SOLUTION
(20 min.) Choosing customers.
If Newbury accepts the additional business from Kimberly, it would take an additional 800
machine-hours. If Newbury accepts all of Kimberly’s and Wallace’s business for February, it
Wallace Kimberly
Corporation Corporation
Contribution margin per machine-hour
$110,400
2,400
= $46
$48,000
800
= $60
Because the $160,000 of additional Kimberly business in February is identical to jobs
Wallace Kimberly
Corporation Corporation Total
Contribution margin per machine-hour $46 $60
An alternative approach is to use the opportunity cost approach. The opportunity cost
of giving up 800 machine-hours for the Wallace Corporation jobs is the contribution margin
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The net benefit is:
Contribution margin from Kimberly Corporation business $48,000
Less: Opportunity cost (of giving up Wallace Corporation business) (36 ,800)
Net benefit $11 ,200
Although taking the Kimberly Corporation business over the Wallace Corporation business will
maximize Newbury’s profit in the short run, Newbury’s managers must also consider the
long-run effect of this decision. Will Kimberly Corporation continue to demand the same level
of business going forward? Will turning down the Wallace business affect customer satisfaction?
11-32 Relevance of equipment costs. Janet’s Bakery is thinking about replacing the convection
oven with a new, more energy-efficient model. Information related to the old and new ovens
follows:
Ignore the effect of income taxes and the time value of money.
Required:
1. Which of the costs and benefits above are relevant to the decision to replace the oven?
2. What information is irrelevant? Why is it irrelevant?
3. Should Janet’s Bakery purchase the new oven? Provide support for your answer.
4. Is there any conflict between the decision model and the incentives of the manager who has
purchased the “old” oven and is considering replacing it only two years later?
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5. At what purchase price would Janet’s Bakery be indifferent between purchasing the new
oven and continuing to use the old oven?
SOLUTION
(20 min.) Relevance of equipment costs.
1. The current market value and annual operating costs of the old oven, and the purchase
2. The original cost and book value of the old oven are irrelevant because they are
3. Janet’s Bakery should purchase the new oven, based on the following calculations:
Keep the old oven Replace the old oven
Current market value of old
oven
$ 10,000
The cost of replacing the old oven is $57,000, while the cost of continuing to operate the old
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4. The manager may be reluctant to replace because it might re?ect badly on him for
having purchased the old oven in the first place if the new oven was available a year earlier.
5. At a purchase price of $43,000, Janet’s Bakery would be indifferent between purchasing the
new oven and continuing to use the old oven ($40,000 current purchase price + $3,000 savings
11-33 Equipment upgrade versus replacement. (A. Spero, adapted) The TechGuide Company
produces and sells 7,500 modular computer desks per year at a selling price of $750 each. Its
current production equipment, purchased for $1,800,000 and with a five-year useful life, is only
two years old. It has a terminal disposal value of $0 and is depreciated on a straight-line basis.
The equipment has a current disposal price of $450,000. However, the emergence of a new
molding technology has led TechGuide to consider either upgrading or replacing the production
equipment. The following table presents data for the two alternatives:
All equipment costs will continue to be depreciated on a straight-line basis. For simplicity, ignore
income taxes and the time value of money.
Required:
1. Should TechGuide upgrade its production line or replace it? Show your calculations.
2. Now suppose the one-time equipment cost to replace the production equipment is somewhat
negotiable. All other data are as given previously. What is the maximum one-time equipment
cost that TechGuide would be willing to pay to replace rather than upgrade the old
equipment?
3. Assume that the capital expenditures to replace and upgrade the production equipment
are as given in the original exercise, but that the production and sales quantity is not
known. For what production and sales quantity would TechGuide (i) upgrade the
equipment or (ii) replace the equipment?
4. Assume that all data are as given in the original exercise. Dan Doria is TechGuide’s manager,
and his bonus is based on operating income. Because he is likely to relocate aBer about a
year, his current bonus is his primary concern. Which alternative would Doria choose?
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Explain.
SOLUTION
(30 min.) Equipment upgrade versus replacement.
