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Ethics Challenge (90 minutes)
1. The original cost of the facilities at Clayton is a sunk cost and should be
ignored in any decision. The decision being considered here is whether to
continue operations at Clayton. The only relevant costs are the future
facility costs that would be affected by this decision. If the facility were
shut down, the Clayton facility has no resale value. In addition, if the
Increase in rent at Billings and Great Falls .................
$600,000
Decrease in local administrative expenses ..................
(90,000)
Net increase in costs ................................................
$510,000
In addition, there would be costs of moving the equipment from Clayton
and there might be some loss of sales due to disruption of services. In
Ethics Challenge (continued)
Financial Performance
After Shutting Down the Clayton Facility
Rocky Mountain Region
Total
Sales .............................................................
$50,000,000
Selling and administrative expenses:
Direct labor .................................................
32,000,000
Variable overhead........................................
850,000
Equipment depreciation ...............................
3,900,000
Facility expense* .........................................
2,300,000
Local administrative expense** ....................
360,000
Regional administrative expense ...................
1,500,000
Corporate administrative expense .................
4,750,000
Total operating expense .................................
45,660,000
Net operating income .....................................
$ 4,340,000
* $2,800,000 – $1,100,000 + $600,000 = $2,300,000
** $450,000 – $90,000 = $360,000
2. If the Clayton facility is shut down, BSC’s profits will decline, employees
will lose their jobs, and customers will at least temporarily suffer some
decline in service. Therefore, Romeros is willing to sacrifice the interests
of the company, its employees, and its customers just to make her
performance report look better.
Ethics Challenge (continued)
It should be noted that the performance report required by corporate
3. Prices should be set ignoring the depreciation on the Clayton facility. As
argued in part (1) above, the real cost of using the Clayton facility is
Analytical Thinking (120 minutes)
1. The product margins computed by the accounting department for the
drums and bike frames should not be used in the decision of which
product to make. The product margins are lower than they should be
2. Students may have answered this question assuming that direct labor is
a variable cost, even though the case strongly hints that direct labor is a
Solution assuming direct labor is fixed
Manufactured
Purchased
WVD
Drums
WVD
Drums
Bike
Frames
Selling price .....................................
$149.00
$149.00
$239.00
Variable costs:
Direct materials .............................
138.00
52.10
99.40
Variable manufacturing overhead ....
0.00
1.35
1.90
Variable selling and administrative ..
0.75
0.75
1.30
Total variable cost ............................
138.75
54.20
102.60
Contribution margin ..........................
$ 10.25
$ 94.80
$136.40
Analytical Thinking (continued)
3. Because the demand for the welding machine exceeds the 2,000 hours
that are available, products that use the machine should be prioritized
Solution assuming direct labor is fixed
Manufactured
WVD
Drums
Bike
Frames
Contribution margin per unit (above) (a) ............
$94.80
$136.40
Welding hours per unit (b) .................................
0.4 hour
0.5 hour
Contribution margin per welding hour (a) ÷ (b) ..
$237.00
per hour
$272.80
per hour
Analytical Thinking (continued)
Because the contribution margin per unit of the constrained resource (i.e., welding time) is larger for the
bike frames than for the WVD drums, the frames make the most profitable use of the welding machine.
Analysis assuming direct labor is a fixed cost
(a)
(b)
(c)
(a) × (c)
(a) × (b)
Quantity
Unit
Contri-
bution
Margin
Welding
Time
per Unit
Total
Welding
Time
Balance
of
Welding
Time
Total
Contri-
bution
Total hours available ...................
2,000
Bike frames produced .................
1,600
$136.40
0.5
800
1,200
$218,240
WVD Drums—make ....................
3,000
$94.80
0.4
1,200
0
284,400
WVD Drums—buy ......................
3,000
$10.25
30,750
Total contribution margin ............
533,390
Less: Contribution margin from
present operations: 5,000
drums × $94.80 CM per drum ..
474,000
Increased contribution margin
and net operating income ........
$ 59,390
Analytical Thinking (continued)
4. The computation of the contribution margins and the analysis of the
best product mix are repeated here under the assumption that direct
labor costs are variable.
Solution assuming direct labor is a variable cost
Manufactured
Purchased
WVD
Drums
WVD
Drums
Bike
Frames
Selling price ...................................
$149.00
$149.00
$239.00
Variable costs:
Direct materials ...........................
138.00
52.10
99.40
Direct labor .................................
