vendors are not used.