1. Based on the analysis in the table below, TechGuide will be better off by $337,500 over
three years if it replaces the current equipment.
Over 3 years Di&erence in
Comparing Relevant Costs of Upgrade
and Upgrade Replace favor of Replace
Replace alternative (1) (2) (3) = (1) – (2)
Cash operating costs
$150; $75 per desk
´
7,500 desks per
yr.
´
3 yrs. $3,375,00
0
$1,687,50
0 $1,687,5000
2. Suppose the capital expenditure to replace the equipment is $X. From requirement 1,
column (2), substituting for the one-time capital cost of replacement, the relevant cost of
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TechGuide would prefer to replace, rather than upgrade, if the replacement cost of the new
3. Suppose the units produced and sold over 3 years equal y. Using data from requirement 1,
column (1), the relevant cost of upgrade would be $150y + $3,000,000, and from column (2), the
relevant cost of replacing the equipment would be $75y – $450,000 + $4,800,000. TechGuide
would want to upgrade when
4. Operating income for the first year under the upgrade and replace alternatives are shown
below:
Year 1
Upgrade Replace
(1) (2)
Revenues (7,500
´
$750)
$5 ,625,000 $5 ,625,000
Cash operating costs
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aThe book value of the current production equipment is $1,800,000
11-34 Special order, short-run pricing. Diamond Corporation produces baseball bats for kids
that it sells for $37 each. At capacity, the company can produce 54,000 bats a year. The costs of
producing and selling 54,000 bats are as follows:
Required:
1. Suppose Diamond is currently producing and selling 44,000 bats. At this level of
production and sales, its fixed costs are the same as given in the preceding table. Home
Run Corporation wants to place a one-time special order for 10,000 bats at $21 each.
Diamond will incur no variable selling costs for this special order. Should Diamond
accept this one-time special order? Show your calculations.
2. Now suppose Diamond is currently producing and selling 54,000 bats. If Diamond accepts
Home Run’s offer, it will have to sell 10,000 fewer bats to its regular customers. (a) On
financial considerations alone, should Diamond accept this one-time special order? Show
your calculations. (b) On financial considerations alone, at what price would Diamond be
indifferent between accepting the special order and continuing to sell to its regular customers
at $37 per bat. (c) What other factors should Diamond consider in deciding whether to accept
the one-time special order?
(20 min.) Special order, short-run pricing
1.
Revenues from special order ($21
´
10,000 bats) $210,000
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1Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable
manufacturing overhead cost per unit = $14 + $4 + $2 = $20
Diamond should accept Home Run’s special order because it increases operating income by
$10,000. Because no variable selling costs will be incurred on this order, this cost is irrelevant.
Similarly, fixed costs are irrelevant because they will be incurred regardless of the decision.
1Direct materials cost per unit + Direct manufacturing labor cost per unit + Variable
manufacturing overhead cost per unit + Variable selling expense per unit = $14 + $4 + $2 + $2 =
$22
2b. Diamond will be indifferent between the special order and continuing to sell to regular
customers if the special order price is $35. At this price, Diamond recoups the variable
Looked at a different way, Diamond needs to earn the full price of $37 less the $2 saved
on variable selling costs.
2c. Diamond may be willing to accept a loss on this special order if the possibility of future
long-term sales seem likely at a higher price. Moreover, Diamond should also consider the
negative long-term effect on customer relationships of not selling to existing customers.
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11-35 Short-run pricing, capacity constraints. Fashion Fabrics makes pants from a special
material. The fabric is special because of the way it fits many body types. The pants sell for
$142. A well-known retail establishment has asked Fashion Fabrics to produce 3,000 shorts from
the same fabric. The factory has unused capacity, so Barbara Brooks, the owner of Fashion
Fabrics, calculates the cost of making a pair of shorts from the fabric. Costs for the pants and
shorts are as follows:
Required:
1. Suppose Fashion Fabrics can acquire all the fabric that it needs. What is the minimum price
the company should charge for the shorts?
2. Now suppose that the fabric is in short supply. Every yard of fabric Fashion Fabrics uses to
make shorts will reduce the pants that it can make and sell. What is the minimum price the
company should charge for the shorts?
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