0.00
3.60
28.80
Variable manufacturing overhead ..
0.00
1.35
1.90
Variable selling and administrative
0.75
0.75
1.30
Total variable cost ..........................
138.75
57.80
131.40
Contribution margin ........................
$ 10.25
$ 91.20
$107.60
Solution assuming direct labor is a variable cost
Manufactured
WVD
Drums
Bike
Frames
Contribution margin per unit (above) (a) ..........
$91.20
$107.60
Welding hours per unit (b) ...............................
0.4 hour
0.5 hour
Contribution margin per welding hour (a) ÷ (b)
$228.00
per hour
$215.20
per hour
When direct labor is assumed to be a variable cost, the conclusion is
reversed from the case in which direct labor is assumed to be a fixed
cost—the WVD drums appear to be a better use of the constraint than
the bike frames. The assumption about the behavior of direct labor
really does matter.
Analytical Thinking (continued)
Solution assuming direct labor is a variable cost
(a)
(b)
(c)
(a) × (c)
(a) × (b)
Quantity
Unit
Contri-
bution
Margin
Welding
Time
per Unit
Total
Welding
Time
Balance
of
Welding
Time
Total
Contri-
bution
Total hours available ....................
2,000
WVD Drums—make .....................
5,000
$91.20
0.4
2,000
0
$456,000
Bike frames produced ..................
0
$107.60
0.5
0
0
0
WVD Drums—buy .......................
1,000
$10.25
10,250
Total contribution margin .............
466,250
Less: Contribution margin from
present operations: 5,000
drums × $91.20 CM per drum ...
456,000
Increased contribution margin
and net operating income .........
$ 10,250
Analytical Thinking (continued)
5. The case strongly suggests that direct labor is fixed: “The bike frames
could be produced with existing equipment and personnel.”
Nevertheless, it would be a good idea to examine how much labor time
is really needed under the two opposing plans.
Production
Direct Labor-
Hours Per Unit
Total Direct
Labor-Hours
Plan 1:
Bike frames .................
1,600
1.6*
2,560
WVD drums ................
3,000
0.2**
600
3,160
Plan 2:
WVD drums ................
5,000
0.2**
1,000
* $28.80 ÷ $18.00 per hour = 1.6 hour
** $3.60 ÷ $18.00 per hour = 0.2 hour
Some caution is advised. Plan 1 assumes that direct labor is a fixed cost.
However, this plan requires 2,160 more direct labor-hours than Plan 2
and the present situation. At 40 hours per week a typical full-time
Analytical Thinking (continued)
Contribution margin from Plan 1:
Bike frames produced (1,600 × $136.40) ............
218,240
WVD Drums—make (3,000 × $94.80) .................
284,400
WVD Drums—buy (3,000 × $10.25) ...................
30,750
Total contribution margin ...................................
533,390
Less: Additional fixed labor costs ..........................
34,200
Net effect of Plan 1 on net operating income .........
$499,190
Contribution margin from Plan 2: ..........................
WVD Drums—make (5,000 × $94.80) .................
$474,000
WVD Drums—buy (1,000 × $10.25) ...................
10,250
Net effect of Plan 2 on net operating income .........
$484,250
If an additional direct labor employee would have to be hired, Plan 1 is
still optimal.
Chapter 10
Take Two Solutions
Exercise 10-4 (15 minutes)
Only the incremental costs and benefits are relevant. In particular, only the
variable manufacturing overhead and the cost of the special tool are
relevant overhead costs in this situation. The other manufacturing
overhead costs are fixed and are not affected by the decision.
Per Unit
Total
for 20
Bracelets
Incremental revenue .............................
$139.95
$2,799.00
Incremental costs:
Variable costs:
Direct materials ...............................
$ 84.00
1,680.00
Direct labor .....................................
45.00
900.00
Variable manufacturing overhead .....
4.00
80.00
Special filigree .................................
2.00
40.00
Total variable cost ..............................
$135.00
2,700.00
Fixed costs:
Purchase of special tool ....................
250.00
Total incremental cost ...........................
2,950.00
Incremental net operating income .........
$ (151.00)
The special order would not add to the company's net operating income
and should be rejected.
Exercise 10-7 (10 minutes)
A
B
C
Selling price after further processing ....
$20
$13
$32
Selling price at the split-off point .........
16
8
25
Incremental revenue per pound or
gallon ..............................................
$ 4
$ 5
$ 7
Total quarterly output in pounds or
gallons ............................................
×15,000
×20,000
×4,000
Total incremental revenue ...................
$60,000
$100,000
$28,000
Total incremental processing costs .......
57,000
102,000
36,000
Total incremental profit or loss ............
$ 3,000
$ (2,000)
$(8,000)
Therefore, only product A should be processed further.
Exercise 10-8 (30 minutes)
1.
A
B
C
(1)
Contribution margin per unit ...........................
$54
$108
$76
(2)
Direct material cost per unit ...........................
$24
$72
$16
(3)
Direct material cost per pound ........................
$8
$8
$8
(4)
Pounds of material required per unit (2) ÷ (3) .
3
9
2
(5)
Contribution margin per pound (1) ÷ (4) .........
$18
$12
$38
2. The company should concentrate its available material on product C:
A
B
C
Contribution margin per pound (above) .
$ 18
$ 12
$ 38
Pounds of material available ..................
× 5,000
× 5,000
× 5,000
Total contribution margin ......................
$90,000
$60,000
$190,000
3. The price Barlow Company would be willing to pay per pound for
additional raw materials depends on how the materials would be used.
If there are unfilled orders for all of the products, Barlow would
presumably use the additional raw materials to make more of product C.
Exercise 10-11 (20 minutes)
The costs that can be avoided as a result of purchasing from the outside
are relevant in a make-or-buy decision. The analysis is:
Per Unit
Differential
Costs
30,000 Units
Make
Buy
Make
Buy
Cost of purchasing ...................
$21.00
$630,000
Cost of making:
Direct materials .....................
$ 3.60
$108,000
Direct labor ...........................
10.00
300,000
Variable overhead .................
2.40
72,000
Fixed overhead .....................
3.00
*
90,000
Total cost ................................
$19.00
$21.00
$570,000
$630,000
Make
Buy
Total cost, as above ........................................
$570,000
$630,000
Rental value of the space (opportunity cost) .....
50,000
Total cost, including opportunity cost ...............
$620,000
$630,000
Net advantage in favor of making ....................
$10,000
Profits would be $10,000 higher if the outside supplier’s offer is rejected.
Exercise 10-12 (15 minutes)
The company should accept orders first for Product A, second for Product
B, and third for Product C. The computations are:
Product
A
Product
B
Product
C
(1)
Direct materials required per unit ......
$24
$15
$18
(2)
Cost per pound ................................
$3
$3
$3
(3)
Pounds required per unit (1) ÷ (2) ....
8
5
6
(4)
Contribution margin per unit .............
$32
$14
$12
(5)
Contribution margin per pound of
materials used (4) ÷ (3) ................
$4.00
$2.80
$2.00
Exercise 10-13 (10 minutes)
Sales value after further processing
(7,000 units × $12 per unit) ..........................
$84,000
Sales value at the split-off point
(7,000 units × $9 per unit) ...........................
63,000
Incremental revenue from further processing ...
21,000
Cost of further processing ...............................
22,000
Loss from further processing ...........................
$(1,000)
The $60,000 cost incurred up to the split-off point is not relevant in a
decision of what to do after the split-off point.
Exercise 10-15 (30 minutes)
No, the bilge pump product line should not be discontinued. The
computations are:
Contribution margin lost if the line is dropped .....
$(300,000)
Fixed costs that can be avoided:
Advertising .....................................................
$270,000
Salary of the product line manager ..................
32,000
Insurance on inventories .................................
8,000
310,000
Net advantage of dropping the line .....................
$ 10,000
The same solution can be obtained by preparing comparative income
statements:
Keep
Product
Line
Drop
Product
Line
Difference:
Net
Operating
Income
Increase or
(Decrease)
Sales ...............................................
$690,000
$ 0
$(690,000)
Variable expenses:
Variable manufacturing expenses ...
330,000
0
330,000
Sales commissions ........................
42,000
0
42,000
Shipping .......................................
18,000
0
18,000
Total variable expenses ....................
390,000
0
390,000
Contribution margin .........................
300,000
0
(300,000)
Fixed expenses:
Advertising ...................................
270,000
0
270,000
Depreciation of equipment .............
80,000
80,000
0
General factory overhead ...............
105,000
105,000
0
Salary of product line manager ......
32,000
0
32,000
Insurance on inventories................
8,000
0
8,000
Purchasing department ..................
45,000
45,000
0
Total fixed expenses .........................
540,000
230,000
310,000
Net operating loss ............................
$(240,000)
$(230,000)
$ 10,000
